emerging markets monthly - dws · emerging markets and the global economy in the month ahead after...

Deutsche Bank Markets Research

Emerging Markets

Economics Foreign Exchange Rates Credit

Date 11 September 2014

Emerging Markets Monthly

Struggling to Gain Traction

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

(+65) 64 23-8681 (+44) 20 754-71930 (+1) 212 250-7530 (+1) 212 250-7355 (+1)-212-250-2524 +(852 ) 2203-8305

________________________________________________________________________________________________________________

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.

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11 September 2014

EM Monthly: Struggling to Gain Traction


Key Economic Forecasts

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

Global 3.0 3.3 4.0 3.3 3.6 3.7 0.2 0.4 0.4 -3.2 -2.6 -2.3

US 2.2 2.2 3.3 1.5 2.0 2.4 -2.4 -2.8 -2.9 -4.0 -2.8 -2.5

Japan 1.5 1.2 1.3 0.4 2.8 1.6 0.7 0.4 1.3 -9.1 -7.0 -5.9

Euroland -0.4 0.8 1.3 1.3 0.7 1.2 2.4 2.4 2.3 -3.1 -2.5 -2.1

Germany 0.1 1.5 1.8 1.6 1.1 1.6 6.8 7.2 6.8 0.0 0.2 0.0

France 0.4 0.5 1.2 1.0 0.9 1.0 -1.3 -1.1 -1.1 -4.3 -3.9 -3.6

Italy -1.9 -0.1 1.0 1.3 0.5 1.1 1.0 1.6 2.0 -3.0 -3.0 -2.9

Spain -1.2 1.3 1.9 1.5 0.2 1.0 0.8 0.5 0.5 -7.1 -5.7 -4.9

Netherlands -0.8 0.4 1.7 2.6 0.5 1.1 10.4 11.1 10.9 -2.5 -2.9 -2.2

Belgium 0.2 1.2 1.5 1.2 0.8 1.3 -1.6 -1.0 -0.5 -2.6 -2.5 -2.4

Austria 0.3 1.4 1.8 2.1 1.6 1.6 2.7 3.4 3.6 -1.5 -2.7 -1.4

Finland -1.2 -0.3 0.8 2.2 1.2 1.3 -1.1 -0.8 -0.5 -2.1 -2.5 -1.8

Greece -3.9 -0.3 2.2 -0.9 -1.0 0.2 0.8 1.0 1.5 -12.7 -1.5 -0.2

Portugal -1.4 1.0 1.5 0.4 0.0 0.9 0.6 1.0 1.0 -4.9 -4.1 -3.0

Ireland 0.2 1.8 2.3 0.5 0.4 1.1 6.6 6.5 7.0 -7.2 -4.7 -2.6

Other Industrial Countries 1.9 2.8 2.7 1.7 1.7 1.9 -0.9 -0.4 -0.2 -2.7 -2.1 -1.2

United Kingdom 1.7 3.1 2.5 2.6 1.6 1.8 -4.4 -3.7 -3.0 -5.8 -4.6 -3.4

Sweden 1.6 2.4 2.8 0.0 0.1 1.6 6.5 6.3 6.0 -3.6 -1.5 -1.0

Denmark 0.4 1.4 1.8 0.8 0.8 1.8 7.1 6.5 6.5 0.0 -1.5 -2.5

Norway 2.0 2.1 2.4 2.1 1.8 2.2 11.1 11.5 11.0 7.6 9.5 9.0

Switzerland 1.9 1.8 2.0 -0.2 0.0 0.4 16.0 12.5 12.0 0.2 0.0 0.2

Canada 2.0 2.5 3.0 0.9 2.2 2.1 -3.0 -2.3 -1.9 -1.0 -0.8 0.0

Australia 2.4 3.6 3.5 2.4 2.7 2.5 -3.2 -1.5 -1.8 -2.2 -2.4 -1.3

New Zealand 2.9 3.7 2.7 1.1 1.7 2.1 -3.4 -3.5 -5.6 -1.6 -0.4 0.4

Emerging Europe, M iddle East & Africa 2.4 2.4 2.8 4.8 5.4 5.1 0.7 1.6 0.9 -1.2 0.3 -0.7

Czech Republic -0.9 2.4 2.6 1.4 0.4 1.8 -1.4 -1.5 -1.4 -1.4 -2.6 -2.5

Egypt 2.2 2.2 3.7 6.9 10.1 12.0 -2.7 -1.1 -1.7 -13.7 -12.0 -10.5

Hungary 1.1 3.4 2.7 1.7 0.3 2.7 -0.8 1.8 1.8 -2.4 -2.9 -2.7

Israel 3.2 2.7 3.0 1.5 0.6 1.4 2.1 2.4 2.6 -3.1 -3.0 -3.0

Kazakhstan 6.0 5.4 5.2 5.8 6.1 6.7 1.0 2.0 1.5 5.3 5.3 3.3

Poland 1.6 3.1 3.5 0.9 0.4 1.5 -1.3 -1.8 -2.0 -4.4 4.3 -2.9

Romania 3.5 2.5 3.2 4.0 1.6 3.0 -1.1 -1.0 -1.2 -2.3 -2.2 -1.9

Russia 1.3 0.8 1.0 6.8 7.4 6.2 1.5 2.2 1.6 -0.5 0.7 0.4

Saudi Arabia 4.0 4.4 4.1 3.5 3.0 3.2 17.7 14.5 10.5 6.4 7.2 4.8

South Africa 1.9 1.5 3.4 5.8 6.1 5.1 -5.8 -4.6 -4.4 -4.1 -4.0 -3.5

Turkey 4.1 3.0 3.5 7.5 8.9 6.3 -7.9 -5.5 -5.0 -1.2 -1.7 -1.5

Ukraine 0.0 -6.9 0.5 -0.3 10.3 12.8 -9.2 -3.0 -2.1 -4.5 -5.5 -4.5

United Arab Emirates 5.2 3.4 3.5 1.1 2.2 2.5 16.1 15.5 13.0 9.1 10.6 9.3

Asia (ex-Japan) 6.1 6.4 6.9 4.3 3.5 3.9 1.6 2.1 1.9 -2.3 -2.4 -2.0

China 7.7 7.8 8.0 2.6 2.2 3.0 2.0 2.3 2.5 -2.1 -2.1 -1.5

Hong Kong 2.9 2.8 3.6 4.3 4.0 3.2 2.1 -0.7 3.9 1.0 2.6 3.4

India 4.4 5.5 6.5 10.1 7.4 7.4 -2.6 -1.6 -2.5 -4.5 -4.5 -4.2

Indonesia 5.8 5.2 5.5 6.4 5.9 4.9 -3.3 -3.0 -2.7 -2.2 -2.4 -2.6

Korea 3.0 3.6 3.8 1.3 1.5 2.3 6.1 5.6 4.5 1.0 0.2 0.0

Malaysia 4.7 5.5 5.6 2.1 3.2 3.5 4.0 4.0 7.2 -3.9 -3.7 -3.2

Philippines 7.2 6.6 6.8 2.9 4.4 3.6 3.5 4.2 4.2 -1.4 -1.9 -2.2

Singapore 3.9 3.0 4.0 2.4 1.5 2.1 18.4 18.1 16.5 7.1 6.9 6.8

Sri Lanka 7.3 7.5 7.5 6.9 4.0 6.3 -3.9 -3.4 -3.1 -5.8 -5.5 -5.0

Taiwan 2.1 3.7 3.8 0.8 1.6 1.5 11.7 12.9 11.9 -1.4 -2.0 -1.8

Thailand 2.9 1.5 5.0 2.2 2.1 2.4 -0.7 1.8 1.2 -2.0 -2.8 -2.5

Vietnam 5.4 5.6 6.0 6.6 5.0 6.4 3.5 3.8 0.5 -4.0 -4.5 -4.4

Latin America 2.5 1.1 2.1 9.1 12.5 11.7 -2.6 -2.6 -2.4 -3.1 -3.8 -3.5

Argentina 2.9 -1.9 -1.4 25.3 38.1 34.4 -1.4 -1.9 -1.5 -4.6 -4.9 -4.7

Brazil 2.5 0.3 1.2 6.2 6.3 6.1 -3.6 -3.7 -3.4 -3.2 -4.2 -3.6

Chile 4.1 2.1 3.1 1.9 4.2 3.3 -3.5 -1.7 -1.8 -0.5 -1.9 -2.1

Colombia 4.6 5.0 4.8 2.0 2.8 3.2 -3.4 -3.9 -3.0 -2.4 -2.4 -2.2

Mexico 1.1 2.3 3.5 3.8 4.0 3.8 -1.8 -2.1 -2.2 -2.9 -4.2 -4.0

Peru 5.0 4.0 6.0 2.5 3.2 2.6 -5.0 -4.8 -4.5 0.3 0.2 0.2

Venezuela 1.5 -3.1 0.1 40.0 70.0 70.0 1.6 2.9 3.4 -7.2 -4.0 -4.8

M emorandum Lines: 1/

G7 1.5 1.8 2.5 1.3 1.8 2.0 -0.9 -1.0 -0.9 -4.3 -3.2 -2.8

Industrial Countries 1.3 1.8 2.4 1.3 1.7 1.9 -0.4 -0.5 -0.5 -4.2 -3.1 -2.6

Emerging Markets 4.7 4.7 5.3 5.2 5.3 5.4 0.8 1.2 1.0 -2.2 -2.0 -2.0

BRICs 5.8 5.8 6.3 5.1 4.3 4.6 0.4 0.9 0.8 -2.6 -2.5 -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

11 September 2014



Table of Contents Emerging Markets and the Global Economy in the Month Ahead

After a benign interlude earlier this summer, EM assets have again underperformed over the last month on fears of higher US rates and a stronger dollar. While we might see further reprieves as greater clarity emerges about the timing of the first Fed rate hike, these episodes are likely to be short lived given the lack of intrinsic value in EM besides carry. The acceleration in EM growth that would break this cycle is proving elusive, especially in EMEA and Latin America where economic performance has again faltered..……………........ ................................................................................... 04

This Month’s Special Reports Brazil: Marina Silva Changes Election Dynamics

The tragic death of candidate Eduardo Campos in a plane crash in August has upended Brazil’s presidential election. Campos has been replaced by his VP candidate Marina Silva, who has surged in the polls and now poses a much bigger threat to President Dilma Rousseff’s re-election than the PSDB’s Aécio Neves. While Marina’s market-friendly program has buoyed Brazilian asset prices, there is still a long way to go until election day, and the presidential race remains wide open in our opinion..…………….......................................................................................................................................... 12

What explains disappointing Asian exports? There has been a striking breakdown in the relationship between Asia’s exports and demand indicators in the US/EU. Our previously successful export model is presently yielding the largest forecast error in its 15-yr history. Some of the forecast error could be due to the sharply lower than expected Q1 US GDP outturn, but we think three more crucial factors are at play in the industrial economies: (i) unusual contrast between weak consumer demand and strong profits, (ii) a modest rise in import substitution, and (iii) rising trade restrictions. These headwinds will likely persist for a while, posing risks to our Asia forecasts....……………........ .......................................................................................................... 15

Diminishing Expectations in Latin America Latin America growth has disappointed even our pessimistic forecasts, raising further doubts about performance ahead. Declining terms of trade despite improving external trade has been part of the driver, fueling contraction in foreign direct investment and commodity production, while increasing hurdles for industrial growth have continued to be closely related to worsened competitiveness despite marginal corrections in regional currencies. Idiosyncratic factors have been also at play in almost all major regional country. Some hope remains for the year ahead nevertheless, partly due to elections in Brazil and Argentina, fading tax uncertainties in Chile, Mexico´s reform and strong US link, and overall accommodation to a new reality in commodities. Notwithstanding, we now see trend growth in the region below 3% from 4.5% estimated during the last decade....……………........ ......................................................................................... 19

Mexico: Undertaking PEMEX and CFE pension liabilities A bold step in the right direction with some risks. The legal mandate that came along with the energy reform for the federal government to undertake Pemex and CFE unfunded pension liabilities will likely strengthen the companies, make the financial position of the public sector more transparent and boost financial saving by enlarging the Afores system. It basically involves streamlining current pensions to retired workers and getting active and prospective employees into the existing fully-funded pensions system. While a positive step,we see some risks and concerns in the implementation of the pension reform that may limit potential savings and/or create some distortions in the market of government securities..……………........ ................................................................................................................................................. 24

A growth and investment model for India: 2014-2020 The recent political transition to a new government has given rise to heightened investor expectation about an inflection point in the Indian economy. What would it take for India to grow by 7-7.5% by the end of this decade? We present an internally consistent framework of savings, investment, and productivity that would attain such a goal. Our medium term scenario is broadly constructive, but cognizant of the external and internal challenges....……………........ ....................... 30

Will the Russia crisis derail recovery in Central Europe Central Europe has been one of the good EM stories over the past year, but our optimism toward the region is being tested by the crisis in Russia and Ukraine. While weaker demand from these two countries will weigh on Central Europe's exports, both directly and indirectly through its integration with the German supply chain, we estimate that these effects could be quite modest, reducing GDP growth in the region by 0.2ppts on average...………. ……........ ....... 34 Asia Strategy ...................................................................................................................................................................... 39 EMEA Strategy ................................................................................................................................................................... 46 LatAm Strategy ................................................................................................................................................................... 53 Asia Economics .................................................................................................................................................................. 59 EMEA Economics ............................................................................................................................................................... 91 Latam Economics ............................................................................................................................................................. 118 Theme Pieces ................................................................................................................................................... 140

11 September 2014



Emerging Markets and the Global Economy in the Month Ahead

After a benign interlude, EM assets have again come under pressure as fears of higher US rates and a stronger dollar have outweighed the promise of additional liquidity from the ECB.

Further reprieves are possible as greater clarity emerges about the Fed’s exit. But, in the absence of stronger growth in EM, these are likely to be short-lived.

While growth in Asia is holding up relatively well, economic performance in EMEA and Latin America has continued to falter, though upcoming elections in Brazil may create a more supportive backdrop.

Limited EM assets intrinsic value and negative skew to global risk has overshadowed carry over the past month as ECB’s QE triggered a repricing of G3 FX. Possible change in FOMC language has added uncertainty to this backdrop.

While we expect FOMC uncertainty to subside in the coming weeks, EM retracement hinges on taming G3 FX volatility.

Although we find Asia better prepared to deal with USD strength, we favor euro and yen funding and intra-EMFX trades that build on policy divergences.

We prefer long MYR and PHP vs. EUR, CNH vs. KRW, INR vs. SGD, PLN vs. HUF, and TRY vs. ZAR. As short euro proxies, we recommend long MXN and BRL vs. HUF and CZK. Buy BRL via options.

Despite reduced yield differentials across EM, we recommend holding spread compression trades vs. US in Mexico, Chile, and Singapore (but spread wideners in Czech Republic).

We also continue to see pockets of value in Brazilian and Mexican real rates, the belly in Malaysia, Polish, and Indian bonds. Valuation and our views on monetary policy bode for front-end steepeners in Mexico, Chile, Hungary, and steepeners in South Africa, Turkey and Korea.

In sovereign credit, we overweight Turkey, Hungary, Colombia, and Mongolia, while we underweight Argentina, Venezuela, Russia, and Poland. Focusing on relative value, we favor cash curve flatteners (especially in South Africa and Indonesia) and basis tighteners (especially in Turkey and Venezuela).

Struggling to gain traction

After a benign interlude earlier this summer, EM assets have again underperformed over the past month. That this has come against a backdrop of a disappointing

payrolls number in the US and significant new easing measures from the ECB underscores investor nervousness about the asset class, a reflection of its limited intrinsic value (besides carry). Dollar strength will not help, as it weighs on EMFX and further limits the upside for local markets. We might see further reprieves if expectations about the timing of the first Fed rate hike are again pushed back. But these are likely to be small and short-lived.

The acceleration in EM growth that would break this cycle is proving elusive. Growth in Asia has held up relatively well, and this region seems best placed to weather the twin shocks of a stronger dollar and higher US rates, especially with major elections now safely behind us. Elsewhere, the outlook is more challenging. The end of the commodity boom continues to weigh on growth in Latin America. Geopolitics has checked recoveries in parts of EMEA, most notably in Russia itself. With recent data also disappointing, we have, therefore, made a number of downward revisions to our forecasts for these regions.

US: Recovery Still on Track. August employment was disappointing, as nonfarm payrolls came in significantly below market expectations. The increase of 142K was the smallest since last December. We view this as aberration rather than a change in trend because it does not jibe with other leading indicators of the labor market, such as jobless claims, which point to an improvement in the pace of hiring. More broadly, the economy appears to be retaining significant momentum this quarter after expanding by 4.2% last quarter. This has been reinforced by the solid results from both the manufacturing and nonmanufacturing ISM surveys, stronger than expected motor vehicle sales in August, and a narrowing of the trade deficit over the past couple of months. Unless productivity growth was to suddenly and dramatically re-accelerate, this pace of activity is consistent with employment gains closer to the 236k average over the three months prior to the August employment report.

Monetary policymakers are likely to take a similar view when they meet later this month and provide updated economic and financial projections. It will likely be some months, however, before the Fed feels confident enough to start signalling a first rate hike. But the Fed may elect to update the market on the technical details regarding its exit strategy. With the Fed’s asset purchase program set to expire next month, we could conceivably also see a change in its commitment to keep rates unchanged for a “considerable time” thereafter. One FOMC voting member has already objected to this time dependent guidance. Whether the

11 September 2014



Fed would be able to update the markets on its exit strategy and change the nature of its forward guidance on rates without the markets interpreting these as hawkish signals is debatable. So while we continue to think that it will likely be the back end of the year before we see a clear change of signal from the Fed, markets are likely to remain hyper sensitive to its communications over the intervening months.

US labor trends intact despite weak August payrolls

Source: BLS, Haver Analytics, and Deutsche Bank

Europe: ECB Announces Private QE. Following up on its targeted long-term refinancing operation launched in June, the ECB this week announced plans to start purchasing asset-backed securities and covered bonds from October. The move came on the back of Draghi’s speech at Jackson Hole, expressing his concerns about the decline of medium-term inflation expectations (chart below). The objective is to expand the ECB balance sheet to early 2012 levels, implying a Eur1tn expansion, with a view to reinforcing the “significant and increasing differences” in monetary policy cycles between major advanced economies. In effect, therefore, this is an indirect FX policy that could help to weaken the euro and push inflation to the ECB target level in 2017, shortening the period in which inflation is below target.

The question is whether a net balance sheet expansion of this magnitude is credible. Reaching half of the Eur1tn target appears a not too challenging proposition, in our opinion. To get closer to Eur1tn, however, the ECB will have to be aggressive. Given the inevitable doubts about whether this can be achieved and whether it will be enough, it will be important to keep the option of government bond purchases, i.e. public QE, on the table.

ECB responded to declining inflation expectations

Source: Bloomberg Finance LP, Deutsche Bank

EM: Growth Concerns (Again) The US recovery, though hardly remarkable, remains largely on track following the weather-related soft patch earlier this year. We are still several months away from the first Fed rate hike. After a solid start to the year, growth in Europe softened in the second quarter, though ECB has responded with additional stimulus through its targeted long-term refinancing operation and commitment to buy private assets. China has also avoided the hard landing that many had feared. On the face of it, this provides a moderately constructive backdrop for EM, yet growth in many EM countries continues to disappoint.

EM Growth by Region: EMEA and LatAm disappoint

0

2

4

6

8

10

10Q4 11Q2 11Q4 12Q2 12Q4 13Q2 13Q4 14Q2

EMEA LatAm Asia

Average annualized quarterly growth rate, last four quarters %

Source: Haver Analytics, Deutsche Bank

As usual, the pattern differs both within and across regions. Growth in emerging Asia has not accelerated meaningfully but has at least held up rather better than in EMEA and Latin America. In China, for example, while industrial activity has been going through a soft patch, the service sector is growing steadily and

11 September 2014



economic reforms continue to advance at an impressive pace. Reflecting this, the tertiary sector has overtaken the secondary sector as the largest contributor to GDP growth. In short, we think that the economy is rebalancing nicely, albeit expanding at a slower pace than at breakneck rates of the past.

Elsewhere in Asia, as we discuss later in this monthly (see “What explains disappointing Asian exports?”), export performance has been lower than expected given the strength of activity indicators in the US and Europe. We think this reflects a number of factors, including, among other things, a contrast between weak consumer demand and strong profits in the US. The US manufacturing sector has also enjoyed something of a revival, leading to some imports from Asia to be replaced by domestically-produced goods. Lower investment demand in China has probably also exerted a further drag on exports from the rest of Asia. These headwinds are likely to persist for a while and represent a risk to the acceleration in growth in Asia that we have been anticipating.

Asian exports: relationship with G2 PMIs breaks down

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

2000 2002 2004 2006 2008 2010 2012 2014

Actual Predicted%yoy

Source: CEIC, Haver, Deutsche Bank. The regression model is exports growth = c + USPMI (-6) + EUPMI (-6) + e

Growth has faltered across much of EMEA. It’s tempting to attribute this to the impact of geopolitical risks in Russia. This has indeed played a role, mainly in Russia itself, where we have downgraded our growth forecast for next year to 1% from 2.4% as uncertainty associated with the crisis looks set to linger. It has also affected sentiment elsewhere, especially in Poland. As we discuss later in this monthly (see “Will the Russia crisis derail recovery in Central Europe?”), however, economic and financial linkages with Russia are generally quite modest. Unless the crisis results in an interruption of Russian energy supplies to the region, we think the impact on Central European growth will be correspondingly limited. The outlook for core Europe, where we expect a modest acceleration in growth in the second half, remains more important.

Polish exports: Russian weakness offset by Germany

-20

-10

0

10

20

30

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

Exports by destination YoY% (3mma)

Germany

Russia

Note: in absolute terms, Polish exports to Germany are 5-6 times larger than exports to Russia


The loss of momentum elsewhere in EMEA mostly reflects a range of idiosyncratic factors, including: strikes in South Africa; the strong shekel and conflict with Hamas in Israel; and earlier monetary tightening in Turkey. The impact of these factors should start to fade in the coming months.

Idiosyncratic factors have been also at play in Latin America. For example, Argentina´s recent handling of technical default is inevitably pushing the economy into a deeper and more prolonged recession than initially estimated. Likewise, a comprehensive tax and education reform is still being discussed in Chile, adding significant uncertainty on the downturn of the economic cycle. Furthermore, limits to growth under current policies have been confirmed in Brazil and Venezuela without yet promoting any change in the macroeconomic strategy.

However, Latin America has been also suffering the end of the commodity bonanza. While external demand has been recovering since late last year, stable or declining terms of trade appear to be affecting aggregate investment much more than in the past. Cheap unit labor costs and low credit penetration are no longer available to foster rapid investment growth in the region. On the contrary, uncertainty about the outlook for terms of trade together with an increased public burden on private business in some countries seems to be exacerbating investment retrenchment.

Some hope remains for the year ahead nevertheless. Brazil´s election this year and Argentina´s in 2015 constitute good opportunities for potential improvement in policy making while Chile´s tax uncertainty should be fading away in the next few months. And Mexico´s reform and strong US link should eventually provide a fertile ground for stronger growth in the country.

11 September 2014



Beyond the ongoing crisis in Russia and Ukraine, the main political event in EM will be next month’s Presidential elections in Brazil. The tragic death of candidate, Eduardo Campos, in a plane crash in August has upended the campaign. Campos has been replaced by his Vice Presidential candidate, Marina Silva, who has risen in the polls and now poses a much bigger threat to President Dilma Rousseff’s re-election than the PSDB’s Aécio Neves. While Marina’s market-friendly program has buoyed Brazilian asset prices, there is still a long way to go until election day, and the presidential race remains wide open in our opinion.

Brazil: polls suggest election is too close to call

0%

10%

20%

30%

40%

50%

Feb 14 Apr 14 Jun 14 Aug 14

First round poll rating

Dimla Rousseff (PT)

Eduardo Campos / Marina Silva (PSB)

Aécio Neves (PSDB)

Source: Datafolha, Deutsche Bank

Struggling to perform

After a benign interlude, EM assets have again underperformed global markets over the past month. This performance has been characteristic of what we believe to be an adverse combination of limited intrinsic value (besides carry) and negative skew to global risks. The latest manifestation of these global risks has been the realignment across major currencies triggered by ECB’s QE. The ensuing USD strength has weighed heavily on local markets as the chart below shows. As balance sheet changes of this magnitude tend to underpin persistent realignments across assets, USD strength seems likely to weigh further on EMFX, which – in combination with overall reduced local yields – limits the upside for local markets, in our view.

We believe that Asia is better positioned to absorb these shocks as the two big elections in the region have delivered mandates for change and growth, external imbalances have been reduced, and policymakers have also shown more resolve. EMEA valuation seem particularly unappealing to us when compared with LatAm, but adverse positioning in LatAm may also delay retracement. As we move closer to elections in Brazil, however, the prospect of policy

changes may create attractive opportunities across FX, rates, and equity markets.

Although we find Asia better prepared to deal with USD strength, we favor euro and yen funding and intra-EMFX trades that build on policy divergences rather than – still relatively weak – regional trends. We favor long MYR and PHP vs. EUR, CNH vs. KRW, INR vs. SGD, PLN vs. HUF, and TRY vs. ZAR. As short euro proxies, we recommend long MXN and BRL vs. HUF and CZK. Buy BRL via options.

Despite reduced yield differentials across EM, we recommend holding spread compression trades vs. US in Mexico, Chile, and Singapore (but spread wideners in Czech Republic). We also continue to favor long real rates in Brazil and Mexico, long the belly in Malaysia, and bonds in Poland, and India. Hold front-end steepeners in Mexico, Chile, Hungary, and steepeners in South Africa, Turkey and Korea.

Performance: EMFX bears the brunt of adjustment

-9% -6% -3% 0% 3% 6% 9% 12% 15%

EM Eq

S&P

UST (10-15Y)

EU Eq

DB-EMLIN (hedged)

IG

EMBI-G

HY

EMFX (Total Return)

DB-EMLIN

EMFX Spot

Com'dty

Since end of June

Over the past yearReturns of various asset classes

18.5%

Source: DB Global Markets Research, Bloomberg Finance LP.

In sovereign credit, the recent performance of the overall index has been dragged down entirely by the idiosyncratic problems within the high-yielders, as well as in Russia. Underneath, there have been pockets of strength supported by valuation and technicals. Over the near term, we believe the environment will continue to support the outperformance of mid-beta credits in general, such as Turkey and Hungary, due to carry and scope for further spread compression. Otherwise, we focus on country differentiation and relative value. The dynamics in Argentina and Venezuela – oftentimes the main sources of superior returns when yields are elevated - remain negative, in our view. In relative value, we favor cash curve steepeners (especially in Indonesia and South Africa) and basis tighteners (especially in Turkey and Venezuela).

11 September 2014



EMFX: An idiosyncratic sideshow EMFX remains the weakest link across EM assets. After being battered by EM specifics in Q1 and US rates throughout the recent years, EMFX has been hit by the surge in the USD (or the fall of the euro, pound and yen) that gained momentum in mid-August. A trade-weighted basket of EM currencies vs. the USD is now hovering near the lows of end-January (over 3% down) while the DXY index is almost 6% stronger since the beginning of July. While the outlook for the pound is more binary, DB expects outflows to push the yen lower and the euro to continue to slide as compressing yields incentivize capital flight. Accordingly, we focus on yen and euro as funding currencies in additional to our intra-EM relative-value.

Within EM, long LatAm vs. CE3 FX is the natural vehicle to express short euro trades. The charts below show betas, carry, and “valuation” for selected EM crosses1. As expected it suggests long BRL vs. HUF and CZK (high carry and beta) and also long MXN/HUF (lower carry). Although PLN could also be used for funding despite lower carry and beta, we fundamentally prefer PLN vs. HUF and also CZK and thus pick the latter for funding. In addition to their positive carry and betas, most of these crosses have lagged the recent move in EUR/USD as the bottom panel shows.

While country-specifics remain important, overall EM fundamentals continue to provide little support for EMFX. Looking beyond Asia, recent data have been soft and most central banks maintain a dovish bias – either because of low inflation (as in CE3 and Israel) or because of their emphasis on economic weakness. Accordingly, we keep a bearish view on ILS (vs. USD) as we believe the BoI may introduce a USD/ILS floor. We also recommend keeping long PLN/HUF as our view on monetary policy diverges from what is priced. We also prefer long TRY/ZAR as carry is positive, inflation keeps the CBT on hold, and South Africa’s CA renders the ZAR vulnerable.

In LatAm, BRL will likely be in focus over the next month as we gear up to the first round of elections. In our view, the currency has lagged the repricing in local rates and credit and – despite competitiveness limitations over the longer haul – the potential unwinding of hedges, speculative positions, and equity inflows bode well for BRL longs into the likely second round of vote. Elsewhere, we believe that COP is in overshooting territory (as, in our view, net inflows remain positive and the economy is poised to

1 The “valuation” metric is simply the residual of a regression in levels vs.

EUR/USD since the beginning of the sell-off and the crosses are selected

according to the significance of the regressions (excluding R-squares

below 70%).

outperform) and see USD strength as MXN positive – barring an outright hawkish FOMC statement.

EM proxies for euro weakness

BRLCZK

BRLHUF

BRLPLN

TRYHUF

ZARCZK

TRYPLN

ZARHUF

ZARPLN

MXNCZK

MXNHUF

MXNPLN

30%

40%

50%

60%

70%

80%

90%

100%

110%

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0%

beta to EUR/USD (since the beggining of the selloff)

FX carry (3 months)

-2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0%

BRLCZK

BRLHUF

BRLPLN

TRYHUF

ZARCZK

TRYPLN

ZARHUF

ZARPLN

MXNCZK

MXNHUF

MXNPLN

ILSCZK Rich(-)/Cheap(+)

Carry

underperfomedUSD strength

outperfomed USD strength

Source: DB Global Markets Research, Bloomberg Finance LP

Risks: DB’s baseline rangebound view on UST and positive outlook on US equities support carry trades vs. the EUR still, but we doubt EMFX will gain traction before G3 FX subsides. Moreover, as the chart below shows, euro funding is unable to eliminate negative betas vs. UST and equities, which thus remain important risk factors to bear in mind – especially for higher carry pairs as the chart indicates.

11 September 2014



Assessing risk for short EUR/EMFX

EUR/BRL(3%)

EUR/RUB(2%)

EUR/IDR(2%)

EUR/ZAR(2%)

EUR/INR(2%)

EUR/COP(1%)

EUR/CLP(1%)

EUR/MXN(1%)

EUR/PLN(1%)

EUR/KRW(1%)

EUR/HUF(%)

EUR/SGD(%)

EUR/ILS(%)

EUR/ILS(%)

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

-100% -80% -60% -40% -20% 0% 20% 40% 60%

beta to S&P

beta to US10s

EUR/EMFX betas (3m carry)

Source: DB Global Markets Research.

Asian currencies are better positioned to withstand the realignment in global FX and ripple effects from a possible change in FOMC statement. In addition to reduced external imbalances and geopolitical risks, policymakers have been more forceful. Malaysia and Philippines have hiked rates, and will likely do so again, while India and Indonesia have shown their intent to keep policy tight until internal and external imbalances ease. Although this may not suffice to overcome USD strength, we expect Asia FX to outperform European FX (EUR, CHF, EMEA) and JPY. We recommend long MYR and PHP versus EUR; and favor long INR vs. SGD for carry, and long CNH vs. KRW on relative FX policies as these crosses also have low USD beta. We stay long USD versus IDR and SGD (via digital calls).

Asia: Buy CNH/KRW (target 176); USD/CNH put spreads; 6M USD/IDR (target 12,300). Buy MYR and PHP versus EUR and USD/SGD via 1.2750 digital calls. Short 6M SGD/INR (target 46).

EMEA: Long PLN/HUF (target 78.50), long TRY/ZAR (target 5.015), long USD/ILS (target 3.70).

LatAm: Long BRL and MXN vs. HUF and CZK (target 17.95 on the 50/50 basket). Finance a 1M USD/BRL put struck at 2.29 with a 2-week USD/BRL strangle (2.20, 2.30). Buy a 1M USD/COP put struck ATMS at 1.3%. Finance a 3M USD/MXN put struck 1% OTMS (with RKO at 12.50) with a 3M USD/HUF put struck at 231.

Local rates: Diminished opportunities We still see some pockets of value across EM rates, but the yield differential vs. US has compressed substantially over the past six months. In real terms (nominal rates deflated by inflation expectations), the yield of our market-weighted index of 14 accessible local bond markets has compressed by about 150bp vs. US TIPS of similar duration and – at around 2.7% - it is trading closer to the lows post-crisis. As the chart below, the differentials remain substantial in some

lower-risk curves such as Poland and Colombia and in higher-risk ones such as Brazil and Russia. Among the latter, however, we prefer to focus on Brazil where the prospect of changes in the conduct of monetary and fiscal policies seems underpriced. In addition, NTNBs will likely benefit from inflation staying high (for supply reasons) in 2015. Although the chart suggests that real rates are “fair” (vs. credit spreads) in Mexico, we recommend keeping exposure to MUDI40s as H2 inflation accelerates, the curve is steep, and the prospect of long-term (real) MXN appreciation remains intact, in our view. In Asia, we favor direction longs only in China and India, while, in EMEA, we favor 5Y-10Y Polish bonds.

EM-US real interest rate differentials: Pockets of value

BR

CL

CO

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.

Although we believe that ECB QE will have positive spillovers into EM and short-term weakness in activity will keep EM CBs on the defensive, markets seem to underestimate the pace of normalization beyond 2015. The chart below shows carry and UST betas across selected front-end steepeners. With few exceptions, they are positive carry and also positive beta to continued repricing up in US yields. This benefits our view that neutral rates in EM are not generally as low as priced and that delayed tightening would require catching up later on.

In LatAm, this means keeping front-end steepeners in Mexico and Chile. In EMEA, we find valuations particularly unappealing, but avoid outright payers while ECB balance sheet expands aggressively and soft data delays central bank action. We favor instead positive carry implementations that would also benefit from a gradual move up in US rates as normalization proceeds. This bodes for 1s2s IRS steepeners in Hungary and 1Y vs. 5Y5Y IRS steepeners in the South Africa. Carry and valuation support butterfly receivers in Israel, while in Poland we believe that markets price in too dovish a monetary policy path. In contrast, we believe that the bias in Turkey is for more easing than priced and recommend steepeners in XCCY.

11 September 2014



Front-end steepeners: Carry and beta to US10s

CZK (30%)

HUF (87%)

PLN (82%)

ILS (86%)

ZAR (85%)

MXN (71%)

COP (58%)

CLP (26%)

TRY (10%)

RUB (4%)

KRW (87%)

INR (3%)

USD (66%)

EUR (13%)

-4

-2

0

2

4

6

8

10

12

-0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Carry (bp,3M)

Beta (vs US10s, 2Y hist)

Source: DB Global Markets Research - 1s3s steepeners.

In Asia, we also recommend steepeners in KTB, but would look to buy 10Y Thai bonds on weakness and also see value in the belly of the Malay curve. Although yield differentials have compressed, we still see fundamental room for spread compression in Singapore, Mexico, and Chile versus the US. In contrast, valuation suggests swap-spread wideners and a short position in 10Y government bonds in Czech Republic vs. Poland/Germany.

Asia: In India, long 10Y IGBs, (target 8.25%); in Malaysia, receive 2s5s10s fly; receive SGD 2Y3Y IRS versus USD, (target +75bp); pay 3Y/10Y KTB steepener (target +80bp); long 10Y Thai GB on back up to 3.60%

EMEA: Pay 6x9 PLN FRAs (target 2.5%) and/or stay in 2s10s PLN IRS flatteners, (target 55bp); enter long (belly) via ILS 1Y:2Y1Y:5Y5Y (target 100bp). Receive 3x6 HUF FRAs (target 2.05%); 1s2s HUF IRS steepeners, (target 40bp). Enter swaps-spread wideners in CZK, being short May-24 (target +40bps). Buy ZAR 1Y vs. paying 5Y5Y (target 3.25). Pay 2Y RUB XCCY (target 9.00), and enter 1s5s TRY XCCY steepener (target 50 bps).

LatAm: In Brazil hold long NTNB 22s (targeting 5.0%). In Mexico maintain MUDI 40s (target 3.0%) and front-end steepener vs. the US (1Y3M vs. 2Y1Y, target 30bp). Hold 1s3s steepener (target 50bp) in Chile, and TES 16 (target 4.5%) in Colombia. Maintain TES 24s vs. paying IBR 1Y (target 1.75%, stop 2.05%). In Peru, keep Soberanos 23s (target 4.9%).

Credit: focus on carry and differentiation The spread of DB-EMSI index has widened by about 35bp over the past two months, thanks in large part to the risk-off episode in early August. We have maintained our constructive view throughout the summer, including that particular period of volatility, as we believed the weakness then was mostly driven by

technical and some temporary factors. At the same time, we also expressed a bearish view on a few idiosyncratic developments, most notably the geopolitical conflict in Russia/Ukraine and the unsettling debt situation in Argentina.

The widening of spreads, however, was more than fully attributed to the selloff in the high yielders (Venezuela, Argentina, and Ukraine) as well as Russia, as shown in the graph below. Together, these four credits make up of 22% of DB-EMSI and contributed over 50bp to the widening of the index.

DB-EMSI sub-index spread changes over the past two

months

-200

-100

0

100

200

300

400

500

EC

SV ID ZA

HU

EG

CL

LB

PH

PA

TR

UY

PL

BR

CO PE

MX

RU

UA

AR

VE

DB-EMSI Sub-index Spread Change, Since 10-July-2014


In addition, outside these “problem credits”, higher-spread sovereigns (e.g. South Africa and Indonesia) have clearly outperformed the low-spread ones (e.g. Poland and Mexico), as shown in the graph below.

DB-EMSI sub-index spread changes since 10-July vs.

spread levels

ZA

PE

ID

UY

TR

PA

HU

BRPL

CLPH

MX

CO

-25

-20

-15

-10

-5

0

75 100 125 150 175 200 225

Spread change sine 10-July

Spread level as of 10-July


The summer is over, but its themes are likely to carry on. The external backdrop – in terms of global monetary conditions – remains supportive, with

11 September 2014



prospects of ECB QE and likely range-bound USTs over the near term. Valuation, while not cheap, is certainly not stretched – especially relative to the core markets2. Technicals, while no longer in a “sweet spot”, remain strong, with moderate outflows seen in August likely proven to be temporary, positioning lightened, and primary market supplies likely to be (unusually) subdued in September and also remainder of the year (see chart below).

EM sovereign issuance plans for 2014 are almost fully

undertaken (according to our projections)

Source: Deutsche Bank, Bloomberg Finance LP

On the other hand, a number of idiosyncratic factors continue to be unfavorable. We remain skeptical about the durability of the current “ceasefire” in eastern Ukraine, and biased to adding hedges on strength. We remain bearish on Argentina – an early 2015 settlement is no longer our baseline – and believe the bond prices, after the some correction incurred during August, are still too high. We have also turned bearish on Venezuela following the removal of Mr. Ramirez from his economic duties, which, in our view, would mean more policy uncertainty and less economic adjustment going forward. The intensified efforts by the government to divest CITGO also sent a negative signal.

Outside of these “problem credits”, we remain generally in favor of those curves featuring a higher spread for better carry as well as greater scope for spread compression and, accordingly, we stay overweight Turkey and also increase to overweight South Africa. We disfavor credits with very tight spreads, such as Mexico and Poland, despite their good fundamentals. Among low-beta names, the only overweight we maintain is Colombia.

2 EM benchmarks remain at +60bp over 2013 tights, while both global HY

and IG spreads are already significantly tighter than any time in 2013. EM

sovereign BBB spreads are now at +30bp vs. the core markets, while EM

corp BBBs are +70bp on top of that.

In relative value, we believe EM cash curves are generally still too steep; we specifically favor 10s30s flatteners in South Africa and Indonesia. We also expect CDS/bond basis to tighten from historically wide levels on a few curves, and find the most attractive short basis opportunities in Turkey and Venezuela.

Summary of recommendations:

Overweights: Turkey, Hungary, Colombia, and Mongolia (the latter in the Asia credit portfolio)

Underweights: Argentina, Venezuela, Russia, Poland

Inter-country RV: Buy Brazil 5Y CDS vs. Colombia

Basis trades: Short basis in Venezuela (5Y CDS vs. 22s), short basis in Turkey (10Y CDS vs. 25s), and long basis in Russia (30s vs. 5Y CDS)

Cash curve RV: Long 41s vs. 25s in South Africa; Long 37s vs. 19s in Indonesia; Long 24s vs. 19s in Poland.

Select longs or shorts: Long PDVSA 15s and 37s, and Mongolia 18s. Short Argentina USD Discounts. Buy China 5Y CDS.

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

Hongtao Jiang, London, +1 212 250 2524

11 September 2014



Brazil: Marina Silva Changes Election Dynamics

The tragic death of PSB candidate Eduardo Campos in August has upended Brazil’s presidential election. Marina Silva, Campos’ replacement, has become President Dilma Rousseff’s main contender and seems to pose a much bigger threat to the continuation of a PT government than the PSDB’s Aécio Neves.

Marina Silva has signaled that she would pursue market-friendly economic policies if elected, hence the positive market reaction to her rise in the polls.

While the latest polls show Marina Silva slightly ahead of President Rousseff in a runoff, the election is still a long way off. The incumbent president has enormous resources at her disposal, and the election remains wide open in our opinion.

A sea change

The tragic death of presidential candidate Eduardo Campos in a plane crash on 13 August 2014 has upended Brazil’s presidential election. Campos has been replaced by his running mate, former senator Marina Silva, who had decided to support him and join the Brazilian Socialist Party (PSB) only as a last resort after failing to found her own party (“Rede Sustentabilidade”) last year. The makeshift alliance between Marina’s group and the PSB has been far from smooth, in particular due to strong disagreements about the regional alliances forged by Campos with other parties. Nevertheless, after losing its main star, the small PSB party lacked any candidate who was as nearly as popular as Marina, and therefore appeared to have no option other than supporting her candidacy. The PSB appointed its Lower House whip Beto Albuquerque as Marina’s running mate, consolidating the alliance.

Key election dates

19-Aug Beginning of advertisement on radio and TV

2-Oct Last day of advertisement on radio and TV

5-Oct First-round vote

11-Oct Beginning of advertisement on radio and TV for the second-round vote

24-Oct Last day of advertisement on radio and TV for the second-round vote

26-Oct Second-round vote

Source: Tribunal Superior Eleitoral (TSE)

Having served as former President Lula’s environment minister between 2003 and 2008 and run for president in 2010 for the Green Party (finishing third with 19.3% of the vote despite having very little time on the mandatory TV campaign), Marina was more widely known than Campos, whose popularity was still concentrated in the state of Pernambuco, where he

had served as governor. A steadfast environmentalist, Marina is perceived by voters as an unconventional politician who benefits from the frustration with traditional politics embodied in the massive anti-establishment demonstrations staged in June 2013, and from the widespread demand for changes in the political system captured by the opinion polls. In a charged political environment, Marina has risen as a “third way” capable of breaking the usual polarization between the PT and the PSDB.

Presidential polls (first-round vote)

0

10

20

30

40

50

60 D. Rousseff (PT)

A. Neves (PSDB)

E. Campos/M. Silva (PSB)

%

Source: Datafolha

Presidential polls (second-round vote)

49

4748

45

43

4041

43

32 32

35

38

47

50

4847

25

30

35

40

45

50

55

D. Rousseff (PT)

M. Silva (PSB)

%

Source: Datafolha

Marina’s candidacy has caused an earthquake in the presidential race. While Campos had been stuck in the polls with approximately 9% of the vote, she immediately jumped to 21% in one of the first polls conducted after her nomination, and rose further to 34%, as she gained votes not only from the other candidates, but also from voters who had been previously reported as undecided. Moreover, the polls quickly indicated that, for the first time, Rousseff was no longer the favorite to win the second-round vote, as

11 September 2014



Marina was forecast to beat her by 48% to 41% (according to the Datafolha poll conducted on September 3). Since then, Rousseff has been able to recover some ground – probably due to her TV ads and intense criticism against Marina leveled by her opponents and the local press – but remains technically tied with Marina in the second round simulations. According to the latest Datafolha poll published on September 10, Rousseff led the first-round vote with 36%, followed by Marina with 33% and Neves with 15%. In the second round, Marina led Rousseff by 47% to 43%, a technical tie given the poll’s 2% margin of error.

Despite the decline in support for President Rousseff, opposition candidate Aécio Neves (PSDB) has been the main loser, as he has lost several points to 15%. Running against Aécio Neves in the runoff, Rousseff would beat him 48% to 40%, according to Datafolha. Marina Silva seems to be a bigger threat to Rousseff than Neves not only due to her “third-way” allure, but also because it is harder for the Workers Party (PT) to criticize a former party member 3 who served as President Lula’s minister (at some point, Lula even stated that Marina was his most important minister, comparing her to the famous football player Pelé). Voters who benefit from the welfare programs introduced and expanded by the PT and fear that the new government could trim them are also probably more comfortable voting for Marina than for Neves, given her political background.

Time of TV advertisement before the first round

46%18%

8%

5%

4%4%3%

12%D. Rousseff (PT)

A. Neves (PSDB)

M. Silva (PSB)

Pastor Everaldo (PSC)

E. Jorge (PV)

L. Genro (PSOL)

L. Fidelix (PRTB)

Others

Source: TSE

In our opinion, however, despite Marina’s meteoric rise, the election remains wide open, as President Rousseff has more resources than the opposition candidates. In addition to benefitting from being the incumbent president, Rousseff has almost as much air time on TV as all the opposition candidates combined before the first-round vote. While the TV time advantage will disappear in the second round (as the two candidates

3 Marina Silva was a member of the Workers Party (PT) from 1986 to 2009.

will have the same time allotment), Rousseff’s campaign should still benefit from ample financial resources and the support of a large party coalition. Moreover, despite the latest negative news on GDP growth, the polls have shown an incipient recovery in Rousseff’s approval ratings and a decline in her rejection rate, probably reflecting persistently low unemployment, the seasonal decline in inflation, and, in particular, the TV campaign.

President Rousseff’s approval ratings

0

10

20

30

40

50

60

70

Good/very good

Regular

Bad/very bad

%

Source: Datafolha

It is not clear whether the latest scandal involving government-owned oil company Petrobras will affect Rousseff. A former Petrobras director, currently in jail, has agreed to testify in exchange for a reduced sentence, and has allegedly told the Federal Police that several politicians of the ruling coalition earned a 3% kickback on every contract signed by the company under his supervision between 2004 and 2012, during the PT administration. However, given that the accusations have not yet been corroborated by evidence, and the allegations also involve the late Eduardo Campos (thus potentially affecting Marina Silva as well), it remains to be seen whether the scandal will influence voters.

It is also important to bear in mind that there is still a long way to go before the first-round vote on October 5 and the second-round vote on October 26, so there is plenty of time for changes to occur. We note, for example, that in the 2002 elections, candidate Ciro Gomes (of the PPS party then) staged an impressive rally and appeared as a viable alternative to the PT-PSDB polarization, until he made some controversial comments that led to a fast collapse in the polls.

Marina Silva’s rise in the polls has buoyed Brazilian asset prices, on expectations that she could support market-friendly policies if elected. This perception is reinforced not only by the candidate’s rhetoric, but also by her team of advisors, which includes economists with strong credentials such as Professor Eduardo Giannetti and André Lara Resende, one of the

11 September 2014



architects of the Real Plan. Marina has pledged to restore the so-called “three pillars” of macroeconomic policy, namely fiscal discipline, inflation targeting, and a floating exchange rate regime. Her proposals are not only similar to Aécio Neves’s economic program, but she went even further by pledging to introduce formal bank independence (instead of just informal operational autonomy), and establish a “Fiscal Responsibility Council” to oversee adherence to the fiscal targets with improved transparency.

Polls ahead of the 2002 presidential elections

5

15

25

35

45 Lula (PT)

Gomes (PPS) Serra

(PSDB)

Garotinho (PSB)

%

Source: Ibope

Economists have raised several questions about a possible contradiction between Marina’s pledge for fiscal austerity and her proposal to extend some public services and social programs. Such plans would include, for example, raising the number of recipients of the Bolsa Familia welfare program to 24mn from 14mn families, increasing public healthcare spending to 10% of GDP, and doubling the number of homes to be built under the Minha Casa Minha Vida program to 4mn in four years. Total extra spending could reach as much as 3% of GDP. Marina’s economic advisor Giannetti claims that the increase in spending would be conditional on fiscal performance, which would depend on economic growth, tax revenues, and a reduction in wasteful subsidies. Even so, it would not be politically easy to adjust the level of expectations created by Marina’s program to the fiscal reality.

Marina’s seemingly market-friendly agenda might have important implications for administered prices (esp. of fuel and electricity), as her advisors have signaled that they would quickly adjust them. An increase in gasoline prices – which have been lagging international prices for a long time – would also be consistent with Marina’s environmental principles, as artificially low prices stimulate the demand for automobiles vis-à-vis public transportation and contribute to increase pollution. On the other hand, the candidate’s pro-environment stance has raised some concerns about

the pace of investments in the oil sector, and potential delays of infrastructure projects due to a convoluted environmental licensing process. Farmers also worry that Marina’s environmental priorities could hurt production, although the candidate is making a strong effort to dispel the notion that she has an inherent prejudice against the agricultural sector.

The main risk of a Marina Silva government, however, could be the lack of congressional support. One of the reasons behind Marina’s high popularity is her aversion to the traditional Brazilian political system whereby the president obtains support in Congress by distributing positions in the federal administration to allied parties. Since the PSB currently has only 24 representatives in the Lower House (out of 513) and 4 senators (out of 81), it would be particularly difficult for Marina to govern without a broad alliance of political parties. Lack of support in Congress would not only obstruct approval of the important structural reforms listed in Marina’s program (political, administrative, labor, tax reforms), but also increase the risk of measures introduced by lawmakers that could hinder the federal administration (by raising mandatory expenditures, for example).

Reacting to criticism about the lack of political support, Marina Silva has stated that, if elected, she would like to work with the best politicians of all parties. Her economic advisor Eduardo Giannetti has even claimed that she would like to work with former presidents Fernando Henrique Cardoso (PSDB) and Lula (PT), who are political enemies with diametrically opposing views. However, we think it is more likely that, if elected, Marina will have to choose one of these parties to build an alliance in Congress (on top of the PMDB, the flexible second largest Brazilian party that joined the coalitions that supported both the PSDB and the PT governments).

While Marina’s economic agenda puts her very close to the PSDB, her political background suggests a better match with the PT, so it is not clear which path she would choose. An alternative – strongly emphasized in the PSB program – would be to include in the political reform a model of “participative democracy,” where the population would be asked to participate in the decision making process through plebiscites and referendums. We believe, however, that such model would be very hard to implement and face strong resistance. As an example, a decree recently enacted by President Rousseff instituting “popular councils” that could influence the federal agencies’ decisions, which has a strong flavor of “participative democracy,” has faced enormous criticism from the local press and resistance from Congress.

José Carlos de Faria, São Paulo, (+55) 11 2113-5185

11 September 2014



What explains disappointing Asian exports?

We examine the weaker-than-expected outturn in

Asia’s exports this year.

There has been a striking breakdown in the relationship between Asia’s exports and demand indicators in the US/EU. Our previously successful export model is presently yielding the largest forecast error in its 15-yr history.

Some of the forecast error could be due to the sharply lower than expected Q1 US GDP outturn, but we think three more crucial factors are play in the industrial economies: (i) unusual contrast between weak consumer demand and strong profits, (ii) a modest rise in import substitution, and (iii) rising trade restrictions. These headwinds will likely persist for a while, posing risks to our Asia forecasts.

Delving deeper in this issue, we summarize that: (i) there is some evidence that surveys like PMIs have been more optimistic than actual data in this cycle; (ii) with a few exceptions, developments in the US matter more for Asia than in the EU; (iii) while trade has lost momentum, Asia’s share of global trade continues to rise; (iv) changes in the nature of the regional value chain may explain some of the data anomaly; (v) India, not a major part of the regional value chain, relies more on EU demand than any other country in Asia; (vi) China’s domestic demand slowdown is an additional factor explaining the disconnect.

Exports headwinds likely to persist

We have long been used to looking at external demand as a major driver of Asia’s growth outlook. Historically this has made forecasting Asia’s growth largely a function of getting industrial country demand right. Most Asian countries have grown by a multiple of US/EU growth in recent decades. The reason for the strong multiplier is straight-forward; a pick-up in orders in the industrial countries have readily translated into exports for Asia, which has in turn tended to boost income and investment.

2013 ended on a bright note for Asia, as PMIs in both the US and EU began gathering strength. Bad weather in the US followed, causing a sharp contraction in activity, although the bounce-back in Q2 was strong, and the economy has continued to gather momentum since then. It was therefore reasonable to expect a strong export-led growth recovery in Asia by now.

Unfortunately that has hardly been the case. Data through July show only small pockets of strength, with

the region as a whole exporting much less than expected.

An exceptionally weak export cycle

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

2001 2003 2005 2007 2009 2011 2013

US PMI (new orders) EU PMI (new orders)

Asia exports, right yoy

Source: CEIC, Haver, Deutsche Bank

Indeed, a regression of Asian exports on US and EU PMI show the largest forecast error in 1H2014 in the sample (with data going all the way back to 2000). We have tinkered with the model to see if changing the lag structure of the independent variables improve the fit or capture a break, but have not found anything compelling. Regardless of how one models the relationship, the new disconnect between US/EU demand and Asian exports seems be firm.

Initially our suspicion was that the dislocation was simply due to the surprise US contraction in Q1, which was clearly not anticipated by the PMIs. But data from Q2 and beyond have not rebounded sufficiently to satisfy us. Something deeper seems to be at play.

Wide gap between predicted and actual exports

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

2000 2002 2004 2006 2008 2010 2012 2014

Actual Predicted%yoy


11 September 2014



Largest forecast error in the history of the model

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

2000 2002 2004 2006 2008 2010 2012 2014


We think three additional factors are behind this disconnect:

First, as widely reported, the recovery in the US has been accompanied by unusually weak labor market conditions. The unemployment rate has declined, but some of that is has been due to a large rise in discouraged workers. A large pool of contract workers has emerged, with far less sense of job security than permanent hires. This, in combination with tightened bank lending conditions, in turn can lead to lower incentive to consume. In contrast, corporate profit has surged with wage and input price pressure muted as well as the cost of financing at historic lows. Consequently PMI gauges have picked up, but without the typical boost for employment, income, and consequently consumer demand for goods. Strikingly, average weekly earnings growth lagged inflation during 2011-13. The situation is even worse in the EU. As long as labor market weakness persists, Asian exporters will struggle to find the type of eager buyers of the past.

Second, US manufacturing has rebounded, leading to some degree of import substitution. In a notable development, US industrial production growth since 2011 has been about a 100bps higher than seen in the first half of last decade. Surging shale gas and oil production has reduced imports, lowered energy costs, and revitalized long dormant segments of manufacturing. This phenomenon is not going to threaten large chunks of Asian exports given the sustained comparative advantage and economies scale enjoyed by the region’s manufacturers, but nevertheless this marks a notable reversal of a multi-decade trend of production off-shoring.

