emerging markets monthly - dws · 9 october 2014 em monthly: em vulnerabilities exposed page 2...

Deutsche Bank Markets Research

Emerging Markets

Economics Foreign Exchange Rates Credit

Date 09 October 2014

Emerging Markets MonthlyEM Vulnerabilities Exposed

Taimur Baig Robert Burgess Gustavo Cañonero Drausio Giacomelli Hongtao Jiang Michael Spencer

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Deutsche Bank Securities Inc.

Note to U.S. investors: US regulators have not approved most foreign listed stock index futures and options for US investors. Eligible investors may be able to get exposure through over-the-counter products. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.

Special Reports Assessing EM Vulnerabilities

Venezuela: To Pay or Not to Pay, is that the Question?

Remember, Not All EM Currencies Are Equal

EU Structural Funds and Their Impact: 10 Questions Answered

Analyzing Relative Value Using Snapshot

9 October 2014

EM Monthly: EM Vulnerabilities Exposed


Key Economic Forecasts

2013 2014F 2015F 2013 2014F 2015F 2013 2014F 2015F 2013 2014F 2015F

Global 3.0 3.3 3.9 3.3 3.5 3.8 0.2 0.4 0.4 -3.2 -2.7 -2.4

US 2.2 2.4 3.6 1.5 1.8 2.2 -2.4 -2.5 -2.5 -4.0 -2.9 -2.5

Japan 1.5 1.0 1.3 0.4 2.9 1.7 0.7 0.2 1.4 -9.1 -7.0 -6.1

Euroland -0.4 0.7 1.0 1.3 0.5 1.1 2.4 2.5 2.1 -3.0 -2.6 -2.5Germany 0.1 1.5 1.5 1.6 0.9 1.5 6.8 7.2 6.7 0.0 0.2 -0.1France 0.4 0.4 0.9 1.0 0.6 0.9 -1.3 -1.8 -1.8 -4.3 -4.4 -4.3Italy -1.8 -0.4 0.4 1.3 0.2 0.8 1.0 1.6 1.6 -3.0 -3.0 -2.9Spain -1.2 1.2 1.9 1.5 -0.1 0.8 0.8 0.4 0.5 -7.1 -5.6 -4.6Netherlands -0.7 0.7 1.7 2.6 0.5 1.1 10.9 10.9 11.4 -2.5 -2.5 -2.0Belgium 0.2 1.0 1.0 1.2 0.7 1.3 -1.9 -1.0 -0.8 -2.6 -2.5 -2.3Austria 0.3 0.8 1.3 2.1 1.5 1.7 2.7 2.7 2.9 -1.5 -3.0 -1.8Finland -1.2 -0.4 0.6 2.2 1.1 1.2 -2.2 -2.0 -1.7 -2.0 -2.4 -1.8Greece -3.9 -0.2 2.1 -0.9 -1.0 0.4 0.5 1.0 1.5 -12.7 -1.8 -0.6Portugal -1.4 1.0 1.1 0.4 -0.1 0.9 0.7 1.0 1.0 -4.9 -4.2 -3.3Ireland 0.1 3.7 2.5 0.5 0.4 1.1 6.2 6.5 7.0 -7.2 -4.0 -2.7

Other Industrial Countries 1.9 2.7 2.6 1.7 1.6 1.9 -1.2 -0.8 -0.6 -2.7 -2.1 -1.3United Kingdom 1.7 3.1 2.5 2.6 1.7 1.9 -4.5 -4.0 -3.2 -5.9 -4.6 -3.5Sweden 1.5 2.2 2.6 0.0 0.2 1.5 6.7 6.0 5.5 -3.5 -1.5 -1.0Denmark 0.4 1.0 2.0 0.8 1.0 1.5 7.2 6.7 6.4 0.0 0.0 -1.0Norway 2.0 2.4 2.5 2.1 1.8 2.2 11.1 11.0 10.5 7.6 7.0 6.7Switzerland 1.9 1.3 1.8 -0.2 0.0 0.3 13.0 12.0 11.0 0.2 0.0 0.2Canada 2.0 2.5 3.2 0.9 2.0 2.2 -3.2 -2.0 -1.4 -1.0 -0.8 0.0Australia 2.3 3.1 2.7 2.4 2.4 2.0 -3.3 -3.0 -3.2 -2.2 -2.5 -1.4New Zealand 2.8 3.6 2.6 1.1 1.4 1.8 -3.3 -4.1 -6.5 -1.6 -0.5 0.3

Emerging Europe, Middle East & Africa 2.4 1.9 2.7 4.8 5.6 5.4 0.8 1.6 0.9 -1.3 -0.4 -1.2Czech Republic -0.9 2.4 2.6 1.4 0.4 1.8 -1.4 -1.5 -1.4 -1.4 -2.6 -2.5Egypt 2.1 2.1 3.7 6.9 10.1 12.0 -2.3 -0.8 -1.7 -13.7 -12.0 -10.5Hungary 1.1 3.4 2.7 1.7 0.2 2.6 0.3 1.6 1.5 -2.4 -2.9 -2.7Israel 3.2 2.7 3.0 1.5 0.5 1.2 2.1 2.4 2.6 -3.1 -3.0 -3.1Kazakhstan 6.0 5.4 5.2 5.8 6.1 6.7 1.0 2.0 1.5 5.3 5.3 3.3Poland 1.6 3.1 3.5 0.9 0.2 1.1 -1.3 -1.8 -2.0 -4.4 4.3 -2.9Romania 3.5 2.5 3.0 4.0 1.2 2.5 -1.1 -1.0 -1.2 -2.3 -2.2 -1.9Russia 1.3 0.5 1.0 6.8 7.3 6.2 1.5 2.7 1.7 -0.5 0.2 0.3Saudi Arabia 4.0 4.4 4.1 3.5 3.0 3.2 17.7 14.8 11.7 6.4 6.0 3.7South Africa 1.9 1.5 3.4 5.8 6.2 5.4 -5.8 -4.6 -4.4 -4.1 -4.2 -3.9Turkey 4.1 3.0 3.3 7.5 8.9 6.4 -7.9 -5.5 -5.0 -1.2 -1.7 -1.7Ukraine 0.0 -6.9 0.5 -0.3 10.3 12.8 -9.2 -3.0 -2.1 -4.5 -5.5 -4.5United Arab Emirates 5.2 3.8 3.6 1.1 2.2 2.5 16.1 14.2 11.6 6.2 6.1 4.9

Asia (ex-Japan) 6.1 6.4 6.9 4.2 3.5 3.9 1.7 2.0 1.8 -2.3 -2.3 -2.0China 7.7 7.8 8.0 2.6 2.2 3.0 2.0 2.3 2.5 -2.1 -2.1 -1.5Hong Kong 2.9 2.8 3.6 4.3 4.0 3.2 2.1 -0.7 3.9 1.0 2.6 3.4India 4.4 5.5 6.5 10.1 7.7 7.1 -2.6 -1.6 -2.5 -4.5 -4.5 -4.2Indonesia 5.8 5.2 5.5 6.4 5.9 4.9 -3.3 -3.0 -2.8 -2.3 -2.5 -2.7Korea 3.0 3.6 3.8 1.3 1.4 2.3 6.1 5.6 4.5 1.0 0.2 0.0Malaysia 4.7 5.5 5.6 2.1 3.2 4.1 4.0 2.6 3.0 -3.9 -3.5 -3.2Philippines 7.2 6.6 6.8 2.9 4.4 3.7 3.8 3.6 3.3 -1.4 -1.8 -2.2Singapore 3.8 3.0 4.0 2.4 1.5 2.1 18.4 18.5 17.7 7.1 6.9 6.8Sri Lanka 7.3 7.5 7.5 6.9 4.0 6.3 -3.9 -3.4 -3.1 -5.8 -5.5 -5.0Taiwan 2.1 3.7 3.8 0.8 1.4 1.5 11.7 12.9 11.9 -1.4 -2.0 -1.8Thailand 2.9 1.5 5.0 2.2 2.1 2.4 -0.7 1.8 1.2 -2.0 -2.8 -2.5Vietnam 5.4 5.8 6.2 6.6 5.0 6.4 3.5 3.8 0.5 -4.0 -4.5 -4.4

Latin America 2.5 1.0 1.8 9.1 12.0 13.0 -2.6 -2.6 -2.4 -3.2 -3.8 -3.6Argentina 2.9 -2.3 -2.8 25.3 38.3 39.1 -1.4 -1.4 -0.4 -4.6 -4.9 -5.3Brazil 2.5 0.3 1.0 6.2 6.3 6.4 -3.6 -3.9 -3.7 -3.3 -4.2 -3.7Chile 4.1 2.0 3.1 1.9 4.3 3.4 -3.5 -1.7 -1.8 -0.5 -1.9 -2.1Colombia 4.6 5.0 4.8 2.0 2.8 3.2 -3.4 -3.9 -3.0 -2.4 -2.4 -2.2Mexico 1.1 2.3 3.5 3.8 4.0 3.8 -1.8 -2.1 -2.2 -2.9 -4.2 -4.0Peru 5.0 3.5 6.1 2.5 3.2 3.1 -5.0 -5.0 -4.7 0.3 0.2 0.2Venezuela 1.5 -3.5 -1.1 40.0 60.0 80.0 1.6 3.0 3.1 -7.2 -4.0 -4.8

Memorandum Lines: 1/

G7 1.5 1.9 2.6 1.3 1.7 1.9 -1.0 -1.0 -0.8 -4.3 -3.3 -2.9Industrial Countries 1.3 1.8 2.4 1.3 1.5 1.8 -0.4 -0.5 -0.4 -4.1 -3.2 -2.7Emerging Markets 4.7 4.6 5.2 5.2 5.3 5.6 0.8 1.2 1.0 -2.2 -2.2 -2.1BRICs 5.8 5.8 6.3 5.1 4.3 4.5 0.4 0.9 0.7 -2.6 -2.6 -2.1

For Egypt numbers are reported for financial year ending June.

Real GDP (%) Consumer prices (% pavg) Current account (% GDP) Fiscal balance (% GDP)

1/ Aggregates are PPP-weighted within the aggregate indicated. For instance, EM growth is calculated by taking the sum of each EM country's individual growth rate multiplied it by its share in global PPP divided by the sum of EM PPP weights.

Source: Deutsche Bank

Saturday, October 11, 2014 – U.S. Chamber of Commerce, Washington, D.C. 8:30 a.m. – 3:00 p.m.: All Day Conference Registration (Foyer) 8:30 a.m. – 9:15 a.m.: Buffet Breakfast (Briefing Center) 9:15 a.m. – 9:30 a.m.: Opening Remarks (Hall of Flags)

Jürgen Fitschen, Co-Chief Executive Officer, Deutsche Bank 9:30 a.m. – 10:45 a.m.: Global Challenges: From Debt Overhang to Secular Stagnation Moderator: Peter Hooper, Chief Economist, Co-Head of Global Economics, Deutsche Bank

Stephan Danninger, Division Chief, Asia Pacific Department, International Monetary Fund Laurence Meyer, President, Meyer’s Monetary Policy Insights, and Former Board Member of the FRS Dr. Lorenzo Bini Smaghi, Member, Executive Board of the European Central Bank (2005-2011)

10:45 a.m. – 11:30 a.m.: Geopolitical Risks Moderator: Peter Garber, Senior Advisor, Research, Deutsche Bank Ian Bremmer, President, Eurasia Group

11:30 a.m. – 11:45 a.m.: Coffee Break (Briefing Center) 11:45 a.m. – 1:00 p.m.: Emerging Markets Fragilities and Outlook Moderator: Drausio Giacomellli, Head of Emerging Market Research, Deutsche Bank Dr. Urjit Patel, Deputy Governor, Reserve Bank of India

Ksenia Yudaeva, First Deputy Governor, Central Bank of Russia Alejandro Werner, Director, Western Hemisphere Department, International Monetary Fund

1:00 p.m. – 1:45 p.m.: Featured Keynote Speaker Lawrence H. Summers, Charles W. Eliot University Professor, Harvard University, and former Secretary of Treasury, USA

2:00 p.m. – 3:00 p.m.: Conference Reception (Briefing Center) * All Panels will be held in the Hall of Flags.

Emerging Markets 2014 Conference

Deutsche Bank

9 October 2014



Table of Contents Emerging Markets and the Global Economy in the Month Ahead Heading towards the turn of the year, it is becoming clear that the global economy has bottomed but that recovery is increasingly reliant on the US. The associated normalization of US monetary policy will present challenges for EM, amplified in some cases by the stronger dollar, softer commodity prices, and faltering growth in Europe. Against this backdrop, the theme of diverging performance within EM that underlined our outlook for the year seems set to extend into the coming quarters..……………........ ........................................................................................................................... 05

This Month’s Special Reports Assessing EM Vulnerabilities With multiple headwinds still facing EM, we revisit our assessment of underlying vulnerabilities across 25 EM economies. We find that vulnerabilities remain generally low or moderate in Asia. Since our last assessment almost two year ago, however, parts of EMEA are now more resilient whereas Latin America is more fragile.……………........ ......................... 14

To Pay or Not to Pay, Is That The Question? The ongoing economic crisis in Venezuela has fueled speculation about the possibility of a default in external indebtedness by the Republic and/or PDVSA. In this report, we argue that although the economic crisis and policy inaction has increased the vulnerability of the country to withstand external shocks, economic authorities still have the ability and willingness to pay external financial debt. We believe the administration recognizes the importance of access to external financing and would be willing to take the necessary measures and continue honoring external obligations ............................................................................................................................................................................ 20

Remember, not all EM currencies are equal After a broad-based sell-off in EM FX over the past couple of months, we cannot help to feel the gloom is overdone and expect greater differentiation will once again be the rule over the next few months given the substantially different outlooks for many of the EM currencies. We assess currency vulnerability over a plethora of angles, combining all in a unified metric. The latter should in principle help to shed some light on the vulnerability question within the EMFX universe....……………........ .................................................................................................................................................... 27

EU Structural Funds and Their Impact: 10 Questions Answered The absorption of EU structural funds will be an important cog in the Central European growth story in the coming years. Poland emerged as the big winner in the EU Cohesion Policy funds allocation for the 2014-2020 budgeting period, capturing by far the largest allocation (nearly EUR 80bn). In this report, we shed light on the absorption and impact of these EU funds, with a focus on the performance of Poland and Romania. We find that Poland has the appropriate administrative and financial capacity to continue its good performance in absorbing EU funds, whereas in Romania the absorption rate is expected to remain relatively low in the upcoming budgeting period..……………........ ........................ 30

Analyzing relative value using Snapshot We introduce the latest enhancements to our daily report, the EM Sovereign Credit Valuation Snapshot (or simply the Snapshot), and discuss some relative value themes and opportunities using graphs and data provided in this report....……………................................................................................................................................................................ 36

Asia Strategy .......................................................................................................................................................................... 43

EMEA Strategy ....................................................................................................................................................................... 50

LatAm Strategy ....................................................................................................................................................................... 58

Asia Economics ...................................................................................................................................................................... 64

EMEA Economics ................................................................................................................................................................... 88

Latam Economics ................................................................................................................................................................. 113

Theme Pieces ................................................................................................................................................... 134

9 October 2014



Emerging Markets and the Global Economy in the Month Ahead

The closing months of the year should bring clearer signs that the global economy has bottomed out but also that recovery is becoming increasingly dependent on the US.

The associated normalization in US rates will test some EM economies. This challenge will be amplified in some cases by the stronger dollar, softer commodity prices, and faltering growth in Europe.

Asian economies remain best placed to survive this stress test. Years of deleveraging should also pay dividends in central Europe, which is more resilient as a result. Latin America, however, has become more fragile and is struggling to deliver growth.

We still see some pockets of value across EM curves, especially in Latin America and idiosyncratic cases such as India and China. We also favour defensive longs in Thailand, Singapore vs. US. Position for further front-end steepening in Mexico and Chile, and bear-flattening in Poland.

Brazil remains largely binary, but its forward curve now seems too flat regardless of the election outcome. Colombia is wide and Mexico is too steep now vs. the US. We expect steepening in South Africa and Turkey. Inflation breakevens are low in Mexico, but they seem to have overshot in Turkey. Tactically pay rates in Malaysia and Korea.

We expect Asia FX to continue to perform relatively better on lower or benign sensitivity to geopolitical risks, commodities, and a better policy mix. We believe that the USD/BRL tail risks are wider than priced in straddles.

As we expect any retracement in USD strength to be temporary, we favor CNH vs. KRW, and INR vs. SGD, long USD/MYR and long USD/ILS and expect low-beta LatAm FX to outperform CE3 under EUR weakness – though with a lower beta than in previous episodes of USD strength

On credit, we recommend overweight Indonesia, Turkey, Hungary, Colombia, and Mongolia, underweight Argentina, South Africa, Poland, and Peru. Our main relative value trade recommendations include PDVSA 17Ns vs. Venezuela 20s, Indonesia 44s vs. South Africa 41s, Pemex 24s vs. UMS 23s, 10s30s cash curve flatteners in Brazil and 10s30s cash curve steepeners in Russia. Meanwhile, we hold long PDVSA 15s and 37s, and short Argentina USD Discounts

Vulnerabilities exposed

As we enter the latter part of the year, we expect to see clearer signs that the global economy has bottomed and is accelerating into 2015. With DB’s considerable downward revisions in EU growth, it is also clearer that the recovery we foresee has become increasingly dependent on the outlook for the US, which DB expects to accelerate from 2.3% to 3.4% in 2015 while the EU and Japan hover near 1%. This acceleration is likely to spillover to EM (mainly through pent up exports), but we expect EM growth to remain well below past trends – in part a by-product of the reduced growth potential in some countries.

The “Diverging Economies” theme that underlined our 2014 outlook seems poised to carry on over the next quarters. Although the common shocks of gradually tightening liquidity will weigh on EM at large, the recent years of massive balance sheet expansion have shown that domestic (pull) factors have overshadowed supply (push) factors. As the last major election in this year’s heavy political cycle concludes in Brazil, it should also be clear which countries are willing to make the necessary adjustments to promote faster growth. The contrasts across the BRICs should remain stark. Although DB forecasts China growth in the 7.0-8.0% over the next couple of years and India accelerates to 6.5% in 2015, Brazil and Russia are expected to hover just above 1% next year.

US: Pulling ahead. The latest data has reaffirmed our view that US growth is on solid footing and that the Fed is on track to start tightening in June of 2015. Consumer spending has been robust (reflecting the improvement in balance sheets) and job growth has also been sound. Job gains over the past quarter are back in line with the year-to-date average of 227k – the strongest pace since 1999. Gains were broad-based, with both public and private sectors adding jobs. Also encouraging, this acceleration in activity has lately been driven by pent-up business spending – especially capital expenditures, which expanded at 11% annualized in Q2 after years of sluggish growth.

The new orders subcomponent of the ISM, aging capital stock, and rising capacity utilization support a fast pace of expansion ahead and – as USD strength weighs on net exports – this is a welcomed development is support of labor markets and overall confidence. The recent recovery in homebuilders’ sentiment, tightening supply, easing lending conditions, and rising income also bode well for residential investment. In addition, after three years of fiscal drag, the outlook for local and state government spending (the dominant drivers) has brightened (chart).

9 October 2014



Moderate tailwind from government spending

Source: BEA, Haver Analytics & DB Global Markets Research

Altogether, the economy seems poised to grow at 3%+ over the upcoming quarters and DB has revised its H2 2014 GDP by 50bp to 4.1%. Most important, however, the latest figures have also reaffirmed our view that inflation pressures remain subdued. Slack in labor markets continue to contain wage pressures (hourly wages were flat in the month and only 2% up over the past year) and DB expects core inflation to rise gently toward the Fed’s goal over the next two years. This should allow the Fed to proceed gradually and DB forecasts a slightly faster pace of tightening than the median FOMC expectation. According to this baseline view, the US yield curve should continue to bear-flatten substantially in the years to come.

EU: Following the Fed steps, at its own pace. The outlook for EU growth remains dim and supportive of broader-based QE. Accordingly, DB has revised down this and next year’s GDP growth forecasts by 40bp and 50bp to 0.7% and 1.0%, respectively. Russia and Ukraine have weighed on exports, and this drag has eased in the past weeks. Still, the geopolitical outlook remains uncertain and the details of the latest IP numbers out of Germany, France, Italy, and Spain suggest that the slowdown in activity is more structural or persistent than geopolitical shocks alone would suggest.

On a more positive note, credit supply constraints seem to be easing, and the AQR/stress test results due this month will be important to monitor. Although we believe that systemic banks will pass, the latest indicators point to weak demand for credit so that an extra push may be required anyway. Private and public deleveraging has also eased, but domestic demand seems on feeble grounds still to drive a rebound in growth. Therefore, the prospect of recovery in the EU still hinges on external demand and the ECB’s push to weaken the euro and rebalance banks’ balance sheets.

Although Draghi was less dovish than expected last week this has been in line with other significant

changes in policymaking by the ECB, as a pause to reassess the outlook for the economy and the impact of stimulus has been a preamble for additional easing. This time around should be no different given the prospect for inflation, domestic demand, and credit expansion. The intention to grow the balance sheet to 2012 levels was reaffirmed, but the Council still forecasts 1.6% and 1.9% growth for this year and next. As these (and inflation) are likely revised down in the months to come, the door for public sector QE should then open. Although the ECB may not use an explicit target, DB estimates that the one trillion euro expansion hinted at by Draghi is consistent with EUR/USD at 1.16 and 2019 inflation at 1.9% (chart).

QE needed to normalize inflation

0.0

0.5

1.0

1.5

2.0

2.5

2012 2013 2014 2015 2016 2017

Impact of balance sheet expansion on creditImpact of balance sheet expansion on FX

Baseline HICP forecastsECB target area

% yoy

Forecast

Source: Deutsche Bank Research , Eurostat

EM: Kicking the Tires While the decent outlook for growth in the US provides a solid foundation for the global economy, the associated normalization in US rates will test some EM economies. This challenge will be amplified in some cases by the stronger dollar, softer commodity prices, and faltering growth in Europe. Later in this monthly, we therefore take a closer look at vulnerabilities within EM (see “Assessing EM Vulnerabilities”) to see which countries appear best placed to survive this stress test. It is now almost two years since we last ran a similar exercise. Since then, while vulnerabilities have generally remained low or moderate in Asia, parts of EMEA look more resilient, whereas much of Latin America now seems more fragile.

Latin American countries are struggling to deliver growth. Activity indicators have continued to disappoint across the board. Four consecutive months of negative YoY growth in Brazil or no growth in Argentina so far this year are hardly a surprise. However, two months of economic activity advancing below 2% YoY in Peru, after a weak first quarter, and a relatively subpar 2013 performance, perfectly reflects existing challenges in the region. Even in Colombia, an exception to the regional pattern so far this year, industrial production failed to maintain its trend in the last couple of months, decelerating more than anticipated in July. The only marginally positive

9 October 2014



surprise has come in Mexico, though even here, growth in July remained at 2.5% YoY and a solid recovery of domestic demand might take time. Overall, we now believe growth in the region is likely to be only around 1%, and accelerating only gradually next year to 2.0%, far from the 4% plus of the good old days.

Vulnerabilities have increased in Latin America

Asia

EMEA

LatAm

0.40

0.45

0.50

0.55

0.60

0.65

Mar-07 Dec-08 Sep-10 Jun-12 Mar-14

Average percentile ranking of vulnerability indicators within regions

More vulnerable

Less vulnerable


Furthermore, softer commodity prices and a strengthening dollar have weighed on local currencies, further complicating the policy dilemma in many of these countries. Inflation pass-through from FX slide is now threatening central banks inflationary comfort zone. This moved the central bank of Peru to stop its last easing cycle, and it is making Chile´s decision to continue cutting rates increasingly difficult. Likewise, a deterioration of the inflation outlook led Banxico to adopt a more hawkish stance in its last policy decision and the door to further cuts now seems definitely shut. We now anticipate that Banxico will stay on hold and start to hike rates in tandem with the Fed in 2Q2015 (at the earliest). On a more positive tone, the reform process that started last year in Mexico was completed with the approval of the energy and telecommunications by-laws.

The outlook in Brazil continues to hinge on elections. The runner-up in last Sunday´s first round vote, Aécio Neves, is the candidate offering clearest break from current policies. Marina Silva, the third-placed candidate has hinted that she would support Aécio, recognizing that society has demands changes, which cannot happen under the current administration. President Dilma Rousseff has already set the tone for the second-round campaign, claiming that voters do not want the return of the “ghosts of the past.” She also said that her government will be able to control inflation without strong adjustment and unpopular measures. She will obviously center the campaign on the economic comparison between the Fernando Henrique Cardoso and Lula governments. Dilma's

strong showing in the first round suggests that she is still the likely favourite to win. However, Aécio has gone into the second round in a much stronger position than we had expected, he will have as much time as Dilma on TV now, and Dilma is clearly weaker than 4 years ago. Also, the investigation into the Petrobras scandal continues, and, although it seems that it has not had a significant effect yet, more revelations involving politicians of the ruling coalition might hurt Dilma. The second round will take place on October 26.

High Yielders Top Our Vulnerability Rankings

0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70 0.75

VENARGZAFSGPBRZTURIND

HKGMEXTHARUSISR

MALCHLIDNPOL

TWNCOLCZE

CHNKORPERPHL

ROMHUN

More vulnerable


Our vulnerability assessment suggests that Asia should remain quite resilient, though private sector debt is high in a number of economies, including China, Hong Kong, Malaysia, South Korea, Singapore, and Taiwan, leaving them open to risks of sudden rise in interest rates from the prevailing, historically low levels. India is the exception in the region where vulnerabilities extend beyond this to high inflation and weak public finances. Recent developments, however, are encouraging. Expectations about reform and policy efficacy have risen since the elections, capital flows have surged, external imbalances and the inflation situation have improved, and growth indicators have bottomed. In Indonesia on the other hand, things have gone the other way: growth has continued to slow while the political situation has become complicated, with the president-elect suffering setbacks in controlling the legislature.

One area where we have seen a clear reduction in vulnerabilities in recent years has been in central Europe. Going into the last crisis, they were among the most vulnerable in EM, with varying combinations of rapid credit growth, high inflation, overvalued exchange rates, and large external and fiscal deficits. Since then, they have undergone a period of significant deleveraging, something that we have argued leaves them well-placed to deliver solid recoveries after years

9 October 2014



Private debt levels are highest in Asia

0

20

40

60

80

100

120

140

160

180

KOR

TWN

THA

CH

NM

AL

IND

PH

LID

N

ISR

ZAF

TUR

CZE

RU

SP

OL

HU

NR

OM

CH

LB

RZ

MEX

CO

LP

ERVE

NA

RG

Private debt (% GDP)

Source: Haver Analytics, Deutsche Bank

of underperformance. The main risk for this group stems now from further disappointing growth in the euro area and, especially, Germany.

Elsewhere in EMEA, vulnerabilities are likely to stay relatively high in South Africa and Turkey. In the former, deeper fiscal consolidation is needed to stabilize debt (and preserve investment grade status) but will weigh on growth. Progress is being made on reducing infrastructure bottlenecks but the momentum behind structural reforms more broadly remains unconvincing. More imminently, weaker commodity exports are threatening to undermine what limited progress we have seen in reducing the current account deficit. Turkey will also remain fragile so long as policymakers remain reluctant to deliver the kind of sustained adjustment in real rates necessary to reduce inflation, boost private savings, and bring down external imbalances.

At the other end of the spectrum, Russia’s low debt, high reserves, current account surplus, and moderate fiscal deficit, will remain in place for some time. But we remain pessimistic about the longer term trajectory. Potential growth has fallen significantly in recent years. Even if the political crisis in Ukraine is resolved quickly, the structural reforms that are needed to change this seem further away now than ever if, as seems probably, Russia looks to pursue a more inward-looking growth strategy.

Strategy: Uphill battle

EM local markets have borne the brunt of the recent sell-off across risk markets. As the chart below shows, equities have led the correction, but local rates have also lost over 4% since end-August – mainly on currency depreciation. EM credit was not immune, but weakness was concentrated in the (idiosyncratic) high yielders and limited otherwise. As US rates are

hovering near the lows and inflation is well contained, USD strength and some pull-back in developed equity markets have this time underpinned the selling pressure. While the nature of the external shocks has been evolving over the months, however, EM’s response has been relatively stable: the most growth-sensitive FX and equity markets have proven also most vulnerable.

Local markets bear the brunt of USD adjustment

-12% -9% -6% -3% 0% 3% 6% 9% 12%

UST (10-15Y)

IG

S&P

DB-EMLIN (hedged)

HY

EMBI-G

EMFX (Total Return)

EM Eq

DB-EMLIN

EU Eq

EMFX Spot

Com'dty

Since end of Juneyear to date

Returns of various asset classes


As the recent data have reinforced the case of a US-centric recovery, USD strength will likely prove a persistent shock. As a silver lining for credit, US wage inflation remains well anchored, additional QE from the ECB likely looming, and EM positions have been resilient to HY outflows (chart). Fundamentals still support EM rates – for now – but valuation seems less supportive than in credit. The cushions seem most limited still for EMFX, where monetary anchors are largely absent and valuation is dislocated only in high-beta FX.

EMD flows: Weakening, but resilient to HY outflows

-3

-2

-1

0

1

2

Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14

EM weekly flows

EMD 4wk MA

US HY 4wk MA

Debt fund flows (% AUM)


9 October 2014



In credit, we see scope for a moderate recovery in credit spreads on valuation and some reduction in volatility. EM assets continue to face headwinds and some idiosyncratic stories are still negative, but these do not preclude tactical opportunities. Credit differentiation and relative value remain key.

We still see some pockets of value across EM curves, especially in LatAm and idiosyncratic cases such as India and China. Brazil remains largely binary, but its forward curve seems now two flat regardless of elections. Colombia is wide and Mexico is too steep now vs. the US. We also favour defensive longs in Thailand, Singapore vs. US. Position for further front-end steepening in Mexico and Chile, and bear-steepening in Poland. We expect steepening in South Africa and Turkey. Inflation breakevens are low in Mexico, but they seem to have overshot in Turkey. Tactically pay rates in Malaysia and Korea.

We expect Asia FX to perform relatively better on lower or benign sensitivity to geopolitical risks, commodities, and a better policy mix. With any retracement in USD likely to be temporary, we favor CNH versus KRW, and INR versus SGD, long USD/MYR and long USD/ILS and expect low-beta LatAm FX to outperform CE3 – though with a lower beta than in previous episodes of USD strength. We believe that the USD/BRL tail risks are 3%+ wider than priced in straddles.

FX: Between a rock and a hard place EMFX is in a difficult position. If the US economy continues to recover as we expect and the Fed gradually pulls ahead of the ECB in normalizing rates, USD strength (and gradually rising funding rates) would remain a drag for emerging currencies. Conversely, in such a US-centric world, a faltering US economy would likely bring equity markets down and rising risk aversion. It is naturally best for EMFX if corner scenarios are avoided and volatility subsides. But this requires the global economy to follow a reasonably narrow path of gradual reflation in the US (and also in Europe, with the help of an effective QE program), and more balanced growth across the globe (and within China). As the EU may not have yet reached bottom, however, more USD strength seems likely in the near term.

Accordingly, we favor EUR funding (and also JPY funding in Asia), crosses that could perform well under a strong USD such as long CNH/KRW, and INR/SGD, and USD longs for currencies where valuation is not yet stretched as in MYR and ILS. Although the BRL, RUB, and ZAR would be obvious candidates for high beta USD longs, we still see some value in being long skews in BRL instead (where we see a wide trading range of 2.20-2.60 post-elections) and we find that valuation is already stretched in ZAR and RUB despite fundamental vulnerability.

Assessing EMFX valuation after the sell-off

-25% -15% -5% 5% 15%

ZAR

CLP

IDR

COP

TRY

MYR

PLN

RUB

HUF

BRL

PHP

PEN

MXN

CZK

TWD

ILS

HKD

INR

KRW

THB

CNY

SGD

ARS

Fundamental Valuation

undervalued

BRL

CLP

COPMXN

PENCZK

HUFPLN

RUB

TRY

ZAR

ILS

IDR

INR

KRWMYR

SGDTHB

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

-8% -6% -4% -2% 0% 2% 4%

financial overvaluation

implied volatility (3M)

As the chart above shows, both the ZAR and the RUB are among the cheapest currencies in our sample from a fundamental and financial standpoint. Not surprisingly, however, the bottom panel shows that the most undervalued pairs are also most volatile. With no policy change or current account improvement in the making that could support a more durable rally, but more supportive valuation, we recommended taking profit on long TRY/ZAR and are now neutral the rand. We are moderately more constructive the RUB, as we find that proper provision of USD funding could go a long way in supporting the currency.

Looking more broadly across EM currencies, better valuation is one of the reasons we are not recommending outright long USD vs. EMFX. Regionally, however, we expect Asia FX to remain better supported vs. the USD given its positive beta to lower commodities, reduced political risks, and – especially in South Asia – improved external positions and tighter policy mix.

9 October 2014



Looking beyond Asia, we expect low-beta LatAm FX to outperform CE3 on continued USD strength – but less clearly so than in the past. As the chart below shows, this has historically been the norm, but the relative betas to DXY have been tamed by fragility in commodities, LatAm’s softness (amid a downturn in Chile, deceleration in Colombia, gradual recovery in Mexico and political turmoil in Brazil), and recent weakness in global equities.

EMFX response to USD strength: Now vs. 2009/10 and

2011/12

BRL MXN

COP

CLP

PEN

ZAR

RUB

TRY ILS

CZK

HUF

PLN

LatAm

EMEA

CE3

LatAm/CE3

-1.5

-1.0

-0.5

0.0

0.5

1.0

-2.0 -1.0 0.0 1.0

beta to DXY since July

avg beta to DXY in previous dollar strength episodes

Note: betas from multivariate regressions on weekly returns which also include S&P 500, US 5Y rate, CRY index. Previous dollar strength episodes are 11/09-6/10 and 8/11-7/12 Source: Deutsche Bank

We favor holding long MXN vs. HUF and CZK, or a basket of low-beta LatAm FX (MXN, CLP, and COP) vs. CE3 FX. The MXN tends to outperform during USD strength and we find current levels attractive. Although the recent deceleration in Colombia and overall commodities weakness weighs on CLP and COP, these currencies have already lagged substantially and positioning is now light.

Asia: Long CNH/KRW (target 180); Short 6M SGD/INR (target 46); Long 3M USD/MYR NDF, (target 3.35); Stay long USD/SGD via 1.2750 digital calls.

EMEA: Long MXN vs. HUF and CZK (target 13.90); Long USD/ILS (target 3.78); long PLN/HUF (target 78.50); Long 1m EUR/RUB put strike @ 48.10; long TRY vs. ILS (target 1.69).

LatAm: Buy 1M USD/BRL straddle (B/E’s 2.28/2.52); Buy 3M EUR/COP put (ATMS, EKO @ 2480, ref FX 2590) for 0.7%; Buy 3M USD/CLP put (ATMS, EKO 575) for 0.6%.

Rates: Normalization moves on – slowly but surely In contrast with EMFX, relatively low growth and/or low inflation continue to bide EM central banks time. However, also in contrast with EMFX, valuation has

adjusted accordingly and we see diminished pockets of value across EM curves. As the chart below shows, real EM yields1 have compressed vs. US this year. Once we simply subtract credit spreads, the premium vs. comparable US real rates is just about 150bp. This may be enough to attract long-term foreign investors as many EM currencies seem undervalued vs. long-term fundamentals. However, the current volatility may continue to be a deterrent for shorter-term allocations.

There are still attractive pockets of value, however, and they seem concentrated in LatAm. Poland’s real rates are still relatively high (supporting our overweight in 5-10 year bonds), but access to linkers is limited when compared to LatAm and inflation is likely to normalize over the coming years. Real rates are higher in the low-debt Chile, where inflation is probably peaking as the economy slows, and in Mexico (the best risk-reward in long-dated linkers, in our view).

Pockets of value across EM rates

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Jan 10 Sep 10 May 11 Jan 12 Sep 12 May 13 Jan 14 Sep 14

Diff. cred-adjusted

Real differential

Yield diff, %

BR

CLCO

HU

ID

IL

MX

MY

PE

PH

PL

RU

TRZA

Index

US

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

15 65 115 165 215 265

5Y real yield, %

5Y CDS, bp

Source: DB Global Markets Research - 1s3s steepeners.

We believe that the recent sell-off in both FX and rates in Colombia provides an attractive to entry point. The spread vs. the US is near recent highs and the

1 Local EM bonds (ex-China and India, but including Israel) are deflated by inflation expectations and market-weighted.

9 October 2014



fundamental prospect for the country remains solid. The situation is naturally a lot more binary in Brazil, where we could see 100bp+ in each direction depending on the outcome of elections. Looking beyond elections, however, the outlook for the currency rather than rates under an adverse scenario will likely weigh more heavily on foreign flows. From a monetary policy perspective, we believe that the curve should be positive-sloping two years forward under either scenario rather than inverted.

Carry-seeking inflows have not only reduced premium across EM curves but also distorted the pricing of monetary policy. We have favored front-end steepeners across several EM curves as a core recommendation over the past months. Although in markets such as Mexico and Chile the repricing has been advanced, the inflation risks in Mexico still seem underpriced. As the chart below shows, the long-end of Mexico has lagged the recent rally in the US so that altogether, the shape of the Mexican curve bodes for flattening with spread tightening vs. the US.

The situation is similar in Chile, where recent inflation suggests that eventual rates normalization will go farther than priced. Still, we see room for Chilean yields to compress vs. US yields as these cycles remain de-coupled. Limited correlation with US rates also supports receivers in India and China, as well as defensive longs in Thailand and Singapore vs. US. In contrast, we recommend tactical shorts in and Korea.

Relative performance across EM and DM

CZK

HUF

PLN

ILS

ZAR

MXN

COP

CLP

TRYRUB

KRW

INR

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5

z-score (5s10s box EM vs US or EU, 252d)

z-score (1s3s box EM vs US or EU, 252d)

Source: DB Global Markets Research.

Quantitative easing in the Eurozone has also brought extra-life to carry trades in the region. We may see some additional squeeze lower in the short ends of Hungary and South Africa, but, as the chart above shows, front-end rates across EMEA are very flat already. The longer end in Russia, Turkey and South Africa also look relatively flat. We expect bear-

flattening in Poland and bull- steepening in South Africa and also a steeper Turkish curve.

Asia: In India, long 10Y IGBs (target 8.25%); in Malaysia, pay 5Y swaps (target 4.20%); receive SGD 2Y3Y IRS versus USD (target +75bp); Sell 10Y KTBs below 2.8% (target 3.1%).

EMEA: Short CZGB May24 vs. 10Y Germany/Poland Oct23 (target 50bp). In Hungary, receive 3x6 FRA; pay the belly in a 1s2s5 butterfly; overweight HGB Apr18 vs. Nov17 and Jun19 vs. Dec18. In Israel, receive ILS IRS 2Y fwd 1y rate vs. 5Y5Y. In Poland maintain PLN 2s10s flatteners, overweight POLGB Oct23 vs. Oct19. In South Africa, receive 1Y vs. 5Y5Y, overweight SAGB Dec-18. In Russia, short 2Y RUB XCCY or enter 1s2s steepeners, overweight RFLB Apr17 vs. RFLB Mar18. In Turkey, maintain TRY XCCY 1s5s steepeners and keep short BEs best expressed in TURKGB Apr20 or May23. Overweight TURKGB Jun16 vs. TURKGB Jan20.

LatAm: In Mexico keep 2Y1Y spread wideners vs 5Y5Y spread tightener (target 20bp), switch from MBONOS 34s to MBONOS 24s, long breakevens in the belly (UDI20s vs. TIIE 5Y, target 390); In Brazil enter a Jan 17-Jan 21 DI steepener; In Chile keep the 1s3s steepener (target 65bp), receive 10s (CLP/CAM) vs US (target 190bp); In Colombia buy TES 24s vs US10s (target 380bp). Keep a neutral stance in Peru.

Credit: scope for some recovery The third quarter of 2014 has seen DB-EMSI spreads widen by 80bp as investors turned bearish EM assets on a variety of reasons encompassing dollar strength, lower commodity prices, lingering growth concerns, and idiosyncratic factors. The latter impacted mainly the high-yielders and Russia, on renewed default concerns in Venezuela, tension in Russia/Ukraine, as well as adverse legal and macro developments in Argentina. These four credits contributed with almost 60bp of spread widening from the end of June to date. Most of the other credits have posted moderately higher spreads, and the relative performance has been broadly consistent with their betas. The main idiosyncratic shocks have been political in nature, including Brazil’s underperformance (due to the strengthening of President Rousseff’s position in the elections, according to market participants) and the outperformance of Indonesia (on Jokowi’s election as President and associated optimism about reforms).

9 October 2014



DB-EMSI sub-index spread changes since end-June

2014

-100

0

100

200

300

400

500

600

EG LB SV

CL

PA ID PH PE PL

ZA MX

CO TR UY

BR

EC HU

RU

AR

UA VE

Spread Change, Since end of June 2014


Technicals have not been disruptive, but they have provided less supports than in the first half of the year. EM hard currency fund flows have been mixed over the past three months, but remain positive YTD (USD 2bn or +1.5% AUM). This is in stark contrast with the flows out of US HY (see chart below), though considerably weaker compared to the flows into the intermediate and long duration sectors of US IG funds. So far, HY outflows have not had a material impact on flows to EM hard currency funds, which have been driven mainly by EM specifics, in our view.

EMD funds: Mediocre flows; weaker institutional

support

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14

Retail Instituitional

4-wk MA EM Hard Currency Flows ( % AUM)

Source: Deutsche Bank, EPFR

We believe fund flows will likely remain sluggish during the remainder of the year, as the stabilizing force of institutional flows seemed to have weakened (judging from the EPFR survey – see second graph above). However, supply/demand dynamics still look supportive, as most sovereign issuers have fully undertaken their issuance plans for the year with remaining issuances likely serving as pre-funding. According to our projection, the net supplies by sovereign issuers will be negative at –USD3.0bn during the remainder of the year.

From a pricing perspective, EM credit now offers a decent level of risk premium. The BBB average spread across EM sovereigns is hovering more than 50bp over global counterparts, and our EM benchmark index DB-EMSI (with an average rating of BB+/BBB-) is just 84bp tighter than US high yield (average rating B+), a very tight spread historically (average 230bp over the past five years).

Based on valuation, we see the glass as half full. We believe there is scope for spreads to moderately tighten to the year-end as volatility eases somewhat from the elevated levels of the past month. Low UST yields and well-contained inflation should help limit the impact of dollar strength and weakness in the DM equity markets. We believe DB-EMSI spreads can tighten from the current level of 372bp to 340bp (in terms of EMBI-Global, this translates in a drop from the current 347bp to 320bp). However, this may not suffice to generate positive total returns as the UST 10s yields may well move higher from the current low levels of 2.32%.

The recent dislocations have created interesting opportunities in relative value, in our view. Also, overall EM credit performance in the coming months will likely hinge on a few idiosyncratic and vulnerable credits. We continue to hold a bearish view on Argentina as we believe continued deterioration in macro conditions will challenge the stronghold of the distressed investors and potentially unravel the current decoupling between fundamentals and bond prices. While strategically underweight, we hold a relatively more constructive tactical position in Venezuela over the short term as the market is still pricing too much risk of imminent default. The repayments of Venezuela 14s (this week) and PDVSA 14s (end of month) should inject some confidence back into the market, making the curve dis-invert to some extent. While potential ICSID ruling on some high profile arbitration cases will likely present negative headlines, their actual financial impacts will not be binding until a few years later and the amounts to be disbursed could be a fraction of the headline figures. In Russia/Ukraine, we are bearish on fundamentals, but over the near term we see the cease-fire as broadly holding and we expect relative normalcy until elections at the end of this month. With

9 October 2014



spreads close to this year’s highs, we retain tactical neutral on both for now.

Looking beyond the vulnerable credits above, we favor Indonesia vs. South Africa on the diverging trend of their fundamentals and favor Colombia vs. Peru given the latter’s stretched valuation and deterioration in growth dynamics. Elsewhere, given our view of moderate spread compression and a decrease in volatility, we generally favor those curves featuring a higher spread for better carry as well as greater scope for spread compression and, accordingly, we stay overweight Turkey and Hungary. We disfavor credits with very tight spreads, such as Peru and Poland, despite their fundamentals.

In relative value, we generally favor cash curve flatteners given our view of steeper UST curves, but also see Russia’s curve as too flat. We look to position for CDS re-widening in Brazil (vs. Mexico) as polls may disappoint in the coming weeks. In the quasi-sovereign space, we position for re-convergence of Pemex vs. UMS.

Summary of recommendations:

Overweights: Indonesia, Turkey, Hungary, Colombia, Mongolia

Underweights: Argentina, South Africa, Poland, Peru

Inter-credit RV: Switch from Venezuela 20s to PDVA 17Ns; switch from South Africa 41s to Indonesia 44s; switch from 23s to 19s in Hungary; switch from UMS 23s to Pemex 24; switch from Argentina USD Discounts (NY law) to USD Discounts (local law).

Basis trades: hold short basis in Venezuela (5Y CDS vs. 22s)

Cash curve trades: 10s30s curve flatteners in Brazil (41s vs. 23s), 10s30s curve steepeners in Russia (22s vs. 42s)

Select longs or shorts: long PDVSA 15s and 37s, long Indonesia 44s, Mongolia 18s. Short Argentina USD Discounts

Drausio Giacomelli, New York, +1 212 250 7355 Robert Burgess, London, +44 20 7547 1930

Hongtao Jiang, London, +1 212 250 2524

9 October 2014



Assessing EM Vulnerabilities

These are testing times for emerging markets: growth has slowed and a period of rising US rates looks ahead, warranting a reassessment of their resilience.

We provide a structured and objective evaluation of the underlying vulnerabilities of 25 EM economies, based on a range of measures that we think capture a country’s susceptibility to an economic crisis or painful adjustment if external conditions become more challenging.

Ranking these indicators over the last 20 quarters using the distribution of our sample confirms that the risks are highest in the high yielders, Venezuela and Argentina, as growth is weak, inflation high, exchange rates overvalued, foreign reserves limited, and public finances under pressure. While lack of comparable data did not permit the inclusion of Ukraine in the analysis, proxies suggest it also belongs to this group.

Besides these extreme cases, vulnerabilities appear high in South Africa, Brazil, Turkey, India, Indonesia, Mexico, Thailand, and Russia, although the source of these vulnerabilities differs from country to country.

There are also pockets of vulnerabilities across the rest of EM, such as significant private debt levels in other parts of Asia (China, Korea, and Taiwan), a large current account deficit in Peru, and high public debt in Hungary.

The average level of vulnerability has remained relatively stable in EM if the 2008 global crisis is excluded. However differences between regions have been rather noticeable.

While starting levels of vulnerability was conspicuously higher in EMEA than in Asia and Latin America few years ago, these have steadily declined in EMEA while increasing recently in Latin America. The absolute and relative improvement in EMEA has been driven largely by Central Europe and Israel, while Latin America deterioration has been led by Venezuela and Argentina.

The single most remarkable change is probably Hungary, which has gone from having the highest overall vulnerability score in late 2007 to the lowest score in this last measure, though high levels of foreign currency debt (not properly captured in this exercise) remain worrisome.

Introduction

These are testing times for emerging markets. The golden age in which strong growth was the norm, almost across the board, is well behind us. In particular, a number of the larger emerging economies, Brazil, Russia, and South Africa, are struggling to deliver any kind of positive growth, while activity levels elsewhere are also subdued.

Within the next year, emerging markets will once again need face up to a period of rising US interest rates. The last such hiking cycle, from 2004-06, proved to be a relatively benign one for EM, but this was seldom the case prior to that. Most emerging markets remain better placed than in the past to weather such a shock: public debt levels are lower, foreign reserves are much higher, foreign currency mismatches are less prominent, and most FX regimes appear more flexible and resilient.

Nevertheless, the normalization of US monetary policy will provide a stress test for emerging markets that is likely to underscore our expectations of diverging performance across countries. Countries with large external financing needs, or those that have seen rapid increases in leverage, are among those likely to face a period of difficult adjustment. Weaker commodity prices will provide additional challenges for some but relief for others. Geopolitical risks are adding to concerns in some cases.

Last summer’s “taper tantrum” put policymakers in emerging markets on notice of the coming storms. Some have taken heed. But the adjustment has so far been modest. Real rates remain extraordinarily low in most cases. And there is little sense of urgency regarding the need for difficult structural reforms to boost flagging growth rates.

This seems like an opportune moment, therefore, to revisit our assessment of vulnerabilities in emerging markets. In doing so, we build on the exercises that we have undertaken in previous years, and also more recently for Asian emerging markets.2

2See our EM Monthlies for December 2011 and 2012 and the Asian Vulnerability Monitor for February and May of this year.

9 October 2014



Assessing Vulnerability

We provide a structured and objective assessment of the underlying vulnerabilities of 25 EM economies. Our analysis is based on a range of measures that we think capture a country’s susceptibility to an economic crisis. We are not necessarily trying to predict crises as such. But “kicking the tyres” of each economy in this way can give us a sense of which ones are more or less likely to face a period of painful adjustment as external conditions become more challenging.

As ever with such exercises, the precise choice of indicators is partly a question of practicality: we’re looking for indicators that are readily available and comparable across countries. We’ve selected 10 indicators, capturing vulnerabilities across four key dimensions:

Macroeconomic stability Economic momentum, as reflected in our “growth

tracker”

Inflation

Private leverage A measure of excess credit growth

Private indebtedness

Level of real interest rates

External imbalances Current account

Foreign reserve adequacy

Exchange rate valuation

Sovereign risk Fiscal balance

Government indebtedness.

For each country, we measure vulnerability by comparing the latest observation (our assessment is based on data through June of this year) for each indicator with the distribution of that indicator across our sample of 25 emerging markets over the preceding five-year period. For example, China’s current account surplus of 1.7% of GDP is in the 39th percentile of the distribution of current account balances across EM over the last 20 quarters. In this way, we’re able to capture not only the relative ranking of a particular indicator across countries at any particular point in time, but also how good or bad this looks relative to the recent history of emerging markets.

We then take the average of these percentile rankings across all indicators to come up with a composite

indicator of overall vulnerability for each country. This then enables us to rank countries from the most to the least vulnerable according to their average overall scores. For convenience, we also provide an indication of whether a country’s overall vulnerability is high, medium, or low, based on the five-year distribution of these overall rankings.

EM Growth Tracker Asia '10 '11 '12 '13 '14China

Hong Kong

India

Indonesia

Korea

Malaysia

Philippines

Singapore

Taiwan

Thailand

EMEACzech Rep.

Hungary

Israel

Poland

Romania

Russia

South Africa

Turkey

Latin AmericaArgentina

Brazil

Chile

Colombia

Mexico

Peru

Venezuela

Contracting at increasing rate Below trend and acceleratingContracting at declining rate Above trend and deceleratingBelow trend and decelerating Above trend and accelerating

Based on our Macroeconomic Momentum Indicators for EM. Source: Deutsche Bank

We’re conscious that there is a lot that this exercise does not cover. It says nothing about political risks. It makes no attempt to measure structural weaknesses, such as infrastructure bottlenecks or governance issues. Nor does it say much about sources of stress in asset markets, such as froth in property markets or excessive levels of foreign investor positioning. Some indicators may also be more relevant for some countries and regions than others. These are issues that we can delve into in future updates. Our intention here is simply to provide a basic framework that can offer an initial assessment of relative vulnerabilities within EM.

Below we summarize the main results, our current overall vulnerability rankings, and the evolution of these overall rankings over the last eight years, i.e. since before the global financial crisis.

9 October 2014



EM Vulnerabilities June 2014: Summary Table

Growth Inflation Credit growth

Private debt

Real rates Current account

Reserve cover

FX valuation

Public debt

Fiscal balance

Overall

Z-score YoY% Excess % % GDP % % GDP % GEFR % % GDP % GDP PercentileVEN -0.32 60.5 14.1 32.3 -28.6 0.5 121.3 61.0 43.2 -14.4 0.76ARG -0.42 40.5 5.0 14.8 -12.8 -1.1 72.6 6.1 49.9 -4.4 0.72ZAF -0.89 6.6 0.2 77.8 -0.8 -5.6 103.5 -15.2 46.3 -4.4 0.66SGP -0.46 1.8 8.7 130.5 -1.4 18.8 27.0 8.7 103.1 6.4 0.63BRZ -1.19 6.5 4.8 71.9 4.1 -3.7 301.9 2.7 66.5 -3.3 0.62TUR -0.25 9.2 16.2 57.2 0.3 -6.5 73.1 -5.7 35.9 -1.9 0.62IND -0.75 7.5 1.6 55.9 1.3 -1.1 293.3 2.0 66.0 -7.2 0.61HKG -0.13 3.6 11.9 325.1 -3.1 1.6 33.6 2.3 33.5 1.7 0.61MEX -0.07 3.8 7.4 44.6 -0.3 -1.9 147.9 1.2 47.3 -4.0 0.60THA -0.75 2.4 5.7 132.3 -0.2 3.3 269.3 4.3 46.0 -0.9 0.56RUS -0.64 7.8 8.9 51.9 -0.4 2.5 553.5 2.7 13.2 -1.0 0.50ISR -0.34 0.5 -1.7 111.7 0.1 2.8 238.0 3.2 66.5 -3.0 0.49MAL -0.12 3.3 1.2 122.9 0.2 5.9 166.8 -5.3 57.3 -4.1 0.49CHL -0.64 4.3 2.9 78.2 -0.3 -2.4 164.7 -10.8 12.4 -0.9 0.49IDN -0.04 6.7 5.9 33.8 1.4 -3.1 146.5 -8.5 26.1 -2.3 0.45POL -0.05 0.5 0.1 51.2 2.1 -1.2 129.0 -2.8 53.5 -4.0 0.45TWN 0.08 1.6 1.7 147.7 -0.7 12.9 246.8 -1.0 41.5 -3.1 0.44COL -0.42 2.8 4.1 42.1 1.0 -3.5 178.9 -2.9 31.8 -1.0 0.44CZE 0.30 0.0 0.8 57.1 0.4 -0.4 166.7 -0.3 48.6 -2.8 0.44CHN -0.84 2.4 4.4 131.6 2.3 1.7 557.8 2.7 21.3 -1.9 0.44KOR -0.26 1.7 -0.9 156.9 1.0 6.4 296.1 10.9 37.4 1.1 0.42PER -0.38 3.5 9.8 32.3 1.5 -5.1 386.9 -0.5 18.9 0.3 0.42PHL 0.68 4.4 5.1 44.1 -3.5 3.6 843.9 -2.4 36.8 -0.4 0.38ROM -0.26 0.7 -9.4 33.5 1.6 -1.7 204.4 0.0 39.5 -2.4 0.36HUN 0.31 -0.4 -8.3 45.1 2.8 4.4 214.9 -0.7 79.2 -2.7 0.32

0.3 0.5 0.7

VENARGZAFSGPBRZTURIND

HKGMEXTHARUSISR

MALCHLIDNPOL

TWNCOLCZECHNKORPERPHL

ROMHUN

Notes: (1) credit growth is measured as the excess of private credit growth over nominal GDP growth over the last four quarters; (2) reserve cover is measured relative to the sum of short term external debt (at original maturity) and the current account deficit (for those countries that have deficits; (3) FX Valuations are taken from our Behavioral Equilibrium Exchange Rate Model (BEER), or Productivity-Adjusted Purchasing Power Parity Model for the couple of countries not covered by the BEER model (see our monthly EM FX Valuation Snapshot) . Source: Haver Analytics, Bloomberg Finance LLP, Deutsche Bank

Perhaps not surprisingly, we find that two of the high-yielding sovereign credits, Venezuela and Argentina, are the most vulnerable according to our metric.3 In both cases, growth is weak, inflation is high, exchange rates are overvalued, foreign reserves are limited, and the public finances are under pressure. This fragility is only partly offset by relatively low levels of private leverage. Likewise, since we are using the IMF definition of public debt, it does not net out holdings of this debt by public entities, which in Argentina reduces the overall level of public indebtedness to just half-

Below this pair, there is a group of countries where vulnerabilities also appear to be relatively high by recent historical standards, although the source of these vulnerabilities differs from country to country.

In Asia, with the key exception of India, the countries fall in the medium or low vulnerability cohorts, characterized by moderate inflation, manageable public sector debt and deficit, positive real interest rates, stable current account surplus, and strong reserves position. However, since the study ends in June, a couple of key developments since then make India less and Indonesia more vulnerable. In the former, expectations about reform and policy efficacy has risen since the

3 Ukraine is not included in this exercise due to data constraints but would likely also show up as highly vulnerable.

elections, capital flows have surged, external imbalances and the inflation situation have improved, and growth indicators have bottomed. Still, external financing needs are high, which need to be kept into account. On the latter, growth has continued to slow while the political situation has become complicated, with the president-elect suffering setbacks in controlling the legislature. A key pending fuel price decision stands before perception of external funding difficulties is reexamined. Private sector debt is high in a number of economies, including China, Hong Kong, Malaysia, S Korea, Singapore, and Taiwan, which leave them open to risks of sudden rise in interest rates from the prevailing, historically low levels. Hong Kong and Singapore are however two special cases by their nature of being hubs of regional finance (as well as being characterized strong public and private sector asset positions). Their high vulnerability rankings should be seen in that context and discounted somewhat.

In EMEA, South Africa, for example, suffers from weak growth, high inflation, a large current account deficit, low reserves, and a relative large fiscal deficit. The issues are similar in Turkey although, whereas the public finances are in better shape, private leverage levels have been rising rapidly, partly fuelled by overly loose monetary policy.

9 October 2014



In Latin America, beyond the high yielders, vulnerabilities are also quite high in Brazil and Mexico, although to a lesser extent. Weak growth and elevated inflation are clear vulnerabilities in Brazil, amplified to some extent by relatively high public debt, rising private debt levels, and a moderate current account deficit. Mexico is unusual: while it does not look particularly vulnerable according to any one indicator, they’re almost all on the wrong side of average. It is this moderate vulnerability across a broad range of areas that see it make the list.

There are also vulnerabilities across the rest of EM, such as rising inflation in Russia, a large current account deficit in Peru, and high public debt in Hungary. By and large, these reflect isolated rather than broad-based sources of weakness, though they nevertheless bear watching.

Vulnerabilities in retrospective

Beyond this current snapshot, we’re also able to track how the resilience of emerging markets has waxed and waned over time. Data availability becomes a bit of a problem once we extend the exercise back beyond the last decade or so; but we do have enough to cover the evolution of our overall metric since before the global financial crisis. Many aspects of vulnerability tend to change only relatively slowly over time. This is especially true for debt levels. But there is also a large amount of inertia in inflation performance, external balances, and even fiscal positions.

