Emerging Markets Monthly EM Vulnerabilities Exposed Deutsche Bank Markets Research

Transcription

Deutsche Bank
Markets Research
Emerging Markets
Economics
Foreign Exchange
Rates
Credit
Date
09 October 2014
Emerging Markets Monthly
EM Vulnerabilities Exposed
Taimur Baig
Robert Burgess
Gustavo Cañonero
Drausio Giacomelli
Hongtao Jiang
Michael Spencer
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Special Reports
Assessing EM Vulnerabilities
Venezuela: To Pay or Not to Pay, is that the Question?
Remember, Not All EM Currencies Are Equal
EU Structural Funds and Their Impact: 10 Questions Answered
Analyzing Relative Value Using Snapshot
________________________________________________________________________________________________________________
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.
9 October 2014
EM Monthly: EM Vulnerabilities Exposed
Key Economic Forecasts
Real GDP (%)
2013
2014F
2015F
Global
3.0
US
Japan
Consumer prices (% pavg)
2013
2014F
2015F
Current account (% GDP)
2013
2014F
2015F
Fiscal balance (% GDP)
2013
2014F
2015F
3.3
3.9
3.3
3.5
3.8
0.2
0.4
0.4
-3.2
-2.7
-2.4
2.2
2.4
3.6
1.5
1.8
2.2
-2.4
-2.5
-2.5
-4.0
-2.9
-2.5
1.5
1.0
1.3
0.4
2.9
1.7
0.7
0.2
1.4
-9.1
-7.0
-6.1
-0.4
0.1
0.4
-1.8
-1.2
-0.7
0.2
0.3
-1.2
-3.9
-1.4
0.1
0.7
1.5
0.4
-0.4
1.2
0.7
1.0
0.8
-0.4
-0.2
1.0
3.7
1.0
1.5
0.9
0.4
1.9
1.7
1.0
1.3
0.6
2.1
1.1
2.5
1.3
1.6
1.0
1.3
1.5
2.6
1.2
2.1
2.2
-0.9
0.4
0.5
0.5
0.9
0.6
0.2
-0.1
0.5
0.7
1.5
1.1
-1.0
-0.1
0.4
1.1
1.5
0.9
0.8
0.8
1.1
1.3
1.7
1.2
0.4
0.9
1.1
2.4
6.8
-1.3
1.0
0.8
10.9
-1.9
2.7
-2.2
0.5
0.7
6.2
2.5
7.2
-1.8
1.6
0.4
10.9
-1.0
2.7
-2.0
1.0
1.0
6.5
2.1
6.7
-1.8
1.6
0.5
11.4
-0.8
2.9
-1.7
1.5
1.0
7.0
-3.0
0.0
-4.3
-3.0
-7.1
-2.5
-2.6
-1.5
-2.0
-12.7
-4.9
-7.2
-2.6
0.2
-4.4
-3.0
-5.6
-2.5
-2.5
-3.0
-2.4
-1.8
-4.2
-4.0
-2.5
-0.1
-4.3
-2.9
-4.6
-2.0
-2.3
-1.8
-1.8
-0.6
-3.3
-2.7
Other Industrial Countries
United Kingdom
Sweden
Denmark
Norway
Switzerland
Canada
Australia
New Zealand
1.9
1.7
1.5
0.4
2.0
1.9
2.0
2.3
2.8
2.7
3.1
2.2
1.0
2.4
1.3
2.5
3.1
3.6
2.6
2.5
2.6
2.0
2.5
1.8
3.2
2.7
2.6
1.7
2.6
0.0
0.8
2.1
-0.2
0.9
2.4
1.1
1.6
1.7
0.2
1.0
1.8
0.0
2.0
2.4
1.4
1.9
1.9
1.5
1.5
2.2
0.3
2.2
2.0
1.8
-1.2
-4.5
6.7
7.2
11.1
13.0
-3.2
-3.3
-3.3
-0.8
-4.0
6.0
6.7
11.0
12.0
-2.0
-3.0
-4.1
-0.6
-3.2
5.5
6.4
10.5
11.0
-1.4
-3.2
-6.5
-2.7
-5.9
-3.5
0.0
7.6
0.2
-1.0
-2.2
-1.6
-2.1
-4.6
-1.5
0.0
7.0
0.0
-0.8
-2.5
-0.5
-1.3
-3.5
-1.0
-1.0
6.7
0.2
0.0
-1.4
0.3
Emerging Europe, Middle East & Africa
Czech Republic
Egypt
Hungary
Israel
Kazakhstan
Poland
Romania
Russia
Saudi Arabia
South Africa
Turkey
Ukraine
United Arab Emirates
2.4
-0.9
2.1
1.1
3.2
6.0
1.6
3.5
1.3
4.0
1.9
4.1
0.0
5.2
1.9
2.4
2.1
3.4
2.7
5.4
3.1
2.5
0.5
4.4
1.5
3.0
-6.9
3.8
2.7
2.6
3.7
2.7
3.0
5.2
3.5
3.0
1.0
4.1
3.4
3.3
0.5
3.6
4.8
1.4
6.9
1.7
1.5
5.8
0.9
4.0
6.8
3.5
5.8
7.5
-0.3
1.1
5.6
0.4
10.1
0.2
0.5
6.1
0.2
1.2
7.3
3.0
6.2
8.9
10.3
2.2
5.4
1.8
12.0
2.6
1.2
6.7
1.1
2.5
6.2
3.2
5.4
6.4
12.8
2.5
0.8
-1.4
-2.3
0.3
2.1
1.0
-1.3
-1.1
1.5
17.7
-5.8
-7.9
-9.2
16.1
1.6
-1.5
-0.8
1.6
2.4
2.0
-1.8
-1.0
2.7
14.8
-4.6
-5.5
-3.0
14.2
0.9
-1.4
-1.7
1.5
2.6
1.5
-2.0
-1.2
1.7
11.7
-4.4
-5.0
-2.1
11.6
-1.3
-1.4
-13.7
-2.4
-3.1
5.3
-4.4
-2.3
-0.5
6.4
-4.1
-1.2
-4.5
6.2
-0.4
-2.6
-12.0
-2.9
-3.0
5.3
4.3
-2.2
0.2
6.0
-4.2
-1.7
-5.5
6.1
-1.2
-2.5
-10.5
-2.7
-3.1
3.3
-2.9
-1.9
0.3
3.7
-3.9
-1.7
-4.5
4.9
Asia (ex-Japan)
China
Hong Kong
India
Indonesia
Korea
Malaysia
Philippines
Singapore
Sri Lanka
Taiwan
Thailand
Vietnam
6.1
7.7
2.9
4.4
5.8
3.0
4.7
7.2
3.8
7.3
2.1
2.9
5.4
6.4
7.8
2.8
5.5
5.2
3.6
5.5
6.6
3.0
7.5
3.7
1.5
5.8
6.9
8.0
3.6
6.5
5.5
3.8
5.6
6.8
4.0
7.5
3.8
5.0
6.2
4.2
2.6
4.3
10.1
6.4
1.3
2.1
2.9
2.4
6.9
0.8
2.2
6.6
3.5
2.2
4.0
7.7
5.9
1.4
3.2
4.4
1.5
4.0
1.4
2.1
5.0
3.9
3.0
3.2
7.1
4.9
2.3
4.1
3.7
2.1
6.3
1.5
2.4
6.4
1.7
2.0
2.1
-2.6
-3.3
6.1
4.0
3.8
18.4
-3.9
11.7
-0.7
3.5
2.0
2.3
-0.7
-1.6
-3.0
5.6
2.6
3.6
18.5
-3.4
12.9
1.8
3.8
1.8
2.5
3.9
-2.5
-2.8
4.5
3.0
3.3
17.7
-3.1
11.9
1.2
0.5
-2.3
-2.1
1.0
-4.5
-2.3
1.0
-3.9
-1.4
7.1
-5.8
-1.4
-2.0
-4.0
-2.3
-2.1
2.6
-4.5
-2.5
0.2
-3.5
-1.8
6.9
-5.5
-2.0
-2.8
-4.5
-2.0
-1.5
3.4
-4.2
-2.7
0.0
-3.2
-2.2
6.8
-5.0
-1.8
-2.5
-4.4
Latin America
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Venezuela
2.5
2.9
2.5
4.1
4.6
1.1
5.0
1.5
1.0
-2.3
0.3
2.0
5.0
2.3
3.5
-3.5
1.8
-2.8
1.0
3.1
4.8
3.5
6.1
-1.1
9.1
25.3
6.2
1.9
2.0
3.8
2.5
40.0
12.0
38.3
6.3
4.3
2.8
4.0
3.2
60.0
13.0
39.1
6.4
3.4
3.2
3.8
3.1
80.0
-2.6
-1.4
-3.6
-3.5
-3.4
-1.8
-5.0
1.6
-2.6
-1.4
-3.9
-1.7
-3.9
-2.1
-5.0
3.0
-2.4
-0.4
-3.7
-1.8
-3.0
-2.2
-4.7
3.1
-3.2
-4.6
-3.3
-0.5
-2.4
-2.9
0.3
-7.2
-3.8
-4.9
-4.2
-1.9
-2.4
-4.2
0.2
-4.0
-3.6
-5.3
-3.7
-2.1
-2.2
-4.0
0.2
-4.8
Memorandum Lines: 1/
G7
Industrial Countries
Emerging Markets
BRICs
1.5
1.3
4.7
5.8
1.9
1.8
4.6
5.8
2.6
2.4
5.2
6.3
1.3
1.3
5.2
5.1
1.7
1.5
5.3
4.3
1.9
1.8
5.6
4.5
-1.0
-0.4
0.8
0.4
-1.0
-0.5
1.2
0.9
-0.8
-0.4
1.0
0.7
-4.3
-4.1
-2.2
-2.6
-3.3
-3.2
-2.2
-2.6
-2.9
-2.7
-2.1
-2.1
Euroland
Germany
France
Italy
Spain
Netherlands
Belgium
Austria
Finland
Greece
Portugal
Ireland
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.
For Egypt numbers are reported for financial year ending June.
Source: Deutsche Bank
Page 2
Deutsche Bank
Emerging Markets
2014 Conference
Saturday, October 11, 2014 – U.S. Chamber of Commerce, Washington, D.C.
8:30 a.m. – 3:00 p.m.:
All Day Conference Registration (Foyer)
8:30 a.m. – 9:15 a.m.:
Buffet Breakfast (Briefing Center)
9:15 a.m. – 9:30 a.m.:
Opening Remarks (Hall of Flags)
Jürgen Fitschen, Co-Chief Executive Officer, Deutsche Bank
9:30 a.m. – 10:45 a.m.:
Global Challenges: From Debt Overhang to Secular Stagnation
Moderator: Peter Hooper, Chief Economist, Co-Head of Global Economics, Deutsche Bank
Stephan Danninger, Division Chief, Asia Pacific Department, International Monetary Fund
Laurence Meyer, President, Meyer’s Monetary Policy Insights, and Former Board Member of the FRS
Dr. Lorenzo Bini Smaghi, Member, Executive Board of the European Central Bank (2005-2011)
10:45 a.m. – 11:30 a.m.:
Geopolitical Risks
Moderator: Peter Garber, Senior Advisor, Research, Deutsche Bank
Ian Bremmer, President, Eurasia Group
11:30 a.m. – 11:45 a.m.:
Coffee Break (Briefing Center)
11:45 a.m. – 1:00 p.m.:
Emerging Markets Fragilities and Outlook
Moderator: Drausio Giacomellli, Head of Emerging Market Research, Deutsche Bank
Dr. Urjit Patel, Deputy Governor, Reserve Bank of India
Ksenia Yudaeva, First Deputy Governor, Central Bank of Russia
Alejandro Werner, Director, Western Hemisphere Department, International Monetary Fund
1:00 p.m. – 1:45 p.m.:
Featured Keynote Speaker
Lawrence H. Summers, Charles W. Eliot University Professor, Harvard University, and former Secretary of
Treasury, USA
2:00 p.m. – 3:00 p.m.:
Conference Reception (Briefing Center)
* All Panels will be held in the Hall of Flags.
9 October 2014
Table of Contents
Emerging Markets and the Global Economy in the Month Ahead
Heading towards the turn of the year, it is becoming clear that the global economy has bottomed but that recovery is
increasingly reliant on the US. The associated normalization of US monetary policy will present challenges for EM,
amplified in some cases by the stronger dollar, softer commodity prices, and faltering growth in Europe. Against this
backdrop, the theme of diverging performance within EM that underlined our outlook for the year seems set to extend
into the coming quarters..……………........ ........................................................................................................................... 05
This Month’s Special Reports
With multiple headwinds still facing EM, we revisit our assessment of underlying vulnerabilities across 25 EM economies.
We find that vulnerabilities remain generally low or moderate in Asia. Since our last assessment almost two year ago,
however, parts of EMEA are now more resilient whereas Latin America is more fragile.……………........ ......................... 14
To Pay or Not to Pay, Is That The Question?
The ongoing economic crisis in Venezuela has fueled speculation about the possibility of a default in external
indebtedness by the Republic and/or PDVSA. In this report, we argue that although the economic crisis and policy
inaction has increased the vulnerability of the country to withstand external shocks, economic authorities still have the
ability and willingness to pay external financial debt. We believe the administration recognizes the importance of access
to external financing and would be willing to take the necessary measures and continue honoring external
obligations ............................................................................................................................................................................ 20
Remember, not all EM currencies are equal
After a broad-based sell-off in EM FX over the past couple of months, we cannot help to feel the gloom is overdone and
expect greater differentiation will once again be the rule over the next few months given the substantially different
outlooks for many of the EM currencies. We assess currency vulnerability over a plethora of angles, combining all in a
unified metric. The latter should in principle help to shed some light on the vulnerability question within the EMFX
universe....……………............................................................................................................................................................ 27
The absorption of EU structural funds will be an important cog in the Central European growth story in the coming years.
Poland emerged as the big winner in the EU Cohesion Policy funds allocation for the 2014-2020 budgeting period,
capturing by far the largest allocation (nearly EUR 80bn). In this report, we shed light on the absorption and impact of
these EU funds, with a focus on the performance of Poland and Romania. We find that Poland has the appropriate
administrative and financial capacity to continue its good performance in absorbing EU funds, whereas in Romania the
absorption rate is expected to remain relatively low in the upcoming budgeting period..……………........ ........................ 30
Analyzing relative value using Snapshot
We introduce the latest enhancements to our daily report, the EM Sovereign Credit Valuation Snapshot (or simply the
Snapshot), and discuss some relative value themes and opportunities using graphs and data provided in this
report....……………................................................................................................................................................................ 36
Asia Strategy .......................................................................................................................................................................... 43
EMEA Strategy ....................................................................................................................................................................... 50
LatAm Strategy ....................................................................................................................................................................... 58
Asia Economics ...................................................................................................................................................................... 64
EMEA Economics ................................................................................................................................................................... 88
Latam Economics ................................................................................................................................................................. 113
Theme Pieces ................................................................................................................................................... 134
Page 4
9 October 2014
Emerging Markets and the Global Economy in the Month Ahead

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

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

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

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

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

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

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

On credit, we recommend overweight Indonesia,
Turkey, Hungary, Colombia, and Mongolia,
underweight Argentina, South Africa, Poland, and
Peru.
Our
main
relative
value
trade
recommendations include PDVSA 17Ns vs.
Venezuela 20s, Indonesia 44s vs. South Africa 41s,
Pemex 24s vs. UMS 23s, 10s30s cash curve
flatteners in Brazil and 10s30s cash curve
steepeners in Russia. Meanwhile, we hold long
PDVSA 15s and 37s, and short Argentina USD
Discounts
Vulnerabilities exposed
As we enter the latter part of the year, we expect to see
clearer signs that the global economy has bottomed
and is accelerating into 2015. With DB’s considerable
downward revisions in EU growth, it is also clearer that
the recovery we foresee has become increasingly
dependent on the outlook for the US, which DB expects
to accelerate from 2.3% to 3.4% in 2015 while the EU
and Japan hover near 1%. This acceleration is likely to
spillover to EM (mainly through pent up exports), but
we expect EM growth to remain well below past trends
– in part a by-product of the reduced growth potential
in some countries.
The “Diverging Economies” theme that underlined our
2014 outlook seems poised to carry on over the next
quarters. Although the common shocks of gradually
tightening liquidity will weigh on EM at large, the
recent years of massive balance sheet expansion have
shown that domestic (pull) factors have overshadowed
supply (push) factors. As the last major election in this
year’s heavy political cycle concludes in Brazil, it
should also be clear which countries are willing to
make the necessary adjustments to promote faster
growth. The contrasts across the BRICs should remain
stark. Although DB forecasts China growth in the 7.08.0% over the next couple of years and India
accelerates to 6.5% in 2015, Brazil and Russia are
expected to hover just above 1% next year.
US: Pulling ahead. The latest data has reaffirmed our view
that US growth is on solid footing and that the Fed is on
track to start tightening in June of 2015. Consumer
spending has been robust (reflecting the improvement in
balance sheets) and job growth has also been sound. Job
gains over the past quarter are back in line with the yearto-date average of 227k – the strongest pace since 1999.
Gains were broad-based, with both public and private
sectors adding jobs. Also encouraging, this acceleration
in activity has lately been driven by pent-up business
spending – especially capital expenditures, which
expanded at 11% annualized in Q2 after years of
sluggish growth.
The new orders subcomponent of the ISM, aging
capital stock, and rising capacity utilization support a
fast pace of expansion ahead and – as USD strength
weighs on net exports – this is a welcomed
development is support of labor markets and overall
confidence.
The recent recovery in homebuilders’
sentiment, tightening supply, easing lending conditions,
and rising income also bode well for residential
investment. In addition, after three years of fiscal drag,
the outlook for local and state government spending
(the dominant drivers) has brightened (chart).
Page 5
9 October 2014
Moderate tailwind from government spending
changes in policymaking by the ECB, as a pause to
reassess the outlook for the economy and the impact of
stimulus has been a preamble for additional easing.
This time around should be no different given the
prospect for inflation, domestic demand, and credit
expansion. The intention to grow the balance sheet to
2012 levels was reaffirmed, but the Council still
forecasts 1.6% and 1.9% growth for this year and next.
As these (and inflation) are likely revised down in the
months to come, the door for public sector QE should
then open. Although the ECB may not use an explicit
target, DB estimates that the one trillion euro expansion
hinted at by Draghi is consistent with EUR/USD at 1.16
and 2019 inflation at 1.9% (chart).
QE needed to normalize inflation
Source: BEA, Haver Analytics & DB Global Markets Research
2.5
Altogether, the economy seems poised to grow at 3%+
over the upcoming quarters and DB has revised its H2
2014 GDP by 50bp to 4.1%. Most important, however,
the latest figures have also reaffirmed our view that
inflation pressures remain subdued. Slack in labor
markets continue to contain wage pressures (hourly
wages were flat in the month and only 2% up over the
past year) and DB expects core inflation to rise gently
toward the Fed’s goal over the next two years. This
should allow the Fed to proceed gradually and DB
forecasts a slightly faster pace of tightening than the
median FOMC expectation. According to this baseline
view, the US yield curve should continue to bear-flatten
substantially in the years to come.
EU: Following the Fed steps, at its own pace. The
outlook for EU growth remains dim and supportive of
broader-based QE. Accordingly, DB has revised down
this and next year’s GDP growth forecasts by 40bp and
50bp to 0.7% and 1.0%, respectively. Russia and
Ukraine have weighed on exports, and this drag has
eased in the past weeks. Still, the geopolitical outlook
remains uncertain and the details of the latest IP
numbers out of Germany, France, Italy, and Spain
suggest that the slowdown in activity is more structural
or persistent than geopolitical shocks alone would
suggest.
On a more positive note, credit supply constraints seem
to be easing, and the AQR/stress test results due this
month will be important to monitor. Although we
believe that systemic banks will pass, the latest
indicators point to weak demand for credit so that an
extra push may be required anyway. Private and public
deleveraging has also eased, but domestic demand
seems on feeble grounds still to drive a rebound in
growth. Therefore, the prospect of recovery in the EU
still hinges on external demand and the ECB’s push to
weaken the euro and rebalance banks’ balance sheets.
Although Draghi was less dovish than expected last
week this has been in line with other significant
Page 6
% yoy
Impact of balance sheet expansion on
credit
Impact of balance sheet expansion on FX
Baseline HICP forecasts
2.0
1.5
ECB target area
Forecast
1.0
0.5
0.0
2012
2013
2014
2015
2016
2017
Source: Deutsche Bank Research , Eurostat
EM: Kicking the Tires
While the decent outlook for growth in the US provides
a solid foundation for the global economy, the
associated normalization in US rates will test some EM
economies. This challenge will be amplified in some
cases by the stronger dollar, softer commodity prices,
and faltering growth in Europe. Later in this monthly,
we therefore take a closer look at vulnerabilities within
EM (see “Assessing EM Vulnerabilities”) to see which
countries appear best placed to survive this stress test.
It is now almost two years since we last ran a similar
exercise. Since then, while vulnerabilities have
generally remained low or moderate in Asia, parts of
EMEA look more resilient, whereas much of Latin
America now seems more fragile.
Latin American countries are struggling to deliver
growth. Activity indicators have continued to
disappoint across the board. Four consecutive months
of negative YoY growth in Brazil or no growth in
Argentina so far this year are hardly a surprise.
However, two months of economic activity advancing
below 2% YoY in Peru, after a weak first quarter, and a
relatively subpar 2013 performance, perfectly reflects
existing challenges in the region. Even in Colombia, an
exception to the regional pattern so far this year,
industrial production failed to maintain its trend in the
last couple of months, decelerating more than
anticipated in July. The only marginally positive
9 October 2014
surprise has come in Mexico, though even here,
growth in July remained at 2.5% YoY and a solid
recovery of domestic demand might take time. Overall,
we now believe growth in the region is likely to be only
around 1%, and accelerating only gradually next year
to 2.0%, far from the 4% plus of the good old days.
Vulnerabilities have increased in Latin America
Average percentile ranking of vulnerability indicators within regions
0.65
EMEA
strong showing in the first round suggests that
she is still the likely favourite to win. However,
Aécio has gone into the second round in a much
stronger position than we had expected, he will have
as much time as Dilma on TV now, and Dilma is clearly
weaker than 4 years ago. Also, the investigation into
the Petrobras scandal continues, and, although it
seems that it has not had a significant effect yet, more
revelations involving politicians of the ruling coalition
might hurt Dilma. The second round will take place on
October 26.
More vulnerable
0.60
High Yielders Top Our Vulnerability Rankings
LatAm
0.55
0.50
Asia
Less vulnerable
0.45
0.40
Mar-07
Dec-08
Sep-10
Jun-12
Mar-14
Furthermore, softer commodity prices and a
strengthening dollar have weighed on local currencies,
further complicating the policy dilemma in many of
these countries. Inflation pass-through from FX slide is
now threatening central banks inflationary comfort
zone. This moved the central bank of Peru to stop its
last easing cycle, and it is making Chile´s decision to
continue cutting rates increasingly difficult. Likewise, a
deterioration of the inflation outlook led Banxico to
adopt a more hawkish stance in its last policy decision
and the door to further cuts now seems definitely shut.
We now anticipate that Banxico will stay on hold and
start to hike rates in tandem with the Fed in 2Q2015 (at
the earliest). On a more positive tone, the reform
process that started last year in Mexico was completed
with
the
approval
of
the
energy
and
telecommunications by-laws.
The outlook in Brazil continues to hinge on elections.
The runner-up in last Sunday´s first round vote, Aécio
Neves, is the candidate offering clearest break from
current policies. Marina Silva, the third-placed
candidate has hinted that she would support Aécio,
recognizing that society has demands changes, which
cannot happen under the current administration.
President Dilma Rousseff has already set the tone for
the second-round campaign, claiming that voters do
not want the return of the “ghosts of the past.” She
also said that her government will be able to control
inflation without strong adjustment and unpopular
measures. She will obviously center the campaign on
the economic comparison between the Fernando
Henrique Cardoso and Lula governments. Dilma's
VEN
ARG
ZAF
SGP
BRZ
TUR
IND
HKG
MEX
THA
RUS
ISR
MAL
CHL
IDN
POL
TWN
COL
CZE
CHN
KOR
PER
PHL
ROM
HUN
0.30
More vulnerable
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
Our vulnerability assessment suggests that Asia should
remain quite resilient, though private sector debt is
high in a number of economies, including China, Hong
Kong, Malaysia, South Korea, Singapore, and Taiwan,
leaving them open to risks of sudden rise in interest
rates from the prevailing, historically low levels. India is
the exception in the region where vulnerabilities extend
beyond this to high inflation and weak public finances.
Recent developments, however, are encouraging.
Expectations about reform and policy efficacy have
risen since the elections, capital flows have surged,
external imbalances and the inflation situation have
improved, and growth indicators have bottomed. In
Indonesia on the other hand, things have gone the
other way: growth has continued to slow while the
political situation has become complicated, with the
president-elect suffering setbacks in controlling the
legislature.
One area where we have seen a clear reduction in
vulnerabilities in recent years has been in central
Europe. Going into the last crisis, they were among the
most vulnerable in EM, with varying combinations of
rapid credit growth, high inflation, overvalued
exchange rates, and large external and fiscal deficits.
Since then, they have undergone a period of significant
deleveraging, something that we have argued leaves
them well-placed to deliver solid recoveries after years
Page 7
9 October 2014
hovering near the lows and inflation is well contained,
USD strength and some pull-back in developed equity
markets have this time underpinned the selling
pressure. While the nature of the external shocks has
been evolving over the months, however, EM’s
response has been relatively stable: the most growthsensitive FX and equity markets have proven also most
vulnerable.
Private debt levels are highest in Asia
Private debt (% GDP)
180
160
140
120
100
Local markets bear the brunt of USD adjustment
80
Since end of June
year to date
Returns of various asset classes
60
40
UST (10-15Y)
20
IG
CHL
BRZ
MEX
COL
PER
VEN
ARG
ISR
ZAF
TUR
CZE
RUS
POL
HUN
ROM
KOR
TWN
THA
CHN
MAL
IND
PHL
IDN
0
S&P
DB-EMLIN (hedged)
HY
Source: Haver Analytics, Deutsche Bank
EMBI-G
of underperformance. The main risk for this group
stems now from further disappointing growth in the
euro area and, especially, Germany.
EMFX (Total Return)
EM Eq
DB-EMLIN
EU Eq
Elsewhere in EMEA, vulnerabilities are likely to stay
relatively high in South Africa and Turkey. In the
former, deeper fiscal consolidation is needed to
stabilize debt (and preserve investment grade status)
but will weigh on growth. Progress is being made on
reducing infrastructure bottlenecks but the momentum
behind structural reforms more broadly remains
unconvincing. More imminently, weaker commodity
exports are threatening to undermine what limited
progress we have seen in reducing the current account
deficit. Turkey will also remain fragile so long as
policymakers remain reluctant to deliver the kind of
sustained adjustment in real rates necessary to reduce
inflation, boost private savings, and bring down
external imbalances.
At the other end of the spectrum, Russia’s low debt,
high reserves, current account surplus, and moderate
fiscal deficit, will remain in place for some time. But we
remain pessimistic about the longer term trajectory.
Potential growth has fallen significantly in recent years.
Even if the political crisis in Ukraine is resolved quickly,
the structural reforms that are needed to change this
seem further away now than ever if, as seems
probably, Russia looks to pursue a more inwardlooking growth strategy.
Strategy: Uphill battle
EM local markets have borne the brunt of the recent
sell-off across risk markets. As the chart below shows,
equities have led the correction, but local rates have
also lost over 4% since end-August – mainly on
currency depreciation. EM credit was not immune, but
weakness was concentrated in the (idiosyncratic) high
yielders and limited otherwise. As US rates are
Page 8
EMFX Spot
Com'dty
-12% -9% -6% -3% 0%
3%
6%
9% 12%
As the recent data have reinforced the case of a UScentric recovery, USD strength will likely prove a
persistent shock. As a silver lining for credit, US wage
inflation remains well anchored, additional QE from the
ECB likely looming, and EM positions have been
resilient to HY outflows (chart). Fundamentals still
support EM rates – for now – but valuation seems less
supportive than in credit. The cushions seem most
limited still for EMFX, where monetary anchors are
largely absent and valuation is dislocated only in highbeta FX.
EMD flows: Weakening, but resilient to HY outflows
Debt fund flows (% AUM)
2
1
0
-1
-2
-3
Jan-12
EM weekly flows
EMD 4wk MA
US HY 4wk MA
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
9 October 2014
In credit, we see scope for a moderate recovery in
credit spreads on valuation and some reduction in
volatility. EM assets continue to face headwinds and
some idiosyncratic stories are still negative, but these
do not preclude tactical opportunities. Credit
differentiation and relative value remain key.
We still see some pockets of value across EM curves,
especially in LatAm and idiosyncratic cases such as
India and China. Brazil remains largely binary, but its
forward curve seems now two flat regardless of
elections. Colombia is wide and Mexico is too steep
now vs. the US. We also favour defensive longs in
Thailand, Singapore vs. US. Position for further frontend steepening in Mexico and Chile, and bearsteepening in Poland. We expect steepening in South
Africa and Turkey. Inflation breakevens are low in
Mexico, but they seem to have overshot in Turkey.
Tactically pay rates in Malaysia and Korea.
We expect Asia FX to perform relatively better on lower
or benign sensitivity to geopolitical risks, commodities,
and a better policy mix. With any retracement in USD
likely to be temporary, we favor CNH versus KRW, and
INR versus SGD, long USD/MYR and long USD/ILS and
expect low-beta LatAm FX to outperform CE3 – though
with a lower beta than in previous episodes of USD
strength. We believe that the USD/BRL tail risks are
3%+ wider than priced in straddles.
FX: Between a rock and a hard place
EMFX is in a difficult position. If the US economy
continues to recover as we expect and the Fed
gradually pulls ahead of the ECB in normalizing rates,
USD strength (and gradually rising funding rates)
would remain a drag for emerging currencies.
Conversely, in such a US-centric world, a faltering US
economy would likely bring equity markets down and
rising risk aversion. It is naturally best for EMFX if
corner scenarios are avoided and volatility subsides.
But this requires the global economy to follow a
reasonably narrow path of gradual reflation in the US
(and also in Europe, with the help of an effective QE
program), and more balanced growth across the globe
(and within China). As the EU may not have yet
reached bottom, however, more USD strength seems
likely in the near term.
Accordingly, we favor EUR funding (and also JPY
funding in Asia), crosses that could perform well under
a strong USD such as long CNH/KRW, and INR/SGD,
and USD longs for currencies where valuation is not
yet stretched as in MYR and ILS. Although the BRL,
RUB, and ZAR would be obvious candidates for high
beta USD longs, we still see some value in being long
skews in BRL instead (where we see a wide trading
range of 2.20-2.60 post-elections) and we find that
valuation is already stretched in ZAR and RUB despite
fundamental vulnerability.
Assessing EMFX valuation after the sell-off
Fundamental Valuation
ARS
SGD
CNY
THB
KRW
INR
HKD
ILS
TWD
CZK
MXN
PEN
PHP
BRL
HUF
RUB
PLN
MYR
TRY
COP
IDR
CLP
ZAR
undervalued
-25%
18%
-15%
-5%
5%
15%
implied volatility (3M)
BRL
16%
14%
RUB
12%
IDR
ZAR
10%
TRY
8%
COP
6%
4%
CZK
PEN
CLP
MYR
INR
HUF
THB
KRW
MXN
ILS
PLN
SGD
2%
financial overvaluation
0%
-8%
-6%
-4%
-2%
0%
2%
4%
As the chart above shows, both the ZAR and the RUB
are among the cheapest currencies in our sample from
a fundamental and financial standpoint. Not
surprisingly, however, the bottom panel shows that the
most undervalued pairs are also most volatile. With no
policy change or current account improvement in the
making that could support a more durable rally, but
more supportive valuation, we recommended taking
profit on long TRY/ZAR and are now neutral the rand.
We are moderately more constructive the RUB, as we
find that proper provision of USD funding could go a
long way in supporting the currency.
Looking more broadly across EM currencies, better
valuation is one of the reasons we are not
recommending outright long USD vs. EMFX. Regionally,
however, we expect Asia FX to remain better
supported vs. the USD given its positive beta to lower
commodities, reduced political risks, and – especially in
South Asia – improved external positions and tighter
policy mix.
Page 9
9 October 2014
Looking beyond Asia, we expect low-beta LatAm FX to
outperform CE3 on continued USD strength – but less
clearly so than in the past. As the chart below shows,
this has historically been the norm, but the relative
betas to DXY have been tamed by fragility in
commodities, LatAm’s softness (amid a downturn in
Chile, deceleration in Colombia, gradual recovery in
Mexico and political turmoil in Brazil), and recent
weakness in global equities.
adjusted accordingly and we see diminished pockets of
value across EM curves. As the chart below shows,
real EM yields1 have compressed vs. US this year. Once
we simply subtract credit spreads, the premium vs.
comparable US real rates is just about 150bp. This may
be enough to attract long-term foreign investors as
many EM currencies seem undervalued vs. long-term
fundamentals. However, the current volatility may
continue to be a deterrent for shorter-term allocations.
EMFX response to USD strength: Now vs. 2009/10 and
2011/12
There are still attractive pockets of value, however, and
they seem concentrated in LatAm. Poland’s real rates
are still relatively high (supporting our overweight in 510 year bonds), but access to linkers is limited when
compared to LatAm and inflation is likely to normalize
over the coming years. Real rates are higher in the lowdebt Chile, where inflation is probably peaking as the
economy slows, and in Mexico (the best risk-reward in
long-dated linkers, in our view).
beta to DXY since July
1.0
LatAm/CE3
RUB
0.5
CLP
TRY ILS LatAm
PEN
EMEA
BRL MXN
0.0
-0.5
PLN
CE3
-1.0
ZAR
Pockets of value across EM rates
Yield diff, %
COP
CZK
Diff. cred-adjusted
4.5
Real differential
4.0
HUF
3.5
-1.5
-2.0
-1.0
0.0
1.0
avg beta to DXY in previous dollar strength episodes
Note: betas from multivariate regressions on weekly returns which also include S&P 500, US 5Y
rate, CRY index. Previous dollar strength episodes are 11/09-6/10 and 8/11-7/12
3.0
2.5
2.0
1.5
1.0
We favor holding long MXN vs. HUF and CZK, or a
basket of low-beta LatAm FX (MXN, CLP, and COP) vs.
CE3 FX. The MXN tends to outperform during USD
strength and we find current levels attractive. Although
the recent deceleration in Colombia and overall
commodities weakness weighs on CLP and COP, these
currencies have already lagged substantially and
positioning is now light.
0.5
0.0
Jan 10
Sep 10 May 11 Jan 12

Asia: Long CNH/KRW (target 180); Short 6M
SGD/INR (target 46); Long 3M USD/MYR NDF,
(target 3.35); Stay long USD/SGD via 1.2750 digital
calls.
EMEA: Long MXN vs. HUF and CZK (target 13.90);
Long USD/ILS (target 3.78); long PLN/HUF (target
78.50); Long 1m EUR/RUB put strike @ 48.10; long
TRY vs. ILS (target 1.69).
LatAm: Buy 1M USD/BRL straddle (B/E’s
2.28/2.52); Buy 3M EUR/COP put (ATMS, EKO @
2480, ref FX 2590) for 0.7%; Buy 3M USD/CLP put
(ATMS, EKO 575) for 0.6%.
Rates: Normalization moves on – slowly but surely
In contrast with EMFX, relatively low growth and/or
low inflation continue to bide EM central banks time.
However, also in contrast with EMFX, valuation has
Page 10
Sep 14
5Y real yield, %
5.0
BR
4.0
RU
3.0
Index
CO
CL
PL

Sep 12 May 13 Jan 14
ID
PE
2.0
ZA
TR
MX
1.0
HU
US
MY
IL
0.0
5Y CDS, bp
PH
-1.0
15
65
115
165
215
265
Source: DB Global Markets Research - 1s3s steepeners.
We believe that the recent sell-off in both FX and rates
in Colombia provides an attractive to entry point. The
spread vs. the US is near recent highs and the
1
Local EM bonds (ex-China and India, but including Israel) are deflated by
inflation expectations and market-weighted.
9 October 2014
fundamental prospect for the country remains solid.
The situation is naturally a lot more binary in Brazil,
where we could see 100bp+ in each direction
depending on the outcome of elections. Looking
beyond elections, however, the outlook for the
currency rather than rates under an adverse scenario
will likely weigh more heavily on foreign flows. From a
monetary policy perspective, we believe that the curve
should be positive-sloping two years forward under
either scenario rather than inverted.
flattening in Poland and bull- steepening in South
Africa and also a steeper Turkish curve.

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

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

LatAm: In Mexico keep 2Y1Y spread wideners vs
5Y5Y spread tightener (target 20bp), switch from
MBONOS 34s to MBONOS 24s, long breakevens in
the belly (UDI20s vs. TIIE 5Y, target 390); In Brazil
enter a Jan 17-Jan 21 DI steepener; In Chile keep
the 1s3s steepener (target 65bp), receive 10s
(CLP/CAM) vs US (target 190bp); In Colombia buy
TES 24s vs US10s (target 380bp). Keep a neutral
stance in Peru.
Carry-seeking inflows have not only reduced premium
across EM curves but also distorted the pricing of
monetary policy.
We have favored front-end
steepeners across several EM curves as a core
recommendation over the past months. Although in
markets such as Mexico and Chile the repricing has
been advanced, the inflation risks in Mexico still seem
underpriced. As the chart below shows, the long-end of
Mexico has lagged the recent rally in the US so that
altogether, the shape of the Mexican curve bodes for
flattening with spread tightening vs. the US.
The situation is similar in Chile, where recent inflation
suggests that eventual rates normalization will go
farther than priced. Still, we see room for Chilean yields
to compress vs. US yields as these cycles remain decoupled. Limited correlation with US rates also
supports receivers in India and China, as well as
defensive longs in Thailand and Singapore vs. US. In
contrast, we recommend tactical shorts in and Korea.
Relative performance across EM and DM
3.0
z-score (5s10s box EM vs US or EU, 252d)
2.5
COP
2.0
ILS
INR
1.5
KRW
MXN
1.0
TRY
RUB
0.5
CLP
ZAR
PLN
0.0
-0.5
HUF
-1.0
-1.5
-2.0
CZK
z-score (1s3s box EM vs
US or EU, 252d)
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Source: DB Global Markets Research.
Quantitative easing in the Eurozone has also brought
extra-life to carry trades in the region. We may see
some additional squeeze lower in the short ends of
Hungary and South Africa, but, as the chart above
shows, front-end rates across EMEA are very flat
already. The longer end in Russia, Turkey and South
Africa also look relatively flat. We expect bear-
Credit: scope for some recovery
The third quarter of 2014 has seen DB-EMSI spreads
widen by 80bp as investors turned bearish EM assets
on a variety of reasons encompassing dollar strength,
lower commodity prices, lingering growth concerns,
and idiosyncratic factors. The latter impacted mainly
the high-yielders and Russia, on renewed default
concerns in Venezuela, tension in Russia/Ukraine, as
well as adverse legal and macro developments in
Argentina. These four credits contributed with almost
60bp of spread widening from the end of June to date.
Most of the other credits have posted moderately
higher spreads, and the relative performance has been
broadly consistent with their betas. The main
idiosyncratic shocks have been political in nature,
including Brazil’s underperformance (due to the
strengthening of President Rousseff’s position in the
elections, according to market participants) and the
outperformance of Indonesia (on Jokowi’s election as
President and associated optimism about reforms).
Page 11
9 October 2014
We believe fund flows will likely remain sluggish during
the remainder of the year, as the stabilizing force of
institutional flows seemed to have weakened (judging
from the EPFR survey – see second graph above).
However,
supply/demand
dynamics
still
look
supportive, as most sovereign issuers have fully
undertaken their issuance plans for the year with
remaining issuances likely serving as pre-funding.
According to our projection, the net supplies by
sovereign issuers will be negative at –USD3.0bn during
the remainder of the year.
DB-EMSI sub-index spread changes since end-June
2014
Spread Change, Since end of June 2014
600
500
400
300
200
100
0
VE
AR
UA
RU
EC
HU
BR
TR
UY
CO
MX
PL
ZA
PE
ID
PH
CL
PA
SV
EG
LB
-100
Technicals have not been disruptive, but they have
provided less supports than in the first half of the year.
EM hard currency fund flows have been mixed over the
past three months, but remain positive YTD (USD 2bn
or +1.5% AUM). This is in stark contrast with the flows
out of US HY (see chart below), though considerably
weaker compared to the flows into the intermediate
and long duration sectors of US IG funds. So far, HY
outflows have not had a material impact on flows to
EM hard currency funds, which have been driven
mainly by EM specifics, in our view.
EMD funds: Mediocre flows; weaker institutional
support
2.0
4-wk MA EM Hard Currency Flows ( % AUM)
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
May-13
Retail
Aug-13
Source: Deutsche Bank, EPFR
Page 12
Nov-13
Feb-14
Instituitional
May-14
Aug-14
From a pricing perspective, EM credit now offers a
decent level of risk premium. The BBB average spread
across EM sovereigns is hovering more than 50bp over
global counterparts, and our EM benchmark index DBEMSI (with an average rating of BB+/BBB-) is just 84bp
tighter than US high yield (average rating B+), a very
tight spread historically (average 230bp over the past
five years).
Based on valuation, we see the glass as half full. We
believe there is scope for spreads to moderately tighten
to the year-end as volatility eases somewhat from the
elevated levels of the past month. Low UST yields and
well-contained inflation should help limit the impact of
dollar strength and weakness in the DM equity
markets. We believe DB-EMSI spreads can tighten
from the current level of 372bp to 340bp (in terms of
EMBI-Global, this translates in a drop from the current
347bp to 320bp). However, this may not suffice to
generate positive total returns as the UST 10s yields
may well move higher from the current low levels of
2.32%.
The recent dislocations have created interesting
opportunities in relative value, in our view. Also, overall
EM credit performance in the coming months will likely
hinge on a few idiosyncratic and vulnerable credits. We
continue to hold a bearish view on Argentina as we
believe continued deterioration in macro conditions will
challenge the stronghold of the distressed investors
and potentially unravel the current decoupling between
fundamentals and bond prices. While strategically
underweight, we hold a relatively more constructive
tactical position in Venezuela over the short term as the
market is still pricing too much risk of imminent
default. The repayments of Venezuela 14s (this week)
and PDVSA 14s (end of month) should inject some
confidence back into the market, making the curve disinvert to some extent. While potential ICSID ruling on
some high profile arbitration cases will likely present
negative headlines, their actual financial impacts will
not be binding until a few years later and the amounts
to be disbursed could be a fraction of the headline
figures. In Russia/Ukraine, we are bearish on
fundamentals, but over the near term we see the
cease-fire as broadly holding and we expect relative
normalcy until elections at the end of this month. With
9 October 2014
spreads close to this year’s highs, we retain tactical
neutral on both for now.
Looking beyond the vulnerable credits above, we favor
Indonesia vs. South Africa on the diverging trend of
their fundamentals and favor Colombia vs. Peru given
the latter’s stretched valuation and deterioration in
growth dynamics. Elsewhere, given our view of
moderate spread compression and a decrease in
volatility, we generally favor those curves featuring a
higher spread for better carry as well as greater scope
for spread compression and, accordingly, we stay
overweight Turkey and Hungary. We disfavor credits
with very tight spreads, such as Peru and Poland,
despite their fundamentals.
In relative value, we generally favor cash curve
flatteners given our view of steeper UST curves, but
also see Russia’s curve as too flat. We look to position
for CDS re-widening in Brazil (vs. Mexico) as polls may
disappoint in the coming weeks. In the quasi-sovereign
space, we position for re-convergence of Pemex vs.
UMS.
Summary of recommendations:

Overweights:
Indonesia,
Colombia, Mongolia
Turkey,
Hungary,

Underweights: Argentina, South Africa, Poland,
Peru

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

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

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

Select longs or shorts: long PDVSA 15s and 37s,
long Indonesia 44s, Mongolia 18s. Short Argentina
USD Discounts
Drausio Giacomelli, New York, +1 212 250 7355
Robert Burgess, London, +44 20 7547 1930
Hongtao Jiang, London, +1 212 250 2524
Page 13
9 October 2014

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

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

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

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

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

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

While starting levels of vulnerability was
conspicuously higher in EMEA than in Asia and
Latin America few years ago, these have steadily
declined in EMEA while increasing recently in Latin
America. The absolute and relative improvement in
EMEA has been driven largely by Central Europe
and Israel, while Latin America deterioration has
been led by Venezuela and Argentina.
The single most remarkable change is probably
Hungary, which has gone from having the highest
overall vulnerability score in late 2007 to the lowest
score in this last measure, though high levels of
foreign currency debt (not properly captured in this
exercise) remain worrisome.
Introduction
These are testing times for emerging markets. The
golden age in which strong growth was the norm,
almost across the board, is well behind us. In particular,
a number of the larger emerging economies, Brazil,
Russia, and South Africa, are struggling to deliver any
kind of positive growth, while activity levels elsewhere
are also subdued.
Within the next year, emerging markets will once again
need face up to a period of rising US interest rates. The
last such hiking cycle, from 2004-06, proved to be a
relatively benign one for EM, but this was seldom the
case prior to that. Most emerging markets remain
better placed than in the past to weather such a shock:
public debt levels are lower, foreign reserves are much
higher, foreign currency mismatches are less
prominent, and most FX regimes appear more flexible
and resilient.
Nevertheless, the normalization of US monetary policy
will provide a stress test for emerging markets that is
likely to underscore our expectations of diverging
performance across countries. Countries with large
external financing needs, or those that have seen rapid
increases in leverage, are among those likely to face a
period of difficult adjustment. Weaker commodity
prices will provide additional challenges for some but
relief for others. Geopolitical risks are adding to
concerns in some cases.
Last summer’s “taper tantrum” put policymakers in
emerging markets on notice of the coming storms.
Some have taken heed. But the adjustment has so far
been modest. Real rates remain extraordinarily low in
most cases. And there is little sense of urgency
regarding the need for difficult structural reforms to
boost flagging growth rates.
This seems like an opportune moment, therefore, to
revisit our assessment of vulnerabilities in emerging
markets. In doing so, we build on the exercises that we
have undertaken in previous years, and also more
recently for Asian emerging markets.2
2
See our EM Monthlies for December 2011 and 2012 and the Asian
Vulnerability Monitor for February and May of this year.
Page 14
9 October 2014
Assessing Vulnerability
We provide a structured and objective assessment of
the underlying vulnerabilities of 25 EM economies. Our
analysis is based on a range of measures that we think
capture a country’s susceptibility to an economic crisis.
We are not necessarily trying to predict crises as such.
But “kicking the tyres” of each economy in this way
can give us a sense of which ones are more or less
likely to face a period of painful adjustment as external
conditions become more challenging.
indicator of overall vulnerability for each country. This
then enables us to rank countries from the most to the
least vulnerable according to their average overall
scores. For convenience, we also provide an indication
of whether a country’s overall vulnerability is high,
medium, or low, based on the five-year distribution of
these overall rankings.
EM Growth Tracker
Asia
China
'10
'11
'12
'13
'14
Hong Kong
India
As ever with such exercises, the precise choice of
indicators is partly a question of practicality: we’re
looking for indicators that are readily available and
comparable across countries. We’ve selected 10
indicators, capturing vulnerabilities across four key
dimensions:
Macroeconomic stability

Economic momentum, as reflected in our “growth
tracker”

Inflation
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
EMEA
Czech Rep.
Hungary
Israel
Poland
Romania
Russia
South Africa
Turkey
Private leverage

A measure of excess credit growth

Private indebtedness

Level of real interest rates
Latin America
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Venezuela
External imbalances

Current account

Foreign reserve adequacy

Exchange rate valuation
Sovereign risk

Fiscal balance

Government indebtedness.
For each country, we measure vulnerability by
comparing the latest observation (our assessment is
based on data through June of this year) for each
indicator with the distribution of that indicator across
our sample of 25 emerging markets over the preceding
five-year period. For example, China’s current account
surplus of 1.7% of GDP is in the 39th percentile of the
distribution of current account balances across EM over
the last 20 quarters. In this way, we’re able to capture
not only the relative ranking of a particular indicator
across countries at any particular point in time, but also
how good or bad this looks relative to the recent history
of emerging markets.
Contracting at increasing rate
Contracting at declining rate
Below trend and decelerating
Below trend and accelerating
Above trend and decelerating
Above trend and accelerating
Based on our Macroeconomic Momentum Indicators for EM.
We’re conscious that there is a lot that this exercise
does not cover. It says nothing about political risks. It
makes no attempt to measure structural weaknesses,
such as infrastructure bottlenecks or governance issues.
Nor does it say much about sources of stress in asset
markets, such as froth in property markets or excessive
levels of foreign investor positioning. Some indicators
may also be more relevant for some countries and
regions than others. These are issues that we can delve
into in future updates. Our intention here is simply to
provide a basic framework that can offer an initial
assessment of relative vulnerabilities within EM.
Below we summarize the main results, our current
overall vulnerability rankings, and the evolution of
these overall rankings over the last eight years, i.e.
since before the global financial crisis.
We then take the average of these percentile rankings
across all indicators to come up with a composite
Page 15
9 October 2014
EM Vulnerabilities June 2014: Summary Table
VEN
ARG
ZAF
SGP
BRZ
TUR
IND
HKG
MEX
THA
RUS
ISR
MAL
CHL
IDN
POL
TWN
COL
CZE
CHN
KOR
PER
PHL
ROM
HUN
Growth
Inflation
Z-score
-0.32
-0.42
-0.89
-0.46
-1.19
-0.25
-0.75
-0.13
-0.07
-0.75
-0.64
-0.34
-0.12
-0.64
-0.04
-0.05
0.08
-0.42
0.30
-0.84
-0.26
-0.38
0.68
-0.26
0.31
YoY%
60.5
40.5
6.6
1.8
6.5
9.2
7.5
3.6
3.8
2.4
7.8
0.5
3.3
4.3
6.7
0.5
1.6
2.8
0.0
2.4
1.7
3.5
4.4
0.7
-0.4
Credit
growth
Excess %
14.1
5.0
0.2
8.7
4.8
16.2
1.6
11.9
7.4
5.7
8.9
-1.7
1.2
2.9
5.9
0.1
1.7
4.1
0.8
4.4
-0.9
9.8
5.1
-9.4
-8.3
Private
debt
% GDP
32.3
14.8
77.8
130.5
71.9
57.2
55.9
325.1
44.6
132.3
51.9
111.7
122.9
78.2
33.8
51.2
147.7
42.1
57.1
131.6
156.9
32.3
44.1
33.5
45.1
Real rates
%
-28.6
-12.8
-0.8
-1.4
4.1
0.3
1.3
-3.1
-0.3
-0.2
-0.4
0.1
0.2
-0.3
1.4
2.1
-0.7
1.0
0.4
2.3
1.0
1.5
-3.5
1.6
2.8
Current
account
% GDP
0.5
-1.1
-5.6
18.8
-3.7
-6.5
-1.1
1.6
-1.9
3.3
2.5
2.8
5.9
-2.4
-3.1
-1.2
12.9
-3.5
-0.4
1.7
6.4
-5.1
3.6
-1.7
4.4
Reserve
cover
% GEFR
121.3
72.6
103.5
27.0
301.9
73.1
293.3
33.6
147.9
269.3
553.5
238.0
166.8
164.7
146.5
129.0
246.8
178.9
166.7
557.8
296.1
386.9
843.9
204.4
214.9
FX
valuation
%
61.0
6.1
-15.2
8.7
2.7
-5.7
2.0
2.3
1.2
4.3
2.7
3.2
-5.3
-10.8
-8.5
-2.8
-1.0
-2.9
-0.3
2.7
10.9
-0.5
-2.4
0.0
-0.7
Public
debt
% GDP
43.2
49.9
46.3
103.1
66.5
35.9
66.0
33.5
47.3
46.0
13.2
66.5
57.3
12.4
26.1
53.5
41.5
31.8
48.6
21.3
37.4
18.9
36.8
39.5
79.2
Fiscal
balance
% GDP
-14.4
-4.4
-4.4
6.4
-3.3
-1.9
-7.2
1.7
-4.0
-0.9
-1.0
-3.0
-4.1
-0.9
-2.3
-4.0
-3.1
-1.0
-2.8
-1.9
1.1
0.3
-0.4
-2.4
-2.7
Overall
Percentile
VEN
0.76
ARG
0.72
ZAF
0.66
SGP
0.63
BRZ
0.62
TUR
0.62
IND
0.61
HKG
0.61
MEX
0.60
THA
0.56
RUS
0.50
ISR
0.49
MAL
0.49
CHL
0.49
IDN
0.45
POL
0.45
TWN
0.44
0.44
COL
0.44
CZE
0.44
CHN
0.42
KOR
0.42
PER
0.38
PHL
0.36
ROM
0.32
HUN
0.3
0.5
0.7
Notes: (1) credit growth is measured as the excess of private credit growth over nominal GDP growth over the last four quarters; (2) reserve cover is measured relative to the sum of short term external debt (at original
maturity) and the current account deficit (for those countries that have deficits; (3) FX Valuations are taken from our Behavioral Equilibrium Exchange Rate Model (BEER), or Productivity-Adjusted Purchasing Power
Parity Model for the couple of countries not covered by the BEER model (see our monthly EM FX Valuation Snapshot) .
Source: Haver Analytics, Bloomberg Finance LLP, Deutsche Bank
Perhaps not surprisingly, we find that two of the highyielding sovereign credits, Venezuela and Argentina,
are the most vulnerable according to our metric.3 In
both cases, growth is weak, inflation is high, exchange
rates are overvalued, foreign reserves are limited, and
the public finances are under pressure. This fragility is
only partly offset by relatively low levels of private
leverage. Likewise, since we are using the IMF
definition of public debt, it does not net out holdings of
this debt by public entities, which in Argentina reduces
the overall level of public indebtedness to just half-
elections, capital flows have surged, external
imbalances and the inflation situation have
improved, and growth indicators have bottomed.
Still, external financing needs are high, which need
to be kept into account. On the latter, growth has
continued to slow while the political situation has
become complicated, with the president-elect
suffering setbacks in controlling the legislature. A
key pending fuel price decision stands before
perception of external funding difficulties is
reexamined. Private sector debt is high in a number
of economies, including China, Hong Kong,
Malaysia, S Korea, Singapore, and Taiwan, which
leave them open to risks of sudden rise in interest
rates from the prevailing, historically low levels.
Hong Kong and Singapore are however two special
cases by their nature of being hubs of regional
finance (as well as being characterized strong
public and private sector asset positions). Their
high vulnerability rankings should be seen in that
context and discounted somewhat.
Below this pair, there is a group of countries where
vulnerabilities also appear to be relatively high by
recent historical standards, although the source of
these vulnerabilities differs from country to country.

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

In EMEA, South Africa, for example, suffers from
weak growth, high inflation, a large current
account deficit, low reserves, and a relative large
fiscal deficit. The issues are similar in Turkey
although, whereas the public finances are in better
shape, private leverage levels have been rising
rapidly, partly fuelled by overly loose monetary
policy.
3
Ukraine is not included in this exercise due to data constraints but would
likely also show up as highly vulnerable.
Page 16
9 October 2014

In Latin America, beyond the high yielders,
vulnerabilities are also quite high in Brazil and
Mexico, although to a lesser extent. Weak growth
and elevated inflation are clear vulnerabilities in
Brazil, amplified to some extent by relatively high
public debt, rising private debt levels, and a
moderate current account deficit. Mexico is
unusual: while it does not look particularly
vulnerable according to any one indicator, they’re
almost all on the wrong side of average. It is this
moderate vulnerability across a broad range of
areas that see it make the list.
There are also vulnerabilities across the rest of EM,
such as rising inflation in Russia, a large current
account deficit in Peru, and high public debt in
Hungary. By and large, these reflect isolated rather
than broad-based sources of weakness, though they
nevertheless bear watching.
years. Vulnerability across EM has again risen a little in
recent years but not yet to the same extent that we
saw prior to the last crisis.
The differences between regions, however, are
somewhat more marked. All three regions saw a rise
and fall in vulnerability levels before and after the
global financial crisis, though the starting level of
vulnerability was notably higher in EMEA than in Asia
and Latin America. More recently, however, whereas
vulnerability has on average continued to decline in
EMEA (driven largely by Central Europe but also Israel),
we have seen an increase in Latin America.
Vulnerability by regional averages:
Average percentile ranking within regions
0.65
EMEA
0.60
Vulnerabilities in retrospective
LatAm
Beyond this current snapshot, we’re also able to track
how the resilience of emerging markets has waxed and
waned over time. Data availability becomes a bit of a
problem once we extend the exercise back beyond the
last decade or so; but we do have enough to cover the
evolution of our overall metric since before the global
financial crisis. Many aspects of vulnerability tend to
change only relatively slowly over time. This is
especially true for debt levels. But there is also a large
amount of inertia in inflation performance, external
balances, and even fiscal positions.
For emerging markets as a whole, the average level of
vulnerability has not fluctuated all that much in recent
years. There was, however, a notable uptick prior to the
last crisis, with vulnerability peaking in around June
2008, before receding again over the following two
EM average vulnerability over time:
Average percentile ranking across EM
0.65
0.60
0.55
0.50
Asia
0.45
0.40
Mar-07
Dec-08
Sep-10
Jun-12
Mar-14
Whereas this partly reflects the rising vulnerabilities in
Argentina and Venezuela, other countries in the region
have also been experiencing a gradual increase in the
degree of macro vulnerabilities we are measuring. This
notwithstanding, there are still countries with relatively
low levels of absolute vulnerability, like Peru, Colombia
and Chile. But basic economic performance as
measured by growth and inflation has deteriorated
much more than has been the case in other regions.
Likewise Latin American countries have recorded
worsening current account and reserve adequacy levels,
as well as fiscal positions
Indeed at a country level, there have been some
significant fluctuations in the relative resilience of
emerging market countries over the last several years.
This is clear in the graphic below, which shows the
evolution of our overall vulnerability scores in the form
of a heat map.
0.55
0.50
EM
0.45
0.40
Mar-07
Dec-08
Sep-10
Jun-12
Mar-14
Page 17
9 October 2014
Evolution of EM Vulnerabilities
Asia
China
Hong Kong
India
Indonesia
Malaysia
Philippines
Singapore
South Korea
Taiwan
Thailand
EMEA
Czech Republic
Hungary
Israel
Poland
Romania
Russia
South Africa
Turkey
LatAm
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Venezuela
2007
2008
2009
2010
2011
Low vulnerability
2012
2013
2014
High vulnerability
A number of points become clearer as we analyze the
evolution of country vulnerabilities over time:

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

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

Central European countries on the other hand have
become less vulnerable. Going into the last crisis,
they were among the most vulnerable in EM, with
varying combinations of rapid credit growth, high
inflation, overvalued exchange rates, and large
external and fiscal deficits. Since then, they have
undergone a period of significant deleveraging,
something that we had argued would leave them
Page 18
well place to deliver solid recoveries after years of
underperformance.4

4
Perhaps most remarkable of all in this regard is
Hungary, which has gone from having the highest
overall vulnerability score of any EM country (in
any period covered by our exercise) in late-2007 to
having the lowest score across EM for the current
period. One does of course need to be cautious
about reading too much into this: there are some
indicators not covered in this exercise on which
Hungary would score poorly (e.g. the level of
external debt and the share of foreign currency
debt in total debt). And we continue to have doubts
about the country’s long-term growth prospects.
But the reduction in vulnerability is undeniable.
See, ‘Central Europe: A Good EM Story’ (EM Monthly, March 2014)
9 October 2014
The road ahead
While this look in the rear view mirror is useful, more
important is what these trends will look like going
forward.
A good example of this dynamic aspect of
vulnerabilities is nicely represented by India and
Indonesia, both firmly considered to be part of the
fragile EM camp during the “Taper Tantrum” episode
of last year, undergoing sharp FX depreciation and
capital flow reversal. The comparative ranking within
our 25 country sample shows clearly that these two
economies ranked poorly a year ago with respect to
reserve adequacy. Much has changed since, with India
taking forceful measures to compress the current
account and rebuild reserves. As a result, its ranking on
this metric has improved considerably, while Indonesia
remains stuck on a high vulnerability plane (see
following chart). This analysis underscores the
importance of examining the individual indicators
beyond the aggregate scores. Clearly going forward,
investor perception of resiliency with respect to the
capacity to handle external funding pressure would be
better for India and remain poor for Indonesia.
Change of fortune on the reserve adequacy ranking
Ranking
India
Indonesia
25
20
15
10
5
0
Source: CEIC, Haver, BIS, Deutsche Bank. Reserves as percent of sum of current account deficit
and short term external debt by residual maturity
Recent history is also illuminating in Latin America as
many of the region’s large economies were examples
of robustness up to early 2012. Since then, however,
performance has worsened and policy inaction has
only reinforced that negative path. As noted, the end of
the commodity bonanza marked a critical turn around
for the region´s fortunes, revealing inconsistent policies
in some cases. For example, expansionary fiscal
stances and consumption driven growth in Argentina,
Brazil and Venezuela during the boom years, become
unsustainable as the economic cycle turned around.
Absent corrective policies, this triggered a continued
growth and inflation struggle, and increasing external
vulnerability. Given strong ideological biases by the
authorities in all these three countries, elections appear
as the only venue for hope. This is exactly what market
prices have been reflecting since last Sunday’s election
in Brazil, although political continuity remains the most
likely scenario for the October 26 run off vote. More
promising seems the outlook for Argentina, albeit from
a worse economic status, as failing economic
performance is eroding the political capital of the
government and more orthodoxy seems the most
natural outcome independently of the October 2015
election result. The possibility of a political change in
Venezuela seems further apart, but a critical economic
situation might eventually fuel a process towards
changes.
Mexico is on the opposite side of a changing spectrum
in Latin America. It was the only major country in the
region that did not benefit from the commodity
bonanza and was also negatively affected by sub-par
US growth, its main trading partner. Now, an improved
outlook for the US economy, together with structural
reforms in the energy sector, should help support
economic growth in the years ahead.
In EMEA, the prognosis is mixed. Russia is unlikely to
be flashing amber or red according to our metrics any
time soon. Its low debt, high reserves, current account
surplus, and moderate fiscal deficit, will remain in place
for some time. But we remain pessimistic about the
longer term trajectory. Potential growth has fallen
significantly in recent years. Even if the political crisis
in Ukraine is resolved quickly, the structural reforms
that are needed to change this seem further away now
than ever if, as seems probably, Russia looks to pursue
a more inward-looking growth strategy.
South Africa and Turkey will also likely remain under
strain. In the former, deeper fiscal consolidation is
needed to stabilize debt but will weigh on growth.
Progress is being made on reducing infrastructure
bottlenecks but the momentum behind structural
reforms more broadly remains unconvincing. More
imminently, weaker commodity exports are threatening
to undermine what limited progress we have seen in
reducing the current account deficit. Vulnerabilities in
Turkey are also likely to remain moderate to high as
policymakers remain reluctant to deliver the kind of
sustained adjustment in real rates necessary to reduce
inflation, boost private savings, and bring down
external imbalances.
We are optimistic, however, that the recent reduction
in vulnerabilities in central Europe will be sustained.
External positions, for example, might weaken a little
as domestic demand continues to recover but are
unlikely to return to the credit-fuelled peaks of the past.
The main risk for this group would stem rather from
further disappointing growth in the euro area, and
specifically Germany. The resulting pressure on growth
would slow the process of reducing government debt
levels, which remain moderate to high in these
countries, especially in Hungary.
Taimur Baig, Singapore, (65) 64 23 8681
Robert Burgess, London, (44) 20 7547 1930
Gustavo Cañonero, New York (1) 212 250-7530
Page 19
9 October 2014
To Pay or Not to Pay, Is That The Question?