Emergence of Mexico as a major hub of manufacturing destined for the US is also a contributing factor. Asian auto manufactures have moved parts of their production capacity to Mexico in recent years. It is

estimated by Business Insider Magazine that Mexico will export 1.7mn cars to the US in 2014, while Japan’s auto exports to US will be 1.5mn. Auto exports from Japan and Korea will likely decline in the coming years as more manufactures use Mexico as their production base.

Third, global trade growth has been anemic in the aftermath of the global financial crisis. While Asia’s share of global trade has continued to rise, the stagnant trade environment suggests little scope for vigorous exports growth.

After a short post-crisis rebound, export value growth

has been well below-trend

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

2005 2006 2007 2008 2009 2010 2011 2012 2013

World Asiayoy

Source: UNCTAD, Deutsche Bank

Export volumes are barely growing

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

World Asiayoy

Source: UNCTAD, Deutsche Bank

What explains the anemic trade environment? While it may be tempting to explain it away simply as function of the hangover of the global financial crisis and below-trend growth in the aftermath, a more ominous explanation is available. According the trade monitors of WTO and UNCTAD, there has been a marked rise in trade restrictions in recent years. In its latest report of trade measures, the WTO points out that the vast

11 September 2014



majority of trade-restrictive measures taken by G-20 members since the onset of the global financial crisis remain in place. 1185 trade-restrictive measures have been recorded since late 2008, and only a fifth of these had been removed by May 2014. Even since the beginning of this year, G-20 members put in place 112 new trade-restrictive measures. As has been the case lately, the number of trade-restrictive measures applied by G-20 members during this period exceeded the number of liberalizing measures. Rising protectionism is an unambiguous negative for Asia’s exporters.

Will any of these headwinds disappear soon? We doubt it. As the Fed Chairperson Yellen pointed out at her address in Jackson Hole last week, ongoing shifts in the structure of the labor market and the possibility that the global financial crisis has caused persistent changes in the labor market’s functioning will continue to act as brakes to employment and income. Import substitution may rise in the near term, and there is little sign of trade restrictions abating. Our Asia forecasts, driven heavily by US/EU demand, could therefore be at risk.

Delving deeper

The thesis presented above, published as a note a few weeks ago, received a number of comments and questions, forcing us to go deeper into country-by-country data and industry trends, as well as look closely at the role of China in this narrative. Below we go over six popular queries.

Would replacing survey readings with actual data improve the fit of the exports equation?

This question stems from the view that surveys have been too optimistic in this cycle. We explore this hunch by replacing US and EU PMI with industrial production in our Asia exports regression. We find that over the 15 year time-span of the regression model, PMIs offer a better fit, except in the past year or so, during which period the model with IPs is superior in tracking Asian exports.

This corroborates the view about surveys being too optimistic in this cycle, perhaps reflecting the atypical natural of the recovery, where profits have not materialized into a commensurate pick-up in employment or income. Hence managers have turned optimistic long before their employees have.

Note however that even after replacing the PMIs with IP data, the forecast error remains exceptionally large.

Historically PMIs have been better than IP in gauging

Asian demand, but not in the past year

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

2000 2002 2004 2006 2008 2010 2012 2014

Residual-PMI Residual-IP


Is Asia a higher beta to the US or EU?

From a purchasing power perspective of Asian goods, both the US and EU are almost equal blocks. Remarkably, in our regression, the coefficient estimates on the US and EU PMIs are almost identical, 0.76 and 0.73. In this cycle however, with the US recovery leading that of Europe substantially, whatever upside that has been for Asia’s exports have stemmed mostly from the US. Drag from the EU is considerable, while on the margin the US still matters more. Below we summarize the US and EU weights in country-by-country regressions, which show that for a number of countries (surprisingly, in addition to the Philippines, the list includes highly open and trade dependent economies like Singapore, South Korea, and Taiwan), EU does not even feature in the model in a statistically significant manner.

Export regression coefficient estimates

US EU

China 0.84 ** 0.83 **

Hong Kong 0.70 ** 0.34 **

India 0.77 ** 1.29 **

Indonesia 0.78 ** 1.19 **

Malaysia 1.12 ** 0.48 **

Philippines 1.26 ** -0.10

Singapore 1.19 ** 0.14

South Korea 1.32 ** 0.11

Taiwan 1.97 ** -0.27

Thailand 0.56 ** 0.96 **

Model: exports (t) = c + a*USPMI (t-6) + b*EUPMI (t-6) +e Source: CEIC, Haver, Deutsche Bank. * and ** denote statistical significance at 5% and 1% levels, respectively.

11 September 2014



With weaker than expected growth and signs of import substitution in the US, has Asia’s share of global trade begun to shrink?

Looking at data reported by WTO-UNCTAD, we find Asia’s position in global trade intact. Although the annual value of world trade seems to have hovered around USD18trln in recent years (since 2006, global trade value has grown by an annual rate of just 2.8%), Asia’s share of global trade actually rose from 33.5% to 35.6% during that period.

Exports may not be growing vigorously for Asia, but that’s true for the rest of the world as well. On a relative basis, Asia remains the world’s trade hub. With respect to import substitution in the US, the trend is exceptionally new and marginal.

Is the regional supply chain going through a structural shift?

The answer is yes, always. The electronics exports sector, Asia’s core strength, is highly dynamic, with industry trend, shifts in demand, and evolution of technology causing the supply chain to evolve. Chinese manufacturers continue to move the up the value chain, importing less electronics parts from South Korea and Japan, for instance, while at the same time some lower value-added Chinese manufacturing is moving to Indonesia, Vietnam, and other ASEAN economies.

We are however skeptical if such shifts can change Asia’s export dynamic in a profound manner. Since the shifts are typically intra-regional, they should not affect aggregate data. Moreover, the shifts are taking place on a continual basis, and there is no evidence available to us to suggest that something out of the ordinary is taking place right now.

Is India, which is not a big part of the regional supply chain, also subject to the same “disconnect?” Indian exports also move up and down with US and EU demand, but the regression fit is weaker (adjusted R-squared of 0.40) than for the region (0.62), supporting the point that India’s linkage to the regional supply chain aimed at the US/EU is marginal. We find the regression results interesting though; given the magnitude of the EU coefficient, which, at 1.3, is the largest in our study (see table in the previous page).

Sharp depreciation of the rupee in 2013 and the new government’s resolve to push for manufacturing suggest that India may have bright exports prospects ahead. We can foresee the relationship examined in this study becoming tighter in the coming years as exports rise. This would also mean India will become more integrated in the Asian economic cycle.

How does China fit into all this? China is a critical part of the story, in our view. As the region’s largest (and the world’s second largest) economy, trade related developments in China are bound of have profound impact in the region.

In the past, countries traded mostly through China, supplying intermediate goods bound for re-exports. Export demand bound for to China was therefore largely a proxy of demand in the US/EU. But with China expanding substantially in recent decades, it has begun to import more final demand goods. This first became apparent in the commodity sector during 2005-07, but regional non-commodity exporters have noticed a major rise in final demand goods to China in recent years as well. With upside also comes downside: as China has slowed, perhaps the explanation behind some of the exports weakness lies there.

Exports to China:

-50.0

-25.0

0.0

25.0

50.0

75.0

100.0

125.0

2007 2008 2009 2010 2011 2012 2013 2014

Singapore South Korea

Taiwan Thailand

Indonesia

%yoy,

3mma

Source: CEIC, Deutsche Bank

It turns out that we have good circumstantial evidence to back up this notion. The Philippines is an integral part of the regional supply chain with little final demand in China. Turns out its exports have been doing well, both total and to China, with virtually no forecast error in our regression model. In other words, the US and EU PMIs have done well to capture Philippines' exports.

In contrast, Indonesia and Malaysia, two major commodity exporters, have some of the largest errors in our model, i.e. UE/EU demand fails to explain their recent export performance the most. Tellingly, these two countries have seen their exports to China weaken considerably. In addition to the various factors examined so far, weakening domestic demand in China seems to be an important part of the story.

Taimur Baig, Singapore, +65 6423 8681

11 September 2014



Diminishing Expectations in Latin America

Latin America’s economic growth has continued to surprise on the downside even compared with our already pessimistic forecasts, raising new doubts about performance looking forward. Meanwhile, external demand has been recovering, but reflected in stable or declining terms of trade, which appear to be affecting aggregate investment much more than previously.

As we have discussed repeatedly, cheap unit labor costs and low credit penetration are no longer available to foster rapid investment growth. On the contrary, uncertain terms of trade outlook together with increased public burden on private business in some countries seem to be exacerbating investment retrenchment in the current cycle.

Increasing hurdles for industrial growth seem to be closely related to worsening competitiveness, as expected. Surprisingly, service sectors have also denoted higher sensitivity to the economic cycle than in the past, despite higher levels of wealth and more macro stability than before.

Idiosyncratic factors are not collaborating either. Argentina´s recent handling of the default is inevitably deepening the current recession. A

comprehensive tax and education reform is still being

discussed in Chile, adding significant uncertainty to

the downturn of the economic cycle. Limits to growth

under current policies have been confirmed in Brazil

and Venezuela without yet promoting any change in

the macroeconomic strategy. Meanwhile, Peru

reported a sharp deceleration in 2Q, mostly driven by

climatic shocks in primary production and an

important contraction in mining after months of good

performance.

Nevertheless, some hope remains for the year ahead. Brazil´s election this year and Argentina´s in 2015 constitute great opportunities for likely improvement in policy making. Chile´s tax uncertainty should be fading away in the next few months and investment should catch up, at least partially. Peru and Colombia are expected to remain the fastest growing economies in the region, once all adjustments to the new reality take place. Meanwhile, Mexico´s reform and its link to the US should eventually set the stage for stronger growth in the country.

Furthermore, the commodity bonanza might be over but current terms of trade levels should maintain enough income to sustain a decent pace of growth. All this notwithstanding, we now see trend growth in the region below 3%, down from the 4.5% estimated during the last decade.

Diminishing regional forecasts

Latin America’s economic growth has continued to surprise on the downside in the last quarter, ever beyond the negative outlook painted in our Characterizing Elusive Growth in Latin America 4 , published last May. We are currently projecting regional growth to be just 1.0% this year, from 2.0% estimated in May 2014 and 2.6% hoped for in December 2013. The recent correction in outlook has also affected forecasts for 2015, as we now project only 2.1% growth, from 2.8% in May 2014 and 3.1% in December 2013. It is worth noting that the latest forecasts acknowledge a significant slowdown in consumption, expected this year to advance by 1.6% from 2.6% originally estimated. Nonetheless, we find more remarkable the downward revision in investment growth, which is now projected to be -2.6% in 2014 after an expected 1.3% increase few months ago.

Latin American: Main economic forecasts (w avg.)

(% yoy unless stated) 2012 2013 2014F 2015F

Real GDP growth 2.8 2.4 1.0 2.1

Priv. consumption 4.3 3.7 1.6 2.3

Investment 1.6 2.8 -2.6 2.1

Inflation (eop) 7.8 10.3 12.9 11.3

Exports, USD bn 977.1 981.0 989.2 1036.7

Imports, USD bn 892.9 924.5 924.6 961.2

Industrial production 0.8 3.2 0.2 1.9

Unemployment (%) 6.1 5.9 5.7 5.9

Fiscal bal. (% of GDP) -2.8 -3.1 -3.8 -3.5

CA bal. (% of GDP) -1.6 -2.6 -2.6 -2.4 Source: Deutsche Bank

As anticipated, the industrial sector is one of the productive sectors, evidencing the most current growth disappointment. The industry is now forecast to barely advance this year or grow by 0.2%, down from 1.9% projected in May. On the contrary, and surprisingly, external conditions have not been revised dramatically and are thus not the straightforward candidate to explain this worsening outlook.

Besides some common weakening growth prospects for the region, there still persists important diversion within countries. As noted, this is likely to continue in the years to come, contrasting with relatively homogenous growth motion witnessed in Latin America during almost the entire last decade. Driving factors and expected outlook for the most important regional countries are analyzed below.

4 Emerging Market Monthly, May 2014

11 September 2014



Disentangling recent performance

Although idiosyncratic factors are well known highlights in the region, recent economic performance seems to be following a common path independently of the policy making quality: growth slowdown. This is well represented in the following chart, containing the monthly proxies of economic activity in the major 6 countries of the region (excluding Venezuela for lack of accurate information and for being the most evident case of flawed policies). There we can see a downward trend, applicable to all countries, starting sometime in early 2012. Since then, there have been some sporadic recoveries but we saw another turn down in late 2103, most recently in the case of Peru. Currently, Colombia seems to be the exception but is mostly confirming the rule, as this year’s performance appears to be partly catching up from a relatively bad 2012-2013. Actually, the last couple of months are witnessing growth slowdown also in Colombia, but from a relatively rapid pace.

Monthly activity performance by country (YoY)

-10%

-5%

0%

5%

10%

15%

20% Argentina Brazil Chile

Colombia Mexico Peru


External factors have been the main suspects in this script, as they led the regional turnaround early last year, fueled by increasing uncertainty regarding Chinese growth and US economic and financial recovery, as well as their potential effect on global currencies, rates, and commodity prices. Indeed, at some point in late 2012 commodity prices began to weaken, capital flows began to dry, and overall financing conditions began to tighten in a meaningful way. The initial effect of such a change in external conditions had been evident in 2013 growth performance when compared to previous years.

However, when analyzing the very recent behavior of external drivers, they do not seem to have worsened, at least not enough to fuel a sharp correction in economic activity as reported in recent months. Export volumes, for example, have been recovering in tandem with overall global trade since late last year. Indeed, net

exports are becoming once again positive contributors to economic growth this year in most of the countries in the region.

Export volumes, however, might not offer the full story, or represent the most relevant external drivers, as the terms of trade chart presented below might hint. Latin American export prices did suffer in recent months, and significantly in the case of Peru, Mexico, and Brazil, falling by 8%, 5%, and 3%, respectively, when 1H2014 is compared with the same period in 2013. In the rest of the countries, terms of trade fell by around 1% during the same period. Thus, the external drag has still been active and has been affecting activity and confidence in the region. Consistently, foreign direct investment in Latin America is down 15% YoY in the first half of 2014. This median fall overshadows sharp declines in Chile and Mexico – and in Peru, albeit to a lesser extent. Consistently, the CLP depreciated the most among other regional currencies since the beginning of 2013, by some 12% in real terms, followed by the PEN and the BRL that accumulated a real depreciation of 4% and 2% in the same period, after adjusting for inflation differentials.

Regional terms of trade (100=March 2003)

80

100

120

140

160

180

200

220

240Argentina

Brazil

Chile

Colombia

Mexico

Peru

Source: IMF, Deutsche Bank

The long-term relationship between terms of trade and economic growth in the region is well documented, and graphically confirmed in the chart below. There we compare GDP growth and investment growth with changes in terms of trade since 1990. In the last 25 years, the correlation between GDP growth and terms of trade changes was 60% when measured on an annual basis. The second most important demand variable related to terms of trade is import volumes, with a correlation of 47%, followed by investment with 31%, and export volumes with 29%. Thus, as noted repeatedly, terms of trade have been a key determinant of Latin American growth. Furthermore, they have been also critical to leading investment in the region, always magnifying the growth drive. Actually, investment has been correlated almost 80% to the square of GDP growth in the last couple of decades.

11 September 2014



Terms of trade and economic performance (YoY)

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

1990 1993 1996 1999 2002 2005 2008 2011 2014

Gross domestic product

Terms of trade

Investment, rhs


The following chart pictures the regional aggregate (as measured by the median) experience regarding the main demand components of GDP. As expected from the terms of trade chart above, and also normal in any economic cycle, investment has been the component that greatly reflected economic swings. After decelerating since late 2011, investment growth collapsed by mid 2012. Furthermore, it has shown a renewed slowdown and contraction starting early this year. In the meantime, consumption growth has also followed a decelerating path, although smoother, while government expenditure has barely made any compensation to private sector tightening. On the contrary, next exports have started to contribute positively to economic growth since end-2013. The recent slowdown in investment contribution to GDP growth represents 240bps from the average contribution recorded before the 2008 financial crisis. The slowdown in the contribution from consumption to growth is 170bps.

The performance of productive sectors has a parallel to the demand behavior, as pictured in the chart below, where manufacturing has been the most sensitive sector, followed by services, but with the latter denoting a rather extraordinary slowdown in recent months. As discussed in our May article, high unit labor cost, poor infrastructure, and red tape characterize a challenging backdrop for manufacturing growth in the region. However the slowdown in the growth of the service sector appears remarkable in a context where labor markets have remained relatively resilient to the ongoing economic slowdown. Interesting, commodity related sectors have not followed a clear pattern in recent months, although mining does not yet seem to reflect the declining price of metals behind worsening terms of trade

Demand contribution to GDP growth (YoY)

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

GovernmentInvestmentConsumptionNet exports

Source: IMF, Haver Analytics, Deutsche Bank

Supply contribution to GDP growth (YoY)

-6%

-4%

-2%

0%

2%

4%

6%

-2%

-2%

-1%

-1%

0%

1%

1%

2%

2%

Agriculture+Fishing Mining

Manufacturing Services, rhs


Searching for a decelerating pattern

On aggregate it appears that investment has collapsed beyond historical standards but this is probably explained by renewed weakness in commodity prices. The latter does not become totally clear by analyzing performance by productive sectors, where manufacturing is showing an expected struggle and services are denoting a higher sensitivity to the economic cycle than before; but primary production does not show any particular trend.

Among countries, there are a number of different realities. Unsurprisingly, countries with unsustainable policies, like Argentina and Brazil, were those showing deeper slowdowns almost across the board. As discussed in our previous piece5, expansionary fiscal and monetary policies exacerbated the boom in these countries, making a sharp correction now inevitable. With high unit labor costs and interventionist bias in the policies, investment has been low for quite some time in Argentina and Brazil and therefore not the main

5 Characterizing Elusive Growth in Latin America, May 2014

11 September 2014



driver of recent slowdown. Consumption expenditure in Argentina actually fell proportionally more than investment. The following chart shows the average growth in consumption and investment in the last four quarters up to 2Q2014 compared with the average performance prior to the global crisis, 2003-2008.

Demand contribution to GDP growth (YoY)

-4%

-2%

0%

2%

4%

6%

8%

Con Inv Con Inv Con Inv Con Inv Con Inv Con Inv

Argentina Brazil Chile Colombia Mexico Peru

Last 4 Quarters 2003-2008


Chile and Peru were the countries in the region that witnessed quite sharp decelerations in investment growth, significantly more than in any other demand item. In both cases, volatility in metal prices was an important determinant of performance. In Chile, the uncertainty brought by the tax reform together with the additional fiscal burden potentiated the economic drivers.

Mexico is another case where all demand components were down, but different from other countries, the contribution from public sector demand simply collapsed in 2Q13 and 2Q14, from an average contribution of almost 100bps to GDP growth on average in the past. This reflected the usual under execution of public projects during the transition to a new administration. Public sector aggregate spending in all other regional countries has remained more or less unchanged. The only exception was Colombia, where fiscal expansion added 25bps to GDP growth in the last four quarters. Fiscal and monetary policies in Colombia have been quite effective to help the economy turn around, but a temporary slump in 2012-2013 produced by a number of one-off factors, particularly in the mining industry.

The supply side of the growth equation in the last few months further helps understand the causes behind the recent economic slowdown. The two charts included below show the contribution to GDP growth from the four big productive activities in these economies. For example, they confirm that recent worsening in economic conditions in Argentina and Brazil were reflected massively in the big industries and the service

sector, further supporting the sense of overall macroeconomic constraints.

Supply contribution to GDP growth (YoY)

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

Agric Min Agric Min Agric Min Agric Min Agric Min Agric Min



-1%

0%

1%

2%

3%

4%

5%

6%

7%

Man Ser Man Ser Man Ser Man Ser Man Ser Man Ser




In the case of Chile and Peru, the contrasting good performance of agriculture and fishing with the declining importance of mining seems to be a common feature. Likewise, the worsening situation in manufacturing and services is present in both cases, although deeper in the case of Chile, partly for the reasons discussed above. Meanwhile, in Colombia and Mexico the overall weakness of commodity production has been partially mollified by resilient manufacturing in Mexico and services in the case of Colombia.

Idiosyncrasies and outlook

As discussed, idiosyncratic factors are not collaborating either to current economic performance. Argentina´s recent handling of technical default is inevitably deepening and prolonging the current recession more than initially expected. Chile´s comprehensive tax and education reform is still being

discussed, adding significant uncertainty to the downturn

of the economic cycle. Recent lackluster growth has

confirmed the limits to perform of the current policies in

Brazil and Venezuela while failing to promote any change

in the macroeconomic strategy as of yet.

11 September 2014



Nonetheless, some hope remains for the year ahead. As discussed in another special piece in this monthly6, Brazil´s election this year is suddenly a great opportunity for economic policy enhancement, starting shortly after October. In Argentina, that chance for a likely improvement in policy making will come in October 2015. Likewise, Chile´s tax uncertainty should be fading away in the next few months and investment should catch up, at least partially.

We still expect diversion in economic outlook in the region as past policies will continue to condition future performance. The updated relationship between expected growth and the size of the public sector, illustrated in the figure below, perfectly summarizes the trade offs, as discussed in previous publications. For these reasons we continue to see Peru and Colombia remaining the fastest growing economies in the region, once all adjustments to the new reality take place. Similarly, we also believe Mexico´s reform and link to the US should eventually set the stage for stronger growth in the country.

The burden of past policies revised

ARG

BRA

CHI

COL

MEX

PER

VEN*

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0

Expected GDP growth 2014 (%,DB forecast)

Government expenditure % of GDP, 2013 (IMF)


6 Brazil: Marina Silva Changes Election Dynamics.

Furthermore, the commodity bonanza might be over but current terms of trade levels should maintain enough income to sustain a decent pace of growth. All this notwithstanding, we now see trend growth in the region below 3%, down from the 4.5% estimated during the last decade.

Likewise we see likely further reduction in unit labor cost in dollar terms, gradually, either by additional currency depreciation, relative wage deflation, and/or faster productivity growth. The latter, however, severely conditioned by costly and inefficient large public sectors in some countries and by recent underperformance in investment demand all over the region.

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

The author of this report wishes to acknowledge the collaboration of Ramiro Lucas and Gerald Leon, employees for Evalueserve, a third party provider to Deutsche Bank of offshore support services.

11 September 2014



Mexico: Undertaking PEMEX and CFE pension liabilities

A key element of the energy reform

As part of the energy bylaws package, those for Pemex and CFE were approved by Congress and enacted by President Peña Nieto on August 11. These laws direct the Mexican federal government to undertake Pemex and CFE unfunded pensions liabilities, a move likely to increase headline public debt. In general terms, the laws approved mandate that both companies should create savings to fund these liabilities and call for an effort on the workers’ side by conditioning the government funding to a change in Pemex and CFE's labor rules. Specifics and details of such directions are still to be discussed as part of the fiscal plan for the following years, along with negotiations between the companies and their respective unions. In this regard, information about the issue is still scant but this note briefly outlines a baseline scenario for the undertaking of Pemex and CFE pension liabilities and its implications.

Pemex’s total unfunded pension liabilities amounted to USD$90bn as of June 2014. This amount includes the net present value of the pension payments to retired workers, which we estimate at USD$31bn, and the accrued benefits of active workers, that we estimate at USD$59bn. In the case of CFE, total unfunded pension liabilities amount to USD$41bn as of June 2014 and includes the net present value of the pension payments to retired workers, USD$14bn, and the accrued benefits of active workers, USD$27bn. As a proportion of GDP, these liabilities amount to approximately 10%.

Reforming the pension systems for both companies, along with changes to their tax regimes, are necessary steps to make them competitive. In fact, we expected the pensions challenge to be addressed later to avoid risking the reform process. So, we see this as a positive surprise and a bold step maybe even ahead of its time. There would be two main benefits. First, excessive liabilities that may prevent Pemex and CFE to be cost-efficient are lifted. Second, it is an important step to solve part of a broader pending problem, since some pensions systems within the public sector remain unreformed, as defined-benefit plans or pay-as-you-go, and should be migrated into defined contribution schemes. In any case, it adds to transparency by recognizing implicit liabilities, thus making the net financial position of the public sector clearer.

Pemex unfunded liabilities (USD$bn)

59

31

Active workers

Retired workers

Source: Pemex and DB Research

CFE unfunded liabilities (USD$bn)

27

14

Active workers

Retired workers

Source: CFE and DB Research

Pemex active workers (thousand)

130

135

140

145

150

155

160

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: PEMEX

11 September 2014



Transition to a fully-funded system

In our view, the natural way to address the challenge of unfunded pension liabilities is by shifting the current Pemex and CFE systems into fully-funded or defined-contribution schemes within the Afores system. In this case, the government would foot the bill by writing the workers’ accrued benefits as public debt deposited in the Afores. There are several experiences about a transition to a fully-funded system, but the closest is the recent federal employee social security institute (ISSSTE) reform, reached in 2007. Fundamentally, the ISSSTE reform shifted the public employees’ pension system from a defined-benefit scheme to a fully-funded one, by getting the new employees into the new scheme and letting active workers to choose between staying in the old one or migrate.

In the transition to a fully-funded scheme, there are three groups of workers involved in dealing with unfunded pension liabilities:

Retired workers: Currently inactive workers that retired under the old system and get regular pension payments, included in the yearly budgets of both companies. Pemex and CFE had approximately 80k and 41k retired workers as of June 2014, respectively (some are beneficiaries that receive the pension payments after the retiree died, according to the Pemex’s current scheme). They represent a relatively high budget pressure for Pemex and CFE, approximately USD$2.3bn and USD$0.8bn per year, respectively (the number for CFE does not include those retired workers from the former utilities company Luz y Fuerza del Centro, as their pensions are now directly paid by the federal government). Such costs would be expected to increase exponentially if active workers keep retiring under the current system and the path may be explosive if prospective workers keep enrolling under the old rules. Approximately 15k active Pemex workers retire per year and enter this population and 7k for CFE.

Pemex labor (thousand)

156

80

Active workers

Retired workers


CFE labor (thousand)

97

41

Active workers

Retired workers


Active workers: Pemex and CFE had approximately 156k and 97k active workers in their payrolls by June 2014, respectively. In the case of Pemex they are divided into five subsidiaries and approximately 88% are permanent and the remaining 12% are temporary. It is worth noticing that the share of temporary workers increased in the last few years.

Pemex active employees

Total Permanent Temporary

Upstream 54,093 42,703 11,390

Mid & downstream 74,911 68,256 6,655

Corporate 27,278 26,640 638

Total 156,282 137,599 18,683 Source: Pemex

Prospective workers: Changes to the labor and pension rules for Pemex and CFE have to take into consideration the funding of those liabilities associated to the newcomers, particularly as personnel of both is expected to grow due to their roles under the reform. Even though prospective workers are not part of existing liabilities, any migration to a fully-funded system starts by limiting the explosive path of liabilities by defining new rules for the new hires. Changes to prospective workers ended up being the most important part of the ISSSTE pension reform, as a large majority of active workers chose to remain in the defined-benefit scheme, so most of the savings came from the prospective workers that had no choice but to enroll under the new fully-funded scheme.

For these groups of workers, we expect the following in the modifications to the pension systems:

Hiring rules and contracts for Pemex and CFE will be changed so prospective workers will enter a fully-funded system based on defined contributions and individual accounts when they start. Thus, we expect the reform to cut at least the explosive trajectory path of pensions liabilities for both companies. This would accelerate the pace of growth of the Afores system in the coming years, as Pemex and CFE have hired

11 September 2014



roughly 3k workers per year together since 2000. It is worth mentioning that the changes for CFE could be slightly easier, as it already funds part of its pension liabilities using a system of individual accounts in place, in which approximately USD$380m are deposited (1% of its overall liabilities).

Pemex + CFE: Pensions (USD$bn)

0

1

2

3

4

5

6

7

8

9

10

20

14

20

16

20

18

20

20

20

22

20

24

20

26

20

28

20

30

20

32

20

34

20

36

20

38

20

40

20

42

20

44

20

46

20

48

20

50

Reform (baseline scenario)

No reform

Source: DB Research

With respect to retired workers, current pensions payments are expected to remain within Pemex and CFE as a cost to be financed with current operating revenues. Such a pressure should be manageable as the new tax regimes for both companies reduce the tax burden, a drop estimated by the government in USD$7bn per year for the case of Pemex. Moreover, as part of the audits to pensions that Congress is likely to carry out as mandated by the reform, the registries of pensioners are likely to be revised and streamlined, thus potentially reducing this cost going forward. As mentioned before, in the case of Pemex we estimate total unfunded pensions liabilities for retired workers at USD$31bn, so this part of the liabilities could be streamlined, documented and considered a Pemex’s operating cost.

Workers in Afores (million)

11

13

15

17

19

21

23

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

No reform


Source: CONSAR and DB Research

Afores’ assets under mgmt (%GDP)

0

5

10

15

20

25

30

35

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

20

20


No Reform

Source: CONSAR and DB Research

Thus, the core challenge lies in the transition of active workers in both companies to a fully-funded pension system that frees them from such a large burden. In our view, the elements in such a transition are the following:

Change of parameters. The reform is likely to start by modifying the main parameters of the current defined benefits system, basically increasing the retirement age for active workers, currently at 55 years, and reducing some benefits in the current rules. For example, Pemex’s benefits like the current right for pensioners to appoint a beneficiary that can receive payments from 3 years to life after the death of the retired worker are likely to be scrapped from contracts. The change in parameters is likely to deliver significant present-value savings in the overall liabilities. From previous experiences in which retirement parameters were changed, we estimate that approximately USD$21bn (25%) would be subtracted from total net-present value liabilities (assuming that retirement age is lifted to 65 years, in line with the ISSSTE reform). We expect a fierce opposition from both unions, particularly from Pemex’s, which has voiced that changes to the current collective contract that applies to active workers violates the law and even international agreements. Thus, negotiations will be difficult but the recently approved bylaws establish that they cannot go beyond one year for Pemex and CFE to receive funding from the federal government.

Individual accounts system. The core element of the change is to get active and prospective Pemex and CFE’s workers into the existing fully-funded pensions system managed by the current retirement fund managers or Afores. This would require to “monetize” the overall accrued benefits for the active workers through a “recognition bond” or lump-sum transfer to be deposited into the newly created retirement account. Clearly, such funds would then be managed according to existing rules for Afores and could represent an

11 September 2014



important contribution to financial savings in the country, not to mention the overall deepness of the Afores system and eventually to the liquidity of government securities. If overall unfunded pension liabilities are transferred to the Afores system, it would add approximately USD$86bn to the existing USD$180bn in assets under management, so the system would reach a balance of 23% of GDP, up from 14% now (assuming that all active workers are migrated to the fully-funded system).

Accrued benefits recognition. A key challenge for the transition to the new system is the design of an adequate and fair methodology to determine the accrued workers’ benefits and the corresponding deposit in the individual account. This will be particularly difficult since Pemex and CFE’s are generous pension systems that entail numerous benefits that are not proportional to wages and imply an actuarial imbalance. Not much information about the calculation of unfunded pension liabilities has been released by Pemex and CFE so far, but we assume that it is proportional to the monetary part of workers’ compensation. This is, the theoretical accumulated balance of accrued benefits in workers’ retirement accounts. It is worth highlighting that the change should lead to increased labor mobility as accrued benefits would be portable, a positive effect on an industry that is very likely to gain dynamism in the coming years.

Public debt (%GDP)

13

18

23

28

33

38

43

48

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

20

20

No reform


Source: SHCP and DB Research

Govt debt & mkt securities (%GDP)

20

25

30

35

40

45

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Govt total debt

Govt market securities

Source: SHCP and DB Research

Government funding. Once the individual accounts system is ready and the mechanism for recognizing accrued benefits has been designed and approved, government funding would take place. Ideally, the funding should come in the form of zero-coupon bonds with face value equal to the future value of the accrued benefits at the moment of the reform, maturing at the expected time of retirement. Such bond would be in the name of the active worker and deposited in his individual account. Again, this would be equivalent to the main scheme of the public sector employees pension system reform (ISSSTE). There are three reasons in favor of this scheme:

— As the interests earned by the amount of accrued benefit from the time of the reform to the moment in which the worker retires are included in the face value of the zero-coupon bond, the overall obligation with the worker is guaranteed and there is no need to budget the financing costs each year and inflate current expenditures. Under this scheme, there would be no impact on the public deficit except for the financing costs of the zero-coupon bonds maturing each year. We estimate that approximately 0.35% of GDP would have to be issued in extra government securities to cover the maturing bonds, which would increase the public deficit in about 0.025% of GDP each year.

— The zero-coupon bonds would stay deposited in the workers’ individual accounts as non-market public debt, so the government does not have to issue additional debt and since the bond is not tradable, there is no distortion in debt market by issuing such securities. This is extremely important, as it implies that supply and demand for the new securities are created equal on day one and the disturbances one may expect from the government issuing a large amount of market securities at once are avoided.

— Government’s issuance needs will come gradually as zero-coupon bonds mature and they are exchanged in the individual account by tradable government securities (Cetes, MBonos, etc). As retirement funds portfolios would be readily reshuffled after the exchange to include other assets (equity, corporate debt, etc), the government could be at liberty to use the securities that better fit their public debt strategy at that moment.

Public debt management. This scheme would involve no active debt management on the zero-coupon bonds deposited in the individual accounts but until they mature and are cashed-in through the issuance of government securities. This minimizes the impact on market debt, as supply

11 September 2014



and demand are matched at the zero-coupon bonds stage and the additional issuance of government securities comes gradually and can be accommodated to current market conditions.

In sum, this change would increase total outstanding public debt as a proportion of GDP from current levels of 36.5% to 43.8% at the moment of the implementation of the new scheme. However, the amount of government securities in circulation would increase but gradually in the course of several decades, as active workers retire and their zero-coupon bonds mature. This scheme should deliver a relatively smooth transition to a fully-funded pension system and should have a net positive impact on public finances. In fact, it could even have a positive impact on Mexico’s prospects for a debt upgrade, as the pensions liabilities were already incorporated in the sovereign’s net financial position and the reform would eliminate the unsustainable path of the old system.

Risks

While this process is positive, there are issues about its implementation that raise concerns. In other words, the central scenario is positive but some elements may go wrong down the road and require special attention:

Workers’ choice. It is very likely that Pemex and CFE will allow active workers individually to choose between the new fully-funded system and the old benefit-defined system. This is not the ideal scenario, as the actuarial imbalance of the old system will make financial pressure to keep growing fast over the next few years. Moreover, in a scenario in which most workers stay in the defined-benefits scheme, savings will be limited to the prospective workers. This is similar to the experience with the ISSSTE pension reform, in which a small proportion of active workers choose the new system. In this case, we see two main disadvantages:

— There would be additional challenges for the government to finance Pemex and CFE’s liabilities in such a way that the goal of enhancing the cost-competitiveness of the companies is attained. One possibility would be to give the companies bonds that mature according to the retirement profile but this would allow the expensive current system to prevail for longer.

— Financial savings in the economy would not grow, as the new resources do not become part of the Afores system

Inflated costs. There are two main scenarios in which we see that the pension liabilities with active workers of Pemex and CFE could be inflated:

— Temporary workers in both companies may be granted benefits that they have not accrued formally given their status. Due to budget restrictions in the last few years, very likely a large fraction of the increase in the payroll had to be carried out through temporary workers, which perform core duties. Such temporary workers may have a legitimate claim but could have remained outside the estimated unfunded liabilities due to their status.

— Pemex and CFE currently have generous pensions systems that include either disproportionate retirement benefits or benefits not linked to wages and salaries. Thus, a traditional formula that calculates accrued benefits as if the employee had accumulated retirement funds since day one given their salary history, may deliver amounts that do not make the new system “equivalent” to the old one. Workers then may push either for a methodology that inflates costs or a premium on the baseline calculation to cover for the extra benefits, as a condition to give up on the benefits accrued under the current contract.

Form of payment. Workers could be inclined to receive part of the recognition bond in cash or other marketable asset that does not stay dormant in their individual account until retirement. This may work as a liquidity bonus that even the government may be willing to pay in order to get the reform plan through with the unions. In this scenario, the federal government would have to issue large amounts of debt that could create distortions in the market for government securities. This could also imply that the positive effects on financial savings are smaller than in the base case scenario.

Separate system. In the baseline scenario, active workers of Pemex and CFE enter the Afores system and their pension funds are managed according to its rules. Even if special Afores are created to receive each company’s workers, we would expect such to be regulated as the other funds, as it happened when the special Afore to catch government employees following the ISSSTE refom, PensionISSSTE, was created. Nevertheless, it is possible that pension funds guided by different rules are created to host Pemex and CFE active workers. This could cause distortions with the rest of the system.

The risks and concerns outlined in this section could make savings, government debt and Afores’ assets under management to deviate from the baseline or “reform” scenario.

11 September 2014



Remarks

We see the government undertaking Pemex and CFE unfunded pension liabilities in the context of a defined-contribution scheme as a positive step. This would increase the competitiveness of both companies, make overall public liabilities more transparent and boost financial savings in the country. However, its implementation carries important risks regarding potential savings and the mechanics of undertaking liabilities on the government side. We do not see a likely scenario in which the costs outweigh the benefits, but flaws in its implementation could hamper its potential advantages.

Alexis Milo, +52(55)52018534

11 September 2014



A growth and investment model for India: 2014-20

We highlight the key assumptions and implications

behind our central macro forecast for India for the rest of the decade.

Savings. We expect a gradual improvement in the savings rate as the public sector consolidates its fiscal position, corporate profitability returns, and households find savings worthwhile as inflation eases and real rates rise. Buoyed by the improvement in savings rate, the investment ratio rises from 30% to 35% of GDP.

Growth. Improvement in investment pushes up real GDP growth, which bottoms out from FY15 onward, rising initially to 5.5%, then to 6.5% by FY17, and 7.5% by FY19.

Nominal GDP crosses USD3.2trln by 2020, raising per capita GDP to around USD2500. This constitutes about a 4.5% annual average growth of real per capita income.

Inflation. RBI targets inflation successfully, bringing it down to below 6% by FY16 and below 5% by FY19.

Rupee. The exchange rate appreciates gradually in real terms. In nominal terms, against the USD, the rupee ranges from 63 to 65.

Framework for sustainable growth

The recent political transition to a new government has given rise to heightened investor expectation about an inflection point in the Indian economy. Growth is expected to turn a corner as governance becomes more effective, facilitating a surge in investment.

What would it take for India to grow by 7-7.5% by the end of this decade? Below we present an internally consistent framework of savings, investment, and productivity that would attain such a goal. Our medium term scenario is broadly constructive, but cognizant of the external and internal challenges.

In our view, the growth spurt seen in the past decade coincided with a favorable global backdrop of strong demand, abundant liquidity, general optimism about EM economies, and stable geopolitics. Even if one is optimistic of an enabling domestic environment and more effective governance, it is unlikely that the external pull will be as strong for the remainder of this decade. Also, the loss of momentum of recent years will be difficult and time consuming to recover.

With these caveats in mind, in this piece we highlight the key assumptions and implications of the model.

Assumptions

Savings and investment India’s domestic savings rate fell from 37% of GDP in FY07 to 30% of GDP in FY13 due to a variety of factors. Public sector deficit widened first to stimulate the economy around the global financial crisis in 2008 and then due to a ballooning subsidy bill. Corporate savings declined along with a sharp reduction in profits during the same period, while households dis-saved as inflation soared.

We expect a gradual improvement in the savings rate in the coming years as the public sector consolidates its fiscal position, corporate profitability returns, and households find savings worthwhile as inflation eases and real rates rise. We don’t however expect a sharp reversion to pre-crisis savings rate as we think it will take time for private sector savings rate to turn, primarily because households and firms have years of balance-sheet consolidation ahead. Our assumption is for the savings rate to bottom in FY14 at slightly below 30% of GDP, gradually rising to 34% of GDP by FY20.

Gross domestic savings

10

15

20

25

30

35

40

FY04 FY06 FY08 FY10 FY12 FY14 FY16 FY18 FY20

% of GDP

Source: CEIC, Deutsche Bank. Dotted lines denote projections.

Buoyed by the improvement in savings, the investment/GDP ratio rises from 30% in FY14 to 35% by FY20. Current account deficit persists at the 1-1.5% of GDP range, which is readily financed by sustained FDI and portfolio flows.

11 September 2014



Investment recovery will likely be accompanied by a

persistent but sustainable current account deficit

-3

-2

-1

0

1

2

3

4

5

6

10

15

20

25

30

35

40


Investment, left

C/A deficit, right

% of GDP

Source: CEIC, Deutsche Bank. Dotted lines denote projections.

Growth Improvement in investment pushes up real GDP growth, which bottoms out from FY15 onward, rising initially to 5.5%, then to 6.5% by FY17, and 7.5% by FY19. Nominal GDP crosses USD3.4trln by 2020 in our scenario, raising per capita GDP to around USD2500. This constitutes about a 4.5% annual average growth of real per capita income.

Inflation RBI targets inflation successfully, bringing it down to below 6% by FY16 and below 5% by FY19, as per our scenario.

Rupee The exchange rate appreciates gradually in real terms. In nominal terms, against the USD, the rupee ranges 63-65 during this period.

Incremental capital-output ratio (ICOR) Boosted by productivity enhancing measures and efficiency gains through effective governance, the incremental capital-output ratio improves gradually, helping growth prospects to be boosted without excessive creation of capacity.

The issue of raising the investment ratio and improving productivity goes at the heart of India’s past challenges and future potential. There was substantial dividend to the investment surge of last decade, boosting growth and income, but the cycle was also accompanied with lapses in governance, over-investment in some areas, insufficient improvement in productivity, and poor macro policies. Going forward, while an investment spurt is essential, it would be important to lay the groundwork for more balanced and sustainable growth through productivity enhancement.

7%+ growth by the end of the decade would require

significant improvements in productivity

0

1

2

3

4

5

6

7

8

9

10


Growth ICOR

Source: CEIC, Deutsche Bank. ICOR stand for incremental capital output ratio, derived by dividing gross investment by real GDP growth. Dotted lines denote projections.

Key constraints

While our scenario may not come across as particularly exuberant, it is nevertheless rather constructive, and subject to some risks.

Subdued global demand for the rest of the decade. In its latest forecasts, the International Monetary Fund projects 3% (or lower) real growth for the United Stated during 2014-20, while the forecast is less than 1.5% for Germany and Japan during the same period. This implies 100-150bps in lower growth rate in key industrial economies in the coming years relative to the pre-global financial crisis average. Clearly this will hamper demand globally, and India’s exporters will face some consequent headwinds.

Weak productivity growth. India’s TFP growth rate has slowed considerably in recent years. Many areas of the economy have seen excessive investment, while other areas are capacity constrained. Turning around the productivity engine will take time. (More on this in the appendix at the end of this report)

A relatively shallow financial sector. India’s bank and nonbank financial sector have experienced considerable stress in recent years due to slowing economic growth and market volatility. Wide ranging regulatory constraints and uncertainty have also gotten in the way for healthy financial sector activities. Burdened with major capital impairment and regulatory issues, domestic financial intermediation would likely remain curtailed for some time. Furthermore, local bond markets remain shallow and foreign access to the market limited, which may get in the way of expeditious capital-raising.

11 September 2014



Another complicating factor would be if inflation is not tamed soon and the central bank is compelled to maintain a relatively tight policy stance for a prolonged period.

Financing needs

The model suggests that the above macro outcome would necessitate the current account to run a deficit of 1-1.5% of GDP during 2015-20, with a cumulative net external BOP financing need of USD250bn. A proactive disinvestment agenda, along with capital account liberalization measures, could readily generate USD75bn in FDI and an equal amount of net portfolio flows during this period, in our view.

External debt will rise gradually

0

5

10

15

20

25

30

0

100

200

300

400

500

600

700

800

900

1000


USD bn, left

% of GDP, right

USD bn

Source: CEIC, Deutsche Bank. Dotted lines denote projections

If the target is 9-months of imports, RBI will have to

add another USD300bn to reserves by end-2020

0

100

200

300

400

500

600

700


Target ActualUSD bn

Source: CEIC, Deutsche Bank. Dotted lines denote projections

The rest of the financing can come from a well supervised external borrowing program by capital deficient Indian banks and corporations. Even if it doesn’t rise substantially as a share of GDP (we see external debt rising from 22% to 27% of GDP by 2020), there would be a need to build safeguard against possible funding crunch around events of global market stress. We assume that faced with such risks the RBI would aggressively build reserves. If the central bank targets reserves amounting to 9 months of imports, it would need to accumulate considerably more reserves (to over USD600bn by 2020) than the current position, as per our calculations (see chart below). This would in turn reinforce our stable rupee outlook.

With respect to total infrastructure investment, if India follows the recommendation from recent high level commissions on development and growth to devote 10% of GDP worth of resources annually, it would need a cumulative USD1trln in infra investment during the remainder of the decade. Under a best case scenario, this would be financed 50-50 between the public and private sector, in our view.

Conclusion

The above discussion highlights an internally consistent scenario of India’s medium term macroeconomic path. We have not delved into the details of fiscal or monetary adjustment here, focusing instead on issues such as productivity and external financing. Clearly this path would not be achievable without the RBI maintaining real positive interest rates and the Ministry of Finance bringing to the central government fiscal deficit to below 3% of GDP.

We have also refrained from going over the well-trodden topic of the much needed structural reforms in agriculture, infrastructure (particularly power and transportation), finance, manufacturing mining, and services. Assuming progress is made in all of these areas, India’s macro path for the rest of decade could well be a promising and sustainable one.

Appendix: Total factor productivity

Why has India fallen behind, and how to push for a revival India’s total factor productivity growth rate (which is derived as the residual of a growth regression after controlling for contribution from key factors of production, i.e. capital and labor) has averaged around 2.5% in the past decade. In a worrisome development, TFP growth has declined almost each year since 2007, presently running below 2%. In contrast, Indonesia, Philippines, and Thailand have seen TFP rise during the same period (see chart below).

11 September 2014



To boost TFP, India needs to focus on the following:

Larger scale of manufacturing. Vast majority of Indian firms are small by international comparison, which restricts them from exploiting economies of scale. Incentives need to be provided for firm merger, consolidation, and expansion.

Reducing product market regulation. Stringent rules prevent efficient shipment and transaction of goods and services. Many food items, for example, are required to be traded through centralized wholesales markets, which are often characterized by cartels and monopoly pricing.

Easing of employment protection. Reforms to allow businesses to hire workers on variable tenure and terminate contracts expeditiously (while respecting labor laws) would allow for greater labor mobility and business flexibility.

Removal of barriers to entry. Indian corporate sector tends to feature a low degree of entry-exit by international comparison. This also gets in the way of employment creation. Efforts to remove barriers to entry will foster competition and more dynamic corporate sector activity.

Total factor productivity

0

1

2

3

4

5

6

2003-07 2008-10 2011-13%yoy

Source: IMF, Deutsche Bank. * TFP calculations are derived from “Potential Growth in Emerging Asia.” by Rahul Anand, Kevin C. Cheng, Sidra Rehman, and Longmei Zhang, IMF Working paper 14/2, 2014, Washington DC


11 September 2014



Will the Russia crisis derail recovery in Central Europe?

Central Europe has been one of the better performing EM stories over the last year, emerging from a protracted period of economic stagnation with past imbalances largely addressed. Since the middle of last year, the region has enjoyed a robust recovery, growing at an average annualized rate of over 3%.

Our optimism toward the region is being tested, however, by the escalating crisis in Russia and Ukraine. We think Russia will avoid a recession but our growth forecast for this year of 0.8% is probably subject to downside risks. Ukraine’s economy is expected to contract by 5% or more this year.

Weaker demand from Russia and Ukraine will weigh on Central Europe’s exports, both directly and indirectly through its integration within the German supply chain. We estimate that these effects could be quite modest, however, reducing GDP growth in the region by about 0.2ppts on average. The impact would be somewhat larger than this in Hungary, largely reflecting its greater openness and somewhat lower in the more closed Polish economy.

The recent ban on food imports by Russia might amplify the impact somewhat. But only Poland is significantly exposed through this channel; and even then, its exports of food products to Russia amount to little more than 0.2% of GDP.

The other potential pressure point is the region’s dependence on Russian gas, which accounts for about 7% of total primary energy supplies in Poland, 12% in Hungary, and 16% in the Czech Republic. This degree of dependence is towards the middle of the pack by European standards. The Czech Republic and Hungary are more exposed insofar as their Russian gas arrives through Ukraine, the most likely source of disruption. But new pipeline interconnectors with Poland and Slovakia might help to mitigate some disruption.

Contagion through other channels is likely to be modest. Investment ties are limited, with the notable exception of Hungary’s agreement with Russia to upgrade its nuclear power plant. Russian banks have only a very limited presence in the Czech Republic and Hungary and none at all in Poland. Less directly, other European banks facing losses on their Russian assets might be forced to cut lending elsewhere, including in central Europe; but their exposure to Russia is small relative to their total assets.

All in all, therefore, barring a further significant escalation in the crisis, we remain optimistic that

growth across the region should remain relatively robust this year.

The recent slowdown in some activity data in Poland is a little puzzling in this regard, especially when viewed against the continued strength of indicators in the Czech Republic and Hungary. This decoupling has been popularly attributed to Poland’s supposedly stronger links to Russia, an explanation that we do not find convincing. If anything, we find that Poland should be relatively less affected than its more open central European neighbors. At this stage, therefore, we prefer to take a more agnostic view on the softer data in Poland, which may reflect confidence effects as much as any direct impact from the crisis.

Introduction

Last year, we became increasingly optimistic about the economic outlook for Central Europe, which was emerging from a period of protracted economic stagnation with past imbalances largely addressed. Our optimism was reinforced by the strong economic performance in the first quarter of this year, when the region grew by 3.3% on average.7 This optimism is now being tested on several fronts:

The crisis in Russia has escalated and is starting to have a material impact on growth in Europe. Exports to Russia and Ukraine have fallen. The fear of a further escalation in the crisis, and uncertainty about the economic impact of sanctions, is probably also affecting confidence and investment plans. We expect the Russian economy to grow by 0.8% this year but the risks to this outlook are skewed to the downside. Output in Ukraine is likely to contract by 5% or more this year.

Growth in Germany, the dominant trading partner for the region, looks to have softened. Some of this is payback from the strong performance in Q1, which was boosted by good weather. But the underlying momentum behind growth looks to have weakened, partly on the back of the Russia crisis. Our European economists have, therefore, revised down their forecast for GDP growth this year to 1.5% from 1.8%.

Recent monthly activity indicators in Poland have slowed notably, although the data in the Czech Republic and Hungary remains more robust.

7 See, for example, “Central Europe: A Good EM Story”, Emerging

Markets Monthly (March 2014).

11 September 2014



Against this backdrop, we reconsider our view on the outlook for Central Europe, and in particular its vulnerability to a further escalation in the crisis in Russia. This could affect the region through multiple channels. The most immediate will be through reduced exports, either due to sanctions or simply slower growth in Russia and Ukraine. Less likely, but potentially more damaging given the region’s reliance on Russian energy would be any restrictions in these supplies. We discuss these two issues in more detail below.

There are other potential transmission channels but these are likely to be much more modest in terms of their impact. Russian banks, for example, are not major players in the region. Sberbank was seeking to expand its operations in the Czech Republic and Hungary, but currently accounts for less than 2% of the total assets of the banking sectors in these countries. Russian banks have no material presence in Poland. Less directly, it is possible that western banks facing losses on their Russian assets could reduce their lending elsewhere. Austrian banks would be the most likely source of spillovers in this regard given their presence in CEE. They also have the largest exposure to Russia relative to the size of their assets, albeit still relatively limited at 1.4% of their assets. Similarly, investment ties between Russia and CEE are also limited. One exception to this is Hungary’s EUR 10bn loan agreement with Russia to finance (and partially provide) upgrades to its nuclear power plant.

Reduced demand from Russia, Ukraine, and Germany

Direct impact: Russia and Ukraine Russia is a moderately important export market for the region, accounting for about 5% of total Polish exports and about 3% of exports from the Czech Republic and Hungary. If we add Ukraine, this would bring the total share of exports to the two countries at the centre of the crisis to 8.0% in Poland, 5.3% in Hungary, and 4.4% in the Czech Republic (chart below). To put these figures into some sort of context, Germany accounts for over one quarter of exports from each of the CE3 countries.

Russia and Ukraine are moderately important export

markets for Central Europe

Source: Deutsche Bank, Haver Analytics

Relative to GDP, however, the picture changes a little. Poland is less open than its central European neighbors. While Russia and Ukraine account for a somewhat larger share of its total exports, relative to GDP, its exposure is, therefore, lower than that of the Czech Republic and Hungary (chart below).

Poland’s exposure (relative to GDP) is the lowest in

CE3


We think that the direct impact of slower growth in Russia on Central Europe is likely to be relatively small. Historically, exports from the region to Russia have tended to move closely in line with Russian GDP. More specifically, we find that 1% contraction in Russian GDP typically results in a 1.4ppt fall in Hungarian exports to Russia. The corresponding elasticities in Poland and the Czech Republic are a little lower at 1.3 and 0.9, respectively. Given the relatively small size of exports to Russia relative to GDP, these elasticities suggest that the reduction in exports resulting from a 1% drop in Russian GDP would directly reduce Hungarian GDP by 0.05ppts, Czech GDP by 0.04ppts and Polish GDP by only 0.02ppts.

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Even this small impact might be partially offset if it goes hand in hand with a reduction in intermediate imports used in the export process. However, a relatively large share of CE3 gross exports to Russia reflects domestic valued added (chart below), so the bulk of the reduction in exports is likely to feed through to GDP.

Local content of exports to Russia and Germany

Source: Deutsche Bank, OECD Trade in Value Added Database

We have revised our forecast for Russian GDP growth in 2014 from 2.4% to 0.8% in the wake of the crisis, i.e. a drop of 1.6 ppts. The analysis above suggests that this would directly reduce growth in Central Europe by less than 0.1%.

Once we factor in the reduction in growth in Ukraine, however, the impact is a little larger. While Ukraine is a smaller export market, the reduction in growth has been much more dramatic. The economy is now expected to contract by 5% or more this year whereas prior to the crisis, we had been expecting growth of around 1.5%. This turnaround might reduce growth by a little less than 0.3ppts in Hungary and by around 0.1ppts in the Czech Republic and Poland.

Indirect impact: Germany So far, we have only considered the direct impact of the crisis via reduced Central European exports to Russia and Ukraine. But the crisis in Russia will also weigh on other countries, which may in turn affect growth in Central Europe. Most important in this regard will be the impact on Germany given the role that CE3 economies play in the German supply chain.

Our European economists find that German exports are indeed quite sensitive to Russian growth. They find that a 1% contraction in Russian GDP has historically resulted in a 3.5ppts fall in German exports to Russia, much higher than the elasticities that we found for Central European exports. This may reflect the composition of trade and in particular the greater prominence of capital goods in German exports. For

example, of all German exports to Russia, machinery and transport equipment account for nearly 56%. In comparison, for Poland – which has the lowest elasticity within CE3 – only 37% of exports to Russia are in the form of machinery and transport equipment (this is also the lowest share among the CE3 countries). On the other hand, food represents a relatively large fraction (14%) of Polish exports to Russia; the corresponding share for Germany is only 3%. With capital expenditure the most volatile component of GDP, exports of capital goods such as machinery to Russia are likely to be more sensitive to changes in Russian GDP than food (the demand for this necessity is likely to be more stable).