For emerging markets as a whole, the average level of vulnerability has not fluctuated all that much in recent years. There was, however, a notable uptick prior to the last crisis, with vulnerability peaking in around June 2008, before receding again over the following two

EM average vulnerability over time:

EM

0.40

0.45

0.50

0.55

0.60

0.65


Average percentile ranking across EM


years. Vulnerability across EM has again risen a little in recent years but not yet to the same extent that we saw prior to the last crisis.

The differences between regions, however, are somewhat more marked. All three regions saw a rise and fall in vulnerability levels before and after the global financial crisis, though the starting level of vulnerability was notably higher in EMEA than in Asia and Latin America. More recently, however, whereas vulnerability has on average continued to decline in EMEA (driven largely by Central Europe but also Israel), we have seen an increase in Latin America.

Vulnerability by regional averages:

Asia

EMEA

LatAm

0.40

0.45

0.50

0.55

0.60

0.65


Average percentile ranking within regions


Whereas this partly reflects the rising vulnerabilities in Argentina and Venezuela, other countries in the region have also been experiencing a gradual increase in the degree of macro vulnerabilities we are measuring. This notwithstanding, there are still countries with relatively low levels of absolute vulnerability, like Peru, Colombia and Chile. But basic economic performance as measured by growth and inflation has deteriorated much more than has been the case in other regions. Likewise Latin American countries have recorded worsening current account and reserve adequacy levels, as well as fiscal positions

Indeed at a country level, there have been some significant fluctuations in the relative resilience of emerging market countries over the last several years. This is clear in the graphic below, which shows the evolution of our overall vulnerability scores in the form of a heat map.

9 October 2014



Evolution of EM Vulnerabilities

AsiaChinaHong KongIndiaIndonesiaMalaysiaPhilippinesSingaporeSouth KoreaTaiwanThailand

EMEACzech RepublicHungaryIsraelPolandRomaniaRussiaSouth AfricaTurkey

LatAmArgentinaBrazilChileColombiaMexicoPeruVenezuela

2007 2008 2009 2010 2011 2012 2013 2014

Low vulnerability High vulnerabilitySource: Deutsche Bank

A number of points become clearer as we analyze the evolution of country vulnerabilities over time:

While Argentina and Venezuela have always been towards the more vulnerable end of the spectrum, these vulnerabilities have increased further over the last 2-3 years, especially in Venezuela.

The same is to some extent also true for India, though its vulnerability peaked in late-2012 and early-2013 and has been gradually receding over the last year or so.

Central European countries on the other hand have become less vulnerable. Going into the last crisis, they were among the most vulnerable in EM, with varying combinations of rapid credit growth, high inflation, overvalued exchange rates, and large external and fiscal deficits. Since then, they have undergone a period of significant deleveraging, something that we had argued would leave them

well place to deliver solid recoveries after years of underperformance.4

Perhaps most remarkable of all in this regard is Hungary, which has gone from having the highest overall vulnerability score of any EM country (in any period covered by our exercise) in late-2007 to having the lowest score across EM for the current period. One does of course need to be cautious about reading too much into this: there are some indicators not covered in this exercise on which Hungary would score poorly (e.g. the level of external debt and the share of foreign currency debt in total debt). And we continue to have doubts about the country’s long-term growth prospects. But the reduction in vulnerability is undeniable.

4 See, ‘Central Europe: A Good EM Story’ (EM Monthly, March 2014)

9 October 2014



The road ahead

While this look in the rear view mirror is useful, more important is what these trends will look like going forward.

A good example of this dynamic aspect of vulnerabilities is nicely represented by India and Indonesia, both firmly considered to be part of the fragile EM camp during the “Taper Tantrum” episode of last year, undergoing sharp FX depreciation and capital flow reversal. The comparative ranking within our 25 country sample shows clearly that these two economies ranked poorly a year ago with respect to reserve adequacy. Much has changed since, with India taking forceful measures to compress the current account and rebuild reserves. As a result, its ranking on this metric has improved considerably, while Indonesia remains stuck on a high vulnerability plane (see following chart). This analysis underscores the importance of examining the individual indicators beyond the aggregate scores. Clearly going forward, investor perception of resiliency with respect to the capacity to handle external funding pressure would be better for India and remain poor for Indonesia.

Change of fortune on the reserve adequacy ranking

0

5

10

15

20

25

India IndonesiaRanking

Source: CEIC, Haver, BIS, Deutsche Bank. Reserves as percent of sum of current account deficit and short term external debt by residual maturity

Recent history is also illuminating in Latin America as many of the region’s large economies were examples of robustness up to early 2012. Since then, however, performance has worsened and policy inaction has only reinforced that negative path. As noted, the end of the commodity bonanza marked a critical turn around for the region´s fortunes, revealing inconsistent policies in some cases. For example, expansionary fiscal stances and consumption driven growth in Argentina, Brazil and Venezuela during the boom years, become unsustainable as the economic cycle turned around. Absent corrective policies, this triggered a continued growth and inflation struggle, and increasing external vulnerability. Given strong ideological biases by the authorities in all these three countries, elections appear as the only venue for hope. This is exactly what market prices have been reflecting since last Sunday’s election in Brazil, although political continuity remains the most

likely scenario for the October 26 run off vote. More promising seems the outlook for Argentina, albeit from a worse economic status, as failing economic performance is eroding the political capital of the government and more orthodoxy seems the most natural outcome independently of the October 2015 election result. The possibility of a political change in Venezuela seems further apart, but a critical economic situation might eventually fuel a process towards changes.

Mexico is on the opposite side of a changing spectrum in Latin America. It was the only major country in the region that did not benefit from the commodity bonanza and was also negatively affected by sub-par US growth, its main trading partner. Now, an improved outlook for the US economy, together with structural reforms in the energy sector, should help support economic growth in the years ahead.

In EMEA, the prognosis is mixed. Russia is unlikely to be flashing amber or red according to our metrics any time soon. Its low debt, high reserves, current account surplus, and moderate fiscal deficit, will remain in place for some time. But we remain pessimistic about the longer term trajectory. Potential growth has fallen significantly in recent years. Even if the political crisis in Ukraine is resolved quickly, the structural reforms that are needed to change this seem further away now than ever if, as seems probably, Russia looks to pursue a more inward-looking growth strategy.

South Africa and Turkey will also likely remain under strain. In the former, deeper fiscal consolidation is needed to stabilize debt but will weigh on growth. Progress is being made on reducing infrastructure bottlenecks but the momentum behind structural reforms more broadly remains unconvincing. More imminently, weaker commodity exports are threatening to undermine what limited progress we have seen in reducing the current account deficit. Vulnerabilities in Turkey are also likely to remain moderate to high as policymakers remain reluctant to deliver the kind of sustained adjustment in real rates necessary to reduce inflation, boost private savings, and bring down external imbalances.

We are optimistic, however, that the recent reduction in vulnerabilities in central Europe will be sustained. External positions, for example, might weaken a little as domestic demand continues to recover but are unlikely to return to the credit-fuelled peaks of the past. The main risk for this group would stem rather from further disappointing growth in the euro area, and specifically Germany. The resulting pressure on growth would slow the process of reducing government debt levels, which remain moderate to high in these countries, especially in Hungary.

Taimur Baig, Singapore, (65) 64 23 8681 Robert Burgess, London, (44) 20 7547 1930

Gustavo Cañonero, New York (1) 212 250-7530

9 October 2014



To Pay or Not to Pay, Is That The Question?

In this report, we argue that although the economic crisis and policy inaction has increased the vulnerability of the country to withstand external shocks, economic authorities still have the ability and willingness to pay external financial debt.

In our opinion, the ongoing economic crisis is the result of a catastrophic policy mix, the consequence of which would not be solved by the savings from a potential default

A default in financial external debt would only create a sharp collapse in economic activity with disruptions in trade financing and put in peril the political stability of the regime without major savings of resources.

We believe the administration recognizes the importance of access to external financing and would be willing to take the necessary measures and continue honoring external obligations.

Economic authorities are not facing the dilemma of paying foreign debt or paying for imports of essential goods, yet. A pertinent question to ask, however, is how long economic authorities will be able to delay the adjustment measures to correct the macroeconomic imbalances, and whether a sufficiently extreme external shock will create the aforementioned dilemma in the future.

We continue to hold a strategically bearish position and underweight the Venezuela/PDVSA complex. On the near term we hold a tactical neutral position, and employ some defensive asset allocation strategy (being long on the very front-end and the very low-priced bonds) and relative value positions to keep engaged

Introduction

The ongoing economic crisis in Venezuela has fueled

speculation about the possibility of a default in external

indebtedness by the Republic and/or the state-owned

oil company PDVSA. The yields of the PDVSA bonds

maturing in October 2014 surged to over 50% before

recovering to 25%, and the spread curve deeply

inverted, pricing a very high probability of imminent

default. Press reports and statements from economic

authorities on the sale of CITGO, international

arbitration cases against the Republic that would

potentially award the claimants multi-billion dollar

amounts, and policy inaction to address the pressing

issues of the domestic and external imbalances from

economic policy makers, have all contributed in recent

weeks to the heightened risk perception

In this special report, we argue that although the

economic crisis and policy inaction has increased the

vulnerability of the country to withstand external

shocks – mainly on the revenues generated by oil

exports – economic authorities still have the ability and

willingness to pay external financial debt. In our

opinion, the ongoing economic crisis is the result of a

catastrophic policy mix that is characterized by

growing expenditure from the public sector, financed

by an expansionary monetary policy, and a fixed

exchange rate regime with tight capital controls. These

imbalances would not, in our opinion, be solved by the

increase in liquidity in foreign currency that savings

from missed amortization and principal payments in

external indebtedness could provide, a fact that

economic authorities seem to understand. Moreover,

even though economic authorities have been rationing

the supply of hard currency, the interest and principal

payments (around USD 10bn in the coming years) do

not seem challenging for an economy with around

85bn in exports and that is still running a current

account surplus.

Venezuela/PDVSA debt repayment schedule for next 10

years – challenging but manageable

0

2

4

6

8

10

12

2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

VENEZUELA + PDVSA Interest

Principal

Source: Deutsche Bank, Bloomberg

The policy mix described has created rampant inflation,

currency overvaluation, an increase in the demand for

foreign currency, a steep depreciation of the black

market exchange rate, an increase in the demand for

imports of goods and services, and a depletion of the

foreign exchange public reserves. The measures taken

by economic authorities have so far worsened the

situation: price subsidies and controls have created

incentives for smuggling, goods shortages and a

deterioration of the productive capacity of the private

sector, and a multi-tiered exchange rate system has

created an inefficient mechanism to supply foreign

currency for imports. Foreign exchange revenues have

9 October 2014



not grown at the same pace as oil production and exports have slowly but steadily declined.

Plans to partially address the source of these imbalances were nipped in the bud with the departure of Rafael Ramirez from the helm of economic management, just after he had announced measures such as gasoline price hikes, relaxation of good prices controls, unification of the different official exchange rates and consolidation of the different public funds in foreign currency. More likely, internal opposition inside the government was the main reason for the new change in direction, using as an argument that the political cost of these measures would not be successfully contained and would put in danger the prospects of the government ahead of the National Assembly elections in late 2015.

We expect policy makers to continue muddling through via half-hearted measures, exacerbating the domestic and external imbalances. However, a default in financial external debt would only create a sharper collapse in economic activity with disruptions in trade financing – for a country that depends largely on imports - and the possibility of developing further the oil industry through external financing, as well as the disruption to the export of tradable goods such as oil, which could be subject to the risk of a creditor’s attempt at attachment or seizure in a foreign court.

Stagnation in economic activity

Source: Deutsche Bank and Banco Central de Venezuela

In our opinion, regardless of the constraints posed by ideology, the administration still recognizes the importance of access to external financing and would be willing to take the necessary measures and continue honoring external obligations. The sharp drop in imports in the last two years shows the willingness to undertake an external adjustment through the quantitative rationing of goods and services, creating extra liquidity in foreign currency.

In the short term, economic authorities are not yet facing the dilemma of paying foreign debt or paying for imports of essential goods. Shortages of imported goods and the supply of dollars to the private sector arise as the politically feasible solutions given the overvaluation of the exchange rate, the vast demand for imports and foreign currency that this overvaluation fosters, and the reluctance of economic authorities to embark on a complete adjustment plan. Under this backdrop, a pertinent question to ask is how long economic authorities will be able to delay the adjustment measures to correct the macroeconomic imbalances, and whether a sufficiently extreme external shock will create the aforementioned dilemma in the future.

Economic crisis: separating causes from consequences

Growth, oil sector and inflation Economic activity has taken a serious hit during the ongoing economic crisis. Real GDP growth data by sectors has not been released by the government since the third quarter of 2013. However, the slowdown in growth has been considerable since the end of 2012, mostly explained by a stagnant oil sector and the end of the temporary stimulus to non-oil economic activity after the housing missions ahead of the 2012 Presidential elections. Construction activity reached a growth rate 31.4% YoY during the first quarter of 2012 followed by 20.76% during the second quarter of that same year. The latest numbers point to 1.3% growth during 2013 but activity data that has been released foretells a deep recession for 2014, as many industries have almost come to a halt given the decrease in imports and the policy of price controls.

For example, automobile assembly had decreased by a staggering 75% as of September 2014 compared to the same month one year ago according to data released by the Chamber of Automotives of Venezuela. According to Ecoanalitica (a local consultant) this grim outlook in economic activity is the common denominator in most of the non-oil sectors of the economy, with manufacturing activity growing by 0.9%, mining falling at an 18.2% annual rate, construction activity falling by 3.9%, and retail sales dropping by 1.6% for 2014.

9 October 2014



Inflation accelerated deepening crisis


According to estimates, oil production will continue decreasing from the 2.89 Mbpd in 2013 to 2.82 Mbpd in 2015. The bulk of the expansion in production is coming from marginal increases in the Orinoco Oil Belt Areas (OOB) at around 1.2Mbpd, while production in traditional areas has decreased to between 750Kbpd in the fields in the west to around 850Kbpd in the eastern fields, according to oil sector consultant IPD-Latin America. Adding this stagnant behavior in production to the recent weakness in oil prices, this implies that the oil sector will not be able to sustain the fall in overall economic activity. Real GDP growth for 2014 would print at -3.5 pps.

After significant delays in the release of inflation figures and a non-explained change in the methodology, the Central Bank released a report in September that surpassed the 60% mark for the headline number and is close to 90% for food and beverages, as the graph below shows. The acceleration in inflation during 2013, which continued in 2014, has been related to the deep depreciation in the black market exchange rate and the different exchange rate mechanisms that have proved inefficient in attaining their goals; in addition, the policy of tight price controls has not been able to decrease the pressure in the growth in the price level.

Fiscal and Monetary Policy The behavior of government expenditure in real terms has amplified the economic activity cycle, as the figure shows. During the period of the financial crisis, government expenditure suffered a large contraction, reflecting the fall in revenues after oil prices plunged. However, the recovery of oil prices and the run up to the Presidential elections of 2012 (Chávez vs. Capriles) triggered a rapid and sustained increase, even after adjusting for inflation. Since 2013, central government

expenditure experienced a large drop that has added to the current slowdown but this trend has been reversed in recent months, adding to the imbalances. These figures do not take into account the expenditure implemented by state owned companies directly, especially by PDVSA, which we will describe below.

Monetary policy has continued an expansionary stance, exemplified by the Central Bank’s purchase of the public sector’s debt, surpassing 100% of the monetary base. This monetary financing has stabilized in the last few months according to the latest figures, putting a stop to the acceleration in inflation experienced last year, as the graph shows. However, to tackle inflation, a stronger adjustment of credit and monetary aggregates is needed.

Central government primary expenditure (YoY growth–

infl. adj)

Source: Deutsche Bank, Econalitica and MPPFE

Monetary financing of fiscal deficit


Balance of Payments Crisis and Exchange Rate Policy Sustained increases in fiscal expenditure, financed by expansionary monetary policy amid a fixed exchange rate regime, is a long understood recipe for a Balance of Payments crisis, precisely the situation that

9 October 2014



Venezuela has been suffering in the last two years. Central bank reserves and the public sector’s net foreign assets dwindled during the period in which economic authorities tried to supply foreign currency to the economy while maintaining an overvalued exchange rate. However, this behavior stopped during 2013 as the Central Bank’s foreign exchange reserves hovered around USD 20bn.

Imports collapse without devaluation


This “sudden stop” in the supply of foreign currency is behind the worsening of economic conditions during the last two years. For an economy that depends heavily on imports for essential goods, as well as for inputs of production for manufacturing, the fall in imports has caused the deep deceleration in economic activity, especially in the non-oil sector. However, foreign exchange revenues have not fallen to the same extent that outlays have. While exports – mostly oil – have remained between USD 80 and USD 90 bn, we expect imports to close the year at around USD 45 bn, a sharp drop from the USD 60 bn of 2012.

The reason behind this protracted drop in imports, as we argued above, is that economic authorities have chosen to apply quantitative restrictions to the supply of foreign currency to the private sector, rather than use an outright devaluation of the official exchange rate to curb down the demand for imported goods. The main reason behind this reluctance is related to the fear of the possible effects that this devaluation might have in inflation. However, price controls and other measures to stop inflation have failed and if a complete adjustment package is not enacted, prices could soon reach annual growth rates in the triple digits. In our opinion, a main cause of the acceleration in inflation is the depreciation of the parallel (black market) exchange rate. The quantitative measures to limit dollar supply have created a rapid widening in the differential between the official rates and the black market rate that has been translated into accelerating prices in the last few months.

The current exchange rate regime that combines three different official exchange rates has not been able to counteract the effects of the protracted crisis in economic activity. Local consultants estimate that around 60% of disbursements during the second quarter of 2014 have been at the 6.3 rate (Cencoex) while 17% have been at the SICAD rate (around 10 VEF/USD) and the remaining 23% have been at the SICAD 2 (around 50 VEF/USD), implying an effective exchange rate of around 17.3 VEF/USD. Clearly, this implies a steep depreciation but the inefficiency of the system that arises in the huge differential between the rates, makes the success of this regime unlikely in improving in efficiency. A more sensible policy would imply devaluation to a unified exchange rate close to the effective exchange rate accompanied by a fiscal and monetary policy consolidation plan. However, the political and ideological constraints would most likely preclude these radical measures from taking place, extending vulnerability to an external revenue shock

Debt Sustainability and External Liquidity

Solvency still not at peril… It is a well known truism that countries do not go bankrupt just as a corporate entity. However, well documented empirical evidence has found that the stock of sovereign debt plays a major role in determining if a country would face a financial crisis that in many occasions has included defaults in external sovereign debt. The table below shows that for most metrics, Venezuela currently is still below the average threshold that has triggered default episodes through history in middle income economies. In the first row, total financial external debt is close to USD 115 bn, around USD 90 bn in bonds and USD 25bn in debt to China, and valuing GDP at the official exchange rate implies a ratio to GDP of 25 and 20 pps, respectively. However, when measuring annual GDP at the effective exchange rate (around 17 VEF/USD according to the disbursements of the different exchange rate systems, this ratio increases to 70 and 55 percent, respectively, which are closer to the average default (69%) in the historical sample for middle income countries.

Using another proposed metric of solvency, total debt as a percent of annual exports – a metric that does not need to impose any assumption on a “fair” value for the nominal exchange rate – the ratio is below the average default in the Reinhart and Rogoff sample. Considering cash generating exports, the ratio increased to around 145%, but most of the non-cash generating exports go to pay for the government-to-government agreements with China; excluding these loans implies a ratio of around 109%. To reach the average ratio for a defaulting country, annual exports would need to plunge to below USD 40bn per year. However, it has not been unusual for emerging economies to default at much lower debt ratios with

9 October 2014



extreme cases at levels below 20% as a percentage of GDP and below 80% as a percentage of total exports. Moreover, it is not encouraging that Venezuela, which has experienced 10 episodes since independence in 1830, has been dubbed the “modern day sovereign-default champion” by these authors.

Foreign financial debt

USD bn% of GDP

(official rate)

% of GDP (effective

rate)

% of annual exports

% of cash-generating

exportsTotal External Debt 114 25% 70% 156% 167%

Sovereign and PDVSA Bonds (w/o China loans)

89** 20% 54% 122% 131%

Reinhart and Rogoff's average default (*)

n.a.

(**) Including loans by PDVSA not related to China, but not including interest payment (USD55bn)

69% 230%

(*) From Reinhart and Rogoff's: This Time is Different. Chapter 2, Table 2.1. External debt at the time of default: Middle-income countries, 1970-2008

Source: Deutsche Bank, Sintesis Financier, and Reinhart and Rogoff (2009): This Time is Different: Eight Centuries of Financial Folly

…but liquidity gets tighter While central bank reserves and money available on the various off-budget funds have been fairly stable over the past year5, the total resources have sharply declined from 2012 levels, as shown in the table below. It is also a question as to how much money held in the off-budget funds is in liquid form.

Public sector hard currency resources

Dec-11 Dec-12 Dec-13Fonden and China Fund 21.9 14 8.3

Fonden 6.1 4.9 2China Fund 15.8 9.1 6.3

Other Public Sector entities 6 5.2 2.6Bonds in Central Bank 2.2Bonds in Public Banks 1.3Foreign Reserves in Central Bank 29.9 29.9 21.5

Liquid 5.6 5.5 1.6Non-liquid 24.3 24.4 19.8

Total Foreign Assets 57.8 49.1 35.9

Source: Deutsche Bank, Sintesis Financiera and Banco Central de Venezuela

We believe these resources will continue to decline next year given the now lower oil prices. PDVSA’s contribution of its “excess” revenues from the “windfall oil tax” to Fonden, which was USD13bn in 2013 and estimated at USD10bn this year, will likely shrink to USD6bn in 2015 assuming oil prices stay at the current level (USD85 for the Venezuela mix). However, even without an increase in oil export revenues, there are various means for the government to save hard

5 Note that the central bank reserves have reportedly dropped by USD1.8bn this past week, which we believe was for the repayment of sovereign bonds maturing this year.

currency and prioritize debt payments, including the following.

Further cuts in imports. During the first half of 2014, imports have been reduced by 22% compared to the same period of 2013. We estimate 2014 imports will be about USD42bn, down from USD52bn in 2013. The government could further reduce exports in 2015 in order to squeeze some more dollars to help meet debt payments.

While keeping the oil windfall tax formula unchanged, the government could allow PDVSA to transfer more dollars at a weaker exchange rate to improve PDVSA’s finances while boosting the government’s social spending ability at the same time, effectively devaluing the exchange rate and improving the efficiency of the supply of foreign currency to the private sector by increasing the supply at a more devalued exchange rate.

Reduce non-revenue generating G2G oil export programs. We do not think Venezuela could cut its exports to Cuba (about 105kbpd), but it has quietly lowered exports to Petrocaribe (excluding Cuba) to about 66kbpd from 116kbpd in 2010 according to Sintesis Financiera, a local consultant. Further cuts to the non-revenue generating portion of this export program could save USD1bn hurting the country’s diplomatic standing in the region.

CITGO Sale. While the government has removed this from the table for now, a sale of CITGO assets could generate immediate cash for the government for up to USD6-8bn. However, the sale of CITGO would be a poor decision from a long-term business perspective and would be perceived as negative by the market.

Hiking domestic gasoline prices. While this proposal is off the table at the moment, as the government decided that the political cost of doing this would be too high ahead of the parliamentary elections in 2015, the opportunity cost of this subsidy is around USD 12.5 bn per year. We do not see feasible that the government would increase prices to cover the opportunity cost, given that the current price is 28 times lower than international average price of gasoline, and most likely the quantity demanded would fall sharply, but a sensible cut of the subsidy could be targeted to increase revenue by a significant amount. Currently, around 750kbd are used for domestic consumption.

Debt issuance and/or liability management transactions. While there has been speculation about liability management transactions by PDVSA, they have not materialized yet. Both the government and PDVSA could issue foreign bonds, but at a very high cost at this point. Clearly, it would be better if they announce some policy adjustment first to suppress yields and give investors some confidence.

9 October 2014



Finally, the government and PDVSA could continue to pursue multilateral agreements, with China, Russia, etc, as they have done in the past. However, given the increasingly distressed financing, the lenders have become more prudent and more stringent in their conditions. China, for example, has demanded to put loan repayment into law, so its claim has de facto become senior to other debt.

All these issues aside, the main point is that with a daily 1.85mbpd of crude exports, out of which about 1.45mbpd generate cash flows 6 , USD10bn debt repayments can be made next year. The risk, however, is clearly to the downside, as Venezuela is increasingly vulnerable to further drops in oil price. A USD5 drop in the oil price (average for the year) means Venezuela receives around USD4bn less in oil revenues a year. So far in 2014, the Venezuela mix has averaged USD95 and the current price is around USD85. A further drop to USD85 will likely create some panic in the market, and as we can see, the cushion looks pretty thin at the moment.

Prices of the Venezuela mix, since Jan 2013

80

85

90

95

100

105

110

115

4-Jan-13 4-Jun-13 4-Nov-13 4-Apr-14 4-Sep-14

Veenzuela crud mix, price


Conclusion and market implications

There are several conclusions we can draw from our analysis above:

First, the current economic situation has not been triggered by a sharp contraction in economic activity and/or foreign exchange revenue, but by an unsustainable set of policies that create domestic and external imbalances.

Second, the current policy mix, if not significantly altered, is clearly unsustainable over the medium

6 According oil consultancy IPD/LatinAmerica, the total daily shipment included in the Energy Supply Cooperation Agreements (ESCAs) amount to 914kp per day. Out of this about 390kp per day affecting cash flows

term. We expect piece-meal measures, more along the line of further stealth devaluation, over the course of next year, but that will likely not be enough. The risk of the country running into a blow-up scenario over the medium term, especially if oil prices drop further, is very high.

Over the near term, however, the government still has the resources and means to muddle through. To this end, we continue to believe Venezuela/PDVSA will meet their debt obligations in 2014 and 2015

Finally, we believe the government has a strong willingness to pay as the cost of a default is prohibitively high. A default in financial external debt would only create a sharper collapse in economic activity with severe disruptions in trade financing and ability to import essential goods, and cause significant disruption to the export of tradable goods such as oil given the risk of creditors attempting to attach or seize in foreign courts. In short, under our baseline scenario, the country still has the willingness and ability to service foreign financial debt.

We continue to hold a strategically bearish position and underweight the Venezuela/PDVSA complex. Over the near term, however, we hold a tactical neutral position, and employ some defensive asset allocation strategy and relative value positions to keep engaged.

Specifically, we continue to favor a defensive, barbell position of being long on the very front-end (PDVSA 15s and EUR 15s) and the lowest-priced bonds (PDVSA 24s and 37s). On relative value, we believe confirmation of Venezuela 14s repayment (this week) and PDVSA 14 repayment at the end of the month, which we expect, will help alleviate some concerns of near-term default.

While we have discussed in length above the rationale for keeping the long recommendation in shorter duration bonds, the reasons for us to focus on the very low priced bonds is their defensive traits – the prices on those bonds tend to find stronger support once they fall below 50 and bondholders will likely incur only limited losses under the worst case scenario of a default. Historically, the average recovery value in the major EM sovereign default is around 50%. While it is difficult to put a number on potential Venezuela or PDVSA restricting scenarios, there are reasons to believe they will likely be on the high side. First, since a default would likely be the result of poor economic policies and significant mis-management of the vast oil resources in this case, it would likely lead to a government change. A new government could turn around the ship with more market friendly policies, leading to a low exit yield

9 October 2014



in a potential debt restructuring. Second, creditors could potentially attempt to attach or seize oil shipments or revenues offshore in the event of Republic default, and CITGO assets in the event of PDVSA default . If such attempts are successful, it would limit creditors’ loss upon a potential default.

Debt reliefs in EM some major EM sovereign

restructurings

Source: Deutsche Bank, IMF

Finally, in relative value, we position for some recovery of PDVSA bonds relative to the sovereign curve via long PDVSA 17Ns vs. Venezuela 20s. Please refer to the LatAm Strategy section of our EM Monthly for more details on our strategy recommendations.

Armando Armenta, New York, (1) 212 250-0664 Hongtao Jiang, New York, (1) 212 250-2524

9 October 2014



Remember, not all EM currencies are equal

After a broad-based sell-off in EM FX over the past couple of months, we cannot help to feel the gloom is overdone and expect greater differentiation again at some point over the next few months as an indiscriminate 2013 taper-style EM FX sell-off makes little sense given the substantially different outlooks for many EM currencies. It also makes little sense given the lack of wage pressures in this cycle, as it would suggest that any hiking cycle will be very gradual, giving the recovery further time to take root. Different criteria according to which we examine EM FX will result in different ranks. We therefore ultimately assemble a combine metric that should in principle help to shed some light on the “currency vulnerability” question within the EMFX universe. We examine:

balance sheet risk: without taking price information into account we rank vulnerabilities from the external accounts point of view

long term valuation: valuation from the real exchange perspective is considered under this criteria

short term valuation: being a risky asset itself, we compute the relative valuation versus contemporaneous financial drivers and use the resulting under/overvaluation as an input in our vulnerability index

real rates: We look at FX resilience from the real monetary policy perspective

EM balance sheet vulnerability metric For the balance sheet assessment we focus on variables such as the adequacy of foreign reserves vis-à-vis the C/A balance and short-term external debt, the degree of leverage that has been built up in recent years in the private sector, FX valuation according to our fundamental metrics, public debt as % of GDP, as well as fiscal balances also as % of GDP. Most of these variables are neatly summarized by our Economics team elsewhere in this EM Monthly in “Assessing EM Vulnerabilities”, but below we present a scaled down version, where we simply offer a relative ranking rather than measuring the ‘absolute’ level of vulnerability. The chart below summarizes the aggregate measures (average percentiles) across EM

EM FX ‘balance sheet vulnerability’ – from least to most

‘risky’ – in percentiles 2009 to date

0.3 0.4 0.5 0.6 0.7

ZARTRYBRLINR

MXNSGDMYRCLPTHBIDRPLNCOPRUB

ILSCNYPENCZK

TWDKRWRONHUFPHP

most vulnerable

least vulnerable


By our measure PHP, RUB, PEN, CNY, KRW, RON, COP, IDR, CLP, HUF, TWD, and THB are all in the lower 50th percentiles for the past 6 years, i.e. they have relatively low balance sheet risk, and should not suffer major funding problems in response to a turn in the US interest rate cycle. ZAR, TRY and BRL, on the other hand, continue to be vulnerable to a turn in the US interest rate cycle, due to large C/A deficits, limited foreign exchange reserves and limited room for fiscal stimulus (BRL and ZAR).

FX valuations wildly different across EM Valuation can also in principle be used as a vulnerability indicator – less/more valuable FX would be associated with more/less vulnerable FX In this section we define valuation with respect to a set of real exchange models that we currently have in place. The chart below left shows our latest (August) estimates of longer-term fair value for EM exchange rates based on three alternative models adjusted PPP, BEER and FEER. Our calculations point to overvaluation across all three approaches in China, Hong-Kong, Singapore, Russia, Argentina, Brazil, Mexico, and [almost] Peru; and undervaluation in Taiwan, Czech Republic, Hungary, Poland, Romania and Turkey, with India undervalued on FEER and PPP, whilst largely fairly-valued on BEER. and South Africa and fairly-valued on BEER.

9 October 2014



Our latest estimates of longer-term fair-value in EM

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

35

CN

Y

HK

D

INR

IDR

KR

W

MY

R

PH

P

SG

D

TW

D

TH

B

CZK

HU

F

ILS

PLN

RO

N

RU

B

ZA

R

TR

Y

AR

S

BR

L

CLP

CO

P

MX

N

PE

N

VE

F

BEER FEER PPP%

Asia EMEA LatAm

Ov

erv

alu

ed

Un

de

rva

lue

d

VEF PPP estimate: +75.0%


Short term valuation: where do we stand? Being a risky asset itself, EMFX tends to fluctuate to benchmark financial assets in accordance to markets overall appetite for risk. Beyond its long term intrinsic valuation, mean reversion of shorter tern deviations from these benchmark asset can also be used as a source in EMFX. The deviations from the short term model (regression based) are presented in the chart below. Accordingly, other than KRW most EMFX seem to be either fair or undervalued on this metric. Particularly interesting are COP and PEN - low volatility currencies that besides being “cheap” are currently sitting on the top of their range. The metric also implies value on high beta currencies such as BRL, RUB, TRY, IDR and ZAR. These however have the caveat of having higher volatility and consequently higher drawdowns associated with the longs

Our latest estimates of longer-term fair-value in EM

BRL

CLP

COPMXN

PENCZK

HUFPLN

RUB

TRY

ZAR

ILS

IDR

INR

KRWMYR

SGDTHB

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

-8% -6% -4% -2% 0% 2% 4%

financial overvaluation

implied volatility (3M)


Where are policy adjustments sufficient to cover current account deficits? A good additional measure of FX resilience is whether real monetary policy has been sufficiently adjusted to compensate for a country’s external vulnerability. Here, rather than being proxied by the current account deficit, vulnerability is proxied by the (negative of) the basic balance (C/A deficit+FDI). This is especially important in correctly assessing the vulnerability of currencies such as PEN and COP, which are less vulnerable than they appear based only on their C/A deficits. Using this measure, ZAR and TRY stand out, with monetary policy which has not adjusted sufficiently to compensate for the severity of the external deficits: TRY exhibits a positive but too small real rate, where ZAR currently has a negative real rate. Elsewhere MXN, IDR and COP appear somewhat vulnerable, despite positive real rates in the two latter countries.

Another Vulnerability angle: Real rates

-6

-4

-2

0

2

4

6

TRY ZAR IDR BRL PLN MXN COP INR PEN CZK RUB CLP RON MYR CNY PHP KRW ILS THB

Basic balance (% GDP)

Real short-term rates

-6

-4

-2

0

2

4

6

8

ZAR TRY MXN IDR COP PHP INR RUB CZK PLN CLP PEN BRL MYR RON THB ILS KRW CNY

Real ST rate - Basic balance


However, there are a few exceptions, most noticeable Brazil, where a negative basic balance is offset by real rates firmly in positive territory. Other poor balance currencies arguably offering attractive enough returns to offset fundamentals include PLN, PEN, and INR, where the rupee is supported by a central bank intent on stemming inflation. At the other end of the spectrum KRW, MYR, CNY, THB and ILS all appear strongly out of line with real returns. Should markets stabilize CNY, KRW, MYR and THB seem to represent good value

9 October 2014



Conclusion:

Most EM currencies have weakened over the past few months, despite outlooks that differ, in some cases substantially. Our vulnerability assessment above would suggest that while there are noticeable exceptions (Turkey, and to a smaller extent South Africa), emerging markets in general are not facing a balance sheet crisis. Instead it is a lack of growth that has seen EM central banks ease policy aggressively, resulting in reduced carry and FX weakness. However, economies with external surpluses, attractive FX valuations and relatively low inflation should see growth pick-up as demand in the developed world improves. A pick-up in growth would allow for some policy normalization, which in turn would provide support for those currencies as Fed eventually starts to tighten policy. Conversely, currencies most at risk of a further sell-off are those with large current account deficits, sticky inflation and therefore also a need for a more restrictive monetary policy, which in turn is weighing on growth prospects.

Obviously there are other dangers which will or could change the ‘rankings’ above, with weaker commodity prices providing additional challenges for some but relief for others, while geopolitics are adding to concerns in other cases. Also, and as we have seen repeatedly in this cycle, positioning will also be of relevance, with the more vulnerable EM credits typically also the ones where most of the shorts are lined up.

Aggregated EM currency ranking – from ‘resilient’ EM

FX to ‘vulnerable’ EM FX

-0.800

-0.600

-0.400

-0.200

0.000

0.200

0.400

0.600

0.800

1.000

1.200

HUF TWD RON MYR PLN CZK KRW CLP IDR PHP THB RUB CNY PEN SGD INR ILS ZAR TRY MXN COP BRL

EM currency score

vulnerable EM FX

resilient EM FX


Nonetheless, to better assess balance sheet risk, and in order to also take into account the currency adjustment which have already taken place and to what extent policy is offsetting fundamentals we build an indicator where we score emerging markets using the three different metrics presented above. The currencies with the healthiest readings in each category get a score of +1, while the worst get a mark of -1, with +0.5, 0 or -0.5 for the currencies in between. The indicator hence provides a relative strength ranking, narrowing down the currencies more likely to face balance sheet pressures, and where valuation and/or policy have not adjusted sufficiently to provide protection. At the other positive end of the spectrum we find currencies where balance sheet risk is limited, valuation competitive and/or real rates more attractive. For these economies currency depreciation in recent months has been more a reflection of risk aversion and USD momentum, taking FX increasingly out of line with fundamentals.

Henrik Gullberg, London, +44 207 545 9847 Guilherme Marone, New York, +212 250 8640

Assaf Shtauber, New York, +212 250 5932 .

9 October 2014



EU Structural Funds and Their Impact: 10 Questions Answered

With the EU Cohesion Policy funds allocation for the 2014-2020 budgeting period announced earlier this year, Poland emerged as the big winner, capturing by far the largest allocation. In this report, we shed light on the absorption, application and impact of these EU funds, with a focus on the performance of Poland and Romania in the previous budgeting period (2007-2013); these two countries have had contrasting fortunes in the EU funds arena. We answer the following questions in relation to EU funds:

1) What is the Cohesion Policy framework?

2) What were the structural funds allocations for the 2014-2020 period?

3) How are these funds allocated to investment projects?

4) What were the structural funds allocations for the 2007-2013 budgeting period?

5) What were the structural funds absorption rates for the 2007-2013 budgeting period?

6) What are the main causes of divergence in absorption rates between countries?

7) Why does Poland have such a high absorption rate?

8) What are the expected amounts of EU funds inflows into Poland over the coming years?

9) What is the impact of EU funds inflows on growth?

10) What are the other major EU funds programs, and what is the impact of EU funds on a country’s external balance?

EU structural funds

With the EU Cohesion Policy funds allocation for the 2014-2020 budgeting period announced earlier this year, Poland emerged as the big winner, capturing by far the largest allocation. In this report, we shed light on the absorption, application and impact of these EU funds, with a focus on the performance of Poland and Romania in the previous budgeting period (2007- 2013); these two countries have had contrasting fortunes in the EU funds arena.

1) What is the Cohesion Policy framework? It is the policy framework within which investment projects receive funding from the EU’s two structural funds – European Regional Development Fund (ERDF) and European Social Fund (ESF) – as well as the Cohesion Fund. The primary aim of the Cohesion Policy is to reduce “disparities between the various regions and the backwardness of the least-favoured regions”. Formally, the Cohesion Policy aims to, via specifying investment priorities for accessing EU structural funds, (a) assist lesser developed regions and improve convergence through accelerating growth; (b) increase regional competitiveness and employment; (c) encourage cooperation across EU states. The bulk of structural funds (around 80%) under the Cohesion Policy are earmarked for convergence objective (a), while objective (c) is allocated a very small fraction (around 3%).

The specific aim of the Cohesion Policy for the 2014-2020 period is to fund investments that help deliver the Europe 2020 goals: creating growth and jobs, tackling climate change and energy dependence, and reducing poverty and social exclusion. Investment projects that target these goals will be given priority for receiving Cohesion Policy funds, the EU’s main tool for investing in physical capital (primarily infrastructure), human capital and research and development (R&D).

2) What were the structural funds allocations for the 2014-2020 period? For this budgeting period, EUR 351.8bn of structural funds will be available to invest within the Cohesion Policy framework, which is 1.4% higher than the amount allocated for the 2007-2013 period (EUR 347bn).

The country allocations for the 2014-2020 period are shown in the chart below.

Cohesion Funds allocation for 2014-2020 (EUR bn)

-

10

20

30

40

50

60

70

80

PL IT ES RO CZ

HU PT DE

FR EL SK UK

HR

BG LT LV EE SI BE SE FI NL

AT IE CY

MT

DK LU

Source: Deutsche Bank EC

9 October 2014



Poland obtained an allocation of EUR 77.6bn, by far the largest national allocation among the 28 EU member states, with Italy the next biggest beneficiary (EUR 32.8bn). Aside from Poland, the other CEE4 countries – Romania, Czech Republic and Hungary – also obtained sizable allocations of EUR 21-23bn. Of these CEE4 countries, only Poland and Romania secured a higher allocation than in the previous budgeting period.

Country allocations are determined, through a negotiation process, by the EC on the basis of need (accounting for population size) as well as ability to absorb the funds. As the chart below shows, poorer countries generally get larger allocations of EU Cohesion policy funds. Within CEE4, Romania’s allocation was relatively small given its low level of GDP per capita, likely because of Romania’s record of weak absorption of EU funds. In the previous budgeting period (2007-2013), Romania was only able to absorb 45% of its allocated Cohesion Policy funds, one of the lowest absorption ratios in the EU.

Lesser developed countries generally get larger

allocations of structural funds

Source: Deutsche Bank, EC

3) How are these funds allocated to investment projects? The projects are selected by administrative/government authorities in each country, and therefore firms apply to these authorities for funding via the EU’s structural funds. To a large extent, only projects which satisfy the criteria noted in (1) are selected to receive EU funding. Within each country, a larger amount of EU funds are allocated to lesser developed regions, and thus investment projects in the poorer regions of a country are given priority.

Investments receiving EU structural funds must be co-financed by public or private institutions. The level of EU co-financing varies between 50% and 85% (of the total project cost), depending on socio-economic factors. In less developed (poorer) regions and for investment projects which fulfill the higher priorities of

the Cohesion Policy, the level of EU co-financing is larger. Therefore, while the priorities for investments using EU structural funds are set at the European level, project implementation and management (as well as selection) are handled by national or regional authorities.

It is also important to note that EU funds are not paid to firms in advance, and thus pre-financing of projects (through government bodies or private banks) is required.

4) What were the structural funds allocations for the 2007-2013 budgeting period? As is the case for the upcoming budgeting period, Poland was allocated the highest amount (EUR 67bn) in the 2007-2013 period as well (see chart below).

Cohesion Policy funds allocation for 2007-2013 (EUR bn)

0

10

20

30

40

50

60

70

80

PL ES IT CZ DE HU PT GR RO FR SK UK LT BG LV SI EE BE NL SE FI AT MT IE CY DK


5) What were the structural funds absorption rates for the 2007-2013 budgeting period? The absorption rate, i.e. the extent to which a country is able to access and spend its allocation of EU structural funds, varied considerably across countries (see chart below).

Absorption rates (expressed as a % of total country

allocation) of Cohesion Policy funds

0

10

20

30

40

50

60

70

80

90

Est

onia

Por

tuga

lG

reec

eLi

thua

nia

Finl

and

Bel

gium

Ger

mna

yD

enm

ark

Irela

ndS

wed

enN

ethe

rland

sP

olan

dA

ustri

aC

ypru

sLu

xem

bour

gLa

tvia

Spa

inFr

ance UK

Slo

veni

aH

unga

ryC

zech

Rep

.Ita

lyS

lova

kia

Mal

taB

alga

riaR

oman

iaC

roat

ia

%


9 October 2014



Within CEE4, Poland had the highest absorption rate, a substantial 71%. This amounts to EUR 48bn obtained in subsidies within the EU’s Cohesion Policy framework.

On the other hand, Romania had the lowest absorption rate in CEE4 (45%), which was also the second lowest rate (after Croatia, which only joined the EU in 2013) within all of EU.

6) What are the main causes of divergence in absorption rates between countries? There are two main determinants of a country’s absorption rate.

Financial capacity: As noted in (3), the financial sector (including public and private banks) plays an important role in the absorption of EU structural funds, as it provides the pre- and co-financing that are crucial for obtaining EU funds. Therefore, a country’s financial sector development/effectiveness is a crucial determinant of its absorption rate, and there is generally a positive relationship between the two, as illustrated in the chart below.

Absorption rate vs. financial sector development

(2007-2013 period)

Source Deutsche Bank, World Bank, EC

Administrative capacity: In addition to financial capacity, administrative capacity, or the effectiveness of the government in general, plays an important role in determining absorption of EU Cohesion Policy funds. This is primarily because projects are selected, managed and monitored at a national or regional level by government/administrative bodies. If the application and project selection process is not streamlined and transparent, this could discourage applications for EU funds by firms. Similarly, greater bureaucracy and longer lengths of time taken by authorities for project assessment also deter applications (as is the case for Romania), while projects need to be carefully selected in order to ensure they meet the EU criteria and are thus eligible to receive structural funds. Further, as the

subsidies from EU funds are not paid to firms in advance but rather in installments over time as the investment project progresses, the correct selection of projects and proper management of selected projects by the authorities are important determinants of the timely absorption of EU funds.

We use the World Bank’s government effectiveness index as a broad measure to capture the factors noted above, and a country’s administrative capacity in general. The chart below, which plots the absorption rate for the 2007-13 period vs. government effectiveness, shows a positive relationship between the two.

Absorption rate vs. government effectiveness (2007-

2013 period)

Source Deutsche Bank, World Bank, EC

The chart indicates that Romania’s low level of government effectiveness (which is in fact the lowest in the EU) is the likely cause of its low absorption rate. This extremely poor government effectiveness could also explain why Romania’s absorption rate is even lower than indicated by its financial sector development (as shown in the previous chart). Further, Romania only joined the EU in 2007, which also likely contributed to its low absorption rate in the 2007-13 period.

7) Why does Poland have such a high absorption rate? In contrast to Romania, the performance of Poland in absorbing structural funds has been even better than implied by our general measures of government effectiveness and financial sector development. This is partly due to the fact that Poland joined the EU three years earlier than Romania, and this greater experience with EU funds no doubt left its administrative processes better evolved to efficiently absorb EU funds.

Further, on the administrative side, the Polish government has paid special attention to the issue of EU funds and their successful absorption. Provisions and processes were setup to properly monitor and

9 October 2014



manage investment projects through regional bodies. In addition to private firms, local authorities also undertook investment projects which accessed EU funds. The decentralized administration in Poland – within which the flexible regional bodies play a large role in project selection, management and implementation – contributed to increasing the absorption rate by dividing the administrative burden between local governments and stimulating competition for funds between them.

However, all issues associated with structural funds are overseen by the central Ministry of Regional Development, which was created in 2005 with the primary objective of attracting and efficiently managing EU funds. This Ministry, under the stable leadership of Elzbieta Bienkowska (who was earlier this month appointed as a European Commisioner), coordinated and monitored local authorities in all matters associated with EU funds. The dual governance structure for the management of EU funds significantly increased the administrative capacity of Poland. In contrast, the central government in Romania bears the bulk of the administrative burden associated with EU funds, and the Ministry controlling EU funds has seen substantial personnel turnover in recent years.

On the financial side, almost all of the co-financing of projects in Poland was provided by the government via the central budget. Additionally, these payments were often made in advance, with the government then claiming the money from the EU structural funds – this reduced uncertainty for firms and encouraged applications for EU funds, as well as speeding up the implementation of investment projects.

8) What are the expected amounts of EU funds inflows into Poland over the coming years? As the figure below shows, for the 2007-2013 budgeting period, EU funds inflows into Poland amounted to approximately EUR 7bn annually at the start of the period and rose to EUR 15bn at the end of the period, likely due to improvements in financial and administrative capacity over the budgeting period.7

7 Note that these figures include inflows from all EU funds, not just those within the Cohesion Policy framework.

EU funds inflows into Poland

0

2

4

6

8

10

12

14

16

18

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

EU Transfers (gross) EU Transfers (net of contributions to the EU)

EUR bn

Source Deutsche Bank, Haver Analytics

Focusing on Cohesion Policy funds for the upcoming budgeting period, we believe that the Polish absorption rate will be at least as high as it was in the previous period (71%), but is likely to be higher (possibly closer to around 75-80%) as the administrative setup for overseeing and managing EU funds has improved over the past budgeting period. Assuming an absorption rate of 75%, this implies a total of EUR 58.2bn of structural funds inflows into Poland between 2014 and 2020, or an average of EUR 8.3bn annually over the seven years (however, the structural funds inflows in 2014 from the current budgeting period allocation are likely to be lower than this, as the allocations were only announced in March). This amounts to a significant 2.1% of 2013 GDP.

9) What is the impact of EU funds inflows on growth? The substantial EU funds inflows during the 2007-13 budgeting period helped Poland's economy to grow during the crisis, unlike most other European peers. These funds were absorbed at a very opportune time, i.e. arguably when they were most required and had a substantial impact on growth – EU structural funds were able to replace (partially) FDI flows which dried up during, and in the aftermath of, the crisis. Most of these EU funds went towards infrastructure projects (roads, highways, railways), with large amounts also going to the IT, education and healthcare sectors. Polish real GDP growth in 2009 was 1.6% and in 2010 was 3.9%. On the other hand, real GDP in Romania – which absorbed only EUR 8.6bn of the EUR 19.1bn Cohesion Policy EU funds allocated to it for 2007-2013 – declined by 6.6% in 2009 and by 1.2% in 2010.

9 October 2014



Poland was the only CEE4 country to register positive

growth throughout the crisis

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14

Euro area avg. Poland

Romania

Real GDP (YoY %)

Source Deutsche Bank, Haver Analytics

However, isolating and accurately estimating the causal impact of EU funds inflows on growth is problematic, a point which has been noted by the European Commission. 8 In the existing academic research, the view by and large is that EU funds increase growth, but only upto a point and only when combined with an effective governance framework. The administrative or governance framework plays a crucial role in a country’s efficiency in translating EU funds inflows into growth, as the administration is responsible for appropriately choosing projects (in the correct sectors) and also managing these projects (Everdeen et al, 2006).9 Further, while poorer countries benefit more from EU funds in general, EU funds also have a decreasingly positive effect on growth. Becker (2012), for example, suggests that EU transfers in excess of 1.3% of the recipient country's GDP do not generate any additional growth.10

Focusing on the case of Poland, the government estimates that Cohesion Policy funds will add 0.7pps to annual GDP growth, on average, over the 2004-2015 period. 11 Additionally, these funds contributed to Poland having the fastest pace of economic convergence within the EU between 2007 and 2011; during this period, the difference between Polish and EU average GDP per capita decreased by 12pps, with government estimates indicating that 20% of this reduction was due to EU funds. The boost to growth

8 See the EU Economic 2004 Review published by the European Commission. 9 See Ederveen S., H.L.F. Groot and R. Nahuis (2006) ‘Fertile Soil for Structural Funds? A Panel Data Analysis of the Conditional Effectiveness of European Cohesion Policy’, Kyklos vol 59(1), pp 17-42, 02, Blackwell Publishing 10 See Becker, S. (2012) ‘EU Structural Funds: Do They Generate More Growth?’, The CAGE-Chatham House Series, No. 3, December 2012. 11 See Polish Ministry of Regional Development manuscript: http://www.europarl.europa.eu/document/activities/cont/201307/20130710ATT69468/20130710ATT69468EN.pdf

via EU funds was primarily driven by the resulting increase in investment (mainly in infrastructure); EU funds are estimated to have increased the investment rate by 3.5pps, also causing a significant reduction in unemployment. We believe that structural funds inflows will continue to provide upward impetus to Polish growth in the upcoming budgeting period, though not as large an upward push as during the 2007-2013 period (when the incoming funds during the crisis assisted Poland in avoiding a recession); the impetus to growth from EU structural funds would be greater if Poland were indeed able to increase its absorption rate.

Polish investment rate (gross fixed capital formation as

a % of GDP, in nominal terms)

Source: Polish Ministry of Regional Development

YoY growth in investment

-15-10-505

1015202530

2004 -Q2

2006 -Q2

2008 -Q2

2010 -Q2

2012 -Q2

2014 -Q2

Gross fixed capital formation (real, YoY %)

Source: Deutsche Bank, Haver Analytics

10) What are the other major EU funds programs, and what is the impact of EU funds on a country’s external balance? In addition to the structural funds provided within the Cohesion Policy framework, the EU also provides funds via the Common Agricultural Policy (CAP). These subsidies are aimed at supporting agriculture and

9 October 2014



building sound and (economically as well as environmentally) sustainable agricultural sectors in European countries. EU funds within CAP are provided via direct payments (mostly subsidies to farmers) and rural development funds. As a result of this policy, Poland will get another EUR 32bn in EU funds during the 2014-2020 budgeting period, while Romania will also get a substantial EUR 20bn.

EU Common Agricultural Policy allocations for CEE4

0

5

10

15

20

25

30

35

Poland Hungary Czech Republic Romania

2007-2013 2014-2020

EUR bn


The inflows of EU funds (structural funds as well as funds from other programs such as the CAP) register as credits in a country’s capital account, and thus lead to an improvement in the balance of payments. As a result of substantial EU funds inflows, Poland has an extraordinarily large positive net capital account; further, EU funds represent a relatively stable source of funding (capital inflows) for Poland and, along with net foreign direct investment inflows, the capital account has financed a significant fraction of the current account deficit (see charts below).

Poland has an extraordinarily large positive net capital

account as a result of substantial EU funds inflows

-2

0

2

4

6

8

10

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Poland Romania Hungary Czech Rep.

Capital Account (EUR bn)


EU funds have enabled a significant fraction of the

Polish CAD to be financed by the net capital account

and FDI

020406080

100120140160180

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Poland

% of CAD covered by net Capital Account and FDI


Gautam Kalani, London, +44 207 545 7066

9 October 2014



Analyzing relative value using Snapshot

There is currently more uncertainty, and less conviction in the EM credit market. While volatility is high and market direction unclear, relative value becomes more important in the sovereign credit market.

Our daily report, the EM Sovereign Credit Valuation Snapshot (or simply the Snapshot), which we created in July 2013 and enhanced a couple of times since then, covers the most important valuation aspects of the sovereign credit market. It is one of the main tools we use to not only monitor market pricing and asset performance but also to analyze relative value opportunities.

We have recently added 16 major quasi-sovereign names in the report covering all three regions, focusing on the valuation of these quasi-sovereign bonds as well as the relative value between these bonds and their counterparts on the sovereign curve.

We introduce these new enhancements and also discuss some relative value themes and opportunities using graphs and data provided in this report.

There is currently more uncertainty, and less conviction in the EM credit market. Valuation has recently improved, but the market will likely continue to face headwinds in the coming weeks. Against this backdrop, we continue to favor relative value while volatility is high and market direction is unclear.

Our daily report, the EM Sovereign Credit Valuation Snapshot (or simply the Snapshot), which we created in July 2013 and enhanced a couple of times since then, covers the most important valuation aspects of the sovereign credit market. It is one of the main tools we use to not only monitor market pricing and asset performance but also to analyze relative value opportunities.

In this article, we introduce some of the latest enhancement to this report, and discuss a couple of relative value themes and opportunities based on the information and graphs provided by the report.

Recent enhancements to the Snapshot

Before discussing the outstanding relative themes and opportunities, we provide a quick introduction to our latest enhancements to the report.

First, it is worth noting that, we have now added a table of contents with full indexing capability to the report. Now it is much easier to navigate to a particular country or ticker in the report by clicking on the corresponding line in the table of contents, or by using the PDF bookmarks.

New feature in Snapshot – table of content with full

PDF indexing


More importantly, we have recently included a number of major quasi-sovereign curves that cover all the three regions. The curves we have covered for now are shown in the table below. We vote one half page for each of these quasi-sovereign names and put them after the sovereign credits (page 24 through 31).

9 October 2014



Quasi-sovereign names included in the Snapshot

Country Ticker Name SectorIndonesia PLNIJ PERUSAHAAN LISTRIK NEGAR UtilitiesIndonesia PERTIJ PERTAMINA PERSERO PT EnergyBrazil BNDES BANCO NAC DE DESEN ECONO GovernmentBrazil CAIXBR CAIXA ECONOMICA FEDERAL FinancialBrazil BANBRA BANCO DO BRASIL (CAYMAN) FinancialBrazil PETBRA PETROBRAS GLOBAL FINANCE EnergyMexico PEMEX PETROLEOS MEXICANOS EnergyMexico CFELEC COMISION FED DE ELECTRIC UtilitiesChile CDEL CODELCO INC Basic MaterialsColombia ECOPET ECOPETROL SA EnergyRussia SBERRU SBERBANK (SB CAP SA) FinancialRussia VTB VTB BANK (VTB CAPITAL SA FinancialRussia GAZPRU GAZPROM (GAZ CAPITAL SA) EnergyKazakhstan KZOKZ KAZMUNAYGAS NATIONAL CO EnergyArgentina BUENOS PROVINCIA DE BUENOS AIRE GovernmentVenezuela PDVSA PETROLEOS DE VENEZUELA S Energy


Similar to the sovereign curves, we focus on the valuation aspects of the bond curves as well as 5y CDS, wherever it is applicable. Due to lack of liquidity on the other tenors, we only focus on 5Y CDS for these quasi-sovereigns. In the following text, we provide some details on these enhancements, both in terms of the content and methodology involved.

Spread curve and cash performance Similar to a sovereign page, we first show the spread curve (cash and CDS, if applicable), overlaid with the corresponding sovereign par curve, as shown in the example below (Pemex). The sovereign par curve is simply a result from our Term Structure Model (TSM)12.

Example of quasi-sovereign spread curve, in

comparison with the sovereign par curve (PEMEX)


12 The term structure model is a bond fair valuation model to identify the richness/cheapness of a bond to the credit (cash) curve and to calculate fair yield for a new issuance. It is based on deriving a term structure of survival probability that fits the market price of the curve as closely as possible, where the term structure is expressed in a parametric form (linear combination of exponential functions) and calibrated via optimization

To the right of this graph, we show two time series with different valuation aspects of the quasi-sovereign bonds. The first is the z-spread of the benchmark (or the most liquid) bonds on the curve. This is typically the 10Y benchmark, with the exception of BUENOS, for which we use the 21s. The second time series is the spread to sovereign curve measure for the same benchmark bond. See the next section for a definition of this measure.

Example of benchmark spread & benchmark spread to

sovereign (PEMEX)


Spread to sovereign curve One of the unconventional measures we employ and show in this report is the so-called “spread to the sovereign curve” for a quasi-sovereign bond (or a corporate bond in general). It is not the relative performance of the bond vs. its corresponding sovereign benchmark bonds – a scheme that is quite widely used among EM corporate investors. Rather, we present the concept of each bond’s relative spread to the sovereign curve. This is essentially the difference between the bonds z-spread over the US Libor/swap curve and the same spread measure obtained assuming the bond is priced fairly on the sovereign cash curve. In other words, we calculate the spread of the bond with the sovereign cash curve implied default probabilities and recovery value (i.e., sovereign curve implied spread), and then take the difference between the market spread of the bond and this calculated sovereign curve implied spread to arrive at the spread to sovereign curve. This spread has been calculated on daily basis and saved in our system so that we can examine this measure for each bond on historical basis.

Bond and CDS valuation Similar to our presentations for a sovereign curve, we provide a table showing the current market pricings and analytics (price, labor spread, and par-equivalent spread for select distressed curves), as well as past 1-day, 1-week, and 1-month changes in the labor spreads.

