emerging markets monthly - dws · emerging markets monthly taimur baig marc balston robert burgess...

Deutsche Bank Markets Research

Emerging Markets

Economics Foreign Exchange Rates Credit

Date 10 April 2014

Biding Time for EM Growth

Emerging Markets Monthly

Taimur Baig Marc Balston Robert Burgess Gustavo Cañonero Drausio Giacomelli Michael Spencer

(+65) 64 23-8681 (+44) 20 754-71484 (+44) 20 754-71930 (+1) 212 250-7530 (+1) 212 250-7355 (+852 ) 2203-8305

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Deutsche Bank Securities Inc. Note to U.S. investors: US regulators have not approved most foreign listed stock index futures and options for US investors. Eligible investors may be able to get exposure through over-the-counter products. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013.

Special Reports

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

10 April 2014

EM Monthly: Biding Time for EM Growth

Deutsche Bank Securities Inc.

Key Economic Forecasts

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

Global 2.8 3.4 3.9 3.2 3.5 3.6 0.2 0.3 0.2 -3.5 -2.8 -2.5

US 1.9 3.1 3.8 1.5 2.1 2.3 -2.3 -2.4 -2.4 -4.0 -2.9 -2.5

Japan 1.5 0.4 1.4 0.4 3.0 1.7 0.7 0.8 1.8 -9.2 -7.2 -5.6

Euroland -0.4 1.1 1.5 1.4 0.8 1.3 2.3 2.4 2.1 -3.0 -2.5 -2.1Germany 0.4 1.5 2.0 1.6 1.1 1.7 7.5 7.5 7.3 0.0 0.1 0.1France 0.3 1.0 1.4 1.0 1.0 1.1 -1.7 -1.5 -1.3 -4.1 -3.6 -3.1Italy -1.8 0.6 1.1 1.3 0.7 1.2 0.8 1.2 1.2 -3.0 -2.9 -2.6Spain -1.2 0.7 1.5 1.5 0.5 1.1 0.7 2.1 2.5 -6.6 -5.8 -4.5Netherlands -0.8 0.9 1.4 2.6 0.5 1.2 10.3 10.5 11.0 -3.9 -3.1 -2.9Belgium 0.2 1.4 1.6 1.2 1.1 1.5 -2.5 -2.0 -1.0 -2.7 -2.5 -2.6Austria 0.4 1.4 1.8 2.1 1.5 1.7 3.0 3.6 3.7 -1.7 -2.8 -1.5Finland -1.4 0.3 1.4 2.2 1.6 1.8 -0.8 0.0 0.3 -2.0 -2.1 -1.6Greece -3.9 1.0 2.2 -0.9 -0.8 0.1 0.5 1.0 1.5 -13.1 -1.6 -0.9Portugal -1.4 1.4 1.1 0.4 0.3 0.9 0.5 1.0 2.0 -5.8 -4.2 -3.0Ireland -0.3 1.8 2.2 0.5 0.5 1.2 7.0 7.0 7.0 -7.2 -4.7 -2.6

Other Industrial CountriesUnited Kingdom 1.8 2.9 2.2 2.6 1.6 1.8 -3.6 -2.7 -2.6 -5.8 -4.7 -3.8Sweden 1.5 2.7 3.0 0.0 0.5 1.8 6.2 5.6 5.5 -3.6 -1.6 -0.8Denmark 0.4 1.4 1.5 0.8 1.4 1.8 7.2 6.5 6.5 0.0 -1.5 -2.0Norway 2.1 2.5 2.6 2.1 1.9 2.1 10.6 11.5 11.5 7.6 9.5 10.5Switzerland 2.0 1.8 2.0 -0.2 0.4 0.8 12.5 12.5 12.5 0.2 0.0 0.0Canada 2.0 2.6 2.9 0.9 1.8 2.3 -3.0 -2.5 -1.9 -1.0 -0.8 -0.1Australia 2.4 3.5 3.3 2.4 3.0 2.6 -2.9 -3.0 -2.7 -2.1 -2.3 -1.4New Zealand 2.7 3.6 2.4 1.1 1.7 2.2 -3.4 -2.9 -5.3 -1.4 -0.1 0.8

Emerging Europe, M iddle East & Africa 2.3 2.0 3.2 4.9 5.2 4.9 0.8 1.1 0.3 -1.5 -0.3 -1.5Czech Republic -0.9 2.0 2.5 1.4 1.0 2.0 -0.6 -1.0 -1.4 -2.7 -2.8 -2.7Egypt 2.1 3.0 4.2 6.9 9.9 10.4 -2.2 -0.4 -2.9 -14.7 -13.2 -14.3Hungary 1.1 2.1 2.2 1.7 0.7 2.8 2.1 1.9 1.4 -2.2 -2.9 -2.7Israel 3.3 3.4 3.6 1.5 1.2 1.8 2.5 2.6 2.7 -3.1 -2.9 -2.5Kazakhstan 6.0 5.4 5.2 5.8 5.6 6.7 0.1 2.0 1.5 5.3 5.3 3.3Poland 1.6 3.0 3.9 0.9 1.5 2.3 -1.5 -2.2 -1.9 -4.5 4.3 -3.1Romania 3.5 2.8 3.2 4.0 2.0 3.3 -1.1 -2.0 -2.1 -2.5 -2.2 -1.9Russia 1.3 0.6 2.2 6.8 6.2 4.9 1.5 2.3 1.7 -0.6 0.6 0.3Saudi Arabia 3.8 4.4 4.1 3.8 3.6 3.5 18.0 13.3 8.9 7.4 5.5 2.6South Africa 1.9 2.7 3.5 5.8 6.2 5.4 -6.0 -4.0 -3.9 -4.1 -4.0 -3.5Turkey 4.0 2.2 3.8 7.5 8.3 7.3 -7.9 -5.7 -5.5 -2.1 -2.6 -2.6Ukraine 0.0 -4.9 2.5 -0.3 4.3 6.1 -9.2 -5.9 -4.3 -4.5 -2.5 -2.2United Arab Emirates 4.9 3.4 3.4 1.1 2.5 2.5 18.0 16.4 13.8 9.5 9.1 7.8

Asia (ex-Japan) 5.9 6.4 6.7 4.3 3.5 4.0 1.7 1.7 1.5 -3.0 -2.9 -2.5China 7.7 7.8 8.0 2.6 2.2 3.0 2.0 2.3 2.5 -2.1 -2.1 -1.5Hong Kong 2.9 4.2 4.5 4.3 3.5 3.2 2.1 3.5 2.7 0.6 2.6 3.4India 3.9 5.5 6.0 10.1 6.8 6.9 -2.6 -2.5 -3.0 -7.0 -7.0 -6.7Indonesia 5.8 5.2 5.5 6.4 6.3 5.4 -3.3 -3.0 -2.7 -2.2 -2.4 -2.6Korea 3.0 3.9 3.6 1.3 1.9 2.8 6.1 4.4 3.2 -0.7 -0.1 0.1Malaysia 4.7 5.5 5.6 2.1 3.4 3.3 3.8 3.5 3.9 -3.9 -3.8 -3.3Philippines 7.2 6.8 6.8 2.9 4.2 3.7 3.5 2.8 1.3 -1.4 -2.4 -2.2Singapore 4.1 3.5 4.5 2.4 2.2 3.4 18.4 18.1 16.5 7.1 6.9 6.8Sri Lanka 7.2 7.3 7.5 6.9 5.0 7.0 -2.1 -1.9 -2.0 -5.8 -5.5 -5.0Taiwan 2.1 3.7 3.4 0.8 1.1 1.2 11.7 10.2 9.1 -2.3 -1.5 -0.8Thailand 2.9 3.5 4.5 2.2 2.7 2.3 0.1 1.0 0.3 -3.0 -3.2 -3.3Vietnam 5.4 5.8 6.3 6.6 6.2 9.5 2.9 2.4 -3.1 -6.0 -6.2 -5.5

Latin America 2.4 2.1 2.8 9.0 11.9 10.7 -2.5 -2.4 -2.3 -3.5 -3.8 -3.7Argentina 2.9 -2.1 1.9 24.9 39.8 29.4 -1.1 0.1 0.5 -4.5 -4.1 -3.8Brazil 2.3 1.7 1.4 6.2 6.4 6.0 -3.6 -3.6 -3.6 -3.2 -4.0 -3.6Chile 4.1 3.6 4.1 1.9 3.5 3.0 -3.3 -3.5 -3.3 -0.6 -0.8 -0.6Colombia 4.3 4.5 4.3 2.0 2.7 3.3 -3.4 -2.7 -3.0 -2.4 -2.3 -2.2Mexico 1.1 3.0 3.7 3.8 4.1 3.8 -1.8 -2.1 -2.2 -2.9 -4.0 -3.6Peru 5.0 6.0 6.5 2.5 2.7 2.9 -5.0 -4.8 -4.5 1.0 0.6 0.5Venezuela 1.5 0.5 3.5 40.0 55.0 57.0 1.6 2.0 3.1 -14.3 -8.5 -11.5

M emorandum Lines: 1/

G7 1.3 2.2 2.8 1.3 1.9 2.0 -0.8 -0.7 -0.5 -4.3 -3.3 -2.7Industrial Countries 1.2 2.1 2.6 1.4 1.8 1.9 -0.3 -0.2 -0.2 -4.1 -3.2 -2.6Emerging Markets 4.5 4.7 5.2 5.2 5.3 5.3 0.8 0.9 0.6 -2.7 -2.5 -2.5BRICs 5.5 5.8 6.1 5.1 4.1 4.4 0.3 0.6 0.5 -3.1 -3.1 -2.7

For Egypt numbers are reported for financial year ending June.

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

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

Source: Deutsche Bank

10 April 2014



Table of Contents Emerging Markets and the Global Economy in the Month Ahead The reprieve offered by improving US economic data and a cautious Fed has encouraged investors back into EM, despite the ongoing crisis in Ukraine and the continued absence of a broad-based acceleration in EM growth. Policymakers in EM have been given more time to prepare for the first Fed hike, but we expect their responses to be mixed with some prevaricating and inviting renewed market pressure down the line. We expect carry to support further inflows, but we see this mainly as a relief rally. We remain selective – favoring valuation and better growth prospects.……………............4

This Month’s Special Reports China: A year of economic rebalancing We have revised down our 2014 GDP growth to 7.8% from 8.6% previously and our 2015 growth forecast to 8.0% from 8.2%. Our forecast reflects a slower-than-expected start to the year and an expectation that as export growth returns as a source of support to growth the government will scale back investment further in order to rebalance growth away from investment and towards consumption. With growth slowing in Q1 towards the bottom of the government’s 7% - 8% ‘comfort zone’, we expect there will be some modest monetary and fiscal stimulus – much of which has perhaps already been announced. Hence, we expect Q1 will mark the low-point of growth this cycle at perhaps 7.4%........... .................. 12

India: Signs of a turnaround in the investment cycle We look at a rich database of firm level investment in India. We find a marked decline in the value and number of projects in operation since 2011, but the Jan-March 2014 data suggests a modest but clear turnaround in private sector investment............ .................................................................................................................................................................. 16

Breakeven Oil Prices We update our estimates of the price of oil needed to balance budgets in the major EM oil producers. Despite lower growth, the weaker rouble will boost revenues in Russia and the breakeven price should fall to about USD 102bbl this year. Breakeven prices are also set to fall in Nigeria and Venezuela but will still be above the spot price at about USD120bbl. Gulf producers have greater headroom though the breakeven price for Saudi Arabia is set to remain over USD90bbl this year.......... ....................................................................................................................................................... 20

Implications of increase in foreign participation in Colombia The expected increase in foreign participation in Colombia’s local market resulted in the significant bull flattening in the COLTES cash curve. We argue that the extra demand derived from the increase in participation implies a structural shift leading to lower yields, a flatter curve and lower FX realized volatility........... ..................................................................... 26

Asia Strategy .......................................................................................................................................................................... 30

EMEA Strategy ....................................................................................................................................................................... 35

LatAm Strategy ....................................................................................................................................................................... 41

Asia Economics ...................................................................................................................................................................... 47

EMEA Economics ................................................................................................................................................................... 73

Latam Economics ................................................................................................................................................................... 93

Theme Pieces ................................................................................................................................................... 114

10 April 2014



Emerging Markets and the Global Economy in the Month Ahead

As the weather in the US has improved, the underlying performance of the US economy has become a bit clearer: growth is back on trend and wage inflation pressures are subdued.

This has reinforced the wedge between tapering and hiking. With the ECB also contemplating QE, fears of an early withdrawal of global liquidity have been allayed.

This reprieve has encouraged investors back into EM, despite the ongoing crisis in Ukraine and the continued absence of a broad-based acceleration in EM growth.

Policymakers in EM have thus been given more time to prepare for the first Fed hike. The response will inevitably be mixed with some tempted to delay adjustment until market pressure returns.

EM assets have recovered the ground lost earlier in the year and carry has helped push returns into positive territory.

We expect carry to support further inflows, but we see this mainly as a relief rally and remain selective – favoring valuation and better growth prospects.

EM currencies are back to the levels of the beginning of January amid some convergence between “good” and “bad” EM. We expect investors to become more selective as the positioning bonus dissipates.

Among the high yielders, we continue to favor ZAR vs. TRY and BRL (which we now expect to trail the MXN). Take profit on long RUB, but stay long PLN and HUF vs. the EUR and favor USD shorts in Asia vs. MYR and PHP.

In rates, we believe that the trend remains bearish for local curves as “neutral” rates are underpriced. However, delayed cycles still bode for short-end receivers in South Africa, Chile, Mexico, and Hungary.

In Brazil, Chile, Mexico, and Thailand, we favor linkers, while we continue to recommend long nominal bonds in Peru and Poland. We also favor steepeners in Korea and China.

In sovereign credit, the market remains cheap according to our model, but now by just 20bp (down from a high of 70bp at the end of August) and while we remain constructive on the market, we don’t find the risk–reward sufficiently compelling to argue for an outright overweight exposure.

Biding time for growth

The previous months have been a rollercoaster for EM assets. Looking beyond the weather, fundamentals have changed little in comparison with perceptions, which have swung from the blatant EM skepticism that we have highlighted in previous Monthly publications to the now more benign view on global policy trade-offs and EM vulnerabilities.

Tame wage inflation, a measured Fed, the prospect of further accommodation from the ECB (and down the road, from the BoJ), and a gradual but sound recovery in the US certainly form a sweeter spot for risky markets, which allows investors to bide their time while waiting for EM growth to finally show more convincing signs. As such, we believe the ongoing retracement in EM assets after months of exaggerated selling pressure is warranted.

However, we also believe that the US economy is poised to reaccelerate, thus reigniting fears of earlier liquidity withdrawal later in the year. Furthermore, evidence of resurgent EM growth may continue to lag the recovery in the US. This combination risks re-igniting some of the concerns which dominated 2013 and as a result, we don’t think the recovery in EM asset prices should turn into a more structural repricing of EM assets at large – at least while many important emerging economies are unwilling to adopt growth-enhancing policies.

The US economy seems back on trend – without near-term inflationary pressures. The latest nonfarm payroll release (192k) was slightly higher than the 187k/month of the past year and the relatively steady 189k monthly average gains observed since January of 2012. The latest figures have also been more reliable, as the impact of inclement weather seems behind us (only 148k did not report to work because of the weather, which is in line with history). The employment figures were encouraging (up 476k in March and 1.2 million in the quarter), pushing labor participation to a seven-month high of 63.2%. The workweek also improved, but altogether the latest labor report is consistent with a 2% Q1 GDP growth. More importantly for risky markets, the latest figures have reaffirmed that labor cost remains quite benign (1% lower oya).

Fed tapering is thus likely to proceed, but no test of forward guidance is in sight. We expect the Fed to trim its asset purchases by another $10bn following the April 29-30 FOMC meeting – on its way to conclude tapering by October. With the Fed unlikely to bring surprises in the near term, markets should be reassured by renewed signs that the US economy is on a sound

10 April 2014



path to recovery. Weekly jobless claims have continued to improve and at a rate that is consistent with growth acceleration in Q2. Tax receipts (up by 8% in March) also support a considerably stronger quarter – a scenario that is corroborated by rising consumer confidence, strong auto sales, and improvements across several regional surveys.

Sound and steady payroll gains

Source: BLS, Haver Analytics & DB Global Markets Research

The latest from Europe is also supportive for risky markets. By explicitly putting QE on the table, the ECB is contributing to taming the risk of (debt) deflation and also limiting EUR/USD upside. But rather than a signal that it will be more proactive, we see this as an additional signal that the ECB is ready to react to a stronger euro, lower inflation, and potential stress in the periphery. As such it limits downside more than it creates upside. The ECB decision will likely be based mainly on exchange rate and inflation developments. The recent PMIs and other short-term data suggest that the outlook for growth remains stable and thus unlikely to be a game changer (chart). As its new set of forecasts will be released in June, we expect the market to follow closely the April and May prints.

It is unclear what the first line of defense would be, as the potential measures to deal with “a too prolonged period of low inflation“ encompass not only QE, but also unsterilized SMP, extended LTROs, and negative deposit rates. As the main focus in the near term is likely the euro, negative deposit rates and – the least controversial – extension of full allotment would likely be the first in line. QE would require some push from markets, and, in DB’s view, private securities would be the starting point despite the relatively small size of the ABS market.

Recent data points to stable growth (Q1)

Country Composite

PMI

National

Surveys

PMI +

IP^

DB Consensus

Euro a rea 0.3 0.4 0.4 0.3 0.3

Germany 0.6 1.1 0.5 0.5 0.5

France 0.0 0.1 0.1 0.2 0.2

Italy 0.0 0.1 0.2 0.2 0.2

Spain 0.3 - 0.3 0.2 0.3

Source: Deutsche Bank, Markit, Haver, INSEE, ISTAT, IFO, IN, Bloomberg Finance LP National surveys refer to EC economic sentiment for the euro area, IFO for Germany, INSEE for France and ISTAT for Italy. ^Based on Q1 PMIs and assuming industrial production is unchaged in February and March at January level.

EM: Taming tail risks EM asset markets have continued to perform well over the last month, arguably better than the economic performance of EM warranted. Policy adjustment and rebalancing is underway in the more fragile EMs. This is encouraging but the process is still in its early stages. There some signs of life, such as the pickup in domestic demand in central Europe. But a broad-based acceleration in EM growth remains elusive. Nevertheless, with the normalization of Fed policy seemingly still some way off, and valuations in many non-EM asset markets looking increasingly stretched, this has been enough to persuade many investors to dip their toes back into EM waters, shrugging off the crisis in Russia and Ukraine in the process.

EM growth: failure to launch

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-6

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-2

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Mar 07 Dec 08 Sep 10 Jun 12 Mar 14

GDP (lhs) PMI (rhs)

QoQ saar (%) Manufacturing PMI

Both series are PPP-weighted averages for EM

Source: Haver Analytics, Deutsche Bank

Since our last EM Monthly, we have revised our outlook for China. Data so far this year are consistent with GDP growth of about 7.4% in Q1, well below what we had expected. The recovery in export growth

10 April 2014



observed in the second half of last year should continue through this year and into 2015, in line with our outlook for growth in the G3 economies. But we now expect the government will use this as an opportunity to depress investment in heavy industry even more. We think infrastructure and manufacturing investment will be well supported by global growth and the government’s urbanization and other reform plans. But consolidation in mining, steel and other heavy industries will likely offset some of the external impulse. We therefore see less upside to growth this year than previously and have, accordingly, revised our GDP growth forecast for this year down to 7.8% from 8.6%. We see growth edging a little higher in 2015 to 8.0%. We discuss these revisions in more detail later in this EM Monthly (see “China: A Year of Economic Rebalancing”).

India on the other hand is enjoying a bout of stability and positive dataflow that seemed unlikely just a few months ago. Balance of payments pressures have dissipated, the rupee has been rallying on the back of a strong recovery in portfolio flows, and inflation has been easing steadily. Markets are also rallying on expectations of a reform-friendly mandate in Parliamentary elections that began this week and will be completed in mid-May. We remain of the view that regardless of the election outcome, the reforms put in motion in recent years will continue, especially in the areas of fuel price adjustment, FDI liberalization, project clearance, and disinvestment, which bodes well for a solid recovery. Later in this EM Monthly, we dig a little deeper into India’s investment cycle, which we find to be in the early stages of a revival (see “India: Signs of a Turnaround in the Investment Cycle”).

Outside Asia, the crisis in Russia and Ukraine continues to evolve. Following Russia’s decision to proceed with the annexation of Crimea last month, the US and EU extended their lists of individuals subject to asset freezes and visa bans. The US also imposed sanctions on one Russian bank. Tensions again escalated in recent days when pro-Russian activists occupied government buildings in a number of cities in eastern Ukraine. We still think that Russian military intervention in eastern Ukraine is unlikely but so too is a quick negotiated solution to the crisis. Amidst all this, the IMF reached preliminary agreement a USD 27bn support package for Ukraine. The package doesn’t include haircuts to private bondholders, but requires a flexible exchange rate and about 6% of GDP of fiscal adjustment over 2 years, including cutting subsidies to domestic gas prices. The domestic economic adjustment will be painful, with a significant recession inevitable. This will set the context for presidential elections on May 25, which is shaping up to be one of the next key milestones in the evolution of the crisis.

The rouble: “conscious uncoupling”

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Russia Fragile EM **

USD vs local currency (indexed)

** Brazil, India, Indonesia, South Africa, and Turkey

Source: Bloomberg Finance LP, Deutsche Bank

Elsewhere in EMEA, the deficit twins of South Africa and Turkey have both seen their currencies strengthen over the past month. Current account imbalances in both cases have peaked though the rebalancing process seems to be more firmly underway in South Africa. Local elections in Turkey passed off without incident last month, providing some additional relief for the lira. Monetary policymakers, however, continue to follow different paths. The South African Reserve Bank has signaled that it has embarked on a tightening cycle but that the pace of tightening will be measured and data dependent. It has so far hiked by just 50bps and real policy rates are still mildly negative. With less credibility, higher inflation, and other imbalances, the Central Bank of Turkey delivered much larger upfront adjustment (effectively 400bps), but seems now to have reverted to an easing bias. For the time being, markets seem to have bought into both stories but we are inclined to think that the consistency of policy is greater in South Africa and that its revival will therefore be the more durable of the two.

The rebound in EMFX has been largest in Brazil and yet its outlook remains challenging. The latest economic data suggest that although GDP growth likely remained positive in Q1, the risk to our growth forecast for this year of 1.7% remains on the downside. Drought has also added to inflationary pressure at a time when core inflation and inflation expectations were already quite high. Inflation accelerated to 6.2% in March, its highest level since July, and we think it will end the year at 6.3%. Despite this, the BCB has signaled that the monetary tightening cycle is coming to an end, though, given higher-than-expected inflation, we expect another 25bps hike in May before the BCB keeps rates on hold until after the elections in October.

Finally, later in this EM Monthly, we present our latest assessment of the price of oil needed to balance budgets in the major EM oil producers (see “Breakeven

10 April 2014



Oil Prices”). Perhaps somewhat counter-intuitively, we find that the breakeven price for Russia is set to decline to USD 102bbl this year, despite the crisis in Ukraine, as the positive impact of the weaker rouble on the local currency value of oil revenues more than offsets the negative impact of weaker growth on public spending and non-oil revenues. Elsewhere, breakeven prices are also set to fall in Venezuela and Nigeria, albeit remaining well above spot prices at around USD 120bbl.

Budget breakeven oil prices (USD bbl)

2007 2008 2009 2010 2011 2012 2013e 2014fGCC 43.2 44.0 70.4 68.4 78.8 73.2 79.1 81.7

Bahrain 66.9 80.0 82.9 103.9 118.1 127.1 125.3 134.9Kuw ait 32.6 42.1 47.0 45.7 47.4 53.6 68.3 71.9Oman 99.3 96.4 69.9 80.2 112.3 112.5 80.4 75.7Qatar 41.8 49.1 27.2 61.7 80.1 62.8 59.6 71.0S. Arabia 52.7 47.0 72.6 70.6 84.5 80.9 91.4 93.4UAE 25.1 44.5 105.8 86.4 95.0 77.7 72.2 70.4

Nigeria 75.1 79.9 125.3 105.3 128.5 112.3 143.6 118.8Russia 28.1 59.7 109.5 116.7 102.8 112.0 113.9 101.7Venezue la 76.9 134.2 140.7 194.4 145.7 153.1 151.3 121.0Brent price 72.7 97.7 61.9 79.6 111.0 111.7 108.9 106.5

Source: Haver Analytics, JODI, Deutsche Bank

Stretching a relief rally

EM assets have broadly reversed the overshooting of January, when a confluence of negative shocks triggered a more systematic repricing of EM risk. After so many months of outflows and the Fed’s successful separation of tapering from hiking, EM assets may well continue to benefit from this renewed search for yield. After all, as the performance chart below suggests, carry remains an important contributor to EM’s absolute and relative performance across credit and local markets. Looking beyond carry and technicals, however, we find no reason to be bullish while EM

growth still is broadly a by-product of the US recovery. Therefore, we remain selective, favoring the better mixes of valuation, growth prospect – besides carry.

EMFX has returned to the levels seen at the start of the year amid some convergence between “good” and “bad” EM. We see this movement as mainly technical and a response to exaggerated EM pessimist earlier in the year. Accordingly, we expect it to wane as the positioning bonus dissipates. Among the high yielders, we continue to favor ZAR vs. TRY and BRL (that we expect to underperform the MXN too) on valuation and policy quality, and recommend taking profit in long RUB. We are constructive PLN and HUF vs. the EUR and favor USD shorts in Asia vs. MYR and PHP.

In rates, we believe that the trend remains bearish for local curves as “neutral” rates are underpriced. However, central banks may delay their cycles, leading to extended gains for short-end receivers in South Africa, Chile, Mexico, and Hungary. In Brazil, Chile, Turkey and Mexico, however, we favor inflation linkers on upside risk to inflation in the former three and the likely undershooting of breakevens in the latter. We also recommend linkers in Thailand and long cash in Peru and Poland. We also favor steepeners in Korea and China.

In sovereign credit a significant degree of normality has returned to the market with the negative correlation between spreads and UST yields returning. The market has also successfully absorbed many significant country-specific shocks, without triggering systemic risk. Relative to our model for BBB spreads, the market remains cheap, but now by just 20bp (down from a high of 70bp at the end of August) and while we remain constructive on the market, we don’t find the risk –reward sufficiently compelling to argue for an outright overweight exposure. We also remain close to benchmark on country exposures, the one key underweight being Russia (hedging Ukraine as much as it represents a view on the domestic situation in Russia).

EMFX: Still waiting for growth EM currencies have broadly recovered the ground lost earlier in the year. As the first chart below shows, EMFX (proxied by a trade-weighted basket) is back to its December close and 1.2% up when carry is included. This is more in line with our EMFX outlook for the year, as we expect carry to account for most of the roughly 6% total return we pencil in for 2014

Performance has remained differentiated, as the scatter plot below shows. However, under more reassuring signs of protracted accommodation and sound but gradual US recovery, “bad EM” currencies have outperformed this time. While most currencies have returned to their end-2013 levels, four of the “fragile

EM performance in perspective: A round-trip

-10% -5% 0% 5% 10%

Com'dty

UST (10-15Y)

EMBI-G

IG

HY

DB-EMLIN

EU Eq

EMFX (Total Return)

S&P

EM Eq

EMFX Spot

DB-EMLIN (hedged)

YTDSince a year ago

Returns of various asset classes

23%

20%

Source: DB Global Markets Research, Bloomberg Finance LP .

10 April 2014



five” have rallied (INR, IDR, TRY, and BRL). In contrast, the underperformers include the “good” CLP (on lower copper prices and a marked economic downturn) and the RUB, where geopolitical tension is likely to linger until Ukraine’s May 25th Presidential elections.

The anatomy of the latest EMFX rebound

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102

104

Apr 13 Jun 13 Aug 13 Oct 13 Dec 13 Feb 14 Apr 14

EMFX Total

EMFX Spot

Total and spot return indices

MXN

BRL

COPCLP

PEN

ZAR

TRYRUB

ILS

HUF

PLN

CZK

INR

KRW

MYR

SGD

IDR

PHP

-20%

0%

20%

40%

60%

80%

100%

-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

carry/vol

appreciation ytd

Source: DB Global Markets Research, Bloomberg Finance LP.

Carry, lower vol, and reduced monetary policy risks bode for further retracement and some additional convergence between “bad” and “good” EMFX. But as favorable initial technical conditions and the unwinding of exaggerated EM skepticism have accounted for a significant share of the recent recovery, this rally is unlikely to last much further, in our view.

EM policy response and some macro rebalancing have certainly contributed to limit downside, but – by-and-large – they are far from complete. More importantly, in our assessment, EM growth remains elusive and domestic absorption still needs to be compressed more aggressively to credibly facilitate macro rebalancing, which now hinges heavily on currency weakness.

Therefore, we are most comfortable recommending long positions in currencies where – besides the benefit of technicals and carry – valuation is most appealing and growth/policies most supportive. This is why, among the “bad EM”, we favor ZAR vs. TRY and BRL.

We expect USD/ZAR to grind lower to 10.25 on improving CA, reduced correlation with US yields, and most favorable fundamental long-term valuation (see charts below). A delay in tightening policy would only happen under rand strength, in our view.

We are more skeptical about persistent policy support in Turkey, but valuation, some current account improvement, positioning, history, and activity suggest a range-bound lira in the month ahead. In contrast, we are skeptical USD/BRL will hold its recent range, as policy deterioration may have stalled, but no progress is in sight. This applies to its CA deficit, which hovers above USD80bn with no near-term prospect of turning. BRL valuation is not supportive anymore and we believe that the central bank is accepting a stronger currency because of the rally in other EM currencies rather than using it to anchor inflation. Besides, the recent drop in Dilma’s vote intentions is likely to reverse once the campaign starts. In our view, the BRL is likely to underperform both the MXN and ZAR.

Weighing in carry and valuation

MXN

BRL

COPCLP

PEN

ZAR

TRYRUB

ILS

HUF

PLN

CZK

INR

KRW

MYR

SGD

IDR

PHP

-20%

0%

20%

40%

60%

80%

100%

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

carry/vol

ST model: implied overvaluation

MXN

BRL

COPCLP

PEN

ZAR

TRYRUB

ILS

HUF

PLN

CZK

INR

KRW

MYRSGD

IDRPHP

-20%

0%

20%

40%

60%

80%

100%

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

carry/vol

LT model: implied overvaluation

Source: DB Global Markets Research, Bloomberg Finance LP.

We keep short EUR/PLN and EUR/HUF, as economic momentum seems robust and policy accommodation is already priced in. Although we don’t expect easing in Russia soon, we prefer to take profit on our tactical RUB long despite valuation and favorable terms of trade, since tension may resurface into elections. We

10 April 2014



also expect the COP rally to stall as index inclusion is already priced, and we see room for disappointment and possible acceleration in USD purchases by the government and possibly pension funds. We are more bearish the CLP, where we find risks biased toward a more aggressive easing cycle.

Although positioning has deteriorated recently, flows seem to be accelerating in Asia, led by equities but also into bonds. As growth expectations have been subdued, the data surprise index for the region is likely to move higher. In addition, inflation risk has increased and raised doubt about some central banks’ commitment to their targets (arguably in Korea, Malaysia, and the Philippines). While we recommend keeping long CNH vols, we favor lower USD/MYR and USD/PHP.

Asia: Short USD/MYR (target 3.15), short USD/PHP (target 43). Long CNH vol.

EMEA: Short EUR/PLN (target 4.075), short EUR/HUF (target 300); short USD/ZAR (target 10.25).

LatAm: Buy MXN/BRL (target: 0.1830). Buy ZAR/BRL (target: 0.24). Buy cash neutral 6M USD/CLP 1x2s call spread (ATMF/579).Stay neutral COP. Buy 3M USD/MXN put (ATMS/KO at 12.35) financing it with a 3M USD/MXN call struck at the top of the recent range (13.60). Short USD/PEN targeting 2.75.

Local rates: Normalization delayed The underlying trend remains bearish EM rates. With few exceptions (namely Brazil, India, and Russia), we believe that markets continue to underestimate “neutral” policy rates across EM despite much tighter output gaps and inflation challenges when compared with developed markets. However, reduced Fed anxiety and the recent rally in EM currencies have created some breathing room for EM central banks. Accordingly, we expect them to move at a slower pace than what is priced this year before having to catch up with “neutral” rates in 2015.

The chart below compares market pricing vs. our 2014 and 2015 policy forecasts. Market premium is mostly negative when we compare pricing with our 2015 forecasts. In contrast, this premium is mostly positive when we focus on market vs. forecasts in 2014, which suggests room for front-end bull-steepening.

Turkey and Poland are exceptions, as more easing is priced through year-end than our baseline scenario. In light of the recent bull steepening in Turkey we thus prefer to take profit on our steepener and stay long via linkers, as the central bank’s bias to ease too much and too early should favor inflation protection. As we don’t expect Poland to deliver any further easing or extend

forward guidance, as indicated in its latest minutes, we favor flatteners instead.

Monetary policy normalization: A flat path priced in

USD

ZAR

ILS

BRL

CLP

COP

MXNEUR CZK

HUF

PLN

RUB

TRYKRW

INR

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

-1.5% -0.5% 0.5% 1.5% 2.5%

Market vs. DB fcst (2015)

Market vs. DB fcst (2014)

Source: DB Global Markets Research, Bloomberg Finance LP

The potential delay in tightening cycles or additional easing favors front-end steepeners in South Africa, and receivers in Chile, Hungary, and Mexico. The upside seems limited, however. In Hungary we lower the target on our outstanding receiver recommendation aiming at a final cut, while in Chile we prefer to receive via linkers (UF swaps), since possible inflation upside surprises could prevent the central bank from being more aggressive than priced. As the easing cycle is about to end in Hungary and the curve is steep, we also favor flattening in longer tenors.

Although our call for Banxico on hold until 1Q15 points to receiving, we find better value in longer tenors of the curve. It is also likely that the Colombian central bank delivers less than priced, but with activity accelerating and inflation bottoming out, premium does not seems excessive, in our view. Premium is more appealing in Brazil, but as the risk that inflation surpasses the upper band of the target has risen, we also favor linkers. We find the largest gap between pricing and our baseline scenario for policy rates in Russia (see chart above), but we look for opportunities to receive into the run up to Ukraine’s elections, as tension may again escalate.

Search for carry is likely support flattening. After almost one year of outflows from local markets, apparently more mean-reverting currencies, and still wide yield differentials vs. developed markets, some influx may be in order. As the chart below shows, real (deflated by inflation expectations) local yields seem to have leveled at almost 400bp above UST. As the scatter plot shows, real rates look attractive in Brazil, Turkey, Russia, Peru, and Poland among others. While we wait for possibly better entry levels in Russia, we continue to recommend long Soberanos (though moving to shorter tenors after the rally in the long end)

10 April 2014



and favor Poland vs. Czech Republic spread compression in cash.

In our view, premium in the Mexican curve remains concentrated in longer tenors. The low inflation season ahead has compressed breakeven inflation rates, but we see signs of overshooting with long-dated real rates at historical highs and breakevens at historical lows. We also favor linkers in Thailand, and – elsewhere in Asia – we recommend steepeners in Korea and China.

Real yield differentials widening stalls

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Jan 10 Jan 11 Jan 12 Jan 13 Jan 14

Credit-adj. differential

Real differential

Yield diff, %

BR

CL CO HUID

IL

MX

MY

PE

PH

PL RUTR

ZA

Index

US

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

20 70 120 170 220 270

5Y real yield, %

5Y CDS, bp

Source: DB Global Markets Research.

Asia: Hold 2s5s IRS steepener in China (target +45bp) and 2s10s IRS steepener (1Y fwd) in Korea (target +55bp). Long Singapore swap spreads (10Y SGS v 5Y IRS – target -60bp).

EMEA: Stay received in HUF 6x9, (target 2.75); enter ILS 2s5s flattener (target 75). Enter 2s10s PLN flattener at 95bp (target 70bp). Stay long PLN Oct-19 vs. Czech Oct-19. Receive ZAR 6x9 FRA vs. pay 2Y IRS with total carry of 20bp. Buy TRY IL-bond April-20 with real yield of 3.4% and B/E at 6.65%.

LatAm: In Mexico, buy Udibono’40 (target 3.35%). Scale up long inflation breakeven (long Udibono’22 vs. 10Y TIIE). Keep 5Y5Y spread compression vs.

US swaps (target 350bp). In Brazil, buy NTN-B’35 (target 6.25%). Hold Jan16/Jan21 steepeners (target 90bp). In Chile, hold 1Y UF receivers vs. 5Y CLP swap payers, DV01-neutral (target 400bp) and 10Y swap spread vs. the US (target 200bp). In Colombia, take profit in long TES 20s and COLOM’27 – stay neutral. In Peru, switch from Sob’31 to SOB’20 (target 5.5%).

Credit: A welcome return to normality 2014q1 was a fascinating quarter for EM sovereign credit. Despite the plethora of country-specific risk – including currency devaluations, emergency rate hikes, corruption scandals, social unrest, elections and territorial disputes – the behavior of the market as a whole indicated a return to ‘normality’ after three quarters of abnormal behavior. By this concept of normality, we mean the relationship between EM spreads and UST yields and the resultant relationship between spread volatility and total return (price) volatility. This is illustrated on the chart below, which compares these two measures of vol in recent quarters. While spread vol in Q1 was approaching that seen in the middle of 2013, return vol was considerably lower.

2014q1 has seen a return to ‘normality’ for the EM

credit market after 3 abnormal quarters

0

20

40

60

80

100

120

140

0

2

4

6

8

10

12

14

12q2 12q3 12q4 13q1 13q2 13q3 13q4 14q1

Return vol, % (lhs)

Spread vol, bp (rhs)

Note: volatilities are computed on the basis of 1 week changes in the EMBI Global Diversified, annualised.


Of course, the relationship between these two measures of volatility is governed primarily by the correlation between spreads and UST yields. The lower return vol indicating a return to the normal negative correlation between the two measures. This return to normality is somewhat surprising, given that flows have remained negative (almost 5% of AUM withdrawn from EM hard currency bond funds) and issuance has been at record levels (USD39bn in EM sovereign issuance in Q1), but it is perhaps an indication that the fears over the impact of Fed tightening on the EM debt market have reached their zenith. We do not discount the possibility of a resurgence in these fears (and a return of positive spread-UST yield correlation), but it

10 April 2014



would likely require a very rapid move higher in UST yields (50-100bp) to trigger it.

In the meantime, the return of normality persuades us to revist our model1 for credit spreads to see to what extent it can explain recent EM spread dynamics. The EM market BBB spread remains cheap to the model, but the extent of this cheapness has declined over the past couple of months and now stands at +20bp (down from a high of +72bp at the end of August and +51bp as recently as the end of January).

EM sovereign spreads are converging to their model-

implied level

0

200

400

600

2002 2006 2010 2014

Model fitted

EM BBB

Z-Spread, bp

-100

-80

-60

-40

-20

0

20

40

60

80

100

2002 2006 2010 2014

Market vs model, bp


Interestingly, despite the multitude of shocks the market has experienced over the past year and the ‘abnormal’ behavior of spreads (vs UST yields), the model2 still does a good job at explaining the month-by-month changes in the EM BBB spread (see chart below). Looking forward, the model indicates that all else being equal, the current 20bp ‘cheapness’ should contribute to 6bp of spread compression. This could be negated by any one of…

— a) 65bp rally in 10Y swap rate

— b) 1.5 point rise in the VIX

— c) 1.5 additional sovereign downgrades

— d) 1.9% of AUM outflows from EM HC bond funds

Now, while (a) and (d) seem unlikely, we would certainly not rule out (b) or (c). Considering this and considering that the market has performed very well

1 First introduced in the EMM of June 2013, the model uses US 10Y swaps, Fed Funds, VIX and EM sovereign downgrades to model the average z-spread of BBB EM sovereigns. 2 As discussed in the EMM of Sept 2013, we ‘explain’ changes with a second model which has as its inputs the current residual of the first model, changes in the implied level of the first model and EPFR fund flows during the month.

over the past two months, we refrain from recommending an outright overweight exposure, although we are, on balance, constructive.

Despite the shocks of the past year, our model does a

good job of explaining the monthly spread changes

-40

-30

-20

-10

0

10

20

30

40

50

-25 -20 -15 -10 -5 0 5 10

Actual change in EM BBB Spread, bp

Model-implied change in EM BBB Spread, bp


Summary of main recommendations:

Overweights: Poland

Underweights: Russia

Basis trades: Long 10Y basis in Russia (23s v 10Y)

10s30s cash curve steepeners in Mexico, Turkey and S.Africa. 5s10s CDS flattener in Brazil

Favor Pars in Argentina, PDV14s in Venezuela and Pemex 45s in Mexico

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

Marc Balston, London, +44 20 7547 1484 .

10 April 2014



China: A year of economic rebalancing

New economic agenda with multiple goals

We have revised down our 2014 GDP growth to 7.8% from 8.6% previously and our 2015 growth forecast to 8.0% from 8.2%. Our forecast reflects a slower-than-expected start to the year and an expectation that as export growth returns as a source of support to growth the government will scale back investment further in order to rebalance growth away from investment and towards consumption.

With growth slowing in Q1 towards the bottom of the government’s 7% - 8% ‘comfort zone’, we expect there will be some modest monetary and fiscal stimulus. Hence, we expect Q1 will mark the trough of growth this cycle at perhaps 7.4%, then, in part because we see a policy response aimed at providing a little stimulus. More important, though, we expect the external sector to re-emerge for the first time in four years as a source of growth in the economy.

Recent slowdown is largely the outcome of the government’s efforts to rebalance the economy’s structure. What government will seek to do is to support growth to prevent an increase in financial risks and to ensure adequate employment growth in near term, however, any stimulus to be very modest, in our view. Aggressive monetary stimulus could, to be sure, boost growth rapidly, but at the cost of the rebalancing agenda. So the reform agenda constrains the policy response in some ways but also shapes the response towards accelerated liberalization in a bid to support growth through means other than traditional stimulus.

The return of exports as a source of growth will allow the government to hasten its reforms, effectively trading off higher external demand growth for slower investment growth at home. So readers will note that in our new forecast, the main change to domestic demand growth has been to forecast a slower rate of growth of investment this year where previously we expected a slight increase.

It is our belief that the government no longer has a singled-minded pursuit of GDP growth, but a balanced consideration of employment, social and environmental issues, structural adjustment, and financial system soundness will shape policy. Two themes dominate the reform agenda, in our view: expanding the scope of the private sector and ensuring that the financial system supports the aspirations of private investors. This also likely means weaning state owned enterprises off easy credit. But there are important social aspects to development: facilitating rural-to-urban migration,

ensuring the provision of an adequate social safety net and education and health services. The government’s plans for reform in the coming five to ten years are dramatic and what they need is stability of growth more than a high rate of growth.

Rebalancing to continue in 2014

As we noted above, we expect the recovery in GDP growth to be driven mainly by rising export growth. We think consumption growth will be modestly higher this year, despite the apparently slow start to the year, as income growth picks up. We expect investment growth will continue to slow down – to rates that are in some respects very low by Chinese historical standards. But that is what rebalancing requires. The slower rate of investment likely dominates any reduction in the savings rate and we expect this means the current account surplus will widen as imports grow more slowly than exports.