In this report, we argue that although the economic
crisis and policy inaction has increased the
vulnerability of the country to withstand external
shocks, economic authorities still have the ability
and willingness to pay external financial debt.

In our opinion, the ongoing economic crisis is the
result of a catastrophic policy mix, the
consequence of which would not be solved by the
savings from a potential default

A default in financial external debt would only
create a sharp collapse in economic activity with
disruptions in trade financing and put in peril the
political stability of the regime without major
savings of resources.

We believe the administration recognizes the
importance of access to external financing and
would be willing to take the necessary measures
and continue honoring external obligations.

Economic authorities are not facing the dilemma of
paying foreign debt or paying for imports of
essential goods, yet. A pertinent question to ask,
however, is how long economic authorities will be
able to delay the adjustment measures to correct
the macroeconomic imbalances, and whether a
sufficiently extreme external shock will create the
aforementioned dilemma in the future.

We continue to hold a strategically bearish position
and underweight the Venezuela/PDVSA complex.
On the near term we hold a tactical neutral position,
and employ some defensive asset allocation
strategy (being long on the very front-end and the
very low-priced bonds) and relative value positions
to keep engaged
Introduction
The ongoing economic crisis in Venezuela has fueled
speculation about the possibility of a default in external
indebtedness by the Republic and/or the state-owned
oil company PDVSA. The yields of the PDVSA bonds
maturing in October 2014 surged to over 50% before
recovering to 25%, and the spread curve deeply
inverted, pricing a very high probability of imminent
default. Press reports and statements from economic
authorities on the sale of CITGO, international
arbitration cases against the Republic that would
potentially award the claimants multi-billion dollar
amounts, and policy inaction to address the pressing
issues of the domestic and external imbalances from
economic policy makers, have all contributed in recent
weeks to the heightened risk perception
Page 20
In this special report, we argue that although the
economic crisis and policy inaction has increased the
vulnerability of the country to withstand external
shocks – mainly on the revenues generated by oil
exports – economic authorities still have the ability and
willingness to pay external financial debt. In our
opinion, the ongoing economic crisis is the result of a
catastrophic policy mix that is characterized by
growing expenditure from the public sector, financed
by an expansionary monetary policy, and a fixed
exchange rate regime with tight capital controls. These
imbalances would not, in our opinion, be solved by the
increase in liquidity in foreign currency that savings
from missed amortization and principal payments in
external indebtedness could provide, a fact that
economic authorities seem to understand. Moreover,
even though economic authorities have been rationing
the supply of hard currency, the interest and principal
payments (around USD 10bn in the coming years) do
not seem challenging for an economy with around
85bn in exports and that is still running a current
account surplus.
Venezuela/PDVSA debt repayment schedule for next 10
years – challenging but manageable
VENEZUELA + PDVSA
12
Interest
Principal
10
8
6
4
2
0
2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Source: Deutsche Bank, Bloomberg
The policy mix described has created rampant inflation,
currency overvaluation, an increase in the demand for
foreign currency, a steep depreciation of the black
market exchange rate, an increase in the demand for
imports of goods and services, and a depletion of the
foreign exchange public reserves. The measures taken
by economic authorities have so far worsened the
situation: price subsidies and controls have created
incentives for smuggling, goods shortages and a
deterioration of the productive capacity of the private
sector, and a multi-tiered exchange rate system has
created an inefficient mechanism to supply foreign
currency for imports. Foreign exchange revenues have
9 October 2014
not grown at the same pace as oil production and
exports have slowly but steadily declined.
Plans to partially address the source of these
imbalances were nipped in the bud with the departure
of Rafael Ramirez from the helm of economic
management, just after he had announced measures
such as gasoline price hikes, relaxation of good prices
controls, unification of the different official exchange
rates and consolidation of the different public funds in
foreign currency. More likely, internal opposition inside
the government was the main reason for the new
change in direction, using as an argument that the
political cost of these measures would not be
successfully contained and would put in danger the
prospects of the government ahead of the National
Assembly elections in late 2015.
We expect policy makers to continue muddling through
via half-hearted measures, exacerbating the domestic
and external imbalances. However, a default in
financial external debt would only create a sharper
collapse in economic activity with disruptions in trade
financing – for a country that depends largely on
imports - and the possibility of developing further the
oil industry through external financing, as well as the
disruption to the export of tradable goods such as oil,
which could be subject to the risk of a creditor’s
attempt at attachment or seizure in a foreign court.
Stagnation in economic activity
Source: Deutsche Bank and Banco Central de Venezuela
In our opinion, regardless of the constraints posed by
ideology, the administration still recognizes the
importance of access to external financing and would
be willing to take the necessary measures and continue
honoring external obligations. The sharp drop in
imports in the last two years shows the willingness to
undertake an external adjustment through the
quantitative rationing of goods and services, creating
extra liquidity in foreign currency.
In the short term, economic authorities are not yet
facing the dilemma of paying foreign debt or paying for
imports of essential goods. Shortages of imported
goods and the supply of dollars to the private sector
arise as the politically feasible solutions given the
overvaluation of the exchange rate, the vast demand
for imports and foreign currency that this overvaluation
fosters, and the reluctance of economic authorities to
embark on a complete adjustment plan. Under this
backdrop, a pertinent question to ask is how long
economic authorities will be able to delay the
adjustment measures to correct the macroeconomic
imbalances, and whether a sufficiently extreme
external shock will create the aforementioned dilemma
in the future.
Economic crisis: separating causes from
consequences
Growth, oil sector and inflation
Economic activity has taken a serious hit during the
ongoing economic crisis. Real GDP growth data by
sectors has not been released by the government since
the third quarter of 2013. However, the slowdown in
growth has been considerable since the end of 2012,
mostly explained by a stagnant oil sector and the end
of the temporary stimulus to non-oil economic activity
after the housing missions ahead of the 2012
Presidential elections. Construction activity reached a
growth rate 31.4% YoY during the first quarter of 2012
followed by 20.76% during the second quarter of that
same year. The latest numbers point to 1.3% growth
during 2013 but activity data that has been released
foretells a deep recession for 2014, as many industries
have almost come to a halt given the decrease in
imports and the policy of price controls.
For example, automobile assembly had decreased by a
staggering 75% as of September 2014 compared to the
same month one year ago according to data released
by the Chamber of Automotives of Venezuela.
According to Ecoanalitica (a local consultant) this grim
outlook in economic activity is the common
denominator in most of the non-oil sectors of the
economy, with manufacturing activity growing by
0.9%, mining falling at an 18.2% annual rate,
construction activity falling by 3.9%, and retail sales
dropping by 1.6% for 2014.
Page 21
9 October 2014
Inflation accelerated deepening crisis
According to estimates, oil production will continue
decreasing from the 2.89 Mbpd in 2013 to 2.82 Mbpd
in 2015. The bulk of the expansion in production is
coming from marginal increases in the Orinoco Oil Belt
Areas (OOB) at around 1.2Mbpd, while production in
traditional areas has decreased to between 750Kbpd in
the fields in the west to around 850Kbpd in the eastern
fields, according to oil sector consultant IPD-Latin
America. Adding this stagnant behavior in production
to the recent weakness in oil prices, this implies that
the oil sector will not be able to sustain the fall in
overall economic activity. Real GDP growth for 2014
would print at -3.5 pps.
After significant delays in the release of inflation figures
and a non-explained change in the methodology, the
Central Bank released a report in September that
surpassed the 60% mark for the headline number and
is close to 90% for food and beverages, as the graph
below shows. The acceleration in inflation during 2013,
which continued in 2014, has been related to the deep
depreciation in the black market exchange rate and the
different exchange rate mechanisms that have proved
inefficient in attaining their goals; in addition, the policy
of tight price controls has not been able to decrease
the pressure in the growth in the price level.
Fiscal and Monetary Policy
The behavior of government expenditure in real terms
has amplified the economic activity cycle, as the figure
shows. During the period of the financial crisis,
government expenditure suffered a large contraction,
reflecting the fall in revenues after oil prices plunged.
However, the recovery of oil prices and the run up to
the Presidential elections of 2012 (Chávez vs. Capriles)
triggered a rapid and sustained increase, even after
adjusting for inflation. Since 2013, central government
Page 22
expenditure experienced a large drop that has added to
the current slowdown but this trend has been reversed
in recent months, adding to the imbalances. These
figures do not take into account the expenditure
implemented by state owned companies directly,
especially by PDVSA, which we will describe below.
Monetary policy has continued an expansionary stance,
exemplified by the Central Bank’s purchase of the
public sector’s debt, surpassing 100% of the monetary
base. This monetary financing has stabilized in the last
few months according to the latest figures, putting a
stop to the acceleration in inflation experienced last
year, as the graph shows. However, to tackle inflation,
a stronger adjustment of credit and monetary
aggregates is needed.
Central government primary expenditure (YoY growth–
infl. adj)
Source: Deutsche Bank, Econalitica and MPPFE
Monetary financing of fiscal deficit
Balance of Payments Crisis and Exchange Rate Policy
Sustained increases in fiscal expenditure, financed by
expansionary monetary policy amid a fixed exchange
rate regime, is a long understood recipe for a Balance
of Payments crisis, precisely the situation that
9 October 2014
Venezuela has been suffering in the last two years.
Central bank reserves and the public sector’s net
foreign assets dwindled during the period in which
economic authorities tried to supply foreign currency to
the economy while maintaining an overvalued
exchange rate. However, this behavior stopped during
2013 as the Central Bank’s foreign exchange reserves
hovered around USD 20bn.
Imports collapse without devaluation
The current exchange rate regime that combines three
different official exchange rates has not been able to
counteract the effects of the protracted crisis in
economic activity. Local consultants estimate that
around 60% of disbursements during the second
quarter of 2014 have been at the 6.3 rate (Cencoex)
while 17% have been at the SICAD rate (around 10
VEF/USD) and the remaining 23% have been at the
SICAD 2 (around 50 VEF/USD), implying an effective
exchange rate of around 17.3 VEF/USD. Clearly, this
implies a steep depreciation but the inefficiency of the
system that arises in the huge differential between the
rates, makes the success of this regime unlikely in
improving in efficiency. A more sensible policy would
imply devaluation to a unified exchange rate close to
the effective exchange rate accompanied by a fiscal
and monetary policy consolidation plan. However, the
political and ideological constraints would most likely
preclude these radical measures from taking place,
extending vulnerability to an external revenue shock
Debt Sustainability and External Liquidity
This “sudden stop” in the supply of foreign currency is
behind the worsening of economic conditions during
the last two years. For an economy that depends
heavily on imports for essential goods, as well as for
inputs of production for manufacturing, the fall in
imports has caused the deep deceleration in economic
activity, especially in the non-oil sector. However,
foreign exchange revenues have not fallen to the same
extent that outlays have. While exports – mostly oil –
have remained between USD 80 and USD 90 bn, we
expect imports to close the year at around USD 45 bn,
a sharp drop from the USD 60 bn of 2012.
The reason behind this protracted drop in imports, as
we argued above, is that economic authorities have
chosen to apply quantitative restrictions to the supply
of foreign currency to the private sector, rather than
use an outright devaluation of the official exchange
rate to curb down the demand for imported goods. The
main reason behind this reluctance is related to the fear
of the possible effects that this devaluation might have
in inflation. However, price controls and other
measures to stop inflation have failed and if a complete
adjustment package is not enacted, prices could soon
reach annual growth rates in the triple digits. In our
opinion, a main cause of the acceleration in inflation is
the depreciation of the parallel (black market) exchange
rate. The quantitative measures to limit dollar supply
have created a rapid widening in the differential
between the official rates and the black market rate
that has been translated into accelerating prices in the
last few months.
Solvency still not at peril…
It is a well known truism that countries do not go
bankrupt just as a corporate entity. However, well
documented empirical evidence has found that the
stock of sovereign debt plays a major role in
determining if a country would face a financial crisis
that in many occasions has included defaults in
external sovereign debt. The table below shows that for
most metrics, Venezuela currently is still below the
average threshold that has triggered default episodes
through history in middle income economies. In the
first row, total financial external debt is close to USD
115 bn, around USD 90 bn in bonds and USD 25bn in
debt to China, and valuing GDP at the official exchange
rate implies a ratio to GDP of 25 and 20 pps,
respectively. However, when measuring annual GDP at
the effective exchange rate (around 17 VEF/USD
according to the disbursements of the different
exchange rate systems, this ratio increases to 70 and
55 percent, respectively, which are closer to the
average default (69%) in the historical sample for
middle income countries.
Using another proposed metric of solvency, total debt
as a percent of annual exports – a metric that does not
need to impose any assumption on a “fair” value for
the nominal exchange rate – the ratio is below the
average default in the Reinhart and Rogoff sample.
Considering cash generating exports, the ratio
increased to around 145%, but most of the non-cash
generating exports go to pay for the government-togovernment agreements with China; excluding these
loans implies a ratio of around 109%. To reach the
average ratio for a defaulting country, annual exports
would need to plunge to below USD 40bn per year.
However, it has not been unusual for emerging
economies to default at much lower debt ratios with
Page 23
9 October 2014
extreme cases at levels below 20% as a percentage of
GDP and below 80% as a percentage of total exports.
Moreover, it is not encouraging that Venezuela, which
has experienced 10 episodes since independence in
1830, has been dubbed the “modern day sovereigndefault champion” by these authors.
currency and prioritize debt payments, including the
following.

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

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

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

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

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

Debt issuance and/or liability management
transactions. While there has been speculation
about liability management transactions by PDVSA,
they have not materialized yet. Both the
government and PDVSA could issue foreign bonds,
but at a very high cost at this point. Clearly, it
would be better if they announce some policy
adjustment first to suppress yields and give
investors some confidence.
Foreign financial debt
Total External Debt
% of GDP
USD bn (official rate)
114
25%
Sovereign and PDVSA
Bonds (w/o China loans)
89**
Reinhart and Rogoff's
average default (*)
n.a.
20%
% of GDP
(effective
rate)
70%
% of
annual
exports
156%
% of cashgenerating
exports
167%
54%
122%
131%
69%
230%
(*) From Reinhart and Rogoff's: This Time is Different. Chapter 2, Table 2.1. External debt at the time of default:
Middle-income countries, 1970-2008
(**) Including loans by PDVSA not related to China, but not including interest payment (USD55bn)
Source: Deutsche Bank, Sintesis Financier, and Reinhart and Rogoff (2009): This Time is Different:
Eight Centuries of Financial Folly
…but liquidity gets tighter
While central bank reserves and money available on
the various off-budget funds have been fairly stable
over the past year5, the total resources have sharply
declined from 2012 levels, as shown in the table below.
It is also a question as to how much money held in the
off-budget funds is in liquid form.
Public sector hard currency resources
Fonden and China Fund
Fonden
China Fund
Other Public Sector entities
Bonds in Central Bank
Bonds in Public Banks
Foreign Reserves in Central Bank
Liquid
Non-liquid
Total Foreign Assets
Dec-11
21.9
6.1
15.8
6
29.9
5.6
24.3
57.8
Dec-12
14
4.9
9.1
5.2
29.9
5.5
24.4
49.1
Dec-13
8.3
2
6.3
2.6
2.2
1.3
21.5
1.6
19.8
35.9
Source: Deutsche Bank, Sintesis Financiera and Banco Central de Venezuela
We believe these resources will continue to decline
next year given the now lower oil prices. PDVSA’s
contribution of its “excess” revenues from the “windfall
oil tax” to Fonden, which was USD13bn in 2013 and
estimated at USD10bn this year, will likely shrink to
USD6bn in 2015 assuming oil prices stay at the current
level (USD85 for the Venezuela mix). However, even
without an increase in oil export revenues, there are
various means for the government to save hard
5
Note that the central bank reserves have reportedly dropped by
USD1.8bn this past week, which we believe was for the repayment of
sovereign bonds maturing this year.
Page 24
9 October 2014

Finally, the government and PDVSA could continue
to pursue multilateral agreements, with China,
Russia, etc, as they have done in the past. However,
given the increasingly distressed financing, the
lenders have become more prudent and more
stringent in their conditions. China, for example,
has demanded to put loan repayment into law, so
its claim has de facto become senior to other debt.
All these issues aside, the main point is that with a
daily 1.85mbpd of crude exports, out of which about
1.45mbpd generate cash flows 6 , USD10bn debt
repayments can be made next year. The risk, however,
is clearly to the downside, as Venezuela is increasingly
vulnerable to further drops in oil price. A USD5 drop in
the oil price (average for the year) means Venezuela
receives around USD4bn less in oil revenues a year. So
far in 2014, the Venezuela mix has averaged USD95
and the current price is around USD85. A further drop
to USD85 will likely create some panic in the market,
and as we can see, the cushion looks pretty thin at the
moment.
Prices of the Venezuela mix, since Jan 2013
term. We expect piece-meal measures, more along
the line of further stealth devaluation, over the
course of next year, but that will likely not be
enough. The risk of the country running into a
blow-up scenario over the medium term, especially
if oil prices drop further, is very high.

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

Finally, we believe the government has a strong
willingness to pay as the cost of a default is
prohibitively high. A default in financial external
debt would only create a sharper collapse in
economic activity with severe disruptions in trade
financing and ability to import essential goods, and
cause significant disruption to the export of
tradable goods such as oil given the risk of
creditors attempting to attach or seize in foreign
courts. In short, under our baseline scenario, the
country still has the willingness and ability to
service foreign financial debt.
We continue to hold a strategically bearish position and
underweight the Venezuela/PDVSA complex. Over the
near term, however, we hold a tactical neutral position,
and employ some defensive asset allocation strategy
and relative value positions to keep engaged.
Veenzuela crud mix, price
115
110
105
100
95
90
85
80
4-Jan-13
4-Jun-13
4-Nov-13
4-Apr-14
4-Sep-14
Conclusion and market implications
There are several conclusions we can draw from our
analysis above:

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

Second, the current policy mix, if not significantly
altered, is clearly unsustainable over the medium
6
According oil consultancy IPD/LatinAmerica, the total daily shipment
included in the Energy Supply Cooperation Agreements (ESCAs) amount to
914kp per day. Out of this about 390kp per day affecting cash flows
Specifically, we continue to favor a defensive, barbell
position of being long on the very front-end (PDVSA
15s and EUR 15s) and the lowest-priced bonds (PDVSA
24s and 37s). On relative value, we believe
confirmation of Venezuela 14s repayment (this week)
and PDVSA 14 repayment at the end of the month,
which we expect, will help alleviate some concerns of
near-term default.
While we have discussed in length above the rationale
for keeping the long recommendation in shorter
duration bonds, the reasons for us to focus on the very
low priced bonds is their defensive traits – the prices on
those bonds tend to find stronger support once they fall
below 50 and bondholders will likely incur only limited
losses under the worst case scenario of a default.
Historically, the average recovery value in the major
EM sovereign default is around 50%. While it is difficult
to put a number on potential Venezuela or PDVSA
restricting scenarios, there are reasons to believe they
will likely be on the high side. First, since a default
would likely be the result of poor economic policies and
significant mis-management of the vast oil resources in
this case, it would likely lead to a government change.
A new government could turn around the ship with
more market friendly policies, leading to a low exit yield
Page 25
9 October 2014
in a potential debt restructuring. Second, creditors
could potentially attempt to attach or seize oil
shipments or revenues offshore in the event of
Republic default, and CITGO assets in the event of
PDVSA default . If such attempts are successful, it
would limit creditors’ loss upon a potential default.
Debt reliefs in EM some major EM sovereign
Finally, in relative value, we position for some recovery
of PDVSA bonds relative to the sovereign curve via
long PDVSA 17Ns vs. Venezuela 20s. Please refer to
the LatAm Strategy section of our EM Monthly for
more details on our strategy recommendations.
Armando Armenta, New York, (1) 212 250-0664
Hongtao Jiang, New York, (1) 212 250-2524
restructurings
Source: Deutsche Bank, IMF
Page 26
9 October 2014
Remember, not all EM currencies are equal
After a broad-based sell-off in EM FX over the past
couple of months, we cannot help to feel the gloom is
overdone and expect greater differentiation again at
some point over the next few months as an
indiscriminate 2013 taper-style EM FX sell-off makes
little sense given the substantially different outlooks for
many EM currencies. It also makes little sense given
the lack of wage pressures in this cycle, as it would
suggest that any hiking cycle will be very gradual,
giving the recovery further time to take root. Different
criteria according to which we examine EM FX will
result in different ranks. We therefore ultimately
assemble a combine metric that should in principle
help to shed some light on the “currency vulnerability”
question within the EMFX universe. We examine:

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

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

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

real rates: We look at FX resilience from the real
monetary policy perspective
EM balance sheet vulnerability metric
For the balance sheet assessment we focus on
variables such as the adequacy of foreign reserves visà-vis the C/A balance and short-term external debt, the
degree of leverage that has been built up in recent
years in the private sector, FX valuation according to
our fundamental metrics, public debt as % of GDP, as
well as fiscal balances also as % of GDP. Most of these
variables are neatly summarized by our Economics
team elsewhere in this EM Monthly in “Assessing EM
Vulnerabilities”, but below we present a scaled down
version, where we simply offer a relative ranking rather
than measuring the ‘absolute’ level of vulnerability. The
chart below summarizes the aggregate measures
(average percentiles) across EM
EM FX ‘balance sheet vulnerability’ – from least to most
‘risky’ – in percentiles 2009 to date
PHP
HUF
RON
KRW
TWD
CZK
PEN
CNY
ILS
RUB
COP
PLN
IDR
THB
CLP
MYR
SGD
MXN
INR
BRL
TRY
ZAR
least vulnerable
most vulnerable
0.3
0.4
0.5
0.6
0.7
By our measure PHP, RUB, PEN, CNY, KRW, RON, COP,
IDR, CLP, HUF, TWD, and THB are all in the lower 50th
percentiles for the past 6 years, i.e. they have relatively
low balance sheet risk, and should not suffer major
funding problems in response to a turn in the US
interest rate cycle. ZAR, TRY and BRL, on the other
hand, continue to be vulnerable to a turn in the US
interest rate cycle, due to large C/A deficits, limited
foreign exchange reserves and limited room for fiscal
stimulus (BRL and ZAR).
FX valuations wildly different across EM
Valuation can also in principle be used as a
vulnerability indicator – less/more valuable FX would be
associated with more/less vulnerable FX In this section
we define valuation with respect to a set of real
exchange models that we currently have in place. The
chart below left shows our latest (August) estimates of
longer-term fair value for EM exchange rates based on
three alternative models adjusted PPP, BEER and FEER.
Our calculations point to overvaluation across all three
approaches in China, Hong-Kong, Singapore, Russia,
Argentina, Brazil, Mexico, and [almost] Peru; and
undervaluation in Taiwan, Czech Republic, Hungary,
Poland, Romania and Turkey, with India undervalued
on FEER and PPP, whilst largely fairly-valued on BEER.
and South Africa and fairly-valued on BEER.
Page 27
9 October 2014
Our latest estimates of longer-term fair-value in EM
BEER
%
35
FEER
PPP
EMEA
Asia
30
VEF PPP
estimate:
+75.0%
LatAm
25
20
Overvalued
15
10
5
0
Undervalued
-5
-10
-15
-20
VEF
PEN
MXN
CLP
COP
BRL
TRY
ARS
ZAR
RUB
RON
ILS
PLN
CZK
HUF
THB
TWD
PHP
SGD
MYR
KRW
INR
IDR
CNY
HKD
-25
Short term valuation: where do we stand?
Being a risky asset itself, EMFX tends to fluctuate to
benchmark financial assets in accordance to markets
overall appetite for risk. Beyond its long term intrinsic
valuation, mean reversion of shorter tern deviations
from these benchmark asset can also be used as a
source in EMFX. The deviations from the short term
model (regression based) are presented in the chart
below. Accordingly, other than KRW most EMFX seem
to be either fair or undervalued on this metric.
Particularly interesting are COP and PEN - low volatility
currencies that besides being “cheap” are currently
sitting on the top of their range. The metric also implies
value on high beta currencies such as BRL, RUB, TRY,
IDR and ZAR. These however have the caveat of having
higher volatility and consequently higher drawdowns
associated with the longs
Our latest estimates of longer-term fair-value in EM
18%
COP
6%
4%
0
-2
Basic balance (% GDP)
Real short-term rates
-4
-6
TRY ZAR IDR BRL PLN MXN COP INR PEN CZK RUB CLP RON MYR CNY PHP KRW ILS THB
8
Real ST rate - Basic balance
0
TRY
8%
2
IDR
ZAR
10%
4
2
14%
RUB
6
4
BRL
12%
Another Vulnerability angle: Real rates
6
implied volatility (3M)
16%
Where are policy adjustments sufficient to cover
current account deficits?
A good additional measure of FX resilience is whether
real monetary policy has been sufficiently adjusted to
compensate for a country’s external vulnerability. Here,
rather than being proxied by the current account deficit,
vulnerability is proxied by the (negative of) the basic
balance (C/A deficit+FDI). This is especially important
in correctly assessing the vulnerability of currencies
such as PEN and COP, which are less vulnerable than
they appear based only on their C/A deficits. Using this
measure, ZAR and TRY stand out, with monetary policy
which has not adjusted sufficiently to compensate for
the severity of the external deficits: TRY exhibits a
positive but too small real rate, where ZAR currently
has a negative real rate. Elsewhere MXN, IDR and COP
appear somewhat vulnerable, despite positive real rates
in the two latter countries.
CZK
PEN
-2
CLP
MYR
INR
HUF
THB
KRW
MXN
ILS
-4
-6
PLN
ZAR TRY MXN IDR COP PHP INR RUB CZK PLN CLP PEN BRL MYR RON THB ILS KRW CNY
SGD
2%
financial overvaluation
0%
-8%
-6%
Page 28
-4%
-2%
0%
2%
4%
However, there are a few exceptions, most noticeable
Brazil, where a negative basic balance is offset by real
rates firmly in positive territory. Other poor balance
currencies arguably offering attractive enough returns
to offset fundamentals include PLN, PEN, and INR,
where the rupee is supported by a central bank intent
on stemming inflation. At the other end of the
spectrum KRW, MYR, CNY, THB and ILS all appear
strongly out of line with real returns. Should markets
stabilize CNY, KRW, MYR and THB seem to represent
good value
9 October 2014
Conclusion:
Most EM currencies have weakened over the past few
months, despite outlooks that differ, in some cases
substantially. Our vulnerability assessment above
would suggest that while there are noticeable
exceptions (Turkey, and to a smaller extent South
Africa), emerging markets in general are not facing a
balance sheet crisis. Instead it is a lack of growth that
has seen EM central banks ease policy aggressively,
resulting in reduced carry and FX weakness. However,
economies with external surpluses, attractive FX
valuations and relatively low inflation should see
growth pick-up as demand in the developed world
improves. A pick-up in growth would allow for some
policy normalization, which in turn would provide
support for those currencies as Fed eventually starts to
tighten policy. Conversely, currencies most at risk of a
further sell-off are those with large current account
deficits, sticky inflation and therefore also a need for a
more restrictive monetary policy, which in turn is
weighing on growth prospects.
Obviously there are other dangers which will or could
change the ‘rankings’ above, with weaker commodity
prices providing additional challenges for some but
relief for others, while geopolitics are adding to
concerns in other cases. Also, and as we have seen
repeatedly in this cycle, positioning will also be of
relevance, with the more vulnerable EM credits
typically also the ones where most of the shorts are
lined up.
Nonetheless, to better assess balance sheet risk, and in
order to also take into account the currency adjustment
which have already taken place and to what extent
policy is offsetting fundamentals we build an indicator
where we score emerging markets using the three
different metrics presented above. The currencies with
the healthiest readings in each category get a score of
+1, while the worst get a mark of -1, with +0.5, 0 or 0.5 for the currencies in between. The indicator hence
provides a relative strength ranking, narrowing down
the currencies more likely to face balance sheet
pressures, and where valuation and/or policy have not
adjusted sufficiently to provide protection. At the other
positive end of the spectrum we find currencies where
balance sheet risk is limited, valuation competitive
and/or real rates more attractive. For these economies
currency depreciation in recent months has been more
a reflection of risk aversion and USD momentum,
taking FX increasingly out of line with fundamentals.
Henrik Gullberg, London, +44 207 545 9847
Guilherme Marone, New York, +212 250 8640
Assaf Shtauber, New York, +212 250 5932
.
Aggregated EM currency ranking – from ‘resilient’ EM
FX to ‘vulnerable’ EM FX
1.200
1.000
resilient EM FX
0.800
0.600
0.400
0.200
0.000
-0.200
-0.400
-0.600
vulnerable EM FX
-0.800
HUF TWD RON MYR PLN CZK KRW CLP IDR PHP THB RUB CNY PEN SGD INR ILS ZAR TRY MXN COP BRL
EM currency score
Page 29
9 October 2014
With the EU Cohesion Policy funds allocation for the
2014-2020 budgeting period announced earlier this
year, Poland emerged as the big winner, capturing by
far the largest allocation. In this report, we shed light
on the absorption, application and impact of these EU
funds, with a focus on the performance of Poland and
Romania in the previous budgeting period (2007-2013);
these two countries have had contrasting fortunes in
the EU funds arena. We answer the following
questions in relation to EU funds:
1)
What is the Cohesion Policy framework?
2)
What were the structural funds allocations for the
2014-2020 period?
3)
How are these funds allocated to investment
projects?
4)
What were the structural funds allocations for the
2007-2013 budgeting period?
5)
What were the structural funds absorption rates
for the 2007-2013 budgeting period?
6)
What are the main causes of divergence in
absorption rates between countries?
7)
Why does Poland have such a high absorption
rate?
8)
What are the expected amounts of EU funds
inflows into Poland over the coming years?
9)
What is the impact of EU funds inflows on
growth?
10) What are the other major EU funds programs, and
what is the impact of EU funds on a country’s
external balance?
EU structural funds
1) What is the Cohesion Policy framework?
It is the policy framework within which investment
projects receive funding from the EU’s two structural
funds – European Regional Development Fund (ERDF)
and European Social Fund (ESF) – as well as the
Cohesion Fund. The primary aim of the Cohesion Policy
is to reduce “disparities between the various regions
and the backwardness of the least-favoured regions”.
Formally, the Cohesion Policy aims to, via specifying
investment priorities for accessing EU structural funds,
(a) assist lesser developed regions and improve
convergence through accelerating growth; (b) increase
regional competitiveness and employment; (c)
encourage cooperation across EU states. The bulk of
structural funds (around 80%) under the Cohesion
Policy are earmarked for convergence objective (a),
while objective (c) is allocated a very small fraction
(around 3%).
The specific aim of the Cohesion Policy for the 20142020 period is to fund investments that help deliver the
Europe 2020 goals: creating growth and jobs, tackling
climate change and energy dependence, and reducing
poverty and social exclusion. Investment projects that
target these goals will be given priority for receiving
Cohesion Policy funds, the EU’s main tool for investing
in physical capital (primarily infrastructure), human
capital and research and development (R&D).
2) What were the structural funds allocations for the
2014-2020 period?
For this budgeting period, EUR 351.8bn of structural
funds will be available to invest within the Cohesion
Policy framework, which is 1.4% higher than the
amount allocated for the 2007-2013 period (EUR
347bn).
The country allocations for the 2014-2020 period are
shown in the chart below.
Cohesion Funds allocation for 2014-2020 (EUR bn)
80
70
60
50
40
30
20
LU
DK
MT
IE
AT
CY
FI
NL
SI
SE
BE
LT
LV
EE
BG
HR
EL
SK
UK
PT
FR
DE
CZ
HU
IT
ES
-
RO
10
PL
With the EU Cohesion Policy funds allocation for the
2014-2020 budgeting period announced earlier this
year, Poland emerged as the big winner, capturing by
far the largest allocation. In this report, we shed light
on the absorption, application and impact of these EU
funds, with a focus on the performance of Poland and
Romania in the previous budgeting period (20072013); these two countries have had contrasting
fortunes in the EU funds arena.
Source: Deutsche Bank EC
Page 30
9 October 2014
Poland obtained an allocation of EUR 77.6bn, by far the
largest national allocation among the 28 EU member
states, with Italy the next biggest beneficiary (EUR
32.8bn). Aside from Poland, the other CEE4 countries –
Romania, Czech Republic and Hungary – also obtained
sizable allocations of EUR 21-23bn. Of these CEE4
countries, only Poland and Romania secured a higher
allocation than in the previous budgeting period.
Country allocations are determined, through a
negotiation process, by the EC on the basis of need
(accounting for population size) as well as ability to
absorb the funds. As the chart below shows, poorer
countries generally get larger allocations of EU
Cohesion policy funds. Within CEE4, Romania’s
allocation was relatively small given its low level of
GDP per capita, likely because of Romania’s record of
weak absorption of EU funds. In the previous
budgeting period (2007-2013), Romania was only able
to absorb 45% of its allocated Cohesion Policy funds,
one of the lowest absorption ratios in the EU.
Lesser developed countries generally get larger
allocations of structural funds
the Cohesion Policy, the level of EU co-financing is
larger. Therefore, while the priorities for investments
using EU structural funds are set at the European level,
project implementation and management (as well as
selection) are handled by national or regional
authorities.
It is also important to note that EU funds are not paid
to firms in advance, and thus pre-financing of projects
(through government bodies or private banks) is
required.
4) What were the structural funds allocations for the
2007-2013 budgeting period?
As is the case for the upcoming budgeting period,
Poland was allocated the highest amount (EUR 67bn)
in the 2007-2013 period as well (see chart below).
Cohesion Policy funds allocation for 2007-2013 (EUR bn)
80
70
60
50
40
30
20
10
0
PL ES IT CZ DE HU PT GR RO FR SK UK LT BG LV SI EE BE NL SE FI AT MT IE CY DK
Source: Deutsche Bank, EC
allocation) of Cohesion Policy funds
90
%
80
70
60
50
40
30
20
10
Croatia
Malta
Balgaria
Romania
Italy
Slovakia
Czech Rep.
UK
Slovenia
Hungary
Spain
France
Cyprus
Luxembourg
Latvia
Poland
Austria
Ireland
Sweden
Netherlands
Denmark
Belgium
Germnay
0
Greece
Investments receiving EU structural funds must be cofinanced by public or private institutions. The level of
EU co-financing varies between 50% and 85% (of the
total project cost), depending on socio-economic
factors. In less developed (poorer) regions and for
investment projects which fulfill the higher priorities of
Absorption rates (expressed as a % of total country
Lithuania
Finland
3) How are these funds allocated to investment
projects?
The projects are selected by administrative/government
authorities in each country, and therefore firms apply
to these authorities for funding via the EU’s structural
funds. To a large extent, only projects which satisfy the
criteria noted in (1) are selected to receive EU funding.
Within each country, a larger amount of EU funds are
allocated to lesser developed regions, and thus
investment projects in the poorer regions of a country
are given priority.
Estonia
Portugal
5) What were the structural funds absorption rates for
the 2007-2013 budgeting period?
The absorption rate, i.e. the extent to which a country
is able to access and spend its allocation of EU
structural funds, varied considerably across countries
(see chart below).
Page 31
9 October 2014
Within CEE4, Poland had the highest absorption rate, a
substantial 71%. This amounts to EUR 48bn obtained
in subsidies within the EU’s Cohesion Policy
framework.
On the other hand, Romania had the lowest absorption
rate in CEE4 (45%), which was also the second lowest
rate (after Croatia, which only joined the EU in 2013)
within all of EU.
6) What are the main causes of divergence in
absorption rates between countries?
There are two main determinants of a country’s
absorption rate.
Financial capacity: As noted in (3), the financial sector
(including public and private banks) plays an important
role in the absorption of EU structural funds, as it
provides the pre- and co-financing that are crucial for
obtaining EU funds. Therefore, a country’s financial
sector
development/effectiveness
is
a
crucial
determinant of its absorption rate, and there is
generally a positive relationship between the two, as
illustrated in the chart below.
subsidies from EU funds are not paid to firms in
advance but rather in installments over time as the
investment project progresses, the correct selection of
projects and proper management of selected projects
by the authorities are important determinants of the
timely absorption of EU funds.
We use the World Bank’s government effectiveness
index as a broad measure to capture the factors noted
above, and a country’s administrative capacity in
general. The chart below, which plots the absorption
rate for the 2007-13 period vs. government
effectiveness, shows a positive relationship between
the two.
Absorption rate vs. government effectiveness (20072013 period)
Absorption rate vs. financial sector development
(2007-2013 period)
Source Deutsche Bank, World Bank, EC
Source Deutsche Bank, World Bank, EC
Administrative capacity: In addition to financial
capacity, administrative capacity, or the effectiveness
of the government in general, plays an important role
in determining absorption of EU Cohesion Policy funds.
This is primarily because projects are selected,
managed and monitored at a national or regional level
by government/administrative bodies. If the application
and project selection process is not streamlined and
transparent, this could discourage applications for EU
funds by firms. Similarly, greater bureaucracy and
longer lengths of time taken by authorities for project
assessment also deter applications (as is the case for
Romania), while projects need to be carefully selected
in order to ensure they meet the EU criteria and are
thus eligible to receive structural funds. Further, as the
Page 32
The chart indicates that Romania’s low level of
government effectiveness (which is in fact the lowest
in the EU) is the likely cause of its low absorption rate.
This extremely poor government effectiveness could
also explain why Romania’s absorption rate is even
lower than indicated by its financial sector
development (as shown in the previous chart). Further,
Romania only joined the EU in 2007, which also likely
contributed to its low absorption rate in the 2007-13
period.
7) Why does Poland have such a high absorption rate?
In contrast to Romania, the performance of Poland in
absorbing structural funds has been even better than
implied by our general measures of government
effectiveness and financial sector development. This is
partly due to the fact that Poland joined the EU three
years earlier than Romania, and this greater experience
with EU funds no doubt left its administrative
processes better evolved to efficiently absorb EU funds.
Further, on the administrative side, the Polish
government has paid special attention to the issue of
EU funds and their successful absorption. Provisions
and processes were setup to properly monitor and
9 October 2014
manage investment projects through regional bodies.
In addition to private firms, local authorities also
undertook investment projects which accessed EU
funds. The decentralized administration in Poland –
within which the flexible regional bodies play a large
role
in
project
selection,
management
and
implementation – contributed to increasing the
absorption rate by dividing the administrative burden
between
local
governments
and
stimulating
competition for funds between them.
EU funds inflows into Poland
18
EUR bn
16
14
12
10
8
6
4
However, all issues associated with structural funds
are overseen by the central Ministry of Regional
Development, which was created in 2005 with the
primary objective of attracting and efficiently managing
EU funds. This Ministry, under the stable leadership of
Elzbieta Bienkowska (who was earlier this month
appointed as a European Commisioner), coordinated
and monitored local authorities in all matters
associated with EU funds. The dual governance
structure for the management of EU funds significantly
increased the administrative capacity of Poland. In
contrast, the central government in Romania bears the
bulk of the administrative burden associated with EU
funds, and the Ministry controlling EU funds has seen
substantial personnel turnover in recent years.
On the financial side, almost all of the co-financing of
projects in Poland was provided by the government via
the central budget. Additionally, these payments were
often made in advance, with the government then
claiming the money from the EU structural funds – this
reduced uncertainty for firms and encouraged
applications for EU funds, as well as speeding up the
implementation of investment projects.
8) What are the expected amounts of EU funds inflows
into Poland over the coming years?
As the figure below shows, for the 2007-2013
budgeting period, EU funds inflows into Poland
amounted to approximately EUR 7bn annually at the
start of the period and rose to EUR 15bn at the end of
the period, likely due to improvements in financial and
administrative capacity over the budgeting period.7
2
0
2004
2005
2006
2007
EU Transfers (gross)
2008
2009
2010
2011
2012
2013
EU Transfers (net of contributions to the EU)
Source Deutsche Bank, Haver Analytics
Focusing on Cohesion Policy funds for the upcoming
budgeting period, we believe that the Polish absorption
rate will be at least as high as it was in the previous
period (71%), but is likely to be higher (possibly closer
to around 75-80%) as the administrative setup for
overseeing and managing EU funds has improved over
the past budgeting period. Assuming an absorption
rate of 75%, this implies a total of EUR 58.2bn of
structural funds inflows into Poland between 2014 and
2020, or an average of EUR 8.3bn annually over the
seven years (however, the structural funds inflows in
2014 from the current budgeting period allocation are
likely to be lower than this, as the allocations were only
announced in March). This amounts to a significant
2.1% of 2013 GDP.
9) What is the impact of EU funds inflows on growth?
The substantial EU funds inflows during the 2007-13
budgeting period helped Poland's economy to grow
during the crisis, unlike most other European peers.
These funds were absorbed at a very opportune time,
i.e. arguably when they were most required and had a
substantial impact on growth – EU structural funds
were able to replace (partially) FDI flows which dried
up during, and in the aftermath of, the crisis. Most of
these EU funds went towards infrastructure projects
(roads, highways, railways), with large amounts also
going to the IT, education and healthcare sectors.
Polish real GDP growth in 2009 was 1.6% and in 2010
was 3.9%. On the other hand, real GDP in Romania –
which absorbed only EUR 8.6bn of the EUR 19.1bn
Cohesion Policy EU funds allocated to it for 2007-2013
– declined by 6.6% in 2009 and by 1.2% in 2010.
7
Note that these figures include inflows from all EU funds, not just those
within the Cohesion Policy framework.
Page 33
9 October 2014
Poland was the only CEE4 country to register positive
growth throughout the crisis
Real GDP (YoY %)
Euro area avg.
10
Romania
Poland
12
8
6
4
2
0
-2
-4
-6
via EU funds was primarily driven by the resulting
increase in investment (mainly in infrastructure); EU
funds are estimated to have increased the investment
rate by 3.5pps, also causing a significant reduction in
unemployment. We believe that structural funds
inflows will continue to provide upward impetus to
Polish growth in the upcoming budgeting period,
though not as large an upward push as during the
2007-2013 period (when the incoming funds during the
crisis assisted Poland in avoiding a recession); the
impetus to growth from EU structural funds would be
greater if Poland were indeed able to increase its
absorption rate.
-8
-10
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
Apr-12
Apr-13
Apr-14
Polish investment rate (gross fixed capital formation as
a % of GDP, in nominal terms)
Source Deutsche Bank, Haver Analytics
However, isolating and accurately estimating the
causal impact of EU funds inflows on growth is
problematic, a point which has been noted by the
European Commission. 8 In the existing academic
research, the view by and large is that EU funds
increase growth, but only upto a point and only when
combined with an effective governance framework.
The administrative or governance framework plays a
crucial role in a country’s efficiency in translating EU
funds inflows into growth, as the administration is
responsible for appropriately choosing projects (in the
correct sectors) and also managing these projects
(Everdeen et al, 2006).9 Further, while poorer countries
benefit more from EU funds in general, EU funds also
have a decreasingly positive effect on growth. Becker
(2012), for example, suggests that EU transfers in
excess of 1.3% of the recipient country's GDP do not
generate any additional growth.10
Focusing on the case of Poland, the government
estimates that Cohesion Policy funds will add 0.7pps to
annual GDP growth, on average, over the 2004-2015
period. 11 Additionally, these funds contributed to
Poland having the fastest pace of economic
convergence within the EU between 2007 and 2011;
during this period, the difference between Polish and
EU average GDP per capita decreased by 12pps, with
government estimates indicating that 20% of this
reduction was due to EU funds. The boost to growth
Source: Polish Ministry of Regional Development
YoY growth in investment
30
25
20
15
10
5
0
-5
-10
-15
2004 Q2
2006 Q2
2008 Q2
2010 Q2
2012 Q2
2014 Q2
Gross fixed capital formation (real, YoY %)
8
See the EU Economic 2004 Review published by the European
Commission.
Source: Deutsche Bank, Haver Analytics
9
See Ederveen S., H.L.F. Groot and R. Nahuis (2006) ‘Fertile Soil for
Structural Funds? A Panel Data Analysis of the Conditional Effectiveness of
European Cohesion Policy’, Kyklos vol 59(1), pp 17-42, 02,
Blackwell Publishing
10
See Becker, S. (2012) ‘EU Structural Funds: Do They Generate More
Growth?’, The CAGE-Chatham House Series, No. 3, December 2012.
11
See Polish Ministry of Regional Development manuscript:
http://www.europarl.europa.eu/document/activities/cont/201307/20130710
ATT69468/20130710ATT69468EN.pdf
Page 34
10) What are the other major EU funds programs, and
what is the impact of EU funds on a country’s external
balance?
In addition to the structural funds provided within the
Cohesion Policy framework, the EU also provides funds
via the Common Agricultural Policy (CAP). These
subsidies are aimed at supporting agriculture and
9 October 2014
15
2013
2012
2011
2010
2009
2008
2007
20
2006
2000
25
2005
30
2004
EUR bn
2003
35
180 % of CAD covered by
160 net Capital Account and FDI
140
120
100
80
60
40
20
0
2002
EU Common Agricultural Policy allocations for CEE4
EU funds have enabled a significant fraction of the
Polish CAD to be financed by the net capital account
and FDI
2001
building sound and (economically as well as
environmentally) sustainable agricultural sectors in
European countries. EU funds within CAP are provided
via direct payments (mostly subsidies to farmers) and
rural development funds. As a result of this policy,
Poland will get another EUR 32bn in EU funds during
the 2014-2020 budgeting period, while Romania will
also get a substantial EUR 20bn.
Poland
10
5
0
Poland
Hungary
Czech Republic
2007-2013
Gautam Kalani, London, +44 207 545 7066
Romania
2014-2020
The inflows of EU funds (structural funds as well as
funds from other programs such as the CAP) register
as credits in a country’s capital account, and thus lead
to an improvement in the balance of payments. As a
result of substantial EU funds inflows, Poland has an
extraordinarily large positive net capital account;
further, EU funds represent a relatively stable source of
funding (capital inflows) for Poland and, along with net
foreign direct investment inflows, the capital account
has financed a significant fraction of the current
account deficit (see charts below).
Poland has an extraordinarily large positive net capital
account as a result of substantial EU funds inflows
10
Capital Account (EUR bn)
8
6
4
2
Poland
Romania
Hungary
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
-2
2000
0
Czech Rep.
Page 35
9 October 2014
Analyzing relative value using Snapshot

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

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

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

We introduce these new enhancements and also
discuss some relative value themes and
opportunities using graphs and data provided in
this report.
First, it is worth noting that, we have now added a
table of contents with full indexing capability to the
report. Now it is much easier to navigate to a particular
country or ticker in the report by clicking on the
corresponding line in the table of contents, or by using
the PDF bookmarks.
New feature in Snapshot – table of content with full
PDF indexing
There is currently more uncertainty, and less conviction
in the EM credit market. Valuation has recently
improved, but the market will likely continue to face
headwinds in the coming weeks. Against this backdrop,
we continue to favor relative value while volatility is
high and market direction is unclear.
Our daily report, the EM Sovereign Credit Valuation
Snapshot (or simply the Snapshot), which we created in
July 2013 and enhanced a couple of times since then,
covers the most important valuation aspects of the
sovereign credit market. It is one of the main tools we
use to not only monitor market pricing and asset
performance but also to analyze relative value
opportunities.
In this article, we introduce some of the latest
enhancement to this report, and discuss a couple of
relative value themes and opportunities based on the
information and graphs provided by the report.
Recent enhancements to the Snapshot
Before discussing the outstanding relative themes and
opportunities, we provide a quick introduction to our
latest enhancements to the report.
Page 36
More importantly, we have recently included a number
of major quasi-sovereign curves that cover all the three
regions. The curves we have covered for now are
shown in the table below. We vote one half page for
each of these quasi-sovereign names and put them
after the sovereign credits (page 24 through 31).
9 October 2014
Quasi-sovereign names included in the Snapshot
Country
Indonesia
Indonesia
Brazil
Brazil
Brazil
Brazil
Mexico
Mexico
Chile
Colombia
Russia
Russia
Russia
Kazakhstan
Argentina
Venezuela
Ticker
PLNIJ
PERTIJ
BNDES
CAIXBR
BANBRA
PETBRA
PEMEX
CFELEC
CDEL
ECOPET
SBERRU
VTB
GAZPRU
KZOKZ
BUENOS
PDVSA
Name
PERUSAHAAN LISTRIK NEGAR
PERTAMINA PERSERO PT
BANCO NAC DE DESEN ECONO
CAIXA ECONOMICA FEDERAL
BANCO DO BRASIL (CAYMAN)
PETROBRAS GLOBAL FINANCE
PETROLEOS MEXICANOS
COMISION FED DE ELECTRIC
CODELCO INC
ECOPETROL SA
SBERBANK (SB CAP SA)
VTB BANK (VTB CAPITAL SA
GAZPROM (GAZ CAPITAL SA)
KAZMUNAYGAS NATIONAL CO
PROVINCIA DE BUENOS AIRE
PETROLEOS DE VENEZUELA S
Sector
Utilities
Energy
Government
Financial
Financial
Energy
Energy
Utilities
Basic Materials
Energy
Financial
Financial
Energy
Energy
Government
Energy
To the right of this graph, we show two time series
with different valuation aspects of the quasi-sovereign
bonds. The first is the z-spread of the benchmark (or
the most liquid) bonds on the curve. This is typically the
10Y benchmark, with the exception of BUENOS, for
which we use the 21s. The second time series is the
spread to sovereign curve measure for the same
benchmark bond. See the next section for a definition
of this measure.
Example of benchmark spread & benchmark spread to
sovereign (PEMEX)
Similar to the sovereign curves, we focus on the
valuation aspects of the bond curves as well as 5y CDS,
wherever it is applicable. Due to lack of liquidity on the
other tenors, we only focus on 5Y CDS for these quasisovereigns. In the following text, we provide some
details on these enhancements, both in terms of the
content and methodology involved.
Spread curve and cash performance
Similar to a sovereign page, we first show the spread
curve (cash and CDS, if applicable), overlaid with the
corresponding sovereign par curve, as shown in the
example below (Pemex). The sovereign par curve is
simply a result from our Term Structure Model (TSM)12.
Example of quasi-sovereign spread curve, in
comparison with the sovereign par curve (PEMEX)
12
The term structure model is a bond fair valuation model to identify the
richness/cheapness of a bond to the credit (cash) curve and to calculate
fair yield for a new issuance. It is based on deriving a term structure of
survival probability that fits the market price of the curve as closely as
possible, where the term structure is expressed in a parametric form
(linear combination of exponential functions) and calibrated via optimization
Spread to sovereign curve
One of the unconventional measures we employ and
show in this report is the so-called “spread to the
sovereign curve” for a quasi-sovereign bond (or a
corporate bond in general). It is not the relative
performance of the bond vs. its corresponding
sovereign benchmark bonds – a scheme that is quite
widely used among EM corporate investors. Rather, we
present the concept of each bond’s relative spread to
the sovereign curve. This is essentially the difference
between the bonds z-spread over the US Libor/swap
curve and the same spread measure obtained
assuming the bond is priced fairly on the sovereign
cash curve. In other words, we calculate the spread of
the bond with the sovereign cash curve implied default
probabilities and recovery value (i.e., sovereign curve
implied spread), and then take the difference between
the market spread of the bond and this calculated
sovereign curve implied spread to arrive at the spread
to sovereign curve. This spread has been calculated on
daily basis and saved in our system so that we can
examine this measure for each bond on historical basis.
Bond and CDS valuation
Similar to our presentations for a sovereign curve, we
provide a table showing the current market pricings
and analytics (price, labor spread, and par-equivalent
spread for select distressed curves), as well as past 1day, 1-week, and 1-month changes in the labor spreads.
Page 37
9 October 2014
The color mapping scheme is the same as for a
sovereign13.
Example of cash slope time series (Gazprom 10s30s)
In addition, the right-most column of the table shows a
range bar chart of the spread to sovereign measure we
have defined above, with the light blue area covering
the 2% to 98% range of the past one year (mostly for
filtering out bad data), the dark blue showing the 25%
to 75% range of the past one year, the solid dot
indicating the current level, and the little bar
representing the median of the past three months.
Example of bond and CDS valuation table (PEMEX)
Current observations on the quasisovereign curves
A glance at the quasi-sovereign section of the current
Snapshot reveals some interesting observations.