9 October 2014



The color mapping scheme is the same as for a sovereign13.

In addition, the right-most column of the table shows a range bar chart of the spread to sovereign measure we have defined above, with the light blue area covering the 2% to 98% range of the past one year (mostly for filtering out bad data), the dark blue showing the 25% to 75% range of the past one year, the solid dot indicating the current level, and the little bar representing the median of the past three months.

Example of bond and CDS valuation table (PEMEX)


Slope of the cash curve The final chart for a quasi-sovereign curve is the slope of the cash curve, typically the slope between the 10Y and 30Y benchmark bonds on the curve, or the slope between the 5Y and 10Y benchmarks if the curve is a short one (e.g., BNDES).

13 We apply a 3-color scale: red indicates increases in values, blue indicates decreases in value, and white indicates no change. The density of the color depends on the size of the changes scaled by the average annual volatility across the curve. In other words, the color density indicates how many standard deviations the value has changed.

Example of cash slope time series (Gazprom 10s30s)


Current observations on the quasi-sovereign curves

A glance at the quasi-sovereign section of the current Snapshot reveals some interesting observations.

PERTIJ: long end offers more attractive pickup over sovereign. Consistent with our existing views on the Indonesia complex, the PERTIJ curve is currently on the steep side. While the 10Y PERTIJ bonds are trading only 60p wider than corresponding sovereign counterparts, at the long end it is 80-90bp wider. The 10s30s slope has widened from around 25bp at the beginning of the year to the current level of 75bp, while spreads have been tightening. While we understand this partly reflects the fact the 23s are very expensive to the curve, this nevertheless supports our preference of long end of Indonesia quasi-sovereign curves (especially PERTIJ 44s) for exposure to Indonesia. The main risk to our view is the higher supply risk by the quasi-sovereigns than the sovereign during the remainder of the year.

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PERTIJ curve: 10s30s appears very steep; long end

offers more attractive pickup over sovereign


PEMEX: the curve has cheapened again vs. UMS. Last month, we turned to neutral between Pemex/UMS following a few months of steady convergence of the credit spreads between the two curves to a historically tight level of close to 50bp. We noted that further compression potential would likely be tempered by greater supply risk in Pemex. The spread differential has sharply re-widened over the past two weeks; see the chart below. The move was mostly driven by the higher beta move by Pemex during the recent market selloff as well as by the dual tranche issuances earlier this week (Monday 6-October). At the current level of spread differential of 70bp on average, we see Pemex bonds as having become more attractive once gain relative to their UMS counterparts, especially at the 10Y sector. Specifically, we recommend switch from UMS 23s to Pemex 4.75 24s (also see LatAm Strategy section of this Monthly for a more detailed discussion on this trade).

Pemex bonds have widened out from UMS recently


PDVSA: curve pricing of imminent default risk seems exaggerated. The PDVSA curves, together with the Venezuela sovereign curve, have continued to sell off, but the table below shows an excessive inversion move even at the very front end of the curve, indicating the market is pricing a very high risk of imminent default in this curve. At the shorter end of the PDVSA curve, there has also been significant widening from the sovereign curve. See our LatAm Strategy section in this Monthly for a detailed discussion, but we continue to recommend staying in the very front end of the PDVSA curve (15s) as we believe Venezuela/PDVSA still have the resources and means of meeting its debt obligations next year and the confirmation of payments on both Venezuela 14s and PDVSA 14s this month (which we expect) should alleviate some concerns and give a boost to the PDVSA 15s.

Another obvious observation is the significant underperformance of PDVSA bonds relative to the sovereign curve, especially at the shorter end and the belly of the curve. Spreads to sovereign for most PDVSA bonds are at the very high end of the past year’s range. As market prices out some of the imminent default risk, as we expect, we believe PDVSA spreads will converge somewhat vs. Republic and recommend switching from Venezuela 20s to PDVSA 17Ns (entry: 595bp; target: 400bp; stop: 750bp).

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PDVSA: bond underperforming sovereign; curve

severely inverted


Cash curve trades opportunities14

One of the interesting themes in the relative value space is the steepening of the spread curves over the past few months, largely driven by the bull-flattening of the US rates curves, in our view.

EM 10s30s on average has steadily steepened while

UST 10s30s flattened

Note: the slopes shown are the average of Brazil, Mexico, Colombia, Peru, Panama, Uruguay, Turkey, Russia, South Africa, Indonesia, and the Philippines curves. Source: Deutsche Bank

After some correction in August, many EM 10s30s spreads have re-steepened in September (see graph below). We believe, once again, the main driver is the recent bull-flattening of the UST curve. In the last Rates and Credit Weekly, DB’s rate strategists held the view UST 5s10s steepener should offer asymmetric risk/reward. They see reasons for steeper curves both under a positive macro scenario (due to pick-up in inflation expectations) and a negative one (given the

14 This section is mostly taken from EM Sovereign Credit Weekly of 3-October-14, updated and shortened.

likely delay of the rate-hike cycle). The dynamics of the 10s30s should not be very different from that of the 5s10s given the 5/10/30 fly relationship. So overall, the risk seems biased to some steepening of the 10s30s in the US.

Against this backdrop, we are inclined to think that most low-beta curves will likely flatten in the coming weeks, given that most of the curves are close to the steepest in a year. However, in light of the uncertainty in the US rate outlook, we would proceed carefully and only focus on the curves that are looking excessively steep.

With exception of Russia, most low beta curves are at

or close to the steepest in a year


In the following table, we present the 10s30s slopes of major curves in comparison with the slopes that are expected from the cross-sectional relationship as well as from historical relationships (past 1Y). We have highlighted the ones that stand out as excessively flat (e.g. Russia) and excessively steep (Brazil, Indonesia). We note that in the case of the Philippines, while, in terms of cross-section, it is clearly much flatter than the rest of EM, it is less obvious based on historical data. This is because this curve has been quite flat for a long time.

9 October 2014



10s30s curve slope vs. expected from cross-sectional

and historical relationships


The picture depicted in the table above is also consistent with the cross-sectional graph we have in our Snapshot, shown below.

EM 10s30s slope vs. 10Y spreads cross-sectional graph

in Snapshot

`


Based on the analysis above, we have the following recommendations

Brazil 10s30s flatteners. We see 10s30s in Brazil as excessively steep and recommend 41s vs. 25Ns in Brazil (entry: 61; target: 45; stop: 70). We believe Brazil 5y CDS and 30Y bonds fully price in the scenario of Dilma’s victory in the election, while 10Y bonds look relatively expensive in this context.

Russia 10s30s steepeners. We hold our existing recommendation of Russia 10s30s curve steepners (22s vs. 42s) at the current level of -3bp, keeping the target at -25bp.

Brazil 10s30s curve in Snapshot (curve just off recent

wides)


Russia 10s30s curve in Snapshot (curve remains very

flat)


Long-end Peru looks expensive. While less obviously a candidate for steepeners, Peru’s 10s30s curve is nevertheless flatter than comparables. Peru 10s30s has significantly lagged the recent steepening move in rest of EM, with the bonds at the long end of the curve significant outperforming their peers following the recent upgrade by Moody’s to A3. Investors on Peru focus mostly on the long-end given their better liquidity, but valuations of those bonds look stretched at the moment, especially in light of the sharp deterioration in Peru’s growth dynamics on lower demand from China and lower commodity prices. We believe the bonds at the long end of Peru curve as expensive relative to its peers, such as Colombia and Brazil – we recommended switching out of the 37s to Brazil 41s last week. The positive has moved by 20bp in our favor but we expect some further convergence.

9 October 2014



Peru 10s30s has bucked trend and been flattening until

just a couple of days ago


Peru 37s are retracing their richness to Brazil 41s


Cash switch opportunities based on rich/cheap analysis

Rich/cheap analysis for major sovereign curves using the table at the left of the “Bond Valuation and CDS/Bond basis” section of the report is quite straightforward. The following graph shows this table for Hungary. As we discuss in the EMEA Strategy section of this EM Monthly, Hungary 21s stand out as the cheapest bonds on the curve, and especially cheap to the 19s; we recommend switching from the 19s to 21s in Hungary (entry: 41bp; target: 20bp; stop: 50bp).

Similarly, in Poland, we find that the 22s have recently moved significantly cheap to the curve, while the 19s and the 23s are relatively expensive. We recommend switching from the 23s to the 22s in Poland at the current spread differential of 20bp, target 5bp.

Rich/cheap analysis in Hungary and Poland


… and in Hungary


Hongtao Jiang, New York, (1) 212 250-7530 Srineel Jalagani, Jacksonville, (1) 212 250-7530

The authors of this report would like to acknowledge the collaboration by Salil Rajpal and Jayanth Gupta, employees of Evalueserve, a third-party provider to Deutsche Bank of offshore support services

9 October 2014



Asia Strategy

The past month has been a tough one for emerging markets, and for many a reminder of the early part of taper tantrum from summer of last year. In typical EM fashion, correlation between rates and FX has gone up in the selloff, though the bulk of the adjustment has been borne by currencies this time. Suppressed bond yields in the developed markets have helped buttress some of the fallout on rates. Asia has been noticeably absent from the bottom half of EM performance, with the exception of Indonesia, where the drawdown has been driven to a large extent by a worsening picture on local politics. North Asian currencies have done somewhat worse than South Asia (again, excluding Indonesia), which can largely be put down to their greater sensitivity to EUR and JPY weakness, and arguably greater exposure to a slowing China. South Asia, in contrast, has benefited in a relative sense from improved external positions, better valuations, and tighter mix of policies.

A continuation of the themes from over the past month will set investors up for an increasingly bearish EM construct into end of the year. Asia, we believe, will continue to hold its own relatively well in such an environment, given its more positive beta to lower commodity prices, and significantly reduced political risks. Besides, valuations for most currencies in the region are close to the lows from over the past 18 months. As before, we do not see value in fighting the broad dollar trend, but instead stay with our preference for relative value trades – CNH versus KRW, and INR versus SGD. We find MYR the most optimal direct expression of our long USD bias, with also some residual long USD exposure against SGD via options. Given that the broader fixed income scenario is only reluctantly getting incrementally bearish, we stick mostly with value in idiosyncratic rates stories (India, China) and defensive longs (Thailand, Singapore vs. US). We also suggest a couple of tactical short rates trades in Malaysia (5Y swaps) and Korea (10Y KTBs).

We have a more constructive view on credit. Overall, we believe that the recent sell-off is an opportunity to add risk on Asia Sovereign credit into the year-end. Political headlines in Indonesia will most likely be preoccupying investor’s minds in October. We see reason to remain hopeful on Jokowi’s ability to deliver even though downside risks are on the rise. We recommend OW positioning in INDO sovereign dollar credit via cash and/or CDS. We maintain our bullish stance on Mongolia’s credit and have changed our bearish view on China CDS to Neutral.

Local Markets

CHINA

— FX: Long CNH/KRW, target raised to 180

— Rates: Modest overweight

Value in cash CGBs. We believe the relaxation of mortgage policies and loosening of financing conditions for property developers is the latest part of targeted easing policies aimed at boosting property sector demand in Q4. It suggests financial regulators are keen to lower corporate financing costs, one of the key tasks in H2. PBoC’s statement for the Q3 MPC meeting further affirms our view that policy accommodation will be maintained for the remainder of this year. This will anchor market expectations for a continuation of targeted easing policy and we maintain our bullish view on cash CGB bonds. We expect money market rates to settle in the 2-3% range. To effectively lower mortgage rates and financing costs for property developers, we believe it is necessary to ensure cheap and stable interbank funding costs by commercial banks, which implies that the range of money market rates may shift lower. We expect the overnight repo rate to settle within the 2-2.5% range and the 7D repo fixing rate at between 2.5-3%. We favor a steepening bias on the cash CGB curve. We believe the front end of the IRS curve has priced in our expectation of money market rates and we retain our view that relative value between the cash and IRS curve suggests cash CGBs offer value, particularly at the short end with flush liquidity support and with potentially concentrated demand from offshore investors under the RMB QFII and interbank bond market access programs. We prefer to trade IRS curve with the view of receiving on selloffs.

HONG KONG

— FX: Neutral

— Rates: Neutral

HKD strength to persist. Since the start of the protests (on 22 September), the Hang Seng index traded down as much as 6.3% before bouncing back 4.3%. USD/HKD meanwhile reached a high of 7.77 before moving lower to 7.76 as of the time of writing. We see the price action as consistent with the assessment that the protests will be temporary, and that markets, while being cautious, are not in panic mode. We remain of the view that USD/HKD will continue to trade at the lower range of its band (7.75-7.80) for a few reasons. First USD/HKD tends to face downside pressure at this time of the year due to corporate repatriation ahead of

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the tax season beginning around October. Around 65% of the government’s revenue is received in 4Q and 1Q of each fiscal year. Second, the recent RMB weakness has also dented retail demand for RMB, which lowers the pressure on HKD. Third, the strong demand for HKD tightens domestic liquidity, resulting in a rise in HKD interest rates. 3M HIBOR has traded persistently above the 3M USD LIBOR since last year, and the gap has been widening very gradually over 2014. Part of this is due to the excessively loose US monetary policy, but the recent increase in demand for HKD has exacerbated the issue and triggered the need for the HKMA to step in and defend the band. In addition, the recent liquidation of equity positioning in HSI would also result in tightening HKD liquidity, resulting in a higher HK interest rates. This consequently helps stabilize outflows and the currency. Only a significant deterioration in the current situation would possibly trigger capital outflows, or a particularly negative market reaction. What might be a bigger risk for markets is, as our Chief Economist Michael Spencer points out (see An economic commentary on Hong Kong’s protest, 2 October 2014), if China were to feel rather less disposed towards expanding its use of HK as a testing ground for capital liberalization. Given the current tightness in CNH liquidity, the unwillingness of China to open up more flow channels into HK would keep the CNH curve steep. In addition, the establishment of financial connections with other nations such as Singapore could hurt HK’s financial competitiveness, which could affect its GDP as the service sector makes up more than 75% of GDP growth, with the financial sector contributing about 20%.

INDIA

— FX: Short 6M SGD/INR, target 46

— Rates: Long 10Y IGBs, target 8.25%

Among the best picks in EM. India to our mind is still among the best carry-vol prospects in EM, having arguably made more progress than any of its erstwhile 'Fragile 5' peers in managing its imbalances, and reducing tail risks. The turnaround in India's current account has been impressive, with the deficit more than halving from its peak. And this compression is likely to endure, given that the restrictions on gold imports are being kept in place. The Prime Minister's political honeymoon remains in play, with his attempts to cut down the bureaucracy surrounding decision making, and his pitch in particular for global investment into India likely to be key in driving FDI and offshore interest in government disinvestments. We would look to these two sources of capital to maintain the run rate on flows, even as portfolio inflows slow down, especially into debt markets which are closing in on the limits. The two other big winners for India are its positive beta to lower commodity prices, and the gain in credibility for its central bank. While the latter's

resolute stance on policy rates limits the scope for further gains on duration, it should be positive for the long term value of the rupee if it manages to break inflation down. Our main concern on India is that the good news is widely internalized by markets. Indeed, the scale of offshore positioning via NDFs and cash bonds/offshore derivative structures has gone up significantly in the last few months, though we would argue offset to some extent by more recent spec short INR exposure (as per our dbSelect indicators), and lack of positioning in onshore markets. There is the wider EM beta to consider in an environment of broadening dollar strength. And the marginal worsening of technicals in bond markets following the reduction of HTM ceiling (and cut in SLR) by RBI. Finally, it would be prudent to keep a close watch on a couple of key state elections this month, which will be a comment on the ability of PM Modi to sustain his initial momentum. Given also that the central bank is unlikely to yield on rates anytime soon, we are reluctant to add further to exposure on IGBs (while staying with our current overweight). We also stay long INR, but as a cross against SGD, rather than funded in dollars.

INDONESIA

— FX: Neutral

— Rates: Market weight

Most like other EM. We had been wary all this while of the fractured nature of polity left behind by the contentious elections from earlier this year. But even we have been surprised in the tenacity shown over the past few weeks by the coalition surrounding General Prabowo, called Koalisi Merah Putih (KMP), in rejecting overtures from the winning combine of Jokowi-Kalla (except for PPP), and in their determination to control (and divide among themselves) important levers of power. Indeed, this has effectively driven a wedge between the incoming Executive and Legislative wings of the government, and left in its wake an increasing likelihood that any move from the Jokowi administration to pursue much needed policy reforms will be met with stiff opposition. Unless Jokowi were to pull off a last minute surprise - talks with the Democrats, for example, are still in a state of flux - before his inauguration on the 20th, his political honeymoon seems increasingly at risk. And puts the focus more than ever on two key issues - the choice of his Cabinet (and whether it can defy the compulsions of coalition politics), and the decision on cutting back fuel subsidies. The economic case on the latter has been compelling for a while, and in particular recently with consumption of subsidized fuel closing in on legislated limits. The hurdle meanwhile, we fear, has shifted higher, and the market would be disappointed with anything less than a swiftly executed price hike of between Rp2000 to 3000 per liter. If on the mark, however, such a move would be a key lifeline for the

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macro backdrop facing Indonesian assets into 2015. An increase towards the top end of this range could shave off up to 1.5ppt of GDP from the current account deficit, and free up 10-15% of the fiscal spending budget, not to mention a significant dent into energy mispricing as a key source of suppressed inflation in the economy. The fuel price decision becomes therefore a key digital risk in the near term. Away from that, Indonesia looks most like other EM from among its Asian peers, and in particular because of its structural exposure to commodity terms of trade, and its vulnerability to capital flows because of limited market depth. To be sure, we are likely past the worst on external deficits. And the central bank's credibility is an important positive differentiating factor from back in the summer of 2013. But one cannot wish away the headwinds ahead. We are at market weight on both currency and duration ahead of the fuel price decision, and given the high negative cost of carry, and that supply will run out soon. Once past this event risk, however, we would consider opening up a more active underweight for next year.

MALAYSIA

— FX: Long 3M USD/MYR NDF, target 3.35

— Rates: Pay 5Y swaps at 4%, target 4.20%

Structural pressures for rates to grind higher. KLIBOR remains elevated not just due to rate hike expectations, but also due to structural reasons, particularly influenced by banks’ Basel-III requirements. CD funding rates are rising as banks prepare for the Basel-III requirements. Meanwhile, PDS issuances this year has been growing at roughly twice the pace seen last year, partly owing to the rise in Basel-III related issuances. Banking system deposit growth has fallen considerably and the competition for deposits is now growing. This overall dynamic i.e. Banks’ Basel-III requirements and increasing competition to attract deposits will continue to keep interbank rates at relatively elevated levels. Meanwhile, inflation bugaboo will raise its ugly head next year towards the GST implementation in April, quickening to 5% for a month or two. BNM kept the policy rate unchanged in its last MPC in September, but the rate normalization cycle is not yet over. The central bank is still closely monitoring risks of financial imbalances. Whereas, assuming the 'new normal' for the spread between the 3M Klibor and the overnight policy rate, swap curve is only pricing in less than a 25bp hike over one year period. With 3M Klibor at 3.74% and potentially grinding higher, and 5Y IRS at 4%, there is very little risk-premium priced into the curve. We recommend paying 5Y swaps, targeting 4.20%, and stop at 3.94%. We do not see much juice in MGS at current levels, especially with Klibor expected to remain elevated, and 10Y UST yield already at YTD lows and expected to gradually push higher. Based on our template for the 10Y MGS, ‘fair value’ is around 4%.

Indeed, the onshore community (local real money and banks/PDs) mentioned in our recent visit to Malaysia that current levels are not compelling for them. As such, the onus remains on the offshore community to keep the market supported at these levels. Meanwhile, the markets will have to absorb higher net supply going into next quarter. Supply outlook was very supportive in Q3 with almost zero net issuance, but MGS and GII net supply would be higher in Q4. Moreover, net PDS issuance also tends to be higher in Q4.

PHILIPPINES

— FX: Buy USD/PHP on dips

— Rates: Modest underweight

Blemishes build on a former EM moon. A significant current account surplus and ongoing tightening in monetary policy should have placed PHP in the “good” EM category. However, the PHP has been underperforming its surplus Asian peers since mid-2013. The current account has generally remained healthy, but balance of payments woes have come in the form of the financial account, where large portfolio and other investment outflows have been seen this year. This trend suggests some reversal of the dramatic inflows Philippines received in these categories over 2010-12 when foreign appetite was high for her internally reformist, externally strong story. Now however, overvalued equities are no longer attracting foreign interest, the need for tightening has kept bonds out of favor, and money has been leaking out of PHP in the "currency and deposits” category suggesting some domestic dollarization is underway. The basic balance position (current +financial account) in the past four quarters has fallen to levels last seen during the 2008 crisis when USD/PHP traded above 48. Monetary policy tightening has also failed to add much support to the PHP. Despite recent hikes, real rates remain in deep negative territory with real 2 year yields the poorest in the region. Although the BSP could still adjust SDA rates this year, our economists believe policy rates will not be hiked till next year. Politics has also turned murkier. The President’s popularity has fallen after recent fiscal scandals, and his government’s relationship with the Supreme Court has deteriorated. The reform impulse, which already appears to have turned, would not be helped by greater policy gridlock. Worryingly, over-easy monetary policy settings and the maturation of the reform-rerating cycle are both features that Philippines shares with the Indonesia of three years ago. The PHP also offers little incentive from valuation or carry. Along with SGD and CNY, PHP remains one of the most overvalued currencies in the region, and after SGD, TWD and JPY is one of the lowest yielders. With blemishes building, the PHP will have less insulation from the broader USD cycle. We would use any breather in the USD uptrend, to build long USD/PHP positions.

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SINGAPORE

— FX: Stay long USD/SGD via 1.2750 digital calls. Short SGD/INR, target 46.

— Rates: Receive SGD 2Y3Y IRS versus USD, target +75bp

MAS to stay on hold, but don’t hold SGD. We expect MAS to remain on hold at their semiannual policy meeting next Tuesday. Headline inflation has admittedly eased sharply, but the main target variable for monetary policy is core inflation – which authorities still project will stay elevated at 2-3% because of domestic cost pressures. This would be consistent with retaining a 2% p.a. appreciation bias to the SGD NEER. However, we have been challenging the long-standing logic that MAS’ policy bias is a reason to be constructive on the SGD. First, SGD NEER itself is no longer trading near the top end of the band. Reserves, including the forward book, have been declining. While this is partly attributable to FX valuation effects associated with a stronger USD, MAS has likely also been supporting the SGD NEER at the mid-band. This adds to our view that MAS intends to remain on hold next week, as whenever they have allowed NEER to fall below the mid-band, they have subsequently gone on to ease policy. We remain biased to be short the SGD, against the USD and against favored intra-regional longs like INR. Our bearish bias on the SGD stems from a combination of extreme overvaluation, high sensitivity to USD strength, and a softening property market. SGD remains one of the most overvalued currencies in the world, and with others in the group, like NZD finally yielding to valuation pressure; the SGD is unlikely to remain immune. Unlike during the taper tantrum, when the EUR and JPY actually strengthened, this episode of USD strength has seen the EUR and JPY at the forefront of losses. Importantly, SGD has historically had greater sensitivity to G10 low yielders given their high weighting in the basket. USD/SGD is trading near a critical technical level, with 1.28 having acted as a strong resistance in the past. We are also near breakout levels from the pair’s three year long triangle formation. While SGD may consolidate in the near-term around the MAS review, and if the USD rally takes a breather, our medium-term view is for a decisive breakout higher in USD/SGD. We thus retain our in-the-money USD/SGD 1.2750 digital call position.

SOUTH KOREA

— FX: Long CNH/KRW, target raised to 180

— Rates: Sell 10Y KTBs below 2.8%, target 3.1%

Defying gravity. The combination of a BOK rate cut at the October MPC and a possible subsequent rally in the 10Y KTB below 2.80% would be an opportunity we feel to go short. Into end of the year, the prospect of higher UST yields, the lack of participation of local prop desks,

the risk of profit taking in foreign 3Y KTB futures net long positions and a persistent weakening in KRW suggest the risk-reward is in favor of being short rates. The market is fully pricing in a 25bp rate cut, and possibly even more in the long end. Level and timing are of course key to positioning for short rates. Our base scenario is that the BOK is likely to cut the policy rate to 2.0% at the 15 October MPC. Otherwise, the expectations of a rate cut will be transferred to the November MPC, which will postpone potential profit taking too. At the Congressional BOK audit this week, the overall tone of the BOK was not as dovish as to suggest multiple rate cuts. As expected, the independence of the BOK, household debt and the probable downward revision of economic forecasts were intensely questioned by the Congressmen. Our read is that while the BOK is willing to coordinate on macro policies with the MOSF to some extent, but it remains cautious about the side effects of a policy rate cut. We don’t think the central bank would favor going deeper than 2%. On the FX front, over the past few months, flows into Korea have been strong, owing to its external balance, valuation and inflows. However, these trends are running out of steam. And portfolio flows too are starting to reverse. In the past few weeks, foreign investors have withdrawn about $1.5bn and, given our equity teams’ cautious outlook, more outflows are likely. In addition, we also see more evidence of domestic investors diversifying into overseas assets in view of the low levels of return in Korea. Another reason for our bearish view on the currency is Korea’s FX policy. Given the weakness in the domestic economy and the lackluster performance of its exports, the authorities have been more active of late in curbing KRW appreciation, as suggested by the increase in FX reserves. After adjusting for valuation changes, we estimate that authorities have bought about $41bn in spot and forward markets over the past five months. And this could continue for two reasons. First, the rhetoric from both the central bank and the government has shifted towards a distinctly more dovish policy stance, including introducing a string of stimulus measures. We believe it would be rather incongruous for the authorities in that instance to permit further FX appreciation at a time when the bias seems to lean towards supporting the economy. Second, the recent rapid JPY depreciation is becoming a concern for the authorities. We stay long CNH/KRW 6M NDF, and raise our target to 180, while moving our stop to 168, slightly above our entry level.

TAIWAN

— FX: Neutral

— Rates: Neutral

Currency weakness preferred. Similar to its Asian peers, following the negative shift in risk sentiment, Taiwan equity market experienced a $2.7bn of equity outflows

9 October 2014



in September. This subsequently resulted in the currency weakening by just over 2%. Strong global headwinds we suspect could cause further foreign equity outflows in the short term. Apart from global conditions, domestic factors such as (1) the ongoing concern that KNT could lose majority in the upcoming local election; and (2) unfavorable tax implementation in 2015, would also affect flows. Following the recent loosening of investment regulations, we note that foreign asset investments activities of Lifers are also starting to pick up. Lifers bought about $9.3bn of foreign asset in July- August. However, TWD weakness is not just a function of overseas investments but also possibly USD buying by the CBC. After adjusting for FX valuations, we estimate that it bought about $4bn in September. This is one of the largest interventions since August 2010. The CBC’s cautious stance is driven by Taiwan’s still-fragile external sector recovery while inflation is benign. In addition, with China’s economic growth momentum slowing down, the Taiwanese authorities are likely to prefer a weaker TWD.

THAILAND

— FX: Neutral

— Rates: Modest overweight

Defensive long. We continue to favor Thailand as a defensive long in our cash bond portfolio, especially given our view of gradually rising US rates. Growth continues to weaken as attempts by the military regime to revive consumption and investment is yet to provide a boost to the economy, while trade remains in contractionary territory. Inflation is benign and BoT’s latest proposal to switch its policy target from core to headline inflation just adds to a firmly accommodative bias. The current 2014 target for core inflation is ‘0.5 to 3%’ (latest core CPI at 1.73%), whereas target range for headline inflation is proposed to be ‘3 ± 1.5%’ for next year. This will put the lower end of the inflation target at 1.5% versus latest CPI print of 1.7% and BoT’s 2015 inflation forecast of 2.1%. Arguably this consideration is not very new and the central bank had proposed this change earlier as well, but if approved this time it certainly allows the central bank to maintain its accommodative bias for an extended period. The supply outlook for Loan Bonds in FY15 is supportive. Arguably, 'Bond Switching' will define the effective quantum of ThaiGB supply in FY15, but, even if the debt office decides to switch the entire amount of ‘LB155A’ into longer dated bonds, this would still put issuance at no worse than the average of the last three years. Our base case projection is for an overall net issuance and $DVo1 supply to the market being similar to FY14. Demand outlook is fairly robust, with flush onshore liquidity and given that offshore buying has more to catch-up. The liquid assets of commercial banks are rising as banking deposits continue to grow and loan growth is moderate. BoT is absorbing more than THB600bn in excess

liquidity each day via its open market operations. Meanwhile, AUM of both domestic Lifers and Mutual Funds continues to grow, keeping plenty of cash with the locals ready to be deployed. In terms of valuations – Thai curve is still very steep, especially in the context of a central bank firmly on hold. Correlation to US rates has broken down amidst the back-drop of dominating domestic factors/technicals. Against this backdrop, we remain overweight ThaiGBs in our portfolio.

Sameer Goel, Singapore, +65 6423 6973 Swapnil Kalbande, Singapore, +65 6423 5925 Perry Kojodjojo, Hong Kong, +852 2203 6153

Linan Liu, Hong Kong, +852 2203 8709 Mallika Sachdeva, Singapore, +65 6423 8947

Kiyong Seong, Hong Kong, +852 2203 5932

9 October 2014



Credit

Overall, we believe that the recent sell-off is an opportunity to add risk and remain constructive on Asia Sovereign credit into the year-end. Expect no major surprises on the new issues from the sovereigns, while on the quasis’ level we still think that Indonesia and South Korea entities would be likely visitors in the primary. Political headlines in Indonesia will most likely be preoccupying investor’s minds in October, given the Presidential inauguration and formal election of the new cabinet. Together with our Indo equity strategy colleagues we do believe there are reasons to remain hopeful. We view Indonesia displaying visibly more stable-to-improving fundamental metrics vs. Brazil, Turkey and South Africa and recommend an OW via cash (more in the long end) and CDS. We also maintain our bullish stance on Mongolia’s credit and changed our bearish view on China CDS to Neutral.

CHINA

— Credit Neutral

— Reduced Buy CHINA 5Y CDS to Neutral, awaiting clearer signals

Our call to use China 5Y CDS as a hedging tool worked out well in September. It has materially underperformed during the month that proved to be challenging for credit risk in general, but also was coupled with increasingly mixed economic data coming from China. Given the degree of China 5Y underperformance, we believe that the likelihood for it to widen further is somewhat low. We believe that the CDS will stabilise at current levels or tighten slightly as we remain constructive on credit risk into the year end. We recently reduced our Buy recommendation on China 5Y CDS to Neutral awaiting further signals from both primary corporate bonds market and China macro. Such potential factors as excessive bank sub-debt issuance, post-PIMCO management changes risk repositioning, and continuous “below the market expectations” data releases by China, could negatively impact CDS valuations. Should China 5Y CDS trade down to around 70bp (currently trades at ~85bp) we would be likely buyers of protection, but should it widen to above 100bp, we might look to sell it. Key risks: (in addition to those mentioned above) materially stronger economic data, positive ratings action, and a lack of primary supply by SOEs and state-owned banks.

CHINA 5Y CDS u/performed Itraxx in Sep., bp

60

70

80

90

100

110

120

130

140

150

Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14

Itraxx IG CHINA 5Y

Source: Deutsche Bank, Bloomberg Finance LP

INDONESIA

— Recommend Overweight;

— Sovereign cash looks more attractive on the long end, given spread underperformance;

— 5Y CDS presents good value here: SELL;

— Viable RV proposition vs. our UW call on South Africa

Indonesia sovereign curve and CDS have visibly underperformed many of their Asian peers and the degree of the spread widening presents, in our view, an opportunity to get long the risk in Indo. Such an opportunity, in our opinion, is well underpinned by the stable-to-improving macro indicators vs. such EM peers as Brazil, South Africa and Turkey, which will become more prominent as the countries enter 2015 when the new policy and reform decisions taken by the newly elected (or re-elected) governments and presidential cabinets in these countries will start bearing fruit. For the good part of 2014 Indo cash and CDS have been perceived as a “safe haven of EM” in the wake of increased geopolitical instability in Eastern Europe, which was also supported by the relative stability of it economic performance. However, the latest pricing action tells us that Indo risk has been trading weaker in sympathy with that of Brazil, which we believe is unwarranted. We would expect Indo spreads to decouple from those in Brazil and regain the momentum, especially in light of continued negative headlines from Russia/Ukraine. Conversely, should Brazil’s political game surprise on the upside, the subsequent rally of Brazil’s USD asset prices would drag Indo alongside, especially considering INDO 5Y CDS underperformance of late vs. Brazil 5Y CDS.

9 October 2014



We presented a comprehensive fundamental comparison of the main economic indicators for Indo vs. Brazil, Turkey and South Africa in our recent Asia Credit Monthly (please follow this link: https://gm.db.com/servlet/ShowContent?ResourceType=S&ServerLocation=1&ResourceId=1775172) whereby Indo is the net beneficiary of the changes throughout 2014 YTD. Our economics team also remains confident in such vital factors for Indo as CAD and CPI into 2015 and 2016 with the only vulnerable point being local currency exchange rate against USD. And all this assumes no meaningful upward fuel price adjustments. The negative impact from a potential further IDR depreciation could be more prominent for local corporate balance sheets, which still could be partially offset by gradually recovering global commodity prices in 2H15 (coal, iron ore, nickel and zinc).

Economic performance is, of course, only one part to any decision making process, while the other one is about politics, which ultimately are closely intertwined. The latest news on Jokowi’s coalition still falling short of 50% threshold does present a serious setback in the deliverability of the future reforms package, but still should not be taken too negatively. According to our Indonesia equity strategists, reforms could still be done at government level and infrastructure spending spearheaded through SOEs, where major decisions do not have as much parliament intervention. After an extended period of screening, an announcement on the Cabinet formation is expected by mid-Oct. Thus far, there are reasons to remain hopeful. A bold decision on fuel price hike would be construed as decisive leadership in our view; a Rp2-3k/litre hike (+30-46%) by early Nov and cap the subsidy, would be the other much needed prerequisite. The main downside risk, in our view, at this stage remains the political stalemate that Jokowi’s opposition could induce should Prabowo’s personal ambitions get at the centre stage before the national interests.

At this junction, Indonesia’s economic stability appears to be more palpable, which, in combination with the recent negative correction of its cash bond spreads and CDS called for an upgrade of our Neutral view on this credit to Overweight. The 10Y30Y spread slope still remains steep, despite underperformance of the belly in September. We recommend adding Indo risk more via the long-dated bonds (37s, 42s, 43s, 44s), but INDON '21 and '22 also have value here. We recommend Selling INDON 5Y CDS with the target of 145-150bp (currently ~170bp) and a stop-loss of 180bp. Key risks: negative ratings action for Indonesia, aggressive new issuance by quasi-sovereigns, a drop in the global commodity prices, Fed-related sentiment deterioration, and Jokowi failing to pursue budget reforms.

Viacheslav Shilin, Singapore, +65 6423 5726

https://gm.db.com/servlet/ShowContent?ResourceType=S&ServerLocation=1&ResourceId=1775172

9 October 2014



EMEA Strategy

In FX, we switch out of long TRY/ZAR having hit our revised 4.95 stop (+1.2%), and into long TRY/ILS in order to capture favourable October seasonals and attractive carry in the Lira. We stay short ILS vs USD, and move the target to 2.7750 (3.70) and stop to 3.65 (3.58). While we were stopped out of our short USD/RUB from Sep 2nd (rvsd stop 37.85, -1.1%), we recommend a 1m EUR/RUB put with a strike at 48.10 for an indicative 11bps of EUR notional (ref rate 50.45). We also maintain long PLN/HUF. Target remains 78.50, with a revised stop @ 73.15 (73.65).

In rates, and despite the richness in absolute terms, we continue to favor trades with attractive carry which at the same time provide protection against a selloff in US rates. Enter steepeners in Israel (2Y fwd 1y rate vs 5Y5Y IRS), South Africa (1Y vs 5Y5Y) and Turkey (1s5s XCCY). In Hungary receive 3x6 FRA, underweight the belly in a 1s2s5s butterfly and enter longs in 5Y vs PLN. In Poland pay 3x6 FRAs to position for less easing than currently priced whilst keeping 2s10s flatteners in IRS to benefit from additional liquidity provided by the ECB. In Czech remain short in May24 vs Germany and Poland while keep paying 2Y XCCY in Russia. Enter BE wideners in Israel (April-18) and Poland (short end) and tighteners in Turkey (Apr20 and May23). In government bonds overweight the belly in Hungary (Apr18 and Jun19) and South Africa (Dec18), the long end in Poland (Oct-23) and on the domestic RV front Jun16 vs Jan20 in Turkey and Apr17 vs Mar18 in Russia.

In credit, we tactically covered underweight on Russia while retaining a bearish view on the fundamentals and remaining skeptical on the long-term solution to the conflict. We stay neutral on Ukraine. We stay overweight Turkey and Hungary but reduce to underweight on South Africa (on fundamentals concerns) and stay underweight Poland (on valuation). In relative value, we recommend switching from South Africa 41s to Indonesia 44s, maintaining 10s30s curve steepeners in Russia (22s vs. 42s) and 5s10s flatteners in Hungary (24s vs. 19s), switching from 23s to 19s in Hungary, and switching from 23s to the 22s in Poland.

Local Markets

CZECH REPUBLIC FX: We are long a basket of BRL and MXN vs short CZK and HUF, but adjusted the weights in the FX Blueprint on Sep 23rd (from 50/50 to BRL 30% & MXN 70%) vs. Equally short CZK and HUF. Currently trading @ 13.12. Target 13.90, with a stop @ 12.90.

Rates In rates remain duration neutral while in government bonds remain short May24 at 1.13% vs equally weighted longs in 10Y Germany/Poland (Oct23) - current spread: 88bp / target 50bp / stop 125bp

Rationale: Despite downward revision to the final 2Q GDP print, some recent weakness in sentiment surveys and a disappointing 2Q current account balance the healthy and broad based economic recovery remains intact. Another strong PMI reading well above 50 and a continuous gradual decrease in the unemployment rate further support economic activity and should at least for now overshadow geopolitical uncertainty around Ukraine/Russia. As highlighted in the previous EMM low inflation pressure should keep rates depressed going forward, but the likelihood of the CNB raising the EUR/CZK floor (27) has diminished after July and August saw inflation slightly above expectations.

Given record low rate levels, almost no carry, and market’s rate expectations priced more or less in line with DB forecast we see receivers as unattractive. On the other hand we also don’t expect any increase in volatility to move short end rates up given suppressed rates levels in Europe and the continuous low inflation pressure. Nevertheless as a cross country trade we recommend to underweight the long end vs Poland and Germany. Investors search for a yield pickup preferring countries with a rather limited sensitivity to normalization in US rates makes a long position in Poland attractive. In addition Bunds in Germany should further benefit from a broad-based asset purchase”-programme by the ECB. On the other hand the flattest yield curve in over 5 years, a pickup of only 20bps vs. Bunds, tight swap spreads and the FX floor vs a weakening Euro makes investments in Czech in particular for non-European investors less attractive.

9 October 2014



Czech - position for underperformance in long end vs

Germany/Poland

-40

-20

0

20

40

60

80

100

120

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Oct/10

Jan/11

Apr/11

Jul/11

Oct/11

Jan/12

Apr/12

Jul/12

Oct/12

Jan/13

Apr/13

Jul/13

Oct/13

Jan/14

Apr/14

Jul/14

Oct/14

10Y Czechequally weighted 10Y Germany/PolandSpread rhs in bps


HUNGARY FX: Bearish bias. HUF overbought after prospects of QE in the Eurozone encouraged capital inflows over the past couple of weeks.

Rates: In money markets receive 3x6 FRA at 2.14% / In IRS keep paying the belly in a 1s2s5 butterfly and enter longs in 5Y vs Poland / In government bonds overweight Apr18 at 3.02% vs Nov17 at 2.55% and Jun19 at 3.52% vs Dec18 at 3.23%.

Rationale: On the economic front surprisingly strong activity data, multiple year lows in the unemployment rate and robust sentiment surveys point towards a relatively strong economic recovery in Hungary. Despite concerns about low spot inflation the NBH’s dovish monetary policy including rate cuts to new record low levels, robust economic activity, the weakness in the forint and administered price cuts falling out of the basis should lead to a gradual increase in underlying price pressure over the upcoming months with headline inflation reaching the NBH’s target of 2.5% by mid-15. Following NBHs comments that the easing cycle (most likely) have come to an end markets priced out any further rate cuts and now expecting with 6bps of hikes by end-14 and another 25bps of hikes in 2015 a rather moderate hiking cycle.

We keep our monetary policy view that the positive external environment will lead to a NBHs on hold until at least Q2-15 and would not rule out further near term easing in case of weakness in growth in the Euro-area, an increase in geopolitical tension in Russia/Ukraine and a favorable domestic inflation picture. This speaks in favor of receiving 3x6 FRA at 2.14 with target 1.9 and a stop at 2.30. However, regardless of further easing we expect a more aggressive unwinding of the rate cuts in the second half of 2015 which makes underweighting the 2Y sector in either a 1s2s

steepener (target 30bps / stop 5bp) or a 2s5s flattener (target 40bps / stop 80bp), our favorite position. Despite our fundamental view that Hungary is the most sensitive of the CEE countries to a normalisation in US-rates even in case Euro-rates remain suppressed we see – given the recent weakness and investors search for yield - attractive risk/return opportunities in the belly of the curve and enter longs vs. PLN in 5Y sector (target 50bp / 100bp stop) and an overweight in Apr18 and Jun19.

ISRAEL FX: We stay short ILS vs USD, and move the target to 3.7750 (3.70) and stop to 3.65 (3.58).

Rates: Keep receiving 2Y fwd 1y rate vs 5Y5Y in IRS. Keep B/E wideners in ILCPI April-18 at 1.25%.

Rationale: On the economic front we saw another month with declining sentiment and activity data in combination with a disappointing inflation print driving headline CPI into negative territory for the first time since 2007. With rate cuts pushed to the limits, a weakening domestic economy, expected negative inflation prints in the near term and a further decline in the medium term inflation expectations well below the BoI target of 2.0% an FX intervention including a Swiss/Czech FX floor getting a more and more likely scenario.

However, regardless of further action by the BoI, on the rates front we see current valuation as very attractive to benefit from the ECB vs FED ’tug-of-war’. Despite attractive carry opportunities for receivers in the short end of the curve (2Y fwd 1y rates sweet spot with 3m roll of 25bp) we expect limited risks for a selloff in this sector given the low domestic inflation pressure and suppressed rate level in Europe. On the other hand similar to previous episodes we expect the long end to be highly sensitive to a normalization in US rates. In addition any kind of FX intervention should be mainly beneficial for medium term inflation expectations leading to a selloff further out the curve. Hence we favor 2Y1Y vs 5Y5Y steepeners providing 15bp of roll over 3m (enter the trade at 231bp with a target of 260bp, keeping a stoploss of 210bp). For a more direct trade on inflation expectations we also like to position into BE wideners in particular in the belly of the curve (April-18) where current recorded low BE inflation of 1.25% is even well below our pessimistic 4 year inflation profile.

9 October 2014



Israeli inflation is moderating rapidly

Source: Deutsche Bank, Bloomberg Financial LP

POLAND FX: Maintain long PLN/HUF. Target remains 78.50, with a revised stop @ 73.15 (73.65).

Rates: Pay 3x6 FRAs at 1.71% with target 1.90% and stop at 1.55%. Keep 2s10s flatteners in IRS at +73bp with target +55bp and stop of +95bp, and overweight Oct23 vs Oct19 in government bonds.

Rationale: On the back of weaker activity data, a delay in the inflation pick up, geopolitical uncertainties, a struggling Euro area economy and the continous dovishness of surrounding CBs the NBP decided to cut interest rates by a more than expected 50bp to 2.00%. Although some argue that further rate cuts will not be effective since demand for corporate loans is low and zloty depreciation on rate cuts could hurt households with FX loans, thereby furhter cutting not uderpinning demand, further easing remains on the table if the domestic economic does not see a turnaround over the next couple months.

On the balance we favour another rate cut by 25bps to 1.75% but with market priced for another 45bps of further easing over the next 6-12 months the impact on PLN will be limited. We remain long PLN/HUF from the EMM on July 17th. It is a carry positive inter-regional trade, largely insulated to swings in EUR/USD. PLN is one of few EM currencies consistently undervalued on all our longer term valuation metrics (BEER, FEER and PPP). Polish EU fund conversion will provide PLN support going into Q4.

In rates even the more than expected easing did not lead to a bull steepening of the curve (curve with parallel shift lower) given the already excessive market pricing in the short end. We keep this view and see another 45bps of cuts as too much and favour money

market payers best expressed in 3x6 FRAs. However, we continue to see Poland as well supported by excess liquidity provided by an accommodative ECB and value the long end of the curve from a risk/return perspective as the most attractive among CEE countries for investors searching for additional carry.

ECB QE prospects have seen inflows

Fore

ign

hold

ing

% o

f out

stan

ding

0

5

10

15

20

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30

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40

45

PLN

/EU

R

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

2000 2002 2004 2006 2008 2010 2012 2014

Poland Domestic Treasuries Held by Foreign Investors, lhsEUR/PLN (inverted), rhs


SOUTH AFRICA FX: After having stopped out of our long TRY/ZAR @ 4.95, having locked in 1.2% profit (entry 4.89), we are more neutral ZAR. Near-term, trade the 11.00-11.50 range in USD/ZAR.

Rates: Receive 12x15 FRAs at 7.16% (target 6.85% and stop at 7.35%) while in IRS keep receiving 1Y vs. paying 5Y5Y (target +260bp / stop +210bp). In government bonds overweight Dec-18 at 7.51%.

Rationale: The run of poor economic data continues, with mining strikes continuing to weigh on exports of precious metals, whilst electricity shortages are underpinning oil imports. As a result the C/A balance has weakened again, now sitting at -6.2% of GDP.

DB Economics are still looking for a hike (+25bps) in November, but have revised the policy rate profile for next year lower to 6.5% (from 7.50% previously). While new SARB governor Mr Kganyago is a well known hawk the rates market continues to price in around 150bp of rate hikes by Q2 2016. This we believe is excessive. No improvement in the external balances and very sluggish domestic growth are limiting the scope for rate hikes. Hence we continue to advocate rates trades benefitting from a delay in the hiking cycle whilst also offering protection against normalization in US rates.

9 October 2014



Renewed weakness in SA’s external balances

-225000

-200000

-175000

-150000

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-100000

-75000

-50000

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0 5

6

7

8

9

10

11

12

2006 2008 2010 2012 2014

South Africa Current Account SA, lhsUSD/ZAR, rhs


RUSSIA FX: Buy a 1m EUR/RUB put with a strike @ 48.10 for an indicative 11bps.

Rates: Remain short 2Y XCCY at 8.09 (target 8.30 / stop 7.95) or enter 1s2s steepeners at -15bp (target 10bp / stop -30bp). In government bonds overweight Apr17 at 9.46% while underweight Mar18 at 9.38%.

Rationale: The Russian economy has continued to decelerate, with the growth rate testing zero in August, on the back of a deceleration in household consumption and stagnation on the fixed investment side. Sanctions launched by the US and the EU against Russia in September worsened the investment climate further, with the significant decline in oil prices adding to depreciation pressures on the RUB. Inflation meanwhile, accelerated again in September, to 8% YoY, from 7.6%, driven by price increases in the food segment on goods for which imports were restricted from the EU, the US, Canada and Norway.

As for monetary policy, the CBR views the current spike in inflation as transitory, arguing that the absence of demand-push pressures and lower credit and money supply growth will enable the economy to accommodate food price shocks and reduce inflation dynamics in the medium term. However, if high inflation risks persist and inflation expectations remain elevated the CBR stands ready to tighten policy further. On FX, RUB remains very headline news driven, but is also currently trading more than 2std deviations away from PPP, has never diverged this much from Russia’s Terms of Trade, and is at/near CBR intervention levels.

Russia: Key economic indicators

-35%

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-15%

-5%

5%

15%

25%

35%

2007 2008 2009 2010 2011 2012 2013 2014

% y

oy

IP, YoY, real, % Retail sales, YoY, real, %

Fixed investment, YoY, real, % Construction, YoY, real, %


TURKEY FX: While we have taken profit on our long TRY/ZAR (+1.2%), we switch into long TRY vs ILS. Seasonals going into the month of October are typically very TRY supportive, and 3m carry is around 9.25% (ann’d). The pair is currently at 1.6385, target 1.6875, with a stop @ 1.6100 (200dma 1.6150). Rates: Keep 1s5s steepeners in XCCY at 1bp (target 20bp / stop -20bp) and remain short BEs best expressed in TURKGB Apr20 at 7.73% or May23 at 7.72%. In nominals overweight Jun16 at 9.70% while underweight Jan20 at 9.42%. Rationale: Despite Lira weakness the CBT left all of its key policy rates on hold last month but it has since restricted the amount of funding that it provides through its one week repo auctions, driving (overnight) market rates towards the upper bound of the CBT’s interest rate corridor, an increase of some 250bps. This has resulted in some stabilization in TRY, though it is still trading in the upper 2.20s vs the USD. On the inflation side, and in a welcome move for the CBT, headline CPI in Sep dipped below 9% for the 1st time in 5 months. Elsewhere recent trade data suggest that the rebalancing process is running out of steam, though lower oil prices will now start to provide some relief given Turkey’s large energy import bill.

9 October 2014



Positive seasonals in October - USD/TRY MoM returns

(past 10 years ex 2008)

-1.75%

-3

-2

-1

0

1

2

3

4


Henrik Gullberg, London, (44) 20 7545 4987

Christian Wietoska, London, (44) 20 7545 2424 Raj Chatterjee, Mumbai, (91) 22 7181 1601

Credit

RUSSIA — Stay neutral

— Maintain 10s30s cash curve steepeners (22s vs. 42s)

While we retain a bearish view on Russia’s fundamentals and remain skeptical on the long-term solution to the conflict, we tactically covered underweight on 22 September following a series of de-escalatory developments. We saw relative calm in the near term – at least through the elections at the end of this month – as the fragile “cease-fire” would broadly hold and the parties would keep the status quo of what some describe as a “frozen conflict”. We maintain such a position at this juncture.

Over a longer term, however, we continue to see reasons to be strategically underweight and reduce on strength because the conflict will likely persist given the fundamental differences and the wide gap between the positions taken by the different parties, while the economic conditions continue to deteriorate. We continue to look to add hedges on strength against potential further escalation (and maintain target entry to buy Russia 5Y CDS at 220bp).

In terms of fundamentals, our economists believe that the prospects are now even dimmer against the backdrop of higher sanctions, which induces ruble

weakness, higher borrowing cost for Russia’s corporates, as well as the acceleration of capital flight (USD100bn in 2014 is expected). Growth was testing zero in August. With all three ratings agencies holding a negative outlook on Russia, downgrade risk is likely to be high over the next six months, especially by S&P, which has had a negative outlook since April.

On the bond curve, we maintain 10s30s cash curve flatteners (22s vs. 42s), and also look to enter 2s5s CDS curve steepeners when the technical condition in which dealers still have a sizeable demand in short dated CDS for risk management purposes dissipates (see our 26 September EM Sovereign Credit Weekly for a more detailed discussion on this potential trade).

Russia 2s5s CDS curve looks excessively flat; dv01-

neutral steepener has attractive breakeven of 4bp per

month


UKRAINE — Stay neutral

We maintain a neutral position on Ukraine. At this elevated level, the market is already pricing high risk to debt sustainability amid a collapse in the economy and sharp depreciation of the currency. The Naftogaz 14s have been paid, and near-term maturity of debts and repayment to the IMF seems manageable (see chart below), but the amount of support needed to recapitalize the banks appears to be much larger than expected. The repayment of USD 2.1bn due in the remainder of the year is expected to covered by the next tranche of the IMF disbursement in December Over a longer term, however, it is a widely held view that a much larger IMF program and/or a debt restructuring will be inevitable if there is not a turnaround to the crisis situation soon. According to the IMF, if the fighting continues into next year Ukraine may need as much as USD19bn in additional financing support.

9 October 2014



Ukraine’s government debt repayment schedule for

2014 and 15 (pressure point towards the end of 2015)

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IMF

Interest for UKRAIN and UKRGB bonds

Principal for UKRAIN and UKRGB bonds

Ukraine Repayments, USD bn

Note: repayment of USD 2.1bn during remainder of the year is expected to covered by the next tranche of the IMF disbursement in December Source: Deutsche Bank, IMF, Bloomberg

The risk to the economic situation in Ukraine is clearly still to the downside. Our economists have revised their 2014 forecast for GDP growth to be -6.9% yoy, fiscal deficits to -5.5% GDP. Despite the substantial external financing package, central bank reserves declined to USD16bn in July. The risk to these forecasts is to the downside, especially under a scenario of prolonged conflict. The gas negotiation has been halted, but an EC official recently suggested that an interim gas deal could be completed this month, enabling Russian gas deliveries to Ukraine this winter and curbing the threat of cuts to Europe.

We stay neutral for now, but will nevertheless take the opportunity of any strength to cut to underweight if situations do not meaningfully improve.

TURKEY — Stay overweight

— Take profit from short basis of 10Y CDS vs. 25s

Turkey has underperformed over the past month on general risk off and geo-political tensions (Iraq). Specifically, the Turkey sub-index widened by 20bp to 70bp wide to EM investment grade average, and now stands as the cheapest investment grade sovereign name in EM. Consequently our tactically overweight position held for the past two months – on mixed fundamentals and relatively higher carry in what we thought to be a range-bound environment – has proven a poor trade. However, seen from a glass-half–full perspective, a macro adjustment to reduce its external weakness has been under way, with the current account deficit on a narrowing path and FX valuation also much more supportive, even though this does not change the fact that Turkey remains one of most

sensitive in EM to tighter global liquidity conditions and risk appetite. Though not one of Turkey’s weaknesses, its fiscal deficit is also on a narrowing path. High inflation remains a problem, reflecting some credibility issues on the part of the CBT. Overall, given that political noise will likely remain low in the country within the next few months and US rates are likely to remain range-bound within the next few months, we like Turkey’s chances to recover from the recent underperformance and hence remain overweight at this point. The main risk to our view stems from the geo-political situation in Iraq/Syria, especially in the border city of Kobane and related protests by Kurds.

Turkey’s CDS/bond basis has tightened substantially from its recent peak, and our recommendation of selling 10Y CDS vs. 25s has moved by more than 30bp. At the current level, the risk/reward for holding this short basis position is not attractive. We recommend taking profit from this position.

HUNGARY — Stay overweight

— Hold 5s10s flattener (24s vs. 19s) and switch from 19s to 21s.

Despite the setback of the past two weeks, Hungary remains the best performing sub-investment grade sovereign credit so far this year. Since 24 July, when EM credit began to widen from lows, Hungary sub-index widened by only 20bp and posted a flat total return despite its high yield credit rating. We continue to see reasons to stay overweight at this juncture. If the market continues to recover from the recent risk off, Hungary will likely outperform; conversely, the curve will likely retain its stability shown over the widening of the past few months and behave more like lower beta credit. Growth remains robust driven by strong domestic demand. Downside risk exists due to weakness in the euro area and potential contagion from weak economic performance in Russia and Ukraine but it will unlikely derail strong demands for the yield REPHUN bonds offer even at a tight level relative to its credit rating given the problems in EM high yields elsewhere. The curve has also benefited from strong technicals with only USD3bn issuance this year, much less than its repayments (almost USD5bn) and than previous years’ amount of issuances, as the government shifted financing towards local markets. During the remainder of this year, repayments dry out but we also don’t expect any Eurobond sales.

On the curve, 10s30s have markedly flattened, so we revise our current preference of 30Y bonds and turn neutral on 10s vs. 30s. The 21s stand out as the cheapest bonds on the curve, and especially cheap to the 19s; we recommend switching from the 19s to 21s (entry: 41bp; target: 20bp; stop: 50bp).

9 October 2014



Cash switch from HU ’19s to HU ‘21s looks attractive


POLAND

— Stay underweight

— 22s are cheap to the curve while 19s and 23s are expensive

During the risk-off of the past month, Poland has performed relatively well given its lower beta. As we believe the market will likely re-settle in a range-bound environment – with some moderate spread tightening – we continue to disfavor Poland given its tight valuation and large negative carry vs. the benchmark (at -75bp vs. EM investment grade average). While our underweight position is motivated by valuation, not fundamentals, economic activities have indeed slowed thanks in part to the weakness in the euro area, with risk still skewed to the downside due to the possibility of a protracted slowdown in euro area growth and/or an escalation in the Russia/Ukraine crisis.

Poland 5s10s cash slope looks steep while PL ‘23s look

expensive


While we hold our curve flattener recommendation of 24s vs. 19s (entry: 49bp; current: 44bp; target: 25bp), we find that the 22s have recently moved significantly

cheap to the curve, while the 19s and the 23s are relatively expensive. We recommend switching from the 23s to the 22s at the current spread differential of 20bp, target 5bp.

SOUTH AFRICA

— Reduce to underweight

— Short 41s vs. Indonesia 44s

South Africa’s credit metrics are clearly on a downward trajectory. This has been reflected by S&P’s downgrade of South Africa’s credit rating by one notch to BBB- in June, but there will be further downgrade pressure from both Fitch (BBB, negative) and Moody’s (Baa1, negative) in the coming months.

Even with a moderate, seasonal pickup in Q3, growth remains weak. Our economist has recently revised 2014 growth forecasts down to 1.5% from her beginning of the year estimate of 2.9%, as result of recent labor strikes and sluggish global recovery. Current account forecast was also widened to 4.6% from beginning of the year forecast of 4.0%. A good track record of prudent fiscal policy aside, public finances face significant challenges in the low growth environment. To stabilize the government’s finance debt ratio in the future, tax hikes are inevitable. Additional challenges to public finance come from the troubled state-owned enterprises (especially Eskom), which will add to the state's contingent liabilities. Eskom, specifically, suffers from a significant funding gap. Apart from debt issuance, how the rest of the gap will be filled remains unclear at this stage. To this end, the medium-term budget policy statement (MTBPS) on 22 October, the first under new Finance minister Nene, may reveal some important information. A fiscal slippage and deterioration in the fiscal path are widely expected.

All in all, this represents undisputed underperformance of South Africa in comparison with some of its “fragile five” peers, especially Indonesia and India, and to a less extent, also Turkey. The other country in this group that shows deterioration – rather than positive rebalancing – is Brazil.

Even with these fundamentals weaknesses, we have kept South Africa at neutral over the past few months as it remained a relatively cheaper credit within EM investment grade space, and we had viewed positively recent personnel changes (especially Kganyago’s appointment to succeed Marcus as head of central bank was welcomed by the market) and macro policy framework with the Central Bank and the Finance Ministry. South Africa has been one of the better performers in EM credit until September. However, recently weakened risk sentiment and weaker political position of President Zuma (amid corruption scandals and health concerns) make it more challenging for

9 October 2014



South Africa. The South African sub-index spread has recently widened to over 35bp relative to the EM investment grade average from +20bp over a month ago. We see further weakness and hence recommend reducing exposure to South Africa to underweight.