Specifically, we expect real private consumption growth to rise to 8.1%yoy, up from 7.7%yoy in 2013, contributing 2.9ppts to overall real GDP growth. We expect government consumption growth to decelerate to 7%, contributing only 1.0ppt to GDP growth. We forecast 11%yoy growth in urban households’ disposable income, up from 9.7% 2013 and slightly higher than our forecast of nominal GDP growth of 10.5%. We believe that rising incomes are gradually setting the stage for a consumption driven economy although it may not be apparent for a few more years.

Contribution to GDP growth rate

3.0 3.5 3.0 4.0 3.0 2.8 2.9 3.1

1.2 1.1 1.51.3

1.2 1.0 1.0 0.9

4.5

8.1

5.5 4.4

3.6 4.2 3.3 3.5

0.9

-3.5

0.4

-0.4 -0.1 -0.3

0.6 0.5

9.6 9.210.4

9.3

7.7 7.7 7.8 8.0

-4-3-2-10123456789

10111213

2008 2009 2010 2011 2012 2013 2014F 2015F

Private consumption Govt. consumptionGCF Net ExportsGDP

%

Source: Deutsche Bank, CEIC, Haver Analytics

10 April 2014



We expect real gross capital formation (GCF) growth of 7% in 2014 down from an estimated 9% in 2013 and the slowest growth in at least eight years. The need to work out overcapacity in some sectors – particularly in heavy industry – and a likely slowdown in property investment growth will lead to a significant decline in the growth contribution from investment to 3.3ppts from 4.2ppts last year.

This will be possible because we expect real exports to grow 11% this year, up from 6.5% last year due to a pickup in growth in the advanced economies, especially the US and Europe. But with slowing investment growth, we expect imports to grow only 10% this year. Hence, we forecast a 0.6ppts contribution to real GDP growth this year from net exports. This follows three years in which net exports have been a drag on growth as imports have grown faster than exports.

We expect FAI growth slow to 17% in 2014 We expect that FAI growth will moderate to 17% from 19.7% in 2013, as the government focuses on economic restructuring and rebalancing than on the pursuit of investment-led growth. We expect a continued suppression of investment growth in heavy industries and other sectors with significant over-capacity, as well as in government spending, due to financial sector reforms and the anti-corruption drive. Financial liberalization, including further deposit rate liberalization, which we expect this year, could push SOEs’ funding costs higher – especially as greater recognition of credit risk in the bond market has made it easier for banks to raise interest rates on loans to less financially secure SOEs. While this is an important contribution to improving the efficiency of capital allocation, it does carry a negative growth impact. To some extent, this will be mitigated by the increase in the share of lending to private enterprise, often at interest rates that, while substantially higher than those charged to SOEs are lower than these private companies have historically faced.

A deceleration in investment growth is necessitated by the current high level of leverage in the SOE sector, the poor mix of the investment, the unbalanced economic structure, as well as frictions in the economy. It is clearly beneficial for China to deleverage its SOEs sooner than later.

Economic rebalancing requires a deceleration in investment growth. China is much more leveraged than it was pre-crisis. Over the past five years, China’s total debt to GDP ratio has risen to 230% from 150% in 2008, mostly driven by the build-up of corporate debt. The local government debt to GDP ratio doubled in the past five years and reached 24% by the end of 2013 while central government to GDP ratio remained stable during the same period. Within the 230% of total debt

to GDP ratio in 2013, 153% is debt owed by non-LGFV corporate via loans, bonds and shadow banking credits, 35% is household debt (mostly housing and auto mortgage loans), 24% is local government debt and 19% is central government debt.

China debt as % of GDP

98% 101%122% 129% 130%

142% 153%

19% 18%

24%28% 29%

31%35%

12% 12%

18%18% 19%

21%

23.9%

25% 21%

22%21% 19%

19%

18.7%

0%

50%

100%

150%

200%

250%

2007 2008 2009 2010 2011 2012 2013

Corporate (LGFVs exculded)HouseholdLocal govt. (LGFVs included)

Central govt.

Source: Deutsche Bank, CEIC, Haver Analytics, NAO

We expect a healthier mix of FAI growth outlook in 2014. China has no shortage of investment spending, obviously. The problem, though, has been with its quality. The solution is to remove the subsidy on investment by SOEs and to reallocate capital to more efficient private sector. But some government expenditures are worthwhile and will require continued financing, especially in healthcare, education, transportation, clean energy, environment and internet.

In 2013, we saw a healthy trend of FAI growth in sectors like manufacturing, transport infrastructure, social services, and real estate. Manufacturing FAI growth decelerated from 22% in 2012 to 18% in 2013. Investment in transportation infrastructure accelerated from 11% in 2012 to 19% in 2013, which was a major component of the government’s stimulus measures. Investment in social services (including water conservancy, environment & management, education and healthcare) rose to 26% in 2013 up from 19% in 2012. The real estate sector had steady FAI growth of 21% in 2013. However, mining investment grew slightly faster -- 12% in 2013 versus 11% in 2012 – which we think runs contrary to the government’s plans for consolidation.

Given that over-capacity still persists in heavy industry (e.g. steel, shipbuilding and aluminum) and mining (especially coal), we expect FAI growth in manufacturing and mining to decline to 16% and 6% respectively. The slowdown in manufacturing FAI will be attenuated by a rebound in exporters’ investment,

10 April 2014



but this represents a relatively small share of manufacturing investment (perhaps about 20%). We expect to see an increase in FAI growth in infrastructure, particularly in transportation, reflecting the emphasis on growth of small and medium-sized cities and new city clusters and on strengthening connectivity among city clusters. In light of the new urbanization plan and environmental campaign, we expect FAI growth in social services to remain at the high level of 25%. We expect real estate investment growth to moderate to 17.0%, due to likely slowing housing price inflation, tighter credit conditions (especially in the shadow market), and over-supply conditions in lower tier cities.

FAI growth rate by sector Growth

2012 Growth

2013 Growth

2014 Weight

2013

Manufacturing 22% 18% 16% 34%

Mining 11% 12% 6% 3%

Transport infrastructure 11% 19% 20% 8%

Transport infrastructure: railway

5% 8% 10% 1%

Real estate 22% 21% 17% 26%

Social services (environment, education, healthcare )

19% 26% 25% 11%

Agriculture 33% 3% 10% 2%

Others 24% 22% 16% 16%

Total FAI growth 21% 20% 17% Source: Deutsche Bank, CEIC

Exports is the main driver of recovery We remain positive on China's export outlook this year on improving external demand especially from the US and the Euro area, and we expect real export growth will recover to around 11% in 2014 and 12% in 2014, up from around 6.5% in 2013. We forecast G3 GDP growth (weighted by Chinese exports to these destinations rather than their GDP) will increase from 1% in 2013 to 1.9% in 2014, and to 2.5% in 2015.

With the expectation of real imports to grow by 10% in 2014 and 11.5% in 2015 respectively, net export contribution to GDP is 0.6ppts to 2014 GDP growth, 0.5ppts to 2015 GDP growth.

China still remains a highly competitive exporter, according to a 2013 survey done by Deloitte and the US Council on Competitiveness, although RMB appreciation and rising unit labor costs over the past years have weighed on competitiveness. Latest data suggest that China continues to gain market share in major economies: the US Census Bureau data indicate that the share of US imports from China has risen from 18.7% in 2012, to 19.4% in 2013 and further to 20.7% in January of 2014. As for the Euro Area, the share of imports from China stabilized around 11.8% in 2012-2013 but recently picked up to 12.9% in January 2014.

We expect that export growth will accelerate in Q2 and well into 2015 given the following: 1) the recent soft export growth is mainly cyclical and influenced by the high base effect due to over-invoicing in the beginning of the last year, and external demand will improve significantly; 2) RMB appreciation in REER terms decelerates in 2014, compared with the 6% of RMB in REER term; 3) reforms such as those in the Shanghai Free Trade Zone should provide additional upside to exports in the medium term.

Macro policies

We expect CPI inflation to average 2.2% this year, rising to 3.0% in 2015. We think in the near-term inflation will slow to 1.7% from 2% in February and then gradually rise in the second half of the year to 2.8% in December. With the PBOC’s forecast/target of 3.5%, this means we see scope for an easing of monetary policy this year.

Since the middle of last year, credit conditions have been getting tighter, reflected in the decline of growth rates of various liquidity measures, including M2 growth, bank loan growth and TSF stock growth, as well as the increase in funding costs, such as medium term corporate bond yields, trust product yields and RMB WMP yields. But monetary conditions remain accommodative, especially lately, with both the 7D SHIBOR and 7D repo rate at an average of 3% in March, a level much lower than the average rate of 4% in 2013. The “disconnect” between conditions in the interbank market and markets for corporate financing is probably due to the development of non-banking financing activities and the re-pricing of credit instruments. Moreover, the excess reserve ratio is likely to be between 2.5% and 3% in March (Dec 2013 was 2.3%). So there seems to be no need for aggressive monetary easing – for example cutting the RRR -- unless growth slows significantly more, although there are tools that can be utilized, such as window guidance on lending or an increase in the loan-to-deposit ratio to try to fine tune monetary conditions.

Still, we expect further declines in the growth rates of various measures such as M2, the stock of bank loans and the stock of TSF over the course of 2014. We expect the growth of total bank credit will slow to 12.4%yoy by the end of 2014, down from 14.1% at the end of 2013, implying a new loan creation of RMB8.9tn in 2014, the same as in 2013. Growth in the stock of TSF is expected to decline to 16.5% by the end of 2014. M2 growth is expected to decelerate to 12% by the end of 2014 from the 13.6% in Dec.

Financial sector reforms We expect China to deepen financial reforms in 2014, including the opening up of the banking sector to private investment, issuance of local government

10 April 2014



bonds and development of securitization products, interest rate liberalization, and capital account liberalization. On interest rate liberalization, we expect China to establish a deposit insurance scheme, to widen the deposit rate ceiling (to at least 1.2 times the benchmark deposit rates) and to expand the number of issuers of certificates of deposit (CDs).

These reforms will likely raise the cost of funding for banks and their traditional borrowers (i.e., SOEs). In the CD market for example, our analysis shows that the pricing of the first interbank CDs issued by ten commercial banks seems rich by 40-50bps. As we expect more medium- to smaller-sized banks and foreign banks to be permitted to issue CDs in 2014, more frequent issuance and trading of CDs will help rationalize the pricing relationship and improve the pricing discovery of the CDs and SHIBOR fixing rates.

Accordingly, we expect interest rates to rise in 2014 against the backdrop of more default events of credit products, government bond supply risk and headwinds to the banking sector amid interest rate reforms and new regulations aimed at reducing shadow banking activities. As a result, funding allocation will be ameliorated, the deleverage of over-capacity sectors will be expedited while qualified borrowers in under-capacity sectors and in the private sector will be granted more access to funding, particularly.

An expansionary fiscal policy in 2014 The budget deficit of the general government (including central and local) is set at RMB1.35tr, up from RMB1.2tr last year. These numbers represent a slight expansion of the fiscal stance. Given that budgeted fiscal spending is about 23% of GDP in 2014, the timing of spending can have a meaningful impact on the growth pattern and can be particularly stimulative when the economy is at a cyclical low point. Given the current downward pressure on growth, we see the higher possibility for government to quicken the pace of its planned fiscal spending. And we think there is room for government to expand the fiscal spending, in particular in areas like environmental, healthcare, education, social housing, public infrastructure and etc.

CNYUSD to appreciate 2% over next twelve months The RMB has depreciated about 2.6% against the USD since the PBOC’s cross-border RMB business work conference on Feb 18, which emphasized the need to further increase the flexibility of the RMB exchange rate. And on March 15, the PBOC widened the daily trading band of USDCNY to +/-2% (up from previous +/-1%) around the fixing rate effective from March 17. We believe the depreciation was likely engineered by the PBOC for the purpose of deterring speculative capital inflows by introducing higher volatility and reducing the attractiveness of the RMB carry trade, rather than establishing a depreciation trend for RMB

against US dollar. The risk of a disorderly CNYUSD depreciation process is manageable with the USD3.8tn worth of foreign exchange reserves held by the PBOC.

We forecast a 2% appreciation of the RMB against USD over the next twelve months and an increase in its two-way volatility. Potentially continued capital inflow in the medium term will support a moderately stronger RMB, due to: First, China's growth will remain stronger than all other major economies, and would thus continue to attract foreign investments. Second, Chinese interest rates will remain higher than corresponding rates in its major trading partners and could rise even more than those rates. Third, reforms to open up the capital account would attract more inflow to invest in Chinese bond and equity market. Fourth, we expect China will reduce its market access restrictions on foreign investment via implementing a "negative list" system, as has already been proposed for the Shanghai Free Trade Zone. Finally, stronger G2 growth this year should push up Chinese exports and lead to a stronger trade surplus.

As of the future RMB exchange rate policies, we see a gradual shift in RMB exchange rate policy towards managing RMB against a proper basket of currencies as was originally planned in 2005. In a generally strong USD environment, which we expect for the coming few years, this will gradually bring to an end the trend appreciation of the RMB against the USD even if the currency appreciates on a trade-weighted basis.

Risks

We see three major risks to our GDP forecasts:

1. Export growth doesn't hold up. The assumption of about 1ppt higher GDP growth for the G3 and associated recovery in import demand is embedded in our export forecast. Should that fail us, we think Chinese GDP growth would likely be about 7.3%-7.5%, in which case credit tightening will be less aggressive than what we forecast in our base case scenario.

2. The sharp rise in credit instrument. The risk could happen due to many more sizeable credit defaults down the road. Should the funding cost rise too high and credit condition become too tight, corporate’ well-being will further deteriorate.

3. A sharp decline in property prices. This would both drag down residential investment (which is 25% of total FAI) and impart a negative wealth effect on consumption.

Michael Spencer, Hong Kong, +852 2203 8303 Lin Li, Hong Kong, +852 2203 6187

Audrey Shi, Hong Kong, +852 2203 6139

10 April 2014



India: Signs of a turnaround in the investment cycle Using a large database of company reports on present and planned investment, we examine India’s fixed capital formation cycle.

We first show that the data is a good approximation of the investment cycle, as the growth rate of investment calculated by the data follows the gross fixed capital formation series published in national accounts reports. The advantage of the investment database is it offers expedited and richer details compared to the national accounts.

Second, we use the data to illustrate the evolution of the investment cycle in recent years. Real value of outstanding investment began to taper from 2011 onward, followed by a sharp decline in projects completed and a commensurate rise in projects under suspension. The weakness has been pervasive across the private and public sectors.

Finally, we present some good news. According to the latest available data, investment bottomed during the Oct-Dec quarter, and there was a modest but clear turn in the investment cycle in the Jan-March quarter. The turnaround has been particularly pronounced in private sector.

Our findings show that contrary the prevailing popular narrative, investment does not remain paralyzed in India. Faced with an adverse macroeconomic environment and a myriad of structural and policy impediments to the business environment, there was, understandably, a marked slowdown in fixed asset investment in recent years.

But as policy adjustments were made, the external environment improved, and businesses adjusted to the more subdued reality, investment bottomed, and the latest evidence suggests the economy is on the early-stage of an investment revival. This bodes well for the growth outlook in 2014 and beyond, provided the macro and regulatory environment remains conducive to investment.

Micro data from a large database

National accounts data shows that investment has slowed sharply in recent years, bringing down GDP growth sharply. Indeed, investment’s contribution to growth has been around zero lately, and it is hard to see how India’s short or long-term growth prospects can improve materially unless investment revives.

Real GDP and investment growth

4

6

8

10

-1

4

9

14

19

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Investment growth, lhs

Real GDP growth, rhs% yoy % yoy

Source: CEIC, Deutsche Bank

There is a fairly rich set of data available for tracking firm level investment in India, constructed by the Centre for Monitoring Indian Economy (CMIE). We have analyzed the CMIE’s CapEx database, which breaks down investment between the public and private sectors, in ongoing and postponed projects, as well as the value and number of investments.

The database presently collects information on around 45000 projects by 9000 firms. The outstanding value of projects captured by the database is about 80% of GDP. Key features:

The CapEx database captures new projects being announced, tracks the various events of all the projects in its radar and captures the end of the project;

It captures projects with a capital expenditure of INR10mn or more;

Outstanding projects are those that are still under implementation or are under consideration for implementation as of the date of reference. These projects have not yet been completed, stalled, shelved or abandoned.

A project is deemed completed when it begins commercial production or when it starts providing the services it intended to provide. Completed projects also reflect the changes in cost and time in completion of the projects.

Stalled/shelved/abandoned projects are those that ceased to progress towards completion for various reasons.

Apart from aggregated data, the database also provides capex trend broken between the private and public sectors.

10 April 2014



The firm level investment data adds up to a good approximation of the investment data reported in the national accounts. The following chart shows that over the long run, the real incremental investment series derived from the CMIE data tracks the investment data reported in the national accounts well, broadly capturing the turns in the cycle.

Firm level data is a good proxy for investment

measured in national accounts

-10-5051015202530

-200

-125

-50

25

100

175

250

Incremental investments (real)Real GFCF, rhs

% yoy % yoy

Source: CMIE, CEIC, Deutsche Bank. GFCF stands for Gross Fixed Capital Formation from the national accounts database

Anemic investment momentum

The CMIE CapEx data shows that investment momentum has decelerated appreciably in recent years, across private and public sectors. The slowdown in investment momentum is unambiguous, irrespective of how it is measured - in terms of absolute level (in real terms, deflated by CPI, and seasonally adjusted, see chart on left below), relative to its historical trend which we measure by calculating z-scores (chart on right), or expressed in terms of growth rates (yoy% or qoq%).

Total outstanding investments have been declining

steadily since early 2012

0

100

200

300

400

500

1997 1999 2002 2004 2006 2009 2011 2014

Outstanding investments (real)INR bn

Source: CMIE, Deutsche Bank

Momentum of the private and public sector

investments, measured in z-scores

-2.0

-1.0

0.0

1.0

2.0

3.0

1997 1999 2002 2004 2006 2009 2011 2014

Outstanding investments, real (Govt.)Outstanding investments, real (Pvt.)

z-score


The surge in capacity expansion was the most distinct during 2003-2008, which coincided with India recording above 8% real GDP growth on an average during the same time period. While there was some recovery in growth and investments post the great-financial crisis in 2008, the momentum failed to sustain and the economy witnessed a sharp decline again from 2011 onward, resulting in a sharp decline in growth, and arguably a decline in potential GDP growth rate (the potential growth rate is estimated to be 6.0% under the prevailing conditions).

Outstanding private investment in real terms

-10

-5

0

5

10

15

20

-20

0

20

40

60

80

2005 2006 2008 2009 2011 2012 2014

SA,% yoy, lhsSA,% qoq, rhs

% yoy % qoq


10 April 2014



Outstanding public investment in real terms

-5

0

5

10

15

-10

0

10

20

30

40

2005 2006 2008 2009 2011 2012 2014


% yoy % qoq


A sobering picture of investment slowdown

There has been a sharp rise in stalled projects in recent years (see chart below), both in absolute terms and as a share of completed projects. This corroborates the perception that in response to an adverse macroeconomic environment and a myriad of structural and policy impediments to the business environment, there has been a marked slowdown in fixed asset investment in recent years.

Cost of projects stalled/shelved have surpassed those

of completed projects since FY12

0

1000

2000

3000

4000

5000


Stalled/shelved

Projects completedINR bn


Absolute number of projects – completed vs.

stalled/shelved/abandoned

0

10

20

30

40

50

0

500

1000

1500

2000


Projects completedStalled/shelvedStalled/completed, rhs

No. of projects


We believe that factors behind the investment slowdown can be broken down into two categories. First, in the post-global financial crisis period, many Indian companies found waning demand at a time when they had aggressively invested (and borrowed) in expanding capacity, which prompted a need to deleverage and consolidate. Second, the already-challenging macro environment (high inflation, interest rate, and current account deficit, plus a weakening exchange rate) was coupled with many investigations into corruption in project allocation (by the public sector), pushback from civil society and judiciary on investments in mining, and an overall malaise in sentiments. This affected both private and public sector investment.

Value of completed projects and real gross capital

formation

-10

-5

0

5

10

15

20

25

-100

-50

0

50

100

2000 2002 2004 2006 2008 2010 2012 2014

Projects completed, realReal GFCF, rhs

% yoy % yoy


10 April 2014



Looking forward – a recovery in the making?

Finally, we present some good news. According to the latest available data, investment bottomed during the Oct-Dec quarter, and there was been a modest but clear turn in the investment cycle in the Jan-March quarter. The turnaround has been particularly pronounced in private sector investment.

Outstanding private investment, in real terms

-8

-6

-4

-2

0

2

4

6

-15

-10

-5

0

5

10

15

2010 2011 2012 2013 2014


% yoy % qoq


Our findings show that contrary the prevailing popular narrative, investment does not remain paralyzed in India. While there is no denying that there was a marked slowdown in fixed asset investment in recent years for reasons discussed above, the data suggests that when the Jan-March national accounts data is released, investment’s contribution to growth will turn positive.

In response to the worsening investment environment of recent years, policy adjustments were made by Indian policy makers, the external environment improved, and businesses adjusted to the more subdued reality. Consequently, investment has bottomed, and the latest evidence suggests the economy is on the early-stage of an investment revival. Indeed data from the latest PMI and labor surveys also point in the same direction (see the following charts).

Private sector investment is turning

-10

0

10

20

30

2006 2007 2008 2010 2011 2012 2014

Incremental investments (real, pvt.)Incremental investments (real, govt.)

INR bn


Composite PMI trend in Q1’2014 suggests that

investment and growth may have bottomed in 2013

-5

-2

1

4

7

10

42

47

52

57

62

2009 2010 2011 2012 2014

Composite PMI, lhsTotal oustanding investments, rhs

3mma SA, % qoq

Source: CMIE, CEIC, Deutsche Bank

Employment outlook trend also looks promising going

into 2Q’2014

40

45

50

55

60

65

70

16

24

32

40

48

56

2006 2007 2008 2010 2011 2012 2014

Net Emp. Outlook (t-1), lhsComposite PMI, rhs

% 3mma

Source: Manpower Survey, Haver Analytics, Deutsche Bank

Taimur Baig, Singapore, +65 6423 8681 Kaushik Das, Mumbai, +91 22 7158 4909

10 April 2014



Breakeven Oil Prices

The price of oil needed to balance the government budgets of oil producing economies provides a useful measure of their vulnerability to movements in oil prices. We routinely track these breakeven prices for major EM oil producers, adding Venezuela to our assessment for the first time this year.

While the crisis in Ukraine has led to a further deterioration in the economic outlook for Russia, the impact on the public finances is more than fully offset by the weaker rouble. As such, we think the budget breakeven price will fall from USD 114bbl last year to USD 102bbl this year. The balance of risks, however, is skewed towards a weaker fiscal outcome and higher breakeven price, especially in the (unlikely) event that the crisis results in a disruption to energy exports.

Nigeria’s budget breakeven price increased to USD 143bbl last year as oil production declined, the government’s revenue take from oil production fell further, and oil savings were used to boost spending. Oil savings are now close to fully depleted, however, and this should help to enforce greater spending restraint this year. We think the budget breakeven price will accordingly drop to USD 119bbl.

In Saudi Arabia, temporary cuts in oil production and continued real growth in public spending pushed the budget breakeven price up to USD 91bbl last year. While oil production has recovered, the breakeven price may edge up a little further this year as spending growth continues. With substantial accumulated oil savings, however, Saudi Arabia would be well able to weather even a sustained drop in oil prices without the need for sharp adjustment.

Elsewhere in the Gulf, there has been some convergence in budget breakeven prices, which we expect to be clustered in the USD 70-75bbl range this year. Countries with greater headroom, such as Kuwait and Qatar, have pursued more expansionary fiscal policies, whereas those with higher starting breakeven prices, such as UAE and Oman, have consolidated. Bahrain is an exception in running a fiscal deficit, which has widened further.

Populist policies in Venezuela have taken a toll on oil production while government spending has increased, pushing the budget breakeven price to around USD 150bbl in recent years. Proposed reforms to the exchange rate system should alleviate matters, bringing the breakeven price back to around USD 120bbl this year.

Introduction

The price of oil needed to ensure that a budget is in balance for a given level of government spending and nonoil revenue provides a useful measure of the vulnerability of fiscal positions to movements in oil prices. We therefore routinely track these budget breakeven prices across a range of major oil producers in the EMEA region. This year, we have also added Venezuela to our assessment.

We defined our approach to estimating breakeven prices in some detail two years ago.3 We will not repeat the details here but the simplifying assumptions that we make are worth reiterating:

Our calculations are based on a uniform oil price (Brent). In practice, variations between this and actual selling prices (e.g. Urals, Dubai Fateh) have been relatively small.

While our breakeven price estimates are defined in terms of the price of a barrel of oil, we also include gas revenues in our assessment. For the forecast period, we assume that gas prices move in line with oil prices.

The amount of revenue accruing to a government from each unit of oil and gas production can vary significantly from year to year. We hold these revenue shares constant at their latest observed levels over the forecast period.

Finally, swings in oil prices can affect other revenues, either indirectly through their impact on nonoil activity, or directly through investment income on accumulated oil savings. Movements in oil prices can also affect the level of public spending through, for example, the cost of fuel subsidies. But we make no attempt to account for these effects, which we think are likely to be of second order importance

Our commodities team anticipates that the price of Brent oil will remain within a relatively narrow range, averaging about USD 106bbl this year and USD 102bbl next year. Expectations of significantly lower oil prices on the back of stronger supply from the US and weaker demand from China have not materialized. This reflects ongoing disruptions to supply elsewhere, most notably in Libya, and stronger demand from the US (partly weather related) and Europe. Given the potential for Libyan and Iranian crude to recover from currently

3 See “Breakeven Oil Prices”, EM Monthly, June 2012, for a technical discussion of how we define and calculate our breakeven oil prices.

10 April 2014



depressed levels and our view that the US dollar is likely to strengthen, the risks to this outlook are probably skewed to the downside.

The evolution of budget breakeven oil prices

Russia

GCC

Nigeria

Venezuela

0

20

40

60

80

100

120

140

160

180

200

2007 2008 2009 2010 2011 2012 2013e 2014f

Brent price

USD bbl


In the rest of this note, we update our breakeven prices to reflect estimated budget outturns for last year and provide initial estimates for this year based on fiscal forecasts for the major oil producers. We also present some analysis of the sensitivity of these estimates to different assumptions for oil production and public spending. The countries covered in our assessment, Bahrain, Kuwait, Oman, Nigeria, Qatar, Russia, Saudi Arabia, United Arab Emirates, and Venezuela, account for 46 percent of world oil production. We have again paid particular attention to Russia in this update given the risks to the budget outlook following the crisis in Ukraine and further deterioration in the outlook for growth.

Breakeven estimates for 2013 and 2014

Breakeven oil prices among GCC countries fell in 2012 as the sharp increase in public spending following the Arab Spring was partially unwound while oil production increased. As we anticipated in last year’s report, this dip proved to be temporary and breakeven prices have again begun to edge upwards. For the region as a whole, we estimate that the breakeven price increased by about USD 6bbl to USD 79bbl in 2013 as oil production stabilized but public spending continued to grow. We think that the breakeven price for the region will increase a little further this year to USD 81bbl with a moderate increase in oil production helping to offset the impact of further growth in government spending. But this masks some significant differences within the region, which we discuss in more detail below.

Outside the Gulf region, despite greater spending restraint following elections, the breakeven price in

Russia edged up to USD 114bbl last year as non-oil revenues disappointed. The breakeven price should drop to USD 102bbl this year, however, as the weaker rouble boosts the local currency value of oil revenues. We think the breakeven price in Nigeria will drop significantly this year, partly on the back of higher oil production, but largely because the past depletion of oil savings will enforce greater spending restraint. The breakeven price will nevertheless remain one of the highest the highest among major oil producers at USD 119bbl. It is exceeded only by Venezuela where, despite economic adjustment this year, the breakeven price is likely to be around USD 121bb.

Budget breakeven oil prices ($bbl)

2007 2008 2009 2010 2011 2012 2013e 2014fGCC 43.2 44.0 70.4 68.4 78.8 73.2 79.1 81.7


Nigeria 75.1 79.9 125.3 105.3 128.5 112.3 143.6 118.8Russia 28.1 59.7 109.5 116.7 102.8 112.0 113.9 101.7Venezue la 76.9 134.2 140.7 194.4 145.7 153.1 151.3 121.0Brent price 72.7 97.7 61.9 79.6 111.0 111.7 108.9 106.5

Source: Haver Analyics, JODI, Deutsche Bank

Overall budget balances (% GDP)

2007 2008 2009 2010 2011 2012 2013e 2014fGCC 13.2 22.7 -3.6 4.4 10.7 13.1 9.8 7.9

Bahrain 1.6 4.3 -5.6 -5.8 -1.5 -3.2 -4.3 -5.7Kuw ait 26.6 32.5 11.4 23.3 33.1 31.5 21.0 17.8Oman -10.1 0.3 -3.7 -0.2 -0.4 -0.3 10.3 10.9Qatar 9.8 9.2 12.9 4.6 6.3 10.7 11.0 7.4S. Arabia 11.3 29.8 -5.4 4.4 11.6 13.6 7.4 5.4UAE 16.0 16.9 -13.1 -1.9 4.1 8.5 9.4 9.0

Nigeria -0.7 4.8 -13.0 -5.1 -3.7 -0.1 -5.2 -1.8Russia 5.4 4.1 -5.9 -3.9 0.8 0.0 -0.5 -1.0Venezue la -0.8 -4.2 -8.6 -8.2 -4.1 -4.7 -5.6 -3.3

Note: figures for Nigeria do not take into account the recent rebasing of the national accounts, which has resulted in large upward revisions to GDP. Source: Haver Analytics, JODI, Deutsche Bank

Russia. The political crisis unfolding in Ukraine will weigh on the outlook for the Russian economy. Since the start of the year, we have therefore reduced our forecast for GDP growth in Russia this year to 0.6% from 2.4%. The impact of the crisis on the public finances is less clear. Slower economic growth will likely reduce non-oil revenues. Public spending could also come under pressure. Russian government officials, for example, have estimated that the budget deficit of Crimea and Sevastopol at around RUB 55bn. The government has also promised to develop local infrastructure. But these costs are likely to be relatively small relative to the size of the Russian economy. The bigger risks will come from domestic spending pressure in a low growth environment, especially given

10 April 2014



that budget plans involve further modest real compression of spending this year following a 3% reduction in real spending last year.

The local currency value of oil revenues on the other hand will be boosted by the depreciation of the rouble. We think the latter (USDRUB) will average 36.2 this year versus the exchange rate of 33.4 assumed in the budget plans for this year. Our oil price forecast of USD 106bbl is also a little higher than the USD 101bbl (Urals) price on which the budget was based. We estimate that these two factors combined will boost revenues by about RUB 925bn (1.3% of GDP) this year.

We have assumed that non-oil revenues are about 2% weaker than initially budgeted this year but that the government is able to stick to its nominal spending plans. This would result in a small budget surplus this year of 0.6% of GDP compared with a modest deficit of 0.5% of GDP last year. This brings the budget breakeven price of oil down from USD 114bbl last year to USD 102bbl this year.

Russia: Fiscal Outlook Boosted by Weaker Rouble

2013Outturn Budget DB forecast

Revenues 13019 13571 14386Oil 6533 6528 7453Non-oil 6486 7043 6933

Spending 13330 13960 13960

Balance -311 -389 426Balance (% GDP) -0.5 -0.5 0.6

Memo items:Nominal GDP 66689 73315 72546USDRUB (avg.) 31.9 33.4 36.2Oil price (Brent bbl) 109 102 106Breakeven price (bbl) 114 108 102

2014

(Rub bns)


The balance of risks, however, is probably skewed towards a weaker outturn and a larger breakeven price. Non-oil revenues could well disappoint more than we are anticipating. Spending is more likely to exceed rather than fall short of budgeted amounts. We think the risk of disruptions to energy exports is low but this would of course have a major impact on fiscal outturns and the breakeven price.

The longer term evolution of the breakeven oil price for the budget will depend on the resolution of structural issues, in particular problems with the pension system. Throughout the past several years the rising deficit in the PAYG part of the system represented by the state Pension fund was financed by budgetary transfers, which are seen as increasing given the adverse demographics and the lack of development in the non-state fully funded pension system. Most recently the Finance Minister again highlighted the need to raise the pension age, but we see little chance of this taking place, which implies that longer term pressures on the

budget system and the oil price that balances the budget are likely to persist.

Saudi Arabia. Despite a brief cut in oil production early in the year when oil prices threatened to dip below USD 100bbl, oil production averaged 9.6mbd last year, only a little below the record production of 9.8mbd in 2012. Production has remained broadly at these levels so far this year, notwithstanding the possibility of increased supply from elsewhere. We have assumed that the Kingdom continues to produce about 9.8mbd on average this year.

Saudi Arabia oil production has remained stable

20

40

60

80

100

120

140

7.5

8.0

8.5

9.0

9.5

10.0

10.5

2006 2008 2010 2012 2014

Saudi production, lhs Oil price (Brent), rhs

Million barrels a day USD bbl

Source: JODI, Haver Analytics, Deutsche Bank

While this provides a relatively favorable backdrop for the budget, we think the budget breakeven price nevertheless increased by USD 10bbl last year to USD 91bbl. The increase stems from: the small drop in oil production last year; moderate growth in real public spending of about 2%; and a drop in nonoil revenues.4 Even if oil production remains at current levels, i.e. a little above the average for last year, we think the budget breakeven price will edge up a little further to USD 93bbl this year. This would allow for further positive real growth in public spending of about 1%. The breakeven price could be lower than this, however, if nonoil revenues rebound more strongly than we have assumed.

This would bring the breakeven price to within USD 15bbl of the spot price, which would be the smallest margin since the collapse in oil prices in 2008-09 when the government ran a budget deficit. As we have noted before, however, gross government debt is negligible and the government has accumulated substantial assets in recent years as it has run large budget surpluses. The net foreign assets of the Saudi

4 This is based on preliminary data from the Saudi Ministry of Finance of total budget revenues last year less our own estimate of oil revenues.

10 April 2014



Monetary Authority (SAMA), for example, increased by a further USD 70bn last year to USD 727bn, or about 97% of GDP. Government deposits at SAMA are about 60% of GDP. This provides the Kingdom with substantial leeway to withstand even a sustained drop in oil prices. From a fiscal perspective, therefore, there is little to stop Saudi Arabia from continuing to play a stabilizing role in global oil markets, varying its production levels according to the ebbs and flows of global demand and supply elsewhere.

Other GCC. Oil and gas production in other GCC countries has been relatively stable in the last year or two and is likely to remain so. As such, the movements in our breakeven estimates for these countries are driven largely by public spending patterns. In the United Arab Emirates, for example, significant fiscal expansion (including support for government-regulated entities) following the global financial crisis pushed the breakeven price to USD 95bbl on average from 2009-11. This support is being unwound and the breakeven price has dropped accordingly: we think it will reach USD 70bbl this year. Fiscal consolidation is also bringing down the breakeven price in Oman following a spike in government spending in 2012. In Qatar, gas production has reached a near-term plateau while oil production from mature fields has fallen. The government is proceeding with efforts to diversify the economy, with a number of large capital projects, and this will push the breakeven price up to USD 68bbl this year. Fiscal expansion is also continuing in Kuwait and Bahrain, which will see breakeven prices increase, though from very different levels. Having been the lowest in the region for many years, the breakeven price in Kuwait will probably exceed USD 70bbl this year. Bahrain remains the outlier in the region in running an increasingly large overall budget deficit even at current oil price levels.

Nigeria.5 Like Bahrain, Nigeria is also running a budget deficit at current oil prices. Oil production declined by about 7% to 2.2mbd last year and the government’s revenue take from this production also fell a little further. Public spending nevertheless increased as the government ran down its oil savings, bringing the balance on its Excess Crude Account to USD 3bn by the end of last year. This pushed the overall budget position from close to balance in 2012 to a deficit of 5% of GDP. The budget breakeven price thus increased by a little over USD 30bbl to USD 144bbl last year, even higher than the USD 135bbl that we had anticipated in our assessment one year ago.

5 We have not yet incorporated recently revised GDP series for Nigeria into our analysis. Following a rebasing exercise, the preliminary GDP estimate for last year was revised upwards by 90%. The revisions for earlier years are smaller but still 60% for 2010, the earliest year for which new data are available. These upward revisions will affect the ratios of fiscal balances to GDP but do not affect our breakeven oil price estimates.

With oil savings now more or less fully depleted, this will at least limit the scope for further large spending increases this year. Indeed we think that if the balance on the Excess Crude Account remains more or less unchanged at USD 3-4bn this year, public spending would fall by about 5% in nominal terms. Oil production has also recovered a little and should reach 2.3mbd this year. This should see the breakeven price drop sharply to USD 119bbl this year. Presidential elections are just around the corner in February 2015, however, and there is a risk is that spending will be higher than this, though, in the absence of oil savings, this would mean increased borrowing.

As usual, the outlook will also depend on the amount of revenue that the government retains from each barrel of oil extracted. The government’s revenue take has fallen from an average of over 70% of the value of production from 2006-08 to 50% last year. The government has typically based its budget plans on a revenue take of around 66%. To put this into context, the resulting cumulative shortfall in oil revenues, i.e. the gap between the planned take and the actual take from each barrel of oil, amounts to almost USD 50bn over the last five years.

Nigeria: oil revenues continue to disappoint

0

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12

14

16

2006 2007 2008 2009 2010 2011 2012 2013e

Theoretical value of oil production

Government oil and gas revenues

Naira trillions

Source: Haver Analytics, Nigeria Federal Ministry of Finance, Deutsche Bank

Venezuela. The populist approach to economic affairs has taken a toll in the last two years with high fiscal deficits, expansive monetary policy, rampant inflation, scarcity, and exchange rate misalignment, worsening the outlook for 2014. The fiscal deficit of the central government has hovered around 5% of GDP in the last two years.

Oil production has also disappointed. Capital spending by PDVSA, the state oil company, has been constrained as it has been given the additional roles of executing social expenditure as well as subsidizing the exchange rate system for public and private imports by funding it at an artificially overvalued exchange rate. In 2014, we

10 April 2014



expect production to be around 2.5mbd, out of which exports will be around 73% in the coming years and transfers to the central government in royalties, taxes, and dividend payments will be around 43%.

As a result, the budget breakeven price has been running at around USD 150bbl over the last few years. The government is implementing economic adjustment this year, which should reduce the deficit and bring the breakeven price down to USD 123bbl. A key component of this adjustment is exchange rate reform, in which PDVSA and its major partners, just as the rest of the private sector, will be allowed to sell dollars at a devalued exchange rate. This should alleviate the burden for PDVSA and allow it invest and boost production in the coming years.

For the current account the situation is not as stark given that the country has kept a current account surplus. However, the rapid deterioration in external accounts and the harsh quantitative measures to curb imports has seen the oil price needed to balance the current account increase to over USD 90bbl in the last couple of years.

Sensitivity analysis. Our breakeven estimates are based on a number of assumptions, which are subject to a good deal of uncertainty. We illustrate the sensitivity of our breakeven estimates to changes in our assumptions about oil and gas production and public spending in the table below. The increase in oil production that we are expecting in Nigeria, for example, reduced the budget breakeven price by USD 7bbl.

The unsustainable nature of last year’s increases in spending in some countries is clear from this table. We saw double digit real increases in Bahrain, Kuwait, and Qatar, and a high single digit increase in Nigeria. If spending continued to increase at these rates, breakeven prices would be much higher than our estimates for this year. In Nigeria, for example, if real spending increased by another 7% this year, the breakeven price would be USD 35bbl higher than we are anticipating.

Sensitivity to production and spending assumptions

2013 2014 2013 2014

Bahrain 0.5 0.5 -0.8 12.4 2.7 -13.9Kuw ait 3.2 3.3 -1.2 19.4 3.7 -12.4Oman 1.6 1.6 -2.8 -21.9 -3.3 18.0Qatar 2.6 2.6 3.5 9.7 3.8 -8.2S. Arabia 11.5 11.8 -1.0 2.1 1.1 -0.8UAE 4.1 4.2 -0.9 -0.9 -1.5 -0.6Nigeria 2.2 2.3 -6.9 7.2 -11.4 -35.0Russia 22.0 22.3 -1.3 -3.0 -1.0 4.4Venezue la

Oil and gas production

(mbd)Real spending increase (%)

Impact on breakeven

price ($bbl)

Impact on breakeven

price ($bbl)


Current account breakeven prices. So far, our assessment has focused on the price of oil needed to balance the budget. Below, we also report the price of oil that would balance the external current account. The level of oil and gas production is a key determinant of the breakeven price in both cases. Whereas our budget breakeven prices are then determined by the government’s revenue take for a given level of oil production, and the levels of government spending and nonoil government revenues, our current account breakeven prices depend on the level of imports, nonoil exports, and the share of oil exports that is exported. In Russia, for example, we estimate that the current account would swing into deficit this year if the price of oil fell below USD 95bbl.

Current account breakeven prices

2007 2008 2009 2010 2011 2012 2013 2014GCC 42.1 54.9 50.6 54.7 54.7 55.1 57.6 61.9


Nigeria ** 64.9 83.4 95.7 72.0 102.4 93.0 117.4 114.1Russia 46.8 65.0 45.8 57.3 78.8 88.3 98.5 94.8Venezue la 46.4 44.9 58.6 65.1 72.2 96.9 91.5 93.0Brent price 72.7 97.7 61.9 79.6 111.0 111.7 108.9 106.5

** Adjusted to include Nigeria’s large negative errors and omissions Source: Deutsche Bank

10 April 2014



Current account balances (% GDP)

2007 2008 2009 2010 2011 2012 2013e 2014fGCC 18.4 21.0 6.6 12.3 23.5 24.0 21.2 17.9

Bahrain 13.4 8.8 2.4 3.0 11.2 13.7 13.9 10.0Kuw ait 36.0 40.9 26.7 30.8 41.8 43.2 37.1 35.6Oman 5.8 8.2 -1.0 8.6 12.9 10.5 9.2 7.2Qatar 14.4 23.1 6.5 19.0 30.3 32.4 30.9 26.6S. Arabia 22.4 25.4 4.9 12.7 23.6 22.4 18.0 13.5UAE 7.6 7.1 3.1 2.5 14.6 17.3 18.0 16.6

Nigeria ** 3.9 5.2 -17.4 2.7 2.2 4.8 -2.2 -1.6Russia 6.0 6.2 4.0 4.8 5.3 3.6 1.5 1.9Venezue la 6.9 10.2 0.7 2.2 7.7 2.9 4.0 5.1

** Adjusted to include Nigeria’s large negative errors and omissions Source: Deutsche Bank

In most cases, the price of oil needed to balance the current account is significantly less than the budget breakeven price, though this gap has closed in some cases like Russia and Venezuela. This reflects the relatively high share of oil and gas production that is exported. Nigeria is the only country where this price is above the current spot price. This is because we have used an augmented measure of the current account balance, which includes large negative errors and omissions. Last year, for example, the officially recorded current account surplus was 8% of GDP but outflows under errors and omissions were 10% of GDP. We add these together, which gives us an adjusted current account deficit of 2% of GDP last year and a current account breakeven price of USD 114bbl.