Breakdown of Polish and German exports to Russia

Source: Deutsche Bank, UNCTAD

Our European economists have revised down their forecast for German GDP growth by 0.3ppts, largely due to the Russia crisis. Using estimates (from historical data) of the impact of German growth on CE3 exports to Germany, we calculate that this drop in German GDP should lower Polish GDP by 0.02ppts, Czech GDP by 0.04ppts and Hungarian GDP by 0.07ppts (the implied decline of exports to Germany is around 0.2ppts in all three cases). Therefore, the indirect impact of the crisis on CE3 growth through reduced demand from Germany may also be limited.

Further, a much higher proportion of CE3 exports to Germany reflect processing trade rather than domestic value added. The share of the latter in CE3 exports to Germany is about 50% on average compared to about 70% for exports to Russia. The impact on CE3 GDP is thus likely to be correspondingly lower as some of the reduction in exports will be offset by a reduction in intermediate imported goods.

What are the actual export data telling us? Export performance through the first five months of this year appears to be largely in line with this assessment. German exports to Russia, for example, have indeed been more sensitive to slower Russian

11 September 2014



growth, declining by 15% YoY. The reduction in Central European exports to Russia has been lower, although varying across countries from 12.7% for Hungary, to 8.3% for Poland, and a relatively small 1.7% for the Czech Republic.

What is less clear is whether there has been much of an indirect impact via Germany. Exports to Germany are up by 13% YoY for Poland, 19% for Hungary and 19% for Czech Republic. It’s possible that export growth would have been even higher in the absence of the crisis in Russia and Ukraine. But these are relatively healthy numbers, suggesting that the indirect impact via Germany has so far been modest. In Poland, for example, the growth of exports to Germany has actually accelerated from about 6.6% YoY in the first two months of the year to 17.2% YoY between March and May.

Summary On the back of the Russia crisis, DB economists have lowered the forecast for the growth of Russian GDP by 1.6ppts, Ukrainian GDP by 6.5ppts and German GDP by 0.3ppts. We estimate that this, in turn, could lower Hungarian GDP by a total of 0.4ppts, Czech GDP by 0.2ppts and Polish GDP by a little over 0.1ppts. In the absence of a (strong) Russia effect, the recent weakness in Polish activity and survey data (retail sales, PMI) remains a puzzle, and is in contrast to the strong prints observed for Hungary and Czech Republic.

Polish PMI and retail sales have been weak recently, in

contrast to the rest of CE3


The ban on imports of food from the EU imposed by Russia earlier this month may amplify the impact of the crisis on CE3 in the coming months.8 Poland would appear to be most at risk in this regard, though its exports of food products to Russia amount to only about 0.3% of GDP; and some of these exports will likely find alternative markets, including domestically, albeit perhaps at a reduced price. Hungarian food exports to Russia are also about 0.3% of GDP, while Czech food exports to Russia are negligible.

Dependence of Central Europe on natural gas from Russia

The other potential source of vulnerability for the region would come through the disruption of imports from Russia, which account for 9% of total imports on average. Most of these imports (over 80% on average) are in the form of energy, but manufactured goods and chemicals also account for a significant fraction of imports from Russia (around 7% on average). While it would probably be relatively straightforward to find alternative sources of crude oil and coal, the same is not true for natural gas, which is much harder to transport and store.

The Czech Republic is almost totally reliant for its natural gas on Russia, which accounts for 97% of its gas consumption. Poland and Hungary, however, produce some gas domestically and also import some gas from elsewhere (e.g. Germany and central Asia). According to the International Energy Agency, imports from Russia accounted for 53% of gas consumption in Poland and 34% in Hungary, though this may understate their dependence insofar as some of the other imports are ultimately supplied either by or through Russia.

The importance of natural gas in the overall energy mix varies across countries. Poland and Czech Republic, for example, have substantial domestic coal resources. Natural gas therefore represents only 14% and 16% of their total primary energy supplies. Hungary, however, gets 36% of its primary energy from natural gas.

This implies that Russian gas accounts for about 7% of total primary energy supplies in Poland, 12% in Hungary, and 16% in the Czech Republic. This degree of dependence is towards the middle of the pack by European standards (chart below). But disruption of these supplies could nevertheless be damaging.

8 Russia had already restricted imports of pork from the EU in January. It

had also banned imports of fruit and vegetables from Poland at the

beginning of this month.

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European exposure to Russian natural gas

0%

10%

20%

30%

40%

50%

60%

Russian gas (% of total primary energy supply)

Source: Deutsche Bank, IEA

The extent of the potential damage would depend on the nature of the disruption. Following completion of the Nord Stream pipeline in 2012, for example, only about 50% of Russian gas to Europe comes through Ukraine compared with about 80% previously. European countries have also built more pipeline interconnectors between themselves, including from Poland to the Czech Republic and Slovakia to Hungary, as well as pumps that can reverse the flow of gas in transit pipelines.9

All of this should help in the event of another interruption of gas transit through Ukraine. This is certainly possible. Russia has already suspended gas supplies to Ukraine for domestic use following another pricing dispute. Shipments through Ukraine to Europe are continuing. By winter, however, Ukraine’s domestic gas reserves will likely be fully depleted, and it may, therefore, need to siphon off deliveries destined for Europe or look to reverse flow agreements from Europe. Either way, this could trigger further restrictions in supplies from Russia. Most at risk, in this regard, would be Czech Republic and Hungary, which receive their Russian gas via Ukraine, though, as noted above, they may now be able to import some gas through Poland and Slovakia.

9 Poland is also constructing an LNG terminal, which will reduce its

dependence on natural gas, albeit with higher cost LNG, though it will not

be ready until the middle of next year.

But this would not be much help if Russia decides to restrict the supply of gas through other routes, i.e. not only through Ukraine but also through the Nord Stream and Yamal Europe pipelines to Germany and through Poland, respectively. This seems unlikely given the damage it would do to Russia itself: energy accounts for about half of federal government revenues – although the bulk of this is admittedly from oil rather than natural gas. But it remains a tail risk given the possible further escalation of sanctions.

Robert Burgess, London, +44 207 547 1930 Gautam Kalani, London, +44 207 545 7066

11 September 2014



Asia Strategy

The end of summer has brought with it the possibility of a new regime in global markets, driven after a gap of several quarters by divergence in monetary policy in the developed world. ECB is set to accelerate its balance sheet just as the Fed’s plateaus. Which portends 1) increasing volatility of capital flows; and 2) likely re-correlation of trends in Asia/EM with the global factors after being driven for much of this year by localized issues.

Asia we believe is in a better place now versus its own history in 2013, and likely versus other EM, in its capacity to handle volatility. For starters, it has lesser geopolitical and governance concerns. The two big elections in the region have delivered mandates for change and growth. External imbalances have been moderating, though arguably more by way of import compression. Earnings revisions have been generally favorable. And policymakers have their eyes on the ball. Malaysia and Philippines have hiked rates, and will likely do so again. India and Indonesia have shown their intent to keep policy tight till internal and external imbalances have eased. The more the developed world delays raising the price of capital, the more time they afford to economies in Asia to build their defenses, and to work through their adjustments.

Asian currencies might find it hard to fight off the broader USD strength, but we think will hold their ground well versus European FX (EUR, CHF, EMEA) and JPY. We stay long MYR and PHP versus EUR; and are keen on some intra-regional crosses to avoid the dollar leg. We like long INR versus SGD as a carry play, and long CNH versus KRW as a play on relative FX policies. We stay long USD versus IDR and SGD (digital calls). Our rates are still more tactical, with long directional bias only in China and India. We like 3Y/10Y KTB steepeners, and look to buy 10Y Thai bonds on back up to 3.6%. We also like the belly of the Malay curve (2Y/5Y/10Y fly) and Singapore versus US (2Y3Y).

We have maintained an overall neutral stance on Asia sovereign credit year to date, and remain of the opinion that trading would largely be technicals-driven given the lack of clear near-term fundamental catalysts and an overall absence of primary supply in the rest of the year. We believe that the new issue supply has been nearly fully undertaken YTD and we expect a ballpark of $1-2bn of opportunistic borrowing in the remainder of the year (excluding the newly priced 10Y & 5Y sukuk deals by Indonesia and HK respectively). Should such issuance materialize, it would most likely be from HY borrowers – Mongolia and Vietnam.

Local Markets

CHINA

— FX: Buy CNH/KRW, target 176; long USD/CNH put spreads

— Rates: Small overweight

Using FX as a policy lever to ease liquidity. Positioning surveys, like the one conducted by Thomson Reuters, continue to suggest that the markets are looking to remain short on USD/RMB. This shift in sentiment is mostly driven by: (1) a rebound in China’s trade surplus, which our economist expects will continue, given the gradual recovery in the G3 economies and a boost from the recent RMB weakness; and (2) the expectation that the Chinese government will introduce more stimuli. Although risk on growth remains to the downside, we do not believe this will translate into a weaker RMB because: (1) flows into China remain balanced; and (2) given the ongoing tight liquidity situation in the onshore market, the PBoC is likely to allow more RMB appreciation to help loosen onshore liquidity by encouraging inflows. In fact, this has been the case in the past few days whereby the PBoC has fixed USD/CNY 450pips lower. This is possibly an indication that the PBoC is using FX as monetary policy lever to help loosen liquidity conditions via attracting more inflows. We recommend buying CNH/KRW 6M NDF with a target of 176. On the rates side, we recommend staying overweight cash CGBs and CDBs. First, Premier Li confirmed in its speech at the 2014 Summer Davos in Tianjin that monetary easing will remain targeted this year to lower corporate funding costs in sectors which are structurally important; this is in line with our expectation and implies further targeted easing is likely which supports the overall liquidity condition. We expect money market rates to drop by another 10-20bp over the next few months (after having fallen by 10bp since August 20th). Secondly, supply risk is largely priced in and the pace of supply will slow down as we approach Q4. Third, concerns over credit risk deterioration and flight to quality flows are supportive to the CGB and financial bonds; lastly, carry is attractive on cash bonds (for example 6bps/month for 3Y CGBs). We expect the CGB curve to trade in a 20-30bp range this month (10Y CGBs within 4.2-4.4%) and we would look to increase our exposure during any liquidity squeeze driven selloffs. Seasonal liquidity risk is high during September- October given Q3 quarter end and the October National long holiday and we expect volatilities in the money market rates to rise in the near-term. We stay neutral on IRS curve for now and look for opportunities to go long.

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HONG KONG

— FX: Neutral

— Rates: Steepening bias on the Hi-Li basis curve

Hibor-Libor basis risk. Hibor Libor basis has risen sharply since the end of August, with the basis level at the long end hitting the highest level since middle of 2013. We believe strong corporate liability hedging demand has bear-steepened the long end of the Hibor - Libor curve. As long term corporate funding activities will likely continue to recover towards the year end, we see further steepening risk in the basis curve (about 10bp in the 5Y/10Y slope).

INDIA

— FX: Short 6M SGD/INR, target 46

— Rates: Long 10Y IGBs, target 8.25%

Fundamentally long. We see three key factors as supportive of a fundamental long position in the rupee. First, compression in India’s current account deficit has been more enduring than expected, largely because gold import restrictions have been kept in place. Second, India is a big winner from falling commodity prices. With oil making up a third of India’s import bill, the sharp decline in global prices will help the trade balance. India’s fiscal and inflation profiles could also see relief. The under recovery on diesel prices is now close to zero; hence a further fall in oil prices would allow the government to cut diesel prices for the first time in seven years. With energy making up close to 10% of India’s CPI basket, this would be a welcome source of disinflation. Third, RBI’s strong anti-inflation stance – while encumbering hopes of a rapid growth revival – is a positive for currency. The contrast between RBI’s continued hawkish stance, and the trend of creeping easing across the globe is itself an optical positive. But if RBI finally manages to break inflation’s back, it would improve the long-term fair value of the rupee on a PPP basis. We are mindful of the risks to bullish FX story, but on weighing them up, still find in favor of some long rupee exposure. The first key risk is of US rate re-pricing, with the market beginning to anticipate a shift in the Fed’s tone. However, even as US front-end rates move higher, the introduction of ECB QE should help keep global long-end rates better anchored, containing damage to carry FX. Moreover, portfolio flows could prove stickier in India with government and central bank credibility now higher versus mid-2013. The second detracting factor is aggressive intervention by RBI with the aim of both improving reserves adequacy and maintaining FX fair value. However, having bought $65bn this year, RBI has covered back their short forward book, and re-attained the pre-2008 peak in reserves. There is thus scope for intervention intensity to reduce on the margin. The third key risk is that inflow momentum slows down.

Over 50% of YTD portfolio flows to India have come in debt markets (+$17bn), but the scope for further debt money now looks very limited with 98% of the open $25bn quota for government bonds taken up. Barring further quota liberalization, we would look to FDI and foreign interest in government stake sales to maintain the run-rate on flows. The balance of reasons suggests that while the rupee may not make spot headway against the USD, there is room for it to outperform its forwards and other currencies in the region. We are happy to be fundamentally long INR against the SGD.

INDONESIA

— FX: Long 6M USD/IDR, target 12300

— Rates: Marketweight

Most of the good news is in the price. There is plenty more to like about Indonesia today than from before the summer. The elections have yielded a positive mandate for change, though encumbered to some extent by the fragmented nature of polity which is the legacy of a contentious electoral battle. The Jokowi team has emphasized their commitment to tackle the issue of energy subsidies, which has been one of the main drags to Indonesia's macro credit profile. We are likely past the worst on external deficit, though the current account gap is now wider than anywhere else in Asia. Reallocation of capital away from troubles in other part of EM, and now the promise of balance sheet extension in Europe, continue to feed the interest in buying Indonesia carry. Close to $10bn has come into Indonesian bonds this year. And we are left with only 20% of supply for the remainder of the year. About 60% of the reserve drawdown since 2011 has been built back. The macro economy is in a sweet spot, with more sustainable growth levels, and well anchored inflation expectations. And Bank Indonesia has rather commendably stuck to its guns on keeping policy tight to curb the external deficit. All of this is good news. We worry though that most of this good news is already in the price. There are disturbing reports in the local press about the transition in government being less smooth than earlier expected. The outgoing President's refusal to hike fuel prices has put the burden of adjustment squarely with the new administration. An increase in fuel prices by 10-15% is widely expected; and it would probably need something more substantial - like a move to a fixed subsidy system - to buoy market sentiment. Again, the good news on inflation is likely well factored in as well, as also the probability of BI staying on the sidelines. The trade account could start to see cyclical pressures again if the government manages to revive growth. The relationship with commodities is still a headwind. And we see little reason for the central bank to back away from building reserves. More than the domestic factors though, we worry that the markets will re-correlate to the global impulse, and in particular to the stronger dollar, and

11 September 2014



higher US rates thematic. Old concerns about record offshore ownership of domestic bond markets (37%) will at some stage bear again on price action. It’s never easy to fight carry. This is why we have been marketweight on duration for the past few weeks. But we keep our more cautious stance on the currency, and stay long dollars.

MALAYSIA

— FX: Long MYR vs. EUR

— Rates: Receive 2Y/5Y/10Y Fly

What drives the 10Y MGS? Our economists expect the BNM to hike OPR by 25bp to 3.50% next week. Indeed, the 3M Klibor has been grinding higher, as the rate hike expectations are building up. The spread between 3M Klibor and policy rate has now widened to 48bp from 32bp at the time of the last MPC. With front-end getting re-priced on rising rate hike expectations, while back-end remaining relatively supported given low core rates and carry friendly environment, both MGS and swap curves have witnessed relentless flattening. It begs the question if the back-end rates, in particular the 10Y MGS is pricing in sufficient term premium. We present a simple framework, where 3M Klibor, $/MYR and 10Y UST explain movement in the 10Y MGS in a fairly consistent and statistically significant manner (R-squared of 87%, and desired T-stats) for the last 5 years. The first variable i.e. 3M Klibor defines the general level of interest rate (funding/borrowing cost) in the domestic economy. Second variable i.e. $/MYR broadly helps to capture the sentiment of foreigners. With offshore investors holding more than 47% of the MGS market, their activities are becoming increasingly important – not only for rates market but for the currency too. Note that over the last few years, current account balance has been declining, whereas domestic outflows have been rising as locals continue to diversify/expand overseas. The positive current account balance is now completely offset by the domestic outflows (FDI + portfolio). That means the balance is tipped by the offshore portfolio flows. Our analysis show that, for every 1% increase in the offshore flows on average, $/MYR moves lower by roughly 0.25%. So, keeping this in mind, it is reasonable to assume that the foreign sentiment can be inferred from the moves in $/MYR which is the second variable in our 10Y MGS model framework. It is also interesting to note that $/MYR is increasingly explaining the slope of the curve (steepness/flatness). Finally, the third variable i.e. 10Y US Treasury yield, has a big influence on the 10Y MGS, which should come as a no surprise. Based on these three variables, the 10Y MGS currently at 4% is arguably fairly valued. However, given our forecasts of slightly higher 10Y UST yield, 3M Klibor and $/MYR over the next 3 months, the near term path for 10Y MGS yield is likely to be higher rather than lower. On the swap curve, we stay with our recommendation to

receive the belly (5Y) vs. paying the wings (2Y and 10Y), which also offers a positive carry and roll-down. With Klibor grinding higher, front-end paid will continue to perform. Meanwhile, 5Y/10Y appears very flat on our models, and any rates re-pricing on the global front will lead to descent steepening in the 5Y/10Y part of the curve.

PHILIPPINES

— FX: Long PHP versus EUR

— Rates: Small underweight

A long path to normalizing policy. Things are moving mostly to script in the peso markets. This is an economy we have long considered as having among the easiest policy settings in the region. The good news is that the central bank has been proactive this year in responding to the increasing signs of inflationary pressure through tightening policy settings. It has worked on both tightening the quantum and price of liquidity. We think more needs to be done, though, and in particular to narrow the basis between the price point on SDA (which anchors the effective interest rates in the economy), and BSP's policy rate. Monetary aggregates have optically normalized, but only because of the base effect from the surge in liquidity last year. More needs to be done to take out liquidity from the system, at a time when the economy is showing strong growth momentum, government spending is likely to pick up, and supply side factors like energy crunch are putting relentless upside pressure on inflation. The peso fixed income markets have gradually adjusted - mostly in the far end - to this normalization trend. The front end is still well anchored by flush liquidity. We stay small underweight, as this normalization will continue to be a headwind for fixed income. Spread to USTs, while unlikely to revert to the 300+bp levels from before 2012, still suggest scope for further cheapening of peso bonds. We still like the currency, though mostly versus EUR rather than USD. Positioning is much cleaner, the external surpluses are still healthy, and peso markets should partake too (to some extent) in the capital push from balance sheet expansion in Europe. It remains a somewhat binary trade though, dependent very crucially on whether the central bank continues to stay with the curve, or decide to fall behind.

SINGAPORE

— FX: Long USD/SGD via 1.2750 digital calls

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

Appreciation bias is no insulation against the USD. We expect MAS to remain on hold at their next policy meeting in October. While headline inflation is

11 September 2014



anticipated to ease, authorities expect core inflation – which is the main target variable for monetary policy – to stay elevated at 2-3%, consistent with retaining a 2% p.a. appreciation bias to the SGD NEER. However, we do not believe the appreciation bias is a reason to be constructive on the SGD. Despite a consistent upward slope SGD NEER has tellingly not traded near the top end of the band this year. Reserves, including the forward book, have also declined, suggesting MAS has been supporting the currency, likely near the mid-band. Our bearishness on the SGD stems from a combination of four negative factors. First, the softening in the property market, to which flows and FX has historically been correlated. Second, widespread consensus on our FX models of overvaluation. Third, the recent underperformance of exports driven by a loss of competitiveness in manufacturing and electronic sectors. Fourth, a high beta to USD strength: correlations to EUR/USD for instance, are the highest amongst all Asian currencies. We retain our outstanding USD/SGD 1.2750 digital call position, and would use the SGD as a funder for intraregional carry trades.

SOUTH KOREA

— FX: Buy CNH/KRW, target 176

— Rates: Pay 3Y/10Y KTB steeepener, target +80bp

Seasonality of steepening in 4Q. We like to pay 3Y/10Y KTB steepener, positioning for the seasonal steepening bias in 4Q. Our rationale for steepeners includes; 1) the residual possibility of another BOK rate cut; 2) seasonally weak demand from local long-term investors; 3) a slowdown in structured notes issuance in 4Q; and 4) a delicate tweak in the household debt policy aimed at curbing the debt service burden. First, we believe it is reasonable for the market to price in 50% of another rate cut within this year. While the front-end rates have come off a fair bit, the current curve prices in only 25% of another 25bp rate cut by year end. This is mainly due to a greater decline in the 91D CD rate. The high frequency data are showing some signs of recovery, albeit not solid enough for the BOK to shrug off government pressure. And we believe the market will continue to price in easing irrespective of an actual BOK cut at the coming MPCs. Second, local long-term investors have tended to soften their bond investments in 4Q. Lifers’ bond investments have tended to pick up in August and September, and slow down in 4Q. For example, lifers’ monthly bond investments in December were slower at 5%, 8% and 2% for 2012, 2011, and 2010, respectively. The same goes for the National Pension Service (NPS). Third, structured note issuance has been traditionally sluggish by year end. Hence, long-end swap receiving flows by structured note issuance should be weak going forward. Finally, there has been a delicate tweak in the

household debt policy, in our view, posing downward pressure on the 91D CD rate. Policy focus is moving to a reduction in debt service burden from an improvement in household debt quality. We feel the government is trying to maximize the effect of the August rate cut. The historical average response (16-17bp decline) in the 91D CD would not be enough for the government to turn around sentiment. Given the fact that floating rate loans still account for 82% of the entire household debt, a reduction in the reference rates (mainly CD and COFIX) for floating rate loans would surely mitigate the debt service burden.

TAIWAN

— FX: Neutral

— Rates: Maintain neutral weight on duration

Risks towards higher yields. We maintain our neutral weight on duration given the limited absolute scope of a correction. However, we believe the risk to the TGB curve is skewed toward the upside to yields. The TGB yield curve has bear steepened on the back of stronger-than-anticipated macro prints as well as increasing supply of foreign currency bonds inside Taiwan. The prospect of TGB supply has remained quite stable, but there were meaningful changes to the bond market technicals. In our Taiwan bond market guide, we pointed out that the risk of dilution in domestic bond demand could be a game changer in the Taiwan bond market. Despite a recent correction in the TGB yields, the yield differential between the TGB and UST yields is substantial, encouraging offshore company branches domiciled in Taiwan to issue foreign currency bonds. Insurers have a hurdle of 45% for their foreign asset investment, but Formosa bonds and foreign currency bonds listed in the Taiwan exchange are categorized as domestic bonds. As a result, this policy factor has effectively limited the scope of any rally, which we believe will likely continue. The Formosa bond market is also likely to grow faster than before. The CNY7.0bn issuance in August and September accounted for nearly 30% of total Formosa bonds outstanding of 21bn. At the beginning of the Formosa bond market in 2013, Taiwanese corporates led the market. However, Chinese corporations have driven the recent pick-up. Given the wider pool of issuers, active participation from Chinese corporations could augur well for acceleration in the development of the market, which would likely pose upward pressure on TGB yields.

THAILAND

— FX: Neutral

— Rates: Buy 10Y ThaiGB on back up to 3.60%

Long rates story is still appealing. With the 10Y and 30Y ThaiGB auctions scheduled on 24-Sep, the supply for FY14 will come to an end. Meanwhile, the PDMO is

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expected to have a dialogue with Primary Dealers on 17-Sep, where the tentative issuance plan for FY15 will be discussed. There are concerns that the supply might be higher given the need of additional borrowing for the infrastructure project. However, as we have been arguing in these pages, the borrowing for infra projects is spanned over 2015-2022. Moreover, there are other avenues of borrowing for the infra funding and not just the Loan Bond issuances. Indeed, the PDMO had stated in their bond market booklet earlier that the Infrastructure Bill passed under previous government’s administration was planned to be funded via short-term bank loans, which provide more flexibility and cost saving. The plan was to then convert them into long-term instruments later. Also, note that the government has penciled a FY15 budget deficit of THB250bn only, the same amount as this year’s. Junta has been saying on the wires that they will maintain the fiscal discipline. So, our arithmetic tells us that the Loan Bond issuance numbers for FY15 will very likely to be lower like this year’s. What makes it even interesting is the fact that there are large redemptions lined up ahead, with TH8bn on 24-Sep, 46bn on 26-Nov and another 44bn on 3-Dec. On the demand side, there is no shortage of cash with the locals. Whereas, for the foreigners, arguably they cut some of their underweight positions in Thai Bonds after the coup, but there’s still more to go as per our estimates. Meanwhile, the initial optimism, euphoria following the coup hasn’t translated into the actual macro data yet. We do not anticipate further easing from the central bank at this juncture, but given benign inflation outlook on back of the price control measures implemented by the Junta and still weak growth, any normalisation of rates will take much longer – keeping the BoT firmly on hold for an extended period. This makes Thai bond curve the steepest in the region. In nutshell, we are constructive on the duration amidst the backdrop of positive supply/demand technicals, a central bank in no rush of normalizing rates, and a very steep curve. We are looking to go long 10Y ThaiGB at 3.60%.

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

Credit

Overall, our strategy of being defensive has played out relatively well in August, when we recommended a tactical move OW IG vs. HY. We are now switching back to our longer term call of OW HY vs. IG and reiterate our constructive stance on Asia credit. We expect Asian sovereigns to outperform IG and HY corporates driven by strong market technicals. We recommend using China 5yr CDS as a hedge ahead of

what is expected to be a heavy bank issuance autumn, while respecting the roll technicals as we approach 20 September. We stay long on both MONGOL sovereigns and DBMMN bonds, but consider Sri Lanka sovereigns and quasis complex as overvalued (particularly banks). Indo quasis offer a better value at the current levels, although investors might also look to express this view vs. five-year CDS on a dip to 125bp area pre-roll.

SRI LANKA

— Credit Neutral

— The sovereign bonds become increasingly overvalued vs. global peers, but technicals remain supportive

— Quasi-sovereign spreads underperformance vs. sovereign brings bonds closer to FV

The better-than-expected trade deficit (i.e., lower imports) and low-single-digit inflation have been a consequence of lower-than-expected credit expansion in the country. At the same time, as our economists are guiding for a ~50bp rate cut in 2H14, the credit expansion dynamics could change should the banks be more aggressive in pre-empting policy easing and start pushing credit to the borrowers in higher volumes. This is quite likely, in our view, as the government has already labeled the slow credit growth YTD as a “temporary phenomenon”. Looking at the bond spreads wider in August we welcome the initial weakness that we saw earlier in the month. Sri Lanka cash bonds have already been the most expensive among B/BB-rated sovereign paper relative to EM peers and we do not believe that the optical spread tightening of late is fundamentally sustainable. SRILAN ‘19s are currently trading at a YTD tightest spread of Z+265 and look increasingly overvalued in the global context (i.e., vs. African and LatAm B/BB sovereign bonds). Also, the ~80bp spread differential between BAKCEY and NSBLK bonds vs. SRILAN equivalents is off the historic tights of ~55bp observed last week, but continues to look unattractive vs. similar pick-up between PERTIJ and PLNIJ bonds and INDON sovereigns, which are at the same time rated three notches higher. We see no upside potential in the new NSBLK ‘19s, which are trading through NSBLK ’18s spread-wise and are 3x smaller in size.

11 September 2014



Quasis vs. sov spreads. Underperformance of SL

credits brings them closer to FV vs. global peers

20

40

60

80

100

120

140

160

180

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

z-sp

read

diffe

rential (b

ps)

BAKCEY '18 vs. SRILAN '19

NSBLK '18 vs. SRILAN '19

PLN '19 vs. INDON '19

PERTIJ '21 vs. INDON '21


MONGOLIA

— Remain Overweight

— Consider any weakness in MONGOL or DBMMN spreads as an opportunity to add

The importance of the strategic link with China and our base case scenario of China extending its financial support to Mongolia in case of the need that was evidenced during the recent visit by China’s President to the country. As a result, China pledged to help Mongolia join the Asia-Pacific Economic Cooperation mechanism. China also agreed to offer sea ports and railway transport access to Mongolia and help finance a number of projects in medical care, education, railroad, and residential construction. Petrochina and the Mongolian government signed an MOU to further develop their cooperation in oil explorations in the country. As the most immediate step in extending its cooperation in the financial sector, PBOC has increased the swap line with BOM from RMB10bn to RMB15bn. We maintain our Buy recommendations on MONGOL 5.125% ’22 and 4.125% ’18, DBMMN 5.75% ’17 bonds and we believe that they have the potential for a further 60-70bp spread tightening, which would bring them to fairer levels vs. Sri Lanka. Key risks: new USD issuance, a sharp downward move in global coal and copper prices, a spike in MNT volatility, and instability within the incumbent government.

Mongolia bonds underperform Sri Lanka vs. global

peers, which we believe is unwarranted

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

mid-yield % MONGOL '22 MONGOL '18SRILAN '19 SRILAN '22IVYCST '24 GHANA '17ZAMBIN '22 MEMATU '20


INDONESIA

— Credit Neutral

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

— 5Y CDS appears increasingly tight; would be buyers should it get closer to 125bp

Following the Presidential elections, the hard part for Jokowi now really begins and the fuel subsidy question is unlikely to be the first one to be successfully tackled when the new parliament is formed in October. Jokowi is still in the process of forming a stronger coalition for his party, which thus far has proved challenging. The recent decision by BI to keep rates on hold was not a surprise to us (as opposed to a hike), given the slowdown in economic growth and credit expansion in the country YTD. Our economists believe that current macro conditions in Indonesia would most likely allow the country to record a sub-5% inflation reading for the rest of the year (July’s print was 4.5%, with 3.9% for August). At the same time, a single fuel price hike by 10-15% this year could add as much as 200bp to the inflation level, forcing BI to hike rates, which in turn could be counter-productive for credit growth and could be negative for GDP trajectory too. We also note a 49.5 print for August PMI – the lowest in the past 12 months. In addition, we believe that quasi-sovereigns have largely under-borrowed in 1H14 based on their capex and M&A plans. The relatively high leverage of Indonesian banks vs. Asian peers and the series of rate hikes earlier in 2013/2014 already make it quite challenging for Indonesian conglomerates to raise funds domestically. In our view, we could see up to USD5bn worth of HC borrowings from the Indonesian quasi-sovereign space in 2H14, which could soften the valuations in the belly of the sovereign curve. Notably, the 10Y30Y slope remains too steep in Indonesia at

11 September 2014



~60bp – just 5bp below the YTD widest point. 10Y spreads have tightened by ~40bp since 1-Aug, while 30Y spreads moved ~30bp tighter in the same period. The ongoing issuance of “Pelindo-III” inaugural USD bond would most likely, in our view, be of up to 10Y in maturity and could bring weakness to INDON’s belly of the curve.

INDON curve becomes increasingly steep

-40

-20

0

20

40

60

80

100

120

z-s

pre

ad

dif

fere

ntial (

bp

s)

INDON '44 vs. INDON '24 PHILIP '37 vs. PHILIP '19

PHILIP '34 vs. PHILIP '24 INDON '38 vs. INDON '19


CDS looks increasingly mispriced to us even despite Brazilian 5Y CDS moving ~30bp tighter in the past month, which still makes Indonesian 5Y CDS at ~130bp look too tight. INDON 5Y CDS is only 5bp wider vs. five-year tights observed in October 2010, January 2011, December 2012 and May 2013. We do not believe that in the absence of legislative and fiscal reforms, Indonesia has enough fundamental pull to make these technically strong valuation levels sustainable. We would be Buyers of INDON 5Y CDS should it breach the 125bp mark. We recommend investors to enter curve flattener trades in INDON cash bonds, while also reallocating from the belly/long-end of the quasi-sovereign credit curve back into sovereign in the anticipation of new USD supply from the former. New INDOIS ’24 look optically more attractive on the sovereign curve vs. INDON ‘24s, but we see more value in the longer end. BUY INDON 6.625% ’37, 5.25% ’42 & 6.75% ’44. SELL INDON 11.625% ’19,

INDON 5.375% ’23 and INDON 5.875% ’24. 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 form a viable parliamentary coalition.

CHINA

— Credit: Neutral

— Tactial buy on CHINA 5Y CDS as a hedge

The fragility of investor sentiment toward its credit story could be tested once again, following quite a disappointing Flash PMI print earlier in August. However, the latest CHINA 5Y CDS trading trajectory has been boding well with our in-house view of the country’s steady macroeconomic improvement, which mainly is stemming from the progress of the array of fiscal, economic, and corporate sector (e.g., SOEs) reforms that the government has been rigorously pursuing. We view that at current levels (~70bp) CHINA 5Y CDS could be used as a hedging tool in the current market environment. We would recommend investors consider Buying CHINA 5Y CDS with a stop-loss at 65bp and the target of ~85bp. We believe that the upcoming primary supply by China’s quasi-sovereign banks in large volumes could drive CDS spreads wider. The caveat with China CDS is that with the roll coming up on 20 September, technicals might be supportive of a move sub-70bp first and could present a better entry point. Key risks: materially stronger economic data, positive ratings action, and a lack of primary supply by SOEs and state-owned banks.

Viacheslav Shilin, Singapore, +65 6423 5726

11 September 2014



EMEA Strategy

In FX, we stay long PLN/HUF and TRY/ZAR, as country specific factors over the next couple of months are likely to be increasingly manifested in FX. It also allows us EM higher at a time when USD positioning is increasingly stretched (see latest IMM report). Moreover, in order to capture attractive carry, some election promise in Brazil and an environment of broad-based EUR weakness we go long an equally weighted basket of BRL and MXN vs short HUF and CZK.

In rates, we keep our medium term strategy view and see valuation in EMEA rates as rich. However, given the attractive external environment with a dovish ECB and some recent weakness in US economic data we favor trades still benefiting from attractive carry whilst at the same time providing some protection against a normalisation in US rates. Receive the belly in a 1Y:2Y1Y:5Y5Y butterfly in Israel to squeeze the attractive carry while benefitting from the high beta against US-rates during selloffs. In Hungary and South Africa position for a delay in the start of the hiking cycle by keeping the 1s2s IRS steepener in the former and a 1Y vs. 5Y5Y IRS steepener in the latter. In Poland position for an unwinding of the aggressive cuts priced by paying 6x9 FRAs or position into 2s10s IRS flatteners. In Czech benefit from the tight swap-spread levels in the long end by position into swap-spread wideners and a short position in 10Y government bonds vs. Poland/Germany. In Turkey we keep our steepening view in XCCY while in Russia we favor 2Y XCCY payers to profit from the positive carry and to position for further rate hikes.

In credit, we stay underweight Russia (while maintaining neutral on Ukraine for carry considerations) and remain biased to adding hedges against potential further escalation on strength. For the rest of EMEA, we continue to favor mid-beta credits for scope of spread compression as well as higher carry – we increase Hungary to overweight, while maintaining Turkey at overweight. We remain underweight Poland and neutral South Africa. In relative value, we favor short basis in Turkey (10Y CDS vs. 25s), long basis in Russia (30s vs. 5Y CDS), and cash curve flatteners in South Africa (41s vs. 25s) and Poland (24s vs. 19s).

Local Markets

CZECH REPUBLIC

— FX: Go long an equally weighted basket of BRL and MXN vs short HUF and CZK. Target 17.95, a return to round the highs from last year. Stop @ 16.75.

— Rates: Given tight level in long end swap-spreads, position into swaps-spread wideners being short May-24 (target: 40bp / stop:-25bp). As a cross-country trade we favour a short 10Y vs. equally weighted longs in Poland and Germany.

Short CZK & HUF vs long BRL & MXN


The fundamental situation in Czech has not changed over the last couple months. Despite somewhat softer activity data in recent weeks, the Czech recovery is largely intact, benefiting from a gradual decline in the unemployment rate and historically low refinancing costs. Low inflation pressure will 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. The market continues to price another cut to 0% in official rates by end-14, and sees 0.10% by end-15 (current rates at 0.05%).

11 September 2014



HUNGARY

— FX: Stay short HUF vs PLN, target 78.50, stop @ 73.65.

— Rates: Position for a delay in the hiking cycle or further by receiving 3x6 FRAs (target: 2.05%, stop: 2.35) or by entering 1s2s IRS steepeners (target 40bp / stop: 0bp). Underweight the belly of the curve in a 2s5s10s butterfly.

Government officials have stated that they aim to convert the entire remaining FX loan stock (EUR11.6bn) to forint by year-end. While this is too optimistic, in our opinion, the process could only impact HUF negatively. Indirectly through higher risk premia if banks have to absorb large losses, while the more direct impact would come from banks needing to access FX liquidity as FX loans are converted into HUF. The early repayment scheme in 2011 saw EUR4.4bn repaid by borrowers. Banks bought EUR2.6bn from the NBH, and EUR1.8bn on the market. A similar 40% share of the EUR11.6bn would suggest EUR4.6bn will be bought on the market this time around, ie more than twice as much. In 2011 HUF depreciated by 6-7% vs PLN and CZK over this period.

On the policy front, continuous low inflation pressure and a positive external environment could keep the NBH on hold for longer than what the market is pricing in currently (markets now pricing ~10bps of hikes by year-end and another 30bps to 2.50% by end-15). In fact, in case the FED remains dovish, we would not rule out further easing in Hungary in the near term, followed by more aggressive unwinding of the rate cuts in the second half of 2015. Hence regardless of further easing the short end of the curve looks attractive to steepen further.

Hungary wants to eliminate FX loans stock by yr-end


ISRAEL

— FX: Stay short ILS vs USD until ILS is trading at around 4.23/4.24 vs an equally weighted EUR & USD basket. Target 3.70, with a stop @ 3.58.

— Rates: Enter a 1Y:2Y1Y:5Y5Y butterfly long the belly in IRS (target 100bp / stop 40bp and attractive carry of 18bps over 3m). Benefit from the sweet spot in carry while combining with a payer position in the long end to protect the trade against normalization in US-rates.

The run of poor activity data and very subdued CPI has continued, resulting in the BoI surprising the markets on Aug 25th, cutting rates by another 25bp to 0.25%. With inflation currently running at a mere 0.3% YoY (July), and with inflation expectations also having declined, the Bank will be very sensitive to monthly CPI reports as a further deceleration would take prices dangerously close to deflationary territory. Market pricing reflects this by not pricing further rate cuts but on the other hand pricing a very benign hiking cycle over the next 15 months (+30bps by end-15). Hence with policy rate close to zero, FX intervention is now the more likely route should the BoI want to ease further, especially given its concerns about the impact of the strong shekel on export performance.

Inflation expectations have fallen significantly

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2006 2008 2010 2012 2014

% YoY

One year (analyst forecasts)

Five year (capital market derived)

Inflation target range


POLAND

— FX: Stay long PLN/HUF, target 78.50, with a stop @ 73.65.

— Rates: Position for an unwinding of the aggressive cuts priced by paying 6x9 FRA (target: 2.50 and stop 1.75). Express our strategic flattening view by staying into 2s10s IRS flatteners with a positive carry/roll of 4bps

11 September 2014



over 3m. As cross country trade - despite the historical tight levels – position for a delay in the hiking cycle in Hungary and a reduction in the dovish bias in Poland by entering a short 1Y PLN vs. HUF providing carry/roll of 10bps over 3m.

Despite leaving rates unchanged at 2.50% the dovish sounding statement led markets to scale up further their rate cut expectations, now pricing 25bps of easing for the October meeting and 70bps of rate cuts by year-end. Activity data have weakened somewhat over recent weeks but this is unlikely to change the NBPs optimistic view on the economic recovery. Given very subdued inflation pressures and the supportive monetary policy of surrounding central banks, further rate cuts cannot be ruled out. However, we still see the aggressive easing cycle priced as too dovish and favour short end payers. Although already quite rich, longer dated rates in Poland should remain supported by a dovish ECB and flows from Euro-area peripherals into CE3 in particular given the underperformance vs. those countries since 2012.

Market expectations for rates in Hungary and Poland -

pricing in Poland looks too dovish

-80bps -70bps

+15bps

+37bps

-80

-60

-40

-20

0

20

40

60

Au

g-14

Sep-1

4

Oct-1

4

No

v-14

Dec-1

4

Jan-1

5

Feb-1

5

Mar-1

5

Ap

r-15

May-1

5

Jun

-15

Jul-1

5

Au

g-15

Sep-1

5

Oct-1

5

No

v-15

Dec-1

5

Jan-1

6

Poland

Hungary

rate expectations priced relative to todays level


SOUTH AFRICA

- FX: Stay short ZAR vs TRY, revise target and stop to 5.0450 (5.0150) and 4.95 (4.89) respectively.

- Rates: To position for a delay in the hiking cycle in combination with long end weakness given a) the recent outperformance vs peers b) the weak underlying economic momentum and c) the vulnerability in case of a normalization in US rates by entering a long 1Y vs. paying 5Y5Y at 2.66 with target 3.25, stop 2.25 and a carry/roll of 10bps over 3m.

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 6.50% (from 7.50% previously). Markets are fully pricing the 25bps of hikes by year end and rates at 6.80% by end-15 (+105bps). Although headline inflation is still running above the ceiling of the SARB inflation target range of 6% the recent lower than expected inflation prints are welcomed from a rates perspective, particularly given the difficulty the SARB is facing between balancing inflation risks, the risk of a weaker ZAR and a soft economic backdrop.

We expect the ZAR IRS curve to steepen over

upcoming months

200

250

300

350

400

450

500

01/01/2010 01/01/2011 01/01/2012 01/01/2013 01/01/2014

1Y - 5Y5Y spread in ZAR IRS


RUSSIA

— FX: Stay short USD/RUB from Sept 2nd (entry 37.45), targeting 36.50, with the stop revised to 37.85 (37.72).

— Rates: On the back of the recent rally in XCCY position into a short 2Y XCCY at currently 8.36 with target 9.00, stop 7.75 and carry/roll of 13bps over 3m.

The weak economic trend has been reinforced by further sanctions on the Russian economy, with DB Economics now anticipating a mere +0.8% GDP growth this year, and +1.0% in 2015. Inflation re-accelerated slightly in August to 7.6% YoY, from 7.5% in July, primarily reflecting the pas-through from RUB depreciation, as well as the restriction on imports (boosting food prices). Elsewhere the CBR continued to widen the parameters of the exchange rate policy with the targeted rate band of the dual currency basket being shifted from RUB/BASK7.0 to RUB/BASK9.0. The CBR stated that the changes were carried out as part of the transition to an inflation targeting regime, which the monetary authorities expect to launch at the beginning of 2015.

11 September 2014



CBR moves further towards free-floating


TURKEY

— FX: Long TRY/ZAR. Lock in profit, move target and stop higher to 5.0450 (5.0150) and 4.95 (4.89) respectively.

— Rates: Enter 1s5s XCCY steepeners at 15bp

with a stop at 0bps, target at 50bp and a positive carry/roll of 5bps over 3m to position for further easing than currently priced in the near term in combination with higher rates in the belly given the high sensitivity of Turkish rates to a selloff in US-rates. In B/E space we keep our fundamental view and recommend to use B/Es below 7.0% as entrance level for wideners (Aug-23 and Nov-23 both at 7.10%) while dissuade from those positions at levels above 7.40%.

Decent activity data, stable confidence surveys, high spot inflation, combined with the high sensitivity of domestic rate markets to a normalization in US rates and some recent weakness in the lira have all led to an aggressive re-pricing of rate expectations over the course of the next few quarters. While the market was pricing further easing a couple weeks back we now have ~25bps of hikes priced by year end and another 15bps of hikes expected by end-15. With inflation running close to 10%, and with USD/TRY at around 2.20 at the time of writing, the CBT will be cautious in adding to depreciation pressures, suggesting rates will be left unchanged at the next meeting on Sept 25th. High inflation, in combination with global risks factors, should lead to a steepening of the XCCY curve.

Further easing has been priced into EMEA over the last

months with the exception of Turkey and Russia

Country today end-14change

last 30dend-15

change

last 30d

Czech 0.05% 0.01% -4bp 0.09% -1bp

Hungary 2.10% 2.21% -9bp 2.51% -15bp

Poland 2.50% 1.83% -25bp 1.83% -35bp

Israel 0.25% 0.25% -25bp 0.53% -15bp

South Africa 5.75% 6.07% -3bp 6.81% -15bp

Turkey 8.25% 8.53% +53bp 8.67% +40bp

Russia 8.00% 8.50% +25bp 8.00% +10bp Source: Deutsche Bank, Bloomberg Finance LP

Henrik Gullberg, London, (44) 20 7545 4987 Christian Wietoska, London, (44) 20 7545 2424

Raj Chatterjee, Mumbai, (91) 22 7181 1601

11 September 2014



Credit

RUSSIA

— Stay underweight

— Keep long basis (30s vs. 5Y CDS)

The spread of Russian bonds remains close to multi-year wides on the escalation of the crisis during the summer and associated further sanctions by the west, as well as weaker fundamentals. We remain skeptical on the durability of the “ceasefire”, as we believe Russia will seek to sustain economic and military pressure on the ground as a means to achieving some sort of “federalism” in Ukraine. Meanwhile, the significant political constraint that President Poroshenko is facing domestically will likely prevent any meaningful compromises, at least over the near term. The new sanctions, currently delayed, will likely be implemented in the near future.

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). 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, who has had a negative outlook since April.

So, overall, we see risk as still biased to the downside even considering the elevated level of spreads. We continue to look to add hedges on strength against potential further escalation (and maintain target entry to buy Russia 5Y CDS at 220bp).

CDS/bond basis in Russia has been on an opposite

trend as compared to the rest of the EMs


CDS/bond basis across EMs has widened over the past few weeks as the market recovered from the early August selloff, but Russia has been an exception to this trend for obvious reasons. We recommended a tactical long basis trade on 4 September via long 30s vs. 5Y CDS and we maintain this position (entry: -40bp; current: -30bp; target: -20bp; stop: -50bp). If the market recovers over the near term, Russian basis should normalize. Conversely, if spreads widen again, the basis is also somewhat supported as the level is already fairly close to the lowest level of the past two years.

UKRAINE

— Stay neutral, but only in conjunction with underweight Russia

Our neutral position on Ukraine – in conjunction with an underweight position in Russia for carry considerations – has proven non-optimal, as Ukraine’s spreads have widened by over 200bp in July and August. However, as the IMF has disbursed the second tranche of its assistance package (USD1.4bn)10, we believe the Nafto 14s will be paid and the near-term default risk should be averted. We stay neutral for now, but will nevertheless take the opportunity of any strength to cut to underweight if situations do not meaningfully improve.

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 USD16.1bn in July. Over the longer term, we believe the existing IMF program, which has clearly drifted in terms of its economic assumptions of a timely resolution of the conflict, will need to be replaced with a new one with a substantial amount of additional support. In fact, under a scenario of prolonged conflict, Ukraine’s GDP is expected to contract by 7.3% in 2014 and 4.2% in 2015, according to the latest IMF report available on its web site. Also according to the fund, if the fighting continues into next year Ukraine may need as much as USD19bn in additional financing support.

On the bond curve, a correction to the richness of the

23s has recently taken place, and it has become cheap

to the curve. Meanwhile, the 21s are looking relatively

expensive.

10 The fund also approved Ukraine’s request to merge the next two

tranches (totaling USD2.3bn) to be directed to Ukraine in December, but

that would be conditional on that the conflict in eastern Ukraine subsides in

the coming months.

11 September 2014



TURKEY

— Stay overweight

— Enter short basis 10Y CDS vs. 25s

Even after its outperformance over the summer, Turkey’s sub-index spread remains at +50bp over the investment grade average. Political noise will likely be low in the coming months, with elections over, new cabinets set, and policy continuity broadly expected. Fundamentals are mixed. Growth has slowed and inflation will likely remain high. On the other hand, 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 Turkey remains one of the EM economies that are most sensitive to tighter global liquidity conditions.

All these being said, the main value for Turkey’s credit curve, in our view, is its +50bp above EM investment grade average in this yield-seeking environment epitomized by relatively low volatility, low core rates, and tight credit spreads across EM investment universe. For this reason, and because we do not foresee significant sources for acute volatility over the next few months due to Turkey specific events, we recommend staying overweight on Turkey.

The Turkish 10s30s curve has steepened over the past month, but CDS/bond basis has also moved wider. Consequently, our recommended trade of selling 10Y CDS vs. 43s has not moved much. Given our view that most EM 10s30s curve slopes are biased to flattening in the coming weeks, we see little scope for this position to perform in the coming days. Instead, we recommend entering an outright short basis position of selling 10Y CDS vs. 25s (entry: 33bp; target: -5bp: stop: 50bp). CDS/bond in Turkey, especially at the 10Y sector, is currently at the widest levels of the past two years.

10Y basis in Turkey is at historical wides


HUNGARY

— Move to overweight

Hungary has been one of the best performers in EMs over the past few months due in part to the relatively higher levels of carry the curve offers. Valuation does not look particularly attractive relative to its credit rating as the market is pricing more than one full notch upgrade, which is unlikely to materialize over the near term, although we believe it is broadly justified by the fundamentals underpinned by a strong growth dynamic driven by robust domestic demands. However, the absolute level of credit spreads with 10Y bonds at 185bp and 30Y bonds at 215bp remains attractive in the current carry seeking environment. On the REPHUN curve, 10s30s remain steeper in a cross-sectional context in comparison with EM peers; we continue to favor the long end of the curve (41s). At the shorter end of the curve, we prefer 23s to the 21s.

POLAND


— Keep cash curve flatteners 24s vs. 19s

Poland credit spreads vs. EM investment average has been hovering around -70bp, clearly unattractive from a carry perspective. On 13 August, we recommended reducing exposure to Poland to underweight (from neutral) and maintain such a position. Downside risk to growth due to contagion from a potential escalation of the Russia/Ukraine crisis offered another reason to be under-allocated towards this curve. We recommended entering a DV01neutral cash curve flattener via 24s vs. 19s on September 4 and maintain this position (entry: 40bp; current: 41bp; target: 25bps; stop: 60bps).

SOUTH AFRICA

— Remain neutral

— Maintain cash curve flatteners 41s vs. 25s

The macro picture in South Africa is not very pretty. Growth continues to be weak, inflation remains uncomfortably high, and long standing structural problems – particularly in the labor market –are being addressed only very slowly. A good track record of prudent fiscal policy aside, public finances face significant challenges in the low growth environment. Credit metrics are on a downward trajectory, as an even higher economic growth trajectory and/or tax hikes would be needed in the future to stabilize the government’s debt ratio. This has resulted in S&P’s downgrade of South Africa’s credit rating by one notch to BBB- in June, but there is further downgrade pressure from Moody’s in the coming months.

11 September 2014



However, benefiting from yield seeking and acute problems in some of its EM peers, South Africa has been one of the best performers over the past few months. The South African sub-index spread has tightened by 20bp relative to the EM investment grade average and currently at +20bp over. We believe South African bonds continue to offer superior carry compared to most Asian and LatAm high grade credits under the current backdrop, but the abovementioned macro weaknesses will likely constrain the performance of the curve going forward. We remain neutral on South Africa.

In relative value, we recommended 10s30s flatteners 41s vs. 25s on 3 September (entry: 27bp; current: 20bp; target: 8bp; stop: 38bp) and maintain this position. We expect a continued retracement from the steepening of EM spread curves and 10s30s in South Africa is just off its steepest levels in a year.

10s30s in South Africa has room to flatten further


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

.

.

11 September 2014



LatAm Strategy

LatAm FX: In Brazil, finance a 1M USD/BRL put struck at 2.29 with a two-week USD/BRL strangle (2.20,2.30). In Colombia, buy a 1M USD/COP put struck ATMS at 1.3%. In Mexico, finance a 3M USD/MXN put struck ATMS with RKO at 12.75 with a 3M USD/HUF put struck at 230. In Chile, buy a 1M USD/CLP put struck ATMS at 1% (all indicative prices).

Rates: In Brazil, switch from NTNB 22s to NTNB 40s, targeting 5% and stopping at 6%. In Mexico maintain Mudi 40s (target 3%, stop 3.4%) and front-end steepener vs. the US (1Y3M vs. 2Y1Y, target 30bp, stop 0bp). In Chile, maintain 1s3s steepener, targeting 50bp and stopping at 25bp. In Colombia, maintain TES 16, targeting 4.5% and stopping at 5.25%, and maintain TES 24s vs. paying IBR 1Y (target 1.75%, stop 2.05%). In Peru switch into Soberanos 23s, targeting 4.9% and stopping at 5.3%.

Credit: We remain underweight Argentina and see further downside to bonds’ prices. We have recently cut Venezuela to underweight following the cabinet changes but employ a more defensive barbell asset allocation strategy of long 15s and (low-priced) 37s to maintain exposure. We remain overweight Colombia on strong fundamentals, underweight Mexico on tight valuation, and neutral on Brazil and Peru. In relative value, we recommend long Brazil 5Y CDS vs. Colombia and short basis in Venezuela (5Y CDS vs. 22s).

Local Markets

BRAZIL

— FX: Finance a 1M USD/BRL put struck at 2.29

with a 2-week USD/BRL strangle (2.20-2.30)

(indicative).

— Rates: Buy NTNB 22s (target 5.00% stop at

6.00%).

FX: With less than four weeks to the first round of the presidential elections (October 5, second round October 26), the BRL has been increasingly driven by poll results, with Marina Silva currently having a slight lead over incumbent Dilma Rousseff. Other than the polls (and USD strength backdrop), the main driver has continued to be the BCB’s volatility-dampening FX intervention. We expect the adjustment of the extent of FX swaps rollover to keep USD/BRL roughly in the 2.20-2.30 range over the next few weeks. Pressure on the exchange rate (in either direction) should increase, however, as the electoral picture becomes clearer. Sensitivity to an EM-wide risk-off episode also remains high, especially considering that speculative

positioning is quite heavy. This backdrop bodes well for a calendar trade, which exploits the expected range-bound USD/BRL movement over the next several weeks and the expected volatility around the elections. Consider selling a two-week strangle struck at the endpoints of the recent range (2.20,2.30, indicative prices). The proceeds could be used to finance several structures that expire in 1M (after the October 5 first round), most notably a 1M USD/BRL put struck at 2.29. Although exposed to USD strength (a view that we in principle would avoid, favoring CE3 as funding instead), the relatively flat vol. curve makes the risk-reward of the trade attractive.