In conjunction with our overweight view on Indonesia we recommend long INDO 44s vs. SOAF 41s. The 41s are expensive to the South Africa curve, while the Indonesia curve is steeper than that of South Africa (entry: 32bp; target: 0bp, stop: 45bp).

Indonesia 44s to continue tightening vs. South Africa

41s


Hongtao Jiang, New York, (1) 212 250 2524

9 October 2014



LatAm Strategy

LatAm FX: Buy 3M EUR/COP put (ATMS, EKO @ 2480 ref FX 2590) for 0.7% (50% cheapening), buy 1M USD/BRL straddle (b/e’s 2.28/2.52). Buy 3M USD/CLP put (ATMS EKO 575) for 0.6% (70% cheapening from vanilla ref FX 596). Long MXN vs. HUF and CZK (target 13.90).

Rates: In Brazil enter Jan17/Jan21 steepener (target 40 bp). In Mexico keep 2Y1Y spread wideners vs 5Y5Y spread tightener (target 20bp), switch from MBONOS 34s to MBONOS 24s, buy breakevens in the belly (UDI20s, target 390). In Chile keep the 1s3s steepener (target 65 bp), receive 10s (CLP/CAM) vs US (target 190). In Colombia buy TES 24s vs US10s (target 380). Keep a neutral stance in Peru.

Credit: We continue to hold a bearish view on Argentina as we believe continued deterioration in the macro conditions will likely challenge the stronghold of the distressed situation investors. While we are strategically underweight on Venezuela, we hold a relatively more constructive tactical position over the short term as the market is still pricing too much risk of imminent default (long PDVSA 15s and 37s, long PDVSA 71Ns vs. Venezuela 20s, keep short basis on Venezuela). We favor overweight Colombia vs. underweight Peru. We stay underweight UMS but overweight Pemex (switching from UMS 23s to Pemex 24s). We remain neutral on Brazil, but look to enter long Brazil CDS again vs. Mexico at 60bp. Other relative value opportunities include 10s30s cash curve flatteners in Brazil, switching from NY law Discounts to local law Discounts in Argentina, keep short basis in Venezuela.

Local Markets

BRAZIL — FX: Buy 1M USD/BRL straddle (B/E’s 2.28/2.52)

— Rates: Enter Jan17/Jan21 steepener (target 40 bp)

FX: The outcome of the first round of the elections prompted a sharp retracement in the BRL, which has, as of the time of writing, gained back about half of the 10% lost in September, when market participants perceived a Dilma Rousseff victory as highly likely. While EM-wide trends, such as continued dollar strength, should impact the BRL in the coming weeks, the obvious focus will be on the run-off elections on October 26, with poll results likely inducing violent swings in the currency. The BCB, which had been successful in keeping the currency range-bound in April-September through its FX swaps program (accumulating a USD 95bn position in the process), is

already set to roll over 100% of swaps maturing in November, hence is limited in its ability to control volatility (on the BRL downside, at least). As the election-dependent scenarios for the BRL are extremely divergent, we like buying a 1M straddle on USD/BRL. Struck ATMF, the straddle breaks even at 2.28 and 2.52 (indicative pricing), both breakevens falling inside the highly divergent values which would plausibly materialize in each of the possible election scenarios.

Rates: In Brazil, rates markets continue to be a hostage of the election dynamics, as evidenced by the dramatic bull-flattening that followed after the results of the presidential election’s first round. Despite the win, the (historically) poor performance of the incumbent party not only in the presidential but also in the lower house election together with the surprising performance of the competing party resulted in a significant rally in risky assets in general. The latter adjustment clearly reflects improvements in market implied credibility and the predicated increase in inflows and overall improvement in business confidence. All that said, an eventual opposition, victory faces some serious hurdles which in our view, favors trades that would profit if curves retrace to pre-1st round levels. Consider scaling into steepeners in the Jul17/Jul21 sector of the curve for example. The eventual pricing of risk premium in case the incumbent’s victory materializes should result in significant steepening of the curve. Further flattening associated with an incumbent’s loss obviously poses a risk to the view. The proximity to historical lows and eventual normalization of the curve suggest that MTM losses might be limited making the risk/return of the steepener favorable.

CHILE — FX: Buy 3M USD/CLP put (ATMS EKO 575) for

0.6% (70% cheapening from vanilla ref FX 596)

— Rates: Keep the 1s3s steepener (target 65 bp), receive 10s (CLP/CAM) vs US (target 190).

FX: CLP was stable in September, hovering under the 600 barrier vs. the USD and outperforming most EM currencies. We see the currency maintaining its stability in the near future, and possibly outperforming other EMs on continued dollar strength, for several reasons. First, our outlook for China is relatively optimistic, hence we see copper maintaining its ground. Second, the easing cycle is likely close to its end, and reflected in the currency. We foresee, if anything, the CLP supported by signals of rates being raised sooner than expected by markets (especially given persistently high inflation). Third, while recent data continues to point to stagnation, the planned fiscal stimulus should offset (to some extent, at least) the drag caused by the tax reform, increased clarity on which should help

9 October 2014



stimulate investment. Finally, the treasury is planning to sell a significant amount of dollar assets in order to finance the fiscal position next year, which should also be peso supportive. Consider buying a 3M USD/CLP put (ATMS, EKO 575) for 0.6%, about 70% cheaper due to the EKO.

Rates: In Chile we continue to call for another 50bp worth of cuts but also argue that despite well-anchored inflation expectations, the BCCh might embark on an aggressive (yet short) hiking cycle in early 2016. The latter is predicated on the possible reduction in trend growth and potential compression in the output gap, which render the local economy less prone to accommodation. Moreover, the dependence on commodities and potential effects of the tax reform on growth could result not only in reduced potential growth but also in a lower neutral rate. Altogether, compared to the curve-implied cycle we envision further cuts by the end of the year and a more aggressive, shorter hiking cycle, ending at a lower terminal rate. Altogether, this view bodes well for our core “butterfly” views, paying 3Y vs 1Y and 5Y (CLP/CAM). In terms of implementation we continue to like the 1s3s steepener (despite the recent steepening and negative carry). Enhancement of this view can be achieved in forward starting space (receiving 1Y6M vs 2Y1Y for example) or in cash (switching from Jan18s to Jan22s). In the back end we see room for Chilean yields to compress vs. US yields as these cycles remain de-coupled – keep the spread tightener vs the US in the 10Y sector.

COLOMBIA — FX: Buy 3M EUR/COP put (ATMS, EKO @ 2480

ref FX 2590) for 0.7% (50% cheapening) (indicative)

— Rates: Buy TES 24s vs US10s (target 380).

FX: COP, the worst performer in EM in recent months (other than RUB), continued its relentless decline in September, erasing almost all of the gains seen since the index weight change in March and reaching 5yr lows vs. the dollar. Declining oil prices (and weak domestic production), together with the end of the hiking cycle, have weighed on the currency, which we currently see as somewhat oversold (about 3.5% undervalued vs. its financial drivers, according to our model). Valuation, together with impressive, near-potential growth (we forecast 4.6% for 2H14, lower than the first half of the year but higher by far than its peers), lead us to stay positive on the COP. Having said that, the outlook for oil prices is uncertain, and authorities have repeatedly expressed their desire for a less appreciated exchange rate, as the level of pass-through is low. Hence the risk of further depreciation exists, and we continue to express our COP view through options, preferably against EUR as we expect continued dollar strength. A 3M EUR/COP put struck at

2590 (ATMS) with a EKO at 2480 costs 0.7%, about 50% cheaper due to the EKO (indicative prices).

Rates: After 125bp worth of hikes (5x25bp), Banco de la Republica - the only central bank in the region to tighten rates - has decided to halt the current cycle with the policy rate at 4.5%. And with inflation inching below 3% and activity numbers portraying some signs of deceleration we expect the policy rate to hover around the current levels at least in the short term. That said, we would not rule out the odds of additional adjustments (residual hikes) in case the Fed surprises on the positive side. Altogether we see terminal rates at 5% by the end of 2015 - roughly what is being priced and consistent with the neutral real rate (2%) and the center of the inflation band (3%). And while premium priced in the 1Y-2Y sector of the curve (around 40 bp) in principle bodes well for front end receivers (1Y1Y), at this point we rather remain neutral in the front end given the exposure to US rates. On the curve, despite the recent flattening the 2s10s slope still looks a bit steep both vs the US and the front end. Consider buying TES 24, which looks cheap relative to neighboring bonds, vs. US 10s (target 380bp).

MEXICO — FX: Long MXN vs. HUF and CZK (target 13.90)

— Rates: Keep 2Y1Y spread wideners vs 5Y5Y spread tightener (target 20bp), switch from MBONOS 34s to MBONOS 24s, buy breakevens in the belly (UDI20s, target 390).

FX: Consistent with previous bouts of dollar strength, MXN has been performing well relative to EM peers (in particular, relative to CE3 currencies) for the first part of the current dollar strength episode. This pattern reversed, however, in the past few weeks, demonstrating the currency’s high sensitivity to US equities. Going forward, we are constructive MXN (relative to other EMs, at least), as we expect continued dollar strength and positive US performance to benefit the currency vs. its peers. Similarly, we expect the local economic recovery, signs of which are already apparent, to be aided by increased US demand. Continued optimism regarding the reforms process should also help. Another positive for MXN is speculative positioning, which is heavier than it was at the beginning of the year, but still very light compared to pre-taper tantrum figures. Consider going long MXN vs. a basket of HUF and CZK.

Rates: In Mexico we see the potential for deteriorating inflation expectations in early 2015, due to possible front-loading of gasoline price hikes, as well as discussions of an increase in the minimum wage. The deterioration in inflation expectations and the proximity to the Fed cycle could potentially lead to a change in Banxico perceived stance from reactive to pro-active. Accordingly we see Banxico’s implied monetary policy path as too mild (vs the US cycle) and would warn those positioning on the rather popular carry capturing

9 October 2014



strategies (receivers) in the to-left corner of the forward matrix. Instead we recommend paying 2Y1Y in TIIE vs. receiving in the US. Accordingly, we see Banxico hiking about 300bp by the end of 2016 (vs 200 bp priced) if the scenario implied by the US curve (about 150bp hikes by end-2016) materializes. Further down the curve we continue to see the premium priced in TIIE as excessive and recommend keeping the 5y5y box vs the US (receive TIIE pay USD ) open as a core recommendation. In cash we see the flattening as a bit exaggerated and would recommend switching from the 34s to the 24s. Finally, we favor going long breakevens, especially in the belly of the curve. Breakevens implied by MUDI 20s have recently retraced somewhat, but are still trading very close to forecasted inflation, incorporating a very small premium.

PERU — FX: Stay neutral

— Rates: Stay neutral

FX: PEN continued weakening in September, breaking the 2.90 mark vs. the dollar despite increased intervention by the central bank. While likely satisfied with the recent depreciation (down about 4% relative to the previous year-long range) given the recent economic weakness, authorities are determined to reduce volatility in the currency. In addition to selling USD-linked CDs, which had been the preferred policy instrument before the recent sell-off, the BCRP also intervened in the spot market in September, and introduced a new FX swap, used for the first time last week. The BCRP’s involvement, together with low sensitivity to global factors, favorable positioning, and valuation (3% undervalued vs. financial drivers in our model, the most undervalued it has been in the past 2 years), make PEN an attractive long. However, the growth outlook is relatively weak, monetary policy is loose, and terms of trade are worsening, in the short-medium term at least. We stay neutral for now.

Rates: In spite of the recent spike in PEN, rates have been more or less range-bound in Peru since July’s cut in the reference rate. And despite lackluster growth, persistent inflation suggests that the BCRP might for now remain on “wait and hold” mode. In the front-end of the Soberanos curve, we continue to believe that the 23s are relatively cheap versus the 20s (although the latter enjoy some benchmark premium due to their liquidity) and issues further down such as the 31s are cheap versus the front. With the front-end reflecting levels that in our opinion are close to fair and the term premium close to historical lows, other than the aforementioned switches we rather take chips off the table and turn our stance on rates to neutral for now.

Guilherme Marone, New York, (212) 250-8640 Assaf Shtauber, New York, (212) 250-5932

Credit

ARGENTINA — Stay underweight

— Stay short USD Discount. Continue to favor local law Discounts

While we would not rule out a settlement scenario in 2015 after RUFO expires, it is certainly not our baseline. We do not see any indication that the government is willing to negotiate with NML. The Republic’s position to only negotiate with the entire universe of holdouts collectively and continued efforts to alter payment mechanism make a benign outcome all but impossible. That Judge Griesa holds the Republic in contempt (though without imposing any monetary punishment yet) also makes the situation more difficult. Meanwhile, the deterioration in the macro conditions will eventually test the stronghold of the distressed situation investors, and potentially unravel the current decoupling between fundamentals and bond prices.

Argentina could see a USD10-12bn fall in international reserves next year mostly due to a current account deficit compounded by a number of bond obligations coming due for the government (mostly the USD6bn due for Boden 15s), and for the Province and City of Buenos Aires (totaling USD2.3bn). Some debt management transitions in 2015, including swapping some of the Boden 15s for longer maturity local law bonds and forcing the Province and City to issue new debts at very unfavorable market conditions, remain options, but look difficult given the lack of confidence on the policy outlook and macro conditions. The swap with China helps alleviate the balance of payment concerns to the extent of financing its bilateral deficit, but that would be far from enough to restore confidence given that the international reserve stands at only USD27bn now (net reserve under USD20bn).

Therefore, while a correction has taken place recently to the bond prices following the change in the central bank governor, which signaled further deterioration of policy outlook, the fundamentals still do not justify USD Discount price in the 80s. We remain short the USD Discounts, with a target all-in price of 75.

We recently recommended long the local law USD Discount vs. New York law USD Discounts and maintain such a position. During a recent hearing Judge Griesa clarified that he did not think the local law bonds as pari-passu with the FAA bonds as they should not be considered “external indebtedness” pursuant to the FAA indenture (something we have argued all along), and that he never intended for these bonds to be within the scope of the injunction. A final decision will likely be forthcoming by the end of the month as

9 October 2014



Judge Griesa gave 30 days for further discovery and debates by the parties. We maintain this position despite some renewed concerns of “pesofication” over the past week. In our view, “pesofication” on the local law dollar bonds would be equivalent to an outright default, which the government will try its best to avoid. Such risk on private sector contracts, as we already know, is high, but that does not apply to the government bonds, in our view.

The Euro denominated bonds, on the other hand, are still within the scope of pari-passu injunction. We see no technical argument to suggest they are not “external indebtedness” pursuant to FAA documents. While we understand that there are arguments and legal proceedings in the UK and Belgium that many perceive to support “carve-out” of these bonds in the end, we see the likelihood for this as low. However, not being legal experts, we acknowledge that this is not a strong opinion.

BRAZIL — Stay neutral, but look to reduce on strength

— Favor 10s30s cash curve flatteners

— Look to enter long Brazil CDS vs. Mexico at 60bp (current 65bp)

The market rallied sharply after the first round of elections ended, as the market is now priced to a decent level of probability of an Aécio upset at the second round. Marina would have to transfer 69% of her votes to the PSDB candidate (all else equal) and, according to DataFolha, only 59% manifested their intention to do so last week and this number does not reflect those who have already jumped ship. Also, the incumbent’s campaign has so far focused on Marina and the re-focus could also weigh on the opposition. Therefore, we believe the market will likely retrace the latest rally and fully price a Dilma victory, possibly after some further tightening on upcoming polls, which may show a narrow gap between Rousseff and Neves. While our previous recommendation of long Brazil 5Y CDS vs. Colombia reached its target at the end of September following polls showing a commanding lead of Dilma vs. Marina (as we had expected), this time we would look to enter long Brazil 5Y CDS vs. Mexico at 60bp (current level: 67bp).

These tactical moves aside, strategically we retain a bearish view. We are not optimistic about a significant change to the policy mix during President Rousseff’s second term. Fundamentals remain on a negative trend, as the disappointing growth performance and steady deterioration in the fiscal accounts prompted Moody’s – which has held a relatively more bullish view on Brazil among rating agencies – to lower its outlook to negative in August, while holding its credit rating at BBB. Brazil will face additional downgrade pressure

over the next year. However, at parity spread levels with EM investment grade average and strong technical conditions on the curve, we continue to see Brazil’s spreads as likely range-bound and therefore stay neutral on Brazil cash at this level.

Finally, our recommended switch from BNDES 23s to Brazil 23s (see our EM Sovereign Credit Weekly of 3-October) has reached it target and we recommend taking profit in this position.

Brazil / Mexico CDS spread differential is currently

moving tighter, but will likely re-widen


COLOMBIA — Stay overweight.

Despite some slowdown in growth, Colombia still offers the best growth/inflation dynamics in the region (5% GDP growth, and CPI at 3.2%, within target range). Lower oil prices and decreased production have a negative impact on government revenues, but fiscal standing will not suffer given the fiscal rules in place. The new tax reform to extend wealth tax and financial transaction tax for four more years, which we expect to be passed by Congress by year end, should help cover any gap between revenues and expenditures in 2015. Sensitivity to commodity prices exists, as shown in the deterioration in the external account this year and last year, but Colombia seems better positioned in comparison with most of its peers in the environment of weak global growth recovery, lower commodity prices and the prospect of lower international liquidity down the road. The credit rating migration path remains positive. Colombia may issue again later this year but likely only in small amounts, less than the USD1bn repayments during the remainder of the year.

Colombia sub-index has outperformed EM investment grade average over the past few months; as a result, valuation (at -25bp vs. investment grade average) does

9 October 2014



not look particularly attractive. However, Colombia

remains our favorite LatAm low-beta credit based on

valuation and fundamentals.

The 10s30s curve on the cash side is one of the steepest in EM, but we see more attractive flattener trades in Brazil.

MEXICO — Stay underweight UMS

— But compensate the under-allocation with Pemex (switching from UMS 23s to Pemex 24s)

The Mexico has obviously been a very good defensive

trade over the past month given the selloff. However,

given the potential for market recovery and renewed

importance of carry, we would not chase the market at

the current level and remain underweight UMS. Pemex

bonds, on the other hand, have seen their valuation

improve relative to the sovereign curve once again due

to the recent selloff and also the dual tranche issuances

earlier this week. Last month, we turned neutral on

Pemex vs. UMS after some steady convergence in the

spread differentials and potential near-term supply risk

in Pemex. Now that the spreads have backed up and

bond issuances have taken place, we revert to

overweight Pemex vs. Mexico. Currently, the Pemex

24s stand as the cheapest vs. sovereign, with a pick-up

of 70bp in spread to the sovereign curve. We

recommend switching from Mex 23s to Pemex 4.875

24s (entry: 71; target: 50bp; stop: 80bp). .

PEMEX bonds look attractive to UMS once again


PERU — Move to underweight

— Long-end Peru looks expensive.

Peru’s global bonds look expensive in our view,

especially at the long end of the curve. The bonds at

the long end of the curve – the only part of the curve

that offers decent liquidity – significant outperformed

their peers following the upgrade by Moody’s to A3 in

July. Valuations on these bonds look stretched at the

moment. We remain cautious on Peru given the sharp

deterioration in its growth dynamics on lower demand

from China and lower commodity prices. In addition,

Peru also has among the highest current account

deficit compared with its regional peers (though it is

fully financed by FDI), with a high sensitivity to the

prices of mining products and activities in the mining

sector. We continue to favor Colombia at this point, for

the former’s better fundamentals momentum as well as

slightly cheaper valuation. Recently we recommended

switching out of the 37s to Brazil 41s on Peru’s

richness and recent cheapening of Brazil bonds having

Dilma victory almost completely priced in (before the

first run election result came out). This trade has

moved by 18bp in our favor but we keep the target at

40bp (vs. current 50bp).

VENEZUELA

— Stay tactically neutral

— Switch from Venezuela 20s to PDVSA 17Ns

— Keep short basis (selling 5y CDS vs. 22s)

We covered underweight on 25 September following

the announcement of exchange rate agreement No 30,

as we expected the curve to continue recovering and

price out the imminent risk of default. This policy tweak,

while a tiny step of stealth devaluation, should provide

some help. However, this did not work out as bond

prices bond prices resumed falling after a brief recovery

as the market is rattled with concerns about that

potential ruling by ICSID on the Exxon/Mobil profile

arbitration claim 15 , which would be “imminent”

according to some reports, as well as speculations

about the impact from a potential re-allocation by a

large EM funds recently in the headlines due to

management changes.

We see scope for some near-term recovery and hence

stay neutral at these levels for the following reasons.

First, the repayments of Venezuela 14s this week and

PDVSA 14s at the end of the month, as we expect, will

15 The two most high-profile cases are filed by ExxonMobil (asking amount:

USD10bn) and ConocoPhillips (asking amount: USD30bn). The tribunal has

already ruled that Venezuela was liable on the Conoco case and expected

to rule on the monetary terms in the coming months. The tribunal has yet

to rule on the liability of the Exxon case, but it has been widely speculated

that a ruling - mostly likely negative for Venezuela – is imminent. When it

rules, it could be only on liability, or both on liability and on monetary

award.

9 October 2014



help alleviate some concerns of near-term default.

Second, while the potential ICSID ruling will

undoubtedly present some negative headlines

(especially if it comes with monetary awards this time

that are larger than expected), there should not be any

near-term financial impact. The normal way out from

these kinds of arbitration cases is through settlement,

and it could take multiple years for the parties to

negotiate and find a solution. Finally, if the reallocation

of certain large funds indeed has an impact on bond

prices, the impact of that would likely be temporary.

We continue to believe Venezuela/PDVSA has enough

resources and means to meet its debt obligations in

2014 and 2015. In addition, we believe the government

has a strong willingness to pay as the cost of a default

is prohibitively high given that it would likely

compromise its ability of generating petro-revenue as

well as its ability to import – remember, Venezuela is a

country that heavily relies on import for some of the

very basic goods.

Beyond 2015, however, continued payment ability will

be conditional on significant changes to the current

policy mix. Our confidence on that is low, hence our

strategic underweight position.

Stay long the very front end and very low priced bonds On the bond curves, we continue to favor a defensive, barbell position of being long the very front-end and the lowest-priced bonds. Specifically, we would stay long PDVSA 15s (and also consider long EUR 15s at the yield of 21%) as well as PDVSA 37s. We favor the 37s given that it is of the lowest price, but understand many investors favor the 24s at a slightly higher price but with much better liquidity and better valuation in spread terms.

Valuation snapshot of the Venezuela/PDVSA complex


Enter long PDVSA 17Ns vs. Venezuela 20s We recommended switching from Venezuela 22s to PDVSA 17s on 25 September as we thought PDVSA bonds were oversold and that the market would likely recover of the recent losses; the 17s looked especially wide to the sovereign curve. However, the renewed selloff has pushed this spread differential even wider and our position hit the stop level on 1 October. At the current levels, we believe the market is pricing an excessive level of imminent default risk. Venezuela 14s repayment is being made, and we expect the PDVSA 14s due on 28 October will also be paid. Confirmation of that repayment will instill some confidence and prompt some recovery of the market, and PDVSA bonds in particular. We there recommend reentering a similar position: switching from Venezuela 20s to PDVSA 17Ns (entry: 595bp; target: 400bp; stop: 750bp) to position for the potential convergence. Among shorter duration bonds, the 17Ns are the cheapest bonds on PDVSA while the 20s are the richest on the sovereign curve.

PDVSA 17Ns look excessively cheap to Venezuela 20s


Finally, we remain short basis on the sovereign curve via selling 5Y CDS vs. 22s16 as we continue to believe the basis should tighten once the imminent default risk is priced out as we expect.

Hongtao Jiang, New York, (212) 250-2524 Srineel Jalagani, Jacksonville, (212) 250-2060

16 See Trade Recommendation – Venezuela: Enter short basis, 10

September 2014 for details.

9 October 2014



China Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic outlook: Flat manufacturing PMI, slightly

weak services PMI and falling steel output reiterated an anemic domestic demand in September. On the other hand, HSBC new export orders PMI hit 53 months high, showing a stronger-than-expected external recovery. Going forward, we expect rising exports to allow at least stable GDP growth in coming quarters, even with weaker investment growth. Moreover, the government is likely embrace a “new economic/policy norm” of less broad stimulus but quicker structural reforms, which will focus on financial liberalization, deregulation, SOE and railway reforms in Q4 and 2015.

Main risks: Property sector remains the key risk, yet with previous HPR relaxation, latest mortgage easing and up-coming price cut, sales should rebound in early 2015 and in turn spur real estate investment.

Embracing the “new norm”

Manufacturing PMI unchanged, exports outstand The HSBC Markit final PMI was revised down to 50.2 from the flash reading of 50.5, remaining unchanged from August. This echoed the flat NBS PMI of 51.1. Looking into the sub-indexes of the HSBC PMI, while the output index dropped from 51.8 in Aug to 51.3 in Sep, the new orders index improved 0.2ppts to 51.5, pointing to gradual future recovery. Importantly for us, because this seems to be what differentiates our view on China most from the consensus, the new export orders index recorded a strong lift of 2.6ppts to 54.5, the highest value in five and a half years. Such readings support our view that China is going through a modest recovery characterized by economic rebalancing and supported by a global cyclical pickup.

In the meantime, deceleration was witnessed in input and output prices which dropped by 1.9ppts (to 47.1) and 1.8ppts (to 47.1). This is consistent with the very deflationary signal being sent by the producer price index, which has been declining for more than two years. We interpret these developments, and the moderating CPI impulse, as a sign that the economy is growing slightly below its potential. Given the deflation pressure, policymakers should not, in our view, be trying to slow growth down. They should be trying to rebalance growth away from investment.

Going forward, we view the targeted 7.5% annual GDP growth as achievable, as the strong base effect will dissipate in Q4 and the external demand will expand enough to offset the decline in investment growth. In

2015, the GDP growth could be a little higher, lifted by a full year of US&EU growth and therefore higher export growth than this year will be achieved.

While the European economy is expected to grow slowly over the coming year, we look for 3%-3.5% growth in the US. Combined, the two main export markets for China are likely to grow almost as fast as they did in pre-GFC years, and we've seen in recent quarters that Chinese exports are almost as responsive to that growth impulse as they were before.

China manufacturing PMI vs. service PMI

46

47

48

49

50

51

52

53

54

55

56

57HSBC PMIHSBC PMI New Export Orders IndexNBS Non-manufacturing PMI

Source: Deutsche Bank, Markit

“New norm” of slower growth but quicker reform We believe that consensus has been reached among top leaders to allow slower-yet-healthier growth and only very targeted stimulus measures. Our conviction comes from the recent reform momentum, especially local-level examples: a focus of construction activity for environmental protection, healthcare and clean energy in 2014-15; RMB20bn was set aside by the PBOC for relending to agriculture; 87 administrative items were abolished; licenses for foreign hospitals and private oil importers were granted; the Budget Law was revised to regulate local government debt.

Most interestingly, China unveiled on Aug 19 its Plan to Revitalize the Northeast, a region which saw the most severe industrial decline. The 35 measures offered by the State Council provide a hint of how the authorities would respond to a more protracted investment slowdown nationwide. The most noteworthy are: 1) to speed up construction of rail lines, airports, power transmission, nuclear plants and other clean energy projects; 2) to encourage SOEs to sell assets or equity to private investors to finance restructuring; 3) to establish a regional state-owned assets investment

9 October 2014



company; 4) to support emerging industries like integrated circuits, services, robotics, marine engineering, etc.; 5) to improve grain storage and logistical facilities so as to modernize agriculture; 6) to fund the affordable housing construction, including a RMB60bn credit reserve for shantytown renovation.

The on-going Hebei economy restructuring is another example. The province closed more than 8,000 polluting factories and reported GDP growth of 5.8%yoy in H1 2014 versus 8.2% in 2013. The slowdown, however, was praised by local authorities, as it brought down the energy consumption per unit of industrial value added by 10%, enhanced air quality by 13% and increased the contribution of tertiary sectors to GDP by 18ppts. This is, in our view, a typical “new norm” approach that might be replicated in other provinces in the coming years.

Mortgage and property policies relaxed Sep 30, PBoC and CBRC jointly issued the Notice on Improving Home Financing Service, with the highlights of:

Encouraging bank loans to support shanty town renovation and public housing projects, extending the duration of such lending up to 25 years;

Relaxing mortgage polices: Households who own one home and have repaid mortgages will be eligible to first home mortgage arrangements. In cities without/lifted HPR, banks are allowed to apply the favorable policies to mortgage applicants with two or more homes and have paid off all mortgages. Banks are also allowed to extend mortgages to eligible non-local citizens;

Expanding funding channels for commercial banks. Banks are encouraged to issue mortgage-backed securities and long term bonds to support lending to first home buyers and upgrading home buyers;

Supporting reasonable financing needs of the developers. Under the premise of risk control, banks have to support normal commodity construction by developers with good quality and credit. Developers are allowed to issue bonds in the interbank market and develop pilot REITs.

Such policy support, first time of its kind since 2008, should boost upgrade demand and overall market sentiment. Together with the recent HPR relaxation by 42 out of 46 cities, and more price cuts from developers, we expect to see a more solid recovery in sales volume in the coming months. According DB property research team, seven out of ten major developers surveyed expect MoM sales growth in September.

Michael Spencer, Hong Kong, +852 2203 8305 Audrey Shi, Hong Kong, + 852 2203 6139

China: Deutsche Bank forecasts 2012 2013 2014F 2015FNational Income Nominal GDP (USD bn) 8389 9358 10516 12002Population (mn) 1354 1362 1369 1374GDP per capita (USD) 6196 6871 7682 8735

Real GDP (YoY%)1 7.7 7.7 7.8 8.0 Private consumption 8.4 7.7 8.1 8.4 Government consumption 8.7 7.7 7.0 7.0 Gross capital formation 7.7 9.0 7.0 7.4 Export of goods & services 2.8 6.5 11.0 12.0 Import of goods & services 3.7 8.5 10.0 11.5

Prices, Money and Banking CPI (YoY%) eop 2.0 2.5 2.8 3.2CPI (YoY%) ann avg 2.6 2.6 2.2 3.0Broad money (M2) eop 13.8 13.6 12.0 12.0Bank credit (YoY%) eop 15.0 14.1 12.4 11.0

Fiscal Accounts (% of GDP) Budget surplus -1.6 -2.1 -2.1 -1.5 Government revenue 22.7 22.9 23.0 23.0 Government expenditure 24.3 25.0 25.0 24.5Primary surplus -0.9 -1.3 -1.3 -0.8

External Accounts (USD bn) Merchandise exports 2048.8 2209.9 2545.8 2958.2Merchandise imports 1818.6 1951.1 2228.2 2580.2Trade balance 230.2 258.8 317.6 378.0 % of GDP 2.7 2.8 3.0 3.1Current account balance 215.4 182.8 241.7 302.0 % of GDP 2.6 2.0 2.3 2.5FDI (net) 176.3 185.0 160.0 150.0FX reserves (USD bn) 3311.6 3821.3 4021.3 4221.3FX rate (eop) CNY/USD 6.3 6.1 6.1 6.0

Debt Indicators (% of GDP) Government debt2 19.0 18.9 18.0 17.5 Domestic 18.5 18.4 17.5 17.0 External 0.5 0.5 0.5 0.5Total external debt 8.8 9.2 9.2 9.0 in USD bn 737 863 967 1083 Short-term (% of total) 73.4 78.4 78.4 78.4

General (YoY%) Fixed asset inv't (nominal) 20.3 20.0 17.0 15.0Retail sales (nominal) 14.4 13.2 13.2 14.0Industrial production (real) 10.0 9.7 9.5 10.0Merch exports (USD nominal) 7.9 7.9 15.2 16.2Merch imports (USD nominal) 4.3 7.3 14.2 15.8

Financial Markets Current 14Q4 15Q1 15Q31-year deposit rate 3.00 3.00 3.00 3.0010-year yield (%) 3.98 4.10 4.10 4.30CNY/USD 6.14 6.11 6.08 6.02Source: CEIC, DB Global Markets Research, National Sources Note: (1) Growth rates of GDP components may not match overall GDP growth rates due to inconsistency between historical data calculated from expenditure and product method. (2) Including bank recapitalization and AMC bonds issued

9 October 2014



Hong Kong Aa1/AAA/AA+ Moody’s/S&P/Fitch

Economic outlook: As we expected, Hong Kong has witnessed narrowing trade deficit and warming domestic consumption towards the end of Q3. Yet the subsequent recovery in Q4 and the coming year is now overshadowed by the political uncertainty, which may hurt the already-fragile visitor arrivals, retail sales and property sector.

Main Risks: We reiterate our structural concerns on emigration of middle class, lack of economic diversity, competition from Mainland opening up and instability due to political transformation. Occupy Hong Kong protests may be ending, but the culture of protest that has emerged in recent years may become a long-term concern for the economy. Much will depend on how the government responds to the rising frequency of demonstrations. An adversarial climate could over time erode Hong Kong's reputation for stability.

Protests weigh on economy

Domestic consumption and exports point to better Q3 August retail sales grew 3.4%/2.8%yoy in value/volume, recovering from six consecutive months of decline and beating consensus of -2%/-3.3%. While sales value of jewelry, watches and gifts (-6.1%yoy) and electronic goods (-10.5%) continued to fall, food, alcohol and tobacco increased strongly by 20%yoy, followed by medicines and cosmetics (17.2%) and auto (12.6%), demonstrating healthy local consumption momentum. Together with narrowing trade deficit (July-Aug monthly average HKD-36.8bn vs. -46.9bn in Q2 and -39.6bn in Q3 2013) and dissipating high base effect, we expect a pickup in qoq(sa) growth in Q3.

Retail sales and visitor arrivals at risk

-20%

-10%

0%

10%

20%

30%

40%

Jan-

13

Apr

-13

Jul-1

3

Oct

-13

Jan-

14

Apr

-14

Jul-1

4

Oct

-14

Retail Sales Volume, yoy %Mainland Visitor Arrivals, yoy %

Source: Deutsche Bank, Hong Kong C&SD

Political uncertainty to overshadow Q4 recovery However, the demonstrations of Occupy Hong Kong have cast pressure on the forth-coming recovery. With the thoroughfares in Mongkok, Causeway Bay and Admiralty blocked for more than a week, some retailers like Chow Tai Fook, Sa Sa and Hengdeli took cautious approach to close certain stores in these key business centers, and mainland tourist arrivals during the Golden Week were seriously affected.

Hong Kong Immigration Department data showed that from Oct 1 to 5, though the number of visitors into Hong Kong grew by 14%yoy, that of mainland visitors (who usually contribute the majority of tourist spending) edged up by only 2.2%yoy (vs. 15.5%yoy Jan-Aug 2014, 16%yoy in the Golden Week 2013). The decision by the China National Tourism Administration to suspend visits by tour groups to Hong Kong represented, therefore, an important cost to Hong Kong. By contrast, the total number of outbound Mainland tourists increased robustly by c. 20%yoy during the Golden Week. Destinations like Korea, Japan and European countries have witnessed high double-digit Chinese visitors’ growth. The Seoul Government even estimated that around 160,000 Chinese would visit Korea during the Chinese National Holiday, up 33%yoy.

As a result of slowing tourist traffic growth and temporary store closure, Hong Kong retail sectors saw sluggish sales. According to the Hong Kong Retail Management Association, from Oct 1 to 5, most of its 30 surveyed retail companies recorded mid double-digit drop in sales compared with the same period a year earlier. The drop ranged from 15% to over 50%, and watch, jewelry, fashion and catering were worst performing sectors. SME retailers operating exclusively in Mong Kok, Causeway Bay or Tsim Sha Tsui are most adversely affected, with some reporting up to 80%yoy sales decline. DB consumer research team estimated that one week of sales loss in HK could reduce annual sales by 0.1-1.6% and net profit by 0.3-7.1% for listed retailers and restaurants under its coverage, assuming fixed opex.

Moreover, retail sales are more important to Hong Kong economy today than were a decade ago. Retail sales were 23.3% of GDP in 2013, up from 13.6% in 2002. Spending by non-residents accounted for 14.3% of GDP last year (19.2% of consumption), up from 4.5% (8%) in 2002. Our sensitivity analysis has shown that if Mainland tourist arrivals drop by one-third for one month about 0.3% of GDP of sales (about HKD6.8bn) would be lost. In the meantime, the negative impact on GDP would be partially offset by a decline in imports, as less retail sales would lead to less imports of relevant goods (esp. watches, handbags and jewelry.)

9 October 2014



Long-lasting structural concerns Although the demonstrations winded down during the past two days and the market rebounded, the negative impact of the political uncertainty on Hong Kong’s competitiveness may last longer than perception. The absence of a consensus on political reform would be a potential hazard to the economy and the capital markets from now till 2017 election.

Furthermore, the government in Beijing may feel rather less disposed to expand on its use of Hong Kong as a testing ground for capital account liberalization as long as there are anti-government protests, which would put Hong Kong at a disadvantage versus other offshore centers and Shanghai.

Tourism would be another interrelated problem. Even before the outbreak of demonstrations, visitor arrivals from the Mainland have slowed to 14.7% growth over the past year, down from c. 25% during 2010-12. Spending by non-residents has been essentially unchanged in the first half of the year from a year ago, the worst outcome since the first half of 2009. This has been a key drag on growth in the economy over the past 18 months. One of the key reasons is that the social tension between Mainland tourists and Hong Kong residents and the proposed Individual Visit Scheme (IVS) cut have already sent “unwelcoming” signal to Mainland shoppers, who are reconsidering Hong Kong as a touring destination. Moreover, as China consumers (especially the emerging middle class) are now pursing genuine travel experience in new destinations rather than pure shopping, Hong Kong may no longer be their prime choice for holidays.

On property, we see limited imminent impact from the protests as turnover rent is insignificant to most landlords and many (most?) Mainland property investors don’t actually live in the apartments they buy. In the medium-term, however, the market may be of less attraction to Mainland capital given uncertainty surrounding the political atmosphere and economic outlook.

Audrey Shi, Hong Kong, +852 2203 6139 Michael Spencer, Hong Kong, +852 2203 8303

Hong Kong: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income

Nominal GDP (USD bn) 263.1 273.7 292.3 312.2Population (mn) 7.15 7.19 7.26 7.31GDP per capita (USD) 36802 38071 40258 42685 Real GDP (YoY%) 1.5 2.9 2.8 3.6 Private consumption 4.1 4.2 2.2 3.7 Government consumption 3.6 2.7 2.8 3.4 Gross fixed investment 6.8 3.3 2.7 4.2 Exports 1.9 6.5 6.7 12.7 Imports 2.9 6.9 6.5 12.8 Prices, Money and Banking CPI (YoY%) eop 3.8 4.3 3.5 3.0CPI (YoY%) ann avg 4.1 4.3 4.0 3.2Broad money (M3, eop) 10.5 12.5 9.5 9.0HKD Bank credit (YoY%, eop) 5.7 8.2 8.3 8.0 Fiscal Accounts (% of GDP)1 Fiscal balance 3.1 0.6 2.6 3.4 Government revenue 21.4 20.9 20.6 20.2 Government expenditure 18.3 20.4 18.0 16.9Primary surplus 3.2 0.6 2.6 3.4 External Accounts (USD bn) Merchandise exports 464.7 508.7 542.6 611.8Merchandise imports 487.4 534.9 569.6 642.6Trade balance -22.7 -26.2 -26.9 -30.8 % of GDP -8.6 -9.6 -9.2 -9.9Current account balance 3.5 5.6 -1.9 12.2 % of GDP 1.3 2.1 -0.7 3.9FDI (net) -9.4 -14.9 -17.2 -18.0FX reserves (USD bn) 317.3 311.2 333.0 356.3FX rate (eop) HKD/USD 7.76 7.76 7.80 7.80 Debt Indicators (% of GDP) Government debt1 8.8 9.9 9.0 9.0 Domestic 8.3 9.5 8.5 8.6 External 0.5 0.5 0.5 0.4Total external debt 397.7 426.2 433.9 419.2 in USD bn 1046.5 1166.4 1250.0 1300.0 Short-term (% of total) 71.9 74.1 74.0 74.0 General Unemployment (ann. avg, %) 3.3 3.4 3.3 3.2 Financial Markets Current 14Q4 15Q1 15Q3Discount base rate 0.50 0.50 0.75 1.003-month interbank rate 0.36 0.50 0.60 0.8010-year yield (%) 1.93 2.10 2.25 2.45HKD/USD 7.75 7.75 7.78 7.80 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Fiscal year ending March of the following year. Debt includes government loans, government bond fund, retail inflation linked bonds, and debt guarantees.

9 October 2014



India Baa2/BBB-(Neg)/BBB- Moody’s/S&P/Fitch

Economic outlook: Some aspects of the economy are improving, especially production and auto sales, but anemic bank credit growth and lackluster trade underscore a lack of vigor in the economic dynamic.

Main risks: While India’s vulnerability metrics have improved considerably, its external financing needs are still considerable. A sudden tightness in dollar liquidity will leave India’s external borrowers in distress.

Uneven recovery; declining vulnerability; RBI on prolonged pause

Leading indicators of production and a rebounding consumption picture (especially auto sales) offer some evidence of an economic recovery. Still, the economy lacks vigor. Trade has slowed in recent months (exports and imports were up just 2.4%yoy and 2.1%yoy, respectively through August), credit growth continues to weaken, and tax collection is poor (up just 1%yoy in the April-August period). Once agriculture production data start coming through, which would also likely be weak given the late arrival of the monsoon, chances are that the ground would be set for a weaker July-Sept quarter over the previous one.

Mixed momentum

-2.0

-1.5

-1.0

-0.5

0.0

0.5

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14

IP ExportsVeh. Prod CreditImports

z score, 3mma

Source: CEIC< Deutsche Bank. Z-score calculated over 1995-2014

Even if growth is not vigorous, India will be entering the Fed rates normalization cycle on a stronger footing than it was last year. Current account deficit has improved, reserves have been rebuilt, investor sentiment is much stronger, and real rates have turned positive thanks to a resolute RBI. While the economy’s gross external funding needs for 2015 are still considerable (better than only Indonesia among the EM Asia peers), the situation is clearly better than in 2013.

Against the backdrop of a mixed recovery and somewhat improved resiliency to shocks, monetary policy is unlikely to do a great deal for the time being. Except for an adjustment to liquidity provided under the export refinancing facility, the Reserve Bank of India stayed the course in its late September policy meeting, leaving all key rates unchanged.

The central bank’s assessment of the global and local economic situation took cognizance of the improvement in the US, stall speed in the EU, risk of disorderly adjustment in the presently buoyant financial markets, some loss of momentum in India during the July-September quarter (with exports offsetting somewhat a weak manufacturing outturn), broadly stable exchange rate and liquidity conditions, and a welcome respite in food and fuel price pressures recently, along with a gradual easing of core inflation.

The policy statement also included an impressive array of reform measures aimed at (i) strengthening the monetary policy framework (by reducing sector-specific refinance facilities); (ii) reforming the structure of the financial system (including revamped provisioning for liquidity coverage and improved monitoring of liquidity); (iii) deepening financial markets (time-bound easing of SLR ceiling, increased limit on hedging for importers); (iv) expanding access to finance (rationalization of KYC needs for banks); and (v) dealing with stress in corporate and financial assets (putting in place an Early Warning System to track banks’ critical financial parameters).

Monetary policy rate call

7.0

7.5

8.0

8.5

9.0

0

2

4

6

8

10

12

2012 2013 2014 2015 2016

CPI, lhs Forecast, lhs

Repo, rhs Forecast, rhs%% yoy

Source: CEIC, Deutsche Bank

9 October 2014



We agree with the RBI that the inflation situation has improved and the near-term outlook is positive. Recent easing of food and fuel prices has set the CPI on course to ease to the 6.5-7% range of the rest of the year. Indeed, there is a good chance for inflation to fall even further if global commodity prices continue to correct.

The uncertainty about the path of inflation beyond a six-month window however remains considerable. A rebound in economic activity, locally and globally, could push up prices; geopolitics in the Middle-east and Russia could complicate the oil price dynamic; and of course weather and infrastructure bottlenecks could create supply side inflationary shocks. These uncertainties are well appreciated by the RBI, as clearly seen in its depiction of a rather wide risk band around its 2015 inflation projection path. We have little doubt in our mind from the latest policy documents that the RBI would prefer maintaining an unchanged stance for a prolonged period, given an improving growth and still-uncertain inflation outlook.

We are not sure if the central bank will manage to remain immune from political pressure, however. We think that it is quite likely that in a few quarters the demand for policy easing will rise considerably as inflation is seen to be stable and growth aspirations soar. It is this political calculus that may well push the central bank into cutting rates in the middle of the next fiscal year (Sept/Oct), in our view.

We assign a probability of 45% to rate cuts next year, although the chance of a resolute RBI holding the line is not trivial (35%). Note that we have left 20% chance for a third scenario. If global market turmoil spikes along with a US rates normalization cycle, few economies will be spared capital flow and FX volatility next year. India, given its large external financing needs (the sum of projected residual maturity external debt and current account deficit for next year is USD 232bn) and modest reserves coverage (about 8 months of imports despite recent accumulation), may find it difficult to differentiate itself among fragile EM economies without exceptional policy measures. One such measure would be to hike rates. It may seem unthinkable right now, but market stress could well push the RBI into moving in this direction next year.

Taimur Baig, Singapore, +65 6423 8681

India: Deutsche Bank Forecasts 2012 2013 2014F 2015FNational Income Nominal GDP (USD bn) 1838 1882 1986 2254

Population (mn) 1218 1236 1255 1274

GDP per capita (USD) 1509 1522 1583 1770

Real GDP (YoY %) 4.9 4.4 5.5 6.5

Private consumption 5.7 4.0 5.6 6.0

Government consumption 7.6 4.4 2.9 5.0

Gross fixed investment 2.4 1.0 3.7 6.5

Exports 8.3 5.3 10.9 13.2

Imports 11.6 -1.0 5.2 10.5

Real GDP (FY YoY %) 1,2 4.5 4.7 5.5 6.5

Prices, Money and Banking

CPI (YoY%) eop 10.6 9.9 6.7 6.6

CPI (YoY%) avg 9.7 10.1 7.7 7.1

Broad money (M3) eop 11.2 14.8 13.5 15.5

Bank credit (YoY%) eop 15.1 13.6 15.0 16.5

Fiscal Accounts (% of GDP) 2

Central government balance -4.9 -4.5 -4.5 -4.2

Government revenue 9.1 9.3 9.3 9.3

Government expenditure 13.9 13.8 13.7 13.5

Central primary balance -1.8 -1.2 -1.2 -1.2

Consolidated deficit -7.2 -7.0 -7.0 -6.7

External Accounts (USD bn)

Merchandise exports 301.9 319.7 329.6 354.3

Merchandise imports 503.5 466.2 484.5 544.2

Trade balance -201.7 -146.5 -154.9 -189.8

% of GDP -11.0 -7.8 -7.6 -8.4

Current account balance -91.5 -49.2 -32.4 -57.3

% of GDP -5.0 -2.6 -1.6 -2.5

FDI (net) 15.4 26.3 25.0 30.0

FX reserves (USD bn) 295.6 293.9 334.2 373.9FX rate (eop) INR/USD 54.8 61.8 61.0 63.0

Debt Indicators (% of GDP)

Government debt 68.5 66.6 64.6 62.9

Domestic 64.9 63.3 61.5 60.0

External 3.6 3.3 3.1 2.9

Total external debt 21.4 22.7 23.6 23.3

in USD bn 394.1 426.9 469.6 526.0

Short-term (% of total) 23.7 21.7 22.7 23.3

General Industrial production (YoY %

-0.6 0.1 6.0 3.8

Financial Markets Current 14Q4 15Q1 15Q3

Repo rate 8.00 8.00 8.00 7.75

3-month treasury bill 8.55 8.50 8.25 8.10

10-year yield (%) 8.50 8.40 8.25 8.20

INR/USD 61.5 61.0 61.6 62.8Source: CEIC, Deutsche Bank. (1) We report “production-side” GDP growth rates for FY. (2) Fiscal year ending March of following year.

9 October 2014



Indonesia Baa3/BB+/BBB- Moody’s/S&P/Fitch

Economic outlook: Although credit and production growth rates are weak, trade appears to be bottoming and auto sales have rebounded. Real GDP growth is unlikely to fall below 5% as growth momentum has stopped worsening.

Main risks: Political risk has spiked with the opposition coalition mounting a major challenge to the incoming President’s ability to govern effectively. Investor concerns could rise at a time of global market stress, with adverse implication for flows, rates, and the rupiah.

Push back

It’s all politics now. In a set of negative developments that took us by surprise, incoming President Joko Widodo has seen not only his efforts to form a majority coalition in the Parliament thwarted, but a recently passed law by the outgoing Parliament appears to have cast doubts on his ability to govern effectively. The new law, if implemented, will see the end of direct election of local leaders, a hallmark of Indonesia’s devolution of power over the past decade and a half. Indeed, Mr. Jokowi himself is a product of these elections, which allowed him to rise to the top of local political offices with a popular following but apparently without the backing of parties that have been part of the establishment for long. We see the passing of this controversial law as sharp push-back by the old establishment to ensure that the opposition does not let Mr. Jokowi govern effectively. Indonesia’s first non-establishment President will likely have his task cut out in office, as a result.

The key outcome of this law would be to effectively allow major opposition parties to appoint heads of local governments wherever they have local legislative control. With the regional governments and the parliament by and large in opposition hand, Mr. Widodo will have very little operating room when he takes office. We see this development as an unmitigated negative.

The investor community has been remarkably patient with recent developments so far, with little sign of selloff, but the nervousness is spreading with each successive negative political development. Queries are rising about investor positioning and mood, and while few investors have blinked yet, these political setbacks come at particularly sensitive time for the Indonesian economy and markets.

Recent trade data suggest that while there is no sign of further deterioration, the current account deficit will continue to be non-trivial (2-3% of GDP) for the time being. Considering the other deficit economy in the region, India, has seen some improvement in its external balances and reserves position, Indonesia runs the risk of being singled out in Asia for its macro fragility in periods of market stress. A year ago, reserves divided by gross external financing (current account plus short term debt on residual maturity) stood at 122% and 114% for India and Indonesia respectively, placing the two economies at the bottom of the EM cohort in terms of reserves adequacy. Since then India has taken forceful measures to compress its current account deficit and accumulate reserves, while Indonesia has made little progress. Consequently, the latest data show the two ratios at 231% and 130%, respectively.

Thus India has seen its vulnerability ranking improve considerably, while Indonesia remains stuck on a high vulnerability plane. Clearly going forward, investor perception of resiliency with respect to handling external funding pressure would be better for India and remain poor for Indonesia.

While we expect the IDR to remain around 12,000 for the rest of the year, undoubtedly the risk of further weakness and volatility is rising. The key event risk is the much anticipated and promised fuel price decision. If the government can put a fuel price adjustment package together by the end of this month, investors will remain calm. A setback on this issue could be very damaging, however.

People power and small parties in the parliament are now critical

All is not lost on the political front though. The controversial law has created an uproar among the population (local polls by Kompass show 80% of the population against the new law), sufficient to galvanize the energy of outgoing President Yudhoyono. The President has made a last-ditch attempt to counter the law by issuing his own decree or emergency legislation which would prevent implementation of the new law. That he had to go this far is revealing, as the President’s own party members abstained when the controversial law was put for a vote in the Parliament. Indeed, with some members of the Parliament who voted for the law already changing their tone, it seems that people power is playing a key role in trying to uphold local elections.

9 October 2014



How does the Presidential decree work? At this stage, it is the overriding law in the country, and the national election commission (KPU) has confirmed it would use the decree as their legal basis to implement more than 200 local elections scheduled for next year. Note that the new Parliament, when it takes office in January, will have to vote on abiding by the decree or rejecting it in favor of the law passed earlier. If the decree is rejected by the legislature, quite plausible if Mr. Jokowi does not manage to expand his existing coalition, then there is a risk of a constitutional crisis as the President-elect could issue yet another decree.

Coalition math remains tricky. Mr. Jokowi’s coalition (consisting of PDIP, PKB, Nasdem, and Hanura parties) has a total of 37% of the seats in the Parliament, and it is still expected that the outgoing President’s PD party, with about 11% of the seats, will support the coalition, especially on the issue of the decree. The possibility that some other lawmakers may break ranks with their parties in support of the decree cannot also be ruled out.

Restoring direct election at the local government level has now become a major imperative for the incoming President. Sorting this issue and reverting focus back on economic issues, especially on dealing with fuel subsidies, will go a long way in establishing Mr. Jokowi’s Presidential credential.

Highlights of the Presidential decree:

Governors, district heads and mayors to be directly elected by the people;

Revocation of controversial Parliamentary Law No. 22/2014 on the appointment of governors, district heads and mayors by their respective local legislatures;

Incorporation of a vetting process for prospective candidates, including public hearings;

Regulations to improve accountability in the use of campaign funds with the aim of reducing corruption;

A ban on involving the local bureaucratic apparatus in campaign activities with the aim of upholding the principle of fairness in local elections and eliminating an unfair advantage of incumbents;

A ban on the removal of local officials in post-elections for political reasons


Indonesia: Deutsche Bank forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 876.9 868.4 868.1 962.4Population (mn) 247.2 250.4 254.8 259.2GDP per capita (USD) 3547 3468 3407 3713 Real GDP (YoY%) 6.3 5.8 5.2 5.5 Private consumption 5.3 5.3 5.3 4.8 Government consumption 1.3 4.9 2.8 4.0 Gross fixed investment 9.7 4.7 5.2 6.5 Exports 2.0 5.3 3.2 6.3 Imports 6.7 1.2 2.1 5.5 Prices, Money and Banking CPI (YoY%) eop 3.7 8.1 4.6 5.4CPI (YoY%) ann avg 4.0 6.4 5.9 4.9Core CPI (YoY%) 4.4 5.0 4.8 4.5Broad money (M2) 15.0 12.7 13.0 15.0Bank credit (YoY%) 24.7 20.1 16.0 20.0 Fiscal Accounts (% of GDP) Budget surplus -2.3 -2.2 -2.4 -2.6 Government revenue 16.5 16.6 16.2 15.8 Government expenditure 18.8 18.8 18.6 18.4Primary surplus -0.3 -0.2 -0.4 -0.6 External Accounts (USD bn) Merchandise exports 188.5 183.5 188.2 199.8Merchandise imports 179.9 177.4 181.8 192.8Trade balance 8.6 6.1 6.4 6.9 % of GDP 1.0 0.7 0.7 0.7Current account balance -24.4 -28.5 -25.9 -26.1 % of GDP -2.8 -3.3 -3.0 -2.7FDI (net) 13.7 14.8 14.0 20.0FX reserves (USD bn) 112.8 99.4 101.9 110.2FX rate (eop) IDR/USD 9646 12087 12000 12000 Debt Indicators (% of GDP) Government debt 23.0 22.2 22.0 22.5 Domestic 12.2 11.2 11.0 11.0 External 10.8 11.0 11.0 11.5Total external debt 28.7 29.7 32.8 30.5 in USD bn 252.4 260.0 290.0 300.0 Short term (% of total) 17.8 19.2 19.0 19.0 General Industrial production (YoY%) 8.0 8.0 7.0 7.0Unemployment (%) 6.8 6.5 6.0 6.0 Financial Markets Current 14Q4 15Q14 15Q3BI rate 7.50 7.50 7.50 7.5010-year yield (%) 8.53 8.40 8.70 9.00 IDR/USD 12200 12000 12100 12150 Source: CEIC, DB Global Markets Research, National Sources

9 October 2014



Malaysia A3/A-/A-(Neg) Moody’s/S&P/Fitch

Economic outlook: The economy is likely to remain on a steady growth path in 2014-15 despite headwinds coming from a high base on exports and decelerating private consumption.

Main risks: Economic fundamentals are improving with rising growth, steady current account surplus, and declining fiscal deficit but sharp swings to the ringgit remain a key risk with a possible reversal of foreign investments and amplified by aggressive overseas investments by Malaysian residents.

Approaching the Budget Speech

Ahead of the Budget Speech on October 10, the government decided to cut fuel subsidies by about 10% effective on October 2. This move consequently raises the retail price of fuel by 20 sen per litre, for RON95 petrol to MYR2.30 and diesel to MYR2.20, against the market rates of MYR2.58 and MYR2.52 per litre, respectively. Meanwhile, the subsidy on RON97 petrol has already been lifted when government last cut subsidies by 20 sen in September 2013.

Inflation likely to remain stable on base effect This most recent fiscal consolidation measure comes at a favorable time when inflation is likely to fall on base effect in September. After the 3.3% inflation print in August, we are forecasting inflation to drop to 2.6% in September because of the base effect from the fuel subsidy cut last year. As a result, the effective 10% hike in fuel prices is only likely to bring inflation back to the previous level of 3.2-3.3% from October to December this year. This would put annual inflation still in line with our 2014 forecast of 3.2%.

BNM: Still one and done for the year We do not see the need for the central bank to respond with a rate hike in the near term, especially as resulting inflation from the fuel subsidy cut comes from a low print in the previous month and growth is likely to moderate in the second half of the year. Also, after the BNM raised the OPR by 25bps in July, the short-term real interest rate in the same month already reverted to positive territory. We see this positive real interest rate fairly sustained through year-end (despite perhaps, a month or two when it goes slightly below zero) and should give the BNM room to keep the OPR steady. This is not to say that risks to financial imbalances have already dissipated. In fact, we think rates are still low and could still spur risk-taking behavior among economic agents. However, we think the BNM would rather take a measured approach in adjusting interest rates and complement the recent rate hike with

existing or additional macro-prudential measures. This is because relying on interest rates alone to correct financial imbalances could bring about an over-adjustment in the economy, to cite the central bank’s report on the matter. 17 Moreover, risks to financial imbalances may already be subsiding with the annual growth in outstanding loans, including those by households, moderating. Bank loans decelerated to 8.6%yoy in July-August from 11% at the start of the year and the same trend can be said for household sector loans.

One rate hike may be enough for 2014.

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That said, we are looking at July 2015 as the next period when the BNM may decide to hike the OPR again, by 25bps to 3.50%. We see this as a move to counter risks of a prolonged spike in inflation induced by the GST in April and other fiscal adjustment measures (such as the recent fuel subsidy cut and other measures likely to come with the Budget Speech). There might, however, be risks of this call being pushed forward to May ahead of a possible normalization of the US Federal Funds Rate in June. But we do not see the rate hike coming earlier in Q12015 as growth could continue to moderate due to de-stocking when firms cut down production before the GST. And, while there might be some frontloading in private expenditures ahead of the GST in April, the degree will likely be contained by higher inflation, tighter credit conditions, and the heavy household debt.