Nigeria: current account and errors and omissions

-40

-30

-20

-10

0

10

20

30

40

50

2006 2007 2008 2009 2010 2011 2012 2013e 2014f

Current account

Adjusted current account (including errors and omissions)

USD bn


Robert Burgess, London, (44) 20 7547 1930 Yaroslav Lissovolik, Moscow,(7) 495 933 9247

Armando Armenta, New York, (1) 212 250 0664 Artem Zaigrin, Moscow, (7) 495 797 5274

10 April 2014



Implications of increase in foreign participation in Colombia

Introduction

The recent announcement made of the increase in the COLTES weights on widely followed emerging markets bond indices has resulted in a significant increase in foreign participation in Colombia’s local government debt market. Moreover, Ministry of Finance officials have mentioned the possibility of decreasing the tax to below 5%, reducing furthermore the hurdles for foreign investing in Colombia’s local markets. The effect of these announcements has been a sharp appreciation in the FX rate (6% total return since the announcement versus 2.7% for all EM) and a compression in yields of all tenors (-100bps for the benchmark COLTES 24 and COLOM 27).

We expect foreign participation in the COLTES market to increase from the February average of 6.7% to around 15-17% in the next months, summing up to around USD 10 bn in increased flows. In this article we quantify the most likely structural effect of these changes using different degrees of foreign participation in local markets across EM. We also show how the tax reform caused a rapid increase in participation during 2013, even during a year of massive outflows from EM dedicated funds. Finally, we compare the risk of this structural change with the possibility of regulatory changes in the calculation of minimum required return for pension funds that would shift positioning away from TES and into dollar denominated assets.

In sum, we find using a panel fixed effect estimation model for 10 emerging market countries with varying degrees of foreign participation, that an increase in the share of foreigners in the local debt market shifts down and flattens the yield curve and decreased the realized FX volatility. This result is robust to the correction of possible endogeneity between participation, the yield curve, and FX volatility.

Portfolio inflows and foreign share in TES market

After last year’s tax reform, foreign participation in Colombia’s local debt market rapidly rose from around 3% to more than 6% (see chart below). This increase exerted a significant impact in balance of payments accounts after portfolio inflows for the economy accelerated from around USD 1.6 bn on average per quarter to an average of USD 3.0 bn per quarter. Putting the magnitude of these inflows in perspective, one quarter worth of portfolio inflows were enough to match Foreign Direct Investment (FDI) flows during the third quarters of 2012 and 2013.

The recent increase in the weight to local debt announced implies further inflows of around USD 10 bn compared to around 17 bn in total FDI in a year. Given that the outstanding nominal value of COLTES instruments is expected to be to around COP 135 tn (USD 65 bn), the total amount share of foreign could grow to around 15%. Beyond the effect on the level of yields, the structural change in the demand for local debt instruments could potentially impact the monetary policy transmission channel. Regarding the latter, long term financing costs for the overall economy, now tied to the back end of the government yield curve, would show a more muted response to changes in monetary policy.

Portfolio inflows and foreign participation in Colombia


Foreign participation across EM

The current (February 2014 is the latest data point) level of foreign participation in the local government debt market differs markedly by country. However, of the sample of 10 EM countries selected from EMEA and LatAm, Colombia’s foreign participation ranks the lowest, as the chart below shows. The participation varies from close to 50% (Peru) to levels similar to the one Colombia would achieve in the coming months (around 15%, like Brazil and Czech Republic). A notable exception from this sample is Chile where high rates of withholding taxes imply a very low level of foreign participation in the local government debt market.

10 April 2014



Foreign participation in local government debt market

(February 2014)


An expected structural change from the increase in foreign participation in local debt markets would imply a lowering of funding costs. But how would this increase in foreign participation impact the shape of the yield curve and FX volatility? Before attempting to answer this question we gauge some basic intuitions by simply looking at correlations. For that we use monthly data for the EM countries above mentioned on foreign participation and nominal yields on local government debt instruments from January 2007 to February 2014.

As the charts below show, there is negative correlation between local debt yields and the degree of foreign participation at the front and back end of government’s yield curves. The correlation coefficients between yields and the foreign participation rate are -0.13 and -0.40 (and both significant at a 99% confidence level) for the 2Y-yields and the 10y-yields respectively. For the slope of the yield curve (10Y – 2Y), the result in the chart is not as definitive as there does not seem to be a clear relationship with foreign participation.

In FX we believe that volatility should also be impacted by the higher share of foreign participants in the local debt market. And data indeed confirms the intuition with the coefficient between these two variables is -0.30 and significant at the 99% confidence level. But beyond correlations how can one actually gauge the effect of an increase of foreign participation in the aforementioned market instruments? We try to answer this question in the next section.

Yields, FX volatility and Foreign participation


10 April 2014



Estimation procedure and results

To estimate the effect of the change in foreign participation for the sample of EM countries selected we conduct a panel regression analysis using monthly observations. The specification estimates the average change in the variables of interest (yields, slope, and FX volatility) for a given change in the level of participation. We control for the effect of the business cycle on yields, slope, and volatility by including the monetary policy rate and inflation for each of the countries. Moreover, to control for time unvarying country characteristics we include a country fixed effect coefficient. The estimating equation is the following: = + + . . + + .+

Where y denotes the variable (2Y Yield, 10Y Yield, Slope, FX Volatility), i denotes country, and t of each of months of the sample data. The results in the Table below show that the coefficients are significant and have the expected sign The first column implies that the effect of an increase in 10 percentage points of the share of foreign investors, controlling for inflation, the monetary policy rate, and unobserved non-time varying country specific fixed effects, for the average EM country in the sample, implying a 40 basis point drop in the 2Y sector and about 50 bp in the 10Y sector. The result for the slope (measured in basis points) just corroborates the difference: 10% increase in foreign participation implies 8.5 basis points of flattening in 2s10s.Realized volatility also decreases with foreign participation. The control variables all have the expected coefficients: an increase in inflation increases yields, as well as the monetary policy rate with a larger effect in the front end of the government’s yield curve. The effect of inflation on the slope is not significant but an increase in the monetary policy rate has a flattening effect (as expected) in the yield curve. FX realized volatility increases with inflation and after increases in the monetary policy rate.

Results of Panel-Fixed Effects model 2Y

Yield 10Y Yield

Slope FX Vol

2Y Yield

10Y Yield

Slope FX Vol

Constant 3.47 6.49 301.3 8.23 3.74 6.60 286.5 4.99

(19.85) (34.36) (27.63) (6.68) (16.83) (27.84) (23.87) (3.4)

Foreign participation

-3.99 -4.81 -82.47 -13.98 -5.44 -6.53 -109 -14.84

(-9.34) (-10.44) (-3.09) (-4.65) (-8.78) (-9.88) (-3.27) (-9.88)

Inflation 0.08 0.08 -0.15 0.58 0.10 0.02 -7.20 0.63

(2.94) (2.68) (-0.08) (2.9) (2.69) (0.63) (-3.74) (8.94)

Policy Rate 0.56 0.24 -32.58 1.03 0.56 0.34 -21.7 27.84

(19.75) (7.75) (-18.26) (5.11) (15.66) (8.94) (-11.31) (8.97)

R^2 0.92 0.89 0.59 0.43 0.92 0.90 0.60 0.53

Adjusted R^2 0.92 0.89 0.59 0.42 0.92 0.89 0.60 0.52

IV No No No No Yes Yes Yes Yes t-stat in parentheses


To control for possible endogeneity given that participation could be driven by higher yields, lower FX volatility or steeper slope, we instrument the right hand side variables using the one year lag of the participation rate. The results are shown in the 5th to 8th column of the table above. The significance and magnitude of the coefficients do not change by a large magnitude and the main effects still hold: an increase in foreign participation lowers yields for the 2Y and 10Y tenor, flattens the yield curve, and decreases the realized volatility of the exchange rate

Conclusion

The expected increase in foreign participation in Colombia’s local market resulted in the significant bull flattening in the COLTES cash curve. Our findings suggest that the extra demand derived from the increase in participation implies a structural shift in the level of yields. Moreover, controlling for macroeconomic factors, higher foreign participation results in lower yields, a flatter curve and lower realized volatility for COP.

Interest Rate Trajectories and Foreign Participation

4.00

4.50

5.00

5.50

6.00

6.50

Jan-10 Oct-10 Jul-11 Apr-12 Jan-13 Oct-13 Jul-14 Apr-152Y Forecast 2Y Forecast Constant

6.20

6.40

6.60

6.80

7.00

7.20

7.40

7.60

Jan-

10

May

-10

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

10Y Forecast 10Y Forecast Constant


In order to illustrate the effect we present our yield projections (taking into account our monetary policy and inflation projections) holding constant foreign participation at the current level (named “constant” in

10 April 2014



the charts above) and after the projected increase in foreign participation. As illustrated above, the interest rate trajectories are indeed lower for the case of higher foreign participation. Our result suggest that after the tax reform and the increase of the weight of TES in tracked benchmark indices, nominal rates in Colombia will be structurally lower and less exposed to the global re-pricing in policy rates.

Armando Armenta, (1) 212 250 0664 Guilherme Marone (1) 212 250 8640

10 April 2014



Asia Strategy

The sweet spot for EM keeps getting extended. Data is not strong enough to give reason for markets to challenge the dovishness of Yellen Fed. But it has been sufficient to keep alive hopes that EM/Asia will ultimately re-link with the global growth/trade beta. Vols keep getting crushed, and carry stays in the driving seat. The pain trade is still for a squeeze on flows back to EM assets, with developed equities underperforming, and credit tightening to near levels from before 2013 summer.

Before you fade the recent moves in Asia, consider the following; 1) Data in the region has scope to surprise to the upside, particularly if the fiscal stimulus in China is front loaded; 2) Inflation is back on the radar, and while still at relatively low absolute levels for most economies, gives reason for central banks to accommodate more currency strength; 3) April is seasonally a strong month for Asian currencies, with the second highest monthly returns after December; and 4) Positioning is yet to be a headwind to a move higher in Asian FX. Price action is moving down the carry curve, with the chase for high yielders (INR, IDR) giving way to more pronounced gains in the low yielders (KRW, SGD, MYR). Asian rates have mostly underperformed the US, but if the currency moves persist, could be forced to participate more significantly in this carry driven move, as investors extend duration.

Like many others, we have been wrong footed by the dollar move, and are cutting out of most of our long USD trades. We remain selective though about our exposure to the downside move in USD/Asia, preferring to express the same through MYR (target 3.15) and PHP (target 43). We continue to like being long RMB vol. In rates, we still like steepeners in China (2Y/5Y) and Korea (2Y/10Y), and paying swap spreads in Singapore. We also recommend buying linkers in Thailand. We are keeping with our small structural duration underweights on Indonesia and the Philippines. We have moved to neutral on cash bonds in India and Malaysia, and are overweight in Thailand.

Despite a continuous market rally and strong performance of Asia sovereign credit as a whole, we believe our overall Neutral positioning is still warranted. As expected, we have already started to see first shoots of what promises to be a month of heavy supply in April with cracks appearing in the valuations of some sovereign curves. We recommend Buying INDON 5Y CDS. We also opened a new long basis trade recommendation via long 23Ns vs. 5Y CDS. In Korea, we recommend Selling KOREA ‘23s and reiterate our curve-steepening trade in Philippines (26s vs. 34s).

Local Markets

CHINA

— FX: Bearish, Long CNH vol

— Rates: Hold 2Y/5Y IRS steepeners, target 45bp

Balancing between liquidity, supply and credit risks. We expect liquidity risk to rise in the near term for two reasons: (a) fiscal deposit growth in April, which we estimate at about RMB400bn largely due to tax collection (much more than fiscal spending), will net drain liquidity out of the banking system; and (b) RMB supply from FX intervention will moderate in April, given the extent of the RMB depreciation against the USD YTD, and particularly as we expect trade balances to revert to surplus in March. On the other hand, we believe the central bank should keep interbank liquidity stable given the benign inflation outlook. for two reasons, (a) stable inflation outlook; and (b) to support demand for cash bonds, given the seasonal pickup in the supply of government bonds and corporate bonds usually in Q2. Large redemption of repo operations in April (over RMB400bn) should allow the central bank to inject liquidity in the open market if needed. We expect 7D repo rate to stay between 3.5-4%. We believe rising concerns over liquidity and cash bond supply risk will keep yields in a range. We expect the front end of the CGBs yield curve to be volatile and fluctuate with liquidity, and the bias on the long end of the CGBs yield curve to be on the upside as duration supply is heavy in Q2 (average maturity of CGB supply is about 10 years). We expect 10Y CGBs to trade in the 4.4-4.6% range. The steepening bias on the CGB curve will drive the steepening bias on the repo IRS curve. On the credit market, we expect a few more orderly defaults in the trust and credit bond market and several corporate bonds to be delisted due to sub-par operating performance in Q2. The combination of defaults and the rollover pressure in the trust and credit market implies domestic credit spreads are unlikely to narrow much. We recommend staying with highly rated names and in the 3Y tenor.

HONG KONG

— FX: Neutral

What contagion? One of the concerns we had in the past few weeks was that the RMB complex, which was thrown into disarray, would lead to a spillover effect into the North Asia FX, including HKD. However, this risk did not materialize, given (1) China’s recent announcement of front loading in infrastructure projects, which has resulted in Hang Seng rebounding

10 April 2014



by 7% from the low in March; and (2) a less dovish Fed. As such, in the short term, with global risk sentiment picking up, USD/HKD is likely to remain close to the bottom of the trading band. However, in the medium term, with the Fed likely to stop its monetary stimulus by 4Q14 and China’s growth still looking wobbly, USD/HKD is likely to move back into the middle of the band.

INDIA

— FX: Neutral

— Rates: Marketweight

FX theme has played out; the rates story will have to wait. We have been fans of both the currency and fixed income story in India since before turn of the year. The former has indeed been rewarding on the back of improving trade balances, return of portfolio flows, and RBI's success in intermediating the market flows. The latter though has been disappointing, and inspite of the currency performance. We have now exited both positions. We don’t see the risk-reward on being long INR as attractive any more, as we kick off elections this week in India. The currency move seems over extended on the back of expectations of a strong political mandate. While we have no expertise in predicting election outcomes, we worry that the reality of political permutations in a national election might be more complicated than what market positioning suggests has now been priced in. The balance of risks at the very least seems to have shifted for now towards a greater scope to disappoint rather than exceed market expectations. The positive fixed income story we think will have to wait till later in the year. It is increasingly obvious that the central bank will not be letting down its guard on inflation anytime soon, and is inclined to see much of recent disinflation as temporary. The cost of funding will to that extent not ease either. In fact RBI is gradually and effectively tightening the cost of liquidity, including by pushing more of the marginal funding for banks away from overnight LAF to term repos. The supply for the new fiscal year has started, and is as before subject to up scaling risk once the new administration is in place. We have closed out our long bond exposure, and have shifted to market weight on duration.

INDONESIA

— FX: Neutral

— Rates: Small underweight

Election euphoria dims. We had highlighted that as election sentiment coalesces around a market positive outcome, the balance of risks also shifts towards disappointment. We were still surprised though by the quick count results of this week’s legislative elections,

which showed PDIP falling short of the 25% popular vote threshold (19.7%) required to nominate Jokowi for the Presidency without a coalition. While the central outcome of a Jokowi presidency persists, markets will recalibrate expectations for a more protracted election cycle and a more difficult policy-making environment thereafter, with a greater reliance on smaller parties in the legislature. Large equity inflows into Indonesia ($2.8bn YTD) could thus face headwinds in the coming days. With election euphoria dimming, positioning short USD/IDR, valuations less inviting, BI accumulating reserves, and significant FX gains behind us, IDR is less well placed now to leverage on the broader EM and carry revival. To be sure, we are not expecting a renewed cycle of weakness in the currency. Indonesia’s external balances – while still in deficit – have improved meaningfully. The trade balance is back in surplus, driven almost entirely by non-energy import compression suggesting that rate hikes and import taxes have been effective. The concessions on the mineral ore export ban could see exports nudge back up in Q2. Admittedly, the energy deficit is likely to remain stubborn, given that the likelihood of a shift to a fixed-subsidy regime now appears slimmer. While this will mean a higher revision to the fiscal deficit and additional issuance burden, the upshot is that the ongoing disinflationary dynamic will continue to play out, securing higher real yields for IDR. The near-term tactical case for short USD/IDR positions has been tempered by positioning and the underwhelming legislative election, establishing IDR as more of a range trade for now.

MALAYSIA

— FX: Short USD/MYR, target 3.15

— Rates: Market weight

Tussle between carry and looming rate hike. MGS market was extremely quiet over the past month, with 10Y yield virtually unchanged at 4.10%. Carry friendly environment amidst the lack of clear direction from US rates failed to garner much buying interest in MGS. Clearly, the growing rate hike expectations against the back-drop of strong domestic data and successive higher inflation prints kept buyers on the sidelines. Jan-Feb trade surplus accelerated to 46%yoy from 2% in 4Q2013, and our economists see sustained GDP growth pick-up in the first quarter. Meanwhile, latest inflation print came above market consensus for yet another month. So, while a looming rate hike will continue to weigh on the sentiment, favorable supply technicals (with a large MYR16bn due to mature on 30-Apr), lack of direction from USTs, seasonal factors favoring carry, and an appreciating currency will lend some support to the market. In nutshell, it is likely to be another quiet month for the MGS, with room for modest rally if USD/MYR continues to head lower. Curve is likely to see some flattening over the next few weeks as front-

10 April 2014



end remains well anchored on rising rate hike expectations, whereas back-end will likely benefit from the carry friendly environment and a more positive outlook for the currency. We have been positive on the MYR’s fundamentals with both the trade and fiscal balances moving in the right direction. Moreover, Malaysia’s trade improvement has been entirely on account of exports, unlike India and Indonesia where the burden of trade improvement has fallen much more on import compression. Indeed, Malaysia’s exports growth have been the second strongest in the region led by electronics. We have been long the MYR against SGD as a relative value play, but are now switching funding to USD.

PHILIPPINES

— FX: Short USD/PHP, target 43

— Rates: Small underweight

Retracement potential. The peso’s underperformance has been confounding. While many of last year’s battered currencies have recovered with impressive gains (INR, IDR), the PHP has not exploited its retracement potential. The peso’s struggles are surprising given the Philippines’ strong exports growth and her large services and income surplus. Valuations are less stretched and positioning certainly lighter. The PHP’s high and rising correlation to the broader USD also suggests that the dollar’s softness should drag USD/PHP lower. The main detracting factor for the PHP, in our opinion, has been monetary policy. The domestic bond market has been highly correlated to the currency and bond outflows in the early part of the year contributed in large part to the FX sell-off. With policy rates still at their post-crisis lows, inflation set to grind higher, and at least 50bps of hikes required this year, the market has understandably been skeptical towards the currency. The initial move by BSP to hike RRR rates is encouraging though and signals their intent to begin the process of tightening. The backdrop of benign back-end yields in the US should also take the bite out of local re-pricing. While the PHP’s full potential is likely only to come through after formal policy tightening gets underway, the PHP’s positive external fundamentals, scope for retracement and a high beta to the USD supports entering USD shorts at current levels.

SINGAPORE

— FX: Neutral

— Rates: Long 10Y SGS versus 5Y IRS

Relative value. Technicals remain supportive for SGS, but their higher beta to USTs makes us wary of outright duration exposure. We express our positive SGS view via swap spread wideners instead. We stay with our trade to be long 10Y SGS versus over borrowed in 5Y

swaps, recommended initially at -90bp. This spread has since moved by about 20bp in our favor, and we continue to target -60bp. We also stay received SGD rates versus USD rates. In particular, we remain received SGD 2Y3Y IRS versus USD, targeting +75bp for the spread. SGD rates will continue tracking the USD rates for direction. Nonetheless, they are likely to outperform the US rates, given positive technicals of the former and rising risk of normalisation in the belly of the curve for the latter. We are neutral on the currency here. MAS is likely to keep policy unchanged at their meeting next week. There is no smoking gun on inflation: commodity disinflation should preclude tightening, while domestic cost pressures mean easing is unlikely to be on the table. Moreover, there are signs that policy is returning to the pre-crisis cruise control regime where it was kept unchanged for long periods at the ‘equilibrium’ 2% slope-2% band settings. With SGD NEER trading 0.5% above the mid-band – a level which has been very supportive over the past year – and MAS likely to keep policy unchanged, SGD appears biased to trade stronger against the basket. Combined with the broader softness in the USD, we step aside for now from our long-standing long USD/SGD view.

SOUTH KOREA

— FX: Neutral

— Rates: Hold 1Y forward 2Y/10Y IRS steepener, target +55bp.

Stay with steepeners. The market is going through important events – the April BOK MPC meeting, the press conference and the BOK’s revision of economic forecast. However, we believe they are likely to be non-events again. 10Y KTB yields have traded in a tight range of 3.47-3.61% in the past two months, and are likely to remain within the same range for the time being. In the medium term, we continue to believe that the risk to the Korea yields/rates remains to the upside with a steepening bias. The market has front-run the supply concession story, but will react to the bear factors such as an increase in MBS issuance (government target of KRW29tr issuance this year) and an introduction of covered bond market in line with household debt revamp plan. Moreover, despite the recent Chinese slowdown, the prospect of economic recovery remains relatively intact. We maintain our stance of moderate underweight on duration with the view of grinding higher yields/rates in the medium term. The reasons why we believe three BOK related events are likely to be non-events are: 1) the BOK will likely stay on the sidelines at 2.50%; 2) the new Governor is unlikely to fixate his policy bias at the press conference (i.e., more of data dependant like the Fed); and 3) the revision on economic forecast, if any, would be very moderate. On the swap front, we maintain our trade of paying 1Y forward 2Y/10Y IRS spread at +40bp with a positive roll-down of 3.5bp for three months. We also

10 April 2014



consider receiving the 5Y KRW CCS basis (i.e., receive 5Y CCS and pay 5Y IRS) at above -50bp (current -55bp). The CCS curve has steepened much faster than other Korean curves since 2Q 2013. This dislocation is attributable to the contrasting technicals of a rise in Korea paper issuance and subsequent liability swap flows (i.e., KRW CCS paying flows in the belly and long-end), compared to the supply concession in cash bonds in 1Q 2014. In the medium term, Korea paper maturity profile will also peak in April ($6.6bn) and May ($5.8bn) versus monthly average in 2H of $1.8bn. Therefore, the current upward pressure on the KRW CCS rates due to liability swap flows is likely to ease. Furthermore, most domestic investors have run duration mismatch in their FX hedge for their foreign currency bonds investments (e.g., buy 3-5Y foreign currency bonds and roll over short-term FX hedge positions). This misalignment will gradually be corrected, in particular, given the prospect of the Fed hiking rates and potentially slower BOK response.

TAIWAN

— FX: Neutral

— Rates: Market weight

Fundamentals still poor. With the (1) US data not improving notably, (2) ongoing Fed dovishness, and (3) strong equity inflows, USD/TWD is likely to break the 30 handle in the short term. Since March, Taiwan has experienced net equity inflows of about $3.8bn. The appreciation is also driven by (1) trimming of market’s net long USD/TWD positions and a pick-up in Lifers’ hedging activities. Given that we closed out our long USD/TWD 6M NDF position and shift to a neutral stance. However, we are not convinced that the time is ripe for selling USD/TWD. This is because in our view CBC is likely to maintain its preference for a weaker TWD given (1) inflation is still benign and (2) external data has not improved notably. In addition, CBC governor has continuously re-iterated his concern over ongoing erosion of Taiwan’s export competitiveness to China due to recent reforms in China. Furthermore, Taiwan’s fundamentals do not justify a stronger TWD. From our recent trip to Taiwan, we get the sense that in the absence of structural reforms, TWD is likely to weaken due to four factors – (1) the active corporate recycling of the current account surplus, (2) strong investment preference by domestic to invest in the RMB, (3) a shift in the hedging and investment activities of Lifers and (4) the ongoing intervention by the CBC to limit TWD appreciation (see Asia FX Strategy Notes - Taiwan trip notes, 27 March 2014). All in all we have temporarily shifted back to neutral but would look for opportunity to buy USD/TWD in the future.

THAILAND

— FX: Neutral

— Rates: Modest overweight. Buy 15Y linkers, target 1.95%.

Don’t forget the linkers. Thailand’s domestic economy remains mired in steady decline. Our economists note that that both consumption and investment sentiments continue to worsen, hurt by continuation of the political impasse, lack of guidance by the government on large-scale investment projects, removal of various one-offs that have supported growth in recent years. In addition to the supportive macro/political back-drop, the supply outlook for ThaiGBs is also very positive. The PDMO plans to raise THB113bn in Q3 FY14 (Apr-June14), same as that of Q2. This gross issuance amount, however, is lower from previous years. Moreover, net supply is negative owing to the large maturities of THB147bn in Q3. The demand equation is more mixed, but arguably still positive. Impact from the impending re-weighting in the GBI-EM index should be modest, as much of index tracking investors are still underweight Thailand. Local demand on the other hand is likely to remain strong given their large cash balances. We recommend buying 15Y ILB (ILB283A) at current level (2.26%), targeting 1.95%. Valuation on the linker is compelling when compared against the nominals, especially against the back-drop of rising inflation. 15Y ILB sold off 135bp between mid July to mid-Sep, whereas 15Y nominals (LB27DA) sold-off only 50bp during the same period. Falling inflation might have added to some extent to the underperformance of ILBs then. 15Y nominals have rallied about 60bp since then and are now back to the mid-July levels. 15Y ILB on the other hand failed to re-visit the July lows despite the inflation pushing higher since October. Meanwhile, 15Y ILB holding pattern is now more balanced than it was first issued in our opinion, following the offshore led sell-off earlier. Moreover, the PDMO has cut-down on the ILB issuance this year to only THB25bn, and after today’s THB5bn of 15Y ILB auction, next ILB supply will only hit in Q4 (Jul-Sep). With 15Y nominal yield (LB27DA) at 3.94% and real yield (ILB283A) of 2.26%, breakeven stands at 1.68% versus average inflation of 3.15% over the past 10 years. We thus like the value in linkers, given that inflation has bottomed out and should pick up from here on favorable base effects.

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

10 April 2014



Credit

INDONESIA

— Remain neutral

— We recommend Buying INDON 5Y CDS with a target of 200bp and stop at 160bp (currently at ~170bp).;

— Buy INDON 43s and 42s; We closed our INDON curve flattener trade in the latest sovereign weekly after prices have moved in our favor

INDON CDS and cash valuations look increasingly overstretched to us, and still heightened near-term macro-economic and political risks, highlighted by the legislative and presidential elections in Indonesia in the near future. We note an increasing degree of investor complacency by assuming the “best case” outcome as a given and dismissing potential risks along the way. It is quite possible to see INDON CDS to touch that of BRAZIL, considering the pair is trading only 8-10bp apart. At the same time, we believe that the latest selling of INDON 5Y was done by investors into a month-end and the resumption of new supply (Pertamina’s recent roadshow and PGN mandating banks too) will result in widening of 5Y CDS.

The steepness has only increased MoM and its 10Y30Y slope is approaching 60bp (vs. ~20bp in Jan). However, with the increased likelihood of Pertamina's new issue materializing at some point in the near future, we think perhaps staying in INDON long-end makes more sense for now. Besides, all three most long-dated INDON bonds are featuring amongst the worst performing Asian sovereign papers in March. Those who remain concerned about Turkey and Russia risk and are willing to sell long end there would find INDON long-end as the most attractive entry point in diversifying their holdings.

In Indonesia, our 10s30s curve flattener recommendation of 44s vs. 24s has moved by 20bp in our favor, with a correction already taking place even before Friday’s NPF. On Friday, the position flattened by another 3bp. The current slope is broadly in line with the historical average, and we recommend taking profit from this position even though it has not yet reached our target.

At the current level of basis on the Indonesia curve, which is close to the tightest of past year, we see the balance of risk as tilted towards widening, especially if spreads continue to tighten. We see long basis via 23Ns vs. 5Y CDS as especially attractive in Indonesia (at notional ratio of 1x1.6 CDS; entry: -50bps; target: -25bps; stop: -60bps). While 10Y CDS would be an optimal match in terms of duration with 10Y bonds, we

choose 5Y CDS for its superior liquidity. We choose 23Ns given the extent of tightening in its basis.

PHILIPPINES

— Stay neutral

— Recommend tactical curve steepening trade by switching out of the long end (e.g. PHILIP ’34) into the belly (e.g. PHILIP ’26) with a target differential of 30bp;

— Recommend Buying 5Y CDS as we consider it still trading rich to its rating and be under pressure of the narrowing CA surplus and tighter domestic liquidity conditions.

BSP has started to tighten domestic liquidity by hiking its banks’ reserve requirements by 100bp to 19% from 4-April, which should to some extent cool down local appetite for PHILIP external debt. For now, PHILIP cash curve remains abnormally flat, in our view. Following the steepener trade to Sell PHILIP 6.375% ‘32s and Buy PHILIP 4% 2021s, which had moved the spread differential from 18bp on 28-Feb to 45bp on 25-Mar, when we closed it, we suggested investors to switch their attention to another bond pair: Sell PHILIP 34s (current 125.00 price/119bp Z) and Buy PHILIP 26s (current 113.6 price/104bp Z) with a target differential of 30bp.

SOUTH KOREA

— Remain neutral

— We see more downside risks for the long-end and recommend Selling KOREA ’23.

The March FOMC meeting has generally triggered a continuous front-end & belly outperformance in many of the Asian sovereign curves. In KOREA the 23s have lagged and are trading slightly wider to 19s. We see more downside risks for KOREA 23s at this junction and would recommend selling this bond. Fundamentally, our view is also supported by the new IP data released in South Korea where IP dropped 1.8% MoM in February for the second straight month, raising concerns that economic conditions might not be improving as expected. Korea has also mandated banks for the upcoming USD or EUR senior bond issue, which we expect to be of a long tenor and to be completed within a month.

Viacheslav Shilin, Singapore, +65 6423 5726

Harsh Agarwal, Singapore, +65 6423 6967

10 April 2014



10 April 2014


EMEA Strategy

In FX, we remain long HUF, and PLN and also remain constructive on ZAR. We reenter into ZAR outperformance vs. TRY and expect the latter to be trading in a 2.05-2.25 range over the next weeks.

In rates, we shift our focus into a more aggressive medium term monetary policy response by CBs and favor flatteners in countries with very moderate hiking cycle priced. We recommend 2s5s flatteners in Hungary and Israel but favor 2s10s flattener and a long 5Y vs. Czech in Poland given support for the belly and long end in case of QE by the ECB. In SA we receive 6x9 FRA but pay 2Y IRS to position of a delay in the hiking cycle while we favor I/L-bonds in Turkey (Apr-20) evaluating the current environment as supportive for pricing in additional inflation risk premium.

In credit, we recommend underweight in Russia, overweight Poland, and neutral in Turkey (covering underweight), Ukraine and South Africa. We enter long 10Y basis and look to re-enter long 5Y CDS in Russia, hold 10s30s cash curve steepeners in Turkey (22Ns vs. 41s) and South Africa (25s vs. 41s).

Local Markets

HUNGARY

— Go short EUR/HUF, target 299.50, with a trailing 1% stop

— Stay received in 6x9, keep target at 2.75 but move the stop loss down to 3.00 and lock in ~40bps of profit. To position for a more aggressive monetary policy response in 2015/16 we recommend flattener in 2s5s IRS.

FX There is an expectation in the market that the NBH will take rates down to 2.50% at the next rate meeting. While we are slightly at loss as to why the NBH has been so determined to continue easing policy at a time when our economic momentum index for Hungary is at the highest level since the rebound in 2009, for EUR/HUF the question is what sort of damage another 10bps could do? First, it will depend on whether a further cut is accompanied by an indication from the Bank that this actually represents the end of the easing cycle. The fact that loans under the NBH's Funding for Growth Scheme (FGS) are capped at 2.5%, while non-FGS loans are facing the policy rate plus a premium, could be a factor for the NBH (i.e. there is a desire to limit/reduce/eliminate this duality). If it is, and 2.50% represents the end of this easing cycle, then we believe at these levels, and given the relatively supportive economic backdrop, even a further 10bp cut would be HUF supportive. We are short EUR/HUF from March

13th (entry 313). Move the target down to 299.50 (302), with a trailing 1% stop.

Rates: Following the 10bps interest rate cut to a record low level of 2.60%, the market has further scaled back on expected interest rate hikes in 2014/15. In fact, the market has positioned for a chance of further easing; economists also forecast another 10bp rate cut at the meeting at the end of April. On the back of the HUF stabilization, the continued benign headline spot inflation and the supportive external environment with a healthy but moderate economic recovery in the US and a dovish ECB monetary policy stance, we see another rate cut as a likely scenario. We have recommended receiving the 6x9 FRA in the last two EMMs at 3.53 with an initial target of 3.00. The target has reached with 6x9 FRAs trading at 2.88 at the time of writing. Although the room for a further rally has narrowed, we argue that from a risk reward perspective the very short end still looks somewhat more attractive for receivers. We keep the 6x9 FRA with a positive roll of 16bp and move the target to 2.75 and the stop to 3.00. Nevertheless, given the clear signs of improvements in underlying economic activity and real rates in negative territory we expect a more aggressive hiking cycle than currently priced for 2015/16 once spot inflation has started to pick up. To position for this we recommend a flattener in 2s5s in IRS currently at 80bp with a target of 50bps. This position is carry neutral.

ISRAEL

— Move into 2s5s flattener. target 75, stop at 140.

Rates: Following the consensus rate cut in February the BoI left official rates unchanged at 0.75% in March. In fact, the decision was unanimous and the minutes showed a shift in the language indicating that the easing cycle could have come to an end. While another interest rate cut cannot be ruled out, we at least expect the Bol to remain on hold for longer following a slowdown in the pace of house price increases and the benign inflation pressure forecast not to reach the target by mid-15. The market, however, is pricing 50% probability of another 25bp interest rate cut by the end of 2014 and rates close to 1.25% by the end of 2015. While in our view the short end does from a risk/return perspective not provide much room for a clear position, we expect a higher sensitivity of ILS rates in case of a more hawkish Fed. Hence, we favor a 2s5s flattener to position for a start of the hiking cycle by Q1-15. The slope remains with 110bp close to the widest level since mid-10 and the position provides a positive total carry of 7bps. Target of 75bp and stop at 140bp.

10 April 2014



POLAND

— Remain short EUR/PLN spot, target 4.075 and move stop down to 4.2250 locking in profit

— Enter 2Y-10Y IRS flattener at 97bp with target of 70bp. Favor long PLN Oct-19 vs. Czech Oct-19 in government bonds to benefit from dovish monetary policy environment in Europe

FX: As the recovery matures and as we are getting closer to the bottom in spot CPI in this cycle, sentiment on the NBP board is again becoming more differentiated with the latest set of minutes showing that while the board managed to agree to extend forward guidance for rates to remain flat (2.50%) to the end of Q3, this was a compromise reflecting noticeable differences on the board. Indeed, while the doves wanted to extend forward guidance to year-end (due to low spot CPI) and others wanted to leave it unchanged at the end of Q2 (low spot CPI offset by increased geopolitical risks), a 3rd group actually wanted to bring it forward arguing that rising economic activity meant there was a risk inflation returned to target earlier than anticipated. This group also argued that low inflation was due to factors outside of the NBP's influence (energy primarily), and that a rate hike could be justified to stave off rising house prices. We believe the minutes were a reminder that while most central banks globally will maintain policy accommodative until there is evidence of rising price pressures, the NBP will pursue a much more traditional policy, raising rates not just in response to spot CPI but also taking more forward looking indicators into account, such as rising economic activity, capacity utilization, as well as incorporating rising house prices. We remain short EUR/PLN spot from the EM Monthly on Mar 13th. Lock in profit and move stop down to 4.2250 (4.2750), and target down to 4.0750 (4.1250). We also recommend buying a 2m EUR/PLN put with a strike @ 4.05 for an indicative 0.086% of EUR notional.

Rates: Despite the low interest rate level of 2.50% and the fact that an already very moderate hiking cycle had been priced, the market pushed expectations for interest rate hikes even further out the curve over the last couple weeks now pricing only ~10bp of hikes by the end of 2014. Our fundamental view on Poland has not changed and we continue to see the benign pricing at odds given increasing German demand, a strong interlinkage into the German production chain, higher credit growth and improving underlying domestic economic activity. However, the dovish language by the ECB and the weak inflation dynamics continue to undermine any immediate change in the NBPs policy stance. On the other hand, the NBP has historically been very sensitive to real rates which speaks in favor of a more aggressive monetary policy response in 2015 in case our base case scenario of a gradual pickup in inflation pressure close to the target of 2.5% by Q2-15 is realized. Hence, given the low negative total carry

we see from a risk-reward perspective a good timing to position for a flatter 2Y-10Y slope of the curve. The belly as well as the long end of the curve could be further supported in case of QE in Europe while we see rate cuts by the NBP as rather unlikely even in case of a similar response by the ECB. Enter 2Y-10Y IRS at 97bp and target of 70bp with a negative total carry of 3bp over 3m. On the back of the dovish monetary policy environment in Europe we see from a RV perspective more room for a rally in Poland vs. Czech and favor long PLN Oct-19 vs. Czech Oct-19 in the nominal government bond space at a spread of 230bps with a target of 200bps.

RUSSIA

— Remain in 3m one-touch USD/RUB put, with a barrier @ 33.75 costs an indicative 5.5% of USD notional and pay-out ratio of 18/1.

— Stay paid in 1Y XCCY.

FX: President Putin ordering a partial withdrawal of troops from the Ukrainian border has added impetus to the RUB rally of late, and with FX weakness still excessive compared with the improving Terms of Trade & stabilisation in the current account, as well as attractive risk-adjusted carry, we are comfortable holding on to our long RUB position expressed in the EM Monthly on Mar 13th through a 3m one-touch USD/RUB put, with a barrier @ 33.75 (cost an indicative 5.5% of USD notional, unwinding the position now would return an indicative 10.84%).

Rates: The situation for rates in Russia has not materially changed over the last weeks with curves bear flattened further and the XCCY and IRS swap curves both showing an inverted shape. Political uncertainty around the Russia-Ukraine conflict, net capital outflows, a weaker growth outlook in combination with upside risk to inflation continues to weigh on markets in the near term and makes a clear view challenging. Any unwinding of the +150bp rate hike earlier in the year will in our view only follow a substantial and more importantly sustainable appreciation of the RUB. On the other hand further rate hikes can’t be rule out if geopolitical tension intensifies further. As for now, we stick with our bearish bias in RUB rates and continue to favor payers in the 1y part or the XCCY swap curve providing a positive total carry of 24bp over 3m.

SOUTH AFRICA

— Stay constructive in ZAR and position for gradual move lower extending to 10.25

— Receive 6x9 FRA and Pay 2Y IRS with total carry of 20bp to position for a delayed but more aggressive monetary policy response

10 April 2014



10 April 2014


FX: In the last EM Monthly we argued that expectations for a marked improvement in the C/A deficit over the next 12 months will see ZAR trade at 10.25 over the next 3-6 months. Since then US 10y yields are up by almost 15bps on the back of a much more hawkish than expected Fed, but ZAR is another 20 big figures stronger vs the USD. A similar pattern is evident in much of the rest of EM FX, something which is backed up in correlations, with the rolling USD/ZAR correlation with US short and long-term rates having collapsed, from having been close to 10y highs from May last year when the Fed opened the door for tapering, up until the 2nd half of January, when it started to moderate substantially. The question now is whether the correlation will pick up yet again, or if we have now moved into a new correlation regime, where EM FX is not insulated against higher US rates, but much less sensitive than was the case between May to February. There are a few reasons why that might be the case: 1) EM central banks did eventually respond to the rout in EM FX and the subsequent deterioration in inflation prospects. Hence real rates have, in most cases, now been returned to positive territory and carry is attractive; 2) the real FX adjustment has been substantial, with EM as a group now looking much more competitive than 12-18 months ago; 3) partly as a result of ‘2)’ the external balances have started to improve, with the Fragile 5 having seen improvements, albeit very gradual improvements, in their external balances, underpinned by slowing domestic demand in response to tighter fiscal & monetary policies, but also a pick-up in exports; 4) Continued subdued price pressures in the US and sluggish activity data, most noticeably in the housing market, have enabled the Fed to credibly drive a wedge between tapering and the beginning of the rate hiking cycle. We remain constructive ZAR on a multi-month horizon, seeing the gradual move lower extending to 10.25. While we have been stopped out of our reiterated short TRY/ZAR from the EM Monthly on 13th March, we remain long a 6m dual digital 4% OTM USD/TRY call / ATMS USD/ZAR put (cost an indicative 13.5% of notional).

Rates: Although the short end has rallied aggressively over the last weeks, with around 100bps of rate hikes still priced until end 2014 the market continues to expect a rather hawkish monetary policy response over the next few months. Last month we expressed our constructive view on the short end of the curve through a 2s10s steepener to be also protected from an aggressive sell off in US rates. While the decision to leave interest rates unchanged in March led to a bull steepen of the curve the lack of repricing of US rates has flattened the curve over the last few trading days. Given the recent appreciation of the ZAR and improvements in the CA deficits - which our economists expect to continue – the current pricing looks from a risk/reward perspective still attractive for receivers in the short end and to position for a SARB on hold for longer. However, with real rates in negative

territory, the SARBs high sensitivity to inflation expectations above the target of 5% and continues economic structural difficulties could all increase pressure for the SARB to react in a more aggressive manner in the medium term. Hence we see little room for our steepener to perform and close the trade at 151bp (entry 143). Instead, we favor positioning into receiving 6x9 FRA and paying 2Y IRS expressing the view that current external factors look more favorable against an immediate monetary policy response but the hiking cycle could be more aggressive further out the curve in case of capital outflows driven by a normalization in core-rates. Enter the trade at 8bps with a target of 40bps and positive total carry of 20bp over 3m.

TURKEY

— Expect TRY to be trading in 2.05-2.25 range over the next weeks

— Buy IL-bond April-20 with real yield of 3.4% and B/E at 6.65%

FX: Since the emergency rate hike by the CBT on Jan 28th, the Lira has appreciated by some 9% v the USD. Apart from real rates having been returned firmly into positive territory, the Turkish unit has also been underpinned by PM Erdogan's convincing win in the recent regional elections on the perception that at least it provides some stability over the near-term. So the question now is: where do we go from here? Looking back historically at exchange rate cycles in Turkey would suggest that a real depreciation of 15-20% has typically been sufficient to stabilise the REER TRY. The Lira sells off by at least 15-20%, then rallies back somewhat, which is then followed by a 12-18 months period of stabilisation/rangebound, before a repeat of the same historical pattern. For stabilization, we need to see evidence that the weaker Lira is now leading to an improvement in the external balances, something which was evident in the January BoP report, which saw the C/A deficit narrowing from -8.3bn to -4.9bn. Moreover, the TRY REER at historically competitive levels also bodes well for equities, which in the past and once the Lira has stabilized, have traditionally responded well to a period of Lira depreciation. Thus, while there are reasons to be cautiously constructive on TRY (current CBT policy stance, signs of narrowing C/A deficit, FX Valuations, and the outlook for TRY equities), that ought to be balanced against ongoing political uncertainty, Turkey’s external financing needs, as well as the possibility that the CBT will quickly change focus towards reversing some of the policy tightening if growth were to disappoint. What we can say: if history is a good template, going forward we should be moving into a period of consolidation, with our short- and long- term metrics suggesting a broad 2.05-2.25 trading range in USD/TRY.