Rates: The dramatic change in Brazil’s political landscape ahead of the election resulted in a significant re-shaping of the DI curve during the last couple of weeks. The re-pricing of risk premium first led to a strong rally in the BRL and the inversion of the DI curve, followed by eventual reversions upon the release of the latest polls and the general USD strength environment. Meanwhile the front-end was rather stable, pricing around 150bp of residual hikes and seemingly immune to the political jitteriness. Going forward, less than a month away from the presidential election, we believe that rather than trading on fundamentals the curve will continue to be hostage to the election dynamics. Given the detrimental market expectations associated with the choice of policy adopted by the current government, we expect curves to steepen in case of a victory by the incumbent. Flattening (and further inversion) would, on the other hand, probably resume if the opposition wins, on improvement in expectations regarding the eventual choice of prospective economic policies (although not necessarily materialized). The dichotomy between election scenarios is also present in the front end, which in our opinion justifies the presence of the aforementioned premium. While the incumbent central bank governor has been clearly signaling the end of the current cycle, we would not be surprised if further hikes materialize under a “new” (opposition chosen) CB as part of a credibility shock, possibly together with a large fiscal adjustment. Altogether, the opposing scenarios make it difficult to position in terms of nominal rates and at these levels we rather remain neutral. Real rates however still show some value. We stick to our current “buy” in NTNBs from 22s, given the cushion offered by breakevens and potential upside (and draw-downs).

11 September 2014



CHILE

— FX: Stay neutral.

— Rates: Maintain 1s3s steepener, targeting 50bp

and stopping at 25bp.

FX: CLP has continued to sell off, reaching levels last seen in 2009 and currently down about 20% since October 2013 (vs. USD). Some believe that this is excessive, especially in light of improved growth outlook in China and stabilization in copper prices, as well as the slightly better-than-expected activity print of last week. The current level of the currency likely already reflects the widely anticipated September-11 rate cut (after we go to press). If anything, potentially hawkish communication from the BCCH, hinting that rates would be raised sooner than the market expects, could support the CLP. Positioning is also favorable at the moment. Still, given the weak economic outlook and dovish monetary policy, we rather remain neutral for now. For those wishing to capture the potential for USD/CLP downside and exploit relatively cheap vols (1M implied vol is currently equal to 1M realized vol), consider buying a 1M USD/CLP put, struck ATMS (590), costing approximately 1% (indicative).

Rates: The combination of a rather dovish BCCH communiqué indicating the possibility of further cuts in the reference rate followed by a pick-up in inflation expectations resulted in the relentless steepening of the local curve after months of range-bounding and low realized volatility. Markets are pricing roughly 75bp of cuts (consistent with our call) followed by a long period of pause (hikes resuming in the 3rd quarter of 2016). Despite the real effects of the proposed fiscal agenda (which could in theory be detrimental to GDP growth next year), the possible reduction in trend growth and resulting tightness in output gap could reduce, in our view, room for excessive accommodation, resulting in an earlier-than-expected hiking cycle and further steepening of the front-end. Predicated on that view, we have been recommending steepeners in the 1s3s sector of the curve. We keep that for now, extending the target to 50 (stopping at 20). In cash space, it is interesting to notice that the 20s/21s sector of the curve has underperformed its surrounding neighbors, making the latter interesting targets for switches.

COLOMBIA

— FX: Buy a 1M USD/COP put struck ATMS at

1.3% (indicative)

— Rates: Maintain TES 16, targeting 4.5% and

stopping at 5.25%. Maintain TES 24s vs.

paying IBR 1Y (target 1.75%, stop 2.05%)

FX: COP has been one of the worst performers in the EM-wide sell-off that started in late July, losing more

than 7% and giving up most of the impressive gains seen since the index weight change announcement in March. The sell-off has been justified by market participants as representing the end of the index change-based inflows. We are still constructive the COP, however, for several reasons. First, the economic recovery remains stable, especially against the backdrop of disappointing growth in the region. Second, following the hiking cycle (likely close to its end), carry (over 4% at the 3M horizon, annualized) is high relative to peers, which have recently cut rates. Third, we anticipate more index change-based inflows. 11 Fourth, we believe that the pension fund reform, which is due to be unveiled soon, will be less negative for COP than markets anticipate.12 However, we are reluctant to outright short USD/COP given the potential for further dollar strength. Consider buying a 1M USD/COP put struck ATMS (1,973) and costing 1.3% (breaking even at approximately 1,950, indicative).

Rates: In terms of monetary policy, we continue to believe that the IBR curve is pricing in a cycle that is excessively back-loaded and call for another 25bp hike into the end of 2014 (market is currently pricing in 10 bp) followed by a long pause (market is pricing 50 bp of hikes in 2015). Although reduced over time, the potential premium compression bodes well for very front-end flatteners, paying the very front of the IBR curve vs. receiving longer maturities (3M3M vs 1Y1Y for example, at 3 bp/month of carry) or outright longs in the short-end of the TES curve (3M3M vs COLTES16, carrying at 7 bp/month). Further down the curve, we still believe in the mispricing of index-related inflows and keep a “buy” recommendation on the TES24s (vs. paying IBR1Y). In terms of relative value, we believe that the Nov18s/Sep19s sector of the TES curve is rather rich and would switch to either the 22s or 24s.

MEXICO

— FX: Finance a 3M USD/MXN put struck 1%

OTMS with RKO at 12.50 with a 3M USD/HUF

put struck at 231 (indicative).

— Rates: Maintain Mudi 40s (target 3%, stop 3.4%) and front-end steepener vs. the US (1Y3M vs. 2Y1Y, target 30bp, stop 0bp).

FX: During the recent sell-off, MXN has been the best performer in the region, being down only 2% since mid-July. Rates are expected to remain low at least until the Fed begins its hiking cycle, yet we maintain a constructive stance on MXN. The economy has been showing signs of pick-up after the disappointing beginning to the year, and should continue to benefit

11 See “Colombia: Are we there yet?” from August 20th

12 See “Colombia: Potential implications of pension fund regulation

reform” from August 11th

11 September 2014



from a continued recovery of US demand. And while the recently approved reforms will probably take time to directly affect growth and FDI flows, they should continue to positively impact expectations and benefit the currency even before actually coming into effect. Moreover, speculative positioning in MXN is relatively favorable. Altogether we continue to recommend USD/MXN RKO puts as well as long MXN intra-EM crosses, in order to avoid potentially significant short-term sell-offs in response to indications of US policy tightening. On the latter, consider buying USD/MXN downside (3M USD/MXN put struck at 13.05 RKO at 12.50, ref spot at 13.18) versus USD/HUF downside (3M USD/HUF put struck at 231, ref spot at 244) on the view that further EUR weakness will weigh on CE3 vs. LatAm (indicative prices).

Rates: The benign inflation backdrop and persistent activity weakness in some of the EM suggest that carry-capturing strategies (fading EM CBs implied hikes) could still make sense, especially if one adds a hedging overlay to US driven sell-offs. Such is the case in Mexico, where the frail backdrop, combined with relatively aggressive implied cycles, and steep term premium bode well for short-term “hedged receivers” and front-end steepeners. Despite the recent uptick in the IGAE (bouncing from the lows) and CPI being printed north of 4%, we anticipate Banxico staying on hold, not only in 2014 but also prior to an eventual Fed hike. Favorable carry and low implied volatilities in the upper left corner of the forward matrix increase, in our opinion, the attractiveness of a protected version of the ”Banxico complacency” trade. Further down the curve we continue to like flatteners, compression trades (vs. the US) and real rates exposure on the possibility of prospective reform-related inflows. More specifically, in the front-end we keep steepeners versus the US (1Y3M vs. 2Y1Y) and 3M5Y 1x2s receiver spreads (ATMF, cash neutral) as protected carry plays. Further down the curve, we keep the box spread versus the US as a core view due to the expected adjustment in the neutral rates and exposure to real rates (MUDI 40s) given the steepness in the real rate curve and low level of breakevens.

PERU

— FX: Stay neutral

— Rates: buy Soberanos 23s, targeting 4.9% and

stopping at 5.3%

FX: PEN has recently broken the tight range it had been trading in for about a year (approximately 2.76-2.81), following the very disappointing June economic activity print (0.3% YoY), continuous intervention and ensuing expectations of another rate cut at the September 11 meeting (after we go to press). The BCRP did not resist the currency movement, and signaled its new preferred

range by buying dollars at 2.79 and leaning against USD strength at around 2.85 (where PEN currently stands). Depreciation pressures might resume, however, following a potential rate cut or further data disappointments. We therefore remain neutral, despite the attractive carry and very light NDF positioning.

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 while the BCRP’s

intervention pattern (see above) might suggest a switch

in policy instrument (with an increased focus on FX),

we believe that subdued inflation and lackluster growth

will ultimately lead to another 25bp cut at the

September 11 meeting (conducted after we go to

press). 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 26s and 29s. 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 short USD Discount

We remain puzzled by how strong the bond markets have been after the default, even after the government sent a bill to enable a local debt swap to the Congress, with the price of USD Discounts still above 80.

The reality is, the announcement of the government’s attempt to change the trustee and alter the payment mechanism makes the situation even more complicated. First, we do not believe it is a viable solution for Argentina. The chance of success seems low due to both procedural/execution difficulties and likely lack of motivation of bondholders. We believe many bond holders will prefer having the case settled rather than opening an account in Argentina and receive payments from Banco Nacion. Valuation is also not supportive for a debt swap – local law bonds are trading substantially wider than the global bonds. Liquidity is another concern – losing Euroclearability and having their assets become less liquid will turn off many investors.

11 September 2014



In addition, with the situation getting further complicated and the chance of a settlement further compromised, the risk of acceleration by the holders of the Par bonds will also rise.

While there remains a chance that the expected deterioration of macro conditions forces the government back to the negotiation table, an early 2015 settlement is no longer our base-case scenario. There will be better hopes when the new administration comes in after October 2015, provided the macro situation at that time would still be amenable to a resolution. In our view, the risk of a multi-year limbo on the debt situation has risen, along with negative consequences for the country’s macro conditions. Further weakening of the blue dollar to the 15 region (currently around 14.5) could cause panic in the market. Therefore, we still see significant downside to the bond prices – both global and local law bonds. We remain short the USD Discounts, with a target all-in price of 7513.

The local law Discount bonds payments are not yet safe as Citibank’s appeal to process payment is in process. It is our opinion that these bonds should not be enjoined under the current context as they fall into exceptions of “external indebtedness” as specified in exchange bonds documents. But until the Appeals court decides they are out of Judge Griesa’s injunctive order (which may come at the end of September), the payment for these bonds remains at risk.

BRAZIL

— Stay Neutral.

— Buy Brazil 5Y CDS vs. Colombia.

The late summer outperformance of Brazilian bonds related to election dynamics has been met with a correction in September, as bonds sales (re-tap of the 25s) and narrowing gap in the election polls between two primary candidates tempered investors’ appetite. Brazil’s sub-index spread has now reverted to almost parity with EM investment average, which is also the center of the past six-month trading range. Poll results will likely continue to play a role in Brazil’s credit spreads over the next couple of months as the election campaigns are in full force.

At the same time, fundamentals remain on a negative trend, as the disappointing growth performance and steady deterioration in the fiscal accounts prompted the Moody’s – who has held a relatively more bullish

13 See Data Flash – Argentina: In default but a private party solution

remains possible, 31-Jul-14. While liquidity in the market may not always

support going short the bonds, we nevertheless use this “trade” to exhibit

our view and track it in our Trade Tracker.

view on Brazil among the rating’s agencies – to lower its outlook to negative on Tuesday (September 9), while holding its credit rating at BBB.

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.

In terms of CDS, we see Brazil / low-beta differential recently moving towards the lower end of the past year’s range, having converged by over 20bp since mid August – see chart below. We believe this outperformance by Brazil CDS was related to election poll dynamics and it will likely fade over the next few weeks on potential tightening of the poll results. Specifically, we recommend buying Brazil CDS vs. Colombia at the current level of 50bp (target 70bp, stop 40bp).

Brazil CDS differential to its peers will likely be range

bound for now


COLOMBIA

— Stay overweight.

While it does not offer an attractive level of carry with its sub-index spreads around -20bp vs. the EM investment grade average, Colombia remains our favorite LatAm low-beta curve. Our positive view is supported by strong fundamentals, with a mix of best growth dynamics in the region (among major economies) and benign inflation scenarios. Colombia’s credit migration path remains positive over the medium term, in our view, and this was reflected in Moody’s upgrade Baa2 in July.

11 September 2014



MEXICO

— Stay underweight UMS

— Move to neutral on Pemex vs. UMS

The relative valuation of UMS bonds has marginally improved vs. the EM investment-grade average over the past month, but still at -40bp. Fundamentals aside (growth seems to have finally picked up in Mexico), it clearly does not look attractive with essentially large negative carry vs. the benchmark in this environment where carry plays an important role in the returns of the portfolios. There has been some significant Pemex/UMS spread convergence over the past few months. At the current spread differential of 55bp, which are historical tights, we move to neutral on PEMEX/UMS spreads. Further compression potential will likely be tempered by greater supply risk in Pemex. Having issued USD8bn worth of bonds, we believe UMS has seen its financing plan fully undertaken for 2014, but are not so certain about Pemex.

PEMEX bonds have steadily tightened vs. UMS

counterparts this year


PERU

— Stay neutral.

Peru underperformed during the summer, as its sub-index spread has widened out to be just 15bp tighter than EM investment average, despite Moody’s two-notch upgrade of its credit rating to A3 (outlook: stable) in July. Peru does offer an outstanding government balance-sheet and solid fiscal framework, but its growth dynamics has sharply deteriorated this year, with weak Chinese demand and lower metal prices being among the main reasons. In addition, Peru also features one of the highest current account deficits in LatAm (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 over Peru at this point, for the former’s better

fundamentals momentum as well as slightly cheaper valuation.

VENEZUELA


— Favor a barbell allocation strategy of long PDVSA 15s and (the lowest priced) 37s

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

Following the cabinet changes announced by President Maduro on Tuesday (September 2), in which Rafael Ramirez was removed as Vice President of Economics, Oil Minister, and President of PDVSA, we revised our recommendation on Venezuela complex to underweight from overweight14.

Even though the cabinet changes were mostly a political move, the exit of Mr. Ramirez increases the likelihood of further policy inaction, which has tested investors’ patience recently. Policy framework will also likely be more ad-hoc and feature a higher level of uncertainty going forward. Economic policy is now in the hands of Rodolfo Marco Torres, who is known mostly as a pragmatist, but does not have as much technocratic credentials as Mr. Ramirez and is also much less influential; Mr. Torres’s policy preferences are not very clear. If there is a silver lining in the changes, the new head of PDVSA, Eulogio del Pino, is known to be a very competent oil sector executive even though he is unlikely to be a powerful figure within the structure.

Without implementation of further pragmatic measures along the lines proposed by Mr. Ramirez, the deterioration on the macro condition is likely to accelerate. In fact, the dollar shortage has worsened and the parallel rate has surged to 90 VEB/USD. At the same time, Venezuela’s hard currency resource at off-budget funds has declined sharply from about USD18bn at the beginning of the year to USD9.3bn in July, according to Ecoanalítica. Instead of meaningful adjustments, the government has apparently resorted to more controls. Politically-costly economic policy adjustments will be increasingly difficult as we move closer to parliamentary elections towards the end of 2015. The intensified effort by the government to divest CITGO also sent a negative signal to the market, undermining investors’ confidence.

In terms of asset selection strategy, we favor a defensive, barbell position of being long the very front-end and the lowest-priced bonds. Specifically, we would re-enter long PDVSA 15s at the current yield of

14 See Trade Recommendation – Venezuela: cut to underweight after

changes in economic team, September 3 2014.

11 September 2014



over 20% as a carry-oriented strategy, as we believe Venezuela/PDVSA have both the willingness and capacity to service the debt within the next couple of years. A confirmation next month on the repayment of Ven 14s and PDV 14s will likely provide some confidence, we believe. At the same time, we would enter long PDVSA 37s at the current price of 50.5, which is close to historical lows. A long position in such a low-priced bond would incur limited loss at default given its proximity to the recovery value.

Low priced bonds on PDVSA are approaching two-year

lows again


Last week, we recommended PDV 26s vs. 17s as an alternative trade to an outright short position to express a bearish view (better carry and less loss under a rallying scenario), as we believed the curves would likely increase their levels of inversion as the market likely to continue to weaken. This position reached its target on Monday (September 8). We would look to re-enter this trade in the event that the curve dis-inverts to the 200bp area and we remain bearish on the credit.

CDS/bond basis in Venezuela is historically wide:

-400

-300

-200

-100

0

100

200

Aug-10 Aug-11 Aug-12 Aug-13 Aug-14

5Y CDS vs. 22s (Par-eq spread)


Finally, the recent “default concerns”, thanks in part to a recent article by Professor Haussman, have caused a surge in CDS/bond basis to historically high levels – see chart above. While we are currently underweight the complex, we expect CDS spreads to recover relative to cash as more market participants become – as we expect – less concerned about imminent default risk though they may retain their bearish view over the medium term. Specifically, we recommend entering short basis via selling 5Y CDS vs. 22s (entry: 140bp; target: 0bp; stop: 200bp)15.

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

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

September 2014 for details.

11 September 2014



China Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic outlook: Chinese economy continued to convey mixed message: while industrial indicators saw soft patch, service sectors reported steady growth and the reforms advanced at an impressive pace. The economic “rebalancing” is indeed unfolding. Going forward, we expect a global cyclical recovery led by the US and fueled by the ECB easing to allow for a pickup in Chinese exports. Even if the investment growth sees further decline, the overall growth could be sustained by rising current account balance.

Main risks: Although we started to witness more developers cutting price and more local authorities relaxing HPRs, any delayed property rebound, together with weaker-than-expected exports growth are the major upside risks facing our outlook.

Economic rebalancing ongoing

Manufacturing growth slowing, service expediting Manufacturing and service PMIs told distinct stories. The NBS manufacturing PMI was down to 51.1 in August from 51.7 in July after six months’ rally. The reading is consistent with the decelerating HSBC manufacturing PMI (50.2 in Aug vs. 51.7 in July). This confirms our view that industrial sectors continue to recover, albeit at a slower rate than they did in previous months. Pressure on prices came back, with input price index registering 1.2ppts decline to 49.3, below 50 for the first time in four months, showing halting raw material demand rebound.

Similarly, the electricity consumption growth slowed by 2.9ppts to 3%yoy in July; IP growth registered 9%yoy, lower than that of 9.2%yoy; FAI growth decelerated to 17%yoy Jan-July, from 17.3%yoy Jan-June. The slowdown can be attributed to deterioration of real sector, destocking in over-capacity sectors and slowing fiscal revenues growth.

Nonetheless, one should note that secondary industry is only part of China economic picture today. Since Q1 2014, tertiary sector has “officially” taken over the role of biggest GDP growth driver. This probably explains the reason why the Keqiang Index (among which the factors of electricity and railway transportation are much manufacturing-oriented) detached from GDP growth trend in recent quarters.

Secondary vs. Tertiary industry contribution to growth

35

40

45

50

55

60

65Secondary industry contribution to GDP growth, %

Tertiary industry contribution to GDP growth, %

Source: Deutsche Bank, CEIC, NBS

In August, the HSBC China services PMI rose to a 17-month high of 54.1 from 50 in July and NBS non-manufacturing PMI rose to 54.4 from 54.2 in July. “Production-related” services like wholesales, transport and IT were most dynamic among all, demonstrating the intention of service corporates to lift their output in the coming months.

Exports recovery continues Merchandise exports increased by 9.4%yoy in August, down from 14.5%yoy in July but higher than the consensus expectation of 9%yoy.

By destination, exports to G2 remained healthy – the growth of exports to the US registered 11.4%yoy in Aug (vs. 12.3% in July, 5.1%yoy in H1), that to EU 12.5%yoy (vs. 17.0% in July and 9.9% in H1) – confirming stronger demand from G2 economies as well as a sustained competitiveness of Chinese goods. Merchandise exports to Japan fell by 3.1%yoy in August from +2.9%yoy in July and 4%yoy in H1, echoing worsening Japan economy indicators.

Export growths of major commodities remained strong in August, e.g., steel products (26.4%yoy), TV (39.1%), footwear (16%), aluminum (21.9%), coke (78.4%), and integrated circuit (10.6%).

11 September 2014



Exports growth by destination, yoy%

-30%

-20%

-10%

0%

10%

20%

30%

US EU

Japan +Emerging Asia Rest of the world

Source: Deutsche Bank, CEIC, WIND

Imports fell by 2.4%yoy, after a 1.5%yoy fall in previous month, missing the consensus forecast of a 3%yoy increase. As a result, trade balance in August recorded a surplus of USD49.8bn.

Looking forward, we still expect the export growth rate to keep the strong momentum and higher export growth would also offset lower investment growth, and equally importantly, if imports stay subdued (partly due to the low commodity prices and partly to the lukewarm domestic economy), net exports in Q3 could well be a large positive contributor to growth. Moreover, a rising current account surplus over the last couple of quarters (and in the coming quarters) underpins our expectation that the RMB should continue to appreciate.

China trade surplus

-40

-30

-20

-10

0

10

20

30

40

50

60 Trade balance, USDbn

Trade balance, USDbn, 3mma

Source: Deutsche Bank, CEIC, WIND

Stimulus measures not to be expanded but to be deepened Despite the dissipation of strong stimuli impact on growth momentum, we do not expect at this time PBoC to cut interest rates or do a broad RRR cut. In the meantime, current “targeted” policies will continue to deepen and more “targeted” measures are likely. It’s worth noting that a considerable amount of previously released liquidity still sits in banks instead of being lent out, due to loan quota limit imposed on banks. We foresee more measures to “activate” these monetary stocks, so as to unleash the vitality of agriculture, service and other under-capacity sectors, especially private firms.

On fiscal front, fiscal revenue growth decelerated sharply to 6.9%yoy in July vs. 8.8% seen in June and the expenditures went up only by 9.6%yoy, retreating from 26.1%yoy in previous month. Given the on-going VAT reform and high base effect, it will be difficult for the government to lift fiscal revenues growth in Q4 and to carry out broad fiscal stimulus.

This determination on “targeted control measures” has been confirmed by a series of recent announcements including:

Sep 9, Premier Li Keqiang said on Summer Davos Forum, China will continue its prudent monetary policy and "targeted control measures". “The country now resorts to strong reform and keeps the total money supply at a stable level with M2 growth of 12.8%yoy in August this year. More money will be only channeled into agriculture, small and micro businesses, emerging industries and high-tech sector.”

Aug 27, State Council vowed that in 2014 and 2015, China would speed up construction in environment protection, healthcare facilities and clean energy (especially projects for wind, hydro, photovoltaic and nuclear) will be focused.

Aug 27, PBoC set aside another 20bn yuan for a relending program, under which the central bank would extend loans to commercial banks on the condition that they in turn lend to “targeted” sectors, especially agriculture.

Aug 20, State Council abolished 87 items that previously required government approvals and stressed the importance of developing service sectors relating to science and technology

Aug 19, policies to revitalize the Northeast were unveiled to free up private business, deepen SOE reforms and develop modern agriculture.

The only industrial areas that might see policy support upside are railway construction and shantytown renovation in our view. In contrast with the annual railway investment target of RMB 800bn, H1 2014 has

11 September 2014



accomplished merely RMB 235bn, less than 30% of the goal. To speed up the construction, Premier Li has reiterated, in August, the urgency to invite more private investors and to provide financing tools. In addition, the government will firmly support fund raising for shantytown renovation through bond issuance, special funding unit in China Development Bank and prioritized loans from commercial banks. The renovation work is also the key part in the development plan for Northeastern Liaoning, Jilin and Heilongjiang provinces, which reported sluggish growth in H1.

SOE reform to bear more fruits The government's commitment to structural reform has been impressive, which was confirmed recently by the initiation of official car reform, the announcement of Hukou reform, the draft discussion on property tax as well as the investigation on Zhou Yongkang and other some senior officials.

While some investors continue to doubt the impact of previously-announced reforms, positive outcomes are already evident. For example, approximately 1.6m new companies have been registered after business registration procedure was stream-lined in March, up 65%yoy; VAT reform has already resulted in a tax reduction of Rmb268bn; and the Shanghai-Hong Kong Connect (announced Apr 10) launched trial operations on 11 Aug, beating market expectation.

We expect the coming quarters to bear more fruits in multiple areas especially SOE reform, capital account liberalization, interest and exchange rate deregulation, fiscal and tax reform, etc. All these will help curb financial risk, lower financing cost and develop capital markets.

In regard to SOE reform, particularly, on 15 July, SASAC named six SOEs to undergo pilot programs with respect to mixed-ownership, establishment of state-owned asset investment companies, reform of the board of directors system and disciplinary inspection reform. Various provincial governments also issued SOE reform plans.

Base on the principle of “differentiated management” revealed in 3rd Plenum Decision, we see various reform paths for SOEs: 1) Central pan-national SOEs in monopolized sectors (e.g. oil & gas, telecom and transport) may allow private capital investments in minority stakes or in certain business units; 2) local SOEs in competitive sectors including F&B, apparel, electrics and healthcare, may be taken over by private investors in their entirety; 3) proceeds from the sale of competitive SOEs may be managed by the state-owned assets operation companies, which will channel more capital into utilities and strategic sectors; and 4) more SOEs assets may be listed or injected into listcos.

We expect this aggressive focus on SOE reforms to have a material impact on economic outlook. Not only will these moves result in a substantial expansion in the private sector but the large-scale inclusion of private player in current SOE sectors will also promote the more efficient allocation of capital, result in further productivity gains and underpin longer-term growth.

Property sector sees signs of gradual recovery A sustained decline in property prices is still the major domestic risk facing China. In Aug, the price index of 100 cities dropped 0.6% mom, the fourth negative sequential change in a row. But we think the “bubble burst” scenario is unlikely. Evidence from past two cycles in six years showed that significant price cuts were sufficient to revive demand and bring inventories back down to normal levels within a few months.

As we enter September, developers with high gearing kicked off more aggressive price cutting, and consequently residential sales volume was up 16.8% wow – the third consecutive week of increase.

Moreover, 37 out of 46 cities with HPRs have already had HPRs relaxed or removed since July and more banks have started to either expedite mortgage approval or lower interest rates. Together with the impact of such relaxations, sales in coming quarters should show stronger momentum, in our view, and in turn spur new housing starts and FAI.

China residential property sales, 40 cities

3000

3500

4000

4500

5000

5500

6000

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

40 cities sales, ksqm, rhs 3WMA, yoy%

Source: Deutsche Bank, Soufun

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

11 September 2014



China: Deutsche Bank forecasts

2012 2013 2014F 2015F

National Income

Nominal GDP (USD bn) 8389 9358 10516 12002

Population (mn) 1354 1362 1369 1374

GDP 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 3.2

CPI (YoY%) ann avg 2.6 2.6 2.2 3.0

Broad money (M2) eop 13.8 13.6 12.0 12.0

Bank 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 24.5

Primary surplus -0.9 -1.3 -1.3 -0.8

External Accounts (USD bn)

Merchandise exports 2048.8 2209.9 2545.8 2958.2

Merchandise imports 1818.6 1951.1 2228.2 2580.2

Trade balance 230.2 258.8 317.6 378.0

% of GDP 2.7 2.8 3.0 3.1

Current account balance 215.4 182.8 241.7 302.0

% of GDP 2.6 2.0 2.3 2.5

FDI (net) 176.3 185.0 160.0 150.0

FX reserves (USD bn) 3311.6 3821.3 4021.3 4221.3

FX 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 0.5

Total 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 15.0

Retail sales (nominal) 14.4 13.2 13.2 14.0

Industrial production (real) 10.0 9.7 9.5 10.0

Merch exports (USD nominal) 7.9 7.9 15.2 16.2

Merch imports (USD nominal) 4.3 7.3 14.2 15.8

Financial Markets Current 14Q4 15Q1 15Q3

1-year deposit rate 3.00 3.00 3.00 3.00

10-year yield (%) 4.29 4.30 4.30 4.50

CNY/USD 6.13 6.11 6.08 6.02 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Growth rates of GDP components may not match overall GDP growth rates due to inconsistency between historical data calculated from expenditure and product method. (2) Including bank recapitalization and AMC bonds issued

11 September 2014



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

Economic outlook: Hong Kong economy again disappointed. In Q214, both investment and consumption registered slowest growth since Q1 2009. Retail sales saw negative growth for six consecutive months, despite the sales season in July. Merchandise exports are the only segment that saw growth acceleration. Going forward, our expectation is for a pickup in qoq(sa) growth in Q3 largely supported by export growth and associated domestic consumption warming. The dissipation of the high base effect in retail sales would also help.

Risks: In short-term, we see deterioration of tourist spending, uncertainty in property sector, weaker-than-expected EM and EU recovery and earlier-than-expected US rates hike as downside risks to our forecasts. From a structural perspective, emigration of middle class, lack of economic diversity, competition from Mainland opening up and instability due to political transformation are obstacles to the city’s long-term development.

Hong Kong at cross road

Weak consumption and investment, strong exports GDP growth decelerated to 1.8%yoy in Q2 from 2.6%yoy in Q1. On a sequential basis, the economy contracted by 0.1%qoq(sa) after growing 0.2%qoq in Q1. The decline was led by a slowdown in tourist spending as well as weak investment (5.6%yoy in Q2 from 3.5%yoy in Q1). Given H1 growth of 2.2%, we trim our 2014 annual GDP forecast to 2.8%yoy from 3.3%yoy. Meanwhile, we continue to look for an export-led pickup in growth in H2 of the year.

Hong Kong GDP growth by components

-10%

-5%

0%

5%

10%

15%

20%

Mar-

11

Jun-1

1

Sep-1

1

Dec-1

1

Mar-

12

Jun-1

2

Sep-1

2

Dec-1

2

Mar-

13

Jun-1

3

Sep-1

3

Dec-1

3

Mar-

14

Jun-1

4

Consumption, yoy%GCF, yoy%Merchandise exports, yoy%

Source: Deutsche Bank, CEIC

Merchandise exports growth accelerated to 2.3%yoy in Q2 from 0.5% in Q1 mostly on recovering US demand. On a sequential basis, merchandise exports rose by 0.7qoq(sa) vs. -3.4%qoq in Q1. In July, export and imports growth sustained at 6.8%yoy and 7.5%yoy respectively. We reiterate our positive outlook on Hong Kong’s export recovery as China bottoms out and the economic momentum of major developed economies, especially the US, accelerates.

Upcoming recovery clouded by uncertainties We do, however, see downside risks to our forecasts:

Despite the dissipation of high base effect in retail sales, tourism spending is likely to remain sluggish in H2 due to slowing growth in visitor arrivals (partially affected by political uncertainty) and more importantly, shifts in tourist consumption patterns (demonstrated by significant drop in spending per visitor). Should the sector continue to lose pace, the labor market will feel the pressure. Note that the unemployment rate has quickly risen by 0.2ppts to 3.3% in the past two months, after remaining unchanged for five consecutive months. Given the employment data are calculated by three month moving average, such hike implies an undeniable trend of layoffs.

Retail sales growth detached from visitor growth

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Jan

-13

Mar-

13

May-1

3

Ju

l-1

3

Se

p-1

3

No

v-1

3

Jan

-14

Mar-

14

May-1

4

Ju

l-1

4

Retail Sales Volume, yoy %

Visitor Arrivals: Total, yoy %

Source: Deutsche Bank, CEIC

Uncertainty regarding the property sector still weighs on the economy. We view the recent property sales rebound as unlikely to be sustained in the absence of policy easing and fundamental improvement. Any further price climb from now to the next US rates hike only builds up the risk.

11 September 2014



Weaker-than-expected EM and EU recovery and earlier-than-expected rates hike in the US. The disappointing Q2 GDP reports from the Eurozone and Japan remind us that the external environment remains weak and unusually uncertain.

Structural reasons behind the economic slowdown Apart from the cyclical factors of this round slowdown, we see more structural reasons, which will continue to drag the economy if not properly handled. Hong Kong is now at the cross road.

Competitive advantages fade, as Hong Kong faces competition from a much opened Mainland China with rigorous deregulation and opening up measures. The establishment of SHFTZ is a perfect example. Although the short-term impact from SHFTZ on Hong Kong is limited, given different legal frameworks, administrative systems and geographical locations, in the longer term, if SHFTZ successfully leads to faster capital account liberalization and more convenient trade services, it may imply a greater challenge to the status of Hong Kong's RMB offshore center and exports hub.

Hong Kong struggles to diversify industrial structure. Confined by the high land price and labor cost, the city’s effort to find new economic growth pole hasn’t seen much progress. The severe dependency on financial and exports sectors has exposed the economy to higher risk. Note that over HKD 1 trillion capital has flown into Hong Kong in the past several years, leaving substantial uncertainty in the capital market and financial system.

Increasing instability and risk associated with 2017 election and further political transformation. The tension between Hong Kong authorities and social/political groups like “Occupy Central” has casted negative impact on social order, government efficiency and even economic development. In the latest release of IMD 2014 World Competitiveness Yearbook, Hong Kong’s rank dropped to No. 4, first time out of top 3 in the past decade and the main drag was exactly -- the poor performance in “government decision” and “social policies”.

As a result of all abovementioned structural changes, more middle class population has started to consider, for the first time after 1997, move to another country. In 2014, emigration from Hong Kong to Canada was up 26%yoy and agencies now report fast growing interests in moving to Australia, Canada, the UK and the US. The departure of these talents would hinder Hong Kong’s competitiveness in the long run.

Audrey Shi, Hong Kong, +852 2203 6139

Hong Kong: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income

Nominal GDP (USD bn) 263.1 273.7 292.3 312.2

Population (mn) 7.15 7.19 7.26 7.31


Real GDP (YoY%) 1.5 2.9 2.8 3.6



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


CPI (YoY%) eop 3.8 4.3 3.5 3.0

CPI (YoY%) ann avg 4.1 4.3 4.0 3.2

Broad money (M3, eop) 10.5 12.5 9.5 9.0

HKD 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



Primary surplus 3.2 0.6 2.6 3.4




Trade balance -22.7 -26.2 -26.9 -30.8

% of GDP -8.6 -9.6 -9.2 -9.9

Current account balance 3.5 5.6 -1.9 12.2

% of GDP 1.3 2.1 -0.7 3.9

FDI (net) -9.4 -14.9 -17.2 -18.0


FX rate (eop) HKD/USD 7.76 7.76 7.80 7.80


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 0.4


in USD bn 1046.5 1166.4 1250.0 1300.0


General

Unemployment (ann. avg, %) 3.3 3.4 3.3 3.2


Discount base rate 0.50 0.50 0.75 1.00

3-month interbank rate 0.36 0.50 0.60 0.80

10-year yield (%) 1.92 2.10 2.25 2.45

HKD/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.

11 September 2014



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

Economic outlook: There are some signs of a growth recovery but market exuberance reflects largely expectations of pipeline reforms than ground reality. The first quarter of the fiscal year marked a significant improvement in economic performance, but the second quarter looks mixed with some poor reading on production .data and business surveys.

Main risks: Inflation may prove to be sticky; fiscal slippage may be more pronounced; global market volatility could affect asset markets and fund raising capacity for Indian firms.

FY14/15 off to a good start

GDP growth fastest in two years Real GDP growth improved in April-June’14, after having slowed sharply in the last two years. The growth of 5.7%yoy was in line with our expectations and about 100bps higher than the outturn of the previous two quarters.

Real GDP growth was 100bps higher in April-June vs.

the previous two quarters

-4

0

4

8

12

16

0

2

4

6

8

10

12

14

2007 2008 2009 2010 2011 2013 2014

Real GDP, lhs

Non-farm sector, rhs

Agriculture, rhs

% yoy% yoy


Non-farm sector growth of 6% at a 2-year high Non-farm sector grew by 6.0%yoy in April-June, rebounding sharply from the 4.3%yoy outturn in the previous quarter. The improvement was led by both industrial and services sectors.

Industry has rebounded; power demand to remain strong but coal availability could become an issue Industrial sector GDP grew by 4.0%yoy in April-June’14, after having contracted -0.5%yoy and -0.9%yoy in the previous two quarters. Within industry, electricity sector growth was the strongest (10.2% in April-June

vs. 7.2% in Jan-March), followed by manufacturing (3.5% vs. -1.4%) and mining (2.1% vs. -0.4%).

Going forward, we expect power demand to remain strong based on cyclical recovery in manufacturing, but domestic coal availability will remain constrained, in the near to medium term, which implies India will have to import coal to meet the higher demand.

Widespread recovery in services Services sector GDP grew by 6.6%yoy in April-June, marking an improvement over last quarter’s 5.8%yoy growth, contributing to about two-thirds of the GDP outturn. Within services, community/social/personal services (9.1%yoy vs. 3.3%yoy) and construction (4.8%yoy vs. 0.7%yoy) components recorded a strong rebound, while growth in the other two key sectors – trade/hotels/transport/communication (2.8%yoy vs. 3.9%yoy) and financing/insurance/real estate/business (10.4%yoy vs. 12.4%yoy) moderated. The improvement in the construction sector growth is reflected in the robust pick-up in cement production growth (9.5%yoy in April-June vs. 1.2% in Jan-March), which is considered as a proxy for construction sector activities.

Financial services could be boosted in the long term by financial inclusion reforms, but not in the near term, especially with banks saddled with bad loans. Public spending may have to remain restrained if the authorities strive for fiscal discipline (fiscal deficit has already touched 61.2% of the budget estimate by end-July 2014).

Poor agriculture sector performance and outlook Agriculture sector growth slowed to 3.8%yoy in April-June, from 6.3%yoy in the previous quarter. The production of coarse cereals and pulses registered growth rates of 11.2% and 6.2% respectively during the Rabi season of agriculture year 2013-14 (which ended in June 2014) and rice and wheat also registered growth of 15.0% and 2.6% over the production in the corresponding season of previous agriculture year. Among the commercial crops, the production of oilseeds increased by 3.0% during the Rabi season of 2013-14.

The outlook for agriculture is clouded by a poor monsoon. Monsoon rains continue to be below normal (14% below long period average) which is undoubtedly going to impact food production and manifest in lower GDP numbers in the quarters ahead. We have factored in 1.3%yoy agricultural sector growth for FY14/15 as a whole, building in the prospect of a below-trend harvest (area sown of Kharif crop is 4%yoy down as on

11 September 2014



22nd August). To put the forecast in perspective, India’s agricultural sector growth was 0.8%yoy in FY09/10 (monsoon rains were 22% below normal in 2009) and 1.4%yoy in FY12/13 (monsoon rains were 8% below normal in 2012).

Expenditure side GDP data quality remains suspect According to the expenditure side GDP data, India’s real GDP grew 5.8%yoy in April-June, slowing down from 6.1%yoy in the previous quarter (versus 4.6%yoy growth according to production side GDP data). Excluding discrepancy, which subtracted 3% from expenditure side growth, India’s real GDP growth works out to 8.8%yoy in April-June (vs. 7.4% in Jan-March), which hardly makes sense.

Within the expenditure side GDP data, investment growth improved to 7.0%yoy in April-June (from -0.9%yoy and 0.2%yoy in the previous two quarters), while consumption sector growth moderated slightly to 6.2%yoy, from 6.8%yoy in the previous quarter. Within consumption, private consumption expenditure growth moderated to 5.6%yoy (from 8.2%yoy in the previous quarter), while government consumption growth rose sharply (8.8%yoy vs. -0.4%yoy). Net exports contributed 3.0% to overall growth in April-June, but this was lower than the contribution in the previous two quarters (3.7% and 5.3%).

Investment and real GDP growth

-15

-5

5

15

25

0

2

4

6

8

10

12

2005 2007 2008 2010 2012 2014

Real GDP, lhs Investment growth, rhs

% yoy % yoy


We are maintaining the FY15 and FY16 growth estimate of 5.5% and 6.5% respectively for now We think the April-June GDP outturn of 5.7% is in line to meet our full year growth estimate of 5.5% for FY15, and do not see the need to revise up the forecast at this stage. As mentioned above, agriculture sector growth is likely to slow down sharply in the quarters ahead and industrial sector growth may also stabilize around current levels, rather than accelerating sharply on a sequential basis. Within industry, electricity sector has performed the best so far, but going forward it is reasonable to expect some moderation, given the

lingering power sector problems. Services sector growth has scope to improve in the coming quarters, which will in our view help to offset the moderation in agricultural and industrial sector growth momentum, and help achieve a 5.5% growth outturn for FY15 as a whole.

We remain constructive regarding the growth outlook for FY15/16; we expect real GDP growth to improve further to 6.5% from 5.5% in the current year. We expect investment growth to gain momentum in the quarters ahead, led by de-clogging of stalled projects and fresh capex spending. Consumption growth would also likely improve in the next 12-18 months, as the RBI eases monetary policy and liquidity conditions in the second half of next year. Net exports will however contribute lesser to growth next year, as imports growth rises from depressed levels of last year, but this should be seen positively as it would be a reflection of improvement in domestic demand.

External risks warrant a degree of caution While we see domestic factors being conducive of supporting a growth rate of 6-6.5% in the next 18-24 months, it is also important to note the headwinds that could arise on account of the US Federal Reserve embarking on a rate hike cycle from next year. If the turn in the US monetary policy cycle causes severe disruption in the financial markets, it could then spill over to the real economy and create a drag on growth. Indeed, the turning point of the US rate cycle has been associated with financial market turmoil and growth slowdown often in the past. While it is too early to take a definite view on this at this stage, we build in a degree of cautiousness in our growth forecast, to reflect scope of increased volatility and uncertainty in global financial markets, on account of a likely change in US monetary policy stance.

Real GDP growth forecast

% yoy FY13/14 FY14/15F FY15/16F

Real GDP 4.7 5.5 6.5

Agriculture 4.7 1.3 2.9

Industry -0.1 3.7 4.3

Services 6.2 6.9 7.8

Memo

Non-farm sector 4.7 6.2 7.1


Long road ahead As reported by us in our medium term scenario elsewhere in this publication, India would need to see a major improvement in household, corporate, and public sector savings to generate the resources necessary to undergo a sustainable, investment-led recovery. This would also require productivity enhancing reforms and policies to ensure macroeconomic stability. We therefore see a long and challenging road ahead for the authorities.

11 September 2014



Savings/GDP has fallen from a peak of 37% in 2007/08

to 30% in FY12/13

15

20

25

30

35

40

-2

2

6

10

14

18

22

26

30

Household, lhsCorporate, lhsPublic, lhs

% of GDP % of GDP


Household savings mix has deteriorated

20

21

22

23

24

25

26

0

4

8

12

16

Financial Savings, lhs

Physical Savings, lhs

Household savings, rhs

% of GDP % of GDP


Private investment has slowed sharply

15

20

25

30

35

40

-2

2

6

10

14

18

22

26

30

Public investment, lhsPrivate investment, lhsTotal investment, rhs

% of GDP % of GDP


How is the July-Sep quarter shaping up?

April-June’14 was a good quarter for India. The decisive election outcome helped improve business and consumer confidence appreciably. Real GDP growth was 100bps higher in April-June from the previous quarter, CPI inflation eased, capital flows were strong, while the rupee remained stable.

But the July-September quarter is not off to a flying start. After recording a robust growth in June (7.3%yoy), core infrastructure production growth moderated sharply to 2.7%yoy in July, indicating risks of a similar slowdown in industrial production growth. Manufacturing PMI, which had recorded a sharp improvement in July (to 53.0 from 51.5 June), slowed down in August to 52.4, led by moderation in new orders (54.5 vs. 55.9) and output (54.1 vs. 54.9). Auto sales growth (domestic and exports combined) improved to 15.0%yoy in July, from an average 12.1% in April-June, but passenger car sales growth dropped sharply from the June outturn (1.3%yoy vs. 14.0%yoy).

Production indicators reflecting slow improvement

-10

-4

2

8

14

20

40

45

50

55

60

65

2008 2009 2010 2011 2012 2013 2014

Manufacturing PMI, lhs

Services PMI, lhs

Industrial production

Core infra growth

% yoy,

3mma3mma

Source: Haver Analytics, CEIC, Deutsche Bank

Total auto sales has picked up too in recent months

-20

0

20

40

60

2009 2010 2011 2012 2013 2014

Total motor vehicle sales

Passenger car sales

%yoy, 3mma


11 September 2014



The production indicators are reflecting continued improvement in the real economy on a yoy basis, but the sequential improvement seems to have eased in July and August. This suggests that the July-Sep quarter real GDP growth would not be too different from the previous quarter, even though it would mark an improvement from the corresponding period of the previous year.

On inflation, after moderating to 7.5% in June, CPI inflation accelerated to 8% in July, led by sharp spike in food prices. Consequently, the Reserve Bank of India, which had sounded relatively dovish in the June policy, changed its tone, citing upside risks to its medium-term inflation target of 6% (to be achieved by January 2016).

Our daily food price tracker shows that the rate of increase in vegetable prices eased in August after having recorded a sharp spike in July. Prices of six key vegetables – potatoes, tomatoes, onions, cabbage, brinjal, cauliflower – increased 6.4%mom on an average, lower than the 43.3%mom increase in July.

Vegetable prices (% mom)

Vegetables Weights May-14 Jun-14 Jul-14 Aug-14

Onion 0.57 11.1 22.6 32.4 -1.4

Potato 0.55 0.0 13.6 15.2 17.0

Tomato 0.56 8.0 3.1 134.4 19.4

Brinjal 0.42 6.1 13.9 21.2 -1.6

Cauliflower 0.37 39.3 28.2 19.8 3.5

Cabbage 0.34 16.9 22.5 36.6 1.8

Total weight and average % mom

2.82 13.6 17.3 43.3 6.4

Source: National Horticulture Board, Deutsche Bank

We estimate that these six vegetables (combined weight is 2.8%), which had accounted for 1.3%mom of the increase in July CPI food prices (CPI food prices were up 2.8%mom in July), will account for only 0.2% increase to the overall CPI food prices in August. Despite this moderation, we build in total food price increase of 1.5%mom in August (+2.8%mom in July), to reflect i) additional pass-through of vegetable prices which was probably not fully captured in July; and ii) higher prices of milk, cereals, dairy and poultry products.

Average price of 6 vegetables vs. CPI vegetable prices

-3

-2

-1

0

1

2

3%mom Total 6 vegetables

CPI: Food

Source: National Horticulture Board, CEIC, Deutsche Bank

Assuming lower rate of increase in fuel (0.2%mom vs. 0.6%mom) and core prices (0.7%mom vs. 0.8%mom) compared to July, we arrive at a CPI inflation forecast of 7.9% for August, with core CPI moderating to 7.2% (from 7.4%). Beyond August, we see some scope of easing of inflation pressure. Favorable seasonality for food prices should kick in; while flat or easing commodity price trend in the global markets should help the fuel component of the CPI. However, an adverse base effect looms from November onward, which could push CPI inflation toward 8% in the first quarter of 2015, leaving no room for monetary policy easing.

RBI to maintain a prolonged pause

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


Latest data on the fiscal position of the central government is not comforting. Fiscal deficit has already touched 61.2% of the budget estimate by end-July, led by weaker tax (15.0% of budget estimate achieved in April-July’14 vs. 16.4% in April-July’13) and non-tax revenue (13.5% vs. 18.0%) collections. While it is too early to ascertain, how much the slippages could be on the revenue side (disinvestments could prove to be a key swing factor), it is clear that the government’s FY15 fiscal deficit target of 4.1% of GDP can only be

11 September 2014



met, if capital expenditure is held down substantially versus the budgeted target. This will be challenging, given the government’s urgency in reviving the growth momentum through public and private investments. While the easing in global oil prices is likely to make it easier for the government to meet the fuel subsidy target, some compromise will still have to be made on the capital expenditure front, to achieve the optimistic fiscal deficit target, in our view.

BOP and rupee outlook

India’s current account deficit widened to USD7.9bn (1.7% of GDP) in April-June’14, from USD1.3bn (0.2% of GDP) in Jan-March, led by an increase in trade deficit and moderation in net invisibles. The trade deficit rose to USD34.6bn in April-June’14 (from USD30.7bn in Jan-March’14), led by a smaller decline in imports growth (-6.5%yoy vs. -12.3%yoy), while net invisibles moderated by about USD2.5bn, primarily on account of lower travel- services-related flows (USD394mn vs. USD2.1bn). Within invisibles, software services (USD17.0bn vs. USD17.7bn) saw a marginal decline while remittances (USD16.6bn vs. USD16.2bn) improved a tad versus the previous quarter.

Balance of Payments snapshot

USD bn Jan-March'14

Apr-June'14

Jan-June'14

Exports 83.7 81.7 165.4

Imports 114.3 116.4 230.7

Trade balance (a) -30.7 -34.6 -65.3

Invisibles (b) 29.3 26.8 56.1

of which: Software services 17.7 17.0 34.7

Private transfers 16.2 16.6 32.8

Current account balance (a + b) -1.3 -7.9 -9.2

% of GDP 0.2 1.7 0.9

Capital account balance 9.2 19.8 29.0

of which: Foreign investment 10.2 20.6 30.8

- FDI 0.9 8.2 9.1

- Portfolio Investment

9.3 12.4 21.7

Loans 1.6 1.9 3.4

- ECB 5.1 1.7 6.8

Banking capital -1.8 -0.1 -1.9

- NRI deposit 3.7 2.4 6.2

Rupee debt service 0.0 -0.1 -0.1

Other capital -0.7 -2.5 -3.2

BOP balance 7.1 11.2 18.3


Capital account surplus was USD19.8bn in April-June, significantly higher than the USD9.2bn outturn of the previous quarter. The improvement in capital account can be primarily attributed to a sharp surge in FDI flows (USD8.2bn vs. USD910mn) and buoyant portfolio investment flows (USD12.4bn USD9.3bn). Other component of capital flows such as loans (USD1.9bn vs. USD1.6bn) and banking capital (USD-115mn vs. USD-1.8bn) improved somewhat, while ‘other capital’ related outflows (USD-2.5bn vs. USD-730mn) increased in April-June compared to the previous quarter. Within loans, external commercial borrowings (USD1.7bn vs. USD5.1bn) and within banking capital, NRI deposits (USD2.4bn vs. USD3.7bn) recorded a moderation in net inflows from the previous quarter.

Despite the increase in current account deficit, the overall BOP balance improved to USD11.2bn in April-June, from USD7.1bn in the previous quarter, due to robust capital inflows during the quarter.

The latest BOP data indicate that the current account deficit has bottomed in the Jan-March’14 quarter and has started stabilizing from April-June onward. Along with the likely revival in domestic demand, we expect imports growth to normalize further going forward, which will lead to a sequential widening of the trade and current account deficit. We see the annual current account deficit rising to USD41bn (2.0% of GDP) in FY15 (from USD32bn in FY14; 1.7% of GDP), but financing the deficit is unlikely to become an issue, as we expect capital flows to remain buoyant in the remainder part of the fiscal year as well.

Balance of Payments forecast

USD bn FY14 FY15F FY16F

Exports 318.6 338.6 367.5

Imports 466.2 496.9 549.8

Trade account -147.6 -158.3 -182.3

% of GDP -7.9 -7.6 -8.1

Invisibles, net 115.3 117.2 126.6

% of GDP 6.1 5.6 5.6

Current account -32.4 -41.1 -55.7

% of GDP -1.7 -2.0 -2.5

Capital account 48.7 70.3 89.2

% of GDP 2.6 3.4 3.9

Overall BOP 15.5 29.2 33.4 Source: CEIC, Deutsche Bank

11 September 2014



We expect the rupee to remain broadly stable in the 60-62 range for the remainder part of this fiscal year, aided by RBI’s two way intervention strategy. Scope for rupee to appreciate appreciably from current levels remain limited, i) given RBI’s strategy to buy Dollars and build reserves at every opportune moment of rupee appreciation and ii) given that the period of current account deficit contraction is already behind us. Overall, while we remain constructive on the rupee, we think the currency could come under pressure from the fourth quarter of 2014, led by probable US Fed rate-hike-related volatility in the global financial markets. We however see little risk of disorderly depreciation of the rupee, as the RBI is likely to protect the rupee from rising beyond a certain threshold level (62 versus the Dollar, in our view).


Kaushik Das, Mumbai, +91 22 7180 4909

India: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 1218 1236 1255 1274


Real GDP (YoY %) 4.9 4.4 5.5 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


CPI (YoY%) eop 10.6 9.9 7.2 6.0

CPI (YoY%) avg 9.7 10.1 7.4 7.4

Broad money (M3) eop 11.2 14.8 13.5 15.5


Fiscal Accounts (% of GDP) 2

Central government balance -4.9 -4.5 -4.5 -4.2



Central primary balance -1.8 -1.2 -1.2 -1.2

Consolidated deficit -7.2 -7.0 -7.0 -6.7




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 rate (eop) INR/USD 54.8 44.8

61.8 53.3

61.0 48.5

63.0 47.5


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


in USD bn 394.1 426.9 469.6 526.0


General

Industrial production (YoY %) -0.6 0.1 6.0 3.8


Repo rate 8.00 8.00 8.00 7.75

3-month treasury bill 8.55 8.25 8.00 7.50

10-year yield (%) 8.50 8.40 8.25 8.20

INR/USD 60.8 61.0 62.0 63.0 Source: CEIC, Deutsche Bank. (1) We report “production-side” GDP growth rates for FY. (2) Fiscal year ending March of following year.

11 September 2014



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

Economic outlook: Growth has slowed, but fundamentals are well supported with rebounding consumer confidence and an orderly Presidential transition process.

Main risks: The markets would be tested if the new President fails to deliver on elevated expectations.

Return of the fuel price question

Indonesia’s President-elect Joko Widodo will be taking office in October with considerable macroeconomic breathing room. Inflation has been well behaved lately, with the August CPI inflation easing to 4% (core inflation was 4.5%). We see a number of factors to take note from the recent price developments:

Despite last year’s fuel price increase, second round effects were minimal, with core inflation remaining under 5% over the past year. This suggests inflation expectations are in fairly well anchored territory.

Waning momentum in the commodity sector may have played a role in dampening wage and price expectations. Since the widely observed wage spurt seen since 2008 originated in the commodity sector, it should not be surprising if the sector’s doldrums spread to the rest of the economy.

Benign inflation dynamic and stable FX rate

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With real GDP growth rate about 100bps lower than experienced in recent years, the output gap has arguably opened up somewhat in the past few quarters, reducing inflation risks.

Excess capacity (due to large scale investment in recent years) and fierce competition may have eroded pricing power at the retail level.

With this backdrop of well anchored expectation, favorable base effect, and slowing growth, conditions are in place for mid-4% inflation reading for the rest of this year. The benign projected path has two important implications:

The government can go ahead with a 10-15% fuel price hike in the coming months while exploiting the favorable base effect and well-anchored expectations. Indeed, we see a 15% fuel price hike pushing up inflation to no more than 7%.

Bank Indonesia need not counter the price hike with a rate hike decision under prevailing macro conditions of waning growth and weak pricing power among producers.

While the chance is not very high, we think it is conceivable that the Parliament would pass a targeted cash transfer decision in October (to mitigate the impact of the price hike among the poor), right after which the fuel price adjustment can take place. Note that the gap between international and local price is much narrower than the previous instances of price hikes (see chart below). A pledge to hike prices by 10-15% this year and again next year could assure the market that by the end of 2015 fuel subsidies would either be eliminated or compressed greatly.

Modest increases can close the fuel price gap

100

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300

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2008 2010 2012 2014

International price

Local price/litre

Jan

2005 =

100

Source: Bloomberg Finance LP, CEIC, Deutsche Bank

A conclusive elimination of fuel subsidies would be an unmitigated positive for Indonesia’s inflation, fiscal, and BOP outlook, which in turn will be a major source of support for the rates and FX markets. It will also form a solid policymaking foundation for the new President at the very beginning of his term. We take comfort from the fact that the transition team has already engaged with the outgoing administration in figuring out the various legislative and administrative dimensions of the fuel price increase issue.