17 Financial Imbalances and the Role of Monetary Policy. BNM Annual Report 2010. http://www.bnm.gov.my/files/publication/ar/en/2010/cp03_001_whitebox.pdf

9 October 2014



Increasingly likely to meet 2014 fiscal deficit target The government estimates at least MYR21bn for the fuel subsidy bill this year, about 8% of the projected total expenditures as indicated in this year’s Budget. This corresponds to about a MYR5bn reduction from our estimated fuel subsidy bill last year, of which savings we think are possible through today’s fuel subsidy cut, the softer fuel prices this year, and the electricity rate adjustment back in January. Add the stronger-than-expected GDP growth this year and moves to cut operating expenditures announced in January, we think the likelihood is high for the government to meet its 3.5%-to-GDP fiscal deficit target for 2014 after exceeding the target last year (deficit came in at 3.9% in 2013 vs. the 4% target).

Expectations of the upcoming Budget Speech We expect the 2015 Budget, set to be tabled on October 10, to provide finality on the implementation of the 6% GST in April 2015 and details of the subsidy rationalization programme (such as moving towards a targeted subsidy program while electricity and toll rates may be adjusted), which would pave the way for a lower fiscal deficit target (3.0% of GDP) next year. The government is also likely to uphold its commitment to increase financial assistance to low-income households and reduce corporate and personal income tax rates, as a means to counter rising living costs from the series of fiscal consolidation measures.

High base capped the growth in exports Meanwhile, exports growth slightly picked up in August as it rose to 1.7%yoy—on the back of increased demand for electronic goods and LNG—from 0.8% in the previous month (4.9% vs. 1.1% in USD terms). On a sequential basis, merchandise exports also expanded 1.9%mom (sa) in August after falling 0.6% in July. But with the favorable base on exports growth dissipating in the second half, it would be hard for Malaysia to experience the type of double-digit growth in exports as seen early in the year. From September through December, exports could gain traction to grow about 6%yoy, in our view, but still slower than the 12.6% average in the first six months of the year.

Merchandise imports also gained pace in August, surging by 7.6%yoy from the 0.7% fall in July (11.0% vs. -0.3% in USD). The acceleration in imports was broad-based, with increases recorded for intermediate, capital, and consumption goods. But with imports rising faster than exports, the trade surplus fell 45%yoy to MYR3.9bn (USD1.2bn) during the month. Increased demand for imported capital goods, arising from a pick-up in public investments going forward, could reduce the trade surplus. Against this backdrop, we maintain our relatively conservative growth outlook of 5.5% (real GDP growth) for 2014.

Diana del Rosario, Singapore, +65 6423 5261

Malaysia: Deutsche Bank forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 305.3 313.3 323.0 336.4Population (mn) 29.5 29.9 30.4 30.8GDP per capita (USD) 10342 10462 10630 10914 Real GDP (YoY%) 5.6 4.7 5.5 5.6Private consumption 8.2 7.2 6.3 4.0Government consumption 5.0 6.3 4.4 6.6Gross fixed investment 19.2 8.5 6.2 6.0Exports -1.8 0.6 5.6 8.2Imports 2.5 2.0 5.2 7.8 Prices, Money and Banking (YoY%) CPI (eop) 1.2 3.2 3.2 3.7CPI (ann avg) 1.7 2.1 3.2 4.1Broad money (eop) 9.0 8.1 7.4 8.6Private credit (eop) 11.9 9.9 8.4 8.5 Fiscal Accounts (% of GDP) Central government surplus -4.5 -3.9 -3.5 -3.2 Government revenue 22.1 21.6 21.4 21.5 Government expenditure 26.5 25.5 24.9 24.7Primary balance -2.4 -1.8 -1.3 -0.9 External Accounts (USD bn) Goods exports 222.3 215.6 232.8 271.4Goods imports 181.8 181.3 206.0 244.0Trade balance 40.6 34.4 26.7 27.4 % of GDP 13.3 11.0 8.3 8.1Current account balance 17.6 12.7 8.4 10.2 % of GDP 5.8 4.0 2.6 3.0FDI (net) -7.9 -1.7 -3.0 -2.2FX reserves (eop) 139.7 134.9 131.7 126.0MYR/USD (eop) 3.06 3.28 3.32 3.36 Debt Indicators (% of GDP) Government debt1 68.4 70.6 67.8 67.1 Domestic 66.7 68.9 66.3 65.5 External 1.8 1.7 1.5 1.6Total external debt 63.7 70.4 61.3 60.9 in USD bn 196.2 211.7 197.4 204.2 Short-term (% of total) 47.0 48.6 46.7 47.9 General (ann. avg) Industrial production (YoY%) 4.5 3.4 3.7 3.4Unemployment (%) 3.0 3.1 3.0 3.1 Financial Markets (%, eop) Current 14Q4 15Q1 15Q3Overnight call rate 3.25 3.25 3.25 3.503-month interbank rate 3.68 3.71 3.71 3.9610-year yield 3.86 4.05 4.20 4.40MYR/USD 3.26 3.32 3.31 3.39 (1) Includes government guarantees Source: CEIC, DB Global Markets Research, National Sources

9 October 2014



Philippines Baa3(Pos)/BBB-/BBB- Moody’s/S&P/Fitch

Economic outlook: Growth could further improve from the rebound in Q2 due to a favourable base on government spending.

Main risks: The balance of payments could turn into deficit in 2014-15 suggesting downside risks to the peso, although ample reserves can still shield the currency from sharp depreciations.

Downside risks to the peso

BOP outlook Year-to-date balance of payments has been in deficit, according to BSP data. From January to August of this year, the deficit amounted to USD3.5bn which was a reversal to the USD3.4bn surplus recorded in the same period in 2013. The BOP deficit reached a record high in January 2014 when the surge in merchandise imports brought the current account into deficit for the first time in 19 months, while non-resident portfolio outflows contributed to the substantial financial account deficit. The same month also reported a drop in the country’s gross international reserves, by about USD3.8bn, and a 1.7% depreciation of the peso (against the USD) over the previous month.

Accumulated BOP has been in deficit year-to-date.

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Source: CEIC and Deutsche Bank

The BOP had since reverted to a small net surplus until the latest print in August. The central bank remains optimistic that a USD1.1bn surplus for the year is attainable. This would mean that September through December would have to generate a BOP surplus of USD4.6bn. The last time the country generated a surplus close to this amount within the same period was in 2012 (USD4.2bn) when strong non-resident inflows boosted the financial account.

We, however, think that 2014 could see the BOP in deficit of about USD1.2bn. This is because stronger growth in exports and remittances through year-end could be pared down by increased demand for imported goods related to public works and typhoon-related reconstruction. Net portfolio inflows could also shrink on expectations of an imminent US Fed rate hike. That said, we are still looking at a modest surplus in Sep-Dec but which may not be sufficient to overturn the year-to-date deficit in the BOP. This deficit could also extend through 2015 as the Aquino administration moves to accelerate infrastructure spending, inflation rises on power supply issues, domestic economic uncertainty looms with the upcoming 2016 presidential elections, and as capital reversals get amplified with the normalization of US rates.

BOP could be in deficit in 2014 and 2015.

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Impact on the peso The peso has fallen against the dollar over the past year, along with its Asian peers. In our view, it may gain a bit by year-end from its current rate on the back of an improvement in the BOP position, supported by remittances that tend to gain pace during the Christmas holidays and possibly by another SDA rate hike by the BSP in December.

The appreciation, however, may prove to be short-lived as the peso could weaken again through 2015 on another year of deficit in the BOP. Uncertainty lurking around the May 2016 elections, especially if odds are high of a non-administration candidate to take the presidential post, could also contribute to the peso’s modest depreciation against the dollar in Q42015.

9 October 2014



Ample reserves can still shield sharp losses in the peso While the country’s GIR has fallen along with the deficit in the BOP, it remains in a healthy position especially when compared to the rest of emerging Asia. September-2014 GIR at USD80.4bn is still sufficient to cover at least 13 months’ worth of goods imports. The Philippines’ record just comes after China and Taiwan’s substantial import cover and is superior to the rest of emerging Asian countries that have reserves worth less than 10 months of goods imports. The country also has minimal gross external financing needs (at less than 1.5% of GDP), due to its current account surplus and low short-term external liabilities. Projected GIR next year is equivalent to 28 times the country’s gross external funding needs, suggesting the Philippines’ stronger cushion relative to its Asian peers. Thus, even if the market for dollar were to shut down for all of 2015, the economy has more than enough reserves to service its immediate foreign liabilities and to defend sharp movements in the peso.

Philippines has the strongest external funding cushion

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28

2015 Reserves/GEF

GEF = Gross external funding needs, sum of the current account deficit and short-term external debt by residual maturity. Source: CEIC, BIS-IMF-OECD-World Bank Joint External Debt Hub, and Deutsche Bank.

BSP likely to pause this October We have been expecting inflation to start moderating in September on base effects—barring the occurrence of severe natural disasters—to welcome 2015 with a headline print within the 2-4% target. With September inflation falling 50bps to 4.4% from the previous month on a slower increase in food prices, we think odds are now higher for the BSP to keep rates steady at this month’s monetary policy meeting. In fact, we no longer expect the BSP to hike the repo and reverse repo rates until May 2015 when inflation rises again because of a shortage in power supply. Yet, the BSP may hike the SDA rate by another 25bps in December 2014 in a move to bring credit growth back to the more sustainable, long-term average of about 15%yoy.

Diana del Rosario, Singapore, +65 6423 5261

Philippines: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 250.2 272.1 283.1 312.3Population (mn) 96.6 98.4 100.2 102.0GDP per capita (USD) 2590 2764 2825 3062

Real GDP (YoY%) 6.8 7.2 6.6 6.8 Private consumption 6.6 5.7 5.0 4.9 Government consumption 15.5 7.7 7.9 9.7 Gross fixed investment 10.8 11.9 9.0 10.6 Exports 8.5 -1.1 9.2 10.6 Imports 4.9 5.4 5.8 11.4

Prices, Money and Banking (YoY%) CPI (eop) 3.0 4.1 3.8 3.6CPI (ann avg) 3.2 2.9 4.3 3.6Broad money (M3, eop) 9.4 31.8 13.8 11.0Private credit (eop) 14.8 16.5 14.8 10.0

Fiscal Accounts (% of GDP)1 Fiscal balance -2.3 -1.4 -1.8 -2.2 Government revenue 14.5 14.9 15.9 15.8 Government expenditure 16.8 16.3 17.7 18.0Primary surplus 0.7 1.4 0.8 0.6

External Accounts (USD bn) Goods exports 46.4 44.5 47.5 55.4Goods imports 65.3 62.2 67.0 77.0Trade balance -18.9 -17.7 -19.4 -21.5 % of GDP -7.6 -6.5 -6.9 -6.9Current account balance 6.9 10.4 10.1 10.3 % of GDP 2.8 3.8 3.6 3.3FDI (net) -1.0 -0.2 1.0 0.4FX reserves (eop) 83.8 83.2 82.0 81.9PHP/USD (eop) 41.2 44.4 44.4 45.4

Debt Indicators (% of GDP) General government debt2 56.2 53.3 54.2 53.9 Domestic 34.2 33.5 35.4 36.1 External 22.0 19.8 18.8 17.8External debt 24.1 21.5 18.0 19.3 in USD bn 60.3 58.5 50.8 60.3 Short-term (% of total) 14.1 19.2 15.7 14.9

General (ann. avg) Industrial production (YoY%) 7.7 13.9 11.7 15.2Unemployment (%) 7.0 7.1 7.3 7.0

Financial Markets (%, eop) Current 14Q4 15Q1 15Q3Policy rate (BSP o/n repo) 6.00 6.00 6.00 6.25Policy rate (BSP o/n rev repo) 4.00 4.00 4.00 4.253-month T-bill rate 1.14 1.49 1.79 2.3910-year yield (%) 4.16 4.35 4.60 4.80PHP/USD 44.6 44.4 44.2 45.4 (1) Refers to general government. (2) Includes guarantees on SOE debt. Source: CEIC, DB Global Markets Research, National Sources

9 October 2014



Singapore Aaa/AAA/AAA Moody’s/S&P/Fitch

Economic outlook: The outlook is characterized by benign inflation and incipient pressure on rates and FX. The growth dynamic is contingent on a long overdue pick-up in external demand.

Main risks: Key risk is disorderly USD and US rates movements, which could impact financial flows, as well as household and corporate balance sheets

How to deal with a US rally

Singapore’s open economy characteristic offers many virtues while making is vulnerable to shifts in global investor risk appetite as well as external demand. Both risks are weighing heavily on the economy right now, and will likely continue to do so for a number of quarters ahead, in our view.

Domestic economic dynamic is broadly stable. Inflation is exceptionally benign, with CPI inflation easing to 0.9% in August from 1.2% in July. Private road transport costs continue to decline (down 2.9% in August after -1.6% in the previous month, reflecting lower COE premiums). Fuel prices rose at a slower pace of 0.7%, compared to 3.1% a month ago, with benign commodity prices becoming a worldwide phenomenon and a major risk dampener.

Services inflation edged down to 2.1% in August from 2.5% in July; this reflected softer rate of increases in the costs of recreation & entertainment, as well as holiday travel.

Accommodation costs, a major source of concern and policy measures in recent years, have ceased to command headlines, easing by 0.2% after coming in flat in July. The housing rental market, reflecting an adverse supply-demand dynamic, has softened considerably this year.

Even food prices are no longer a source of inflationary pressure, with overall food inflation slightly lower at 2.9% in August compared to 3.0% a month ago. The only area where there was some upward pressure was “non-cooked food prices,” which rose by 3.4% compared to 2.8% in July, reflecting steeper price increases for seafood and vegetables.

As one would expect, given these developments, the MAS core inflation index (which excludes the costs of accommodation and private road transport) eased to 2.1% in August (2.2% in July).

Given this backdrop, and expecting both rental and auto prices to remain stable for the rest of the year, we

see inflation ending the year slightly below 1%. Presently we see 2015 being a sub-2% inflation year as well, with inflation momentum firmly in negative territory (see chart).

Little risk from inflation

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The benign inflation situation begs the question if the time has come for easing of monetary and financial conditions in Singapore, especially if external demand remains lackluster and domestic exposure to the rate cycle is considerable. We think that the MAS will find it prudent to maintain an unchanged policy stance for the time being as the property market cooling measures have just begun to pay dividends without causing any volatility. Also, the political economy of benign property prices is substantial, which the authorities will appreciate. Hence cooling measures will remain on the table, in our view.

As far as the exchange rate policy is concerned, we also don’t see any point any changing the present stance. Low inflation and weakening of the SGD against the USD has begun to have an impact on the direction of the REER and NEER already. Even without changing its explicit policy, the authorities have allowed conditions to ease (since the exchange rate has depreciated and rates have been stable). With rates in the US going up next year and further pressure on the exchange rate inevitable, allowing the NEER to trade toward the bottom half of the policy band will be a natural move for the MAS, in our view. But with growth likely track cyclical improvement in the G2 economies, we don’t think there will be a need to add further accommodation.

9 October 2014



REER has flattened, SGD/USD has weakened

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Vulnerability metrics

Another reason why the authorities may not want to allow for a markedly weaker exchange rate is that the resulting rise in rates could hurt Singapore’s households and firms. Private sector leverage is about 130% of GDP, compared to less than 100% of GDP in 2010. Gross external financing needs, despite a large current account surplus, is substantial (see chart below).

Reserves over gross external financing

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South KoreaMalaysiaThailand

ChinaPhilippines

TaiwanSingapore

Hong Kong

Source: CEIC< World Bank, Deutsche Bank. GEF is the sum of 2015 projected current account and debt due over the year (on a residual maturity basis.

While the economy remains characterized by strong assets, the liability accumulation in recent years cannot be ignored, especially since it has taken place with rates at historic lows. We think declining inflation and a mildly weaker exchange rate will still keep Singapore’s real returns attractive for investors, leaving liquidity and funding conditions in stable territory.


Singapore: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 284.5 295.8 298.9 311.3Population (mn) 5.3 5.4 5.5 5.6GDP per capita (USD) 53547 54594 54339 55588 Real GDP (YoY%) 2.5 3.9 3.0 4.0 Private consumption 3.9 2.6 1.1 1.0 Government consumption -0.1 9.9 6.7 8.3 Gross fixed investment 8.9 -1.9 -7.0 -2.0 Exports 1.5 3.6 3.6 5.5 Imports 3.1 3.1 2.0 4.5Prices, Money and Banking

CPI (YoY%) eop 4.3 1.5 0.9 2.3CPI (YoY%) ann avg 4.6 2.4 1.3 1.8Broad money (M2) 10.4 9.7 8.5 11Bank credit (YoY%) 12.9 9.8 10.4 10.5

Fiscal Accounts (% of GDP)

Fiscal balance 7.8 7.1 6.9 6.8 Government revenue 22.8 21.9 22.1 22.3 Government expenditure 15.0 14.8 15.2 15.5 External Accounts (USD bn)

Merchandise exports 434.6 436.9 463.1 495.5Merchandise imports 371.7 369.0 391.2 422.5Trade balance 62.9 67.9 71.9 73.1 % of GDP 22.1 22.9 23.5 22.0Current account balance 49.4 54.4 55.3 55.0 % of GDP 17.4 18.4 18.1 16.5FDI (net) 47.6 36.9 10.0 12.0FX reserves (USD bn) 259.3 273.1 305.3 335.4FX rate (eop) SGD/USD 1.22 1.26 1.30 1.35

Debt Indicators (% of GDP) Government debt 106.1 110.9 115.6 117.7 Domestic 106.1 110.9 115.6 117.7 External 0.0 1.0 1.0 1.0Total external debt 416 410 391 362 in USD bn 1151 1208 1214 1220 Short-term (% of total) 69.5 68.8 69.0 70.0General

Industrial production (YoY%) -1.2 2.8 1.6 3Unemployment (%) (eop) 2.6 2.8 2.6 2.5

Financial Markets Current 14Q4 15Q1 15Q33-month interbank rate 0.41 0.50 0.55 0.8010-year yield (%) 2.39 2.50 2.60 2.80SGD/USD 1.28 1.30 1.33 1.35 Source: CEIC, DB Global Markets Research, National Sources Note: includes external liabilities of ACU banks.

9 October 2014



South Korea Aa3/A+/AA- \Moody’s/S&P/Fitch

Economic outlook: Investment takes over from consumption as weak link in growth in Q3.

Main risks: Along with deregulation, better labour-employer relations are needed to keep jobs onshore.

Investment headwinds

Business investment weakens... Equipment investment growth momentum fell sharply in August, by 9.1% 3m/3m saar, vs. 6.3% and 8.9% growth in July and Q2, respectively, as both machinery and transportation equipment investments fell. Although business sentiment bottomed, its weakness remains a point of concern. While the recovery in the domestic economy supported domestic enterprises’ sentiment, that of exporting enterprises remained weak, dragged down by large enterprises.

Weaker exports and investment growth momentum

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…amid limited rebound in exports, as labour strikes continued… Although export growth rebounded in September, to 6.9%yoy, its weakness the previous month left Q3 growth at 4.0%, only modestly higher than the 3.3% growth reported in Q2, as the labour strike in the auto industry negatively affected its exports. According to the full month trade data, auto exports growth slowed to 0.5% in July/August, down from the 3.4% rise in Q2. Meanwhile, the trade data for the first 20 days pointing to a 1.6% decline in Q3 vs. the 3.7% rise in Q2. Meanwhile, auto production fell 14.8% yoy in August, leaving the July/August growth rate at 2.8%, down from 3.6% in Q2. As we warned in our report South Korea: Labour at a crossroads, published on 5 June 2014, labour disputes weighed on manufacturing this year.

Labour strikes hurt the auto sector

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Overseas production now constitutes about 60% of total production for the auto industry, up 20ppts over the past decade. Korea risks further hollowing out its manufacturing sector in terms of employment, as poor labour-employer relations, the relatively high cost of production and the won’s strength drive investment outward.

…while overall production recovers modestly, supported by stimulus measures… Amid weakness in the auto sector, headline manufacturing production growth was low, at 0.6% yoy in July/August, albeit better than the 0.2% increase reported in Q2. In contrast, growth in administration activities rose sharply during the same period, to 3.9% from a 0.4% fall in Q2, as the government increased its support of the economy. Meanwhile, services production also saw improvement, rising 2.4% in July/August, up from 1.4% growth in Q2, helping to guide overall production higher at 1.7% from 0.8% in the same period.

Manufacturing growth momentum weaker vs. services

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Mfg Services (rhs)% 3m/3m saar


9 October 2014



Within the sector, services growth was led by financial and real estate, which saw higher growth of 5.3% and 6.7%, respectively, in July/August, vs. 4.3% and 3.5% in Q2. The local stock market turnover rose 44% in Q3 vs. Q2, in expectation of and response to policy actions by the government and BoK, while banks’ lending rates (newly extended) to households fell to 3.76% in August from 3.93% in July. Banks’ mortgage loans growth was higher in July/August, at 6.9% vs. 5.6% in Q2, supporting housing prices. The latter rose 1.8%yoy in Q3, up from 1.4% in Q2, as the number of unsold residential properties fell to its lowest level in ten years.

Housing prices and loan growth rise

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Consumer sentiment on the domestic economic situation trended modestly higher, to 83 in September from 81 in August, albeit still lower than the pre-Sewol accident level of 91 in April. As consumer sentiment improved, retail sales growth momentum recovered, reaching its highest level in two years in August, at 6.2% 3m/3m saar, after falling 5% in April, its lowest level in six years. On a yoy basis, retail sales growth rebounded modestly, to 1.4% in July/August, from 0.8% in Q2. This was led by semi-durable goods sales, which saw 0.9% growth in July/August vs. a 2.5% fall in Q2, while other categories, including auto sales, saw their growth slow.

…with more support planned ahead. Amid tepid signs of recovery, the government requested a 5.7% increase in its budget for 2015 vs. its medium-term target growth of 3.5%. In line with its policy priorities, following National Disaster Management, R&D and creative activities will see the largest increases in their budgets, albeit from low levels. Meanwhile, the sustained fall in headline inflation, to 1.1% in September from 1.4% in August, supports our expectation of another rate cut by the Bank of Korea, especially as the KRW reer hovers around pre-GFC levels.

Juliana Lee, Hong Kong, +852 2203 8312

South Korea: Deutsche Bank forecasts 2012 2013 2014F 2015F

National income

Nominal GDP (USDbn) 1223 1305 1429 1475 Population (m) 50.0 50.2 50.4 50.6GDP per capita (USD) 24469 25979 28374 29144

Real GDP (yoy %) 2.3 3.0 3.6 3.8 Private consumption 1.9 2.0 2.0 2.8 Government consumption 3.4 2.7 1.7 2.0 Gross fixed investment -0.5 4.2 4.2 4.3 Exports 5.1 4.3 4.8 6.8 Imports 2.4 1.6 3.4 6.5 Prices, money and banking

CPI (yoy %) eop 1.4 1.1 1.5 2.7CPI (yoy %) ann avg 2.2 1.3 1.4 2.3Broad money (Lf) 8.8 9.0 9.5 9.5 Bank credit (yoy %) 5.0 4.0 6.0 6.5 Fiscal accounts (% of GDP)

Central government surplus 1.5 1.0 0.2 0.0 Government revenue 24.5 22.0 21.4 21.4 Government expenditure 23.0 21.0 21.2 21.4Primary surplus 2.7 0.6 0.0 1.2 External accounts (USDbn)

Merchandise exports 603.5 617.1 625.2 649.7Merchandise imports 554.1 536.6 540.6 581.3Trade balance 49.4 80.6 84.6 68.4 % of GDP 4.0 6.2 5.9 4.6Current account balance 50.8 79.9 79.4 66.9 % of GDP 4.2 6.1 5.6 4.5FDI (net) -21.1 -17.0 -16.0 -14.0FX reserves (USDbn) 1 327.0 346.5 376.5 388.6FX rate (eop) KRW/USD 1064 1050 1060 1080

Debt indicators (% of GDP) Government debt2 33.2 34.8 35.1 35.6 Domestic 32.6 34.3 34.4 34.8 External 0.6 0.5 0.7 0.8Total external debt 33.4 31.9 30.2 29.6 in USDbn 408.9 416.1 430.0 432.0 Short-term (% of total) 31.3 27.7 27.4 27.8

General

Industrial production (yoy %) 1.5 0.2 3.0 4.5 Unemployment (%) 3.2 3.1 3.1 3.1

Financial markets Current Q4 14 Q1 15 Q315BoK base rate 2.25 2.00 2.00 2.2591-day CD 2.35 2.15 2.15 2.45

10-year yield (%) 2.86 3.10 3.30 3.50KRW/USD 1069 1060 1070 1080

Source: CEIC, Deutsche Bank estimates, Global Markets Research, National Sources Note: (1) FX swap funds unaccounted for (2) Includes government guarantees

9 October 2014



Sri Lanka B1(stable)/B+/BB- Moody’s/S&P/Fitch

Economic outlook: Sri Lanka registered an average real GDP growth of 7.7% in 1H’2014; we expect growth momentum to moderate slightly in the second half of 2014 (7.3% average), mainly due to a negative base effect.

Main risks: Prospects of volatility in global financial markets, led by anticipation of a quicker than expected turn in the US rate cycle, could put pressure on Sri Lanka’s exchange rate, thereby complicating monetary policy decisions.

CBSL delivers an “effective rate cut”

We had expected the central bank to cut policy rates by 50bps in the September meeting, given the sluggish credit growth rate and benign inflation environment. While the Central Bank of Sri Lanka kept all key policy rates unchanged in the September monetary policy review, it took some specific steps to improve private sector credit growth momentum in the economy. These are:

i) Access of OMO participants to the Standing Deposit Facility (SDF) of the central bank at the currently applicable SDF rate of 6.50% will be limited to a maximum of three times per calendar month.

ii) Any deposits at the SDF window exceeding three times by an OMO participant to be accepted at a reduced interest rate of 5.0% per annum (made effective from 23rd September 2014; will continue until further notice).

iii) Daily auction facility was suspended with effect from 23rd September until further notice.

These above measures constitute an “effective rate cut”, in our view, as the commercial banks would have lesser incentive to deploy funds with the central bank now and would also likely lend out the funds at a relatively lower rate than the pre-policy rate.

These measures will likely help the credit growth momentum to gain traction in the coming months, albeit from a depressed base, but are unlikely to lead to major inflationary pressure in the economy, at least in the next 4-6 months. While inflation has probably bottomed in this cycle, we expect CPI inflation to remain in the mid-single digit range over the next 6 months. This should help the central bank to remain on the sidelines for an extended period.

Private sector credit growth remains anemic

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Inflation and policy rate forecast: extended pause likely

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Healthy growth momentum in 1H’2014; some moderation likely in 2H

Sri Lanka’s real GDP grew 7.8%yoy in Q2, as we expected, with the outturn being slightly better than Q1 (7.6%yoy). Consequently, the Sri Lankan economy registered an average growth of 7.7% in the first half of 2014, which is one of the strongest growth outturn within the Asian region.

As far as the details of the Q2 growth composition is concerned, we note that agricultural sector growth rebounded sharply (6.5%yoy in Q2 vs. 0.2%yoy in Q1), while industrial (12.2%yoy vs. 12.6%yoy) and services (5.8%yoy vs. 6.5%yoy) sector growth moderated from the previous quarter. Consequently, non-farm sector growth moderated to 7.9%yoy in Q2, from 8.7%yoy in Q1 of 2014.

9 October 2014



Growth momentum remains healthy

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Going forward, we expect the growth momentum to moderate in 2H of 2014, mainly due to a negative base effect. We expect real GDP growth to average 7.3% in 2H, which should likely result in a full year growth outturn of 7.5%yoy in 2014 (vs. 7.3%yoy in 2013).

Despite headline growth remaining robust, we suspect that consumption growth momentum remains weak, given anemic credit growth rate. Last year, while Sri Lanka achieved a 7.3% annual growth rate, consumption growth momentum was extraordinarily weak (3.2%yoy in 2013 vs. 5.5%yoy in 2012), and this led the central bank to maintain an accommodative monetary stance. While we don’t have the expenditure side data on a quarterly basis, we think the same dynamic is playing out in this year as well, leading the central bank to remain accommodative, despite strong headline growth rate. We expect the accommodative stance of CBSL to continue at least for the next two quarters, by which time there should be some improvement in the private sector credit growth and consumption momentum.

Consumption growth rate has fallen sharply

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Kaushik Das, Mumbai, +91 22 7180 4909

Sri Lanka: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 59.0 67.0 76.2 88.3

Population (mn) 21.1 21.3 21.5 21.7


Real GDP (YoY %) 6.3 7.3 7.5 7.5

Total consumption 5.5 3.2 5.0 6.8 Total investment 10.7 9.7 11.1 11.7

Private 9.2 10.0 12.0 13.0

Government 16.0 9.5 8.0 7.0 Exports 0.2 5.9 9.0 10.0

Imports 0.5 -0.3 6.0 11.5


CPI (YoY%) eop 9.2 4.7 5.4 6.2

CPI (YoY%) avg 7.6 6.9 4.0 6.3Broad money (M2b) eop 17.6 16.7 13.0 16.5

Bank credit (YoY%) eop 17.6 7.5 8.0 21.0


Central government balance -6.4 -5.8 -5.5 -5.0

Government revenue 14.1 13.8 14.0 14.2 Government expenditure 20.5 19.7 19.5 19.2

Primary balance -1.1 -0.7 -1.1 -0.7



Merchandise imports 19.2 18.0 19.4 21.2Trade balance -9.4 -7.6 -8.3 -9.2

% of GDP -16.0 -11.4 -10.9 -10.4

Current account balance -3.9 -2.6 -2.6 -2.8 % of GDP -6.6 -3.9 -3.4 -3.2

FDI (net) 0.9 0.9 1.0 1.3

FX reserves (USD bn) 6.9 7.2 10.0 11.0FX rate (eop) LKR/USD 127.7 130.8 130.0 128.0

Debt Indicators (% of GDP) Government debt 79.1 79.4 77.3 75.0

Domestic 42.6 42.5 41.0 39.4

External 36.5 36.9 36.3 35.6Total external debt 48.2 46.7 45.2 43.3

in USD bn 28.4 31.3 34.4 37.9


General

Industrial production (YoY %) 6.0 7.5 8.0 8.5Unemployment (%) 4.2 4.1 4.0 4.0

Financial Markets Current 14Q4 15Q1 15Q3Reverse Repo rate 8.00 8.00 8.00 8.50

LKR/USD 130.4 130.0 129.4 128.5 Source: CEIC, DB Global Markets Research, National Sources

9 October 2014



Taiwan Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic outlook: We see stronger GDP growth than the government forecast of 3.6% in Q3.

Main risks: Weaker stock prices pose downside risks to our relatively positive view on growth.

Sentiment tempered by the market

Steady rates… The Central Bank of China (CBC) left its policy rate unchanged at its September meeting, as we expected, noting that the current policy rate is suitable in fostering growth amid “lingering uncertainties in the global economy, a negative domestic output gap, and a mild outlook for inflation.” As the CBC sees the balance of risks tilted towards growth, we maintain our forecast of no change in policy rates until mid-2015.

…as lower stock prices weigh on sentiment… Although the CBC expects “the moderate expansion of the global economy…to boost Taiwan's exports,” it noted its concerns about domestic demand. In particular, it said that “private investment may increase at a slightly slower pace,” while private consumption growth may be dampened as “food safety concerns weigh on consumer confidence.”

Sentiment weakens, led by stock market concerns

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Consumer confidenceMfg and service industry sentimentCCI on investment prospect of stock market

Index


While consumer sentiment indeed fell sharply in August and has been moving sideways since then, this weakness can be attributed largely to a deteriorating consumer view on stock market investment prospects, not food safety concerns. Meanwhile, although consumer sentiment on the economic climate also worsened sharply, the view on employment opportunities remained relatively positive, albeit falling modestly. Payrolls continued to rise at a steady pace of around 1%, guiding the unemployment rate lower to 3.9% in August, its lowest level since the GFC. Retail sales growth rose modestly to 3% in July/August from 2.8% in Q2.

Rebound in trade activities

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Exports Imports

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…despite stronger exports and overall growth momentum… Although export growth surprised to the downside in September, it averaged sharply higher at 6.7% in Q3, vs. 2.9% in Q2, led by stronger electronics exports. Meanwhile, imports rose even faster at 7.9% in Q3 vs. 3.7% in Q2. In particular, imports of machinery/electrical equipment rose 6.4% in Q3, vs. 2.7% in Q2, pointing to stronger investments in Q3, unless construction disappoints. The latter looks unlikely as far as construction industry sentiment is concerned, with the index rising to its highest level since December 2013.

Stronger overall growth momentum

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Driven by stronger exports, the coincident index continued to point to stronger growth momentum in August, with 3m/3m saar at 6.4% vs. 4.9% in Q2. On a yoy basis, the index rose 4.9% in July/August vs. 4.0% in Q2, suggesting that Taiwan’s GDP growth may again be stronger than the government’s forecast in Q3. In its latest MPC statement, the CBC reiterated the

9 October 2014



Directorate-General of Budget, Accounting, and Statistics (DGBAS)’s forecast of 3.1% for Q4 and 3.4% for 2014, suggesting lower GDP growth of 3.6% in Q3 vs. 3.7% in Q2, in contrast to our forecast of stronger GDP growth of around 4%.

Inflations falls as food prices normalize

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…while inflation falls as food prices normalize... CPI inflation fell sharply in September, to 0.7%yoy from 2.1% in August, as food price inflation normalized. Taiwan’s fresh vegetable prices fell sharply in September, by 20.9%, after several typhoons pushed up their prices by 11.1% in August. Meanwhile, meat price inflation eased modestly, to 11.1% in September from 11.9% in August. The latter have remained high since the outbreak of porcine epidemic diarrhea virus (PEDv) early this year. Despite a continued recovery in growth, we see headline inflation remaining relatively stable, averaging 1.5% in 2015 vs. 1.4% in 2014, as food prices continue to normalize and international commodity prices remain in check. The DGBAS also expects CPI inflation of 1.5% in 2015, down from 1.6%.

…and asset bubble concerns ease. The Central Bank of China (CBC) noted that banks' mortgage-related risk management has improved, while the concentration of real estate lending in banks' loan portfolios and growth in loans collateralized against land classified for industrial use both easing in response to its prudential measures. Loan growth slowed to 4.4% in July/August from 4.7% in Q2. Meanwhile, there was a broader moderation in the increase in housing prices in July/August, when compared to Q2 levels. The asset quality of Taiwan’s domestic banks was stable. The NPL ratio stood at only 0.28% in July/August, down from 3% in Q2, while the LTD ratio fell to 77.58% from 77.9%.


Taiwan: Deutsche Bank forecasts 2012 2013 2014F 2015FNational income Nominal GDP (USDbn) 476.4 490.8 504.3 525.6Population (m) 23.3 23.4 23.4 23.5GDP per capita (USD) 20432 20996 21510 22353

Real GDP (yoy %) 1.5 2.1 3.7 3.8 Private consumption 1.6 2.0 2.6 2.9 Government consumption 1.0 -0.3 0.7 0.6 Gross fixed investment -4.0 4.7 3.3 3.5 Exports 0.1 3.8 5.5 6.7 Imports -2.2 3.9 5.1 6.3

Prices, money and banking CPI (yoy %) eop 1.6 0.3 1.6 1.5

CPI (yoy %) annual average 1.9 0.8 1.4 1.5

Broad money (M2) 4.9 4.3 6.0 6.5

Bank credit1 (yoy %) 3.3 2.7 3.5 4.0

Fiscal accounts (% of GDP) Budget surplus -2.5 -1.4 -2.0 -1.8

Government revenue 16.5 16.9 16.4 16.2

Government expenditure 19.0 18.3 18.3 17.9Primary surplus -1.5 -0.4 -0.8 -0.6

External accounts (USDbn) Merchandise exports 300.4 304.6 321.9 342.3


Trade balance 31.6 37.0 39.4 41.3 % of GDP 6.6 7.5 7.8 7.9

Current account balance 50.7 57.4 64.9 62.5

% of GDP 10.6 11.7 12.9 11.9FDI (net) -9.9 -1.0 -11.0 -14.0

FX reserves (USD bn) 403.2 416.8 430.8 436.4

FX rate (eop) TWD/USD 29.2 29.8 30.0 30.2

Debt indicators (% of GDP)

Government debt2 42.9 41.3 41.7 41.8 Domestic 42.2 40.9 41.2 41.3

External 0.7 0.5 0.5 0.4

Total external debt 27.6 34.6 37.6 36.2 in USDbn 130.8 170.1 190.0 190.0


General

Industrial production (YoY%) 0.0 0.8 3.8 4.0

Unemployment (%) 4.2 4.2 4.0 4.0

Financial markets Current Q4 14 Q1 15 Q3 15Discount rate 1.88 1.88 1.88 2.0090-day CP 0.83 0.85 0.88 1.00

10-year yield (%) 1.71 1.80 1.95 2.10

TWD/USD 30.4 30.0 30.1 30.2 Source: CEIC, Deutsche Bank Global Markets Research, National Sources Note: (1) Credit to private sector. (2) Including guarantees on SOE debt

9 October 2014



Thailand Baa1/BBB+/BBB+ Moody’s/S&P/Fitch

Economic outlook: Growth continues to weaken as attempts by the military regime to revive consumption and investment have yet to provide a discernible boost to the economy, while trade remains in contractionary territory.

Main risks: Markets remain resilient in expectation of greater policy efficacy and political stability. These assumptions could be tested if growth remains lackluster for a few more quarters and global market volatility hits Thailand.

Still in doldrums

Our core view, detailed in last month’s special publication “Thailand: Is this time different?” remains unchanged. While the near-term outlook may have improved somewhat due to the stabilization imposed by the military regime, the economy remains mired in a number of structural constraints. As the external environment becomes more challenging, we worry that Thailand’s high public and private debt, worsening demographics, eroding competiveness, and long-term political uncertainty may weigh in considerably.

Despite the authorities attempts to turn around the consumption and investment situation, latest data offer little constructive, putting at risk our 2014 economic growth forecast. Consider the following:

Domestic demand continues to be weak, with the private consumption index for August declining by 0.8%yoy as consumer spending on non-durable goods such as food & beverages softened, on top of the continued decline in car sales.

The private investment index slipped by 5.6%yoy. Capital spending related to machinery & equipment underwent further contraction, following sluggish exports. Related to this, the index of industrial shipment was down 7.3%yoy through August, and the index of inventory rose for the second consecutive month (only 5% below a record cyclical high).

Trade continued to disappoint, with exports down 7.4%yoy through August and imports down 14.2%yoy.

The indicator of consumer confidence, so far on an upward trend since the military takeover, declined in September, stalling at a level well below than what was seen in early 2013.

With price controls firmly in place, inflation has eased to 1.8%yoy in September (core 1.7%), pushing up the real interest in positive territory for

the first time since February. We think however that suppressed inflation and external risks will keep BoT on the sideline with its rates decision.

Falling inflation has brought real rates in positive

territory

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The government’s leading index of business cycle has remained flat (at around 120) since the beginning of this year.

The Thai industries sentiment index has stalled lately after showing some signs of a rebound a few months ago.

Flattening business sentiments

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Business sentiment

Business sentiment: next 3 months


These developments clearly put our 2014 GDP growth forecast of 1.5% is under some risk. Exports would need to pick up expeditiously for growth to exceed 1%, but that is still not an unrealistic expectation, in our view.

9 October 2014



Provided the ongoing economic acceleration in US demand translates into higher orders and tourism turns around, the end of the calendar year could well be a tad better than the poor performance seen so far this year.

Budget blues

The government confirmed that despite a major shortfall in revenues (amounting to BHT276bn or 2.2% of GDP), the FY2014 budget managed to incur a deficit of BHT112bn, lower than projected (BHT250bn). This was accomplished by holding back spending, especially capital spending which fell short of the budgetary target by a third.

It is conceivable to make a bullish case for next year under the scenario that left-over cash from this year’s budgetary savings would ease financing pressures and allow for a front-loaded boost to spending. It will be a test of the incumbent regime’s administrative efficiency and sense of urgency for that scenario to pan out, but for now we will not build expedited spending in our forecast model.

We are also unimpressed with the much-anticipated stimulus package announced recently. Most of the measures contained in the THB365bn (nearly 3% of GDP) package should be considered as simply expedited spending of prevailing budgetary items. Interestingly, the military regime has opted to go along with a rice subsidy program to support rural income, much like previous governments have done.

Infrastructure push continues

The authorities continue to try to galvanize investor sentiment by pushing for investment projects. In its latest iteration, the transportation ministry has announced the following:

Expanding the Bangkok international airport. The project would be worth BHT62bn (USD2bn), featuring the expansion of the passenger terminal, a monorail train to link the old and new terminals, new runway, additional bays for planes, and a new car park.

In anticipation of the ASEAN Economic Community (AEC), the authorities will conduct a study for building six more airports to link neighboring countries. Construction could begin as early as next year if the feasibility studies are endorsed by the government.

The Board of Investment (BoI) approved investment applications worth BHT90bn recently, with a focus on supporting the auto industry.


Thailand: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USDbn) 370.5 367.8 384.1 407.4Population (m) 64.5 64.8 65.1 65.4GDP per capita (USD) 5749 5677 5900 6227 Real GDP (yoy %) 6.5 2.9 1.5 5.0 Private consumption 6.7 0.3 0.8 2.5 Government consumption 7.5 4.9 2.8 3.5 Gross fixed investment 13.2 -2.0 -5.5 7.0 Exports 3.1 4.2 0.0 8.8 Imports 6.3 2.3 -3.8 11.5

Prices, Money and Banking CPI (yoy %) eop 3.6 1.7 1.8 2.7CPI (yoy %) ann avg 3.0 2.2 2.1 2.4Core CPI (yoy %) ann avg 2.1 1.0 1.5 1.3Broad money 10.4 7.3 7.5 8.0Bank credit1 (yoy %) 15.3 9.4 8.0 10.0 Fiscal Accounts2 (% of GDP)

Central government surplus -2.6 -2.0 -2.8 -2.5 Government revenue 19.5 19.0 18.5 19.0 Government expenditure 22.1 21.0 21.3 21.5Primary surplus -1.3 -0.7 -1.5 -1.2 External Accounts (USDbn)

Merchandise exports 225.9 225.4 230.0 245.0Merchandise imports 219.9 218.7 210.4 229.4Trade balance 6.0 6.7 19.5 15.6 % of GDP 1.6 1.8 5.1 3.8Current account balance -1.5 -2.5 7.0 5.0 % of GDP -0.4 -0.7 1.8 1.2FDI (net) 10.7 12.8 12.0 15.0FX reserves (USDbn) 181.6 167.3 172.0 180.0FX rate (eop) THB/USD 30.7 32.4 33.0 34.0

Debt Indicators (% of GDP) Government debt2,3 45.4 45.3 46.6 46.7 Domestic 43.3 43.4 45.6 45.7 External 2.2 1.9 1.0 1.0Total external debt 35.3 36.7 36.4 35.6 in USDbn 130.7 135.0 140.0 145.0 Short-term (% of total) 44.5 45.0 45.0 45.5

General

Industrial production (yoy %) 2.5 2.6 1.0 5.0Unemployment (%) 0.8 0.8 0.9 1.0

Financial Markets Current 14Q4 15Q1 15Q3BoT o/n repo rate 2.00 2.00 2.00 2.253-month Bibor 2.18 2.20 2.25 2.5010-year yield (%) 3.35 3.45 3.55 3.70THB/USD (onshore) 32.6 33.0 33.3 34.0Source: CEIC, Deutsche Bank Global Markets Research, National Sources Note: (1) Credit to the private sector & SOEs. (2) Consolidated central government accounts; fiscal year ending September. (3) excludes unguaranteed SOE debt

9 October 2014



Vietnam B2/BB-/B+ Moody’s/S&P/Fitch

Economic outlook: Investment leads GDP growth higher, supported by loans and FDI.

Main risks: A sudden surge in credit growth in September warrants some caution.

Construction-led recovery

GDP growth accelerates, led by construction… GDP growth surprised sharply to the upside in Q3, accelerating to 6.2%, from 5.4% (revised up from 5.3%) in Q2. This rise was led by construction and mining, which, together, contributed 0.70ppts more to overall growth in Q3 than in the previous quarter. Construction rose 8.8% in Q3, vs. 5.5% in Q2, while mining rose 3.1%, vs. a 2.4% decline in Q2.

Q3 GDP growth led by stronger growth in construction

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While manufacturing also saw its growth rise, to 9.8% in Q3, from 9.1% in Q2, services growth, in contrast, slowed to 6%, from 6.1%. This deceleration was led by accommodation and food services, growth of which fell sharply, to 5.3% in Q3, from 9.3% in Q2, as the number of Chinese tourists fell 23.6% in Q3, vs. 25.9% growth in Q2. On a positive note, the latter appeared to have bottomed in July and is improving, albeit slowly.

…as auto purchases surge... While most services saw their growth worsen or remain mostly unchanged, wholesale, retail sales and auto services reported faster growth, at 6.4% in Q3, vs. 6% in Q2. Given weak retail sales growth of 10.2%, vs. 12.2% in the same period, we attribute this strength to auto sales. We note that auto imports (led by completed autos) have surged this year, rising 57.1% (143.9%), vs. 42% (76.7%) in Q2.

Auto purchases surge

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…investments rise… Imports of machinery continued to strengthen, rising 29% yoy in Q3, up from 22.7% yoy in Q2. Note that FDI investments (implemented) rose 7.9% in Q3, vs. a 3.3% fall in Q2, suggesting that the FDI sector led the acceleration in overall investment growth in Q3, followed by the central government, investment of which rose 8.3%, up from 6.2% growth in Q2. In contrast, local government investment growth slowed to 0.1% in Q3, from 0.4% in Q2, limiting the rise in overall state investment growth to 1.8%, from 1.7%.

…real estate rebounds, supported by stronger loan growth, in September… Meanwhile, real estate also saw a sustained acceleration in growth, to 3.5% in Q3, from 2.9% in Q2. According to the governor of State Bank Vietnam (SBV) (quoted by Reuters), loan growth (ytd) surged to 7% in September, from 4.5% in August and 3.5% in Q2. This growth was led by loans for the high-tech and property sectors, at 13% and 12%, respectively, with the latter pointing to a bottoming of the housing market and its recovery ahead. Given such a rapid increase in credit growth in a single month, we agree with the SBV governor’s assessment that credit target growth will achieve the government target of 12-14% this year.

…while tech exports disappoint, external balance remains supportive of the dong… Export growth slowed to 11.2% in Q3, from 16.3% in Q2, as export growth of the top items, such as phones/parts and textiles/garments, weakened, to 0.7% and 17.4% in Q3, respectively, from 13.7% and 20% in Q2. On a positive note, despite higher import growth of 12.9% in Q3, vs. 10.7% in Q2, Vietnam enjoyed a larger trade surplus of USD425m in Q3, vs. USD390m in Q2, supporting the dong’s stability. While the dong’s weakness of late may be attributed largely to the general strengthening

9 October 2014



of the US dollar, it remains a source of concern, due to the rapid increase in foreign currency loans so far this year, of more than 20%yoy ytd (about 5 times faster than local currency loan growth).

Tech weakness weighs on overall exports

-20

0

20

40

60

80

-10

10

30

50

70

2013 2014

Phones & Spare Parts

Computer & Electronic Components

Exports (rhs)

%yoy contribution %yoy


…and while inflation falls further. While low commodity prices have limited Vietnam’s export growth thus far, they have also eased inflationary pressure. CPI inflation continued to surprise to the downside in September, falling further to 3.6%yoy from 4.3% in August, led by falling health and transportation price inflation. Although lower inflation has guided real rates higher, the SBV’s governor supported steady policy rates, noting that they help to boost market sentiment and support its stability. While the SBV may opt to keep its policy rates steady, in contrast to our expectation of one more 50bps rate cut, we see it guiding banks’ lending rates at least lower ahead.

Lower inflation, led by health and transportation

0

10

20

30

40

50

60

70

0

5

10

15

20

25

2010 2011 2012 2013 2014

CPITransportationHealth (rhs)

%yoy 3mma



Vietnam: Deutsche Bank forecasts 2012 2013 2014F 2015F

National income Nominal GDP (USD bn) 155.8 171.3 185.6 201.4Population (m) 88.8 89.7 90.7 91.6


Real GDP (yoy %) 5.2 5.4 5.8 6.2


Government consumption 7.2 7.3 7.3 7.3 Gross fixed investment 1.9 5.3 6.7 7.5

Exports 11.0 11.5 12.0 15.0

Imports 3.2 10.5 12.0 16.0

Prices, money and banking

CPI (yoy %) eop 6.8 6.0 4.5 5.0CPI (yoy %) ann avg 9.3 6.6 4.5 6.4

Broad money (yoy %) 18.5 16.0 16.5 18.0

Bank credit (yoy %) 8.7 12.4 12.5 16.0

Fiscal accounts1 (% of GDP)

Federal government surplus -4.8 -4.0 -4.5 -4.4 Government revenue 22.9 22.2 22.5 22.8

Government expenditure 27.7 26.2 27.0 27.2

Primary fed. govt. surplus -3.3 -2.7 -3.0 -2.6

External accounts (USD bn)

Merchandise exports 114.5 132.0 153.0 185.0Merchandise imports 110.0 131.0 151.0 189.0

Trade balance 4.5 1.0 2.0 -4.0

% of GDP 2.9 0.6 1.1 -2.0Current account balance 7.5 6.0 7.0 1.0

% of GDP 4.8 3.5 3.8 0.5

FDI (net) 10.5 11.5 12.0 12.0FX reserves (USD bn) 25.4 38.7 50.0 60.0

FX rate (eop) VND/USD 20900 21200 21600 22200



Domestic 22.7 22.5 24.0 24.5 External 29.0 29.0 29.5 29.5


in USD bn 61.0 67.0 68.0 73.0 Short-term (% of total) 16.4 17.9 19.1 19.2

General Industrial production (yoy %) 3.6 7.9 8.2 8.9

Unemployment (%) 3.2 3.2 3.2 3.2

Financial markets Current Q4 14 Q1 15 Q3 15Refinancing rate 6.50 6.00 6.00 6.00

VND/USD 21285 21600 22000 22200 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Fiscal balance includes off-budget expenditure, while revenue and expenditure include only budget items. .

9 October 2014



Egypt Caa1(negative)/B-(stable)/B-(stable) Moody’s/S&P/Fitch

Economic outlook: Real GDP growth is set to strengthen in FY 2014/15 on the back of firm domestic demand and a rise in investment. Lower official transfers will lead to a widening of the current account deficit, but higher capital inflows should prevent a renewed deterioration of the BoP. The energy subsidy reform implemented in July will help to reduce the fiscal deficit towards 10% of GDP but has pushed inflation up to double digits.

Main risks: Slow improvements in living standards and rising inflation might lead to a renewed escalation of social and political tensions which would stall any recovery in tourism and capital inflows and result in renewed FX reserve losses and pressure on the EGP. Still elevated fiscal deficits keep the public debt level at close to 100% of GDP.

Signs of recovery

Tentative growth return Following a difficult last year Egypt’s economic recovery is slowly gaining traction. Real GDP increased by 3.5% YoY (5.3% QoQ) in Q4 FY 2013/14 (Q2 2014) compared to only 1.3% YoY in the same period last year. The growth rebound towards the end of FY 2013/14 keeps the total fiscal year growth rate unchanged at 2.1% despite the sharp slowdown in economic activity in the first half of the fiscal year due to the security problems and turbulent domestic politics following the ousting of Mohamed Morsi.

Growth is picking up from low levels

Real GDP, % YoY

-4%

-2%

0%

2%

4%

6%

Q1 2009

Q4 2009

Q3 2010

Q2 2011

Q1 2012

Q4 2012

Q3 2013

Q2 2014

Pre-crisis average

"Arab Spring" "2nd Revolution"

Sources: Ministry of Planning, Deutsche Bank

Key sectors driving the increase in economic activity have been manufacturing and construction. Growth in the manufacturing sector accelerated sharply in Q4 bringing its total FY 2013/14 growth rate to 8.3% YoY. The manufacturing sector last grew by over 8% back in 2008 while growth averaged only around 2.2% YoY over the past 5 years. On the other side the mining sector as well as restaurant and hotel services continued their contraction in FY 2013/14.

Forward-looking indicators suggest that growth will continue to strengthen in H1 FY 2014/15. In September the PMI moved further into expansionary territory and reached at 52.4 a ten-month high and its second highest level since 2011. The September PMI reading indicates that especially growth in the manufacturing sector is set to strengthen further underlined by a solid increase in output and a sharp rise in new orders. A similar conclusion can be drawn from the industrial production index, which increased by 25% YoY in July. Over the next quarters, growth will also benefit from public mega projects, most prominently the expansion of the Suez Channel, as well as a recovery in tourism. Tourism was heavily affected by the deteriorating security situation, but recently the number of tourist arrivals has started to rise again and reached a three-year high in August. An important factor in this regard is that Germany and many other European countries lifted their travel bans for South Sinai, including Sharm el-Sheikh, in July.

Nevertheless, plenty of obstacles to growth exist. Among the most pressing issues are energy supply bottlenecks. In early September, for example, a large-scale blackout left half of Egypt without power for hours, halting factories and shutting parts of the Cairo metro system. Upgrading the decrepit power grid will be difficult given the government’s lacking fiscal space and take years. An important question is also whether the domestic banking sector will be able to support the economic recovery. Although credit growth to the private sector increased throughout the year, reaching a growth rate of 7.4% YoY in July, it is still subdued given the high inflationary environment. The private sector credit impulse remained in negative territory for the third quarter in a row in Q4 FY 2013/14. Continuously high borrowing needs of the government will most likely continue to absorb domestic credit in FY 2014/15 and partly crowd out credit to the private sector. Thus, we expect private sector credit growth to remain subdued.

9 October 2014



Private sector credit impulse still negative

YoY change, % of GDP

-4

-3

-2

-1

0

1

2

3

4

10 11 12 13 14


Given those factors we maintain our real GDP growth forecast for FY 2014/15 at 3.7%. However, even if this relatively optimistic forecast materialized, growth would still be significantly lower than the 4.95% YoY average experienced in the decade preceding the outbreak of the “Arab Spring”. It would also be insufficient to put a dent in unemployment and to yield a significant reduction of poverty and broad based-improvement in living standards for Egypt’s fast growing population.

BoP improved, but foreign investment needed to sustain this trend. Egypt’s balance of payments improved significantly in FY 2013/14, recording a surplus of USD 1.5 bn compared to USD 237 m in the previous fiscal year. The improvement was driven by a reduction of the current account deficit, which fell from 2.3% of GDP in FY 2012/13 to 0.8% of GDP in FY 2013/14. The decline in the current account deficit was almost entirely driven by higher official transfers (mainly grants from GCC governments), which jumped from USD 836 m to USD 11.9 bn. Abstracting from official flows, however, the underlying balance of payments dynamics remained weak. The trade deficit widened as solid import growth outpaced stagnating exports, and the surplus of the service balance plunged by 80% mainly reflecting the drop in tourism. The surplus of the financial account fell as a small increase in FDI could not offset a decline in cross-border bank lending.

To prevent a renewed deterioration of the balance of payments in FY 2014/15, when official transfers are unlikely to match last year’s record levels, the government is trying to promote private investment inflows. A large international investor conference is scheduled for February. In order to increase transparency for potential investments, the government reportedly asked the IMF for a new Article IV consultation to be carried out prior to the conference. It would be the first IMF assessment on Egypt since 2010. The shift from official grants to private FDI and

portfolio inflows would result in a changing composition of the balance of payments. Whereas the financial account should improve, the current account is likely to deteriorate in FY 2014/15. We think that an increase in the service balance, due to a tentative recovery in tourism and higher Suez Channel revenues, will not be sufficient to offset the expected drop in official transfers. Overall, we expect the balance of payments to remain in small surplus, and thus FX reserves to continue their modest upward trend.

Official transfers drive narrowing of current account deficit

% of GDP

-15%

-10%

-5%

0%

5%

10%

15%

FY 2009/10

FY 2010/11

FY 2011/12

FY 2012/13

FY 2013/14

Trade (net)

Services (net)

Transfers (private)

Transfers (official)

Current account balance

Sources: Central Bank of Egypt, Deutsche Bank

Subsidy reform pushes up inflation, CB hiked preemptively. As expected, inflation increased sharply following the comprehensive energy subsidy reform and the rise in consumption taxes implemented in early July. Month-on-month inflation jumped to 3.5% in July (the highest monthly increase since February 2008), but subsequently slowed down to 1.1% in August. Year-on-Year CPI inflation increased to 11.5% in August compared to 8.2% in June. The increase in inflation was largely driven by higher prices for regulated goods, mainly fuel and electricity as well as increasing prices for food due to the high content of energy needed in production and transport of food products.

An even higher increase in the headline inflation was mitigated by a pre-emptive 100 bps rate hike by the Central Bank of Egypt in July. The move was surprising, but concerns over inflation pressure from the subsidy reform seem to have overridden concerns about the still fragile growth. We do not expect a further tightening at this stage as the growth outlook remains subdued and the overnight deposit and lending rates

9 October 2014



are already high at 9.25% and 10.25%, respectively. We expect the Central Bank to remain in wait-and-see position and to assess the second-round effects of the higher energy prices on wages and production costs as well as the development in long-run inflation expectations.