10 April 2014



Rates: Sentiment has been quite favorable for rates in Turkey over the last few weeks. While the lira received initial support by the emergency rate hike earlier this year, improved external factors, in particular reduced risks of a hard landing in China and a lack of re-pricing in US rates have reduced tail risks for the Turkish economy. In fact, the much expected negative impact of higher official rates on domestic growth has not yet materialized and recent economic data point towards upside risks to current GDP forecasts for H1-14. In addition the political uncertainly has settled for now and even the noticeable higher than expect inflation print for March has not renewed fears of another hiking scenario. Overall, the market has priced out around 250bps of rate hikes now pricing ~50bp of cuts over the next 12m. We had positioned for a bull-steepening scenario but have been surprised by the pace of the normalization in the curve. While our pay 1s5s in cross currency space has reached the target of 0 (flat) and is now trading with a positive spread (40bps) for the first time since mid-Jan the 2Y-10Y slope in government bonds has also dis-inverted and is trading with 25bp (trade entry at -27bp) now close to our target. As for now we get more neutral on rates in Turkey and close our 1s5s CCY payer. We favor to position into trades which benefit from higher inflation risk premia to be priced into the curve. While we see room for another 10-20bps steepening in the 2Y-10Y slope we also recommend buying inflation protection. Although with ~6.6%-7.0% B/E inflation priced into the 5y-8y sector IL-bonds do not look extremely cheap. However, additional inflation prima could be priced in if realized inflation continues to surprise to the upside and/or any interest rate cut by the CBRT could delay the process of bringing spot inflation back to the upper end of the CBRT’s medium term “comfort zone” of 7.0%. Buy IL-bond April-20 with real yields of 3.4% (B/E inflation of 6.6%).

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

Credit

RUSSIA

— Underweight. Also look to enter outright long (5Y) CDS protection.

— Long basis (23s vs. 10Y CDS)

On April 7th, we moved Russia back to underweight again (see EM Sovereign Credit Weekly) and retain underweight at this juncture.

When we covered underweight in Russia a week earlier (see EM Sovereign Credit Weekly of April 1), we noted that it was a tactical move and we were biased

towards reducing on strength. We continue to believe that Russia’s actions with respect to Ukraine and the response of western nations (sanctions) have added long-term damage to the already fragile economy through weaker sentiment, increased risk perception and increased capital outflows. Furthermore, we believe that the cost of sanctions and increasing economic and political isolation has yet to materialize fully. In addition, the risk of re-escalation in the Ukraine crisis is significant and increasing as we approach the May 25 presidential election in Ukraine. We believe Russia is likely to keep pressure on Ukraine so as to push the new government away from EU integration. Recently, we have seen signs of rising tension again with Russia’s decision to cut off gas subsidy to Ukraine (though expected) and protests by pro-Russian separatists. In addition, following the recent cancellation of gas discounts to Ukraine, the risk of gas disruptions to Ukraine (and to Europe) and also escalation of West’s sanctions has become more likely. So in our view, a case for reducing to underweight again has been built with Russia’s credit spreads having recovered more than half of their previous widening.

We recommend looking to enter long 5Y CDS if it tightens to close to 200bp (current level: 220bp), where the risk/reward will get more asymmetric. On the cash curve, 10s30s in Russia remains flatter than the EM average so we favor the 10Y sector on relative basis. Finally, CDS/bond basis is closer to the tight end of range and we are biased in being long basis via 23s vs. 10Y CDS (entry: 25bp, target 40bp, stop: 20bp). We believe a potential re-escalation of the crisis will create additional demand for long protections and help push basis move wider –as we have seen in mid March around the time of Crimea annexation.

UKRAINE

— Remain neutral.

We recommended covering underweight on Ukraine following the announcement of the IMF agreement on 27-Mar-14 that topped market expectations. The agreement was based on the same blueprint that the Fund has been advocating for several years and which successive governments have been unwilling or unable to implement. However, in light of the status of relations with Russia, the new government has few options for prevarication and the speed with which they moved on some of the apparent pre-conditions of the program (such as beginning to adjust domestic gas tariffs) was significant. The full implementation of the program will remain extremely challenging and there is a significant risk of it going off track in the months after the May presidential election. However, with the IMF Executive Board expected to meet by the end of this month to approve the program, we expect risks to the market to be skewed to the upside in the near term.

10 April 2014



10 April 2014


The most likely source of downside risk in our view remains an escalation of unrest in the Eastern provinces and heightened tensions with Russia. However, we would expect such developments to also have a negative impact on Russian assets (given the risk or actuality of tightened sanctions) and thus we see our underweight recommendation on Russia as providing some protection vis-à-vis this scenario.

TURKEY

— Cover underweight and move to neutral

— Hold 10s30s cash curve steepener

The Turkish sub-index is now trading at 90bp above EM investment grade average, with political uncertainty and weak fundamentals likely priced in. Politics remains a source of market volatility leading to the Presidential elections scheduled for this summer. Uncertain remains and PM Erdogan has stated his intention to crack down further on the Gulenists. The economy has shown some resilience in the face of political turbulence, weaker capital flows, and higher interest rates, and the lira has stabilized since the CBT rate hike, but a meaningful macro adjustment to reduce its vulnerability to international liquidity conditions has not taken place. Turkey will likely be among the first EM credits to suffer if stronger US data prompts markets to price earlier rate hikes by the Fed, the risk of which has risen recently.

Fitch has recently affirmed Turkey’s credit rating (BBB-) and stable outlook, taking the view that the policy adjustment delivered by the CBT in January was sufficient and that the risks of a sudden stop in capital flows have accordingly receded. Moody’s (Baa2) is scheduled to release its review on Turkey on April 11. A revision to a negative outlook is possible but an outright downgrade to the rating is unlikely in our view. Market pricing is now consistent with an average rating between BB and BB+, ie a 1.5 notch downgrade by each of the three agencies (see graph below). It seems very unlikely that the rating agencies would consider such a reduction in the near term, but we believe that this pricing correctly reflects the balance of risks given the macro weakness and political troubles.

While covering underweight, we favor the 10Y sector of the curve as Turkey remains one of the flatter curves in EM even after the recent steepening; we hold 10s30s cash curve steepener (22Ns vs. 41s).

Market pricing on Turkey is consistent with 1.5 notch

downgrade

5

7

9

11

13

Mar-10 Mar-11 Mar-12 Mar-13 Mar-14

actual ratingimplied rating

Turkey credit rating vs. implied rating


POLAND

— Stay overweight.

Poland has underperformed (widening by 20bp vs. EM investment grade average) during the past month as the market rallied with higher-yielding credits having offered superior performance. Since we believe there is limited potential for a further overall market rally, we see better value in keeping Poland overweight based on its fundamentals. Poland’s credit spreads remain slightly cheap in comparison with the developed market. The March PMIs for Poland (54.0, slightly below February’s level) affirmed continued economic recovery in the country on the back of improving domestic demand. Inflation and inflation expectations remain subdued. Technicals are also supportive, with the bulk of external issuances fulfilled (almost USD5bn bonds sold), and USD2.5bn principal and interest scheduled to be repaid during the remainder of the year. We therefore continue to maintain an overweight exposure to Poland to balance our more bearish position in some other EMEA countries, including Russia and Ukraine. On the bond curve, the 19s still look somewhat expensive vs. 22s, and we maintain the switch of 22s vs. 19s for further correction (entry: 40bp, current: 33bp, target: 20bp; tighten stop to 40bp).

HUNGARY

— Neutral

Consistent with our view that the valuation had become expensive and the balance of risks had shifted towards more downside, Hungary’s credit spreads have widened by 50bp relative to the EM benchmark since late January, the peak of its long standing outperformance. At the current level of -60 vs. overall benchmark, it still looks somewhat expensive. On the other hand, we also think the valuation is broadly justified by fundamentals, with strong and accelerating

10 April 2014



economic recovery and subdued inflation, and improving fiscal and external accounts. On the negative side, policy risk remains as Fidesz – re-elected earlier this month – is expected to continue with its populist and interventionist policies, particularly given the relatively strong showing by far-right Jobbik. Also, the NBH has been pushing the limits of monetary easing, despite low real rates (negative vs. the core), the large amount of fx debts, and bouts of volatility in the forint.

After having sold USD3bln on March 18, technical conditions in terms of supply/demand have improved, with more than USD3.0bln redemptions scheduled during the remainder of the year and at most USD1.5bn Eurobonds still to be sold (likely denominated in EUR). We favor long end of the curve (41s) at the moment as the REPHUN curve is very steep in comparison with peers with similar spread levels. The recent steepening of the curve was likely due to supplies of the new 5Y and 10Y benchmarks. While the next tranche of new issues could well be at the long end of the curve, we do not expect Hungary to come to the market in the near term.

REPHUN 10s30s looks steep relative to EM

comparables


SOUTH AFRICA

— Stay neutral

— Hold cash curve steepener of 25s vs. 41s.

South Africa has underperformed the average of EM investment grade sovereigns by 15-20bp over the past month, which in our view was a correction to its previous rally which started late January and had, in our view, become a little excessive. Market participants may also have become more concerned with the impending election (in May), but the election in South Africa is less likely to surprise and hence should be less disruptive than those in many other EM countries in our view. Recent economic data has continued to surprise moderately on the positive side, especially in

its CA deficit which has narrowed materially on an improving trade deficit. In addition, credible central bank policy (currently engaged in a hiking cycle) helps keep inflation in check and stabilize the rand, which has rallied by 8% since the end of January. Finally, wage strikes have persisted but the chances for them to wind down before the elections have increased. Risk of a ratings downgrade (by S&P and/or Fitch) remains significant but will not come before June due to EU regulated rating change schedules. On the technical side, South Africa has yet to issue this year and will likely come to the market within the next couple of months - we project USD 1.5bn issuance in Eurobonds in 2014 and it will be due to repay about USD1bn in June.

Overall, risk seems balanced with an improved valuation that has the fundamentals weakness priced in and South Africa’s sensitivity to a rise of US rates has likely reduced as well. We therefore retain a neutral view on the credit. 10s30s in South Africa remains one of the flattest in EM, with the long 41s looking expensive. We hold a cash curve steepener of long 25s vs. 41s (current: 4bp; target: 20bp).

Hongtao Jiang, New York, (1) 212 250 2524 Marc Balston, London, (44) 20 8547 1484


10 April 2014


LatAm Strategy

LatAm FX: Buy MXN/BRL (target: 0.1830 stop: 0.1650). Buy ZAR/BRL (target: 0.24 stop: 0.2050). Buy cash neutral 6M USD/CLP 1x2s call spread (ATMF/584). Buy 3M USD/MXN put (ATMS/KO at 12.35) financing it with a 3M USD/MXN call struck at the top of the recent range (13.60). Short USD/PEN targeting 2.75, stopping at 2.82

Rates: In Mexico, buy Udibono’40 (target 3.35%). Scale up long inflation breakeven (long Udibono’22 vs. 10Y TIIE). Keep 5Y5Y spread compression vs. US swaps (target 350bp). In Brazil, buy NTN-B’35 (target 6.25%). Hold Jan16/Jan21 steepeners (target 90bp). In Chile, hold 1Y UF receivers vs. 5Y CLP swap payers, DV01-neutral (target 400bp) and 10Y swap spread vs. the US (target 200bp). In Colombia, take profit in long TES 20s and COLOM’27 – stay neutral. In Peru, switch from the SOB’s 31s to SOB’20 (target 5.5%).

Credit: Cover underweight on Venezuela, reduce to neutral on Colombia, and stay neutral on Brazil, Mexico, and Peru. In Argentina, we favor the global bonds at the long end (Discounts and Pars) and look to enter long GDP Warrants on better entry levels. In Venezuela, we hold long PDV 14s, take profit in short basis, and favor 17Ns on PDVSA and 18s on sovereign. In Mexico, we look to enter 10s30s cash curve steepeners and continue to favor Pemex 45s over UMS 45s. Finally, we hold long 5s10s CDS curve flatteners in Brazil.

Local Markets

BRAZIL

— FX: Buy MXN/BRL (target: 0.1830 stop: 0.1650). Buy ZAR/BRL (target: 0.24 stop: 0.2050).

— Rates: Favor DV01 neutral steepeners –Jan 16 vs Jan 21, targeting 90 bp and stopping at 40 bp. We also like receiving real rates: Buy NTN-B’35 (target 6.25%)..

FX: It was a month of stellar performance for the BRL. Fueled by the generalized “EM risk on” environment, the combination of foreign inflows chasing valuation and carry together with the perception of more lenient authorities towards a stronger currency resulted in BRL being the strongest performer across EM. While hard to call a bottom, we believe that the currency is starting to show some signs of stretchiness. Positioning in BRL is the heaviest in the region and the valuation gap (versus its financial peers) has completely

closed over the last month, suggesting that the currency is now slightly over valued (around 3%). Besides the political jitteriness, high CAD and structural issues related to economic policy mismanagement persist, exposing the BRL to significant downside risk especially if data improves in the US. We keep a short BRL bias. However, without a “trigger” the USD short is heavily penalized by the negative carry, especially in a low volatility environment. Instead, we would rather express the view versus MXN (buy MXN/BRL, target: 0.1830 stop: 0.1650) and ZAR (buy ZAR/BRL, target: 0.24 stop: 0.2050). In options this time we rather take advantage of the low volatility environment, a steep skew to express our long USD bias – consider the “broken-seagull” – Buy 3M USD/BRL call spread (ATMF/5% ATMF, with a low strike KO at 2.55) can be fully financed by a 3M USD/BRL put at 2.10. Alternatively, one can finance high strike in BRL with high strike in the rather stable INR – Buy 3M USD/BRL call (ATMF,KO at 2.40) sell 3M USD/INR put (5.7% OTMF).

Rates: The rather dovish communiqué that followed the last BCB meeting (25 bp hike) indicated that after 350 bp the current cycle is coming close to the end. And while there is still some residual uncertainty regarding the outcome of the next meeting (we call for a pause) the market indeed re-priced the post-election continuation of the cycle, partially correcting the “hump” in the 1Y1Y point. With the polls suggesting the current government will remain in power and the curve still pricing 125 bp of hikes we still see value in receiving the front end of the curve. We also believe that the recent flattening in the nominal curve is not consistent with the uptick in inflation, reflecting instead the strong foreign inflows in a low volatility environment rather than actual change in the fundamentals. Together with the re-pricing of US growth, the backdrop suggests, in our opinion, scaling into steepeners. We like receiving the Jan16 vs Jan21s (target 100 stop 40). We also like receiving real rates: buy NTN-B’35 (target 6.25%).

CHILE

— FX: Buy cash neutral 6M USD/CLP 1x2s call spread (ATMF/584). Buy PEN/CLP target 205, stop at 193).

— Rates: Receive 1Y in UF vs pay 5Y CLP/CAM (target 400bp in spread) receive 10Y CLP/CAM vs pay US in the 10Y sector (target 200bp)

FX: Despite copper continuing it underperformance and the BCCh signaling further easing, the CLP staged a

10 April 2014



strong rally in the month of April. With the valuation gap almost closed and the positioning on the lighter side, we take a slightly bearish stance on the CLP going forward. Lackluster economic performance and concerns regarding China will challenge the peso performance going forward. Moreover, the possibility of further cuts potentially reduces even more the burden of being long USD. Altogether, while slightly cheap from the valuation perspective, we believe that the peso will grind lower to the top of the range. At the current level we like selling versus USD through options: Buy cash neutral 6M USD/CLP 1x2s call spread (ATMF/584). Outright one can mitigate the negative carry by going short CLP vs PEN (long PEN/CLP target 205, stop at 193).

Rates: Our views in Chile remain the same as last month. Despite some positive news we believe that the market is underpricing the magnitude of upcoming cuts. Accordingly, we believe the continued weakness in economic activity, a decrease in copper demand, and concerns about China’s growth will increase the odds of further accommodation. The latter should translate into further bull-steepening of the nominal curve given the BCCh’s average response to overall economic weakness. Inflation pass-through has been relatively low but weakness of the CLP could translate into wider breakevens, especially in the front end. We keep our exposure to steepeners through a hybrid real/nominal position: receive 1Y in UF vs pay 5Y in CLP/CAM. Further down the curve we keep our core box receivers vs the US (10Y) predicated on the current countercyclical nature of the economies. In the cash space, bonds have been outperforming swaps with the Jan-18s leading the pack on the belly of the curve – we believe that the bond is a bit on the rich side especially when compared to the Jan-20 or the Jun-17.

COLOMBIA

— FX: Neutral.

— Rates: Neutral

FX: Besides benefiting from the “EM friendly” environment, the rally in COP reflected the expected significant increase in foreign participation in Colombia’s local markets. Like its peers, COP is now trading close to December levels but valuation and positioning suggest that rally might be running out of steam. Supporting the latter, seasonal repatriation of USD by corporates, election risk and recent comments by the Ministry of Finance regarding the recent appreciation suggest some hurdles for the COP going forward. We keep a neutral stance for now, looking for a better entry point to go long USD.

Rates: Activity has been slowing improving in Colombia and the recent uptick in inflation, together with the

hawkish tone adopted by the authorities, suggests that the start of tightening cycle is near. Market expectations imply a first hike of 25bp in July, which in our opinion is consistent with the current trend in CPI. While we believe that the market is overestimating the amount of hikes until December (approximately 125 bp), we for now keep a neutral stance in the front end of the rates curves given the uncertainty regarding the magnitude of the cycle. We take the same neutral stance on the curve where the rally has been relentless mostly due to the recent increase of TES weight in the benchmark indices. Regarding the latter we believe that the move might be a bit overdone given the uncertainty on the actual implementation of tax cuts. On the latter, we take profits on our TES 22s and COLOM’s 27 recommendations.

MEXICO

— FX: Buy MXN/BRL (target: 0.1830 stop: 0.1650). Buy 3M USD/MXN put (ATMS/KO at 12.35) financing it with a 3M USD/MXN call struck at the top of the recent range (13.60).

— Rates: Buy Udibono’40 (target 3.35%). Scale up long inflation breakeven (long Udibono’22 vs. 10Y TIIE). Keep 5Y5Y spread compression vs. US swaps (target 350bp).

FX: After a couple of months of range bounding, the MXN finally had a month of consistent appreciation. Going forward we believe that the fundamentals continue to be positive and keep a bullish bias for the currency. Supportive valuation (2% undervalued versus financial drivers), spillovers from the US, favorable reforms backdrop, and balanced CA continue to outweigh low FDI and weak activity with relatively high inflation, boding well for MXN longs. Moreover, we believe that MXN would be less exposed (than its peers) to an eventual bout of USD strength. We particularly like going long MXN versus COP and BRL In options – buy 3M USD/MXN put (ATMS/KO at 12.35) financing it with a 3M USD/MXN call struck at the top of the recent range (13.60).

Rates: In Mexico, the gap between front-end real rates and the “natural” fair level continues to support bear flatteners in the long run. Activity, however, remains subdued with prospective growth heavily dependent on the US. As a consequence, the front end continues to be trapped in a range after the re-pricing of early hikes observed early in the year. On the curve, slopes continue to grind lower as the term premium built during the “tapering days” continues to be slowly priced out. We keep our core positions in TIIE -2s10s flatteners and receive TIIE – pay US 5Y5Y box as we expect flattening to eventually resume as growth picks up in 2014. That said, continued weakness in activity might justify some retracement trades, especially in


10 April 2014


cash, which, differently from the previous sell-off, underperformed swaps, especially in the belly end of the MBONOS curve. Dec 24 continues to look cheap versus surrounding issues (more specifically Dec 23) and versus TIIE, while in the front end the Jun17s and Nov36s look rich versus swaps – one could, for example, long the 24s vs 16s and 36s on the fly. In real rates we like buying Udibono’40 (target 3.35%) and scaling to long inflation breakeven (long Udibono’22 vs. 10Y TIIE)..

PERU

— FX: Short USD/PEN targeting 2.75, stopping at 2.82

— Rates: Buy Sob20s (target 5.5%).

FX: PEN continues to be rather stable despite the recent market developments. From the valuation perspective, the currency is mildly cheap (around 1% vs the USD) and with the authorities happy with the current levels we expect PEN to continue to grind lower, being relatively immune to external shocks given the current policy of currency management. Position continues to be the heaviest in the region (pension fund holdings of USD is still high) and from the BoP perspective, the rather wide CAD (5%) is safely covered by FDI, and should not pose a threat to PEN’s stability.

Rates: Last month, the reduction political risk-premium that followed Peru’s newly appointed cabinet members led to considerable bull-flattening of the back end of the Soberano’s curve. The rally continued during last month led by the longer tenors and with no monetary policy surprise on the radar we continue to favor longer tenors that are high vs fundamentals. We like the 7-10 year sector that lagged a bit the long end. We switch from Sob’31 to SOB’20 (target 5.5%).

Guilherme Marone, New York, (212) 250-8640

Credit

ARGENTINA

Neutral, favor Pars. Current prices for Warrants are close to fair but look to enter long only at better levels after market prices out any hope of 2013 GDP print above trigger.

The extent of the rally in Argentina bonds has exceeded our expectations, with the prices of global bonds now only a touch below the levels seen in October 2012 when the market began to sell off following the pari-passu ruling. Indeed, on top of the prospects of political changes down the road, the current administration has exceeded market expectations on

multiple fronts with pragmatic policies; also, investors’ chance to avoid loss from a technical default has also significantly reduced on better prospects of getting a reversal from the US Supreme Court or settling with the holdouts.

The extent of the rally can be seen in a clearer way if we compare the total returns of the Argentina sub-index (both local law and global bonds) with the overall EM index using DB-EMSI (see graph below). If we rebase the two indices on 24-Oct-12, the Argentina sub-index has returned about 21.5% while the overall EM index is still slightly under water!

Total return index: Argentina in comparison with EM,

rebased on 24-Oct-12 (when legal selloff began)

7580859095

100105110115120125

Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

Argentina

EMTotal return, rebased on 24-Oct-12


At this point, we believe the scope for continued rally in the near term should be more limited as most good news is perhaps already priced in (if not more than priced in) given the still unresolved legal situation and that policy responses have been inconsistent – for example, the overall policies have remained expansionary despite attempts to moderate fiscal deficit and monetary financing, and the government has continued to resort to price controls to tame inflation.

To our surprise, the government reported that 2013 GDP growth re-based to 2004 was preliminarily estimated at 3%%, below the trigger level for GDP Warrant payment is expected in December 2014, with the final revision due in September. The prices of GDP Warrants have dropped by almost 3pts following the news before stabilizing. As we noted in EM Sovereign Credit Weekly of 01-April-14, the current price of the Warrants (around 6.9 mid) is close to (but not completely) pricing out the December 2014 payments; our valuation model suggests that the revision of 2013 GDP below trigger was worth about 30-35% reduction in the prices. In our view, any future revision by the government on 2013 GDP will not bring it above trigger, whether through a higher GDP print or lower yoy

10 April 2014



trigger6. We see the 3.0% GDP print for 2013 as a political decision made by the government; it is a done deal. There shouldn’t be any hope that one day it will be revised to be above trigger. While we remain constructive on the Warrants for the long term, we do not see the current level as sufficiently attractive as it still embeds some slight hope of getting a coupon payment in December 2014.

On the bond curve, we continue to prefer longer duration global bonds to both Global 17s and the local law bonds. The local law curve will likely see supplies at the long end as a result of recent YPF settlement, while at the front end of the curve, Boden 15s (maturing in October 2015 with more than USD6bn) are more exposed to the risk of reserve depletion without the benefit of the expected policy improvement after the new administration takes over. We are rather indifferent between the Discounts and Pars at this point. While the former probably offers more upside if market continues to rally, the latter is more defensive under a bearish scenario.

BRAZIL

— Stay Neutral.

Brazil has underperformed EM investment average by some 15bp and its regional peers since the S&P downgrade and recent bond issuances. The positive tone in the market after the more realistic budget announcement in February has now faded. We believe the recent performance correctly reflects fundamentals weaknesses in Brazil with stagflation, worsening BoP, deteriorating fiscal quality, and still challenging policy outlook before the elections. We believe the October elections remain a constraining factor, limiting the scope for significant changes in economic policies. The support seen in the local markets by the recent drop in the polls by President Rousseff has been absent in the credit market, which we believe was the correct market response. We continue to believe the re-election of President Rousseff will be the mostly likely scenario.

In relative value, we hold dv01-neutral 5s10s curve flatteners (entered at 58bp, current 54bp, target 45bp, stop 70bp), as well as switching from BNDES 20s to 23s and switching from Petrobras 3% 19s to 7.875% 19s on these quasi-sovereign curves for further gains.

6 Based on our readings of the prospectus and indenture of the Warrants, change of base year should not change the yoy trigger. However, we understand this is subject to different interpretations.

COLOMBIA

— Reduce to neutral on tighter valuation. Favor 10Y sector of the curve (especially the 21s).

Colombia has been the best performer among LatAm low beta curves over the past two months and now its valuation looks much less attractive with its subindex spread almost 30bp tighter than EM investment grade average. Both fundamentals and technicals are supportive. Economic recovery looks solid, FDI remains strong, and Colombia’s public finance continues to improve. Colombia has completed its external debt issuance plan, with more than USD1.6bn repayment scheduled during the remainder of the year.

However, the current valuation looks rather tight in light of potential volatility stemmed from presidential elections in the coming months, for which we believe President Santos remains the front runner but is facing increasing challenge, and the potential retracement in local market rally due to pension reform and/or delay of tax reform, which may negatively impact the performance of Colombia’s credit spreads as well. We therefore recommend taking profit from overweight and reducing exposure to neutral.

In relative value, the 21s have continued to cheapen and our recommended switch from 19s to 21s hit stop loss on March 16. However, we continue to favor the belly section of the curve (21s being the most attractive) over both the shorter end and the long end.

MEXICO

Stay neutral but continue to see better potential in Pemex via switching to Pemex 45s from UMS 45s.

Over the past month, Mexico has given back some of its outperformance relative to EM investment grade average. However, at 50bp tighter Mexico still does not offer attractive valuation. Economic activity has disappointed in the latest data, raising concerns about recovery but our economists’ believe that downside risks to economic activity should be limited going forward, as the US cyclic upturn and government spending in infrastructure should start delivering some extra growth later in the year. So we continue to like the credit fundamentals in Mexico and stay neutral at this level.

In terms of asset selection, we continue to favor Pemex, especially at the long end of the curve, over UMS, at the current spread differential of 75bp. At the shorter end of the curve, the spread pickup of Pemex over UMS bonds is about 15bp less that at the long end. On the UMS curve, 10s30s has bull-flattened over the past month, following the general trend. We favor the 10Y sector – where we think the 22Ns are more attractive than both 19Ns and 23s – as we believe the bull-


10 April 2014


flattening in EM low beta curves has gone too far and is vulnerable to the scenario of UST long bond yields breaking out of the recent range on the upside. We look to enter 10s30s steepeners in Mexico.

PERU

— Remain neutral.

Peru has outperformed the EM investment grade average recently, recouping most of the loss incurred in March. Overall, Peru has been an outperformer YTD thanks in part to its long average duration and bull-flattening at the long end of the UST curve. However, large CAD (-5.5% GDP), though more than 100% financed by FDI, remains a source of concern, especially with the recent fall in mineral prices, which could lead to weakening of foreign investment down the road (Peru’s metal exports fell by 25% in February). From that perspective, we continue to favor Colombia over Peru. Currently 25bp tighter than EM investment average, the tight valuation and long duration make the Peru curve more exposed to the risk of potential rise in US bonds yields if US economic releases come out better than expected in the coming weeks.

VENEZUELA

Cover underweight. Take profit in short basis. Hold long PDVSA 14s. Favor PDVSA 17Ns and Venezuela for duration exposure.

The market has continued to rally after SICAD II began to operate on March 24, with daily volume averaging USD55mm so far. The implementation of SICAD II has exceeded our expectations, even though how effective it will be in terms of alleviating the economic imbalances remains to be seen. Nevertheless, the government should be given fair amount of credit for pushing through this stealth devaluation at a minimal political cost. As a byproduct of this system, there is also an monetary tightening with SICAD II as now monetary financing for PDVSA by the Central Bank has dramatically reduced as the former can sell up to USD10bn at SICAD II rates per year. According to Central Bank data, the level of excess bank reserve has dropped by almost 30% in April from March. In addition, the market has also embraced the prospect of improved policy making as the pragmatists such as Ramirez and Merentes have gained more decision making power in terms of economic policies.

While we were correct in being disappointed by the initial devaluation measure at the beginning of the year and reducing to underweight, we have been clearly on the wrong side of the market by staying underweight through the past three months. We have been over skeptical on the exchange rate policy and also over-estimated the impact of opposition protests and their constraints on the policy front. After the strong rally

since mid February, bonds spreads are now about 100bp tighter than the levels seen in mid January when we cut it to underweight. While we do think the bulk of rally is over and further potential is more limited, credit spreads in the Venezuela complex remain the widest in EM sovereign space, and its valuation remains more favorable in comparison with both Argentina and Ukraine at this stage. We therefore cover underweight at this point.

Our strategy recommendations are as follows.

We continue to hold long PDVSA 14s to maturity.

For investors to position for continued spread tightening and curve dis-inversion, we favor 17Ns on the PDVSA curve and the 18s on the sovereign curve. PDVSA 26s are cheap as well, but are facing continued supply pressure from local markets. The 3-5Y bonds offer the most significant rolldown given that the hump point of the curve will continue to be pushed to the shorter end if spreads continue to tighten.

We no longer hold the bias in favor of PDVSA bonds over their sovereign counterparts given the recent outperformance of the former. PDVSA will be the biggest beneficiary of SICAD 2 but its relative upside vs. sovereign bonds has been priced in, in our view.

Par-equivalent spread curve of the Venezuela complex

V'16

V'18 (7%)

V'19V'20

V'22 V'23

V'24

V'25

V'26

V'27

V'28

V'31

V'34

V'38

P'15

P'16P'17

P'17N

P'21

P'22

P'26

P'27

P'35

P'37

900

950

1000

1050

1100

1150

1200

1250

1300

1350

1400

1 2 3 4 5 6

Par-equivalent Spread

Par-eq spread duration


Take profit in short basis on the sovereign curve. Our recommended short basis trade of selling 5Y CDS vs. 24s has tightened by 180bp, effectively reaching our target of parity in par-equivalent differentials. The recent underperformance of bonds has been partly caused by supplies of PDVSA bonds from the local markets as result of SICAD 2 transactions. Basis remains wide from a historical perspective, but risk/rewards in keeping short basis is not very attractive at this point.

10 April 2014



CDS/bond basis on Venezuela curve has moved sharply

lower from multi-year wides

-500

-400

-300

-200

-100

0

100

200

Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14

Par-equivalent spread differential, 5Y CDS vs. VEN 24s


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

Srineel Jalagani, Jacksonville, (212) 250-2060

.

10 April 2014



China Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic outlook: While the Jan-Feb economic

data and March NBS PMI still indicated broad weakness in domestic demand in Q1, weekly prices of major raw materials suggested that the economic activities might have begun to improve at late March. We expect the economy to recover in Q2 from its Q1 trough, supported by the accommodative fiscal and monetary conditions.

Main risks: Q2 growth could surprise to downside due to weaker-than-expected real estate investment and exports.

Weak data and positive policy responses

China macro data remained weak lately. NBS PMI edged up to 50.3 in Mar from 50.2 in Feb, but after adjusting the strong seasonality, March PMI still suggested a weak domestic demand. The industrial profits gave a consistent story as well, with the growth decelerating to 9.4%yoy in Jan-Feb from 9.8%yoy in Q4 last year. Weak data has prompted positive policy responses recently, and some mini stimulus measures may have already been generating positive impact, as indicated by the slight improvement in the major raw material prices.

Government responded with mini-stimulus measures Recent stimulus packages include: three measures announced by State Council on April 2, namely tax reduction for SMEs, renovation of shanty towns in urban areas and promotion of railway construction; the slight increase of the budgeted railway FAI from RMB700bn to 720bn, and the increase of targeted completion of new lines from 6600km to 7000km; the recent accelerated integration of the Beijing-Tianjin-Hebei city cluster with the official plan to be announced by June; the roll out of several deregulation measures in April on internet finance, internet access services and healthcare sector, intending to lower the entry barrier and to attract more private investment; the approval of RMB142bn railway projects in mid-March, etc. While there may be more to come, we expect any stimulus to be very modest, as we believe what government aims to do is to support growth to prevent an increase in financial risks and to ensure adequate employment. Aggressive stimulus could comprise the rebalancing agenda.

More room for faster fiscal spending for the rest of the year These abovementioned measures will be largely financed by government expenditure, and we see a possibility for the government to quicken the pace of its planned spending and plenty room for it to

expand/front-load its spending in the coming months. The fiscal impulse remained negative in Jan-Feb, as government spending growth slowed to 6%yoy, lower than Q4’s 15.5%yoy and 2013’s annual growth of 9.5%. At the same time, government revenues strengthened, as reflected in fiscal deposits, which rose by 28%yoy in Jan-Feb, up from 23%yoy last year.

Fiscal spending and deposit

0%

5%

10%

15%

20%

25%

30%

35%

40%

-20%

-10%

0%

10%

20%

30%

40%

Feb

-11

Apr

-11

Jun

-11

Aug

-11

Oct

-11

Dec

-11

Feb

-12

Apr

-12

Jun

-12

Aug

-12

Oct

-12

Dec

-12

Feb

-13

Apr

-13

Jun

-13

Aug

-13

Oct

-13

Dec

-13

Feb

-14

Fiscal deposit, % yoy

Fiscal spending, % yoy ytd, rhs

Source: Deutsche Bank, WIND, CEIC

Other financing sources were also made available to ensure the funding needs As articulated in the stimulus packages, other financing channels include: 1) a railway development fund to attract social capital, whose total value is expected to reach RMB200-300bn per annum; 2) an innovated bond financing mechanism for railway construction, with up to RMB150bn worth of railway bonds to be issued in 2014; 3) a special unit to be established by the National Development Bank to issue 'special housing financing bonds', raising funds for shanty town renovation as well as other municipal infrastructure; 4) the window guidance from the government to channel bank financing into the “right sectors” like railway, healthcare and social services. We see a sharp rise in the bonds issuance in March by LGFVs which reached six month high. RMB163bn bonds were issued, up from 127bn in Feb and 68bn in Jan, implying a slight pickup in infrastructure investment ahead.

Subdued CPI inflation implies scope for a moderate easing of monetary policy Given the low base effect in last March, CPI inflation is likely to rise in March, however only moderately from the 2% in Feb, given the continued sizable price decline of food this month. Weekly data shows that prices of

10 April 2014



food products have declined by 2% since Feb. Subdued CPI inflation gives scope for monetary easing. In fact, during first 8 days of April, the PBOC’s open market operations resulted in a net liquidity injection of RMB107bn, with RMB225bn repo issued and RMB332bn repo matured. The PBoC has been draining liquidity from the system in both Feb and March.

China central bank open market operation, RMB bn Jan-

2014 Feb-2014

Mar-2014

Apr 1-82014

Repo 0 268 602 225

Maturity of repo 0 0 346 332

Reverse repo 525 0 0 0

Maturity of reverse repo 75 450 0 0

Treasury cash deposit 90 50 0 0

Maturity of treasury deposit 50 30 30 0

SLO withdraw 0 10 0 0

Total net injection 490 -708 -286 107Source: Deutsche Bank, WIND, PBOC

Improving raw material prices hinted the economic activities might have begun to improve at late March. We see a moderate improvement in the prices of raw materials since late March, including coal, steel, non-ferrous metals and plastic. This may be due to 1) the removal of both “anti-pollution emergency measures" as coal burning for heating ends and negative seasonal effect; and 2) the acceleration in infrastructure construction as a result of recent mini-stimulus packages. We expect PPI deflation to narrow a bit for April, while the March figure to stay roughly stable as the price recovery didn’t take place until late March.

Price index for agriculture products and raw material

2014 (2014.1.1=100)

858687888990919293949596979899

100101102

04-J

an

11-J

an

18-J

an

25-J

an

01-F

eb

08-F

eb

15-F

eb

22-F

eb

01-M

ar

08-M

ar

15-M

ar

22-M

ar

29-M

ar

05-A

pr

SteelCoalNon-ferrousPlasticMeatTotal agri. products

Source: Deutsche Bank, WIND, Ministry of Commerce

Lin Li, Hong Kong, +852 2203 6187

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

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

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

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

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

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

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

Financial Markets Current 3M 6M 12M1-year deposit rate 3.00 3.00 3.00 3.0010-year yield (%) 4.50 4.60 4.60 4.60CNY/USD 6.20 6.17 6.14 6.08 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

10 April 2014



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

Economic outlook: The macro data for Hong Kong softened further in March. Exports continued to disappoint, housing market demand remained sluggish and retail sales weakened, while CPI inflation eased and employment held up strongly. Going into Q2, we expect the economy to recover on the pick-up of the US and the EU as well as China.

Main risks: The major risks for Hong Kong are still weaker-than-expected external recovery and sharper-than-expected housing price decline.

Soft patch of macro indicators

Retail sales weakened Retail sales dropped by 2.2%yoy in Feb, significantly down from 14.4% in Jan. In real term, the sales volume was also down 2.2%, lower than 16.6% in January. The sharp decline should be largely attributed to the seasonal effect of CNY. Yet after adjusting seasonality, the real growth was only 4.9% vs. 8.3% in Jan. The data are consistent with slowing tourist arrival in February: 4.4mn visitors arrived in HK in Feb vs. 5.5mn in Jan.

March PMI fell back to the contraction territory Hong Kong composite PMI dropped below 50 to 49.9 this March, ending the five-month long expansion. Within the sub-index, output, new orders and quantity of purchase decreased sharply by 5.9ppts, 5.7ppts and 5.2ppts respectively, while employment, supplier’s delivery time and staff costs improved by 0.7ppts, 1.5ppts and 0.2ppts.

The continuous recovery in employment amid weak economic output over the past months (or even years) may be explained by the resilience in the unskilled labor market. Structural factors like a declining young population and job creation by inbound tourism have helped to keep the market tight. Moreover, empirical studies by HKMA suggest that the skill mismatch has been reduced and frictional unemployment has declined.

February exports surprised to the downside HK exports contracted by 1.3%yoy in Feb, lower than the market consensus of +8.3%. Exports in Jan and Feb combined fell by 0.8%yoy. The deterioration in Feb exports was led by a sharp decline in shipment to major destinations, in particular, Germany (-19.7%yoy), the US (-19.5%), India (-18.0%) and Japan (-13.7%). Meanwhile, imports rose 6.8%yoy in Feb, up from a

2.7%yoy decline in Jan. As a result, the trade deficit widened to HKD53.7bn in Feb from HKD20.0bn in Jan.

Looking ahead, we remain positive on the outlook for Hong Kong exports, as we believe the potential pick-up in the growth of advanced economies and China will generate stronger demand for Asian exports later this year.

Trade and trade balance

-60

-40

-20

0

20

40

60

-25%

-15%

-5%

5%

15%

25%

Jan-

13

Feb-

13

Mar

-13

Apr

-13

May

-13

Jun-

13

Jul-1

3

Aug

-13

Sep-

13

Oct

-13

Nov

-13

De

c-13

Jan-

14

Feb-

14

Trade blance, HKD bn, (rhs)Import, yoy %Export, yoy %

Source: Deutsche Bank, CEIC, Haver

CPI Inflation eased in February February composite CPI inflation moderated sharply to 3.9%yoy from 4.6% in Jan, slightly higher than the consensus of 3.8%. The underlying CPI also eased to 3.6%yoy from 4.3% in Jan, after netting out the effects of one-off relief measures. This deceleration was primarily guided by the CNY seasonal effect and easing of private housing rentals. The holiday-sensitive items such as meals away from home and the price of package tours registered smaller increases during the month.

Looking forward, CPI inflation is expected to remain contained in the near term as a result of subdued imported inflation as well as the moderate increases in fresh letting residential rentals since early 2013.

Housing prices under pressure February Hong Kong housing prices registered yoy growth of 1.7%. Although still remaining in positive territory, it is the weakest monthly yoy growth in the HK property market since July 2009. The mom price change was -0.3%, reporting negative growth six months in a row. Moreover, the Feb agreement for

10 April 2014



sales was a mere 3,692 units, the lowest since Nov 2008, reaffirming the weak demand.

Going forward, while sluggish demand is the key issue, the 2014 supply would gradually increase, casting more pressure on the housing price. Data recently reported by HK Government Rating and Valuation Department concluded that for the private residential market (ex. HOS and other public schemes), completions are expected to be 17,610 units in 2014 and 12,660 units in 2015, significantly up from the 8,250 units in 2013.

Moreover, Cheung Bing-leung, Head of Transport and Housing Bureau, announced last Friday the start of the presale of 2,200 Housing Ownership Scheme (HOS) units as early as end of 2014, which is ahead of the previous schedule. Note that this is the first round of presale of newly constructed HOS in 11 years. Over the past decade, due to the cessation of HOS production from 2003 to 2011, there were only 832 HOS flats sold to the public, all of which are unsold and returned old units (collectively known as surplus HOS flats) built before 2003.

Accordingly, these 2,200 units, to be offered at 30% to 40% below prevailing market prices this time, will be of substantial market impact and further weigh on the declining home price trend in the city.

Property price and sales in Hong Kong

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

Jan-

06

Aug

-06

Mar

-07

Oct

-07

May

-08

Dec

-08

Jul-0

9

Feb-

10

Sep-

10

Apr

-11

No

v-11

Jun-

12

Jan-

13

Aug

-13

Property price, domestic premise, yoy %, (lhs)

Agreement for Sales & Purchase: Volume

Source: Deutsche Bank, CEIC, Haver

Lin Li, Hong Kong, +852 2203 6187

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

National Income Nominal GDP (USD bn) 263.1 273.7 294.7 316.8Population (mn) 7.15 7.19 7.26 7.31GDP per capita (USD) 36802 38071 40596 43318 Real GDP (YoY%) 1.5 2.9 4.2 4.5 Private consumption 4.1 4.2 4.6 5.2 Government consumption 3.6 2.7 2.4 2.2 Gross fixed investment 6.8 3.3 4.5 5.2 Exports 1.9 6.5 11.3 12.3 Imports 2.9 6.9 11.4 12.5 Prices, Money and Banking CPI (YoY%) eop 3.8 4.3 3.5 3.0CPI (YoY%) ann avg 4.1 4.3 3.5 3.2Broad money (M3) 10.5 12.5 9.5 9.0HKD Bank credit (YoY%) 5.7 8.2 8.3 8.0 Fiscal Accounts (% of GDP)1 Fiscal balance 3.1 0.6 2.6 3.4 Government revenue 21.4 20.9 20.5 20.0 Government expenditure 18.3 20.4 17.9 16.7Primary surplus 3.2 0.6 2.6 3.4 External Accounts (USD bn) Merchandise exports 464.7 508.7 566.1 635.8Merchandise imports 487.4 534.9 595.8 670.3Trade balance -22.7 -26.2 -14.7 -34.5 % of GDP -8.6 -9.6 -5.0 -10.9Current account balance 3.5 5.6 10.3 8.5 % of GDP 1.3 2.1 3.5 2.7FDI (net) -9.4 -14.9 -17.2 -18.0FX reserves (USD bn) 317.3 311.2 349.2 353.4FX rate (eop) HKD/USD 7.76 7.76 7.80 7.80 Debt Indicators (% of GDP) Government debt1 8.8 9.9 9.0 8.9 Domestic 8.3 9.5 8.5 8.5 External 0.5 0.5 0.5 0.4Total external debt 397.7 426.2 429.5 411.1 in USD bn 1046.5 1166.4 1250.0 1300.0 Short-term (% of total) 71.9 74.1 74.0 74.0 General Unemployment (ann. avg, %) 3.3 3.4 3.1 3.0 Financial Markets Current 3M 6M 12MDiscount base rate 0.50 0.50 0.50 0.503-month interbank rate 0.38 0.38 0.50 0.6010-year yield (%) 2.06 2.15 2.30 2.90HKD/USD 7.76 7.78 7.78 7.78 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Fiscal year ending March of the following year. Debt includes government loans, government bond fund, retail inflation linked bonds, and debt guarantees.