11 September 2014



Trade dynamic

With Q2 GDP growth slowing down to 5.1%yoy and trade data from July showing sustained weakness in exports (-6%yoy) and imports (-19.3%yoy), concerns about the economic outlook are understandable. We however don’t find the trade data grave enough to warrant a rethink on our forecast (5.2% for the year).

Our relatively benign view on trade and growth stems from the fact that most drivers of slowdown were well anticipated and a few of those drivers could readily bottom in a quarter or two. The ban on raw minerals, for instance, was bound to hurt exports, and that has indeed been the case so far this year. We had expected that monetary policy tightness and the end of the multi-year mining investment boom was going to arrest some economic momentum, which we see as a welcome development. The waning of investment demand may also have been due to the political cycle, with large scale projects being put on the sideline till clarity on the election outcome was achieved.

Overall trade balance not unhealthy

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With the Presidential transition around the corner, and the adverse base effect from the raw material exports ban disappearing by the end of the year, it is reasonable to be more constructive about the 2015 outlook. Weak demand from China, policy risk around the fuel price hike, and external environment uncertainty around US Fed policy normalization will remain key sources of headwind, but the with consumer and business sentiment improving, fiscal consolidation and monetary discipline likely to remain at the core of the authorities’ agenda, Indonesia could well see good quality and sustainable growth in the coming quarters.


Indonesia: Deutsche Bank forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 247.2 250.4 254.8 259.2


Real GDP (YoY%) 6.3 5.8 5.2 5.5




Exports 2.0 5.3 3.2 6.3

Imports 6.7 1.2 2.1 5.5


CPI (YoY%) eop 3.7 8.1 4.6 5.4

CPI (YoY%) ann avg 4.0 6.4 5.9 4.9

Core CPI (YoY%) 4.4 5.0 4.8 4.5

Broad money (M2) 15.0 12.7 13.0 15.0

Bank credit (YoY%) 24.7 20.1 16.0 20.0


Budget surplus -2.3 -2.2 -2.4 -2.6







Trade balance 8.6 6.1 6.4 6.9

% of GDP 1.0 0.7 0.7 0.7


% of GDP -2.8 -3.3 -3.0 -2.7

FDI (net) 13.7 14.8 14.0 20.0


FX rate (eop) IDR/USD 9646 12087 11700 12000



Domestic 12.2 11.2 11.0 11.0

External 10.8 11.0 11.0 11.5


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 7.0

Unemployment (%) 6.8 6.5 6.0 6.0


BI rate 7.50 7.50 7.50 7.50

10-year yield (%) 8.01 8.00 8.50 8.75

IDR/USD 11750 11700 11850 12000 Source: CEIC, DB Global Markets Research, National Sources

11 September 2014



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

Economic outlook: Slowing exports growth and weak tourism revenues are seen to pull down GDP growth in the second half of 2014.

Main risks: While we expect another 25bp-hike in the OPR this month to prevent further build-up of financial imbalances from the stronger-than-expected economic performance in H1, the BNM could instead leave the OPR unchanged until mid-2015 after the GST implementation.

Waning exports momentum

Resilient consumer spending and a favorable base on exports supported Malaysia’s rebound in real GDP growth to 6.3% in the first half after slowing to 4.7% in 2013. Private consumption sustained about trend growth despite the inflationary impact of subsidy rationalization measures imposed since September last year. Exports also gained pace on an annual basis although we warned that the acceleration in exports could be largely due to a low base in the first half of last year when external trade was lackluster. The true test of Malaysia’s exports would then be when growth is roughly sustained in the second half of this year despite a high base kicking in. That would mean the the sector is gaining from the expected improvement of the external environment.

Waning exports growth momentum

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Jan-13 May-13 Sep-13 Jan-14 May-14

3m/3m, saar (in MYR) yoy (in MYR)

3m/3m, saar (in USD)

%

Source: CEIC and Deutsche Bank

By July, however, it is possible that the period of the favorable base had passed as merchandise exports decelerated to its slowest pace of 0.6%yoy (in MYR terms) in 13 months. On a seasonally adjusted basis, exports fell by 0.7%mom compared to the 6.1%mom increase a year ago. In fact, exports growth had actually been losing momentum since the start of the year, both in USD and MYR terms, despite the

satisfactory year-on-year expansions that supported GDP growth in H1. The appreciation of the MYR in Q2 though was one factor to the waning momentum.

This weak outturn of July exports has left us concerned with the exports trend going forward. Had July exports sustained growth in the first half, we would have already raised our GDP growth forecast to 5.9% in 2014. However, the prolonged contraction in demand coming from China, as seen in the July data, could pose a drag despite the firming recovery of the US economy. We are thus maintaining our 5.5% growth forecast with the view that quarterly growth in H2 could sharply moderate on weaker exports, but also on weaker consumer spending.

While lower export earnings could spill over to an anemic private consumption, we are also looking at the spending impact of a possible downturn in tourism revenues. The twin tragedies that afflicted Malaysian Airlines in March and July could result in negative sentiments among tourists, ruling out Malaysia as a choice destination. Tourist arrivals still accelerated in March and April, after the MH370 tragedy, despite the decline in Chinese tourists. However, the data could weaken, as suggested by the declining momentum, especially in the second half of the year after the downing of MH17 in July.

The pace of tourist arrivals could weaken

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Tourist Arrivals

Others Asia: Others

Asia: China Total

Momentum (right)

%yoy%3m/3m

, saar


Tourism revenues account for about 6.6% of Malaysia’s GDP. To illustrate this sector’s economic importance, our regression model estimates that a 1-percentage-point fall in revenues could result to a 2-percentage-pt fall in Malaysia’s private consumption-to-GDP ratio.

11 September 2014



Against this backdrop of weakening growth, our conviction of another policy rate hike this month has weakened. However, we think that 2014 growth coming in at the higher end of the government’s forecast would still send a signal of strong economic performance. And BNM would make a pre-emptive move of preventing further build-up of financial imbalances, amid substantial household debt and possible frontloading of expenditures (which could be financed by cheap credit if not corrected) ahead of the GST implementation in April.

How then would a 50bp increase in the policy rate affect households? Stress testing by the IMF indicates that a 50bp hike in the OPR over the course of one year, assuming deposit rates increase by the same amount, increases the household debt-servicing ratio (DSR) only by 11bps.16 We only see a slight increase in DSR as the higher deposit rates would also result in higher savings income. Indeed, if savings income is excluded from households, the DSR rises by 50bps. Estimated household DSR in 2013Q3 was at 44%. Also, of the 83% household debt-to-GDP in September 2013 (rose to 86% in 14Q2), about 55% of the debt is owed on residential property, of which about 70% are variable rate mortgages.

Meanwhile, our baseline forecast for inflation through year-end has still penciled in a 15% fuel subsidy cut this month. But despite inflationary pressure in the transport index, the high base from last year’s fuel subsidy adjustment would prevail, resulting to September inflation of at most 3%, 20bps lower than in July. Without the fuel adjustment, inflation could fall below 2.5%, just about the long-run average. There is a possibility that the next phase of subsidy adjustment will only take place early next year as the government has yet to issue the request for proposal with regard to the management of the fuel subsidy rationalization program. The resulting arrangement could be similar to the BR1M program where a database is maintained to determine individuals eligible for cash transfers or rebates.

Diana del Rosario, Singapore, +65 6423 5261

16 IMF (March 2014). Malaysia 2013 Article IV Consultation Staff Report.

Malaysia: Deutsche Bank forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 29.5 29.9 30.4 30.8


Real GDP (YoY%) 5.6 4.7 5.5 5.6




Exports -1.8 0.6 5.6 8.2

Imports 2.5 2.0 5.2 7.8

Prices, Money and Banking (YoY%)

CPI (eop) 1.2 3.2 2.9 3.2

CPI (ann avg) 1.7 2.1 3.2 3.5

Broad money (eop) 9.0 8.1 7.8 8.7

Private credit (eop) 11.9 9.9 8.7 8.7


Central government surplus -4.5 -3.9 -3.7 -3.2



Primary balance -2.4 -1.8 -1.5 -0.9


Goods exports 222.3 215.6 234.9 281.5

Goods imports 181.8 181.3 204.1 242.6

Trade balance 40.6 34.4 30.8 38.9

% of GDP 13.3 11.0 9.4 11.0


% of GDP 5.8 4.0 3.7 4.8

FDI (net) -7.9 -1.7 -1.9 -0.4

FX reserves (eop) 139.7 134.9 134.9 145.1

MYR/USD (eop) 3.06 3.28 3.25 3.14


Government debt1 68.4 70.6 67.8 68.1

Domestic 66.7 68.9 66.3 66.5

External 1.8 1.7 1.5 1.6


in USD bn 196.2 211.7 197.1 203.8


General (ann. avg)


Unemployment (%) 3.0 3.1 3.0 3.1

Financial Markets (%, eop) Current 14Q4 15Q1 15Q3

Overnight call rate 3.50 3.50 3.50 3.75


10-year yield 3.98 4.10 4.20 4.40

MYR/USD 3.19 3.25 3.27 3.25 (1) Includes government guarantees Source: CEIC, DB Global Markets Research, National Sources

11 September 2014



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

Economic outlook: A favorable base effect on government spending, despite modest allowance for potential under-spending, could push GDP growth to at least 7%yoy in H2.

Main risks: Power supply issues, amid increased demand from an economy again gaining traction, could raise inflation towards year-end.

An economy again gaining traction

Q2 growth makes way for an economic rebound Second quarter growth raised hopes of a rebound after the preceding quarters pointed to an economic slowdown. In Q2, real GDP expanded 6.4%yoy after the slowing trend that started in the third quarter of last year ended with a 5.6% growth in Q1. Economic momentum, as measured by the quarter-on-quarter seasonally adjusted annualized rate of real GDP, also climbed 180bps over the previous quarter to 7.7% in Q2, suggesting a sustained rebound in the succeeding quarters. This recent development, together with a favorable base effect on government spending in H2, has helped us hold on to our 6.6% growth forecast for 2014. That is, we believe it is possible for the economy to grow at least 7%yoy in the second half after year-to-date growth of 6%.

Rising economic momentum

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GDP: q/q, saar MMI (right)

% %

Note: MMI stands for macroeconomic momentum indicator. For Philippines, it is an aggregate of the z-scores of vehicle sales, credit, imports, exports, remittances, IP, and employment. Source: CEIC and Deutsche Bank

Government spending to augment GDP growth in H2 Growth in the second half could be boosted by a surge in government spending after last year’s spending was front-loaded in the first half, a practice typical of election years. We have concerns that government disbursements could fall below target through year-end over issues of previous spending practices as flagged

by the Supreme Court. However, a bottom-up approach in forecasting real GDP growth shows that even if government spending were to fall 11%qoq in Q3-Q4 (after rising 24%qoq in Q1-Q2), corresponding annual growth rates would still be at least 12% higher. Moreover, the disbursement rate is likely to pick up through year-end as it is one of the eligibility requirements of the performance-based bonus. This improvement in the pace of government disbursements could also manifest in public construction as the government ramps up infrastructure spending and as rehabilitation efforts from Typhoon Haiyan gain pace.

Under the General Appropriations Act, total disbursement this year is targeted at Php2.265 trillion, 20% higher than last year’s actual spending. This amount is also 6% above trend, a sharp reversal from the past three years where disbursements were about 1% below trend. Disbursements from January to June of this year accounted for 43% of the budget and even if only 90% would be disbursed throughout the year, spending could still augment overall GDP growth. In fact, we see this improved pace of disbursements to more than offset the deceleration in consumer spending and private construction, amid higher inflation and BSP tightening measures, as well as a wider trade deficit, as imports growth catches up with strengthening exports (as port congestion, arising from the truck ban in Manila, eases).

Government spending to offset drag from consumer

spending and net exports

-8-6-4-202468

101214

2012Q4 2013Q2 2013Q4 2014Q2 2014Q4

Net exports Change in inventories

Fixed investments Govt consumption

Private consumption GDP growth, yoy

contributions to GDP growth (bps)

DB

forecasts


Production catch-up likely to continue Meanwhile, factory output is likely to continue catching up in the next quarters after the larger drawdown in inventories in Q2. This view already started to play out in Q2 when manufacturing output, in real terms,

11 September 2014



accelerated to 10.8%yoy after slowing to 6.9% in the previous quarter. However, the expansion in output during this period apparently was still not enough to bring about a build-up in inventories as it mainly catered to strengthening external demand (exports rose 10.3%yoy) and robust private consumption (consumer spending held up at 5.3%yoy). We think this trend will continue through year-end on the favorable exports outlook as the US and EU economies improve and on robust domestic demand as remittance inflows and public spending gain pace.

While electronic products and other manufactures have been the country’s main export drivers, accounting for about 80% of total exports, April-June also saw a pick-up in exports of mineral ores, slag & ash, especially to China. It appears that the Philippines gained from Indonesia’s export ban on mineral exports.

Phil exports rose after Indonesia’s ore export ban

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Exports of Ores, Slag, and Ash

from Phils to Others from Phils to China

from Philippines from Indonesia (right)

USD mnUSD mn


Limited energy supply poses risks to growth, inflation Rising domestic activity could, however, put a toll on the country’s aging power plants and highlight inadequate generation capacity. The country’s Energy Secretary is already warning of rolling brownouts in the main island of Luzon by March next year if the additional 600 MW of power supply is not met immediately. There is a risk of this power shortage being pushed earlier this year as domestic activity accelerates. Just this month, Luzon faced severe power deficiency due to the shutdown of critical power plants.

Rising power demand amid tight supply, especially towards the Christmas holidays, could also put further pressure on electricity rates. July and August already saw moderately higher electricity rates in many parts of Luzon. And if rates continue to advance, inflation could again pick up, complicating the BSP’s task of anchoring inflation within the 2-4% target next year.

Diana del Rosario, Singapore, +65 6423 5261

Philippines: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 96.6 98.4 100.2 102.0


Real GDP (YoY%) 6.8 7.2 6.6 6.8




Exports 8.5 -1.1 9.2 10.6

Imports 4.9 5.4 5.8 11.4


CPI (eop) 3.0 4.1 3.9 3.6

CPI (ann avg) 3.2 2.9 4.4 3.6

Broad money (M3, eop) 8.9 32.7 14.3 11.0

Private credit (eop) 14.1 17.3 13.9 10.0

Fiscal Accounts (% of GDP)1

Fiscal balance -2.3 -1.4 -1.9 -2.2





Goods exports 46.4 44.7 49.8 58.8

Goods imports 65.3 63.3 67.3 76.8

Trade balance -18.9 -18.5 -17.4 -18.0

% of GDP -7.6 -6.8 -6.1 -5.7


% of GDP 2.8 3.5 4.2 4.2

FDI (net) -1.0 0.2 0.4 0.8

FX reserves (eop) 83.8 83.2 86.4 92.4

PHP/USD (eop) 41.2 44.4 43.4 43.7


General government debt2 56.2 53.3 54.3 53.8

Domestic 34.2 33.5 35.7 36.4

External 22.0 19.8 18.6 17.4

External debt 24.1 21.5 17.9 19.2

in USD bn 60.3 58.5 50.8 60.3


General (ann. avg)


Unemployment (%) 7.0 7.1 7.3 7.0

Financial Markets (%, eop) Current 14Q4 15Q1 15Q3

Policy rate (BSP o/n repo) 5.75 6.00 6.00 6.25

Policy rate (BSP o/n rev repo) 3.75 4.00 4.00 4.25

3-month T-bill rate 1.24 1.49 1.79 2.39

10-year yield (%) 4.21 4.35 4.60 4.80

PHP/USD 43.8 43.4 43.2 44.0 (1) Refers to general government. (2) Includes guarantees on SOE debt. Source: CEIC, DB Global Markets Research, National Sources

11 September 2014



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

Economic outlook: Expectation of a strong second half of the year has so far disappointed, prompting us to revise downward the 2014 growth outlook modestly. Inflation remains muted and likely to remain so for the rest of the year.

Main risks: More weakness in exports (especially to China) could darken the outlook further. Property market slowdown could accelerate, with adverse implication for household and bank balance sheets.

After a flat Q2, Q3 may have more disappointment in store

As per revised national accounts data, the economy was essentially flat in Q2, growing by 0.02% on a qoq (sa) basis. Data released for the post-June period provide little room for comfort. Excluding the volatile biomedical manufacturing, industrial production declined by 0.8%mom (sa) in July. Many clusters in the manufacturing sector are in contraction territory, including electronics (-2.9%yoy), food/beverage (-1.8%yoy), transport engineering (-9.9%yoy). Chemicals and biomedical manufacturing have been growing, but not sufficiently to compensate for the drag from the other sectors. Indeed, on a three-month moving average basis, industrial production growth has come to a standstill (see chart below).

Production growth has slowed

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Given its open nature and strong dependence on trade, clearly some of the weakness in local production stems from the exports situation. Indeed, non-oil domestic exports were down 3.3%yoy through July, with both electronics and non-electronics exports performing poorly. Overall trade developments remain disappointing, with total trade contracting by

0.6%mom (sa) in July, building on the 3.5% decrease in the previous month. Electronics exports to the US and EU remained in negative growth territory, although the trend seems to be improving.

Elsewhere in this publication we have examined in detail the phenomenon of Asian exports doing far less well than one should expect at this stage of the cycle. Moving from the general Asia case to the specific one of Singapore, we see similar issues. As the chart below makes clear, the traditionally tight relationship between US PMI’s new orders and exports out of Singapore has broken down this year. Weak demand in China this year has also likely played a role in this dynamic, although the latest exports figures to China suggest the worst might be over.

Disconnect between Singapore’s exports and US

orders

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US PMI: New Orders, left

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Even if production and exports were to pick up in the remaining months of the year, given lackluster retail sales, slowing property and auto market, and likely persistence of MAS policy tightness, our view on the upside to growth has moderated. We have accordingly revised down the 2014 and 2015 real GDP forecast by 50bps each to 3% and 4%, respectively.

A bi-product of the slowing of economic momentum is dissipation of inflation pressures. CPI inflation eased to 1.2%yoy in July, while core inflation was 2.2%. With housing inflation virtually flat while clothing (-1.7%yoy), transportation (-0.8%yoy), and communication (-0.7%yoy) prices falling, the ground is set for 1.5-2% inflation not only for the rest of the year, but also for 2015, in our view.

11 September 2014



Inflation drivers largely at bay

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Housing Transportsa, %yoy


Singapore’s key challenge at this juncture is in fact not the macro environment, in our view. Despite our subdued expectation about exports, growth will likely be in line with trend, with no major impetus to change policy stance, whether it is from the government or the MAS’ perspective. High household debt creates vulnerability to a rising rate environment, but that risk seems manageable considering the strong asset side position of the government. The key challenge, we think is structural.

A wealthy but rapidly aging society, Singapore needs to find ways to improve productivity or risk losing competitiveness, see its manufacturing base get hollowed out, and remain mired in its excessive reliance on cheap foreign labor. The government recognizes this risk and has taken many initiatives in recent years to nudge Singaporean businesses to embrace productivity enhancing technologies and practices. The chart below shows that the result so far has been unsatisfactory.

Economic restructuring yet to produce fruit

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Source: CEIC, Deutsche Bank. 2014 data is through Q2


Singapore: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 5.3 5.4 5.5 5.6


Real GDP (YoY%) 2.5 3.9 3.0 4.0


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 4.5


CPI (YoY%) eop 4.3 1.5 1.3 2.4

CPI (YoY%) ann avg 4.6 2.4 1.5 2.1

Broad money (M2) 10.4 9.7 8.5 11

Bank credit (YoY%) 12.9 9.8 10.4 10.5


Fiscal balance 7.8 7.1 6.9 6.8






Trade balance 62.9 67.9 71.9 73.1

% of GDP 22.1 22.9 23.5 22.0


% of GDP 17.4 18.4 18.1 16.5

FDI (net) 47.6 36.9 10.0 12.0


FX rate (eop) SGD/USD 1.22 1.26 1.27 1.27


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 1.0

Total external debt 416 410 391 362

in USD bn 1151 1208 1214 1220


General

Industrial production (YoY%) -1.2 2.8 1.6 3

Unemployment (%) (eop) 2.6 2.8 2.6 2.5



10-year yield (%) 2.34 2.50 2.60 2.80

SGD/USD 1.25 1.27 1.30 1.30 Source: CEIC, DB Global Markets Research, National Sources Note: includes external liabilities of ACU banks.

11 September 2014



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

Economic outlook: The pace of recovery remains insufficient, pointing to mid-3% growth in Q3, while inflation remains benign.

Main risks: While we expect further monetary accommodation, ongoing concerns about high household indebtedness pose risks to our view.

Increased foreign competition

Consumer sentiment bottoms… Thanks to the government and BoK measures, consumer sentiment appears to have bottomed. In particular, CSI on the domestic economy rebounded in August, although well below the pre-Sewol tragedy level. Moreover, consumer sentiment with regards to the housing market has also improved, with the number of apartment transactions rebounding, albeit still lower than months prior to the tragedy.

However, the government’s move to ease loan restrictions and rate cut by the Bank of Korea have prompted some criticism due to rising household indebtedness, posing risks to our rates view – one more rate cut before the year end. Indeed, household loans continued to rise, but this is not new as it bottomed mid-last year and has turned up since. Having said that, this growth in household loans (6.1%yoy 3mma in July vs. 5.9% in June) was led by mortgage growth (6.5% vs. 6.2%). By institution, this mortgage growth was led by nonbank financial institutions (9.4% vs. banks’ 5.7%).

…supporting limited rebound in private consumption, not necessarily a big boost to domestic producers... Retail sales rose 4.0% 3m/3m saar in July after three months of decline. However, the retail sales level has yet to rise past the recent peak in January. By goods, this growth in retail sales was led by strong durable goods sales. In particular, auto sales rose 17.6% 3m/3m saar in July, albeit down from 19.7% in June. On a yoy basis, auto sales rose 2.1% ytd in August, led by foreign car sales. The latter rose 24.6%, sharply higher than the domestic auto sales growth of 3.6%. Since the KOR-EU FTA, the foreign share of total auto sales in Korea rose sharply, to above mid-13% from below 7% in 2010. Meanwhile, non-durable goods sales rebounded sharply, up 9.2% in July vs. 0.8% in June, led by cosmetics. In contrast, semi-durable goods sales fell at a faster pace of 12.3% in July, vs. 5.4% in June, prompting some concerns.

Consuming foreign goods and services

0

3

6

9

12

15

50

70

90

110

130

150

2007 2008 2009 2010 2011 2012 2013 2014

Travel debit/GDP (lhs)

KRW BIS reer (lhs)

Import share of domestic car sales

2010=100 3mma

Sources: CEIC, Deutsche Bank

…while external demand disappoint, amid a stronger won, as inventories continue to trend higher…The won’s relative strength prompted locals to travel abroad. Their overseas expenditure continued to report double digit growth in July, surpassing the pre-crisis level. This, however, did not translate into a larger travel deficit due to increased visitors from China. In July, China represented 51% of total visitors to Korea, after overtaking Japan in 2012. Looking ahead, the XVII Asian Games in Incheon (19 September to 4 October) and the Chuseok holidays this week are expected to boost travel credit and deficit, respectively.

Facing renewed competition

0

60

120

180

240

2007 2008 2009 2010 2011 2012 2013 2014

CH imports of electrical machinery (EM)

Korean EM exports to China

Japan EM exports to China

2010=100 3mma


In contrast, Korean goods exports have been disappointing, with growth falling to 2.7% in July/August from 3.3% growth in Q2, although we may attribute some of the weakness in August to fewer working days and labour strikes (see Special Report on

11 September 2014



South Korea: Labour at a crossroads, published on 5 June 2014), Korean exporters face renewed competition amid the won’s appreciation. In July, Korean exports to China (25% of total exports) dragged on overall growth (of 5.4%) by 1.7ppts as exports of electrical machineries (making up 28% of total exports to China) fell 14.4%. In contrast, Japan’s exports to China contributed positively in July, 0.5ppts, to overall growth of 3.9%, with electrical machineries (making up 10% of total exports China) rising 10%. Also, Germany’s exports to China continued to trend higher. Meanwhile, Taiwan’s exports to China contributed positively, 1.4ppts in July/August, to its overall exports growth of 7.7%, supported by stronger electronics exports (which make up 29% of total exports to China).

Inventory to shipment soared to GFC highs

0.8

0.9

1.0

1.1

1.2

1.3

2000 2002 2004 2006 2008 2010 2012 2014

Mfg inventory/shipment

2010=100 sa 3mma


…keeping business pessimistic, limiting investment growth… Amid weak demand, the inventory to shipment ratio continued to trend higher, back to GFC highs. Unsurprisingly, businesses remained depressed, with BSI falling to 93.2 in September from 94.2 in August. In fact, BSI for investment failed to improve in the latest survey, challenging investment prospects ahead. This is disconcerting as equipment investor growth momentum rolled over in July, to 6.7% 3m/3m saar from 9.0% in June. The government’s tax policies to prompt firms to invest (if not increase wages or dividend payout) have yet to be reviewed by the National Assembly. (See South Korea: Tax to boost growth, published on 6 August 2014, for further details.)

…suggesting further stimulus ahead. Barring positive surprises in September, we see GDP growth hovering around mid-3% in Q3, at best, while inflation remains benign at around mid-1%. Inflation again surprised to the downside, falling to 1.4% in August from 1.6% in July. In response, we see the Bank of Korea providing further monetary support to the economy, as long as the government capacity to boost the economy remains challenged by the National Assembly gridlock.

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) 49.8 50.0 50.2 50.4


Real GDP (YoY %) 2.3 3.0 3.6 3.8



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 1.8 2.5

CPI (YoY %) ann avg 2.2 1.3 1.5 2.3

Broad 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




External accounts (USDbn)



Trade balance 49.4 80.6 84.6 68.4

% of GDP 4.0 6.2 5.9 4.6


% of GDP 4.2 6.1 5.6 4.5

FDI (net) -21.1 -17.0 -16.0 -14.0

FX reserves (USDbn) 1 327.0 346.5 376.5 388.6

FX rate (eop) KRW/USD 1064 1050 1040 1080

Debt indicators (% of GDP)

Government debt2 33.2 34.8 34.3 34.0

Domestic 32.6 34.3 33.6 33.2

External 0.6 0.5 0.7 0.8


in USDbn 408.9 416.1 430.0 432.0


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 Q315

BoK base rate 2.25 2.00 2.00 2.25

91-day CD 2.35 2.15 2.15 2.45

10-year yield (%) 3.07 3.30 3.45 3.60

KRW/USD 1032 1040 1060 1070

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

11 September 2014



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

Economic outlook: Sri Lanka is likely to achieve 7.5% real GDP growth in 2014, while maintaining CPI inflation around mid-single digit levels.

Main risks: External risks including possible escalation of geo-political concerns could undermine the macro improvement that has been achieved in the last two years.

In a sweet spot

2014 has been a good year for Sri Lanka so far. Growth momentum has remained strong (7.6%yoy real GDP growth in Q1), inflation has fallen to low single-digit levels (3.5%yoy in August), trade deficit has narrowed (-20.1%yoy in 1H’14), the rupee has stabilized (around 130.20 levels) and gross official reserves have touched historical highs (USD9.2bn). Reflecting the positive sentiment, the Colombo stock exchange has risen by 28.6% in Dollar terms since September of last year.

Stock market is up 28.6% from September last year

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8

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2009 2010 2011 2012 2013 2014

Gross official reserves, lhs

CSEALL Index, rhs

USDbn


While growth momentum remains strong (we expect 2Q real GDP growth to be 7.7%yoy vs. 7.6%yoy in Q1), credit growth has slowed down appreciably, led by a drastic reduction in gold-backed lending. Private sector credit growth was up only 2%yoy in June’14, the lowest reading since April 2010. The slowdown in credit growth has persisted despite the central bank having kept monetary policy accommodative since the last several months (between December 2012 and January 2014, the CBSL has cut the standing deposit facility rate by 125 basis points and the standing lending deposit rate by 175 bps). The hope is that the recently announced credit guarantee scheme on pawning advances should help improve the credit growth momentum in the second half of 2014.

Private sector credit growth has collapsed

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2009 2010 2011 2012 2013 2014

Credit growth, lhs CPI, rhs

Core CPI, rhs

% yoy, 3mma % yoy


Monetary policy outlook. The CBSL kept all key policy rates unchanged in the August monetary policy review, citing that the economy is on the right track and monetary policy adjustment is not required at this stage. However, it is clear from the CBSL Governor’s recent press statements that the bias of the central bank authorities remains towards further easing.

We assign a 50/50 chance for the CBSL to cut rates by 50bps in the September policy review. The argument against cutting rates are as follows: i) inflation is likely to have bottomed and will rise gradually from here on; ii) growth momentum remains sufficiently strong and does not require further monetary stimulus; iii) the low credit growth problem cannot be resolved by additional rate cuts; and iv) further monetary policy easing could create imbalances in the economy, albeit with a lag, thereby endangering exchange rate stability.

Headline CPI and core CPI inflation forecast

0

2

4

6

8

10

12

2009 2010 2011 2012 2013 2014 2015

CPI CPI proj.

Core CPI Core CPI proj.

% yoy


11 September 2014



It would indeed be a positive development, if the CBSL authorities give greater weight to these above arguments and refrain from cutting the policy rate any further, which is already at a historic low level. But as has been noted above, the CBSL’s bias lies toward maintaining a dovish stance, and therefore chances of an additional rate cut cannot be ruled out completely. We are in fact forecasting a 50bps rate cut in the September policy review, which we think should be the last rate cut in this cycle.

FX outlook. The sharp moderation in global oil prices will help improve Sri Lanka’s trade and current account deficits, as oil imports constitute 27% of total imports. We have factored in a 50bps improvement in the current account deficit for 2014, from the previous year (3.4% of GDP vs. 3.9% of GDP), but the improvement could turn out to be larger if global oil prices sustain at current levels for the rest of this year. This should be favorable for the rupee, assuming capital flows also remain resilient in the months ahead.

Global oil prices and current account deficit

-10

-8

-6

-4

-2

0-50

-30

-10

10

30

50

1992 1995 1998 2001 2004 2007 2010 2013

Dubai crude, lhs CAD, rhs% yoy % of GDP


However, we do not expect the rupee to appreciate materially from current level, at least in 2014 (our year-end target for the rupee is 130.0). The CBSL Governor has clearly stated that the central bank is not in favor of allowing sharp appreciation in the currency. Year to date, the CBSL has purchased over USD1bn from the domestic FX market on a net basis, and the same strategy is likely to persist, if the rupee faces further appreciation pressure in the remainder period of this calendar year.

We think this is a prudent strategy, as building up reserves at this stage will help strengthen Sri Lanka’s reserves adequacy position as well as create an insurance against Fed monetary policy-related potential volatility in the quarters ahead.

Kaushik Das, Mumbai, +91 22 7180 4909

Sri Lanka: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


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 6.3

Broad money (M2b) eop 17.6 16.7 13.0 16.5



Central government balance -6.4 -5.8 -5.5 -5.0







Trade balance -9.4 -7.6 -8.3 -9.2

% of GDP -16.0 -11.4 -10.9 -10.4


% of GDP -6.6 -3.9 -3.4 -3.2

FDI (net) 0.9 0.9 1.0 1.3


FX rate (eop) LKR/USD 127.7 130.8 130.0 128.0



Domestic 42.6 42.5 41.0 39.4

External 36.5 36.9 36.3 35.6


in USD bn 28.4 31.3 34.4 37.9


General


Unemployment (%) 4.2 4.1 4.0 4.0


Reverse Repo rate 8.00 7.50 7.50 8.50

LKR/USD 130.2 130.0 129.4 128.5 Source: CEIC, DB Global Markets Research, National Sources

11 September 2014



Taiwan Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic outlook: Stronger growth momentum, led by electronics exports.

Main risks: Despite the improvement in data, aggressive monetary easing by other central banks is likely to keep the CBC on hold this year.

Electronics-led optimism

Stronger GDP growth momentum… Taiwan’s GDP accelerated to 3.7%yoy (1%qoq sa) from 3.2% (0.6%) in Q1, led by strengthening domestic demand. Moreover, with exports surprising to the upside in Q3, after disappointing for the better part of 1H, we have decided to keep our GDP growth forecast unchanged at 3.7%.

Balanced growth in Q2

-5

0

5

10

2011 2012 2013 2014

PCE GovtInvt StocksNet exports GDP

%contribution to GDP


…supported by acceleration in electronic exports… Exports rose 7.7%yoy in July/August, up sharply from 2.9% in Q2, led by electronics exports. The latter contributed 5.5ppts in July/August, up from 3.8ppts in Q2. With electronics making up about a third of Taiwan’s exports, an upturn in global demand for electronics bodes well for Taiwan. In contrast to Korea, Taiwan saw its exports to China (26% of total exports) contribute positively to its overall exports growth, by 1.4ppts in July/August, up from 0.7ppts in Q2. Taiwan’s exports to China rose 5.3% in July/August, vs. 2.6% in Q2, as electronic exports contributed 4ppts, while electrical machineries subtracted 0.5ppts. Note that while electronics make up 28% of Taiwan’s exports to China (average this year), electrical machinery dominates Korean exports to China (28% of the total). Korean electrical machinery exports to China fell sharply, by 14.4% in July, dragging growth by 3.6ppts.

Exports led by electronics

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0

10

20

30

2011 2012 2013 2014

Electronic products contribution

Total exports growth

%yoy 3mma


Meanwhile, strong tourism inflows continue to support services exports. Mainland Chinese tourists remained the driver of tourism growth, making up 43% of total visitors in July. Indeed, they were responsible for more than half of the 27% growth in total visitors to Taiwan thus far this year. In 1H, travel receipts stood at USD7.2bn, up 18.5% from last year, while debit stood at USD6.5bn, up 10.8%.

Strong capital imports point to robust investment

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-20

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80

100

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2006 2008 2010 2012 2014

Imports of capital goods

Facility investment

%yoy


…and stronger consumption and investment… A combination of stronger exports, a buoyant stock market and high asset (housing) prices bodes well for domestic demand in Q3. In particular, we expect stronger exports to support sustained growth in facility investments, as reflected in the acceleration in capital goods imports. The latter rose 21.2% in July/August, up from 5% in Q2. In Q2, overall facility investment rose 4.1%, up from no growth in Q1, led by the private sector. Private facility investments rose 8.2% in Q2, vs.

11 September 2014



a 2.0% fall in Q1, led by a 52.1% rise in transportation equipment investment, followed by weak but still positive 0.8% growth in investment in machinery equipment. In contrast, public facility investment declined 13.8% in Q2 vs. a 14% rise in Q1. The improvement in construction investment was also led by the private sector, in which investment rose 6.2% in Q2, up further from 2.5% in Q1, amid a strong housing market, more than making up for the sustained fall (6.1%) in public construction during Q2.

Divergence in housing prices: Taiwan vs. Korea

40

80

120

160

1994 1999 2004 2009 2014

Korea kookmin housing index

Taiwan cathay real estate index

2010=100


…and high housing prices point to a hawkish stance by the CBC… In contrast to South Korea’s continued efforts to boost the housing market, including a rate cut and reversal of prudential regulations on household loans, Taiwan continued its efforts to limit housing price increases. Moreover, while the former revised down its GDP forecast, Taiwan continued to revise up its own. Earlier this year, in response to stronger-than-expected growth in Q4 2013, the government revised up its GDP growth forecast to 2.8% and inflation to 1.4%. Since then its GDP forecast has been revised up twice and now stands at 3.5%, while its inflation forecast has remained relatively stable at 1.5%.

…but it is likely to wait before hiking its policy rates. While we expect the Central Bank of China (CBC) to strike a more hawkish tone, we think it will fall short of hiking its policy rate this year as the ECB and BoJ continue their aggressive monetary easing, guiding their respective currencies weaker. The Bank of Korea’s monetary easing may also weigh on its decision. Hence, we do not see the CBC moving until next year, or at least until there is a clear indication that the Fed will soon do so.


Taiwan: Deutsche Bank forecasts 2012 2013 2014F 2015F

National income

Nominal GDP (USDbn) 476.4 490.8 504.3 525.6

Population (m) 23.3 23.4 23.4 23.5


Real GDP (yoy %) 1.5 2.1 3.7 3.8


Government consumption 1.0 -0.3 0.7 0.6


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 1.8

CPI (yoy %) annual average 1.9 0.8 1.5 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




External accounts (USDbn)



Trade balance 31.6 37.0 39.4 41.3

% of GDP 6.6 7.5 7.8 7.9


% of GDP 10.6 11.7 12.9 11.9

FDI (net) -9.9 -1.0 -11.0 -14.0


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


in USDbn 130.8 170.1 190.0 190.0


General


Unemployment (%) 4.2 4.2 4.0 4.0

Financial markets Current Q4 14 Q1 15 Q3 15

Discount rate 1.88 1.88 1.88 2.00

90-day CP 0.83 0.85 0.88 1.00

10-year yield (%) 1.70 1.80 1.95 2.10

TWD/USD 30.0 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

11 September 2014



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

Economic outlook: Growth may bottom in Q3, but

the outlook for 2014 remains grim with a myriad of

domestic and external headwinds.

Main risks: Political transition may not be smooth; investment recovery may run into administrative hurdles, fiscal situation could continue to worsen as the cost of price control and other supporting measures mount.

Is this time different?

The stabilization of the security situation and quelling of political unrest since late May have provided much needed breathing room to the economy. Consumer sentiment has recovered, investor sentiment has been revived, and flows have returned. With the new regime keen to get investment going and inflation and rates remaining in comfortable territory, one can see the makings of a bottoming-out of the economy. Thailand’s longstanding economic anchors--tourism, manufacturing, trade, and regional demand--have the potential to provide traction for a broad-based short-term recovery.

Efforts to stabilize and revive the real economy

With the military leadership receiving royal endorsement to form a cabinet, consisting of a large number of active or retired members of armed forces and some bureaucrats, there is now clarity about the make-up of the government. Some of the more well-known technocrats, who some might view as necessary to chart the course of the envisaged investment revival, are not part of the new cabinet. We nevertheless recognize the value of at least filling a governance vacuum that had been persisting in recent months.

The state of the economy remains precarious but there are some tentative signs of a bottom. First, we focus on the positives. Markets have rallied and confidence readings (both consumer and business) have improved since May. Some parts of the industrial sector (such as hard drive, integrated circuit, and rubber/plastics) have undergone production acceleration. Electricity consumption is up, the private consumption index is no longer in negative territory, and financial market conditions (rates, liquidity, inflation and exchange rate) remain in comfortable territory.

On the negatives, the list is still long. Data through July show poor exports, investment, and tourism, and it remains to be seen how much improvement takes place in the coming months. On trade, Thailand’s poor exports figures (both value and volume in negative territory through July) reflect weak demand from the US and China, with no clear sign of a turnaround. On investment, while the government is trying to expedite project approvals, it will take a while before execution begins and private sector participation is cemented. It also remains to be seen if the new cabinet is skilled at dealing with the complexity of large scale investment projects (e.g. dual tracking, high speed railway, and port renovation). Tourism is likely to remain hampered by caution expressed by travelers about the political situation, notwithstanding the authorities’ efforts to ease travel related logistics.

Consumption is weak but improving

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Private consumption index (sa), left

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Bottoming investment

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11 September 2014



Against this backdrop, we see no more than 1.5% real GDP growth rate this year. Base effect and a cyclical recovery in consumption and investment could pave the way for 5% growth next year. Inflation should be around 2% this year and 2.5% next even as the economy picks up, reflecting price controls and a subdued global commodity price dynamic. Assuming exports and imports recover, the current account would hover around a surplus of 2% of GDP. We however see risks of fiscal slippage (perhaps 3% of GDP this year and 2.5% of GDP next) as the government boosts spending and eases taxes to get the economy going.

Production still in negative territory

-15%

-10%

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Value added prod Manuf machinary%yoy


Weak tourism

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2010 2011 2012 2013 2014

Tourist arrival. Yoy% Hotel occupancy tate

3mma


Fiscal

With weak economic growth persisting through this year, we see considerable fiscal slippage risk with the deficit likely to exceed the budget target by THB100bn. We may see efforts to ensure fiscal discipline, but the government will face the difficulty of needing to spend to support the economy.

Further fiscal stimulus is likely in the coming years if the economy doesn’t show signs of picking up. We won’t rule out further support for consumption and investment, although it remains to be seen if such measures would come with further risk of fiscal slippage. While we don’t expect another car buying tax credit scheme, support for the rural population through cash transfers may well be on the cards. On the revenue side, the authorities may revisit land taxes, which could help local government finance and may be astute from a political economy angle. VAT increase could be another option that may be needed for restoring fiscal discipline.

Some reform is critically needed; especially, measures to bring more spending and financing on-budget would be welcome. The previous government’s attempts to administer subsidies and infrastructure spending and financing partly off-budget gave rise to concerns about the opacity of fiscal operations. There is considerable room for improvement in this area, but might require modification of budget laws.

Trade

Trade, for decades an anchor of the Thai economy, is facing cyclical and structural challenges. Weak prices for rice, seafood, and rubber are hurting exporters, while the electronics sector is facing weak demand, stiff competition, and shifts in industry trends. Many electronics products that have supported exports in recent decades (disk drives, for instance) are seeing waning structural demand, necessitating reorientation of production.

Lackluster trade

-60.0

-40.0

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80.0

2008 2009 2010 2011 2012 2013 2014

Exports Imports%yoy,

3mma


One bright outlook for trade is the fact that the immediate neighbors (Myanmar, Cambodia, Laos, and Vietnam) have rising demand for goods and services produced in Thailand. With proper infrastructure development, Thai exporters could gain substantially in becoming the key supplier of the fast growing Mekong delta region.

11 September 2014



Monetary and financial sector

Persistence of a wide output gap, weak commodity prices, and a number of price control measures have made the inflation situation benign for the time being, and we see little upside risk through 2014 and 2015. Since May, price controls have become rather aggressive; notwithstanding the adverse fiscal implication, we expect inflation to be restrained from these measures.

There are three areas of consideration for the medium term inflation outlook: (i) timing and magnitude of fuel price adjustment (especially diesel and LPG), (ii) VAT increase (perhaps in late 2015), and (iii) civil service wage increase. In all cases we don’t see the current path of inflation (2-2.5%) changing materially until 2016.

On the direction of the baht, the BoT may well allow the exchange rate to depreciate if inflation remains benign. Recent years’ wage increases and lack of productivity growth have caused competiveness to wane, which could be ameliorated to some extent by a weaker baht. With the current account likely to remain in surplus territory, the scope for exchange rate depreciation however may be limited.

Beyond inflation and FX, there are lingering concerns about the financial sector. Thai banks and nonbanks have lent heavily to households in recent years, raising question about their exposure to rising global interest rates. Even if rates don’t rise soon, household income may struggle to keep pace with debt service requirements. If the economic cycle does not improve considerably for a number of years, banks may remain under pressure, in our view. Loan growth is no longer robust, which means banks may not be adding risk, but how they deal with legacy loans (options include write-off, restructuring, roll-over) would be critical for the economy in the coming quarters.

Looking beyond the near-term

While the near-term outlook has improved, there are considerable medium term concerns, not least of which is the challenge of transitioning to an accountable, sustainable, and stable political system. Efforts to control inflation through price controls are bound to have distortionary effects and adverse fiscal implications. Push for a cyclical turnaround could delay addressing critical structural issues such as aging, productivity, and competitiveness. High household debt and the risk of a possible rise in global interest rates could slow the recovery, eliciting possible policy stimulus measures from the authorities who may be keen to produce quick dividends.

Substantial household debt burden

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Public debt keeps rising

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Indonesia Malaysia Philippines Thailand

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Thailand has unfortunately been at this juncture of political uncertainty followed by periods of military rule many times in recent years, which makes it a challenge to be optimistic about the direction of the political economy. We remain concerned that the ongoing relief rally and economic recovery due to the arrival of the military junta could fade if long-term challenges are not addressed expeditiously.

Thailand has lagged regional peers substantially in

recent years

100.0

100.5

101.0

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102.0

102.5

103.0

103.5

2006 2007 2008 2009 2010 2011 2012 2013 2014F

Thailand Indonesia

Philippines Malaysia

Real GDP,

log scale,

2006=100


11 September 2014



Dependency ratio has bottomed: aging is soon to

become a major issue

0

10

20

30

40

50

60

70

80

90

100

Source: UN, Deutsche Bank. Dependency ratio is the number of population below 15 and above 64 relative to total population


Thailand: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (m) 64.5 64.8 65.1 65.4


Real GDP (yoy %) 6.5 2.9 1.5 5.0



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


CPI (yoy %) eop 3.6 1.7 1.8 2.7

CPI (yoy %) ann avg 3.0 2.2 2.1 2.4

Core CPI (yoy %) ann avg 2.1 1.0 1.5 1.3

Broad money 10.4 7.3 7.5 8.0

Bank 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




External Accounts (USDbn)



Trade balance 6.0 6.7 19.5 15.6

% of GDP 1.6 1.8 5.1 3.8

Current account balance -1.5 -2.5 7.0 5.0

% of GDP -0.4 -0.7 1.8 1.2

FDI (net) 10.7 12.8 12.0 15.0

FX reserves (USDbn) 181.6 167.3 172.0 180.0

FX rate (eop) THB/USD 30.7 32.4 32.0 32.5


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 1.0


in USDbn 130.7 135.0 140.0 145.0


General

Industrial production (yoy %) 2.5 2.6 1.0 5.0

Unemployment (%) 0.8 0.8 0.9 1.0


BoT o/n repo rate 2.00 2.00 2.00 2.25

3-month Bibor 2.20 2.15 2.30 2.60

10-year yield (%) 3.45 3.55 3.65 3.85

THB/USD (onshore) 32.1 32.0 32.3 32.5 Source: 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

11 September 2014



Vietnam B2/BB-/B+ Moody’s/S&P/Fitch

Economic outlook: Disappointing exports and retail sales point to limited improvement in GDP growth in Q3, possibly leading to further stimulus measures as inflation remains benign.

Main risks: As private demand disappoints, public expenditure and investment may be boosted, pointing to further pressure on the public finances.

Investing for the future

Despite limited private consumption and external demand… High frequency data suggest that an improvement in growth is likely to be led by an acceleration in investment, as private consumption growth remains weak. In particular, retail sales data point to sustained weakness in private consumption, perhaps even weaker in Q3. Discounted by CPI inflation, retail sales rose 6.2%yoy in July/August, vs 7.5% in Q2.

Weak consumption and exports

-30

-20

-10

0

10

20

30

40

50

2007 2008 2009 2010 2011 2012 2013 2014

Retail sales Exports

%yoy 3mma


Worse still, exports growth also slowed, to 10.2%yoy in July/August from 16.3% in Q2. This slowdown was broad-based as both new (phones) and old exports (commodities) came under pressure. Growth in exports of phones and parts (16% of total exports in 2013) slowed to 8.1% in July/August from 13.7% in Q2, while that of textile and garments (14%) fell to 18.9% from 20% in the same period. Meanwhile, exports of computers and electronic components (8%) and rubber (2%) fell at faster rates of 6.6% and 31% in July/August, respectively, vs. 0.2% and 26.3% in Q2. Weakness in exports of phones and parts and computers and electronic components is particularly worrisome as this has not been the case in Korea or Taiwan.

Weak exports of computers and electronics

-40

-20

0

20

40

60

80

100

120

140

160

2008 2009 2010 2011 2012 2013 2014

Exports: Computer/electronic parts

Exports: Phones and parts

Imports: Electronics goods

%yoy 3mma


Looking ahead, the sustained contraction in imports of electronic products (2.8% in July/August vs. 4.1% in Q2) bodes ill for future exports. Also, service export receipts (travel) remain weak. The number of visitor arrivals fell 9.2%yoy 3mma in August, with Chinese tourists (25% of total in 2013) accounting for 4.8ppts of this fall. Having said that, however, weak domestic demand has kept imports in check, resulting in a continued goods surplus of USD51mn in July/August, albeit narrowing from USD390mn in Q2. This has kept the dong relatively stable.

Stronger facility investments

-100

-50

0

50

100

150

200

250

300

-40

-20

0

20

40

60

80

100

2008 2009 2010 2011 2012 2013 2014

Imports of machinery and parts

Auto imports (rhs)

%yoy 3mma


…stronger investment growth, supported by the state and FDI sectors... In contrast, indicators of facility investment fared better, with a rebound in machinery investment. Imports of machinery and spare parts rose 34.7% in July/August, up from 22.7% in Q2. Transportation imports also trended higher, to 62.6% in July/August, vs. 42% in Q2.

11 September 2014



FDI continued to find its way to Vietnam in August, reflecting sustained belief in the economy’s potential, despite its ongoing struggle in the banking/ construction sectors and global economic challenges. Implemented FDI rose 4.5%yoy ytd in August to USD7.9bn, vs. 3.9% growth in the same period last year, although registered capital fell slightly by 2% to USD7.2bn. Meanwhile, state investment turned around sharply, rising 10.8%yoy ytd in August, vs. the 14.6% decline reported during the same period last year. Meanwhile, we could see further potential capital inflows in the form of FDI and portfolio investments through the equitization of SOEs. Out of the over 400 companies targeted, less than 10% have been equitized thus far. The government’s completion target date remains unchanged at end-2015.

Volatile items keep headline inflation stable

0

5

10

15

20

25

30

35

40

2010 2011 2012 2013 2014

Headline

Food

Transportation

%yoy 3mma


Weaker-than-expected growth and inflation point to further accommodation by the authorities. Given disappointing exports thus far, we cut our GDP growth forecast by 0.2ppts for this year to 5.6%, slightly below the government’s target of 5.8%, unless public investments are accelerated. Meanwhile, inflation continued to surprise to the downside, suggesting that it will average well below the government’s inflation target of 7%, at 5%. In response, we think the State Bank of Vietnam may provide further stimulus, especially as credit growth remained anemic at 4.5% ytd in August. While we expect a rebound in exports to support stronger GDP growth next year, in an effort to achieve the government’s aim of 6.0% we think that stimulus policies may not be reversed. As such, we think Vietnam may require price controls to be maintained to keep inflation stable at around the government’s target of 5% for next year.


Vietnam: Deutsche Bank forecasts

2012 2013 2014F 2015F

National Income


Population (m) 88.8 89.7 90.7 91.6


Real GDP (yoy %) 5.2 5.4 5.6 6.0




Exports 11.0 11.5 12.0 15.0

Imports 3.2 10.5 12.0 16.0


CPI (yoy %) eop 6.8 6.0 6.1 4.2

CPI (yoy %) ann avg 9.3 6.6 5.0 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



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




Trade balance 4.5 1.0 2.0 -4.0

% of GDP 2.9 0.6 1.1 -2.0


% of GDP 4.8 3.5 3.8 0.5

FDI (net) 10.5 11.5 12.0 12.0


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


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 15

Refinancing rate 6.50 6.00 6.00 6.00

VND/USD 21205 21600 22100 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..

11 September 2014



Czech Republic A1(stable)/AA-(stable)/A+(stable) Moodys/S&P/Fitch

Economic outlook: GDP growth in Q2 stagnated, due to softer external demand and a slowdown in investment. There has also been weakening of some recent high frequency data. However, the weakness in growth should prove largely transitory, and inflation has begun to pick up.

Main risks: The risks to growth are skewed to the downside, due to the potential for a prolonged slowdown in euro area growth and/or an escalation of the Russia-Ukraine crisis (and its adverse impact on euro area activity).

Growth slowed but inflation is picking up

Growth faltering a little. After accelerating markedly in late 2013/early 2014 real GDP growth slowed down in Q2 2014 from 2.9% to 2.7% YoY, as the economy returned to stagnation in QoQ terms (consensus +0.3% qoq) after four quarters of growth. The recent slowdown seems to reflect a mixture of a softer external demand profile coupled with a (potentially temporary) slowdown in fixed investment although the broader domestic picture remains robust. Indeed, private consumption growth accelerated further in Q2 to 2.0% YoY, reflecting solid real wage growth and consumer confidence and falling unemployment.

Rather the slowdown in Q2 was driven by weaker exports (-0.4% QoQ) and, following two strong quarters, a reversal in fixed investment (-1.4% qoq). Nominal exports, although up 13.6% yoy in July, have largely flatlined since the start of 2014 in seasonally adjusted terms with the earlier impact of the Koruna depreciation waning and the impact of the Russia/Ukraine crisis likely weighing down on exports.

Indirect risks from Russia/Ukraine crisis. Factors surrounding the Russia/Ukraine crisis have likely weighed on external demand, although the effects are not as obvious as for some countries – exports to Russia account for only 3.7% of Czech exports and have been posting near zero growth since the start of 2012. The recent exchange of sanctions, including Russia’s ban on EU food imports, should have limited direct effect. However, the Czech Republic has a large exposure to the euro area, which represents 64% of Czech goods exports (57% and 54% for Hungary and Poland) with Germany accounting for half that figure.

Our German economists revised the 2014 German GDP growth forecast from 1.8% to 1.5% last month, with further downside risks to this stemming from the summer escalation of the Ukraine conflict and Russia sanctions Russia on exports and, through the

confidence channel, on investment. Softer external traction for Czech exports may thus continue, although the impact of any slowdown would be partially mitigated by their relatively high import content in exports to the German supply chain17.

Czech exports flat lining since the start of 2014

-30

-20

-10

0

10

20

30

50

100

150

200

250

300

350

2006 2007 2008 2009 2010 2011 2012 2013 2014

Goods exports, SA

Bil. CZK % yoy

Source: Deutsche Bank, CNB, CSO, Haver Analytics

A softening of external traction is also confirmed by survey indicators with the decline in manufacturing new export orders (-7.2 pts from peak) more pronounced than in the new orders series (-2.9 pts). The short-term indicators do support a still positive domestic picture. Although manufacturing PMI has eased from its peak (54.3 Aug from 57.3 May) it is still consistent with the solid industrial production growth – at +6.0% YoY in July. With consumer confidence reaching new post Great Recession highs in June/July the consumption picture also remains positive.

However, both consumer confidence and manufacturing PMI weakened in August. It is too early to read too much into this, but it is a potential worry insofar as it coincided with an escalation in Ukraine conflict and increased Russia sanctions and could thus represent contagion from external uncertainty to domestic confidence. Our baseline remains that the recent signs of a weakening in growth should prove largely transitory – we expect +2.4% GDP growth in 2014 and +2.6% in 2015 – but risks around this are tilted to the downside.

17 See Special report Will the Russia crisis derail recovery in Eastern

Europe from 12 August 2014.

11 September 2014



Inflation is gathering pace. Inflation in August was reported at 0.6% YoY (vs. 0.5% expected). This is the second month running for which headline inflation has increased (and has been above market expectations), providing some evidence that inflation has indeed turned around after being very low in the first half of the year (as a result of low imported inflation from the euro area and weak food price growth).

As expected, the main upward pressure on the headline rate in both July and August came from food price inflation, which is now picking up after being subdued for a prolonged period. This should continue to rise – as this year’s harvest is unlikely to be as strong as last year’s bumper one – and add upward impetus to headline inflation. We expect headline YoY CPI to rise gradually in the coming months and reach 0.9% by year-end (averaging 0.4% in 2014), and continue rising next year (averaging 1.8% in 2015); it is expected to re-enter the Czech National Bank’s (CNB) 1pp tolerance band around its 2% target in early 2015, when base effects also add significant upward pressure (as administered price cuts drop out of the base). This is largely in line with the CNB’s latest forecasts.