Slope of the cash curve
The final chart for a quasi-sovereign curve is the slope
of the cash curve, typically the slope between the 10Y
and 30Y benchmark bonds on the curve, or the slope
between the 5Y and 10Y benchmarks if the curve is a
short one (e.g., BNDES).
PERTIJ: long end offers more attractive pickup over
sovereign. Consistent with our existing views on
the Indonesia complex, the PERTIJ curve is
currently on the steep side. While the 10Y PERTIJ
bonds are trading only 60p wider than
corresponding sovereign counterparts, at the long
end it is 80-90bp wider. The 10s30s slope has
widened from around 25bp at the beginning of the
year to the current level of 75bp, while spreads
have been tightening. While we understand this
partly reflects the fact the 23s are very expensive to
the curve, this nevertheless supports our
preference of long end of Indonesia quasisovereign curves (especially PERTIJ 44s) for
exposure to Indonesia. The main risk to our view is
the higher supply risk by the quasi-sovereigns than
the sovereign during the remainder of the year.
13
We apply a 3-color scale: red indicates increases in values, blue
indicates decreases in value, and white indicates no change. The density of
the color depends on the size of the changes scaled by the average annual
volatility across the curve. In other words, the color density indicates how
many standard deviations the value has changed.
Page 38
9 October 2014
PERTIJ curve: 10s30s appears very steep; long end
offers more attractive pickup over sovereign
Pemex bonds have widened out from UMS recently

PEMEX: the curve has cheapened again vs. UMS.
Last month, we turned to neutral between
Pemex/UMS following a few months of steady
convergence of the credit spreads between the two
curves to a historically tight level of close to 50bp.
We noted that further compression potential would
likely be tempered by greater supply risk in Pemex.
The spread differential has sharply re-widened over
the past two weeks; see the chart below. The move
was mostly driven by the higher beta move by
Pemex during the recent market selloff as well as
by the dual tranche issuances earlier this week
(Monday 6-October). At the current level of spread
differential of 70bp on average, we see Pemex
bonds as having become more attractive once gain
relative to their UMS counterparts, especially at the
10Y sector. Specifically, we recommend switch
from UMS 23s to Pemex 4.75 24s (also see LatAm
Strategy section of this Monthly for a more detailed
discussion on this trade).
PDVSA: curve pricing of imminent default risk
seems exaggerated. The PDVSA curves, together
with the Venezuela sovereign curve, have
continued to sell off, but the table below shows an
excessive inversion move even at the very front
end of the curve, indicating the market is pricing a
very high risk of imminent default in this curve. At
the shorter end of the PDVSA curve, there has also
been significant widening from the sovereign curve.
See our LatAm Strategy section in this Monthly for
a detailed discussion, but we continue to
recommend staying in the very front end of the
PDVSA
curve
(15s)
as
we
believe
Venezuela/PDVSA still have the resources and
means of meeting its debt obligations next year
and the confirmation of payments on both
Venezuela 14s and PDVSA 14s this month (which
we expect) should alleviate some concerns and
give a boost to the PDVSA 15s.
Another obvious observation is the significant
underperformance of PDVSA bonds relative to
the sovereign curve, especially at the shorter
end and the belly of the curve. Spreads to
sovereign for most PDVSA bonds are at the
very high end of the past year’s range. As
market prices out some of the imminent
default risk, as we expect, we believe PDVSA
spreads will converge somewhat vs. Republic
and recommend switching from Venezuela 20s
to PDVSA 17Ns (entry: 595bp; target: 400bp;
stop: 750bp).
Page 39
9 October 2014
PDVSA: bond underperforming sovereign; curve
severely inverted
likely delay of the rate-hike cycle). The dynamics of the
10s30s should not be very different from that of the
5s10s given the 5/10/30 fly relationship. So overall, the
risk seems biased to some steepening of the 10s30s in
the US.
Against this backdrop, we are inclined to think that
most low-beta curves will likely flatten in the coming
weeks, given that most of the curves are close to the
steepest in a year. However, in light of the uncertainty
in the US rate outlook, we would proceed carefully and
only focus on the curves that are looking excessively
steep.
Cash curve trades opportunities14
With exception of Russia, most low beta curves are at
or close to the steepest in a year
One of the interesting themes in the relative value
space is the steepening of the spread curves over the
past few months, largely driven by the bull-flattening of
the US rates curves, in our view.
EM 10s30s on average has steadily steepened while
UST 10s30s flattened
Note: the slopes shown are the average of Brazil, Mexico, Colombia, Peru, Panama, Uruguay,
Turkey, Russia, South Africa, Indonesia, and the Philippines curves.
In the following table, we present the 10s30s slopes of
major curves in comparison with the slopes that are
expected from the cross-sectional relationship as well
as from historical relationships (past 1Y). We have
highlighted the ones that stand out as excessively flat
(e.g. Russia) and excessively steep (Brazil, Indonesia).
We note that in the case of the Philippines, while, in
terms of cross-section, it is clearly much flatter than the
rest of EM, it is less obvious based on historical data.
This is because this curve has been quite flat for a long
time.
After some correction in August, many EM 10s30s
spreads have re-steepened in September (see graph
below). We believe, once again, the main driver is the
recent bull-flattening of the UST curve. In the last Rates
and Credit Weekly, DB’s rate strategists held the view
UST 5s10s steepener should offer asymmetric
risk/reward. They see reasons for steeper curves both
under a positive macro scenario (due to pick-up in
inflation expectations) and a negative one (given the
14
This section is mostly taken from EM Sovereign Credit Weekly of 3October-14, updated and shortened.
Page 40
9 October 2014
10s30s curve slope vs. expected from cross-sectional
and historical relationships
Brazil 10s30s curve in Snapshot (curve just off recent
wides)
The picture depicted in the table above is also
consistent with the cross-sectional graph we have in
our Snapshot, shown below.
Russia 10s30s curve in Snapshot (curve remains very
flat)
EM 10s30s slope vs. 10Y spreads cross-sectional graph
in Snapshot

`
Based on the analysis above, we have the following
recommendations

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

Russia 10s30s steepeners. We hold our existing
recommendation of Russia 10s30s curve steepners
(22s vs. 42s) at the current level of -3bp, keeping
the target at -25bp.
Long-end Peru looks expensive. While less
obviously a candidate for steepeners, Peru’s
10s30s curve is nevertheless flatter than
comparables. Peru 10s30s has significantly lagged
the recent steepening move in rest of EM, with the
bonds at the long end of the curve significant
outperforming their peers following the recent
upgrade by Moody’s to A3. Investors on Peru focus
mostly on the long-end given their better liquidity,
but valuations of those bonds look stretched at the
moment, especially in light of the sharp
deterioration in Peru’s growth dynamics on lower
demand from China and lower commodity prices.
We believe the bonds at the long end of Peru curve
as expensive relative to its peers, such as Colombia
and Brazil – we recommended switching out of the
37s to Brazil 41s last week. The positive has moved
by 20bp in our favor but we expect some further
convergence.
Page 41
9 October 2014
Peru 10s30s has bucked trend and been flattening until
just a couple of days ago
Similarly, in Poland, we find that the 22s have recently
moved significantly cheap to the curve, while the 19s
and the 23s are relatively expensive. We recommend
switching from the 23s to the 22s in Poland at the
current spread differential of 20bp, target 5bp.
Rich/cheap analysis in Hungary and Poland
Peru 37s are retracing their richness to Brazil 41s
… and in Hungary
Cash switch opportunities based on
rich/cheap analysis
Rich/cheap analysis for major sovereign curves using
the table at the left of the “Bond Valuation and
CDS/Bond basis” section of the report is quite
straightforward. The following graph shows this table
for Hungary. As we discuss in the EMEA Strategy
section of this EM Monthly, Hungary 21s stand out as
the cheapest bonds on the curve, and especially cheap
to the 19s; we recommend switching from the 19s to
21s in Hungary (entry: 41bp; target: 20bp; stop: 50bp).
Page 42
Hongtao Jiang, New York, (1) 212 250-7530
Srineel Jalagani, Jacksonville, (1) 212 250-7530
The authors of this report would like to acknowledge the
collaboration by Salil Rajpal and Jayanth Gupta, employees of
Evalueserve, a third-party provider to Deutsche Bank of offshore
support services
9 October 2014
Asia Strategy

The past month has been a tough one for emerging
markets, and for many a reminder of the early part
of taper tantrum from summer of last year. In
typical EM fashion, correlation between rates and
FX has gone up in the selloff, though the bulk of the
adjustment has been borne by currencies this time.
Suppressed bond yields in the developed markets
have helped buttress some of the fallout on rates.
Asia has been noticeably absent from the bottom
half of EM performance, with the exception of
Indonesia, where the drawdown has been driven to
a large extent by a worsening picture on local
politics. North Asian currencies have done
somewhat worse than South Asia (again, excluding
Indonesia), which can largely be put down to their
greater sensitivity to EUR and JPY weakness, and
arguably greater exposure to a slowing China.
South Asia, in contrast, has benefited in a relative
sense from improved external positions, better
valuations, and tighter mix of policies.
A continuation of the themes from over the past
month will set investors up for an increasingly
bearish EM construct into end of the year. Asia, we
believe, will continue to hold its own relatively well
in such an environment, given its more positive
beta to lower commodity prices, and significantly
reduced political risks. Besides, valuations for most
currencies in the region are close to the lows from
over the past 18 months. As before, we do not see
value in fighting the broad dollar trend, but instead
stay with our preference for relative value trades –
CNH versus KRW, and INR versus SGD. We find
MYR the most optimal direct expression of our long
USD bias, with also some residual long USD
exposure against SGD via options. Given that the
broader fixed income scenario is only reluctantly
getting incrementally bearish, we stick mostly with
value in idiosyncratic rates stories (India, China) and
defensive longs (Thailand, Singapore vs. US). We
also suggest a couple of tactical short rates trades
in Malaysia (5Y swaps) and Korea (10Y KTBs).
We have a more constructive view on credit.
Overall, we believe that the recent sell-off is an
opportunity to add risk on Asia Sovereign credit
into the year-end. Political headlines in Indonesia
will most likely be preoccupying investor’s minds in
October. We see reason to remain hopeful on
Jokowi’s ability to deliver even though downside
risks are on the rise. We recommend OW
positioning in INDO sovereign dollar credit via cash
and/or CDS. We maintain our bullish stance on
Mongolia’s credit and have changed our bearish
view on China CDS to Neutral.
Local Markets
CHINA
—
FX: Long CNH/KRW, target raised to 180
—
Rates: Modest overweight
Value in cash CGBs. We believe the relaxation of
mortgage policies and loosening of financing conditions
for property developers is the latest part of targeted
easing policies aimed at boosting property sector
demand in Q4. It suggests financial regulators are keen
to lower corporate financing costs, one of the key tasks
in H2. PBoC’s statement for the Q3 MPC meeting
further affirms our view that policy accommodation will
be maintained for the remainder of this year. This will
anchor market expectations for a continuation of
targeted easing policy and we maintain our bullish view
on cash CGB bonds. We expect money market rates to
settle in the 2-3% range. To effectively lower mortgage
rates and financing costs for property developers, we
believe it is necessary to ensure cheap and stable
interbank funding costs by commercial banks, which
implies that the range of money market rates may shift
lower. We expect the overnight repo rate to settle
within the 2-2.5% range and the 7D repo fixing rate at
between 2.5-3%. We favor a steepening bias on the
cash CGB curve. We believe the front end of the IRS
curve has priced in our expectation of money market
rates and we retain our view that relative value between
the cash and IRS curve suggests cash CGBs offer value,
particularly at the short end with flush liquidity support
and with potentially concentrated demand from
offshore investors under the RMB QFII and interbank
bond market access programs. We prefer to trade IRS
curve with the view of receiving on selloffs.
HONG KONG
—
FX: Neutral
—
Rates: Neutral
HKD strength to persist. Since the start of the protests
(on 22 September), the Hang Seng index traded down
as much as 6.3% before bouncing back 4.3%.
USD/HKD meanwhile reached a high of 7.77 before
moving lower to 7.76 as of the time of writing. We see
the price action as consistent with the assessment that
the protests will be temporary, and that markets, while
being cautious, are not in panic mode. We remain of
the view that USD/HKD will continue to trade at the
lower range of its band (7.75-7.80) for a few reasons.
First USD/HKD tends to face downside pressure at this
time of the year due to corporate repatriation ahead of
Page 43
9 October 2014
the tax season beginning around October. Around 65%
of the government’s revenue is received in 4Q and 1Q
of each fiscal year. Second, the recent RMB weakness
has also dented retail demand for RMB, which lowers
the pressure on HKD. Third, the strong demand for HKD
tightens domestic liquidity, resulting in a rise in HKD
interest rates. 3M HIBOR has traded persistently above
the 3M USD LIBOR since last year, and the gap has
been widening very gradually over 2014. Part of this is
due to the excessively loose US monetary policy, but
the recent increase in demand for HKD has exacerbated
the issue and triggered the need for the HKMA to step
in and defend the band. In addition, the recent
liquidation of equity positioning in HSI would also result
in tightening HKD liquidity, resulting in a higher HK
interest rates. This consequently helps stabilize
outflows and the currency. Only a significant
deterioration in the current situation would possibly
trigger capital outflows, or a particularly negative
market reaction. What might be a bigger risk for
markets is, as our Chief Economist Michael Spencer
points out (see An economic commentary on Hong
Kong’s protest, 2 October 2014), if China were to feel
rather less disposed towards expanding its use of HK as
a testing ground for capital liberalization. Given the
current tightness in CNH liquidity, the unwillingness of
China to open up more flow channels into HK would
keep the CNH curve steep. In addition, the
establishment of financial connections with other
nations such as Singapore could hurt HK’s financial
competitiveness, which could affect its GDP as the
service sector makes up more than 75% of GDP growth,
with the financial sector contributing about 20%.
INDIA
—
FX: Short 6M SGD/INR, target 46
—
Rates: Long 10Y IGBs, target 8.25%
Among the best picks in EM. India to our mind is still
among the best carry-vol prospects in EM, having
arguably made more progress than any of its erstwhile
'Fragile 5' peers in managing its imbalances, and
reducing tail risks. The turnaround in India's current
account has been impressive, with the deficit more
than halving from its peak. And this compression is
likely to endure, given that the restrictions on gold
imports are being kept in place. The Prime Minister's
political honeymoon remains in play, with his attempts
to cut down the bureaucracy surrounding decision
making, and his pitch in particular for global investment
into India likely to be key in driving FDI and offshore
interest in government disinvestments. We would look
to these two sources of capital to maintain the run rate
on flows, even as portfolio inflows slow down,
especially into debt markets which are closing in on the
limits. The two other big winners for India are its
positive beta to lower commodity prices, and the gain
in credibility for its central bank. While the latter's
Page 44
resolute stance on policy rates limits the scope for
further gains on duration, it should be positive for the
long term value of the rupee if it manages to break
inflation down. Our main concern on India is that the
good news is widely internalized by markets. Indeed,
the scale of offshore positioning via NDFs and cash
bonds/offshore derivative structures has gone up
significantly in the last few months, though we would
argue offset to some extent by more recent spec short
INR exposure (as per our dbSelect indicators), and lack
of positioning in onshore markets. There is the wider
EM beta to consider in an environment of broadening
dollar strength. And the marginal worsening of
technicals in bond markets following the reduction of
HTM ceiling (and cut in SLR) by RBI. Finally, it would be
prudent to keep a close watch on a couple of key state
elections this month, which will be a comment on the
ability of PM Modi to sustain his initial momentum.
Given also that the central bank is unlikely to yield on
rates anytime soon, we are reluctant to add further to
exposure on IGBs (while staying with our current
overweight). We also stay long INR, but as a cross
against SGD, rather than funded in dollars.
INDONESIA
—
FX: Neutral
—
Rates: Market weight
Most like other EM. We had been wary all this while of
the fractured nature of polity left behind by the
contentious elections from earlier this year. But even
we have been surprised in the tenacity shown over the
past few weeks by the coalition surrounding General
Prabowo, called Koalisi Merah Putih (KMP), in rejecting
overtures from the winning combine of Jokowi-Kalla
(except for PPP), and in their determination to control
(and divide among themselves) important levers of
power. Indeed, this has effectively driven a wedge
between the incoming Executive and Legislative wings
of the government, and left in its wake an increasing
likelihood that any move from the Jokowi
administration to pursue much needed policy reforms
will be met with stiff opposition. Unless Jokowi were to
pull off a last minute surprise - talks with the
Democrats, for example, are still in a state of flux before his inauguration on the 20th, his political
honeymoon seems increasingly at risk. And puts the
focus more than ever on two key issues - the choice of
his Cabinet (and whether it can defy the compulsions of
coalition politics), and the decision on cutting back fuel
subsidies. The economic case on the latter has been
compelling for a while, and in particular recently with
consumption of subsidized fuel closing in on legislated
limits. The hurdle meanwhile, we fear, has shifted
higher, and the market would be disappointed with
anything less than a swiftly executed price hike of
between Rp2000 to 3000 per liter. If on the mark,
however, such a move would be a key lifeline for the
9 October 2014
macro backdrop facing Indonesian assets into 2015. An
increase towards the top end of this range could shave
off up to 1.5ppt of GDP from the current account deficit,
and free up 10-15% of the fiscal spending budget, not
to mention a significant dent into energy mispricing as
a key source of suppressed inflation in the economy.
The fuel price decision becomes therefore a key digital
risk in the near term. Away from that, Indonesia looks
most like other EM from among its Asian peers, and in
particular because of its structural exposure to
commodity terms of trade, and its vulnerability to
capital flows because of limited market depth. To be
sure, we are likely past the worst on external deficits.
And the central bank's credibility is an important
positive differentiating factor from back in the summer
of 2013. But one cannot wish away the headwinds
ahead. We are at market weight on both currency and
duration ahead of the fuel price decision, and given the
high negative cost of carry, and that supply will run out
soon. Once past this event risk, however, we would
consider opening up a more active underweight for
next year.
MALAYSIA
—
FX: Long 3M USD/MYR NDF, target 3.35
—
Rates: Pay 5Y swaps at 4%, target 4.20%
Structural pressures for rates to grind higher. KLIBOR
remains elevated not just due to rate hike expectations,
but also due to structural reasons, particularly
influenced by banks’ Basel-III requirements. CD funding
rates are rising as banks prepare for the Basel-III
requirements. Meanwhile, PDS issuances this year has
been growing at roughly twice the pace seen last year,
partly owing to the rise in Basel-III related issuances.
Banking system deposit growth has fallen considerably
and the competition for deposits is now growing. This
overall dynamic i.e. Banks’ Basel-III requirements and
increasing competition to attract deposits will continue
to keep interbank rates at relatively elevated levels.
Meanwhile, inflation bugaboo will raise its ugly head
next year towards the GST implementation in April,
quickening to 5% for a month or two. BNM kept the
policy rate unchanged in its last MPC in September, but
the rate normalization cycle is not yet over. The central
bank is still closely monitoring risks of financial
imbalances. Whereas, assuming the 'new normal' for
the spread between the 3M Klibor and the overnight
policy rate, swap curve is only pricing in less than a
25bp hike over one year period. With 3M Klibor at
3.74% and potentially grinding higher, and 5Y IRS at
4%, there is very little risk-premium priced into the
curve. We recommend paying 5Y swaps, targeting
4.20%, and stop at 3.94%. We do not see much juice in
MGS at current levels, especially with Klibor expected
to remain elevated, and 10Y UST yield already at YTD
lows and expected to gradually push higher. Based on
our template for the 10Y MGS, ‘fair value’ is around 4%.
Indeed, the onshore community (local real money and
banks/PDs) mentioned in our recent visit to Malaysia
that current levels are not compelling for them. As such,
the onus remains on the offshore community to keep
the market supported at these levels. Meanwhile, the
markets will have to absorb higher net supply going
into next quarter. Supply outlook was very supportive in
Q3 with almost zero net issuance, but MGS and GII net
supply would be higher in Q4. Moreover, net PDS
issuance also tends to be higher in Q4.
PHILIPPINES
—
FX: Buy USD/PHP on dips
—
Rates: Modest underweight
Blemishes build on a former EM moon. A significant
current account surplus and ongoing tightening in
monetary policy should have placed PHP in the “good”
EM category. However, the PHP has been
underperforming its surplus Asian peers since mid-2013.
The current account has generally remained healthy,
but balance of payments woes have come in the form
of the financial account, where large portfolio and other
investment outflows have been seen this year. This
trend suggests some reversal of the dramatic inflows
Philippines received in these categories over 2010-12
when foreign appetite was high for her internally
reformist, externally strong story. Now however,
overvalued equities are no longer attracting foreign
interest, the need for tightening has kept bonds out of
favor, and money has been leaking out of PHP in the
"currency and deposits” category suggesting some
domestic dollarization is underway. The basic balance
position (current +financial account) in the past four
quarters has fallen to levels last seen during the 2008
crisis when USD/PHP traded above 48. Monetary policy
tightening has also failed to add much support to the
PHP. Despite recent hikes, real rates remain in deep
negative territory with real 2 year yields the poorest in
the region. Although the BSP could still adjust SDA
rates this year, our economists believe policy rates will
not be hiked till next year. Politics has also turned
murkier. The President’s popularity has fallen after
recent fiscal scandals, and his government’s
relationship with the Supreme Court has deteriorated.
The reform impulse, which already appears to have
turned, would not be helped by greater policy gridlock.
Worryingly, over-easy monetary policy settings and the
maturation of the reform-rerating cycle are both
features that Philippines shares with the Indonesia of
three years ago. The PHP also offers little incentive
from valuation or carry. Along with SGD and CNY, PHP
remains one of the most overvalued currencies in the
region, and after SGD, TWD and JPY is one of the
lowest yielders. With blemishes building, the PHP will
have less insulation from the broader USD cycle. We
would use any breather in the USD uptrend, to build
long USD/PHP positions.
Page 45
9 October 2014
SINGAPORE
—
FX: Stay long USD/SGD via 1.2750 digital calls.
Short SGD/INR, target 46.
—
Rates: Receive SGD 2Y3Y IRS versus USD,
target +75bp
MAS to stay on hold, but don’t hold SGD. We expect
MAS to remain on hold at their semiannual policy
meeting next Tuesday. Headline inflation has
admittedly eased sharply, but the main target variable
for monetary policy is core inflation – which authorities
still project will stay elevated at 2-3% because of
domestic cost pressures. This would be consistent with
retaining a 2% p.a. appreciation bias to the SGD NEER.
However, we have been challenging the long-standing
logic that MAS’ policy bias is a reason to be
constructive on the SGD. First, SGD NEER itself is no
longer trading near the top end of the band. Reserves,
including the forward book, have been declining. While
this is partly attributable to FX valuation effects
associated with a stronger USD, MAS has likely also
been supporting the SGD NEER at the mid-band. This
adds to our view that MAS intends to remain on hold
next week, as whenever they have allowed NEER to fall
below the mid-band, they have subsequently gone on
to ease policy. We remain biased to be short the SGD,
against the USD and against favored intra-regional
longs like INR. Our bearish bias on the SGD stems from
a combination of extreme overvaluation, high sensitivity
to USD strength, and a softening property market. SGD
remains one of the most overvalued currencies in the
world, and with others in the group, like NZD finally
yielding to valuation pressure; the SGD is unlikely to
remain immune. Unlike during the taper tantrum, when
the EUR and JPY actually strengthened, this episode of
USD strength has seen the EUR and JPY at the
forefront of losses. Importantly, SGD has historically
had greater sensitivity to G10 low yielders given their
high weighting in the basket. USD/SGD is trading near
a critical technical level, with 1.28 having acted as a
strong resistance in the past. We are also near breakout
levels from the pair’s three year long triangle formation.
While SGD may consolidate in the near-term around the
MAS review, and if the USD rally takes a breather, our
medium-term view is for a decisive breakout higher in
USD/SGD. We thus retain our in-the-money USD/SGD
1.2750 digital call position.
SOUTH KOREA
—
FX: Long CNH/KRW, target raised to 180
—
Rates: Sell 10Y KTBs below 2.8%, target 3.1%
Defying gravity. The combination of a BOK rate cut at
the October MPC and a possible subsequent rally in the
10Y KTB below 2.80% would be an opportunity we feel
to go short. Into end of the year, the prospect of higher
UST yields, the lack of participation of local prop desks,
Page 46
the risk of profit taking in foreign 3Y KTB futures net
long positions and a persistent weakening in KRW
suggest the risk-reward is in favor of being short rates.
The market is fully pricing in a 25bp rate cut, and
possibly even more in the long end. Level and timing
are of course key to positioning for short rates. Our
base scenario is that the BOK is likely to cut the policy
rate to 2.0% at the 15 October MPC. Otherwise, the
expectations of a rate cut will be transferred to the
November MPC, which will postpone potential profit
taking too. At the Congressional BOK audit this week,
the overall tone of the BOK was not as dovish as to
suggest multiple rate cuts. As expected, the
independence of the BOK, household debt and the
probable downward revision of economic forecasts
were intensely questioned by the Congressmen. Our
read is that while the BOK is willing to coordinate on
macro policies with the MOSF to some extent, but it
remains cautious about the side effects of a policy rate
cut. We don’t think the central bank would favor going
deeper than 2%. On the FX front, over the past few
months, flows into Korea have been strong, owing to its
external balance, valuation and inflows. However, these
trends are running out of steam. And portfolio flows too
are starting to reverse. In the past few weeks, foreign
investors have withdrawn about $1.5bn and, given our
equity teams’ cautious outlook, more outflows are likely.
In addition, we also see more evidence of domestic
investors diversifying into overseas assets in view of
the low levels of return in Korea. Another reason for our
bearish view on the currency is Korea’s FX policy. Given
the weakness in the domestic economy and the
lackluster performance of its exports, the authorities
have been more active of late in curbing KRW
appreciation, as suggested by the increase in FX
reserves. After adjusting for valuation changes, we
estimate that authorities have bought about $41bn in
spot and forward markets over the past five months.
And this could continue for two reasons. First, the
rhetoric from both the central bank and the government
has shifted towards a distinctly more dovish policy
stance, including introducing a string of stimulus
measures. We believe it would be rather incongruous
for the authorities in that instance to permit further FX
appreciation at a time when the bias seems to lean
towards supporting the economy. Second, the recent
rapid JPY depreciation is becoming a concern for the
authorities. We stay long CNH/KRW 6M NDF, and raise
our target to 180, while moving our stop to 168, slightly
above our entry level.
TAIWAN
—
FX: Neutral
—
Rates: Neutral
Currency weakness preferred. Similar to its Asian peers,
following the negative shift in risk sentiment, Taiwan
equity market experienced a $2.7bn of equity outflows
9 October 2014
in September. This subsequently resulted in the
currency weakening by just over 2%. Strong global
headwinds we suspect could cause further foreign
equity outflows in the short term. Apart from global
conditions, domestic factors such as (1) the ongoing
concern that KNT could lose majority in the upcoming
local election; and (2) unfavorable tax implementation in
2015, would also affect flows. Following the recent
loosening of investment regulations, we note that
foreign asset investments activities of Lifers are also
starting to pick up. Lifers bought about $9.3bn of
foreign asset in July- August. However, TWD weakness
is not just a function of overseas investments but also
possibly USD buying by the CBC. After adjusting for FX
valuations, we estimate that it bought about $4bn in
September. This is one of the largest interventions since
August 2010. The CBC’s cautious stance is driven by
Taiwan’s still-fragile external sector recovery while
inflation is benign. In addition, with China’s economic
growth momentum slowing down, the Taiwanese
authorities are likely to prefer a weaker TWD.
liquidity each day via its open market operations.
Meanwhile, AUM of both domestic Lifers and Mutual
Funds continues to grow, keeping plenty of cash with
the locals ready to be deployed. In terms of valuations –
Thai curve is still very steep, especially in the context of
a central bank firmly on hold. Correlation to US rates
has broken down amidst the back-drop of dominating
domestic factors/technicals. Against this backdrop, we
remain overweight ThaiGBs in our portfolio.
Sameer Goel, Singapore, +65 6423 6973
Swapnil Kalbande, Singapore, +65 6423 5925
Perry Kojodjojo, Hong Kong, +852 2203 6153
Linan Liu, Hong Kong, +852 2203 8709
Mallika Sachdeva, Singapore, +65 6423 8947
Kiyong Seong, Hong Kong, +852 2203 5932
THAILAND
—
FX: Neutral
—
Rates: Modest overweight
Defensive long. We continue to favor Thailand as a
defensive long in our cash bond portfolio, especially
given our view of gradually rising US rates. Growth
continues to weaken as attempts by the military regime
to revive consumption and investment is yet to provide
a boost to the economy, while trade remains in
contractionary territory. Inflation is benign and BoT’s
latest proposal to switch its policy target from core to
headline inflation just adds to a firmly accommodative
bias. The current 2014 target for core inflation is ‘0.5 to
3%’ (latest core CPI at 1.73%), whereas target range for
headline inflation is proposed to be ‘3 ± 1.5%’ for next
year. This will put the lower end of the inflation target
at 1.5% versus latest CPI print of 1.7% and BoT’s 2015
inflation forecast of 2.1%. Arguably this consideration is
not very new and the central bank had proposed this
change earlier as well, but if approved this time it
certainly allows the central bank to maintain its
accommodative bias for an extended period. The supply
outlook for Loan Bonds in FY15 is supportive. Arguably,
'Bond Switching' will define the effective quantum of
ThaiGB supply in FY15, but, even if the debt office
decides to switch the entire amount of ‘LB155A’ into
longer dated bonds, this would still put issuance at no
worse than the average of the last three years. Our base
case projection is for an overall net issuance and $DVo1
supply to the market being similar to FY14. Demand
outlook is fairly robust, with flush onshore liquidity and
given that offshore buying has more to catch-up. The
liquid assets of commercial banks are rising as banking
deposits continue to grow and loan growth is moderate.
BoT is absorbing more than THB600bn in excess
Page 47
9 October 2014
CHINA 5Y CDS u/performed Itraxx in Sep., bp
Credit
Overall, we believe that the recent sell-off is an
opportunity to add risk and remain constructive on Asia
Sovereign credit into the year-end. Expect no major
surprises on the new issues from the sovereigns, while
on the quasis’ level we still think that Indonesia and
South Korea entities would be likely visitors in the
primary. Political headlines in Indonesia will most likely
be preoccupying investor’s minds in October, given the
Presidential inauguration and formal election of the new
cabinet. Together with our Indo equity strategy
colleagues we do believe there are reasons to remain
hopeful. We view Indonesia displaying visibly more
stable-to-improving fundamental metrics vs. Brazil,
Turkey and South Africa and recommend an OW via
cash (more in the long end) and CDS. We also maintain
our bullish stance on Mongolia’s credit and changed
our bearish view on China CDS to Neutral.
150
Itraxx IG
140
CHINA 5Y
130
120
110
100
90
80
70
60
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
Source: Deutsche Bank, Bloomberg Finance LP
INDONESIA
CHINA
—
—
—
Recommend Overweight;
Credit Neutral
—
Reduced Buy CHINA 5Y CDS to Neutral, awaiting
clearer signals
Sovereign cash looks more attractive on the
long end, given spread underperformance;
—
5Y CDS presents good value here: SELL;
—
Viable RV proposition vs. our UW call on South
Africa
Our call to use China 5Y CDS as a hedging tool worked
out well in September. It has materially underperformed
during the month that proved to be challenging for
credit risk in general, but also was coupled with
increasingly mixed economic data coming from China.
Given the degree of China 5Y underperformance, we
believe that the likelihood for it to widen further is
somewhat low. We believe that the CDS will stabilise at
current levels or tighten slightly as we remain
constructive on credit risk into the year end. We
recently reduced our Buy recommendation on China 5Y
CDS to Neutral awaiting further signals from both
primary corporate bonds market and China macro.
Such potential factors as excessive bank sub-debt
issuance, post-PIMCO management changes risk
repositioning, and continuous “below the market
expectations” data releases by China, could negatively
impact CDS valuations. Should China 5Y CDS trade
down to around 70bp (currently trades at ~85bp) we
would be likely buyers of protection, but should it
widen to above 100bp, we might look to sell it. Key
risks: (in addition to those mentioned above) materially
stronger economic data, positive ratings action, and a
lack of primary supply by SOEs and state-owned banks.
Page 48
Indonesia sovereign curve and CDS have visibly
underperformed many of their Asian peers and the
degree of the spread widening presents, in our view, an
opportunity to get long the risk in Indo. Such an
opportunity, in our opinion, is well underpinned by the
stable-to-improving macro indicators vs. such EM peers
as Brazil, South Africa and Turkey, which will become
more prominent as the countries enter 2015 when the
new policy and reform decisions taken by the newly
elected (or re-elected) governments and presidential
cabinets in these countries will start bearing fruit. For
the good part of 2014 Indo cash and CDS have been
perceived as a “safe haven of EM” in the wake of
increased geopolitical instability in Eastern Europe,
which was also supported by the relative stability of it
economic performance. However, the latest pricing
action tells us that Indo risk has been trading weaker in
sympathy with that of Brazil, which we believe is
unwarranted. We would expect Indo spreads to
decouple from those in Brazil and regain the
momentum, especially in light of continued negative
headlines from Russia/Ukraine. Conversely, should
Brazil’s political game surprise on the upside, the
subsequent rally of Brazil’s USD asset prices would
drag Indo alongside, especially considering INDO 5Y
CDS underperformance of late vs. Brazil 5Y CDS.
9 October 2014
We
presented
a
comprehensive
fundamental
comparison of the main economic indicators for Indo vs.
Brazil, Turkey and South Africa in our recent Asia Credit
Monthly
(please
follow
this
link:
https://gm.db.com/servlet/ShowContent?ResourceType
=S&ServerLocation=1&ResourceId=1775172) whereby
Indo is the net beneficiary of the changes throughout
2014 YTD. Our economics team also remains confident
in such vital factors for Indo as CAD and CPI into 2015
and 2016 with the only vulnerable point being local
currency exchange rate against USD. And all this
assumes no meaningful upward fuel price adjustments.
The negative impact from a potential further IDR
depreciation could be more prominent for local
corporate balance sheets, which still could be partially
offset by gradually recovering global commodity prices
in 2H15 (coal, iron ore, nickel and zinc).
Economic performance is, of course, only one part to
any decision making process, while the other one is
about politics, which ultimately are closely intertwined.
The latest news on Jokowi’s coalition still falling short
of 50% threshold does present a serious setback in the
deliverability of the future reforms package, but still
should not be taken too negatively. According to our
Indonesia equity strategists, reforms could still be done
at government level and infrastructure spending
spearheaded through SOEs, where major decisions do
not have as much parliament intervention. After an
extended period of screening, an announcement on the
Cabinet formation is expected by mid-Oct. Thus far,
there are reasons to remain hopeful. A bold decision on
fuel price hike would be construed as decisive
leadership in our view; a Rp2-3k/litre hike (+30-46%) by
early Nov and cap the subsidy, would be the other
much needed prerequisite. The main downside risk, in
our view, at this stage remains the political stalemate
that Jokowi’s opposition could induce should
Prabowo’s personal ambitions get at the centre stage
before the national interests.
At this junction, Indonesia’s economic stability appears
to be more palpable, which, in combination with the
recent negative correction of its cash bond spreads and
CDS called for an upgrade of our Neutral view on this
credit to Overweight. The 10Y30Y spread slope still
remains steep, despite underperformance of the belly in
September. We recommend adding Indo risk more via
the long-dated bonds (37s, 42s, 43s, 44s), but INDON
'21 and '22 also have value here. We recommend
Selling INDON 5Y CDS with the target of 145-150bp
(currently ~170bp) and a stop-loss of 180bp. Key risks:
negative ratings action for Indonesia, aggressive new
issuance by quasi-sovereigns, a drop in the global
commodity prices, Fed-related sentiment deterioration,
and Jokowi failing to pursue budget reforms.
Viacheslav Shilin, Singapore, +65 6423 5726
Page 49
9 October 2014
EMEA Strategy

In FX, we switch out of long TRY/ZAR having hit
our revised 4.95 stop (+1.2%), and into long
TRY/ILS in order to capture favourable October
seasonals and attractive carry in the Lira. We stay
short ILS vs USD, and move the target to 2.7750
(3.70) and stop to 3.65 (3.58). While we were
stopped out of our short USD/RUB from Sep 2nd
(rvsd stop 37.85, -1.1%), we recommend a 1m
EUR/RUB put with a strike at 48.10 for an
indicative 11bps of EUR notional (ref rate 50.45).
We also maintain long PLN/HUF. Target remains
78.50, with a revised stop @ 73.15 (73.65).
In rates, and despite the richness in absolute terms,
we continue to favor trades with attractive carry
which at the same time provide protection against
a selloff in US rates. Enter steepeners in Israel (2Y
fwd 1y rate vs 5Y5Y IRS), South Africa (1Y vs 5Y5Y)
and Turkey (1s5s XCCY). In Hungary receive 3x6
FRA, underweight the belly in a 1s2s5s butterfly
and enter longs in 5Y vs PLN. In Poland pay 3x6
FRAs to position for less easing than currently
priced whilst keeping 2s10s flatteners in IRS to
benefit from additional liquidity provided by the
ECB. In Czech remain short in May24 vs Germany
and Poland while keep paying 2Y XCCY in Russia.
Enter BE wideners in Israel (April-18) and Poland
(short end) and tighteners in Turkey (Apr20 and
May23). In government bonds overweight the
belly in Hungary (Apr18 and Jun19) and South
Africa (Dec18), the long end in Poland (Oct-23) and
on the domestic RV front Jun16 vs Jan20 in Turkey
and Apr17 vs Mar18 in Russia.
In credit, we tactically covered underweight on
Russia while retaining a bearish view on the
fundamentals and remaining skeptical on the longterm solution to the conflict. We stay neutral on
Ukraine. We stay overweight Turkey and Hungary
but reduce to underweight on South Africa (on
fundamentals concerns) and stay underweight
Poland (on valuation). In relative value, we
recommend switching from South Africa 41s to
Indonesia
44s,
maintaining
10s30s
curve
steepeners in Russia (22s vs. 42s) and 5s10s
flatteners in Hungary (24s vs. 19s), switching from
23s to 19s in Hungary, and switching from 23s to
the 22s in Poland.
Page 50
Local Markets
CZECH REPUBLIC
FX: We are long a basket of BRL and MXN vs short
CZK and HUF, but adjusted the weights in the FX
Blueprint on Sep 23rd (from 50/50 to BRL 30% & MXN
70%) vs. Equally short CZK and HUF. Currently trading
@ 13.12. Target 13.90, with a stop @ 12.90.
Rates In rates remain duration neutral while in
government bonds remain short May24 at 1.13% vs
equally weighted longs in 10Y Germany/Poland (Oct23)
- current spread: 88bp / target 50bp / stop 125bp
Rationale: Despite downward revision to the final 2Q
GDP print, some recent weakness in sentiment surveys
and a disappointing 2Q current account balance the
healthy and broad based economic recovery remains
intact. Another strong PMI reading well above 50 and a
continuous gradual decrease in the unemployment rate
further support economic activity and should at least
for now overshadow geopolitical uncertainty around
Ukraine/Russia. As highlighted in the previous EMM
low inflation pressure should keep rates depressed
going forward, but the likelihood of the CNB raising the
EUR/CZK floor (27) has diminished after July and
August saw inflation slightly above expectations.
Given record low rate levels, almost no carry, and
market’s rate expectations priced more or less in line
with DB forecast we see receivers as unattractive. On
the other hand we also don’t expect any increase in
volatility to move short end rates up given suppressed
rates levels in Europe and the continuous low inflation
pressure. Nevertheless as a cross country trade we
recommend to underweight the long end vs Poland and
Germany. Investors search for a yield pickup preferring
countries with a rather limited sensitivity to
normalization in US rates makes a long position in
Poland attractive. In addition Bunds in Germany should
further benefit from a broad-based asset purchase”programme by the ECB. On the other hand the flattest
yield curve in over 5 years, a pickup of only 20bps vs.
Bunds, tight swap spreads and the FX floor vs a
weakening Euro makes investments in Czech in
particular for non-European investors less attractive.
9 October 2014
Czech - position for underperformance in long end vs
Germany/Poland
10Y Czech
equally weighted 10Y Germany/Poland
Spread rhs in bps
6.0
5.0
120
100
80
4.0
60
3.0
40
20
2.0
steepener (target 30bps / stop 5bp) or a 2s5s flattener
(target 40bps / stop 80bp), our favorite position.
Despite our fundamental view that Hungary is the most
sensitive of the CEE countries to a normalisation in USrates even in case Euro-rates remain suppressed we
see – given the recent weakness and investors search
for yield - attractive risk/return opportunities in the belly
of the curve and enter longs vs. PLN in 5Y sector
(target 50bp / 100bp stop) and an overweight in Apr18
and Jun19.
0
1.0
-20
0.0
-40
Oct/14
Jul/14
Apr/14
Jan/14
Oct/13
Jul/13
Apr/13
Jan/13
Oct/12
Jul/12
Apr/12
Jan/12
Oct/11
Jul/11
Apr/11
Jan/11
Oct/10
HUNGARY
FX: Bearish bias. HUF overbought after prospects of QE
in the Eurozone encouraged capital inflows over the
past couple of weeks.
Rates: In money markets receive 3x6 FRA at 2.14% / In
IRS keep paying the belly in a 1s2s5 butterfly and enter
longs in 5Y vs Poland / In government bonds
overweight Apr18 at 3.02% vs Nov17 at 2.55% and
Jun19 at 3.52% vs Dec18 at 3.23%.
Rationale: On the economic front surprisingly strong
activity data, multiple year lows in the unemployment
rate and robust sentiment surveys point towards a
relatively strong economic recovery in Hungary.
Despite concerns about low spot inflation the NBH’s
dovish monetary policy including rate cuts to new
record low levels, robust economic activity, the
weakness in the forint and administered price cuts
falling out of the basis should lead to a gradual
increase in underlying price pressure over the
upcoming months with headline inflation reaching the
NBH’s target of 2.5% by mid-15. Following NBHs
comments that the easing cycle (most likely) have
come to an end markets priced out any further rate
cuts and now expecting with 6bps of hikes by end-14
and another 25bps of hikes in 2015 a rather moderate
hiking cycle.
We keep our monetary policy view that the positive
external environment will lead to a NBHs on hold until
at least Q2-15 and would not rule out further near term
easing in case of weakness in growth in the Euro-area,
an increase in geopolitical tension in Russia/Ukraine
and a favorable domestic inflation picture. This speaks
in favor of receiving 3x6 FRA at 2.14 with target 1.9
and a stop at 2.30. However, regardless of further
easing we expect a more aggressive unwinding of the
rate cuts in the second half of 2015 which makes
underweighting the 2Y sector in either a 1s2s
ISRAEL
FX: We stay short ILS vs USD, and move the target to
3.7750 (3.70) and stop to 3.65 (3.58).
Rates: Keep receiving 2Y fwd 1y rate vs 5Y5Y in IRS.
Keep B/E wideners in ILCPI April-18 at 1.25%.
Rationale: On the economic front we saw another
month with declining sentiment and activity data in
combination with a disappointing inflation print driving
headline CPI into negative territory for the first time
since 2007. With rate cuts pushed to the limits, a
weakening domestic economy, expected negative
inflation prints in the near term and a further decline in
the medium term inflation expectations well below the
BoI target of 2.0% an FX intervention including a
Swiss/Czech FX floor getting a more and more likely
scenario.
However, regardless of further action by the BoI, on the
rates front we see current valuation as very attractive
to benefit from the ECB vs FED ’tug-of-war’. Despite
attractive carry opportunities for receivers in the short
end of the curve (2Y fwd 1y rates sweet spot with 3m
roll of 25bp) we expect limited risks for a selloff in this
sector given the low domestic inflation pressure and
suppressed rate level in Europe. On the other hand
similar to previous episodes we expect the long end to
be highly sensitive to a normalization in US rates. In
addition any kind of FX intervention should be mainly
beneficial for medium term inflation expectations
leading to a selloff further out the curve. Hence we
favor 2Y1Y vs 5Y5Y steepeners providing 15bp of roll
over 3m (enter the trade at 231bp with a target of
260bp, keeping a stoploss of 210bp). For a more direct
trade on inflation expectations we also like to position
into BE wideners in particular in the belly of the curve
(April-18) where current recorded low BE inflation of
1.25% is even well below our pessimistic 4 year
inflation profile.
Page 51
9 October 2014
Israeli inflation is moderating rapidly
market payers best expressed in 3x6 FRAs. However,
we continue to see Poland as well supported by excess
liquidity provided by an accommodative ECB and value
the long end of the curve from a risk/return perspective
as the most attractive among CEE countries for
investors searching for additional carry.
POLAND
45
3.00
40
3.25
35
3.50
30
3.75
25
4.00
20
4.25
15
PLN/EUR
Source: Deutsche Bank, Bloomberg Financial LP
Foreign holding % of outstanding
ECB QE prospects have seen inflows
4.50
10
4.75
5
5.00
0
2000 2002 2004 2006 2008 2010 2012 2014
FX: Maintain long PLN/HUF. Target remains 78.50, with
a revised stop @ 73.15 (73.65).
Rates: Pay 3x6 FRAs at 1.71% with target 1.90% and
stop at 1.55%. Keep 2s10s flatteners in IRS at +73bp
with target +55bp and stop of +95bp, and overweight
Oct23 vs Oct19 in government bonds.
Rationale: On the back of weaker activity data, a delay
in the inflation pick up, geopolitical uncertainties, a
struggling Euro area economy and the continous
dovishness of surrounding CBs the NBP decided to cut
interest rates by a more than expected 50bp to 2.00%.
Although some argue that further rate cuts will not be
effective since demand for corporate loans is low and
zloty depreciation on rate cuts could hurt households
with FX loans, thereby furhter cutting not uderpinning
demand, further easing remains on the table if the
domestic economic does not see a turnaround over the
next couple months.
On the balance we favour another rate cut by 25bps to
1.75% but with market priced for another 45bps of
further easing over the next 6-12 months the impact on
PLN will be limited. We remain long PLN/HUF from the
EMM on July 17th. It is a carry positive inter-regional
trade, largely insulated to swings in EUR/USD. PLN is
one of few EM currencies consistently undervalued on
all our longer term valuation metrics (BEER, FEER and
PPP). Polish EU fund conversion will provide PLN
support going into Q4.
In rates even the more than expected easing did not
lead to a bull steepening of the curve (curve with
parallel shift lower) given the already excessive market
pricing in the short end. We keep this view and see
another 45bps of cuts as too much and favour money
Page 52
EUR/PLN (inverted), rhs
Poland Domestic Treasuries Held by Foreign Investors, lhs
SOUTH AFRICA
FX: After having stopped out of our long TRY/ZAR @
4.95, having locked in 1.2% profit (entry 4.89), we are
more neutral ZAR. Near-term, trade the 11.00-11.50
range in USD/ZAR.
Rates: Receive 12x15 FRAs at 7.16% (target 6.85% and
stop at 7.35%) while in IRS keep receiving 1Y vs.
paying 5Y5Y (target +260bp / stop +210bp). In
government bonds overweight Dec-18 at 7.51%.
Rationale: The run of poor economic data continues,
with mining strikes continuing to weigh on exports of
precious metals, whilst electricity shortages are
underpinning oil imports. As a result the C/A balance
has weakened again, now sitting at -6.2% of GDP.
DB Economics are still looking for a hike (+25bps) in
November, but have revised the policy rate profile for
next year lower to 6.5% (from 7.50% previously). While
new SARB governor Mr Kganyago is a well known
hawk the rates market continues to price in around
150bp of rate hikes by Q2 2016. This we believe is
excessive. No improvement in the external balances
and very sluggish domestic growth are limiting the
scope for rate hikes. Hence we continue to advocate
rates trades benefitting from a delay in the hiking cycle
whilst also offering protection against normalization in
US rates.
9 October 2014
Renewed weakness in SA’s external balances
-25000
-50000
5
35%
6
25%
-75000
7
-100000
8
-125000
9
-150000
10
-175000
11
-200000
-225000
12
2006
USD/ZAR, rhs
2008
2010
2012
2014
South Africa Current Account SA, lhs
RUSSIA
FX: Buy a 1m EUR/RUB put with a strike @ 48.10 for
an indicative 11bps.
Rates: Remain short 2Y XCCY at 8.09 (target 8.30 / stop
7.95) or enter 1s2s steepeners at -15bp (target 10bp /
stop -30bp). In government bonds overweight Apr17 at
9.46% while underweight Mar18 at 9.38%.
Rationale: The Russian economy has continued to
decelerate, with the growth rate testing zero in August,
on the back of a deceleration in household
consumption and stagnation on the fixed investment
side. Sanctions launched by the US and the EU against
Russia in September worsened the investment climate
further, with the significant decline in oil prices adding
to depreciation pressures on the RUB. Inflation
meanwhile, accelerated again in September, to 8%
YoY, from 7.6%, driven by price increases in the food
segment on goods for which imports were restricted
from the EU, the US, Canada and Norway.
15%
% yoy
0
Russia: Key economic indicators
5%
-5%
-15%
-25%
-35%
2007
2008
2009
IP, YoY, real, %
2010
Fixed investment, YoY, real, %
2011
2012
2013
2014
Retail sales, YoY, real, %
Construction, YoY, real, %
TURKEY
FX: While we have taken profit on our long TRY/ZAR
(+1.2%), we switch into long TRY vs ILS. Seasonals
going into the month of October are typically very TRY
supportive, and 3m carry is around 9.25% (ann’d). The
pair is currently at 1.6385, target 1.6875, with a stop @
1.6100 (200dma 1.6150).
Rates: Keep 1s5s steepeners in XCCY at 1bp (target
20bp / stop -20bp) and remain short BEs best
expressed in TURKGB Apr20 at 7.73% or May23 at
7.72%. In nominals overweight Jun16 at 9.70% while
underweight Jan20 at 9.42%.
Rationale: Despite Lira weakness the CBT left all of its
key policy rates on hold last month but it has since
restricted the amount of funding that it provides
through its one week repo auctions, driving (overnight)
market rates towards the upper bound of the CBT’s
interest rate corridor, an increase of some 250bps. This
has resulted in some stabilization in TRY, though it is
still trading in the upper 2.20s vs the USD.
On the inflation side, and in a welcome move for the
CBT, headline CPI in Sep dipped below 9% for the 1
time in 5 months. Elsewhere recent trade data suggest
that the rebalancing process is running out of steam,
though lower oil prices will now start to provide some
relief given Turkey’s large energy import bill.
st
As for monetary policy, the CBR views the current
spike in inflation as transitory, arguing that the absence
of demand-push pressures and lower credit and money
supply growth will enable the economy to
accommodate food price shocks and reduce inflation
dynamics in the medium term. However, if high
inflation risks persist and inflation expectations remain
elevated the CBR stands ready to tighten policy further.
On FX, RUB remains very headline news driven, but is
also currently trading more than 2std deviations away
from PPP, has never diverged this much from Russia’s
Terms of Trade, and is at/near CBR intervention levels.
Page 53
9 October 2014
Positive seasonals in October - USD/TRY MoM returns
(past 10 years ex 2008)
4
3
weakness, higher borrowing cost for Russia’s
corporates, as well as the acceleration of capital flight
(USD100bn in 2014 is expected). Growth was testing
zero in August. With all three ratings agencies holding
a negative outlook on Russia, downgrade risk is likely
to be high over the next six months, especially by S&P,
which has had a negative outlook since April.
2
On the bond curve, we maintain 10s30s cash curve
flatteners (22s vs. 42s), and also look to enter 2s5s CDS
curve steepeners when the technical condition in which
dealers still have a sizeable demand in short dated CDS
for risk management purposes dissipates (see our 26
September EM Sovereign Credit Weekly for a more
detailed discussion on this potential trade).
1
0
-1
-2
-1.75%
-3
Russia 2s5s CDS curve looks excessively flat; dv01neutral steepener has attractive breakeven of 4bp per
month
Henrik Gullberg, London, (44) 20 7545 4987
Christian Wietoska, London, (44) 20 7545 2424
Raj Chatterjee, Mumbai, (91) 22 7181 1601
Credit
RUSSIA
—
Stay neutral
—
Maintain 10s30s cash curve steepeners (22s vs.
42s)
While we retain a bearish view on Russia’s
fundamentals and remain skeptical on the long-term
solution to the conflict, we tactically covered
underweight on 22 September following a series of deescalatory developments. We saw relative calm in the
near term – at least through the elections at the end of
this month – as the fragile “cease-fire” would broadly
hold and the parties would keep the status quo of what
some describe as a “frozen conflict”. We maintain
such a position at this juncture.
Over a longer term, however, we continue to see
reasons to be strategically underweight and reduce on
strength because the conflict will likely persist given
the fundamental differences and the wide gap between
the positions taken by the different parties, while the
economic conditions continue to deteriorate. We
continue to look to add hedges on strength against
potential further escalation (and maintain target entry
to buy Russia 5Y CDS at 220bp).
UKRAINE
—
Stay neutral
We maintain a neutral position on Ukraine. At this
elevated level, the market is already pricing high risk to
debt sustainability amid a collapse in the economy and
sharp depreciation of the currency. The Naftogaz 14s
have been paid, and near-term maturity of debts and
repayment to the IMF seems manageable (see chart
below), but the amount of support needed to
recapitalize the banks appears to be much larger than
expected. The repayment of USD 2.1bn due in the
remainder of the year is expected to covered by the
next tranche of the IMF disbursement in December
Over a longer term, however, it is a widely held view
that a much larger IMF program and/or a debt
restructuring will be inevitable if there is not a
turnaround to the crisis situation soon. According to
the IMF, if the fighting continues into next year Ukraine
may need as much as USD19bn in additional financing
support.
In terms of fundamentals, our economists believe that
the prospects are now even dimmer against the
backdrop of higher sanctions, which induces ruble
Page 54
9 October 2014
Ukraine’s government debt repayment schedule for
2014 and 15 (pressure point towards the end of 2015)
Ukraine Repayments, USD bn
IMF
3.5
Interest for UKRAIN and
UKRGB bonds
3.0
Principal for UKRAIN and
UKRGB bonds
2.5
2.0
1.5
1.0
0.5
Oct-16
Jul-16
Apr-16
Jan-16
Oct-15
Jul-15
Apr-15
Jan-15
Oct-14
0.0
Note: repayment of USD 2.1bn during remainder of the year is expected to covered by the next
tranche of the IMF disbursement in December
sensitive in EM to tighter global liquidity conditions and
risk appetite. Though not one of Turkey’s weaknesses,
its fiscal deficit is also on a narrowing path. High
inflation remains a problem, reflecting some credibility
issues on the part of the CBT. Overall, given that
political noise will likely remain low in the country
within the next few months and US rates are likely to
remain range-bound within the next few months, we
like Turkey’s chances to recover from the recent
underperformance and hence remain overweight at this
point. The main risk to our view stems from the geopolitical situation in Iraq/Syria, especially in the border
city of Kobane and related protests by Kurds.
Turkey’s CDS/bond basis has tightened substantially
from its recent peak, and our recommendation of
selling 10Y CDS vs. 25s has moved by more than 30bp.
At the current level, the risk/reward for holding this
short basis position is not attractive. We recommend
taking profit from this position.
Source: Deutsche Bank, IMF, Bloomberg
The risk to the economic situation in Ukraine is clearly
still to the downside. Our economists have revised their
2014 forecast for GDP growth to be -6.9% yoy, fiscal
deficits to -5.5% GDP. Despite the substantial external
financing package, central bank reserves declined to
USD16bn in July. The risk to these forecasts is to the
downside, especially under a scenario of prolonged
conflict. The gas negotiation has been halted, but an
EC official recently suggested that an interim gas deal
could be completed this month, enabling Russian gas
deliveries to Ukraine this winter and curbing the threat
of cuts to Europe.
We stay neutral for now, but will nevertheless take the
opportunity of any strength to cut to underweight if
situations do not meaningfully improve.
TURKEY
—
Stay overweight
—
Take profit from short basis of 10Y CDS vs. 25s
Turkey has underperformed over the past month on
general risk off and geo-political tensions (Iraq).
Specifically, the Turkey sub-index widened by 20bp to
70bp wide to EM investment grade average, and now
stands as the cheapest investment grade sovereign
name in EM. Consequently our tactically overweight
position held for the past two months – on mixed
fundamentals and relatively higher carry in what we
thought to be a range-bound environment – has proven
a poor trade. However, seen from a glass-half–full
perspective, a macro adjustment to reduce its external
weakness has been under way, with the current
account deficit on a narrowing path and FX valuation
also much more supportive, even though this does not
change the fact that Turkey remains one of most
HUNGARY
—
Stay overweight
—
Hold 5s10s flattener (24s vs. 19s) and switch
from 19s to 21s.
Despite the setback of the past two weeks, Hungary
remains the best performing sub-investment grade
sovereign credit so far this year. Since 24 July, when
EM credit began to widen from lows, Hungary subindex widened by only 20bp and posted a flat total
return despite its high yield credit rating. We continue
to see reasons to stay overweight at this juncture. If the
market continues to recover from the recent risk off,
Hungary will likely outperform; conversely, the curve
will likely retain its stability shown over the widening of
the past few months and behave more like lower beta
credit. Growth remains robust driven by strong
domestic demand. Downside risk exists due to
weakness in the euro area and potential contagion
from weak economic performance in Russia and
Ukraine but it will unlikely derail strong demands for
the yield REPHUN bonds offer even at a tight level
relative to its credit rating given the problems in EM
high yields elsewhere. The curve has also benefited
from strong technicals with only USD3bn issuance this
year, much less than its repayments (almost USD5bn)
and than previous years’ amount of issuances, as the
government shifted financing towards local markets.
During the remainder of this year, repayments dry out
but we also don’t expect any Eurobond sales.
On the curve, 10s30s have markedly flattened, so we
revise our current preference of 30Y bonds and turn
neutral on 10s vs. 30s. The 21s stand out as the
cheapest bonds on the curve, and especially cheap to
the 19s; we recommend switching from the 19s to 21s
(entry: 41bp; target: 20bp; stop: 50bp).
Page 55
9 October 2014
Cash switch from HU ’19s to HU ‘21s looks attractive
cheap to the curve, while the 19s and the 23s are
relatively expensive. We recommend switching from
the 23s to the 22s at the current spread differential of
20bp, target 5bp.
SOUTH AFRICA
—
Reduce to underweight
—
Short 41s vs. Indonesia 44s
South Africa’s credit metrics are clearly on a downward
trajectory. This has been reflected by S&P’s downgrade
of South Africa’s credit rating by one notch to BBB- in
June, but there will be further downgrade pressure
from both Fitch (BBB, negative) and Moody’s (Baa1,
negative) in the coming months.
POLAND
—
Stay underweight
—
22s are cheap to the curve while 19s and 23s
are expensive
During the risk-off of the past month, Poland has
performed relatively well given its lower beta. As we
believe the market will likely re-settle in a range-bound
environment – with some moderate spread tightening –
we continue to disfavor Poland given its tight valuation
and large negative carry vs. the benchmark (at -75bp vs.
EM investment grade average). While our underweight
position is motivated by valuation, not fundamentals,
economic activities have indeed slowed thanks in part
to the weakness in the euro area, with risk still skewed
to the downside due to the possibility of a protracted
slowdown in euro area growth and/or an escalation in
the Russia/Ukraine crisis.
Poland 5s10s cash slope looks steep while PL ‘23s look
Even with a moderate, seasonal pickup in Q3, growth
remains weak. Our economist has recently revised
2014 growth forecasts down to 1.5% from her
beginning of the year estimate of 2.9%, as result of
recent labor strikes and sluggish global recovery.
Current account forecast was also widened to 4.6%
from beginning of the year forecast of 4.0%. A good
track record of prudent fiscal policy aside, public
finances face significant challenges in the low growth
environment. To stabilize the government’s finance
debt ratio in the future, tax hikes are inevitable.
Additional challenges to public finance come from the
troubled state-owned enterprises (especially Eskom),
which will add to the state's contingent liabilities.
Eskom, specifically, suffers from a significant funding
gap. Apart from debt issuance, how the rest of the gap
will be filled remains unclear at this stage. To this end,
the medium-term budget policy statement (MTBPS) on
22 October, the first under new Finance minister Nene,
may reveal some important information. A fiscal
slippage and deterioration in the fiscal path are widely
expected.
expensive
All in all, this represents undisputed underperformance
of South Africa in comparison with some of its “fragile
five” peers, especially Indonesia and India, and to a
less extent, also Turkey. The other country in this group
that shows deterioration – rather than positive
rebalancing – is Brazil.
While we hold our curve flattener recommendation of
24s vs. 19s (entry: 49bp; current: 44bp; target: 25bp),
we find that the 22s have recently moved significantly
Page 56
Even with these fundamentals weaknesses, we have
kept South Africa at neutral over the past few months
as it remained a relatively cheaper credit within EM
investment grade space, and we had viewed positively
recent personnel changes (especially Kganyago’s
appointment to succeed Marcus as head of central
bank was welcomed by the market) and macro policy
framework with the Central Bank and the Finance
Ministry. South Africa has been one of the better
performers in EM credit until September. However,
recently weakened risk sentiment and weaker political
position of President Zuma (amid corruption scandals
and health concerns) make it more challenging for
9 October 2014
South Africa. The South African sub-index spread has
recently widened to over 35bp relative to the EM
investment grade average from +20bp over a month
ago. We see further weakness and hence recommend
reducing exposure to South Africa to underweight.
In conjunction with our overweight view on Indonesia
we recommend long INDO 44s vs. SOAF 41s. The 41s
are expensive to the South Africa curve, while the
Indonesia curve is steeper than that of South Africa
(entry: 32bp; target: 0bp, stop: 45bp).
Indonesia 44s to continue tightening vs. South Africa
41s
Hongtao Jiang, New York, (1) 212 250 2524
Page 57
9 October 2014
LatAm Strategy