10 April 2014



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

Economic outlook: There are nascent signs of recovery, which should gain traction once the election uncertainty gets out of the way.

Main risks: A poor monsoon could lead to higher food price inflation and a negative election outcome could cause a sharp selloff in the asset markets.

Policy pause but hawkish tone

Continuing to focus on anchoring inflation expectations, the Reserve Bank of India delivered yet another policy statement characterized by a firm hawkish tone in its April monetary policy meeting. Recent disinflation (headline CPI has fallen by 1.4% between November and February) was attributed to a helpful vegetable price dynamic, but it was seen as unlikely to soften further; concern was expressed about the flat but high core inflation; uncertainty was expressed about the monsoon outlook; the likely decline in headline inflation in the period ahead was dismissed as a pull from a favorable base effect. Overall, the central bank was at pains to point out that it will look through all possible transitory effects that could lead to an easing of inflation this year.

While rates were left unchanged, the RBI proceeded to further reduce access to overnight repos under the LAF to 0.25% of banks’ deposit base (from 0.5%), while it increased access to 7-day and 14-day day repos to 0.75% of the deposit base (from 0.5%). Holding everything else constant, this move constituted a 10bps rise in the effective cost of borrowing funds from the central bank. This measure should be seen in the context of the central bank's keenness to deepen the term repo market so that it becomes the key indicator of underlying liquidity conditions. With the term market clearing well above the repo rate lately, the effective policy rate seems set to remain at least 25bps above the policy repo rate for the time being.

Reiterating its recent pronouncements of achieving 8% headline inflation by end-2014 and 6% by end-2015, the RBI finds the present monetary policy stance appropriate to achieve its goals. The key question for us is if the central bank would find conditions amenable toward re-calibrating its policy stance this year. If both headline and core inflation rates were to jump and remain high for a few months, there is no doubt a rate hike would be entertained, but the central bank’s projections clearly see this as a low probability scenario. But what if inflation remained benign and

growth well below potential? Will the central bank then cut rates, or will it remain resolute in maintaining a pause, even if the near-term forecasting horizon suggests inflation well below its glide path?

Cost of accessing liquidity from the RBI

7.0

7.5

8.0

8.5%

Source: RBI, Bloomberg Finance LP, Deutsche Bank. Note: The above chart captures the cost of accessing liquidity from the RBI. From January to mid-July, the repo rate was the cost. After that, a quantitative restriction was placed on the amount of LAF liquidity accessible at the repo rate. We calculate a weighted average of LAF, MSF, term repo and export-refinance liquidity thereafter.

Liquidity accessed through RBI’s different windows

0

400

800

1200

1600

Export refinance Term repo

MSF LAFINR bn

Source: RBI, Bloomberg Finance LP, Deutsche Bank

If growth is no more than 5% for a couple of more quarters (which, by the central bank’s latest estimates, would constitute about 100bps below the potential rate of growth) and CPI inflation heads below 7%, there will be room for the central bank to cut rates in the fourth quarter, in our view. But given the signals being sent out by the RBI lately, inflation and growth would have to decline substantially and persistently for any easing to be entertained.

10 April 2014



RBI Governor Rajan has recognized the difficulty of targeting CPI, especially when half the weight of the index is from food, which is being driven by factors not fully under the remit of monetary policy. Minimum support price for agriculture products and rural income programs, for example, have driven up food prices in recent years, something that fiscal policy, not interest rate or reserve requirement decisions, can influence. Same goes with the prevailing state of dysfunction in logistics, wholesale market behavior, and overall supply chain efficiency. The central bank may strive to impact expectations and demand through tight policy in the coming years, but the question remains if that would be sufficient to reduce India’s long-standing inflation problem.

Dealing with taper tantrum, part 2

Last month’s FOMC meeting nudged the central dynamic of 2014 back into focus, which is monetary policy normalization in the US. Mixed data due to harsh weather and concern about China had pushed this issue to the back-burner for a while, but all it took was a slight change in Fed Chairwoman Yellen's tone about when rates could begin to rise to make it the issue of the moment again. US Federal Reserve's broadly positive view on the economy has a number of implications for flows, asset prices, and financial stability in Asia.

So here we go again, notwithstanding some lingering questions about the quality of the US recovery, concerns about China and Russia, and little manifestation of demand pull inflation globally, we are sure that tapering will continue through the rest of the year, interest rates will rise, flows will be more discriminating, and Asian FX will be under pressure, at least for a while. One can debate about the pace, magnitude, and timing of taper and rates normalization (which, it is increasingly apparent, will be tied not just to growth and job creation, but to quality of growth and employment as well), but the fact of the matter is that rates have only one way to go, barring some major negative shock to global growth or sentiments.

India, in our view, is in a much better position to deal with this scenario. Policy actions have reduced the economy’s external account deficits and reliance of short term external flows, fiscal consolidation has continued (even though at the expense of growth supportive public investment), and inflation respite is palpable. Financial markets have rallied considerably in anticipation of an economic reform friendly election outcome, foreign investor interest has surged, rupee has been remarkably strong, and latest data suggest an economic recovery is in the making.

We are however not going to get carried away in this wave of political optimism. Election cycles have come and gone over the past decade or two, with the markets rallying exuberantly in the lead-up or aftermath of decisive electoral results. These rallies have almost inevitably fizzled though as the reality of running a large, complex, and noisy democracy set in. No amount of electoral triumph will change civil society's opposition to expansion of mining or fast acquisition of land to proceed with large scale infrastructure development. Similarly, getting the support from local governments, headed by opposition parties in many cases, will remain as challenging after the elections as it has been before. Many projects have been delayed due to judicial oversight into corrupt practices in bidding, allocation of contracts, and financing. Courts are not going to go quiet in these areas just because a new term is beginning in the political cycle.

Our optimism rests instead on the fact that tough measures (fuel price hike, tight monetary and fiscal policy, FDI liberalization) have been taken over the past 18 months that will hold India on strong footing independent of the election outcome. We are encouraged by prospects of the economy; we just don’t have a strong view on which party can deliver more than the other.

PMI disappoints in March, but improves from the Oct-Dec’13 quarter

Manufacturing PMI fell to 51.3 in March, after having improved steadily from December. The key sub-components – output (52.2 vs. 54.0) and new orders (52.7 vs. 54.9) – registered a sharp decline, while new export orders continued to improve (56.8 vs. 54.1). Both input (57.2 vs. 61.0) and output prices (51.0 vs. 51.4) eased during the month, but the fall was striking in case of the former.

Manufacturing, services and composite PMI

40

45

50

55

60

65

2007 2008 2009 2010 2011 2012 2013 2014

Manufacturing PMIServices PMIComposite PMI

3mma

Source: Haver Analytics, Deutsche Bank

10 April 2014



Services PMI also fell sharply in March to 47.5 (from 48.8 in February), remaining below the threshold 50 mark for the third consecutive quarter. The moderation was led by a fall in new business component (47.6 vs. 49.5) even as other key sub-components - business expectations (66.0 vs. 63.4) and outstanding business (52.2 vs. 48.2) - recorded an improvement from the previous month. Input prices (53.2 vs. 53.9) and output prices (51.2 vs. 52.0) eased, in line with the trend of the manufacturing sector.

The composite PMI weakened in March (48.9 vs. 50.3), falling below the threshold 50 mark once again. Despite the disappointing PMI data in March, the quarterly average of composite PMI has improved to 49.6 in Jan-March, up from 48.0 in October-December, indicating the likelihood of a higher industrial sector GDP growth in Q1’14 versus Q4’13.

CPI and WPI inflation to be higher in March vs. February

CPI and WPI inflation would likely rise to 8.5% and 5.6% respectively in March, from 8.1% and 4.7% in February. An ongoing spike in some food item prices will be the main driver; we estimate the food part of the indices to be up by 1.0%mom in case of CPI and +1.3%mom for WPI, respectively.

We track the price of 10 food items on a daily basis. In February, the average price decline of these 10 food items was -3.4%mom; which was then reflected in both WPI (-0.3%mom) and CPI food prices (-0.4%mom). However, in March, food prices increased once again due to unseasonal rains in certain parts of the country. The average price of the 10 food items tracked by us was up +5.8%mom in March and we think this constitutes an upside risk to WPI and CPI food prices, thereby guiding the headline inflation higher.

Prices of 10 food items tracked by us vs. CPI food

prices

-3

-2

-1

0

1

2

3

-10

-6

-2

2

6

10

Monthly avg. price of 10 food items, lhs

CPI: food, rhs% mom % mom

Source: CEIC, Bloomberg Finance LP, Deutsche Bank

Fuel prices also increased in March, going by the trend of the ET commodities index, which is an input in our exercise. We have factored in 0.2%mom increase in fuel inflation in case of WPI and +0.3%mom for CPI.

ET Commodities index (Fuel) vs.CPI fuel component

-0.2

0.2

0.6

1.0

-1

0

1

2

3

4

5

Jul-13 Sep-13 Nov-13 Jan-14 Mar-14

Fuel, ET, lhs

CPI fuel, rhs% mom % mom

Source: CEIC, ET Commodities Index, Deutsche Bank

Finally, in case of CPI, we estimate the core component to have recorded a 0.4%mom increase in prices, while in the case of WPI we estimate non-food manufactured goods prices to have risen by 0.2%mom. Combining these, we arrive at a CPI inflation forecast of 8.5%yoy, with core CPI inflation likely to be 7.8% (vs. 7.9% in the previous month). WPI inflation is likely to rise above the 5% mark, to 5.6% in March (from 4.7% in February), with core WPI inflation probably rising to 3.2%, from 3.1% in the previous month.

Repo rate and CPI inflation forecast

7.0

7.5

8.0

8.5

9.0

0

2

4

6

8

10

12

2012 2013 2014 2015

CPI, lhs Forecast, lhs

Repo, rhs Forecast, rhs%% yoy


10 April 2014



Employment outlook positive for 2Q’14

According to the Manpower Employment Outlook Survey (5,302 employers are surveyed across India), hiring activity is expected to improve in the 2Q (April- June) of 2014, rebounding from a sharp dip in the present quarter. Net employment outlook rose to +45% in 2Q’14 (a positive number indicates employers’ intention to increase hiring), from +29% in 1Q’14 and +30% in 2Q’13, led by improvement in hiring intentions across sectors.

Employment outlook of all sectors – finance (46% vs. 31%), manufacturing (43% vs. 29%), mining/construction (35% vs. 33%), public administration (40% vs. 27%), services (49% vs. 30%), transportation/utilities (53% vs. 23%), and wholesale/retail trade (52% vs. 33%) – improved sharply in Q2 vs. Q1 as per the Manpower Survey, which augurs well for overall growth outlook in the coming quarters, given the broad directional similarity between the employment outlook and GDP growth that has held in the past. Between services and manufacturing, the bigger improvement is expected in the services related sectors, which is good news, given that services comprise of over 65% of GDP.

Net employment outlook vs. real GDP growth

2

4

6

8

10

12

15

25

35

45

55Overall Net Emp. Outlook, lhsReal GDP, rhs

% %yoy

Source: Manpower Survey, CEIC, Deutsche Bank

The findings of the employment outlook survey broadly match with the latest trend of the PMI, for both manufacturing and services sector, which show that the economy has likely bottomed and is poised for an upswing in the coming period. The pace of recovery is likely to be gradual, no doubt, but what the leading indicators seem to be suggesting is that India has probably seen the worst of the growth slowdown in this cycle.

Taimur Baig, Singapore, +65 6423 8681 Kaushik Das, Mumbai, +91 22 7158 4909

India: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 1838 1868 1998 2186Population (mn) 1218 1236 1255 1274GDP per capita (USD) 1509 1511 1592 1716

Real GDP (YoY %) 1 5.1 3.9 5.5 6.0 Private consumption 6.3 2.8 4.3 5.5 Government consumption 7.2 3.9 4.3 5.0 Gross fixed investment 2.2 0.1 4.5 6.5 Exports 6.7 5.9 11.7 13.2 Imports 10.8 1.0 6.4 11.0

Real GDP (FY YoY %) 1,2 4.5 4.7 5.5 6.0

Prices, Money and Banking

CPI (YoY%) eop 10.6 9.9 6.1 5.9CPI (YoY%) avg 9.7 10.1 6.8 6.9Broad money (M3) eop 11.2 14.9 15.0 15.8Bank credit (YoY%) eop 15.1 14.1 16.7 18.2

Fiscal Accounts (% of GDP) 2

Central government balance -4.9 -4.6 -4.5 -4.2 Government revenue 9.1 9.4 9.0 9.3 Government expenditure 14.0 14.0 13.5 13.5Central primary balance -1.8 -1.3 -1.3 -1.2Consolidated deficit -7.2 -7.0 -7.0 -6.7

External Accounts (USD bn)

Merchandise exports 301.9 319.7 341.2 371.0Merchandise imports 503.5 475.8 513.0 565.5Trade balance -201.7 -156.1 -171.8 -194.5 % of GDP -11.0 -8.4 -8.7 -8.9Current account balance -91.5 -49.2 -48.5 -61.0 % of GDP -5.0 -2.6 -2.5 -3.0FDI (net) 15.4 26.3 25.0 30.0FX reserves (USD bn) 294.9 295.7 299.7 308.3FX rate (eop) INR/USD 54.8 61.8 61.0 63.0

Debt Indicators (% of GDP)

Government debt 66.9 66.7 66.2 65.0 Domestic 63.1 62.9 62.4 61.3 External 3.8 3.8 3.8 3.8Total external debt 20.5 23.1 24.2 25.2 in USD bn 376.3 429.0 480.5 547.7 Short-term (% of total) 24.4 25.7 27.1 28.5

General

Industrial production (YoY %) -0.6 -0.2 6.0 3.8

Financial Markets Current 3M 6M 12M

Repo rate 8.00 8.00 7.50 7.503-month treasury bill 8.85 8.70 8.50 8.40

10-year yield (%) 9.10 9.00 9.00 8.70

INR/USD 60.2 61.8 61.0 62.0 Source: CEIC, Deutsche Bank. (1) By convention, we report “production-side” GDP growth rates (both FY and CY). The expenditure components may not add up to the headline GDP growth rate (even for historical data) due to discrepancies between these GDP figures and the “expenditure-side” GDP estimates. (2) Fiscal year ending March of following year.

10 April 2014



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

Economic outlook: Strong consumption demand, gradual easing of external imbalances and inflationary pressure, and a generally benign external environment have combined to engineer a substantial improvement in Indonesia’s outlook lately. Consumer confidence has soared and election related optimism has risen at the same time; and the chance of last year’s difficulties to recur is widely seen as low.

Main risks: We maintain our caution that the economy remains at risk of overheating, which could lead to a boom-bust cycle, leaving Indonesia particularly vulnerable if the external environment becomes turbulent again.

Macro view

The last few months have brought in a heightened degree of comfort with regard to the Indonesian economic outlook. Inflation has eased, domestic consumption demand has remained strong, trade balances have stopped deteriorating, and the exchange rate has appreciated thanks to vigorous capital inflows to the asset markets. Add to this a general feel-good factor revolving around the ongoing Parliamentary and forthcoming Presidential elections, the economy seems to be on a much surer footing than it was just a quarter or so ago.

We agree that much of the improvement that has been seen in the macro data will likely persist for the time being. The only major risk is the trade balance, which could worsen in the coming months if export growth (-3%yoy in Feb) remains subdued while imports rebound (-10%yoy in Feb). Barring any fuel price adjustment (which we think is highly unlikely), inflation will remain moderate in the coming months, while GDP will continue to grow by more than 5%. Asset markets also look primed to remain at elevated levels as long as the domestic consumption story stays in place and the external environment continues to be EM-friendly.

We are however concerned that Indonesia’s fragility could be revealed quite quickly if the following developments were to take place: (i) worsening of the trade balance; (ii) demand pull inflation, especially of food; (iii) worsening of the fiscal balance in the absence of fuel price adjustment; (iv) turmoil in the global financial market which causes a shortage of dollar liquidity; (v) a series of populist and investor unfriendly policy measures after the elections. Some of these factors manifested last year; we don’t think the risk of a recurrence this year is trivial.

Consider the much asserted fact that Indonesia is a low-leverage economy with little risk a credit boom-bust cycle. The chart below shows that credit/GDP, while relatively low, has been rising sharply in recent years, by 10% of GDP since 2010. It should be of no surprise if it turns out that banks, while handing out credit at such a furious pace, have not managed to enforce credit standards properly.

Leverage level is low but the pace of increase is sharp

2.0

2.5

3.0

3.5

4.0

20

25

30

35

2006 2007 2008 2009 2010 2011 2012 2013

Credit/GDP, left M2/Reserves, right%


Money growth has eased, but credit growth is robust

0

10

20

30

40

5

10

15

20

25

2006 2007 2008 2009 2010 2011 2012 2013 2014

M2. lhs

Bank credit, rhs

%yoy, 3mma %yoy, 3mma


There is also the question of external debt. The following charts show that while public sector exposure seems manageable, the pace with which external private sector leverage has risen is worrisome. In just four years, private sector’s exposure to short-term external debt has doubled to over USD40bn. To put this in perspective, note that the amount is roughly twice that of the projected current account deficit for 2014.

10 April 2014



Outstanding private sector external debt

0

20

40

60

80

100

2009 2010 2011 2012 2013

Due in a year Due in more than a yearUSD bn

Source: Bank Indonesia, Deutsche Bank. End-year data.

Outstanding public sector external debt

0

20

40

60

80

100

120

2009 2010 2011 2012 2013

Due in a year Due in more than a yearUSD bn

Source: Bank Indonesia, Deutsche Bank. End-year data.

Bank Indonesia’s strategy

Bank Indonesia continues to maintain an unchanged stance while stressing that it stays vigilant. In its April statement, the central bank once again expressed comfort with the project path of current account deficit (and its financing), the inflation dynamic, and the prevailing conditions in the financial sector. It sees the economy undergoing rebalancing through a correction in the investment cycle, precipitated by what it sees as tight monetary policy. We have a more cautious view, and worry that the ongoing calm in global markets should be used to implement more corrective measures.

Taimur Baig, Singapore, +65 6423 8681

Indonesia: Deutsche Bank forecasts 2012 2013F 2014F 2015F

National Income Nominal GDP (USD bn) 878.3 868.4 864.1 967.7Population (mn) 247.2 250.4 254.8 259.2GDP per capita (USD) 3553 3468 3392 3733 Real GDP (YoY%) 6.2 5.8 5.2 5.5 Private consumption 5.3 5.3 5.0 4.8 Government consumption 1.2 4.9 3.6 4.0 Gross fixed investment 9.8 4.7 5.0 6.5 Exports 2.0 5.3 7.0 6.3 Imports 6.6 1.2 6.5 5.5 Prices, Money and Banking CPI (YoY%) eop 3.7 8.1 5.4 5.6CPI (YoY%) ann avg 4.0 6.4 6.3 5.4Core CPI (YoY%) 4.4 5.0 5.0 4.5Broad money (M2) 13.5 13.0 13.0 15.0Bank credit (YoY%) 24.7 21.0 16.0 20.0 Fiscal Accounts (% of GDP) Budget surplus -2.3 -2.2 -2.4 -2.6 Government revenue 16.5 16.6 16.2 15.8 Government expenditure 18.8 18.8 18.6 18.4Primary surplus -0.3 -0.2 -0.4 -0.6 External Accounts (USD bn) Merchandise exports 188.5 183.5 188.2 199.8Merchandise imports 179.9 177.4 181.8 192.8Trade balance 8.6 6.1 6.4 6.9 % of GDP 1.0 0.7 0.7 0.7Current account balance -24.4 -28.5 -25.9 -26.1 % of GDP -2.8 -3.3 -3.0 -2.7FDI (net) 13.7 14.8 14.0 20.0FX reserves (USD bn) 112.8 99.4 101.9 110.2FX rate (eop) IDR/USD 9646 12087 11700 12000 Debt Indicators (% of GDP) Government debt 23.0 22.2 22.0 22.5 Domestic 12.2 11.2 11.0 11.0 External 10.8 11.0 11.0 11.5Total external debt 28.7 29.7 32.8 30.5 in USD bn 252.4 260.0 290.0 300.0 Short term (% of total) 17.8 19.2 19.0 19.0 General Industrial production (YoY%) 8.0 8.0 7.0 7.0Unemployment (%) 6.8 6.5 6.0 6.0 Financial Markets Current 3M 6M 12MBI rate 7.50 7.50 7.50 7.5010-year yield (%) 7.84 7.80 8.00 8.20IDR/USD 11300 11500 11600 11900 Source: CEIC, DB Global Markets Research, National Sources

10 April 2014



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

Economic outlook: Growth recovery will likely be sustained in the first quarter on the back of a favorable external trade balance.

Main risks: Already negative real rates and upside surprises to inflation and growth could prompt the BNM to hike the OPR earlier than expected.

Evidence of better GDP growth in 1Q

Jan-Feb data suggest sustained growth pick-up in 1Q The first two months of 2014 delivered a favorable external trade balance for Malaysia. With exports rising faster than imports, the trade surplus accelerated to 46%yoy from just 2% in the previous quarter. This strength in the merchandise trade data, at least on year-on-year terms, are expected to more than offset some moderation in domestic demand due to rising inflation and tight fiscal policy.

Consumer sentiment surveys suggest weakening growth in private consumption in the first quarter but demand for imported consumption goods grew faster in Jan-Feb (13.4%yoy) than in the previous quarter (4.8%). Manufacturing sales (12%yoy vs. 3.3%) and industrial production (3.6% vs. 2.9%) have also, turned in higher growth readings in January than last quarter. And with the Lunar New Year drag dropping out of the data in February through March, we expect growth in manu sales and factory output to further improve.

This apparent expansion in economic activity is also mirrored in bank lending activity where loans to various sectors have recently picked up pace. Although aggregate lending growth was around the same in February and end-4Q2013 at 10.7%yoy, we see more loans extended to sectors such as mining & quarrying, manufacturing, utilities, construction, and transportation, storage & communication in February. Active lending in these sectors is also corroborated by the strong outturn of approved investments (30%yoy, 1H2013) last year, which gives us a sense of sustained growth of investments in the near term. For instance, the manufacturing sector saw approved investments in 2013 grow by 27%yoy (vs. -27% in 2012), underpinned by plans to increase capex spending in electrical and electronics, basic metals, and food production.

Meanwhile, loans to the wholesale and retail trade sector decelerated, perhaps reflecting waning consumer sentiments. The pace of household borrowing also moderated and since household loans accounted for more than 50% of total loans outstanding, it capped the increase in aggregate bank

lending in February. Despite the weakness in domestic consumption, investments and exports are likely to guide first quarter GDP growth higher than 5.1% last quarter, to come close to 5.5%.

Exports to China and EU leading the way We noted in last month’s report that the recent acceleration of exports has been driven by stronger demand coming from China and the EU. Exports to China, accounting for about 13% of Malaysia’s total exports, have posted double-digit growth for eight consecutive months.

Malaysia’s exports to China mainly consist of machinery and transport equipment (41% of total), manufactured goods (15%), mineral fuels (15%), chemicals (9%), and animal, vegetable oils and fats (9%). Most notably, mineral fuel exports surged at a monthly rate of least 40%yoy for six straight months (Sep-Feb). This trend perhaps reflects, among others, China’s rapidly growing demand for automobiles to which Malaysia stands to gain.

Similarly, manufactured goods exports to China steadily increased by at least 50%yoy per month from July 2013 to February. Meanwhile, machinery and transport equipment grew at a more modest pace of 14%yoy monthly average.

Exports to China could sustain strong growth post-1Q

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contribution to yoy growth (bps)

Source: Bloomberg Finance LP, CEIC, and Deutsche Bank

The consistent strength in Malaysia’s exports to China has helped us hold on to our growth outlook for Malaysia, despite the recent move to downgrade China’s GDP growth by 80bps this year. And as China’s economic activity improves post-1Q (as already reflected by slightly better PMI readings), Malaysia’s exports to China could sustain its strength as well.

10 April 2014



The EU is another market of Malaysia’s exports that has gathered pace along with China. With the EU accounting for 9% of Malaysia’s total exports, the resurgence of EU demand in the second half of 2013 through early this year has definitely supported the growth of Malaysia’s exports. As growth in the EU bottoms out this year, we see Malaysia’s EU exports to sustain growth of about 15%yoy through mid-year partly due to base effects, before it retreats to single-digit rates thereafter.

Likewise, Malaysia is likely to see improvement in its exports to the US (8% of total exports), which until February had posted negative growth for a year. Meanwhile, the recent recovery of its exports to Japan—Malaysia’s third largest exports market (11% of total exports) after Singapore and China—is bound for some volatility as the Japanese economy adjusts to the consumption tax increase effective this month.

Getting close to monetary tightening With February inflation reaching the mid-point of the BNM’s 3-4% forecast in 2014, we think the BNM would take its cue on 1Q GDP growth and early indicators for 2Q at its next monetary policy meeting in May. We still hold on to our view of a 25bps OPR hike in July but it is also likely for this rate hike to be pushed back earlier in May, especially if 1Q GDP growth surprises to the upside. Although private consumption would likely decelerate in 1Q, strong gains in the external sector could improve consumer sentiment thereafter. This renewed vigor in consumer spending along with elevated inflation could prompt the BNM to hike rates earlier than expected. Short-term real interest rates have also turned negative since January and would likely remain so even if inflation moderates by 10-20bps in the coming months.

Rising inflation have led to negative ST real rates

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Note: Real interest rate is the difference between 10y yield (long-term) or 3m KLIBOR (short-term) and inflation rate.. Source: CEIC and Deutsche Bank

Diana del Rosario, Singapore, +65 6423 5261

Malaysia: Deutsche Bank forecasts 2012 2013F 2014F 2015F

National Income

Nominal GDP (USD bn) 305.1 310.5 327.6 340.1Population (mn) 29.3 29.6 29.9 30.2GDP per capita (USD) 10400 10483 10953 11263 Real GDP (YoY%) 5.6 4.7 5.5 5.6Private consumption 7.7 7.6 6.4 6.5Government consumption 5.1 6.3 5.3 3.4Gross fixed investment 19.9 8.2 5.9 5.4Exports -0.1 -0.3 3.7 5.3Imports 4.7 1.9 4.6 5.3 Prices, Money and Banking CPI (YoY%) eop 1.2 3.2 3.6 2.5CPI (YoY%) ann avg 1.7 2.1 3.4 3.3Broad money (M3) 9.0 8.1 10.3 9.2Bank credit (YoY%) 11.9 9.9 10.3 9.2 Fiscal Accounts (% of GDP) Federal government surplus -4.5 -3.9 -3.8 -3.3Government revenue 22.1 21.7 20.8 21.7Government expenditure 26.5 25.6 24.6 25.0Primary fed. gov’t fiscal -2.4 -1.8 -1.7 -1.1 External Accounts (USD bn) Merchandise exports 227.9 217.9 240.2 262.7Merchandise imports 187.2 185.5 209.7 233.4Trade balance 40.7 32.4 30.5 29.3 % of GDP 13.3 10.4 9.3 8.6Current account balance 18.6 11.8 11.3 13.2 % of GDP 6.1 3.8 3.5 3.9FDI (net) -7.0 -1.3 -1.5 -0.2FX reserves (USD bn) 139.7 134.9 131.0 123.4FX rate (eop) MYR/USD 3.05 3.25 3.30 3.35 Debt Indicators (% of GDP) Government debt* 68.5 70.8 67.1 68.4 Domestic 66.7 69.1 65.6 66.8 External 1.8 1.7 1.5 1.6Total external debt 26.9 32.3 22.6 24.9 in USD bn 82.6 96.9 73.9 85.3 Short-term (% of total) 36.8 40.3 43.3 41.7 General Industrial production (YoY%) 4.5 3.3 3.2 3.3Unemployment (%) 3.0 3.1 3.0 3.1 Financial Markets Current 3M 6M 12MOvernight call rate 3.00 3.25 3.25 3.253-month interbank rate 3.30 3.55 3.55 3.5510-year yield (%) 4.09 4.20 4.40 4.50MYR/USD 3.26 3.29 3.26 3.28 *Includes government guarantees Source: CEIC, DB Global Markets Research, National Sources

10 April 2014



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

Economic outlook: Brisk investments, even beyond the construction sector, are likely to support growth this year and next, which could increase the economy’s absorptive capacity and reduce the risk of overheating.

Main risks: Rapid domestic economic activity and continued EM-DM capital flow rotation could result to a less favourable external balance, putting pressure on the peso and headline inflation.

Overheating concerns

BSP commences tightening cycle The BSP decided to raise the reserve requirement ratio (RRR) by 100bps to 19% effective 4 April at its monetary policy meeting in March. While policy rates were kept unchanged, the BSP noted that its decision to hike the RRR is intended to guard the economy from potential risks to financial stability arising from the continued strong growth in liquidity and lending. Bank lending has been steadily increasing, growing by 19% in February, while M3 growth has remained above 30% in the past eight months.

Though unexpected on our part, we welcome the BSP’s recent move and see it as a measure to prevent the high growth in liquidity from contributing to the build-up in inflation. The BSP has stressed that liquidity growth will eventually moderate because of base effect and as funds that exited the SDA facility find their way to productive investments. However, the possible impact of flush liquidity in an economy with high growth momentum is apparently becoming a concern and has prompted the BSP to embark on a pre-emptive measure instead.

The BSP is likely to increase the RRR by another 100bps to 20% at its next meeting in May. This series of RRR hikes will absorb about a quarter of the PHP500bn released from the SDA facility in 2013. We see this RRR adjustment as a moderate measure to curb liquidity growth while inflation remains well within the BSP’s 3-5% inflation target.

Relative to increasing SDA rates, raising the reserve requirement will be more favorable to the central bank’s balance sheet since the BSP does not pay interest on banks’ reserve deposits. As of December 2013, the share of SDA deposits in the central bank’s total liabilities remained substantial even as it fell to 33% from 42% in 2012.

With PHP6.4tn worth of peso deposits in the banking system, the 100bps increase in RRR effective this month is expected to mop up PHP60bn of liquidity in the system. The RRR was last adjusted in April 2012—reduced by 300bps to 18%—in line with its operational adjustments that involved (1) the unification of the statutory and liquidity reserve requirements into a single set of reserve requirement and (2) the elimination of interest paid to banks on their reserve deposits. The RRR adjustment happened around the time that the BSP also decided to cut policy rates (25bps each in January and March 2012) amid moderating growth and falling inflation. Although a 300bps hike in the RRR is possible this year, we think the BSP would not overdo tightening as the government aims to accelerate investments.

These RRR hikes will have to be complemented with policy rate hikes in middle towards the second half of the year. Inflation may have eased in February and March but the same inflationary pressures we have been highlighting remain. Electricity charges are likely to pick up during the summer months of April and May, aside from the pending hike in electricity rates as power companies aim to recover unbilled charges in previous months. Food inflation also continues to hold up, adding to the risk of lower produce during the dry months. In addition, inflationary pressures remain with the continued weakness in the peso coupled with a potential uptick in oil prices. These factors, along with the strong growth in liquidity and bank lending, are likely to keep inflation above its 4% midpoint in the first half of this year.

The BSP still sees policy rates as the main lever to control inflation. For instance, simulations done by the central bank show that a 100bps increase in the reverse repo rate has a larger impact on inflation, compared to a 100bps increase in the RRR (1-52bps vs. 2-6bps fall in inflation within the first year of the shock).

As such, negative real rates and another episode of rising inflation in the months ahead will likely prompt the central bank to hike the repo and reverse repo rates by 25bps both in June and September. Risks of a rate hike coming earlier in May are also high as the real reverse repo rate has been negative since December. Meanwhile, the rate hike towards year-end will be needed if BSP continues to commit to a lower inflation target of 2-4% in 2015.

Broad-based bank lending points to investment pick-up One of the reasons cited by the BSP in raising the RRR is the rapid pace of credit expansion. Recent data show

10 April 2014



that the growth of outstanding loans of commercial banks (19.4%yoy), net of reverse repurchase placements with the BSP, have exceeded the country’s 2013 nominal GDP growth (9.3%) by more than 200%. This rapid growth in bank lending puts the country at risk of overheating, having posted above-trend growth in the past two years and inflation on an uptrend in recent months.

But the risk of overheating can be reduced if both public and private sectors invest in infrastructure that can eliminate supply bottlenecks, thereby, enabling the economy to increase production in line with rising demand. In our February report, we noted that 2013 saw investments in durable equipment catching up with the rapid growth in the construction sector. This is a positive development which places the economy less reliant on the real estate boom. Having said that though, the country still has to accelerate investments in productivity-enhancing machinery as last year’s growth in durable equipment was mainly due to purchases of transport equipment.

Perhaps, examining recent bank lending activity can provide us a sense of where spending in the next few months are likely to be. At least in the past three months, lending has surged in sectors other than real estate and construction. Loans to the manufacturing sector grew 13%yoy in Dec-Feb, far exceeding the sub-5% growth in the past decade. Lending to the utilities sector also soared 33% recently, in line with the power sector’s almost 50% share in total approved investments in 2013.

In fact, all productive sectors except for transportation, storage, & communication and public administration & defense have registered double-digit loan growth in December through February. Meanwhile, household credit decelerated to about 9% in the same period from its long-run average of 15%. While, this rapid pace of credit expansion in almost all productive sectors bodes for increased output (without necessarily translating to a sustainable increase in productivity), it also gives us a sense of accelerated investment activity, cutting across sectors, going forward.

Add the government’s plan to bring infrastructure spending to 3% of GDP this year, some PPP projects that are to be rolled-out in the near term, and typhoon-related rehabilitation efforts, the investment sector may see another year or two of double-digit expansion; a welcome development to improve the country’s absorptive capacity.

Diana del Rosario, Singapore, +65 6423 5261

Philippines: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 250.2 272.0 285.4 322.4Population (mn) 97.6 99.5 101.3 103.1GDP per capita (USD) 2562 2735 2818 3128

Real GDP (YoY%) 6.8 7.2 6.8 6.8 Private consumption 6.6 5.6 5.7 6.0 Government consumption 12.2 8.6 6.4 6.8 Gross fixed investment 10.4 11.7 13.0 9.4 Exports 8.9 0.8 9.5 10.6 Imports 5.3 4.3 9.9 10.9

Prices, Money and Banking CPI (eop, YoY%) 3.0 4.1 4.0 3.5CPI (YoY%) ann avg 3.2 2.9 4.2 3.7Broad money (M3, YoY%) 8.9 32.7 8.2 11.0Credit to private sector 14.1 17.3 10.0 10.0

Fiscal Accounts (% of GDP) Fiscal balance -2.3 -1.4 -2.4 -2.2 Government revenue 14.5 14.9 14.8 14.8 Government expenditure 16.8 16.3 17.2 17.0Primary surplus 0.7 1.4 0.5 0.7

External Accounts (USD bn) Merchandise exports 46.4 44.7 50.8 56.8Merchandise imports 65.3 63.3 72.9 84.8Trade balance -18.9 -18.5 -22.1 -28.0 % of GDP -7.6 -6.8 -7.8 -8.7Current account balance 6.9 9.4 7.9 4.2 % of GDP 2.8 3.5 2.8 1.3FDI (net) -1.0 0.2 0.7 1.2FX reserves (USD bn) 83.8 83.2 83.5 79.9FX rate (eop) PHP/USD 41.2 44.4 44.3 43.9

Debt Indicators (% of GDP) Government debt1 56.2 53.3 53.2 50.3 Domestic 34.2 33.5 32.6 31.2 External 22.0 19.8 20.6 19.2Total external debt 24.1 21.5 18.0 15.0 in USD bn 60.3 58.5 51.5 48.4 Short-term (% of total) 14.1 19.2 15.5 17.1

General Industrial production (YoY%) 7.7 9.5 7.7 7.7

Financial Markets Current 3M 6M 12MBSP o/n repo 5.50 5.75 6.00 6.25BSP o/n reverse repo 3.50 3.75 4.00 4.253-month Tbill rate 1.00 1.25 1.50 2.1010-year yield (%) 4.15 4.20 4.50 4.80PHP/USD 44.9 44.1 44.9 43.8 (1) Incl. guarantees on SOE debt. Source: CEIC, DB Global Markets Research, National Sources

10 April 2014



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

Economic outlook: Production, sales, and exports have begun picking up, reflecting improving domestic and external demand. Inflation is muted, which should pave the way for an unchanged policy stance by the MAS in its April policy meeting.

Main risks: External demand could turn out to be weaker than expected, which could in turn hurt the growth outlook. A slowdown in China and negative financial market spillover could affect Singapore substantially.

Benign macro environment, for now

2014 has started of promisingly for Singapore. After GDP grew by 5.5% in Q4 2013, data initially seemed weak due to the Lunar New Year effect, but subsequently have bounced back. The index of industrial production was up 12.8%yoy in February; total trade was up 9%yoy during the same period; the CPI eased to 0.4%yoy. Labor market conditions remained tight, keeping the outlook for employment and wages positive for Singaporeans, which bodes well for consumption for the remainder of the year.

The mix of improvement in trade and easing of inflation pressure puts Singapore in a macro sweet spot. With non-oil domestic exports bouncing back to be up 9.1% in February (after -3.3%yoy in January), riding principally on the back of non-electronics demand, there are reasons to be optimistic about the favorable exports tailwind this year.

Non-oil domestic exports have recovered at last

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Most encouragingly, Singapore’s three major trading partners are showing signs of strength. Exports to US, EU, and China were up considerably through February. Even after taking into account seasonality and other one-offs, exports to these three destinations were up by about 15%yoy. We expect more of the same in the coming months.

CPI inflation moderated sharply to 0.4%yoy (-0.1%mom) in February, from 1.4% in January. This was primarily due to decline in private transport (-7.1% vs. -3.5%), supported by base effects from last year (due to the rise in COE premiums in January 2013), as well as a fall in petrol pump prices.

Food (2.3% vs. 3.0%) and services inflation (2.1% vs. 2.9%) eased during the month, as did accommodation cost (2.0% vs. 2.4%). MAS core inflation, which excludes the costs of accommodation and private road transport, eased to 1.6% (from 2.2% in the previous month). These are comfortable figures for the monetary authority, in our view.

With respect of monetary and exchange rate policy, we don’t think the authorities would entertain steepening the NEER band further under the current macro mix. An unchanged stance looks likely for April, with the focus of policy making on prudential measures to ensure that the economy transitions into the higher rate plain with as little friction as possible. At the same time, we see no urgent reason to ease monetary policy or any of the macro-prudential measures to cool the property in the near term.

Singapore’s exposure to China

While the macro environment is favorable, there are concerns about the implication of a slowdown in China. The rising likelihood of a weakening investment environment could hurt Singapore’s trade dynamic, and financial market stress could stem the flow of Chinese capital to Singapore’s businesses, private banks, and property markets.

On trade, the following chart shows that trade with China, measured as a share of Singapore’s exports to and imports from China with respect to its total exports and imports, is now about three times that of the level in the early part of last decade. Singapore’s trade exposure to China has therefore increased substantially. In past cycles, US/EU demand mattered much more, but in this round the China dynamic will most likely be crucial as well.

10 April 2014



Singapore has substantial trade exposure to China

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Beyond trade, there is concern that economic slowdown and financial sector restructuring would lead to asset price correction and credit events in China, putting at risk regional banks that have raised their China exposure in recent years. The concentration of risk is clearly in the three RMB clearing centers of the region—Hong Kong, Singapore, and Taiwan.

Even without full convertibility, the use of the RMB as a trade currency has soared. BIS statistics show that the RMB is now the number 7 payment currency in the world. RMB settlement as a proportion of China’s total trade grew from 3% in 2010 to 16.5% in 2013. Consequently, the RMB is now the 9th most actively traded currency in the world, up from 17 in 2012.

The Monetary Authority of Singapore has reported that Singaporean banks’ combined loans to China reached 9.2% of their total loans portfolio last year (it was 2% in 2007). RMB deposits stood at 200bn at end-2013, a 70%yoy increase (Hong Kong and Taiwan have deposits worth RMB920bn and RMB250bn). RMB-denominated loans made by Singaporean banks, mainly trade credit, grew by 25%yoy to reach over 300bn at end-2013. Based on SWIFT data, Singapore accounts for about 60% of RMB trade finance outside China and Hong Kong.

Singapore’s sharp rise in RMB exposure is understandable, as China’s recent liberalization measures have allowed Singapore-based multinationals and trading houses to tap into local liquidity for RMB-related transactions. As long as much of the transactions are trade related, systemic risk will be muted in our view. Still, the rise in exposure has been rapid, and warrants scrutiny in the coming days.


Singapore: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 284.5 295.8 305.4 329.7Population (mn) 5.3 5.4 5.5 5.6GDP per capita (USD) 53547 54594 55536 58877 Real GDP (YoY%) 3.5 4.1 3.5 4.5 Private consumption 3.7 2.7 2.2 3.2 Government consumption -1.3 11.2 1.5 3.3 Gross fixed investment 8.9 -2.6 5.0 5.9 Exports 0.5 3.6 4.5 7.0 Imports 3.7 3.0 4.4 7.2Prices, Money and Banking

CPI (YoY%) eop 4.3 1.5 2.6 3.7CPI (YoY%) ann avg 4.6 2.4 2.2 3.4Broad money (M2) 10.4 9.7 8.5 11Bank credit (YoY%) 12.9 9.8 10.4 10.5

Fiscal Accounts (% of GDP)

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

Merchandise exports 434.6 436.9 463.1 495.5Merchandise imports 371.7 369.0 391.2 422.5Trade balance 62.9 67.9 71.9 73.1 % of GDP 22.1 22.9 23.5 22.0Current account balance 49.4 54.4 55.3 55.0 % of GDP 17.4 18.4 18.1 16.5FDI (net) 47.6 36.9 10.0 12.0FX reserves (USD bn) 259.3 273.1 305.3 335.4FX rate (eop) SGD/USD 1.22 1.26 1.27 1.27

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

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

Financial Markets Current 3M 6M 12M3-month interbank rate 0.41 0.48 0.60 1.0010-year yield (%) 2.48 2.55 2.70 2.90SGD/USD 1.25 1.25 1.25 1.30 Source: CEIC, DB Global Markets Research, National Sources Note: includes external liabilities of ACU banks.

10 April 2014



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

Economic outlook: After a temporary easing in Q1, we see Korea resuming its growth recovery, led by exports.

Main risks: Domestic demand growth momentum is not strong enough to sustain recovery in overall growth.