Inflation jumps to double digits

0%

2%

4%

6%

8%

10%

12%

14%

-2%

-1%

0%

1%

2%

3%

4%

Jan, 2011

Jul, 2011

Jan, 2012

Jul, 2012

Jan, 2013

Jul, 2013

Jan, 2014

Jul, 2014

MoM (lhs) YoY (rhs)

Sources: Central Bank of Egypt, Deutsche Bank

Oliver Masetti, Frankfurt, +49 69 910 41643

Egypt: Deutsche Bank Forecasts 2011/12 2012/13 2013/14E 2014/15F

National Income

Nominal GDP (USD bn) 262.8 271.9 284.0 320.0Population (mn) 82.4 84.7 85.8 87.5GDP per capita (USD) 3,229 3,250 3,330 3,660

Real GDP (YoY %) 2.2 2.1 2.1 3.7Priv. consumption 6.5 2.8 3.0 3.9Govt consumption 3.1 3.5 4.5 3.5Investment 5.8 -9.6 1.0 4.3Exports -2.3 2.1 -2.0 4.0Imports 9.7 -1.1 2.0 5.0


CPI (YoY%, eop) 7.3 9.8 8.2 11.0CPI (YoY%, pavg) 8.7 6.9 10.1 12.0Broad money supply (M2) 7.8 18.4 17.8 15.0

Fiscal Accounts (% of GDP) Overall balance -10.6 -13.7 -12.0 -10.5 Revenue 19.3 20.0 22.7 23.2 Expenditure 29.9 33.5 34.7 33.7


External Accounts (USD bn) Exports 25.1 26.9 26.1 29.0Imports 59.2 57.5 59.8 62.0Trade balance -34.1 -30.6 -33.7 -33.0

% of GDP -13.0 -11.3 -11.9 -10.3Current account balance -10.1 -6.3 -2.3 -5.5

% of GDP -3.9 -2.3 -0.8 -1.7FDI (net) 3.7 2.8 3.4 5.6FX reserves (USD bn) 15.5 14.9 16.7 18.0EGP/USD (eop) 6.1 7.0 7.15 7.3

Debt Indicators (% of GDP) Government debt 83.1 93.8 96.4 96.0 Domestic 73.3 82.4 85.4 84.5 External 9.8 11.4 11.0 11.5

Total external debt 13.2 17.3 16.2 16.6 in USD bn 34.4 43.2 46.1 53.0


General (%) Industrial production (YoY %) -4.8 -8.1 15.0 6.0Unemployment 12.6 13.0 13.5 13.7

Financial Markets (eop) Current 14Q4 15Q1 15Q3CBE deposit rate 9.25 9.25 9.25 9.25CBE discount rate 9.75 9.75 9.75 9.75CBE lending rate 10.25 10.25 10.25 10.25EGP/USD 7.15 7.3 7.3 7.3Sources: IMF, Central Bank of Egypt, Ministry of Finance, Deutsche Bank

9 October 2014



Hungary Ba1(neg)/BB(stable)/BB+(stable) Moody’s/S&P/Fitch

Economic outlook: Q2 GDP growth was relatively strong, with the details also encouraging, showing domestic demand as the main driver of growth. High frequency data in recent months have been positive as well, indicating that the growth momentum likely carried into Q3. Inflation is beginning to show signs of picking up.

Main risks: The main downside risks come from the prolonged weakness in euro area activity. Further downside risk comes from the possible deterioration in the investment climate from the government’s interventionist policies, particularly in the banking and utility sectors. On the other hand, growth could surprise to the upside if the government is able to successfully increase the absorption of EU funds.

Activity data remains encouraging; no changes to monetary policy expected

High frequency data indicate relatively robust growth in Q3. After the strong growth reading in Q2 (3.9% YoY, 0.8% QoQ), the activity and survey data in recent months have also been encouraging (despite the activity slowdown in the euro area), indicating that the growth momentum has carried into Q3 as well. Industrial production (in seasonally and working day adjusted terms) grew by 12.1% YoY in July; however, it (likely temporarily) dipped to 5.1% in August as a major car manufacturer temporarily halted production in August after producing too many vehicles in the earlier period (production is scheduled to restart in September). Construction growth has also been strong, printing at 17.2% YoY in July. Retail sales continues to grow, albeit at a slower rate than seen earlier in the year.

IP and construction growth have both been strong in

recent months

-30

-20

-10

0

10

20

-20

-10

0

10

20

30

2008 - Aug 2010 - Aug 2012 - Aug 2014 - AugConstruction (SWDA, YoY, %)IP (SWDA, YoY, %, rhs)


In addition, the soft data have also been positive – manufacturing PMI has been in expansionary territory for over a year, while economic sentiment is also relatively high.

PMI remains in expansionary territory, in part due to a

robust forward-looking new orders component

30

35

40

45

50

55

60

65

2008 - Sep 2010 - Sep 2012 - Sep 2014 - Sep

Manufacturing PMI New orders

Expansion

Contraction


We expect activity and survey data to remain relatively strong in the coming months and the robust growth momentum should carry forward to the coming quarters; we forecast real GDP to grow by 3.4% in 2014 (with domestic demand, and particularly investment, remaining the main driver of growth), before slowing to 2.7% next year.

The main downside risks to growth come from external factors, most importantly prolonged weakness in euro area activity. Further downside risk comes from the possible deterioration in the investment climate from the government’s interventionist policies, particularly in the banking and utility sectors. On the other hand, growth could surprise to the upside if the government is able to successfully increase the absorption of EU funds, or if consumption growth picks up pace on the back of rising real income (in the low inflation environment).

Inflation continues to pick up gradually. In August, headline inflation ticked up to 0.2% YoY from 0.1% in July. These positive prints came after three months of deflation. The recent pickup in inflation was driven by better-than-expected food price developments. While food prices continue to decline and food price deflation continues to weigh on the headline rate, it is showing signs of a turnaround (rising from -1.3% YoY in June to -0.2% in August). Weakness in commodity price growth and administered utility price cuts have also

9 October 2014



added downward pressure to headline inflation. As a result, core inflation – which excludes unprocessed food items, electricity/gas and motor fuels – has remained relatively stable in recent months, at a level well above the headline rate (around 2.5%).

Core CPI remains well above the headline rate


We expect headline inflation to continue rising gradually in the coming months (mainly on the back of food inflation picking up), before a relatively sharp increase at the end of the year (due to base effects as the administered utility price cuts drop out of the base). Continued domestic demand expansion, tightening labour market conditions and a narrowing output gap should also add upward impetus to inflation towards the end of 2014 and through 2015. As a result, while average inflation is expected to be a subdued 0.2% in 2014, it is expected to rise to 2.6% next year. Our forecasted inflation profile suggests that inflation will near the 3% target in mid-2015, which is broadly in line with the National Bank of Hungary’s (NBH) forecast.

NBH inflation projection fan chart

Source: NBH

No changes expected in monetary policy. As was the case in August, the NBH kept rates on hold (at the record low 2.10%) in September. The NBH had signaled the end of the two year long easing cycle in July.

In its September statement, the NBH remained relatively optimistic on the growth outlook following the strong GDP readings in the first half of the year. Despite weaker external demand (on the back of weakness in euro area activity and the Russia-Ukraine crisis), economic growth is expected to continue, driven by domestic demand. While investment should continue to be boosted by easing credit constraints and the NBH’s Funding for Growth scheme (which provides loans to SMEs at capped interest rates), private consumption is also likely to expand gradually on the back of improving employment and real income (in the low inflation environment). As a result, the NBH raised its GDP growth forecast for 2014 to 3.3% (from 2.9% previously), while the forecast for 2015 was largely unchanged.

As it did in the previous month, the NBH stated that the easing cycle is finished and reiterated that “maintaining the current low level of interest rates for an extended period ensures the achievement of the Bank’s medium-term inflation target and a corresponding degree of support to the real economy”. This, combined with inflation showing signs of a gradual pick up and the relatively strong activity data, leads us to believe that rates will remain on hold through 2014.

We expect that the first rate hikes will likely be delivered in mid-2015, as inflation approaches the target. There are risks to this view on either side. If rates in the US stay lower for longer, this could lead to a further delay in the hiking cycle; the NBH would prefer to keep rates low for as long as external conditions permit it. However, sustained pressure on the forint could prompt the NBH to hike even earlier and more aggressively than expected.

FX loans issue at the forefront. The NBH announced in late September that it would be willing to provide all of the fx (via its reserves) that banks would require for (1) refunds associated with the use of fx margins and unilateral contract changes, and (2) conversion of the fx loan stock to forint. The main aim of this is to ensure that the phasing out of fx loans is carried out in a “rapid and well-organized manner”, while limiting the impact on the exchange rate and on financial system stability.

On (1): The latest bill on fx loans (which was passed earlier in September) covers how and when borrowers need to be refunded by banks for the use of fx margins and unilateral contract changes (mostly interest rate hikes). This legislation specifies that for loans that are

9 October 2014



currently open, the refunds should be in the form of a reduction in the outstanding principal amount. As a result, there will be a balance sheet mismatch for banks and as such they will have to repay some of their fx funding (to reduce fx liabilities to match the reduction in fx assets/loans). Therefore, as part of this refund process, banks will need to access fx – the NBH has stated that it will make available EUR 3bn (the entire estimated refund amount) in fx for this purpose.

On (2): Further, the NBH is willing to provide the entire amount of fx required for the conversion of the fx loan stock to forint. While the details of how this conversion will take place have not been provided by the government, it remains a high priority on the government’s agenda and indications are that it will take place around mid-2015. The NBH estimates that as part of this conversion process banks would require fx of around EUR 9-11bn, though the exact amount would depend on the details of the conversion. This estimated amount is likely to comfortably cover the outstanding fx loan stock (which currently stands at EUR 11.6bn but will be reduced through the refund process), and therefore cover the entire amount demanded by banks during the conversion process. However, the NBH is willing to provide banks with as much fx as they require for the refund and conversion process, even if it is larger than this initial estimate. This is in contrast to earlier comments from NBH officials which indicated that it would provide some, but not all, of the required fx amount.

The NBH’s statement also reiterates that this program will not jeopardize the adequacy of fx reserves, the stock of which will “remain above the level expected by international financial institutions and investors”. The stock of fx reserves currently stands at a comfortable EUR 34bn, sufficient to cover nearly 6 months of imports. Therefore, even a EUR 11-12bn reduction in fx reserves will not lead to a position of vulnerability, especially given that external debt (and so the NBH’s need for fx reserves) will also reduce during this process.

NBH fx reserves are at a relatively comfortable level

10

15

20

25

30

35

40

2008 - Sep 2010 - Sep 2012 - Sep 2014 - Sep

FX reserves (EUR bn)


The fx will be provided (at close to market rates) by the NBH through two facilities:

a) A spot euro sale which is conditional on banks reducing their short-term external debt by 50% of the fx received. This will cause a reduction in fx reserves in the short term.

b) An unconditional instrument, which is a combination of a spot euro sale and a long fx swap. This is targeted at those banks whose financing structure relies on long-term swaps and long-term liabilities. While this instrument enables banks to manage exchange rate risks, effectively the fx can only be accessed by banks as and when their liabilities mature (maturities must be longer than one year). As a result, this instrument will not cause the NBH’s fx reserves to drop in the short term, but rather gradually over time, matching the reduction in banks’ long-term liabilities.

What are the implications for HUF?

While the NBH is willing to provide banks with the entire fx required for the refund and conversion process, this does not necessarily mean that banks will obtain the entire required amount from the NBH. Using the early repayment scheme in 2011 as a guide, the NBH was then willing to provide as much fx liquidity as banks required, to cover loans repaid early (using an exchange rate that was at a discount of 20% to the spot rate) through the scheme. In total, EUR 4.4bn was repaid by borrowers, but the total amount of fx that banks purchased from the NBH amounted to only around EUR 2.6bn. The remainder (EUR 1.8bn) banks purchased from their parent banks or on the market. Back in September 2011 (announcement), this contributed to 6-7% depreciation in the HUF vs. peer currencies over the following months.

It is likely that banks did not purchase the entire fx amount from the NBH because of: some pre-hedging (possibly due to uncertainty regarding the NBH’s instrument for providing fx, and its price); the NBH’s instrument, which at that time was also a spot euro sale combined with a long fx swap (similar to the current proposed instrument), was designed in a way that made it costly for banks to over-hedge fx risk using the instrument, and so banks were likely to have purchased less than the required fx amount from the NBH; the fx was never offered by the NBH at a rate preferable to the market rate, and therefore it is likely that, particularly in the case of repaying short-term liabilities, banks purchased some fx from the market.

Given that the size of the current proposed loans conversion is much larger than the conversion involved in the early repayment scheme in 2011, HUF underperformance seems at least equally likely this time around. There could also be an indirect negative

9 October 2014



impact on the forint through affecting investor confidence (particularly if the conversion is done at below market exchange rates with limited cost-sharing by the government).

Therefore, while the provision of the entire fx amount by the NBH possibly reduces the downside risk to HUF at the margin, we believe that banks will still buy fx on the market (particularly to repay short-term fx liabilities, for which there is no foreseeable upside to purchasing fx from the NBH). As a result, we believe the conversion process will be HUF negative.


Hungary: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 125 130 130 120

Population (mn) 10.0 9.9 9.9 9.9

GDP per capita (USD thousands) 12.6 13.0 13.2 12.2

Real GDP (YoY%) - 1.7 1.1 3.4 2.7

Private Consumption - 1.7 - 0.1 2.1 2.3 Government consumption 0.1 4.0 1.0 1.2

Gross Fixed Investment - 3.7 5.8 6.3 4.6

Exports 1.7 5.3 6.3 5.2 Imports - 0.1 5.3 7.6 5.5

Prices, Money and Banking (YoY%) CPI (eop) 5.0 0.4 1.3 2.8

CPI (period avg) 5.7 1.7 0.2 2.6

Broad money (eop) - 3.3 2.0 5.2 6.0


Overall balance - 2.1 - 2.4 - 2.9 - 2.7 Revenue 46.2 48.0 46.2 44.8

Expenditure 48.3 50.4 49.1 47.5

Primary Balance 2.2 2.1 0.9 1.1


Goods Exports 90.4 95.8 106.5 102.1Goods Imports 86.5 91.1 100.6 96.6

Trade Balance 3.9 4.7 5.9 5.5

% of GDP 3.1 3.7 4.5 4.6Current Account Balance - 2.5 0.3 2.3 2.1

% of GDP - 2.0 0.3 1.6 1.5

FDI (net) 35.5 3.7 13.8 17.6FX Reserves (eop) 41.9 43.3 43.0 42.6

USD/FX (eop) 221 216 242 283

EUR/FX (eop) 292 297 315 325


Government Debt 79.8 75.9 76.2 78.1 Domestic 45.1 39.5 38.7 46.3

External 34.7 36.4 33.3 31.7

External debt 127.9 120.0 118.0 in USD bn 165 166 157 142


General (ann. avg)

Industrial Production (YoY%) - 0.8 1.4 8.5 6.5

Unemployment (%) 10.9 10.3 8.1 7.8

Spot 14Q4F 15Q1 15Q3F

Financial Markets Key official interest rate (eop) 2.10 2.10 2.10 2.60

USD/HUF (eop) 243 242 255 273

EUR/HUF (eop) 308 315 319 324 Source: NBH, DB Global Markets Research, Haver Analytics

9 October 2014



Poland A2(stable)/A-(stable)/A-(stable) Moodys/S&P/Fitch

Economic outlook: Recent activity and survey data have been weak, indicating a further slowdown in growth in Q3. We expect the activity and inflation data to pick up gradually only in Q4.

Main risks: The risks to growth are skewed to the downside, mainly due to the potential for a prolonged slowdown in the euro area (Poland’s main export partner) and/or an escalation in the Russia-Ukraine crisis.

Weakness in activity data and low inflation prompt a 50bps rate cut

Survey and activity data disappoint. The high frequency data indicate that the slowdown in growth observed in Q2 (to 0.6% QoQ from 1.1% in Q1) has continued in Q3 as well. PMI has been in contractionary territory for the past three months, driven in part by weakness in the forward-looking new orders component. Industrial production performance has been particularly weak, providing the first negative YoY print in 15 months in August (-1.9%) on the back of a decline in car production. Additionally, construction growth – another indicator that the NBP believes provides important information on the state of the economy – has been negative for the past four months. Retail sales, however, has continued to grow, albeit at a moderate pace (and lower than that seen in the first half of the year).

Polish PMI has dipped into contractionary territory

30

35

40

45

50

55

60

65

Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14

Euro area PolandExpansion

Contraction

PMI


The slowdown in Polish activity is occurring in an environment of, and is partly driven by, weakness in the euro area (which is Poland’s main trading partner, accounting for over 50% of Polish exports). The September PMI figures for the euro area confirm the

prolonged weakness in activity, with Germany in particular disappointing with a print of 49.9 (the first reading in contractionary territory in over a year). The grind lower in inflation also highlights the lack of demand pressures in the euro area. As a result, our euro area economists have lowered their growth forecast for the coming quarters, and are also expecting public QE to be announced by the ECB in the next six months.

The slowdown in IP growth has come in tandem with a

decline in export orders growth

40

45

50

55

60

-15

-10

-5

0

5

10

15

2008 - Sep 2010 - Sep 2012 - Sep 2014 - Sep

IP (YoY %, lhs) PMI New export orders


While a potential prolonged period of weakness in the euro area adds downside risk to the growth prospects for Poland, we continue to believe that the Polish recovery remains broadly on track. The upcoming activity and survey data (for example, PMIs) could decline in the short term, but we expect these to bounce back in Q4, and the economy is expected to continue growing on the back of improving domestic demand; significant EU funds inflows should also add some upward impetus to growth.18 While we are likely to see a further modest slowdown in growth in Q3, our forecast for real GDP growth in 2014 is a relatively healthy 3.1% (NBP forecast is 3.6%, though this is likely to be revised down in the November Inflation Report), and in 2015 is 3.5%.

However, we view the risks to our growth forecast as skewed to the downside due to the possibility of a protracted slowdown in euro area growth and/or an escalation in the Russia-Ukraine crisis (which could also impact Poland through its adverse effect on euro area growth prospects).

18 For a detailed analysis of EU structural funds allocations, absorptions and impact, see the Special Report “EU Structural Funds and Their Impact: 10 Questions Answered”.

9 October 2014



Food prices continue to decline. Headline inflation sank further into negative territory in August, printing at a record low -0.3% YoY (well below the National Bank of Poland’s 1pp tolerance band around its 2.5% target).

While low imported inflation from the euro area continues to add downward pressure on headline inflation, food price deflation remains the main drag on the headline rate. Food price growth contributed, on average, nearly +1pp to YoY headline CPI over the five years between 2009 and 2013; in contrast, its contribution has been negative in the past four months. While food prices in the rest of the Central European region are showing signs of gradually turning around, Polish food price inflation declined further in August to -2.3% YoY because the harvest of most crops this year has been stronger than that of last year. Additionally, the contributions of the rent and energy component and the transport component have been markedly below their long term averages in the past 3-4 months, primarily on the back of falling energy prices.

Food and energy components are keeping headline

inflation low

-4.0

-3.0

-2.0

-1.0

0.0

1.02.0

3.0

4.0

5.0

6.0

Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14

Transport Rent & Energy

Food Headline CPI (%YoY)

pps contribution to %YoY CPI


Though headline inflation is expected to remain subdued (and likely negative) for the coming few months, we expect it to begin picking up at year-end (and continue rising gradually next year) on the back of improving domestic demand, a narrowing output gap and tightening labour market conditions. We expect average YoY CPI to be only 0.2% in 2014 but rise to 1.1% in 2015.

Base rate cut by 50bps. The NBP this week cut the base rate by 50bps, bringing it to a record low 2%. The main reasons for the cut were the weakness in recent activity data (which pointed to a further deceleration in growth in Q3), persistent low inflation with “an increased risk of inflation running below target in the medium term” and the euro area slowdown. Poland’s high real rates (one of the highest within EM) and the rate cut by the ECB last month also provided room for rate cuts. As a result of these factors, while the

magnitude of the rate cut was larger than our own and consensus expectations (for a 25bps cut), it does not come as a major surprise. Further, in the post-meeting press conference, Governor Belka stated that this decision was not a unanimous one.

In addition to the cut in the base rate, the lombard rate (the upper bound of the interest rate corridor) was lowered by 100bps to 3%. The lombard rate is the interest rate at which banks can obtain credit (against collateral) from the NBP on an overnight basis (marginal lending facility). This short-term emergency liquidity facility is not extensively used – in 2013, approximately EUR 40mn was borrowed by banks under this facility, while in 2012 this figure was only EUR 5mn. However, this relatively large cut in the lombard rate could have implications for the real economy. Consumer lending rates in Poland are capped, by legislation, at 4 times the lombard rate. Therefore, today’s cut reduces the upper limit of the interest rate on consumer loans from 16% to 12%. With the average rate on consumer loans (including credit card loans) currently at 12.5% – above the new upper bound – this cut in the lombard rate is significant and could boost consumer spending. On the other hand, it could also lead to a reduction in new lending to riskier borrowers.

The interest rate corridor was narrowed as the lower bound, the deposit rate, was unchanged at 1%. Belka noted that the reason for narrowing the corridor was to bring all three policy rates in the same “domain” given the new lower level of the base rate.

NBP leaves the door open for further cuts In its statement, the NBP noted that it “does not rule out further adjustment of monetary policy”; the possibility of further cuts depends on incoming data, including the projections in the November Inflation Report, and whether these confirm that inflation will remain below target in the medium term. However, Belka also added that the council preferred an adjustment of rates that was “concentrated” in time rather than drawn out (which is reflected in the decision for a larger 50bps cut today).

In the coming few months, we expect inflation to remain subdued (and likely negative), while the activity data is also expected to remain weak on the back of the euro area slowdown and adverse confidence effects of the Russia-Ukraine crisis (we see the activity data picking up only around year end). Further, the NBP’s inflation and growth projections are likely to be revised down significantly in the November Inflation Report. As a result, we expect another rate cut in November, albeit a smaller 25bps one, after which we expect rates to be on hold.

9 October 2014



Politics: Civic Platform makes a comeback in opinion polls. The appointment (on 30th August) of Polish PM Tusk as the next president of the EU Council has significantly boosted the popularity of the ruling Civic Platform (after it suffered due to the leaked tapes controversy), as it signals Poland's rising importance in the EU and also ties in well with its increased allocation of EU funds. These are important issues for Poland, and the Civic Platform (PO) could use this – i.e. its success in increasing Poland's importance within the EU – as a major campaign platform for upcoming elections. There are three important elections coming up: local elections in November 2014, presidential elections in May 2015 and general/parliamentary elections around October 2015.

The latest opinion polls show that PO and the main opposition Law and Justice Party (PiS) currently have approximately equal support. As a result, the local elections in November are likely to be a close race between these two parties; these elections will provide important insights into the support for each party and thus into the likelihood of victory in the 2015 general elections.

Civic Platform (PO) and main opposition Law and

Justice (PiS) are now neck-and-neck in opinion polls

0%

10%

20%

30%

40%

50%

Sep-10 Sep-11 Sep-12 Sep-13 Sep-14

PO PiS SLD PSL Nowa Prawica (KNP)

Tape scandal aftermath

Tusk chosen as EU Council president

Source: Deutsche Bank, Homo Homini


Poland: Deutsche Bank Forecasts 2012 2013 2014F 2015

National Income

Nominal GDP (USDbn) 490 503 543 538

Population (mn) 37.6 38.6 37.5 37.4

GDP per capita (USD thousands) 13.0 13.0 14.5 14.4

Real GDP (YoY%) 1.9 1.6 3.1 3.5

Private Consumption 1.3 0.8 3.0 3.2


Gross Fixed Investment - 0.3 - 0.8 5.0 5.4

Exports 3.9 4.5 7.7 8.3

Imports - 0.6 1.3 7.1 8.0

Prices, Money and Banking (YoY%)

CPI (eop) 2.4 0.7 0.5 1.1

CPI (period avg) 3.7 0.9 0.2 1.1

Broad money (eop) 10.0 11.0 5.0 8.7


Overall balance - 3.9 - 4.4 4.3 - 2.9

Revenue 38.3 37.5 45.5 38.0

Expenditure 42.2 41.9 41.2 40.9

Primary Balance - 1.1 - 1.8 6.5 - 0.7


Goods Exports 190.8 207.2 224.3

Goods Imports 197.5 204.2 223.7

Trade Balance - 6.7 3.0 0.6 - 1.4

% of GDP - 1.4 0.6 0.1 - 0.3

Current Account Balance - 18.3 - 6.6 - 9.9 - 11.0

% of GDP - 3.7 - 1.3 - 1.8 - 2.0

FDI (net) 5.3 - 1.3 6.4 6.1

FX Reserves (eop) 96.1 94.0 97.3 86.6

USD/FX (eop) 3.09 3.02 3.18 3.48

EUR/FX (eop) 4.07 4.16 4.13 4.00


Government Debt 52.6 53.8 46.3 47.1

Domestic 36.1 37.5 29.6 29.7

External 16.5 16.3 16.7 17.4

External debt 71.1 73.6 72.0 76.5

in USD bn 349 370 391 412


General (ann. avg)

Industrial Production (YoY%) 1.4 2.4 5.0 6.2

Unemployment (%) 12.8 13.5 12.5 11.5

Spot 14Q4 15Q1 15Q3

Financial Markets

Key official interest rate (eop) 2.00 1.75 1.75 2.00

USD/PLN (eop) 3.30 3.18 3.26 3.40

EUR/PLN (eop) 4.19 4.13 4.08 4.03Source: Haver Analytics, CEIC, DB Global Markets Research, NBP

9 October 2014



Romania Baa3(stable)/BBB-(stable)/BBB-(stable) Moodys/S&P/Fitch

Economic outlook: Growth was surprisingly low in Q2 on the back of weakness in investment, but we expect some modest rebound in the coming quarters. Inflation remains subdued, although it is expected to pick up in the coming months.

Main risks: We view the risks to our growth outlook as skewed to the downside due to the still weak lending dynamics (especially on fx loans to the corporate sector), euro area weakness and political uncertainty around the upcoming presidential elections. However, improving consumption (in the low inflation environment) could offer upside.

Growth figures signal increasing concerns on the economic front

Growth faltered in Q2 on the back of a decline in investment. After a relatively strong Q1 GDP reading (3.8% YoY), growth in Q2 fell markedly to 1.2% YoY; in QoQ terms, the economy contracted by 1%. The drop in growth was primarily due to investment, which fell by 12.8% YoY on the back of negative net lending in the corporate sector and likely also adverse confidence effects from the Russia-Ukraine crisis. Net exports also contributed negatively to GDP growth. On the other hand, household consumption growth remained relatively robust at 3.9% YoY.

Breakdown of contributions to real GDP growth

-30

-20

-10

0

10

20

30

-40

-30

-20

-10

0

10

20

30

Q2-08 Q2-09 Q2-10 Q2-11 Q2-12 Q2-13 Q2-14

InventoriesGFCFGovt ConsPvt ConsNet ExportsReal GDP (% YoY, rhs)Domestic demand (rhs)

pps contribution to YoY GDP


In the recent past, net exports had been the main driver of growth in Central Europe. However, given the recent weakness in activity in the euro area (the main export partner for the region), the upward impetus provided by net exports has been decreasing across the region. However, in other Central European countries (e.g.

Hungary and Poland) this has been offset by improving domestic conditions and rising domestic demand growth. In Romania, the positive contribution of domestic demand to growth decreased in Q2, while net exports contributed negatively. With the slowdown in euro area activity expected to persist, the weakness in the Romanian domestic economy is an even greater cause for concern and could be a drag on growth in the coming quarters.

The level of investment is now down nearly 35% from

the 2008 peak and domestic demand is down 13%

50556065707580859095

100

Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14

Peak = 100

Investment (-34.3%)

Domestic demand (-13.1%)


While this increases the downside risk to growth, we expect growth to rebound, albeit modestly, from its depressed Q2 level and pick up gradually in the coming quarters. The recent high frequency data have been reasonably encouraging, and consumption is expected to continue to benefit from rising real wages (as a result of the low inflation and increase in minimum wage).

Retail sales and industrial production have grown at a

reasonable pace in recent months

-20-15-10-505

101520

2008 - Aug 2010 - Aug 2012 - Aug 2014 - Aug

IP (YoY %) Retail sales (YoY %)


9 October 2014



As a result, we expect the economy to expand by 2.5% this year and by 3% in 2015. However, we view the risks to this forecast as skewed to the downside due to the still weak lending dynamics (especially on fx loans to the corporate sector), euro area weakness and political uncertainty around the upcoming presidential elections.

Inflation remains subdued. Inflation in August fell to 0.8% YoY (from 1% in July), dropping back to close to the record low of 0.7% (observed in June). Thus, inflation remains well below the National Bank of Romania’s (NBR) tolerance band of ±1pp around its 2.5% target. The main driver of the subdued headline inflation in recent months has been the deflation in food prices (-2% YoY in August); low imported inflation from the euro area has also contributed to the low inflation environment.

Subdued food inflation is the main driver of the low

headline rate

-4

0

4

8

12

2008 - Aug 2010 - Aug 2012 - Aug 2014 - AugHeadline inflation (YoY %) Food inflation (YoY %)

Current NBR target Target lower bound

Target upper bound


On the back of the persistent low inflation as well as the slowing of economic growth, the NBR cut rates by 25bps in September. It noted that headline inflation remained on a lower path than previously forecasted and it remained uncertain whether or not the inflation path would remain below forecast going forward. The NBR also lowered the minimum reserve requirement ratio for leu deposits to 10% from 12%, in order to stimulate a recovery in lending and also to bring the reserve requirements in line with EU standards. However, the NBR kept the reserve requirement ratio for fx denominated liabilities unchanged.

We expect the headline inflation rate to pick up markedly in September and near the NBR’s 1.5% lower bound, as food inflation rebounds on the back of last year’s VAT cut on certain foods dropping out of the base and a relatively weaker harvest this year than last year’s bumper one. Going forward, we expect inflation to rise gradually in the coming months and end the year at 1.9% (averaging 1.2% for 2014); this gradual

upward trend is expected to continue in 2015, with inflation forecasted to end 2015 at 2.9% (averaging 2.5% for the year as a whole). As a result of this expected rise in inflation, as well as a modest rebound in growth in the coming quarters, we believe that the NBR will keep rates on hold in the near future (while further cuts to reserve requirements remain likely).

Political uncertainty persists. The upcoming Presidential elections (first round: 2nd November, second round: 16th November) have maintained uncertainty in the political environment. 14 candidates will run for the post of President in the first round; of these, the most likely candidates to enter the second round runoff are the Prime Minister and ruling Social Democratic Party (PSD) leader, Victor Ponta, and the leader of the opposition National Liberal Party (PNL), Klaus Johannis. These two candidates are well ahead of the others in the opinion polls, which predict Ponta will obtain 42% of the votes in the first round, with Johannis securing 27%.19

The second round, however, is likely to be much closer, with polls showing a relatively narrow victory for Ponta (57%) over Johannis (43%). A major factor in determining the outcome in the second round is the ability of the centre right opposition parties to present a united front (despite inter-party differences) and channel votes to Johannis. If the main centre right opposition parties (National Liberal Party, Democratic Liberal Party and Civic Force) are able to unite and also secure support from some of the other smaller parties (e.g. the Hungarian Union of Democrats in Romania) in the second round, the chances of a Johannis victory would be greatly increased. This remains a distinct possibility and we expect the second round election to be a close one. However, as the polls indicate (pollster: CSCI), a victory for Ponta currently appears the more likely outcome.

The President holds relatively little executive power but has responsibility for selecting the PM and signing off on cabinet appointments and international treaties, thereby exhibiting considerable influence over the government. Therefore, friction between the President and the government can undermine the government’s agenda and also have important economic consequences – for example, the feud between the outgoing centre-right President Basescu and the left-leaning PSD-led government was disruptive and caused the stalling of the IMF agreement, and thus of the related structural reforms, late last year. The importance of the Presidential election is also reflected by PSD putting forward as its candidate PM Ponta, who previously had not committed to the race which would require him to give up the PM post; after

19 Pollster: CSCI

9 October 2014



narrowly losing the last two Presidential elections, the pressure within PSD to put forward the best (most likely to win) candidate is high.

Securing the President’s post would therefore be important for PSD to achieve government stability through to the next parliamentary elections in 2016. An opposition victory would likely see the resumption of tensions between the offices of the President and Prime Minister, increasing political uncertainty. On the other hand, while a PSD victory would increase political stability, it would leave the centre-left PSD largely unchecked in the governing of the country, with control of both the President’s post and the parliament. The PSD has in the past shown reluctance to push through important, but sometimes contentious, structural reforms such as those in the health sector, the privatization of state-owned enterprises and liberalization of the gas market. A delay of these reforms could adversely affect investor confidence.

We expect some, but not major, fiscal easing approaching the election but the full effect of any fiscal relaxation will not be felt until next year; this includes, for example, the effect of the 5pps cut in the social security contributions of employers starting this month.20 Material slippage relative to the headline fiscal targets remains unlikely in 2014 (the budget deficit target for 2014 is 2.2% of GDP). On the other hand, meeting the 1.4% of GDP fiscal target in 2015 is ambitious (and unlikely in our view).


20 The fiscal relaxation also includes increased defence spending hikes announced in April, which should add 0.1pp to the deficit.

Romania: Deutsche Bank Forecasts 2012 2013 2014F 2015FNational Income Nominal GDP (USDbn) 169 188 199 197Population (mn) 21.3 21.3 21.2 21.2GDP per capita (USD) 7 948 8 853 9 395 9 323 Real GDP (YoY%) 0.5 3.5 2.5 3.0 Private Consumption 1.4 1.1 3.0 3.2 Government consumption 0.6 - 1.6 1.5 2.5 Gross Fixed Investment 4.2 - 3.4 0.5 4.2 Exports - 1.8 13.1 6.4 5.8 Imports - 0.3 2.3 6.0 6.2 Prices, Money and Banking (YoY%) CPI (eop) 5.0 1.6 1.9 2.9CPI (period avg) 3.3 4.0 1.2 2.5Broad money (eop) 4.6 8.8 4.4 6.4 Fiscal Accounts (% of GDP) Overall balance - 2.9 - 2.3 - 2.2 - 1.9 Revenue 33.5 33.7 33.7 33.9 Expenditure 36.4 36.0 35.9 35.8Primary Balance - 1.1 - 0.5 - 0.4 - 0.1 External Accounts (USD bn) Goods Exports 62.8 69.0 72.9 72.0Goods Imports 73.0 73.8 78.3 78.0Trade Balance - 10.3 - 4.8 - 5.4 - 6.0 % of GDP - 6.1 - 2.5 - 2.7 - 3.1Current Account Balance - 8.1 - 2.1 - 2.0 - 2.4 % of GDP - 4.8 - 1.1 - 1.0 - 1.2FDI (net) 3.1 3.7 4.0 2.4FX Reserves (eop) 44.4 44.8 41.5 40.0USD/FX (eop) 3.36 3.26 3.35 3.70EUR/FX (eop) 4.43 4.49 4.35 4.25 Debt Indicators (% of GDP) Government Debt 38.0 38.4 40.3 40.2 Domestic 18.6 17.5 19.8 20.2 External 19.4 20.9 20.5 20.0External debt 75.7 69.8 65.5 66.6 in USD bn 128 132 131 132 General (ann. avg) Industrial Production (YoY%) 2.8 7.0 8.2 8.5Unemployment (%) 5.1 5.3 5.2 5.0 Spot 14Q4F 15Q1F 15Q3FFinancial Markets Key official interest rate (eop) 3.00 3.00 3.00 3.25USD/RON (eop) 3.49 3.35 3.46 3.61EUR/RON (eop) 4.40 4.35 4.33 4.28

Source: Haver Analytics, NBR, DB Global Markets Research

9 October 2014



Russia Baa1(neg)/BBB(neg)/BBB-(neg) Moody’s/S&P/Fitch

Economic outlook: Economic prospects dimmer against the backdrop of higher sanctions.

Main risks: Elevated geopolitical risks relate to Ukraine; scale of sanctions against Russia.

Returning to stagnation path

The Russian economy has continued to decelerate, with the growth rate testing zero in August, on the back of a deceleration in household consumption and stagnation on the fixed investment side. The outlook further worsened on the back of new sanctions launched by the US and the EU against Russia in September as well as a number of developments that further worsened the investment climate. Another headwind on the global front was the significant decline in oil prices, which exerted pressure on the rouble to depreciate further.

Key economic indicators: July returns to a downward trend On the economic growth front, industrial production exhibited no growth in August, with the manufacturing segment declining by 0.6% yoy. Fixed asset investments continued to weaken further: -2.7% yoy in August, after -2.0% yoy in July. On the consumer side, retail sales continued to improve marginally to reach 1.4% yoy in August, after 1.1% yoy in July and 0.7% yoy in June, driven by improvements in real disposable income. The unemployment rate declined to another historical low of 4.8%, from 4.9% in July.

Overall, the results appear to be skewed to the downside. This may be concluded from the dynamics of the core economic activities index, published by Rosstat, which serves as a proxy for GDP growth dynamics. The index declined by 0.5% yoy in August, after 0.3% yoy in July, 0% yoy in June and 0.7% yoy in May. The preliminary monthly GDP estimate from the Ministry of Economy pointed to zero growth in August, after 1% yoy growth in July. On a seasonally adjusted basis, the economy grew 0.4% mom, after +0.4% mom in July. Over the 8M14 period, the growth rate reached 0.7% yoy.

Meanwhile, Rosstat released 2Q14 expenditure growth figures (0.8% yoy): household consumption decelerated significantly, to 0.8% yoy, after 3.7% yoy in 1Q14 and 4.1% yoy in 4Q13; public consumption remained near zero level; fixed asset investment was down, at -2.1%, partially recovering from -7.0% yoy in 1Q14. The contribution of net exports increased again, with decelerating exports (1.3% yoy in 1Q14, vs. 1.6% yoy in

2Q14) and sharply decreasing imports (-7.7% yoy in 2Q14 and -4.4% yoy in 1Q14) accounting for the bulk of the improvement.

Russia: Key economic indicators

-35%

-25%

-15%

-5%

5%

15%

25%

35%

2007 2008 2009 2010 2011 2012 2013 2014%

yoy

IP, YoY, real, % Retail sales, YoY, real, %

Fixed investment, YoY, real, % Construction, YoY, real, %

Source: Rosstat, Deutsche Bank

Given the recent economic trends in Russia, along with a lower oil price environment, we expect the Russian economy to grow by 0.5% yoy in 2014 and 1.0% yoy in 2015. Changes to our forecasts made in our September edition of The World Outlook (0.5% yoy from the previous 0.8% yoy for 2014) reflect our expectation of a further deceleration in household consumption, driven by an increase in savings ratios, lower salary growth in the public sector and higher inflation sapping disposable income growth. On the investment front, we expect growth to decline quite significantly in 2014, with a marginal recovery in 2015, on the back of base effects and support from the infrastructure stimulus. We also note the adverse effects of the import-substitution policy, as we believe it will result in higher inflation, rather than a significant improvement in output dynamics amid structural bottlenecks, high levels of capacity utilization and the decrepit state of capital equipment in the industrial sector.

Fiscal balance posts 2.0% GDP surplus in 8M14 Russia’s fiscal balance remained resilient in August, following strong prints for May-July. According to the fiscal authorities, the federal budget surplus in August increased by RUB166bn, to RUB906bn, reaching 2.0% of 8M14 GDP. Overall, both oil and non-oil revenues were broadly in line with the budget plan, while fiscal outlays were behind budget projections. Overall, the federal budget continued to post a surplus on the back of a weaker ruble, expenditures being subdued and oil prices being favourable throughout most of this year.

9 October 2014



Russia: T12M budget execution

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

18

19

20

21

22

Jan-

12Fe

b-12

Mar

-12

Apr

-12

May

-12

Jun-

12Ju

l-12

Aug

-12

Sep

-12

Oct

-12

Nov

-12

Dec

-12

Jan-

13Fe

b-13

Mar

-13

Apr

-13

May

-13

Jun-

13Ju

l-13

Aug

-13

Sep

-13

Oct

-13

Nov

-13

Dec

-13

Jan-

14Fe

b-14

Mar

-14

Apr

-14

May

-14

Jun-

14Ju

l-14

Aug

-14

% G

DP

% G

DP

Budget Revenues, % GDP Budget Expenditure, % GDPBudget Balance, % GDP (RHS)

Source: Ministry of Finance, Rosstat, Deutsche Bank

In September the government has approved the draft law of the federal budget for 2015-17, and submitted it to the State Duma. The budget is expected to feature a deficit of 0.6% GDP for the next three years. In 2015, the budget is expected to earn RUB15,082bn and spend RUB15,513bn, leading to a deficit of RUB430.8bn. The projections were made on the back of a projected growth rate of the economy of 1.2% yoy, an inflation rate of 5.5% yoy and a dollar rate of RUB/USD37.7.

External borrowing is expected at USD7bn, as projected earlier, while, according to Vedomosti, the domestic borrowings plan was to be cut to RUB280bn in 2015, but is expected to be RUB800-900bn in 2016-17. The government has also reserved the right to exchange its external debt into domestic debt, if agreed with Eurobond holders, but this decision will apply only to 2015. According to Siluanov’s statements yesterday, neither sales tax nor higher VAT tax were incorporated into the three-year fiscal projections. In our view, at this stage, the sales tax will not be incorporated in 2015; however, given the changes in the economic environment in the medium term, the authorities may revisit this issue next year.

Consumer inflation accelerates to 8.0% yoy in September Russia’s consumer prices grew by 0.8% mom in September, pushing the headline rate to 8.0% yoy, up from 7.6% yoy in August and 7.5% yoy in July. On a YTD basis, inflation amounted to 6.3% ytd, vs. 4.7% ytd over 9M13. Core CPI remained at the level of 8.0% yoy, as in August 2014. The rise in inflation in September appeared to be atypical for this period of the year, which is usually dominated by seasonal effects in the food segment (mainly fruits and vegetables).

Russia: CPI and its key components

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%

10.0%11.0%12.0%13.0%14.0%

Jan-

06A

pr-0

6Ju

l-06

Oct

-06

Jan-

07A

pr-0

7Ju

l-07

Oct

-07

Jan-

08A

pr-0

8Ju

l-08

Oct

-08

Jan-

09A

pr-0

9Ju

l-09

Oct

-09

Jan-

10A

pr-1

0Ju

l-10

Oct

-10

Jan-

11A

pr-1

1Ju

l-11

Oct

-11

Jan-

12A

pr-1

2Ju

l-12

Oct

-12

Jan-

13A

pr-1

3Ju

l-13

Oct

-13

Jan-

14A

pr-1

4Ju

l-14

Food, %, YoY Non-food, %, YoY Services, %, YoY

Source: Rosstat, Deutsche Bank

Across the key components, food items’ price growth accelerated to 11.4% yoy, from 10.3% yoy in August and 9.8% yoy in July. In the non-food segment, inflation remained at the same level as it was in August, at 5.5% yoy, lower than in July (5.6% yoy). As for services, their price growth acceleration appeared to be marginal, at 6.9% yoy in September, from 6.7% yoy in August.

Overall, the main drivers of price increases in the food segment appeared to be goods for which imports were restricted from the EU, the US, Canada and Norway. The highest increase in prices was for poultry (4.5% mom), which was up 3.7% mom. Significant increased were also registered in pork (3.2% mom), and frozen fish (2.3% mom), while cheese prices were up by 6.0% yoy.

We highlighted earlier that the introduction of trade sanctions could result in higher inflationary pressures in 2014-15, although a lot will depend on the ultimate duration of these restrictions. In our most recent research (Special Report – Russia: assessing the impact of trade restrictions, dated 1 September), we estimated the impact of food restrictions at 1.5pp to the headline inflation rate over the next 12–18 months.

CBR keeps rates on hold in September Despite the surge of inflation in September (CPI up to 7.7% yoy in early September), the CBR kept the key policy rate unchanged, at 8.0%. The latest acceleration in inflation originated from food import restrictions, which reversed the effect of lower growth in regulated tariffs and the decline in food prices on the back of seasonal effects. Despite this acceleration, according to the CBR, the current monetary policy stance, along with the absence of demand-push pressures and lower credit and money supply growth, enable the economy to accommodate food price shocks and reduce inflation dynamics in the medium term. The CBR states that it will further tighten monetary policy if high inflation risks persist and inflation expectations remain elevated.

9 October 2014



The monetary authorities expect the CPI to persist at a level exceeding 7.0% yoy, with future dynamics being influenced by the speed of the accommodation of the economy to imposed trade restrictions. The CBR expects the effects of price growth on restricted food items to be temporary. The CPI is expected to decline in 1H15 on the back of the dissipation of external shocks, lower inflation expectations and the absence of demand-push pressures. The CBR sees its current monetary stance as consistent with the attainment of its medium-term target of 4% yoy.

Russia: CBR’s key policy rates

fixed o/ncredit

1D fixed repo

RUB-legFX-swap

min-maxfixed 312P

1W auction repo

o/n fixeddepo

1W auctiondepo

CPI,% yoy

min auction312

1M AVG RUONIA

2.02.53.03.54.04.55.05.56.06.57.07.58.08.59.09.5

10.010.5

Dec

-10

Jan-

11Fe

b-11

Mar

-11

Apr-1

1M

ay-1

1Ju

n-11

Jul-1

1A

ug-1

1S

ep-1

1O

ct-1

1N

ov-1

1D

ec-1

1Ja

n-12

Feb-

12M

ar-1

2A

pr-1

2M

a y-1

2Ju

n-12

Jul-1

2Au

g-12

Sep-

12O

ct-1

2N

ov-1

2D

ec-1

2Ja

n-13

Feb-

13M

ar-1

3A

pr-1

3M

ay-1

3Ju

n-13

Jul-1

3Au

g-13

Sep-

13O

ct-1

3N

ov-1

3D

ec-1

3Ja

n-14

Feb-

14M

ar-1

4A

pr-1

4M

ay-1

4Ju

n-14

Jul-1

4Au

g-14

Sep-

14O

ct-1

4

(%)

Source: Rosstat, CBR, Deutsche Bank

We believe that the CBR’s decision is motivated, in part, by the need to gauge near-term developments in inflationary dynamics (including the effects of import restrictions) and broader economic uncertainty before deciding on the scale of further monetary policy tightening. Our sense is that, given these risks, as well as the dynamics – not just in headline inflation, but also in the core inflation indicator – the CBR is likely to resort to additional interest rate increases later this year, which could reach another 50 bps by end-2014.

Russia: Banking sector funding, %

0

10

20

30

40

50

60

70

80

90

2008 2009 2010 2011 2012 2013 2014

(%)

RUB Corp/Household Deposit Funding FX Corp/Household Deposit Funding Interbank funding CBR +MinFin funding

Source: Rosstat, CBR, Deutsche Bank

Still, large-scale depreciation remains an issue for the monetary authorities, filtering into headline inflation via pass-though channels of imports. A structural deficit of

FX liquidity is believed by the market participants to be one of the reasons for pronounced rouble depreciation in recent periods. In response to these issues, the CBR has introduced 1D fixed USD/RUB Sell/Buy FX swaps, starting on today/tomorrow and tomorrow/spot settlement terms. The CBR set the interest rate for the rouble swap leg operation at a key rate minus 1pp (now it is 7.0%), which is equivalent to the depo rate, while, for the US dollar leg, the rate is fixed at 1.5%. The maximum allotments on FX swaps with today/tomorrow and tomorrow/spot settlements are set at USD1bn and USD2bn, respectively. According to the CBR, these operations are aimed at improving the short-term FX liquidity conditions for the banking sector. In our view, although the announced conditions are not particularly attractive (modest size and the rates are not particularly appealing), we believe this shows the commitment of the central bank to improve the domestic liquidity conditions, which have suffered from high capital flight and deteriorating external market borrowing conditions. Moreover, in the begging of October CBR, Governor Elvira Nabuillina stated that the CBR might introduce the 7D and 27D repo, with FX used as collateral. If introduced, this tool could provide further serve to improve domestic liquidity conditions.

Another concern that has put pressure on the rouble is the possibility of the imposition of capital controls, although the CBR issued a press release in connection with media reports denying the fact that such measures were being discussed as a reserve option. Earlier this year, high-ranking CBR and Minfin officials declared that capital controls would not be introduced and that no such plans were discussed.

At this stage, the introduction of capital controls in Russia is not our base case, and the timing of such measures would be particularly questionable if there were progress in the near term in resolving the regional conflict, including the gas dispute with Ukraine. The scale of the negative impact sustained by the macro economy (even taking into account the weakness in the rouble) does not appear to warrant such measures. Also, Russia’s past history suggests that such controls were frequently ineffective and economic agents found ways to by-pass such restrictions. Finally, such measures could trigger stepped up currency conversion by the population, which could further put pressure on the rouble.

EU/US introduce further sanctions against Russia In mid-September, the EU and the US launched another round of economic sanctions against Russia in light of the developments in the Ukrainian crisis. Strengthened EU sanctions included the following: 1) restrictions on raising new equity and debt with maturity exceeding 30 days for five state-owned banks, Sberbank, Gazprombank, VTB, VEB and RSHB, and Russian energy companies Rosneft, Gazprom neft and

9 October 2014



Transneft; 2) EU restricted provision of services necessary for deep-water oil exploration and production; arctic oil exploration or production and shale oil projects in Russia would no longer be provided; 3) extension of the EU ban on exporting dual-use goods and technology for military use in Russia to also include a list of nine defense companies that must not receive dual-use goods from the EU.

Following the publication of strengthened sanctions against Russia by the EU today, the US followed with its expanded set of measures against Russia’s corporates and sectors. The new sanctions include restrictions on new equity/debt (maturity >30 days) financing for major state-owned Russian banks (Sberbank, VTB, Bank of Moscow, Gazprombank, RSHB), large energy companies (Gazprom neft, Transneft, Rosneft and Novatek) barred from equity/debt raising with maturity >90 days. In addition to financing restrictions, the new sanctions prohibit the export of goods, services or technology in support of exploration or production for Russian deepwater, Arctic offshore, or shale oil projects by five Russian energy companies, namely Gazprom, Gazprom neft, Lukoil, Rosneft and Surgutneftegaz.

The impact of another round of sanctions is likely to result in higher capital outflows, further pressure on the ruble and concerns over the direction of Russia’s economic policy, which, via retaliatory measures, is likely to gravitate increasingly towards import-substitution. The latter, in our view, is fraught with further inflationary pressures and a lack of response on the production side, which is hampered by high capacity utilization and a decrepit state of capital equipment. Earlier, Russia's officials declared that restrictions on imports of capital equipment from the West could be considered as part of the retaliatory measures. Nonetheless, in the end Russia’s authorities opted not to proceed with retaliatory measures – according to the First Deputy Prime Minister Arkady Dvorkovich retaliatory measures are not seen as a priority.

Yaroslav Lissovolik, Moscow, +7 495 933 9247 Artem Zaigrin, Moscow, +7 495 797 5274

Russia: Deutsche Bank forecasts 2012 2013 2014F 2015FNational Income Nominal GDP (USDbn) 2 002 2 096 2 005 2 123 Population (mn) 143.1 143.2 143.5 143.7 GDP per capita (USD) 13 993 14 621 14 008 14 841

Real GDP (YoY%) 3.4 1.3 0.5 1.0 Private Consumption 6.6 4.7 2.0 1.1 Government consumption 0.0 0.4 - 0.5 - 0.3 Exports 1.8 4.1 0.1 0.8 Imports 8.7 3.9 - 2.5 - 0.6


%

CPI (eop) 6.6 6.5 7.4 6.4 CPI (period avg) 5.1 6.8 7.3 6.2 Broad money (eop) 11.9 14.0 10.3 12.2 Private Credit (eop) 19.1 17.1 15.6 15.0

Fiscal Accounts (% of GDP) Overall balance - 0.1 - 0.5 0.2 0.3 Revenue 20.5 19.3 19.2 19.7 Expenditure 20.6 19.8 19.0 19.5 Primary Balance 0.5 0.1 0.8 0.9

External Accounts (USD bn) Trade Balance 193.3 177.3 201.1 174.9 % of GDP 9.6 8.7 10.0 8.2 Current Account Balance 72.0 33.0 56.3 38.6 % of GDP 3.7 1.5 2.7 1.7 FDI (net) 1.8 - 15.6 - 10.2 - 5.6 FX Reserves (eop) 537.6 510.0 460.0 483.0 USD/FX (eop) 30.37 32.73 36.70 36.00

Debt Indicators (% of GDP) Government Debt 11.5 11.7 12.0 12.1 Domestic 8.0 8.1 8.6 8.7 External 3.5 3.6 3.4 3.4 External debt 31.8 32.9 36.1 34.2 in USD bn 636 732 763 726

General (ann. avg) Industrial Production (YoY%) 2.6 0.0 - 1.2 1.6 Unemployment (%) 5.5 5.5 6.0 6.3

Current 14Q4F 15Q1F 15Q3FFinancial Markets Policy rate (Key rate) 8.00 8.50 8.50 8.50 USD/RUB (eop) 39.70 36.70 36.53 36.18 * - central government, ** - general government Source: Official statistics, Deutsche Bank Global Markets Research

9 October 2014



South Africa Baa1 (negative)/BBB- (stable)/BBB (negative) Moody’s/S&P/Fitch

Economic outlook: some normalcy has returned to industrial activity, but the outlook remains uncertain against a weak global backdrop and upcoming GDP revisions. Prepare for some revenue slippage and pressure on the focus to reduce the current spending overshoot. For now, a weak growth landscape should ensure policy rates continue to adjust slowly.

Main risks: weak capital flows, wider current account and fiscal deficits and additional exchange rate pressure are adding to inflation risks, which could trigger further ratings downgrades from Moody’s and Fitch. Focus remains on Eskom’s funding plan to be announced in the upcoming mid-term budget.

Fiscal pressure mounting

On the 22nd of October the new Finance Minister, Mr Nhlanhla Nene will deliver his first mid-term budget policy statement. As it stands, economic growth is at the weakest in five years and monetary policy is tightening from ultra accommodative levels. Inflation is above the target band, business and consumer confidence, though off recent lows, are still significantly below their long-term averages, and labour market frictions have not disappeared. Though recent PMI and vehicle sales/export data confirmed a return to some ‘normalcy’ after the series of hits from labour strikes, the outlook for the economy remains weak.

Growth forecasts – uncertain trajectory

1

1.5

2

2.5

3

3.5

4

4.5

2014 2015 2016

IMF (Jul) DB (Sep)

NT (Feb) SARB (Sep)

Consensus (Jan)

GDP YoY %

Source: Deutsche Bank, StatsSA, SARB

Admittedly, our growth forecast (3.4% in 2015) do appear rather optimistic given the recent downgrades to global growth, coal import restrictions from China

and the deterioration in terms of trade. This is partly owing to the low base in GDE (0.4% in 2014), and the expected improvement in net trade next year as imports lag weakness in domestic demand. But there is significant uncertainty as to how these projections will change after the major overhaul of historical GDP statistics on the 25th of November. Indeed, the starting point of all GDP components from which existing forecasts are based will change. The risks currently point to a cumulative upward revision to real GDP of 0.5% - 1%, and upgrades will be made to expenditure components to reflect new advances in methods, definitions and data sources. The risk we face from a significant upward revision to the GDP base level is that the business cycle trough is yet to be reached – i.e. growth does not rebound as expected in 2015. The National Treasury may therefore want to base their forecasts on more conservative estimates than presented in February.

All in all, maintaining the existing consolidation path with the fiscal deficit reaching -2.8% of GDP in 2016/17 will be hard to achieve under current circumstances. In the first five months of the 2014/15 fiscal year, the budget deficit has deteriorated significantly and is 2% ahead of target compared to previous years (Figure below). At the current spending rate, it will be difficult to stick to the nominal spending limits. While revenue collections currently appear to be broadly on track to reach the budget targets, we see some scope for slippage.

Year-to-date budget deficit significantly worse than the

past

0%

20%

40%

60%

80%

100%

120%

April July October January

2014-15

Year-to-date deficit as % of budget forecast

Shaded area represents range of outcomes for the

preceding four years

Source: Deutsche Bank, StatsSA

As illustrated in the Figure below, a sustained increase in non-interest expenditure may lead to an overrun of c.R23bn, pushing the deficit to -4.7% of GDP (vs -4% in February), all else being equal. Credit ratings agencies

9 October 2014



will not be pleased with such an outcome. But this does imply a significant reprioritisation in expenditure is needed to maintain the effective expenditure ceilings announced in 2012. It also appears that the new Finance Minister is reluctant to announce any expenditure cuts at this stage. From what we gather, there is probably around R10bn to R15bn worth of fat in budgeted expenditure – eg. vacant posts, contingency reserves – that could be trimmed if necessary.

Fiscal framework: Revenue slippage expected

NT YTD DBe* NT DBe* NT

Revenue 1099 1100 1095 1201 1191 1325

Expenditure 1252 1275 1252 1352 1352 1452Non-interest 1131 1154 1131 1218 1218 1307Interest 121 121 121 133 133 145

Overall balance -153 -175 -157 -150 -160 -127Primary balance -32 -54 -36 -17 -27 18

Revenue 29.0 29.6 29.5 28.9 29.0 29.1Expenditure 33.0 34.3 33.7 32.6 32.9 31.9

Non-interest 29.8 31.0 30.4 29.3 29.7 28.7Interest 3.2 3.3 3.3 3.2 3.2 3.2

Overall balance -4.0 -4.7 -4.2 -3.6 -3.9 -2.8Primary balance -0.8 -1.5 -1.0 -0.4 -0.7 0.4

FY16

(Rand bil lions)

(% GDP)

FY14 FY15

Source: Deutsche Bank, National Treasury

The expenditure overshoot may have to do with increased administrative pressure resulting from the elections and new cabinet announcements. Based on Stats SA statistics, total employment in the public sector rose by a significant 5.8% q/q in Q2 – significantly more than in the 0.8% q/q increase in the 2009 election year.

Non-interest expenditure above target for two

consecutive months

0%

20%

40%

60%

80%

100%

April July October January

2014-15

Year-to-date non-interest expenditure as % of budget forecast

Shaded arearepresents range of outcomes for the preceding four years


While there may be a partial reversal as some of these jobs are temporary, the number of cabinet ministers has increased despite some consolidation in the number of ministries. Wage pressure is mounting, with

public sector union demands running at more than double the 6.4% budgeted increase in the wage bill.

At this juncture, revenue collections could marginally undershoot budget by c. R5bn, if downward pressure on non-income tax revenue, VAT in particular, continues. In spite of the economic hardship this year, income tax revenues have held up fairly well compared to previous years. But it is questionable how long this will last and whether the seasonal increase in corporate income tax in December will disappoint or not. Fortunately, non-tax revenues are performing somewhat stronger year-to-date (42.3% of budget vs the average of 39.3%), reflecting positive valuation effects and profit gains on government-held financial assets. If sustained, this could result in some R5bn of additional income support. However, if it turns out that Eskom’s cash injection comes from government’s balance sheet (via asset sales) then this revenue source may run dry.

Mixed prognosis for tax revenue collections

Current 6-yr ave

Personal income 335.9 130.4 37.0 37.9 3.1

Corporate income 221.0 77.9 34.5 33.9 2.9

VAT 267.1 93.2 36.7 35.9 -2.7

Other 169.7 60.7 35.8 38.7 -5.0

Total tax revenue 993.7 362.2 36.4 36.6 -1.7

less SACU payments 51.7 25.9 50.0 50.0 0.0Departmental revenue (non-tax) 20.9 12.8 42.3 39.3 4.6

Total 962.8 349.1 36.4 36.1 1.6

Budget est. (Rbn)

Apr-Aug (Rbn)

YTD % of Budget Rbn over/under


The prognosis for revenue collections remains mixed. At the time of the February Budget, the Treasury expected growth in domestic demand to reach 2.8% in 2014 and 3.4% in 2015. However, year-to-date, growth in real GDE has fallen to 0.1%, reflecting the plunge in domestic income growth (Figure below). In addition, other forms of tax collections such as import duties have collapsed given the decline in real import volumes. This means that a fairly weak exchange rate (inflationary pressures), and a reduction in VAT refunds (as private sector capex have turned negative) are temporarily buoying non-income tax revenues. On the flip side, the decline in import volumes in Q2 suggests that NT’s import growth assumptions of 5.3% in 2014 (vs ytd growth of 0.3%) are too optimistic. Thus budget allocations for SACU transfers are probably overstated. A continuation of lower import volumes – in line with our expectations – could imply a revenue claw back of at least R10bn- R15bn next year.