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

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

Credit: We continue to hold a bearish view on
Argentina as we believe continued deterioration in
the macro conditions will likely challenge the
stronghold of the distressed situation investors.
While we are strategically underweight on
Venezuela, we hold a relatively more constructive
tactical position over the short term as the market
is still pricing too much risk of imminent default
(long PDVSA 15s and 37s, long PDVSA 71Ns vs.
Venezuela 20s, keep short basis on Venezuela). We
favor overweight Colombia vs. underweight Peru.
We stay underweight UMS but overweight Pemex
(switching from UMS 23s to Pemex 24s). We
remain neutral on Brazil, but look to enter long
Brazil CDS again vs. Mexico at 60bp. Other relative
value opportunities include 10s30s cash curve
flatteners in Brazil, switching from NY law
Discounts to local law Discounts in Argentina, keep
short basis in Venezuela.
Local Markets
already set to roll over 100% of swaps maturing in
November, hence is limited in its ability to control
volatility (on the BRL downside, at least). As the
election-dependent scenarios for the BRL are extremely
divergent, we like buying a 1M straddle on USD/BRL.
Struck ATMF, the straddle breaks even at 2.28 and
2.52 (indicative pricing), both breakevens falling inside
the highly divergent values which would plausibly
materialize in each of the possible election scenarios.
Rates: In Brazil, rates markets continue to be a hostage
of the election dynamics, as evidenced by the dramatic
bull-flattening that followed after the results of the
presidential election’s first round. Despite the win, the
(historically) poor performance of the incumbent party
not only in the presidential but also in the lower house
election together with the surprising performance of
the competing party resulted in a significant rally in
risky assets in general. The latter adjustment clearly
reflects improvements in market implied credibility and
the predicated increase in inflows and overall
improvement in business confidence. All that said, an
eventual opposition, victory faces some serious hurdles
which in our view, favors trades that would profit if
curves retrace to pre-1st round levels. Consider scaling
into steepeners in the Jul17/Jul21 sector of the curve
for example. The eventual pricing of risk premium in
case the incumbent’s victory materializes should result
in significant steepening of the curve. Further flattening
associated with an incumbent’s loss obviously poses a
risk to the view. The proximity to historical lows and
eventual normalization of the curve suggest that MTM
losses might be limited making the risk/return of the
steepener favorable.
CHILE
—
FX: Buy 3M USD/CLP put (ATMS EKO 575) for
0.6% (70% cheapening from vanilla ref FX
596)
—
Rates: Keep the 1s3s steepener (target 65 bp),
receive 10s (CLP/CAM) vs US (target 190).
BRAZIL
—
FX: Buy 1M USD/BRL straddle (B/E’s 2.28/2.52)
—
Rates: Enter Jan17/Jan21 steepener (target 40
bp)
FX: The outcome of the first round of the elections
prompted a sharp retracement in the BRL, which has,
as of the time of writing, gained back about half of the
10% lost in September, when market participants
perceived a Dilma Rousseff victory as highly likely.
While EM-wide trends, such as continued dollar
strength, should impact the BRL in the coming weeks,
the obvious focus will be on the run-off elections on
October 26, with poll results likely inducing violent
swings in the currency. The BCB, which had been
successful in keeping the currency range-bound in
April-September through its FX swaps program
(accumulating a USD 95bn position in the process), is
Page 58
FX: CLP was stable in September, hovering under the
600 barrier vs. the USD and outperforming most EM
currencies. We see the currency maintaining its
stability in the near future, and possibly outperforming
other EMs on continued dollar strength, for several
reasons. First, our outlook for China is relatively
optimistic, hence we see copper maintaining its ground.
Second, the easing cycle is likely close to its end, and
reflected in the currency. We foresee, if anything, the
CLP supported by signals of rates being raised sooner
than expected by markets (especially given persistently
high inflation). Third, while recent data continues to
point to stagnation, the planned fiscal stimulus should
offset (to some extent, at least) the drag caused by the
tax reform, increased clarity on which should help
9 October 2014
stimulate investment. Finally, the treasury is planning
to sell a significant amount of dollar assets in order to
finance the fiscal position next year, which should also
be peso supportive. Consider buying a 3M USD/CLP
put (ATMS, EKO 575) for 0.6%, about 70% cheaper due
to the EKO.
Rates: In Chile we continue to call for another 50bp
worth of cuts but also argue that despite well-anchored
inflation expectations, the BCCh might embark on an
aggressive (yet short) hiking cycle in early 2016. The
latter is predicated on the possible reduction in trend
growth and potential compression in the output gap,
which render the local economy less prone to
accommodation. Moreover, the dependence on
commodities and potential effects of the tax reform on
growth could result not only in reduced potential
growth but also in a lower neutral rate. Altogether,
compared to the curve-implied cycle we envision
further cuts by the end of the year and a more
aggressive, shorter hiking cycle, ending at a lower
terminal rate. Altogether, this view bodes well for our
core “butterfly” views, paying 3Y vs 1Y and 5Y
(CLP/CAM). In terms of implementation we continue to
like the 1s3s steepener (despite the recent steepening
and negative carry). Enhancement of this view can be
achieved in forward starting space (receiving 1Y6M vs
2Y1Y for example) or in cash (switching from Jan18s to
Jan22s). In the back end we see room for Chilean
yields to compress vs. US yields as these cycles remain
de-coupled – keep the spread tightener vs the US in the
10Y sector.
COLOMBIA
—
FX: Buy 3M EUR/COP put (ATMS, EKO @ 2480
ref FX 2590) for 0.7% (50% cheapening)
(indicative)
—
Rates: Buy TES 24s vs US10s (target 380).
FX: COP, the worst performer in EM in recent months
(other than RUB), continued its relentless decline in
September, erasing almost all of the gains seen since
the index weight change in March and reaching 5yr
lows vs. the dollar. Declining oil prices (and weak
domestic production), together with the end of the
hiking cycle, have weighed on the currency, which we
currently see as somewhat oversold (about 3.5%
undervalued vs. its financial drivers, according to our
model). Valuation, together with impressive, nearpotential growth (we forecast 4.6% for 2H14, lower
than the first half of the year but higher by far than its
peers), lead us to stay positive on the COP. Having said
that, the outlook for oil prices is uncertain, and
authorities have repeatedly expressed their desire for a
less appreciated exchange rate, as the level of passthrough is low. Hence the risk of further depreciation
exists, and we continue to express our COP view
through options, preferably against EUR as we expect
continued dollar strength. A 3M EUR/COP put struck at
2590 (ATMS) with a EKO at 2480 costs 0.7%, about
50% cheaper due to the EKO (indicative prices).
Rates: After 125bp worth of hikes (5x25bp), Banco de
la Republica - the only central bank in the region to
tighten rates - has decided to halt the current cycle
with the policy rate at 4.5%. And with inflation inching
below 3% and activity numbers portraying some signs
of deceleration we expect the policy rate to hover
around the current levels at least in the short term. That
said, we would not rule out the odds of additional
adjustments (residual hikes) in case the Fed surprises
on the positive side. Altogether we see terminal rates
at 5% by the end of 2015 - roughly what is being priced
and consistent with the neutral real rate (2%) and the
center of the inflation band (3%). And while premium
priced in the 1Y-2Y sector of the curve (around 40 bp)
in principle bodes well for front end receivers (1Y1Y), at
this point we rather remain neutral in the front end
given the exposure to US rates. On the curve, despite
the recent flattening the 2s10s slope still looks a bit
steep both vs the US and the front end. Consider
buying TES 24, which looks cheap relative to
neighboring bonds, vs. US 10s (target 380bp).
MEXICO
—
FX: Long MXN vs. HUF and CZK (target 13.90)
—
Rates: Keep 2Y1Y spread wideners vs 5Y5Y
spread tightener (target 20bp), switch from
MBONOS
34s to
MBONOS
24s,
buy
breakevens in the belly (UDI20s, target 390).
FX: Consistent with previous bouts of dollar strength,
MXN has been performing well relative to EM peers (in
particular, relative to CE3 currencies) for the first part of
the current dollar strength episode. This pattern
reversed, however, in the past few weeks,
demonstrating the currency’s high sensitivity to US
equities. Going forward, we are constructive MXN
(relative to other EMs, at least), as we expect continued
dollar strength and positive US performance to benefit
the currency vs. its peers. Similarly, we expect the local
economic recovery, signs of which are already apparent,
to be aided by increased US demand. Continued
optimism regarding the reforms process should also
help. Another positive for MXN is speculative
positioning, which is heavier than it was at the
beginning of the year, but still very light compared to
pre-taper tantrum figures. Consider going long MXN vs.
a basket of HUF and CZK.
Rates: In Mexico we see the potential for deteriorating
inflation expectations in early 2015, due to possible
front-loading of gasoline price hikes, as well as
discussions of an increase in the minimum wage. The
deterioration in inflation expectations and the proximity
to the Fed cycle could potentially lead to a change in
Banxico perceived stance from reactive to pro-active.
Accordingly we see Banxico’s implied monetary policy
path as too mild (vs the US cycle) and would warn
those positioning on the rather popular carry capturing
Page 59
9 October 2014
strategies (receivers) in the to-left corner of the forward
matrix. Instead we recommend paying 2Y1Y in TIIE vs.
receiving in the US. Accordingly, we see Banxico hiking
about 300bp by the end of 2016 (vs 200 bp priced) if
the scenario implied by the US curve (about 150bp
hikes by end-2016) materializes. Further down the
curve we continue to see the premium priced in TIIE as
excessive and recommend keeping the 5y5y box vs the
US (receive TIIE pay USD ) open as a core
recommendation. In cash we see the flattening as a bit
exaggerated and would recommend switching from the
34s to the 24s. Finally, we favor going long breakevens,
especially in the belly of the curve. Breakevens implied
by MUDI 20s have recently retraced somewhat, but are
still trading very close to forecasted inflation,
incorporating a very small premium.
PERU
—
FX: Stay neutral
—
Rates: Stay neutral
FX: PEN continued weakening in September, breaking
the 2.90 mark vs. the dollar despite increased
intervention by the central bank. While likely satisfied
with the recent depreciation (down about 4% relative to
the previous year-long range) given the recent
economic weakness, authorities are determined to
reduce volatility in the currency. In addition to
selling USD-linked CDs, which had been the preferred
policy instrument before the recent sell-off, the BCRP
also intervened in the spot market in September, and
introduced a new FX swap, used for the first time last
week. The BCRP’s involvement, together with low
sensitivity to global factors, favorable positioning, and
valuation (3% undervalued vs. financial drivers in our
model, the most undervalued it has been in the past 2
years), make PEN an attractive long. However, the
growth outlook is relatively weak, monetary policy is
loose, and terms of trade are worsening, in the shortmedium term at least. We stay neutral for now.
Rates: In spite of the recent spike in PEN, rates have
been more or less range-bound in Peru since July’s cut
in the reference rate. And despite lackluster growth,
persistent inflation suggests that the BCRP might for
now remain on “wait and hold” mode. In the front-end
of the Soberanos curve, we continue to believe that the
23s are relatively cheap versus the 20s (although the
latter enjoy some benchmark premium due to their
liquidity) and issues further down such as the 31s are
cheap versus the front. With the front-end reflecting
levels that in our opinion are close to fair and the term
premium close to historical lows, other than the
aforementioned switches we rather take chips off the
table and turn our stance on rates to neutral for now.
Guilherme Marone, New York, (212) 250-8640
Assaf Shtauber, New York, (212) 250-5932
Page 60
Credit
ARGENTINA
—
Stay underweight
—
Stay short USD Discount. Continue to favor
local law Discounts
While we would not rule out a settlement scenario in
2015 after RUFO expires, it is certainly not our baseline.
We do not see any indication that the government is
willing to negotiate with NML. The Republic’s position
to only negotiate with the entire universe of holdouts
collectively and continued efforts to alter payment
mechanism make a benign outcome all but impossible.
That Judge Griesa holds the Republic in contempt
(though without imposing any monetary punishment
yet) also makes the situation more difficult. Meanwhile,
the deterioration in the macro conditions will eventually
test the stronghold of the distressed situation investors,
and potentially unravel the current decoupling between
fundamentals and bond prices.
Argentina could see a USD10-12bn fall in international
reserves next year mostly due to a current account
deficit compounded by a number of bond obligations
coming due for the government (mostly the USD6bn
due for Boden 15s), and for the Province and City of
Buenos Aires (totaling USD2.3bn). Some debt
management transitions in 2015, including swapping
some of the Boden 15s for longer maturity local law
bonds and forcing the Province and City to issue new
debts at very unfavorable market conditions, remain
options, but look difficult given the lack of confidence
on the policy outlook and macro conditions. The swap
with China helps alleviate the balance of payment
concerns to the extent of financing its bilateral deficit,
but that would be far from enough to restore
confidence given that the international reserve stands
at only USD27bn now (net reserve under USD20bn).
Therefore, while a correction has taken place recently
to the bond prices following the change in the central
bank governor, which signaled further deterioration of
policy outlook, the fundamentals still do not justify USD
Discount price in the 80s. We remain short the USD
Discounts, with a target all-in price of 75.
We recently recommended long the local law USD
Discount vs. New York law USD Discounts and
maintain such a position. During a recent hearing
Judge Griesa clarified that he did not think the local law
bonds as pari-passu with the FAA bonds as they should
not be considered “external indebtedness” pursuant to
the FAA indenture (something we have argued all
along), and that he never intended for these bonds to
be within the scope of the injunction. A final decision
will likely be forthcoming by the end of the month as
9 October 2014
Judge Griesa gave 30 days for further discovery and
debates by the parties. We maintain this position
despite some renewed concerns of “pesofication” over
the past week. In our view, “pesofication” on the local
law dollar bonds would be equivalent to an outright
default, which the government will try its best to avoid.
Such risk on private sector contracts, as we already
know, is high, but that does not apply to the
government bonds, in our view.
The Euro denominated bonds, on the other hand, are
still within the scope of pari-passu injunction. We see
no technical argument to suggest they are not
“external indebtedness” pursuant to FAA documents.
While we understand that there are arguments and
legal proceedings in the UK and Belgium that many
perceive to support “carve-out” of these bonds in the
end, we see the likelihood for this as low. However, not
being legal experts, we acknowledge that this is not a
strong opinion.
over the next year. However, at parity spread levels
with EM investment grade average and strong
technical conditions on the curve, we continue to see
Brazil’s spreads as likely range-bound and therefore
stay neutral on Brazil cash at this level.
Finally, our recommended switch from BNDES 23s to
Brazil 23s (see our EM Sovereign Credit Weekly of 3October) has reached it target and we recommend
taking profit in this position.
Brazil / Mexico CDS spread differential is currently
moving tighter, but will likely re-widen
BRAZIL
—
Stay neutral, but look to reduce on strength
—
Favor 10s30s cash curve flatteners
—
Look to enter long Brazil CDS vs. Mexico at
60bp (current 65bp)
The market rallied sharply after the first round of
elections ended, as the market is now priced to a
decent level of probability of an Aécio upset at the
second round. Marina would have to transfer 69% of
her votes to the PSDB candidate (all else equal) and,
according to DataFolha, only 59% manifested their
intention to do so last week and this number does not
reflect those who have already jumped ship. Also, the
incumbent’s campaign has so far focused on Marina
and the re-focus could also weigh on the opposition.
Therefore, we believe the market will likely retrace the
latest rally and fully price a Dilma victory, possibly after
some further tightening on upcoming polls, which may
show a narrow gap between Rousseff and Neves.
While our previous recommendation of long Brazil 5Y
CDS vs. Colombia reached its target at the end of
September following polls showing a commanding lead
of Dilma vs. Marina (as we had expected), this time we
would look to enter long Brazil 5Y CDS vs. Mexico at
60bp (current level: 67bp).
These tactical moves aside, strategically we retain a
bearish view. We are not optimistic about a significant
change to the policy mix during President Rousseff’s
second term. Fundamentals remain on a negative trend,
as the disappointing growth performance and steady
deterioration in the fiscal accounts prompted Moody’s
– which has held a relatively more bullish view on Brazil
among rating agencies – to lower its outlook to
negative in August, while holding its credit rating at
BBB. Brazil will face additional downgrade pressure
COLOMBIA
—
Stay overweight.
Despite some slowdown in growth, Colombia still
offers the best growth/inflation dynamics in the region
(5% GDP growth, and CPI at 3.2%, within target range).
Lower oil prices and decreased production have a
negative impact on government revenues, but fiscal
standing will not suffer given the fiscal rules in place.
The new tax reform to extend wealth tax and financial
transaction tax for four more years, which we expect to
be passed by Congress by year end, should help cover
any gap between revenues and expenditures in 2015.
Sensitivity to commodity prices exists, as shown in the
deterioration in the external account this year and last
year, but Colombia seems better positioned in
comparison with most of its peers in the environment
of weak global growth recovery, lower commodity
prices and the prospect of lower international liquidity
down the road. The credit rating migration path
remains positive. Colombia may issue again later this
year but likely only in small amounts, less than the
USD1bn repayments during the remainder of the year.
Colombia sub-index has outperformed EM investment
grade average over the past few months; as a result,
valuation (at -25bp vs. investment grade average) does
Page 61
9 October 2014
not look particularly attractive. However, Colombia
remains our favorite LatAm low-beta credit based on
valuation and fundamentals.
The 10s30s curve on the cash side is one of the
steepest in EM, but we see more attractive flattener
trades in Brazil.
MEXICO
—
Stay underweight UMS
—
But compensate the under-allocation with
Pemex (switching from UMS 23s to Pemex
24s)
The Mexico has obviously been a very good defensive
trade over the past month given the selloff. However,
given the potential for market recovery and renewed
importance of carry, we would not chase the market at
the current level and remain underweight UMS. Pemex
bonds, on the other hand, have seen their valuation
improve relative to the sovereign curve once again due
to the recent selloff and also the dual tranche issuances
earlier this week. Last month, we turned neutral on
Pemex vs. UMS after some steady convergence in the
spread differentials and potential near-term supply risk
in Pemex. Now that the spreads have backed up and
bond issuances have taken place, we revert to
overweight Pemex vs. Mexico. Currently, the Pemex
24s stand as the cheapest vs. sovereign, with a pick-up
of 70bp in spread to the sovereign curve. We
recommend switching from Mex 23s to Pemex 4.875
24s (entry: 71; target: 50bp; stop: 80bp). .
PEMEX bonds look attractive to UMS once again
especially at the long end of the curve. The bonds at
the long end of the curve – the only part of the curve
that offers decent liquidity – significant outperformed
their peers following the upgrade by Moody’s to A3 in
July. Valuations on these bonds look stretched at the
moment. We remain cautious on Peru given the sharp
deterioration in its growth dynamics on lower demand
from China and lower commodity prices. In addition,
Peru also has among the highest current account
deficit compared with its regional peers (though it is
fully financed by FDI), with a high sensitivity to the
prices of mining products and activities in the mining
sector. We continue to favor Colombia at this point, for
the former’s better fundamentals momentum as well as
slightly cheaper valuation. Recently we recommended
switching out of the 37s to Brazil 41s on Peru’s
richness and recent cheapening of Brazil bonds having
Dilma victory almost completely priced in (before the
first run election result came out). This trade has
moved by 18bp in our favor but we keep the target at
40bp (vs. current 50bp).
VENEZUELA
—
Stay tactically neutral
—
Switch from Venezuela 20s to PDVSA 17Ns
—
Keep short basis (selling 5y CDS vs. 22s)
We covered underweight on 25 September following
the announcement of exchange rate agreement No 30,
as we expected the curve to continue recovering and
price out the imminent risk of default. This policy tweak,
while a tiny step of stealth devaluation, should provide
some help. However, this did not work out as bond
prices bond prices resumed falling after a brief recovery
as the market is rattled with concerns about that
potential ruling by ICSID on the Exxon/Mobil profile
arbitration claim 15 , which would be “imminent”
according to some reports, as well as speculations
about the impact from a potential re-allocation by a
large EM funds recently in the headlines due to
management changes.
We see scope for some near-term recovery and hence
stay neutral at these levels for the following reasons.
First, the repayments of Venezuela 14s this week and
PDVSA 14s at the end of the month, as we expect, will
15
PERU
—
Move to underweight
—
Long-end Peru looks expensive.
Peru’s global bonds look expensive in our view,
Page 62
The two most high-profile cases are filed by ExxonMobil (asking amount:
USD10bn) and ConocoPhillips (asking amount: USD30bn). The tribunal has
already ruled that Venezuela was liable on the Conoco case and expected
to rule on the monetary terms in the coming months. The tribunal has yet
to rule on the liability of the Exxon case, but it has been widely speculated
that a ruling - mostly likely negative for Venezuela – is imminent. When it
rules, it could be only on liability, or both on liability and on monetary
award.
9 October 2014
help alleviate some concerns of near-term default.
Second, while the potential ICSID ruling will
undoubtedly present some negative headlines
(especially if it comes with monetary awards this time
that are larger than expected), there should not be any
near-term financial impact. The normal way out from
these kinds of arbitration cases is through settlement,
and it could take multiple years for the parties to
negotiate and find a solution. Finally, if the reallocation
of certain large funds indeed has an impact on bond
prices, the impact of that would likely be temporary.
We continue to believe Venezuela/PDVSA has enough
resources and means to meet its debt obligations in
2014 and 2015. In addition, we believe the government
has a strong willingness to pay as the cost of a default
is prohibitively high given that it would likely
compromise its ability of generating petro-revenue as
well as its ability to import – remember, Venezuela is a
country that heavily relies on import for some of the
very basic goods.
Enter long PDVSA 17Ns vs. Venezuela 20s
We recommended switching from Venezuela 22s to
PDVSA 17s on 25 September as we thought PDVSA
bonds were oversold and that the market would likely
recover of the recent losses; the 17s looked especially
wide to the sovereign curve. However, the renewed
selloff has pushed this spread differential even wider
and our position hit the stop level on 1 October. At the
current levels, we believe the market is pricing an
excessive level of imminent default risk. Venezuela 14s
repayment is being made, and we expect the PDVSA
14s due on 28 October will also be paid. Confirmation
of that repayment will instill some confidence and
prompt some recovery of the market, and PDVSA
bonds in particular. We there recommend reentering a
similar position: switching from Venezuela 20s to
PDVSA 17Ns (entry: 595bp; target: 400bp; stop: 750bp)
to position for the potential convergence. Among
shorter duration bonds, the 17Ns are the cheapest
bonds on PDVSA while the 20s are the richest on the
sovereign curve.
PDVSA 17Ns look excessively cheap to Venezuela 20s
Beyond 2015, however, continued payment ability will
be conditional on significant changes to the current
policy mix. Our confidence on that is low, hence our
strategic underweight position.
Stay long the very front end and very low priced bonds
On the bond curves, we continue to favor a defensive,
barbell position of being long the very front-end and the
lowest-priced bonds. Specifically, we would stay long
PDVSA 15s (and also consider long EUR 15s at the
yield of 21%) as well as PDVSA 37s. We favor the 37s
given that it is of the lowest price, but understand
many investors favor the 24s at a slightly higher price
but with much better liquidity and better valuation in
spread terms.
Valuation snapshot of the Venezuela/PDVSA complex
Finally, we remain short basis on the sovereign curve
via selling 5Y CDS vs. 22s as we continue to believe
the basis should tighten once the imminent default risk
is priced out as we expect.
16
Hongtao Jiang, New York, (212) 250-2524
Srineel Jalagani, Jacksonville, (212) 250-2060
16
See Trade Recommendation – Venezuela: Enter short basis, 10
September 2014 for details.
Page 63
9 October 2014
China
Aa3/AA-/A+
Moody’s/S&P/Fitch

Economic outlook: Flat manufacturing PMI, slightly
weak services PMI and falling steel output
reiterated an anemic domestic demand in
September. On the other hand, HSBC new export
orders PMI hit 53 months high, showing a
stronger-than-expected external recovery. Going
forward, we expect rising exports to allow at least
stable GDP growth in coming quarters, even with
weaker investment growth. Moreover, the
government
is
likely
embrace
a
“new
economic/policy norm” of less broad stimulus but
quicker structural reforms, which will focus on
financial liberalization, deregulation, SOE and
railway reforms in Q4 and 2015.
Main risks: Property sector remains the key risk,
yet with previous HPR relaxation, latest mortgage
easing and up-coming price cut, sales should
rebound in early 2015 and in turn spur real estate
investment.
2015, the GDP growth could be a little higher, lifted by
a full year of US&EU growth and therefore higher
export growth than this year will be achieved.
While the European economy is expected to grow
slowly over the coming year, we look for 3%-3.5%
growth in the US. Combined, the two main export
markets for China are likely to grow almost as fast as
they did in pre-GFC years, and we've seen in recent
quarters that Chinese exports are almost as responsive
to that growth impulse as they were before.
China manufacturing PMI vs. service PMI
57
56
HSBC PMI
HSBC PMI New Export Orders Index
NBS Non-manufacturing PMI
55
54
53
52
Embracing the “new norm”
51
50
Manufacturing PMI unchanged, exports outstand
The HSBC Markit final PMI was revised down to 50.2
from the flash reading of 50.5, remaining unchanged
from August. This echoed the flat NBS PMI of 51.1.
Looking into the sub-indexes of the HSBC PMI, while
the output index dropped from 51.8 in Aug to 51.3 in
Sep, the new orders index improved 0.2ppts to 51.5,
pointing to gradual future recovery. Importantly for us,
because this seems to be what differentiates our view
on China most from the consensus, the new export
orders index recorded a strong lift of 2.6ppts to 54.5,
the highest value in five and a half years. Such readings
support our view that China is going through a modest
recovery characterized by economic rebalancing and
supported by a global cyclical pickup.
In the meantime, deceleration was witnessed in input
and output prices which dropped by 1.9ppts (to 47.1)
and 1.8ppts (to 47.1). This is consistent with the very
deflationary signal being sent by the producer price
index, which has been declining for more than two
years. We interpret these developments, and the
moderating CPI impulse, as a sign that the economy is
growing slightly below its potential. Given the deflation
pressure, policymakers should not, in our view, be
trying to slow growth down. They should be trying to
rebalance growth away from investment.
Going forward, we view the targeted 7.5% annual GDP
growth as achievable, as the strong base effect will
dissipate in Q4 and the external demand will expand
enough to offset the decline in investment growth. In
Page 64
49
48
47
46
Source: Deutsche Bank, Markit
“New norm” of slower growth but quicker reform
We believe that consensus has been reached among
top leaders to allow slower-yet-healthier growth and
only very targeted stimulus measures. Our conviction
comes from the recent reform momentum, especially
local-level examples: a focus of construction activity for
environmental protection, healthcare and clean energy
in 2014-15; RMB20bn was set aside by the PBOC for
relending to agriculture; 87 administrative items were
abolished; licenses for foreign hospitals and private oil
importers were granted; the Budget Law was revised to
regulate local government debt.
Most interestingly, China unveiled on Aug 19 its Plan to
Revitalize the Northeast, a region which saw the most
severe industrial decline. The 35 measures offered by
the State Council provide a hint of how the authorities
would respond to a more protracted investment
slowdown nationwide. The most noteworthy are: 1) to
speed up construction of rail lines, airports, power
transmission, nuclear plants and other clean energy
projects; 2) to encourage SOEs to sell assets or equity
to private investors to finance restructuring; 3) to
establish a regional state-owned assets investment
9 October 2014
company; 4) to support emerging industries like
integrated
circuits,
services,
robotics,
marine
engineering, etc.; 5) to improve grain storage and
logistical facilities so as to modernize agriculture; 6) to
fund the affordable housing construction, including a
RMB60bn credit reserve for shantytown renovation.
The on-going Hebei economy restructuring is another
example. The province closed more than 8,000
polluting factories and reported GDP growth of
5.8%yoy in H1 2014 versus 8.2% in 2013. The
slowdown, however, was praised by local authorities,
as it brought down the energy consumption per unit of
industrial value added by 10%, enhanced air quality by
13% and increased the contribution of tertiary sectors
to GDP by 18ppts. This is, in our view, a typical “new
norm” approach that might be replicated in other
provinces in the coming years.
Mortgage and property policies relaxed
Sep 30, PBoC and CBRC jointly issued the Notice on
Improving Home Financing Service, with the highlights
of:

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

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

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

Supporting reasonable financing needs of the
developers. Under the premise of risk control,
banks have to support normal commodity
construction by developers with good quality and
credit. Developers are allowed to issue bonds in
the interbank market and develop pilot REITs.
Such policy support, first time of its kind since 2008,
should boost upgrade demand and overall market
sentiment. Together with the recent HPR relaxation by
42 out of 46 cities, and more price cuts from
developers, we expect to see a more solid recovery in
sales volume in the coming months. According DB
property research team, seven out of ten major
developers surveyed expect MoM sales growth in
September.
Michael Spencer, Hong Kong, +852 2203 8305
Audrey Shi, Hong Kong, + 852 2203 6139
China: Deutsche Bank forecasts
2012
2013
2014F
2015F
8389
1354
6196
9358
1362
6871
10516
1369
7682
12002
1374
8735
Real GDP (YoY%)1
Private consumption
Government consumption
Gross capital formation
Export of goods & services
Import of goods & services
7.7
8.4
8.7
7.7
2.8
3.7
7.7
7.7
7.7
9.0
6.5
8.5
7.8
8.1
7.0
7.0
11.0
10.0
8.0
8.4
7.0
7.4
12.0
11.5
Prices, Money and Banking
CPI (YoY%) eop
CPI (YoY%) ann avg
Broad money (M2) eop
Bank credit (YoY%) eop
2.0
2.6
13.8
15.0
2.5
2.6
13.6
14.1
2.8
2.2
12.0
12.4
3.2
3.0
12.0
11.0
Fiscal Accounts (% of GDP)
Budget surplus
Government revenue
Government expenditure
Primary surplus
-1.6
22.7
24.3
-0.9
-2.1
22.9
25.0
-1.3
-2.1
23.0
25.0
-1.3
-1.5
23.0
24.5
-0.8
National Income
Nominal GDP (USD bn)
Population (mn)
GDP per capita (USD)
External Accounts (USD bn)
Merchandise exports
Merchandise imports
Trade balance
% of GDP
Current account balance
% of GDP
FDI (net)
FX reserves (USD bn)
FX rate (eop) CNY/USD
2048.8 2209.9 2545.8 2958.2
1818.6 1951.1 2228.2 2580.2
230.2 258.8 317.6 378.0
2.7
2.8
3.0
3.1
215.4 182.8 241.7 302.0
2.6
2.0
2.3
2.5
176.3 185.0 160.0 150.0
3311.6 3821.3 4021.3 4221.3
6.3
6.1
6.1
6.0
Debt Indicators (% of GDP)
Government debt2
Domestic
External
Total external debt
in USD bn
Short-term (% of total)
19.0
18.5
0.5
8.8
737
73.4
18.9
18.4
0.5
9.2
863
78.4
18.0
17.5
0.5
9.2
967
78.4
17.5
17.0
0.5
9.0
1083
78.4
General (YoY%)
Fixed asset inv't (nominal)
Retail sales (nominal)
Industrial production (real)
Merch exports (USD nominal)
Merch imports (USD nominal)
20.3
14.4
10.0
7.9
4.3
20.0
13.2
9.7
7.9
7.3
17.0
13.2
9.5
15.2
14.2
15.0
14.0
10.0
16.2
15.8
Current
3.00
3.98
6.14
14Q4
3.00
4.10
6.11
15Q1
3.00
4.10
6.08
15Q3
3.00
4.30
6.02
Financial Markets
1-year deposit rate
10-year yield (%)
CNY/USD
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
Page 65
9 October 2014
Hong Kong
Aa1/AAA/AA+
Moody’s/S&P/Fitch

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

Main Risks: We reiterate our structural concerns on
emigration of middle class, lack of economic
diversity, competition from Mainland opening up
and instability due to political transformation.
Occupy Hong Kong protests may be ending, but
the culture of protest that has emerged in recent
years may become a long-term concern for the
economy. Much will depend on how the
government responds to the rising frequency of
demonstrations. An adversarial climate could over
time erode Hong Kong's reputation for stability.
Protests weigh on economy
Domestic consumption and exports point to better Q3
August retail sales grew 3.4%/2.8%yoy in value/volume,
recovering from six consecutive months of decline and
beating consensus of -2%/-3.3%. While sales value of
jewelry, watches and gifts (-6.1%yoy) and electronic
goods (-10.5%) continued to fall, food, alcohol and
tobacco increased strongly by 20%yoy, followed by
medicines and cosmetics (17.2%) and auto (12.6%),
demonstrating healthy local consumption momentum.
Together with narrowing trade deficit (July-Aug
monthly average HKD-36.8bn vs. -46.9bn in Q2 and 39.6bn in Q3 2013) and dissipating high base effect,
we expect a pickup in qoq(sa) growth in Q3.
Retail sales and visitor arrivals at risk
Retail Sales Volume, yoy %
Mainland Visitor Arrivals, yoy %
40%
30%
20%
10%
0%
-10%
Source: Deutsche Bank, Hong Kong C&SD
Page 66
Oct-14
Jul-14
Apr-14
Jan-14
Oct-13
Jul-13
Apr-13
Jan-13
-20%
Political uncertainty to overshadow Q4 recovery
However, the demonstrations of Occupy Hong Kong
have cast pressure on the forth-coming recovery. With
the thoroughfares in Mongkok, Causeway Bay and
Admiralty blocked for more than a week, some retailers
like Chow Tai Fook, Sa Sa and Hengdeli took cautious
approach to close certain stores in these key business
centers, and mainland tourist arrivals during the Golden
Week were seriously affected.
Hong Kong Immigration Department data showed that
from Oct 1 to 5, though the number of visitors into
Hong Kong grew by 14%yoy, that of mainland visitors
(who usually contribute the majority of tourist
spending) edged up by only 2.2%yoy (vs. 15.5%yoy
Jan-Aug 2014, 16%yoy in the Golden Week 2013). The
decision by the China National Tourism Administration
to suspend visits by tour groups to Hong Kong
represented, therefore, an important cost to Hong Kong.
By contrast, the total number of outbound Mainland
tourists increased robustly by c. 20%yoy during the
Golden Week. Destinations like Korea, Japan and
European countries have witnessed high double-digit
Chinese visitors’ growth. The Seoul Government even
estimated that around 160,000 Chinese would visit
Korea during the Chinese National Holiday, up 33%yoy.
As a result of slowing tourist traffic growth and
temporary store closure, Hong Kong retail sectors saw
sluggish sales. According to the Hong Kong Retail
Management Association, from Oct 1 to 5, most of its
30 surveyed retail companies recorded mid doubledigit drop in sales compared with the same period a
year earlier. The drop ranged from 15% to over 50%,
and watch, jewelry, fashion and catering were worst
performing sectors. SME retailers operating exclusively
in Mong Kok, Causeway Bay or Tsim Sha Tsui are most
adversely affected, with some reporting up to 80%yoy
sales decline. DB consumer research team estimated
that one week of sales loss in HK could reduce annual
sales by 0.1-1.6% and net profit by 0.3-7.1% for listed
retailers and restaurants under its coverage, assuming
fixed opex.
Moreover, retail sales are more important to Hong
Kong economy today than were a decade ago. Retail
sales were 23.3% of GDP in 2013, up from 13.6% in
2002. Spending by non-residents accounted for 14.3%
of GDP last year (19.2% of consumption), up from 4.5%
(8%) in 2002. Our sensitivity analysis has shown that if
Mainland tourist arrivals drop by one-third for one
month about 0.3% of GDP of sales (about HKD6.8bn)
would be lost. In the meantime, the negative impact on
GDP would be partially offset by a decline in imports,
as less retail sales would lead to less imports of
relevant goods (esp. watches, handbags and jewelry.)
9 October 2014
Long-lasting structural concerns
Although the demonstrations winded down during the
past two days and the market rebounded, the negative
impact of the political uncertainty on Hong Kong’s
competitiveness may last longer than perception. The
absence of a consensus on political reform would be a
potential hazard to the economy and the capital
markets from now till 2017 election.
Furthermore, the government in Beijing may feel rather
less disposed to expand on its use of Hong Kong as a
testing ground for capital account liberalization as long
as there are anti-government protests, which would put
Hong Kong at a disadvantage versus other offshore
centers and Shanghai.
Tourism would be another interrelated problem. Even
before the outbreak of demonstrations, visitor arrivals
from the Mainland have slowed to 14.7% growth over
the past year, down from c. 25% during 2010-12.
Spending by non-residents has been essentially
unchanged in the first half of the year from a year ago,
the worst outcome since the first half of 2009. This has
been a key drag on growth in the economy over the
past 18 months. One of the key reasons is that the
social tension between Mainland tourists and Hong
Kong residents and the proposed Individual Visit
Scheme (IVS) cut have already sent “unwelcoming”
signal to Mainland shoppers, who are reconsidering
Hong Kong as a touring destination. Moreover, as
China consumers (especially the emerging middle
class) are now pursing genuine travel experience in
new destinations rather than pure shopping, Hong
Kong may no longer be their prime choice for holidays.
On property, we see limited imminent impact from the
protests as turnover rent is insignificant to most
landlords and many (most?) Mainland property
investors don’t actually live in the apartments they buy.
In the medium-term, however, the market may be of
less attraction to Mainland capital given uncertainty
surrounding the political atmosphere and economic
outlook.
Audrey Shi, Hong Kong, +852 2203 6139
Michael Spencer, Hong Kong, +852 2203 8303
Hong Kong: Deutsche Bank Forecasts
2012
2013
2014F
2015F
263.1
7.15
36802
273.7
7.19
38071
292.3
7.26
40258
312.2
7.31
42685
1.5
4.1
3.6
6.8
1.9
2.9
2.9
4.2
2.7
3.3
6.5
6.9
2.8
2.2
2.8
2.7
6.7
6.5
3.6
3.7
3.4
4.2
12.7
12.8
CPI (YoY%) eop
CPI (YoY%) ann avg
Broad money (M3, eop)
HKD Bank credit (YoY%, eop)
3.8
4.1
10.5
5.7
4.3
4.3
12.5
8.2
3.5
4.0
9.5
8.3
3.0
3.2
9.0
8.0
Fiscal Accounts (% of GDP)1
Fiscal balance
Government revenue
Primary surplus
3.1
21.4
18.3
3.2
0.6
20.9
20.4
0.6
2.6
20.6
18.0
2.6
3.4
20.2
16.9
3.4
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX rate (eop) HKD/USD
464.7
487.4
-22.7
-8.6
3.5
1.3
-9.4
317.3
7.76
508.7
534.9
-26.2
-9.6
5.6
2.1
-14.9
311.2
7.76
542.6
569.6
-26.9
-9.2
-1.9
-0.7
-17.2
333.0
7.80
611.8
642.6
-30.8
-9.9
12.2
3.9
-18.0
356.3
7.80
National Income
Population (mn)
Real GDP (YoY%)
Private consumption
Gross fixed investment
Exports
Imports
Government debt1
Domestic
External
Total external debt
in USD bn
General
Unemployment (ann. avg, %)
Financial Markets
Discount base rate
3-month interbank rate
10-year yield (%)
HKD/USD
8.8
9.9
9.0
9.0
8.3
9.5
8.5
8.6
0.5
0.5
0.5
0.4
397.7 426.2 433.9 419.2
1046.5 1166.4 1250.0 1300.0
71.9
74.1
74.0
74.0
3.3
3.4
3.3
3.2
Current
0.50
0.36
1.93
7.75
14Q4
0.50
0.50
2.10
7.75
15Q1
0.75
0.60
2.25
7.78
15Q3
1.00
0.80
2.45
7.80
Note: (1) Fiscal year ending March of the following year. Debt includes government loans,
government bond fund, retail inflation linked bonds, and debt guarantees.
Page 67
9 October 2014
India
Baa2/BBB-(Neg)/BBBMoody’s/S&P/Fitch

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

Main risks: While India’s vulnerability metrics have
improved considerably, its external financing needs
are still considerable. A sudden tightness in dollar
liquidity will leave India’s external borrowers in
distress.
Uneven recovery; declining vulnerability;
RBI on prolonged pause
Leading indicators of production and a rebounding
consumption picture (especially auto sales) offer some
evidence of an economic recovery. Still, the economy
lacks vigor. Trade has slowed in recent months
(exports and imports were up just 2.4%yoy and
2.1%yoy, respectively through August), credit growth
continues to weaken, and tax collection is poor (up just
1%yoy in the April-August period). Once agriculture
production data start coming through, which would
also likely be weak given the late arrival of the
monsoon, chances are that the ground would be set for
a weaker July-Sept quarter over the previous one.
Mixed momentum
z score, 3mma
0.5
IP
Veh. Prod
Imports
Exports
Credit
0.0
Against the backdrop of a mixed recovery and
somewhat improved resiliency to shocks, monetary
policy is unlikely to do a great deal for the time being.
Except for an adjustment to liquidity provided under
the export refinancing facility, the Reserve Bank of
India stayed the course in its late September policy
meeting, leaving all key rates unchanged.
The central bank’s assessment of the global and local
economic
situation
took
cognizance
of
the
improvement in the US, stall speed in the EU, risk of
disorderly adjustment in the presently buoyant financial
markets, some loss of momentum in India during the
July-September quarter (with exports offsetting
somewhat a weak manufacturing outturn), broadly
stable exchange rate and liquidity conditions, and a
welcome respite in food and fuel price pressures
recently, along with a gradual easing of core inflation.
The policy statement also included an impressive array
of reform measures aimed at (i) strengthening the
monetary policy framework (by reducing sectorspecific refinance facilities); (ii) reforming the structure
of the financial system (including revamped
provisioning for liquidity coverage and improved
monitoring of liquidity); (iii) deepening financial markets
(time-bound easing of SLR ceiling, increased limit on
hedging for importers); (iv) expanding access to finance
(rationalization of KYC needs for banks); and (v) dealing
with stress in corporate and financial assets (putting in
place an Early Warning System to track banks’ critical
financial parameters).
Monetary policy rate call
% yoy
-0.5
12
-1.0
CPI, lhs
Forecast, lhs
Repo, rhs
Forecast, rhs
%
9.0
10
-1.5
8.5
8
-2.0
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Source: CEIC< Deutsche Bank. Z-score calculated over 1995-2014
8.0
6
4
7.5
2
Even if growth is not vigorous, India will be entering
the Fed rates normalization cycle on a stronger footing
than it was last year. Current account deficit has
improved, reserves have been rebuilt, investor
sentiment is much stronger, and real rates have turned
positive thanks to a resolute RBI. While the economy’s
gross external funding needs for 2015 are still
considerable (better than only Indonesia among the EM
Asia peers), the situation is clearly better than in 2013.
Page 68
7.0
0
2012
2013
2014
2015
2016
Source: CEIC, Deutsche Bank
9 October 2014
We agree with the RBI that the inflation situation has
improved and the near-term outlook is positive. Recent
easing of food and fuel prices has set the CPI on course
to ease to the 6.5-7% range of the rest of the year.
Indeed, there is a good chance for inflation to fall even
further if global commodity prices continue to correct.
The uncertainty about the path of inflation beyond a
six-month window however remains considerable. A
rebound in economic activity, locally and globally,
could push up prices; geopolitics in the Middle-east
and Russia could complicate the oil price dynamic; and
of course weather and infrastructure bottlenecks could
create supply side inflationary shocks. These
uncertainties are well appreciated by the RBI, as clearly
seen in its depiction of a rather wide risk band around
its 2015 inflation projection path. We have little doubt
in our mind from the latest policy documents that the
RBI would prefer maintaining an unchanged stance for
a prolonged period, given an improving growth and
still-uncertain inflation outlook.
India: Deutsche Bank Forecasts
2012
National Income
Population (mn)
Real GDP (YoY %)
Private consumption
Exports
Imports
Real GDP (FY YoY %)
1,2
CPI (YoY%) eop
CPI (YoY%) avg
Broad money (M3) eop
2013 2014F 2015F
1838
1882
1986
2254
1218
1236
1255
1274
1509
1522
1583
1770
4.9
4.4
5.5
6.5
5.7
4.0
5.6
6.0
7.6
4.4
2.9
5.0
2.4
1.0
3.7
6.5
8.3
5.3
10.9
13.2
11.6
-1.0
5.2
10.5
4.5
4.7
5.5
6.5
10.6
9.9
6.7
6.6
9.7
10.1
7.7
7.1
11.2
14.8
13.5
15.5
15.1
13.6
15.0
16.5
-4.9
-4.5
-4.5
-4.2
9.1
9.3
9.3
9.3
13.9
13.8
13.7
13.5
-1.8
-1.2
-1.2
-1.2
-7.2
-7.0
-7.0
-6.7
301.9
319.7
329.6
354.3
503.5
466.2
484.5
544.2
-201.7
-146.5
-154.9
-189.8
2
We are not sure if the central bank will manage to
remain immune from political pressure, however. We
think that it is quite likely that in a few quarters the
demand for policy easing will rise considerably as
inflation is seen to be stable and growth aspirations
soar. It is this political calculus that may well push the
central bank into cutting rates in the middle of the next
fiscal year (Sept/Oct), in our view.
We assign a probability of 45% to rate cuts next year,
although the chance of a resolute RBI holding the line
is not trivial (35%). Note that we have left 20% chance
for a third scenario. If global market turmoil spikes
along with a US rates normalization cycle, few
economies will be spared capital flow and FX volatility
next year. India, given its large external financing needs
(the sum of projected residual maturity external debt
and current account deficit for next year is USD 232bn)
and modest reserves coverage (about 8 months of
imports despite recent accumulation), may find it
difficult to differentiate itself among fragile EM
economies without exceptional policy measures. One
such measure would be to hike rates. It may seem
unthinkable right now, but market stress could well
push the RBI into moving in this direction next year.
Taimur Baig, Singapore, +65 6423 8681
Central government balance
Government revenue
Central primary balance
Consolidated deficit
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX rate (eop) INR/USD
Government debt
Domestic
External
Total external debt
in USD bn
General
Industrial production (YoY
%
Financial Markets
Repo rate
3-month treasury bill
10-year yield (%)
INR/USD
-11.0
-7.8
-7.6
-8.4
-91.5
-49.2
-32.4
-57.3
-5.0
-2.6
-1.6
-2.5
15.4
26.3
25.0
30.0
295.6
54.8
293.9
61.8
334.2
61.0
373.9
63.0
68.5
66.6
64.6
62.9
64.9
63.3
61.5
60.0
3.6
3.3
3.1
2.9
21.4
22.7
23.6
23.3
394.1
426.9
469.6
526.0
23.7
21.7
22.7
23.3
-0.6
0.1
6.0
3.8
Current
14Q4
15Q1
15Q3
8.00
8.00
8.00
7.75
8.55
8.50
8.25
8.10
8.50
8.40
8.25
8.20
61.5
61.0
61.6
62.8
Source: CEIC, Deutsche Bank. (1) We report “production-side” GDP growth rates for FY. (2) Fiscal
year ending March of following year.
Page 69
9 October 2014
Indonesia
Baa3/BB+/BBBMoody’s/S&P/Fitch

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

Main risks: Political risk has spiked with the
opposition coalition mounting a major challenge to
the incoming President’s ability to govern
effectively. Investor concerns could rise at a time of
global market stress, with adverse implication for
flows, rates, and the rupiah.
Push back
It’s all politics now. In a set of negative developments
that took us by surprise, incoming President Joko
Widodo has seen not only his efforts to form a majority
coalition in the Parliament thwarted, but a recently
passed law by the outgoing Parliament appears to have
cast doubts on his ability to govern effectively. The new
law, if implemented, will see the end of direct election
of local leaders, a hallmark of Indonesia’s devolution of
power over the past decade and a half. Indeed, Mr.
Jokowi himself is a product of these elections, which
allowed him to rise to the top of local political offices
with a popular following but apparently without the
backing of parties that have been part of the
establishment for long. We see the passing of this
controversial law as sharp push-back by the old
establishment to ensure that the opposition does not
let Mr. Jokowi govern effectively. Indonesia’s first nonestablishment President will likely have his task cut out
in office, as a result.
The key outcome of this law would be to effectively
allow major opposition parties to appoint heads of local
governments wherever they have local legislative
control. With the regional governments and the
parliament by and large in opposition hand, Mr.
Widodo will have very little operating room when he
takes office. We see this development as an
unmitigated negative.
The investor community has been remarkably patient
with recent developments so far, with little sign of
selloff, but the nervousness is spreading with each
successive negative political development. Queries are
rising about investor positioning and mood, and while
few investors have blinked yet, these political setbacks
come at particularly sensitive time for the Indonesian
economy and markets.
Page 70
Recent trade data suggest that while there is no sign of
further deterioration, the current account deficit will
continue to be non-trivial (2-3% of GDP) for the time
being. Considering the other deficit economy in the
region, India, has seen some improvement in its
external balances and reserves position, Indonesia runs
the risk of being singled out in Asia for its macro
fragility in periods of market stress. A year ago,
reserves divided by gross external financing (current
account plus short term debt on residual maturity)
stood at 122% and 114% for India and Indonesia
respectively, placing the two economies at the bottom
of the EM cohort in terms of reserves adequacy. Since
then India has taken forceful measures to compress its
current account deficit and accumulate reserves, while
Indonesia has made little progress. Consequently, the
latest data show the two ratios at 231% and 130%,
respectively.
Thus India has seen its vulnerability ranking improve
considerably, while Indonesia remains stuck on a high
vulnerability plane. Clearly going forward, investor
perception of resiliency with respect to handling
external funding pressure would be better for India and
remain poor for Indonesia.
While we expect the IDR to remain around 12,000 for
the rest of the year, undoubtedly the risk of further
weakness and volatility is rising. The key event risk is
the much anticipated and promised fuel price decision.
If the government can put a fuel price adjustment
package together by the end of this month, investors
will remain calm. A setback on this issue could be very
damaging, however.
People power and small parties in the
parliament are now critical
All is not lost on the political front though. The
controversial law has created an uproar among the
population (local polls by Kompass show 80% of the
population against the new law), sufficient to galvanize
the energy of outgoing President Yudhoyono. The
President has made a last-ditch attempt to counter the
law by issuing his own decree or emergency legislation
which would prevent implementation of the new law.
That he had to go this far is revealing, as the
President’s own party members abstained when the
controversial law was put for a vote in the Parliament.
Indeed, with some members of the Parliament who
voted for the law already changing their tone, it seems
that people power is playing a key role in trying to
uphold local elections.
9 October 2014
How does the Presidential decree work? At this stage,
it is the overriding law in the country, and the national
election commission (KPU) has confirmed it would use
the decree as their legal basis to implement more than
200 local elections scheduled for next year. Note that
the new Parliament, when it takes office in January,
will have to vote on abiding by the decree or rejecting it
in favor of the law passed earlier. If the decree is
rejected by the legislature, quite plausible if Mr. Jokowi
does not manage to expand his existing coalition, then
there is a risk of a constitutional crisis as the Presidentelect could issue yet another decree.
Coalition math remains tricky. Mr. Jokowi’s coalition
(consisting of PDIP, PKB, Nasdem, and Hanura parties)
has a total of 37% of the seats in the Parliament, and it
is still expected that the outgoing President’s PD party,
with about 11% of the seats, will support the coalition,
especially on the issue of the decree. The possibility
that some other lawmakers may break ranks with their
parties in support of the decree cannot also be ruled
out.
Restoring direct election at the local government level
has now become a major imperative for the incoming
President. Sorting this issue and reverting focus back
on economic issues, especially on dealing with fuel
subsidies, will go a long way in establishing Mr.
Jokowi’s Presidential credential.
Highlights of the Presidential decree:

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

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

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

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

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

A ban on the removal of local officials in postelections for political reasons
Indonesia: Deutsche Bank forecasts
2012
2013
2014F
2015F
876.9
247.2
3547
868.4
250.4
3468
868.1
254.8
3407
962.4
259.2
3713
Real GDP (YoY%)
Private consumption
Exports
Imports
6.3
5.3
1.3
9.7
2.0
6.7
5.8
5.3
4.9
4.7
5.3
1.2
5.2
5.3
2.8
5.2
3.2
2.1
5.5
4.8
4.0
6.5
6.3
5.5
CPI (YoY%) eop
CPI (YoY%) ann avg
Core CPI (YoY%)
Broad money (M2)
Bank credit (YoY%)
3.7
4.0
4.4
15.0
24.7
8.1
6.4
5.0
12.7
20.1
4.6
5.9
4.8
13.0
16.0
5.4
4.9
4.5
15.0
20.0
Budget surplus
Government revenue
Primary surplus
-2.3
16.5
18.8
-0.3
-2.2
16.6
18.8
-0.2
-2.4
16.2
18.6
-0.4
-2.6
15.8
18.4
-0.6
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX rate (eop) IDR/USD
188.5
179.9
8.6
1.0
-24.4
-2.8
13.7
112.8
9646
183.5
177.4
6.1
0.7
-28.5
-3.3
14.8
99.4
12087
188.2
181.8
6.4
0.7
-25.9
-3.0
14.0
101.9
12000
199.8
192.8
6.9
0.7
-26.1
-2.7
20.0
110.2
12000
Government debt
Domestic
External
Total external debt
in USD bn
Short term (% of total)
23.0
12.2
10.8
28.7
252.4
17.8
22.2
11.2
11.0
29.7
260.0
19.2
22.0
11.0
11.0
32.8
290.0
19.0
22.5
11.0
11.5
30.5
300.0
19.0
8.0
6.8
8.0
6.5
7.0
6.0
7.0
6.0
14Q4 15Q14
7.50
7.50
8.40
8.70
12000 12100
15Q3
7.50
9.00
12150
National Income
Population (mn)
General
Industrial production (YoY%)
Unemployment (%)
Financial Markets
BI rate
10-year yield (%)
IDR/USD
Current
7.50
8.53
12200
Page 71
9 October 2014
Malaysia
A3/A-/A-(Neg)
Moody’s/S&P/Fitch

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

Main risks: Economic fundamentals are improving
with rising growth, steady current account surplus,
and declining fiscal deficit but sharp swings to the
ringgit remain a key risk with a possible reversal of
foreign investments and amplified by aggressive
overseas investments by Malaysian residents.
Approaching the Budget Speech
Ahead of the Budget Speech on October 10, the
government decided to cut fuel subsidies by about 10%
effective on October 2. This move consequently raises
the retail price of fuel by 20 sen per litre, for RON95
petrol to MYR2.30 and diesel to MYR2.20, against the
market rates of MYR2.58 and MYR2.52 per litre,
respectively. Meanwhile, the subsidy on RON97 petrol
has already been lifted when government last cut
subsidies by 20 sen in September 2013.
existing or additional macro-prudential measures. This
is because relying on interest rates alone to correct
financial imbalances could bring about an overadjustment in the economy, to cite the central bank’s
report on the matter. 17 Moreover, risks to financial
imbalances may already be subsiding with the annual
growth in outstanding loans, including those by
households, moderating. Bank loans decelerated to
8.6%yoy in July-August from 11% at the start of the
year and the same trend can be said for household
sector loans.
One rate hike may be enough for 2014.
ST real rate, t-1
OPR, bps
4.00
2.00
Jul-15
1.50
1.00
3.50
0.50
3.25
0.00
3.00
-0.50
2.75
-1.00
Inflation likely to remain stable on base effect
This most recent fiscal consolidation measure comes at
a favorable time when inflation is likely to fall on base
effect in September. After the 3.3% inflation print in
August, we are forecasting inflation to drop to 2.6% in
September because of the base effect from the fuel
subsidy cut last year. As a result, the effective 10%
hike in fuel prices is only likely to bring inflation back to
the previous level of 3.2-3.3% from October to
December this year. This would put annual inflation still
in line with our 2014 forecast of 3.2%.
BNM: Still one and done for the year
We do not see the need for the central bank to respond
with a rate hike in the near term, especially as resulting
inflation from the fuel subsidy cut comes from a low
print in the previous month and growth is likely to
moderate in the second half of the year. Also, after the
BNM raised the OPR by 25bps in July, the short-term
real interest rate in the same month already reverted to
positive territory. We see this positive real interest rate
fairly sustained through year-end (despite perhaps, a
month or two when it goes slightly below zero) and
should give the BNM room to keep the OPR steady.
This is not to say that risks to financial imbalances have
already dissipated. In fact, we think rates are still low
and could still spur risk-taking behavior among
economic agents. However, we think the BNM would
rather take a measured approach in adjusting interest
rates and complement the recent rate hike with
Page 72
3.75
2.50
-1.50
2010
2011
2012
2013
2014
2015
Short-term real inetrest rate = OPR minus inflation.
Source: CEIC and Deutsche Bank
That said, we are looking at July 2015 as the next
period when the BNM may decide to hike the OPR
again, by 25bps to 3.50%. We see this as a move to
counter risks of a prolonged spike in inflation induced
by the GST in April and other fiscal adjustment
measures (such as the recent fuel subsidy cut and
other measures likely to come with the Budget Speech).
There might, however, be risks of this call being
pushed forward to May ahead of a possible
normalization of the US Federal Funds Rate in June.
But we do not see the rate hike coming earlier in
Q12015 as growth could continue to moderate due to
de-stocking when firms cut down production before
the GST. And, while there might be some frontloading
in private expenditures ahead of the GST in April, the
degree will likely be contained by higher inflation,
tighter credit conditions, and the heavy household debt.
17
Financial Imbalances and the Role of Monetary Policy. BNM Annual
Report 2010.
http://www.bnm.gov.my/files/publication/ar/en/2010/cp03_001_whitebox.p
df
9 October 2014
Increasingly likely to meet 2014 fiscal deficit target
The government estimates at least MYR21bn for the
fuel subsidy bill this year, about 8% of the projected
total expenditures as indicated in this year’s Budget.
This corresponds to about a MYR5bn reduction from
our estimated fuel subsidy bill last year, of which
savings we think are possible through today’s fuel
subsidy cut, the softer fuel prices this year, and the
electricity rate adjustment back in January. Add the
stronger-than-expected GDP growth this year and
moves to cut operating expenditures announced in
January, we think the likelihood is high for the
government to meet its 3.5%-to-GDP fiscal deficit
target for 2014 after exceeding the target last year
(deficit came in at 3.9% in 2013 vs. the 4% target).
Expectations of the upcoming Budget Speech
We expect the 2015 Budget, set to be tabled on
October 10, to provide finality on the implementation of
the 6% GST in April 2015 and details of the subsidy
rationalization programme (such as moving towards a
targeted subsidy program while electricity and toll rates
may be adjusted), which would pave the way for a
lower fiscal deficit target (3.0% of GDP) next year. The
government is also likely to uphold its commitment to
increase financial assistance to low-income households
and reduce corporate and personal income tax rates, as
a means to counter rising living costs from the series of
fiscal consolidation measures.
High base capped the growth in exports
Meanwhile, exports growth slightly picked up in
August as it rose to 1.7%yoy—on the back of increased
demand for electronic goods and LNG—from 0.8% in
the previous month (4.9% vs. 1.1% in USD terms). On a
sequential basis, merchandise exports also expanded
1.9%mom (sa) in August after falling 0.6% in July. But
with the favorable base on exports growth dissipating
in the second half, it would be hard for Malaysia to
experience the type of double-digit growth in exports
as seen early in the year. From September through
December, exports could gain traction to grow about
6%yoy, in our view, but still slower than the 12.6%
average in the first six months of the year.
Merchandise imports also gained pace in August,
surging by 7.6%yoy from the 0.7% fall in July (11.0%
vs. -0.3% in USD). The acceleration in imports was
broad-based, with increases recorded for intermediate,
capital, and consumption goods. But with imports
rising faster than exports, the trade surplus fell 45%yoy
to MYR3.9bn (USD1.2bn) during the month. Increased
demand for imported capital goods, arising from a
pick-up in public investments going forward, could
reduce the trade surplus. Against this backdrop, we
maintain our relatively conservative growth outlook of
5.5% (real GDP growth) for 2014.
Malaysia: Deutsche Bank forecasts
2012
2013
2014F
2015F
305.3
29.5
10342
313.3
29.9
10462
323.0
30.4
10630
336.4
30.8
10914
5.6
8.2
5.0
19.2
-1.8
2.5
4.7
7.2
6.3
8.5
0.6
2.0
5.5
6.3
4.4
6.2
5.6
5.2
5.6
4.0
6.6
6.0
8.2
7.8
Prices, Money and Banking (YoY%)
1.2
CPI (eop)
1.7
CPI (ann avg)
9.0
Broad money (eop)
11.9
Private credit (eop)
3.2
2.1
8.1
9.9
3.2
3.2
7.4
8.4
3.7
4.1
8.6
8.5
National Income
Population (mn)
Real GDP (YoY%)
Private consumption
Exports
Imports
Central government surplus
Government revenue
Primary balance
-4.5
22.1
26.5
-2.4
-3.9
21.6
25.5
-1.8
-3.5
21.4
24.9
-1.3
-3.2
21.5
24.7
-0.9
Goods exports
Goods imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (eop)
MYR/USD (eop)
222.3
181.8
40.6
13.3
17.6
5.8
-7.9
139.7
3.06
215.6
181.3
34.4
11.0
12.7
4.0
-1.7
134.9
3.28
232.8
206.0
26.7
8.3
8.4
2.6
-3.0
131.7
3.32
271.4
244.0
27.4
8.1
10.2
3.0
-2.2
126.0
3.36
Government debt1
Domestic
External
Total external debt
in USD bn
68.4
66.7
1.8
63.7
196.2
47.0
70.6
68.9
1.7
70.4
211.7
48.6
67.8
66.3
1.5
61.3
197.4
46.7
67.1
65.5
1.6
60.9
204.2
47.9
4.5
3.0
3.4
3.1
3.7
3.0
3.4
3.1
Current
3.25
3.68
3.86
3.26
14Q4
3.25
3.71
4.05
3.32
15Q1
3.25
3.71
4.20
3.31
15Q3
3.50
3.96
4.40
3.39
General (ann. avg)
Unemployment (%)
Financial Markets (%, eop)
Overnight call rate
10-year yield
MYR/USD
(1) Includes government guarantees
Diana del Rosario, Singapore, +65 6423 5261
Page 73
9 October 2014
Philippines
Baa3(Pos)/BBB-/BBBMoody’s/S&P/Fitch

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

Main risks: The balance of payments could turn
into deficit in 2014-15 suggesting downside risks
to the peso, although ample reserves can still
shield the currency from sharp depreciations.
Downside risks to the peso
BOP outlook
Year-to-date balance of payments has been in deficit,
according to BSP data. From January to August of this
year, the deficit amounted to USD3.5bn which was a
reversal to the USD3.4bn surplus recorded in the same
period in 2013. The BOP deficit reached a record high
in January 2014 when the surge in merchandise
imports brought the current account into deficit for the
first time in 19 months, while non-resident portfolio
outflows contributed to the substantial financial
account deficit. The same month also reported a drop
in the country’s gross international reserves, by about
USD3.8bn, and a 1.7% depreciation of the peso
(against the USD) over the previous month.
We, however, think that 2014 could see the BOP in
deficit of about USD1.2bn. This is because stronger
growth in exports and remittances through year-end
could be pared down by increased demand for
imported goods related to public works and typhoonrelated reconstruction. Net portfolio inflows could also
shrink on expectations of an imminent US Fed rate hike.
That said, we are still looking at a modest surplus in
Sep-Dec but which may not be sufficient to overturn
the year-to-date deficit in the BOP. This deficit could
also extend through 2015 as the Aquino administration
moves to accelerate infrastructure spending, inflation
rises on power supply issues, domestic economic
uncertainty looms with the upcoming 2016 presidential
elections, and as capital reversals get amplified with
the normalization of US rates.
BOP could be in deficit in 2014 and 2015.
USD bn
20
DB
forecasts
15
10
5
0
Accumulated BOP has been in deficit year-to-date.
USD bn
2
-5
USD bn
86
1
85
0
84
-1
83
-2
82
-3
81
-4
80
79
-5
Jan-13
Jun-13
Overall BoP (left)
Nov-13
Apr-14
Sep-14
FX Reserves (right)
The BOP had since reverted to a small net surplus until
the latest print in August. The central bank remains
optimistic that a USD1.1bn surplus for the year is
attainable. This would mean that September through
December would have to generate a BOP surplus of
USD4.6bn. The last time the country generated a
surplus close to this amount within the same period
was in 2012 (USD4.2bn) when strong non-resident
inflows boosted the financial account.
Page 74
-10
08
09
10
11
Net Unclassified Items
Current account
12
13
14H1 14H2F 15F
Financial Account
Overall BoP
Impact on the peso
The peso has fallen against the dollar over the past
year, along with its Asian peers. In our view, it may
gain a bit by year-end from its current rate on the back
of an improvement in the BOP position, supported by
remittances that tend to gain pace during the
Christmas holidays and possibly by another SDA rate
hike by the BSP in December.
The appreciation, however, may prove to be short-lived
as the peso could weaken again through 2015 on
another year of deficit in the BOP. Uncertainty lurking
around the May 2016 elections, especially if odds are
high of a non-administration candidate to take the
presidential post, could also contribute to the peso’s
modest depreciation against the dollar in Q42015.
9 October 2014
Ample reserves can still shield sharp losses in the peso
While the country’s GIR has fallen along with the
deficit in the BOP, it remains in a healthy position
especially when compared to the rest of emerging Asia.
September-2014 GIR at USD80.4bn is still sufficient to
cover at least 13 months’ worth of goods imports. The
Philippines’ record just comes after China and Taiwan’s
substantial import cover and is superior to the rest of
emerging Asian countries that have reserves worth less
than 10 months of goods imports. The country also has
minimal gross external financing needs (at less than
1.5% of GDP), due to its current account surplus and
low short-term external liabilities. Projected GIR next
year is equivalent to 28 times the country’s gross
external funding needs, suggesting the Philippines’
stronger cushion relative to its Asian peers. Thus, even
if the market for dollar were to shut down for all of
2015, the economy has more than enough reserves to
service its immediate foreign liabilities and to defend
sharp movements in the peso.
Philippines has the strongest external funding cushion
2015 Reserves/GEF
Taiwan
Philippines
28
China
Thailand
Malaysia
South Korea
India
Indonesia
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
GEF = Gross external funding needs, sum of the current account deficit and short-term external debt
by residual maturity.
Source: CEIC, BIS-IMF-OECD-World Bank Joint External Debt Hub, and Deutsche Bank.
BSP likely to pause this October
We have been expecting inflation to start moderating in
September on base effects—barring the occurrence of
severe natural disasters—to welcome 2015 with a
headline print within the 2-4% target. With September
inflation falling 50bps to 4.4% from the previous month
on a slower increase in food prices, we think odds are
now higher for the BSP to keep rates steady at this
month’s monetary policy meeting. In fact, we no longer
expect the BSP to hike the repo and reverse repo rates
until May 2015 when inflation rises again because of a
shortage in power supply. Yet, the BSP may hike the
SDA rate by another 25bps in December 2014 in a
move to bring credit growth back to the more
sustainable, long-term average of about 15%yoy.
Philippines: Deutsche Bank Forecasts
2012
2013
2014F
2015F
250.2
96.6
2590
272.1
98.4
2764
283.1
100.2
2825
312.3
102.0
3062
6.8
6.6
15.5
10.8
8.5
4.9
7.2
5.7
7.7
11.9
-1.1
5.4
6.6
5.0
7.9
9.0
9.2
5.8
6.8
4.9
9.7
10.6
10.6
11.4
CPI (eop)
3.0
CPI (ann avg)
3.2
Broad money (M3, eop)
9.4
Private credit (eop)
14.8
4.1
2.9
31.8
16.5
3.8
4.3
13.8
14.8
3.6
3.6
11.0
10.0
Fiscal Accounts (% of GDP)1
Fiscal balance
Government revenue
Primary surplus
-2.3
14.5
16.8
0.7
-1.4
14.9
16.3
1.4
-1.8
15.9
17.7
0.8
-2.2
15.8
18.0
0.6
Goods exports
Goods imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (eop)
PHP/USD (eop)
46.4
65.3
-18.9
-7.6
6.9
2.8
-1.0
83.8
41.2
44.5
62.2
-17.7
-6.5
10.4
3.8
-0.2
83.2
44.4
47.5
67.0
-19.4
-6.9
10.1
3.6
1.0
82.0
44.4
55.4
77.0
-21.5
-6.9
10.3
3.3
0.4
81.9
45.4
General government debt2
Domestic
External
External debt
in USD bn
56.2
34.2
22.0
24.1
60.3
14.1
53.3
33.5
19.8
21.5
58.5
19.2
54.2
35.4
18.8
18.0
50.8
15.7
53.9
36.1
17.8
19.3
60.3
14.9
General (ann. avg)
Unemployment (%)
7.7
7.0
13.9
7.1
11.7
7.3
15.2
7.0
Current
6.00
4.00
1.14
4.16
44.6
14Q4
6.00
4.00
1.49
4.35
44.4
15Q1
6.00
4.00
1.79
4.60
44.2
15Q3
6.25
4.25
2.39
4.80
45.4
National Income
Population (mn)
Real GDP (YoY%)
Private consumption
Exports
Imports
Policy rate (BSP o/n repo)
Policy rate (BSP o/n rev repo)
3-month T-bill rate
10-year yield (%)
PHP/USD
(1) Refers to general government. (2) Includes guarantees on SOE debt.
Diana del Rosario, Singapore, +65 6423 5261
Page 75
9 October 2014
Singapore
Aaa/AAA/AAA
Moody’s/S&P/Fitch

Economic outlook: The outlook is characterized by
benign inflation and incipient pressure on rates and
FX. The growth dynamic is contingent on a long
overdue pick-up in external demand.
see inflation ending the year slightly below 1%.
Presently we see 2015 being a sub-2% inflation year as
well, with inflation momentum firmly in negative
territory (see chart).