Both headline and food inflation are on the uptick

-8

-4

0

4

8

12

2006 -Aug

2008 -Aug

2010 -Aug

2012 -Aug

2014 -Aug

Headline CPI (YoY %) Food price inflation (YoY %)


While revising down significantly its inflation forecast for 2014 and 2015, and highlighting further anti-inflationary risks, the CNB in July pushed further out the end date of fx intervention, stating that it “will not discontinue the use of the exchange rate as a monetary policy instrument before 2016”. In June, this end date had been pushed out to at least Q2 2015 from Q1 2015.

The CNB has stated that it prefers to extend the length of intervention rather than weaken the fx floor, and with inflation (the key indicator for any potential weakening) showing signs of picking up, a weakening of the floor is becoming more unlikely. We expect no changes to monetary policy in the near future.

Gautam Kalani, London, +44 207 545 7066 Peter Sidorov, London, +44 207 547 0132

Czech Republic: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 10.6 10.6 10.6 10.6

GDP per capita (USD) 18 617 18 766 18 250 17 446

Real GDP (YoY%) - 1.0 - 0.9 2.4 2.6

Private Consumption - 2.1 0.1 1.8 1.8

Government consumption

- 1.9 1.6 1.0 1.2

Gross fixed investment - 5.0 - 4.5 3.5 3.2

Exports 4.7 0.2 10.4 6.0

Imports 2.5 0.6 11.2 5.8


CPI (eop) 2.4 1.4 0.9 1.6

CPI (period avg) 3.3 1.4 0.4 1.8

Broad money (eop) 4.5 3.0 5.1 5.0


Overall balance - 4.2 - 1.4 - 2.6 - 2.5

Revenue 40.3 40.9 41.0 41.6

Expenditure 44.5 42.3 43.6 44.1

Primary Balance - 2.7 0.0 - 1.1 - 1.0


Goods Exports 132.9 135.2 151.4 151.5

Goods Imports 125.3 125.5 141.2 141.9

Trade Balance 7.6 9.6 10.2 9.5

% of GDP 3.9 4.9 5.3 5.1

Current Account Balance - 2.6 - 2.8 - 3.0 - 2.6

% of GDP - 1.3 - 1.4 - 1.5 - 1.4

FDI (net) 3.9 4.0 5.0 5.0

FX Reserves (eop) 37.4 42.4 42.9 43.4

USD/FX (eop) 19.1 19.9 20.8 23.5

EUR/FX (eop) 25.2 27.3 27.0 27.0


Government Debt 46.2 46.1 45.2 47.7

Domestic 31.4 33.3 32.3 34.2

External 14.7 12.7 12.8 13.4

External debt 51.8 50.7 51.0 52.0

in USD bn 101.9 100.7 98.7 96.2


General (ann. avg)

Industrial Production (YoY%)

- 0.7 0.9 6.0 6.3

Unemployment (%) 6.8 7.7 7.5 7.0

Current 14Q4 15Q1 15Q3

Financial Markets

Key official interest rate (eop)

0.05 0.05 0.05 0.05

USD/CZK (eop) 21.5 20.8 21.4 22.8

EUR/CZK (eop) 27.7 27.0 27.0 27.0

Source: Haver Analytics, CEIC, DB Global Markets Research Government is defined as general government

11 September 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 remain positive as well, and inflation is beginning to show signs of picking up.

Main risks: The main downside risks come from a potential escalation in the Russia-Ukraine crisis and/or prolonged weakness in euro area activity (which in turn could be adversely affected by an escalation in the crisis). Further downside risk comes from the possible deterioration in the investment climate from the government’s interventionist stance, particularly towards the banking sector in relation to fx loans relief measures. On the other hand, growth could surprise to the upside if the government is able to successfully increase its absorption of EU funds.

Strong growth in Q2 backed by encouraging details

Economic growth in Q2 was a robust 3.9% YoY (0.8% QoQ). This was the highest YoY print since 2006, and above our own, market and NBH expectations (3.5% YoY).

Q2 GDP growth was amongst the highest in Europe


The details were also encouraging, showing that growth was driven by domestic demand. While household consumption picked up gradually by 2.4% YoY (on the back of increasing real wages in the low inflation environment), investment expanded by a substantial 18.7% (which added 3.2pps to GDP growth) mainly on the back of private investment growth. On the other hand, net exports – which had been the main driver of growth previously – had a negligible contribution to growth in Q2 as activity in the euro area (Hungary’s main export partner) slowed.

Domestic demand now the main driver of growth

-15

-12

-9

-6

-3

0

3

6

Q2-06 Q2-08 Q2-10 Q2-12 Q2-14

Net trade contritbution (pps)

Domestic demand contribution (pps)

GDP growth (YoY %)


Thus, there is evidence of strengthening of the domestic economy, aided by low interest rates. The National Bank of Hungary’s (NBH) Funding for Growth Scheme (under which SMEs can access funding at capped interest rates) also likely boosted investment. Thus far in the first two phases of this scheme, 14,000 SMEs accessed a total of HUF 1040bn (EUR 3.3bn) from credit institutions; of this, HUF 337bn has been accessed in the second phase (which is runs from October 2013-December 2014), while the remainder was drawn in the first phase (which was completed last year). Earlier this month, the NBH announced that the available funding under the second phase would be increased to HUF 1000bn (from HUF 500bn previously) as a result of the favourable impact of the program (it estimates the scheme to add 0.5-1pps to annual GDP growth) and a likely rise in loan demand as economic conditions improve.

Activity and survey data remain strong. In addition to Q2 GDP, the high frequency data in recent months continued to be positive. Industrial production growth picked up further, rising to 11.9% YoY in July. Manufacturing PMI has been in expansionary territory for over a year, while retail sales growth continues to print at above 5% (though the pace of growth has reduced slightly over the past few months).

Going forward, we expect activity data to remain relatively strong and the robust growth momentum to carry forward to the coming quarters; we forecast GDP to grow by 3.4% in 2014 (with domestic demand remaining the main driver of growth), before slowing to 2.7% next year. The main downside risks to the relatively open Hungarian economy come from external factors, namely a potential escalation in the Russia-Ukraine crisis and/or prolonged weakness in euro area activity (which in turn could be adversely affected by an escalation in the crisis).

11 September 2014



Industrial production growth continues to pick up

-30

-25

-20

-15

-10

-5

0

5

10

15

Jul-06 Jul-08 Jul-10 Jul-12 Jul-14

Euro Area IP %YoY

Hungary IP %YoY


Inflation is showing signs of a turnaround. Headline inflation was positive in July (0.1% YoY) – after three months in negative territory – mainly on the back of surprisingly robust food inflation. Weak food inflation has been one of the main drivers of the low headline inflation observed in recent months. While food inflation is still mildly negative, the July figure shows a notable pick up (to -0.4% YoY from -1.3% YoY in June). We expect food inflation to continue rising in the coming months, as early indications are for a slightly worse harvest than the bumper one last year.

Headline and food price inflation

-2

0

2

4

6

8

10

12

14

2006 - Jul 2008 - Jul 2010 - Jul 2012 - Jul 2014 - Jul

Headline CPI (YoY %) Food price inflation (YoY %)


In addition to accelerating food price inflation, a narrowing output gap and continued domestic demand expansion, as well as base effects (driven by the administered utility price cuts falling out of the base), are expected to add upward impetus to headline inflation towards the end of 2014 and through 2015. As a result, while average inflation is expected to be a subdued 0.3% in 2014, it is expected to rise to 2.7% next year. Our forecasted inflation profile suggests that inflation will near the 3% target in mid-2015.

NBH measures of underlying inflation remain

substantially higher than the headline rate

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14

Core ex indirect taxes

Demand sensitive inflation

Sticky price inflation

% YoY

Source: Deutsche Bank, NBH

Rates expected to remain on hold. After cutting rates by 20bps and signaling the end of the easing cycle in July, the NBH did indeed keep rates on hold (at the record low 2.10%) in August, bringing to an end the two year long easing cycle.

While the NBH expects inflationary pressures to remain moderate in the medium term (mainly due to weak inflation in external markets), it expects headline CPI to rise gradually and near the 3% target within the policy horizon. As such, the NBH believes the current level of the base rate to be “consistent with the medium-term achievement of price stability and a corresponding degree of support for the economy,” and expects to maintain the current loose monetary conditions for an extended period.

With inflation showing signs of a turnaround and activity data also strong, we expect no further easing by the NBH and expect rates to be on hold through 2014. The NBH has indicated that further easing by the ECB last week increases the NBH’s room to maneuver if inflation and activity data disappoint; however, with this data picking up, we believe that further easing by the NBH, while possible, is unlikely.

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.

Update on the fx loans issue. Ruling Fidesz party parliamentary leader Antal Rogan earlier this month said that the decision on the details of how banks should repay borrowers for unilateral interest rate hikes

11 September 2014



and the use of fx margins (which the July legislation had declared as refundable by banks) will be taken in mid-September, after which legislation on this will be passed. This is as expected, and had been highlighted by various government officials in the past. Rogan also indicated that repayments on these issues should be completed by February 2015, after which conversion of the fx loan stock to forint should take place. Similar comments were made by Economy Minister Varga.

The government had earlier indicated its aim to convert the loan stock by end-2014, but we had flagged this as being too early. In line with the most recent comments from government officials, we expect the conversion of the fx loan stock to forint to take place early next year.

Last week, NBH deputy governor Adam Balog announced that the NBH would be willing to assist banks (through the provision of fx using its reserves) with (1) repayment to borrowers for the use of fx margins and unilateral contract changes and (2) conversion of the fx loan stock to forint.

NBH involvement in (2) has been expected (and indicated by previous NBH and government comments), as banks would need to access a significant amount of fx if the entire fx loan stock (EUR 11.6bn) is converted to forint. However, Balog’s statements provide the first firm indication of NBH involvement in (1). Balog said banks were estimated to have to repay EUR 3bn to borrowers for (1), which is in line with earlier estimates – he also said that the NBH would be willing to provide banks the EUR 3bn in fx (at market rates) using its reserves.

If banks require fx to repay for the use of fx margins and unilateral contract changes, it implies that the refunds to borrowers would be in the form of reductions in the outstanding loan amounts (this has been noted as a possibility by the government, but has not been confirmed). In this case, banks would also need to repay some of their fx funding sources to prevent a mismatch on their balance sheets, and this is where the fx from the NBH could be used. The legislation expected later this month will address, and provide details on, the issue of how and when borrowers need to be refunded for (1); this legislation is not expected to address the issue of fx loan stock conversion.

Gautam Kalani, London, +44 207 545 7066

Hungary: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 10.0 9.9 9.9 9.9


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


Exports 1.7 5.3 6.3 5.2

Imports - 0.1 5.3 7.6 5.5


CPI (eop) 5.0 0.4 1.5 2.9

CPI (period avg) 5.7 1.7 0.3 2.7

Broad money (eop) - 3.3 2.0 5.4 6.1


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 97.3 96.3 107.1 102.6

Goods Imports 92.9 91.3 100.8 96.8

Trade Balance 4.5 5.0 6.2 5.8

% of GDP 3.6 3.9 4.8 4.8

Current Account Balance - 1.1 2.6 2.4

% of GDP - 0.8 1.8 1.8

FDI (net) 34.7 4.3 13.7 17.6

FX Reserves (eop) 41.9 43.3 43.0 42.6

USD/FX (eop) 222 216 250 280.9

EUR/FX (eop) 292 297 325 323



Domestic 45.1 39.5 38.7 46.2

External 34.7 36.4 33.3 31.7

External debt 132.2 127.9 120.0 118.0

in USD bn 165 166 157 143


General (ann. avg)

Industrial Production (YoY%) - 0.8 1.4 8.0 5.5

Unemployment (%) 10.9 10.3 8.8 8.5

Current 14Q4F 15Q1F 15Q3

Key official interest rate (eop) 2.10 2.10 2.10 2.60

USD/HUF (eop) 246 250.0 259.6 273.0

EUR/HUF (eop) 316 325.0 324.5 323.5 Source: NBH, DB Global Markets Research, Haver Analytics

11 September 2014



Israel A1(stable)/A+(stable)/A(positive) Moodys/S&P/Fitch

Economic outlook: growth was slower than expected in Q2 and the recent conflict with Hamas likely weighted on activity in Q3. Past experience suggests that the economic impact of the latter will be moderate and short-lived, though it may further reduce the government’s already limited fiscal policy space. We have accordingly revised down our growth forecasts for 2014 and 2015.

Main risks: The risk of deflation remains low but is rising and the case for an exchange rate floor may be more actively debated. Geopolitical risks remain ever present notwithstanding the ceasefire agreed with Hamas.

Growth fears

The ceasefire between Israel and Hamas agreed last month brought an end to the most protracted of the three conflicts in the Gaza Strip since 2009. Past experience suggests that the economic impact of the conflict will likely be relatively modest and short-lived, except perhaps in the tourism industry where the effects have tended to be more protracted. Nevertheless, the economy was already losing momentum prior to the conflict and activity likely weakened further in Q3. Against this backdrop, and with little scope for fiscal support, the Bank of Israel (BoI) delivered successive 25bps rate cuts in July and August, bringing its policy rate to a record low of 0.25% (see below).

Gaza conflict hits tourism

100

150

200

250

300

350

2006 2008 2010 2012 2014

Tourist arrivials, thousandsLebanon war /

Operations Summer Rains & Autumn Clouds

(151 days)

Operation Returning

Echo(5 days)

Operation Cast Lead(22 days)Operation

Hot Winter(4 days)

Operation Pillar of Defense(7 days)

Operation Protective

Edge(49 days)


Revising our growth forecasts GDP growth decelerated to 1.7% (QoQ saar) in Q2 from 2.8% in Q1, much weaker than expected, on the back of a contraction in investment and exports. Preliminary

data for the current quarter have been soft: the State of the Economy Index was flat in July and the manufacturing PMI slipped further into contractionary territory at 46.8. In this light of this, we have therefore revised down our growth forecast for this year to 2.6% from 3.2%. The government may also find it difficult to avoid raising taxes or cutting civilian spending to meet the costs of its recent military operation. We have therefore also revised down our growth forecast for next year to 3.1% from 3.3%.

Policy rates approach zero: what next? Inflation dipped below the lower limit of the 1-3% target range in June, as the impact of an earlier VAT hike dropped out of the calculations, and fell further in July to 0.3% YoY. While this was mostly expected (albeit a little larger than we had been forecasting), the continued decline in inflation expectations will be a concern for the central bank. In particular, medium-term expectations have fallen below the mid-point of the target range in recent months for the first time since the global financial crisis, when the measure was likely skewed by liquidity shortages. It was probably this, together with weaker than expected growth, that prompted the BoI to deliver successive rate cuts.

Inflation expectations have fallen significantly

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2006 2008 2010 2012 2014

% YoY

One year (analyst forecasts)

Five year (capital market derived)

Inflation target range

Source: Haver Analytics, Bank of Israel, Deutsche Bank

This brings the policy rate close to zero, which begs the question of what the BoI would do if it wanted to provide further monetary stimulus. The BoI is no stranger to unconventional monetary policy having bought government bonds in mid-2009 and intervened in the FX market off and on since 2008. The former made sense following the global financial crisis when the yield curve was very steep. But this much less the case now as the cost of long-term financing has fallen:

11 September 2014



ten year bond yields have fallen to 2.5% from 5.5% in mid-2009.

That leaves FX intervention as the more likely route should the BoI want to ease further, especially given its concerns about the impact of the strong shekel on export performance. The BoI is of course already intervening, on a regular basis to offset the balance of payments impact of the start of natural gas production, and on a discretionary basis whenever it feels movements in the shekel are not in line with fundamentals. It has bought about USD 10bn through these programs since May 2013.

Both tradable and non-tradable inflation is falling

Tradables

Non-Tradables

-4

-2

0

2

4

6

8

2006 2008 2010 2012 2014

Inflation, YoY%


So if it wants to ease monetary conditions, the BoI would need to either intervene more or intervene differently. One option would be to introduce a floor for the shekel along the lines adopted by the Swiss and Czech National Banks. The BoI have shied away from this in the past, arguing that growth and inflation outlook in Israel was very different. 18 But this is changing as growth and inflation (and inflation expectations) decelerated further. We still think the risk of outright deflation on a sustained basis in Israel is low. But it has risen: even non-tradable inflation has fallen in recent months and is currently running at only around 1.2%.

Even if the growth and inflation outlook weaken further, the BoI could explore other options before committing to a floor, including guiding rates even lower, pledging to keep rates lower for longer (i.e. forward guidance), or intervening in the FX market more aggressively. But the case for a floor will surely be more actively debated.

Robert Burgess, London, 44 207 547 1930

18 See for example:

http://www.boi.org.il/en/NewsAndPublications/PressReleases/Pages/09-

06-2014-AbirSpeech.aspx

Israel: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 7.9 8.1 8.2 8.4

GDP per capita (USD) 32,571 36,057 37,626 37,358

Real GDP (YoY%) 3.0 3.2 2.7 3.0

Private. consumption 3.1 3.3 2.9 2.9



Exports 0.9 1.5 2.9 6.5

Imports 2.5 -0.1 3.0 5.5


CPI (eop) 1.6 1.8 0.2 2.0

CPI (period avg) 1.7 1.5 0.6 1.4

Broad money (eop) 8.2 6.6 5.7 5.6


Overall balance -3.9 -3.1 -3.0 -3.0

Revenue 24.9 25.6 25.6 25.6

Expenditure 28.8 28.7 28.6 28.6


External Accounts (USDbn) bn)

Goods Exports 62.0 62.0 65.1 69.0

Goods Imports 71.8 71.3 74.0 77.3

Trade balance -9.7 -9.3 -8.9 -8.3

% of GDP -3.8 -3.2 -2.9 -2.7


% of GDP 0.8 2.1 2.4 2.6

FDI (net) 4.8 7.1 7.6 7.7


ILS/USD (eop) 3.73 3.47 3.60 3.65

ILS/EUR (eop) 4.93 4.79 4.68 4.20



Domestic 55.3 54.8 54.9 54.6

External 11.7 11.5 11.6 11.5


in USD bn 97.0 95.6 95.6 95.6

Short-term (% total) 39.3 39.4 39.4 39.4

General (ann. avg)

Industrial production (YoY%) 4.4 -1.3 2.5 3.5

Unemployment (%) 6.9 6.2 6.0 5.9

Financial Markets Current

14Q4 15Q1 15Q3

BoI Policy rate 0.25 0.25 0.25 0.75

ILS/USD (eop) 3.60 3.60 3.61 3.64

ILS/EUR (eop) 4.66 4.68 4.52 4.31 Source: BoI,CBS, Haver Analytics, DB Global Markets Research

http://www.boi.org.il/en/NewsAndPublications/PressReleases/Pages/09-06-2014-AbirSpeech.aspx

http://www.boi.org.il/en/NewsAndPublications/PressReleases/Pages/09-06-2014-AbirSpeech.aspx

11 September 2014



Nigeria Ba3(stable)/BB-(negative)/BB-(stable) Moody’s/S&P/Fitch

Economic outlook: A strong expansion of the non-oil sector keeps real GDP growth at close to 6% in 2014 and 2015. The hydrocarbon sector continues to face difficulties, but its contraction should slow. Capital flows and the exchange rate remain volatile as domestic political uncertainties have increased ahead of the February 2015 presidential election. Some fiscal slippage ahead of the election is likely, but public and external debt levels remain low.

Main risks: A deterioration of political stability ahead of the presidential election, an increase of ethnic violence or a spread of Ebola would lead to growth slowdown, capital flow reversals, FX reserve losses and pressure on the NGN. Disruptions to oil production and/ or a drop in oil prices would result in a weakening of fiscal and external balances.

More than just an oil economy

GDP rebasing makes Nigeria the largest economy in Africa In April 2014 Nigeria released the results of its long awaited GDP rebasing. The rebasing – the change of the base year for GDP calculation from 1990 to 2010 and the increase in the number of industries measured – raises the size of the economy of Africa’s most populous nation by 89% (2013 GDP). Following the rebasing, Nigeria dethrones South Africa as the largest economy in Africa, albeit with a population more than three times larger.

A larger and more diversified economy

2013 GDP, USD bn

0

100

200

300

400

500

600

pre-rebasing rebased

Hydrocarbon Agriculture Manufacturing

Other Industry Construction Trade

Services

Sources: Nigeria National Bureau of Statistics, Deutsche Bank

Besides increasing the size of the economy, the GDP rebasing also reveals a different structure of the economy. In particular, it shows that Nigeria is much less dependent on the hydrocarbon sector (13% of GDP versus 32% of GDP previously) and agriculture (21% versus 35%) than assumed before. By contrast, the new GDP data show that the economy consists by more than half of services and trade. The higher share of services is due to an increased importance of subsectors such as telecommunications, finance or real estate, as well as the capturing of new services, including the booming Nollywood film industry. Strong growth driven by the non-oil sectors The GDP rebasing results in lower growth rates for 2010-2013 (average of 5% yoy versus 6.97% yoy previously), and also reveals different drivers of growth. It shows that real GDP growth has been mainly driven by the non-oil sectors over the last three years. The largest contributions to growth have stemmed from services, manufacturing and trade. Especially, utilities, transport and consumer goods experienced very high real growth rates. The hydrocarbon sector on the other side has been contracting in real terms. This was mainly caused by disruptions to onshore oil production due to oil theft and pipeline sabotage, which resulted in a fall in oil production from 2.5 mbd in early 2011 to an average of 2.18 mbd in 2013.

Growth driven by services, manufacturing and trade

Contribution to real GDP growth

-4

-2

0

2

4

6

8

Q1 2011

Q3 2011

Q1 2012

Q3 2012

Q1 2013

Q3 2013

Q1 2014

Hydrocarbon Agriculture

Industry (excl. crude oil) Construction

Trade Services

Total GDP (YoY %)

Sources: Nigeria National Bureau of Statistics, Deutsche Bank

11 September 2014



We expect real GDP growth to remain strong, at around 6%, in 2014 and 2015 as the non-oil sector is set to keep expanding, getting a further boost from a pre-election rise in public spending, and the drag of the hydrocarbon sector should decline. In Q2 2014 the hydrocarbon sector experienced positive real growth for the first time in almost two years. An even faster GDP growth rate is hampered by Nigeria’s chronic infrastructure deficit, notable bottlenecks in energy supply that constrain industrial activity. The scale of the energy shortage is illustrated by the fact that per capita electricity consumption in Nigeria is less than 5% that of South Africa. The recent partial privatisation of the power sector should bring some improvements but it will take years to bring energy output to international standards.

High growth rates have failed to reduce poverty The impressive growth in recent years has not been sufficient to reduce poverty and create enough formal employment opportunities for Nigeria’s fast growing population. Approximately 46% of the population, or 75 m people, live below the national poverty line, and the official unemployment rate stands at 24%. The situation is even worse in rural Nigeria. The low pass through of economic growth to formal job creation and poverty reduction can be partly explained by a large informal sector, a high geographic North/South divide in economic development and very low productivity of subsistence-based agriculture. Additionally, growth is increasingly driven by capital-intensive industries, such as telecommunications, that lead to higher output without creating many new jobs.

Booming capital inflows take a break Nigeria’s strong growth rates and its huge demographic potential (the UN estimates that Nigeria will be the world’s fourth most populous nation by 2035) combined with its still unsaturated markets have attracted increased attention among global investors in recent years.

Capital inflows cooled down

USD bn

0123456789

10

2010 Q1

2010 Q3

2011 Q1

2011 Q3

2012 Q1

2012 Q3

2013 Q1

2013 Q3

2014 Q1

FDI Portfolio (equity) Portfolio (debt) Sources: Central Bank of Nigeria, Deutsche Bank

Since 2009 Nigeria has been the largest recipient of FDI in SSA (largely into oil and gas, banking, manufacturing and telecommunications) and in 2012 Nigeria also overtook South Africa as the chief destination for portfolio inflows. However, starting in mid 2013 portfolio inflows slowed down and reached a two year low in Q1 2014 as domestic uncertainties, including the suspension of the respected central bank governor Sanusi, added to the general challenging market environment for frontier markets resulting from Fed tapering. The interbank exchange rate weakened and reached a record low of NGN/USD 165 at end-March and the gap between the interbank rate and the Bureaux de Change (BDC) exchange rate widened to 4%. The Central Bank of Nigeria (CBN) intervened heavily to keep the Naira close to the target range of NGN/USD 150-160. Consequently, FX reserves declined by a quarter yoy to USD 35.4 bn in May 2014. In recent months the pressure on the Naira eased and FX reserves recovered to USD 39.6 bn at end-August.

Naira is trading outside its target band

140

145

150

155

160

165

170

11 12 13 14

Target range NGN/USD

Sources: Central Bank of Nigeria, Bloomberg Finance LP, Deutsche Bank

We expect capital flows and the Naira to remain volatile for the rest of the year. Especially increased political uncertainty ahead of the November 2014 primaries and the February 2015 presidential election, which is expected to be the most contested since the end of military rule in 1999, might weigh on investor sentiment. Additional domestic factors that could derail international investments are a further escalation of sectarian and religious violence and a spread of Ebola. Overall we expect the Naira to experience a modest depreciation and to reach an end-year level of NGN/USD165. The CBN is expected to resist calls for a change of the target band prior to the elections, as it is unwilling to bear the potential inflationary effects stemming from a devaluation. The new CBN Governor Emefiele has repeatedly highlighted the benefits of a stable exchange rate and low inflation. Nevertheless, we expect a small upward adjustment of the exchange rate target band in mid-2015 to improve international competitiveness of the non-oil exports.

11 September 2014



Low indebtedness but fiscal buffers drawn down As a side effect of the GDP rebasing Nigeria’s public debt metrics improved further. Due to the higher nominal GDP public debt accounted for only 10.6% of GDP in 2013 (as opposed to 20% of GDP previously assumed). Public debt is largely domestic as public external debt amounts to only 1.7% of GDP. However, the rebasing did not change the fact that public finances are highly dependent on the hydrocarbon sector. Oil and gas receipts still account for more than two-thirds of total public revenues leaving the budget highly vulnerable to developments in the hydrocarbon sector.

Low oil savings

60

70

80

90

100

110

120

130

140

0

2

4

6

8

10

12

14

10 11 12 13 14Excess Crude Account (USD bn)

Bonny light (USD/bbl) (right) Sources: Central Bank of Nigeria, CEE Market Watch, Deutsche Bank

Despite the fact that the average market price for Nigeria’s oil (Bonny light) was clearly above the budgeted benchmark price of 79 USD/bbl in 2013, oil revenues in 2013 were much lower than initially planned by the government and decreased by roughly one fifth compared to 2012. The underperformance in oil revenues is only partly explained by lower production and motivated the authorities to launch a forensic investigation of the national oil accounts. As a result of the lower oil revenues the consolidated fiscal deficit widened and savings in the Excess Crude Account (ECA) dropped in 2013. ECA holdings, where oil receipts above the budgeted benchmark price should be saved, declined from USD 11.5 bn at end 2012 to only USD 2.2 bn in January 2014. The federal budget for 2014 aims at tightening expenditures and lowers the projection of oil production as well as the budget benchmark oil price. Public revenues improved in the first half of 2014, reflecting an improvement in oil receipts, and resulted in a tentative increase in ECA holdings to USD 4.1 bn at end-July. However, we think that expenditure constraints will be difficult to keep ahead of the presidential election and with high additional spending needed to counter the Islamist insurgency in the North and to contain Ebola. Thus we expect the consolidated fiscal deficit to widen slightly and the ECA savings to remain low, providing only a limited buffer if oil prices should fall.

Oliver Masetti, Frankfurt, +49 69 910 41643

Nigeria: Deutsche Bank Forecasts

Since the election of President Abdel Fattah el-Sisi in late May the authorities have announced a series of concrete measures to reduce Egypt’s large fiscal deficit from its current level of 12% of GDP. El-Sisi rejected an initial budget draft and demanded a stronger reduction of the deficit. The most important measures taken are:

Following the election of President Abdel Fattah el-Sisi in late May the authorities have shifted their focus on fiscal consolidation. El-Sisi rejected an initial budget draft and demanded a stronger reduction of the fiscal deficit, which is estimated to have reached 12% of GDP at the end of FY 2013/14 (ending June). The announced measures aim at cutting expenditures by reducing subsidies as well as at raising revenues by increasing taxes. The most important measures taken are:

Reduction in fuel subsidies

The prices for gasoline and diesel have been increased by 40%-78%, while the price of less widely used natural gas for vehicles was raised by 175%. However, despite these fuel price hikes, retail prices still remain well below world averages. Diesel prices for example increased by 64% to USD 0.25 a

2012 2013 2014F 2015F

National Income


Population (mn) 167 170 173 177


Real GDP (YoY %) 4.2 5.5 6.0 6.0


Govt consumption -2.0 1.4 5.0 4.0

Investment 1.9 10.5 8.0 8.0

Exports -3.6 -8.5 2.0 2.5

Imports -32.9 2.0 5.0 5.0

Prices, Money and Banking (YoY %)

CPI (eop) 12.0 8.0 9.2 8.5

CPI (ann. avg) 12.2 8.5 8.6 8.7

Broad money (eop) 16.4 1.2 5.0 5.0

Bank Credit (eop) 1.3 7.8 6.0 7.0

Fiscal Accounts* (% of GDP)


Revenue 14.5 11.2 11.6 12.0

Expenditure 14.7 13.8 14.4 14.3

Primary balance 0.8 -1.7 -1.9 -1.4


Goods Exports 96.0 93.8 95.0 98.0

Goods Imports 53.6 57.2 60.0 63.0

Trade balance 42.4 36.6 35.0 35.0

% of GDP 9.3 7.2 6.4 5.8


% of GDP 4.5 3.3 3.0 2.6

FDI (net) 5.6 3.0 3.0 5.0


NGN/USD (eop) 157.0 160.0 165.0 170.0



Domestic 9.1 8.9 9.2 9.3

External 1.4 1.7 2.0 2.2


in USD bn 8.2 11.1 12.5 16.5


General (ann. avg)


Unemployment (%) 23.9 24.0 24.0 23.0

Financial Markets (eop) current 14Q4 15Q1 15Q3

Policy Rate 12 12 12 11

NGN/USD (eop) 162 165 165 170

* Consolidated Government Sources: IMF, Central Bank of Nigeria, National Bureau of Statistics, DMO, Deutsche Bank

11 September 2014



Poland A2(stable)/A-(stable)/A-(stable) Moodys/S&P/Fitch

Economic outlook: The economy grew at a reasonable pace in Q2, but some recent high frequency data have been weak. We expect the data to turn around meaningfully only in Q4.

Main risks: The risks to growth are skewed to the downside, due to the potential for a prolonged slowdown in euro area growth and/or an escalation of the Russia-Ukraine crisis (and its adverse impact on euro area activity).

GDP expanded at a reasonable pace in Q2 despite weak high frequency data

Q2 GDP growth in line with expectations. GDP growth in Q2 was a relatively healthy 3.3% YoY (0.6% QoQ). The details were also encouraging, showing domestic demand as the main driver of growth (for the second quarter running), taking over from net exports. While consumption growth was moderate at 2.3% YoY, fixed investment increased by a considerable 8.4%; average investment growth over 2012 and 2013, on the other hand, was -0.6%. Net exports, on the other hand, contributed negatively to growth for the first time in over 3 years, reflecting both an improvement in the domestic economy as well as faltering growth in the euro area (particularly in the main export partner Germany). The slowdown in euro area growth is likely one of the primary causes of the slowdown in Polish growth from 1.1% QoQ in Q1 to 0.6% in Q2.

Domestic demand has taken over from net exports as

the main driver of growth


It is also possible that the crisis in Russia and Ukraine weighed on Polish growth in Q2. Weaker demand from Russia and Ukraine would weigh on exports, both directly and indirectly through its integration within the

German supply chain. We estimate that these effects could be quite modest, however, reducing GDP growth in Poland (which is a relatively closed economy by Central European standards) by about 0.1-0.2ppts. The recent ban on food imports by Russia might amplify the impact somewhat; but even then, Poland’s exports of food products to Russia amount to little more than 0.2% of GDP.19 However, while the direct impact of the crisis is likely to be limited, it does increase uncertainty and could adversely affect investor confidence.

Recent high frequency data have been relatively weak. The Q2 GDP reading indicated that the economy is growing, albeit at a modest pace, despite weak recent prints in some activity and survey data. Manufacturing PMI fell into contractionary territory in July and August, after a year in expansionary territory. The forward looking new orders component of PMI has also fallen, prompting a slowdown in industrial production growth. However, economic sentiment continues to show moderate signs of improvement, while retail sales has also grown at a reasonable pace in recent months (albeit below the growth rate observed in Q1).

The slowdown in IP growth has come in tandem with

the decline in new orders growth


Despite the weakness in some high frequency data, we have a relatively constructive view on Polish growth; our forecast for real GDP growth in 2014 is 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%. We believe growth will continue, albeit at a moderate pace, over the coming quarters on the back

19 For more details, see Special Report: Will the Russia crisis derail

recovery in Central Europe?

11 September 2014



of continued recovery in domestic demand; significant EU fund inflows should also add some upward impetus to growth. We expect the activity and survey data to remain relatively weak in the coming few months, but pick up gradually in Q4. 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 (the euro area accounts for over half of all Polish exports) and/or an escalation in the Russia-Ukraine crisis (which could also impact Poland through its adverse effect on euro area growth prospects).

Real wage growth is accelerating in the low inflation

environment, raising consumer spending growth


Inflation is at a record low. Headline inflation in July was reported at -0.2% YoY, a record low but in line with market and NBP expectations.

Headline inflation has dipped into negative territory


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. While food prices in the rest of the Central European region are showing signs of turning around, Polish food price inflation declined further in July to -1.8% YoY. Food inflation, which has been one

of the major drivers of the recent low inflation environment in Central Europe, has begun to pick up in Czech and Hungary (as indicated by the July CPI data). We believe that it will turn around in Poland in the coming 2-3 months as well, given that food prices are relatively highly correlated across the region; further, initial indications are that the harvest this year is not as good as last year's bumper one.

Food price growth in Poland continues to decline

-2

0

2

4

6

8

10

2008 - Jul 2010 - Jul 2012 - Jul 2014 - Jul

Food inflation (YoY %)


Though headline inflation could remain subdued for the coming few months, we expect it to begin picking up in Q4 (and continue rising next year) on the back of improving domestic demand, a narrowing output gap, tightening labour market conditions and rising food inflation. While the Russian ban on Polish food imports adds some downward risk to our near-term inflation forecast, we estimate the impact of the ban on headline inflation to be relatively modest at around 0.3pps. We expect average YoY CPI to be only 0.4% in 2014 but rise to 1.5% in 2015; inflation is forecast to re-enter the NBP’s 1pp tolerance band around its 2.5% target in mid-2015.

Rate cuts in the coming months are likely. The NBP announced rates on hold (at the record low 2.50%) at its MPC meeting earlier this month. Prior to the meeting, some MPC members had signaled the need for rate cuts on the back of headline inflation in negative territory, weakness in activity data and high real rates. However, in the post-meeting press conference, Governor Belka stated that there is still uncertainty regarding the strength of the economy and as such the council decided to wait for more monthly data before deciding to cut rates; but he did add that the decision was not unanimous.

Belka also stated that rate cuts are “quite probable”, and did not rule out more than one step of easing. This marks an important shift in his rhetoric, as after previous meetings he had stated that rate cuts were improbable and not the baseline scenario of the NBP. The NBP’s statement pointed out that the recent data

11 September 2014



(industrial production, retail sales, construction) indicate a slowdown in economic growth, and increase the uncertainty regarding the economic outlook and return of inflation to the target in the medium term. As such, “If the incoming data confirm weakening of economic activity and an increase in risk of inflation remaining below the target in the medium term, the Council will start an adjustment of monetary policy”.

Previously, the comments of MPC members had indicated that a majority believed rates should be on hold unless there was a marked slowdown in activity data.20 However, the current rhetoric from the MPC suggests that unless the activity data does not improve significantly, rates will be cut in October. Our medium and longer term view of the Polish economy is a constructive one, and we do believe that the activity and inflation data will pick up eventually (in Q4), but not in the coming month. The activity data over the coming month will still be weighed down by faltering euro area activity and adverse confidence effects from the Russia crisis, and therefore are unlikely to be strong enough to deter a rate cut in October.

As a result, we now expect rates to be cut by 25bps in October, followed by another 25bps cut in November, by which point we expect the activity and inflation data to begin showing signs of recovery. This is in line with the comments from some MPC members last week, who stated that there was majority support for cuts in the future (as per their discussion at this month’s MPC meeting). Rate cuts by the ECB last week and the low inflation environment also support further rate cuts, which would help bolster growth amid increasing downside risks from the Russia-Ukraine crisis and weaker activity in Germany.

The above-mentioned MPC members also suggested that the easing cycle would likely comprise of two 25bps rate cuts, while Belka in the post-meeting press conference did not rule out the possibility of multiple rate cuts (rather than a single one). However, it also remains possible that if the activity and/or inflation data does not pick up, the MPC could opt to ease by a total of 75bps – this could be delivered as a 25bps cut in October followed by a 50bps cut in November (if the data over the next two months is sufficiently weak), or as three 25bps cuts.

Increased social spending announced for 2015. Polish PM Tusk announced on 27th August that the government will undertake higher social spending next year than what was earlier planned. These measures include increased tax breaks for families with more than two children, and also higher pension increases. Pension increases are normally indexed to inflation in

20 See Special Report – Poland: Gauging the temperature of the NBP.

the previous year, and thus with the low inflation this year, this would have implied very small pension increases next year. As a result, increasing the pension for next year doesn't come as a major surprise, as this has been a political issue and next year is also an election year.

While the proposed increase in social spending does increase the risk to the budget, in balance, we believe the deficit in 2015 will be slightly below the 3% of GDP mark, as (1) exiting EDP is high on the government's agenda, and (2) comments from both Tusk and Finance Minister Szczurek indicate that the deficit won't exceed 3% of GDP next year despite the planned increase in social spending.

Earlier this month, parliament approved the 2015 budget draft with a deficit target of 2.7% of GDP (PLN 46bn). The social spending increases outlined above amount to PLN 5bn (0.3% of 2013 GDP), and while adding some stimulus for the economy, should not threaten the 3% of GDP deficit threshold. Rather, the main risk to the budget next year is the downside risk to growth. Szczurek stated that the budget was built around a GDP growth forecast of 3.4% in 2015. If the recent slowdown in growth persists, then growth next year could undershoot the 3.4% figure.

Prime Minister Tusk appointed as EU Council president. On 30th August, Polish PM Tusk was chosen as the next president of the EU Council. He will join the post in early December (the term of the outgoing Herman von Rompuy expires on 30th November). As a result, he resigned as PM earlier this week. In accordance with the Polish constitution, the cabinet also submitted its resignation along with that of Tusk. Once the President accepts the resignation, which is expected to be on 11th September, he has 14 days to chose a new PM and cabinet, after which the new government has 14 days to win a confidence vote in parliament (via absolute majority).

We expect this process of appointing a new PM and government to go through fairly smoothly. The President (Komorowski) is also a member of the ruling Civic Platform (PO) party, and has stated that he wants to avoid early elections. The new government should also win the confidence vote as the ruling coalition between Civic Platform and the Polish People’s Party (PSL) still holds a majority in parliament. Therefore, early elections are unlikely at this stage. The new government will only be in power until the general elections which will be held around October next year.

The leading candidate for the PM post is the current speaker of the lower house and close Tusk ally, Ewa Kopacz; Tusk and the ruling coalition have announced their support for her as the new PM, and the President is widely expected to appoint her in the coming week.

http://pull.db-gmresearch.com/p/549-EF02/51638451/DB_SpecialReport_2014-08-29_0900b8c088ad2957.pdf

11 September 2014



The new cabinet should be largely similar to the old one, but there is likely to be some reshuffling. However, despite this there should not be any major changes in policy. There was no controversial legislation planned for this pre-general election period and the new cabinet is likely to follow the path of the previous one. Also, the appointment of Tusk to this prestigious EU post will likely boost the popularity of the Civic Platform (after it has suffered due to the leaked tapes controversy and no longer leads in opinion polls), 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 could use this – i.e. its success in increasing Poland's importance within the EU – as a major campaign platform for upcoming elections.

Opinion polls show main opposition Law and Justice

Party’s (PiS) lead increased after the tapes scandal

0%

10%

20%

30%

40%

50%

Jul-10 Jul-11 Jul-12 Jul-13 Jul-14

PO PiS SLD PSL Nowa Prawica (KNP)

Tape scandal aftermath

Source: Deutsche Bank, Homo Homini

There are three important elections coming up: local elections in November 2014, presidential elections in May 2015 and general/parliamentary elections around October 2015.

Gautam Kalani, London, +44 207 545 7066

Poland: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 37.6 38.6 37.5 37.4


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


CPI (eop) 2.4 0.7 0.9 1.7

CPI (period avg) 3.7 0.9 0.4 1.5

Broad money (eop) 10.0 11.0 5.3 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 190.8 207.2 225.3 224.4

Goods Imports 197.5 204.2 224.6 225.8

Trade Balance - 6.7 3.0 0.6 - 1.4

% of GDP - 1.4 0.6 0.1 - 0.3


% 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 3.15 3.48

EUR/FX (eop) 4.08 4.15 4.10 4.00



Domestic 36.1 37.5 29.6 29.7

External 16.5 16.3 16.7 17.4

External debt 71.1 73.6 71.6 76.4

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 12.9 11.9

Current 14Q4 15Q1 15Q3

Financial Markets

Key official interest rate (eop) 2.50 2.00 2.00 2.25

USD/PLN (eop) 3.26 3.15 3.26 3.40

EUR/PLN (eop) 4.21 4.10 4.08 4.03 Source: Haver Analytics, CEIC, DB Global Markets Research, NBP

11 September 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

After the recent respite, the Russian economy resumed the downward trend witnessed in March-June with a deceleration in consumption and stagnation on the fixed investment side. The main topics that were in the spotlight between the second half of July and the beginning of September appeared to be the impact of Western financial sanctions on the Russian economy, as well as trade restrictions imposed by Russia against the West. This in turn resulted in extended discussions about import substitution and infrastructure stimulus to the economy and inflation concerns from food restrictions.

Key economic indicators: July returns to a downward trend On the economic front, a set of key economic indicators for July appeared to return to the downward trend witnessed in March-June 2014. On the production front, IP continued its stagnation (1.5% yoy in July vs. 0.5% yoy in June and 2.8% yoy in May), while the rest of the indicators exhibited relatively weak performance. Fixed asset investments were down again, -2.0% yoy in July after 0.5% yoy in June and -2.6% yoy in May. Construction returned to a downward trend as well, posting a -4.6% yoy decline in July after 1.2% yoy in June and -5.4% yoy in May. Growth in the transportation sector decelerated to 0.3% yoy vs. 2.8% yoy in June and 1.3% yoy in May. Agriculture rapidly accelerated to 8.5% yoy in July after 1.4% yoy in June and 1.8% yoy in May, digesting the first harvest.

On the consumer side, retail sales marginally improved, up 1.5% yoy after 0.7% yoy in June and 2.1% yoy in May, driven by a hike in disposable income to 2.3% yoy in July and recovering from a decline witnessed in earlier months (-2.9% yoy in June, 6.5% yoy in May). Real wages, although slowing marginally, appeared to be quite resilient: 1.8% yoy in July vs. 2.1% yoy in June and 2.1% yoy in May. The unemployment rate persisted at 4.9% in July, as in June and May.

Russia: Key economic indicators

-35%

-25%

-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, % Source: Rosstat, Deutsche Bank

Following the release of a set of key economic indicators for July, the Ministry of Economy published its monthly GDP growth estimate for the Russian economy. According to the Ministry’s estimates, the Russian economy contracted by 0.2% yoy in July after -0.1% yoy in June, with the 7M14 figure at 0.7% yoy vs. 1.0% yoy in 7M13.

Overall, we believe that the weaker growth dynamics of GDP reflect the trend of the previous months, with consumption, the backbone of Russian growth for the past several years, decelerating on the back of lower wage growth and continuing stagnation on the investment side. On the investment front, the continuing stagnation in the segment is likely to be counterbalanced by higher infrastructure.

We downgrade our economic outlook for the Russian economy for 2015 to 1.0% yoy from 2.4% yoy, as for 2014 we remain with our current forecast of 0.8% yoy. Changes to our forecasts reflect our expectations of further deceleration of household consumption driven by concerns over geopolitical uncertainty prompting an increase in savings ratios, lower growth of salaries in public sector as well as higher inflation sapping the 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 infrastructure stimulus. We also note that the adverse effects of the import-substitution policy, as we believe it is fraught with a higher inflation rather than a significant improvement in output dynamics amide structural bottlenecks, high levels of capacity utilization and the decrepit state of capital equipment in the industrial sector.

11 September 2014



Russia: GDP components contribution

-15

-10

-5

0

5

10

15

20

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

% y

oy

Households Govt Fixed Investments Exports Imports GDP Source: Rosstat, Deutsche Bank

Fiscal balance posting 1.7% GDP surplus in 7M14 The fiscal balance remained resilient in July following strong prints for May and June. According to the fiscal authorities, the ytd federal budget surplus in July by RUB43bn (on the back of deficit July budget execution) decreasing to RUB675bn, 1.7% 7M14 GDP. Revenues totaled RUB8,255bn, with oil revenues amounting to RUB4,314bn and non-oil revenues to RUB3,941bn. Overall, both oil and non-oil revenues marked up with the plan. Expenditure was at RUB7,579bn, lagging the schedule. Overall, the federal budget continued to post a surplus in the wake of a weaker ruble and stronger commodity prices; oil prices remained at USD108/bbl in July, averaging USD109/bbl over 7M14 and the ruble averaged at RUB/USD34.8 in July and RUB/USD35.0 in 7M14.

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-1

2

Feb-1

2

Mar-

12

Apr-

12

May-1

2

Jun-1

2

Jul-12

Aug

-12

Sep

-12

Oct-

12

Nov-1

2

Dec-1

2

Jan-1

3

Feb-1

3

Mar-

13

Apr-

13

May-1

3

Jun-1

3

Jul-13

Aug

-13

Sep

-13

Oct-

13

Nov-1

3

Dec-1

3

Jan-1

4

Feb-1

4

Mar-

14

Apr-

14

May-1

4

Jun-1

4

Jul-14

% G

DP

% G

DP

Budget Revenues, % GDP Budget Expenditure, % GDP

Budget Balance, % GDP (RHS)

Source: Ministry of Finance, Rosstat, Deutsche Bank

As for next year’s budget, according to MinFin officials, due to possible changes in the economic forecast, the key features are likely to be revised, with lower economic growth and, in particular, income growth, expected, while higher inflation is likely to impede indexation of social and regulated tariff payments. Earlier, in July, it was reported that the government revised the guidelines on the fiscal policy for 2015-17.

The new projections guide for deficits: -0.4% GDP in 2015 and -0.6% GDP in 2016- 2017.

As the fiscal authorities are reluctant to increase borrowings, they are aiming at raising revenues via a higher tax burden and off-budget funding. Regarding the higher tax burden, the government is still discussing the modalities of VAT or sales tax changes. In our previous report (see ‘EM Monthly: Picking Up Dimes’ on 17 July), it was stated that a 2pp increase in VAT would add RUB500bn to the federal budget vs. a 3% sales tax adding RUB200bn. In our view, this could have an adverse impact on inflation. The CBR estimates suggest that the introduction of the sales tax could boost CPI inflation by 1.5pp. The final decision, according to PM Medvedev is to be made by end-September.

Another proposal that is likely to get traction in the forthcoming budget cycle (starting end-September) is the decision to transfer the private pension savings into the PAYG part of the pension system again (it first happened last year) with the possibility of full cancellation of the fully-funded pension part. According to the government, in 2015 this will enable the authorities to free up RUB280bn from the budget, which initially was planned for a transfer into the state pension fund. At the same time, the Ministry of Finance and the Ministry of Economy continue to be in clear opposition to this proposal, claiming that the decision could undermine longer-term investments, leading to 2-3pp higher borrowing costs and lower duration of lending resources, which could imply GDP growth loss of as much as 1pp in 2015. The final decision is expected to be made in mid-September.

In our view, such a decision would further undermine the prospects for the creation of a strong fully-funded pension system that would contribute to greater investment activity and the development of financial markets in the long term. More broadly, we see this step as indicative of lack of reformist momentum in economic policymaking, with the near-term focus increasingly pointing in the direction of mobilizing resources for higher social outlays, as well as pursuing import-substitution.

Consumer prices persist at 7.6% yoy in August After taking a breather, consumer prices accelerated again to 7.6% yoy in August from 7.5% yoy in July, and 7.8% yoy in June after the print of 7.6% yoy in May, 6.9% in March and 6.1% yoy in January. The main reasons for the acceleration of consumer prices appear to be the pass-through effect from ruble depreciation as well as the restriction on imports of agriculture products (meat, fish, poultry, cheese, and fruit and vegetables) from the EU, Norway, US, Canada and Australia, which started to boost inflation in the food segment, which usually turns cheaper in this period of the year.

11 September 2014



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-0

6A

pr-

06

Jul-06

Oct-

06

Jan-0

7A

pr-

07

Jul-07

Oct-

07

Jan-0

8A

pr-

08

Jul-08

Oct-

08

Jan-0

9A

pr-

09

Jul-09

Oct-

09

Jan-1

0A

pr-

10

Jul-10

Oct-

10

Jan-1

1A

pr-

11

Jul-11

Oct-

11

Jan-1

2A

pr-

12

Jul-12

Oct-

12

Jan-1

3A

pr-

13

Jul-13

Oct-

13

Jan-1

4A

pr-

14

Jul-14

Food, %, YoY Non-food, %, YoY Services, %, YoY

Source: Rosstat, Deutsche Bank

Across segments, food prices accelerated to 10.3% yoy after 9.8% yoy in June-July; non-food prices decelerated to 5.5% yoy in August after 5.6% yoy in July and 5.3% yoy in June; services prices grew by 6.7% yoy in August after 7.0% yoy in July and 8.7% yoy in June.

Russia: Share of imports of sanctioned countries by

product groups

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Meat, meat products, poultry

Fish and seafood

Animal oils

Milk products

Fat cheese

Poultry eggs

Vvegetables

Fruits and nuts

US AUS CA EU NO Other Source: Rosstat, Deutsche Bank

We believe that, despite the substitution of US, EU, Norwegian, Canadian and Australian goods with goods from Latin America, Africa and the Middle East, the shortage in restricted items could lead to price increases in the respective markets by 5-10% on average within the next 12-18 months, with the restricted items representing c.20% of the CPI basket. This, in turn would translate into 1.5pp of headline CPI. We also believe that the government’s control of food prices would have only a limited effect and temporary impact on price growth. Accordingly, we revise our inflation forecast for December 2014 from 6.5% yoy to 7.4% yoy, and from 5.4% yoy to 6.0% yoy for December 2015 (for details please see our publication ‘Special Report: Russia: assessing the impact of trade restrictions’ published on 1 September).

CBR: inflation monitoring in action Additional inflationary pressures may be addressed by the CBR via higher rates, though policy activism may be tempered in part by uncertainty over the duration of such drivers as ruble weakness and trade restrictions. In August, Russia’s government representatives stated on several occasions that Russia’s trade restrictions could be phased out in the event of lower trade restrictions from the West.

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

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

De

c-1

0Ja

n-1

1F

eb

-11

Ma

r-11

Ap

r-11

Ma

y-1

1Ju

n-1

1Ju

l-11

Au

g-1

1S

ep

-11

Oct-

11

No

v-1

1D

ec-1

1Ja

n-1

2F

eb

-12

Ma

r-1

2A

pr-

12

Ma

y-1

2Ju

n-1

2Ju

l-1

2A

ug-1

2S

ep

-12

Oct-

12

No

v-1

2D

ec-1

2Ja

n-1

3F

eb

-13

Ma

r-1

3A

pr-

13

Ma

y-1

3Ju

n-1

3Ju

l-1

3A

ug-1

3S

ep

-13

Oct-

13

No

v-1

3D

ec-1

3Ja

n-1

4F

eb

-14

Ma

r-1

4A

pr-

14

Ma

y-1

4Ju

n-1

4Ju

l-1

4A

ug-1

4S

ep

-14

(%)

Source: Rosstat, CBR, Deutsche Bank

We believe that the CBR would react to this shock and accommodate the first round impact on inflation and monitor second round effects, possibly tightening monetary policy further if needed. Although we believe that the second round effects on food prices could be limited, more important is the fact that the food price shock could negatively affect inflation expectations, which, in turn, could also be addressed via further tightening of monetary policy. We expect the CBR to raise the key rate by 50bps (for it to reach 8.50%) in the autumn period, on the back of increasing risks to the medium-term inflation outlook.

On the exchange rate front, the CBR continued to widen the parameters of the exchange rate policy with the targeted rate band of the dual currency basket being shifted from RUB/BASK7.0 to RUB/BASK9.0. The level of FX intervention aimed at reducing volatility in the market has been set to zero throughout the whole RUB9 band. The level of cumulative interventions has been reduced from USD1bn to USD350m. The CBR stated that the changes were carried out as part of the transition to an inflation targeting regime, which the monetary authorities expect to launch at the beginning of 2015.

11 September 2014



Russia: CBR’s ER policy parameters dynamics

-12.0

-11.0

-10.0

-9.0

-8.0

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

31

32

33

34

35

36

37

38

39

40

41

42

43

44

2010 2011 2012 2013 2014

RU

R/B

AS

K US

Db

n

CBR interventions on the domestic FX market, USDbn (RHS) RUR/BASK rate Band Range Source: Bloomberg Finance LP, CBR, Deutsche Bank

West imposes further sanctions on Russian economy triggering higher capital flight At end-July, the EU and US imposed further sanctions against Russia. EU sanctions included measures to: (1) restrict Russia’s state-owned banks, namely, Sberbank, VTB, Gazprombank, RSHB and VEB from raising medium- and long-term (maturity exceeding 90 days) funds from EU primary equity and debt markets; (2) suspend technological cooperation in the energy sector by banning exports of energy-related equipment if it is destined for deepwater oil exploration and production, Arctic oil exploration or production and shale oil projects in Russia; (3) restrict arms sales to Europe; and (4) ban the export of dual-use technologies to the country. Following the EU, the US proceeded with additional sanctions targeting Russian state-owned banks, namely Rosselkozbank, VTB Bank and Bank of Moscow (in addition to the previously sanctioned Gazprombank, VEB, Rosneft and Novatek), cutting off these corporates from raising medium- and long-term (maturity exceeding 90 days) funds from US primary equity and debt investor base.

Although, we see the direct impact of the currently-in-place sanctions as contained, the new sanctions reinforce some of the macro risks that have started to mount ever since the launch of US sanctions earlier this month – this relates in particular to ruble weakness, and higher borrowing costs for Russia’s corporates as well as the acceleration of the capital flight. We continue to expect the capital flight at USD100bn in 2014 and set our capital flight estimate at USD50bn for 2015.