A temporary glitch in recovery

Export growth rebounded in March but not strongly enough… While export growth improved in March, its rebound was not strong enough to guide GDP growth higher in Q1. Exports rose 5.2%yoy in March, up from 0.7% in January/February, but the Q1 average stood at 2.2%, lower than 4.8% in Q4. As the weather impact dropped out of the data, exports to the US surged by 20.4%yoy in March, vs. a 4.4% fall in January/February. Notwithstanding this rebound, however, exports to the US rose at a slower pace of 3.7% in Q1, vs. 13% in Q4, while the slowdown in exports to China was less pronounced, with growth falling to 4.1% in Q1 from 5.9% in Q4. In contrast, exports to the EU accelerated, sharply, to 18.6% in Q2 from 8.2% in Q4.

Exports to the US snowed under

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While the details of trade data suggest that severe weather conditions in the US have indeed depressed Korean exports in Q1, their rebound in Q2 may fall short of expectations. First, we may not see the US growth snapping back in Q2, to 4.2% from 2%, as our US colleagues expect. Second, recovery in China’s growth may be slower than expected, even after our downward revision. We have lowered our China growth forecast by 0.8ppts to 7.8% for the year. If such a downward revision is isolated to China only, then our revision to Korea’s growth forecast is likely to be limited to 0.1ppts. Having said that, however, we

refrain from changing our growth forecast for now, until we see more data on domestic demand. Korea will release its Q1 GDP report at end this month, before the March domestic demand data are released.

…slowing recovery in GDP growth, temporarily. January and February data painted a rather mixed picture for domestic demand. Retail sales growth accelerated to 2.4% in January/February, from 1.2% in Q4, pointing to stronger growth in private consumption in Q1, likely supported by the positive wealth effects of recovery in housing prices. The latter continued to recover, increasing 0.8%yoy 3mma in March, up from 0.1% in December, thanks to the government’s stimulus measures. On the other hand, growth in construction completed slowed – albeit still high, to 9.3% in January/February from 11.4% in Q4, while equipment investment growth slowed relatively sharply, to 5.0% from 10.4% during the same period. By comparison, production data fared worse, suggesting that either we will have negative surprise from stocks or a meaningful rebound in production in March. In this regard, we expect manufacturing production to rebound, after reporting weaker growth of 0.3% in January/February, vs. 1.8% growth in Q4. Meanwhile, services and construction growth slowed relatively modestly, to 1.7% and 8.8%, respectively, in January/February, from 2.1% and 9.7% in Q4. As for its overall growth, despite the weaker qoq growth, we see Korea reporting a yoy GDP growth of 3.8% in Q1, largely from Q4, supported by favorable base effects.

Domestic demand mixed

-20

-10

0

10

20

-40

-20

0

20

40

2008 2009 2010 2011 2012 2013 2014

Equipment investmentRetail salesConstruction

%yoy %yoy


A new and fresh BoK, but risks to rates remain balanced. This month marks the first monetary policy rate decision presided over by Governor Lee. While we see the Bank of Korea’s new chief adopting a clear and transparent communication style, we expect the MPC

10 April 2014



to maintain its neutral stance. Having said that, however, his comments will be closely listened to, to see if there are any pending changes to the BoK’s growth and inflation outlook, especially with the Q1 GDP report to be released in slightly over two weeks. Also, there is a question over the central bank’s medium-term inflation target. With inflation remaining well below the target, not only the policy rate but also the target range itself has become a subject of debate. However, given the government’s efforts to support growth, we do not see a change in the target in the near term. There are other pending issues at the BoK, including the appointment (replacement) of the seventh MPC member at end-month.

Volatile goods weighed on inflation

-10

-5

0

5

10

15

20

0

1

2

3

4

5

6

2008 2009 2010 2011 2012 2013 2014

Headline

Core

Agri and oil (rhs)

%yoy 3mma %yoy 3mma


Headline inflation rose in March, to 1.3% from 1% in February, as the LNY effects dropped out of the data. However, it remained well below the core rate of 2.1% in March, due to a sustained fall in prices of volatile items. Food inflation remained low, falling 0.1% in March, albeit better than the 1.5% fall in February, while fuel prices fell at a faster rate of 4.3% in March vs. 2.9% in February. Core inflation rose to 2.1% in March, from 1.7% in February, as prices of miscellaneous goods/services (4.0% vs. 1.6%), clothing/footwear (4.1%yoy in March vs. 3.9% in February), education (1.9% vs. 0.2%), and furnishings (2.0% vs. 1.6%) rose faster during the month. As food and fuel price inflation continues to normalize and as demand strengthens, we see headline inflation heading higher, averaging 1.9% this year, up from 1.3% in 2013. Although we see inflation heading higher, we see it hovering around the lower bound until 2015. Given such a scenario, we continue to expect the central bank to remain on the sidelines until next year, amid ongoing uncertainties about external demand and Japan’s weak yen policy and the ECB’s pending QE. Moreover, the recent strength of the won, in the absence of an improvement in exports, adds to the argument against monetary tightening by the BoK.

Juliana Lee, Hong Kong, +852 2203 8312

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

National income Nominal GDP (USDbn) 1223 1305 1413 1460 Population (m) 49.8 50.0 50.2 50.4GDP per capita (USD) 24577 26094 28140 29003

Real GDP (YoY %) 2.3 3.0 3.9 3.6 Private consumption 1.9 2.0 2.8 2.3 Government consumption 3.4 2.7 1.9 1.9 Gross fixed investment -0.5 4.2 4.6 3.1 Exports 5.1 4.3 8.2 7.3 Imports 2.4 1.6 7.4 6.0 Prices, money and banking

CPI (YoY %) eop 1.4 1.1 2.6 2.9 CPI (YoY %) ann avg 2.2 1.3 1.9 2.8Broad money (M3) 8.8 9.0 9.5 8.0 Bank credit (YoY %) 5.0 4.0 6.0 5.0 Fiscal accounts (% of GDP)

Central government surplus 1.9 -0.7 -0.1 0.1

Government revenue 24.5 23.2 23.4 23.3 Government expenditure 22.5 23.8 23.5 23.2Primary surplus 2.7 0.6 1.4 1.6

External accounts (USDbn)

Merchandise exports 603.5 617.1 655.3 682.6Merchandise imports 554.1 536.6 580.2 630.1Trade balance 49.4 80.6 75.1 52.5 % of GDP 4.0 6.2 5.3 3.6Current account balance 50.8 79.9 62.3 47.1 % of GDP 4.2 6.1 4.4 3.2FDI (net) -21.1 -17.0 -14.0 -14.0FX reserves (USDbn) 1 327.0 346.5 356.8 357.1FX rate (eop) KRW/USD 1064 1050 1060 1090

Debt indicators (% of GDP) Government debt2 36.0 36.3 36.8 34.8 Domestic 35.3 35.4 35.5 33.7

External 0.6 0.9 1.0 1.1Total external debt 36.6 34.2 30.4 28.0

in USDbn 413.6 415.0 400.0 385.0

Short-term (% of total) 30.7 28.4 27.0 25.5

General

Industrial production (YoY %) 1.0 1.3 5.0 4.5 Unemployment (%) 3.2 3.1 3.1 3.1

Financial markets Current 3M 6M 12MBoK base rate 2.50 2.50 2.50 2.75

91-day CD 2.65 2.68 2.75 3.05

10-year yield (%) 3.55 3.65 3.80 4.00KRW/USD 1052 1065 1060 1070

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

10 April 2014



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

Economic outlook: We expect Sri Lanka’s growth momentum to remain strong in the first half of 2014, but some moderation looks likely in the second half, as a negative base effect kicks in and US tapering related volatility starts affecting economic sentiment.

Main risks: Easy monetary policy could fuel overheating and inflation risks eventually, posing a threat to exchange rate stability.

4Q’13 real GDP growth beats expectation

Sri Lanka’s real GDP grew 8.2%yoy in 4Q’13 (up from 7.8% in 3Q’13), slightly above our and consensus expectation of 8.0%. Strong growth in the agricultural and industrial sector led to this favorable outturn. Aided by a favorable base effect, agriculture sector grew 10.4%yoy in Q4, up from 7.0%yoy in the previous quarter. Non-farm sector growth was also robust in Q4 and improved a tad from Q3 (8%yoy vs. 7.9%yoy). Within non farm sector, industrial sector grew 10.7%yoy in Q4, up from 8.1% and 10.1% in the previous two quarters. Manufacturing, which constitutes about 18.0% of the total industrial sector output rebounded sharply, growing 11.9%yoy in Q4 vs. 6.0% in Q3. Construction sector activity also picked up (12.5% vs. 10.0%) while mining/quarrying (5.4% vs. 12.5%) and electricity/gas/water (3.6% vs. 11.2%) slowed. Services sector growth moderated to 6.5%yoy in Q4 from 7.9% in Q3 as wholesale/retail trade (7.1% vs. 7.6%), transport/communication (6.7% vs. 11.8%) and banking/insurance/real estate (4.6% vs. 6.7%) recorded lower growth during the quarter.

Growth momentum remains strong

0

2

4

6

8

10

12

2007 2009 2010 2011 2012 2013 2014

Real GDP Non-farm GDP

Forecast Forecast

% yoy


With the Q4 data, the 2013 full year real GDP growth works out to 7.3%yoy, slightly above our and CBSL's estimate of 7.2%. We expect Sri Lanka’s growth momentum to remain strong in the first half of 2014, but some moderation looks likely in the second half, as a negative base effect kicks in and US tapering related volatility starts affecting economic sentiment. Assuming global financial markets do not become too disruptive, then Sri Lanka should be able to achieve 7.5%yoy real GDP growth in 2014, supported by a pickup in domestic demand (consumption + investment), while next exports is likely to subtract more from growth, as imports start accelerating in the next few quarters.

Sri Lanka’s 2013 real GDP growth vs. regional peers

0

2

4

6

8%yoy


CPI inflation has likely bottomed

The Central Bank authorities are comfortable with the evolving growth-inflation dynamic and external position of the economy at this juncture. Real GDP grew 8.2%yoy in 4Q’13, resulting in an overall growth of 7.3% for 2013, up from 6.3% in 2012. The authorities are confident that this strong growth momentum will persist in 2014 as well, while inflation will remain in mid single-digit through the course of the year. While being comfortable with the overall inflation outlook, the CBSL however acknowledges that drought related supply disruptions could adversely impact the price dynamic in the months ahead.

Sri Lanka’s headline CPI inflation remained unchanged at 4.2% in March, while core CPI inched up higher to 3.4%, from 3.1% in the previous month. The 12-month moving average of headline CPI inflation eased to 5.7% in March, from 6.0% in the previous month.

10 April 2014



Headline CPI and core CPI inflation

0

2

4

6

8

10

12

2009 2010 2011 2012 2013 2014

CPI Core CPI% yoy% yoy


Food prices increased a tad (0.1%mom; 1.2%yoy), but at a lesser rate than what we had anticipated. Pressure on non-food prices also remained muted across key items, except for miscellaneous goods & services, where prices rose 0.8%mom vs. 0.6%mom in the previous month. Overall non-food prices were up only 0.1%mom in March (6.7%yoy in March vs. 7.0%yoy in February).

On a seasonally adjusted basis, core CPI prices were however up 0.4%mom in March vs. +0.2%mom in February, which pushed up the inflation momentum (measured as the 3m/3m seasonally adjusted annualized rate) to 9.1%, from 7.3% in the previous month.

Inflation momentum

-2

2

6

10

14

18

2010 2011 2012 2013 2014

CPI Core CPI3m/3m,sa, annualized, %yoy


We think CPI inflation has bottomed in the first quarter and should be rising, albeit modestly, in the quarters ahead. Weather related supply disruptions are likely to affect the food price dynamic, and sustained strong growth momentum is likely to exert pressure on the core component of the CPI.

Kaushik Das, Mumbai, +91 22 7158 4909

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

National Income Nominal GDP (USD bn) 59.0 67.0 76.2 88.2

Population (mn) 21.1 21.3 21.5 21.7

GDP per capita (USD) 2798 3147 3544 4063

Real GDP (YoY %) 6.4 7.2 7.3 7.5

Total consumption 5.5 6.2 6.7 6.8 Total investment 10.7 11.0 11.1 11.7

Private 9.2 11.0 12.0 13.0

Government 16.0 11.0 8.0 7.0 Exports 0.2 8.6 9.5 10.0

Imports 0.5 9.0 10.0 11.0


CPI (YoY%) eop 9.2 4.7 6.6 6.5

CPI (YoY%) avg 7.6 6.9 5.0 7.0Broad money (M2b) eop 17.6 16.0 15.8 17.5

Bank credit (YoY%) eop 17.6 7.5 17.0 20.0


Central government balance -6.4 -5.8 -5.5 -5.0

Government revenue 13.2 13.8 14.0 14.2 Government expenditure 19.7 19.7 19.5 19.2

Primary balance -1.1 -0.7 -1.1 -0.7


Merchandise exports 9.8 10.4 11.1 12.0

Merchandise imports 19.2 18.0 19.4 21.4Trade balance -9.4 -7.6 -8.3 -9.4

% of GDP -15.9 -11.4 -11.0 -10.7

Current account balance -3.9 -1.4 -1.4 -1.8 % of GDP -6.6 -2.1 -1.9 -2.0

FDI (net) 0.8 1.2 1.3 1.7

FX reserves (USD bn) 6.9 7.2 8.2 9.2FX rate (eop) LKR/USD 127.7 130.8 130.0 128.0

Debt Indicators (% of GDP) Government debt 79.1 78.0 75.7 72.5

Domestic 42.6 41.8 40.1 38.1

External 36.5 36.3 35.6 34.5Total external debt 48.2 46.9 45.3 43.4

in USD bn 28.4 31.3 34.4 37.9


General

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

Financial Markets Current 3M 6M 12MReverse Repo rate 8.00 8.00 8.00 9.00

LKR/USD 130.6 130.3 130.3 130.0 Source: CEIC, DB Global Markets Research, National Sources

10 April 2014



Taiwan Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic outlook: While we see Taiwan’s GDP growth slowing in Q1, to 2.8%yoy from 2.9% in Q4, we consider it a temporary halt in growth recovery.

Main risks: Waiting for tailwinds for exports and the TWD, as the policies lean against the latter.

Still waiting for those export tailwinds

Exports disappoint in Q1, moving sideways… Taiwan exports failed to improve in Q1. In fact, despite the rebound in export growth, to 2.0%yoy in March, from 1.3% in January/February, the Q1 average stood at 1.5%, below 1.7% in Q4. By destination, echoing changes in Korean exports, Taiwanese exporters also saw their shipments to the US surging in March, by 10.3% vs. 4.6% growth in January/February, resulting in a growth acceleration to 6.5% in Q1, from 0.1% in Q4. In contrast, exports to China/HK disappointed, with growth slowing to 2.3% in Q1 from 3.7% in Q4. By goods, while Taiwan's top export item, machinery/electrical equipment, reported stronger export growth of 7.1% in Q1, vs. 6.5% in Q4, exports of commodity-based goods like minerals disappointed, reporting a sharper fall of 11% in Q1 vs. 5.6% in the same period, as their prices remained under pressure.

Exports to G2 rebound

-20

-10

0

10

20

30

2011 2012 2013 2014

China EuroUS Total exports

%yoy


While we expect their rebound in Q2 to guide overall growth higher, there are risks to this outlook. First, we may not see the US growth snapping back in Q2, to 4.2% from 2%, as our US colleagues expect. Second, recovery in China’s growth may be weaker than expected, even after our downward revision. We lowered our China growth forecast by 0.8ppts to 7.8% for the year. If such a downward revision is limited only to China, then we could limit our cut in Taiwan’s GDP growth forecast to at most 0.2ppts. We refrain from

changing our growth forecast for now, however, as we wait for more data out of the US. Meanwhile, there are some concerns about weakness in domestic demand in Taiwan.

…while domestic demand growth weakens… Although imports also improved in March, rising 7.5%, vs. -5.2% in January/February, the Q1 average growth rate stood well below 2.2% growth in Q4, at -0.9%, suggesting weaker domestic demand. Already, high frequency data pointed to their weaker growth. In particular, commercial sales growth fell to 2.1% in January/February, from 2.7% in Q4, pointing to weaker private consumption during the quarter. Meanwhile, both growth in machinery and electrical equipment imports and construction investment slowed relatively sharply in January/February, to -2.1% and 6.7%, from 14.6% and 16.7% in Q4, respectively, suggesting weaker investment growth. On a positive note, production data fared better, with industrial production growth accelerating to 2.6% in January/February, from 2.1% in Q4.

Weaker domestic demand

-20

-10

0

10

20

-100

-50

0

50

100

150

2008 2009 2010 2011 2012 2013 2014

Machinery/ electr equipt imports

Bldg construction permitted (lhs)

Commerce sales

%yoy %yoy


Taiwan’s leading index rose at a slower pace of 3.8% 3m/3m saar in February, vs. 4.2% in Q4, suggesting growth momentum. Our own MMI also suggested slowing growth momentum. However, despite almost no growth on a qoq basis in Q1, after the 1.8% surge in Q4, we see Taiwan’s GDP growth on a yoy basis falling only slightly, to 2.8% in Q1 from 2.9% in Q4, due to favourable base effects.

…but inflation surge, due to food... CPI inflation surprised sharply to the upside, rising to 1.6%yoy in March from 0.4% in January/February, owing largely to base effects and volatile items. In particular, food price

10 April 2014



inflation surged in March, to 5.6% from 2.5% in February, while transportation costs fell at a slower pace of 0.8% vs. 2.1% in the same period. Meanwhile, as high base effects dropped out of the data, core inflation rose to 1.0% in March from -0.2% in February. We discount this as a temporary phenomenon and expect inflation to ease to around 1% in Q2, albeit higher than the Q1 average of 0.8%. Given the March surprise, we now see this year’s inflation at 1.1%, as does the government.

Rebound in inflation

-2

-1

0

1

2

3

4

2010 2011 2012 2013 2014

Headline Core

%yoy 3mma


Despite this rise in inflation and expectation of a pick up in exports in Q2, we continue to see the central bank staying on the sidelines for a prolonged period, given the government’s relatively bearish view on growth, of 2.8% in 2014, vs. the consensus forecast of 3.3%. The Central Bank of China (CBC) left its policy rates unchanged at the last quarterly MPC meeting, at end-March, noting that the current monetary policy stance is appropriate for maintaining price and financial stability and supporting growth. Meanwhile, the TWD came under pressure from various headwinds, including changes in hedging requirements for insurers and demand for foreign assets (led by RMB denominated), albeit the RMB’s recent volatility may have reduced depositors’ preference for the currency. Moreover, weak exports and narrowing goods trade surplus, to USD6.5bn in Q1 from USD10.7bn in Q4, leaned against the TWD. However, we see the tides turning with recovery in exports acting as tailwinds for the TWD.


Taiwan: Deutsche Bank forecasts 2012 2013 2014F 2015FNational income Nominal GDP (USDbn) 476.3 490.8 514.4 533.1

Population (m) 23.3 23.3 23.4 23.5


Real GDP (yoy %) 1.5 2.1 3.7 3.4

Private consumption 1.6 1.8 2.3 2.0 Government consumption 1.0 -0.3 0.2 0.3

Gross fixed investment -4.0 5.3 5.2 2.8

Exports 0.1 3.8 7.2 6.7 Imports -2.2 4.0 7.5 5.6

Prices, money and banking CPI (yoy %) eop 1.6 0.3 1.2 1.6

CPI (yoy %) annual average 1.9 0.8 1.1 1.2

Broad money (M2) 4.9 4.3 6.0 6.5

Bank credit1 (yoy %) 3.3 2.7 3.5 4.0

Fiscal accounts (% of GDP) Budget surplus -2.5 -2.3 -1.5 -0.8

Government revenue 16.5 16.6 17.0 17.3

Government expenditure 19.0 18.9 18.5 18.0Primary surplus -0.8 -0.6 0.4 1.3

External accounts (USDbn) Merchandise exports 300.4 304.6 325.6 346.0

Merchandise imports 268.8 267.6 289.6 310.1

Trade balance 31.6 37.0 36.0 35.9 % of GDP 6.6 7.5 7.0 6.7

Current account balance 50.7 57.4 52.7 48.5

% of GDP 10.6 11.7 10.2 9.1FDI (net) -9.9 -12.0 -13.0 -15.0

FX reserves (USD bn) 403.2 416.8 430.3 430.9

FX rate (eop) TWD/USD 29.2 29.8 29.6 29.8

Debt indicators (% of GDP)

Government debt2 42.9 43.7 43.6 42.8 Domestic 42.2 43.0 42.9 42.1

External 0.7 0.7 0.7 0.7

Total external debt 27.6 28.3 27.4 26.4 in USDbn 130.8 140.0 140.0 140.0


General

Industrial production (YoY%) 0.0 0.9 3.8 3.5

Unemployment (%) 4.2 4.2 4.1 4.1

Financial markets Current 3M 6M 12MDiscount rate 1.88 1.88 1.88 2.0090-day CP 0.82 0.82 0.88 1.00

10-year yield (%) 1.58 1.65 1.75 1.90

TWD/USD 30.2 29.8 29.6 29.7 Source: CEIC, Deutsche Bank Global Markets Research, National Sources Note: (1) Credit to private sector. (2) Including guarantees on SOE debt

10 April 2014



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

Economic outlook: There is little to cheer about the underlying economic momentum, which is decidedly weak at this juncture. We remain cautiously optimistic nevertheless, expecting a revival in exports, tourism, and agriculture to support growth this year.

Main risks: The political situation is the gravest, but not the only, risk to the economy. Independent of the timing or substance of any resolution to the ongoing impasse between the government and the opposition, Thailand needs to face issues ranging from debt (private and public) sustainability, a large fiscal deficit, eroding competitiveness, and infrastructure bottlenecks.

Macro view

Thailand’s domestic economy remains mired in steady decline. Hurt by a continuation of the political impasse, lack of guidance by the government on large-scale investment projects, removal of various one-offs that have supported growth in recent years, it should be of no surprise that both consumption and investment sentiments continue to worsen. Indeed, the consumer confidence index prepared by the Thai Chamber of Commerce makes for bleak reading: the headline index has declined every month since April 2013, with the future outlook component of the survey reporting lows last seen during the Asian financial crisis. It appears that indicators of domestic demand, such as imports, private consumption and investment indices, have yet to bottom in this cycle. Q1 growth could therefore well be in negative territory.

Subdued growth momentum

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

2006 2008 2010 2012 2014

Imports PCI PIIz-score

Source: CEIC, Deutsche Bank. Z-scores are obtained by normalizing the growth rates of the respective series. Mean and standard deviation are calculated over January 1995 to February 2014.PCI and PII stand for Private consumption index and Private Investment Index, respectively.

The malaise extends to bank credit, demand for which had been very strong till last year. Now, despite historically easy monetary conditions, demand for credit is tepid. There are some signs of manufacturing bottoming (see chart below), but the chance of a vigorous recovery is very small, in our view.

Manufacturing may have bottomed, but credit growth

remains tepid:

-4.0-3.0-2.0-1.00.01.02.03.04.05.06.0

2006 2008 2010 2012 2014

Manuf Creditz-score

Source: CEIC, Deutsche Bank. Z-scores are obtained by normalizing the growth rates of the respective series. Mean and standard deviation are calculated over January 1995 to February 2014.PCI and PII stand for Private consumption index and Private Investment Index, respectively.

There is some hope stemming from tourism and exports, however. With the state of emergency lifted, tourism arrivals are likely to pick up in time for European summer holidays. Exports are showing signs of life, as we have been expecting. Agriculture production is also holding up. A better Q2, and an even better 2H14, are still on the cards, in our view.

Key export components are on an upswing

-40

-20

0

20

40

60

80

2010 2011 2012 2013 2014

Agriculture Electronics Autos%yoy, 3mma


10 April 2014



Challenges beyond politics

While the political situation is the gravest risk to the outlook, it is not the only risk facing Thailand. Independent of the timing or substance of any resolution to the ongoing impasse between the government and the opposition, Thailand needs to deal with issues ranging from debt (private and public) sustainability, a large fiscal deficit, eroding competitiveness, and infrastructure bottlenecks.

With the courts invalidating the government’s flagship multi-year BHT2tn capital spending package, fiscal policy is essentially rudderless. Bringing on budget the infrastructure spending will help improve transparency, but at the same time it will raise the officially reported deficit figures. A rethink on the fiscal program is essential, but we don’t think that is part of the agenda at the current juncture.

Private sector debt sustainability could become a major issue as rates start rising, with adverse implication for consumption and the banking system. The likelihood that growth will remain constrained by the political situation in fact magnifies that risk. The key to dealing with the private sector debt burden would be to rev up job creation and wage growth. We worry that the policymakers are not focused on these matters.

Sharp rise in household debt in recent years

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20

30

40

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60

70

80

90

Indonesia Malaysia Philippines Thailand

2007 2013% of GDP



Thailand: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USDbn) 370.5 367.6 398.1 413.3Population (m) 64.5 64.8 65.1 65.4GDP per capita (USD) 5749 5675 6115 6317

Real GDP (yoy %) 6.5 2.9 3.5 4.5 Private consumption 6.7 0.2 2.5 4.5 Government consumption 7.5 4.9 1.9 2.0 Gross fixed investment 13.2 -1.9 2.9 6.0 Exports 3.1 4.2 2.8 11.4 Imports 6.3 2.3 4.1 12.9


CPI (yoy %) eop 3.6 1.7 2.2 3.0CPI (yoy %) ann avg 3.0 2.2 2.7 2.3Core CPI (yoy %) ann avg 2.1 1.0 1.6 1.4Broad money 10.4 7.3 7.5 8.0Bank credit1 (yoy %) 15.3 9.4 9.0 10.0

Fiscal Accounts2 (% of GDP)

Central government surplus -3.5 -3.0 -3.2 -3.3 Government revenue 19.2 18.8 19.0 19.0 Government expenditure 22.7 21.8 22.2 22.3Primary surplus -3.6 -3.1 -1.9 -2.0

External Accounts (USDbn)

Merchandise exports 225.9 225.4 246.7 270.8Merchandise imports 219.9 219.0 238.8 267.6Trade balance 6.0 6.4 7.9 3.1 % of GDP 1.6 1.7 2.0 0.8Current account balance 0.2 0.5 4.0 1.1 % of GDP 0.0 0.1 1.0 0.3FDI (net) -2.0 -3.0 -3.0 2.8FX reserves (USDbn) 181.6 186.1 193.1 199.2FX rate (eop) THB/USD 30.7 32.4 32.0 32.5 Debt Indicators (% of GDP)

Government debt2,3 43.7 45.5 46.0 46.5 Domestic 41.5 43.6 45.0 45.5 External 2.2 1.9 1.0 1.0Total external debt 35.3 36.3 34.6 34.4 in USDbn 130.7 135.0 140.0 145.0 Short-term (% of total) 44.5 45.0 45.0 45.5

General Industrial production (yoy %) 2.5 2.6 4.0 5.0Unemployment (%) 0.8 0.8 0.7 1.0 Financial Markets Current 3M 6M 12MBoT o/n repo rate 2.00 2.00 2.00 2.503-month Bibor 2.18 2.30 2.40 2.8010-year yield (%) 3.64 3.60 3.80 4.00THB/USD (onshore) 32.2 32.5 32.7 32.0Source: CEIC, Deutsche Bank Global Markets Research, National Sources Note: (1) Credit to the private sector & SOEs. (2) Consolidated central government accounts; fiscal year ending September. (3) excludes unguaranteed SOE debt

10 April 2014



Vietnam B2/BB-/B+ Moody’s/S&P/Fitch

Economic outlook: GDP growth slowed to 5.0%yoy in Q1, from 6% in Q4, prompting further measures to boost growth.

Main risks: There is a political will to resolve bad debt and restructure SOEs, but fresh capital is needed.

In need of fresh capital

A cautious start to the year… Vietnam’s GDP rose 5.0%yoy in Q1, down from 6.0% in Q4. The slowdown in growth was seen across all sectors, with growth in agriculture/forestry/fishery (2.4% vs. 2.7%), services (6.0% vs. 6.6%) and industry/construction (4.7% vs. 5.4%) weaker. The latter was led by a sustained contraction in mining (-2.9% vs. -0.2%), while manufacturing growth stood relatively stable (7.3% vs. 7.4%). Meanwhile, construction growth slowed relatively sharply (3.4% vs. 5.8%).

Growth normally accelerates

2

3

4

5

6

7

8

9

2007 2008 2009 2010 2011 2012 2013 2014

quarterly annual%yoy


As Vietnam's growth normally accelerates as it moves further into the year, it is also informative to compare this quarter's growth with that in Q1 2013, which was slightly lower at 4.9%. In this regard, the government called for improvement in investment disbursement, including a more even distribution throughout the year. Traditionally, a lot of disbursement takes place in the latter part of the year. Hence, the acceleration in growth as Vietnam heads further into the year. By sector, while agriculture/forestry/fishery (2.2% in Q1 2013) and services (5.6%) reported stronger growth in Q1 2014, vs. Q1 2013, industry/mining was lower (4.9%), due again to mining. Also, construction was weaker (4.8%), reflecting continued weakness in the housing market weighing on consumption.

Trade surplus maintained

-3

-2

-1

0

1

2

3

4

-60

-40

-20

0

20

40

60

80

2008 2009 2010 2011 2012 2013 2014

Trade Balance (rhs)ExportsImports

%yoy 3mma USD bn


On the demand front, high-frequency data suggested weaker domestic demand in Q1, vs. Q4. In particular, both retail sales and imports of machinery and parts growing at a slower pace of 10.3%yoy and 28.3%, respectively in Q1, vs. 12.2% and 33.5% growth in Q4. Meanwhile, export growth also slowed, to 14.1% in Q1 2014, from 16.8% in Q4. Imports also rose at a slower pace of 13.1% in Q1, vs. 19.0% in Q4, again reflecting weaker domestic demand growth in Q1. On a positive note, however, such a weakness helped to maintain a trade surplus of USD0.59bn in Q1, vs. USD0.56bn in Q4, supporting the dong.

…prompts stronger policy response... To support stronger growth, the SBV responded with policy rate cuts and administrative measures to support credit growth, which has stood still since last year, as inflation continued to surprise to the downside, falling further to 4.4%yoy in March from 4.7% in February. By goods, this moderation in inflation was led by housing/construction material (4.2% in March vs. 5.0% in February), followed by food/food stuff (2.9% vs. 3.3%). This year thus far both food and fuel prices remain weak, helping to keep inflation well in check. Having said that, however, we expect this declining trend to reverse, as food and fuel prices normalize and health care and education price hikes resume. Moreover, rising PPI inflation suggests increasing underlying inflationary pressure. While manufacturing PPI inflation fell 0.9% in Q1 2014, vs. 3.2% in Q4, food PPI inflation continued to rise, to 5.1% in Q1 from 4.8% in Q4. Note that food constituted a very large share of the CPI basket, at about 40%.

Meanwhile, to boost credit growth, the SBV went a step further and relaxed Circular 02/2013 (adoption of

10 April 2014



international account standards), allowing banks to restructure debt without de-rating until April 2015. With the social housing package having prompted few results in terms of reviving the real estate market, the SBV is stepping in to provide a credit package of about VND70tr (USD3.32bn) to support the market, albeit for residential housing, construction and infrastructure construction purposes only. Moreover, the SVB is targeting a bad debt resolution of about 2.5% of outstanding debt. According to the ADB, the NPL ratio stood at 9% at end-2013. This, however, included restructured loans.

Volatile items weighed on inflation but rebounding

-10

-5

0

5

10

15

20

25

30

2009 2010 2011 2012 2013

Headline Food Transportation%yoy


Meanwhile, the government is busy removing barriers to its goal of equitizing about 450 SOEs by end-2015, more than four times what it has done in the past three years. More importantly, the government has enhanced accountability, by making related ministries and SOE management responsible for failures and delays in their equitization and divestment efforts. To support the latter, in the resolution of debt overhang in particular, the government seeks to allow SOE divestment below book value, albeit with government approvals only, among other things. The government continued to add to its list a number of large SOEs for restructuring and equitization. There is a sense of urgency and will on the part of the authorities to make measurable progress, both in planning and execution, ahead of the next National Assembly session in May and with the TPP in mind.


Vietnam: Deutsche Bank forecasts 2012 2013 2014F 2015F

National Income Nominal GDP (USD bn) 154.8 170.3 188.6 212.5Population (m) 88.8 89.8 90.7 91.7


Real GDP (yoy %) 5.2 5.4 5.8 6.3

Private consumption 4.9 4.5 5.0 6.5

Government consumption 7.2 6.0 7.0 6.5 Gross fixed investment 1.9 2.0 5.0 8.0

Exports 11.0 11.5 16.0 14.0

Imports 3.2 10.5 15.8 15.5


CPI (yoy %) eop 6.8 6.0 7.7 8.9CPI (yoy %) ann avg 9.3 6.6 6.2 9.5

Broad money (yoy %) 18.5 16.0 17.0 19.0

Bank credit (yoy %) 8.7 12.0 14.0 16.0

Fiscal Accounts1 (% of GDP)

Federal government surplus -6.0 -6.0 -6.2 -5.5 Government revenue 27.5 27.2 27.5 28.0

Government expenditure 33.5 33.2 33.7 33.5

Primary fed. govt. surplus -4.5 -4.7 -4.2 -3.0


Merchandise exports 112.0 130.0 165.0 195.0 Merchandise imports 109.0 131.0 168.0 206.0

Trade balance 3.0 -1.0 -2.0 -11.0

% of GDP 2.1 -0.6 -1.1 -5.6Current account balance 8.0 5.0 4.5 -6.0

% of GDP 5.7 2.9 2.4 -3.1

FDI (net) 7.0 8.0 8.0 8.0FX reserves (USD bn) 25.4 36.0 46.0 48.0

FX rate (eop) VND/USD 20900 21100 21800 22500


Government debt 53.0 56.0 60.0 61.0

Domestic 22.0 24.0 27.0 28.0 External 31.0 32.0 33.0 33.0

Total external debt 43.3 40.2 39.0 37.4

in USD bn 61.0 63.0 68.0 73.0 Short-term (% of total) 16.4 19.0 19.1 20.5

General Industrial production (yoy %) 3.6 7.7 8.8 9.5

Unemployment (%) 3.2 3.2 3.2 3.0

Financial Markets Current 3M 6M 12MRefinancing rate 6.50 6.50 6.50 7.00

VND/USD 21075 21300 21700 22000 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Fiscal balance includes off-budget expenditure, while revenue and expenditure include only budget items. .

10 April 2014



Hungary Ba1(neg)/BB(stable)/BB+(stable) Moody’s/S&P/Fitch

Economic Outlook: Economic data continues to be strong, while headline inflation remains muted. Growth is expected to accelerate over the coming two years and become increasingly broad-based. Recent forint appreciation could pave the way for further monetary easing.

Main Risks: Economic growth in Hungary is dependent on the pace of the euro area recovery. Upward risks to growth also come from the possibility of another strong agricultural harvest, while downward risks come from the external environment (primarily the Russia-Ukraine crisis and related EM turbulence) and the interventionist policies of the Fidesz party – re-elected earlier this month – which could deter foreign investment.

Economic data is strong but inflation remains subdued; on the political front, Fidesz comfortably wins elections.

Headline inflation is very low and is expected to remain subdued until December. Headline CPI in Hungary has been at record lows, dropping to 0% YoY in January and 0.1% YoY in February. This is mainly due to administered utility price cuts – the government cut the prices of electricity, gas and heating by 10% in January 2013 and by another 10% in November; this has led to a sustained, artificially low headline inflation rate. These cuts are only expected to drop out of the base at the end of this year.

Another reason for the current subdued inflation environment is low food price inflation (the food and non-alcoholic beverages component constitutes 20% of CPI by weight). Food price inflation has been very low over the past year – and particularly the past six months (averaging only 0.5% YoY over this period) – mainly due to strong agricultural harvests at a local and global level. Over the past six months, the average contribution of food price inflation to the headline rate has been only 0.1pps; in comparison, this component contributed, on average, 1.5pps in 2011 and 1.4pps in 2012. Assuming a normal harvest in 2014, we expect food price inflation to rise this year but only gradually, reaching 2% by the end of 2014. In historical terms, this is still quite subdued. Relatively low fuel prices, which are also expected to grow only moderately this year, have also contributed to the subdued headline inflation.

As a result of these factors, headline inflation is expected to remain muted and well below the NBH's target (3%) throughout 2014; we forecast inflation to

average only 0.7% this year. After remaining below the 1% level until Q4, headline inflation is expected to jump to 2.1% in December, as the first two rounds of utility price cuts drop out of the base. Additionally, the ruling Fidesz party announced a third round of utility price cuts to be implemented in three stages this year (April, September and October), which will put further downward pressure on headline inflation. Thereafter, inflation is expected to rise gradually in 2015 and reach the 3% target in April or May 2015, following which it will remain close to the target; we forecast headline inflation to average 2.8% in 2015.

Headline inflation profile

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2

3

4

Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15

Headline CPI (YoY, %) NBH Target

Source: Deutsche Bank, Haver Analytics

Core CPI is higher than the headline rate, but not very high in historical terms. Core CPI is substantially higher than the headline rate, as it excludes electricity, food and fuel prices, all of which have put significant downward pressure on headline inflation. Core CPI has been relatively stable (between 2.8% and 3.6% in YoY terms) over the past year, while headline CPI has fallen significantly over this period. However, in historical terms core CPI is not very high (see chart). Further, the NBH forecasts core inflation to average only 3% in 2014, which is below last year’s average (3.3%).

10 April 2014



Headline vs. Core CPI

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2000 2002 2004 2006 2008 2010 2012 2014

Core CPI (YoY, %) Headline CPI (YoY %)


Underlying inflationary pressures remain weak. The main reason for this moderate growth forecast for core CPI in 2014 is that while domestic demand is growing, it is doing so only gradually. Additionally, there is significant spare capacity in the economy (as is the case across Central Europe), limiting demand pressure on inflation. According to the European Commission’s estimates, output in 2014 is likely to be around 2pps below potential (in 2015, it is expected to be 1pp below potential). As a result, underlying inflationary pressures in the economy are expected to remain weak this year, while a closing output gap will contribute to pushing headline inflation close to the target in mid-2015.

Domestic demand is growing, but only sluggishly

4500

4700

4900

5100

5300

5500

5700

5900

2001 2003 2005 2007 2009 2011 2013

Total Domestic Demand (SA, Billion 2005 Forints)


NBH pushing the limits of monetary easing. At its MPC meeting last month, the NBH announced a 10bps cut to its policy rate, slowing the pace of easing after two 15bps cuts. This brings the policy rate to a record low 2.60%, and brings uninterrupted total easing since August 2012 to 440bps. The NBH has justified the sustained easing by citing the low inflation environment, weak inflationary pressures in the medium term and the degree of spare capacity in the economy. The NBH also revised down its inflation

forecast for 2014 from 1.3% to 0.7%, largely in response to the lower-than-expected inflation readings for January and February.

On the issue of forward guidance, the NBH included two sentences in its March statement which have not been included in previous statements. It noted that the “base rate has significantly approached a level which ensures the medium-term achievement of price stability and a corresponding degree of support for the economy.” It forecasts inflation reaching the target (3%) in early 2015. The NBH also stated that “in case of a significant deterioration in the global financial market environment, the Council will see no scope for continuing the easing cycle.”

In our view, while the first statement is on the hawkish side, it does not definitively signal the end of the easing cycle as it states that the base rate has “significantly approached”, rather than already reached, the level which ensures the achievement of the inflation target in the medium term. Additionally, the second statement leaves open the possibility of further easing, particularly if there is no deterioration in the external environment.

It is a close call but, on balance, we believe that the NBH will cut the base rate one more time, by 10bps this month, with rates expected to be on hold in the near term after this.

We have long believed that internal conditions in Hungary do not necessarily warrant further rate cuts. Real rates (as measured by the differential between the policy rate and core CPI) are negative and near all time lows, providing an indication that the NBH has already pushed the limits of monetary policy easing.

Real rates at very low levels

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10

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Hungary, Base rate vs. Core CPI differential (pps)


With real rates at these levels, continuing to lower policy rates could seriously undermine the appeal of the HUF; given the large outstanding stock of FX loans, extreme currency weakness would be highly

10 April 2014



undesirable, especially with European and local elections later this year.

FX-denominated private debt stock remains large

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2006 2007 2008 2009 2010 2011 2012 2013

FX-denominated private sector credit as % GDP (non-valuation adjusted)


It is also doubtful to what extent a further loosening of policy is necessary against a backdrop of domestic data picking up (Q4 GDP was a relatively strong 2.7% YoY, investment has rebounded, the unemployment rate is at a 5-year low, and other high frequency economic indicators have also been strong), and the external balances in surplus. PMI – which came in at 53.7 in March – has now been in expansionary territory for eight consecutive months, pointing to a continued economic recovery; the PMI breakdown has also been encouraging, with strong readings of the forward-looking new orders component. GDP growth is expected to pick up further over the next two years.

Investment has rebounded

-50-40-30-20-10

0102030

Mar-04 Mar-06 Mar-08 Mar-10 Mar-12

Investment (YoY change, %)


Further, much of the recent weakness in headline inflation is due to administered utility price cuts (while core CPI remains significantly higher than the headline rate); in addition, the NBH has revised up its inflation forecast for 2015 to the target level of 3%, indicating that further rate cuts could cause inflation to rise above target next year.

However, keeping in mind the dovish rhetoric from the NBH – as well as the fact that the MPC voted 7-2 in favour of a rate cut in March – we have maintained that the deciding factor in determining whether the NBH continues the easing cycle (for one more month) would be the external environment. Given that external conditions (in particular, the Russia-Ukraine situation) have not deteriorated since the previous MPC meeting and the forint has appreciated by nearly 2.5% (versus the Euro) since the March meeting, we believe that the NBH will cut rates one last time this month (by 10bps).

We expect the NBH to start hiking rates in Q4 this year. While the output gap will still be negative later this year as well as early next year, it will likely be closing rapidly as economic growth accelerates and domestic demand improves. Further, in an environment of geopolitical tensions and tightening external financing conditions as the Fed continues to normalize its policy, maintaining real rates at the current very low levels will probably not be sustainable without triggering a sharp depreciation in the forint. But there are risks to this view on either side. If rates in the US stay lower for longer and/or the ECB eases further, with headline inflation in Hungary at low levels, this could lead to a delay in the hiking cycle; the NBH would prefer to keep rates low for as long as external conditions permit it without causing sharp forint depreciation. However, sustained pressure on the forint could prompt the NBH to hike even earlier and more aggressively than expected.

Fidesz comfortably wins general elections, but supermajority still uncertain. The preliminary results of the general elections in Hungary (held on April 6th) show that the incumbent Fidesz party easily won the largest number of seats in parliament. PM Viktor Orban is thus set for another term in office. The preliminary results indicate that Fidesz won 44.5% of the votes, followed by the main left-leaning opposition Unity Alliance – a coalition between the Socialist party, E14-PM, the Democratic Coalition party and the Liberal party – which secured 26% of votes. Two other parties crossed the 5% of votes threshold required to hold seats in parliament – the radical nationalist Jobbik party, which secured 20.5% of the votes, and the green liberal Politics Can Be Different (LMP) party, which obtained 5.3% of the votes. This is largely in line with the results of opinion polls.

In terms of parliamentary seats (in the 199-seat National Assembly), the results suggest that Fidesz secured 133, Unity Alliance 38, Jobbik 23 and LMP 5. Thus, the preliminary results suggest that Fidesz obtained another supermajority of two-thirds of the seats in parliament, but by just one seat (the minimum seats required for a supermajority is 133). With the votes of Hungarians living abroad and those who voted outside their city of permanent residence still to be counted, and the race extremely close in five

10 April 2014



constituencies, it is possible that the final results (which will be announced by April 25th at the latest, but likely significantly earlier) will show that Fidesz no longer holds a supermajority.