Main risks: Key risk is disorderly USD and US rates
movements, which could impact financial flows, as
well as household and corporate balance sheets
Little risk from inflation
How to deal with a US rally
Singapore’s open economy characteristic offers many
virtues while making is vulnerable to shifts in global
investor risk appetite as well as external demand. Both
risks are weighing heavily on the economy right now,
and will likely continue to do so for a number of
quarters ahead, in our view.
Domestic economic dynamic is broadly stable. Inflation
is exceptionally benign, with CPI inflation easing to
0.9% in August from 1.2% in July. Private road
transport costs continue to decline (down 2.9% in
August after -1.6% in the previous month, reflecting
lower COE premiums). Fuel prices rose at a slower
pace of 0.7%, compared to 3.1% a month ago, with
benign commodity prices becoming a worldwide
phenomenon and a major risk dampener.
Services inflation edged down to 2.1% in August from
2.5% in July; this reflected softer rate of increases in
the costs of recreation & entertainment, as well as
holiday travel.
Accommodation costs, a major source of concern and
policy measures in recent years, have ceased to
command headlines, easing by 0.2% after coming in
flat in July. The housing rental market, reflecting an
adverse supply-demand dynamic, has softened
considerably this year.
Even food prices are no longer a source of inflationary
pressure, with overall food inflation slightly lower at
2.9% in August compared to 3.0% a month ago. The
only area where there was some upward pressure was
“non-cooked food prices,” which rose by 3.4%
compared to 2.8% in July, reflecting steeper price
increases for seafood and vegetables.
As one would expect, given these developments, the
MAS core inflation index (which excludes the costs of
accommodation and private road transport) eased to
2.1% in August (2.2% in July).
CPI, Headline,yoy%
CPI Momentum, 3m/3m, SA, ann.
10.0
8.0
6.0
4.0
2.0
0.0
-2.0
-4.0
2007
2008
2009
2010
2011
2012
2013
2014
The benign inflation situation begs the question if the
time has come for easing of monetary and financial
conditions in Singapore, especially if external demand
remains lackluster and domestic exposure to the rate
cycle is considerable. We think that the MAS will find it
prudent to maintain an unchanged policy stance for the
time being as the property market cooling measures
have just begun to pay dividends without causing any
volatility. Also, the political economy of benign
property prices is substantial, which the authorities will
appreciate. Hence cooling measures will remain on the
table, in our view.
As far as the exchange rate policy is concerned, we
also don’t see any point any changing the present
stance. Low inflation and weakening of the SGD
against the USD has begun to have an impact on the
direction of the REER and NEER already. Even without
changing its explicit policy, the authorities have
allowed conditions to ease (since the exchange rate
has depreciated and rates have been stable). With rates
in the US going up next year and further pressure on
the exchange rate inevitable, allowing the NEER to
trade toward the bottom half of the policy band will be
a natural move for the MAS, in our view. But with
growth likely track cyclical improvement in the G2
economies, we don’t think there will be a need to add
further accommodation.
Given this backdrop, and expecting both rental and
auto prices to remain stable for the rest of the year, we
Page 76
9 October 2014
REER has flattened, SGD/USD has weakened
NEER
REER
Singapore: Deutsche Bank Forecasts
SGD/USD, right
120
1.20
115
1.25
110
1.30
105
1.35
100
1.40
2012
2013
2014
Vulnerability metrics
Another reason why the authorities may not want to
allow for a markedly weaker exchange rate is that the
resulting rise in rates could hurt Singapore’s
households and firms. Private sector leverage is about
130% of GDP, compared to less than 100% of GDP in
2010. Gross external financing needs, despite a large
current account surplus, is substantial (see chart
below).
Reserves over gross external financing
Hong Kong
Singapore
Taiwan
Philippines
China
Thailand
Malaysia
South Korea
India
Indonesia
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
Source: CEIC< World Bank, Deutsche Bank. GEF is the sum of 2015 projected current account and
debt due over the year (on a residual maturity basis.
While the economy remains characterized by strong
assets, the liability accumulation in recent years cannot
be ignored, especially since it has taken place with
rates at historic lows. We think declining inflation and a
mildly weaker exchange rate will still keep Singapore’s
real returns attractive for investors, leaving liquidity and
funding conditions in stable territory.
National Income
Population (mn)
2012
2013
2014F 2015F
284.5
5.3
53547
295.8
5.4
54594
298.9 311.3
5.5
5.6
54339 55588
Real GDP (YoY%)
Private consumption
Exports
Imports
CPI (YoY%) eop
CPI (YoY%) ann avg
Broad money (M2)
Bank credit (YoY%)
2.5
3.9
-0.1
8.9
1.5
3.1
3.9
2.6
9.9
-1.9
3.6
3.1
3.0
1.1
6.7
-7.0
3.6
2.0
4.0
1.0
8.3
-2.0
5.5
4.5
4.3
4.6
10.4
12.9
1.5
2.4
9.7
9.8
0.9
1.3
8.5
10.4
2.3
1.8
11
10.5
Fiscal balance
Government revenue
7.8
22.8
15.0
7.1
21.9
14.8
6.9
22.1
15.2
6.8
22.3
15.5
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX rate (eop) SGD/USD
434.6
371.7
62.9
22.1
49.4
17.4
47.6
259.3
1.22
436.9
369.0
67.9
22.9
54.4
18.4
36.9
273.1
1.26
463.1
391.2
71.9
23.5
55.3
18.1
10.0
305.3
1.30
495.5
422.5
73.1
22.0
55.0
16.5
12.0
335.4
1.35
106.1
106.1
0.0
416
1151
69.5
110.9
110.9
1.0
410
1208
68.8
115.6
115.6
1.0
391
1214
69.0
117.7
117.7
1.0
362
1220
70.0
-1.2
2.6
2.8
2.8
1.6
2.6
3
2.5
Current
0.41
2.39
1.28
14Q4
0.50
2.50
1.30
15Q1
0.55
2.60
1.33
15Q3
0.80
2.80
1.35
Government debt
Domestic
External
Total external debt
in USD bn
General
Unemployment (%) (eop)
Financial Markets
10-year yield (%)
SGD/USD
Note: includes external liabilities of ACU banks.
Page 77
9 October 2014
South Korea
Aa3/A+/AA\Moody’s/S&P/Fitch

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

Main risks: Along with deregulation, better labouremployer relations are needed to keep jobs
onshore.
Weaker exports and investment growth momentum
Exports
Equipment investment
30
20
10
0
-10
-20
-30
2012
2013
2014
Sources: CEIC, Deutsche Bank
…amid limited rebound in exports, as labour strikes
continued… Although export growth rebounded in
September, to 6.9%yoy, its weakness the previous
month left Q3 growth at 4.0%, only modestly higher
than the 3.3% growth reported in Q2, as the labour
strike in the auto industry negatively affected its
exports. According to the full month trade data, auto
exports growth slowed to 0.5% in July/August, down
from the 3.4% rise in Q2. Meanwhile, the trade data for
the first 20 days pointing to a 1.6% decline in Q3 vs.
the 3.7% rise in Q2. Meanwhile, auto production fell
14.8% yoy in August, leaving the July/August growth
rate at 2.8%, down from 3.6% in Q2. As we warned in
our report South Korea: Labour at a crossroads,
published on 5 June 2014, labour disputes weighed on
manufacturing this year.
Page 78
Exports of vehicles
200
Production of vehicles (rhs)
150
180
125
100
140
Business investment weakens... Equipment investment
growth momentum fell sharply in August, by 9.1%
3m/3m saar, vs. 6.3% and 8.9% growth in July and Q2,
respectively, as both machinery and transportation
equipment investments fell. Although business
sentiment bottomed, its weakness remains a point of
concern. While the recovery in the domestic economy
supported domestic enterprises’ sentiment, that of
exporting enterprises remained weak, dragged down
by large enterprises.
2011
2010=100
160
Investment headwinds
% 3m/3m saar
40
Labour strikes hurt the auto sector
120
75
100
50
80
25
60
40
2006
strikes drag on production
2008
2010
2012
0
2014
Overseas production now constitutes about 60% of
total production for the auto industry, up 20ppts over
the past decade. Korea risks further hollowing out its
manufacturing sector in terms of employment, as poor
labour-employer relations, the relatively high cost of
production and the won’s strength drive investment
outward.
…while overall production recovers modestly,
supported by stimulus measures… Amid weakness in
the auto sector, headline manufacturing production
growth was low, at 0.6% yoy in July/August, albeit
better than the 0.2% increase reported in Q2. In
contrast, growth in administration activities rose
sharply during the same period, to 3.9% from a 0.4%
fall in Q2, as the government increased its support of
the economy. Meanwhile, services production also saw
improvement, rising 2.4% in July/August, up from 1.4%
growth in Q2, helping to guide overall production
higher at 1.7% from 0.8% in the same period.
Manufacturing growth momentum weaker vs. services
% 3m/3m saar
30
Mfg
Services (rhs)
20
10
5
10
0
0
-10
2010
-5
2011
2012
2013
2014
9 October 2014
Within the sector, services growth was led by financial
and real estate, which saw higher growth of 5.3% and
6.7%, respectively, in July/August, vs. 4.3% and 3.5%
in Q2. The local stock market turnover rose 44% in Q3
vs. Q2, in expectation of and response to policy actions
by the government and BoK, while banks’ lending rates
(newly extended) to households fell to 3.76% in August
from 3.93% in July. Banks’ mortgage loans growth was
higher in July/August, at 6.9% vs. 5.6% in Q2,
supporting housing prices. The latter rose 1.8%yoy in
Q3, up from 1.4% in Q2, as the number of unsold
residential properties fell to its lowest level in ten years.
Housing prices and loan growth rise
%yoy 3mma
30
Housing prices (lhs)
20
Bank mortgage loans
25
15
20
15
2012
2013
2014F
2015F
1223
50.0
24469
1305
50.2
25979
1429
50.4
28374
1475
50.6
29144
Real GDP (yoy %)
Private consumption
Exports
Imports
2.3
1.9
3.4
-0.5
5.1
2.4
3.0
2.0
2.7
4.2
4.3
1.6
3.6
2.0
1.7
4.2
4.8
3.4
3.8
2.8
2.0
4.3
6.8
6.5
Prices, money and banking
CPI (yoy %) eop
CPI (yoy %) ann avg
Broad money (Lf)
Bank credit (yoy %)
1.4
2.2
8.8
5.0
1.1
1.3
9.0
4.0
1.5
1.4
9.5
6.0
2.7
2.3
9.5
6.5
Fiscal accounts (% of GDP)
Government revenue
Primary surplus
1.5
24.5
23.0
2.7
1.0
22.0
21.0
0.6
0.2
21.4
21.2
0.0
0.0
21.4
21.4
1.2
External accounts (USDbn)
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (USDbn) 1
FX rate (eop) KRW/USD
603.5
554.1
49.4
4.0
50.8
4.2
-21.1
327.0
1064
617.1
536.6
80.6
6.2
79.9
6.1
-17.0
346.5
1050
625.2
540.6
84.6
5.9
79.4
5.6
-16.0
376.5
1060
649.7
581.3
68.4
4.6
66.9
4.5
-14.0
388.6
1080
Debt indicators (% of GDP)
Government debt2
Domestic
External
Total external debt
in USDbn
33.2
32.6
0.6
33.4
408.9
31.3
34.8
34.3
0.5
31.9
416.1
27.7
35.1
34.4
0.7
30.2
430.0
27.4
35.6
34.8
0.8
29.6
432.0
27.8
1.5
3.2
0.2
3.1
3.0
3.1
4.5
3.1
Current
Q4 14
Q1 15
Q315
2.25
2.35
2.86
1069
2.00
2.15
3.10
1060
2.00
2.15
3.30
1070
2.25
2.45
3.50
1080
National income
Nominal GDP (USDbn)
Population (m)
10
10
5
5
0
-5
2004
South Korea: Deutsche Bank forecasts
0
2006
2008
2010
2012
2014
Consumer sentiment on the domestic economic
situation trended modestly higher, to 83 in September
from 81 in August, albeit still lower than the pre-Sewol
accident level of 91 in April. As consumer sentiment
improved, retail sales growth momentum recovered,
reaching its highest level in two years in August, at
6.2% 3m/3m saar, after falling 5% in April, its lowest
level in six years. On a yoy basis, retail sales growth
rebounded modestly, to 1.4% in July/August, from
0.8% in Q2. This was led by semi-durable goods sales,
which saw 0.9% growth in July/August vs. a 2.5% fall
in Q2, while other categories, including auto sales, saw
their growth slow.
…with more support planned ahead. Amid tepid signs
of recovery, the government requested a 5.7% increase
in its budget for 2015 vs. its medium-term target
growth of 3.5%. In line with its policy priorities,
following National Disaster Management, R&D and
creative activities will see the largest increases in their
budgets, albeit from low levels. Meanwhile, the
sustained fall in headline inflation, to 1.1% in
September from 1.4% in August, supports our
expectation of another rate cut by the Bank of Korea,
especially as the KRW reer hovers around pre-GFC
levels.
Juliana Lee, Hong Kong, +852 2203 8312
General
Industrial production (yoy %)
Unemployment (%)
Financial markets
BoK base rate
91-day CD
10-year yield (%)
KRW/USD
Source: CEIC, Deutsche Bank estimates, Global Markets Research, National Sources
Note: (1) FX swap funds unaccounted for (2) Includes government guarantees
Page 79
9 October 2014
Sri Lanka
B1(stable)/B+/BBMoody’s/S&P/Fitch

Economic outlook: Sri Lanka registered an average
real GDP growth of 7.7% in 1H’2014; we expect
growth momentum to moderate slightly in the
second half of 2014 (7.3% average), mainly due to
a negative base effect.
Main risks: Prospects of volatility in global financial
markets, led by anticipation of a quicker than
expected turn in the US rate cycle, could put
pressure on Sri Lanka’s exchange rate, thereby
complicating monetary policy decisions.
CBSL delivers an “effective rate cut”
We had expected the central bank to cut policy rates
by 50bps in the September meeting, given the sluggish
credit growth rate and benign inflation environment.
While the Central Bank of Sri Lanka kept all key policy
rates unchanged in the September monetary policy
review, it took some specific steps to improve private
sector credit growth momentum in the economy.
These are:
i) Access of OMO participants to the Standing Deposit
Facility (SDF) of the central bank at the currently
applicable SDF rate of 6.50% will be limited to a
maximum of three times per calendar month.
ii) Any deposits at the SDF window exceeding three
times by an OMO participant to be accepted at a
reduced interest rate of 5.0% per annum (made
effective from 23rd September 2014; will continue until
further notice).
iii) Daily auction facility was suspended with effect
from 23rd September until further notice.
These above measures constitute an “effective rate
cut”, in our view, as the commercial banks would have
lesser incentive to deploy funds with the central bank
now and would also likely lend out the funds at a
relatively lower rate than the pre-policy rate.
These measures will likely help the credit growth
momentum to gain traction in the coming months,
albeit from a depressed base, but are unlikely to lead to
major inflationary pressure in the economy, at least in
the next 4-6 months. While inflation has probably
bottomed in this cycle, we expect CPI inflation to
remain in the mid-single digit range over the next 6
months. This should help the central bank to remain on
the sidelines for an extended period.
Page 80
Private sector credit growth remains anemic
Credit growth, lhs
% yoy, 3mma
40
% yoy
10
CPI, rhs
30
8
20
6
10
4
0
2
-10
2009
0
2010
2011
2012
2013
2014
Source: CEIC, CBSL, Deutsche Bank
Inflation and policy rate forecast: extended pause likely
CPI inflation, lhs
Forecast
Policy rate, rhs
Forecast
%yoy
12
10
%
12
11
8
10
6
9
4
8
2
0
2009
7
2010
2011
2012
2013
2014
2015
Healthy growth momentum in 1H’2014;
some moderation likely in 2H
Sri Lanka’s real GDP grew 7.8%yoy in Q2, as we
expected, with the outturn being slightly better than Q1
(7.6%yoy). Consequently, the Sri Lankan economy
registered an average growth of 7.7% in the first half of
2014, which is one of the strongest growth outturn
within the Asian region.
As far as the details of the Q2 growth composition is
concerned, we note that agricultural sector growth
rebounded sharply (6.5%yoy in Q2 vs. 0.2%yoy in Q1),
while industrial (12.2%yoy vs. 12.6%yoy) and services
(5.8%yoy vs. 6.5%yoy) sector growth moderated from
the previous quarter. Consequently, non-farm sector
growth moderated to 7.9%yoy in Q2, from 8.7%yoy in
Q1 of 2014.
9 October 2014
Growth momentum remains healthy
% yoy
Real GDP
10
Sri Lanka: Deutsche Bank Forecasts
Non farm GDP
8
6
4
2
0
2008
2009
2010
2011
2012
2013
2014
Going forward, we expect the growth momentum to
moderate in 2H of 2014, mainly due to a negative base
effect. We expect real GDP growth to average 7.3% in
2H, which should likely result in a full year growth
outturn of 7.5%yoy in 2014 (vs. 7.3%yoy in 2013).
Despite headline growth remaining robust, we suspect
that consumption growth momentum remains weak,
given anemic credit growth rate. Last year, while Sri
Lanka achieved a 7.3% annual growth rate,
consumption growth momentum was extraordinarily
weak (3.2%yoy in 2013 vs. 5.5%yoy in 2012), and this
led the central bank to maintain an accommodative
monetary stance. While we don’t have the expenditure
side data on a quarterly basis, we think the same
dynamic is playing out in this year as well, leading the
central bank to remain accommodative, despite strong
headline growth rate. We expect the accommodative
stance of CBSL to continue at least for the next two
quarters, by which time there should be some
improvement in the private sector credit growth and
consumption momentum.
Consumption growth rate has fallen sharply
NX contr. to GDP, rhs
Real GDP, lhs
Consumption growth, lhs
%yoy
14
12
%
2
1
10
0
8
-1
6
-2
4
-3
2
-4
0
-5
2003
2005
2007
2009
2011
2013
2012
2013
2014F
2015F
National Income
Population (mn)
59.0
21.1
2798
67.0
21.3
3147
76.2
21.5
3544
88.3
21.7
4064
Real GDP (YoY %)
Total consumption
Total investment
Private
Government
Exports
Imports
6.3
5.5
10.7
9.2
16.0
0.2
0.5
7.3
3.2
9.7
10.0
9.5
5.9
-0.3
7.5
5.0
11.1
12.0
8.0
9.0
6.0
7.5
6.8
11.7
13.0
7.0
10.0
11.5
CPI (YoY%) eop
CPI (YoY%) avg
Broad money (M2b) eop
9.2
7.6
17.6
17.6
4.7
6.9
16.7
7.5
5.4
4.0
13.0
8.0
6.2
6.3
16.5
21.0
Central government balance
Government revenue
Primary balance
-6.4
14.1
20.5
-1.1
-5.8
13.8
19.7
-0.7
-5.5
14.0
19.5
-1.1
-5.0
14.2
19.2
-0.7
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX rate (eop) LKR/USD
9.8
19.2
-9.4
-16.0
-3.9
-6.6
0.9
6.9
127.7
10.4
18.0
-7.6
-11.4
-2.6
-3.9
0.9
7.2
130.8
11.1
19.4
-8.3
-10.9
-2.6
-3.4
1.0
10.0
130.0
12.0
21.2
-9.2
-10.4
-2.8
-3.2
1.3
11.0
128.0
Government debt
Domestic
External
Total external debt
in USD bn
79.1
42.6
36.5
48.2
28.4
17.0
79.4
42.5
36.9
46.7
31.3
18.6
77.3
41.0
36.3
45.2
34.4
18.6
75.0
39.4
35.6
43.3
37.9
19.4
6.0
4.2
7.5
4.1
8.0
4.0
8.5
4.0
Current
8.00
14Q4
8.00
15Q1
8.00
15Q3
8.50
130.4
130.0
129.4
128.5
General
Industrial production (YoY %)
Unemployment (%)
Financial Markets
Reverse Repo rate
LKR/USD
Kaushik Das, Mumbai, +91 22 7180 4909
Page 81
9 October 2014
Taiwan
Aa3/AA-/A+
Moody’s/S&P/Fitch

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

Main risks: Weaker stock prices pose downside
risks to our relatively positive view on growth.
Sentiment tempered by the market
Rebound in trade activities
%yoy
30
Exports
Imports
20
Steady rates… The Central Bank of China (CBC) left its
policy rate unchanged at its September meeting, as we
expected, noting that the current policy rate is suitable
in fostering growth amid “lingering uncertainties in the
global economy, a negative domestic output gap, and a
mild outlook for inflation.” As the CBC sees the balance
of risks tilted towards growth, we maintain our forecast
of no change in policy rates until mid-2015.
10
0
-10
2011
2012
2013
2014
…as lower stock prices weigh on sentiment… Although
the CBC expects “the moderate expansion of the global
economy…to boost Taiwan's exports,” it noted its
concerns about domestic demand. In particular, it said
that “private investment may increase at a slightly
slower pace,” while private consumption growth may
be dampened as “food safety concerns weigh on
consumer confidence.”
120
…despite stronger exports and overall growth
momentum… Although export growth surprised to the
downside in September, it averaged sharply higher at
6.7% in Q3, vs. 2.9% in Q2, led by stronger electronics
exports. Meanwhile, imports rose even faster at 7.9%
in Q3 vs. 3.7% in Q2. In particular, imports of
machinery/electrical equipment rose 6.4% in Q3, vs.
2.7% in Q2, pointing to stronger investments in Q3,
unless construction disappoints. The latter looks
unlikely as far as construction industry sentiment is
concerned, with the index rising to its highest level
since December 2013.
100
Stronger overall growth momentum
Sentiment weakens, led by stock market concerns
Index
110
Consumer confidence
Mfg and service industry sentiment
CCI on investment prospect of stock market
100
90
80
80
60
70
60
40
2010
2011
2012
2013
2014
%yoy 3mma
60
Coincident composite index
GDP sa (rhs)
6
40
4
20
2
0
0
-20
-2
-40
-4
While consumer sentiment indeed fell sharply in
August and has been moving sideways since then, this
weakness can be attributed largely to a deteriorating
consumer view on stock market investment prospects,
not food safety concerns. Meanwhile, although
consumer sentiment on the economic climate also
worsened sharply, the view on employment
opportunities remained relatively positive, albeit falling
modestly. Payrolls continued to rise at a steady pace of
around 1%, guiding the unemployment rate lower to
3.9% in August, its lowest level since the GFC. Retail
sales growth rose modestly to 3% in July/August from
2.8% in Q2.
Page 82
-60
Mar-04
-6
Mar-07
Mar-10
Mar-13
Driven by stronger exports, the coincident index
continued to point to stronger growth momentum in
August, with 3m/3m saar at 6.4% vs. 4.9% in Q2. On a
yoy basis, the index rose 4.9% in July/August vs. 4.0%
in Q2, suggesting that Taiwan’s GDP growth may again
be stronger than the government’s forecast in Q3. In its
latest MPC statement, the CBC reiterated the
9 October 2014
Directorate-General of Budget, Accounting, and
Statistics (DGBAS)’s forecast of 3.1% for Q4 and 3.4%
for 2014, suggesting lower GDP growth of 3.6% in Q3
vs. 3.7% in Q2, in contrast to our forecast of stronger
GDP growth of around 4%.
Inflations falls as food prices normalize
%yoy 3mma
CPI
8
CPI x food
Food
6
4
2
0
-2
2010
2011
2012
2013
2014
…while inflation falls as food prices normalize... CPI
inflation fell sharply in September, to 0.7%yoy from
2.1% in August, as food price inflation normalized.
Taiwan’s fresh vegetable prices fell sharply in
September, by 20.9%, after several typhoons pushed
up their prices by 11.1% in August. Meanwhile, meat
price inflation eased modestly, to 11.1% in September
from 11.9% in August. The latter have remained high
since the outbreak of porcine epidemic diarrhea virus
(PEDv) early this year. Despite a continued recovery in
growth, we see headline inflation remaining relatively
stable, averaging 1.5% in 2015 vs. 1.4% in 2014, as
food prices continue to normalize and international
commodity prices remain in check. The DGBAS also
expects CPI inflation of 1.5% in 2015, down from 1.6%.
…and asset bubble concerns ease. The Central Bank of
China (CBC) noted that banks' mortgage-related risk
management has improved, while the concentration of
real estate lending in banks' loan portfolios and growth
in loans collateralized against land classified for
industrial use both easing in response to its prudential
measures. Loan growth slowed to 4.4% in July/August
from 4.7% in Q2. Meanwhile, there was a broader
moderation in the increase in housing prices in
July/August, when compared to Q2 levels. The asset
quality of Taiwan’s domestic banks was stable. The
NPL ratio stood at only 0.28% in July/August, down
from 3% in Q2, while the LTD ratio fell to 77.58% from
77.9%.
Taiwan: Deutsche Bank forecasts
2012
2013
2014F
2015F
476.4
23.3
20432
490.8
23.4
20996
504.3
23.4
21510
525.6
23.5
22353
Real GDP (yoy %)
Private consumption
Exports
Imports
1.5
1.6
1.0
-4.0
0.1
-2.2
2.1
2.0
-0.3
4.7
3.8
3.9
3.7
2.6
0.7
3.3
5.5
5.1
3.8
2.9
0.6
3.5
6.7
6.3
CPI (yoy %) eop
CPI (yoy %) annual average
Broad money (M2)
Bank credit1 (yoy %)
1.6
1.9
4.9
3.3
0.3
0.8
4.3
2.7
1.6
1.4
6.0
3.5
1.5
1.5
6.5
4.0
Budget surplus
Government revenue
Primary surplus
-2.5
16.5
19.0
-1.5
-1.4
16.9
18.3
-0.4
-2.0
16.4
18.3
-0.8
-1.8
16.2
17.9
-0.6
External accounts (USDbn)
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX rate (eop) TWD/USD
300.4
268.8
31.6
6.6
50.7
10.6
-9.9
403.2
29.2
304.6
267.6
37.0
7.5
57.4
11.7
-1.0
416.8
29.8
321.9
282.5
39.4
7.8
64.9
12.9
-11.0
430.8
30.0
342.3
301.0
41.3
7.9
62.5
11.9
-14.0
436.4
30.2
Government debt2
Domestic
External
Total external debt
in USDbn
42.9
42.2
0.7
27.6
130.8
89.1
41.3
40.9
0.5
34.6
170.1
91.5
41.7
41.2
0.5
37.6
190.0
94.2
41.8
41.3
0.4
36.2
190.0
92.1
0.0
4.2
0.8
4.2
3.8
4.0
4.0
4.0
Current
1.88
0.83
1.71
30.4
Q4 14
1.88
0.85
1.80
30.0
Q1 15
1.88
0.88
1.95
30.1
Q3 15
2.00
1.00
2.10
30.2
National income
Nominal GDP (USDbn)
Population (m)
General
Unemployment (%)
Financial markets
Discount rate
90-day CP
10-year yield (%)
TWD/USD
Source: CEIC, Deutsche Bank Global Markets Research, National Sources
Note: (1) Credit to private sector. (2) Including guarantees on SOE debt
Page 83
9 October 2014
Thailand
Baa1/BBB+/BBB+
Moody’s/S&P/Fitch

Economic outlook: Growth continues to weaken as
attempts by the military regime to revive
consumption and investment have yet to provide a
discernible boost to the economy, while trade
remains in contractionary territory.
Main risks: Markets remain resilient in expectation
of greater policy efficacy and political stability.
These assumptions could be tested if growth
remains lackluster for a few more quarters and
global market volatility hits Thailand.
the first time since February. We think however
that suppressed inflation and external risks will
keep BoT on the sideline with its rates decision.
Falling inflation has brought real rates in positive
territory
Policy rate
minus inflation
2.00
1.50
1.00
Still in doldrums
Our core view, detailed in last month’s special
publication “Thailand: Is this time different?” remains
unchanged. While the near-term outlook may have
improved somewhat due to the stabilization imposed
by the military regime, the economy remains mired in a
number of structural constraints. As the external
environment becomes more challenging, we worry that
Thailand’s high public and private debt, worsening
demographics, eroding competiveness, and long-term
political uncertainty may weigh in considerably.
Despite the authorities attempts to turn around the
consumption and investment situation, latest data offer
little constructive, putting at risk our 2014 economic
growth forecast. Consider the following:

Domestic demand continues to be weak, with the
private consumption index for August declining by
0.8%yoy as consumer spending on non-durable
goods such as food & beverages softened, on top
of the continued decline in car sales.
0.50
0.00
-0.50
-1.00
-1.50
-2.00
2011
The government’s leading index of business cycle
has remained flat (at around 120) since the
beginning of this year.

The Thai industries sentiment index has stalled
lately after showing some signs of a rebound a few
months ago.
Flattening business sentiments
Business sentiment
Trade continued to disappoint, with exports down
7.4%yoy through August and imports down
14.2%yoy.
60

The indicator of consumer confidence, so far on an
upward trend since the military takeover, declined
in September, stalling at a level well below than
what was seen in early 2013.
Page 84
Business sentiment: next 3 months
130

With price controls firmly in place, inflation has
eased to 1.8%yoy in September (core 1.7%),
pushing up the real interest in positive territory for
2014

120

2013
The private investment index slipped by 5.6%yoy.
Capital spending related to machinery & equipment
underwent further contraction, following sluggish
exports. Related to this, the index of industrial
shipment was down 7.3%yoy through August, and
the index of inventory rose for the second
consecutive month (only 5% below a record
cyclical high).

2012
110
100
90
80
70
2009
2010
2011
2012
2013
2014
These developments clearly put our 2014 GDP growth
forecast of 1.5% is under some risk. Exports would
need to pick up expeditiously for growth to exceed 1%,
but that is still not an unrealistic expectation, in our
view.
9 October 2014
Provided the ongoing economic acceleration in US
demand translates into higher orders and tourism turns
around, the end of the calendar year could well be a
tad better than the poor performance seen so far this
year.
Thailand: Deutsche Bank Forecasts
2012
2013
370.5
64.5
5749
367.8
64.8
5677
384.1
65.1
5900
407.4
65.4
6227
Real GDP (yoy %)
Private consumption
Exports
Imports
6.5
6.7
7.5
13.2
3.1
6.3
2.9
0.3
4.9
-2.0
4.2
2.3
1.5
0.8
2.8
-5.5
0.0
-3.8
5.0
2.5
3.5
7.0
8.8
11.5
CPI (yoy %) eop
CPI (yoy %) ann avg
Core CPI (yoy %) ann avg
Broad money
Bank credit1 (yoy %)
3.6
3.0
2.1
10.4
15.3
1.7
2.2
1.0
7.3
9.4
1.8
2.1
1.5
7.5
8.0
2.7
2.4
1.3
8.0
10.0
Fiscal Accounts2 (% of GDP)
Government revenue
Primary surplus
-2.6
19.5
22.1
-1.3
-2.0
19.0
21.0
-0.7
-2.8
18.5
21.3
-1.5
-2.5
19.0
21.5
-1.2
External Accounts (USDbn)
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (USDbn)
FX rate (eop) THB/USD
225.9
219.9
6.0
1.6
-1.5
-0.4
10.7
181.6
30.7
225.4
218.7
6.7
1.8
-2.5
-0.7
12.8
167.3
32.4
230.0
210.4
19.5
5.1
7.0
1.8
12.0
172.0
33.0
245.0
229.4
15.6
3.8
5.0
1.2
15.0
180.0
34.0
Government debt2,3
Domestic
External
Total external debt
in USDbn
45.4
43.3
2.2
35.3
130.7
44.5
45.3
43.4
1.9
36.7
135.0
45.0
46.6
45.6
1.0
36.4
140.0
45.0
46.7
45.7
1.0
35.6
145.0
45.5
2.5
0.8
2.6
0.8
1.0
0.9
5.0
1.0
Current
2.00
2.18
3.35
32.6
14Q4
2.00
2.20
3.45
33.0
15Q1
2.00
2.25
3.55
33.3
15Q3
2.25
2.50
3.70
34.0
National Income
Nominal GDP (USDbn)
Population (m)
2014F 2015F
Budget blues
The government confirmed that despite a major
shortfall in revenues (amounting to BHT276bn or 2.2%
of GDP), the FY2014 budget managed to incur a deficit
of BHT112bn, lower than projected (BHT250bn). This
was accomplished by holding back spending,
especially capital spending which fell short of the
budgetary target by a third.
It is conceivable to make a bullish case for next year
under the scenario that left-over cash from this year’s
budgetary savings would ease financing pressures and
allow for a front-loaded boost to spending. It will be a
test of the incumbent regime’s administrative efficiency
and sense of urgency for that scenario to pan out, but
for now we will not build expedited spending in our
forecast model.
We are also unimpressed with the much-anticipated
stimulus package announced recently. Most of the
measures contained in the THB365bn (nearly 3% of
GDP) package should be considered as simply
expedited spending of prevailing budgetary items.
Interestingly, the military regime has opted to go along
with a rice subsidy program to support rural income,
much like previous governments have done.
Infrastructure push continues
The authorities continue to try to galvanize investor
sentiment by pushing for investment projects. In its
latest iteration, the transportation ministry has
announced the following:

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

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

The Board of Investment (BoI) approved investment
applications worth BHT90bn recently, with a focus
on supporting the auto industry.
General
Unemployment (%)
Financial Markets
BoT o/n repo rate
3-month Bibor
10-year yield (%)
THB/USD (onshore)
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
Page 85
9 October 2014
Vietnam
B2/BB-/B+
Moody’s/S&P/Fitch

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

Main risks: A sudden surge in credit growth in
September warrants some caution.
Construction-led recovery
Auto purchases surge
%yoy 3mma
Auto imports
80
Machinery imports
60
40
GDP growth accelerates, led by construction… GDP
growth surprised sharply to the upside in Q3,
accelerating to 6.2%, from 5.4% (revised up from 5.3%)
in Q2. This rise was led by construction and mining,
which, together, contributed 0.70ppts more to overall
growth in Q3 than in the previous quarter. Construction
rose 8.8% in Q3, vs. 5.5% in Q2, while mining rose
3.1%, vs. a 2.4% decline in Q2.
20
0
-20
-40
-60
2011
2012
2013
2014
Q3 GDP growth led by stronger growth in construction
% contribution to growth
Other
Service
7
Construction
Mining
6
Mfg
Agri
5
4
3
2
1
0
-1
2010
2011
2012
2013
Mar-14 Jun-14 Sep-14
While manufacturing also saw its growth rise, to 9.8%
in Q3, from 9.1% in Q2, services growth, in contrast,
slowed to 6%, from 6.1%. This deceleration was led by
accommodation and food services, growth of which
fell sharply, to 5.3% in Q3, from 9.3% in Q2, as the
number of Chinese tourists fell 23.6% in Q3, vs. 25.9%
growth in Q2. On a positive note, the latter appeared to
have bottomed in July and is improving, albeit slowly.
…as auto purchases surge... While most services saw
their growth worsen or remain mostly unchanged,
wholesale, retail sales and auto services reported faster
growth, at 6.4% in Q3, vs. 6% in Q2. Given weak retail
sales growth of 10.2%, vs. 12.2% in the same period,
we attribute this strength to auto sales. We note that
auto imports (led by completed autos) have surged this
year, rising 57.1% (143.9%), vs. 42% (76.7%) in Q2.
Page 86
…investments rise… Imports of machinery continued
to strengthen, rising 29% yoy in Q3, up from 22.7% yoy
in Q2. Note that FDI investments (implemented) rose
7.9% in Q3, vs. a 3.3% fall in Q2, suggesting that the
FDI sector led the acceleration in overall investment
growth in Q3, followed by the central government,
investment of which rose 8.3%, up from 6.2% growth
in Q2. In contrast, local government investment growth
slowed to 0.1% in Q3, from 0.4% in Q2, limiting the rise
in overall state investment growth to 1.8%, from 1.7%.
…real estate rebounds, supported by stronger loan
growth, in September… Meanwhile, real estate also
saw a sustained acceleration in growth, to 3.5% in Q3,
from 2.9% in Q2. According to the governor of State
Bank Vietnam (SBV) (quoted by Reuters), loan growth
(ytd) surged to 7% in September, from 4.5% in August
and 3.5% in Q2. This growth was led by loans for the
high-tech and property sectors, at 13% and 12%,
respectively, with the latter pointing to a bottoming of
the housing market and its recovery ahead. Given such
a rapid increase in credit growth in a single month, we
agree with the SBV governor’s assessment that credit
target growth will achieve the government target of 1214% this year.
…while tech exports disappoint, external balance
remains supportive of the dong… Export growth
slowed to 11.2% in Q3, from 16.3% in Q2, as export
growth of the top items, such as phones/parts and
textiles/garments, weakened, to 0.7% and 17.4% in Q3,
respectively, from 13.7% and 20% in Q2. On a positive
note, despite higher import growth of 12.9% in Q3, vs.
10.7% in Q2, Vietnam enjoyed a larger trade surplus of
USD425m in Q3, vs. USD390m in Q2, supporting the
dong’s stability. While the dong’s weakness of late
may be attributed largely to the general strengthening
9 October 2014
of the US dollar, it remains a source of concern, due to
the rapid increase in foreign currency loans so far this
year, of more than 20%yoy ytd (about 5 times faster
than local currency loan growth).
Tech weakness weighs on overall exports
%yoy contribution
70
%yoy
80
Phones & Spare Parts
Computer & Electronic Components
50
Exports (rhs)
60
40
30
20
10
0
-10
-20
2013
2014
Vietnam: Deutsche Bank forecasts
2012
2013
2014F
2015F
155.8
88.8
1744
171.3
89.7
1905
185.6
90.7
2047
201.4
91.6
2199
Real GDP (yoy %)
Private consumption
Exports
Imports
5.2
4.9
7.2
1.9
11.0
3.2
5.4
5.2
7.3
5.3
11.5
10.5
5.8
5.3
7.3
6.7
12.0
12.0
6.2
5.6
7.3
7.5
15.0
16.0
CPI (yoy %) eop
CPI (yoy %) ann avg
Broad money (yoy %)
Bank credit (yoy %)
6.8
9.3
18.5
8.7
6.0
6.6
16.0
12.4
4.5
4.5
16.5
12.5
5.0
6.4
18.0
16.0
Fiscal accounts1 (% of GDP)
Federal government surplus
Government revenue
Primary fed. govt. surplus
-4.8
22.9
27.7
-3.3
-4.0
22.2
26.2
-2.7
-4.5
22.5
27.0
-3.0
-4.4
22.8
27.2
-2.6
External accounts (USD bn)
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX rate (eop) VND/USD
114.5
110.0
4.5
2.9
7.5
4.8
10.5
25.4
20900
132.0
131.0
1.0
0.6
6.0
3.5
11.5
38.7
21200
153.0
151.0
2.0
1.1
7.0
3.8
12.0
50.0
21600
185.0
189.0
-4.0
-2.0
1.0
0.5
12.0
60.0
22200
51.7
22.7
29.0
39.2
61.0
16.4
51.5
22.5
29.0
39.1
67.0
17.9
53.5
24.0
29.5
36.7
68.0
19.1
54.0
24.5
29.5
36.4
73.0
19.2
3.6
3.2
7.9
3.2
8.2
3.2
8.9
3.2
Current
6.50
21285
Q4 14
6.00
21600
Q1 15
6.00
22000
Q3 15
6.00
22200
National income
Population (m)
…and while inflation falls further. While low
commodity prices have limited Vietnam’s export
growth thus far, they have also eased inflationary
pressure. CPI inflation continued to surprise to the
downside in September, falling further to 3.6%yoy from
4.3% in August, led by falling health and transportation
price inflation. Although lower inflation has guided real
rates higher, the SBV’s governor supported steady
policy rates, noting that they help to boost market
sentiment and support its stability. While the SBV may
opt to keep its policy rates steady, in contrast to our
expectation of one more 50bps rate cut, we see it
guiding banks’ lending rates at least lower ahead.
Lower inflation, led by health and transportation
CPI
Transportation
Health (rhs)
%yoy 3mma
25
70
60
20
50
15
40
10
30
20
5
10
0
0
2010
2011
2012
2013
2014
Government debt
Domestic
External
Total external debt
in USD bn
General
Unemployment (%)
Financial markets
Refinancing rate
VND/USD
Note: (1) Fiscal balance includes off-budget expenditure, while revenue and expenditure include
only budget items.
.
Page 87
9 October 2014
Egypt
Caa1(negative)/B-(stable)/B-(stable)
Moody’s/S&P/Fitch

Economic outlook: Real GDP growth is set to
strengthen in FY 2014/15 on the back of firm
domestic demand and a rise in investment. Lower
official transfers will lead to a widening of the
current account deficit, but higher capital inflows
should prevent a renewed deterioration of the BoP.
The energy subsidy reform implemented in July will
help to reduce the fiscal deficit towards 10% of
GDP but has pushed inflation up to double digits.

Main risks: Slow improvements in living standards
and rising inflation might lead to a renewed
escalation of social and political tensions which
would stall any recovery in tourism and capital
inflows and result in renewed FX reserve losses
and pressure on the EGP. Still elevated fiscal
deficits keep the public debt level at close to 100%
of GDP.
Signs of recovery
Tentative growth return
Following a difficult last year Egypt’s economic
recovery is slowly gaining traction. Real GDP increased
by 3.5% YoY (5.3% QoQ) in Q4 FY 2013/14 (Q2 2014)
compared to only 1.3% YoY in the same period last
year. The growth rebound towards the end of FY
2013/14 keeps the total fiscal year growth rate
unchanged at 2.1% despite the sharp slowdown in
economic activity in the first half of the fiscal year due
to the security problems and turbulent domestic
politics following the ousting of Mohamed Morsi.
Growth is picking up from low levels
Real GDP, % YoY
"2nd Revolution"
"Arab Spring"
6%
4%
2%
0%
-2%
-4%
Q1
2009
Q4
2009
Q3
2010
Q2
2011
Q1
2012
Q4
2012
Pre-crisis average
Sources: Ministry of Planning, Deutsche Bank
Page 88
Q3
2013
Q2
2014
Key sectors driving the increase in economic activity
have been manufacturing and construction. Growth in
the manufacturing sector accelerated sharply in Q4
bringing its total FY 2013/14 growth rate to 8.3% YoY.
The manufacturing sector last grew by over 8% back in
2008 while growth averaged only around 2.2% YoY
over the past 5 years. On the other side the mining
sector as well as restaurant and hotel services
continued their contraction in FY 2013/14.
Forward-looking indicators suggest that growth will
continue to strengthen in H1 FY 2014/15. In September
the PMI moved further into expansionary territory and
reached at 52.4 a ten-month high and its second
highest level since 2011. The September PMI reading
indicates that especially growth in the manufacturing
sector is set to strengthen further underlined by a solid
increase in output and a sharp rise in new orders. A
similar conclusion can be drawn from the industrial
production index, which increased by 25% YoY in July.
Over the next quarters, growth will also benefit from
public mega projects, most prominently the expansion
of the Suez Channel, as well as a recovery in tourism.
Tourism was heavily affected by the deteriorating
security situation, but recently the number of tourist
arrivals has started to rise again and reached a threeyear high in August. An important factor in this regard
is that Germany and many other European countries
lifted their travel bans for South Sinai, including Sharm
el-Sheikh, in July.
Nevertheless, plenty of obstacles to growth exist.
Among the most pressing issues are energy supply
bottlenecks. In early September, for example, a largescale blackout left half of Egypt without power for
hours, halting factories and shutting parts of the Cairo
metro system. Upgrading the decrepit power grid will
be difficult given the government’s lacking fiscal space
and take years. An important question is also whether
the domestic banking sector will be able to support the
economic recovery. Although credit growth to the
private sector increased throughout the year, reaching
a growth rate of 7.4% YoY in July, it is still subdued
given the high inflationary environment. The private
sector credit impulse remained in negative territory for
the third quarter in a row in Q4 FY 2013/14.
Continuously high borrowing needs of the government
will most likely continue to absorb domestic credit in
FY 2014/15 and partly crowd out credit to the private
sector. Thus, we expect private sector credit growth to
remain subdued.
9 October 2014
portfolio inflows would result in a changing
composition of the balance of payments. Whereas the
financial account should improve, the current account
is likely to deteriorate in FY 2014/15. We think that an
increase in the service balance, due to a tentative
recovery in tourism and higher Suez Channel revenues,
will not be sufficient to offset the expected drop in
official transfers. Overall, we expect the balance of
payments to remain in small surplus, and thus FX
reserves to continue their modest upward trend.
Private sector credit impulse still negative
YoY change, % of GDP
4
3
2
1
0
-1
-2
-3
Official transfers drive narrowing of current account
deficit
-4
10
11
12
13
14
% of GDP
15%
Given those factors we maintain our real GDP growth
forecast for FY 2014/15 at 3.7%. However, even if this
relatively optimistic forecast materialized, growth
would still be significantly lower than the 4.95% YoY
average experienced in the decade preceding the
outbreak of the “Arab Spring”. It would also be
insufficient to put a dent in unemployment and to yield
a significant reduction of poverty and broad basedimprovement in living standards for Egypt’s fast
growing population.
10%
5%
0%
-5%
-10%
-15%
FY
2009/10
FY
2010/11
FY
2011/12
FY
2012/13
FY
2013/14
Trade (net)
Services (net)
BoP improved, but foreign investment needed to
sustain this trend.
Egypt’s balance of payments improved significantly in
FY 2013/14, recording a surplus of USD 1.5 bn
compared to USD 237 m in the previous fiscal year.
The improvement was driven by a reduction of the
current account deficit, which fell from 2.3% of GDP in
FY 2012/13 to 0.8% of GDP in FY 2013/14. The decline
in the current account deficit was almost entirely driven
by higher official transfers (mainly grants from GCC
governments), which jumped from USD 836 m to USD
11.9 bn. Abstracting from official flows, however, the
underlying balance of payments dynamics remained
weak. The trade deficit widened as solid import growth
outpaced stagnating exports, and the surplus of the
service balance plunged by 80% mainly reflecting the
drop in tourism. The surplus of the financial account
fell as a small increase in FDI could not offset a decline
in cross-border bank lending.
To prevent a renewed deterioration of the balance of
payments in FY 2014/15, when official transfers are
unlikely to match last year’s record levels, the
government is trying to promote private investment
inflows. A large international investor conference is
scheduled for February. In order to increase
transparency for potential investments, the government
reportedly asked the IMF for a new Article IV
consultation to be carried out prior to the conference. It
would be the first IMF assessment on Egypt since 2010.
The shift from official grants to private FDI and
Transfers (private)
Transfers (official)
Sources: Central Bank of Egypt, Deutsche Bank
Subsidy reform pushes up inflation, CB hiked
preemptively.
As expected, inflation increased sharply following the
comprehensive energy subsidy reform and the rise in
consumption taxes implemented in early July. Monthon-month inflation jumped to 3.5% in July (the highest
monthly increase since February 2008), but
subsequently slowed down to 1.1% in August. Year-onYear CPI inflation increased to 11.5% in August
compared to 8.2% in June. The increase in inflation
was largely driven by higher prices for regulated goods,
mainly fuel and electricity as well as increasing prices
for food due to the high content of energy needed in
production and transport of food products.
An even higher increase in the headline inflation was
mitigated by a pre-emptive 100 bps rate hike by the
Central Bank of Egypt in July. The move was surprising,
but concerns over inflation pressure from the subsidy
reform seem to have overridden concerns about the
still fragile growth. We do not expect a further
tightening at this stage as the growth outlook remains
subdued and the overnight deposit and lending rates
Page 89
9 October 2014
are already high at 9.25% and 10.25%, respectively.
We expect the Central Bank to remain in wait-and-see
position and to assess the second-round effects of the
higher energy prices on wages and production costs as
well as the development in long-run inflation
expectations.
Inflation jumps to double digits
4%
14%
3%
12%
10%
2%
8%
1%
Egypt: Deutsche Bank Forecasts
2011/12
National Income
Population (mn)
2012/13 2013/14E 2014/15F
262.8
82.4
3,229
271.9
84.7
3,250
284.0
85.8
3,330
320.0
87.5
3,660
2.2
6.5
3.1
5.8
-2.3
9.7
2.1
2.8
3.5
-9.6
2.1
-1.1
2.1
3.0
4.5
1.0
-2.0
2.0
3.7
3.9
3.5
4.3
4.0
5.0
CPI (YoY%, eop)
CPI (YoY%, pavg)
Broad money supply (M2)
7.3
8.7
7.8
9.8
6.9
18.4
8.2
10.1
17.8
11.0
12.0
15.0
Overall balance
Revenue
Expenditure
Primary balance
-10.6
19.3
29.9
-4.0
-13.7
20.0
33.5
-5.3
-12.0
22.7
34.7
-3.9
-10.5
23.2
33.7
-2.8
Exports
Imports
Trade balance
% of GDP
% of GDP
FDI (net)
EGP/USD (eop)
25.1
59.2
-34.1
-13.0
-10.1
-3.9
3.7
15.5
6.1
26.9
57.5
-30.6
-11.3
-6.3
-2.3
2.8
14.9
7.0
26.1
59.8
-33.7
-11.9
-2.3
-0.8
3.4
16.7
7.15
29.0
62.0
-33.0
-10.3
-5.5
-1.7
5.6
18.0
7.3
Government debt
Domestic
External
Total external debt
in USD bn
83.1
73.3
9.8
13.2
34.4
8.5
93.8
82.4
11.4
17.3
43.2
16.3
96.4
85.4
11.0
16.2
46.1
20.0
96.0
84.5
11.5
16.6
53.0
18.5
General (%)
Industrial production (YoY %)
Unemployment
-4.8
12.6
-8.1
13.0
15.0
13.5
6.0
13.7
Current 14Q4
9.25
9.25
9.75
9.75
10.25 10.25
7.15
7.3
15Q1
9.25
9.75
10.25
7.3
15Q3
9.25
9.75
10.25
7.3
Real GDP (YoY %)
Priv. consumption
Govt consumption
Investment
Exports
Imports
6%
0%
4%
-1%
2%
-2%
0%
Jan, Jul, Jan, Jul, Jan, Jul, Jan, Jul,
2011 2011 2012 2012 2013 2013 2014 2014
MoM (lhs)
YoY (rhs)
Sources: Central Bank of Egypt, Deutsche Bank
Oliver Masetti, Frankfurt, +49 69 910 41643
Financial Markets (eop)
CBE deposit rate
CBE discount rate
CBE lending rate
EGP/USD
Sources: IMF, Central Bank of Egypt, Ministry of Finance, Deutsche Bank
Page 90
9 October 2014
Hungary
Ba1(neg)/BB(stable)/BB+(stable)
Moody’s/S&P/Fitch