9 October 2014



Real drivers of VAT collections have weakened

-30

-15

0

15

30

45

1994 1997 2000 2003 2006 2009 2012

VAT collections (LHS)ImportsGrowth in terms of trade-adjusted GDP

yoy %


Overall, we expect a moderately weaker revenue outlook in the mid-term budget, which may necessitate the introduction of new tax proposals (only to be announced in February). As it stands, the current revenue slippage could raise the deficit by -0.2% to -0.3% to -4.2% in FY14/15. For the existing consolidation plan to remain credible, the National Treasury will have to stick to the nominal expenditure ceilings. This will be challenging given the year-to-date spending overshoot of more than R20bn, and mounting pressure from the public sector unions for double-digit wage increases. At this point, the weaker economic backdrop, funding pressures from state-owned enterprises and uncertain global outlook may render expenditure ceilings as an inadequate tool for fiscal sustainability, and could result in further ratings downgrades by Moody’s and Fitch. For now, the funding of the deficit remains on track, if not slightly ahead of target (c. R8.5bn), and the debt ratio may very well remain similar to the trajectory posited in February.

No room for further debt uptake

25

30

35

40

45

FY10 FY11 FY12 FY14 FY15 FY16

February Budget 2013

October MTBPS 2013

February Budget 2014

Net national government debt (% GDP)


Danelee Masia, South Africa, 27 11 775-7267

South Africa: Deutsche Bank Forecasts 2012 2013F 2014F 2015F

National Income

Nominal GDP (USD bn) 383.3 349.5 338.9 389.1Population (mn) 52.3 53.0 53.5 54.0GDP per capita (USD) 7331 6596 6333 7200 Real GDP (%) 2.5 1.9 1.5 3.4 Priv. consumption 3.5 2.6 2.0 1.9 Gov’t consumption 4.0 2.4 1.3 2 Gross capital formation 4.5 4.7 2.9 3.7 Exports 0.5 4.2 3.8 4.6 Imports 6.2 4.7 0.1 1.5


CPI (YoY%, eop) 5.7 5.4 6.2 5.4CPI (YoY %, pavg) 5.7 5.8 6.2 5.4 Fiscal Accounts (% of GDP) 1, 2

Overall balance -4.2 -4.1 -4.2 -3.9 Revenue 28.3 29.0 29.5 29.0

Expenditure 32.5 33.0 33.7 32.0


External Accounts (USDbn)

Goods exports 99.5 94.6 93.5 101.1Goods imports 104.3 102.4 99.1 107.2Trade balance -4.8 -7.8 -5.6 -6.0 % of GDP -1.3 -2.2 -1.7 -1.6Current account balance -20.1 -20.9 -15.5 -17.2 % of GDP -5.2 -6.0 -4.6 -4.4FDI (net) 1.5 3.8 2.7 3.1FX reserves (USD bn) 50.7 49.0 48 51ZAR/USD (eop) 8.5 10.1 10.8 10.0ZAR/EUR (eop) 11.2 13.2 13.9 11.5


Government debt 1 42.5 44.8 46.5 47.5

Domestic 38.6 40.5 42.8 43.7

External 3.9 4.3 3.7 3.8


in USD bn 142.3 130.0 135.0 145

Financial Markets (eop) Current 14Q4 15Q1 15Q3

Policy rate 5.75 6.00 6.00 6.253-month Jibar 6.07 6.20 6.20 6.5010-year bond yield 8.2 8.5 9 8.8ZAR/USD 11.0 10.8 10.7 10.2ZAR/EUR 14.2 14.1 13.5 12.5(1) Fiscal years starting 1 April. (2) Starting with the November2013 EM Monthly, numbers are presented using National Treasury’s new format for the consolidated government account. Source: Deutsche Bank, National Sources.

9 October 2014



Turkey Baa3 (negative)/BB+ (negative)/BBB- (stable) Moody’s / S&P / Fitch

Economic outlook: renewed market pressure has prompted the CBT to tighten domestic liquidity conditions. This will help to support the lira and thereby contribute to a deceleration in inflation from current very high levels. But it will also weigh on economic activity. Lower oil prices should support a further reduction in the current account deficit.

Main risks: the ongoing geopolitical sectarian conflict in Iraq and Syria could trigger domestic divisions and unrest. Despite the rebalancing that has taken place and the recent tightening of monetary conditions, external financing needs remain large and the economy will accordingly continue to be highly sensitive to swings in global risk sentiment.

Tightening time

Turkish markets have been under pressure over the last month. This reflects both nervousness about geopolitical risks in the region and broader pressure on emerging markets in anticipation of the normalization of US monetary policy. Against this backdrop, while the Central Bank of Turkey (CBT) left its key policy rates unchanged last month, it nevertheless tightened domestic liquidity conditions significantly. Domestic macro data meanwhile have taken a bit of a back seat. Inflation dipped below 9% for the first time in five months. Newly announced energy price hikes will put upward pressure on headline prices in the near term. Inflation should then start to decelerate more decisively through the middle of next year, especially as food prices correct and assuming some lira stability, though it will remain high by EM standards. Recent trade data suggest that the rebalancing process is running out of steam, though lower oil prices will now start to provide some relief given Turkey’s large energy import bill.

Monetary policy: regime change The CBT left all of its key policy rates on hold last month but has since engineered a significant tightening in monetary conditions by restricting the amount of funding that it provides through its one-week repo auctions. This has driven (overnight) market rates towards the upper bound of the CBT’s interest rate corridor, an increase of some 250bps.

The one-week repo rate has become less meaningful as a signal of the CBT’s monetary stance, which is now effectively being determined on a daily basis by the CBT’s liquidity management. This is a reversion to the kind of regime that we have seen during past episodes

of market stress (see chart). We had expected this. But it has happened sooner, and the tightening has been sharper, than we had expected. It may be that the CBT is trying to deliver a “short sharp shock” to the markets in an attempt to nip pressure in the bud. It does not have enough reserves to do so through currency intervention -- we estimate that the CBT’s net usable FX reserves are about USD 38bn – which leaves interest rates as the only viable defense.

Domestic liquidity conditions have been tightened

Effective

Interbank

Repo

3

4

5

6

7

8

9

10

11

12

13

Dec 11 Apr 12 Aug 12 Dec 12 Apr 13 Aug 13 Dec 13 Apr 14 Aug 14

%

Rate corridor


The CBT will be hoping that by acting early, it will be able to quickly unwind this tightening. The extent to which it is able to do so really depends on external market conditions. Having acted early, it’s probable that we will see some unwinding. But we think it’s unlikely that it will be able to sustain market rates back at 8.25% (i.e. anchored around the current repo rate) for long as markets continue to prepare themselves for the first Fed rate hike. We thus maintain our view that market rates are likely to need to average something like 9.5% through the middle of next year.21

Inflation: energy boost After three months of upside surprises, inflation finally came in lower than markets had been expecting in September, decelerating to 8.9% from 9.5% in August. Food prices have begun to adjust, falling slightly on the month in seasonally adjusted terms. Core inflation also decelerated to 9.3% from 9.7% in August. Monthly

21 We show this in the form of an increase in the effective funding rate in

the table below – though, in practice, the CBT could achieve this in a

variety of ways.

9 October 2014



movements in this series have been quite volatile, but in seasonally adjusted terms, core inflation has been growing at an average annualized rate of 6.7% over the last three months, the lowest rate since the turn of the year. The CBT will be encouraged by this.

Separately, the government announced a 9% increase in the price of electricity and natural gas, the first adjustment in two years, effective from the beginning of this month. We estimate that this will directly add a little over 0.5ppts to the headline rate of inflation. The full impact could be somewhat higher than this, to the extent that the higher energy costs also lead to increases in the prices of other goods.

The adjustment is necessary to cover a shortfall at the state gas company due to the rising cost of energy in local currency. It will reduce but not eliminate the subsidy element. A further significant adjustment in prices may therefore be necessary next year.

Household energy costs needed to be adjusted

90

95

100

105

110

115

120

125

130

Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14

November 2012 = 100

Householdenergy costs

Lira price of oil, lagged


We had largely anticipated this adjustment in energy prices and recent lira weakness, and we are therefore making only a modest upward adjustment to our end-year forecast for inflation to 8.7%. We are also retaining our end-2015 forecast of 6.9%, though this masks an expected brief dip in inflation to below 6% next summer due to base effects as this year’s spike in food prices drops out of the figures. The main risk to our forecasts, however, is probably to the upside in the event that the CBT is unable to prevent further significant depreciation in the lira.

Rebalancing stalls but cheaper oil offers relief Weaker trade numbers in August raised fresh doubts about the progress on economic rebalancing. The trade deficit widened to USD 8.0bn in August from USD 6.5bn in July. These data are volatile and we always caution against reading too much into one observation. Nevertheless, after adjusting for the seasonality in the

data, the momentum behind the improvement in the underlying external balance does seem to have stalled over the last three months (chart below).

Improvement in trade balance stalls

Headline balance

Excluding exports to Iraq,

Russia, and Ukraine

-40

-35

-30

-25

-20

-15

-10

Jan 12 Jun 12 Nov 12 Apr 13 Sep 13 Feb 14 Jul 14

Non-oil and non-gold trade balance (seasonally-adjusted 3mma annualized)

USD bns

Source: Haver Analytics,, Deutsche Bank

Geopolitical events have not helped. Exports to Iraq, Russia, and Ukraine have fallen by about 22% (YoY) over the last three months. In absolute terms, this loss in exports is worth around USD 5bn on a full-year basis, or around 0.6% of GDP. But other exports have also weakened a little. Moreover, imports (excluding gold and oil) rebounded sharply in August. The decline in headline imports in August was entirely seasonal. After stripping out seasonal effects, imports were up 8.6% on the month, more than fully reversing their 3.1% drop in July.

We still think the current account deficit will likely narrow a little further from 6.1% of GDP currently (12 months to July) to 5.5% of GDP by the of this year. But this improvement is now entirely down to cheaper oil imports and lower imports of gold over the remaining months of the year

We think the current account deficit will narrow a little further next year to 5% of GDP, also due to lower oil prices, whereas the current account balance excluding energy should weaken marginally.

9 October 2014



Current account to benefit from cheaper oil

-1

0

1

2

3

4

5

6

7

8

9

2012 2013 2014F 2015F

Non-energy Energy Total

Current account deficit (% GDP)


The risks to our forecast for next year are probably skewed towards a smaller deficit. Our (Brent) oil price forecast of USD 103bbl is quite conservative relative to the current spot price of USD 92bbl. If prices were to remain at current levels, our deficit forecast would be about 0.6% of GDP lower. Equally, while we had been anticipating tighter domestic liquidity conditions and only a moderate recovery in domestic demand, this squeeze could well be tighter than we envisage. In this case, GDP growth would likely drop below 3%. The silver lining in this cloud would be reduced imports and a lower current account deficit.

Robert Burgess, London, +44 20 7547 1930

Turkey: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income

Nominal GDP (USD bn) 788.6 821.9 806.3 859.8

Population (mn) 74.9 75.8 76.8 77.8


Real GDP (YoY%) 2.1 4.1 3.0 3.3

Private consumption -0.5 5.1 0.8 3.7


Gross fixed investment -2.7 4.2 -1.9 3.3

Exports 16.3 -0.3 8.4 4.9

Imports -0.4 9.0 -0.4 5.6


CPI (eop) 6.2 7.4 8.7 6.9

CPI (period avg) 8.9 7.5 8.9 6.4

Broad money (eop) 10.2 22.2 12.1 9.9

Bank credit (eop) 18.5 33.3 18.1 16.4

Fiscal Accounts (% of GDP) Overall balance 1 -2.0 -1.2 -1.7 -1.5

Revenue 23.4 24.9 23.4 23.0

Expenditure 25.4 26.1 25.2 24.5

Primary balance 1.4 2.0 1.3 1.4


Goods Exports 163.2 163.4 172.8 183.5

Goods Imports 228.6 243.4 234.5 245.0

Trade balance -65.3 -80.0 -61.7 -61.4

% of GDP -8.3 -9.7 -7.7 -7.1


% of GDP -6.1 -7.9 -5.5 -5.0

FDI (net) 9.2 9.8 10.3 11.1

FX reserves (eop) 99.9 110.9 115.0 120.0

TRY/USD (eop) 1.79 2.14 2.25 2.26


Government debt 1 37.6 37.4 35.7 34.2

Domestic 27.3 25.7 24.5 23.8

External 10.3 11.7 11.2 10.4


in USD bn 338.3 388.2 406.5 423.4

Short term (% of total) 29.7 33.6 31.8 30.0

General (ann. avg)

Industrial production (YoY) 2.5 3.4 2.9 3.4

Unemployment (%) 8.4 9.1 9.9 9.8

Financial Markets (eop) Current 14Q4 15Q1 15Q3

Policy rate (repo) 8.25 8.25 8.25 8.25

Overnight lending rate 11.25 11.25 11.25 11.00

Effective funding rate 8.53 9.00 9.50 9.25

10-year bond yield 9.50 9.75 10.0 10.0

TRY/USD 2.29 2.25 2.25 2.23 (1) Central government Source: Deutsche Bank, National Sources.

9 October 2014



Ukraine Caa3(negative)/CCC(stable)/CCC(negative) Moody’s/S&P/Fitch

Economic outlook: Ukraine faces significant difficulties on both the growth and inflation fronts.

Main risks: A weak external position could be exacerbated by political uncertainty.

Macroeconomic challenges persist

In August and September, Ukraine’s economy continued to weaken with economic decline exacerbated by currency weakness and mounting inflationary pressures. On the political front, the de-escalation process continued to take place in the Eastern Ukraine with the cease-fire being broadly maintained along the front line, except for some clashes in the vicinity of the Donetsk Airport. Going forward, the political landscape is replete with elections: Ukraine’s parliamentary elections on 26 October; Donetsk People’s republic elections on 2 November, while Kyiv set the date of local elections in Donetsk for 7 December.

On 5th September the cease-fire agreement was signed by the Minsk contact group (leaders of the Donetsk and Luhansk self-proclaimed republics, second president of Ukraine Leonid Kuchma, Russia’s Ambassador to Kyiv Mikhail Zurabov and OSCE representative Heidi Tagliavini) consisting of twelve points, including establishment of immediate ceasefire, release of all hostages and illegally detained persons, withdrawal of all illegal armed groups and military equipment from the territory of Ukraine; conduct decentralization of power via provision to the Donetsk and Luhansk regions of a special status and provision for OSCE the right to monitor and verify the ceasefire regime. The contact group gathered for the second time on 19 September to sign a memorandum on the implementation of the cease-fire agreement of Ukraine’s President Petro Poroshenko and proposals made by Russia’s President Vladimir Putin. In addition to the first agreement, both sides agreed establish a 30km buffer zone withdrawing heavy weaponry and mines and explosives from that zone.

Later the deal was accompanied by Rada’s adoption of a set of laws which set the basis for a resolution of the conflict in Eastern Ukraine, which: (1) grants autonomy to the region for a period of three years with local authorities deciding on a wide range of social, economic and security issues as well as electing prosecutors and judges; (2) guarantees the right to use and study Russian or any other language in Ukraine; (3) sets local elections in Donbass for 7 December; (4) provides a special economic regime in the region with a special target program on development of the region

to be adopted and financed from the budget. At the same time, according to Alexander Zakharchenko, leader of self-proclaimed Donetsk Republic, the pro-Russian forces welcome the steps undertaken by Kiev, but will insist on the granting of independence for Donbas. The Presidential elections in the republic are set for 2 November.

The Rada also ratified the economic part of the FTA agreement with the EU. The new agreements will replace the current Partnership and Cooperation Agreement Ukraine signed with the EU in 1998. According to the agreement, the economic integration itself will be postponed until end-2015 with the country obtaining the right to continue duty-free trade with CIS states, including Russia in 2015. Starting from 2016 Ukraine is set to begin economic integration with the EU. At the same time, Ukraine will benefit from a unilateral cancellation of duties by the European Union, which is to be applied by the EU until end-2015.

On the economic front, industrial production continued its free fall declining by 22% in August after -12.1% yoy in July and -5.0% yoy in June. Construction, a proxy for fixed assets investments, declined by 37% yoy after -31% in July and -25% yoy in June. Agriculture appeared to be the only sector among abovementioned posting positive growth of 6.3% yoy over 8M. On the consumer side, retail sales continued to deteriorate: -5.8% yoy in 8M14 after -3.2% yoy in 7M14, with the downward trend partly coming on the back of the decline in real wages. Unemployment decreased marginally to 9.0% in June after 9.3% in 1Q14 vs. 7.7% in 4Q13.

In terms of monetary conditions, consumer price growth accelerated again to 0.8% mom in August after 0.4% mom in July. On a yoy basis, CPI increased to 14.2% yoy in August after 12.6% yoy. Meanwhile, money supply growth accelerated to 18.3% from 11.1% yoy in July. The key concern on the inflation front remains the significant depreciation of the hryvnia reaching the level of UAH/USD14.5 by the end of September (75% yoy). Since then it stabilized at the level of UAU/USD13.0 by the beginning of October on the back of the launch of the fx auctions on the interbank market. The NBU in its monetary policy guidelines expects GDP growth in 2015 at 1.0% yoy (this year it projects a decline of 6.5% yoy), and an inflation rate of 9% yoy after 19% yoy projected for 2014.

On the fiscal front, the state budget continued to run a deficit, with revenues at UAH231bn vs. expenditures at

9 October 2014



USD266bn over 8M14, increasing the deficit to UAH35bn. Revenues increased primarily on the back of proceeds from the NBU and royalties UAH22.8bn in 8M14; tax revenues were down with the most pronounced decline witnessed in VAT (-4.1% yoy in 8M14) and profit tax (17.4% yoy). As for next year, the government adopted a draft of 2015 state budget, which guides for a decline in the deficit to 3.5-3.7% GDP from 4.5% GDP projected this year.

On the external front, Ukraine’s CA deficit marginally widened to USD2.7bn in 8M14 vs. USD9.0bn in 8M13. After obtaining sizeable external financing from the IMF, EU and WB in the official reserves position improved to USD17.9bn at end-May. However, the reserves declined significantly from those levels to USD16.1bn in end-July. The country actively increased its external debt position over past several months with direct external debt increasing by 8% ytd to USD30.2bn, while overall sovereign debt (including state guarantees) increased by 6.5% to USD40bn.

As for the forthcoming redemptions, according to the NBU Ukraine is to pay USD2.1bn in the fourth quarter of this year, which could be offset by the next tranche of the IMF with the next disbursement expected by December 2014. Overall, after paying out USD1.6bn of Naftogaz Eurobonds in October there are no major peaks in debt payments the forthcoming months of this year. At the same time, there is a risk of early claims from Russia for redemptions of USD3bn Eurobonds, which were issued in December 2013. The early redemptions could take place in case Ukraine exceeds the limit of 60% GDP of external debt. The monetary authorities expect this issue to be raised not earlier than 2Q15 given that the official data on full year nominal GDP will be released not earlier than 31 March 2015.

Meanwhile, on the domestic political front, Ukraine is preparing for early parliamentary elections scheduled for October 26th. Polls conducted at the end of September by Rating+ state favour Petro Poroshenko’s block (23.7%), Lyashko’s Radical Party (7.1%), People’s Front of Yatenyuk and Turchynov (4.3%), Hrytsenko’s Civic Stand (4.2%), Tymoshenko’s Fatherland (4.1%), Tyhypko’s Strong Ukraine (2.9%) followed by Svoboda (2.6%) and Communists (2.3%). According to the poll, the remaining parties are unlikely to overcome the 5% level. According to the polls 10-20% of potential voters are not intending to vote, while approximately 15-20% have not yet decided whom to support.

Yaroslav Lissovolik, Moscow, +7 495 933 9247 Artem Zaigrin, Moscow, +7 495 797 5274

Ukraine: Deutsche Bank forecasts 2012 2013 2014F 2015FNational Income Nominal GDP (USDbn) 176 176 116 121 Population (mn) 45.5 45.4 45.0 45.0 GDP per capita (USD) 3 887 4 024 2 587 2 677

Real GDP (YoY%) 0.3 0.0 - 6.9 0.5 Private Consumption 11.7 6.5 - 5.7 0.4 Government 2.2 2.3 - 1.2 - 0.5 Exports - 7.7 - 6.5 - 3.1 - 1.6 Imports 1.9 1.2 - 6.2 - 5.2

Prices, Money and Banking (YoY%) CPI (eop) - 0.2 0.5 17.2 11.4 CPI (period avg) 0.5 - 0.3 10.3 12.8 Broad money (eop) 12.0 17.6 13.1 9.5 Private Credit (eop) 1.7 11.7 9.6 5.8

Fiscal Accounts (% of GDP) Overall balance - 3.6 - 4.5 - 5.5 - 4.5 Revenue 23.5 24.2 24.6 23.6 Expenditure 26.0 28.7 30.1 28.1

External Accounts (USD bn) Trade Balance - 19.5 - 19.6 - 7.9 - 8.2 % of GDP - 11.1 - 11.2 - 6.5 - 6.3 Current Account Balance - 14.3 - 16.4 - 3.6 - 2.7 % of GDP - 8.2 - 9.2 - 3.0 - 2.1 FDI (net) 6.6 4.3 - 2.3 - 1.5 FX Reserves (eop) 24.5 20.4 15.0 17.3 USD/FX (eop) 8.05 8.24 13.00 14.50

Debt Indicators (% of Government Debt 28.4 36.7 62.0 74.0 Domestic 14.8 14.7 17.7 20.8 External 22.0 22.0 44.3 53.2 External debt 75.5 79.8 105.7 107.1 in USD bn 135 140 123 129

General (ann. avg) Industrial Production - 0.7 - 4.3 - 10.1 - 4.2 Unemployment (%) 8.1 7.2 10.0 9.2

Current 14Q4F 15Q1F 15Q3FFinancial Markets Policy rate (refinancing 12.50 12.50 12.50 12.50 USD/UAH (eop) 12.95 13.00 13.30 13.80 Source: Official statistics, Deutsche Bank Global Markets Research

9 October 2014



Argentina Ca (stable)/SDu (stable)/RD (stable) Moodys /S&P/ /Fitch

Economic outlook: We rule out a negotiated solution with holdouts as the government seems to be planning just muddling through until the presidential election next year. Lack of external financing, however, has triggered more expansionist policies, exacerbating existing disequilibria and deepening the recession while accelerating inflation. The question remains whether the government underestimates the economic and social repercussions of those policy decisions. These repercussions notwithstanding, strong ideological biases together with the need to preserve a political mandate for an opposition role seriously limit President Cristina Fernandez de Kirchner’s (CFK) ability to take a more constructive course.

Main risks: Continued deterioration of the economic situation seems the most likely scenario, in our view. The possibility of more restraining orders from the NY court could worsen the outlook, but might help the government preserve international reserves. Without a resolution to the holdout litigation, a recession with high inflation would test the government’s political will, while a financial stress could remain a permanent threat. Partial access to the Chinese currency swap, plus some minimum rollover of Boden 15 amortization could buy necessary time, but without avoiding a risky and fragile economic and social backdrop.

Neglecting legal and economic principles

Holdouts “will not pass”, for now at least The Economic Minister´s, Axel Kicillof, metaphor that “holdouts will not pass” suggested the authorities´ final intention to associate this litigation to a patriotic epic. This was just reaffirmed in the last few weeks, as it has become increasingly clear that the government does not have any intention to negotiate with holdouts, not even in January, or after the so-called rights upon future offer (RUFO) clause were to expire.22 As we have noted, this is working politically for the time being, as recent opinion polls continue to show support from the population against any unconditional agreement or capitulation with “vulture funds”. In addition, it has helped the government regain the center of the policy spectrum, both locally and internationally. This has been particularly important for the authorities, who have been recently hostage of high inflation and low growth, the vice president’s corruption scandals and

22 Interestingly the local press has continued reporting the possibility of a deal early next year, as noted in the first page of the local newspaper Perfil on Sunday October 5, or previous editorials in La Nacion.

investigations, as well as the fading fortune of long-lasting regional allies Venezuela and Brazil. The government’s effort to bring the debt discussion to the United Nations is noteworthy, where President CFK seemed to enjoy the spotlight, taking the opportunity even to criticize the US external policy affairs without obtaining any clear benefit for Argentina.

The political strategy behind the holdout stance probably factors in CFK’s future role in the opposition. The president´s determination to supposedly defend Argentina´s interests against the predators is quite appealing given her plans to maintain a key position after the elections next year. This is particularly the case for a government facing only temporarily the financing blockade that such strategy implies (until next October). This notwithstanding, the economic cost is not negligible, even in the short term, and such a trade-off will essentially define the government sticking with the current stance or adopting a new stance at some point next year.

Meanwhile, the government continues to search for alternative ways to pay its restructured debt. A few days ago, Congress passed the law that replaces Bank of New York with Nacion Fideicomisos SA as the new fiduciary agent for restructured bonds. The law also allows for the possibility of a swap to voluntarily switch the law governing the bonds to either Argentina or France. In addition, it calls for a new restructuring offer for the remaining 7.6% holders of the original defaulted debt under similar conditions than in 2005-2010. The law establishes that the government will deposit in a special account all funds equivalent to the normal servicing of the new debt offer to holdouts. This money could be accessed any time holdouts agree to accept the restructuring conditions. The latter is probably the only constructive innovation in this new attempt to handle the holdouts’ default.

Simultaneously, the authorities also had partial success freeing payments of restructured debt under the Argentine law. After a number of court hearings, Judge Thomas Griesa decided to let Citibank and JP Morgan proceed with all payments of restructured debt under Argentine law scheduled for the past September 30 (Par bonds). As it happened with the payments of Discounts Argentine law in June, Judge Griesa´s approval just applied to the September payment. This notwithstanding, the Judge has stated his intention to find a permanent decision within 30 days. It is noteworthy, however, that Judge Griesa said in the previous hearing with Citibank on September 26 that Argentina´s law bonds should be treated differently from those covered by the February 23, 2012 Court order.

9 October 2014



As we have repeatedly noted, our interpretation is that the Argentine law bonds, including restructured debt, should not be treated in accordance with the pari-passu injunction simply because they do not constitute external debt. The judge’s hesitation about permanently freeing those payments is worrisome nonetheless, as it indicates the judge’s objective to eventually broaden the reach of the exiting court order against Argentina. A number of analysts have actually raised their concerns about this possibility. The main question remains the interpretation whether these bonds were exclusively offered to local investors, as necessary for not being considered external debt. In our view, it could be argued that this was the case for non-restructured debt, as such bonds were never offered in any public tender offshore. On a similar logic, it could also be sustained that restructured debt was mostly reissuance of local debt. Needless to say, it will be for the Court to decide.

Actually, few hours after allowing the September 30 debt payment for Argentine law bonds, Judge Griesa announced that he was holding the Republic in civil contempt, but reserved determining the associated sanction for the time being. The court concluded that a civil contempt citation was appropriate, pointing to the Republic's efforts to remove Bank of New York as the indenture trustee and effectively attempting to progress with a debt swap to avoid obeying the court ruling regarding exchanged bonds. As a practical matter, there appear to be limited implications to the court holding the republic in contempt. At this stage, plaintiffs demanded a fine of $50,000 a day to be imposed on the republic as well as the attorneys' fees related to plaintiffs' applications due to the republic's allegedly contemptuous conduct. In light of the billions under discussion, the potential fine and award of attorneys' fees does not seem particularly material. The main implication of this decision appears to be putting those non-parties that interact with Argentina or receive payments originating from the republic on notice that the court could find them in contempt too.

As suggested above, the Argentine authorities, however, appear to be too optimistic about the possibility of bypassing the US court blockade. This remains surprising as the ruling is definite, and any international effort to address it would only weigh on future restructurings but not Argentina´s existing case. Alternatively, the Argentine government might well be underestimating the true economic effect of the default and further isolation from international markets. In our view, the government could be successful at reducing the scope of the current default, but this is unlikely to open financial markets for Argentina. Therefore, credit rationing should be expected to continue until a final and comprehensive resolution is found, exacerbating existing fiscal and monetary disequilibria in the country for now.

Price action in Argentina´s financial markets has also suggested some degree of confidence in a rapid resolution on the debt front. Restructured bond prices have fallen from their peaks after the technical default was confirmed, but have remained in the 80s, implying tighter yields than the performing Venezuela, for instance. This probably denotes that the current default in Argentina does not manifest a solvency problem, in particular just 12 months ahead of a presidential election that is expected to bring significant improvement into economic policy making. As noted, a full settlement with all holdouts could cost about USD15bn, representing just 3% of GDP, rapidly paid back at much lower financing costs. Benign market pricing has also reflected a special distribution of the holdings of restructured debt, mostly held in the strong hands of distressed US and EU funds. However, an inevitable decline in international reserves might test investor conviction as we approach extreme liquidity levels, as we discuss below.

The solid solvency backdrop of Argentina, with just 20% of GDP in public debt net of public institutions holdings, is at the same time the most fundamental reason why private sector alternatives to settle the current debt negotiation are rather unlikely. This simply fails to create the proper incentive to mobilize private efforts as the sovereign does not seem to need any special contribution, exacerbating the free ride motive to reject participation in any of these resolutions.

Financing will not take place, as needed at least Absent any improvement in external financing, we believe Argentina’s economic performance will continue to deteriorate. Increased demand for dollars and the recent widening of the gap between the official exchange rate and non-official rates is the best reflection of the worsening economic and financial outlook. At the time of going to press, the non-official exchange rate was above ARS/USD 15.00, compared with 8.48 for the official rate (and 14.30 last month), pushing the gap back to a historic high. In reaction, President CFK accused a number of financial institutions for speculating in the market facilitated by the central bank’s apparent inaction or failure to control. As a consequence, central bank governor Juan Carlos Fabrega resigned and President CFK named the head of the local SEC, Alejandro Vanoli, as the new CB governor. Although Mr. Fabrega was considered a loyal member of the government, as the central bank governor he was known to oppose some of the policy inconsistencies promoted by the economy ministry. Meanwhile Mr. Vanoli has been instrumental in using the renewed powers at the SEC to investigate and tighten the overall auditing of private corporations. Therefore, Mr, Fabrega´s departure as well as Mr. Vanoli´s stepping in likely ensure policy continuity but more controls to counteract the effects of easier financing with growing inflationary expectations and exit from peso demand.

9 October 2014



The very first decisions of the new central bank governor partly confirmed market participants´ anticipation of what this change in command meant. Specifically, the suspension of Mariva Bursatil S.A., accused by President Kirchner of apparent speculative trades on the exchange rate market, together with tighter controls in the non-official exchange rate market, confirmed the expected bias of the new monetary authorities, bringing some nervous tranquility in the dollar market this week. These decisions were made following the power now granted by the new Capital Market Law. They also affected Balanz Capital, now under investigation by the SEC and the Financial Information Unit (UIF) or money laundry watch dog. Meanwhile, during the first few days of the new monetary authorities the main equity index fell more than 10%, followed by a sharp contraction in Argentine ADRs in Wall Street. Similarly, the demand for dollars under the 20% of income allowance reached a new peak, anticipating about USD3.5bn demand a year if this trend were to continue.

Another decision by the new authorities at the central bank was to impose a floor on interest rates for time deposits, directly linking them to the rates in CB letters. This implementation implies that 30 day deposit rate will increase to 23%, from 18% currently, while Lebacs for similar tenor stay at 26%. A similar direct relationship was also introduced on longer tenors, explicitly limiting banks’ benefits. Earlier, the central bank had introduced ceilings for rates on lending to the private sector. Therefore, the new strategy at the monetary authority seems totally consistent with the government’s economic policy bias, which is to control private sector benefits as a mean to restrain inflationary pressures without reducing existing demand stimulus.

Argentina’s International reserves holdings were USD28.0bn on September 26, 2014, day of the last public record. As discussed, it is reasonable to expect further depletion of its international reserves, in the order of USD1.0bn a month. This suggests international reserves could fall below USD25.0bn in December 2014 but including some USD1.3bn of debt services not paid (because of the US court blockade), which explains the meaningful fall in the services line of the current account in the table below. In 2015, the public sector debt services amount to USD14,400mn, of which USD10.2bn are capital amortization, including those for the Province and the City of Buenos Aires, but excluding multilaterals. The pari-passu injunction implies the forced “refinancing” of almost USD1.5bn. Likewise some partial rollover of the Bodens 15 coming due next October could help reduce this service burden a bit more. Similarly, partial use of the Chinese FX swap could be incorporated in the equation, as well as some improvement in the trade balance due to the economic recession.

All this notwithstanding, after all possible debt payments are made, international reserves are likely to dwindle further to less than USD16bn by December 2015. Such a low level of reserves (USD6.0bn net after excluding holdings from private banks) might not represent a sufficient condition for market stress, but the policy tightening to achieve that certainly anticipates a significant economic recession. This projection, for example, assumes that current allowance to buy up to 20% of income for hoarding will be restricted early next year to less than half, otherwise demanding almost USD4.0bn just for that demand item.

Therefore, it is not surprising that the Argentine government is trying to accelerate the disbursement of a couple of financing commitments agreed with Chinese authorities. These included the first USD500mn tranche of financing for hydroelectric projects, together with the possibility of a first disbursement under a renewed currency swap, for USD700-800mn, mostly to finance part of the USD5.2bn trade deficit Argentina currently has with China. The government is still working on the details of the swap execution but this is unlikely to permit full disbursement of more than USD10bn committed. In addition, the planned auction of G4 mobile network, that was expected to bring USD1.5bn-USD2.0bn, is now being questioned in the local justice, which could probably delay the process few months at least, or even after the new government is elected in October next year.

Balance of payment projections (cash basis, USDmn)

2012 2013 2014F 2015F

Current account 3,866 -13,277 -7,823 -6,433 Trade 14,673 1,745 1,800 3,100

Expo 80,772 75,250

Impo 66,099 73,505

Services -3,825 -9,403 -5,000 -4,500 Expo 10,059 8,397

Impo 13,884 17,800

Rents -7,594 -5,886 -4,623 -5,033 Net interest -7,369 -4,523

Profits and dividends -225 -1,363

Other transfers 611 267

Capital account -7,171 1,452 1,800 -2,800

FDI 3,744 2,413 3,500 2,500 In the country 3,976 2,586

Offshore 232 173

Portfolio investment -112 -37 - - Financial loans and credit lines -3,096 -3,326 1,000 1,000 Multilateral and bilateral organizations -1,757 -1,882 -1,000 -800 External assets, non financial private sector -3,404 397 -3,500 -1,300 External assets, financial sector -190 70 700 1,000 Others public sector -1,583 696 100 -6,700 Others -638 3,168 1,000 1,500

Change in international reserves -3,305 -11,825 -6,023 -9,233 43,290 30,828 24,805 15,572

Source: BCRA, and Deutsche Bank

However, the Argentine government needs to also deal with declining soybean prices and unfavorable conditions for agriculture production and exports. A strong peso and restrictions to buy dollars are creating hurdles for a pick-up in exports. Argentina’s international trade fell significantly this year, although

9 October 2014



partly affected by the overstated numbers in 2013. Nevertheless, between January and August, exports and imports decreased 12% and 10% respectively. This explains the 9% contraction reported in the trade surplus so far this year. Manufacturing exports fell 13%, mostly reflecting weak Brazilian demand and growing competitiveness problems. Likewise, despite a good harvest, agriculture exports contracted 26% over the period. Only manufacturing from agricultural origins, mostly derivates from soybeans, are up on the year.

For next year, the outlook does not seem much better, with protracted and subdued growth in Brazil, a similar harvest or worse than in 2014, and increasing competitiveness disadvantages as well as likelihood of dollar- or crop-hoarding. On the positive side, the energy deficit should remain mostly unchanged at about USD6.0bn due to the ongoing economic recession as energy exports have been falling at 8% annual pace as of August. Based on all of the above, this year, the trade surplus could be even lower than the USD8.0bn reported by the official Institute of Statistics (INDEC) during 2013. Thus, a small increase is likely in the trade surplus during 2015, to USD9.4bn, explained by a bigger contraction in imports than exports.

Policy makers keep ignoring reality As we have discussed repeatedly, any improvement in economic performance in the months ahead demands policies that support nominal equilibrium given available financing resources. Unfortunately, these appear to be incompatible with the government’s fiscal and monetary stances. Alternatively, the external financing outlook should improve dramatically, but that is ruled out by the pending legal issues with holdout investors. Indeed, the latter news on the debt case turned around the incipient rebuild of confidence that had started with the January devaluation and the debt agreements reached with Repsol and the Paris Club. Thus, absent a rapid resolution to the holdout demand, we expect only a deepening of the current economic recession. Alternatively, albeit unlikely at this stage, a holdout agreement could open external financing, while the prospect of a new government and new policies beginning in October of next year could fuel a rapid and more dynamic recovery.

Against the current backdrop, everything appears to be pointing to high inflation in a recessionary environment. In addition, recent policy decisions by the government have only aggravated this worsening economic reality as macro impulses collide with external constraints and increased intervention further deters investment. Thus, while fiscal accounts deteriorate further, inflation is only contained by temporary exchange rate stability and an economic slump, but remaining relatively high, further fueling competiveness problems and the need for import rationing and recession.

Confirming current driving forces on economic policies, the public sector reported a total primary surplus of ARS767mn in July, compared with a surplus of ARS803mn in July 2013, denoting a clear reduction in real terms if a 40% YoY inflation is taken into account. Total deficit in July was ARS1.2bn but shoots up to ARS10.4bn if rents on assets from the social security (ANSES) and the central bank are netted out. Total revenues were up 40.4% YoY in July, led by income taxes, VAT, and export taxes, while primary spending increased by 39.5%. July´s figure brings the accumulated primary surplus this year to ARS2.9bn, but incorporating ARS60.7bn from ANSES and central bank rents as revenues. Without these revenues, the accumulated total deficit in fact touched ARS99.1bn by July this year. This is in line with our projection of a deficit of almost 5% of GDP once these exceptional revenues are excluded.

The 2015 budget draft presented by the government a few days ago anticipates more of the same regarding policies, i.e. they utterly neglect the ground reality. Assuming 2.8% growth and 15.6% inflation, the budget for next year envisages an important improvement compared with current projections for 2014, even with respect to official sources that project growth of 0.5% and inflation of 21.3%. It is worth recalling the original 2014 budget included a 5.2% growth projection and a 10.4% inflation expectation. In addition, the 2015 budget draft projects ARS/USD parity of 9.45, from an average projected at 8.21 for the whole 2014, or from an average of 7.96 so far this year. It also factors in exports reaching USD82.4bn next year from an estimated USD76.9bn this year, while imports are projected to be USD73.2bn compared with USD69.4bn projected for 2014.

Turning to the fiscal exercise, the budget draft envisages a total deficit of 1% of GDP, with total spending being 27.2% of GDP, of which 35.5% would be allocated to social security. The document did not specify the expected fiscal outcome for this year, but it will certainly be much worse than the 1.2% of GDP deficit projected initially. According to our estimates, the total deficit next year as measured by the government will be 3.1% of GDP (5.3% of GDP once rents from assets incorporated as current revenues from the CB and ANSES are excluded).

The chart below properly reflects the challenge the current government policies increasingly face. Specifically, monetary base has been growing less than inflation since early this year, partly helped by some increased issuance of central bank paper, representing the mirror image of declining demand for pesos as inflation accelerates. Therefore, instead of facilitating government financing, increasing inflation is eroding peso demand and central bank financing of public sector deficit. In other words, the government´s obsession to keep fueling demand growth with expansionary policies is progressively encountering limits to its own continuity.

9 October 2014



Continued slowdown in credit growth despite steady demand stimulus and stable or accelerating inflation is another indicator of increasing lack of effectiveness of the current policy strategy. During September, banking credit to private sector increased 21.5% YoY, similar to the pace recorded during August, confirming inability of credit to keep up with inflation. Likewise, private sector deposits grew by 21.4% YoY, or below the 28.9% recorded in August and the 29.7% in July.

Falling peso demand reflects limits to stimulus

0

100

200

300

400

500

600 Monetary Base (NSA, bn.Pesos)

BCRA notes and bi l ls- mn.pesos

CPI Jan 2013=100

CPI Jan 2013=300

Source: Congress, Central Bank, and Deutsche Bank

As a result, it is not surprising that economic activity continues to struggle. INDEC reported that economic activity was unchanged in July with respect to the level reached in July 2013. On a monthly basis, seasonally adjusted activity advanced 0.1%, but has failed to register cumulative growth so far this year. Likewise, INDEC also reported that industrial production was down 2.9% YoY and 1.3% MoM, seasonally adjusted in August, while construction activity also showed negative growth, at -2.6% YoY and -2.3% accumulated so far in 2014. According to the private think tank FIEL, industrial output fell 9.7% YoY during August, or 5.1% so far this year. Furthermore, INDEC informed that supermarket and shopping sales advanced 37.9% and 26.3% YoY, respectively, in August too, implying a significant decline in real terms. Shopping sales underperformed inflation for a third consecutive month in August after accumulating almost a 35% annual increase in the preceding months.

Consumer confidence and overall sentiment also continues to worsen. The University Torcuato Di Tella reported that its consumer confidence index fell by 5.4% MoM and 14.7% YoY in September. The index fell across components and in all regions of the country. This was the first fall after a few months of steady improvement, although from a very low level based on a historical perspective. The UTDT also reported that their index of government confidence fell 6% on the month in September, on top of another 3% decline in the month of August. In terms of annual comparison, the index remained 4% below September’s level last year. The index measures five attributes, namely general evaluation, general interest, capacity, efficiency, and honesty, among 1,200 participants in the survey. In

September, the honesty attribute ranked the best, while efficiency was the worst performer. In a metric from 0 to 5, general evaluation is currently at 1.50, general interest at 1.53, efficiency at 1.36, honesty at 2.20, and capacity at 1.95. Last year, capacity was the perceived attribute that fell the most, by 11%. Furthermore, the UTDT also reported its new preliminary indicator of consumption decreased 2.3% MoM in September, or recording a 7.9% annual fall. The index measures changes in consumption at constant prices in commercial centers in the Buenos Aires area.

Economic recession to worsen

-30%

-20%

-10%

0%

10%

20%

30%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

EMAE, YoY 3m MA

IPI FIEL, YoY 3m MA

Tax Revenue (CPI adj), YoY 3M MA, rhs

Source: INDEC, FIEL, and Deutsche Bank

INDEC also reported a slight increase in unemployment to 7.5% during 2Q 2014, from 7.1% in the first quarter and 7.2% last year. However, this apparent stability hides a fall in employment and activity of an almost 2 percentage points in 12 months. Therefore, based on the labor supply of last year, unemployment this year would reach almost 10%.

Despite the weakening economic outlook, INDEC reported that inflation stayed at 1.3% monthly in August. This was the second time of inflation remaining high after six months of steady slowdown in consumer price increases. According to the official consumer index at the national level, year-to-date inflation is 18.2%. Simultaneously, opposition members of Congress reported that inflation in the City and Great Buenos Aires area had accelerated to 2.67% in August from 2.47% in July, and from 2.3% and 2.2%, respectively, in May and June. This privately estimated inflation pegs the number at more than 26.5% so far this year, representing an annual rate of 40%.

While keeping an expansionary fiscal and monetary stance, the government has continued to promote a new consumer defense law that might help contain inflation and increase unemployment. This, however, is likely to further deter investment as the draft law grants significant discretionary power to the government to force price stability and even the continuation of a business facing losses.

9 October 2014



October 2014 remains the main anchor for stability President CFK´s decision to replace the central bank governor not only confirmed her total confidence in the Minister of Finance, but also the end of an alternative command in case this was demanded. Such a turn for an unhedged strategy was not well received by market participants as reflected in the consequent asset price action. Notwithstanding, implied valuation of asset prices continues to reflect expectations for an eventual and positive change in economic policy making.

We have repeatedly noted the critical role presidential elections due next year will play in Argentina´s credit consideration. The legal impediment for President CFK to seek re-election is an important anchor regarding expectations for a change. However the very same negative economic outlook is also working as an endogenous but stabilizing force. Without private and public leverage in the economy, lack of investment for many years, and still abundant natural resources, Argentina has potential for a rapid and significant turnaround as soon as polices were to change for good.

The latest opinion polls fail to show any clear leadership ahead of the presidential election next year. Likewise, they still report up to 50% support for some policy continuity. This notwithstanding, all three main leaders – former Chief of Cabinet Sergio Massa, Buenos Aires governor Daniel Scioli, and BA City Mayor Mauricio Macri – as well as any potential presidential candidate from the center-left alliance UNEN, are believed to be supportive of policy improvement in one way or another. However, recent economic misfortunes have helped to increase public support for BA City Mayor, who is correctly perceived as the main reformer in our view. Based on our negative economic outlook, it is reasonable to expect this trend continuing in the months to come, further adding to a potentially positive terminal condition.

The government confirmed the election schedule: the presidential election will take place on Sunday October 25, 2015, and Sunday November 24 for a run-off election in case it is needed. The same calendar sets for August 24, 2015 as the date for the primary elections within competing political parties.

Gustavo Cañonero, New York, (212) 250 7530

Argentina: Deutsche Bank forecasts 2012 2013E 2014F 2015FNational Income

Nominal GDP (USDbn) 492 510 456 453Population (m) 41.0 41.5 41.9 42.4GDP per capita (USD thousand) 12.0 12.3 10.9 10.7 Real GDP (YoY%) 1.1 2.9 -2.3 -2.8 Priv. consumption 4.4 4.6 -3.2 -3.7 Gov't consumption 6.7 5.5 3.3 3.4 Gross capital formation -11.1 1.2 -5.6 -8.3 Exports -5.6 1.7 -9.3 -2.8 Imports -4.4 9.3 -11.2 -8.5 Prices, Money and Banking

CPI (YoY%, eop) (*) 25.2 27.9 39.2 39.1CPI (YoY%, avg) (*) 23.9 25.3 38.3 39.4Broad money (M2, YoY%) 34.3 24.0 22.0 20.0Bank credit (YoY%) 30.8 31.3 22.0 20.0 Fiscal Accounts (% of GDP)(**) Budget surplus -3.9 -4.6 -4.9 -5.3 Gov't spending 32.5 34.2 34.0 34.0 Gov't revenue 28.6 29.6 29.2 28.8Primary surplus -1.5 -2.8 -3.2 -3.6 External Accounts (USDbn) Merchandise exports 80.9 81.7 73.3 70.5Merchandise imports 68.5 73.7 65.2 61.1Trade balance 12.4 8.0 8.1 9.4 % of GDP 2.5 1.6 1.8 2.1Current account balance -0.1 -7.0 -6.3 -1.9 % of GDP 0.0 -1.4 -1.4 -0.4FDI (net, cash basis) 3.7 2.4 3.5 2.5 FX reserves (USDbn) 43.3 30.8 24.8 15.6FX rate (eop) ARS/USD 4.92 6.52 9.21 12.41 Debt Indicators (% of GDP) Government debt 19.2 19.1 21.6 21.5 Domestic 5.9 7.2 8.2 9.5 External 13.3 11.8 13.3 12.1Total external debt 28.6 26.6 29.9 28.7 in USDbn 140.9 135.8 136.3 130.1 Short-term (% of total) 36.9 38.3 38.2 40.0 General Industrial production (YoY) -1.2 0.8 -4.8 -4.9Unemployment (%) 7.2 7.1 7.7 8.5

Financial Markets (EOP) Current 14Q4 15Q1 15Q398ds Lebac rate 26.8 27.0 28.0 29.01-month Badlar 23.0 23.1 23.8 25.1ARS/USD 8.45 9.21 10.40 11.75Source: DB Global Markets Research, National Sources *Inflation reported by Congress, **Central government

9 October 2014



Brazil Baa2(negative)/BBB-(stable)/BBB(stable) Moody’s/S&P/Fitch

Economic outlook: Economic activity remains sluggish amid a steep decline in confidence caused by interventionist economic policies, high inflation, and fiscal policy deterioration. Although slow growth prevents the central bank from raising interest rates to fight inflation, pressure on the currency could create a serious dilemma for the authorities. A recovery in confidence and growth will hinge on a credible fiscal adjustment that supports the central bank’s efforts to rein in inflation at the same time that the authorities allow a re-alignment of regulated prices.

Main risks: Without a credible fiscal adjustment after the elections, Brazil could be downgraded in 2015 and perhaps even lose the investment grade. Higher interest rates abroad could lead to further currency depreciation and even slower domestic growth.

All eyes on the elections

Aécio Neves (PSDB) will challenge President Dilma Rousseff (PT) in the presidential election runoff on October 26. Neves staged an impressive rally in the last days before the first-round vote on October 5, not only overtaking Marina Silva (PSB), but also significantly cutting into President Rousseff’s lead. The president obtained 41.6% of the valid votes, while Neves got 33.6%, and Silva obtained only 21.3% (just slightly more than the 19.3% she received in 2010). There was a large discrepancy between the votes that Neves received and the opinion polls. The Datafolha poll published one day before the voting, for example, had indicated Rousseff with 44%, Neves with 26% and Marina with 24% of the valid votes. After rising dramatically in the polls following the plane crash that killed candidate Eduardo Campos on August 13, Silva was not able to withstand the aggressive criticism leveled by her opponents (especially the PT), and fell steadily. Silva’s decline in the polls probably produced a “self-fulfilling prophecy” effect: as it became increasingly clearer that she was not going to make it, the anti-PT voters who had planned to vote for her switched to Aécio Neves, who had strong momentum. In her concession speech, Marina Silva hinted that she might support Neves, as she claimed that society clearly showed a demand for change in the polls. Moreover, the economic proposals presented by both candidates are similar. While we expect Silva to support Neves, it remains to be seen whether formal support will translate into a significant number of votes. Based on Sunday’s final numbers, Neves will have to attract approximately 70% of those who voted for Marina to win the election. According to a Datafolha

poll conducted before the first round, 59% of Marina’s voters said they would vote for Neves in the runoff. All in all, the polls available at this juncture suggest that Dilma remains the favorite to win. Moreover, the PT’s powerful propaganda machine spared Neves in the first round because its main priority was to crush Marina Silva’s candidacy, which was accomplished quite well. That said, it will probably be a very tight race, as Neves has advanced to the second round in a much stronger position than we had expected. The PSDB candidate will have as much time as the president on TV from now on, his marketing team is probably better than Silva’s, and Rousseff is weaker than four years ago (she fell from 46.9% in the first round of the 2010 elections, when the PSDB candidate José Serra obtained 32.6% of the votes). The first-round presidential elections occurred simultaneously with congressional elections. The net balance was that the current ruling coalition continued to have a majority in the Senate (where it gained two seats) and in the Lower House (where it lost 35 seats). However, Congress will be much more fragmented, which could make it more difficult for the next president to maintain governability. The Lower House, for example, will have representatives from 28 political parties in 2015.

Brazil: Business confidence

80

95

110

125

140

155Services Retail

Construction Industry

Source: FGV

The economy is recovering slowly in 2H14. Industrial production rose 0.7% MoM in August, exceeding our forecast of 0.3% MoM and the market consensus forecast of 0.1% MoM. Production had increased by 0.7% MoM in July as well, after falling in the previous four months. Thus, despite the MoM gains in July and August, production was still down 5.4% when compared to August 2013. In the YoY comparison, production of durable goods plunged 17.9%, capital goods fell 13.4%, intermediate goods declined 3.3% and non-durable consumer goods were down 3.1% YoY. We still see a correction to the steep decline in

9 October 2014



production observed in 2Q14, when the economic slowdown was aggravated by the World Cup (a rebound that is crucial for our 2014 GDP growth forecast of 0.3% to materialize), but not a sustainable recovery, as domestic and external demand remain weak and business confidence stays depressed amid the lingering uncertainty surrounding the elections and future economic policies. We are keeping our 2014 GDP growth forecast at 0.4% for now, but have cut our 2015 forecast slightly to 1.0% from 1.2% due to the continuing decline in business confidence and rising uncertainty about the global economic environment and domestic economic adjustment.

Unemployment is rising. Official statistics agency IBGE has resumed publishing its complete employment survey, which was interrupted by a strike that prevented the institute from releasing part of the labor market data in May, June and July. The seasonally-adjusted unemployment rate rose to 5.0% in August from 4.6% in April, according to our calculations. As we expected, job creation has decelerated so much that the decline in labor participation is no longer enough to prevent unemployment from rising. After declining sharply between October 2013 and April 2014, the participation rate stabilized at the end of 2Q14 and rose slightly in August. Since we expect job creation to remain subdued and do not see further decline in labor participation, we expect unemployment to rise further – albeit slowly – in the coming months.

The government continues to post disappointing fiscal results and meeting this year’s fiscal target will be extremely difficult. The public sector posted a larger-than-expected BRL14.5bn primary fiscal deficit in August, the fourth consecutive deficit. The gap would have been even larger had the federal government not received BRL5.4bn in dividend payments from state-owned enterprises (mainly BRL3.0bn from BNDES and BRL2.1bn from Caixa Economica Federal), as well as BRL7.1bn through the REFIS tax amnesty program. The consolidated primary surplus totaled BRL10.2bn in 8M14 (0.3% of the period’s GDP), compared to BRL54.0bn in 7M13 (1.7% of GDP). In 12 months, the primary surplus fell to 0.94% of GDP in August, remaining well below this year’s 1.9% target. At the federal level, nominal revenues climbed 7.4% YoY (led by a 26% surge in dividends paid by SOEs) and spending jumped 12.6% YoY (led by a 22.4% increase in discretionary spending, including a 27.4% surge in federal investment). Excluding dividends from SOEs, concession revenues and other extraordinary revenues (such as those from the tax amnesty program), the public sector posted a primary deficit equivalent to 0.3% of GDP in the year to August. It is becoming increasingly difficult for the government to close the gap with extraordinary revenues. The REFIS revenues were lower than expected in August, and will probably not reach the BRL18bn amount anticipated by the government this year. Also, the government sold

telecom concessions for BRL5bn in August, less than the official estimate of BRL8bn. In light of the latest fiscal data and revision to the GDP growth forecast, we cut our primary surplus forecast to 1.0% from 1.2% of GDP for 2014, and to 1.6% from 1.8% of GDP in 2015. While the 2015 budget sets a primary surplus target of 2.0% of GDP, it overestimates revenues by assuming GDP growth of 3.0% next year. In our view, given overall spending rigidity, the government will not be able to significantly raise the primary surplus without cutting investments and raising taxes, which are always a hard nut to crack politically. In addition to mending the budget, the government will have to act on its quasi-fiscal policy, moderating the expansion of subsidized lending by official banks. In our view, failure to address these issues could prompt the rating agencies to further downgrade Brazil’s sovereign debt in 2015.

Brazil: Primary fiscal balance

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Target

Primary surplus

Adjusted surplus

% of GDP, 12m

Source: BCB, Deutsche Bank Research

Consumer price inflation is accelerating, as expected. The IPCA posted a higher-than-expected 0.57% MoM increase in September, mainly due to a rebound in food prices. In 12 months, the IPCA accelerated to 6.75%, the highest rate since October 2011. Service prices have remained under particularly intense pressure (rising 8.6% YoY in September) due to the tight labor market and persistently high inflation expectations. While we expect slow growth and rising unemployment to eventually contribute to moderate inflation of non-tradable goods, we believe the adjustment in regulated prices has just begun (additional adjustments in electricity prices, as well as increases in fuel and public transportation will likely affect inflation next year), and exchange rate depreciation could raise tradable goods inflation as well. Therefore, we have raised our IPCA forecasts to 6.4% from 6.2% for 2014, and to 6.2% from 6.0% for 2015.

While we still expect no change in interest rates in the near future, the risk is rising. The BCB has been on hold since May, maintaining the SELIC overnight rate at 11.0%. Although inflation remains high and would be even higher had the government not contained some

9 October 2014



regulated prices and intervened in the FX market to prop up the currency, economic weakness does not give the authorities much leeway to act. In the most recent COPOM minutes and Inflation Report, the BCB repeated that it expected inflation to converge to the 4.5% target over the next two years, assuming “no reduction in the instrument of monetary policy” (i.e., interest rates), thus indicating that it is comfortable with the inflation outlook. A BCB director, however, claimed that the COPOM might raise rates if necessary to curb inflation, and local markets are roughly pricing in 150bps in interest rate hikes in 2015. Nevertheless, we continue to expect no change in rates until the end of 2015. The government’s decision to lower reserve requirements in August does not suggest any willingness to tighten monetary policy. While rising interest rates could help restore the credibility of the inflation targeting regime, we believe the main macroeconomic imbalance currently lies in the lax fiscal policy, and a credible commitment to curb public spending and official lending would reduce the need for a rate hike. The main risk to our scenario is that excessive exchange rate depreciation could force the BCB to raise rates, deepening the recession.

We revised our BRL forecasts and expect more weakness. The current account deficit reached USD78.4bn (3.5% of GDP) in the 12 months to August. The deficit has displayed a slightly declining trend, reflecting mainly slow domestic growth, which is restraining the demand for important goods. Lower commodity prices, however, could offset this effect and put pressure on the exchange rate. We raised our current deficit forecast to USD83bn from USD82bn for 2014, and to USD80bn from USD77bn for 2015. The BCB continues to calibrate the supply of FX swaps to avoid excessive FX movements, but the outstanding stock (approximately USD99bn) is already quite high and the government seems to prefer a somewhat weaker exchange rate to promote exports (especially after the elections, when the authorities will probably be less concerned about potential inflationary effects). As a matter of fact, the BCB reacted more slowly than expected to the sharp BRL depreciation in September (a consequence of global USD strength and domestic political concerns), hinting that it may ultimately accept a weaker currency. Due to the decline in commodity prices and deterioration in fiscal fundamentals, we have raised our year-end exchange rate forecast to BRL2.45/USD from BRL2.35/USD for 2014, and to BRL2.60/USD from BRL2.50/USD for 2015. It is important to highlight that the FX will be susceptible to the market’s perception about changes in economic policies. Credible measures announced by the next government aimed at improving fiscal sustainability would reduce the risk premium attached to Brazilian financial assets and prop up the BRL, and vice-versa.