From a legislative perspective, securing a supermajority would be very beneficial for Fidesz. It would allow the party to push through laws more easily and also reinforce policies from its current term. A supermajority would also enable Fidesz to make further amendments to the constitution (which require two-thirds support in parliament), including altering measures related to the electoral system; these amendments would be difficult to reverse in the longer term.

In terms of the policy space, Fidesz is likely to continue and consolidate the policies enacted in its current term (Orban summarized Fidesz’s program by stating that “[we will] continue”). It plans to expand public employment, increase domestic ownership in the banking sector, transform energy distribution into a non-profit enterprise and provide further relief for fx debtors. It has already announced a third round of utility price cuts for this year (after two rounds of cuts in 2013). Fidesz has also raised the possibility of reducing the personal tax rate from 16% to 10%.

Gautam Kalani, London, +44 207 545 7066

Hungary: Deutsche Bank Forecasts 2012 2013F 2014F 2015F

National Income

Nominal GDP (USD bn) 125.1 128.5 128.2 121.3Population (mn) 10.0 9.9 9.9 9.9GDP per capita (USD) 12554 12930 12916 12247

Real GDP (% ) -1.7 1.1 2.1 2.2Priv. consumption -1.7 -0.1 1.1 1.9Govt consumption 0.1 4.3 1.3 1.3Investment -3.7 5.9 1.3 3.8Exports 1.7 5.3 6.3 5.1Imports -0.1 5.3 7.5 5.5


CPI (YoY%, eop) 5.0 0.4 2.1 2.6CPI (YoY%, pavg) 5.7 1.7 0.7 2.8Broad money (M3) -3.3 2.0 4.6 5.3

Fiscal Accounts (% of GDP) ESA 95 fiscal balance -2.1 -2.2 -2.9 -2.7 Revenue 46.2 46.4 46.2 44.8 Expenditure 48.3 48.6 49.1 47.5

Primary balance 2.2 1.6 0.9 1.1

External Accounts (USDbn) Exports 97.3 104.3 112.2 105.3Imports 92.9 98.2 106.1 100.2Trade balance 4.5 6.2 6.1 5.1

% of GDP 3.6 4.8 4.8 4.2Current account balance 1.1 2.7 2.6 1.8

% of GDP 0.8 2.1 1.9 1.4FDI (net) 2.6 1.7 1.9 2.1FX reserves (USDbn) 41.9 37.6 37.6 37.1HUF/USD (eop) 220.9 216.3 241.6 272.7HUF/EUR (eop) 291.4 297.2 302.0 300.0

Debt Indicators (% of GDP) Government debt 79.8 78.0 76.2 79.5 Domestic 45.1 39.5 38.7 47.2 External 34.7 38.5 34.8 32.3

Total external debt 131.5 121.6 120.0 118.0 in USD bn 164.4 156.3 153.8 143.1


General (% pavg) Industrial production (YoY%) -0.8 1.4 4.5 4.9Unemployment 10.9 10.2 10.0 9.9

Financial Markets (eop) Current 14Q2 14Q3 15Q1

Policy rate (%) 2.60 2.50 2.50 3.25HUF/EUR 304.4 303.8 302.9 301.5HUF/USD 220.7 230.2 234.8 248.7

Source: NBH, DB Global Markets Research, Haver Analytics

10 April 2014



Kazakhstan Baa2(positive)/BBB+(stable)/BBB+(stable) Moody’s/S&P/Fitch

Economic Outlook: Growth performance is relatively strong, supported by household consumption expansion and high oil prices.

Main Risks: Worsening of the economic environment adversely affecting the banking sector and growth.

Experiencing external shocks

The first quarter of this year appeared to be quite challenging for Kazakhstan, which witnessed sizeable exchange rate depreciation as well as a government reshuffle. With respect to the latter, on 2 March after the meeting with Kazakh President Nursultan Nazarbaev Kazakh PM Serik Ahmetov resigned, which automatically led to the dismissal of the cabinet. The president proposed to appoint to the PM position Karim Massimov, who already chaired the government in 2007-2012. Prior to taking this position, Massimov headed the Presidential Administration, served as a Vice-Premier, headed the Ministry of Economy and Budget Planning as well as was the Minister of Transport and Communications.

Nazarbaev attributed the dismissal of the government to insufficient efforts made by the government towards solving the economic issues, which arose on the back of instability of the global economy and continuing deterioration of the external conditions. Our take is that a change in the government happened on the back of deterioration in the domestic conditions and the significant devaluation of the tenge in February (more than 20%). We note, however, that the Cabinet has undergone similar dismissals in the past that may have been intended to allow for rotation to take place in the upper echelons of power. One of the possible implications is that the position of Massimov as the potential successor to Nazarbayev may have strengthened after the government reshuffle.

In the economic domain, in February 2014 industrial production exhibited deceleration of the growth rate to -0.6% yoy from 0.8% yoy in January 2014 and 2.7% yoy in December 2013. Across the industries, the mineral extraction sector decreased by 0.7% yoy over 2M2014, while manufacturing showed moderate growth at 1.3% yoy; gas/heating and electricity was up by 1.2% yoy by increasing the volume of production and distribution of gaseous fuels by 7.2%. In other production activities, agriculture growth decelerated in the beginning of the year to 2.7% yoy in January and 1.1% yoy in February from 10.8%-10.9% yoy in November and December 2013 respectively. Transportation was up 6.9% yoy over 2M14.

The weakest factor in the growth equation is fixed investment growth, which slid into the red in the beginning of this year. Fixed assets investments deteriorated, registering a decline of 1.2% yoy vs. 4.0% yoy in January 2014. Construction growth accelerated to 5.9% yoy over 2M13 vs 3.8% growth yoy in 2013. As investment decelerates, consumption appears to be the main driver of economic growth supported by low unemployment and stable growth in real incomes. Retail sales posted solid growth of 10.4% yoy in 2M2014, cooling down from 14.2% yoy in 2013, supported by low unemployment, which has stood at 5.2% over the last ten months and by real wage growth and growth in real income of 1.9% yoy in January 2014.

The Kazakh authorities thus far retain their 6% yoy growth projection for 2014 and industrial production growth at 2.7% yoy, while Fitch and S&P project Kazakhstan’s growth this year at 5.5% yoy and 5.0% yoy respectively. The IMF in its most recent review projected Kazakhstan’s growth this year at 5.7%, with a moderate acceleration to 6.1% in 2015. Given the change in our oil price forecasts from USD98.5/bbl to USD106.5/bbl, we revise our GDP growth forecast for 2014 from 4.8% yoy to 5.4% yoy, while retaining the growth projection at 5.2% yoy for 2015.

In the monetary sphere, inflation in March decelerated to 1.0% mom in March from 1.7% mom in February. As a result, the yoy inflation figures accelerated further to 6.2% yoy in March from 5.4% yoy in February and 4.5% yoy in January. Overall, year-to-date inflation stood at 3.3% ytd with food prices growing by 3.3% ytd, non-food by 3.2% ytd, and services prices by 3.3% ytd. Money supply growth continued to accelerate on a yoy basis, reaching 4.6% wow in February from 2.4% wow in January. On a year-to-date basis, the money supply increased 7.2%.

Meanwhile in mid-February, the National Bank of Kazakhstan (NBK) abandoned the exchange rate targeting at the level of KZT/USD145-155 and set the tenge exchange rate at KZT/USD185 (20% from the beginning of February) with allowable fluctuations of +/- KZT/USD3.0, while continuing to smooth the fluctuations in the exchange rate.

The NBK stated that the decision was motivated by 1) EM FX sell-off associated with the capital flight on QE tapering and uncertainty over the world economy, fx and commodity markets developments; 2) uncertainty over the free-floating ruble exchange rate, which depreciated by 7% yoy to the dollar in 2013 and continuation of the trend in January; 3) deterioration of

10 April 2014



the external trade conditions driven by higher imports; 4) strong devaluation expectations and excessive volatility in the tenge; 5) transition of the NBK to inflation targeting in the medium term. According to the monetary authorities, this measure should contribute to an improvement in the conditions of domestic producers in export-oriented and import-substituting industries.

In the external sector, the CA finished the year posting a marginal deficit of USD100m in 2013 vs. a surplus of USD1.1bn in 2012. Meanwhile, exports of goods rose by 24% yoy, while imports declined by 9% yoy in February 2014 mainly reflecting the 20% depreciation of the tenge. The international reserves of NBK reached USD25.65bn, increasing 6.3% ytd and 0.8% mom in March. Meanwhile, gross reserves of both NBK and NFRK reached USD98.4bn increasing by 4% ytd and 1.4% mom in March. As for the outlook for 2014, given the more favorable oil price outlook as well as possibility of higher production growth we revise our CA surplus to 2.0% GDP in 2014.

On the fiscal front, over 2M14 the republican budget balance registered a deficit of KZT3.5bn with the revenues standing at KZT919bn and the NFRK transfer at KZT330bn, while expenditures stood at KZT903.5bn. The change in the currency outlook led the government to review both state and republican budgets increasing both revenues and expenditures, but decreasing the overall budget deficit. The government approved the revision of revenues from KZT5.77tr to KZT 6.21bn; while the expenditures will be increased by KZT409bn to KZT7.12tr. Overall, the budget deficit has been revised to KZT942bn (2.4% GDP) vs. 2.3% GDP previously. Given the change in commodity, currency and growth outlook we revise our consolidated budget estimate surplus from 4.8% GDP this year to 5.3% GDP.

Yaroslav Lissovolik, Moscow, +7 495 933 9247 Artem Zaigrin, Moscow, +7 495 797 5274

Kazakhstan: Deutsche Bank Forecasts

2012 2013F 2014F 2015F

National Income

Nominal GDP (USDbn) 203.5 223.8 244.3 268.9

Population (m) 16.8 17.1 17.2 17.3

GDP per capita (USD) 12 111 13 088 14 203 15 541

Real GDP (yoy %) 5.0 6.0 5.4 5.2

Priv. consumption 11.2 10.5 7.6 6.7

Govt consumption 11.4 4.3 3.7 4.2

Investment 7.1 4.9 4.8 5.2

Exports 2.8 4.6 5.3 5.3

Imports 18.7 8.6 6.5 7.2

Prices, Money and Banking (eop)

CPI (YoY%) ann avg 5.1 5.8 5.6 6.7

Broad money (M3) 7.9 11.2 12.9 12.3

Credit 13.4 18.5 14.8 15.2


Consolidated budget balance

3.9 5.3 5.3 3.3

Revenue 26.1 27.0 26.8 25.9

Expenditure 22.2 21.7 21.5 22.6


Exports 86.9 83.4 102.8 107.2

Imports 49.1 49.6 51.8 54.0

Trade balance 37.9 33.8 51.0 53.2

% of GDP 18.6 15.1 20.9 19.8


% of GDP 0.3 0.1 2.0 1.5

FDI (net) 11.7 8.1 13.4 13.8

FX reserves (USDbn) 28.3 24.678 41.5 47.2

KZT/USD (eop) 148.6 154.4 185 187


Total public debt 12.6 12.8 12.7 12.7


General (% pavg)

Industrial production (% yoy)

0.6 4.0 4.3 5.1

Financial Markets (eop) Spot 2Q14 3Q14 1Q15

Policy rate (refinancing rate)

5.50 5.50 5.50 5.50

KZT/USD (eop) 182 183 185 185 Source: Official statistics, Deutsche Bank Global Markets Research

10 April 2014



Poland A2(stable)/A-(stable)/A-(stable) Moodys/S&P/Fitch

Economic Outlook: After a strong Q4 GDP reading, high frequency data in Q1 this year has also been solid. The recovery is now tangible, and we expect growth to accelerate further on the back of improving domestic demand. The eventual pick up of inflation from the current unusually low levels could pave the way for rate hikes by the end of the year.

Main Risks: Both upside and downside risks to growth come from the pace of the euro area recovery. Additional downside risks come from the external environment, including the crisis in Ukraine, given moderately large trade links (Russia and Ukraine account for 8% of Polish exports).

High frequency data remain strong but inflationary pressures yet to build

Economy picks up pace. The GDP reading for Q4 2013 was a strong 2.7% YoY, increasing from 1.9% in the previous quarter. The details were also promising, highlighting a pick-up in domestic demand and the continued strong export progress.

Economy is picking up momentum

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1.5

Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

Macro momentum index (3mma)


Recent high frequency data have also been promising. Retail sales increased by a better-than-expected 7% YoY in February, building on 4.8% growth in January. Industrial production also accelerated to 5.3% YoY in February from 4.1% in January. While manufacturing PMI declined slightly from a three-year high of 55.9 in February, it remained in expansionary territory in March, recording a solid reading of 54. PMI has now been in expansionary territory for nine consecutive months and the forward-looking new orders component has been strong, providing some evidence of the continued

economic recovery. In addition, our macroeconomic momentum measure – a composite measure of high frequency indicators that track well with GDP – continues to increase and is at its highest level since November 2011. As a result, we expect the economy to expand rapidly in Q1 as well, with GDP growth forecasted to accelerate to 3% this year and 3.9% in 2015 (also becoming increasingly broad-based).

Inflation remains subdued. Despite the relatively strong economic data, inflationary pressures remain muted. Headline inflation in February was a benign 0.7% YoY, and the January CPI reading was revised down by 0.2pps to 0.5% YoY. Over the past 12 months, inflation has averaged only 0.75%, well below the National Bank of Poland’s (NBP) 1pp tolerance band around its 2.5% target. While we expect the excise tax hike for alcohol and tobacco (implemented earlier this year) to have a progressively fading pass-through in the coming months, its upward pressure on inflation in February was largely offset by the seasonal fall in clothing and footwear prices.

Inflation profile

0

1

2

3

4

5

Jan-12 Jan-13 Jan-14 Jan-15

CPI (YoY, %) NBP Target


One of the primary reasons for the subdued inflation in recent months has been the sluggish growth in domestic demand. This growth only turned positive in the past two quarters (after five quarters of decline), and still remains below 1% in YoY terms. Additionally, imported energy and food price inflation has been weak. We expect inflation to rise gradually over the next two years – as domestic demand picks up pace and the output gap closes – crossing 2% by the end of 2014 and nearing the NBP’s target by the end of 2015. We forecast inflation to average 1.5% this year and 2.3% next year; in comparison, the NBP forecast is lower at 1.1% in 2014 and 1.8% in 2015, and we

10 April 2014



continue to believe that the NBP may be underestimating the impact of domestic demand improvement on prices in the medium term.

Domestic demand growth is sluggish

-4-202468

1012

2000 2002 2004 2006 2008 2010 2012

Domestic demand (YoY, %)


No changes in monetary policy. The NBP announced rates on hold (at 2.5%) at the MPC meeting this week, in line with guidance as well as market expectations. The NBP also maintained its guidance that rates would be on hold at least until the end of Q3, and added that the guidance was unlikely to be modified before July (when its new forecasts become available). Low headline inflation, core inflation and inflation expectations – combined with progressive improvements in real activity – were the main reasons for the continuation of the eased monetary conditions.

The NBP remains relatively optimistic on the economic front, with Governor Marek Belka stating that Poland is undergoing a “clear, vigorous economic recovery”, while the recent subdued inflation is in part due to low imported energy and food prices (which is less of a concern as it stimulates consumption). Additionally, the NBP noted that while the recovery is gradually being transmitted into labour market conditions, wage growth is restricted by the elevated unemployment rate.

Although the MPC had discussed in its March meeting the possibility of extending the hold guidance through the fourth quarter, we believe that the hiking cycle will commence in Q4, in a context where inflation should have started to regain some ground and growth to have built up healthily. However, there remains the possibility that the hiking cycle will be pushed out further and rates will be on hold in Q4, particularly if the ECB undertakes quantitative easing. After the MPC meeting, Belka did flag further easing by the ECB as a factor that could affect Polish monetary policy and stated that keeping rates on hold even after Q3 may be justified, but also added that continued tapering by the Fed could offset the impact of stronger ECB easing.

Gautam Kalani, London, +44 207 545 7066

Poland: Deutsche Bank Forecasts 2012 2013F 2014F 2015F

National Income

Nominal GDP (USD bn) 490.0 513.9 501.5 515.3Population (mn) 37.6 37.6 37.5 37.4GDP per capita (USD) 13019 13685 13383 13782

Real GDP (%) 1.9 1.6 3.0 3.9 Priv. consumption 1.2 0.8 3.0 3.5 Gov’t consumption 0.2 2.0 1.2 1.5 Gross capital formation -0.5 -0.9 4.0 5.5 Exports 3.9 4.3 8.0 8.5 Imports -0.6 0.7 7.0 8.0

Prices, Money and Banking CPI (YoY%, eop) 2.4 0.7 2.1 2.4CPI (YoY %, pavg) 3.7 0.9 1.5 2.3Broad money (M3) 10.0 5.0 6.9 8.7

Fiscal Accounts (% of GDP) ESA 95* fiscal balance -3.9 -4.5 4.3 -3.1 Revenue 38.3 36.9 45.5 37.5 Expenditure 42.2 41.4 41.2 40.6

Primary balance -1.1 -1.8 6.5 -0.9

External Accounts (USDbn) Exports 190.8 205.4 218.8 214.6Imports 197.5 202.7 219.0 214.8Trade balance -6.7 2.6 -0.2 -0.2 % of GDP -1.4 0.5 0.0 0.0

Current account balance -18.3 -7.8 -11.0 -9.9 % of GDP -3.7 -1.5 -2.2 -1.9

FDI (net) 5.3 0.1 6.3 5.9FX reserves (USD bn) 96.1 102.4 94.1 83.3PLN/USD (eop) 3.09 3.02 3.48 3.55PLN/EUR (eop) 4.08 4.15 4.00 3.90

Debt Indicators (% of GDP) Government debt 52.7 54.9 47.4 48.2 Domestic 36.1 37.1 29.2 29.3 External 16.6 17.8 18.2 18.9

Total external debt 71.1 72.0 77.9 79.9 in USD bn 348.7 369.9 390.7 411.8 Short-term (% of total) 24.9 24.8 25.0 24.9

General (YoY%) Industrial production 1.4 2.2 4.6 6.0Unemployment 12.8 12.9 11.8 11.0

Financial Markets (eop) Current 14Q2 14Q3 15Q1Policy rate 2.50 2.50 2.50 3.50PLN/EUR 4.17 4.09 4.05 3.98PLN/USD 3.02 3.41 3.43 3.49

Source: Haver Analytics, CEIC, DB Global Markets Research, NBP * Under ESA-95, the general government balance would improve in 2014 by the value of the assets transferred to ZUS from OFEs. Under ESA-2010, which comes into force in September 2014, this one-off transfer would not count as revenue any more.

10 April 2014



Russia Baa1(-)/BBB(neg)/BBB(neg) Moody’s/S&P/Fitch

Economic outlook: Growth to decline as a result of higher capital outflows

Main risks: Elevated geopolitical risks related to Ukraine, scale of sanctions against Russia

Geopolitical risks: first results

In March geopolitical risk became the dominant theme in Russia’s markets, with the incorporation of Crimea into Russia generating a rise in political tensions between Russia and the West. The main implications of greater geopolitical risk appear to be concentrated in increased capital outflows, which according to the CBR estimates have reached up to USD51bn in 1Q14. Meanwhile, further concerns came from the rating agencies with S&P and Fitch changing the outlook for Russia from ‘stable’ to ‘negative’ leaving the ratings unchanged, while Moody’s placed Russia's sovereign rating on review for downgrade.

Key economic indicators: unexpected revival In February Russia’s economy exhibited a relatively strong set of data. Russia’s industrial sector accelerated surprisingly in February: industrial production (IP) rose by 2.1% yoy, after -0.2% yoy in January. Filtering out the calendar and seasonal effects, IP expanded by 0.8% mom, after -1.0% mom in January. Across the key industrial sectors, the main driver of growth was manufacturing, which accelerated to 3.4% yoy, after zero growth in January. Mineral extraction added 0.8% yoy, after 0.9% yoy in January. The only industry exhibiting negative growth was gas/water/electricity supply and distribution, which slumped by 0.3% yoy, after a decline of 3.9% yoy in January. Other production indicators exhibited mixed performance: construction was down only -2.4% yoy after -5.4% yoy in January 2014 and -3.0% yoy in December; the transportation segment further added 0.7% yoy in February after 3.1% yoy in January and 2.5% yoy in December; and agriculture was up a marginal 0.8% yoy after 1.4% yoy in December.

On the consumer side, retail sales grew 4.1% yoy following 2.4% yoy in January 2014 and 3.8% yoy in December 2013, supported by an increase in real disposable income (1.0% yoy in February vs. -1.5% yoy in January and 1.5% yoy in December) and relatively high growth in real wages at 6.0% yoy in February after 2.5% yoy in January and 1.9% yoy in December. Unemployment remained at 5.6% as in the previous month.

Russia: Key economic indicators

-35%

-25%

-15%

-5%

5%

15%

25%

35%

2007 2008 2009 2010 2011 2012 2013 2014

% y

oy

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

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

Source: Rosstat, Deutsche Bank

Al in all, according to Economy Ministry estimates, Russia’s GDP grew 0.3% yoy in February from 0.1% yoy growth in January (lowered from 0.7% yoy). Although the figures point to acceleration in the growth rate, signs of stagnation persist. The Ministry of Economy expects growth at 0.8% yoy in 1Q14, significantly lower than potential.

Overall, the February data appears to be quite strong compared to January, although investment and construction continued to contract. We believe that the sharp decline in investment could be partially explained by the Sochi Olympics effect, with lower infrastructure spending in February 2014 compared to February 2013. Meanwhile, the effect of the Olympics on retail sales seems to have been rather moderate and lower than our expectations.

Federal budget surplus at RUB466bn in January On the fiscal front, according to the Ministry of Finance, the federal budget posted a 2M14 surplus of RUB30.48bn with revenues at RUB2,368bn (3.4% T12M GDP) and expenditure at RUB2,337bn (3.4% T12M GDP). Oil and non-oil revenues amounted to RUB1,233bn (52% of total) and RUB1,134bn, respectively. On a monthly basis in February the federal budget experienced a deficit of RUB435bn (-0.6% T12M GDP) with revenues at RUB1,034bn and expenditures at RUB1,479bn (2.2% T12M GDP) with almost 60% of revenues coming from hydrocarbon revenues.

10 April 2014



Russia: Federal budget implementation, T12M

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

18

19

20

21

22

Jan-

12Fe

b-12

Mar

-12

Apr

-12

May

-12

Jun-

12Ju

l-12

Aug

-12

Sep

-12

Oct

-12

Nov

-12

Dec

-12

Jan-

13Fe

b-13

Mar

-13

Apr

-13

May

-13

Jun-

13Ju

l-13

Aug

-13

Sep

-13

Oct

-13

Nov

-13

Dec

-13

Jan-

14Fe

b-14

% G

DP

% G

DP

Budget Revenues, % GDP Budget Expenditure, % GDPBudget Balance, % GDP (RHS)


Overall, the fiscal performance in February was in line with seasonal patterns, whereby expenditures are significantly increased after moderation in January. Given the depreciation of the ruble and the upward revision in the oil price projection by nearly USD10/bbl, we believe the budget may post a surplus this year of around 0.6% GDP. This compares with the official projection of a 0.5% GDP deficit, which is predicated on an oil price projection of USD98/bbl and a ruble exchange rate of RUB/USD33.4. The improvement of the budget projection for this year is due to the ruble exchange rate factor rather than any qualitative/structural improvements in the fiscal domain, with the non-oil budget deficit remaining high and close to 9.7% GDP this year.

Despite the substantial influx of additional revenues (authorities project it at RUB900bn as a result of a weaker ruble environment and thus higher inflation), the pressure on the budget is far from being assured, as new expenditure pressures mount. One of the additional expenditure items may be the financing of Crimea’s economy, which according to the estimates of Russia’s government officials may be as high as nearly RUB200bn. In particular, according to Russia’s Finance Minister the budget deficit of both Crimea and Sevastopol is estimated at around RUB55bn, with the rest of the allocation being mostly financing of the local infrastructure development needs.

Consumer prices accelerate to 6.9% yoy in March On the monetary front, Russia's CPI rose to 6.9% yoy after 6.2% yoy in February and 6.1% yoy in January. According to Rosstat, the main driver of the increase was faster food price growth (8.4% yoy in February after 6.7% yoy in February), while the pace of acceleration in non-food and services appeared to be more moderate – both up by 0.3ppt (non-food segment up by 4.6% yoy from 4.3% yoy in February and services segment up by 8.2% yoy after 7.9% yoy in February). Core CPI was up 0.4ppt to 6.0% yoy.

Russia: CPI and its key components

0%

5%

10%

15%

20%

25%

Jan-

07Ap

r-07

Jul-0

7O

ct-0

7Ja

n-08

Apr-0

8Ju

l-08

Oct

-08

Jan-

09Ap

r-09

Jul-0

9O

ct-0

9Ja

n-10

Apr-1

0Ju

l-10

Oct

-10

Jan-

11Ap

r-11

Jul-1

1O

ct-1

1Ja

n-12

Apr-1

2Ju

l-12

Oct

-12

Jan-

13Ap

r-13

Jul-1

3O

ct-1

3Ja

n-14

CPI, YoY, % Food, %, YoY Non-food, %, YoYServices, %, YoY Core CPI, %, YoY


The persistence of the exchange rate weakness in view of the significant pass-through from exchange rate to prices (which is asymmetric and is greater on the case of exchange rate weakness), which will likely drive inflation towards a higher-than-targeted CPI level (the CBR’s target for 2014 is 5.0% yoy).

CBR holds interest rates at elevated levels Given that the ruble was weak in March consequently acknowledging the risks for inflation, the CBR kept the key policy rate on hold at 7.00% after an ‘emergency’ hike implemented on 3 March. The tone of the statement was hawkish, with the CBR indicating that it would not lower the key rate in the next several months. Accordingly, the authorities reserve the possibility of using higher rates in case capital outflows intensify in the near term.

Russia: Key policy rate

fixed o/ncredit

1D fixed repo

RUB-legFX-swap

min-maxfixed 312P

1W auction repo

o/n fixeddepo

1W auctiondepo

key policy rate -1W auction repo/depo

CPI,% yoy

2.00

2.50

3.00

3.50

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

9.50

10.00

Dec

-10

Jan-

11Fe

b-11

Mar

-11

Apr-

11M

ay-1

1Ju

n-11

Jul-1

1Au

g-11

Sep-

11O

ct-1

1N

ov-1

1D

ec-1

1Ja

n-12

Feb-

12M

ar-1

2Ap

r-12

May

-12

Jun-

12Ju

l-12

Aug-

12Se

p-12

Oct

-12

Nov

-12

Dec

-12

Jan-

13Fe

b-13

Mar

-13

Apr-

13M

ay-1

3Ju

n-13

Jul-1

3Au

g-13

Sep-

13O

ct-1

3N

ov-1

3D

ec-1

3Ja

n-14

Feb-

14M

ar-1

4

(%)

Source: CBR, Rosstat, Bloomberg Finance LP, Deutsche Bank

In rationalizing its interest rate decision, the CBR pointed to considerable inflationary risks, which prompted the CBR to increase the interest rate on 3 March. According to the monetary authorities, current instability and the surge in volatility lead to elevated uncertainties over Russia’s economic growth prospects. Accordingly, given the need to prioritize stability in

10 April 2014



financial markets and the need to lower inflationary pressures, the CBR is not contemplating at this stage cuts in key rates in the coming months.

Regarding Russia’s growth prospects, the CBR notes that growth remains low amid economic uncertainties, declining profits in the real sector and tighter lending conditions. The monetary authorities continue to view the consumer sector as the major driver of the economy, which has been supported by high retail lending growth, but the sentiment is deteriorating as real wages are slowing. In addition, the global economic recovery is slow and it constrains the demand for exports from Russia and restrains domestic economic activities. Overall, according to the CBR estimates, growth remains below the potential rate.

The CBR estimates the impact of ruble depreciation on inflation as limited. At the same time, increased uncertainties accompanied by deteriorating sentiment in both producer and consumer segments could trigger a decline in fixed assets investment and a further slowdown in consumption. On balance, according to the CBR, lower-than-expected growth could partly offset the exchange rate pass-through to inflation. Still, the CBR emphasizes that the risks of inflation has been above the target so far this year.

Capital outflows intensify on concerns over sanctions On the external sector developments, current account surplus increased by 13.6% yoy to USD27.6bn in 1Q14 partly as a result of 7.1% yoy growth in the trade balance of goods, which amounted to USD51.4bn, while the services balance remained broadly unchanged vs. previous the year, at USD10.8bn. Meanwhile, the financial account experienced a widening of the deficit to USD48.6bn vs. USD12.6bn a year ago. The deficit soared on lower inflows of direct investments and loans into Russia, while financial institutions and the non-financial private sector bought assets to the tune of USD64.2bn, out of which USD20bn of foreign currency was purchased by the population. Consequently, higher spending of fx by Russian residents resulted in net private capital outflows of USD50.6bn in 1Q14 compared to USD27.5bn in 1Q13 and USD59.7bn in 2013 and USD53.9bn in 2012.

Apart from the effects on Russia’s economy emanating from capital outflows, there is also the effect of direct sanction from the West following the incorporation of Crimea into Russia. In the first round of these sanctions, the EU foreign ministers agreed to freeze assets and impose visa travel bans on 21 Russians and Crimeans, while the Obama administration put similar sanctions on seven Russian government officials and four Ukrainians (including ousted President Viktor Yanukovych).

The second round of sanctions came in the form of an increase in the number of sanctioned individuals. In the US version, to the group of seven Russian officials, another 13 people as well as an enterprise were added to OFAC's SDN list. According to Obama, the US authorities are “sanctioning a number of individuals with substantial resources and influence who provide material support to the Russian leadership, as well as a bank that provides material support to these individuals.” In the second round of EU sanctions the EU extended the sanctions list by freezing assets and banning travel of 12 more Russian and Crimean officials, whom the West perceives as people responsible for the seizure of Ukraine’s former region of Crimea by Russia. The EU had imposed its first sanctions on 17 March. The total number of Russian and Ukrainian officials facing EU sanctions now stands at 33, while the United States has sanctioned 20 officials.

Meanwhile, further concerns came from the rating agencies with S&P and Fitch changing the outlook for Russia from ‘stable’ to ‘negative’ leaving the ratings unchanged, while Moody’s placed Russia's sovereign rating on review for downgrade. In particular, Standard & Poor's Ratings Services lowered its outlook on Russia's ratings to negative citing elevated geopolitical risks and the prospects of economic sanctions from the West. S&P expects the European Union and US to impose further sanctions, noting that the lower outlook reflects "material and unanticipated economic and financial consequences" to such sanctions. In line with S&P, Fitch stated that the rating actions reflect the potential impact of sanctions on Russia's economy and business environment. According to the agency, foreign investors may anticipate further official action and restrict Russian entities' access to external financing.

Domestic politics: Putin’s popularity reaches record high in years With the escalation of tensions around Ukraine and the incorporation of Crimea, Putin’s popularity rating has increased from just above 60% several months ago to nearly 80% now. The latter is close to the all-time high popularity rating of President Putin, which in August 2008 (during the stand-off with Georgia) exceeded 80%. At the same time, if the conflict escalates further this may dent Putin’s political capital as well as over 80% of Russians according to the recent Levada-center poll are concerned about a military conflict between Russia and Ukraine.

10 April 2014



Russia: President Putin and PM Medvedev approval

ratings

45

50

55

60

65

70

75

80

85

90

95

2007 2008 2009 2010 2011 2012 2013 2014

Percentage of Putin supporters, % Percentage of Medvedev supporters, %

Source: Levada, Deutsche Bank

As regards the sanctions in the first half of March, more than 50% of Russians were concerned about the severity of the possible sanctions, while in the second half of the month this share declined to 36%, with 59% of the respondents noting that they were either not too concerned or not concerned at all about sanctions.

Russia: Political and economic sanctions concerns

0

5

10

15

2025

30

35

40

45

Very concerned Quite concerned Not much concerned

Not concerned at all

Are you concerned about possible economic sanctions of West imposed on Russia?

7-10 Mar 21-24 Mar

Source: Levada, Deutsche Bank

With political tensions rising again in eastern Ukraine in April, the key question at this stage is whether Russia opts to intervene militarily to support pro-Russian forces. Thus far, Russia has declared that it would not get involved militarily in the conflict in the eastern regions and our baseline scenario remains that no outright military intervention will take place, given the likely escalation of sanctions and domestic and political constraints. The immediate objective for Russia appears to be the attainment of guarantees on the non-membership of Ukraine in NATO as well as the federalization of Ukraine with greater autonomy granted to the largely Russian-speaking eastern parts of the country.


Russia: Deutsche Bank forecasts

2012 2013F 2014F 2015F

National Income

Nominal GDP (USDbn) 2 004 2 223 2 091 2 284

Population (m) 143 143.2 143.2 143.2


Real GDP (yoy %) 3.4 1.3 0.6 2.2


Govt consumption 0.0 -0.1 -0.5 0.1

Investment 6.0 -0.3 -3.6 2.1

Exports 1.8 3.8 2.2 2.6

Imports 8.7 5.9 3.4 3.2


CPI (YoY%) eop 6.6 6.5 5.5 5.4

CPI (YoY%) ann avg 5.1 6.8 6.2 4.9

Broad money 11.9 14.0 10.3 12.2

Credit 19.1 17.1 15.6 15.0


Federal budget balance -0.1 -0.6 0.6 0.3

Revenue 20.5 19.2 19.9 20.2

Expenditure 20.6 19.8 19.3 19.8

Primary surplus 0.5 0.0 1.2 1.0


Exports 529.1 521.6 512.7 524.4

Imports 335.8 344.3 314.6 337.5

Trade balance 193.3 177.3 198.1 186.9

% of GDP 9.6 8.0 9.4 8.2


% of GDP 3.7 1.5 2.3 1.7

FDI (net) 1.8 4.5 4.0 4.0


RUR/USD (eop) 30.5 32.9 35.6 35.2


Public debt 11.5 11.7 12.0 12.1

Domestic 8.0 8.1 8.6 8.7

External 3.5 3.6 3.4 3.4


in USDbn 636.4 732.1 763.2 832.7

General (% pavg)

Industrial production (% yoy) 2.6 0.0 -1.2 1.6

Unemployment 5.7 5.5 6.0 6.3


Policy rate 7.00 6.50 6.00 6.00

RUB/USD 35.80 36.80 36.60 35.00 Source: Official statistics, Deutsche Bank Global Markets Research

10 April 2014



South Africa Baa1 (negative)/BBB (negative)/BBB (stable) Moody’s/S&P/Fitch

Economic outlook: South Africa’s rebalancing is well underway, as much weaker domestic demand is emerging, with positive repercussions for the current account deficit. We see this trend continuing, and as such, remain constructive on the exchange over the medium term.

Main Risks: The US economic data docket will become more important for the domestic economy over the next quarter, given the significant improvement in foreign portfolio inflows. A recoil in the rand exchange rate (DBe 11.5/USD in Q2) on stronger US data prints may provide the SARB the opportunity to hike again. However, the reluctance to do so is reinforced by the downside risks to growth.

South Africa Marketing Perspectives

We concluded a series of roadshows at the end of March, which comprised meetings with local institutions, UK accounts (mostly fixed income) and a couple of domestic trips for offshore clients. In summary, local clients were broadly underweight bonds with some reducing this position opportunistically favouring the back-end. Offshore clients were neutral bonds to slightly underweight in very light positioning. Over the course of the quarter, the political/policy backdrop in Russia and Turkey have left South Africa comparatively better off, but overall flows in EM fixed income have been fairly light. In equities, banks and retailers have fallen out of favour among the locals, but provided buying opportunities for offshore players. Resources saw some interest from locals after a dismal year in 2013. We summarize some of the key take-aways below before unpacking them in more detail.

Both local and foreign investors were concerned over softening domestic growth fundamentals. There was much pushback on DB’s bullish house view on China (notwithstanding recent downward revisions) in particular, as well as the US economy (though to a lesser extent from foreign accounts).

This left most clients skeptical over the degree of compression we foresee in the current account deficit this year, as from an export perspective, growth is likely to be slower than we predict. Despite recent improvements in the trade numbers, most accounts viewed price insensitivity of imports and higher oil requirements as a significant hurdle for CAD compression.

The resilience of the exchange rate was widely in question, especially following the sell-off in

January. Locals were more bearish ZAR over short-to medium term questioning especially our 2015 year-end call of 9.30/USD. In turn, offshore accounts saw value in the exchange rate but were concerned over another bout of weakness. Most agreed, however that the currency could undershoot if our call on the CAD turns out. Short-term catalysts for another sell-off ranged from US related factors (i.e. rising inflation pressure, stronger growth, and earlier than expected Fed tightening) to the response as a result of inaction by the SARB at the March MPC meeting.

Concerns over sovereign downgrades featured in discussions, though slightly less than before. Some clients felt that the credit was deteriorating compared to other EM’s on the back of perennial drift in domestic policy and reform, deteriorating labour conditions, and stubbornly high government debt.

On the rate cycle, views on the timing and quantum of the hiking cycle were mixed, even though the market has displayed a clear bias. We sensed increasing uncertainty among clients regarding the clarity of policy signals from the SARB – though this was rectified to some extent at the last MPC meeting.

Inflation is mostly seen as contained around 6% of the target band, though a few local and offshore accounts expected fx pass through to lead inflation at or above 7% by year-end.

South Africa: Rate expectations have fallen since Jan

5

5.5

6

6.5

7

7.5

8

8.5

DB expectationsFRA strip Jan 29Comparative FRA strip current

%

Source: Deutsche Bank, Bloomberg Finance LP

10 April 2014



The domestic economic recovery is faltering, but consensus expectations vary regarding export drivers and import sensitivity. We forecast a weak domestic economy this year, with demand growth slowing to 1.5% (from 2.2%), which we believe will be a significant drag on import growth (1% yoy in 2014 from 7.1% in 2013). Given this outlook and a more favourable exports vista (thanks to improving global growth) net exports will be one of the main growth drivers in 2014. Should export growth surprise to the downside, which seems to be the consensus view, GDP growth settle at an even weaker 2.2%, below consensus (at 2.5%) and the SARB (at 2.8%).

South Africa: GDE slowed down sharply end-2013 and

should drag imports lower with a lag

-30

-20

-10

0

10

20

30

40

-6

-4

-2

0

2

4

6

8

10

12

1994 1997 2000 2003 2006 2009 2012

yoy %

Real GDE Real imports (RHS)

DBe

Source: Deutsche Bank, SARB

Clients see domestic supply, infrastructure constraints and less exuberant global growth forecasts as the main risk to our export view. The responsiveness of SA exports to a DM recovery is also questioned. Though there may be some growth, the dominance of minerals in the domestic export basket coupled with the negative view on China is seen as overbearing. In turn, imports are also in much debate, but consensus generally views the price inelastic infrastructure component of imports as a hurdle to lower import growth. We think this view is overdone as capex spending appear to be at or nearing their growth peak. The latest trade data also puts to question the degree to which Eskom’s import fuel requirement for powering its gas turbines poses a threat to the outlook.

For these reasons our view on the CAD (DBe -4% in 2014 from -5.8% in 2013) has been a tough sell. However, by following a different approach, which rests on income and expenditure gaps, we have removed some of the uncertainty with regards to the trends in trade. By definition, a compression in the income/expenditure gap will lead to a lower trade deficit. The current weakness in expenditure growth is

thus an essential part of this rebalancing process, which we believe continues during the course of the year – and potentially even more rapidly than we currently predict.

As such, the rand’s resilience has taken many by surprise, but thanks to deteriorating dynamics in Turkey and Russia, the return of equity and bond inflows of late have been rand supportive. Our UK clients believe that the rand’s strength has also been partly driven by an unwind of hedging transactions, and the repatriation of local asset managers’ offshore assets that are in breach of the 30% investment threshold. There has thus been very little pushback on our view that the currency could reverse current strength in Q2, with improving US economic data and inflation prints likely to be key catalysts for the reversal. The correlation between US negative data surprises and the return of capital inflows is not coincidental (Figure below). However, whether the rand tests previous lows remains to be seen, and could be dictated by the SARB’s responsiveness to further exchange rate pressure, the strength of domestic trade data and an end to the strike in the mining sector. Most investors we saw abroad were less concerned over election risk than we thought, and believed that the emergence of the EFF is a positive development that could refocus the ANC on policy deliverables.

South Africa: Portfolio inflows could reverse if US data

surprises to the upside in months ahead

-60

-40

-20

0

20

40-90

-60

-30

0

30

60

90

2012-Jun 2012-Dec 2013-Jun 2013-Dec

Rbn (2m cum sum)

Citi Surprise Index - USNet foreign portfolio flows (RHS - inverted)

Index

Source: Deutsche Bank, Bloomberg Finance LP

Downgrade risks were raised by several clients (both on and offshore), citing deteriorating government debt, concerns over heady fiscal revenue targets, lingering labour tension, weaker capital flows and slow reform as main reasons for weakness in the credit relative to its peers. However, timing is uncertain and would depend on the extent of negative developments ahead of 13 June when S&P, in particular, decides on the

10 April 2014



credit outlook7. S&P and Moody’s have the credit on negative outlook for nearly two years now. Moody’s however, is not restricted by regulatory procedures whereby the date of such an announcement has been fixed. If a downgrade was to ensue, most clients mentioned that it could be a non-event given the recent experience in Brazil, and the fact that the market is currently pricing this credit risk.

In recent interactions with S&P, external vulnerability, underperformance in economic growth and the subsequent knock-on to fiscal finances, and lingering labour disputes were raised as the key risks that are still worrying. On the first issue, however, the S&P acknowledges the recent improvement in the current account deficit, stating that it could mark the inflection point of recovery. However there is still much uncertainty in this regard. South Africa remains particularly vulnerable from a capital flow perspective and has displayed significant sensitivity to the Fed’s tapering announcements. Of the countries S&P monitor, South Africa ranks 8th in the capital outflow vulnerability rankings. For these reasons, the risk of a downgrade is not negligible, however, we do not think these issues will weaken the sovereign sufficient to warrant downgrade to BBB-. The market’s reaction to the elections, the new post election cabinet, and the lingering strike issues at the mines will have to be closely monitored within the next six months.

The 2014 rebasing and benchmarking exercise could be an important event for South Africa – perhaps not as significant as the recent Nigerian experience though. But we believe there is reasonable scope for some upward revision to GDP when the SARB and Stats SA conducts the five-yearly rebasing and benchmarking exercise later this year8. Historically, real growth has been revised by between 0.3% and 0.5% on average, which could raise growth from 1.9% between 2009 and 2013 to 2.3%. These revisions may be small in size, but along with the refinement of balance of payments data that is already underway, could be quite meaningful. BoP data refinement will probably also address the gaping unrecorded transactions line which rose to R119bn in 2013. As such, there is a definite risk that retrospectively, the economy and external vulnerabilities may not be as weak as they currently appear.

7 Fitch is also publishing its outlook on this day, but there is limited risk to any ratings action given the stable outlook on the credit. 8 Some of the changes are the new recording of pension schemes, inclusion of employee stock options in employee compensation, cost of capital services, research and experimental development, military expenditure and goods for processing, some of which could have a significant impact on the GDP.