Economic outlook: Q2 GDP growth was relatively
strong, with the details also encouraging, showing
domestic demand as the main driver of growth.
High frequency data in recent months have been
positive as well, indicating that the growth
momentum likely carried into Q3. Inflation is
beginning to show signs of picking up.
Main risks: The main downside risks come from
the prolonged weakness in euro area activity.
Further downside risk comes from the possible
deterioration in the investment climate from the
government’s interventionist policies, particularly in
the banking and utility sectors. On the other hand,
growth could surprise to the upside if the
government is able to successfully increase the
absorption of EU funds.
In addition, the soft data have also been positive –
manufacturing PMI has been in expansionary territory
for over a year, while economic sentiment is also
relatively high.
PMI remains in expansionary territory, in part due to a
robust forward-looking new orders component
65
Expansion
60
55
50
45
40
Contraction
35
Activity data remains encouraging; no
changes to monetary policy expected
30
2008 - Sep
2010 - Sep
Manufacturing PMI
High frequency data indicate relatively robust growth in
Q3. After the strong growth reading in Q2 (3.9% YoY,
0.8% QoQ), the activity and survey data in recent
months have also been encouraging (despite the
activity slowdown in the euro area), indicating that the
growth momentum has carried into Q3 as well.
Industrial production (in seasonally and working day
adjusted terms) grew by 12.1% YoY in July; however, it
(likely temporarily) dipped to 5.1% in August as a major
car manufacturer temporarily halted production in
August after producing too many vehicles in the earlier
period (production is scheduled to restart in
September). Construction growth has also been strong,
printing at 17.2% YoY in July. Retail sales continues to
grow, albeit at a slower rate than seen earlier in the
year.
IP and construction growth have both been strong in
recent months
30
20
20
10
10
0
0
-10
-10
-20
-20
2008 - Aug
2010 - Aug
2012 - Aug
Construction (SWDA, YoY, %)
IP (SWDA, YoY, %, rhs)
-30
2014 - Aug
2012 - Sep
2014 - Sep
New orders
We expect activity and survey data to remain relatively
strong in the coming months and the robust growth
momentum should carry forward to the coming
quarters; we forecast real GDP to grow by 3.4% in
2014 (with domestic demand, and particularly
investment, remaining the main driver of growth),
before slowing to 2.7% next year.
The main downside risks to growth come from external
factors, most importantly prolonged weakness in euro
area activity. Further downside risk comes from the
possible deterioration in the investment climate from
the government’s interventionist policies, particularly in
the banking and utility sectors. On the other hand,
growth could surprise to the upside if the government
is able to successfully increase the absorption of EU
funds, or if consumption growth picks up pace on the
back of rising real income (in the low inflation
environment).
Inflation continues to pick up gradually. In August,
headline inflation ticked up to 0.2% YoY from 0.1% in
July. These positive prints came after three months of
deflation. The recent pickup in inflation was driven by
better-than-expected food price developments. While
food prices continue to decline and food price deflation
continues to weigh on the headline rate, it is showing
signs of a turnaround (rising from -1.3% YoY in June to
-0.2% in August). Weakness in commodity price
growth and administered utility price cuts have also
Page 91
9 October 2014
added downward pressure to headline inflation. As a
result, core inflation – which excludes unprocessed
food items, electricity/gas and motor fuels – has
remained relatively stable in recent months, at a level
well above the headline rate (around 2.5%).
No changes expected in monetary policy. As was the
case in August, the NBH kept rates on hold (at the
record low 2.10%) in September. The NBH had
signaled the end of the two year long easing cycle in
July.
Core CPI remains well above the headline rate
In its September statement, the NBH remained
relatively optimistic on the growth outlook following
the strong GDP readings in the first half of the year.
Despite weaker external demand (on the back of
weakness in euro area activity and the Russia-Ukraine
crisis), economic growth is expected to continue,
driven by domestic demand. While investment should
continue to be boosted by easing credit constraints and
the NBH’s Funding for Growth scheme (which provides
loans to SMEs at capped interest rates), private
consumption is also likely to expand gradually on the
back of improving employment and real income (in the
low inflation environment). As a result, the NBH raised
its GDP growth forecast for 2014 to 3.3% (from 2.9%
previously), while the forecast for 2015 was largely
unchanged.
We expect headline inflation to continue rising
gradually in the coming months (mainly on the back of
food inflation picking up), before a relatively sharp
increase at the end of the year (due to base effects as
the administered utility price cuts drop out of the base).
Continued domestic demand expansion, tightening
labour market conditions and a narrowing output gap
should also add upward impetus to inflation towards
the end of 2014 and through 2015. As a result, while
average inflation is expected to be a subdued 0.2% in
2014, it is expected to rise to 2.6% next year. Our
forecasted inflation profile suggests that inflation will
near the 3% target in mid-2015, which is broadly in line
with the National Bank of Hungary’s (NBH) forecast.
NBH inflation projection fan chart
As it did in the previous month, the NBH stated that the
easing cycle is finished and reiterated that “maintaining
the current low level of interest rates for an extended
period ensures the achievement of the Bank’s mediumterm inflation target and a corresponding degree of
support to the real economy”. This, combined with
inflation showing signs of a gradual pick up and the
relatively strong activity data, leads us to believe that
rates will remain on hold through 2014.
We expect that the first rate hikes will likely be
delivered in mid-2015, as inflation approaches the
target. There are risks to this view on either side. If
rates in the US stay lower for longer, this could lead to
a further delay in the hiking cycle; the NBH would
prefer to keep rates low for as long as external
conditions permit it. However, sustained pressure on
the forint could prompt the NBH to hike even earlier
and more aggressively than expected.
FX loans issue at the forefront. The NBH announced in
late September that it would be willing to provide all of
the fx (via its reserves) that banks would require for (1)
refunds associated with the use of fx margins and
unilateral contract changes, and (2) conversion of the fx
loan stock to forint. The main aim of this is to ensure
that the phasing out of fx loans is carried out in a
“rapid and well-organized manner”, while limiting the
impact on the exchange rate and on financial system
stability.
Source: NBH
Page 92
On (1): The latest bill on fx loans (which was passed
earlier in September) covers how and when borrowers
need to be refunded by banks for the use of fx margins
and unilateral contract changes (mostly interest rate
hikes). This legislation specifies that for loans that are
9 October 2014
currently open, the refunds should be in the form of a
reduction in the outstanding principal amount. As a
result, there will be a balance sheet mismatch for
banks and as such they will have to repay some of their
fx funding (to reduce fx liabilities to match the
reduction in fx assets/loans). Therefore, as part of this
refund process, banks will need to access fx – the NBH
has stated that it will make available EUR 3bn (the
entire estimated refund amount) in fx for this purpose.
On (2): Further, the NBH is willing to provide the entire
amount of fx required for the conversion of the fx loan
stock to forint. While the details of how this conversion
will take place have not been provided by the
government, it remains a high priority on the
government’s agenda and indications are that it will
take place around mid-2015. The NBH estimates that
as part of this conversion process banks would require
fx of around EUR 9-11bn, though the exact amount
would depend on the details of the conversion. This
estimated amount is likely to comfortably cover the
outstanding fx loan stock (which currently stands at
EUR 11.6bn but will be reduced through the refund
process), and therefore cover the entire amount
demanded by banks during the conversion process.
However, the NBH is willing to provide banks with as
much fx as they require for the refund and conversion
process, even if it is larger than this initial estimate.
This is in contrast to earlier comments from NBH
officials which indicated that it would provide some,
but not all, of the required fx amount.
The NBH’s statement also reiterates that this program
will not jeopardize the adequacy of fx reserves, the
stock of which will “remain above the level expected
by international financial institutions and investors”.
The stock of fx reserves currently stands at a
comfortable EUR 34bn, sufficient to cover nearly 6
months of imports. Therefore, even a EUR 11-12bn
reduction in fx reserves will not lead to a position of
vulnerability, especially given that external debt (and so
the NBH’s need for fx reserves) will also reduce during
this process.
NBH fx reserves are at a relatively comfortable level
40
35
30
25
20
15
10
2008 - Sep
2010 - Sep
2012 - Sep
FX reserves (EUR bn)
2014 - Sep
The fx will be provided (at close to market rates) by the
NBH through two facilities:
a) A spot euro sale which is conditional on banks
reducing their short-term external debt by 50% of the
fx received. This will cause a reduction in fx reserves in
the short term.
b) An unconditional instrument, which is a combination
of a spot euro sale and a long fx swap. This is targeted
at those banks whose financing structure relies on
long-term swaps and long-term liabilities. While this
instrument enables banks to manage exchange rate
risks, effectively the fx can only be accessed by banks
as and when their liabilities mature (maturities must be
longer than one year). As a result, this instrument will
not cause the NBH’s fx reserves to drop in the short
term, but rather gradually over time, matching the
reduction in banks’ long-term liabilities.
What are the implications for HUF?
While the NBH is willing to provide banks with the
entire fx required for the refund and conversion process,
this does not necessarily mean that banks will obtain
the entire required amount from the NBH. Using the
early repayment scheme in 2011 as a guide, the NBH
was then willing to provide as much fx liquidity as
banks required, to cover loans repaid early (using an
exchange rate that was at a discount of 20% to the
spot rate) through the scheme. In total, EUR 4.4bn was
repaid by borrowers, but the total amount of fx that
banks purchased from the NBH amounted to only
around EUR 2.6bn. The remainder (EUR 1.8bn) banks
purchased from their parent banks or on the market.
Back in September 2011 (announcement), this
contributed to 6-7% depreciation in the HUF vs. peer
currencies over the following months.
It is likely that banks did not purchase the entire fx
amount from the NBH because of: some pre-hedging
(possibly due to uncertainty regarding the NBH’s
instrument for providing fx, and its price); the NBH’s
instrument, which at that time was also a spot euro
sale combined with a long fx swap (similar to the
current proposed instrument), was designed in a way
that made it costly for banks to over-hedge fx risk
using the instrument, and so banks were likely to have
purchased less than the required fx amount from the
NBH; the fx was never offered by the NBH at a rate
preferable to the market rate, and therefore it is likely
that, particularly in the case of repaying short-term
liabilities, banks purchased some fx from the market.
Given that the size of the current proposed loans
conversion is much larger than the conversion involved
in the early repayment scheme in 2011, HUF
underperformance seems at least equally likely this
time around. There could also be an indirect negative
Page 93
9 October 2014
impact on the forint through affecting investor
confidence (particularly if the conversion is done at
below market exchange rates with limited cost-sharing
by the government).
Therefore, while the provision of the entire fx amount
by the NBH possibly reduces the downside risk to HUF
at the margin, we believe that banks will still buy fx on
the market (particularly to repay short-term fx liabilities,
for which there is no foreseeable upside to purchasing
fx from the NBH). As a result, we believe the
conversion process will be HUF negative.
Hungary: Deutsche Bank Forecasts
2012
2013 2014F
2015F
National Income
Population (mn)
GDP per capita (USD thousands)
125
10.0
12.6
130
9.9
13.0
130
9.9
13.2
120
9.9
12.2
Real GDP (YoY%)
Private Consumption
Gross Fixed Investment
Exports
Imports
- 1.7
- 1.7
0.1
- 3.7
1.7
- 0.1
1.1
- 0.1
4.0
5.8
5.3
5.3
3.4
2.1
1.0
6.3
6.3
7.6
2.7
2.3
1.2
4.6
5.2
5.5
CPI (eop)
CPI (period avg)
Broad money (eop)
5.0
5.7
- 3.3
0.4
1.7
2.0
1.3
0.2
5.2
2.8
2.6
6.0
Overall balance
Revenue
Expenditure
Primary Balance
- 2.1
46.2
48.3
2.2
- 2.4
48.0
50.4
2.1
- 2.9
46.2
49.1
0.9
- 2.7
44.8
47.5
1.1
Goods Exports
Goods Imports
Trade Balance
% of GDP
Current Account Balance
% of GDP
FDI (net)
FX Reserves (eop)
USD/FX (eop)
EUR/FX (eop)
90.4
86.5
3.9
3.1
- 2.5
- 2.0
35.5
41.9
221
292
95.8 106.5
91.1 100.6
4.7
5.9
3.7
4.5
0.3
2.3
0.3
1.6
3.7
13.8
43.3
43.0
216
242
297
315
102.1
96.6
5.5
4.6
2.1
1.5
17.6
42.6
283
325
79.8
45.1
34.7
75.9
76.2
39.5
38.7
36.4
33.3
127.9 120.0
166
157
16.7
16.3
78.1
46.3
31.7
118.0
142
15.6
Government Debt
Domestic
External
External debt
in USD bn
General (ann. avg)
Industrial Production (YoY%)
Unemployment (%)
Financial Markets
Key official interest rate (eop)
USD/HUF (eop)
EUR/HUF (eop)
165
13.8
- 0.8
10.9
1.4
10.3
8.5
8.1
6.5
7.8
Spot 14Q4F
15Q1
15Q3F
2.10
255
319
2.60
273
324
2.10
243
308
2.10
242
315
Source: NBH, DB Global Markets Research, Haver Analytics
Page 94
9 October 2014
Poland
A2(stable)/A-(stable)/A-(stable)
Moodys/S&P/Fitch

Economic outlook: Recent activity and survey data
have been weak, indicating a further slowdown in
growth in Q3. We expect the activity and inflation
data to pick up gradually only in Q4.

Main risks: The risks to growth are skewed to the
downside, mainly due to the potential for a
prolonged slowdown in the euro area (Poland’s
main export partner) and/or an escalation in the
Russia-Ukraine crisis.
Weakness in activity data and
inflation prompt a 50bps rate cut
low
Survey and activity data disappoint. The high frequency
data indicate that the slowdown in growth observed in
Q2 (to 0.6% QoQ from 1.1% in Q1) has continued in Q3
as well. PMI has been in contractionary territory for the
past three months, driven in part by weakness in the
forward-looking new orders component. Industrial
production performance has been particularly weak,
providing the first negative YoY print in 15 months in
August (-1.9%) on the back of a decline in car
production. Additionally, construction growth – another
indicator that the NBP believes provides important
information on the state of the economy – has been
negative for the past four months. Retail sales,
however, has continued to grow, albeit at a moderate
pace (and lower than that seen in the first half of the
year).
Polish PMI has dipped into contractionary territory
PMI
65
Euro area
60
Poland
Expansion
55
50
45
40
Contraction
35
30
Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14
The slowdown in Polish activity is occurring in an
environment of, and is partly driven by, weakness in
the euro area (which is Poland’s main trading partner,
accounting for over 50% of Polish exports). The
September PMI figures for the euro area confirm the
prolonged weakness in activity, with Germany in
particular disappointing with a print of 49.9 (the first
reading in contractionary territory in over a year). The
grind lower in inflation also highlights the lack of
demand pressures in the euro area. As a result, our
euro area economists have lowered their growth
forecast for the coming quarters, and are also
expecting public QE to be announced by the ECB in the
next six months.
The slowdown in IP growth has come in tandem with a
decline in export orders growth
15
60
10
55
5
0
50
-5
45
-10
-15
2008 - Sep
2010 - Sep
IP (YoY %, lhs)
2012 - Sep
40
2014 - Sep
PMI New export orders
While a potential prolonged period of weakness in the
euro area adds downside risk to the growth prospects
for Poland, we continue to believe that the Polish
recovery remains broadly on track. The upcoming
activity and survey data (for example, PMIs) could
decline in the short term, but we expect these to
bounce back in Q4, and the economy is expected to
continue growing on the back of improving domestic
demand; significant EU funds inflows should also add
some upward impetus to growth.18 While we are likely
to see a further modest slowdown in growth in Q3, our
forecast for real GDP growth in 2014 is a relatively
healthy 3.1% (NBP forecast is 3.6%, though this is
likely to be revised down in the November Inflation
Report), and in 2015 is 3.5%.
However, we view the risks to our growth forecast as
skewed to the downside due to the possibility of a
protracted slowdown in euro area growth and/or an
escalation in the Russia-Ukraine crisis (which could
also impact Poland through its adverse effect on euro
area growth prospects).
18
For a detailed analysis of EU structural funds allocations, absorptions
and impact, see the Special Report “EU Structural Funds and Their Impact:
10 Questions Answered”.
Page 95
9 October 2014
Food prices continue to decline. Headline inflation sank
further into negative territory in August, printing at a
record low -0.3% YoY (well below the National Bank of
Poland’s 1pp tolerance band around its 2.5% target).
While low imported inflation from the euro area
continues to add downward pressure on headline
inflation, food price deflation remains the main drag on
the headline rate. Food price growth contributed, on
average, nearly +1pp to YoY headline CPI over the five
years between 2009 and 2013; in contrast, its
contribution has been negative in the past four months.
While food prices in the rest of the Central European
region are showing signs of gradually turning around,
Polish food price inflation declined further in August to 2.3% YoY because the harvest of most crops this year
has been stronger than that of last year. Additionally,
the contributions of the rent and energy component
and the transport component have been markedly
below their long term averages in the past 3-4 months,
primarily on the back of falling energy prices.
Food and energy components are keeping headline
inflation low
6.0
5.0
pps contribution to %YoY CPI
4.0
2.0
1.0
0.0
-1.0
-2.0
Transport
Rent & Energy
-3.0
Food
Headline CPI (%YoY)
Aug-10
Aug-11
Aug-12
Aug-13
Aug-14
Though headline inflation is expected to remain
subdued (and likely negative) for the coming few
months, we expect it to begin picking up at year-end
(and continue rising gradually next year) on the back of
improving domestic demand, a narrowing output gap
and tightening labour market conditions. We expect
average YoY CPI to be only 0.2% in 2014 but rise to
1.1% in 2015.
Base rate cut by 50bps. The NBP this week cut the
base rate by 50bps, bringing it to a record low 2%. The
main reasons for the cut were the weakness in recent
activity data (which pointed to a further deceleration in
growth in Q3), persistent low inflation with “an
increased risk of inflation running below target in the
medium term” and the euro area slowdown. Poland’s
high real rates (one of the highest within EM) and the
rate cut by the ECB last month also provided room for
rate cuts. As a result of these factors, while the
Page 96
In addition to the cut in the base rate, the lombard rate
(the upper bound of the interest rate corridor) was
lowered by 100bps to 3%. The lombard rate is the
interest rate at which banks can obtain credit (against
collateral) from the NBP on an overnight basis
(marginal lending facility). This short-term emergency
liquidity facility is not extensively used – in 2013,
approximately EUR 40mn was borrowed by banks
under this facility, while in 2012 this figure was only
EUR 5mn. However, this relatively large cut in the
lombard rate could have implications for the real
economy. Consumer lending rates in Poland are
capped, by legislation, at 4 times the lombard rate.
Therefore, today’s cut reduces the upper limit of the
interest rate on consumer loans from 16% to 12%.
With the average rate on consumer loans (including
credit card loans) currently at 12.5% – above the new
upper bound – this cut in the lombard rate is significant
and could boost consumer spending. On the other
hand, it could also lead to a reduction in new lending to
riskier borrowers.
The interest rate corridor was narrowed as the lower
bound, the deposit rate, was unchanged at 1%. Belka
noted that the reason for narrowing the corridor was to
bring all three policy rates in the same “domain” given
the new lower level of the base rate.
3.0
-4.0
Aug-09
magnitude of the rate cut was larger than our own and
consensus expectations (for a 25bps cut), it does not
come as a major surprise. Further, in the post-meeting
press conference, Governor Belka stated that this
decision was not a unanimous one.
NBP leaves the door open for further cuts
In its statement, the NBP noted that it “does not rule
out further adjustment of monetary policy”; the
possibility of further cuts depends on incoming data,
including the projections in the November Inflation
Report, and whether these confirm that inflation will
remain below target in the medium term. However,
Belka also added that the council preferred an
adjustment of rates that was “concentrated” in time
rather than drawn out (which is reflected in the
decision for a larger 50bps cut today).
In the coming few months, we expect inflation to
remain subdued (and likely negative), while the activity
data is also expected to remain weak on the back of
the euro area slowdown and adverse confidence
effects of the Russia-Ukraine crisis (we see the activity
data picking up only around year end). Further, the
NBP’s inflation and growth projections are likely to be
revised down significantly in the November Inflation
Report. As a result, we expect another rate cut in
November, albeit a smaller 25bps one, after which we
expect rates to be on hold.
9 October 2014
Politics: Civic Platform makes a comeback in opinion
polls. The appointment (on 30th August) of Polish PM
Tusk as the next president of the EU Council has
significantly boosted the popularity of the ruling Civic
Platform (after it suffered due to the leaked tapes
controversy), as it signals Poland's rising importance in
the EU and also ties in well with its increased allocation
of EU funds. These are important issues for Poland,
and the Civic Platform (PO) could use this – i.e. its
success in increasing Poland's importance within the
EU – as a major campaign platform for upcoming
elections. There are three important elections coming
up: local elections in November 2014, presidential
elections in May 2015 and general/parliamentary
elections around October 2015.
The latest opinion polls show that PO and the main
opposition Law and Justice Party (PiS) currently have
approximately equal support. As a result, the local
elections in November are likely to be a close race
between these two parties; these elections will provide
important insights into the support for each party and
thus into the likelihood of victory in the 2015 general
elections.
Civic Platform (PO) and main opposition Law and
Justice (PiS) are now neck-and-neck in opinion polls
50%
PO
PiS
SLD
40%
PSL
Nowa Prawica (KNP)
Tape scandal aftermath
30%
20%
Tusk chosen as EU Council president
10%
0%
Sep-10
Sep-11
Sep-12
Sep-13
Sep-14
Source: Deutsche Bank, Homo Homini
Poland: Deutsche Bank Forecasts
2012
2013 2014F 2015
National Income
Nominal GDP (USDbn)
Population (mn)
GDP per capita (USD thousands)
490
37.6
13.0
503
38.6
13.0
543
37.5
14.5
538
37.4
14.4
Real GDP (YoY%)
Private Consumption
Exports
Imports
1.9
1.3
0.2
- 0.3
3.9
- 0.6
1.6
0.8
2.8
- 0.8
4.5
1.3
3.1
3.0
1.4
5.0
7.7
7.1
3.5
3.2
1.4
5.4
8.3
8.0
CPI (eop)
CPI (period avg)
Broad money (eop)
2.4
3.7
10.0
0.7
0.9
11.0
0.5
0.2
5.0
1.1
1.1
8.7
Overall balance
Revenue
Expenditure
Primary Balance
- 3.9
38.3
42.2
- 1.1
- 4.4
37.5
41.9
- 1.8
4.3
45.5
41.2
6.5
- 2.9
38.0
40.9
- 0.7
Goods Exports
Goods Imports
Trade Balance
% of GDP
% of GDP
FDI (net)
FX Reserves (eop)
USD/FX (eop)
EUR/FX (eop)
190.8
197.5
- 6.7
- 1.4
- 18.3
- 3.7
5.3
96.1
3.09
4.07
207.2
204.2
3.0
0.6
- 6.6
- 1.3
- 1.3
94.0
3.02
4.16
Government Debt
Domestic
External
External debt
in USD bn
52.6
36.1
16.5
71.1
349
24.9
53.8
37.5
16.3
73.6
370
24.8
46.3
29.6
16.7
72.0
391
25.0
47.1
29.7
17.4
76.5
412
24.9
General (ann. avg)
Unemployment (%)
1.4
12.8
2.4
13.5
5.0
12.5
6.2
11.5
Spot
14Q4
2.00
3.30
4.19
1.75
3.18
4.13
Financial Markets
USD/PLN (eop)
EUR/PLN (eop)
224.3
223.7
0.6 - 1.4
0.1 - 0.3
- 9.9 - 11.0
- 1.8 - 2.0
6.4
6.1
97.3 86.6
3.18 3.48
4.13 4.00
15Q1 15Q3
1.75
3.26
4.08
2.00
3.40
4.03
Source: Haver Analytics, CEIC, DB Global Markets Research, NBP
Page 97
9 October 2014
Romania
Baa3(stable)/BBB-(stable)/BBB-(stable)
Moodys/S&P/Fitch

Economic outlook: Growth was surprisingly low in
Q2 on the back of weakness in investment, but we
expect some modest rebound in the coming
quarters. Inflation remains subdued, although it is
expected to pick up in the coming months.

Main risks: We view the risks to our growth
outlook as skewed to the downside due to the still
weak lending dynamics (especially on fx loans to
the corporate sector), euro area weakness and
political uncertainty around the upcoming
presidential
elections.
However,
improving
consumption (in the low inflation environment)
could offer upside.
Growth
figures
signal
increasing
concerns on the economic front
Growth faltered in Q2 on the back of a decline in
investment. After a relatively strong Q1 GDP reading
(3.8% YoY), growth in Q2 fell markedly to 1.2% YoY; in
QoQ terms, the economy contracted by 1%. The drop
in growth was primarily due to investment, which fell
by 12.8% YoY on the back of negative net lending in
the corporate sector and likely also adverse confidence
effects from the Russia-Ukraine crisis. Net exports also
contributed negatively to GDP growth. On the other
hand, household consumption growth remained
relatively robust at 3.9% YoY.
Breakdown of contributions to real GDP growth
30
pps contribution to YoY GDP
30
20
20
10
10
0
0
-10
Inventories
GFCF
Govt Cons
Pvt Cons
Net Exports
Real GDP (% YoY, rhs)
Domestic demand (rhs)
-20
-30
-40
Q2-08
Q2-09
Q2-10
Q2-11
Q2-12
Q2-13
-10
-20
-30
Q2-14
In the recent past, net exports had been the main driver
of growth in Central Europe. However, given the recent
weakness in activity in the euro area (the main export
partner for the region), the upward impetus provided
by net exports has been decreasing across the region.
However, in other Central European countries (e.g.
Page 98
Hungary and Poland) this has been offset by improving
domestic conditions and rising domestic demand
growth. In Romania, the positive contribution of
domestic demand to growth decreased in Q2, while net
exports contributed negatively. With the slowdown in
euro area activity expected to persist, the weakness in
the Romanian domestic economy is an even greater
cause for concern and could be a drag on growth in the
coming quarters.
The level of investment is now down nearly 35% from
the 2008 peak and domestic demand is down 13%
Peak =
100
100
95
90
85
80
75
70
65
60
55
50
Jun-09
Investment (-34.3%)
Domestic demand (-13.1%)
Jun-10
Jun-11
Jun-12
Jun-13
Jun-14
While this increases the downside risk to growth, we
expect growth to rebound, albeit modestly, from its
depressed Q2 level and pick up gradually in the coming
quarters. The recent high frequency data have been
reasonably encouraging, and consumption is expected
to continue to benefit from rising real wages (as a
result of the low inflation and increase in minimum
wage).
Retail sales and industrial production have grown at a
reasonable pace in recent months
20
15
10
5
0
-5
-10
-15
-20
2008 - Aug
2010 - Aug
IP (YoY %)
2012 - Aug
2014 - Aug
Retail sales (YoY %)
9 October 2014
As a result, we expect the economy to expand by 2.5%
this year and by 3% in 2015. However, we view the
risks to this forecast as skewed to the downside due to
the still weak lending dynamics (especially on fx loans
to the corporate sector), euro area weakness and
political uncertainty around the upcoming presidential
elections.
upward trend is expected to continue in 2015, with
inflation forecasted to end 2015 at 2.9% (averaging
2.5% for the year as a whole). As a result of this
expected rise in inflation, as well as a modest rebound
in growth in the coming quarters, we believe that the
NBR will keep rates on hold in the near future (while
further cuts to reserve requirements remain likely).
Inflation remains subdued. Inflation in August fell to
0.8% YoY (from 1% in July), dropping back to close to
the record low of 0.7% (observed in June). Thus,
inflation remains well below the National Bank of
Romania’s (NBR) tolerance band of ±1pp around its
2.5% target. The main driver of the subdued headline
inflation in recent months has been the deflation in
food prices (-2% YoY in August); low imported inflation
from the euro area has also contributed to the low
inflation environment.
Political
uncertainty
persists.
The
upcoming
Presidential elections (first round: 2nd November,
second round: 16th November) have maintained
uncertainty in the political environment. 14 candidates
will run for the post of President in the first round; of
these, the most likely candidates to enter the second
round runoff are the Prime Minister and ruling Social
Democratic Party (PSD) leader, Victor Ponta, and the
leader of the opposition National Liberal Party (PNL),
Klaus Johannis. These two candidates are well ahead
of the others in the opinion polls, which predict Ponta
will obtain 42% of the votes in the first round, with
Johannis securing 27%.19
Subdued food inflation is the main driver of the low
headline rate
12
8
4
0
-4
2008 - Aug
2010 - Aug
2012 - Aug
2014 - Aug
Headline inflation (YoY %)
Food inflation (YoY %)
Current NBR target
Target lower bound
Target upper bound
On the back of the persistent low inflation as well as
the slowing of economic growth, the NBR cut rates by
25bps in September. It noted that headline inflation
remained on a lower path than previously forecasted
and it remained uncertain whether or not the inflation
path would remain below forecast going forward. The
NBR also lowered the minimum reserve requirement
ratio for leu deposits to 10% from 12%, in order to
stimulate a recovery in lending and also to bring the
reserve requirements in line with EU standards.
However, the NBR kept the reserve requirement ratio
for fx denominated liabilities unchanged.
We expect the headline inflation rate to pick up
markedly in September and near the NBR’s 1.5% lower
bound, as food inflation rebounds on the back of last
year’s VAT cut on certain foods dropping out of the
base and a relatively weaker harvest this year than last
year’s bumper one. Going forward, we expect inflation
to rise gradually in the coming months and end the
year at 1.9% (averaging 1.2% for 2014); this gradual
The second round, however, is likely to be much closer,
with polls showing a relatively narrow victory for Ponta
(57%) over Johannis (43%). A major factor in
determining the outcome in the second round is the
ability of the centre right opposition parties to present a
united front (despite inter-party differences) and
channel votes to Johannis. If the main centre right
opposition parties (National Liberal Party, Democratic
Liberal Party and Civic Force) are able to unite and also
secure support from some of the other smaller parties
(e.g. the Hungarian Union of Democrats in Romania) in
the second round, the chances of a Johannis victory
would be greatly increased. This remains a distinct
possibility and we expect the second round election to
be a close one. However, as the polls indicate (pollster:
CSCI), a victory for Ponta currently appears the more
likely outcome.
The President holds relatively little executive power but
has responsibility for selecting the PM and signing off
on cabinet appointments and international treaties,
thereby exhibiting considerable influence over the
government. Therefore, friction between the President
and the government can undermine the government’s
agenda
and
also
have
important
economic
consequences – for example, the feud between the
outgoing centre-right President Basescu and the leftleaning PSD-led government was disruptive and
caused the stalling of the IMF agreement, and thus of
the related structural reforms, late last year. The
importance of the Presidential election is also reflected
by PSD putting forward as its candidate PM Ponta,
who previously had not committed to the race which
would require him to give up the PM post; after
19
Pollster: CSCI
Page 99
9 October 2014
narrowly losing the last two Presidential elections, the
pressure within PSD to put forward the best (most
likely to win) candidate is high.
Securing the President’s post would therefore be
important for PSD to achieve government stability
through to the next parliamentary elections in 2016. An
opposition victory would likely see the resumption of
tensions between the offices of the President and
Prime Minister, increasing political uncertainty. On the
other hand, while a PSD victory would increase political
stability, it would leave the centre-left PSD largely
unchecked in the governing of the country, with control
of both the President’s post and the parliament. The
PSD has in the past shown reluctance to push through
important, but sometimes contentious, structural
reforms such as those in the health sector, the
privatization
of
state-owned
enterprises
and
liberalization of the gas market. A delay of these
reforms could adversely affect investor confidence.
We expect some, but not major, fiscal easing
approaching the election but the full effect of any fiscal
relaxation will not be felt until next year; this includes,
for example, the effect of the 5pps cut in the social
security contributions of employers starting this
month.20 Material slippage relative to the headline fiscal
targets remains unlikely in 2014 (the budget deficit
target for 2014 is 2.2% of GDP). On the other hand,
meeting the 1.4% of GDP fiscal target in 2015 is
ambitious (and unlikely in our view).
Romania: Deutsche Bank Forecasts
2012
2013 2014F 2015F
169
21.3
7 948
188
21.3
8 853
0.5
1.4
0.6
4.2
- 1.8
- 0.3
3.5
1.1
- 1.6
- 3.4
13.1
2.3
2.5
3.0
1.5
0.5
6.4
6.0
3.0
3.2
2.5
4.2
5.8
6.2
5.0
3.3
4.6
1.6
4.0
8.8
1.9
1.2
4.4
2.9
2.5
6.4
Overall balance
Revenue
Expenditure
Primary Balance
- 2.9
33.5
36.4
- 1.1
- 2.3
33.7
36.0
- 0.5
- 2.2
33.7
35.9
- 0.4
- 1.9
33.9
35.8
- 0.1
Goods Exports
Goods Imports
Trade Balance
% of GDP
% of GDP
FDI (net)
FX Reserves (eop)
USD/FX (eop)
EUR/FX (eop)
62.8
73.0
- 10.3
- 6.1
- 8.1
- 4.8
3.1
44.4
3.36
4.43
69.0
73.8
- 4.8
- 2.5
- 2.1
- 1.1
3.7
44.8
3.26
4.49
72.9
78.3
- 5.4
- 2.7
- 2.0
- 1.0
4.0
41.5
3.35
4.35
72.0
78.0
- 6.0
- 3.1
- 2.4
- 1.2
2.4
40.0
3.70
4.25
38.0
18.6
19.4
75.7
128
38.4
17.5
20.9
69.8
132
40.3
19.8
20.5
65.5
131
40.2
20.2
20.0
66.6
132
2.8
5.1
7.0
5.3
8.2
5.2
8.5
5.0
National Income
Nominal GDP (USDbn)
Population (mn)
Real GDP (YoY%)
Private Consumption
Exports
Imports
CPI (eop)
CPI (period avg)
Broad money (eop)
Government Debt
Domestic
External
External debt
in USD bn
General (ann. avg)
Unemployment (%)
199
197
21.2 21.2
9 395 9 323
Spot 14Q4F 15Q1F 15Q3F
Financial Markets
USD/RON (eop)
EUR/RON (eop)
3.00
3.49
4.40
3.00
3.35
4.35
3.00
3.46
4.33
3.25
3.61
4.28
Source: Haver Analytics, NBR, DB Global Markets Research
20
The fiscal relaxation also includes increased defence spending hikes
announced in April, which should add 0.1pp to the deficit.
Page 100
9 October 2014
Russia
Baa1(neg)/BBB(neg)/BBB-(neg)
Moody’s/S&P/Fitch

Economic outlook: Economic prospects dimmer
against the backdrop of higher sanctions.

Main risks: Elevated geopolitical risks relate to
Ukraine; scale of sanctions against Russia.
2Q14) and sharply decreasing imports (-7.7% yoy in
2Q14 and -4.4% yoy in 1Q14) accounting for the bulk
of the improvement.
Russia: Key economic indicators
Returning to stagnation path
25%
15%
% yoy
The Russian economy has continued to decelerate,
with the growth rate testing zero in August, on the
back of a deceleration in household consumption and
stagnation on the fixed investment side. The outlook
further worsened on the back of new sanctions
launched by the US and the EU against Russia in
September as well as a number of developments that
further worsened the investment climate. Another
headwind on the global front was the significant
decline in oil prices, which exerted pressure on the
rouble to depreciate further.
35%
5%
-5%
-15%
-25%
-35%
2007
2008
2009
IP, YoY, real, %
2010
Fixed investment, YoY, real, %
2011
2012
2013
2014
Retail sales, YoY, real, %
Construction, YoY, real, %
Source: Rosstat, Deutsche Bank
Key economic indicators: July returns to a downward
trend
On the economic growth front, industrial production
exhibited no growth in August, with the manufacturing
segment declining by 0.6% yoy. Fixed asset
investments continued to weaken further: -2.7% yoy in
August, after -2.0% yoy in July. On the consumer side,
retail sales continued to improve marginally to reach
1.4% yoy in August, after 1.1% yoy in July and 0.7%
yoy in June, driven by improvements in real disposable
income. The unemployment rate declined to another
historical low of 4.8%, from 4.9% in July.
Overall, the results appear to be skewed to the
downside. This may be concluded from the dynamics
of the core economic activities index, published by
Rosstat, which serves as a proxy for GDP growth
dynamics. The index declined by 0.5% yoy in August,
after 0.3% yoy in July, 0% yoy in June and 0.7% yoy in
May. The preliminary monthly GDP estimate from the
Ministry of Economy pointed to zero growth in August,
after 1% yoy growth in July. On a seasonally adjusted
basis, the economy grew 0.4% mom, after +0.4% mom
in July. Over the 8M14 period, the growth rate reached
0.7% yoy.
Meanwhile, Rosstat released 2Q14 expenditure growth
figures (0.8% yoy): household consumption decelerated
significantly, to 0.8% yoy, after 3.7% yoy in 1Q14 and
4.1% yoy in 4Q13; public consumption remained near
zero level; fixed asset investment was down, at -2.1%,
partially recovering from -7.0% yoy in 1Q14. The
contribution of net exports increased again, with
decelerating exports (1.3% yoy in 1Q14, vs. 1.6% yoy in
Given the recent economic trends in Russia, along with
a lower oil price environment, we expect the Russian
economy to grow by 0.5% yoy in 2014 and 1.0% yoy in
2015. Changes to our forecasts made in our September
edition of The World Outlook (0.5% yoy from the
previous 0.8% yoy for 2014) reflect our expectation of a
further deceleration in household consumption, driven
by an increase in savings ratios, lower salary growth in
the public sector and higher inflation sapping
disposable income growth. On the investment front,
we expect growth to decline quite significantly in 2014,
with a marginal recovery in 2015, on the back of base
effects and support from the infrastructure stimulus.
We also note the adverse effects of the importsubstitution policy, as we believe it will result in higher
inflation, rather than a significant improvement in
output dynamics amid structural bottlenecks, high
levels of capacity utilization and the decrepit state of
capital equipment in the industrial sector.
Fiscal balance posts 2.0% GDP surplus in 8M14
Russia’s fiscal balance remained resilient in August,
following strong prints for May-July. According to the
fiscal authorities, the federal budget surplus in August
increased by RUB166bn, to RUB906bn, reaching 2.0%
of 8M14 GDP. Overall, both oil and non-oil revenues
were broadly in line with the budget plan, while fiscal
outlays were behind budget projections. Overall, the
federal budget continued to post a surplus on the back
of a weaker ruble, expenditures being subdued and oil
prices being favourable throughout most of this year.
Page 101
9 October 2014
Russia: T12M budget execution
Russia: CPI and its key components
0.8
0.6
21
0.4
0.0
% GDP
% GDP
0.2
20
-0.2
19
-0.4
-0.6
-0.8
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
18
Budget Revenues, % GDP
Budget Balance, % GDP (RHS)
Budget Expenditure, % GDP
14.0%
13.0%
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%
Jan-06
Apr-06
Jul-06
Oct-06
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
22
Food, %, YoY
Non-food, %, YoY
Services, %, YoY
Source: Ministry of Finance, Rosstat, Deutsche Bank
Source: Rosstat, Deutsche Bank
In September the government has approved the draft
law of the federal budget for 2015-17, and submitted it
to the State Duma. The budget is expected to feature a
deficit of 0.6% GDP for the next three years. In 2015,
the budget is expected to earn RUB15,082bn and
spend RUB15,513bn, leading to a deficit of
RUB430.8bn. The projections were made on the back
of a projected growth rate of the economy of 1.2% yoy,
an inflation rate of 5.5% yoy and a dollar rate of
RUB/USD37.7.
External borrowing is expected at USD7bn, as
projected earlier, while, according to Vedomosti, the
domestic borrowings plan was to be cut to RUB280bn
in 2015, but is expected to be RUB800-900bn in 201617. The government has also reserved the right to
exchange its external debt into domestic debt, if agreed
with Eurobond holders, but this decision will apply only
to 2015. According to Siluanov’s statements yesterday,
neither sales tax nor higher VAT tax were incorporated
into the three-year fiscal projections. In our view, at this
stage, the sales tax will not be incorporated in 2015;
however, given the changes in the economic
environment in the medium term, the authorities may
revisit this issue next year.
Consumer inflation accelerates to 8.0% yoy in
September
Russia’s consumer prices grew by 0.8% mom in
September, pushing the headline rate to 8.0% yoy, up
from 7.6% yoy in August and 7.5% yoy in July. On a
YTD basis, inflation amounted to 6.3% ytd, vs. 4.7% ytd
over 9M13. Core CPI remained at the level of 8.0% yoy,
as in August 2014. The rise in inflation in September
appeared to be atypical for this period of the year,
which is usually dominated by seasonal effects in the
food segment (mainly fruits and vegetables).
Page 102
Across the key components, food items’ price growth
accelerated to 11.4% yoy, from 10.3% yoy in August
and 9.8% yoy in July. In the non-food segment,
inflation remained at the same level as it was in August,
at 5.5% yoy, lower than in July (5.6% yoy). As for
services, their price growth acceleration appeared to be
marginal, at 6.9% yoy in September, from 6.7% yoy in
August.
Overall, the main drivers of price increases in the food
segment appeared to be goods for which imports were
restricted from the EU, the US, Canada and Norway.
The highest increase in prices was for poultry (4.5%
mom), which was up 3.7% mom. Significant increased
were also registered in pork (3.2% mom), and frozen
fish (2.3% mom), while cheese prices were up by 6.0%
yoy.
We highlighted earlier that the introduction of trade
sanctions could result in higher inflationary pressures
in 2014-15, although a lot will depend on the ultimate
duration of these restrictions. In our most recent
research (Special Report – Russia: assessing the impact
of trade restrictions, dated 1 September), we estimated
the impact of food restrictions at 1.5pp to the headline
inflation rate over the next 12–18 months.
CBR keeps rates on hold in September
Despite the surge of inflation in September (CPI up to
7.7% yoy in early September), the CBR kept the key
policy rate unchanged, at 8.0%. The latest acceleration
in inflation originated from food import restrictions,
which reversed the effect of lower growth in regulated
tariffs and the decline in food prices on the back of
seasonal effects. Despite this acceleration, according to
the CBR, the current monetary policy stance, along
with the absence of demand-push pressures and lower
credit and money supply growth, enable the economy
to accommodate food price shocks and reduce
inflation dynamics in the medium term. The CBR states
that it will further tighten monetary policy if high
inflation risks persist and inflation expectations remain
elevated.
9 October 2014
The monetary authorities expect the CPI to persist at a
level exceeding 7.0% yoy, with future dynamics being
influenced by the speed of the accommodation of the
economy to imposed trade restrictions. The CBR
expects the effects of price growth on restricted food
items to be temporary. The CPI is expected to decline
in 1H15 on the back of the dissipation of external
shocks, lower inflation expectations and the absence of
demand-push pressures. The CBR sees its current
monetary stance as consistent with the attainment of
its medium-term target of 4% yoy.
Russia: CBR’s key policy rates
CPI,
% yoy
RUB-leg
FX-swap
fixed o/n
credit
min-max
fixed 312P
(%)
10.5
10.0
9.5
9.0
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1D fixed repo
1W auction
repo
1M AVG
RUONIA
min auction
312
1W auction
depo
Dec-10
Jan-11
Feb-11
Mar-11
Apr-11
May-11
Jun-11
Jul-11
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
Oct-14
o/n fixed
depo
Source: Rosstat, CBR, Deutsche Bank
We believe that the CBR’s decision is motivated, in part,
by the need to gauge near-term developments in
inflationary dynamics (including the effects of import
restrictions) and broader economic uncertainty before
deciding on the scale of further monetary policy
tightening. Our sense is that, given these risks, as well
as the dynamics – not just in headline inflation, but also
in the core inflation indicator – the CBR is likely to
resort to additional interest rate increases later this year,
which could reach another 50 bps by end-2014.
Russia: Banking sector funding, %
90
80
70
60
(%)
50
40
30
FX liquidity is believed by the market participants to be
one of the reasons for pronounced rouble depreciation
in recent periods. In response to these issues, the CBR
has introduced 1D fixed USD/RUB Sell/Buy FX swaps,
starting on today/tomorrow and tomorrow/spot
settlement terms. The CBR set the interest rate for the
rouble swap leg operation at a key rate minus 1pp
(now it is 7.0%), which is equivalent to the depo rate,
while, for the US dollar leg, the rate is fixed at 1.5%.
The maximum allotments on FX swaps with
today/tomorrow and tomorrow/spot settlements are set
at USD1bn and USD2bn, respectively. According to the
CBR, these operations are aimed at improving the
short-term FX liquidity conditions for the banking
sector. In our view, although the announced conditions
are not particularly attractive (modest size and the rates
are not particularly appealing), we believe this shows
the commitment of the central bank to improve the
domestic liquidity conditions, which have suffered from
high capital flight and deteriorating external market
borrowing conditions. Moreover, in the begging of
October CBR, Governor Elvira Nabuillina stated that the
CBR might introduce the 7D and 27D repo, with FX
used as collateral. If introduced, this tool could provide
further serve to improve domestic liquidity conditions.
Another concern that has put pressure on the rouble is
the possibility of the imposition of capital controls,
although the CBR issued a press release in connection
with media reports denying the fact that such
measures were being discussed as a reserve option.
Earlier this year, high-ranking CBR and Minfin officials
declared that capital controls would not be introduced
and that no such plans were discussed.
At this stage, the introduction of capital controls in
Russia is not our base case, and the timing of such
measures would be particularly questionable if there
were progress in the near term in resolving the regional
conflict, including the gas dispute with Ukraine. The
scale of the negative impact sustained by the macro
economy (even taking into account the weakness in
the rouble) does not appear to warrant such measures.
Also, Russia’s past history suggests that such controls
were frequently ineffective and economic agents found
ways to by-pass such restrictions. Finally, such
measures could trigger stepped up currency conversion
by the population, which could further put pressure on
the rouble.
20
10
0
2008
2009
2010
RUB Corp/Household Deposit Funding
2011
2012
FX Corp/Household Deposit Funding
2013
Interbank funding
2014
CBR +MinFin funding
Source: Rosstat, CBR, Deutsche Bank
Still, large-scale depreciation remains an issue for the
monetary authorities, filtering into headline inflation via
pass-though channels of imports. A structural deficit of
EU/US introduce further sanctions against Russia
In mid-September, the EU and the US launched
another round of economic sanctions against Russia in
light of the developments in the Ukrainian crisis.
Strengthened EU sanctions included the following: 1)
restrictions on raising new equity and debt with
maturity exceeding 30 days for five state-owned banks,
Sberbank, Gazprombank, VTB, VEB and RSHB, and
Russian energy companies Rosneft, Gazprom neft and
Page 103
9 October 2014
Transneft; 2) EU restricted provision of services
necessary for deep-water oil exploration and
production; arctic oil exploration or production and
shale oil projects in Russia would no longer be
provided; 3) extension of the EU ban on exporting dualuse goods and technology for military use in Russia to
also include a list of nine defense companies that must
not receive dual-use goods from the EU.
Following the publication of strengthened sanctions
against Russia by the EU today, the US followed with
its expanded set of measures against Russia’s
corporates and sectors. The new sanctions include
restrictions on new equity/debt (maturity >30 days)
financing for major state-owned Russian banks
(Sberbank, VTB, Bank of Moscow, Gazprombank,
RSHB), large energy companies (Gazprom neft,
Transneft, Rosneft and Novatek) barred from
equity/debt raising with maturity >90 days. In addition
to financing restrictions, the new sanctions prohibit the
export of goods, services or technology in support of
exploration or production for Russian deepwater, Arctic
offshore, or shale oil projects by five Russian energy
companies, namely Gazprom, Gazprom neft, Lukoil,
Rosneft and Surgutneftegaz.
The impact of another round of sanctions is likely to
result in higher capital outflows, further pressure on the
ruble and concerns over the direction of Russia’s
economic policy, which, via retaliatory measures, is
likely to gravitate increasingly towards importsubstitution. The latter, in our view, is fraught with
further inflationary pressures and a lack of response on
the production side, which is hampered by high
capacity utilization and a decrepit state of capital
equipment.
Earlier, Russia's officials declared that restrictions on
imports of capital equipment from the West could be
considered as part of the retaliatory measures.
Nonetheless, in the end Russia’s authorities opted not
to proceed with retaliatory measures – according to the
First Deputy Prime Minister Arkady Dvorkovich
retaliatory measures are not seen as a priority.
Yaroslav Lissovolik, Moscow, +7 495 933 9247
Artem Zaigrin, Moscow, +7 495 797 5274
Russia: Deutsche Bank forecasts
2012
National Income
Nominal GDP (USDbn)
Population (mn)
2013
2014F 2015F
2 002 2 096 2 005 2 123
143.1 143.2 143.5 143.7
13 993 14 621 14 008 14 841
Real GDP (YoY%)
Private Consumption
Exports
Imports
3.4
6.6
0.0
1.8
8.7
1.3
4.7
0.4
4.1
3.9
0.5
2.0
- 0.5
0.1
- 2.5
1.0
1.1
- 0.3
0.8
- 0.6
%
CPI (eop)
CPI (period avg)
Broad money (eop)
Private Credit (eop)
6.6
5.1
11.9
19.1
6.5
6.8
14.0
17.1
7.4
7.3
10.3
15.6
6.4
6.2
12.2
15.0
Overall balance
Revenue
Expenditure
Primary Balance
- 0.1
20.5
20.6
0.5
- 0.5
19.3
19.8
0.1
0.2
19.2
19.0
0.8
0.3
19.7
19.5
0.9
Trade Balance
% of GDP
% of GDP
FDI (net)
FX Reserves (eop)
USD/FX (eop)
193.3
9.6
72.0
3.7
1.8
537.6
30.37
177.3
8.7
33.0
1.5
- 15.6
510.0
32.73
201.1
10.0
56.3
2.7
- 10.2
460.0
36.70
174.9
8.2
38.6
1.7
- 5.6
483.0
36.00
Government Debt
Domestic
External
External debt
in USD bn
11.5
8.0
3.5
31.8
636
11.7
8.1
3.6
32.9
732
12.0
8.6
3.4
36.1
763
12.1
8.7
3.4
34.2
726
General (ann. avg)
Unemployment (%)
2.6
5.5
0.0
5.5
- 1.2
6.0
1.6
6.3
Current 14Q4F 15Q1F 15Q3F
Financial Markets
Policy rate (Key rate)
USD/RUB (eop)
8.00
39.70
8.50
36.70
8.50
36.53
8.50
36.18
* - central government, ** - general government
Source: Official statistics, Deutsche Bank Global Markets Research
Page 104
9 October 2014
South Africa
Baa1 (negative)/BBB- (stable)/BBB (negative)
Moody’s/S&P/Fitch

Economic outlook: some normalcy has returned to
industrial activity, but the outlook remains
uncertain against a weak global backdrop and
upcoming GDP revisions. Prepare for some revenue
slippage and pressure on the focus to reduce the
current spending overshoot. For now, a weak
growth landscape should ensure policy rates
continue to adjust slowly.

Main risks: weak capital flows, wider current
account and fiscal deficits and additional exchange
rate pressure are adding to inflation risks, which
could trigger further ratings downgrades from
Moody’s and Fitch. Focus remains on Eskom’s
funding plan to be announced in the upcoming
mid-term budget.
Fiscal pressure mounting
On the 22nd of October the new Finance Minister, Mr
Nhlanhla Nene will deliver his first mid-term budget
policy statement. As it stands, economic growth is at
the weakest in five years and monetary policy is
tightening from ultra accommodative levels. Inflation is
above the target band, business and consumer
confidence, though off recent lows, are still
significantly below their long-term averages, and
labour market frictions have not disappeared. Though
recent PMI and vehicle sales/export data confirmed a
return to some ‘normalcy’ after the series of hits from
labour strikes, the outlook for the economy remains
weak.
GDP YoY %
IMF (Jul)
NT (Feb)
4
Consensus (Jan)
3.5
All in all, maintaining the existing consolidation path
with the fiscal deficit reaching -2.8% of GDP in 2016/17
will be hard to achieve under current circumstances. In
the first five months of the 2014/15 fiscal year, the
budget deficit has deteriorated significantly and is 2%
ahead of target compared to previous years (Figure
below). At the current spending rate, it will be difficult
to stick to the nominal spending limits. While revenue
collections currently appear to be broadly on track to
reach the budget targets, we see some scope for
slippage.
Year-to-date budget deficit significantly worse than the
past
Growth forecasts – uncertain trajectory
4.5
and the deterioration in terms of trade. This is partly
owing to the low base in GDE (0.4% in 2014), and the
expected improvement in net trade next year as
imports lag weakness in domestic demand. But there is
significant uncertainty as to how these projections will
change after the major overhaul of historical GDP
statistics on the 25th of November. Indeed, the starting
point of all GDP components from which existing
forecasts are based will change. The risks currently
point to a cumulative upward revision to real GDP of
0.5% - 1%, and upgrades will be made to expenditure
components to reflect new advances in methods,
definitions and data sources. The risk we face from a
significant upward revision to the GDP base level is
that the business cycle trough is yet to be reached – i.e.
growth does not rebound as expected in 2015. The
National Treasury may therefore want to base their
forecasts on more conservative estimates than
presented in February.
DB (Sep)
SARB (Sep)
0%
Year-to-date deficit as % of budget forecast
20%
40%
3
60%
2.5
2014-15
80%
2
100%
1.5
120%
1
2014
2015
2016
Shaded area represents range of outcomes for the
preceding four years
April
July
October
January
Source: Deutsche Bank, StatsSA
Source: Deutsche Bank, StatsSA, SARB
Admittedly, our growth forecast (3.4% in 2015) do
appear rather optimistic given the recent downgrades
to global growth, coal import restrictions from China
As illustrated in the Figure below, a sustained increase
in non-interest expenditure may lead to an overrun of
c.R23bn, pushing the deficit to -4.7% of GDP (vs -4% in
February), all else being equal. Credit ratings agencies
Page 105
9 October 2014
will not be pleased with such an outcome. But this
does imply a significant reprioritisation in expenditure
is needed to maintain the effective expenditure ceilings
announced in 2012. It also appears that the new
Finance Minister is reluctant to announce any
expenditure cuts at this stage. From what we gather,
there is probably around R10bn to R15bn worth of fat
in budgeted expenditure – eg. vacant posts,
contingency reserves – that could be trimmed if
necessary.
Fiscal framework: Revenue slippage expected
NT
F Y 14
Y TD
Revenu e
1099
1100
Exp end itu re
Non-interest
Interest
Overall b alance
Primary b alance
1252
1131
121
-153
-32
1275
1154
121
-175
-54
Revenue
Expenditure
Non-interest
Interest
Overall b alance
Primary b alance
29.0
33.0
29.8
3.2
-4.0
-0.8
29.6
34.3
31.0
3.3
-4.7
-1.5
F Y 15
DBe *
NT
DBe *
( Ra nd billions)
1095
1201
1191
1252
1352
1131
1218
121
133
-157
-150
-36
-17
( % G DP)
29.5
28.9
33.7
32.6
30.4
29.3
3.3
3.2
-4.2
-3.6
-1.0
-0.4
F Y 16
NT
1325
1352
1218
133
-160
-27
1452
1307
145
-127
18
29.0
32.9
29.7
3.2
-3.9
-0.7
29.1
31.9
28.7
3.2
-2.8
0.4
Source: Deutsche Bank, National Treasury
The expenditure overshoot may have to do with
increased administrative pressure resulting from the
elections and new cabinet announcements. Based on
Stats SA statistics, total employment in the public
sector rose by a significant 5.8% q/q in Q2 –
significantly more than in the 0.8% q/q increase in the
2009 election year.
Non-interest expenditure above target for two
consecutive months
100%
Year-to-date non-interest expenditure as % of
budget forecast
80%
60%
40%
20%
2014-15
Shaded area
represents range of
outcomes for the
preceding four
years
0%
April
July
October
January
While there may be a partial reversal as some of these
jobs are temporary, the number of cabinet ministers
has increased despite some consolidation in the
number of ministries. Wage pressure is mounting, with
Page 106
public sector union demands running at more than
double the 6.4% budgeted increase in the wage bill.
At this juncture, revenue collections could marginally
undershoot budget by c. R5bn, if downward pressure
on non-income tax revenue, VAT in particular,
continues. In spite of the economic hardship this year,
income tax revenues have held up fairly well compared
to previous years. But it is questionable how long this
will last and whether the seasonal increase in corporate
income tax in December will disappoint or not.
Fortunately,
non-tax
revenues
are
performing
somewhat stronger year-to-date (42.3% of budget vs
the average of 39.3%), reflecting positive valuation
effects and profit gains on government-held financial
assets. If sustained, this could result in some R5bn of
additional income support. However, if it turns out that
Eskom’s cash injection comes from government’s
balance sheet (via asset sales) then this revenue source
may run dry.
Mixed prognosis for tax revenue collections
Budget Apr-Aug YTD % of Budget
Rbn
est. (Rbn)
(Rbn)
Current 6-yr ave over/under
Personal income
335.9
130.4
37.0
37.9
Corporate income
221.0
77.9
34.5
33.9
3.1
2.9
VAT
267.1
93.2
36.7
35.9
-2.7
Other
169.7
60.7
35.8
38.7
-5.0
Total tax revenue
993.7
362.2
36.4
36.6
-1.7
less SACU payments
Departmental
revenue (non-tax)
51.7
25.9
50.0
50.0
0.0
20.9
12.8
42.3
39.3
4.6
Total
962.8
349.1
36.4
36.1
1.6
The prognosis for revenue collections remains mixed.
At the time of the February Budget, the Treasury
expected growth in domestic demand to reach 2.8% in
2014 and 3.4% in 2015. However, year-to-date, growth
in real GDE has fallen to 0.1%, reflecting the plunge in
domestic income growth (Figure below). In addition,
other forms of tax collections such as import duties
have collapsed given the decline in real import volumes.
This means that a fairly weak exchange rate
(inflationary pressures), and a reduction in VAT refunds
(as private sector capex have turned negative) are
temporarily buoying non-income tax revenues. On the
flip side, the decline in import volumes in Q2 suggests
that NT’s import growth assumptions of 5.3% in 2014
(vs ytd growth of 0.3%) are too optimistic. Thus budget
allocations for SACU transfers are probably overstated.
A continuation of lower import volumes – in line with
our expectations – could imply a revenue claw back of
at least R10bn- R15bn next year.
9 October 2014
South Africa: Deutsche Bank Forecasts
Real drivers of VAT collections have weakened
45 yoy %
30
15
0
-15
-30
1994 1997 2000 2003 2006 2009 2012
VAT collections (LHS)
Imports
Growth in terms of trade-adjusted GDP
2013F
2014F
2015F
383.3
52.3
7331
349.5
53.0
6596
338.9
53.5
6333
389.1
54.0
7200
2.5
3.5
4.0
4.5
0.5
6.2
1.9
2.6
2.4
4.7
4.2
4.7
1.5
2.0
1.3
2.9
3.8
0.1
3.4
1.9
2
3.7
4.6
1.5
5.7
5.7
5.4
5.8
6.2
6.2
5.4
5.4
-4.2
28.3
32.5
-1.3
-4.1
29.0
33.0
-4.2
29.5
33.7
-3.9
29.0
32.0
-1.0
-1.0
-0.7
Goods exports
Goods imports
Trade balance
% of GDP
% of GDP
FDI (net)
ZAR/USD (eop)
ZAR/EUR (eop)
99.5
104.3
-4.8
-1.3
-20.1
-5.2
1.5
50.7
8.5
11.2
94.6
102.4
-7.8
-2.2
-20.9
-6.0
3.8
49.0
10.1
13.2
93.5
99.1
-5.6
-1.7
-15.5
-4.6
2.7
48
10.8
13.9
101.1
107.2
-6.0
-1.6
-17.2
-4.4
3.1
51
10.0
11.5
Government debt 1
Domestic
External
Total external debt
in USD bn
42.5
38.6
3.9
37.1
142.3
44.8
40.5
4.3
37.1
130.0
46.5
42.8
3.7
36.9
135.0
47.5
43.7
3.8
33.8
145
Current
14Q4
15Q1
15Q3
5.75
6.07
8.2
11.0
14.2
6.00
6.20
8.5
10.8
14.1
6.00
6.20
9
10.7
13.5
6.25
6.50
8.8
10.2
12.5
Real GDP (%)
Priv. consumption
Gov’t consumption
Exports
Imports
CPI (YoY%, eop)
CPI (YoY %, pavg)
Overall, we expect a moderately weaker revenue
outlook in the mid-term budget, which may necessitate
the introduction of new tax proposals (only to be
announced in February). As it stands, the current
revenue slippage could raise the deficit by -0.2% to 0.3% to -4.2% in FY14/15. For the existing
consolidation plan to remain credible, the National
Treasury will have to stick to the nominal expenditure
ceilings. This will be challenging given the year-to-date
spending overshoot of more than R20bn, and mounting
pressure from the public sector unions for double-digit
wage increases. At this point, the weaker economic
backdrop, funding pressures from state-owned
enterprises and uncertain global outlook may render
expenditure ceilings as an inadequate tool for fiscal
sustainability, and could result in further ratings
downgrades by Moody’s and Fitch. For now, the
funding of the deficit remains on track, if not slightly
ahead of target (c. R8.5bn), and the debt ratio may very
well remain similar to the trajectory posited in February.
No room for further debt uptake
45
2012
National Income
Population (mn)
Net national government debt (% GDP)
40
35
February Budget 2013
30
October MTBPS 2013
February Budget 2014
Overall balance
Revenue
Expenditure
Primary balance
Policy rate
3-month Jibar
10-year bond yield
ZAR/USD
ZAR/EUR
1, 2
(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.
25
FY10
FY11
FY12
FY14
FY15
FY16
Danelee Masia, South Africa, 27 11 775-7267
Page 107
9 October 2014
Turkey
Baa3 (negative)/BB+ (negative)/BBB- (stable)
Moody’s / S&P / Fitch

Economic outlook: renewed market pressure has
prompted the CBT to tighten domestic liquidity
conditions. This will help to support the lira and
thereby contribute to a deceleration in inflation
from current very high levels. But it will also weigh
on economic activity. Lower oil prices should
support a further reduction in the current account
deficit.