José Carlos de Faria, São Paulo, (+55) 11 2113-5185

Brazil: Deutsche Bank forecasts

2012 2013 2014F 2015F

National IncomeNominal GDP (USDbn) 2,253 2,245 2,155 2,171

Population (m) 199 201 203 204

GDP per capita (USD) 11,306 11,175 10,636 10,630

Real GDP (YoY%) 1.0 2.5 0.3 1.0



Gross capital formation -4.0 5.2 -7.2 1.7

Exports 0.5 2.5 1.6 2.0

Imports 0.2 8.3 -1.2 1.5


CPI (YoY%, eop) 5.8 5.9 6.4 6.2

CPI (YoY%, avg) 5.4 6.2 6.3 6.4

Money base (YoY%) 8.3 7.6 7.0 6.5

Broad money (YoY%) 5.3 11.2 8.0 6.0


Consolidated budget -2.5 -3.3 -4.2 -3.7

Interest payments -4.9 -5.1 -5.2 -5.3





Trade balance 19.4 2.4 3.0 12.0

% of GDP 0.9 0.1 0.1 0.6


% of GDP -2.4 -3.6 -3.9 -3.7

FDI (net) 65.3 64.0 60.0 65.0

FX reserves (USDbn) 378.6 375.8 379.8 380.8

FX rate (eop) BRL/USD 2.04 2.34 2.45 2.60


Government debt (gross)* 49.4 48.3 49.9 50.5

Domestic -14.1 -14.8 -14.6 -14.5

External 58.8 57.2 60.7 63.2


in USDbn 440.6 482.8 514.8 542.8


General

Industrial production (YoY%) -2.3 2.3 -2.7 1.0

Unemployment (%) 5.5 5.4 5.0 5.6

Financial Markets (EOP) Current 4Q14 1Q15 3Q15Selic overnight rate (%) 11.00 11.00 11.00 11.00

10-year Pré-CDI rate (%) 11.5 12.5 12.0 11.5

BRL/USD 2.40 2.45 2.45 2.55(*) Includes central government, states, municipalities and SOEs. Source: National Statistics, Deutsche Bank forecasts

9 October 2014



Chile Aa3 (stable)/AA- (stable)/A+ (positive) Moodys /S&P/ /Fitch

Economic outlook: Economic activity has confirmed a sharp slowdown, pointing to just 2% GDP growth this year. In the meantime, another month of high inflation in September and a weakening currency is pushing inflation to new highs this year, but is expected to fall early next year as pass-through fades away. The tax reform was finally approved but the government anticipated higher fiscal expenditure in 2015. This is expected to reduce business uncertainty and improve investment perspective ahead. In the short term, however, a lackluster outlook for manufacturing and further deterioration in consumption demand provide room for the central bank to cut rates one or two more times.

Main risks: The authorities expect economic growth to accelerate during the second half of the year, helped by the current monetary stimulus, the low base effect, and fiscal expansion. Further monetary easing together with a more aggressive fiscal stance is likely to support next year’s rebound, but a subdued demand for commodities will remain a medium-term burden for growth. Bureaucratic delays in public outlays, inertia in investment decisions, and lags in consumption to monetary stimulus represent the main threats to a potential rapid recovery.

Fully on countercyclical mode

Economic recovery might take some time Economic activity, according to the Central Bank’s proxy IMACEC, increased by 0.5% MoM and 0.3% YoY during August. The year-over-year number represented the lowest value since March 2010, when activity increased by 0.17% YoY but due to that year´s earthquake. The main positive driver of the monthly result was the performance of services, while manufacturing, mining and wholesale commerce posted contractions. This supports our recent revision in growth forecast for this year to barely 2.0%. Activity should continue to improve gradually during 2015, but a weak commodity cycle together with remaining uncertainties about investment recovery is likely to contained next year´s growth at around 3%.

During August, industrial production fell by 1.8% YoY, having manufacturing as the main negative contributor with a 4.9% YoY decline, well spread among twelve of the thirteen categories that comprise the sector. Mining did not help either, recording a drop of 0.2% YoY, mainly as the result of lower copper production. Utilities were the only sector that posted expansion during August, 1.5% YoY. Similarly, retail sales

recorded a modest advance of 1.7% YoY, confirming the ongoing deceleration in consumption.

After months of being resilient to fluctuations in activity, the rate of unemployment came out at 6.7% for the June-August moving quarter, representing an increase of 1.0pp compared to last year. Behind this labor market deterioration there was a decrease in employment (-0.2% MoM) and the stagnation of the labor force. The sectors that reported the highest contraction in employment were commerce and construction (-3.5% YoY and -4.8% YoY, respectively), while employment increased in other services.

Further CLP depreciation challenges inflation Consumer prices increased by 0.8% MoM during September, bringing 12-month inflation to 4.9% from 4.5% the previous month. There were significant price movements in food items and transportation; the latter is explained by the prices of new cars, gasoline, and the increase in bus fares, the main drivers of this new inflationary shock. Meanwhile, the CPI measure, excluding food and energy, the preferred core measure of the Central Bank, increased by 0.6% MoM, accelerating from the 0.4% MoM posted during August.

Inflation in October is expected to show a significant slowdown, but the impact of the tax reform is likely to keep strong price corrections by the end of the year. Likewise, the peso weakened almost another 2% during September, adding pressure to tradeable prices. Therefore, annual inflation in the next few months is unlikely to fall below current levels. Nevertheless, inflation next year should gradually converge to 3% as this year’s shocks are left behind and the weak economy provides some room for price absorption. August negative wage inflation provides some support to that benign view, as real wages are now advancing at 1.5% YoY pace, or significantly below the 3.4% pace of 12 months ago.

The central bank might not be totally finished anyway The minutes of the last monetary policy meeting of the central bank revealed that the easing process could be in its final stage. The board decided to cut its reference rate by 25bps once again in September, and the monetary authority explicitly noted that the easing cycle was approaching the end. This notwithstanding, further stimulus, albeit gradual, was not disregarded if the economy stays on its weakening path. The monetary authority continues interpreting recent inflation peaks as temporary. Furthermore, the board highlighted the consistency of private expectations, which are remaining stable around 3% YoY one and

9 October 2014



two years ahead. Considering the lackluster numbers reported in industrial production and activity recently, we expect one or two more cuts in the months ahead, although October inflation surprise might add a short pause this month. 23

Inflation challenges rate cuts while activity permits

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14

Headline CPI Policy Rate 3MMA IMACEC%YoY

Source: Central Bank and Deutsche Bank

The focus is moving towards fiscal instruments On September 26, President Michelle Bachelet´s tax initiative became law, amending the income taxation system and introducing major new changes. This seeks to collect 3.02% of GDP mostly from corporations to be primarily spent on education. However, President Bachelet has also indicated the need to improve the infrastructure of the public health system, and to reinforce public investment overall, to compensate for the recent retrenchment in private investment. Despite the new tax burden on the private sector, the final wording of the tax reform might reduce overall uncertainly and slowly permit some improvement in business expectations after reaching historic lows during the last few months.

The 2015 budget draft sent to Congress earlier last week provides a detailed guide of fiscal policies ahead. This envisages a 9.8% increase in total expenditure compared to the budget last year (27.5% for public investment). Likewise, compliance with the 2014 budget demands strong execution in infrastructure for the remainder of the year. Thus, fiscal policy is envisaged to start being openly countercyclical in the months to come. In addition, the financing plan of next year’s budget suggests the need to sell up to USD3.0bn of public assets to minimize crowding out effects. Therefore, if approved in Congress as expected, next year’s budget could be the necessary instrument to facilitate a more robust recovery, although it would further delay convergence with the fiscal structural balance in 2015.

Gustavo Cañonero, New York, (212) 250 7530

23 For a broader discussion regarding monetary policy ahead please see our September 26 piece, Chile: Strategy Update Ahead of the Minutes.

Chile: Deutsche Bank forecasts 2012 2013F 2014F 2015FNational income

Nominal GDP (USDbn) 266.6 277.1 260.2 271.3

Population (m) 17.4 17.6 17.7 17.9


Real GDP (YoY%) 5.4 4.1 2.0 3.1

Priv. consumption 6.0 5.6 2.7 3.0

Gov't consumption 3.4 4.2 5.7 6.2

Investment 10.2 -2.3 -12.9 1.6

Exports 1.1 4.5 1.6 2.9

Imports 4.9 2.6 -6.9 3.2

Prices, money and banking

CPI (YoY%, eop) 1.5 2.8 4.9 2.9

CPI (YoY%, avg) 3.0 1.9 4.3 3.6

Broad money (YoY%, eop) 6.2 13.9 9.1 9.3

Credit (YoY%, eop) 11.9 9.5 8.6 9.0

Fiscal accounts (% of GDP) Consolidated budget balance 0.7 -0.5 -1.9 -2.1

Revenues 22.1 21.0 20.3 20.8

Expenditures 21.5 21.5 22.2 22.9


Exports 78.0 76.7 77.7 79.3

Imports 75.5 74.6 68.9 71.0

Trade balance 2.5 2.1 8.8 8.3

% of GDP 1.0 0.8 3.5 3.3


% of GDP -3.3 -3.5 -1.9 -2.0

FDI (net) 6.2 9.3 8.5 8.1

FX reserves 41.6 41.1 40.7 41.5

FX rate (eop) USD/CLP 478.6 523.8 600.0 600.0



Domestic 10.0 11.1 11.5 12.3

External 1.9 1.7 1.5 1.5


in USDbn 117.6 130.7 134.7 141.0


General (avg)

Industrial production (%) 3.0 3.6 1.1 2.9

Unemployment (%) 6.5 6.0 6.4 6.5

Financial markets (eop) Spot 14Q4 15Q1 15Q3Overnight rate (%) 3.25 2.75 2.75 2.75

3-month rate (%) 3.10 2.80 2.80 2.95

USD/CLP 595 600 600 600Source: DB Forecasts and, National Statistics

9 October 2014



Colombia Baa3 (positive) /BBB (stable) /BBB (stable) Moodys /S&P/ /Fitch

Economic outlook: The release of GDP growth for the second quarter shows a deceleration in economic activity from the high numbers during the first quarter of the year. We expect this moderation to continue in the following months after construction and civil works activity deceleration. Inflation has continued hovering around 3%, which prompted the Central Bank to stop the hiking cycle at 4.5% while the currency continues depreciating.

Main risks: The deceleration in the boost to activity from the external sector could continue into year end and the expected slowdown in other sources of domestic demand could lower economic growth. The willingness of the Central Bank to let the nominal exchange rate act as a shock absorber could cause further currency depreciation if more signals of tightening global liquidity materialize.

Construction as the new engine

Second quarter activity decelerates The figures released for the second quarter confirmed that the high activity numbers during the start of the year had been atypical. Growth printed at 4.3% YoY during the second quarter after a surprising 5.4% YoY in the preceding quarter. On the supply side, construction was again the fastest growing sector with a 10.2% YoY and the financial sector grew by 6.1% YoY. Mining and manufacturing decreased by 2.2% and 1.4% compared to the same quarter last year, respectively. For the first half of the year the scenario is similar. While GDP growth remains high, at 5.4% YoY, the sector that leads from the supply side is construction with 14.2% YoY growth, while mining and manufacturing grew by 1.7 and 0.9 percentage points, respectively. Other non-tradable goods and services like financials, social services, and retail, restaurants and hotels show the same strong behavior, growing faster than total economic activity.

On the demand side, investment contributed with 3.4% YoY of the total growth number and continued breaking records, achieving 29% as a percentage of GDP during the second quarter. Private consumption contributed with 3.4%YoY, while the contribution of government expenditure added 1.07% YoY to the total GDP growth rate. Net exports subtracted 4.27% YoY after a negative contribution from exports due to the fall in oil and coal production, decreasing total exports in real terms by 8.64% YoY while imports continued increasing at a 9.65% YoY rate. The rate of growth of exports for the period 2010-2013 was 6.2% YoY, exemplifying the deep contraction from the external

sector. The component of investment with the largest growth was civil works (8.9% YoY), followed by overall construction (6.7%). On a relative basis, the largest component of investment for the last year was machinery and equipment (9.5%) closely followed by construction (6.7%) and civil works (8.9%). Clearly there is a shift in the source of growth in economic activity for the economy during the last year.

The table below shows that the contribution of civil works during the quarter was from the construction of roads, bridges, highways and tunnels, with around 71% of the contribution. The second quarter of 2014 was the fourth consecutive quarter with the growth rate of public works higher than 15% YoY. The low contribution from investment in public works in mining infrastructure experienced during the last year is noticeable.

We expect that this shift in focus on the engine of growth of the economy to continue in the medium term as the price and production of oil is expected to fall in the coming quarters. The risk to the reliance on construction and public works as the main sources of growth is that the volatility of these sectors can be larger because of political cycles and delays in execution of projects that have characterized government expenditure in the past.

Investment in Civil Works (2Q-2014) Change Contribution

Annual YTD Last 12 Months

Annual YTD Last 12 Months

Total 16.2 20.1 19.3 16.2 20.1 19.3

Roads, bridges, highways, tunnels

37.8 35.1 32.7 11.5 12 10.2

Railways, landing strips and mass transportation system

-21 -11 8.2 -0.3 -0.2 0.1

Waterways, ports, dams, aqueducts, sewage and other ports

15 23.7 46.8 2.2 3.1 6.2

Mining, power generation and pipelines for oil and gas

-0.4 2.2 0.2 -0.2 0.9 0.1

Other engineering work

22.8 36.4 24.5 3.0 4.2 2.7

Source: Deutsche Bank and DANE

Domestic demand grew at a strong 7.3% YoY during the second quarter, as the graph below shows. However, demand decelerated from the stronger print during the first quarter of the year. Separating the sources of demand between the ones that are sensitive

9 October 2014



to the interest rate (durables consumption, services and investment other than in civil works), and the components that are not sensitive (non-durables consumption, government expenditure and investment in public works) shows a divergence in these sources of growth for the past year.

Inflation softens in September The CPI grew by 0.14% during September, compared to 0.29% during the same month last year. The largest contributors to the increase in prices during the month were housing (0.20%), education (0.17%), food (0.16%), and health (0.16%), while the remaining sectors showed close to zero growth rates.

On an annual basis, inflation dropped to 2.86%, while on a year-to-date basis the figure printed at 3.08%. Core prices on an annual basis grew by 2.70%, showing the muted behavior of demand forces in pushing up inflation. The divergence between the annual and the year-to-date figures is explained by the negative growth numbers experienced during October and November of last year.

BanRep to remain neutral while currency depreciates The monetary board decided to stop the hiking cycle at 4.5% in the September meeting. Even though domestic demand remains strong, the members showed fear that the negative impact from the uncertainty in the external sector still remains a threat to economic activity. We expect inflation to surpass 3%, the mid level of the Central Bank's target range, in the coming months due to low base levels from the end of last year. However, the likelihood of strong inflationary surprises that could reignite the monetary policy hiking cycle remains low. The low level of pass through and the long period of currency appreciation experienced by the economy would not trigger an active intervention by BanRep to counteract the depreciation pressures coming from a weaker external demand and tighter global monetary conditions.

Armando Armenta, New York, (212) 250 0664

Colombia: Deutsche Bank forecasts 2012 203 2014F 2015F

Nominal GDP (USDbn) 370.3 378.2 398.8 422.3

Population (m) 46.0 47.0 47.0 48.0


Real GDP (YoY%) 4.2 4.6 5.0 4.8




Exports 5.3 5.5 3.0 3.2

Imports 8.0 4.5 5.5 5.5 Prices, Money and Banking (YoY%)

CPI (eop) 2.4 1.9 3.2 3.3

CPI (ann. avg) 3.2 2.0 2.8 3.2

Broad money (eop) 17.0 15.0 14.5 14.0

Private Credit (eop) 18.2 13.0 14.0 12.0

Fiscal accounts (% of GDP)*

Overall balance -2.3 -2.4 -2.4 -2.2

Revenue 16.1 16.8 17.0 17.1

Expenditure 18.4 19.1 19.4 19.3



Goods Exports 61.0 60.0 58.5 57.8

Goods Imports 56.7 57.0 56.9 57.5


% of GDP 1.2 0.8 0.4 0.1


% of GDP -3.2 -3.4 -4.0 -3.0

FDI (net) 15.7 15.0 14.5 15.0

FX reserves (eop) 37.5 42.0 47.0 50.0

COP/USD (eop) 1768 1950 2060 2150

Debt Indicators (% of GDP) (*)


Domestic 25.7 27.5 26.0 25.0

External 10.4 12.0 9.5 9.0

External debt (**) 21.3 24.1 22.6 22.0

in USD bn 79.1 91.0 90.0 93.0


General (ann. avg)

Industrial production (YoY%) 2.4 -2.6 2.5 2.0

Unemployment (%) 9.6 9.5 8.2 7.8 Financial Markets (end period) Spot 14Q4 15Q1 15Q3

Policy rate (overnight rate) 4.50 4.50 4.50 4.75 3-month rate (DTF Rate) 4.10 4.30 4.50 4.60

COP/USD (eop) 2028 2050 2060 2100 Source: Deutsche Bank and National Sources

Domestic demand and components

Source: Deutsche Bank Research and DANE

9 October 2014



Mexico A3 (stable)/BBB+ (stable)/BBB+ (stable) Moody’s/S&P/Fitch

Economic outlook: Activity accelerated in July and the recovery looks firmer now. On the industrial production side, an increasing number of fast-growing manufacturing activities joined motor vehicles in what now seems a broader-based pickup. Moreover, construction is gaining momentum into the second semester, surprisingly due to the buildings component. In spite of some positive readings, the trend of private consumption remains essentially flat, as consumer confidence is recovering but is still below 2013 levels. By the same token, fixed investment remains weak, except for imported machinery and equipment that may lose steam ahead as the currency has depreciated. Credit to firms and households has continued to decelerate in response to a weak domestic demand and new policies aimed at boosting supply have not delivered a change in trend yet. In this context, inflation climbed due to a combination of seasonal factors and temporary shocks that are expected to cede by year-end but will likely make Banxico miss the target. Thus, recent CPI readings have deteriorated the inflation outlook and the Central Bank has developed a more hawkish tone.

Main risks: Now that the reforms and bylaws have been passed and there are no surprises in the 2015 Economic Program submitted to Congress, domestic risks seem limited. In any case, the main domestic risk is that construction of public infrastructure does not pick up substantially due to the complexity of the projects announced by the government. We maintain our view that the main risks are external: an excessive volatility associated to the normalization of monetary policy in the US and/or a delayed recovery of global demand. However, we see the good story on reforms, sound fundamentals and, eventually, stronger growth, as supports for the Mexican economy to cope with excessive volatility in EMs.

Recovery looks firmer

Activity likely to accelerate further in 4Q2014 According to the Economic Activity Global Index (IGAE) for July, growth continues to gain momentum. Activity grew above expectations at 0.41%MoM and 2.52%YoY in the seventh month of the year, supported by both stronger industrial production and services, which expanded 0.28%MoM and 0.34%MoM, respectively. Positive readings on services is particularly good news, as such activity anchored growth in 2013 and early 2014, but for a moment seemed to be losing resilience relatively fast around mid-year.

Economic activity global index (%)

-2

-1

1

2

3

4

5

2012

/07

2012

/08

2012

/09

2012

/10

2012

/11

2012

/12

2013

/01

2013

/02

2013

/03

2013

/04

2013

/05

2013

/06

2013

/07

2013

/08

2013

/09

2013

/10

2013

/11

2013

/12

2014

/01

2014

/02

2014

/03

2014

/04

2014

/05

2014

/06

2014

/07

%MoM

%YoY

Source: INEGI

July’s data shows that autos remain the main engine of manufacturing but points towards an incipient recovery of the other manufacturing activities. Out of the 21 manufacturing activities monitored by INEGI, now 11 show accumulated growth rates above 3% in the first 7 months of 2014. Thus, the broad-based recovery that we anticipated for manufacturing seems slow but gaining traction into 2H2014. Similarly, construction activity is accelerating and its prospects have improved as the buildings component has maintained steam and the infrastructure component has broken its downward trend, so we expect such a recovery to persist in the second semester of 2014. However, the dynamism of the buildings component in presence of a relatively weak housing market and subpar investment is yet puzzling and the risk of a downturn is high.

Fast-growing mfg activities (number)

4

5

6

7

8

9

10

11

12

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14

Source: INEGI

9 October 2014



These results reiterate that a recovery is under way and have prompted 2014 growth prospects to stop deteriorating. The last Banxico survey of economic analysts shows that growth prospects for 2014 remained stable at 2.47%YoY, unchanged from the previous survey. Similarly, the last Banamex survey puts expected growth for 2014 at 2.46%YoY, virtually unchanged from the last survey. The consensus implicitly assumes that the economy will accelerate to 3.4%YoY in August-December, significantly up from 1.8%YoY in the first seven months of the year. We keep our GDP growth forecast for this year at 2.3%YoY, implicitly assuming that activity will accelerate but to 3%YoY in the last five months of the year. In our view, an acceleration of activity beyond that is unrealistic, given the sluggishness of the economy in 1H2014.

The leading indicators available for 3Q2014 show that the recovery of manufacturing activity is likely to continue. The HSBC-Markit purchasing managers’ index for Mexico manufacturing rose significantly in September and went firmly above the threshold that anticipates an expansion. This is the highest reading since January 2014 and its components now offer a clearer picture of recovery: The employment sub-index rose above the threshold and is now at the highest reading since March and the new orders sub-index rose with respect to the previous month and is now at the highest reading this year. Similarly, the IMEF’s seasonally-adjusted index for manufacturing activity rose above the threshold that anticipates an expansion and the company-weighted index continued to outperform moderately, thus suggesting that the recovery in manufacturing activity remains slightly biased towards big businesses. On the other hand, the IMEF index for non-manufacturing activity fell moderately but remained above the threshold, pointing that services continue to expand but that it may have lost some steam due to the persistent weakness of IP in 2013 and early 2014. We expect this to be transitory and the non-manufacturing indicator to rise in the coming months. Taken together, the HSBC-Markit manufacturing and IMEF indicators show that activity is accelerating in 2H2014 and that manufacturing is on a broader-based recovery in a context of resilient services.

The production of motor vehicles has remained an important source of growth and it is expected to remain strong. In September, domestic sales of autos grew 13.7%YoY, still one of the fastest expansions on record. On the other hand, exports grew mildly in September, 2%YoY, but we see this as a hiccup due to the shipping of some orders, rather than a change in trend (exports of autos have grown 9%YoY in the first nine months of 2014). As a result, total production grew 10.7%YoY in September and we expect such high rates to persist at least for the remainder of the year and moderate somewhat in 2015.

Production of motor vehicles (%YoY, 3-mo avg)

-10%

-5%

0%

5%

10%

15%

20%

25%

Jan-

12

Mar

-12

May

-12

Jul-1

2

Sep-

12

Nov

-12

Jan-

13

Mar

-13

May

-13

Jul-1

3

Sep-

13

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-1

4

Sep-

14

Source: AMIA

On the domestic front, 3Q2014 indicators point to a sustained weakness of private consumption. Retail sales recovered somewhat in July, but its trend remains essentially flat. This not surprising as the trend of consumer confidence is not clearly positive yet. In September, consumer confidence came out above expectations and rose with respect to August, a 2.3%MoM gain. This time, all of its five components grew on a monthly basis, including a strong recovery of the sub-index measuring the perceived capacity to purchase durable goods, which largely accounted for the overall deterioration of consumer confidence in the last months. If this behavior of consumer confidence remains in place, it would re-engage in the vigorous recovery seen early in the year and go above 2013 levels soon. However, it is worth highlighting that consumer confidence remains 2.4% below its September 2013 level, with drops in four of the five components on a yearly basis. Thus, private consumption is likely to accelerate in the coming months but moderately, as consumer confidence remains relatively low.

Retail sales and consumer confidence (Jan11=100)

90

92

94

96

98

100

102

104

106

108

110

2011

/01

2011

/03

2011

/05

2011

/07

2011

/09

2011

/11

2012

/01

2012

/03

2012

/05

2012

/07

2012

/09

2012

/11

2013

/01

2013

/03

2013

/05

2013

/07

2013

/09

2013

/11

2014

/01

2014

/03

2014

/05

2014

/07

2014

/09

Retail sales (SA, Jan11=100)

Consumer confidence (SA, Jan11=100)

Source: INEGI

9 October 2014



Also on the demand side, gross fixed investment grew 0.57%MoM and 3.1%YoY in July, below expectations but still a sign of recovery. The main support of investment in 2014 has been the machinery and equipment component, which grew 2.6%YoY in January-July, while construction contracted 1.6%YoY in the same lapse. The imported component of M&E has clearly outperformed the domestic component in that period, 3.6%YoY vs 0.6%YoY, likely due to a strong currency in 1H2014, a situation that has changed. Moreover, the resilience of residential construction has gone beyond expectations and the risk that it may lose steam in the months ahead persists. Thus, we see risks to the moderate recovery of investment under way.

Credit to households and firms continued to disappoint in the second semester of the year. According to the latest bank lending report from Banxico, net outstanding credit continued to decelerate and total performing loans stood at MXP$2604bn in August, merely 4%YoY up in real terms. Annually, the fastest-growing item in real terms is loans to non-bank intermediaries, which is the smallest component of total loans (4%). Among the major components, mortgages increased 4.2%YoY in real terms, followed by loans to companies and mortgages, both at 3.5%YoY. Thus, bank loans as a proportion of GDP stand at 15%, well below ratios observed in other EMs. In our view, bank loans are growing below potential, as suggested by comparing the current pace with that seen back in 2011/2012, and no increases in retail interest rates or in non-performing loans explain the slowdown.

After negative surprises from labor markets in July’s indicators, August numbers showed a foreseeable correction. The unemployment rate for August stood at 5.18%, well below expectations (5.35%) and in line with the unemployment rate of July 2013, 5.17%. Similarly, the seasonally-adjusted unemployment rate came down to 4.87% in August, from 5.19% in the previous month. July’s unemployment rates were in clear deviations from their medium-term downward trends and August readings partly correct that, and we expect the positive trend to continue.

In this context of slow recovery, inflation has been consistently above expectations in the last months. Bi-weekly CPI inflation came at 0.32% in the first half of September, so the annual rate climbed to 4.21%YoY, above the upper limit of the Central Bank’s target range. The pickup in inflation is explained by a combination of seasonal factors and supply shocks to meat, pork and poultry prices. We expect the effects of these shocks to be persistent and continue to show up on October CPI inflation, leading to a peak of 4.3%YoY then. So, we now anticipate inflation to end 2014 at 4%YoY, up from our previous forecast of 3.8%YoY. It is worth mentioning that we see limited risks for this scenario,

as crops prices play a diminished role in the last part of the year and the drop of inflation in November will be largely due to government-controlled electricity prices.

CPI inflation (%YoY)

2.0

2.5

3.0

3.5

4.0

4.5

5.0

2012

/02

2012

/04

2012

/06

2012

/08

2012

/10

2012

/12

2013

/02

2013

/04

2013

/06

2013

/08

2013

/10

2013

/12

2014

/02

2014

/04

2014

/06

2014

/08

CPI

Core

Source: INEGI

The headline rate is expected to drop fast in the first quarter of 2015 due to the seasonal CPI pattern, combined with the effects of a favorable high-base effect caused by the new taxes in the 2014 Economic Program and a slower increase of gasoline prices in 2015. We maintain such a positive view for CPI inflation next year, but see a moderate deterioration of this outlook for two reasons. First, it is possible that the government will hike gasoline prices 3% in a one-off move in January and leave them unchanged for the rest of the year, thus front-loading inflation pressures into early-2015. This would offset the high-base effect mentioned and creates a higher starting point for CPI inflation next year. Secondly, political conditions seem to be aligning for a minimum wage increase that most likely will be around 23%, the proposed increase from Mexico City government. Even though such effects would materialize mostly in 2016, the discussion is likely to increase expected inflation throughout 2015. In both cases, the risk of an additional contamination to prices and inflation expectations is relatively high.

Thus, we see a possible deterioration of inflation expectations for 2015-2016 which is likely to increase the appetite for indexed assets. Nevertheless, for the longer-term the outlook may be better, as we anticipate a prolonged phase in which government-controlled prices will be adjusted yearly according to expected inflation and the economy copes better with shocks to non-core inflation from agriculture products. In our view, such elements may have helped maintain long-term expected inflation consistently at around 3.5%, particularly gasoline prices which imposed a “floor” to inflation in previous years.

In this context of rising inflation, Banxico left the target overnight rate unchanged at 3% in the last meeting. This decision was widely anticipated, as markets

9 October 2014



seemed convinced that the moderate recovery under way and a headline CPI inflation running above 4%, were not conditions for an additional cut. However, the surprise was not about the decision itself but about the hawkish tone of the communication. Banxico highlighted that the economy displayed an “important” recovery in 2Q2014 as both external and domestic demand gained strength. We see Banxico’s overstatement of the recovery as part of a hawkish tone going forward and there is a drastic change in the tone about inflation, pointing out that part of the recent spike is caused by shocks expected to persist. Noticeably, Banxico points explicitly that it will be on the brink of missing the target at the end of 2014.

Headline CPI inflation in 2014 (%YoY)

ObservedForecast

3.4%

3.6%

3.8%

4.0%

4.2%

4.4%

4.6%

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

Source: INEGI and DB Research

The last policy rate decision confirms our view that Banxico will not cut the policy rate for the remainder of 2014 and most of 2015. On the other hand, in spite of its hawkish tone, we do not see Banxico hiking before the Fed unless a very negative inflation scenario materializes in early 2015 and the recovery accelerates significantly. So, we still see the timing of the Fed as more relevant for Banxico’s next move.

Finally, we anticipate a relatively quiet 4Q2014 as the reforms and bylaws have been passed and there are no surprises or controversial issues in the 2015 Economic Program submitted to Congress. In any case, the main domestic risk is that construction of public infrastructure does not pick up substantially due to the complexity of the projects announced by the government. In our view, the main risks are external: an excessive volatility due to the normalization of monetary policy in the US and/or a delayed recovery of global demand. However, we see the good expectations about reforms, sound fundamentals and, eventually, stronger growth, as elements that will help Mexico to cope with excessive volatility in EMs.

Alexis Milo, Mexico City, (52 55) 5201-8534

Mexico: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income

Nominal GDP (USD bn) 1177 1238 1317 1410

Population (m) 117 119 121 124


Real GDP (YoY%) 3.8 1.1 2.3 3.5

Priv. consumption 4.6 3.8 3.2 4.5

Gov't consumption 2.4 2.2 2.6 4.8

Investment 5.5 -0.1 2.3 4.8

Exports 4.2 1.4 3.5 4.1

Imports 6.0 2.0 4.3 5.1


CPI (Dec YoY%) 4.1 4.0 4.0 3.5

CPI (avg %) 4.1 3.8 4.0 3.8

Broad Money 10.8 11.5 11.0 12.0

Credit 12.0 10.0 16.0 21.0


Consolidated budget -2.6 -2.9 -4.2 -4.0

Revenue 15.7 16.8 17.6 17.5

Expenditure 18.4 19.7 21.8 21.5

Primary Balance -0.6 -0.9 -1.5 -1.6


Exports 371.4 376.6 389.8 405.8

Imports 371.2 378.6 394.9 415.0

Trade Balance 0.2 -2.0 -5.1 -9.3

% of GDP 0.0 -0.2 -0.6 -0.7

Current Account Balance -14.1 -22.3 -27.6 -31.0

% of GDP -1.2 -1.8 -2.1 -2.2

FDI 15.4 13.0 22.0 30.0

FX Reserves 163.5 186.5 225.0 250.0

MXN/USD (eop) 13.0 13.0 13.2 13.3


Government debt** 33.7 35.6 36.7 36.9

Domestic 23.1 24.4 25.2 25.3

External 10.6 11.2 11.5 11.6

Total External Debt 19.3 20.3 21.6 23.1

in USD 227.2 251.1 284.3 326.2

Short term (% of total) 19.0 18.0 17.0 19.0

General (ann. avg)

Industrial Production 2.8 0.9 2.2 3.3

Unemployment 4.9 4.6 4.1 3.9

Financial Markets (end i d)

Spot 14Q3 15Q1 15Q3Overnight rate (%) 3.00 3.00 3.00 3.50

3-month rate (%) 3.30 3.35 3.40 3.50

MXN/USD 13.45 13.20 13.00 13.30*Corresponds to PSBR **Corresponds to PSBR accumulated balance

Source: DB Global Markets Research, National Sources

9 October 2014



Peru Baa2 (positive)/BBB+ (stable)/BBB (neutral) Moodys /S&P/ /Fitch

Economic outlook: Activity numbers recovered during July, growing at 1.16% after the surprising 0.3% print in June. Inflationary pressures continued preventing the annual rate to continue falling during September. The Central Bank has been more active trying to stem the volatility of the exchange rate without allowing the depreciation trend to consolidate.

Main risks: The current weakness of the economy unveiled the vulnerability of the productive sector to mining, given that other sectors followed suit and were not able to counteract the slowdown. The Central Bank appears to be less concerned with the currency depreciation trend, a behavior that could exacerbate the change in positioning from market participants.

The slump in economic activity might be over

Activity started to rebound during second quarter Growth in economic activity during July accelerated to 1.16% YoY after the weak print for June (0.3% YoY). Negative growth in manufacturing (-5.72%), construction (-6.02%), and mining (-1.61%) continued during the month, but fishing (13.5%), financial services (12.4%), and retail (4.21%) continued growing at healthy rates. Agriculture continued disappointing with a meager 1.6% rate of growth.

The weak behavior of mining is explained by a 3.67% fall in metals due to lower gold (-19% due to the close of the Pierina gold mine), copper (-3.3% due to lower productivity sectors is some mines), and molybdenum production (-14.6%). The fall in construction is explained by a fall of around 16% in public works at the three government levels: national, regional, and local due to lower investment in road infrastructure and non-residential buildings.

As the graph below shows, the contribution to growth from the tradable sectors of the economy turned negative during the second quarter of the year, exemplifying the slowdown experienced since the third quarter of 2013. The contribution of the non-tradable sector has continued to be stable but in the last quarter also showed signs of weakness.

From the demand side, the fall in investment in the first and second quarters of the year (-1.7% YoY and -2.3% YoY, respectively) also portrays the deep slump in the economy. During the first quarter, the fall was contained by positive contributions from the external sector, with net exports contributing close to 1% to the overall growth rate (5.1% YoY) in the first quarter.

However, this positive contribution weakened during the second quarter of the year, contributing negatively by 0.6% to the low overall growth rate number. Moreover, the contribution of consumption, both private and public, to close to 2.6% and 0.3%, respectively, from numbers closer to 3.5% and 1.5% on average in the last two years.

We expect the subdued behavior of economic activity to continue rebounding during the next year on the back of a recovery in mining activity, especially after the completion of delayed mining projects. The risk currently relies more on the outlook for commodity prices that could hinder a continuation of investment projects in the sector.

Tradable vs. Non-Tradable contributions to growth

Source: Deutsche Bank and INEI

Inflation stubbornly close to upper level of target range After a lull during August, when prices fell in the monthly figure, taking the annual growth rate to 2.65%, in September prices crept up to 2.90% given the increase of 0.18% during the month. The largest contributors to the increase in prices were food and restaurants (0.35% and 0.29%, respectively). The only sector that contributed with a negative growth rate was communications (-0.26%).

Core prices in Lima grew by 0.09% on the monthly figure and by 2.57% annually. Machinery and equipment prices also showed acceleration to 1.09% during the month as well as construction materials, which grew by 1.07% in September. These increases in prices are related to the larger pace of currency depreciation during the month, with the PEN falling by 1.54%. We expect that price pressures will continue in the following months as pass through from the depreciation trend continues and impacts inflation.

9 October 2014



Monetary and exchange rate policy In the September meeting, the BCRP decided to cut the intervention rate by 25bps to 3.5%, after the aforementioned deceleration in prices and the overall bad numbers in economic activity. Moreover, the Central Bank continued cutting reserve requirements for local currency denominated credit to 10.5% while keeping the ratio for dollar denominated credit close to 50%.

We expect the monetary policy rate to be kept unchanged in the next meeting. The still high inflationary pressures and the bout of currency weakness would preclude monetary authorities from continuing to loosen the policy rate. Moreover, the Central Bank, even after recognizing that the slowdown is more marked than what was originally expected, is still positive that a rebound in economic activity will consolidate in the coming quarters.

On the exchange rate front, the currency has depreciated by 2.21% since the end of August and by almost 4% year to date. The Central Bank has reacted by selling dollars in the spot during the days of larger depreciation pressures and by selling dollar denominated certificates of deposit with 2- to 3-month maturities. Since the beginning of September, the intervention in the spot market was reported at USD 566m while in the swap market it was close to 556m.

However, the intervention does not seem to be defending a particular level for the exchange rate but rather is trimming the volatility. For example, during August of 2013 when the currency also showed a marked depreciation pressure, the Central Bank sold around USD 2.7bn in the spot market while in November the intervention amounted to USD 1.875 bn. In various statements, Julio Velarde, the BCRP’s governor, has explained that it welcomes the current bout of depreciation given the boost to the tradable sectors of the economy but would be ready to act during periods of extreme volatility. The behaviors of the relative supply of tradables to non-tradables explained above seem to warrant a weaker currency and the conduct of exchange rate policy in this latest depreciation period.

Change in cabinet would not impact policy quality Miguel Castilla, Finance Minister since the start of the Humala administration, was replaced by Alonso Segura. Mr. Castilla was deemed a good policy maker by market participants after being a Deputy Minister and Advisor during Alan Garcia’s administration. Mr. Segura’s appointment does not pose any risk to the quality of policy making as he has worked closely with the government as an advisor to Mr. Castilla and as Chief economist to a major local financial institution.

Armando Armenta, New York, (212) 250 0664

Peru: Deutsche Bank forecasts

2012 2013 2014F 2015FNational Income Nominal GDP (USDbn) 199.8 206.6 212.3 224.9

Population (m) 30.0 30.5 31.0 31.5


Real GDP (YoY%) 6.3 5.0 3.5 6.1




Exports 6.4 -3.1 2.2 9.0

Imports 10.4 2.1 5.5 8.0


CPI (eop) 2.7 3.0 2.9 3.3

CPI (ann. avg) 3.7 2.5 3.2 3.1

Broad money (eop) 16.5 15.0 16.0 16.0


Fiscal accounts, % of GDP

Overall balance 2.00 0.30 0.20 0.20

Revenue 21.6 21.1 21.3 21.5

Expenditure 18.6 19.8 20.2 20.4


External accounts (USD bn) Goods Exports 45.2 52.0 55.0 65.0

Goods Imports 39.8 46.0 52.0 55.0


% of GDP 2.7 2.9 1.4 4.4


% of GDP -3.1 -5.0 -5.0 -4.7

FDI (net) 12.2 11.0 10.9 12.5

FX reserves (eop) 64.1 74.0 80.0 78.0

PEN/USD (eop) 2.55 2.80 2.90 3.00

Debt Indicators (% of GDP) Government debt (*) 19.7 18.8 18.0 17.3

Domestic 10.3 10.1 10.7 10.4

External 9.4 8.7 7.3 6.9

External debt 24.4 25.6 26.4 27.6

in USD bn 48.8 52.9 56.0 62.1


General (ann. avg) Industrial production (YoY%) 4.8 6.7 4.0 7.0

Unemployment (%) 6.9 6.8 6.9 6.8

Financial Markets (%, eop) Spot 14Q4 15Q1 15Q3Policy rate 3. 50 3.50 3.50 4.25

3-month rate 4.74 4.60 4.80 5.30

PEN/USD (eop) 2.90 2.95 3.00 3.10

(*) General Government Source: DB Global Markets Research, National Sources

9 October 2014



Venezuela Caa1 (negative)/B (negative)/B+ (negative) Moody’s/S&P/Fitch

Economic outlook: Concerns on an imminent default on financial debt, the potential sale of CITGO, and rulings from international arbitration tribunals characterized the agenda during in the past month. The economic situation continues deteriorating with the black market exchange rate surpassing 100 VEF/USD in September after a major fall in the supply of dollars through the different mechanisms. Price controls have not worked and the food basket advanced by close to 90% in annual basis.

Main risks: The evidenced drop in oil prices will create extra pressure on the already dwindling production and exports. If a larger fall were to materialize in the coming months the government would need to cut already low levels of imports and expenditures putting in peril its popularity, governability, and possibly facing a new bout of public unrest.

Half hearted measures deepen crisis

Inaction continues in economic policy Economic authorities continue delaying the measures needed to correct domestic and external imbalances. Growth continues plunging, even though figures for the first and second quarter have not been released, inflation crossed the 60% mark in the last 3 months, and the parallel exchange rate reached 100 VEF/USD during September.

The source of the government’s inaction seems to be rooted in the possible political cost of curbing subsidies, cutting expenditure, devaluing the official exchange rate, and curtailing credit growth. Even the sale of CITGO, the refining and retail subsidiary of PDVSA, was backtracked after it proved unpopular domestically. The same happened with measures as the gasoline price hikes, the unification of the exchange rates, and the increase in controlled prices.

In a special report on this same monthly we describe the main causes and consequences of the prolonged period of subpar economic policy. However, we conclude that the ability and willingness to pay external debt remains but the vulnerability to unexpected falls in revenue, given the steady fall in oil prices and production, continues growing every day at a faster speed.

Oil sector recovery is badly needed to save the day Even though production levels have steadily declined, enough policy support increasing the private sector participation could boost production in the medium term (3-5 years). In the last two years, foreign investors

have become more important and the government needs to recognize that this policy change will be critical to boost oil output.

Current oil production (2.82mbpd) remains on a mild declining trend; even though production from the Orinoco Oil Belt (OOB) has been increasing, it has not been enough to offset the decline in the traditional areas. Oil exports to Asia have been on the rise, and surpassed exports to the US since 2013. In 2013, an oil price drop (USD5.3pb), higher cost of government to government (G2G) exports (USD10.1bn, an increase of USD3.6bn from 2012), and higher social contributions (USD13bn, an USD4.3bn increase from 2012) were the main contributors to a sharp reduction of PDVSA’s EBITDA, resulting in negative cash flows. The energy supply cooperation agreements (ESCAs) have been on the rise, 400kb/d of which directly affect operational cash flows.

The government’s take from PDVSA remained impervious to the fall in revenues during 2013, slightly increasing from USD 49.7 bn in 2012 to USD 50.5 bn in 2013. This includes the contribution to FONDEN, payment of income taxes, direct social contribution of PDVSA, government to government exports, and dividends. It is clear that the fiscal voracity of the central government is hindering the prospects of boosting oil production and putting a drag on the rest of the economy.

A devaluation of the exchange rate from the 6.3 VEF/USD rate would positively impact PDVSA’s bottom-line as the amount of dollars needed to pay for social contributions and taxes would be diminished sharply. However, political constraints and the need to maintain the high level of expenditure and subsidies seem to have temporarily trumped over economic and financial realities.

Given the lack of willingness to curtail expenditure, PDVSA officials seem to understand that the key for a turnaround in oil production is an increase in the participation of the private sector. This is one area that offers some hope as the government’s oil policy has turned pragmatic since as early as January 2013, when they changed the oil windfall tax law, began to attract foreign investment, and give access to foreign companies. This change in policy is exemplified by structured financing for the expansion of some joint ventures (the ‘Remediation Plan” in the amount of USD13bn), delegation of procurement process to JVs, the use of the SICAD II rate for all Oil and Gas investments, and generally an increase in dialogue with private partners.

9 October 2014



Parallel exchange rate under pressure

Source: Deutsche Bank and Ecoanalitica

Potential adverse rulings by ICSID

Venezuela has 27 pending cases before ICSID, but the two with the highest profile are the claims filed by ExxonMobil (headline claim: USD10bn), and by ConocoPhillips (headline claim: USD30bn 24 ). Gold reserve was recently awarded a US 740 m for the “fair market value” of the Brisas project. The ICSID will likely decide on the Conoco Phillips case as early as November/December of 2014 according legal experts we consulted with, as it already ruled that Venezuela violated the Bilateral Investment Treaties (BIT) in 2013. The ExxonMobil case will likely be decided in the following days, as well with a total claim by the oil company of around USD 10bn. ICSID awards, which are investment claims, can be enforced worldwide, against any Venezuelan asset.

However, the enforcement of an award is not usual, and it would typically take between 2 to 4 years, and settlements have been the normal way out. In these cases, it would not be inconceivable that claimant oil companies are invited back to the Orinoco oil fields as part of a private settlement after the award.

In any case, apart from the headlines that would negatively affect the sentiment, the risk of the Republic having to make an immediate disbursement after the award is announced is minimal. Further legal measures and negotiations would be used by the government’s legal team delaying the outflow.

Armando Armenta, New York, (212) 250-0664

24 The amount of USD30bn claimed by ConocoPhillips likely includes forgone revenues, not just the values of seized assets. According to reports, immediately following the appropriation in 2007 Conoco asked for compensation of about USD6.5bn, which was likely market value of the assets at that time.

Venezuela: Deutsche Bank Forecasts

2012 2013F 2014F 2015F

National Income

Nominal GDP (USDbn) 381 449 737 581

Population (mn) 30 31 31 31


Real GDP (YoY%) 5.6 1.5 -3.5 -1.1




Exports 1.6 3.0 -1.0 2.0

Imports 24.4 7.0 10.0 9.0

Prices, Money and Banking (YoY %)

CPI (eop) 20.1 56.5 70.0 90.0

CPI (ann. avg) 23.8 40.0 60.0 80.0

Broad money (eop) 60.1 65.0 50.0 45.0


Fiscal accounts (% of GDP) (*)

Overall balance -11.5 -7.2 -4.0 -4.8

Revenue 28.5 30.0 28.0 30.0

Expenditure 42.5 40.0 35.0 38.0

Primary balance -14.0 -10.0 -7.0 -8.0


Goods Exports 98.0 92.0 85.0 82.0

Goods Imports 58.0 55.0 45.0 50.0

Trade balance 40.0 37.0 40.0 32.0

% of GDP 10.5 8.2 5.4 5.5

Current account balance 14.0 7.2 14.0 18.0

% of GDP 3.7 1.6 1.9 3.1

FDI (net) 0.0 0.0 1.0 1.5

FX reserves (eop) 29.9 21.7 21.0 30.0

VEF/USD (eop) 4.30 6.30 6.30 15.0

Debt Indicators (% of GDP) (*)


Domestic 15.6 15.5 17.5 22.0

External 22.4 19.1 11.7 15.0

External debt 25.8 22.2 13.7 17.5

in USD bn 98.4 99.6 100.9 101.8


General (ann. avg)

Industrial production (YoY%) 2.4 1.0 -1.0 0.5

Unemployment (%) 8.0 8.3 8.5 8.0 Financial Markets (end period) Spot 14Q4 15Q1 15Q4Policy rate 20.6 25.0 25.0 25.0

3-month rate 14.5 15.5 15.5 17.0VEF/USD (eop) (*) Non-Financial General Public Sector

6.30 6.30 6.30 12.00

Source: DB Global Markets Research, National Sources

9 October 2014



Theme Pieces September 2014

Brazil: Marina Silva Changes Election Dynamics What Explains Disappointing Asian Exports? Diminishing Expectations in Latin America Mexico: Undertaking Pemex and CFE Pension

Liabilities A Growth and Investment Model for India: 2014-2020 Will the Russia Crisis Derail Recovery in Central

Europe?

July 2014 Argentina: Flirting With Default While Aiming at

Resolution Inflation in Turkey: What Goes Up Struggles to Come

Down India: Urbanization and Economic Well-Being Philippines: Investments' Growing Economic

Importance Idiosyncrasies to Drive CEE FX in Different Directions Notes from Russia: Dealing with Structural

Challenges and Geopolitics

June 2014 Mexico's Energy Reform in Perspective India: the Next Government's To-Do List Indonesia: The Challenge from Commodities Brazil: Ten Questions About the Elections South Korea: Labour at a Crossroads Hungary: Explaining Subdued Inflation and Declining

Export Competitiveness Asia Vulnerability Monitor

May 2014 India: the Next Government's Fiscal Challenges Characterizing Elusive Growth in Latin America Euro Area Still a Powerful Driver of EMEA Export

Performance Introducing the EM Derivatives Focus China: Road to Sustainable Local Government

Financing Venezuela: the Value of Opportunistic Adjustment

April 2014 China: A year of Economic Rebalancing India: Evidence of a Turnaround in the Investment

Cycle Breakeven Oil Prices Implications of Increase in Foreign Participation in

Colombia

March 2014 Bailing Out Ukraine Russia Macro Implications of Increased Geopolitical

Risks EMFX:“Good EM/Bad EM” Tail Opportunities Central Europe: a Good EM Story Is the Philippine Peso a (CA) Deficit Currency? India’s Heterogeneous State Finances LMAP – The Next Generation

February 2014 Vulnerabilities, Policy Inaction, and Stigma in the

Recent EM Sell Off Divergent Pricing of Local and External Sovereign

Bonds India: CPI Target Means Higher Rates for Longer Asia Vulnerability Monitor Inside Fragile EM: Trip Notes from Turkey and South

Africa

January 2014 The Durability of Current Account Adjustment in

Central Europe Can DTCC Positioning Data Predict EMFX? Argentina GDP Warrants: More Attractive

Risk/Reward than Bonds

December 2013 Diverging Markets Rates in 2014: Refocusing on EM Fundamentals Sovereign Credit in 2014: Back in the Black FX in 2014: Diverging Currencies

November 2013 China: Economic Benefits of TPP Entry EM Rates: Trading Pre-Taper Anxiety Chile's Presidential Election from a Regional

Perspective Inflation Drivers in EMEA The Mystery of Russia's Deteriorating Current

Account Balance Charting Malaysia's BoP Position

October 2013 EM Allocation: Strategic vs. Tactical Sovereign Credit - Fundamentals Re-pricing and

Credit Differentiation Balance of Payment Sensitivities in Latin America Towards free trade across the Pacific Outlook and Implications of Mexico´s Fiscal and

Energy Reforms Greece: GGBs and Warrant, updated and term

structure of risk

September 2013 Emerging Value in Sovereign Credit Brazil: External Adjustment and FX Intervention Latin America: Challenged by US Tapering and Time

Decay Russian Growth: a View from the Regions Poland – A Deeper Look at Pension Reform

9 October 2014



Contacts

Name Title Telephone Email Location

EMERGING MARKETS

Cañonero, Gustavo Regional Head, LatAm 1 212 250 7530 [email protected] Buenos Aires

Evans, Jed Head of EM Analytics 1 212 250 8605 [email protected] New York

Giacomelli, Drausio Head of EM Research 1 212 250 7355 [email protected] New York

Jiang, Hongtao Head of EM Sovereign Credit 1 212 250 2524 [email protected] New York

Spencer, Michael Regional Head, Asia 852 2203 8305 [email protected] Hong Kong

Ortiz, Nellie Global Research 1 212 250 5851 [email protected] New York

LATIN AMERICA

Armenta, Armando Andean Economist 1-212 250 0664 [email protected] New York

Faria, Jose Carlos Senior Economist, Brazil 5511 2113 5185 [email protected] Sao Paulo

Marone, Guilherme EM Derivatives and Quant Strategist 1 212 250 8640 [email protected] New York

Milo, Alexis Senior Economist, Mexico 5255 5201 8534 [email protected] Mexico

Shtauber, Assaf EM Strategist 1 212 250 5932 [email protected] New York

EMERGING EUROPE, MIDDLE EAST, AFRICA

Burgess, Robert Head of Economics, EMEA 44 20 754 71930 [email protected] London

Grady, Caroline Senior Economist, Central Europe 44 20 754 59913 [email protected] London

Gullberg, Henrik EMEA FX Strategist 44 20 754 59847 [email protected] London

Kalani, Gautam Economist, Central Europe 44 20 754 57066 [email protected] London

Kong, Winnie EMEA Sovereign Credit Strategist 44 20 754 51382 [email protected] London

Lissovolik, Yaroslav Chief Economist, Russia and CIS 7 495 933 9247 [email protected] Moscow

Masetti, Oliver Economist, Egypt 49 69 910 41643 [email protected] Frankfurt

Masia, Danelee Senior Economist, South Africa 27 11 775 7267 [email protected] Johannesburg

Popov, Eugene Head of CEEMEA Corporate Credit 44 20 754 56460 [email protected] London

Porwal, Himanshu EM Corporate Credit 44 121 615 7073 [email protected] Birmingham

Wietoska, Christian Rates Strategist 44 20 754 52424 [email protected] London

Zaigrin, Artem Economist, Russia, Ukraine, Kazakhstan 7 495 797 5274 [email protected] Moscow

ASIA

Agarwal, Harsh Head of Asia Credit Research 65 6423 6967 [email protected] Singapore

Baig, Taimur Head of Economics, Asia 65 6423 8681 [email protected] Singapore

Cheung, Jacphanie Credit Analyst, China Property 852 2203 5930 [email protected] Hong Kong

Das, Kaushik Economist, India, Pakistan, Sri Lanka 91 22 71584909 [email protected] Mumbai

Del-Rosario, Diana Economist, Malaysia,Philippines 65 6423 5261 [email protected] Singapore

Goel, Sameer Head of Asia Rates & FX Research 65 6423 6973 [email protected] Singapore

Kalbande, Swapnil Rates Strategist 65 6423 5925 [email protected] Singapore

Kojodjojo, Perry FX Strategist 852 2203 6153 [email protected] Hong Kong

Lee, Juliana Senior Economist, South Korea, Taiwan, Vietnam 852 2203 8312 [email protected] Hong Kong

Liu, Linan Rates Strategist 852 2203 8709 [email protected] Hong Kong

Sachdeva, Mallika FX Strategist 65 6423 8947 [email protected] Singapore

Seong, Ki Yong Rates Strategist 852 2203 5932 [email protected] Hong Kong

Shi, Audrey Economist, China, Hong Kong 852 2203 6139 [email protected] Hong Kong

Shilin, Viacheslav Credit Analyst, Banks & Sovereigns 65 6423 5726 [email protected] Singapore

Tan, Colin Credit Analyst, IG Corporates 852 2203 5720 [email protected] Hong Kong


9 October 2014


Policy Rate Forecast

Projected Policy Rates in Emerging Markets

Q4-2014 Q1-2015

Emerging Europe, Middle East & Africa

Czech 0.05 0.05 0.05 0.05 0.05 0.05

Hungary 2.10 2.10 2.10 2.30 2.60 3.00

Israel 0.25 0.25 0.25 0.25 0.75 1.25

Kazakhstan 5.50 5.50 5.50 5.50 5.50 5.50

Poland 2.00 ↓ 1.75 ↓ 1.75 ↓ 1.75 ↓ 2.00 ↓ 2.25 ↓

Romania 3.00 ↓ 3.00 ↓ 3.00 ↓ 3.00 ↓ 3.25 ↓ 3.50 ↓

Russia 8.00 8.50 8.50 8.50 8.50 8.50

South Africa 5.75 6.00 6.00 6.00 6.25 6.50

Turkey 8.25 8.25 ↑ 8.25 ↑ 8.25 ↑ 8.25 ↑ 8.25 ↑

Ukraine 12.50 12.50 12.50 12.50 12.50 12.50

Asia (ex-Japan)

China 3.00 3.00 3.00 3.00 3.25 3.50

India 8.00 8.00 8.00 8.00 7.75 7.50

Indonesia 7.50 7.50 7.50 7.50 7.50 ↓ 8.00

Korea 2.25 2.00 2.00 2.00 2.25 2.50

Malaysia 3.25 3.25 ↓ 3.25 ↓ 3.25 ↓ 3.50 ↓ 3.50 ↓

Philippines 4.00 4.00 4.00 4.25 4.25 4.50

Taiwan 1.875 1.875 1.875 2.000 2.125 2.250

Thailand 2.00 2.00 2.00 2.00 2.25 2.50

Vietnam 6.50 6.00 6.00 6.00 6.00 6.00

Latin America

Brazil 11.00 11.00 11.00 11.00 11.00 11.00

Chile 3.25 ↓ 2.75 2.75 2.75 2.75 3.00

Colombia 4.50 4.50 ↓ 4.50 ↓ 4.50 ↓ 4.75 ↑ 5.00 ↑

Mexico 3.00 3.00 3.00 3.00 3.50 4.00

Peru 3.50 ↓ 3.50 3.75 4.25 ↓ 4.50 4.50

↑/↓ Indicates increase/decrease in level compared to previous EM Monthly publication; a blank indicates no change

Policy Rate Forecasts

Current policy rate Q2-2015 Q3-2015 Q4-2015


9 October 2014



Appendix 1

Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Drausio Giacomelli/Jed Evans

9 October 2014



Regulatory Disclosures

1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

2. Short-Term Trade Ideas

Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com.

3. Country-Specific Disclosures

Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Investment Advisers Association. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless "Japan" or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. Qatar: Deutsche Bank AG in the Qatar Financial Centre (registered no. 00032) is regulated by the Qatar Financial Centre Regulatory Authority. Deutsche Bank AG - QFC Branch may only undertake the financial services activities that fall within the scope of its existing QFCRA license. Principal place of business in the QFC: Qatar Financial Centre, Tower, West Bay, Level 5, PO Box 14928, Doha, Qatar. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Business Customers, as defined by the Qatar Financial Centre Regulatory Authority. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation. Kingdom of Saudi Arabia: Deutsche Securities Saudi Arabia LLC Company, (registered no. 07073-37) is regulated by the Capital Market Authority. Deutsche Securities Saudi Arabia may only undertake the financial services activities that fall within the scope of its existing CMA license. Principal place of business in Saudi Arabia: King Fahad Road, Al Olaya District, P.O. Box 301809, Faisaliah Tower - 17th Floor, 11372 Riyadh, Saudi Arabia. United Arab Emirates: Deutsche Bank AG in the Dubai International Financial Centre (registered no. 00045) is regulated by the Dubai Financial Services Authority. Deutsche Bank AG - DIFC Branch may only undertake the financial services activities that fall within the scope of its existing DFSA license. Principal place of business in the DIFC: Dubai International Financial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as defined by the Dubai Financial Services Authority.

9 October 2014



Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements.

Hypothetical Disclaimer Backtested, hypothetical or simulated performance results have inherent limitations. Unlike an actual performance record based on trading actual client portfolios, simulated results are achieved by means of the retroactive application of a backtested model itself designed with the benefit of hindsight. Taking into account historical events the backtesting of performance also differs from actual account performance because an actual investment strategy may be adjusted any time, for any reason, including a response to material, economic or market factors. The backtested performance includes hypothetical results that do not reflect the reinvestment of dividends and other earnings or the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid. No representation is made that any trading strategy or account will or is likely to achieve profits or losses similar to those shown. Alternative modeling techniques or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor guarantee of future returns. Actual results will vary, perhaps materially, from the analysis.

GRCM2014PROD032970

David Folkerts-Landau

Group Chief Economist Member of the Group Executive Committee

Guy Ashton

Global Chief Operating Officer Research

Marcel Cassard Global Head

FICC Research & Global Macro Economics

Richard Smith and Steve Pollard Co-Global Heads Equity Research

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Deutsche Bank Research, Germany

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Americas Research

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