Yaroslav Lissovolik, Moscow, +7 495 933 9247 Artem Zaigrin, Moscow, +7 495 797 5274

Russia: Deutsche Bank forecasts

2012 2013F 2014F 2015F

National Income

Nominal GDP (USDbn) 2 002 2 096 2 121 2 325

Population (m) 143.1 143.2 143.2 143.2


Real GDP (yoy %) 3.4 1.3 0.8 1.0


Govt 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

Prices, Money and Banking (eop)

CPI (YoY%) eop 6.6 6.5 7.4 6.0

CPI (YoY%) ann avg 5.1 6.8 7.4 6.2

Broad money 11.9 14.0 10.3 12.2

Credit 19.1 17.1 15.6 15.0

Fiscal Accounts (% of GDP)*

Federal budget balance - 0.1 - 0.5 0.7 0.4

Revenue 20.5 19.3 19.7 19.8

Expenditure 20.6 19.8 19.0 19.5



Trade balance 193.3 177.3 198.1 186.9

% of GDP 9.6 8.7 9.4 8.1


% of GDP 3.7 1.5 2.2 1.6

FDI (net) 1.8 -15.6 -10.2 -5.6


RUR/USD (eop) 30.5 32.9 35.2 35.0


Public 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


in USDbn 636 732 763 833

General (% pavg)

Industrial production (% yoy) 2.6 0.0 -1.2 1.6

Unemployment 5.7 5.5 6.0 6.3

Financial Markets (eop) Current 14Q3F 14Q4F 15Q2F

Policy rate 8.00 8.50 8.50 8.50

RUB/USD 34.4 35.60 35.20 35.80 * - central government, ** - general government Source: Official statistics, Deutsche Bank Global Markets Research

11 September 2014



South Africa Baa1 (negative)/BBB- (stable)/BBB (negative) Moody’s/S&P/Fitch

Economic outlook: Our forecast revisions reflect weaker growth resulting from recent labour strikes and a sluggish global recovery. This has moderately negative consequences for the current account forecast, though we still remain bullish. The existing backdrop points to a more gradual rate hiking cycle nothwithstanding recent exchange rate pressure.

Main risks: A significant bout of exchange rate weakness and increased volatility may force the SARB to relax its gradual monetary policy tightening stance. However, growth weakness still makes this outcome unlikely in our view.

Dark clouds always have a silver lining

Summary of main forecast revisions: GDP growth has been revised to 1.5% in 2014,

from 1.7%. Growth of 3.4% remains intact for 2015, mostly on account of base effects, a positive contribution from net trade and a positive pace of inventory investment. Exports have been taken a notch lower due to weaker global forecasts.

The current account deficit is seen marginally higher than before at -4.6% in 2014 and -4.4% in 2015 – a downward revision of 0.1% and 0.2% respectively.

Given relative growth weakness, a fairly strong inflation profile and expectations of an uneven global and domestic recovery in 2015, we have revised our policy rate call lower from 7% at the end of next year to 6.5%. In addition, the SARB is likely to continue hiking in 25bps increments next year. This rate profile sees a return to positive real rates in 2H15.

In light of these changes, we have revised our rand call somewhat to 10.8/USD, 10.7/USD and 10/USD at the end of 4Q14, 1Q15 and 4Q15 from 10.5, 10.2 and 9.5, respectively. The recent sell-off in the currency in response to hawkish Fed rhetoric does skew the balance of risks to the rand’s profile asymmetrically to the upside in the short-term.

Wavering sentiment, rand vulnerability and monetary policy Nine months down the line and the negative news that dominated the outlook at the start of the year has not quite dissipated. Fortunately the likelihood of further strike activity this year is fairly low, but the negative ramifications of earlier labour unrest have not disappeared. Investor sentiment has by and large been positive up to now judging from net portfolio inflows

Rand has decoupled from net portfolio flows

10

10.2

10.4

10.6

10.8

11

11.2

11.4-40

-30

-20

-10

0

10

20

30

40

2014-Jan 2014-Jul

R billion

Net purchases of bonds

Net purchases of equities

Total

Dollar-rand (RHS - inverse) Source: Deutsche Bank

this year. Though foreigners held 38% of domestic bonds by the end of July, bond inflows have turned negative again. In contrast, the equity market has seen sustained inflows totaling R35bn this year, though this was reduced to c. R10bn given by outflows from the bond market.

Though it appears from the relative stability in the exchange rate between May and August, that a lot of domestic bad news has been priced, the recent spate of rand weakness affirms the susceptibility to more outflows as we are nearing the turn in the monetary policy cycle in the US. The recent decoupling of the exchange rate from net inflows suggests that the direction the currency is headed is becoming increasingly dollar-dependent. Should this coincide with increased market volatility, the potential synchronization of a more hawkish Fed and domestic risks (e.g. a sovereign downgrade from Moody’s, news around Eskom and electricity tariffs etc.) could result in another January-type sell-off. Though at some point (most likely in 2H15) we believe the combination of improved domestic fundamentals, with the help from firmer global growth, will be more rand-supportive. This could see rand decoupling from the stronger dollar, as it corrects from undervalued territory – c. 15%.

Against this backdrop, there is a lot of uncertainty over the SARB’s response to renewed exchange rate pressure and the poor performance in the economy. But, with a potential 100bps of rate hikes in the base by year-end, the Bank can afford to tighten more gradually than initially thought. As it stands, the switch from the conventional 50bps increments to 25bps, points to the slow but sure stance the SARB is willing

11 September 2014



to take. This may change if the exchange rate developments revive concerns over the potential unanchoring of inflation expectations.

Focus switch from strikes to the health of the consumer. Our growth forecasts have been revised to 1.5% this year from 2.9% at the start of the year. The impact of labour strikes accounts for as much as 1% of this revision with the balance owing to weaker external demand. The impact of the strikes on household demand has been small but meaningful enough given the repercussions for private sector business enterprises, particularly in the clothing retail, banking and furniture space. Though there are several negative factors hampering a recovery in household demand, namely weaker real disposable income, employment pressures and poor credit extension, there are several supporting buffers that were not present at the start of the recession that could alleviate downward pressure on household demand.

Since African Bank Investments Limited (ABIL) was placed under curatorship in August, questions over the health of the consumer, especially in low income segments have come to the fore. ABIL was a significant role player in the provision of unsecured credit to consumers. Unfortunately, however, the current phase of the business cycle tends to be unkind to the lower income segment of the population given higher inflation and threats of job security. Though this may be of concern, we do not see the combination of high debt exposure in the low income segment and a weaker business cycle as posing a destabilizing threat to the economy.

Remuneration per worker could only rebound in Q4. Growth in real remuneration per worker slowed to 0.1% in Q1, and probably contracted in Q2 (data not yet released) due to income losses from the “no-work no-pay” principle when c. 70 000 individuals went on strike in 1H14. A recovery is on the cards for Q3 as these workers return, but the month long strike by NUMSA members in July could hamper this. Members that participated in the strike amount to nearly three times the number of individuals that participated in the platinum strike. Moreover, smaller industries belonging to the National Employers Association of South Africa (NEASA) that employ between 15 000 to 60 000 workers have not accepted the three year wage deal, and some of these individuals are still in lockout. Retail sales numbers will therefore carry more weight than usual in assessing the fallout on growth in Q3.

Remuneration per worker severely impaired by strike

activity.

-15

0

15

30

2008 2009 2010 2011 2012 2013

Mining sector

Manufacturing sector

Total non-farm remuneration per worker

% yoy

Source: Deutsche Bank, Stats SA

Wage and salary adjustments may become more sensitive to the economic cycle in the future. Though nominal wage growth of 8% was recorded in 1H14 (up from 7.9% last year), this only reflects collective bargaining agreements. Less than 30% of all people in employment have salaries determined in this manner (down from 33% four years ago). Indeed, a rising proportion of new jobs created in the economy (54% up from 44%) have their salary levels determined entirely by the employer. This trend means that wage growth is probably less rigid and more sensitive to the business cycle than generally perceived. There are two positive ramifications from this development:

How salary increases are determined

1

2

3

4

5

6

7

8

2010 2011 2012 2013 2014

Number of jobs (million)

Union and employer

Individual and employer

Bargaining council

Employer only

No regular increment Source: Deutsche Bank. StatsSA

Firstly, there should be less crowding out of capital by labour wage demands.

11 September 2014



Secondly, the scope for a price-wage spiral and the risk of additional cost push pressures are probably smaller than feared.

Job prospects are negative… Employment prospects are negative, as illustrated below. The size allocated to job advertisement space has shrunk disproportionately to the growth in the adult population. As it stands, the ratio of permanent to temporary and contract jobs has declined back to levels that reigned during the recession in 2009 as firms are seeking more labour market and hiring flexibility to a manage cost pressures – a trend the labour unions are vehemently opposing.

Job opportunities have more than halved

0

50

100

150

200

250

300

2008 2009 2010 2011 2012 2013 2014Ratio of adult population to job advertisements

Index 2008 = 100

Source: Deutsche Bank, StatsSA, SARB

… but this doesn’t mean that employment conditions have deteriorated. In fact, there has been a significant improvement in employment terms and perks since 2008 such as more people contributing to UIF and pension or provident funds. Medical aid benefits have also improved, limiting direct out-of-pocket medical expenses. By implication, this presents more individuals with temporary income support (c. 1million) in the event of unemployment, while more people are subjected to wealth effects than before (c. 752 000).

Employment conditions are better– number of jobs

(‘000)

2008 2014 Change

Yes 5,599 6,351 752

No 6,555 6,421 (134)

Yes 6,858 7,925 1,067

No 5,325 4,849 (476)

Yes 3,539 4,064 525

No 8,699 8,801 103

Permanent job Yes 7,727 8,144 417

Temporary/contract work Yes 4,588 4,198 (390)

Contributes to a

pension/provident fund

Pays UIF

Medical aid benefits

Source: Deutsche Bank, StatsSA

… but relative debt burden is much lower than before As illustrated below, households are in significantly stronger financial positions than before the recession. The increase in the debt burden is much lower in nominal terms and thus more manageable than in the five years before the recession.

Household balance sheet stronger than pre-recession

100

110

120

130

140

150

160

170

180

190

2009 2010 2011 2012 2013 2014

Index 5-years after the recession

Increase in net wealth = R3 232bn

Increase in debt =

R438bn

Increase in nominal income = R764bn

Inflation +29%

100

150

200

250

300

2003 2004 2005 2006 2007 2008

Index

Net wealth Household debt Nominal income Inflation

5 years before recession

Increase in nominal income

= R653bn

Rand increase in net wealth

= R2 285 bn

Rand increase in debt = R745bn

Inflation +40%

Source: Deutsche Bank, StatsSA, SARB

Growth in household credit has slowed dramatically. All new unsecured credit loans and other credit facilities (like store cards) have been contracting for a year now. Growth in new loans classified as secured credit (like vehicle finance) has grounded to a halt in Q1, with only mortgage loans showing some growth. Household debt now accounts for 73.5% of income, the lowest since 2006, as nominal income growth, while slowing still outpaced household debt.

The market is rightfully concerned over the relative indebtedness of low/middle21 income consumers (given the significant reliance on unsecured credit). We estimate that new credit advances (excluding mortgages), have accounted for up to 48% of low/middle income household expenditure in 2012. This share has already fallen to 41% in 2013. Importantly, however, less than 10% of total household expenditure is currently funded by credit extended to low income households, and this may be even smaller given the significant tightening in loans granted to lower income individuals this year.

21 In this definition low to middle income households include those that

earn below R10 000 per month.80% of all households fall within this

bracket, this is 10% less than before the recession.

11 September 2014



Low income credit share of total

10.1 10.4 12.3 12.0

9.8

33

39

46 48

41

0

10

20

30

40

50

60

2009 2010 2011 2012 2013

Low income credit spend % of total household demand

Credit as % of total low income household demand

Low income cash spend % of total household demand

% of household spending

Source: Deutsche Bank, NCR, SARB

When comparing the credit impulse for different income groups it would appear that a bottom has been reached in 4Q13. This is especially true for the low income segment, suggesting that the slowdown in demand for non-durable goods has troughed in Q2. However, there may be further pressure on semi-durable and durable good demand in 2H14, before a bottom has been reached.

Credit impulse by income group

0

2

4

6

8

10

12

14

16

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

2010 2011 2012 2013 2014

High income credit impulse

Low income credit impulse

Non-durable goods RHS)

Durable and semi durable demand RHS)

% of GDP yoy %

Source: Deutsche Bank, NCR, Stats SA

Danelee Masia, South Africa, 27 11 775-7267

South Africa: Deutsche Bank Forecasts 2012 2013F 2014F 2015F

National Income


Population (mn) 52.3 53.0 53.5 54.0


Real GDP (%) 2.5 1.9 1.5 3.4


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 6.0 5.1

CPI (YoY %, pavg) 5.7 5.8 6.1 5.1

Fiscal Accounts (% of GDP) 1, 2


Revenue 28.3 28.7 28.6 28.5

Expenditure 32.5 32.8 32.6 32.0



Goods exports 99.5 94.6 93.5 101.1

Goods imports 104.3 102.4 99.1 107.2

Trade balance -4.8 -7.8 -5.6 -6.0

% of GDP -1.3 -2.2 -1.7 -1.6


% of GDP -5.2 -6.0 -4.6 -4.4

FDI (net) 1.5 3.8 2.7 3.1

FX reserves (USD bn) 50.7 49.0 51.0 55

ZAR/USD (eop) 8.5 10.1 10.5 9.5

ZAR/EUR (eop) 11.2 13.2 13.7 10.9


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 6.25

3-month Jibar 6.13 6.20 6.20 6.60

10-year bond yield 8.2 8.5 9 8.8

ZAR/USD 11.0 10.8 10.7 10.2

ZAR/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.

11 September 2014



Turkey Baa3 (negative)/BB+ (negative)/BBB- (stable) Moody’s / S&P / Fitch

Economic outlook: growth has slowed in response to earlier tightening measures. Inflation remains close to double digits and will likely decelerate only moderately, ending the year above 8%. The current account deficit is on track to narrow to 5.5% of GDP this year, notwithstanding declining exports to Iraq and Russia.

Main risks: while the external deficit is narrowing, it continues to be financed by shorter-term flows, leaving the economy vulnerable to tighter global liquidity conditions. There are ongoing geopolitical risks from the sectarian conflict in Iraq.

Diminishing room for manoeuvre

Presidential elections passed off smoothly with the expected victory for Erdogan. But the summer brought little respite for the policymakers at the central bank. Inflation remains close to double digits, which is only partly attributable to the drought-related spike in food prices. Fragile global risk sentiment has also once again translated into pressure on the lira. Domestic demand has softened but the scope for further rate cuts against this backdrop is now limited.

Mid-year slowdown GDP growth in Turkey decelerated to 2.1% (YoY) in Q1 from an upwardly revised 4.7% in Q1, a somewhat more marked slowdown than we had expected. This was very much driven by weaker domestic demand, which fell by 0.8% and knocked 0.9ppts off the headline growth rate in Q2. It was also broad-based, with all components of domestic demand (consumption and investment, private and public spending) weakening relative to the previous year. What growth there was came from net exports, which contributed 2.9ppts to the headline growth rate, though relative to the first quarter, this was as much a reflection of weak imports as strong exports.

In sequential terms, output fell by 0.5% QoQ on a seasonally-adjusted basis, following a strong increase of 1.8% in Q1. We have some doubts about the seasonal-adjustment process as this series tends to be quite choppy. But it suggests that the economy has been growing at an annualized rate of about 2.7% over the first half of the year.

We had been expecting a mid-year slowdown in growth followed by a modest acceleration later in the year as earlier monetary tightening was partially unwound and as the some of the uncertainty associated with the election cycle faded. That is still

broadly our view, though it may be that Q2 rather than Q3 marks the low point for growth. At this stage, therefore, we are leaving our full year forecast of 3.0% unchanged.

Moderate acceleration after mid-year slowdown

0

1

2

3

4

5

12Q1 12Q3 13Q1 13Q3 14Q1 14Q3 15Q1 15Q3

YoY%

DB Forecast


Failure of inflation to decelerate reflects more than food Headline inflation edged up to 9.5% in August from 9.3% in July. Food prices remain over 5% above their long-run trend following the recent drought. Core inflation, however, also failed to decelerate, remaining stable at 9.7%.

The Central Bank of Turkey (CBT) has made increasing reference to core measures in its recent communications, essentially arguing that there is not much that it can do about food prices, which are largely a reflection of negative supply side factors such as the drought. It has also argued that the underlying trend of inflation excluding food had been on a marked downward path in recent months.

This is true, but only up to a point. In presenting its last inflation report, for example, the CBT emphasized that monthly core inflation was running at below 5% in annualized terms in June. But this is no longer the case. Below, we replicate the chart used by the CBT in presenting its latest inflation report but extend it to include the July and August inflation prints. It suggests that core inflation has been running at an annualized rate of over 9% on average over the last two months.

11 September 2014



Core inflation accelerated over the last two months

0

2

4

6

8

10

12

14

16

18

20

Dec 12 Apr 13 Aug 13 Dec 13 Apr 14 Aug 14

Core inflation (seasonally-adjusted monthly change, annualized %)

Emergency rate hike

First reporate cut


Window for rate cuts may have closed The CBT kept its main (repo) policy rate on hold at 8.25% in late August but cut its overnight lending rate by 75bps to 11.25%. The decision to leave the repo rate unchanged was not a major surprise given the pressure on the lira that had been building since late July (see chart below). Having erred on the side of caution by leaving the repo rate unchanged, the CBT probably felt that it could safely lower the top end of its interest rate corridor without unsettling the markets. While lowering the overnight lending rate reduces the headroom to push up market rates in the event of more intense pressure on the lira, the CBT probably feels that a ceiling of 11.25% provides an adequate buffer in the current market environment.

This leaves us with little clarity on where next for rates. We do not view the decision to keep the repo rate on hold last month as signaling a definitive end to the latest easing cycle. Indeed the CBT continues to regard its current monetary stance as tight and we think that it would like to guide rates lower if possible. Whether it will be able to do so over the next few months, however, will depend largely on market conditions.

We had always thought that the window for cutting would be a relatively narrow one and that, once markets began to focus more squarely on the prospect of a first rate hike by the Fed, that window would probably close. The Fed’s asset purchase program is set to end next month and, while it has indicated that rate will remain near zero for a considerable time thereafter, markets are watching anxiously for a change of signal.

Our US economists think that the Fed will likely hike rates towards the middle of next year and is unlikely to start signaling this before December of this year. It’s possible, therefore, that the CBT may be able to cut its repo rate by another 25-50bps at some point over the next 2-3 months, but even this would likely require the lira to strengthen a little from current levels.

Lira weakness makes rate cuts less likely

2.0

2.1

2.2

2.3

2.4

1 Dec 30 Jan 31 Mar 30 May 29 Jul

USDTRY

Corruption investigation announced

Interim MPC meeting announced

First repo rate cut


Thereafter, we continue to think that, once US rates begin to adjust, the CBT would likely need to tighten domestic liquidity conditions to support the lira and prevent a further acceleration in inflation. It may well do so by leaving the repo rate unchanged while restricting the provision of liquidity to push market rates back up within its interest rate corridor.

Rebalancing continues In the meantime, the external deficit continues to narrow as domestic demand slows and the economy rebalances. Exports growth has weakened in recent months but this largely reflects a reduction in exports to the geopolitical hotspots of Iraq, Russia and Ukraine. Exports to Iraq, for example, fell by 45% (YoY) in July.

Geopolitics has affected export growth

-20

-10

0

10

20

Jan 13 Jul 13 Jan 14 Jul 14

Exports, YoY%Excluding exports to Iraq, Russia, and Ukraine

Total


Excluding these countries, export growth has actually picked up a little over the last couple of months (chart). Imports also remain weak, in line with weak domestic demand. All in all, we continue to think that the current account deficit is on track to narrow to about 5.5% of GDP this year.

11 September 2014



Erdogan becomes first popularly-elected President As expected, Recep Tayyip Erdogan became Turkey’s first popularly-elected President last month, following a slim first-round victory. Former foreign Minister, Ahmet Davutoglu, replaces Erdogan as Prime Minister. The economic management team of Deputy Prime Minister, Ali Babacan, and Finance Minister, Mehmet Simsek, remains in place.

Erdogan becomes President

AKP candidate,

Erdogan: 51.8%

CHP-MHP

candidate,

Ihsanoglo:

38.4%

HDP candidate,

Demirtas: 9.8%

Results of August Presidential Election

Turnout was 74.1%

Source: Supreme Electoral Council of Turkey, Deutsche Bank

As President, Erdogan has relatively few executive powers. With a loyal Prime Minister and a largely unchanged cabinet, however, he is likely to be able to continue to determine the overall direction of policy.

Robert Burgess, London, +44 20 7547 1930

Turkey: Deutsche Bank Forecasts

2012 2013 2014F 2015F

National Income


Population (mn) 74.9 75.8 76.8 77.8


Real GDP (YoY%) 2.1 4.1 3.0 3.5

Private consumption -0.5 5.1 1.1 2.1



Exports 16.3 -0.3 7.7 7.4

Imports -0.4 9.0 -0.1 3.8


CPI (eop) 6.2 7.4 8.5 6.9

CPI (period avg) 8.9 7.5 8.9 6.3

Broad money (eop) 10.2 22.2 12.1 10.0

Bank credit (eop) 18.5 33.3 18.1 16.5


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

External Accounts (USDbn) bn)

Goods Exports 163.2 163.4 175.0 186.1

Goods Imports 228.6 243.4 236.9 247.7

Trade balance -65.3 -80.0 -61.9 -61.7

% of GDP -8.3 -9.7 -7.7 -7.2


% 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 2.24


Government debt 1 37.6 37.5 35.8 34.0

Domestic 27.3 25.8 24.6 23.4

External 10.3 11.7 11.2 10.6


in USD bn 338.3 388.2 406.7 423.8


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 15Q3M Policy rate (repo) 8.25 8.00 8.00 8.00

Overnight lending rate 11.25 11.00 11.00 11.00

Effective funding rate 8.29 8.38 8.94 9.50

10-year bond yield 8.73 8.75 9.00 9.50

TRY/USD 2.12 2.15 2.25 2.27 (1) Central government Source: Deutsche Bank, National Sources.

11 September 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

Over July and August, the Ukrainian economy continued to subside into deeper recession amid increased violence in the regions of Luhansk and Donetsk. On the economic front, the deterioration of output indicators continued following a shutdown of production facilities in Luhansk and Donetsk. On the consumer front, the decline in consumption deepened as slowing wages growth was further undermined by a weaker hryvnia and higher inflation. On the political front, the ruling coalition broke down with the next parliamentary elections due on 26 October.

Conflict in Eastern Ukraine escalated significantly in July and August. Ukrainian forces led the offensive in August, deploying heavy weaponry and air forces towards the cities of Luhansk and Donetsk, stopping at the suburbs. However, in end-August, pro-Russian forces managed to open up a new front surrounding the city of Mariupol, one of Ukraine’s largest commercial seaports. The hostilities were suspended on September 5 after the signing of a cease-fire agreement.

At the end of August, the IMF Executive Board approved the second tranche of financial assistance for Ukraine totalling USD1.4bn, which brings total disbursements under the arrangement to USD4.5bn. The fund also approved Ukraine's request to merge the third and fourth installments with the next disbursements, amounting to USD2.3bn, to be directed to Ukraine in mid-December as long as Kiev complies with the loan conditions. The IMF noted, however, that the decision is based on the assumption that the conflict in the east of Ukraine will subside in the coming months. IMF officials acknowledged that the escalating conflict in Eastern Ukraine will cause a “deeper recession and deviations from program targets in the short term,” mentioning such conditionality items as international reserves and the Naftogaz deficit. The IMF warned that if fighting continues into next year, Ukraine may need as much as USD19bn in additional financing from donors.

In terms of domestic policy events, at the end of July, Ukrainian PM Yatsenyuk asked for Ukraine’s parliament to be dismissed, citing the breakup of the ruling coalition (“European Chaise”) on the back of the

exit of two political parties (Klitchko’s Udar and Tyahnibok’s Svoboda) and a number of independent deputies. However, Yatsenyuk’s appeal was not heeded and, at end-July, he continued to hold the position of acting prime minister with the cabinet remaining fully operational. The President gave the Rada 20 days to form a new coalition. After it failed to do so, the President dismissed the Rada and set the date for parliamentary elections for 26 October.

Regarding the election, the acting prime minister, parliament speaker, and other prominent politicians have left the Batkivshchina (Fatherland) political party, led by Ukraine’s ex-Premier Yulia Timoshenko. ITAR-TASS quoted local political observers as suggesting that Turchynov and Yatsenyuk’s departure from Batkivshchina is indicative of their intention to pursue an independent political course and to distance themselves from Timoshenko during their parliamentary election campaign.

Polls conducted at the end of August by KIIS state favour Petro Poroshenko’s block (37.1%), compared with Lyashko’s Radical Party (13.1%), Hrytsenko’s Civic Stand (9.7%), Tyhypko’s Strong Ukraine (7.8%), right-radical Ukraine’s Patriots (6,4%) and Batkivshina (6.1%). According to the poll, the remaining parties are unlikely to overcome the 5% level, including Regions Party (3.8%), Communists (4.6%) and nationalist Svoboda (4.4%).

Regarding economic conditions, real sector activity started to deteriorate sharply from June as the military operation intensified in Eastern Ukraine and clashes escalated near Donestk and Luhansk with IP posting -12.1% yoy in July after -5.0% yoy in June and -2.1% yoy in May. Following a pronounced decrease in construction fixed assets, investments recorded a steep decline as well, shrinking by 17.5% yoy in 1H14 after -14.2% yoy in 1Q14. On the consumer side, retail sales continued to deteriorate: -3.2% yoy in 7M14, -2.1% yoy in 6M14 and -0.4% yoy in 5M14. Over 7M14, real wages growth was down by -1.7% yoy. Unemployment continued to rise, reaching 9.3% in 1Q14 after 7.7% in 4Q13. Overall, the most recent estimates from Ukrstat suggest that the economy shrank in 2Q14 by 4.7% yoy in 2Q14 after -1.1% yoy in 1Q14. Based on the continued deterioration and destruction of production captaincies, we revise our GDP growth estimate to -6.9% yoy for 2014 and to 0.5% yoy in 2015.

In terms of monetary conditions, consumer price growth slowed down in July to 0.4% mom after +1.0% mom in June and +3.8% mom in May. On a yoy basis,

11 September 2014



CPI increased to 12.6% yoy in July after 12.0% yoy in June, 10.9% yoy in May and 6.9% yoy in April. The key concern on the inflation front remains the significant depreciation of the hryvnia, which continued to weaken against the USD with depreciation exceeding 60% in mid-August, easing to 50-55% at the beginning of September within the range of UAH/USD12.0-13.0. To some degree, the central bank’s measures such as the rate decisions and further restrictions of hard currency withdrawal from the banking system are likely to have helped avoid further depreciation. In July, the NBU raised the main lending rate to 12.5% from 9.5% set in April, with the projections for CPI set at 17% yoy for 2014 (8.7% yoy in 2015). In light of more pronounced hryvnia depreciation, we revise our CPI and hryvnia projections to 17.2% yoy by December 2014 and to 11.4% yoy by December 2015, while we set our USD/UAH eop forecasts at 13.0 and 14.5 by end-2014 and end-2015.

On the fiscal front, the state budget continued to run a deficit, with revenues at UAH199bn vs. expenditures at USD230bn over 7M14, increasing the deficit to UAH32.7bn. Revenues increased primarily on the back of proceeds from the NBU and royalties; however, tax revenues were down with the most pronounced decline witnessed in VAT (-3.5% yoy), import duties (-3.1% yoy) and profit tax (18.9% yoy). According to the new budget law, revenues were set at UAH377.8bn and expenditures at UAH441.6bn, with the resulting deficit of about UAH65bn. Earlier, Finance Minister Alexander Shlapak stated that the government hopes to keep the deficit below 5% of GDP, which was initially set at 4.5% of GDP. In their most recent forecasts, the authorities estimate a 6.5% yoy decline in Ukraine’s economy and a USD/UAH12.0 exchange rate. At the same time, according to IMF estimates, the general government deficit including the Naftogaz deficit is likely to exceed 10% of GDP. Due to the ongoing difficulties in obtaining revenues, the country is likely to face higher-than-expected deficits; we revise our estimate to -5.5% GDP in 2014 and -4.5% GDP in 2015 with the consequent amendments to debt indicators.

On the external front, Ukraine’s CA deficit reached USD2.25bn in 7M14 vs. USD7.1bn in 7M13. Despite turning positive in April, the current account turned marginally negative in May-July on a sharp deterioration of goods export growth. After obtaining sizeable external financing from the IMF, EU and WB in May with a consequent improvement of the official reserves position to USD17.9bn at end-May, reserves continued to decline to USD17.8bn in June and USD16.1bn in July.

Yaroslav Lissovolik, Moscow, +7 495 933 9247 Artem Zaigrin, Moscow, +7 495 797 5274

Ukraine: Deutsche Bank forecasts

2012 2013 2014F 2015F

National Income


Population (m) 45.5 45.4 45.0 45.0


Real GDP (yoy %) 0.2 0.0 - 6.9 0.5

Private Consumption 11.7 6.5 - 5.7 0.4

Government consumption 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 (eop)

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



Revenue 23.5 24.2 24.6 23.6

Expenditure 26.0 28.7 30.1 28.1


Trade Balance - 19.5 - 19.6 - 7.9 - 8.2

% of GDP - 11.1 - 11.2 - 6.5 - 6.3


% 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

EUR/FX (eop) 10.60 11.34 16.90 16.68



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 (% pavg)

Industrial Production (YoY%) - 1.8 - 4.7 - 10.1 - 4.2

Unemployment (%) 7.8 8.1 10.0 9.2

Financial Markets (eop) Current 14Q3F 14Q4F 15Q2F

Policy rate (refinancing rate) 12.50 12.50 12.50 12.50

USD/UAH (eop) 12.93 13.20 13.00 13.50

EUR/UAH (eop) 16.68 17.56 16.90 16.47 Source: Official statistics, Deutsche Bank Global Markets Research

11 September 2014



Argentina Ca (stable)/SDu (stable)/RD (stable) Moodys /S&P/ /Fitch

Economic outlook: The decision to confront the NY court order of the holdouts case is expected to further limit any potential external financing, deepening the ongoing economic recession, and eventually leading to increasing exchange rate stress. This notwithstanding, the authorities seem to be convinced this is the best policy alternative, preventing any hope of a resolution early next year. The question remains whether the government underestimates the economic and social repercussions of such a decision. Meanwhile, hard currency rationing and money financed by the public sector deficit simply exacerbate existing disequilibria.

Main risks: Continued deterioration of the economic situation seems the most likely scenario. The possibility of more restraining orders from the NY court could just worsen the outlook. Without a debt resolution, a recession with high inflation would test the government’s political will. Gradual execution of the currency swap renewed with China right before the default could give the government some time, but it is unlikely to be enough of a bridge to next year’s presidential elections.

Living in default

Default as a political statement… After two months of speculation that there were different alternatives to avert default, Minister Kicillof disappointed expectations by reporting the impossibility of a deal at the end of the grace period, on July 30. More importantly, Minister Kicillof failed to offer any prospect for a resolution from the very beginning, basically repeating the constrains faced by the government, like the inability to accept anything better than the restructuring offer, as well as the need to resolve broadly the holdout case, incorporating the 7.6% of original bond holders that did not accept the restructuring offer (of which Elliot et al. represented in the current pari-passu case only embodies a bit more than 10% of that universe). Furthermore, Minister Kicillof criticized the US court ruling, threatening to use additional legal means under Argentine or international law to continue challenging the US court. Specifically, Mr. Kicillof argued that Argentina was not in default as payment was transferred but stopped by the US court once already under the name of bond holders.

Later that same day, speaking to the nation, President Cristina Fernandez de Kirchner (CFK) stated that accepting the NY District Court Order to pay holdouts would be akin to accepting extortion. CFK indicated

that compliance with it would mean paying some USD15.0bn to all remaining holdouts, which would represent more than 50% of current international reserve holdings. According to President CFK, this would be both absurd and impossible. The President also noted the potential liability emerging from new demands from current bond holders as another reason not to accept such a decision. The latter refers to the Rights Upon Future Offers (RUFO) clause benefiting restructured bonds, which will expire on January 1, 2015. In addition, the President cast criticism on the US Justice System and the entire international financial architecture for providing conditions for extraordinary benefits, such as those demanded by the holdouts.

Since then, a number of court hearings and meetings with the mediator designed by the court failed to narrow the gap between the government position and the aspirations of the holdouts. Private sector alternatives were also demonstrated as unviable. Meanwhile, the government further radicalized its stance, by cancelling the Bank of New York’s (BoNY) license to operate in Argentina and promoting a Congressional law that would replace BoNY and incorporate a new fiduciary agent (Nacion Fideicomisos SA) for restructured bonds, as well as the possibility of a swap to voluntarily switch the prevailing law of the bonds to either Argentina or France. Such a law has passed the Senate already and it is being discussed in Congress right now. The government is expected to get it approved in the next couple of weeks. Furthermore, the government has threatened to sanction Citibank for failing to honor the payment of restructured bonds under Argentine law.

In the process, the authorities have also tried to move the legal battle to the International Court of Justice (ICJ). A few days after NY Judge Griesa ratified its order to retain restructured bond payments, Argentina filed a dispute seeking to institute proceedings against the USA before the ICJ, contending violations of Argentina sovereignty and immunities. So far, this new line of litigation has not advanced as it demands the US administration’s acceptance of the international court. Meanwhile, Argentina did obtain international support from a number of forums, like the IMF, UN, the Organization of American States, the G77+China, Brazil, France, Russia, and the very same US Treasury, but these demonstrated totally futile in achieving any concrete help, legally or in the negotiation process. This notwithstanding, it appears that the constant pressure in international forums remains one of the fighting channels chosen by the Argentine authorities, now at the center of its foreign policy.

11 September 2014



Simultaneously, the Argentine government has also promoted direct intervention by investors. Among other actions, a group of bond holders filed a request to the Argentine courts for Bank of New York to distribute their payments according to its fiduciary obligation. Likewise, Citibank filed a request to the NY Court of Appeals to clarify the status of Argentina’s restructured debt under local law. Judge Griesa allowed the payment of USD Discounts under Argentina’s law for once, to avoid affecting similar bonds delivered to Repsol in the settlement for YPF nationalization, but noted that future payments will be restrained according to the pari-passu ruling. In our understanding, Argentine law bonds, even USD denominated, are not subject to judge Griesa’s injunction as they do not represent external debt, the only debt reached by the pari-passu bridge. Thus, it is not impossible to see some progress in the coming days, allowing Argentina to circumvent the debt payment restraint to just the NY law issue, and eventually the EU law. However, confronting the NY court by proposing (once again) a swap already banned by judge Griesa, might well risk the possibility of the court finding Argentina in contempt, further restraining the country’s ability to serve its debt in any form.

Thus, at this stage, the government seems totally convinced that this non-negotiating stance is the best option. In principle, this is working politically, as recent opinion polls show increasing support from the population against any unconditioned agreement or capitulation with “vulture funds”. It 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 recently been seized by high inflation and low growth, the vice president’s corruption scandals and investigations, as well as the fading fortune of long lasting allies like the Venezuelan Chavismo.

The Argentine authorities, however, appear to be too optimistic about the possibility of bypassing the US court blockade. Alternatively, it appears to underestimate the true economic effect of default and further isolation from international markets. In our view, the government might 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 some final and comprehensive resolution is reached, exacerbating existing fiscal and monetary disequilibria in the country for now.

Market actions have also suggested some degree of confidence in a rapid resolution on the debt front. Restructured bond prices have fallen from their picks after the default was confirmed, but have remained in the 80s, implying tighter yields than the performing Venezuela, for instance. This partly denotes the fact 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 some 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 discussed below.

The solid solvency backdrop of Argentina 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 efforts as the sovereign does not seem to need any special contribution, exacerbating the free riding motive to reject participation in any of these resolutions.

…but also as a costly economic policy option Absent any improvement in external financing, the outlook is for continued deterioration of economic performance. 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. By the time we went to press, the non-official exchange rate was trading at ARS/USD 14.30, compared with 8.41 for the official rate, while the implied exchange rate in blue chip transactions was around ARS/USD 13.2, pushing both gaps back to their historic highs. In reaction, the government tightened further existing capital controls. On Friday, the government announced an increase of 22.2% in the minimum monthly salary that allows individuals to buy hard currency at the official exchange rate, setting it at ARS8,800. This followed a similar increase in the minimum wage, the base for that calculation. The maximum currency allowance remained at 20% of the salary up to USD2,000 a month. A day earlier, the Central Bank further reduced Banks’ hard currency allowances to 20% of their patrimony, from 30% initially, with an aggregate impact of approximately USD500mn. Early this week, the Central Bank communicated to corporations that the maximum hard currency transaction with automatic approval was reduced by half to just USD150,000 a day.

All the above notwithstanding, the Central Bank lost almost USD300mn in international reserves during the previous week, confirming a new declining trend after the stability reached following the February devaluation. On current basis, it is reasonable to expect further depletion of international reserves, in the order of USD1.0bn a month, with increasing stress in the exchange rate market. This suggests international

11 September 2014



reserves could go from USD28.4bn currently to almost USD22.0bn in December 2014. This includes the payment of hard currency sovereign and quasi sovereign debt services for the remainder of the year, totaling USD1,850mn, but excludes multilateral agencies that are expected to be rolled over. In 2015, the same services amount to USD14,400mn, excluding multilaterals again, but representing most of the net reserves estimated to be held by December 2014.

Therefore, it is not surprising that the Argentine government is trying to accelerate the disbursement of a couple of financing commitments left by the Chinese authorities few weeks ago. These include 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.

Balance of payment projections (cash basis, USDmn)

2012 2013 2014F 2015F

Current account 3,866 -13,277 -9,400 -9,000

Trade 14,673 1,745 1,500 2,000

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 -5,900 -6,500

Net interest -7,369 -4,523

Profits and dividends -225 -1,363

Other transfers 611 267

Capital account -7,171 1,452 700 -3,500

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 -1,500 -1,000

External assets, non financial private sector -3,404 397 -3,500 -3,500

External assets, financial sector -190 70 700 1,000

Others public sector -1,583 696 -500 -5,000

Others -638 3,168 1,000 1,500

Change in international reserves -3,305 -11,825 -8,700 -12,500

43,290 30,828 22,128 9,628 Source: BCRA, and Deutsche Bank

However, the Argentine government needs to deal also with declining soybean prices and unfavorable conditions for agriculture production and exports. A strong peso and restrictions to buy dollars are not exactly contributing to a pick-up in exports. Argentina’s international trade fell significantly this year, although partly affected by overstated numbers in 2013. Nevertheless, between January and July, exports and imports accumulated a 10% and 9% fall, respectively. This explains the 19% contraction reported in the trade surplus so far this year. Manufacturing exports are falling by 13%, mostly reflecting weak Brazilian demand and growing competitiveness problems. Likewise, despite a good harvest, agriculture exports accumulated a 26% contraction. 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 motives for dollar or crop hoarding. On the positive side, the energy deficit should remain mostly unchanged at around USD6.0bn due to the on-going economic recession as energy exports keep falling at a 15% annual pace as of July. 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. For next year, a small increase is likely in the trade surplus, to USD9.0bn, simply explained by a new reduction in imports.

The inevitable recession could deepen further As we have discussed repeatedly, improving economic performance in the months ahead demands policies supporting some 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 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 can only see 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.

However, 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 constrains and increased intervention further deters investment. Thus, while fiscal accounts deteriorate further, inflation is only contained by temporary exchange rate stability and economic slump, but remaining relatively high, further fueling competiveness problems and the need for import rationing and recession.

The public sector reported a total deficit of ARS16.6bn in June, and a primary deficit of ARS286mn. This was the result of total revenues advancing 55.6% YoY, or still below the 56.5% increase recorded in primary spending. According to the press release from the Treasury Secretary, the general government was able to maintain a primary surplus of ARS2.2bn in the first semester of the year, but it accumulated a financial deficit of ARS37.3bn. This compares with a primary surplus of ARS4.7bn and a financial deficit of

11 September 2014



ARS13.8bn in the first semester of 2013. It is worth noting that last year the government included ARS18.6bn in current revenues as rents from assets, while this figure reached ARS51.6bn in 2014. Thus, without transfers from the Central Bank and the Social Security System, the primary balance so far this year is calculated as a deficit of ARS49.4bn, from a deficit of ARS13.9bn in the same period last year, or 260% higher in nominal terms. On current trends, the fiscal deficit this year is likely to reach 4.8% of GDP from an estimated 4.5% last year, once special revenues from the CB and ANSES are excluded.

Meanwhile, the INDEC reported that economic activity was unchanged in June with respect to the level reached in June 2013. On a monthly basis, seasonally adjusted activity advanced by 0.3%, accumulating a 0.8% increase in the year. However, INDEC also reported that industrial production was down 0.7% YoY and 0.1% MoM, seasonally adjusted in July, while construction activity was also reported showing negative growth, at -1.5% YoY and -2.6% MoM, during the same month of July. According to the private think tank FIEL, industrial output has accumulated a 2.8% decline so far this year. Furthermore, INDEC informed that supermarket and shopping sales advanced by 35% and 17.5% YoY, respectively, in July too, implying a significant decline in real terms, as inflation is estimated to have been around 39% according to the average inflation reported by opposition members of the Congress. July is the second month in a row that shopping sales basically collapsed after accumulating almost a 35% annual increase in previous months.

Economic recession to worsen (YoY)

-30%

-20%

-10%

0%

10%

20%

30%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14

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 unemployment slightly increasing 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 for almost 2 percentage points in 12 months. Therefore, based on the labor supply of last year, unemployment this year would have reached almost 10%.

Despite the weakening economic outlook, INDEC reported that inflation in July slightly accelerated to 1.4% from 1.3% in June. This was the first time after

six months of steady slowdown in inflation that consumer price increases have turned around. According to the official consumer index at the national level, inflation so far this year has accumulated 16.3%. On parallel, opposition members of Congress reported that inflation in the City and Great Buenos Aires area had been 2.47% in July, up from 2.3% and 2.2%, respectively, in May and June. This privately estimated inflation accumulates more than 24% so far this year, and represents a annual rate of 39.7%.

While keeping an expansionary fiscal and monetary stance, the government decided to promote a new consumer defense law that might help contain inflation and increasing unemployment. This, however, is likely to further deter investment as the draft law grants significant discretionary power for the government to force price stability and even the continuation of a business facing loses.

Central Bank policies could still help There is very little Central Bank policies can do in the current situation. The monetary authority essentially needs to deal with a large fiscal deficit, high inflation, a relatively strong currency, and lack of enough external financing to sustain any decent level of growth. Despite multiple constraints, the Central Bank might be able to find some equilibrium for peso and dollar demand, while controlling the pace of exchange rate depreciation. However, any equilibrating policy seems to confront the government’s belief that a tight monetary stance only worsens the growth outlook under all circumstances. This is why we have seen apparent erratic behavior from the Central Bank, but overall it appears trying to somehow impose increasing discipline to nominal balances.

In recent days, for example, the Central Bank pushed rates up once again, after the bold decision promoted by the Ministry of Finance to cut rates a few days after the technical default was a reality. Since then, short-term Central Bank rates (98ds Lebac) were back to the pre-cut level of 27%, while longer CB papers moved above those levels, reaching 29% for six month and 29.3% for one year. All Central Bank rates are still low and below the post-February devaluation pick, by 200bps in the short paper and between 50bps and 100bps in the tenors up to one year. Nevertheless, the final outcome is some steepening in the yield curve, which seems quite necessary in the context of inflation in the 1.4-2.4% monthly range, with expectations not revealing any hope for deceleration in the months to come.

The Central Bank is also attempting to implement some order in the financing of the public sector. By the end of August, the Central Bank’s financing of the public sector deficit reached ARS65.7bn, representing a 150% increase with respect to last year. For the remainder of

11 September 2014



the year, current trends suggest the funding need of an additional ARS100bn, doubling the total Central Bank financing of public sector accounts in 2013. Needless to say, this trend is unsustainable as the Central Bank does not have the ability or power to sterilize this amount of pesos. This notwithstanding, there are on-going negotiations with the government to seek additional financing from banks and corporations. Indeed, the local press early this week reported the government’s testing of a potential new issue in pesos, similar to the Bonar 17, with a 600bps spread to Badlar approximately. This could serve the two fold purpose of providing higher return in peso assets and reducing the need of monetization from public sector deficit.

Peso, interest rates, and inflation (YoY)

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14

non-official exchange rate gap, rhs

real interest rate (Badlar/Congress inflation)

real official exchange rate depreciation

Source: BCRA, Bloomberg Finance LP, and Deutsche Bank

Without an equilibrating force, the additional financing of public sector deficit would simply fuel dollar demand, further aggravating the scarcity of hard currency in the country. More debt financing and higher interest rates could facilitate some nominal muddling through until the external financing constrain is reversed. Actually, this could even allow the Central Bank to slide the currency at a faster pace, achieving some real depreciation. Not accepting this basic monetary dynamic might only accelerate inflation and trigger a major stress in the exchange rate market sooner or later.

Meanwhile, credit growth continues to slowdown, supporting the view that negative interest rates are not enough to promote credit and growth. During August, banking credit to the private sector was up by 21.9% YoY, confirming the slowdown in its growth rate for a number of months already. Likewise, private sector deposits grew by 28.9% YoY, or below the 29.7% increase recorded in July. With inflation running at almost 40% YoY, all these nominal increases in liquidity and credit denote a sharp contraction in real terms, completely consistent with a deepening in the current economic recession.

Gustavo Cañonero, New York, (212) 250 7530

Argentina: Deutsche Bank forecasts 2012 2013E 2014F 2015F

National Income Nominal GDP (USDbn) 493 511 455 449

Population (m) 41.0 41.5 41.9 42.4

GDP per capita (USD thousand) 12.0 12.3 10.8 10.6

Real GDP (YoY%) 1.2 2.9 -1.9 -1.4

Priv. consumption 4.6 4.5 -2.8 -1.7

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 37.9 32.0

CPI (YoY%, avg) (*) 23.9 25.3 38.1 34.4

Broad money (M2, YoY%) 34.3 24.0 20.0 20.0

Bank credit (YoY%) 30.8 30.5 25.0 22.0

Fiscal Accounts (% of GDP)(**)

Budget surplus -3.9 -4.6 -4.9 -4.7

Gov't spending 32.4 34.1 32.9 31.0

Gov't revenue 28.6 29.6 28.1 26.3






% of GDP 2.5 1.6 1.6 1.8


% of GDP 0.0 -1.4 -1.9 -1.5

FDI (net, cash basis) 3.7 2.4 2.0 2.5


FX rate (eop) ARS/USD 4.92 6.52 9.37 12.12

Debt Indicators (% of GDP) Government debt 19.2 19.0 21.7 22.3

Domestic 5.9 7.2 8.3 10.1

External 13.3 11.8 13.4 12.2


in USDbn 140.9 135.8 136.3 130.1


General Industrial production (YoY) (nominal)

-1.2 0.8 -4.8 -3.3

Unemployment (%) 7.2 7.1 7.7 8.5

Financial Markets (EOP) Current 14Q3 14Q4 15Q2

98ds Lebac rate 27.0 29.0 31.0 33.0

1-month Badlar 20.5 23.5 28.5 30.5

ARS/USD 8.40 8.66 9.37 11.10 Source: DB Global Markets Research, National Sources *Inflation reported by Congress, **Central governme

11 September 2014



Brazil Baa2(negative)/BBB-(stable)/BBB(stable) Moody’s/S&P/Fitch

Economic outlook: Although economic growth has decelerated sharply, inflation remains significantly above the 4.5% target. The October elections limit the policymakers’ degrees of freedom to tighten fiscal and monetary policies, thus prompting the BCB to keep the FX on a short leash to curb inflation. Despite the government’s efforts to stimulate private investment through infrastructure concessions, its interventionist bias continues to hurt business sentiment and hinder growth.

Main risks: The fiscal adjustment lacks credibility and inflation remains high. Without a credible fiscal adjustment, Brazil will probably be downgraded again after the elections. Higher interest rates abroad could lead to further currency depreciation and even slower domestic growth. The election outcome might not be as market-friendly as asset prices are currently pricing in.

Elections amid a recession

GDP fell 0.6% QoQ in 2Q14 as investment plunged. Brazil’s GDP fell 0.6% QoQ in 2Q14, slightly more than our forecast (and market consensus) of -0.4% QoQ. IBGE revised 1Q14 GDP to -0.2% QoQ from +0.2% QoQ, so Brazil officially fell into a technical recession. As expected, fixed-asset investment and industrial production led the decline in GDP. On the demand side, investment plunged 5.3% QoQ, posting its fourth consecutive quarterly decline. In our view, the fall in investment reflects the sharp deterioration in business confidence triggered by inefficient economic policies, uncertainty about the next government and its economic policies, and industrial sector stagnation. Investment amounted to only 16.5% of GDP in 2Q14 (compared to 18.1% in 2Q13), while savings were just 14.1% of GDP (compared to 16.1% in 2Q13). While household consumption inched up 0.3% QoQ after falling 0.2% in 1Q14, government consumption fell 0.7% after rising 0.4% QoQ in the previous quarter. However, as labor income decelerates and credit remains sluggish, private consumption does not have the same power to boost economic growth as before. The external sector contributed to alleviate the recession, as exports grew 2.8% QoQ and imports fell 2.1% QoQ. On the supply side, industrial GDP fell 1.5% QoQ (its fourth consecutive decline too), as manufacturing fell 2.4% and construction declined 2.9% QoQ. A 3.2% increase in mining production (led by oil) prevented a larger decline in industrial output. The services sector fell 0.5% QoQ after remaining unchanged in 1Q, led by a 2.2% QoQ drop in the retail sector. The agricultural GDP rose 0.2% QoQ. We believe the decline in GDP in 2Q14 was aggravated by

the World Cup, which reduced the number of working days. The normalization of working days will probably produce some relief in 3Q14, when we expect GDP growth to become positive again. However, there is not any sign of improvement in business confidence, and the uncertainty about the elections and future economic policies remain quite high, which does not bode well for investments. Given the revision to 1Q14 and lower-than-expected 2Q14, the carryover for 2H14 is now zero, so we have lowered our forecast for 2014 GDP growth to 0.3% from 0.9%. For 2015, we are keeping our GDP forecast unchanged at 1.2% for now. Although some inevitable adjustments (especially on the fiscal front) will likely have a short-term negative effect on economic activity in 2015, we believe more clarity about the economic policies to be pursued by the next administration will help shore up business and consumer confidence. Our scenario assumes that Brazil will not have to implement energy rationing next year.

There are no signs of a strong recovery in 3Q14. Industrial production rose 0.7% MoM in July, after five consecutive monthly declines. In the year on year comparison, industrial production still fell 3.6%, led by a 13.7% YoY plunge in durable consumer goods, and a 6.4% YoY decline in capital goods. The only sector that has been posting consistently positive results is mining (led by oil), which climbed 1.1% MoM in July, its fifth consecutive increase. We believe the increase in production in July was mainly a pay-back to the steep decline observed in 2Q14, but not a sustainable recovery, as inventories remain high, demand continues to be weak, and business confidence remains depressed amid the lingering uncertainty surrounding the October elections and future economic policies. We are also concerned about the labor market. Although official statistics agency IBGE failed to publish complete data on employment in the past three months due to an employee strike, the CAGED survey on formal employment has registered a marked decline in job creation. While unemployment has remained stable at very low levels so far due to a decline in the participation rate, we expect a gradual increase in the next months.

The BCB has announced measures to boost credit. Aiming to improve liquidity in financial markets, the BCB has unwound some macro-prudential measures enacted in 2010, cutting reserve requirements on bank deposits by approximately BRL40bn (allowing, for example, banks to divert as much as 60% of their reserve requirements on time deposits to finance new loans or to buy loan portfolios) and easing the banks’ capital requirements. The Finance Ministry has also announced several measures aimed at boosting credit, including: introduction of a new tax-exempt

11 September 2014



collateralized bond to be issued by banks for real estate financing, a reduction in bureaucracy involved in mortgage financing, a change in the foreclosure rules making it easier for banks to repossess financed goods (e.g. vehicles) in case of delinquency, and a credit facility financed by the savings accounts whereby consumers will be able to use real estate as collateral. We expect these measures to have a relatively small effect on credit in the near term, as both the banks and consumers remain cautious due to the present heavy debt burden on households, likely increase in unemployment, and uncertainty about economic policies after the October elections.

Inflation has decelerated more than we expected in the middle of the year, but is still poised to rebound in 4Q14. The IPCA rose just 0.01% MoM in July, reflecting seasonal factors, a sharp decline in agricultural prices, and correction of some prices that were temporarily boosted by the World Cup (e.g. hotel and air travel). Slow economic growth is also contributing to some moderation in prices, especially of non-tradables. However, the IPCA accelerated to 0.25% in August, and we expect monthly inflation to climb further in the next months due to seasonal factors and possible adjustments in regulated prices after the October elections. We are assuming, for example, a 5% increase in gasoline prices in December. Additional adjustments in fuel prices, as well as increases in electricity and public transportation will likely affect inflation next year. Thus, although we revised our 2014 IPCA forecast slightly to 6.2% from 6.3%, we are keeping our 2015 forecast unchanged at 6.0% for now despite the negative outlook for economic growth.

We still expect no change in interest rates. The BCB’s decision to keep the SELIC rate at 11.0% in September despite the negative GDP numbers was not a surprise because inflation expectations remain quite high and the BCB had previously stated 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). We continue to expect no change in interest rates until the end of 2015. While economic activity continued to disappoint, inflation remains high at 6.5% and would be even higher had the government not contained some regulated prices and intervened in the FX market to prop up the currency. Monetary easing at this juncture would further erode the credibility of the inflation-targeting regime and lead to another increase in inflation expectations. Moreover, since the economic slowdown has been mainly caused by a decline in confidence, lower interest rates would do little to rekindle growth. In our opinion, the BCB’s measures on reserve and capital requirements were an attempt to stimulate credit without cutting interest rates because of the inflation constraint. We also do not agree with the view that the BCB will hike rates in 2015. While one could argue that monetary tightening may be required to 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 higher interest rates. We expect the SELIC rate to remain unchanged at 11.0% until the end of 2015, and believe the next move will be a rate cut.