Main risks: the ongoing geopolitical sectarian
conflict in Iraq and Syria could trigger domestic
divisions and unrest. Despite the rebalancing that
has taken place and the recent tightening of
monetary conditions, external financing needs
remain large and the economy will accordingly
continue to be highly sensitive to swings in global
risk sentiment.
of market stress (see chart). We had expected this. But
it has happened sooner, and the tightening has been
sharper, than we had expected. It may be that the CBT
is trying to deliver a “short sharp shock” to the markets
in an attempt to nip pressure in the bud. It does not
have enough reserves to do so through currency
intervention -- we estimate that the CBT’s net usable
FX reserves are about USD 38bn – which leaves
interest rates as the only viable defense.
Domestic liquidity conditions have been tightened
%
13
12
Interbank
11
10
Tightening time
Turkish markets have been under pressure over the last
month. This reflects both nervousness about
geopolitical risks in the region and broader pressure on
emerging markets in anticipation of the normalization
of US monetary policy. Against this backdrop, while
the Central Bank of Turkey (CBT) left its key policy rates
unchanged last month, it nevertheless tightened
domestic liquidity conditions significantly. Domestic
macro data meanwhile have taken a bit of a back seat.
Inflation dipped below 9% for the first time in five
months. Newly announced energy price hikes will put
upward pressure on headline prices in the near term.
Inflation should then start to decelerate more decisively
through the middle of next year, especially as food
prices correct and assuming some lira stability, though
it will remain high by EM standards. Recent trade data
suggest that the rebalancing process is running out of
steam, though lower oil prices will now start to provide
some relief given Turkey’s large energy import bill.
Monetary policy: regime change
The CBT left all of its key policy rates on hold last
month but has since engineered a significant tightening
in monetary conditions by restricting the amount of
funding that it provides through its one-week repo
auctions. This has driven (overnight) market rates
towards the upper bound of the CBT’s interest rate
corridor, an increase of some 250bps.
The one-week repo rate has become less meaningful as
a signal of the CBT’s monetary stance, which is now
effectively being determined on a daily basis by the
CBT’s liquidity management. This is a reversion to the
kind of regime that we have seen during past episodes
Page 108
9
8
7
6
Repo
5
4
Effective
Rate corridor
3
Dec 11 Apr 12 Aug 12 Dec 12 Apr 13 Aug 13 Dec 13 Apr 14 Aug 14
The CBT will be hoping that by acting early, it will be
able to quickly unwind this tightening. The extent to
which it is able to do so really depends on external
market conditions. Having acted early, it’s probable
that we will see some unwinding. But we think it’s
unlikely that it will be able to sustain market rates back
at 8.25% (i.e. anchored around the current repo rate)
for long as markets continue to prepare themselves for
the first Fed rate hike. We thus maintain our view that
market rates are likely to need to average something
like 9.5% through the middle of next year.21
Inflation: energy boost
After three months of upside surprises, inflation finally
came in lower than markets had been expecting in
September, decelerating to 8.9% from 9.5% in August.
Food prices have begun to adjust, falling slightly on the
month in seasonally adjusted terms. Core inflation also
decelerated to 9.3% from 9.7% in August. Monthly
21
We show this in the form of an increase in the effective funding rate in
the table below – though, in practice, the CBT could achieve this in a
variety of ways.
9 October 2014
movements in this series have been quite volatile, but
in seasonally adjusted terms, core inflation has been
growing at an average annualized rate of 6.7% over the
last three months, the lowest rate since the turn of the
year. The CBT will be encouraged by this.
data, the momentum behind the improvement in the
underlying external balance does seem to have stalled
over the last three months (chart below).
Separately, the government announced a 9% increase
in the price of electricity and natural gas, the first
adjustment in two years, effective from the beginning
of this month. We estimate that this will directly add a
little over 0.5ppts to the headline rate of inflation. The
full impact could be somewhat higher than this, to the
extent that the higher energy costs also lead to
increases in the prices of other goods.
Non-oil and non-gold trade balance (seasonally-adjusted 3mma annualized)
-10
The adjustment is necessary to cover a shortfall at the
state gas company due to the rising cost of energy in
local currency. It will reduce but not eliminate the
subsidy element. A further significant adjustment in
prices may therefore be necessary next year.
Improvement in trade balance stalls
USD bns
-15
-20
Headline
balance
-25
-30
Excluding
exports to Iraq,
Russia, and
Ukraine
-35
-40
Jan 12
Jun 12
Nov 12
Apr 13
Sep 13
Feb 14
Jul 14
Source: Haver Analytics,, Deutsche Bank
Household energy costs needed to be adjusted
Geopolitical events have not helped. Exports to Iraq,
Russia, and Ukraine have fallen by about 22% (YoY)
over the last three months. In absolute terms, this loss
in exports is worth around USD 5bn on a full-year basis,
or around 0.6% of GDP. But other exports have also
weakened a little. Moreover, imports (excluding gold
and oil) rebounded sharply in August. The decline in
headline imports in August was entirely seasonal. After
stripping out seasonal effects, imports were up 8.6%
on the month, more than fully reversing their 3.1%
drop in July.
November 2012 = 100
130
125
Lira price of oil,
lagged
120
115
110
105
100
Household
energy costs
95
90
Nov-12
Feb-13
May-13
Aug-13
Nov-13
Feb-14
May-14
We had largely anticipated this adjustment in energy
prices and recent lira weakness, and we are therefore
making only a modest upward adjustment to our endyear forecast for inflation to 8.7%. We are also
retaining our end-2015 forecast of 6.9%, though this
masks an expected brief dip in inflation to below 6%
next summer due to base effects as this year’s spike in
food prices drops out of the figures. The main risk to
our forecasts, however, is probably to the upside in the
event that the CBT is unable to prevent further
significant depreciation in the lira.
We still think the current account deficit will likely
narrow a little further from 6.1% of GDP currently (12
months to July) to 5.5% of GDP by the of this year. But
this improvement is now entirely down to cheaper oil
imports and lower imports of gold over the remaining
months of the year
We think the current account deficit will narrow a little
further next year to 5% of GDP, also due to lower oil
prices, whereas the current account balance excluding
energy should weaken marginally.
Rebalancing stalls but cheaper oil offers relief
Weaker trade numbers in August raised fresh doubts
about the progress on economic rebalancing. The trade
deficit widened to USD 8.0bn in August from USD
6.5bn in July. These data are volatile and we always
caution against reading too much into one observation.
Nevertheless, after adjusting for the seasonality in the
Page 109
9 October 2014
Turkey: Deutsche Bank Forecasts
Current account to benefit from cheaper oil
Current account deficit (% GDP)
9
8
Non-energy
Energy
Total
7
2012
2013
2014F
2015F
788.6
74.9
10531
821.9
75.8
10839
806.3
76.8
10500
859.8
77.8
11057
2.1
-0.5
6.1
-2.7
16.3
-0.4
4.1
5.1
6.2
4.2
-0.3
9.0
3.0
0.8
6.0
-1.9
8.4
-0.4
3.3
3.7
3.4
3.3
4.9
5.6
6.2
CPI (eop)
8.9
CPI (period avg)
10.2
Broad money (eop)
18.5
Bank credit (eop)
7.4
7.5
22.2
33.3
8.7
8.9
12.1
18.1
6.9
6.4
9.9
16.4
Overall balance 1
Revenue
Expenditure
Primary balance
-2.0
23.4
25.4
1.4
-1.2
24.9
26.1
2.0
-1.7
23.4
25.2
1.3
-1.5
23.0
24.5
1.4
Goods Exports
Goods Imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (eop)
TRY/USD (eop)
163.2
228.6
-65.3
-8.3
-48.5
-6.1
9.2
99.9
1.79
163.4
243.4
-80.0
-9.7
-65.1
-7.9
9.8
110.9
2.14
172.8
234.5
-61.7
-7.7
-44.3
-5.5
10.3
115.0
2.25
183.5
245.0
-61.4
-7.1
-42.7
-5.0
11.1
120.0
2.26
37.6
27.3
10.3
42.9
338.3
29.7
37.4
25.7
11.7
47.2
388.2
33.6
35.7
24.5
11.2
50.4
406.5
31.8
34.2
23.8
10.4
49.2
423.4
30.0
2.5
8.4
3.4
9.1
2.9
9.9
3.4
9.8
Current
14Q4
8.25
11.25
9.00
9.75
2.25
15Q1
8.25
11.25
9.50
10.0
2.25
15Q3
8.25
11.00
9.25
10.0
2.23
National Income
Population (mn)
6
Real GDP (YoY%)
Private consumption
Exports
Imports
5
4
3
2
1
0
-1
2012
2013
2014F
2015F
The risks to our forecast for next year are probably
skewed towards a smaller deficit. Our (Brent) oil price
forecast of USD 103bbl is quite conservative relative to
the current spot price of USD 92bbl. If prices were to
remain at current levels, our deficit forecast would be
about 0.6% of GDP lower. Equally, while we had been
anticipating tighter domestic liquidity conditions and
only a moderate recovery in domestic demand, this
squeeze could well be tighter than we envisage. In this
case, GDP growth would likely drop below 3%. The
silver lining in this cloud would be reduced imports and
a lower current account deficit.
Robert Burgess, London, +44 20 7547 1930
Government debt 1
Domestic
External
Total external debt
in USD bn
General (ann. avg)
Industrial production (YoY)
Unemployment (%)
Policy rate (repo)
Overnight lending rate
Effective funding rate
10-year bond yield
TRY/USD
8.25
11.25
8.53
9.50
2.29
(1) Central government
Source: Deutsche Bank, National Sources.
Page 110
9 October 2014
Ukraine
Caa3(negative)/CCC(stable)/CCC(negative)
Moody’s/S&P/Fitch

Economic outlook: Ukraine faces significant
difficulties on both the growth and inflation fronts.

Main risks: A weak external position could be
exacerbated by political uncertainty.
Macroeconomic challenges persist
to be adopted and financed from the budget. At the
same time, according to Alexander Zakharchenko,
leader of self-proclaimed Donetsk Republic, the proRussian forces welcome the steps undertaken by Kiev,
but will insist on the granting of independence for
Donbas. The Presidential elections in the republic are
set for 2 November.
In August and September, Ukraine’s economy
continued to weaken with economic decline
exacerbated by currency weakness and mounting
inflationary pressures. On the political front, the deescalation process continued to take place in the
Eastern Ukraine with the cease-fire being broadly
maintained along the front line, except for some
clashes in the vicinity of the Donetsk Airport. Going
forward, the political landscape is replete with
elections: Ukraine’s parliamentary elections on 26
October; Donetsk People’s republic elections on 2
November, while Kyiv set the date of local elections in
Donetsk for 7 December.
The Rada also ratified the economic part of the FTA
agreement with the EU. The new agreements will
replace the current Partnership and Cooperation
Agreement Ukraine signed with the EU in 1998.
According to the agreement, the economic integration
itself will be postponed until end-2015 with the country
obtaining the right to continue duty-free trade with CIS
states, including Russia in 2015. Starting from 2016
Ukraine is set to begin economic integration with the
EU. At the same time, Ukraine will benefit from a
unilateral cancellation of duties by the European Union,
which is to be applied by the EU until end-2015.
On 5th September the cease-fire agreement was
signed by the Minsk contact group (leaders of the
Donetsk and Luhansk self-proclaimed republics,
second president of Ukraine Leonid Kuchma, Russia’s
Ambassador to Kyiv Mikhail Zurabov and OSCE
representative Heidi Tagliavini) consisting of twelve
points, including establishment of immediate ceasefire,
release of all hostages and illegally detained persons,
withdrawal of all illegal armed groups and military
equipment from the territory of Ukraine; conduct
decentralization of power via provision to the Donetsk
and Luhansk regions of a special status and provision
for OSCE the right to monitor and verify the ceasefire
regime. The contact group gathered for the second
time on 19 September to sign a memorandum on the
implementation of the cease-fire agreement of
Ukraine’s President Petro Poroshenko and proposals
made by Russia’s President Vladimir Putin. In addition
to the first agreement, both sides agreed establish a
30km buffer zone withdrawing heavy weaponry and
mines and explosives from that zone.
Later the deal was accompanied by Rada’s adoption of
a set of laws which set the basis for a resolution of the
conflict in Eastern Ukraine, which: (1) grants autonomy
to the region for a period of three years with local
authorities deciding on a wide range of social,
economic and security issues as well as electing
prosecutors and judges; (2) guarantees the right to use
and study Russian or any other language in Ukraine; (3)
sets local elections in Donbass for 7 December; (4)
provides a special economic regime in the region with
a special target program on development of the region
On the economic front, industrial production continued
its free fall declining by 22% in August after -12.1% yoy
in July and -5.0% yoy in June. Construction, a proxy for
fixed assets investments, declined by 37% yoy after 31% in July and -25% yoy in June. Agriculture
appeared to be the only sector among abovementioned
posting positive growth of 6.3% yoy over 8M. On the
consumer side, retail sales continued to deteriorate: 5.8% yoy in 8M14 after -3.2% yoy in 7M14, with the
downward trend partly coming on the back of the
decline in real wages. Unemployment decreased
marginally to 9.0% in June after 9.3% in 1Q14 vs. 7.7%
in 4Q13.
In terms of monetary conditions, consumer price
growth accelerated again to 0.8% mom in August after
0.4% mom in July. On a yoy basis, CPI increased to
14.2% yoy in August after 12.6% yoy. Meanwhile,
money supply growth accelerated to 18.3% from
11.1% yoy in July. The key concern on the inflation
front remains the significant depreciation of the hryvnia
reaching the level of UAH/USD14.5 by the end of
September (75% yoy). Since then it stabilized at the
level of UAU/USD13.0 by the beginning of October on
the back of the launch of the fx auctions on the
interbank market. The NBU in its monetary policy
guidelines expects GDP growth in 2015 at 1.0% yoy
(this year it projects a decline of 6.5% yoy), and an
inflation rate of 9% yoy after 19% yoy projected for
2014.
On the fiscal front, the state budget continued to run a
deficit, with revenues at UAH231bn vs. expenditures at
Page 111
9 October 2014
USD266bn over 8M14, increasing the deficit to
UAH35bn. Revenues increased primarily on the back of
proceeds from the NBU and royalties UAH22.8bn in
8M14; tax revenues were down with the most
pronounced decline witnessed in VAT (-4.1% yoy in
8M14) and profit tax (17.4% yoy). As for next year, the
government adopted a draft of 2015 state budget,
which guides for a decline in the deficit to 3.5-3.7%
GDP from 4.5% GDP projected this year.
On the external front, Ukraine’s CA deficit marginally
widened to USD2.7bn in 8M14 vs. USD9.0bn in 8M13.
After obtaining sizeable external financing from the IMF,
EU and WB in the official reserves position improved to
USD17.9bn at end-May. However, the reserves
declined significantly from those levels to USD16.1bn
in end-July. The country actively increased its external
debt position over past several months with direct
external debt increasing by 8% ytd to USD30.2bn,
while overall sovereign debt (including state
guarantees) increased by 6.5% to USD40bn.
As for the forthcoming redemptions, according to the
NBU Ukraine is to pay USD2.1bn in the fourth quarter
of this year, which could be offset by the next tranche
of the IMF with the next disbursement expected by
December 2014. Overall, after paying out USD1.6bn of
Naftogaz Eurobonds in October there are no major
peaks in debt payments the forthcoming months of this
year. At the same time, there is a risk of early claims
from Russia for redemptions of USD3bn Eurobonds,
which were issued in December 2013. The early
redemptions could take place in case Ukraine exceeds
the limit of 60% GDP of external debt. The monetary
authorities expect this issue to be raised not earlier
than 2Q15 given that the official data on full year
nominal GDP will be released not earlier than 31 March
2015.
Meanwhile, on the domestic political front, Ukraine is
preparing for early parliamentary elections scheduled
for October 26th. Polls conducted at the end of
September by Rating+ state favour Petro Poroshenko’s
block (23.7%), Lyashko’s Radical Party (7.1%), People’s
Front of Yatenyuk and Turchynov (4.3%), Hrytsenko’s
Civic Stand (4.2%), Tymoshenko’s Fatherland (4.1%),
Tyhypko’s Strong Ukraine (2.9%) followed by Svoboda
(2.6%) and Communists (2.3%). According to the poll,
the remaining parties are unlikely to overcome the 5%
level. According to the polls 10-20% of potential voters
are not intending to vote, while approximately 15-20%
have not yet decided whom to support.
Ukraine: Deutsche Bank forecasts
2012
National Income
Nominal GDP (USDbn)
Population (mn)
2013
2014F
2015F
176
45.5
3 887
176
45.4
4 024
116
45.0
2 587
121
45.0
2 677
0.3
11.7
2.2
- 7.7
1.9
0.0
6.5
2.3
- 6.5
1.2
- 6.9
- 5.7
- 1.2
- 3.1
- 6.2
0.5
0.4
- 0.5
- 1.6
- 5.2
CPI (eop)
- 0.2
0.5
CPI (period avg)
0.5
- 0.3
Broad money (eop)
12.0
17.6
1.7
11.7
17.2
10.3
13.1
9.6
11.4
12.8
9.5
5.8
Overall balance
- 3.6
Revenue
23.5
Expenditure
26.0
- 4.5
24.2
28.7
- 5.5
24.6
30.1
- 4.5
23.6
28.1
Trade Balance
- 19.5
% of GDP
- 11.1
Current Account Balance - 14.3
% of GDP
- 8.2
FDI (net)
6.6
FX Reserves (eop)
24.5
USD/FX (eop)
8.05
- 19.6
- 11.2
- 16.4
- 9.2
4.3
20.4
8.24
- 7.9
- 6.5
- 3.6
- 3.0
- 2.3
15.0
13.00
- 8.2
- 6.3
- 2.7
- 2.1
- 1.5
17.3
14.50
28.4
14.8
22.0
75.5
135
36.7
14.7
22.0
79.8
140
62.0
17.7
44.3
105.7
123
74.0
20.8
53.2
107.1
129
- 0.7
8.1
- 4.3
7.2
- 10.1
10.0
- 4.2
9.2
Real GDP (YoY%)
Private Consumption
Government
Exports
Imports
Debt Indicators (% of
Government Debt
Domestic
External
External debt
in USD bn
General (ann. avg)
Industrial Production
Unemployment (%)
Current
Financial Markets
Policy rate (refinancing
USD/UAH (eop)
12.50
12.95
14Q4F
12.50
13.00
15Q1F
12.50
13.30
15Q3F
12.50
13.80
Source: Official statistics, Deutsche Bank Global Markets Research
Yaroslav Lissovolik, Moscow, +7 495 933 9247
Artem Zaigrin, Moscow, +7 495 797 5274
Page 112
9 October 2014
Argentina
Ca (stable)/SDu (stable)/RD (stable)
Moodys /S&P/ /Fitch

Economic outlook: We rule out a negotiated
solution with holdouts as the government seems to
be planning just muddling through until the
presidential election next year. Lack of external
financing,
however,
has
triggered
more
expansionist
policies,
exacerbating
existing
disequilibria and deepening the recession while
accelerating inflation. The question remains
whether the government underestimates the
economic and social repercussions of those policy
decisions. These repercussions notwithstanding,
strong ideological biases together with the need to
preserve a political mandate for an opposition role
seriously limit President Cristina Fernandez de
Kirchner’s (CFK) ability to take a more constructive
course.
Main risks: Continued deterioration of the
economic situation seems the most likely scenario,
in our view. The possibility of more restraining
orders from the NY court could worsen the outlook,
but might help the government preserve
international reserves. Without a resolution to the
holdout litigation, a recession with high inflation
would test the government’s political will, while a
financial stress could remain a permanent threat.
Partial access to the Chinese currency swap, plus
some minimum rollover of Boden 15 amortization
could buy necessary time, but without avoiding a
risky and fragile economic and social backdrop.
Neglecting legal and economic principles
Holdouts “will not pass”, for now at least
The Economic Minister´s, Axel Kicillof, metaphor that
“holdouts will not pass” suggested the authorities´ final
intention to associate this litigation to a patriotic epic.
This was just reaffirmed in the last few weeks, as it has
become increasingly clear that the government does
not have any intention to negotiate with holdouts, not
even in January, or after the so-called rights upon
future offer (RUFO) clause were to expire.22 As we have
noted, this is working politically for the time being, as
recent opinion polls continue to show support from the
population against any unconditional agreement or
capitulation with “vulture funds”. In addition, it has
helped the government regain the center of the policy
spectrum, both locally and internationally. This has
been particularly important for the authorities, who
have been recently hostage of high inflation and low
growth, the vice president’s corruption scandals and
22
Interestingly the local press has continued reporting the possibility of a
deal early next year, as noted in the first page of the local newspaper Perfil
on Sunday October 5, or previous editorials in La Nacion.
investigations, as well as the fading fortune of longlasting regional allies Venezuela and Brazil. The
government’s effort to bring the debt discussion to the
United Nations is noteworthy, where President CFK
seemed to enjoy the spotlight, taking the opportunity
even to criticize the US external policy affairs without
obtaining any clear benefit for Argentina.
The political strategy behind the holdout stance
probably factors in CFK’s future role in the opposition.
The president´s determination to supposedly defend
Argentina´s interests against the predators is quite
appealing given her plans to maintain a key position
after the elections next year. This is particularly the
case for a government facing only temporarily the
financing blockade that such strategy implies (until
next October). This notwithstanding, the economic cost
is not negligible, even in the short term, and such a
trade-off will essentially define the government sticking
with the current stance or adopting a new stance at
some point next year.
Meanwhile, the government continues to search for
alternative ways to pay its restructured debt. A few
days ago, Congress passed the law that replaces Bank
of New York with Nacion Fideicomisos SA as the new
fiduciary agent for restructured bonds. The law also
allows for the possibility of a swap to voluntarily switch
the law governing the bonds to either Argentina or
France. In addition, it calls for a new restructuring offer
for the remaining 7.6% holders of the original defaulted
debt under similar conditions than in 2005-2010. The
law establishes that the government will deposit in a
special account all funds equivalent to the normal
servicing of the new debt offer to holdouts. This money
could be accessed any time holdouts agree to accept
the restructuring conditions. The latter is probably the
only constructive innovation in this new attempt to
handle the holdouts’ default.
Simultaneously, the authorities also had partial success
freeing payments of restructured debt under the
Argentine law. After a number of court hearings, Judge
Thomas Griesa decided to let Citibank and JP Morgan
proceed with all payments of restructured debt under
Argentine law scheduled for the past September 30
(Par bonds). As it happened with the payments of
Discounts Argentine law in June, Judge Griesa´s
approval just applied to the September payment. This
notwithstanding, the Judge has stated his intention to
find a permanent decision within 30 days. It is
noteworthy, however, that Judge Griesa said in the
previous hearing with Citibank on September 26 that
Argentina´s law bonds should be treated differently
from those covered by the February 23, 2012 Court
order.
Page 113
9 October 2014
As we have repeatedly noted, our interpretation is that
the Argentine law bonds, including restructured debt,
should not be treated in accordance with the paripassu injunction simply because they do not constitute
external
debt.
The
judge’s
hesitation
about
permanently freeing those payments is worrisome
nonetheless, as it indicates the judge’s objective to
eventually broaden the reach of the exiting court order
against Argentina. A number of analysts have actually
raised their concerns about this possibility. The main
question remains the interpretation whether these
bonds were exclusively offered to local investors, as
necessary for not being considered external debt. In
our view, it could be argued that this was the case for
non-restructured debt, as such bonds were never
offered in any public tender offshore. On a similar logic,
it could also be sustained that restructured debt was
mostly reissuance of local debt. Needless to say, it will
be for the Court to decide.
Actually, few hours after allowing the September 30
debt payment for Argentine law bonds, Judge Griesa
announced that he was holding the Republic in civil
contempt, but reserved determining the associated
sanction for the time being. The court concluded that a
civil contempt citation was appropriate, pointing to the
Republic's efforts to remove Bank of New York as the
indenture trustee and effectively attempting to
progress with a debt swap to avoid obeying the court
ruling regarding exchanged bonds. As a practical
matter, there appear to be limited implications to the
court holding the republic in contempt. At this stage,
plaintiffs demanded a fine of $50,000 a day to be
imposed on the republic as well as the attorneys' fees
related to plaintiffs' applications due to the republic's
allegedly contemptuous conduct. In light of the billions
under discussion, the potential fine and award of
attorneys' fees does not seem particularly material. The
main implication of this decision appears to be putting
those non-parties that interact with Argentina or
receive payments originating from the republic on
notice that the court could find them in contempt too.
As suggested above, the Argentine authorities,
however, appear to be too optimistic about the
possibility of bypassing the US court blockade. This
remains surprising as the ruling is definite, and any
international effort to address it would only weigh on
future restructurings but not Argentina´s existing case.
Alternatively, the Argentine government might well be
underestimating the true economic effect of the default
and further isolation from international markets. In our
view, the government could be successful at reducing
the scope of the current default, but this is unlikely to
open financial markets for Argentina. Therefore, credit
rationing should be expected to continue until a final
and comprehensive resolution is found, exacerbating
existing fiscal and monetary disequilibria in the country
for now.
Page 114
Price action in Argentina´s financial markets has also
suggested some degree of confidence in a rapid
resolution on the debt front. Restructured bond prices
have fallen from their peaks after the technical default
was confirmed, but have remained in the 80s, implying
tighter yields than the performing Venezuela, for
instance. This probably denotes that the current default
in Argentina does not manifest a solvency problem, in
particular just 12 months ahead of a presidential
election that is expected to bring significant
improvement into economic policy making. As noted, a
full settlement with all holdouts could cost about
USD15bn, representing just 3% of GDP, rapidly paid
back at much lower financing costs. Benign market
pricing has also reflected a special distribution of the
holdings of restructured debt, mostly held in the strong
hands of distressed US and EU funds. However, an
inevitable decline in international reserves might test
investor conviction as we approach extreme liquidity
levels, as we discuss below.
The solid solvency backdrop of Argentina, with just
20% of GDP in public debt net of public institutions
holdings, is at the same time the most fundamental
reason why private sector alternatives to settle the
current debt negotiation are rather unlikely. This simply
fails to create the proper incentive to mobilize private
efforts as the sovereign does not seem to need any
special contribution, exacerbating the free ride motive
to reject participation in any of these resolutions.
Financing will not take place, as needed at least
Absent any improvement in external financing, we
believe Argentina’s economic performance will
continue to deteriorate. Increased demand for dollars
and the recent widening of the gap between the official
exchange rate and non-official rates is the best
reflection of the worsening economic and financial
outlook. At the time of going to press, the non-official
exchange rate was above ARS/USD 15.00, compared
with 8.48 for the official rate (and 14.30 last month),
pushing the gap back to a historic high. In reaction,
President CFK accused a number of financial
institutions for speculating in the market facilitated by
the central bank’s apparent inaction or failure to
control. As a consequence, central bank governor Juan
Carlos Fabrega resigned and President CFK named the
head of the local SEC, Alejandro Vanoli, as the new CB
governor. Although Mr. Fabrega was considered a loyal
member of the government, as the central bank
governor he was known to oppose some of the policy
inconsistencies promoted by the economy ministry.
Meanwhile Mr. Vanoli has been instrumental in using
the renewed powers at the SEC to investigate and
tighten the overall auditing of private corporations.
Therefore, Mr, Fabrega´s departure as well as Mr.
Vanoli´s stepping in likely ensure policy continuity but
more controls to counteract the effects of easier
financing with growing inflationary expectations and
exit from peso demand.
9 October 2014
The very first decisions of the new central bank
governor partly confirmed market participants´
anticipation of what this change in command meant.
Specifically, the suspension of Mariva Bursatil S.A.,
accused by President Kirchner of apparent speculative
trades on the exchange rate market, together with
tighter controls in the non-official exchange rate market,
confirmed the expected bias of the new monetary
authorities, bringing some nervous tranquility in the
dollar market this week. These decisions were made
following the power now granted by the new Capital
Market Law. They also affected Balanz Capital, now
under investigation by the SEC and the Financial
Information Unit (UIF) or money laundry watch dog.
Meanwhile, during the first few days of the new
monetary authorities the main equity index fell more
than 10%, followed by a sharp contraction in Argentine
ADRs in Wall Street. Similarly, the demand for dollars
under the 20% of income allowance reached a new
peak, anticipating about USD3.5bn demand a year if
this trend were to continue.
Another decision by the new authorities at the central
bank was to impose a floor on interest rates for time
deposits, directly linking them to the rates in CB letters.
This implementation implies that 30 day deposit rate
will increase to 23%, from 18% currently, while Lebacs
for similar tenor stay at 26%. A similar direct
relationship was also introduced on longer tenors,
explicitly limiting banks’ benefits. Earlier, the central
bank had introduced ceilings for rates on lending to the
private sector. Therefore, the new strategy at the
monetary authority seems totally consistent with the
government’s economic policy bias, which is to control
private sector benefits as a mean to restrain inflationary
pressures without reducing existing demand stimulus.
All this notwithstanding, after all possible debt
payments are made, international reserves are likely to
dwindle further to less than USD16bn by December
2015. Such a low level of reserves (USD6.0bn net after
excluding holdings from private banks) might not
represent a sufficient condition for market stress, but
the policy tightening to achieve that certainly
anticipates a significant economic recession. This
projection, for example, assumes that current
allowance to buy up to 20% of income for hoarding will
be restricted early next year to less than half, otherwise
demanding almost USD4.0bn just for that demand item.
Therefore, it is not surprising that the Argentine
government is trying to accelerate the disbursement of
a couple of financing commitments agreed with
Chinese authorities. These included the first
USD500mn tranche of financing for hydroelectric
projects, together with the possibility of a first
disbursement under a renewed currency swap, for
USD700-800mn, mostly to finance part of the
USD5.2bn trade deficit Argentina currently has with
China. The government is still working on the details of
the swap execution but this is unlikely to permit full
disbursement of more than USD10bn committed. In
addition, the planned auction of G4 mobile network,
that was expected to bring USD1.5bn-USD2.0bn, is
now being questioned in the local justice, which could
probably delay the process few months at least, or
even after the new government is elected in October
next year.
Balance of payment projections (cash basis, USDmn)
Current account
Trade
Expo
Argentina’s International reserves holdings were
USD28.0bn on September 26, 2014, day of the last
public record. As discussed, it is reasonable to expect
further depletion of its international reserves, in the
order of USD1.0bn a month. This suggests
international reserves could fall below USD25.0bn in
December 2014 but including some USD1.3bn of debt
services not paid (because of the US court blockade),
which explains the meaningful fall in the services line
of the current account in the table below. In 2015, the
public sector debt services amount to USD14,400mn,
of which USD10.2bn are capital amortization, including
those for the Province and the City of Buenos Aires, but
excluding multilaterals. The pari-passu injunction
implies the forced “refinancing” of almost USD1.5bn.
Likewise some partial rollover of the Bodens 15 coming
due next October could help reduce this service burden
a bit more. Similarly, partial use of the Chinese FX
swap could be incorporated in the equation, as well as
some improvement in the trade balance due to the
economic recession.
Impo
Services
2012
2013
2014F
2015F
3,866
-13,277
-7,823
-6,433
14,673
1,745
1,800
3,100
-5,000
-4,500
-4,623
-5,033
80,772
75,250
66,099
73,505
-3,825
-9,403
Expo
10,059
8,397
Impo
13,884
17,800
-7,594
-5,886
Rents
Net interest
Profits and dividends
Other transfers
Capital account
FDI
In the country
Offshore
Portfolio investment
Financial loans and credit lines
Multilateral and bilateral organizations
External assets, non financial private sector
External assets, financial sector
Others public sector
Others
Change in international reserves
-7,369
-4,523
-225
-1,363
611
267
-7,171
1,452
1,800
-2,800
3,744
2,413
3,500
2,500
3,976
2,586
232
173
-112
-3,096
-1,757
-3,404
-190
-1,583
-638
-37
-3,326
-1,882
397
70
696
3,168
1,000
-1,000
-3,500
700
100
1,000
1,000
-800
-1,300
1,000
-6,700
1,500
-3,305
-11,825
-6,023
-9,233
43,290
30,828
24,805
15,572
Source: BCRA, and Deutsche Bank
However, the Argentine government needs to also deal
with declining soybean prices and unfavorable
conditions for agriculture production and exports. A
strong peso and restrictions to buy dollars are creating
hurdles for a pick-up in exports. Argentina’s
international trade fell significantly this year, although
Page 115
9 October 2014
partly affected by the overstated numbers in 2013.
Nevertheless, between January and August, exports
and imports decreased 12% and 10% respectively. This
explains the 9% contraction reported in the trade
surplus so far this year. Manufacturing exports fell 13%,
mostly reflecting weak Brazilian demand and growing
competitiveness problems. Likewise, despite a good
harvest, agriculture exports contracted 26% over the
period. Only manufacturing from agricultural origins,
mostly derivates from soybeans, are up on the year.
For next year, the outlook does not seem much better,
with protracted and subdued growth in Brazil, a similar
harvest or worse than in 2014, and increasing
competitiveness disadvantages as well as likelihood of
dollar- or crop-hoarding. On the positive side, the
energy deficit should remain mostly unchanged at
about USD6.0bn due to the ongoing economic
recession as energy exports have been falling at 8%
annual pace as of August. Based on all of the above,
this year, the trade surplus could be even lower than
the USD8.0bn reported by the official Institute of
Statistics (INDEC) during 2013. Thus, a small increase
is likely in the trade surplus during 2015, to USD9.4bn,
explained by a bigger contraction in imports than
exports.
Policy makers keep ignoring reality
As we have discussed repeatedly, any improvement in
economic performance in the months ahead demands
policies that support nominal equilibrium given
available financing resources. Unfortunately, these
appear to be incompatible with the government’s fiscal
and monetary stances. Alternatively, the external
financing outlook should improve dramatically, but that
is ruled out by the pending legal issues with holdout
investors. Indeed, the latter news on the debt case
turned around the incipient rebuild of confidence that
had started with the January devaluation and the debt
agreements reached with Repsol and the Paris Club.
Thus, absent a rapid resolution to the holdout demand,
we expect only a deepening of the current economic
recession. Alternatively, albeit unlikely at this stage, a
holdout agreement could open external financing,
while the prospect of a new government and new
policies beginning in October of next year could fuel a
rapid and more dynamic recovery.
Against the current backdrop, everything appears to be
pointing to high inflation in a recessionary environment.
In addition, recent policy decisions by the government
have only aggravated this worsening economic reality
as macro impulses collide with external constraints and
increased intervention further deters investment. Thus,
while fiscal accounts deteriorate further, inflation is
only contained by temporary exchange rate stability
and an economic slump, but remaining relatively high,
further fueling competiveness problems and the need
for import rationing and recession.
Page 116
Confirming current driving forces on economic policies,
the public sector reported a total primary surplus of
ARS767mn in July, compared with a surplus of
ARS803mn in July 2013, denoting a clear reduction in
real terms if a 40% YoY inflation is taken into account.
Total deficit in July was ARS1.2bn but shoots up to
ARS10.4bn if rents on assets from the social security
(ANSES) and the central bank are netted out. Total
revenues were up 40.4% YoY in July, led by income
taxes, VAT, and export taxes, while primary spending
increased by 39.5%. July´s figure brings the
accumulated primary surplus this year to ARS2.9bn,
but incorporating ARS60.7bn from ANSES and central
bank rents as revenues. Without these revenues, the
accumulated total deficit in fact touched ARS99.1bn by
July this year. This is in line with our projection of a
deficit of almost 5% of GDP once these exceptional
revenues are excluded.
The 2015 budget draft presented by the government a
few days ago anticipates more of the same regarding
policies, i.e. they utterly neglect the ground reality.
Assuming 2.8% growth and 15.6% inflation, the budget
for next year envisages an important improvement
compared with current projections for 2014, even with
respect to official sources that project growth of 0.5%
and inflation of 21.3%. It is worth recalling the original
2014 budget included a 5.2% growth projection and a
10.4% inflation expectation. In addition, the 2015
budget draft projects ARS/USD parity of 9.45, from an
average projected at 8.21 for the whole 2014, or from
an average of 7.96 so far this year. It also factors in
exports reaching USD82.4bn next year from an
estimated USD76.9bn this year, while imports are
projected to be USD73.2bn compared with USD69.4bn
projected for 2014.
Turning to the fiscal exercise, the budget draft
envisages a total deficit of 1% of GDP, with total
spending being 27.2% of GDP, of which 35.5% would
be allocated to social security. The document did not
specify the expected fiscal outcome for this year, but it
will certainly be much worse than the 1.2% of GDP
deficit projected initially. According to our estimates,
the total deficit next year as measured by the
government will be 3.1% of GDP (5.3% of GDP once
rents from assets incorporated as current revenues
from the CB and ANSES are excluded).
The chart below properly reflects the challenge the
current government policies increasingly face.
Specifically, monetary base has been growing less than
inflation since early this year, partly helped by some
increased issuance of central bank paper, representing
the mirror image of declining demand for pesos as
inflation accelerates. Therefore, instead of facilitating
government financing, increasing inflation is eroding
peso demand and central bank financing of public
sector deficit. In other words, the government´s
obsession to keep fueling demand growth with
expansionary policies is progressively encountering
limits to its own continuity.
9 October 2014
Continued slowdown in credit growth despite steady
demand stimulus and stable or accelerating inflation is
another indicator of increasing lack of effectiveness of
the current policy strategy. During September, banking
credit to private sector increased 21.5% YoY, similar to
the pace recorded during August, confirming inability
of credit to keep up with inflation. Likewise, private
sector deposits grew by 21.4% YoY, or below the
28.9% recorded in August and the 29.7% in July.
Falling peso demand reflects limits to stimulus
600
500
400
Monetary Base (NSA, bn.Pesos)
BCRA notes and bills- mn.pesos
CPI Jan 2013=100
CPI Jan 2013=300
300
200
100
September, the honesty attribute ranked the best,
while efficiency was the worst performer. In a metric
from 0 to 5, general evaluation is currently at 1.50,
general interest at 1.53, efficiency at 1.36, honesty at
2.20, and capacity at 1.95. Last year, capacity was the
perceived attribute that fell the most, by 11%.
Furthermore, the UTDT also reported its new
preliminary indicator of consumption decreased 2.3%
MoM in September, or recording a 7.9% annual fall.
The index measures changes in consumption at
constant prices in commercial centers in the Buenos
Aires area.
Economic recession to worsen
30%
20%
15%
20%
10%
10%
5%
0%
0%
0
-5%
-10%
Source: Congress, Central Bank, and Deutsche Bank
-15%
-10%
EMAE, YoY 3m MA
IPI FIEL, YoY 3m MA
-20%
As a result, it is not surprising that economic activity
continues to struggle. INDEC reported that economic
activity was unchanged in July with respect to the level
reached in July 2013. On a monthly basis, seasonally
adjusted activity advanced 0.1%, but has failed to
register cumulative growth so far this year. Likewise,
INDEC also reported that industrial production was
down 2.9% YoY and 1.3% MoM, seasonally adjusted in
August, while construction activity also showed
negative growth, at -2.6% YoY and -2.3% accumulated
so far in 2014. According to the private think tank FIEL,
industrial output fell 9.7% YoY during August, or 5.1%
so far this year. Furthermore, INDEC informed that
supermarket and shopping sales advanced 37.9% and
26.3% YoY, respectively, in August too, implying a
significant decline in real terms. Shopping sales
underperformed inflation for a third consecutive month
in August after accumulating almost a 35% annual
increase in the preceding months.
Consumer confidence and overall sentiment also
continues to worsen. The University Torcuato Di Tella
reported that its consumer confidence index fell by
5.4% MoM and 14.7% YoY in September. The index fell
across components and in all regions of the country.
This was the first fall after a few months of steady
improvement, although from a very low level based on
a historical perspective. The UTDT also reported that
their index of government confidence fell 6% on the
month in September, on top of another 3% decline in
the month of August. In terms of annual comparison,
the index remained 4% below September’s level last
year. The index measures five attributes, namely
general evaluation, general interest, capacity, efficiency,
and honesty, among 1,200 participants in the survey. In
-20%
Tax Revenue (CPI adj), YoY 3M MA, rhs
-30%
Source: INDEC, FIEL, and Deutsche Bank
INDEC also reported a slight increase in unemployment
to 7.5% during 2Q 2014, from 7.1% in the first quarter
and 7.2% last year. However, this apparent stability
hides a fall in employment and activity of an almost 2
percentage points in 12 months. Therefore, based on
the labor supply of last year, unemployment this year
would reach almost 10%.
Despite the weakening economic outlook, INDEC
reported that inflation stayed at 1.3% monthly in
August. This was the second time of inflation
remaining high after six months of steady slowdown in
consumer price increases. According to the official
consumer index at the national level, year-to-date
inflation is 18.2%. Simultaneously, opposition members
of Congress reported that inflation in the City and Great
Buenos Aires area had accelerated to 2.67% in August
from 2.47% in July, and from 2.3% and 2.2%,
respectively, in May and June. This privately estimated
inflation pegs the number at more than 26.5% so far
this year, representing an annual rate of 40%.
While keeping an expansionary fiscal and monetary
stance, the government has continued to promote a
new consumer defense law that might help contain
inflation and increase unemployment. This, however, is
likely to further deter investment as the draft law grants
significant discretionary power to the government to
force price stability and even the continuation of a
business facing losses.
Page 117
9 October 2014
October 2014 remains the main anchor for stability
President CFK´s decision to replace the central bank
governor not only confirmed her total confidence in the
Minister of Finance, but also the end of an alternative
command in case this was demanded. Such a turn for
an unhedged strategy was not well received by market
participants as reflected in the consequent asset price
action. Notwithstanding, implied valuation of asset
prices continues to reflect expectations for an eventual
and positive change in economic policy making.
We have repeatedly noted the critical role presidential
elections due next year will play in Argentina´s credit
consideration. The legal impediment for President CFK
to seek re-election is an important anchor regarding
expectations for a change. However the very same
negative economic outlook is also working as an
endogenous but stabilizing force. Without private and
public leverage in the economy, lack of investment for
many years, and still abundant natural resources,
Argentina has potential for a rapid and significant
turnaround as soon as polices were to change for good.
The latest opinion polls fail to show any clear
leadership ahead of the presidential election next year.
Likewise, they still report up to 50% support for some
policy continuity. This notwithstanding, all three main
leaders – former Chief of Cabinet Sergio Massa,
Buenos Aires governor Daniel Scioli, and BA City
Mayor Mauricio Macri – as well as any potential
presidential candidate from the center-left alliance
UNEN, are believed to be supportive of policy
improvement in one way or another. However, recent
economic misfortunes have helped to increase public
support for BA City Mayor, who is correctly perceived
as the main reformer in our view. Based on our
negative economic outlook, it is reasonable to expect
this trend continuing in the months to come, further
adding to a potentially positive terminal condition.
The government confirmed the election schedule: the
presidential election will take place on Sunday October
25, 2015, and Sunday November 24 for a run-off
election in case it is needed. The same calendar sets
for August 24, 2015 as the date for the primary
elections within competing political parties.
Gustavo Cañonero, New York, (212) 250 7530
Argentina: Deutsche Bank forecasts
2012
2013E
2014F
2015F
492
41.0
12.0
510
41.5
12.3
456
41.9
10.9
453
42.4
10.7
1.1
4.4
6.7
-11.1
-5.6
-4.4
2.9
4.6
5.5
1.2
1.7
9.3
-2.3
-3.2
3.3
-5.6
-9.3
-11.2
-2.8
-3.7
3.4
-8.3
-2.8
-8.5
CPI (YoY%, eop) (*)
CPI (YoY%, avg) (*)
Broad money (M2, YoY%)
Bank credit (YoY%)
25.2
23.9
34.3
30.8
27.9
25.3
24.0
31.3
39.2
38.3
22.0
22.0
39.1
39.4
20.0
20.0
Fiscal Accounts (% of GDP)(**)
Budget surplus
Gov't spending
Gov't revenue
Primary surplus
-3.9
32.5
28.6
-1.5
-4.6
34.2
29.6
-2.8
-4.9
34.0
29.2
-3.2
-5.3
34.0
28.8
-3.6
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net, cash basis)
FX reserves (USDbn)
FX rate (eop) ARS/USD
80.9
68.5
12.4
2.5
-0.1
0.0
3.7
43.3
4.92
81.7
73.7
8.0
1.6
-7.0
-1.4
2.4
30.8
6.52
73.3
65.2
8.1
1.8
-6.3
-1.4
3.5
24.8
9.21
70.5
61.1
9.4
2.1
-1.9
-0.4
2.5
15.6
12.41
Government debt
Domestic
External
Total external debt
in USDbn
19.2
5.9
13.3
28.6
140.9
36.9
19.1
7.2
11.8
26.6
135.8
38.3
21.6
8.2
13.3
29.9
136.3
38.2
21.5
9.5
12.1
28.7
130.1
40.0
General
Industrial production (YoY)
Unemployment (%)
-1.2
7.2
0.8
7.1
-4.8
7.7
-4.9
8.5
Current
14Q4
15Q1
15Q3
26.8
23.0
8.45
27.0
23.1
9.21
28.0
23.8
10.40
29.0
25.1
11.75
National Income
Nominal GDP (USDbn)
Population (m)
GDP per capita (USD thousand)
Real GDP (YoY%)
Priv. consumption
Gov't consumption
Exports
Imports
Financial Markets (EOP)
98ds Lebac rate
1-month Badlar
ARS/USD
Source: DB Global Markets Research, National Sources
*Inflation reported by Congress, **Central government
Page 118
9 October 2014
Brazil
Baa2(negative)/BBB-(stable)/BBB(stable)
Moody’s/S&P/Fitch

Economic outlook: Economic activity remains
sluggish amid a steep decline in confidence caused
by interventionist economic policies, high inflation,
and fiscal policy deterioration. Although slow
growth prevents the central bank from raising
interest rates to fight inflation, pressure on the
currency could create a serious dilemma for the
authorities. A recovery in confidence and growth
will hinge on a credible fiscal adjustment that
supports the central bank’s efforts to rein in
inflation at the same time that the authorities allow
a re-alignment of regulated prices.

Main risks: Without a credible fiscal adjustment
after the elections, Brazil could be downgraded in
2015 and perhaps even lose the investment grade.
Higher interest rates abroad could lead to further
currency depreciation and even slower domestic
growth.
All eyes on the elections
Aécio Neves (PSDB) will challenge President Dilma
Rousseff (PT) in the presidential election runoff on
October 26. Neves staged an impressive rally in the last
days before the first-round vote on October 5, not only
overtaking Marina Silva (PSB), but also significantly
cutting into President Rousseff’s lead. The president
obtained 41.6% of the valid votes, while Neves got
33.6%, and Silva obtained only 21.3% (just slightly
more than the 19.3% she received in 2010). There was
a large discrepancy between the votes that Neves
received and the opinion polls. The Datafolha poll
published one day before the voting, for example, had
indicated Rousseff with 44%, Neves with 26% and
Marina with 24% of the valid votes. After rising
dramatically in the polls following the plane crash that
killed candidate Eduardo Campos on August 13, Silva
was not able to withstand the aggressive criticism
leveled by her opponents (especially the PT), and fell
steadily. Silva’s decline in the polls probably produced
a “self-fulfilling prophecy” effect: as it became
increasingly clearer that she was not going to make it,
the anti-PT voters who had planned to vote for her
switched to Aécio Neves, who had strong momentum.
In her concession speech, Marina Silva hinted that she
might support Neves, as she claimed that society
clearly showed a demand for change in the polls.
Moreover, the economic proposals presented by both
candidates are similar. While we expect Silva to
support Neves, it remains to be seen whether formal
support will translate into a significant number of votes.
Based on Sunday’s final numbers, Neves will have to
attract approximately 70% of those who voted for
Marina to win the election. According to a Datafolha
poll conducted before the first round, 59% of Marina’s
voters said they would vote for Neves in the runoff. All
in all, the polls available at this juncture suggest that
Dilma remains the favorite to win. Moreover, the PT’s
powerful propaganda machine spared Neves in the first
round because its main priority was to crush Marina
Silva’s candidacy, which was accomplished quite well.
That said, it will probably be a very tight race, as Neves
has advanced to the second round in a much stronger
position than we had expected. The PSDB candidate
will have as much time as the president on TV from
now on, his marketing team is probably better than
Silva’s, and Rousseff is weaker than four years ago
(she fell from 46.9% in the first round of the 2010
elections, when the PSDB candidate José Serra
obtained 32.6% of the votes). The first-round
presidential elections occurred simultaneously with
congressional elections. The net balance was that the
current ruling coalition continued to have a majority in
the Senate (where it gained two seats) and in the
Lower House (where it lost 35 seats). However,
Congress will be much more fragmented, which could
make it more difficult for the next president to maintain
governability. The Lower House, for example, will have
representatives from 28 political parties in 2015.
Brazil: Business confidence
155
140
Services
Retail
Construction
Industry
125
110
95
80
Source: FGV
The economy is recovering slowly in 2H14. Industrial
production rose 0.7% MoM in August, exceeding our
forecast of 0.3% MoM and the market consensus
forecast of 0.1% MoM. Production had increased by
0.7% MoM in July as well, after falling in the previous
four months. Thus, despite the MoM gains in July and
August, production was still down 5.4% when
compared to August 2013. In the YoY comparison,
production of durable goods plunged 17.9%, capital
goods fell 13.4%, intermediate goods declined 3.3%
and non-durable consumer goods were down 3.1%
YoY. We still see a correction to the steep decline in
Page 119
9 October 2014
production observed in 2Q14, when the economic
slowdown was aggravated by the World Cup (a
rebound that is crucial for our 2014 GDP growth
forecast of 0.3% to materialize), but not a sustainable
recovery, as domestic and external demand remain
weak and business confidence stays depressed amid
the lingering uncertainty surrounding the elections and
future economic policies. We are keeping our 2014
GDP growth forecast at 0.4% for now, but have cut our
2015 forecast slightly to 1.0% from 1.2% due to the
continuing decline in business confidence and rising
uncertainty about the global economic environment
and domestic economic adjustment.
Unemployment is rising. Official statistics agency IBGE
has resumed publishing its complete employment
survey, which was interrupted by a strike that
prevented the institute from releasing part of the labor
market data in May, June and July. The seasonallyadjusted unemployment rate rose to 5.0% in August
from 4.6% in April, according to our calculations. As
we expected, job creation has decelerated so much
that the decline in labor participation is no longer
enough to prevent unemployment from rising. After
declining sharply between October 2013 and April 2014,
the participation rate stabilized at the end of 2Q14 and
rose slightly in August. Since we expect job creation to
remain subdued and do not see further decline in labor
participation, we expect unemployment to rise further –
albeit slowly – in the coming months.
The government continues to post disappointing fiscal
results and meeting this year’s fiscal target will be
extremely difficult. The public sector posted a largerthan-expected BRL14.5bn primary fiscal deficit in
August, the fourth consecutive deficit. The gap would
have been even larger had the federal government not
received BRL5.4bn in dividend payments from stateowned enterprises (mainly BRL3.0bn from BNDES and
BRL2.1bn from Caixa Economica Federal), as well as
BRL7.1bn through the REFIS tax amnesty program. The
consolidated primary surplus totaled BRL10.2bn in
8M14 (0.3% of the period’s GDP), compared to
BRL54.0bn in 7M13 (1.7% of GDP). In 12 months, the
primary surplus fell to 0.94% of GDP in August,
remaining well below this year’s 1.9% target. At the
federal level, nominal revenues climbed 7.4% YoY (led
by a 26% surge in dividends paid by SOEs) and
spending jumped 12.6% YoY (led by a 22.4% increase
in discretionary spending, including a 27.4% surge in
federal investment). Excluding dividends from SOEs,
concession revenues and other extraordinary revenues
(such as those from the tax amnesty program), the
public sector posted a primary deficit equivalent to
0.3% of GDP in the year to August. It is becoming
increasingly difficult for the government to close the
gap with extraordinary revenues. The REFIS revenues
were lower than expected in August, and will probably
not reach the BRL18bn amount anticipated by the
government this year. Also, the government sold
Page 120
telecom concessions for BRL5bn in August, less than
the official estimate of BRL8bn. In light of the latest
fiscal data and revision to the GDP growth forecast, we
cut our primary surplus forecast to 1.0% from 1.2% of
GDP for 2014, and to 1.6% from 1.8% of GDP in 2015.
While the 2015 budget sets a primary surplus target of
2.0% of GDP, it overestimates revenues by assuming
GDP growth of 3.0% next year. In our view, given
overall spending rigidity, the government will not be
able to significantly raise the primary surplus without
cutting investments and raising taxes, which are
always a hard nut to crack politically. In addition to
mending the budget, the government will have to act
on its quasi-fiscal policy, moderating the expansion of
subsidized lending by official banks. In our view, failure
to address these issues could prompt the rating
agencies to further downgrade Brazil’s sovereign debt
in 2015.
Brazil: Primary fiscal balance
5.0%
% of GDP, 12m
4.0%
3.0%
2.0%
1.0%
Target
Primary surplus
Adjusted surplus
0.0%
-1.0%
Source: BCB, Deutsche Bank Research
Consumer price inflation is accelerating, as expected.
The IPCA posted a higher-than-expected 0.57% MoM
increase in September, mainly due to a rebound in food
prices. In 12 months, the IPCA accelerated to 6.75%,
the highest rate since October 2011. Service prices
have remained under particularly intense pressure
(rising 8.6% YoY in September) due to the tight labor
market and persistently high inflation expectations.
While we expect slow growth and rising
unemployment to eventually contribute to moderate
inflation of non-tradable goods, we believe the
adjustment in regulated prices has just begun
(additional adjustments in electricity prices, as well as
increases in fuel and public transportation will likely
affect inflation next year), and exchange rate
depreciation could raise tradable goods inflation as well.
Therefore, we have raised our IPCA forecasts to 6.4%
from 6.2% for 2014, and to 6.2% from 6.0% for 2015.
While we still expect no change in interest rates in the
near future, the risk is rising. The BCB has been on hold
since May, maintaining the SELIC overnight rate at
11.0%. Although inflation remains high and would be
even higher had the government not contained some
9 October 2014
regulated prices and intervened in the FX market to
prop up the currency, economic weakness does not
give the authorities much leeway to act. In the most
recent COPOM minutes and Inflation Report, the BCB
repeated that it expected inflation to converge to the
4.5% target over the next two years, assuming “no
reduction in the instrument of monetary policy” (i.e.,
interest rates), thus indicating that it is comfortable
with the inflation outlook. A BCB director, however,
claimed that the COPOM might raise rates if necessary
to curb inflation, and local markets are roughly pricing
in 150bps in interest rate hikes in 2015. Nevertheless,
we continue to expect no change in rates until the end
of 2015. The government’s decision to lower reserve
requirements in August does not suggest any
willingness to tighten monetary policy. While rising
interest rates could help restore the credibility of the
inflation targeting regime, we believe the main
macroeconomic imbalance currently lies in the lax
fiscal policy, and a credible commitment to curb public
spending and official lending would reduce the need
for a rate hike. The main risk to our scenario is that
excessive exchange rate depreciation could force the
BCB to raise rates, deepening the recession.
We revised our BRL forecasts and expect more
weakness. The current account deficit reached
USD78.4bn (3.5% of GDP) in the 12 months to August.
The deficit has displayed a slightly declining trend,
reflecting mainly slow domestic growth, which is
restraining the demand for important goods. Lower
commodity prices, however, could offset this effect
and put pressure on the exchange rate. We raised our
current deficit forecast to USD83bn from USD82bn for
2014, and to USD80bn from USD77bn for 2015. The
BCB continues to calibrate the supply of FX swaps to
avoid excessive FX movements, but the outstanding
stock (approximately USD99bn) is already quite high
and the government seems to prefer a somewhat
weaker exchange rate to promote exports (especially
after the elections, when the authorities will probably
be less concerned about potential inflationary effects).
As a matter of fact, the BCB reacted more slowly than
expected to the sharp BRL depreciation in September
(a consequence of global USD strength and domestic
political concerns), hinting that it may ultimately accept
a weaker currency. Due to the decline in commodity
prices and deterioration in fiscal fundamentals, we
have raised our year-end exchange rate forecast to
BRL2.45/USD from BRL2.35/USD for 2014, and to
BRL2.60/USD from BRL2.50/USD for 2015. It is
important to highlight that the FX will be susceptible to
the market’s perception about changes in economic
policies. Credible measures announced by the next
government aimed at improving fiscal sustainability
would reduce the risk premium attached to Brazilian
financial assets and prop up the BRL, and vice-versa.
Brazil: Deutsche Bank forecasts
2012
National Income
Nominal GDP (USDbn)
Population (m)
2013
2014F
2015F
2,253 2,245 2,155 2,171
199
201
203
204
11,306 11,175 10,636 10,630
Real GDP (YoY%)
Private consumption
Exports
Imports
1.0
3.2
3.3
-4.0
0.5
0.2
2.5
2.6
2.0
5.2
2.5
8.3
0.3
1.2
1.4
-7.2
1.6
-1.2
1.0
0.7
1.0
1.7
2.0
1.5
CPI (YoY%, eop)
CPI (YoY%, avg)
Money base (YoY%)
Broad money (YoY%)
5.8
5.4
8.3
5.3
5.9
6.2
7.6
11.2
6.4
6.3
7.0
8.0
6.2
6.4
6.5
6.0
Consolidated budget
Interest payments
Primary balance
-2.5
-4.9
2.4
-3.3
-5.1
1.9
-4.2
-5.2
1.0
-3.7
-5.3
1.6
Merchandise exports
Merchandise imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (USDbn)
FX rate (eop) BRL/USD
242.6
223.2
19.4
0.9
-54.2
-2.4
65.3
378.6
2.04
242.0
239.6
2.4
0.1
-81.2
-3.6
64.0
375.8
2.34
236.0
233.0
3.0
0.1
-83.0
-3.9
60.0
379.8
2.45
242.0
230.0
12.0
0.6
-80.0
-3.7
65.0
380.8
2.60
Government debt (gross)*
Domestic
External
Total external debt
in USDbn
49.4
-14.1
58.8
19.6
440.6
7.4
48.3
-14.8
57.2
21.5
482.8
6.7
49.9
-14.6
60.7
23.9
514.8
6.5
50.5
-14.5
63.2
25.0
542.8
6.5
-2.3
5.5
2.3
5.4
-2.7
5.0
1.0
5.6
Current
11.00
11.5
2.40
4Q14
11.00
12.5
2.45
1Q15
11.00
12.0
2.45
3Q15
11.00
11.5
2.55
General
Unemployment (%)
Financial Markets (EOP)
Selic overnight rate (%)
10-year Pré-CDI rate (%)
BRL/USD
(*) Includes central government, states, municipalities and SOEs.
Source: National Statistics, Deutsche Bank forecasts
José Carlos de Faria, São Paulo, (+55) 11 2113-5185
Page 121
9 October 2014
Chile
Aa3 (stable)/AA- (stable)/A+ (positive)
Moodys /S&P/ /Fitch

Economic
outlook:
Economic
activity
has
confirmed a sharp slowdown, pointing to just 2%
GDP growth this year. In the meantime, another
month of high inflation in September and a
weakening currency is pushing inflation to new
highs this year, but is expected to fall early next
year as pass-through fades away. The tax reform
was finally approved but the government
anticipated higher fiscal expenditure in 2015. This
is expected to reduce business uncertainty and
improve investment perspective ahead. In the short
term, however,
a lackluster outlook for
manufacturing and further deterioration in
consumption demand provide room for the central
bank to cut rates one or two more times.
Main risks: The authorities expect economic
growth to accelerate during the second half of the
year, helped by the current monetary stimulus, the
low base effect, and fiscal expansion. Further
monetary easing together with a more aggressive
fiscal stance is likely to support next year’s
rebound, but a subdued demand for commodities
will remain a medium-term burden for growth.
Bureaucratic delays in public outlays, inertia in
investment decisions, and lags in consumption to
monetary stimulus represent the main threats to a
potential rapid recovery.
Fully on countercyclical mode
Economic recovery might take some time
Economic activity, according to the Central Bank’s
proxy IMACEC, increased by 0.5% MoM and 0.3% YoY
during August. The year-over-year number represented
the lowest value since March 2010, when activity
increased by 0.17% YoY but due to that year´s
earthquake. The main positive driver of the monthly
result was the performance of services, while
manufacturing, mining and wholesale commerce
posted contractions. This supports our recent revision
in growth forecast for this year to barely 2.0%. Activity
should continue to improve gradually during 2015, but
a weak commodity cycle together with remaining
uncertainties about investment recovery is likely to
contained next year´s growth at around 3%.
During August, industrial production fell by 1.8% YoY,
having manufacturing as the main negative contributor
with a 4.9% YoY decline, well spread among twelve of
the thirteen categories that comprise the sector. Mining
did not help either, recording a drop of 0.2% YoY,
mainly as the result of lower copper production.
Utilities were the only sector that posted expansion
during August, 1.5% YoY. Similarly, retail sales
Page 122
recorded a modest advance of 1.7% YoY, confirming
the ongoing deceleration in consumption.
After months of being resilient to fluctuations in activity,
the rate of unemployment came out at 6.7% for the
June-August moving quarter, representing an increase
of 1.0pp compared to last year. Behind this labor
market deterioration there was a decrease in
employment (-0.2% MoM) and the stagnation of the
labor force. The sectors that reported the highest
contraction in employment were commerce and
construction (-3.5% YoY and -4.8% YoY, respectively),
while employment increased in other services.
Further CLP depreciation challenges inflation
Consumer prices increased by 0.8% MoM during
September, bringing 12-month inflation to 4.9% from
4.5% the previous month. There were significant price
movements in food items and transportation; the latter
is explained by the prices of new cars, gasoline, and
the increase in bus fares, the main drivers of this new
inflationary shock. Meanwhile, the CPI measure,
excluding food and energy, the preferred core measure
of the Central Bank, increased by 0.6% MoM,
accelerating from the 0.4% MoM posted during August.
Inflation in October is expected to show a significant
slowdown, but the impact of the tax reform is likely to
keep strong price corrections by the end of the year.
Likewise, the peso weakened almost another 2%
during September, adding pressure to tradeable prices.
Therefore, annual inflation in the next few months is
unlikely to fall below current levels. Nevertheless,
inflation next year should gradually converge to 3% as
this year’s shocks are left behind and the weak
economy provides some room for price absorption.
August negative wage inflation provides some support
to that benign view, as real wages are now advancing
at 1.5% YoY pace, or significantly below the 3.4% pace
of 12 months ago.
The central bank might not be totally finished anyway
The minutes of the last monetary policy meeting of the
central bank revealed that the easing process could be
in its final stage. The board decided to cut its reference
rate by 25bps once again in September, and the
monetary authority explicitly noted that the easing
cycle was approaching the end. This notwithstanding,
further stimulus, albeit gradual, was not disregarded if
the economy stays on its weakening path. The
monetary authority continues interpreting recent
inflation peaks as temporary. Furthermore, the board
highlighted the consistency of private expectations,
which are remaining stable around 3% YoY one and
9 October 2014
two years ahead. Considering the lackluster numbers
reported in industrial production and activity recently,
we expect one or two more cuts in the months ahead,
although October inflation surprise might add a short
pause this month. 23
Chile: Deutsche Bank forecasts
2012
2014F 2015F
National income
Nominal GDP (USDbn)
Population (m)
Inflation challenges rate cuts while activity permits
2013F
277.1
17.4
17.6
260.2 271.3
17.7
17.9
15,318 15,785 14,672 15,146
5.4
4.1
2.0
3.1
Priv. consumption
6.0
5.6
2.7
3.0
8.0%
Gov't consumption
3.4
4.2
5.7
6.2
6.0%
Investment
10.2
-2.3
-12.9
1.6
4.0%
Exports
1.1
4.5
1.6
2.9
Imports
4.9
2.6
-6.9
3.2
CPI (YoY%, eop)
1.5
2.8
4.9
2.9
CPI (YoY%, avg)
3.0
1.9
4.3
3.6
Broad money (YoY%, eop)
6.2
13.9
9.1
9.3
11.9
9.5
8.6
9.0
10.0%
%YoY
Headline CPI
Policy Rate
Real GDP (YoY%)
266.6
3MMA IMACEC
2.0%
0.0%
-2.0%
-4.0%
Sep-09
Mar-10
Sep-10
Mar-11
Sep-11
Mar-12
Sep-12
Mar-13
Sep-13
Mar-14
Sep-14
Source: Central Bank and Deutsche Bank
Credit (YoY%, eop)
The focus is moving towards fiscal instruments
On September 26, President Michelle Bachelet´s tax
initiative became law, amending the income taxation
system and introducing major new changes. This seeks
to collect 3.02% of GDP mostly from corporations to be
primarily spent on education. However, President
Bachelet has also indicated the need to improve the
infrastructure of the public health system, and to
reinforce public investment overall, to compensate for
the recent retrenchment in private investment. Despite
the new tax burden on the private sector, the final
wording of the tax reform might reduce overall
uncertainly and slowly permit some improvement in
business expectations after reaching historic lows
during the last few months.
The 2015 budget draft sent to Congress earlier last
week provides a detailed guide of fiscal policies ahead.
This envisages a 9.8% increase in total expenditure
compared to the budget last year (27.5% for public
investment). Likewise, compliance with the 2014
budget demands strong execution in infrastructure for
the remainder of the year. Thus, fiscal policy is
envisaged to start being openly countercyclical in the
months to come. In addition, the financing plan of next
year’s budget suggests the need to sell up to
USD3.0bn of public assets to minimize crowding out
effects. Therefore, if approved in Congress as expected,
next year’s budget could be the necessary instrument
to facilitate a more robust recovery, although it would
further delay convergence with the fiscal structural
balance in 2015.
Gustavo Cañonero, New York, (212) 250 7530
Consolidated budget balance
0.7
-0.5
-1.9
-2.1
Revenues
22.1
21.0
20.3
20.8
Expenditures
21.5
21.5
22.2
22.9
Exports
78.0
76.7
77.7
79.3
Imports
75.5
74.6
68.9
71.0
Trade balance
2.5
2.1
8.8
8.3
% of GDP
1.0
0.8
3.5
3.3
-9.1
-9.5
-4.6
-4.9
-3.3
-3.5
-1.9
-2.0
6.2
9.3
8.5
8.1
41.6
41.1
40.7
41.5
478.6
523.8
12.0
12.8
13.2
14.1
10.0
11.1
11.5
12.3
1.9
1.7
1.5
1.5
43.4
49.9
56.1
57.4
117.6
130.7
19.6
15.7
13.7
13.1
Industrial production (%)
3.0
3.6
1.1
2.9
Unemployment (%)
6.5
6.0
6.4
6.5
Overnight rate (%)
Spot
3.25
14Q4
2.75
15Q1
2.75
15Q3
2.75
3-month rate (%)
3.10
2.80
2.80
2.95
USD/CLP
595
600
600
600
% of GDP
FDI (net)
FX reserves
FX rate (eop) USD/CLP
600.0 600.0
Government debt
Domestic
External
Total external debt
in USDbn
134.7 141.0
General (avg)
Financial markets (eop)
Source: DB Forecasts and, National Statistics
23
For a broader discussion regarding monetary policy ahead please see
our September 26 piece, Chile: Strategy Update Ahead of the Minutes.
Page 123
9 October 2014
Colombia
Baa3 (positive) /BBB (stable) /BBB (stable)
Moodys /S&P/ /Fitch

Economic outlook: The release of GDP growth for
the second quarter shows a deceleration in
economic activity from the high numbers during
the first quarter of the year. We expect this
moderation to continue in the following months
after construction and civil works activity
deceleration. Inflation has continued hovering
around 3%, which prompted the Central Bank to
stop the hiking cycle at 4.5% while the currency
continues depreciating.
Main risks: The deceleration in the boost to activity
from the external sector could continue into year
end and the expected slowdown in other sources
of domestic demand could lower economic growth.
The willingness of the Central Bank to let the
nominal exchange rate act as a shock absorber
could cause further currency depreciation if more
signals of tightening global liquidity materialize.
Construction as the new engine
Second quarter activity decelerates
The figures released for the second quarter confirmed
that the high activity numbers during the start of the
year had been atypical. Growth printed at 4.3% YoY
during the second quarter after a surprising 5.4% YoY
in the preceding quarter. On the supply side,
construction was again the fastest growing sector with
a 10.2% YoY and the financial sector grew by 6.1%
YoY. Mining and manufacturing decreased by 2.2%
and 1.4% compared to the same quarter last year,
respectively. For the first half of the year the scenario is
similar. While GDP growth remains high, at 5.4% YoY,
the sector that leads from the supply side is
construction with 14.2% YoY growth, while mining and
manufacturing grew by 1.7 and 0.9 percentage points,
respectively. Other non-tradable goods and services
like financials, social services, and retail, restaurants
and hotels show the same strong behavior, growing
faster than total economic activity.
On the demand side, investment contributed with 3.4%
YoY of the total growth number and continued
breaking records, achieving 29% as a percentage of
GDP during the second quarter. Private consumption
contributed with 3.4%YoY, while the contribution of
government expenditure added 1.07% YoY to the total
GDP growth rate. Net exports subtracted 4.27% YoY
after a negative contribution from exports due to the
fall in oil and coal production, decreasing total exports
in real terms by 8.64% YoY while imports continued
increasing at a 9.65% YoY rate. The rate of growth of
exports for the period 2010-2013 was 6.2% YoY,
exemplifying the deep contraction from the external
Page 124
sector. The component of investment with the largest
growth was civil works (8.9% YoY), followed by overall
construction (6.7%). On a relative basis, the largest
component of investment for the last year was
machinery and equipment (9.5%) closely followed by
construction (6.7%) and civil works (8.9%). Clearly
there is a shift in the source of growth in economic
activity for the economy during the last year.
The table below shows that the contribution of civil
works during the quarter was from the construction of
roads, bridges, highways and tunnels, with around
71% of the contribution. The second quarter of 2014
was the fourth consecutive quarter with the growth
rate of public works higher than 15% YoY. The low
contribution from investment in public works in mining
infrastructure experienced during the last year is
noticeable.
We expect that this shift in focus on the engine of
growth of the economy to continue in the medium
term as the price and production of oil is expected to
fall in the coming quarters. The risk to the reliance on
construction and public works as the main sources of
growth is that the volatility of these sectors can be
larger because of political cycles and delays in
execution of projects that have characterized
government expenditure in the past.
Investment in Civil Works (2Q-2014)
Change
Contribution
Last 12 Annual
Months
YTD
Last 12
Months
16.2
20.1
19.3
11.5
12
10.2
8.2
-0.3
-0.2
0.1
23.7
46.8
2.2
3.1
6.2
-0.4
2.2
0.2
-0.2
0.9
0.1
22.8
36.4
24.5
3.0
4.2
2.7
Annual
YTD
Total
16.2
20.1
19.3
Roads, bridges,
highways, tunnels
37.8
35.1
32.7
Railways, landing
strips and mass
transportation system
-21
-11
Waterways, ports,
dams, aqueducts,
sewage and other
ports
15
Mining, power
generation and
pipelines for oil and
gas
Other engineering
work
Source: Deutsche Bank and DANE
Domestic demand grew at a strong 7.3% YoY during
the second quarter, as the graph below shows.
However, demand decelerated from the stronger print
during the first quarter of the year. Separating the
sources of demand between the ones that are sensitive
9 October 2014
to the interest rate (durables consumption, services and
investment other than in civil works), and the
components that are not sensitive (non-durables
consumption, government expenditure and investment
in public works) shows a divergence in these sources
of growth for the past year.
Colombia: Deutsche Bank forecasts
2012
203
2014F
2015F
370.3
46.0
8,051
378.2
47.0
8,047
398.8
47.0
8,484
422.3
48.0
8,798
4.2
4.4
5.1
5.7
5.3
8.0
4.6
4.2
5.8
6.2
5.5
4.5
5.0
4.5
5.2
8.0
3.0
5.5
4.8
4.4
4.5
7.5
3.2
5.5
2.4
3.2
17.0
18.2
1.9
2.0
15.0
13.0
3.2
2.8
14.5
14.0
3.3
3.2
14.0
12.0
-2.3
16.1
18.4
0.2
-2.4
16.8
19.1
0.1
-2.4
17.0
19.4
0.2
-2.2
17.1
19.3
0.2
61.0
56.7
4.3
1.2
-11.8
-3.2
15.7
37.5
1768
60.0
57.0
3.0
0.8
-12.7
-3.4
15.0
42.0
1950
58.5
56.9
1.6
0.4
-16.0
-4.0
14.5
47.0
2060
57.8
57.5
0.3
0.1
-12.7
-3.0
15.0
50.0
2150
36.1
25.7
10.4
21.3
79.1
35.0
27.5
12.0
24.1
91.0
35.5
26.0
9.5
22.6
90.0
34.0
25.0
9.0
22.0
93.0
13.5
13.0
12.5
13.0
2.4
-2.6
2.5
2.0
9.6
9.5
8.2
7.8
Financial Markets (end period) Spot
14Q4
15Q1
15Q3
4.50
4.10
2028
4.50
4.30
2050
4.50
4.50
2060
4.75
4.60
2100
Nominal GDP (USDbn)
Population (m)
Real GDP (YoY%)
Domestic demand and components
Private consumption
Exports
Imports
(YoY%)
CPI (eop)
CPI (ann. avg)
Broad money (eop)
Source: Deutsche Bank Research and DANE
Fiscal accounts (% of GDP)*
Inflation softens in September
The CPI grew by 0.14% during September, compared
to 0.29% during the same month last year. The largest
contributors to the increase in prices during the month
were housing (0.20%), education (0.17%), food (0.16%),
and health (0.16%), while the remaining sectors
showed close to zero growth rates.
Overall balance
On an annual basis, inflation dropped to 2.86%, while
on a year-to-date basis the figure printed at 3.08%.
Core prices on an annual basis grew by 2.70%,
showing the muted behavior of demand forces in
pushing up inflation. The divergence between the
annual and the year-to-date figures is explained by the
negative growth numbers experienced during October
and November of last year.
Trade balance
Revenue
Expenditure
Primary balance
Goods Exports
Goods Imports
% of GDP
% of GDP
FDI (net)
FX reserves (eop)
COP/USD (eop)
Debt Indicators (% of GDP) (*)
BanRep to remain neutral while currency depreciates
The monetary board decided to stop the hiking cycle at
4.5% in the September meeting. Even though domestic
demand remains strong, the members showed fear
that the negative impact from the uncertainty in the
external sector still remains a threat to economic
activity. We expect inflation to surpass 3%, the mid
level of the Central Bank's target range, in the coming
months due to low base levels from the end of last year.
However, the likelihood of strong inflationary surprises
that could reignite the monetary policy hiking cycle
remains low. The low level of pass through and the
long period of currency appreciation experienced by
the economy would not trigger an active intervention
by BanRep to counteract the depreciation pressures
coming from a weaker external demand and tighter
global monetary conditions.
Government debt
Domestic
External
External debt (**)
in USD bn
General (ann. avg)
Unemployment (%)
Policy rate (overnight rate)
3-month rate (DTF Rate)
COP/USD (eop)
Source: Deutsche Bank and National Sources
Armando Armenta, New York, (212) 250 0664
Page 125
9 October 2014
Mexico
A3 (stable)/BBB+ (stable)/BBB+ (stable)
Moody’s/S&P/Fitch

Economic outlook: Activity accelerated in July and
the recovery looks firmer now. On the industrial
production side, an increasing number of fastgrowing manufacturing activities joined motor
vehicles in what now seems a broader-based
pickup. Moreover, construction is gaining
momentum into the second semester, surprisingly
due to the buildings component. In spite of some
positive readings, the trend of private consumption
remains essentially flat, as consumer confidence is
recovering but is still below 2013 levels. By the
same token, fixed investment remains weak,
except for imported machinery and equipment that
may lose steam ahead as the currency has
depreciated. Credit to firms and households has
continued to decelerate in response to a weak
domestic demand and new policies aimed at
boosting supply have not delivered a change in
trend yet. In this context, inflation climbed due to a
combination of seasonal factors and temporary
shocks that are expected to cede by year-end but
will likely make Banxico miss the target. Thus,
recent CPI readings have deteriorated the inflation
outlook and the Central Bank has developed a
more hawkish tone.
Main risks: Now that the reforms and bylaws have
been passed and there are no surprises in the 2015
Economic Program submitted to Congress,
domestic risks seem limited. In any case, the main
domestic risk is that construction of public
infrastructure does not pick up substantially due to
the complexity of the projects announced by the
government. We maintain our view that the main
risks are external: an excessive volatility associated
to the normalization of monetary policy in the US
and/or a delayed recovery of global demand.
However, we see the good story on reforms, sound
fundamentals and, eventually, stronger growth, as
supports for the Mexican economy to cope with
excessive volatility in EMs.
Recovery looks firmer
Activity likely to accelerate further in 4Q2014
According to the Economic Activity Global Index (IGAE)
for July, growth continues to gain momentum. Activity
grew above expectations at 0.41%MoM and 2.52%YoY
in the seventh month of the year, supported by both
stronger industrial production and services, which
expanded 0.28%MoM and 0.34%MoM, respectively.
Positive readings on services is particularly good news,
as such activity anchored growth in 2013 and early
2014, but for a moment seemed to be losing resilience
relatively fast around mid-year.
Page 126
Economic activity global index (%)
5
%MoM
4
%YoY
3
2
1
-1
-2
2012/07
2012/08
2012/09
2012/10
2012/11
2012/12
2013/01
2013/02
2013/03
2013/04
2013/05
2013/06
2013/07
2013/08
2013/09
2013/10
2013/11
2013/12
2014/01
2014/02
2014/03
2014/04
2014/05
2014/06
2014/07

Source: INEGI
July’s data shows that autos remain the main engine of
manufacturing but points towards an incipient recovery
of the other manufacturing activities. Out of the 21
manufacturing activities monitored by INEGI, now 11
show accumulated growth rates above 3% in the first 7
months of 2014. Thus, the broad-based recovery that
we anticipated for manufacturing seems slow but
gaining traction into 2H2014. Similarly, construction
activity is accelerating and its prospects have improved
as the buildings component has maintained steam and
the infrastructure component has broken its downward
trend, so we expect such a recovery to persist in the
second semester of 2014. However, the dynamism of
the buildings component in presence of a relatively
weak housing market and subpar investment is yet
puzzling and the risk of a downturn is high.
Fast-growing mfg activities (number)
12
11
10
9
8
7
6
5
4
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Source: INEGI
9 October 2014
The leading indicators available for 3Q2014 show that
the recovery of manufacturing activity is likely to
continue. The HSBC-Markit purchasing managers’
index for Mexico manufacturing rose significantly in
September and went firmly above the threshold that
anticipates an expansion. This is the highest reading
since January 2014 and its components now offer a
clearer picture of recovery: The employment sub-index
rose above the threshold and is now at the highest
reading since March and the new orders sub-index
rose with respect to the previous month and is now at
the highest reading this year. Similarly, the IMEF’s
seasonally-adjusted index for manufacturing activity
rose above the threshold that anticipates an expansion
and the company-weighted index continued to
outperform moderately, thus suggesting that the
recovery in manufacturing activity remains slightly
biased towards big businesses. On the other hand, the
IMEF index for non-manufacturing activity fell
moderately but remained above the threshold, pointing
that services continue to expand but that it may have
lost some steam due to the persistent weakness of IP
in 2013 and early 2014. We expect this to be transitory
and the non-manufacturing indicator to rise in the
coming months. Taken together, the HSBC-Markit
manufacturing and IMEF indicators show that activity
is accelerating in 2H2014 and that manufacturing is on
a broader-based recovery in a context of resilient
services.
The production of motor vehicles has remained an
important source of growth and it is expected to
remain strong. In September, domestic sales of autos
grew 13.7%YoY, still one of the fastest expansions on
record. On the other hand, exports grew mildly in
September, 2%YoY, but we see this as a hiccup due to
the shipping of some orders, rather than a change in
trend (exports of autos have grown 9%YoY in the first
nine months of 2014). As a result, total production
grew 10.7%YoY in September and we expect such high
rates to persist at least for the remainder of the year
and moderate somewhat in 2015.
Production of motor vehicles (%YoY, 3-mo avg)
25%
20%
15%
10%
5%
0%
-5%
Jul-14
Sep-14
May-14
Jan-14
Mar-14
Sep-13
Nov-13
Jul-13
May-13
Jan-13
Mar-13
Nov-12
Jul-12
Sep-12
May-12
Jan-12
Mar-12
-10%
Source: AMIA
On the domestic front, 3Q2014 indicators point to a
sustained weakness of private consumption. Retail
sales recovered somewhat in July, but its trend
remains essentially flat. This not surprising as the trend
of consumer confidence is not clearly positive yet. In
September, consumer confidence came out above
expectations and rose with respect to August, a
2.3%MoM gain. This time, all of its five components
grew on a monthly basis, including a strong recovery of
the sub-index measuring the perceived capacity to
purchase durable goods, which largely accounted for
the overall deterioration of consumer confidence in the
last months. If this behavior of consumer confidence
remains in place, it would re-engage in the vigorous
recovery seen early in the year and go above 2013
levels soon. However, it is worth highlighting that
consumer confidence remains 2.4% below its
September 2013 level, with drops in four of the five
components on a yearly basis. Thus, private
consumption is likely to accelerate in the coming
months but moderately, as consumer confidence
remains relatively low.
Retail sales and consumer confidence (Jan11=100)
110
108
106
104
102
100
98
96
94
Retail sales (SA, Jan11=100)
92
Consumer confidence (SA, Jan11=100)
90
2011/01
2011/03
2011/05
2011/07
2011/09
2011/11
2012/01
2012/03
2012/05
2012/07
2012/09
2012/11
2013/01
2013/03
2013/05
2013/07
2013/09
2013/11
2014/01
2014/03
2014/05
2014/07
2014/09
These results reiterate that a recovery is under way and
have prompted 2014 growth prospects to stop
deteriorating. The last Banxico survey of economic
analysts shows that growth prospects for 2014
remained stable at 2.47%YoY, unchanged from the
previous survey. Similarly, the last Banamex survey
puts expected growth for 2014 at 2.46%YoY, virtually
unchanged from the last survey. The consensus
implicitly assumes that the economy will accelerate to
3.4%YoY in August-December, significantly up from
1.8%YoY in the first seven months of the year. We
keep our GDP growth forecast for this year at 2.3%YoY,
implicitly assuming that activity will accelerate but to
3%YoY in the last five months of the year. In our view,
an acceleration of activity beyond that is unrealistic,
given the sluggishness of the economy in 1H2014.
Source: INEGI
Page 127
9 October 2014
Also on the demand side, gross fixed investment grew
0.57%MoM and 3.1%YoY in July, below expectations
but still a sign of recovery. The main support of
investment in 2014 has been the machinery and
equipment component, which grew 2.6%YoY in
January-July, while construction contracted 1.6%YoY
in the same lapse. The imported component of M&E
has clearly outperformed the domestic component in
that period, 3.6%YoY vs 0.6%YoY, likely due to a
strong currency in 1H2014, a situation that has
changed. Moreover, the resilience of residential
construction has gone beyond expectations and the
risk that it may lose steam in the months ahead
persists. Thus, we see risks to the moderate recovery
of investment under way.
as crops prices play a diminished role in the last part of
the year and the drop of inflation in November will be
largely due to government-controlled electricity prices.
CPI inflation (%YoY)
5.0
4.5
4.0
3.5
3.0
CPI
2.5
Core
After negative surprises from labor markets in July’s
indicators, August numbers showed a foreseeable
correction. The unemployment rate for August stood at
5.18%, well below expectations (5.35%) and in line
with the unemployment rate of July 2013, 5.17%.
Similarly, the seasonally-adjusted unemployment rate
came down to 4.87% in August, from 5.19% in the
previous month. July’s unemployment rates were in
clear deviations from their medium-term downward
trends and August readings partly correct that, and we
expect the positive trend to continue.
In this context of slow recovery, inflation has been
consistently above expectations in the last months. Biweekly CPI inflation came at 0.32% in the first half of
September, so the annual rate climbed to 4.21%YoY,
above the upper limit of the Central Bank’s target range.
The pickup in inflation is explained by a combination of
seasonal factors and supply shocks to meat, pork and
poultry prices. We expect the effects of these shocks to
be persistent and continue to show up on October CPI
inflation, leading to a peak of 4.3%YoY then. So, we
now anticipate inflation to end 2014 at 4%YoY, up from
our previous forecast of 3.8%YoY. It is worth
mentioning that we see limited risks for this scenario,
Page 128
2014/08
2014/06
2014/04
2014/02
2013/12
2013/10
2013/08
2013/06
2013/04
2013/02
2012/12
2012/10
2012/08
2012/06
2012/04
Credit to households and firms continued to disappoint
in the second semester of the year. According to the
latest bank lending report from Banxico, net
outstanding credit continued to decelerate and total
performing loans stood at MXP$2604bn in August,
merely 4%YoY up in real terms. Annually, the fastestgrowing item in real terms is loans to non-bank
intermediaries, which is the smallest component of
total loans (4%). Among the major components,
mortgages increased 4.2%YoY in real terms, followed
by loans to companies and mortgages, both at
3.5%YoY. Thus, bank loans as a proportion of GDP
stand at 15%, well below ratios observed in other EMs.
In our view, bank loans are growing below potential, as
suggested by comparing the current pace with that
seen back in 2011/2012, and no increases in retail
interest rates or in non-performing loans explain the
slowdown.
2012/02
2.0
Source: INEGI
The headline rate is expected to drop fast in the first
quarter of 2015 due to the seasonal CPI pattern,
combined with the effects of a favorable high-base
effect caused by the new taxes in the 2014 Economic
Program and a slower increase of gasoline prices in
2015. We maintain such a positive view for CPI
inflation next year, but see a moderate deterioration of
this outlook for two reasons. First, it is possible that the
government will hike gasoline prices 3% in a one-off
move in January and leave them unchanged for the
rest of the year, thus front-loading inflation pressures
into early-2015. This would offset the high-base effect
mentioned and creates a higher starting point for CPI
inflation next year. Secondly, political conditions seem
to be aligning for a minimum wage increase that most
likely will be around 23%, the proposed increase from
Mexico City government. Even though such effects
would materialize mostly in 2016, the discussion is
likely to increase expected inflation throughout 2015. In
both cases, the risk of an additional contamination to
prices and inflation expectations is relatively high.
Thus, we see a possible deterioration of inflation
expectations for 2015-2016 which is likely to increase
the appetite for indexed assets. Nevertheless, for the
longer-term the outlook may be better, as we anticipate
a prolonged phase in which government-controlled
prices will be adjusted yearly according to expected
inflation and the economy copes better with shocks to
non-core inflation from agriculture products. In our
view, such elements may have helped maintain longterm expected inflation consistently at around 3.5%,
particularly gasoline prices which imposed a “floor” to
inflation in previous years.
In this context of rising inflation, Banxico left the target
overnight rate unchanged at 3% in the last meeting.
This decision was widely anticipated, as markets
9 October 2014
seemed convinced that the moderate recovery under
way and a headline CPI inflation running above 4%,
were not conditions for an additional cut. However, the
surprise was not about the decision itself but about the
hawkish tone of the communication. Banxico
highlighted that the economy displayed an “important”
recovery in 2Q2014 as both external and domestic
demand gained strength. We see Banxico’s
overstatement of the recovery as part of a hawkish
tone going forward and there is a drastic change in the
tone about inflation, pointing out that part of the recent
spike is caused by shocks expected to persist.
Noticeably, Banxico points explicitly that it will be on
the brink of missing the target at the end of 2014.
Headline CPI inflation in 2014 (%YoY)
4.6%
4.4%
Forecast
Observed
4.2%
4.0%
3.8%
3.6%
3.4%
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Source: INEGI and DB Research
The last policy rate decision confirms our view that
Banxico will not cut the policy rate for the remainder of
2014 and most of 2015. On the other hand, in spite of
its hawkish tone, we do not see Banxico hiking before
the Fed unless a very negative inflation scenario
materializes in early 2015 and the recovery accelerates
significantly. So, we still see the timing of the Fed as
more relevant for Banxico’s next move.
Finally, we anticipate a relatively quiet 4Q2014 as the
reforms and bylaws have been passed and there are no
surprises or controversial issues in the 2015 Economic
Program submitted to Congress. In any case, the main
domestic risk is that construction of public
infrastructure does not pick up substantially due to the
complexity of the projects announced by the
government. In our view, the main risks are external:
an excessive volatility due to the normalization of
monetary policy in the US and/or a delayed recovery of
global demand. However, we see the good
expectations about reforms, sound fundamentals and,
eventually, stronger growth, as elements that will help
Mexico to cope with excessive volatility in EMs.
Mexico: Deutsche Bank Forecasts
2012
2013
2014F
2015F
1177
117
10063
1238
119
10400
1317
121
10881
1410
124
11374
3.8
4.6
2.4
5.5
4.2
6.0
1.1
3.8
2.2
-0.1
1.4
2.0
2.3
3.2
2.6
2.3
3.5
4.3
3.5
4.5
4.8
4.8
4.1
5.1
CPI (Dec YoY%)
CPI (avg %)
Broad Money
Credit
4.1
4.1
10.8
12.0
4.0
3.8
11.5
10.0
4.0
4.0
11.0
16.0
3.5
3.8
12.0
21.0
Consolidated budget
Revenue
Expenditure
Primary Balance
-2.6
15.7
18.4
-0.6
-2.9
16.8
19.7
-0.9
-4.2
17.6
21.8
-1.5
-4.0
17.5
21.5
-1.6
Exports
Imports
Trade Balance
% of GDP
% of GDP
FDI
FX Reserves
MXN/USD (eop)
371.4
371.2
0.2
0.0
-14.1
-1.2
15.4
163.5
13.0
376.6
378.6
-2.0
-0.2
-22.3
-1.8
13.0
186.5
13.0
389.8
394.9
-5.1
-0.6
-27.6
-2.1
22.0
225.0
13.2
405.8
415.0
-9.3
-0.7
-31.0
-2.2
30.0
250.0
13.3
Government debt**
Domestic
External
Total External Debt
in USD
33.7
23.1
10.6
19.3
227.2
19.0
35.6
24.4
11.2
20.3
251.1
18.0
36.7
25.2
11.5
21.6
284.3
17.0
36.9
25.3
11.6
23.1
326.2
19.0
2.8
4.9
0.9
4.6
2.2
4.1
3.3
3.9
Spot
14Q3
15Q1
15Q3
3.00
3.30
13.45
3.00
3.35
13.20
3.00
3.40
13.00
3.50
3.50
13.30
National Income
Population (m)
Real GDP (YoY%)
Priv. consumption
Gov't consumption
Investment
Exports
Imports
General (ann. avg)
Industrial Production
Unemployment
Financial Markets (end
i d)
Overnight
rate (%)
3-month rate (%)
MXN/USD
*Corresponds to PSBR
**Corresponds to PSBR accumulated balance
Alexis Milo, Mexico City, (52 55) 5201-8534
Page 129
9 October 2014
Peru
Baa2 (positive)/BBB+ (stable)/BBB (neutral)
Moodys /S&P/ /Fitch

Economic outlook: Activity numbers recovered
during July, growing at 1.16% after the surprising
0.3% print in June. Inflationary pressures continued
preventing the annual rate to continue falling
during September. The Central Bank has been
more active trying to stem the volatility of the
exchange rate without allowing the depreciation
trend to consolidate.

Main risks: The current weakness of the economy
unveiled the vulnerability of the productive sector
to mining, given that other sectors followed suit
and were not able to counteract the slowdown. The
Central Bank appears to be less concerned with the
currency depreciation trend, a behavior that could
exacerbate the change in positioning from market
participants.
However, this positive contribution weakened during
the second quarter of the year, contributing negatively
by 0.6% to the low overall growth rate number.
Moreover, the contribution of consumption, both
private and public, to close to 2.6% and 0.3%,
respectively, from numbers closer to 3.5% and 1.5% on
average in the last two years.
We expect the subdued behavior of economic activity
to continue rebounding during the next year on the
back of a recovery in mining activity, especially after
the completion of delayed mining projects. The risk
currently relies more on the outlook for commodity
prices that could hinder a continuation of investment
projects in the sector.
Tradable vs. Non-Tradable contributions to growth
The slump in economic activity might be
over
Activity started to rebound during second quarter
Growth in economic activity during July accelerated to
1.16% YoY after the weak print for June (0.3% YoY).
Negative
growth
in
manufacturing
(-5.72%),
construction (-6.02%), and mining (-1.61%) continued
during the month, but fishing (13.5%), financial
services (12.4%), and retail (4.21%) continued growing
at healthy rates. Agriculture continued disappointing
with a meager 1.6% rate of growth.
The weak behavior of mining is explained by a 3.67%
fall in metals due to lower gold (-19% due to the close
of the Pierina gold mine), copper (-3.3% due to lower
productivity sectors is some mines), and molybdenum
production (-14.6%). The fall in construction is
explained by a fall of around 16% in public works at the
three government levels: national, regional, and local
due to lower investment in road infrastructure and nonresidential buildings.
As the graph below shows, the contribution to growth
from the tradable sectors of the economy turned
negative during the second quarter of the year,
exemplifying the slowdown experienced since the third
quarter of 2013. The contribution of the non-tradable
sector has continued to be stable but in the last quarter
also showed signs of weakness.
From the demand side, the fall in investment in the first
and second quarters of the year (-1.7% YoY and -2.3%
YoY, respectively) also portrays the deep slump in the
economy. During the first quarter, the fall was
contained by positive contributions from the external
sector, with net exports contributing close to 1% to the
overall growth rate (5.1% YoY) in the first quarter.
Page 130
Source: Deutsche Bank and INEI
Inflation stubbornly close to upper level of target range
After a lull during August, when prices fell in the
monthly figure, taking the annual growth rate to 2.65%,
in September prices crept up to 2.90% given the
increase of 0.18% during the month. The largest
contributors to the increase in prices were food and
restaurants (0.35% and 0.29%, respectively). The only
sector that contributed with a negative growth rate
was communications (-0.26%).
Core prices in Lima grew by 0.09% on the monthly
figure and by 2.57% annually. Machinery and
equipment prices also showed acceleration to 1.09%
during the month as well as construction materials,
which grew by 1.07% in September. These increases in
prices are related to the larger pace of currency
depreciation during the month, with the PEN falling by
1.54%. We expect that price pressures will continue in
the following months as pass through from the
depreciation trend continues and impacts inflation.
9 October 2014
Monetary and exchange rate policy
In the September meeting, the BCRP decided to cut the
intervention rate by 25bps to 3.5%, after the
aforementioned deceleration in prices and the overall
bad numbers in economic activity. Moreover, the
Central Bank continued cutting reserve requirements
for local currency denominated credit to 10.5% while
keeping the ratio for dollar denominated credit close to
50%.
We expect the monetary policy rate to be kept
unchanged in the next meeting. The still high
inflationary pressures and the bout of currency
weakness would preclude monetary authorities from
continuing to loosen the policy rate. Moreover, the
Central Bank, even after recognizing that the slowdown
is more marked than what was originally expected, is
still positive that a rebound in economic activity will
consolidate in the coming quarters.
On the exchange rate front, the currency has
depreciated by 2.21% since the end of August and by
almost 4% year to date. The Central Bank has reacted
by selling dollars in the spot during the days of larger
depreciation pressures and by selling dollar
denominated certificates of deposit with 2- to 3-month
maturities. Since the beginning of September, the
intervention in the spot market was reported at USD
566m while in the swap market it was close to 556m.
However, the intervention does not seem to be
defending a particular level for the exchange rate but
rather is trimming the volatility. For example, during
August of 2013 when the currency also showed a
marked depreciation pressure, the Central Bank sold
around USD 2.7bn in the spot market while in
November the intervention amounted to USD 1.875 bn.
In various statements, Julio Velarde, the BCRP’s
governor, has explained that it welcomes the current
bout of depreciation given the boost to the tradable
sectors of the economy but would be ready to act
during periods of extreme volatility. The behaviors of
the relative supply of tradables to non-tradables
explained above seem to warrant a weaker currency
and the conduct of exchange rate policy in this latest
depreciation period.
Change in cabinet would not impact policy quality
Miguel Castilla, Finance Minister since the start of the
Humala administration, was replaced by Alonso
Segura. Mr. Castilla was deemed a good policy maker
by market participants after being a Deputy Minister
and Advisor during Alan Garcia’s administration. Mr.
Segura’s appointment does not pose any risk to the
quality of policy making as he has worked closely with
the government as an advisor to Mr. Castilla and as
Chief economist to a major local financial institution.
Peru: Deutsche Bank forecasts
2012
National Income
Nominal GDP (USDbn)
Population (m)
2013
2014F
2015F
199.8
30.0
6,659
206.6
30.5
6,774
212.3
31.0
6,849
224.9
31.5
7,140
Real GDP (YoY%)
Private consumption
Exports
Imports
6.3
5.8
8.4
9.6
6.4
10.4
5.0
5.3
6.3
11.5
-3.1
2.1
3.5
4.5
4.0
4.0
2.2
5.5
6.1
5.0
6.0
7.5
9.0
8.0
(YoY%)
CPI (eop)
CPI (ann. avg)
Broad money (eop)
2.7
3.7
16.5
16.0
3.0
2.5
15.0
15.0
2.9
3.2
16.0
15.5
3.3
3.1
16.0
17.0
2.00
21.6
18.6
3.0
0.30
21.1
19.8
1.3
0.20
21.3
20.2
1.1
0.20
21.5
20.4
1.1
45.2
39.8
5.4
2.7
-6.1
-3.1
12.2
64.1
2.55
52.0
46.0
6.0
2.9
-10.3
-5.0
11.0
74.0
2.80
55.0
52.0
3.0
1.4
-10.6
-5.0
10.9
80.0
2.90
65.0
55.0
10.0
4.4
-10.6
-4.7
12.5
78.0
3.00
19.7
10.3
9.4
24.4
48.8
15.1
18.8
10.1
8.7
25.6
52.9
14.8
18.0
10.7
7.3
26.4
56.0
14.5
17.3
10.4
6.9
27.6
62.1
15.0
4.8
6.9
6.7
6.8
4.0
6.9
7.0
6.8
Spot
3. 50
4.74
2.90
14Q4
3.50
4.60
2.95
15Q1
3.50
4.80
3.00
15Q3
4.25
5.30
3.10
Fiscal accounts, % of GDP
Overall balance
Revenue
Expenditure
Primary balance
Goods Exports
Goods Imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (eop)
PEN/USD (eop)
Government debt (*)
Domestic
External
External debt
in USD bn
General (ann. avg)
Unemployment (%)
Policy rate
3-month rate
PEN/USD (eop)
(*) General Government
Armando Armenta, New York, (212) 250 0664
Page 131
9 October 2014
Venezuela
Caa1 (negative)/B (negative)/B+ (negative)
Moody’s/S&P/Fitch

Economic outlook: Concerns on an imminent
default on financial debt, the potential sale of
CITGO, and rulings from international arbitration
tribunals characterized the agenda during in the
past month. The economic situation continues
deteriorating with the black market exchange rate
surpassing 100 VEF/USD in September after a
major fall in the supply of dollars through the
different mechanisms. Price controls have not
worked and the food basket advanced by close to
90% in annual basis.
Main risks: The evidenced drop in oil prices will
create extra pressure on the already dwindling
production and exports. If a larger fall were to
materialize in the coming months the government
would need to cut already low levels of imports
and expenditures putting in peril its popularity,
governability, and possibly facing a new bout of
public unrest.
Half hearted measures deepen crisis
Inaction continues in economic policy
Economic authorities continue delaying the measures
needed to correct domestic and external imbalances.
Growth continues plunging, even though figures for the
first and second quarter have not been released,
inflation crossed the 60% mark in the last 3 months,
and the parallel exchange rate reached 100 VEF/USD
during September.
The source of the government’s inaction seems to be
rooted in the possible political cost of curbing
subsidies, cutting expenditure, devaluing the official
exchange rate, and curtailing credit growth. Even the
sale of CITGO, the refining and retail subsidiary of
PDVSA, was backtracked after it proved unpopular
domestically. The same happened with measures as
the gasoline price hikes, the unification of the
exchange rates, and the increase in controlled prices.
In a special report on this same monthly we describe
the main causes and consequences of the prolonged
period of subpar economic policy. However, we
conclude that the ability and willingness to pay external
debt remains but the vulnerability to unexpected falls in
revenue, given the steady fall in oil prices and
production, continues growing every day at a faster
speed.
Oil sector recovery is badly needed to save the day
Even though production levels have steadily declined,
enough policy support increasing the private sector
participation could boost production in the medium
term (3-5 years). In the last two years, foreign investors
Page 132
have become more important and the government
needs to recognize that this policy change will be
critical to boost oil output.
Current oil production (2.82mbpd) remains on a mild
declining trend; even though production from the
Orinoco Oil Belt (OOB) has been increasing, it has not
been enough to offset the decline in the traditional
areas. Oil exports to Asia have been on the rise, and
surpassed exports to the US since 2013. In 2013, an oil
price drop (USD5.3pb), higher cost of government to
government (G2G) exports (USD10.1bn, an increase of
USD3.6bn from 2012), and higher social contributions
(USD13bn, an USD4.3bn increase from 2012) were the
main contributors to a sharp reduction of PDVSA’s
EBITDA, resulting in negative cash flows. The energy
supply cooperation agreements (ESCAs) have been on
the rise, 400kb/d of which directly affect operational
cash flows.
The government’s take from PDVSA remained
impervious to the fall in revenues during 2013, slightly
increasing from USD 49.7 bn in 2012 to USD 50.5 bn in
2013. This includes the contribution to FONDEN,
payment of income taxes, direct social contribution of
PDVSA, government to government exports, and
dividends. It is clear that the fiscal voracity of the
central government is hindering the prospects of
boosting oil production and putting a drag on the rest
of the economy.
A devaluation of the exchange rate from the 6.3
VEF/USD rate would positively impact PDVSA’s
bottom-line as the amount of dollars needed to pay for
social contributions and taxes would be diminished
sharply. However, political constraints and the need to
maintain the high level of expenditure and subsidies
seem to have temporarily trumped over economic and
financial realities.
Given the lack of willingness to curtail expenditure,
PDVSA officials seem to understand that the key for a
turnaround in oil production is an increase in the
participation of the private sector. This is one area that
offers some hope as the government’s oil policy has
turned pragmatic since as early as January 2013, when
they changed the oil windfall tax law, began to attract
foreign investment, and give access to foreign
companies. This change in policy is exemplified by
structured financing for the expansion of some joint
ventures (the ‘Remediation Plan” in the amount of
USD13bn), delegation of procurement process to JVs,
the use of the SICAD II rate for all Oil and Gas
investments, and generally an increase in dialogue with
private partners.
9 October 2014
Parallel exchange rate under pressure
Venezuela: Deutsche Bank Forecasts
2012
National Income
Nominal GDP (USDbn)
Population (mn)
2013F
2014F
2015F
381
30
12,918
449
31
14,721
737
581
31
31
23,764 18,756
Real GDP (YoY%)
Private consumption
Exports
Imports
5.6
7.0
6.3
23.3
1.6
24.4
1.5
5.0
2.7
1.0
3.0
7.0
-3.5
1.0
2.0
0.7
-1.0
10.0
-1.1
2.0
3.0
2.5
2.0
9.0
Prices, Money and Banking (YoY %)
CPI (eop)
CPI (ann. avg)
Broad money (eop)
20.1
23.8
60.1
49.0
56.5
40.0
65.0
55.0
70.0
60.0
50.0
45.0
90.0
80.0
45.0
50.0
Fiscal accounts (% of GDP) (*)
Overall balance
Revenue
Expenditure
Primary balance
-11.5
28.5
42.5
-14.0
-7.2
30.0
40.0
-10.0
-4.0
28.0
35.0
-7.0
-4.8
30.0
38.0
-8.0
Goods Exports
Goods Imports
Trade balance
% of GDP
% of GDP
FDI (net)
FX reserves (eop)
VEF/USD (eop)
98.0
58.0
40.0
10.5
14.0
3.7
0.0
29.9
4.30
92.0
55.0
37.0
8.2
7.2
1.6
0.0
21.7
6.30
85.0
45.0
40.0
5.4
14.0
1.9
1.0
21.0
6.30
82.0
50.0
32.0
5.5
18.0
3.1
1.5
30.0
15.0
Debt Indicators (% of GDP) (*)
Government debt
Domestic
External
External debt
in USD bn
37.9
15.6
22.4
25.8
98.4
8.6
34.6
15.5
19.1
22.2
99.6
13.0
29.2
17.5
11.7
13.7
100.9
14.0
22.0
15.0
17.5
101.8
13.7
General (ann. avg)
Unemployment (%)
2.4
8.0
1.0
8.3
-1.0
8.5
0.5
8.0
Financial Markets (end period)
Spot
14Q4
15Q1 15Q4
20.6
14.5
6.30
25.0
15.5
6.30
25.0
25.0
15.5
17.0
6.30
12.00
Source: Deutsche Bank and Ecoanalitica
Potential adverse rulings by ICSID
Venezuela has 27 pending cases before ICSID, but the
two with the highest profile are the claims filed by
ExxonMobil (headline claim: USD10bn), and by
ConocoPhillips (headline claim: USD30bn 24 ). Gold
reserve was recently awarded a US 740 m for the “fair
market value” of the Brisas project. The ICSID will likely
decide on the Conoco Phillips case as early as
November/December of 2014 according legal experts
we consulted with, as it already ruled that Venezuela
violated the Bilateral Investment Treaties (BIT) in 2013.
The ExxonMobil case will likely be decided in the
following days, as well with a total claim by the oil
company of around USD 10bn. ICSID awards, which
are investment claims, can be enforced worldwide,
against any Venezuelan asset.
However, the enforcement of an award is not usual,
and it would typically take between 2 to 4 years, and
settlements have been the normal way out. In these
cases, it would not be inconceivable that claimant oil
companies are invited back to the Orinoco oil fields as
part of a private settlement after the award.
In any case, apart from the headlines that would
negatively affect the sentiment, the risk of the Republic
having to make an immediate disbursement after the
award is announced is minimal. Further legal measures
and negotiations would be used by the government’s
legal team delaying the outflow.
Armando Armenta, New York, (212) 250-0664
Policy rate
3-month rate
VEF/USD (eop)
37.0
(*) Non-Financial General Public Sector
24
The amount of USD30bn claimed by ConocoPhillips likely includes
forgone revenues, not just the values of seized assets. According to
reports, immediately following the appropriation in 2007 Conoco asked for
compensation of about USD6.5bn, which was likely market value of the
assets at that time.
Page 133
9 October 2014
Theme Pieces
September 2014

Brazil: Marina Silva Changes Election Dynamics
What Explains Disappointing Asian Exports?
Diminishing Expectations in Latin America
Mexico: Undertaking Pemex and CFE Pension
Liabilities
A Growth and Investment Model for India: 2014-2020
Will the Russia Crisis Derail Recovery in Central
Europe?
July 2014

Argentina: Flirting With Default While Aiming at
Resolution
Inflation in Turkey: What Goes Up Struggles to Come
Down
India: Urbanization and Economic Well-Being
Philippines:
Investments'
Growing
Economic
Importance
Idiosyncrasies to Drive CEE FX in Different Directions
Notes from Russia: Dealing with Structural
Challenges and Geopolitics
June 2014

Mexico's Energy Reform in Perspective
India: the Next Government's To-Do List
Indonesia: The Challenge from Commodities
Brazil: Ten Questions About the Elections
South Korea: Labour at a Crossroads
Hungary: Explaining Subdued Inflation and Declining
Export Competitiveness
Asia Vulnerability Monitor
May 2014

India: the Next Government's Fiscal Challenges
Characterizing Elusive Growth in Latin America
Euro Area Still a Powerful Driver of EMEA Export
Performance
Introducing the EM Derivatives Focus
China: Road to Sustainable Local Government
Financing
Venezuela: the Value of Opportunistic Adjustment
April 2014

China: A year of Economic Rebalancing
India: Evidence of a Turnaround in the Investment
Cycle
Breakeven Oil Prices
Implications of Increase in Foreign Participation in
Colombia
March 2014

Bailing Out Ukraine
Russia Macro Implications of Increased Geopolitical
Risks
EMFX:“Good EM/Bad EM” Tail Opportunities
Central Europe: a Good EM Story
Is the Philippine Peso a (CA) Deficit Currency?
India’s Heterogeneous State Finances
LMAP – The Next Generation
Page 134
February 2014

Vulnerabilities, Policy Inaction, and Stigma in the
Recent EM Sell Off
Divergent Pricing of Local and External Sovereign
Bonds
India: CPI Target Means Higher Rates for Longer
Asia Vulnerability Monitor
Inside Fragile EM: Trip Notes from Turkey and South
Africa
January 2014

The Durability of Current Account Adjustment in
Central Europe
Can DTCC Positioning Data Predict EMFX?
Argentina
GDP
Warrants:
More
Attractive
Risk/Reward than Bonds
December 2013

Diverging Markets
Rates in 2014: Refocusing on EM Fundamentals
Sovereign Credit in 2014: Back in the Black
FX in 2014: Diverging Currencies
November 2013

China: Economic Benefits of TPP Entry
EM Rates: Trading Pre-Taper Anxiety
Chile's Presidential Election from a Regional
Perspective
Inflation Drivers in EMEA
The Mystery of Russia's Deteriorating Current
Account Balance
Charting Malaysia's BoP Position
October 2013

EM Allocation: Strategic vs. Tactical
Sovereign Credit - Fundamentals Re-pricing and
Credit Differentiation
Balance of Payment Sensitivities in Latin America
Towards free trade across the Pacific
Outlook and Implications of Mexico´s Fiscal and
Energy Reforms
Greece: GGBs and Warrant, updated and term
structure of risk
September 2013

Emerging Value in Sovereign Credit
Brazil: External Adjustment and FX Intervention
Latin America: Challenged by US Tapering and Time
Decay
Russian Growth: a View from the Regions
Poland – A Deeper Look at Pension Reform
9 October 2014
Contacts
Name
Title
Telephone
Email
Location
EMERGING MARKETS
Cañonero, Gustavo
Regional Head, LatAm
1 212 250 7530
[email protected]
Buenos Aires
Evans, Jed
Head of EM Analytics
1 212 250 8605
[email protected]
New York
Giacomelli, Drausio
Head of EM Research
1 212 250 7355
[email protected]
New York
Head of EM Sovereign Credit
1 212 250 2524
[email protected]
New York
Regional Head, Asia
852 2203 8305
[email protected]
Hong Kong
Global Research
1 212 250 5851
[email protected]
New York
Andean Economist
1-212 250 0664
[email protected]
New York
Senior Economist, Brazil
5511 2113 5185
[email protected]
Sao Paulo
EM Derivatives and Quant Strategist
1 212 250 8640
[email protected]
New York
Senior Economist, Mexico
5255 5201 8534
[email protected]
Mexico
EM Strategist
1 212 250 5932
[email protected]
New York
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
EMEA FX Strategist
44 20 754 59847
[email protected]
London
Economist, Central Europe
44 20 754 57066
[email protected]
London
EMEA Sovereign Credit Strategist
44 20 754 51382
[email protected]
London
Chief Economist, Russia and CIS
7 495 933 9247
[email protected]
Moscow
Economist, Egypt
49 69 910 41643
[email protected]
Frankfurt
Senior Economist, South Africa
27 11 775 7267
Jiang, Hongtao
Spencer, Michael
Ortiz, Nellie
LATIN AMERICA
Armenta, Armando
Faria, Jose Carlos
Marone, Guilherme
Milo, Alexis
Shtauber, Assaf
EMERGING EUROPE, MIDDLE EAST, AFRICA
Gullberg, Henrik
Kalani, Gautam
Kong, Winnie
Lissovolik, Yaroslav
Masetti, Oliver
Masia, Danelee
Popov, Eugene
Porwal, Himanshu
Wietoska, Christian
[email protected] Johannesburg
Head of CEEMEA Corporate Credit
44 20 754 56460
[email protected]
London
EM Corporate Credit
44 121 615 7073
[email protected]
Birmingham
Rates Strategist
44 20 754 52424
[email protected]
London
Economist, Russia, Ukraine, Kazakhstan
7 495 797 5274
[email protected]
Moscow
Head of Asia Credit Research
65 6423 6967
[email protected]
Singapore
Head of Economics, Asia
65 6423 8681
[email protected]
Singapore
Credit Analyst, China Property
852 2203 5930
[email protected]
Hong Kong
Economist, India, Pakistan, Sri Lanka
91 22 71584909
[email protected]
Mumbai
Economist, Malaysia,Philippines
65 6423 5261
[email protected]
Singapore
Head of Asia Rates & FX Research
65 6423 6973
[email protected]
Singapore
Rates Strategist
65 6423 5925
[email protected]
Singapore
FX Strategist
852 2203 6153
[email protected]
Hong Kong
Senior Economist, South Korea, Taiwan, Vietnam
852 2203 8312
[email protected]
Hong Kong
Rates Strategist
852 2203 8709
[email protected]
Hong Kong
FX Strategist
65 6423 8947
[email protected]
Singapore
Rates Strategist
852 2203 5932
[email protected]
Hong Kong
Hong Kong
Zaigrin, Artem
ASIA
Agarwal, Harsh
Baig, Taimur
Cheung, Jacphanie
Das, Kaushik
Del-Rosario, Diana
Goel, Sameer
Kalbande, Swapnil
Kojodjojo, Perry
Lee, Juliana
Liu, Linan
Sachdeva, Mallika
Seong, Ki Yong
Shi, Audrey
Shilin, Viacheslav
Tan, Colin
Economist, China, Hong Kong
852 2203 6139
[email protected]
Credit Analyst, Banks & Sovereigns
65 6423 5726
[email protected]
Singapore
Credit Analyst, IG Corporates
852 2203 5720
[email protected]
Hong Kong
Page 135
9 October 2014
Policy Rate Forecast
Projected Policy Rates in Emerging Markets
Policy Rate Forecasts
Current policy rate

Q4-2014
Q1-2015
Q2-2015
Q3-2015
Q4-2015
Emerging Europe, Middle East & Africa
Czech
0.05
0.05
0.05
0.05
0.05
0.05
Hungary
2.10
2.10
2.10
2.30
2.60
3.00
Israel
0.25
0.25
0.25
0.25
0.75
1.25
Kazakhstan
5.50
5.50
5.50
5.50
5.50
5.50
Poland
2.00 ↓
1.75 ↓
1.75 ↓
1.75 ↓
2.00 ↓
2.25 ↓
Romania
3.00 ↓
3.00 ↓
3.00 ↓
3.00 ↓
3.25 ↓
3.50 ↓
Russia
8.00
8.50
8.50
8.50
8.50
8.50
South Africa
5.75
6.00
6.00
6.00
6.25
6.50
Turkey
8.25
8.25 ↑
8.25 ↑
8.25 ↑
8.25 ↑
Ukraine
12.50
12.50
12.50
12.50
12.50
8.25 ↑
12.50
Asia (ex-Japan)
China
3.00
3.00
3.00
3.00
3.25
3.50
India
8.00
8.00
8.00
8.00
7.75
7.50
Indonesia
7.50
7.50
7.50
7.50
7.50 ↓
8.00
Korea
2.25
2.00
2.00
2.00
2.25
2.50
Malaysia
3.25
3.25 ↓
3.25 ↓
3.25 ↓
3.50 ↓
3.50 ↓
Philippines
4.00
4.00
4.00
4.25
4.25
4.50
Taiwan
1.875
1.875
1.875
2.000
2.125
2.250
Thailand
2.00
2.00
2.00
2.00
2.25
2.50
Vietnam
6.50
6.00
6.00
6.00
6.00
6.00
11.00
Latin America
Brazil
11.00
11.00
11.00
11.00
11.00
Chile
3.25 ↓
2.75
2.75
2.75
2.75
3.00
Colombia
4.50
4.50 ↓
4.50 ↓
4.50 ↓
4.75 ↑
5.00 ↑
Mexico
3.00
3.00
3.00
3.00
3.50
4.00
Peru
3.50 ↓
3.50
3.75
4.25 ↓
4.50
4.50
↑/↓ Indicates increase/decrease in level compared to previous EM Monthly publication; a blank indicates no change
Page 136
9 October 2014
Appendix 1
Important Disclosures
Additional information available upon request
For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this
research, please see the most recently published company report or visit our global disclosure look-up page on our
website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr
Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition,
the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation
or view in this report. Drausio Giacomelli/Jed Evans
Page 137
9 October 2014
Regulatory Disclosures
1. Important Additional Conflict Disclosures
Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the
"Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.
2. Short-Term Trade Ideas
Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are
consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the
SOLAR link at http://gm.db.com.
3. Country-Specific Disclosures
Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the
meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively.
Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and
its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is
indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where
at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the
preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for
its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483.
EU
countries:
Disclosures
relating
to
our
obligations
under
MiFiD
can
be
found
at
http://www.globalmarkets.db.com/riskdisclosures.
Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc.
Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau
(Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures
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Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant
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Page 138
9 October 2014
Risks to Fixed Income Positions
Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise
to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash
flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a
loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the
loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse
macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation
(including changes in assets holding limits for different types of investors), changes in tax policies, currency
convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and
settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed
income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to
FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the
index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended
to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon
rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is
also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be
received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options
in addition to the risks related to rates movements.
Hypothetical Disclaimer
Backtested, hypothetical or simulated performance results have inherent limitations. Unlike an actual performance
record based on trading actual client portfolios, simulated results are achieved by means of the retroactive application of
a backtested model itself designed with the benefit of hindsight. Taking into account historical events the backtesting of
performance also differs from actual account performance because an actual investment strategy may be adjusted any
time, for any reason, including a response to material, economic or market factors. The backtested performance
includes hypothetical results that do not reflect the reinvestment of dividends and other earnings or the deduction of
advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid.
No representation is made that any trading strategy or account will or is likely to achieve profits or losses similar to
those shown. Alternative modeling techniques or assumptions might produce significantly different results and prove to
be more appropriate. Past hypothetical backtest results are neither an indicator nor guarantee of future returns. Actual
results will vary, perhaps materially, from the analysis.
Page 139
David Folkerts-Landau
Group Chief Economist
Member of the Group Executive Committee
Guy Ashton
Global Chief Operating Officer
Research
Michael Spencer
Regional Head
Asia Pacific Research
Marcel Cassard
Global Head
FICC Research & Global Macro Economics
Ralf Hoffmann
Regional Head
Deutsche Bank Research, Germany
Richard Smith and Steve Pollard
Co-Global Heads
Equity Research
Andreas Neubauer
Regional Head
Equity Research, Germany
Steve Pollard
Regional Head
Americas Research
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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
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