Fiscal policy continues to be the Brazilian economy’s Achilles heel. The government continues to post disappointing fiscal results and meeting this year’s fiscal target is becoming increasingly difficult. The consolidated primary surplus totaled BRL24.7bn in 7M14 (0.8% of the period’s GDP), compared to BRL54.4bn in 7M13 (2.0% of GDP). In 12 months, the consolidated primary surplus fell to 1.22% of GDP in July, remaining well below this year’s 1.9% target. At the federal level, nominal revenues climbed 6.8% (led by a 35% surge in dividends paid by SOEs) and total spending jumped 10.5% (led by a 17.9% increase in discretionary spending, including a 21.3% surge in federal investment). The government has reportedly prevented further deterioration in the fiscal statistics by postponing an undisclosed amount of mandatory payments, especially to publicly-owned banks, which potentially undermines transparency and the Fiscal Responsibility Law. Despite a large inflow of extraordinary revenues expected for the next months (including an estimated BRL18bn from the REFIS tax amnesty program and at least BRL8bn from telecom concessions), we do not expect the government to meet its fiscal targets this year. In light of the latest data and revision to GDP growth forecast, we cut our primary surplus forecast to 1.2% from 1.5% of GDP for 2014, and to 1.8% from 2.0% 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, it will be difficult to raise the surplus without significant spending cuts and tax increases. We expect the government to begin tackling these issues after the elections, as failure to do so could prompt the ratings agencies to further downgrade Brazil’s sovereign ratings in 2015.

Slow economic growth is helping to curb the current account deficit. The current account deficit totaled USD49.3bn in 7M14, compared with USD52.2bn in 7M13. The slight decline was mainly due to the trade balance, whose deficit fell to USD0.9bn in 7M14 from USD5.0bn in 7M13. In 12 months, the current account deficit amounted to USD78.4bn (3.5% of GDP), remaining roughly stable since 4Q13. All in all, economic growth is preventing the current account deficit from increasing, while the financial account continues to attract sizeable volumes of foreign investment (both FDI and portfolio flows), reflecting high domestic interest rates and favorable global liquidity conditions. Due to slower growth, we raised our 2014 trade surplus forecast slightly to USD4.0bn from USD3.0bn. However, since tourism inflows related to the World Cup were smaller than we

11 September 2014



expected, we raised our current account deficit forecast to USD82.0bn (3.7% of GDP) from USD80.0bn. For 2015, we cut our deficit forecast to USD77bn (3.4% of GDP) from USD80bn. In the FX market, the BCB has continued to intervene through swaps to minimize volatility, raising the rollover auctions when the BRL comes under pressure, and vice-versa. Although the outstanding volume of FX swaps has reached a hefty USD94bn, approximately, the authorities will probably continue intervening in the FX after the elections to minimize volatility and inflation. However, we still expect some BRL weakness by year-end due to likely higher interest rates in external markets. Thus, we are keeping our year-end exchange rate forecasts at BRL2.35/USD for 2014 and BRL2.50/USD for 2015. Our forecast assumes that economic policies will undergo marginal adjustments next year. A deeper commitment to fiscal discipline and market-friendly policies after the elections could pave the way for a stronger BRL.

The presidential elections are too close to call in our view. The tragic death of PSB presidential candidate Eduardo Campos in a plane crash on 13 August 2014 has upended Brazil’s presidential election. Campos has been replaced by his running mate Marina Silva, who was more widely known than him because she had run for president representing the Green Party in 2010. The latest polls have indicated that Silva has become President Rousseff’s main contender. According to a poll conducted by Datafolha on September 3, Rousseff (PT) led with 35% of the vote, followed by Silva (PSB) with 34%, and Aécio Neves (PSDB) with only 14%. In the second-round vote simulation, Silva led Rousseff 48% to 41%. Marina Silva’s rise in the polls has boosted Brazilian asset prices, as the candidate has pledged to restore the so-called “three pillars” of macroeconomic policy, namely fiscal discipline, inflation targeting (with central bank independence), and a floating exchange rate regime. In our opinion, however, despite the latest polls, the election remains too close to call because President Rousseff has enormous advantages over the opposition candidates. In addition to benefitting from being the incumbent president, Rousseff has almost as much air time on TV as all the opposition candidates combined (before the first-round vote), and a much larger party coalition supporting her campaign. Moreover, despite the latest negative news on GDP growth, the polls have shown an incipient recovery in Rousseff’s approval rating, probably reflecting persistently low unemployment, the seasonal decline in inflation, and the TV campaign. Since there is still a long way to go before the first-round vote (October 5) and the second-round vote (October 26), the election remains wide open in our opinion.

José Carlos de Faria, São Paulo, (+55) 11 2113-5185

Brazil: Deutsche Bank forecasts

2012 2013 2014F 2015F

National Income

Nominal GDP (USDbn) 2,253 2,245 2,238 2,263

Population (m) 199 201 203 204


Real GDP (YoY%) 1.0 2.5 0.3 1.2



Gross capital formation -4.0 5.2 -7.5 1.6

Exports 0.5 2.5 1.6 3.0

Imports 0.2 8.3 -1.2 1.5


CPI (YoY%, eop) 5.8 5.9 6.2 6.0

CPI (YoY%, avg) 5.4 6.2 6.3 6.1

Money base (YoY%) 8.3 7.6 7.0 6.5

Broad money (YoY%) 5.3 11.2 8.0 6.0


Consolidated budget balance

-2.5 -3.2 -4.2 -3.6

Interest payments -4.9 -5.1 -5.4 -5.4





Trade balance 19.4 2.4 4.0 15.0

% of GDP 0.9 0.1 0.2 0.7


% of GDP -2.4 -3.6 -3.7 -3.4

FDI (net) 65.3 64.0 60.0 65.0


FX rate (eop) BRL/USD 2.04 2.34 2.35 2.50


Government debt (gross)* 58.8 57.2 59.6 62.0

Domestic 55.9 54.1 56.6 59.1

External 2.9 3.1 3.0 2.9


in USDbn 440.6 482.8 514.8 539.8


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 3Q15

Selic 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 2.29 2.35 2.35 2.45

(*) Includes central government, states, municipalities and SOEs. Source: National Statistics, Deutsche Bank forecasts

11 September 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. Although inflation was up in August, price increases are expected to continue decelerating as the effects of the CLP depreciation fades away. In the meantime, the tax reform is heading to its final approval after including some corrections that should 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 ease monetary policy further.

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. Nonetheless, this is likely to demand more monetary easing ahead, while fiscal constraints prevent a broader and bigger counter-cyclical stance. Inertia in investment decisions and lags in consumption to monetary stimulus represent the main threats to a potential rapid rebound.

Deciding how much to ease

Activity disappointments just worsen Economic activity, according to the Central Bank’s monthly proxy IMACEC, increased by 0.5% MoM and 0.9% YoY during July. Although a modest growth, it came out much better than the stagnation most analysts were expecting for the month. The main driver of the monthly result was a positive performance in services and mining, while manufacturing, wholesale commerce and the automotive industry posted contractions. This notwithstanding, and incorporating the decelerated path Chilean growth has followed in recent months, we have revised downward our forecasts for GDP this year to 2.0%. Activity should continue to improve gradually during 2015, but remaining uncertainty about investment recovery is likely to keep next year’s growth limited, or around 3%.

During July, industrial production dropped by 2.6% YoY, with a leading negative contribution from manufacturing that decreased by 4.1% YoY due to lower production of common metal items. The mining sector also contributed negatively to the monthly variation of the sector, although to a lesser extent, reporting a decrease of 2.4% YoY, mainly as a result of lower copper production. Utilities were the only sector that posted an increase in activity during July, with +2.4% YoY. Likewise, retail sales posted a modest

increase of 1.5% YoY, confirming the on-going deceleration in consumption.

Meanwhile, the health of the labor market has remained resilient to the fluctuations seen in activity. The rate of unemployment came out at 6.5% for the May-July moving quarter, representing an increase of 0.8pp compared to last year but remaining unchanged on the quarter. The proportion of independent workers is still growing, partially offsetting the drop in occupation levels. The main increase in employment was seen in health and social services (+12.2% YoY), while the biggest drop was reported in retail (-2.1% YoY). Subdued economic growth was partially reflected in some slowdown in the growth of employment and the labor force, advancing by 1% YoY and 1.8% YoY, respectively compared to 2% pace before.

CLP challenges inflation deceleration Consumer prices increased by 0.3% MoM during August, above the 0.2% MoM posted during the previous month, remaining at 4.5% YoY. Foods and non-alcoholic beverages posted the most important increase during the month (+0.9% MoM), followed by apparel (+2.5% MoM) and alcoholic beverages and tobacco (+1.8% MoM), while the main drop was reported in transport prices (-0.5% MoM). The CPI measure, excluding food and energy, the preferred core measure of the Central Bank, increased by 0.4% MoM, accelerating from the 0.2% MoM posted during July. In addition, non-tradable inflation increased by 0.2% MoM (3.4% accumulated), decreasing by 0.1pp compared to the previous month. Conversely, tradable inflation increased by 0.4% MoM (2.9% accumulated) against the 0.2% MoM recorded the previous month.

Inflation in September is also likely to remain high due to seasonal factors, as well as in the last two months of the year, affected by the impact of the tax reform. Therefore, annual inflation for the remainder of the year is unlikely to fall below 4.1-4.2%. Nevertheless, inflation next year should rapidly converge to the 3% as this year’s shocks are left behind and the weak economy provides some room for price absorption.

The Central Bank fines tune monetary easing The minutes of the last monetary policy meeting of the Central Bank confirmed that the monetary authority has decided to maintain its easing cycle. Although the board members decided to cut its reference rate by 25bps once again in August, the discussion included the possibility of a 50bps cut. This revealed that the majority of the Central Bank members share the view that more cuts are needed, albeit at a gradual pace,

11 September 2014 11 September 2014

EM Monthly: Struggling to Gain Traction EM Monthly: Struggling to Gain Traction


given the relatively high inflation still in place. Therefore, we expect the easing process to move forward, consistent with a lackluster economic performance and increasing risks of further deceleration in demand growth. During the last monetary policy report, the Central Bank reduced its growth projection to a figure between 2.25% and 1.75%, from the 3.5-2.5% expected in June. This suggests the reference rate could be down by 2.75% by December, before further evaluating any additional change in the monetary policy stance.

Inflation challenges rate cuts while activity permits

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14

Headline CPI Policy Rate 3MMA IMACEC%YoY

Source: Central Bank and Deutsche Bank

Tax reform and public investment to the rescue The tax reform seems ready to be passed by Congress after the government reached an agreement with the opposition over the most controversial topics of savings incentives and financing for small- and medium-sized enterprises. This agreement is believed to have helped reduce some of the uncertainty created by the original initiative, which should favor recovery in investment demand in the months to come. Nevertheless, the weakening commodity cycle together with the tax burden of the reform will inevitably keep investment decisions subdued in the short term. The project will be revised for the finance commission this week and it is expected to move forward to the deputy chamber for its approval shortly after.

Aiming at fostering a faster economic recovery, President Michelle Bachelet announced a plan of public investment that will inject USD500mn to the local economy, or 0.2% of GDP. According to the authorities, half of the resources will come from reallocations within the treasury, while the other half will come from money collected from the tax reform. The goal is to concentrate on investment in the remaining four months of this year, creating 11,500 new job positions starting in October. Ms. Bachelet also announced a strengthening of infrastructure concessions up to USD2,600mn in new contracts up to March 2016.

Gustavo Cañonero, New York, (212) 250 7530

Chile: Deutsche Bank forecasts 2012 2013F 2014F 2015F

National income

Nominal GDP (USDbn) 266.6 277.1 264.6 269.3 Population (m) 17.4 17.6 17.7 17.9 GDP per capita (USD) 15,318 15,785 14,921 15,033 Real GDP (YoY%) 5.4 4.1 2.1 3.1 Priv. consumption 6.0 5.6 2.7 3.0 Gov't consumption 3.4 4.2 5.6 6.0 Investment 10.2 -2.3 -12.9 1.5 Exports 1.1 4.5 1.5 2.9 Imports 4.9 2.6 -6.9 3.0 Prices, money and banking CPI (YoY%, eop) 1.5 2.8 4.1 3.0 CPI (YoY%, avg) 3.0 1.9 4.2 3.3 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 External Accounts (USDbn) 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 3.3 3.1 Current account balance -9.1 -9.5 -4.6 -4.9 % of GDP -3.3 -3.5 -1.7 -1.8 FDI (net) 7.0 9.3 9.6 10.0 FX reserves 41.6 41.1 40.7 41.5 FX rate (eop) USD/CLP 479 524 590 590 Debt indicators (% of GDP) Government debt 6.3 7.4 8.0 8.9 Domestic 3.9 5.3 6.1 7.2 External 2.5 2.1 1.9 1.7 Total external debt 44.1 47.2 51.0 52.2 in USDbn 117.6 130.7 134.9 140.6 Short-term (% of total) 18.9 15.1 14.5 14.5 General (avg) Industrial production (%) 3.0 3.6 0.7 2.9 Unemployment (%) 6.5 6.0 6.4 6.5 Financial markets (eop) Spot 14Q3 14Q4 15Q2 Overnight rate (%) 3.50 3.25 2.75 2.75

3-month rate (%) 3.88 3.50 3.00 3.00

USD/CLP 591 590 590 590 Source: DB Forecasts and, National Statistics

11 September 2014



Colombia Baa3 (positive) /BBB (stable) /BBB (stable) Moodys /S&P/ /Fitch

Economic outlook: The new Santos administration hit the ground running, announcing a new tax reform that should be passed before year end to cover the gap between revenue and expenditure expected for 2015. The bulk of the proposal is the extension of two sources of revenues that were supposed to expire in 2014: the financial transactions tax and the wealth tax. Economic activity has remained strong while inflation remains at the mid-level of the target range. However, seasonal factors and base level effects would imply a slight acceleration of inflation towards the end of the year.

Main risks: The decrease in oil production during the first half of the year has shown the vulnerability of fiscal accounts to mining related revenue amid the necessity to comply with the fiscal rule. External accounts have also deteriorated in the last few months due to lower exports. An overreaction to the increase in inflation expectations by hiking monetary policy could derail economic activity amid a less supportive external outlook.

Closing gaps in economic activity and fiscal accounts

Output growth at potential while inflation on target Economic activity numbers point to a stabilization of the growth rate slightly below 5%, markedly below the 6.2% YoY growth rate experienced during 1Q-2014 and closer to the level considered by economic authorities to be the potential growth rate of the economy.

Industrial production continued showing mixed results, decreasing by 2% YoY in April, recovering to grow 2% in May and falling again by 0.62% in June. However, for 2014 manufacturing activity continues showing positive growth rates after two years of negative or close to null growth average rates. The recent bout of currency depreciation should alleviate the pressure on industrial sector competitiveness, which members cite as one of the causes of the subdued behavior in manufacturing. Retail sales have continued growing at a decent pace during the year (6.5% on average) even though the growth rate in June plunged to 2.2 percent YoY. Respondents to the survey blamed the decrease in the number on a lower client base due to the World Cup; however, appliances sales increased by 20.5% YoY due to the same factor. We expect that July’s numbers for retail sales will also be impacted by this factor, while there should be a marked recovery during August, confirming the positive trend experienced during the year.

The trade balance turned negative in the first half of the year (USD 1.12 bn) compared to a surplus of USD 1.8 bn for the same period in 2013. Exports decreased by 1.3 bn while imports have increased by 1.7 bn, explaining the deficit in external accounts. The fall in exports is related to lower-than-expected oil production due to an intensification of terrorist attacks by guerilla movements in the oil infrastructure. In July, oil exports recovered by 8.5% compared with the same month last year due to an increase in oil exports of 6.4% and an increase in agriculture, food, and beverages of 23.6%. The increase in imports have been related to large increases in gasoline due to a temporary decline in refining capacity because of the project to increase capacity in the country’s largest refinery. However, we expect the vulnerability of external accounts to disruptions in oil production and exports to continue as this strategy has been used by these groups to gain power in the peace negotiations.

The monthly index of economic activity shows that the rate of growth in the second quarter has slowed down. However, an annual growth rate in real GDP slightly below 5% should be expected during the April-June period. This level is in line with the estimates cited by economic authorities as the potential rate of growth of the economy, and the period of growth above this growth rate would have achieved the closing of the output gap.

Monthly index of Economic Activity (yoy growth )

Source: Deutsche Bank Research and DANE

Inflation reaches mid level of target range In August, CPI inflation reached 3.02% after growing 0.20% during the month. For 2014, the accumulated figure reached 2.94%, above the 1.86% number in 2013 for the same period. The largest contributors to the increase in the monthly rate were food and housing, growing by 0.35% and 0.29%, respectively. As the graph below shows, the trend in the acceleration of inflation is clear from the low numbers experienced at end-2013. In our opinion, this trend

11 September 2014



should continue during the rest of the year but the increases in the price level should be contained below 3.5%.

Inflation accelerates to mid-level of target range

0%

1%

2%

3%

4%

5%

Aug

-11

No

v-11

Feb

-12

May

-12

Aug

-12

No

v-12

Feb

-13

May

-13

Aug

-13

No

v-13

Feb

-14

May

-14

Aug

-14

CPI CPI Core

CPI Core trimmed means Tradables

Non-Tradables Source: Deutsche Bank and DANE

Close to the end of monetary policy normalization The closing of the output gap and anchored inflation expectations imply that the hiking cycle that started in April is close to an end. Monetary authorities have stressed that the aim of monetary policy in the current environment has not been to turn contractionary but rather to be neutral after a long period of stimulus. We expect Banrep to hike 25bps more in the September monetary policy meeting and leave the intervention rate unchanged at 4.75% for the rest of the year. A stronger-than-expected increase in inflation expectations due to the seasonal factors explained above could force monetary authorities to continue hiking during the last quarter. However, we believe this possibility is not likely as authorities will likely try to send the signal that the increase in inflation is temporary and the hikes already experienced would need to take effect in economic activity and inflation during the rest of the year.

Extension of “temporary” taxes to bridge fiscal gap Minister Mauricio Cardenas and Deputy Minister Andres Escobar have stated in interviews that the government will present to Congress a tax reform extending the wealth tax and the financial transactions tax for four more years before year end. These taxes had been scheduled to expire and cut in half, respectively, in 2014 with a phasing down of the financial transaction tax in the years ahead. Since their inception, more than a decade ago, the first one to help with the increase in security expenditure and the second one to bailout the financial system after the end of century financial crisis, have been deemed as temporary but different administrations have continued extending them. We expect that Congress will pass this law although opposition and debate should be expected.

Armando Armenta, New York, (212) 250 0664

Colombia: Deutsche Bank forecasts 2012 2013 2014F 2015F


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


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


Fiscal accounts (% of GDP)*


Revenue 16.1 16.8 17.0 17.1

Expenditure 18.4 19.1 19.4 19.3


External accounts (USD bn)

Goods Exports 61.0 60.0 60.6 60.7

Goods Imports 56.7 57.0 58.9 60.3


% of GDP 1.2 0.8 0.4 0.1


% of GDP -3.2 -3.4 -3.9 -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 1990 2050

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 22.2 21.5

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 14Q3 14Q4 15Q2

Policy rate (overnight rate) 4.50 4.75 4.75 4.75

3-month rate (DTF Rate) 4.10 4.30 4.50 4.60

COP/USD (eop) 1970 1960 1970 1990

Source: Deutsche Bank and National Sources

11 September 2014



Mexico A3 (stable)/BBB+ (stable)/BBB+ (stable) Moody’s/S&P/Fitch

Economic outlook: Activity recovered slowly in 2Q2014, so the economy expanded 1.7% in the first semester of the year. Even if GDP accelerates significantly in 2H2014, growth this year seems bound to disappoint. Low growth in 1H2014 remained a combination of flat non-autos manufacturing, weak construction activity and sluggish domestic demand. However, the latest indicators suggest that the first two drags are reversing, as manufacturing activity seems now in a broader-based recovery and construction is gaining traction on the infrastructure side. On the other hand, domestic demand has remained weak due to flat private consumption following low levels of consumer confidence. We maintain our view that the economy will recover significantly in the second semester, but subpar growth in the first half will drag GDP growth this year to 2.3%YoY. In this context, inflation has climbed due to seasonal factors combined with negative shocks to specific foods. A deterioration of the inflation outlook led the Central Bank to adopt a more hawkish stance in the last policy decision and now we see the door to further cuts shut. We anticipate that Banxico will start to hike rates in tandem with the Fed in 2Q2015 at the earliest. Finally, it is worth highlighting that the reform process that started last year was completed with the approval of the energy and telecommunications bylaws in July. In the coming months, we will follow the discussion and approval of the 2015 Economic Program, which seems uneventful except for some concerns about the public deficit.

Main risks: With the reform agenda now complete at the legislative level and its implementation on track, domestic risks seem more limited. We see the main risks coming from an excessive volatility associated to the normalization of monetary policy in the US and/or a delayed recovery of external demand. The effects of such a negative scenario could be amplified by a deterioration of geopolitical tensions coming from the Middle East and/or Ukraine that affects the mood towards Emerging Markets.

A slow recovery in 2Q2014

Economic activity likely to accelerate further in 2H2014 According to the Economic Activity Global Index (IGAE) for June and the 2Q2014 GDP, activity gained momentum by mid-year. It grew 0.23%MoM and 2.7%YoY in the sixth month of the year, an acceleration of the economy with respect to May which was above expectations. Activity in June was dragged by

industrial production, which fell 0.18%MoM, while services remained resilient and grew 0.33%MoM. This result has important implications, as services anchored growth in 2013 and early 2014 but seemed to be losing resilience relatively fast.

Economic activity (%YoY, 3mo avg)

-10

-8

-6

-4

-2

0

2

4

6

8

10

20

09

/01

20

09

/04

20

09

/07

20

09

/10

20

10

/01

20

10

/04

20

10

/07

20

10

/10

20

11

/01

20

11

/04

20

11

/07

20

11

/10

20

12

/01

20

12

/04

20

12

/07

20

12

/10

20

13

/01

20

13

/04

20

13

/07

20

13

/10

20

14

/01

20

14

/04

IP Services

Source: INEGI

Contrary to the growth pattern seen in 1Q2014, the latest IGAE reading suggests that activity accelerated throughout 2Q2014, so overall GDP came out slightly above expectations. Seasonally-adjusted GDP grew 1.04%QoQ in the second quarter, above expectations and gaining steam considerably with respect to 1Q2014. This puts the GDP annual growth rate for 2Q2014 at 1.6%YoY, slightly above expectations.

From the economic activity indicators for June and 2Q2014, we highlight the following. First, even though industrial activity dropped on a monthly basis in June, due partly to a hiccup in the production of motor vehicles, its composition improved slightly. Manufactures other than autos grew faster and prospects for construction activity improved as the buildings component has maintained steam in spite of weak housing and now the infrastructure component has broken its downward trend. As external demand for autos is expected to remain strong, this points towards a broad-based recovery of industrial activity. Second, the latest IGAE points toward a sustained resilience of services, which grew moderately in June despite a drop in secondary activities. If IP continues to recover as expected, services are likely to pick up more strongly in the coming months.

These results reiterate that a moderate recovery of activity is under way and they are consistent with our 2.3%YoY GDP growth forecast for 2014. As the economy expanded 1.7%YoY in 1H2014, our forecast

11 September 2014



implicitly assumes that activity will accelerate to reach 2.9%YoY in the second semester of the year. The latest indicators support our view that such acceleration will be driven by a broad-based recovery of manufacturing activity and a clear pick up in construction activity.

Construction (Jan12=100)

87

89

91

93

95

97

99

101

103

105

20

12

/01

20

12

/03

20

12

/05

20

12

/07

20

12

/09

20

12

/11

20

13

/01

20

13

/03

20

13

/05

20

13

/07

20

13

/09

20

13

/11

20

14

/01

20

14

/03

20

14

/05

Total

Buildings

Infrastructure

Source: INEGI

A slow recovery in 2Q2014 caused expectations to continue to deteriorate. The latest Banamex survey of economic analysts shows that expected GDP growth for this year is now 2.48%YoY, way down from 4% expected by mid-2013. Similarly, Banxico’s monthly poll among economic analysts shows that growth expectations for 2014 were revised and are now at 2.47%YoY, down from the previous survey. The consensus still implies that the economy has to accelerate above 3.2%YoY in the second semester which, in our view, is unrealistic. It is worth mentioning that expected growth for 2015 in both the Banamex and Banxico surveys has remained unchanged at 3.85%YoY.

The few major indicators available for 3Q2014 show that the recovery of manufacturing activity continues to gain momentum. The HSBC-Markit purchasing managers’ index for Mexico manufacturing rose significantly in August and went firmly above the 50-point threshold that anticipates an expansion. This is the highest reading since January 2014 but its components still offer a mixed picture. The employment sub-index rose above the threshold and is now at the highest reading since March 2014 but the new orders sub-index declined and is now at the lowest reading since October 2013. Similarly, the Mexican Institute of Finance Executives (IMEF) also released its indicators for August. The seasonally-adjusted index for manufacturing activity rose well above expectations and above the 50-point threshold that anticipates an expansion. The company-weighted index also rose significantly, suggesting that the recovery in manufacturing activity remains biased towards big businesses. On the other hand, the seasonally-adjusted index for non-manufacturing

activity increased, thus suggesting that domestic demand is set to improve. Taken together with the HSBC-Markit manufacturing index, IMEF indicators clearly show that activity is accelerating.

The National Automotive Industry Association (AMIA) released domestic sales, total exports and production of autos and light trucks in August 2014. Domestic sales grew solidly at 17.6%YoY, one of the fastest expansions of record. Domestic sales are an important support for the auto industry but with projected sales of 1.1m units in 2014, it remains below potential (we estimate that sales should be at around 1.9m, considering Mexico’s population and income level). On the other hand, exports fell slightly in August, 0.1%YoY. We see such a drop as a hiccup due to the shipping of some orders, rather than a change in trend, as the overall behavior of exports remains clearly strong. As exports account for approximately 80% of overall production, the latter continued to grow strongly. Total output reached 271.4k units in August, 4.7%YoY up and the largest production for that month on record. Since the production of autos and light trucks account for 19.8% of manufacturing activity and 3.5% of GDP, we expect this sector to remain an important source of growth in 2014 and 2015.

Motor vehicles (million)

0.7

1.2

1.7

2.2

2.7

3.2

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Jan

-09

Jul-

09

Jan

-10

Jul-

10

Jan

-11

Jul-

11

Jan

-12

Jul-

12

Jan

-13

Jul-

13

Jan

-14

Jul-

14

Sales (last 12mo, m)

Exports (last 12mo, m)

Production (last 12mo, m)

Source: AMIA

On the other hand, domestic demand has remained sluggish. The National Retailers Association (ANTAD) released same-store sales, which grew 2.2%YoY in July-August. It is not surprising that private consumption remains weak, as consumer confidence has recovered slowly. According to INEGI, the consumer confidence index for August 2014 came out well below expectations and diminished with respect to July, a 0.28%MoM drop. It is worth noticing that, notwithstanding that three out of five components grew on a monthly basis, a large drop of the sub-index measuring the perceived capacity to purchase durable goods explains the overall fall. Thus, after a vigorous recovery early in the year, consumer confidence decelerated and remains well below 2013 levels,

11 September 2014



7.9%YoY down with drops on all five components on a yearly basis. This strongly suggests that private consumption is likely to stay weak for the remainder of the year.

Retail sales and consumer confidence (Jan11=100)

90

92

94

96

98

100

102

104

106

108

110

20

11

/01

20

11

/03

20

11

/05

20

11

/07

20

11

/09

20

11

/11

20

12

/01

20

12

/03

20

12

/05

20

12

/07

20

12

/09

20

12

/11

20

13

/01

20

13

/03

20

13

/05

20

13

/07

20

13

/09

20

13

/11

20

14

/01

20

14

/03

20

14

/05

20

14

/07

Retail sales (SA, Jan11=100)

Consumer confidence (SA, Jan11=100)

Source: INEGI

On the investment side, indicators come with a significant lag and data is not available for 3Q2014. However, gross fixed investment grew 0.2%MoM and 2.2%YoY in June, maintaining a mixed picture with no clear outlook for recovery. Machinery and equipment dropped 3.7%MoM and construction grew 1.5%MoM in June. On a yearly basis, the picture is not clear also, as machinery and equipment grew 3.7%YoY and construction 1.3%YoY. We maintain our view that the pickup in residential construction may be due to existing projects and it may lose steam in the months ahead. On the other hand, while the recovery of infrastructure remains elusive and drags the non-residential component, public works are expected to account for a stronger recovery ahead.

Contrary to our expectations, credit has not become an engine of domestic demand yet. The latest bank lending report for July shows that net outstanding loans continue to decelerate and grew 4.1%YoY in real terms. Annually, the fastest-growing item in real terms is loans to non bank intermediaries, 13.4%YoY, which is the smallest component of total loans (4.6%). Among the major components, loans to companies grew 3.8%YoY real, mortgages up 3.7%YoY real and consumption loans increased 3.2%YoY real. Bank loans as a proportion of GDP stand below 15%, which compares negatively to ratios seen in other EMs. We are becoming increasingly skeptical that the financial reform recently approved will deliver a faster growth of commercial bank loans in the second semester of 2014 or even in 2015, and this role may be taken to some extent by development banks.

On the domestic demand front also, it is worth stressing that the latest indicators for labor markets came out well below expectations. The unemployment

rate for July 2014 stood at 5.47%, well above expectations (4.97%) and above the unemployment rate of July 2013, which stood at 5.12%. This is a disappointing result, particularly if we consider that the participation rate has dropped slightly in the last year. July’s unemployment rate is a clear deviation from the medium-term downward trend. We expect this downward trend to remain in place as the economy accelerates throughout 2014 and 2015, but July’s result challenges that view. Similarly, the seasonally-adjusted unemployment rate reached 5.19% in July, up from 4.84% in June.

In this context of a slow recovery, inflation has been consistently above expectations in the last months. August CPI inflation came out at 0.36%MoM, so the annual rate climbed to 4.15%YoY, well above the upper limit of the Central Bank’s target range. The recent pickup in inflation is explained by a combination of seasonal factors and supply shocks to meat, pork and poultry. We expect the effects of these shocks to be persistent and continue to show on September and October CPI inflation. We maintain our view that inflation will climb further and reach levels around 4.4% in September as seasonal pressures unfold. As headline CPI inflation has been surprising to the upside in 2H2014, we now adjust our forecast for year-end to 4.0% (prior 3.8%). Our forecast still implies that seasonal pressures will recede by year-end but now we see a slim chance that the target range of the Central Bank will be met.

CPI inflation (%YoY)

2.0

2.5

3.0

3.5

4.0

4.5

5.0

20

12

/02

20

12

/04

20

12

/06

20

12

/08

20

12

/10

20

12

/12

20

13

/02

20

13

/04

20

13

/06

20

13

/08

20

13

/10

20

13

/12

20

14

/02

20

14

/04

20

14

/06

20

14

/08

CPI

Core

Source: INEGI

For 2015, the inflation outlook still looks favorable since the government will likely reduce the growth pace of gasoline prices as announced. However, we expected the 2015 Economic Program to shed more light on the policy on government-controlled prices for gasoline and diesel to be followed next year. It fails to clarify two things: First, the magnitude of the increase of gasoline prices, merely stating that it will be “in line with expected inflation.” Secondly, the timing of the increase, which could be either a gradual change

11 September 2014



throughout the year (slide) or a one-off hike in early 2015. The Ministry of Finance has signaled that the latter would be the case, but not much concrete information has been provided. Different scenarios for gasoline prices may have important implications for CPI inflation next year (a one-off hike early in the year would front-load inflation and reduce pressures by year-end).

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 seemed convinced that the moderate recovery under way and a headline CPI inflation now 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 more hawkish tone going forward. More importantly, the communiqué has a drastic change in the tone about inflation, pointing out that part of the recent increase in inflation is due to unexpected rises in prices of meat and poultry, which Banxico expects to show persistence. Noticeably, the Central Bank points explicitly to a deterioration of the balance of risks for inflation and anticipates that it will be on the brink of missing the target at the end of 2014.

Headline CPI inflation in 2014 (%YoY)

Observed

Forecast

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 cements 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 the hawkish tone in the communiqué following the decision, 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 and expect it to hike in tandem with the Fed in 2Q2015 at the earliest.

Reform agenda and Economic Program for 2015 The reform agenda that started last year at the constitutional level was completed in late July with the approval of the energy bylaws in Congress. Thus, the secondary legislation for the two most important reforms, telecommunications and energy, is now complete and the challenges ahead lie in the implementation issues. Two elements of the energy reform in the last stage of discussions were particularly important: Pemex’s round zero approval and the mandate for the federal government to undertake the pension liabilities of Pemex and CFE.

Regarding round zero, the Ministry of Energy announced a month ahead of schedule that Pemex will be allowed to keep 100% of proven reserves (1P), 83% of proven plus probable reserves (2P) and 21% of proven, probable and prospective reserves (3P). This is in line with the company’s request back in March and with expectations. The only surprise was that the Ministry awarded less prospective reserves (Pemex requested originally 71% of 3P). This comes as good news, as it implies that private companies will have more attractive fields to start with in approaching the newly reformed energy sector, thus sparking long-term participation.

The second element is the legal mandate that came along with the energy reform for the federal government to undertake Pemex and CFE unfunded pension liabilities. This step would strengthen the companies, make the financial position of the public sector more transparent and boost financial saving by enlarging the Afores system. The reform basically involves streamlining current pensions to retired workers and getting active and prospective employees into the existing fully-funded pensions system. As a result, we expect the Afores’ assets under management to grow to 23% of GDP by 2015 due to the extra retirement funds. The transition under the baseline scenario implies an orderly undertaking of existing obligations into public debt, which would go from 37% in 2014 to 43% of GDP in 2015. While a positive step, we see some risks and concerns in the implementation of the pension reform that may either limit potential savings or create some distortions in the market of government securities. Fundamentally, the proportion of active workers that are allowed to stay in the old system, inflated accrued benefits for active workers, and cash payments of accrued benefits, may hinder the fruits of this pension reform (see the Special Report “Mexico: Undertaking Pemex and CFE pension liabilities” in this issue).

Finally, on September 5 the Ministry of Finance sent the Economic Program proposal for 2015 to Congress for discussion and approval. The package encompasses the Revenues Law, the Federal Budget and the General Economic Policy Guidelines, which contain the macroeconomic and public finances

11 September 2014



outlook for 2014 and 2015. Unlike in previous years, the package for 2015 does not contain a specific tax program, as no new fiscal obligations are considered in the proposal. According to the Law, the revenues proposal has to be approved by Congress before mid-November and the budget before mid-December, thus completing the legislative process. Since no new taxes are considered, we expect this year’s to be a relatively smooth process.

The proposal contains conservative expectations on growth and the main macroeconomic variables for 2014 and 2015. Mainly, the official GDP growth forecast for this year is maintained at 2.7%YoY and next year’s is 3.7%YoY. It is worth noticing that expected growth for 2015 is below the consensus among private sector analysts. Similarly, the prospects for the MXN/USD exchange rate, interest rates, current account, and oil prices and production are conservative.

Nevertheless, there are some concerns about the fiscal effort to reduce the deficit in 2015 and the assumption of pension liabilities of Pemex and CFE into public debt. The proposal supposedly meets the multi-year target stated in the 2014 Program of reducing the deficit by 0.5% of GDP in 2015. However, since the government is asking Congress to remove investments of Pemex, CFE and high-impact projects from the headline deficit, the overall balance drops only from 3.6% of GDP in 2014 to 3.5% in 2015. This makes the PSBR to drop merely from 4.2% to 4.0% of GDP between 2014 and 2015, a fiscal effort below expectations. In our view, this could reduce the chances for an upgrade this year.

As a result of the moderate fiscal effort in the proposal, overall net indebtedness as a proportion of GDP falls mildly between 2014 and 2015. Net domestic indebtedness is requested at MXN$595bn (up from MXN$570bn in 2014) and external indebtedness is requested at USD$6bn (down from USD$10bn last year). Thus, the net indebtedness ceiling for next year is reduced by a mere 0.15% of GDP. It is worth noticing that such indebtedness limits do not consider the possibility of undertaking the pension liabilities of Pemex and CFE, as established in the energy reform bylaws (unlike the case of the Economic Program for 2008, in which the possibility of undertaking the ISSSTE pension liabilities was explicitly stated).

Alexis Milo, Mexico City, (52 55) 5201-8534

Mexico: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income


Population (m) 117 119 121 124


Real GDP (YoY%) 3.8 1.1 2.3 3.5


Gov't consumption 2.4 2.2 2.6 5.0

Investment 5.5 -0.1 2.3 4.8

Exports 4.2 1.4 3.5 3.9

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 balance*

-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 -30.9

% 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 13.1 13.0


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


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 period)

Spot 14Q3 14Q4 15Q2

Overnight rate (%) 3.00 3.00 3.00 3.00

3-month rate (%) 3.30 3.35 3.40 3.45

MXN/USD 13.20 13.10 13.10 13.00 *Corresponds to PSBR **Corresponds to PSBR accumulated balance

Source: DB Global Markets Research, National Sources




Peru Baa2 (positive)/BBB+ (stable)/BBB (neutral) Moody’s/S&P/Fitch

Main risks: The overall slowdown triggered by the fall in mining activity and exports has shown the vulnerability of the economy to a single sector. Even though we expect the delays in mining activity to be over by year end, the possibility that these delays are more permanent and the production of the projects at full capacity takes longer than currently expected would impact other sectors significatively and continue worsening external accounts.

Further monetary easing on the horizon

Generalized slowdown in economic activity In June, the deceleration experienced in economic activity deepened to a level last witnessed during the 2008-2009 financial crisis, printing at 0.3% YoY.

Manufacturing activity fell by 8.26% during the month, essentially triggered by a 22.6% fall in processing activity related to fishing, mining, and oil refining. Industrial activity not related to primary sectors, which constitutes close to 75% of total manufacturing, also fell albeit at a 1.43% YoY growth rate. This fall is explained by lower activity in clothing, furniture, and dairy products, among other manufacturing sectors.

Mining during June showed an annual deceleration of 5.93%, posting negative numbers for the third consecutive month. Metals decreased by 6.81% due to lower production of gold (-20.36%), zinc (-20.83%), and molybdenum (-23.37%). Copper recovered, growing by 3.93%, with silver growing by 6.37%, iron by 3.97%, and lead by 0.14%. The reasons behind this protracted decline in mining activity are related to lower volumes given lower quality in the sectors of the mines currently being exploited, the temporary halts in production in some mines due to lower international prices, and the permanent close of a large gold mine. The agricultural sector also fell sharply at 5.6% during June, which is explained by lower production of rice, coffee, tomatoes, corn, and wheat, among others.

Economic activity continues to decelerate

Source: Deutsche Bank and Haver Analytics

On the other hand, the financial sector continued growing at a 12.5% annual rate during June, with credit in domestic currency growing at a 25.75% rate and foreign currency at a 6.71% rate. Overall, services (transportation, retail, telecommunications, personal and governmental services, as well as construction, more importantly) showed positive growth rates, pushing up the aggregate rate.

In sum, the recent slowdown in economic activity has been characterized by a sharp contraction in the tradable sector of the economy (mining, manufacturing, and agriculture), while the non-tradable sectors (financial, construction, transportation, and communication) have continued growing, albeit at lower growth rates than in the recent past. This increase in relative supply of non-tradables to tradables should be translated into a real exchange rate depreciation.

It is not only mining (YoY growth)

Source: Deutsche Bank and INEI

11 September 2014



Inflation finally responding to the slowdown in activity

Source: Deutsche Bank and BCRP

Inflation cedes and falls to the target range During August, the fall in economic activity finally translated to lower inflation numbers. As the graph above shows, the behavior of electricity and fuel prices had precluded the headline rate from falling below 3%, the upper-level of the target range. However, after cuts in electricity prices in 24 cities and the fall in residential, utilities, transportation, and communication, the overall headline rate also fell. We expect this behavior to continue in the coming months as the slowdown in activity continues to year end.

Monetary and exchange rate policy The fall of inflation experienced in August will give larger incentives for monetary authorities to deliver an extra cut in the policy rate of 25 bps during September’s meeting and an easing of credit conditions with continued cuts in domestic currency reserve requirements.

The BCRP has tried to lean against the wind in the recent episode of currency depreciation, intervening with the selling of dollar denominated certificates of deposit. We do not expect an aggressive defense of a level for the nominal exchange rate due to the structural factors mentioned above, which would require a weaker real exchange rate. However, given that the economic authorities expect a recovery in the production of tradables, especially related to mining, exchange rate policy would still try to minimize periods of extreme volatility.

Armando Armenta, New York, (212) 250 0664

Peru: Deutsche Bank forecasts

2012 2013 2014F 2015F

National Income


Population (m) 30.0 30.5 31.0 31.5


Real GDP (YoY%) 6.3 5.0 4.0 6.0




Exports 6.4 1.0 2.2 6.0

Imports 10.4 5.2 5.5 8.0


CPI (eop) 2.7 3.0 3.1 3.0

CPI (ann. avg) 3.7 2.5 3.2 2.6

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



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 -4.8 -4.5

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


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 26.2 27.6

in USD bn 48.8 52.9 56.0 62.2


General (ann. avg)


Unemployment (%) 6.9 6.8 6.9 6.8

Financial Markets (%, eop) Spot 14Q3 14Q4 15Q2

Policy rate 3.75 3.50 3.50 4.50

3-month rate 4.65 4.90 5.00 5.00

PEN/USD (eop) 2.86 2.88 2.90 2.92

(*) General Government Source: DB Global Markets Research, National Sources




Venezuela Caa1 (negative)/B (negative)/B+ (negative) Moody’s/S&P/Fitch

Economic outlook: The unexpected cabinet shuffle that moved Minister Rafael Ramirez from the management of economic policy to foreign affairs implies more delays in the much needed stabilization program. The sharp fall in imports experienced during the first half of the year has implied a fall in economic activity, rampant inflation, and black market exchange rate depreciation. In our opinion, economic vulnerability continues to increase, but a default in financial debt in the short term remains unlikely.

Main risks: The accumulation of macroeconomic imbalances continues to fuel inflation and scarcity, which could reignite public discontent and protests. The vulnerability of external accounts to changes in oil revenue and the low level of liquid reserves continue to be the main risk given the high reliance on imports of basic goods.

Economic policy shakedown prolongs inaction and imbalances

The stabilization is delayed once again Prospects of a stabilization plan to correct the macroeconomic imbalances that had been announced in recent months took a serious hit with the departure of Minister Rafael Ramirez from the helm of economic policy. The joint position as VP of Economic Affairs, Minister of Oil and Mining, and President of PDVSA indicated the possibility of coordination and resolve in the measures. With this shuffle, even though parts of the plan should not be discarded, the possibility that more radical sectors inside the government could gain power and block the measures has increased.

Minister Ramirez had announced several measures that would have helped in alleviating the macroeconomic imbalances that make the economy less vulnerable. Among the most needed are the devaluation and unification of the exchange rate, consolidation of foreign currency liquidity sources under the Central Bank, elimination of fuel subsidies, tightening of liquidity and fiscal profligacy. The possibility of all these measures taken suddenly or to a full extent had always been farfetched due to rigidity in ideology and political constraints. However, the acceptance by Minister Ramirez of the need to undertake them showed a clear improvement from past members of economic policy makers and hinted at the possibility of first steps toward normalization.

President Maduro appointed Minister of Finance and Public Banking Rodolfo Marco Torres as VP of Planning. Minister Marco-Torres had been public

banking Minister and is a Venezuelan Army general that has been in charge of different posts among the economic policy maker team. Asdrúbal Chavez, also a longtime member of authorities related to the oil sector was named as the new Minister of Oil and Mining, while Eulogio del Pino a geo-physics engineer by training with a Masters in Exploration from Stanford University 22 , who was also formerly the VP of Exploration and Production of PDSVA, was promoted to head the state oil company. In sum, the main takeaway from these appointments should not be that these individuals would not agree with the measures needed to correct the imbalances, but that the power inside the government that Ramirez had accumulated recently will most likely be dissipated among these posts, delaying the adjustment once again.

Instead of the stabilization plan that had been announced, the economic authorities seem willing to continue fighting inflation and scarcity through quantitative measures and price controls. Moreover, the policy choice seems to be to continue with a multi-tiered exchange rate system with significant restrictions to access hard currency for imports. In our opinion, the delays in the stabilization plan will only exacerbate the imbalances as well as increase the economic costs and the vulnerability to domestic or external shocks.

One timid step forward, several steps back Of all the measures that had been hinted as possible the only one timidly approached was the opening of a government account at the Central Bank to consolidate different funds. This account would be started with USD750m, according to a statement by Minister Marco Torres. We would expect that resources from FONDEN or the different Chinese Funds, which constitute extra liquidity of the public sector, would also be consolidated into this account. This step would bring greater transparency to the public sector’s liquidity conditions. However, economic authorities have not made further announcements regarding this topic.

Some timid increases in administered prices have also been decreed as well as a shift of sectors from the CENCOEX (6.3 VEF/USD), to the SICAD (11 VEF/USD), and SICAD II (around 50 VEF/USD), effectively delivering a devaluation.

22 According to Mr. Del Pino’s biography at PDVSA’s website:

http://www.pdvsa.com/index.php?tpl=interface.en/design/junta2.tpl.html&

newsid_obj_id=9219&newsid_temas=77

11 September 2014



How did the Venezuelan economy get to this situation and why is the stabilization delayed? Characterizing the path of economic conditions and policy responses that have brought Venezuela to the current situation remains important to understand the effect of economic measures and the possible outlook. Arguments for an imminent credit event in external indebtedness have recently gained traction.

The economic authorities in Venezuela have embarked on a high government expenditure agenda coupled with expansionary domestic credit conditions to finance the public sector’s deficit for more than a decade. The growing expenditure is the result of large subsidies to different sectors, an increase in the public sector’s employment and overall role in the economy, with devastating results in efficiency in production and distribution in most of the sectors.

This policy mix creates pressure for a sharp depreciation of the nominal exchange rate that, to be contained requires frequent intervention from exchange authorities selling hard currency to satisfy the excess demand created by this unstable policy. To help maintain the exchange rate without losing reserves rapidly, the government enacted a strict capital controls system. Different schemes to supply dollars to the private sector have been devised in the last decade (SITME, CADIVI, CENCOEX, SICAD, SICAD II) with different characteristics, but with the same goal: restricting the amount of dollars supplied to enough levels to sustain production and consumption in an economy heavily dependent on imports.

Monetary expansion fueling capital flight and inflation

Source: Deutsche Bank and Banco Central de Venezuela

While the system supplied enough dollars, the parallel exchange rate remained close to the official and sufficient imports maintained and even spurred booms in domestic consumption and output levels. However, with stable hard currency revenues from oil exports and growing import needs (a growing part from fraudulent capital flight as repeatedly stated by the authorities), especially ahead of the 2012 Presidential

election, foreign exchange reserves nearly halved from around USD40bn to the current level of around USD20bn. Moreover, liquid reserves at the Central Bank decreased to less than USD3bn.

The dwindling foreign exchange reserves levels prompted the economic authorities to sharply decrease the supply of dollars to the private sector, while maintaining the unstable mix of policies mentioned above. The government has shown that it is unable to distinguish capital flight from the proper need of imports from the private sector and thus, has increased its participation in total imports of goods that are sold at subsidized prices to the population.

The quantitative restrictions to imports have triggered an increase in inflation to more than 60% and scarcity in controlled price goods from basic staples to inputs of production for industrial goods like pharmaceuticals and automotives. The economic authorities have tried to renege or renegotiate obligations with external suppliers of goods and services that had been promised to be able to repatriate profits at a specified exchange rate. However, the government repeatedly has assured holders of financial external debt that they would continue complying with external obligations.

Policy mix creating capital flight and eroding the public

sector’s external position


Clearly, the policy mix just described creates large vulnerabilities to external or domestic shocks and has triggered demonstrations against the government that were heightened in the February-March period. However, even though short-term liquidity conditions remain tight, revenues from oil exports and long-term solvency conditions continue to be supportive, and in our opinion, preclude the government from defaulting on external financial debt obligations. The economic authorities appear to recognize the value of access to international markets, for an economy that relies on imported goods for consumption and requires heavy

11 September 2014



external financing to develop the main sector of the economy.

A mix of ideology, waning political support, and fear of the effect on the government’s popularity based on worsening economic conditions has precluded economic authorities from taking the necessary measures to restore macroeconomic equilibrium. In our opinion, fiscal and monetary restraint along with a sharp devaluation and an increase in confidence from the foreign and domestic private sector would be needed to normalize economic conditions in the medium term. However, the immediate result of these measures would be a sharp recession and further acceleration in inflation, an outlook that the government does not seem willing to tolerate, as the further delays explained above show. In the meantime, the imbalances will continue growing along with the vulnerability to extreme external shocks.

Inflation numbers released – they are still high The Central Bank of Venezuela had not released inflation numbers for the months of June, July, and August. Inflation on an annual basis has stabilized above 60% as the graph below shows. Clearly the acceleration between 2012 and 2013 decreased after mechanisms to supply dollars to the private sector were created. However, in order to decrease these numbers a sharp adjustment would be required as discussed above that tackles the black market exchange rate and fosters domestic production.

Inflation stabilized at a high level during 2014


In sum, the current economic conditions are keeping the Venezuelan economy vulnerable to domestic and external shocks. The exit of Rafael Ramirez, an economic policy maker that had hinted at more pragmatic measures is not positive for the outlook. However, these measures should not be entirely discarded under the current economic administration.

Armando Armenta, New York, (212) 250-0664

Venezuela: Deutsche Bank Forecasts

2012 2013F 2014F 2015F

National Income


Population (mn) 30 31 31 31


Real GDP (YoY%) 5.6 1.5 -3.1 0.1

Private consumption 7.0 5.0 -2.5 2.5


Gross fixed investment 23.3 1.0 -1.0 1.0

Exports 1.6 3.0 0.5 6.0

Imports 24.4 7.0 3.0 8.0

Prices, Money and Banking (YoY %)

CPI (eop) 20.1 56.5 75.0 65.0

CPI (ann. avg) 23.8 40.0 70.0 70.0

Broad money (eop) 60.1 65.0 80.0 75.0


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 90.0 93.0

Goods Imports 58.0 55.0 45.0 50.0

Trade balance 40.0 37.0 45.0 43.0

% of GDP 10.5 8.2 9.4 8.1


% of GDP 3.7 1.6 2.9 3.4

FDI (net) 0.0 0.0 1.0 1.5

FX reserves (eop) 29.9 21.7 25.0 30.0

VEF/USD (eop) 4.30 6.30 10.00 15.0

Debt Indicators (% of GDP) (*)


Domestic 15.6 15.5 17.5 22.0

External 22.4 19.1 18.0 16.5

External debt 25.8 22.2 21.0 19.3

in USD bn 98.4 99.6 100.9 101.8


General (ann. avg)


Unemployment (%) 8.0 8.3 8.5 8.0

Financial Markets (end period) Spot 14Q3 14Q4 15Q2

Policy rate 20.6 25.0 25.0 25.0

3-month rate 14.5 15.5 15.5 17.0

VEF/USD (eop)

(*) Non-Financial General Public Sector

6.30 6.30 6.30 10.00

Source: DB Global Markets Research, National Sources

11 September 2014



Theme Pieces 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

July 2013 Foreign Ownership of EMEA Government Debt: an

Update

Introducing EM Sovereign Credit Valuation Snapshot

India: Battling Vulnerability

11 September 2014 April 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

mailto:[email protected]

mailto:[email protected]

11 September 2014



Policy Rate Forecast

Projected Policy Rates in Emerging Markets

Q3-2014 Q4-2014

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 2.10 2.30 3.00

Israel 0.25 0.25 0.25 0.25 0.25 1.25

Kazakhstan 5.50 5.50 5.50 5.50 5.50 5.50

Poland 2.50 2.50 2.00 2.00 2.00 2.50

Romania 3.25 3.25 3.25 3.25 3.25 3.75

Russia 8.00 8.50 8.50 8.50 8.50 8.50

South Africa 5.75 5.75 6.00 6.00 6.00 6.50

Turkey 8.25 8.25 8.00 8.00 8.00 8.00

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 3.00 3.50

India 8.00 8.00 8.00 8.00 8.00 7.50

Indonesia 7.50 7.50 7.50 7.50 7.50 8.00

Korea 2.25 2.25 2.00 2.00 2.00 2.50

Malaysia 3.25 3.50 3.50 3.50 3.75 3.75

Philippines 4.00 4.00 4.00 4.00 4.25 4.50

Taiwan 1.875 1.875 1.875 1.875 2.000 2.250

Thailand 2.00 2.00 2.00 2.00 2.00 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 3.50 3.25 2.75 2.75 2.75 3.00

Colombia 4.50 4.75 4.75 4.75 4.75 4.50

Mexico 3.00 3.00 3.00 3.00 3.00 4.00

Peru 3.75 3.50 3.50 3.75 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 Q1-2015 Q2-2015 Q4-2015


11 September 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

Deutsche Bank debt rating key

CreditBuy (“C-B”): The total return of the Reference

Credit Instrument (bond or CDS) is expected to

outperform the credit spread of bonds / CDS of other

issuers operating in similar sectors or rating categories

over the next six months.

CreditHold (“C-H”): The credit spread of the

Reference Credit Instrument (bond or CDS) is expected

to perform in line with the credit spread of bonds / CDS

of other issuers operating in similar sectors or rating

categories over the next six months.

CreditSell (“C-S”): The credit spread of the Reference

Credit Instrument (bond or CDS) is expected to

underperform the credit spread of bonds / CDS of other

issuers operating in similar sectors or rating categories

over the next six months.

CreditNoRec (“C-NR”): We have not assigned a

recommendation to this issuer. Any references to

valuation are based on an issuer’s credit rating.

Reference Credit Instrument (“RCI”): The Reference

Credit Instrument for each issuer is selected by the

analyst as the most appropriate valuation benchmark

(whether bonds or Credit Default Swaps) and is detailed

in this report. Recommendations on other credit

instruments of an issuer may differ from the

recommendation on the Reference Credit Instrument

based on an assessment of value relative to the

Reference Credit Instrument which might take into

account other factors such as differing covenant

language, coupon steps, liquidity and maturity. The

Reference Credit Instrument is subject to change, at the

discretion of the analyst.

http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr

11 September 2014



(a) Regulatory Disclosures

(b) 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.

(c) 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.

(d) 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.

(e)

(f)

http://gm.db.com/

http://www.globalmarkets.db.com/riskdisclosures

11 September 2014



(g) 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.

GRCM2014PROD032770

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

Michael Spencer Regional Head

Asia Pacific Research

Ralf Hoffmann Regional Head

Deutsche Bank Research, Germany

Andreas Neubauer Regional Head

Equity Research, Germany

Steve Pollard Regional Head

Americas Research

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Global Disclaimer

Emerging markets investments (or shorter-term transactions) involve significant risk and volatility and may not be suitable for everyone. Readers must make their own investing and trading decisions using their own independent advisors as they believe necessary and based upon their specific objectives and financial situation. When doing so, readers should be sure to make their own assessment of risks inherent to emerging markets investments, including possible political and economic instability; other political risks including changes to laws and tariffs, and nationalization of assets; and currency exchange risk.

Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report.

Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the "Characteristics and Risks of Standardized Options," at http://www.theocc.com/components/docs/riskstoc.pdf If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document.

The risk of loss in futures trading and options, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures and options trading, losses may be incurred that are greater than the amount of funds initially deposited.

Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis. Deutsche Bank makes no representation as to the accuracy or completeness of the information in this report. Deutsche Bank may buy or sell proprietary positions based on information contained in this report. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof. This report is provided for information purposes only. It is not to be construed as an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor's home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorized by the BaFin. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and authorized by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One Raffles Quay #18-00 South Tower Singapore 048583, +65 6423 8001), and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting.

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