South Africa: Historical revisions to GDP growth from

rebasing and benchmarking exercises

-2

-1

0

1

2

3

4

5

6

7

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

1990 1995 2000 2005 2010*

* Based on historical average revision

Real growth

Source: Deutsche Bank, StatsSA

Data revisions may throw a spanner in the works for credit ratings given downward pressure. If the adjustments lead to higher nominal GDP for example, debt and current account ratios will change. For example, a one percentage point increase in nominal GDP growth, if sustained, could knock off around 4% on the government debt ratio for a given level of fiscal deficit. Though this may be an exaggeration, the Treasury’s revenue assumptions which reflect an increase in the tax multiplier may look more credible in the event that nominal GDP has been underestimated. These issues may not necessarily pose a game changer for the market, given the long-term structural issues dogging South Africa, but it could reinforce the current constructive stance clients have on the market in the short- to medium term.

Finally, the discussions on monetary policy were robust. We hold the view that the SARB’s reluctance to hike is a function of the weak economy, which renders the exchange rate the main trigger to further tightening. Our sense is that the total cycle will come to around 200-250 basis points, and the majority clients side with our view. However, there is a clear discrepancy in the expectations between fast and real money funds. The former believes the exchange rate will force further rate hikes, given the pressure on emerging markets to increase real rates, while the majority of real money funds agree with the weakness in growth argument. There is thus very little pushback on our view that the current cycle could evolve in two distinct phases, the first being dependent on currency movements (which could even fall away if the rand remains resilient) and the second marks the reversal of the ultra loose monetary policy stance. A minority of offshore funds however see the SARB as behind the curve.

10 April 2014



Clients mostly see inflation as contained around 6% of the target band, though a few local and offshore accounts expected fx pass through to lead inflation at or above 7% by year-end. Recent revisions to DB’s oil price forecasts have resulted in our inflation forecasts shifting up by 0.3% points to 6.2% in 2014, providing a higher base for 2015, and a subsequently lower reading of 5.4% (previously 5.6%). As a result of higher oil prices and the envisaged exchange rate path in Q2 (DBe 11.50 eop), now adds a distinct short-term peak of 6.6% to our profile. This is mostly on account of the very low base effects around May and June last year when fuel prices came down dramatically, and food prices were broadly stagnant.

Danelee Masia, South Africa, 27 11 775-7267

South Africa: Deutsche Bank Forecasts 2012 2013F 2014F 2015F

National Income

Nominal GDP (USD bn) 383.3 349.5 331.4 413.9Population (mn) 52.3 53.0 53.5 54.0GDP per capita (USD) 7331 6596 6193 7658 Real GDP (%) 2.5 1.9 2.7 3.5 Priv. consumption 3.5 2.6 2.0 2.8 Gov’t consumption 4.0 2.4 1.8 2.8 Gross capital formation 4.4 4.7 3.8 4 Exports 0.5 4.3 6.0 6.3 Imports 6.2 7.1 1.0 2.7


CPI (YoY%, eop) 5.7 5.4 6.3 5.3CPI (YoY %, pavg) 5.7 5.8 6.2 5.4 Fiscal Accounts (% of GDP) 1, 2

Budget balance -4.2 -4.1 -4.0 -3.5 Revenue 32.5 32.8 32.6 32.0 Expenditure 28.3 28.7 28.6 28.5Primary balance -1.3 -1.0 -0.9 -0.4


Exports 99.5 94.6 88.7 106.4Imports 104.3 102.4 92.6 111.6Trade balance -4.8 -7.8 -3.9 -5.2 % of GDP -1.3 -2.2 -1.2 -1.3Current account balance -20.1 -20.9 -13.1 -16.1 % of GDP -5.2 -6.0 -4.0 -3.9FDI (net) 0.4 1.1 0.8 0.8FX reserves (USD bn) 50.7 49.0 51.0 55ZAR/USD (eop) 8.5 10.1 10.5 9.3ZAR/EUR (eop) 11.2 13.2 13.1 10.2


Government debt 1 42.5 44.8 46.5 47.5

Domestic 38.6 40.5 42.8 43.7

External 3.9 4.3 3.7 3.8


in USD bn 142.3 130.0 135.0 145

Financial Markets (eop) Current 14Q2 14Q3 15Q1

Policy rate 5.5 5.5 6.0 6.03-month Jibar 5.6 5.9 6.2 6.310-year bond yield 8.2 8.9 9 8.8ZAR/USD 10.4 11.5 11.0 10.2ZAR/EUR 15.1 15.2 14.9 12.4(1) Fiscal years starting 1 April. (2) Starting with the November EM Monthly, numbers are presented using National Treasury’s new format for the consolidated government account. Source: Deutsche Bank, National Sources.

10 April 2014



Turkey Baa3 (stable)/BB+ (negative)/BBB- (stable) Moody’s / S&P / Fitch

Economic outlook: growth has been more resilient than expected but is expected to decelerate over the next quarter or two in response to earlier tightening measures. Inflation has accelerated further and will likely average over 8% this year, notwithstanding the recent rebound in the lira.

Main risks: while local elections are now out of the way, the political environment may remain volatile in the build up to Presidential elections in August. Growth could surprise to the upside given the stronger than anticipated start to the year, especially if quantitative easing by the ECB gives the CBT room to ease monetary conditions. But this could bring the current account deficit back into the spotlight.

Easing Bias

It has been a good month for the AK Party and for Turkish asset markets. The AKP secured a relatively convincing victory in local elections on March 30. Asset markets rallied strongly across the board (chart). In the meantime, the economy has remained resilient despite the headwinds facing it. GDP growth again exceeded 4% in the final quarter of last year, bringing growth for the year as a whole to 4.0%. If anything, industrial production through February is consistent with a further pickup in growth this quarter.

Turkish asset markets rally (changes since March 12)

-100

-80

-60

-40

-20

00

2

4

6

8

10

12

14

16

18

USDTRY BIST40 5Y Swap Credit spreads

CDS

% bps

left hand scale right hand scale


We still think the economy will slow in the next two quarters as recent monetary tightening begins to bite. But we acknowledge that the risks to our full-year growth forecast of 2.2% have probably now shifted to the upside. Inflation, however, accelerated to over 8%

last month. Nevertheless, we think that having seen markets stabilize following its emergency rate hike in late-January, the Central Bank of Turkey (CBT) now has an easing bias. We discuss these issues in a little more detail below.

AKP “Wins” Local Elections Although the final results have not yet been confirmed, preliminary results indicate that the AKP won 45% of the national vote and retained control of Istanbul and Ankara, though the latter was closely contested. The main opposition Republican People’s Party (CHP) won 28% of the vote, followed by the conservative National Movement Party (MHP) at 15%, and the Kurdish Peace and Democracy Party (BDP) with 4%. Opposition calls for a recount in Ankara have been rejected by the election board.

Assuming these results are confirmed, the AKP share of the vote is thus only a little below the 49% it secured in the general election in 2011 and well above the 38% it registered in local polls in 2009. We think this is likely to pave the way for Prime Minister Erdoğan to run for the Presidency in August. The recovery in Turkish asset markets in the last few weeks was part of a broader emerging market rally but probably also reflects a belief among investors that politics has in some sense returned to business as usual. We think this may be premature and caution that the political environment may well remain volatile in the build up to the Presidential poll this summer.

Inflation still accelerating Inflation surprised to the upside again last month, accelerated to 8.4% from 7.9% in February. This was also above the upper end of the forecast range in the CBT’s own inflation profile. Core inflation also jumped to 9.3% in March from 8.4% a month earlier.

Notwithstanding the recent rally in the lira, there is probably still some further inflation pressure in the pipeline from the earlier period of lira weakness, which feeds through only with a lag. Base effects also turn less favorable next month and, especially, in May. In the absence of a surprise drop in food prices, therefore, we would expect the headline rate to peak at well over 9% in May. Normally, we would also have revised up our end-year inflation forecast on the back of today’s print. But the recent rally in the lira, which has appreciated by 5% in the last four weeks, should help to temper pressure on inflation. We have revised our end-year lira (USDTRY) forecast to 2.15 from 2.25 but leave our inflation forecast unchanged at 8.6%.

10 April 2014



Lira begins to correct

80

90

100

110

120

130

140

Dec 04 Dec 06 Dec 08 Dec 10 Dec 12 Dec 14

Fair value Actual

REER (2003=100)

This is the measure of fair value presented by the CBT, which assumes that the exchange rate was in equilibrium in 2003 and that the equilibrium rate has since appreciated by 1.75% a year since then.

Source: Haver Analytics, CBRT, Deutsche Bank

Easing bias The CBT kept rates on hold as expected last month but signaled that it was considering paying interest on local currency reserve requirements. We would view the latter as an easing measure: paying interest on reserves should in theory reduce the spread between deposit and lending rates, which can help to ease domestic credit conditions without necessarily deterring capital inflows. Governor Basci confirmed this in a meeting with investors in London earlier this month, indicating that the CBT would consider gradual easing of macroprudential measures if credit growth slowed much further.

Notwithstanding recent lobbying by Prime Minister Erdoğan, we think cuts in policy rates are unlikely at this stage. The CBT could increase its liquidity provision and allow market rates to drift downwards within its rate corridor, perhaps next quarter after a period of lira stability and once inflation has peaked. Only then would cuts in policy rate be back on the table. At this stage, we stick with our view that policy rates will be unchanged at 10% for the remainder of the year. This is largely because we think that, in the second half of the year, inflation will be stickier than the CBT anticipate and markets will begin to focus more squarely on the timing of the first Fed rate hike. Against this backdrop, it would be difficult for the CBT to cut rates without precipitating another selloff in the lira. One thing that could change this equation, however, would be quantitative easing by the ECB, which might give the CBT the breathing room it would need to cut rates.

Robert Burgess, London, +44 20 7547 1930

Turkey: Deutsche Bank Forecasts

2012 2013E 2014F 2015F

National Income

Nominal GDP (USD bn) 788.6 820.0 780.4 844.9

Population (mn) 74.9 75.8 76.8 77.8


Real GDP (%) 2.1 4.0 2.2 3.8

Priv. consumption -0.5 4.6 0.3 2.7

Gov’t consumption 6.1 5.9 5.0 4.0

Gross capital formation -2.7 4.3 0.2 3.2

Exports 16.3 0.1 6.5 7.4

Imports -0.4 8.5 1.1 4.4


CPI (YoY%, eop) 6.2 7.4 8.6 7.2

CPI (YoY %, pavg) 8.9 7.5 8.3 7.3

Broad money (YoY%) 12.9 22.8 10.6 11.4

Bank credit (YoY%) 18.5 33.3 15.5 18.2


Consolidated budget -1.9 -2.1 -2.6 -2.6

Interest payments 2.8 2.7 2.6 2.5

Primary balance 0.9 0.6 0.0 -0.1

External Accounts (USDbn) bn)

Exports 163.2 163.4 175.4 185.1

Imports 228.6 243.2 237.9 250.3

Trade balance -65.3 -79.9 -62.5 -65.2

% of GDP -8.3 -9.7 -8.0 -7.7

Current account balance -48.5 -64.9 -44.9 -46.4

% of GDP -6.1 -7.9 -5.7 -5.5

FDI 9.2 9.8 7.4 10.4

FX reserves 99.9 110.9 115.0 120.0

TRY/USD (eop) 1.79 2.14 2.15 2.39



Domestic 25.4 25.1 24.7 23.8

External 10.8 10.3 10.0 10.0


in USD bn 338.3 388.2 408.3 427.6

Short term (% of total) 29.7 33.3 31.6 30.0

General (%)

Industrial production (YoY) 2.5 3.4 2.1 3.7

Unemployment (pavg) 9.2 9.7 9.9 9.8

Financial Markets (eop) Current 14Q2 14Q3M

15Q1M Repo rate 10.0 10.0 10.0 10.0

Overnight lending rate 12.0 12.0 12.0 12.0

Effective funding rate 10.2 10.2 10.1 10.0

10-year bond yield 9.9 10.3 10.5 10.1

TRY/USD 2.12 2.25 2.20 2.22 Source: Deutsche Bank, National Sources.

10 April 2014



Ukraine Caa3(negative)/CCC(negative)/CCC(negative) Moody’s/S&P/Fitch

Economic Outlook: Political turmoil continues; refinancing risks escalate; growth headwinds persist.

Main Risks: A weak external position could be exacerbated by political uncertainty.

Political turmoil leads to economic uncertainty

Political uncertainty continues in Ukraine, making advances towards addressing the economic challenges faced by the country increasingly difficult. In particular, unrest in eastern Ukraine (which is one of the main contributors to the country’s GDP and tax proceeds) is notably hampering economic normalization. The issue of gas transit and supplies has not been resolved with the failure of Ukraine to reach a deal on the reverse gas supplies from the West; while Russia increased the gas prices for the country to USD485/mcm following the cancelation of the treaty on Russia’s Black sea fleet. This followed the previous price hike on 1 April, when the price Ukraine paid for Russian gas went up by 44 percent to USD385/mcm, after Kiev failed to meet its debt obligations.

Following the continuing political turmoil in the country and deepening economic instability, Moody's downgraded Ukraine's sovereign rating by one more notch from Caa2 to Caa3, i.e. from "extremely speculative" rating to "default imminent with little prospect for recovery." Apart from the political events, Moody’s noted that the agency expects a significant contraction of GDP and sizeable currency depreciation, with the public debt level reaching 55-60% GDP by year end.

Some respite in the short term is going to come from a preliminary deal with international lenders led by the IMF to unlock USD27bn (c.18% GDP) of financial support late last month with USD14-18bn of that coming from the IMF’s standby program for the country. The requirements to obtain the support followed much the same blueprint that the IMF has been advocating in Ukraine for a number of years, namely a flexible exchange rate, fiscal adjustment including significantly higher domestic gas tariffs, and governance reforms to improve transparency and reduce corruption. The IMF will likely include a floor on foreign reserves in the program to limit the ability of the NBU to support the hyrvnia. Exchange controls will likely be unwound. The fiscal adjustment envisaged under the program is quite large. The Fund notes that the overall deficit (including Naftogaz) would hit 10% of

GDP this year in the absence of policy action. The aim is to reduce the deficit to 2.5% of GDP by 2016. Domestic gas tariffs would be increased to full cost recovery levels. The government has already announced increases of 40-50%, which is a good start, though this would be a long process given the size of the gap. Social safety nets would be strengthened to mitigate the impact on low income groups. The program will be considered by the IMF Executive Board at some point this month after the government has implemented whatever prior actions have been agreed, increases in domestic gas tariffs likely being one element of that.

As regards the economy, political tensions have in effect accentuated the macroeconomic imbalances characterized by high fiscal and CA deficits as well as low growth and meager reserves. In particular, in the real sector activity continued to deteriorate in February, with industrial production down by 3.7% yoy in February of 2014, continuing the decline witnessed in 2013. Agriculture posted growth of 6.3%, while construction registered another 9% yoy decline in February with fixed assets investments ending 2013 down -11.1% yoy in 4Q13. On the consumer side, retail sales showed growth of 5.7% yoy in January-February 2014 after 5.2% yoy in January. The growth in retail spending took place despite the slowdown in real incomes growth – real average wage growth was 3.6% yoy vs. the 4.6% yoy witnessed in January 2014. The acting authorities warn that in 2014 the economy could shrink by 3% yoy, while inflation could hit up to 14% yoy.

In terms of monetary conditions, consumer prices accelerated their growth in March to 2.2% mom from 0.6% mom in February. As a result, on a yoy basis, consumer prices accelerated to 3.4% yoy after 1.2% yoy in February and 0.5% yoy in January. Meanwhile, producer prices grew 3.9% yoy in March following 3.3% yoy in February and 1.9% yoy in January. The money supply continued to exhibit high growth rates – 18.4% yoy in February after 14.4% yoy in January and 17.6% yoy in December. The key concern on the inflation front is the sizeable depreciation of the Hryvnia.

Weak credit conditions and large-scale conversions of savings of the population into hard currency led to sizeable Hryvnia devaluation. After stabilization vs. the dollar in the beginning of March due to the suspension of fx withdrawals, by mid-March the Hryvnia started to depreciate vs. the dollar from USD/UAH9.2 to USD/UAH11.8 by 8 April. The latter took place despite

10 April 2014



capital controls on fx withdrawals and capital transfers out of the country (introduced on 28 March).

Regarding Ukraine’s external sector performance, the trade balance ended February with a deficit of USD559m and on a yoy basis the deficit widened by as much as 16% yoy as a result of a 7% yoy fall in exports to USD4.9bn and 22% yoy decline in imports to USD5.4bn. The CA deficit in February widened by 20% yoy to USD121m. Meanwhile the country’s reserves continued to decline quickly, down in March to an eight-month low of USD15bn, vs. USD17.8bn at the end of January.

On the political front, the main focus is now on the upcoming presidential elections to be held on 25 May and the unrest in eastern parts of the country. With respect to the presidential race, twenty-four candidates have registered for presidential election. A recent poll conducted jointly by key Ukrainian sociological institutions (SOCIS, KMIS, Rating, Razumkov Center) show Petr Poroshenko, leader of Solidarnost Party, leading the candidate list (24.9% of respondents/36.2% respondents who decided for whom to vote). He is also a Rada deputy, former economy minister, foreign affairs minister and No.7 in Forbes list of the richest Ukrainians (USD1.6bn). Udar party’s Vitaly Klitchko (8.9%/12.9%) was the second most popular candidate, but he has withdrawn from the presidential race in favor of Poroshenko. Batkivschina leader Yulia Timoshenko (8.2%/12%) ranked third by popularity.

In the beginning of April, clashes broke out between pro-Russian and pro-government forces in eastern provinces of Ukraine, namely Lugansk, Donetsk and Kharkiv. In Donetsk the pro-Russian forces convened a Congress of Donbass which ruled for the creation of an independent Donbass republic and set the date of the referendum on the region's incorporation into Russia for 11 May. The reports on the developments in eastern Ukraine were accompanied by statements from Ukraine's PM Yatseniuk on the concentration of Russia's military forces at the border with eastern Ukraine and Russia's plans to stoke unrest in the region. At this stage, our view is that the pro-Russian forces in eastern parts of Ukraine will press for greater federalization and autonomy, with Russia refraining from outright military intervention.


Ukraine: Deutsche Bank forecasts

2012 2013F 2014F 2015F

National Income

Nominal GDP (USDbn) 176.1 175.5 174.0 189.3

Population (m) 45.3 45.1 45.0 45.0


Real GDP (yoy %) 0.2 0.0 -4.9 2.5

Priv. consumption 11.7 6.5 -3.3 4.8

Govt consumption 2.2 2.3 -5.3 1.5

Investment 0.9 -5.4 -8.2 2.5

Exports -7.7 -6.5 -2.8 2.8

Imports 1.9 1.2 2.4 6.6


CPI (YoY%) ann avg 0.5 -0.3 4.3 6.1

Broad money 12.0 17.6 16.0 14.0

Credit 1.7 11.7 8.0 10.0


State budget balance -2.5 -4.5 -2.5 -2.2

Revenue 23.5 24.2 22.8 22.6

Expenditure 26.0 28.7 25.3 24.8


Exports 70.2 64.9 66.2 68.4

Imports 89.7 84.5 82.3 80.1

Trade balance -19.5 -19.6 -16.1 -11.7

% of GDP -11.1 -11.2 -9.3 -6.2


% of GDP -8.2 -9.2 -5.9 -4.3

FDI (net) 6.6 4.3 4.5 4.2


UAH/USD (eop) 8.1 8.4 9.7 10.2


Government debt 28.4 36.7 52.0 62.0 Domestic 14.8 14.7 17.7 20.8 External 22.0 22.0 34.3 41.2 Total external debt 75.5 79.8 88.0 93.0 in USDbn 133.0 140.0 151.0 173.1

General (% pavg)

Industrial production (%) YoY)

-1.8 -4.7 -5.8 -3.2



Policy rate (refinancing rate)

6.50 6.50 6.50 6.50

UAH/USD 11.8 9.55 9.70 9.90 Source: Official statistics, Deutsche Bank Global Markets Research

10 April 2014



Argentina Caa1(stable)/CCC+ (negative)/CC(stable) Moodys /S&P/ /Fitch

Economic outlook: After the January devaluation and rate hikes, authorities are now trying to moderate fiscal deficit and monetary financing, bringing new hopes of an improved outlook. The authorities’ conviction to do what it takes to find a new nominal equilibrium remains a question mark, though. Stricter capital and trade controls might gain some time, but the adjustment mechanism will inevitably result in a recession and a challenging political and social climate ahead.

Main risks: Overconfidence, lack of an effective adjustment, and further depletion of international reserves are the main short-term risks. Continued exchange rate controls and across-the-board state intervention are still blocking any potential recovery. A recession with high inflation will test the government political will to continue the adjustment process. A negative US Supreme Court take on the final holdout ruling could trigger a default on international debt, although the case seems far from being clear cut

Adjusting, but with dubious conviction

Further adjustment announced After deciding to introduce a number of measures that were totally unacceptable by the same authorities in the past, such as devaluation and interest rate hikes, the government continues to accommodate its policy to a difficult reality. The most important announcement in the last few weeks was a revision in the energy and transportation subsidies. In addition, the authorities seemed to have accepted the need to moderate the Central Bank financing of the public sector deficit. These two new initiatives are certainly key to start addressing the inflationary phenomenon in the country. However, the question remains whether the government has the necessary conviction to do what it takes to achieve a new nominal equilibrium.

The Minister of Finance and the Minister of Planning announced two weeks ago the government's plan to start reducing subsidies for water and gas provision initially, and electricity later on. The announcement could be in principle summarized by a planned 20% cut in the total bill in water and gas subsidies to proceed in three stages, during April, June, and August, and the reallocation of part of these resources to social transfers. According to the final decree issued early this week, this could result in increases of up to 500% in household bills in the coming months. This notwithstanding, the final impact of the measure remains still to be quantified. First, the government has announced quite a few exceptions, such as excluding

the whole Patagonia, representing almost one-third of the country´s utility demand, specially in energy. It also introduced the ability to avoid the subsidy correction for users saving 20% from current high consumption levels. Second, it is not clear what cost base the authorities are taking into account, as the recent peso slide increased the cost of providing tradeable energy supply significantly (some 40%-70% depending on the sector). Third, part of the extra revenues are going to be re-routed for social programs. On top of that, inflation is running at 35% annually, making the final effect on the fiscal accounts dependent on too many variables. This notwithstanding, there is certainly a positive element to highlight: the government´s decision to explain why subsidies are no longer needed, bringing some hope that they will eventually be truly determined to scrap them in order to save the fiscal accounts.

Subsidies in 2013 amounted to 5.0% of GDP, and the devaluation increased that bill by almost 50% in nominal terms. The announced adjustment is in principle aimed at saving no more than 1% of GDP. So far the government has announced measures for gas and water and has anticipated a similar decision for energy supply. Transportation subsidies, the other major item in the subsidy bill, have not yet been mentioned. Although we could see some positive surprises given the new utility prices announced, a conservative estimate should forecast the level of subsidies to go back to the situation early last year, still representing at best 4.6% of fiscal outlays.

Furthermore, fiscal performance in February was not exactly encouraging, confirming a deteriorating trend in the government´s accounts. The January-February result shows a 36% YoY increase in total revenues (with and without rents from the social security ANSES and/or the Central Bank), compared with a 44.5% increase in primary current expenditure. Based on this behavior in current income and expenditure, the accumulated primary balance in January-February reached a deficit of ARS4.9bn compared with a surplus of ARS1.1bn last year. Additionally, excluding rents from ANSES and the Central Bank, the widening gap this year would have been ARS2.0bn higher. Excluding these non-traditional resources, the total fiscal deficit for the first two months of the year amounted ARS17.0bn, or more than ARS10bn above the same figure last year, or some 0.3% of annual GDP.

Another important development was the searching for additional sources of financing for public sector deficit. It appears that the Central Bank is trying to limit its financing to the government for an average of

10 April 2014



ARS10bn a month, or similar to last year’s financing. In order to fulfill the financing needs, the government has started to issue local debt directly to the markets. On March 25, the government announced the issuance of a new 2017 peso floater linked to private sector deposit rate (Badlar) for up to ARS10bn. Two days later, the Ministry of Finance reported the issue of ARS5.54bn nominal of these bonds yielding private sector Badlar rate plus 200 bps. Such financing is certainly a small help compared to what is needed, but represents the first step in the right direction. It also helps to better price the government credit risks in the current conjuncture, hopefully introducing a better incentive scheme.

New efforts to achieve a restructuring deal with the Paris Club are also associated with this new emphasis to find alternative financing sources. A couple of weeks ago the Paris Club agreed to start negotiations on May 26. The local press took this news with great optimism, but we would rather keep a more cautious stance. In our view, the Paris Club has not yet accepted Argentina's proposal, but Argentina's goodwill to get this resolved. According to press reports, Argentina has offered 5 annual installments to pay the full debt, but this payment horizon could be shorter if European companies were to bring fresh investment in hard currency. The offer apparently also includes a USD2.0bn upfront payment. Although this offer finally eliminates prior conditionality requested by Argentina (committing fresh money in this process has been unacceptable for the Paris Club), this proposal is still far from the standard practice of the Paris Club, where a full renegotiation with a new payment program audited by the IMF is the norm. At the end, the Paris Club could accept some flexibility. Nevertheless, such a compromise is yet far from guaranteed and might not provide additional financing anytime soon. As noted before, President CFK might be seeking to have a finished legacy on the debt matter and this is good news. But accepting IMF auditing, even regular annual surveillance (as known by Article IV consultation), might be too much of a political cost for the President to pay. This probably explains the government’s willingness to pay the Paris Club even without getting much in return in the immediate future.

Related to the above, during the past weekend there were a number of news reports on the potential reopening of Argentina's external financing sources. Despite some improvement in policy-making and some blessing from international agencies, we still believe that Argentina is not yet ready to access markets, in particular at a reasonable or acceptable price for the authorities. However, some elaboration on the information being reported is worth noting.

The list of financing news started with the quasi official newspaper Pagina 12 reporting that the Central Bank had signed a deal with Goldman Sachs (GS) for a

USD1.0bn loan. This line has a 6.5% cost, which sounds reasonable and credible. Later during the same day, the Minister of Finance denied any plan to issue international debt in the short term by the Treasury, in principle contradicting the report in Pagina 12. Second, the same report in Pagina 12 also talked about a deal with GS to buy holdouts debt using their own capital to later re-sell it to the government. There was no clarification about that by officials. In our view, this appears to be wishful thinking. It is hard to believe Argentina is considering any payment above 2005-2010 restructuring parameters to holdouts while the US Supreme Court is still an option. And officials truly believe the US Court could help given the recent events (March 3 pledge to the Supreme Court by the US solicitor general to not understate sovereign immunity protection in particular). Third, Bloomberg Finance LP published a report regarding a USD3.0bn financing from the World Bank. This is definitely not fresh money. The government is essentially trying to recover a 100% rollover lost a couple of years ago. Argentina's recent efforts to comply with international practices (statistics revision, Repsol, ICSID settlements, Paris Club, etc.) are the Republic´s main card. If successful, this could deliver some USD200mn of voided debt payments. Fourth, talks about IADB financing during the IADB's annual meetings in late March have been also misreported. There could be some small increase in financing but these are really negligible.

Finally, the government had an announcement that could save the Central Bank reserves from more than USD3.0bn in debt service. Specifically, the authorities surprised many market observers by reporting that 2013 GDP growth re-based to the year 2004 was preliminary estimated to be 3%, down from 4.9% initially estimated with the old base. Such a growth number is lower than the 3.22% original threshold that would trigger GDP Warrants payment this year. The director of the National Institute of Statistics (INDEC) together with the Minister of Finance clarified that a final and revised number will be known by September. Although the government had anticipated a change in the base year from the original 1993 methodology, the almost 200bps difference with the preliminary monthly proxies for GDP already published by the INDEC have yet to be explained. The information reported so far does help to suggest that a significant revision in manufacturing growth from 3% initially to negative 1.6%, and for electricity and gas provision from 3% initially to -0.3% in the new methodology, were the main sources of the material change in estimates. The turnaround in manufacturing is rather surprising though as last year was believed to have been a good year for the sector, initially helped by strong car demand from Brazil. Even the private sector estimates were reporting positive growth in the industry in the order of 1%-2% for the year.

10 April 2014



Regrettably, the growth revision did not have the necessary transparency and disclosure for investors to understand how the government is correcting official data and what are the implications looking forward. Furthermore, former Secretary of Finance Guillermo Nielsen, who was in charge of the Republic financing at the time of the Warrants’ first issuance, has argued that a change in the base year demands a change in the reference trigger accordingly with the documents governing the Warrants. Early this week, Economic Minister Axel Kicillof anticipated that the government will provide more information on this by September after a comprehensive analysis is done (in principle referring to preliminary estimates of growth but openly accepting the possibility of looking into the documentation, albeit not explicitly saying it). In our view, this particular development represents terrible news for Warrants holders as the potential payment originally scheduled for this December is unlikely to happen now. If the government is threatened by the legal documents, it could always report the true performance of the economy since 2007, probably avoiding payment anyway. This would obviously represent a political cost for the government but that seems secondary now after the revealed preference to cut down last year’s growth significantly. As a silver lining, the hard currency amount saved will engross the reserves of the Central Bank to face other debt services. Further complicating things, the IMF has just announced its estimation for 2013 growth at 4.3%, “based on official data”.

Inflation will remain challenged by relative prices Thanks to the initiatives discussed above, plus the policy decisions taken since the late January devaluation, the government has been able to stabilize the currency market and international reserves. Inflation acceleration without anchor and further depletion of international reserves were the main risks faced back in January. During February and March, the Central Bank was able to regain control on reserves while achieving peso stability. International reserves have barely dropped since then and the Central Bank has already started to buy dollar exports that are coming with the agriculture season in April and May.

Unfortunately, such a new sense of stability might be misguiding, potentially motivating some policy reversion. Overconfidence by the authorities could actually be a major threat for a smooth ride towards next year’s Presidential election, the critical horizon for policy-making in Argentina nowadays. As noted, absent tighter policies to complement the peso devaluation in January, the authorities were able to anchor post devaluation expectations by forcing banks to unwind most of their long dollar positions accumulated in the previous years. Massive bank selling on the spot and forward market not only stabilized the peso demand but also helped to

completely turn around relative returns in pesos vis a vis hard currency holdings. As the following chart shows, the forward market was implying more than 60% devaluation prior to January, badly competing with 15% rates on Central Bank peso papers. After resolution 5536 was enacted on February 6, this forward curve became mostly negative, introducing a big positive gap after the Central Bank hiked its rates to almost 30%. Today, however, as the most recent curve suggests, we are approaching a new equilibrium where expected depreciation is close to the inflation and Central Bank rates. For this to be sustained, policies should promote just a new nominal equilibrium. Alternatively, the external financing outlook should improve radically, or inflation should decelerate markedly, both unlikely scenarios in our view, at least in the short term.

Implied yields in the ARS forward curve

-60

-40

-20

0

20

40

60

80

1W 1M 2M 3M 4M 5M

17-Jan-14

07-Feb-14

31-Mar-14

Source: ROFEX, BCRA, and Deutsche Bank

Indeed, inflation control will remain challenged by the need to change relative prices without the help of strong anti-inflationary credentials. The authorities did devalue but inflation has accelerated since then. Now the government is raising public utility prices, but these are partly compensating for past inflation and FX pass-through. Thus, the critical key to success is achieving relative price changes while maintaining some price stability. This might need further signs of conviction by the government or simply a much weaker economy.

Meanwhile, inflation is decelerating but still from a high level. In January, the new official CPI index blessed by the IMF reported a 3.7% monthly inflation. In February, the same index showed 3.4% increase, which was a surprise on the downside as the month was expected to get the full pass-through effect from the late January devaluation. The official INDEC argued that there were downward corrections in prices by the end of the month. And for March, preliminary hints by the authorities as reported in the local press suggest inflation in the 3% range.

10 April 2014



Private sector estimates reported February inflation above January and above 4%. Likewise, preliminary indications for March are pointing to an average 3.5%. Private sector data samples are smaller universes than the official. Likewise, they measure inflation in the City and Great Buenos Aires area, contrary to the national index calculated now by the official INDEC. But the main difference in inflation reports might be because of the prices for food and beverages, with a bigger weight in the national index. Food and beverage items dominate the price agreements reached between the government and retail stores and the official index seems to be using these prices as references instead of all prices used by the private sector estimates.

The lack of more efficient tools to coordinate inflation expectations downward places most of the burden on the government’s initiatives to achieve broad price and wage agreements. Early this week, the government announced an expansion of its prices agreements first launched in February, incorporating 108 items with an average price increase of 3%, totaling more than 300 products with ¨monitored¨ prices. In addition, the authorities maintained a strict position regarding wages negotiations, trying to impose a ceiling at 30% YoY. Moderation of wage and price inflation remains fundamental to achieve a new nominal equilibrium, otherwise relative prices changes achieved would not be preserved.

Wage and price inflation show negative income effect

0%

5%

10%

15%

20%

25%

30%

35%

40%

CPI - Private Estimates, YoY Salaries inflation, YoY

Source: FIEL, INDEC, and Deutsche Bank

Conviction will likely be tested by reality As noted, even if the final change in relative prices (exchange rate and tariffs specially) is not significant, the new set of measures could still have an important effect as long as wages do not follow inflation. This has been the case so far, producing a major negative real income effect, which is expected to reduce absorption, a necessary ingredient in the adjustment of the external accounts at least. Thus, as discussed, even a poorly managed devaluation is likely to have consequential effects on import demand, both for goods and services. A costly achievement, done through a recession, might not be totally anticipated by the authorities.

As of April 4, 2014, the Central Bank had USD27.2bn in total reserves, just USD400mn less than a month ago, of which USD8bn are now estimated to be owned by the banks. Looking forward, we could expect an important improvement in the current account, for approximately USD9.0bn, driven by a significant decline in imports, both in goods and services. Actually, imported services are falling at a rate faster than 20% YoY in the first three months of the year. As discussed, this is mostly the byproduct of a negative income effect plus an important price effect, at least affecting some imports witnessing the biggest increase in prices (cars, tourism, and credit cards spending abroad) through devaluation and taxes. Such a revised current account forecast does not demand much from exports, although incorporating a 5% increase in the harvest that could actually surprise on the upside at the end. The following table reports the 2013 balance of payment result based on the Central Bank’s cash transactions. This is becoming a better instrument to follow the external accounts as capital controls distort the account on accrual basis, the standard practice so far. Likewise, for the first time, the cash and accrual version of the current account has a difference of almost USD10bn in 2013 that has yet to be explained.

2013 Balance of payment on a cash basis (USD mn)

2010 2011 2012 2013

Current account 10,965 4,401 3,866 -13,277Goods 17,837 15,041 14,673 1,745Services 127 -1,115 -3,825 -9,403Rents -7,878 -10,397 -7,594 -5,886

Capital account -6,807 -10,510 -7,171 1,452FDI 2,030 3,502 3,744 2,413Portfolio investment -81 -122 -112 -37Financial loans and credit lines 2,787 4,520 -3,096 -3,326Multilateral and bilateral organizations -2,253 6,129 -1,757 -1,882External assets, non financial private sector -11,410 -21,504 -3,404 397External assets, financial sector 114 -67 -190 70Others, public sector -559 600 -1,583 696Others 2,565 -3,192 -638 3,168

Change in international reserves 4,158 -6,109 -3,305 -11,825 Level of reserves by year end 52,190 46,376 43,290 30,828

Source: BCRA, and Deutsche Bank

On the capital account not much is expected to change from the cash balance recorded above. The private sector will repeat what it was able to do last year plus some additional USD1.0bn in outflows with the help of the partial lifting of capital controls. The public sector is expected to issue some additional USD2.0bn mostly through YPF, on a conservative basis, while the Warrants payment avoidance is maintaining the situation last year when Warrants were not triggered either. All together, this could mean international reserves falling by another USD2.0bn-USD3.0bn by the end of the year, but after some recovery in the months to come. This would push reserves down to around USD24bn by December 2014, or before facing pending debt payments of some USD8bn in 2015.

10 April 2014



In the meantime, the negative income shock promoted by the devaluation is being felt together, as higher nominal uncertainty has simply accelerated the slowdown in economic growth. The industrial production as reported by the private think tank FIEL seems to have been resistant early this year, reporting 1.8% YoY growth. However, the outlook for the sector are lackluster, with the car industry falling by more than 30%, and the rest of the sectors compare with relatively good levels of activity starting in 2Q.

Growth proxies trending downwards again

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

EMAE, YoY 3m MAIPI FIEL, YoY 3m MAConsumer confidence (rhs)

Source: Central Bank, FIEL, UTDT, and Deutsche Bank

France support and Moody´s negative outlook A couple of news stories related to Argentina´s most important pending debt case were published recently. First, France President Francois Hollande welcomed the Argentina government´s intention to resolve the pending debt situation between the country and the Paris Club and offered his intermediation in that regard. In the same event, Argentine President Cristina Fernandez de Kirchner thanked the government of France for its supporting presentation to the US Supreme Court. Second, and related to the latter, the US Supreme Court extended the deadline for defaulted debt holders to replay to Argentina´s request for a hearing on its appeal on the pari-passu case, where the NY District Court and the Appeals Court have blocked Argentina´s payment to restructuring debt holders unless defaulted debt is paid as well. The Supreme Court moved this deadline to May 7 from March 24 originally. This together with a strong statement by the US Solicitor General filed on March 3 this year, might lead to further delays in the US Supreme Court decision, likely pushing any resolution to not early than the end of this year.

A few days earlier, Moody’s cut the Republic credit rating to Caa1 from B3 and changed the outlook to stable from negative. According to the report, the reasons for this decision are related to the drop in official reserves and the consequent increase in risk. The agency indicated that the country will face dollar-denominated debt payments of 20bn during the coming two years.

Gustavo Cañonero, New York, (212) 250 7530

Argentina: Deutsche Bank forecasts 2012 2013E 2014F 2015F

National Income

Nominal GDP (USDbn) 496 514 452 452Population (m) 41.0 41.5 41.9 42.4GDP per capita (USD) 12,101 12,400 10,790 10,672 Real GDP (YoY%) 1.2 2.9 -2.1 1.9 Priv. consumption 4.6 4.9 -3.5 2.0 Gov't consumption 6.7 4.5 -1.8 2.0 Gross capital formation -11.1 0.5 -3.3 4.0 Exports -5.6 1.7 1.5 2.5 Imports -4.4 9.3 -6.5 6.0


CPI (YoY%, eop) (*) 25.2 27.5 38.9 25.8CPI (YoY%, avg) (*) 24.0 24.9 39.8 29.4Broad money (M2) 34.3 24.0 20.0 20.0Bank credit (YoY%) 30.8 30.5 25.0 22.0 Fiscal Accounts (% of GDP) Budget surplus -3.8 -4.5 -4.1 -3.8 Gov't spending 32.2 33.9 31.3 29.0 Gov't revenue 28.4 29.4 27.2 25.2Primary surplus -1.5 -2.8 -2.5 -2.3 External Accounts (USDbn) Merchandise exports 80.9 83.0 87.1 90.9Merchandise imports 68.5 74.0 71.5 75.4Trade balance 12.4 9.0 15.6 15.5 % of GDP 2.5 1.8 3.4 3.4Current account balance -0.1 -5.8 0.7 2.1 % of GDP 0.0 -1.1 0.1 0.5FDI (net) 4.0 2.6 2.0 2.0 FX reserves (USDbn) 43.3 30.6 24.2 17.7FX rate (eop) ARS/USD 4.92 6.52 9.62 12.57 Debt Indicators (% of GDP) Government debt 19.1 19.0 22.6 23.8 Domestic 5.9 7.2 9.2 11.7 External 13.2 11.7 13.5 12.1Total external debt 28.4 26.4 30.1 28.8 in USDbn 140.9 135.8 136.3 130.1 Short-term (% of total) 36.9 38.3 38.2 40.0 General Industrial production (YoY) -1.2 1.5 -3.5 2.1Unemployment (%) 7.8 8.0 9.0 9.0 Financial Markets (EOP) Current 2Q2014 4Q2014 1Q2015Overnight rate 15.0 21.0 25.0 30.03-month Badlar 26.3 32.5 35.0 35.0ARS/USD 8.01 8.53 9.62 10.79 Source: DB Global Markets Research, National Sources *Inflation reported by Congress

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Brazil Baa2/BBB-/BBB Moody’s/S&P/Fitch

Economic outlook: Adverse climate conditions are putting additional pressure on food and energy prices, making it more difficult for the central bank to bring inflation back to the target. The October elections reduce the scope for significant changes in economic policies. Despite the government’s efforts to stimulate private investment through infrastructure concessions, its interventionist bias continues to hurt sentiment and hinder growth.

Main risks: While the government has tightened monetary policy and is promising to adjust fiscal policy, inflation remains very high. The risk of energy rationing has increased significantly due to exceptionally dry weather. Higher interest rates abroad could lead to further currency depreciation and even slower domestic growth.

Drought affects inflation and growth

Economic activity remains lukewarm. The latest economic data suggest that although GDP growth will likely remain in positive territory in 1Q14, the risk to our 2014 growth forecast of 1.7% remains on the downside. Industrial production rose 0.4% MoM in February, following a hefty 3.8% MoM increase (revised from 2.9% MoM) in January. However, production just recovered from the 4.2% plunge registered in the last two months of 2013. Industrial production has been essentially fluctuating around a stable trend since 2010, and although the sector could benefit from the weaker exchange rate, it will be negatively affected by rising interest rates and decline in exports of manufactured goods to Argentina this year. It is also worth highlighting that the data available so far show a decline in the production of construction materials and capital goods that is consistent with a drop in fixed-asset investment in 1Q14. Since we expect household consumption to decelerate further due to slower growth in employment and labor income, high consumer indebtedness and sluggish credit origination, we believe investment will be the key variable to determine economic growth this year. Furthermore, business surveys show a steady deterioration in confidence in most sectors, reflecting concerns about high inflation, rising interest rates and criticism about the government’s policies. The rising risk of energy rationing may also explain the deterioration in expectations. Persistently low rainfall combined with a sturdy demand for electricity has lowered the reservoirs of hydroelectric power plants to critical levels in several regions. While it would be advisable to adopt energy rationing as a pre-emptive measure at this juncture, the government will most likely try to avoid it any cost due to its potential effect on the

October elections (the 2001 energy rationing was one of the reasons why President F.H. Cardoso was not able to elect his successor in 2002). This is a high-risk strategy, however, as continuing low rainfall could further deplete the reservoirs and require a much larger rationing effort in 2015. Another important risk for next year will be the likely re-alignment of regulated prices that have been artificially repressed to minimize inflation, especially of fuel and electricity (in this case, the drought has also forced the government to boost the output of expensive thermal power plants, e.g.). We estimate that by suppressing regulated prices, the government has been able to reduce inflation by approximately 150bps this year, and price normalization will probably demand further monetary and fiscal tightening to curb inflation. Thus, although we are keeping our 2014 GDP forecast at 1.7% for now, we lowered our 2015 projection to 1.4% from 1.7%. We stress that this forecast is subject to large errors, not only because of the energy situation, but also great uncertainty about the economic policies to be pursued by the government elected in October.

Brazil: Hydroelectric reservoir levels

20%

30%

40%

50%

60%

70%

80%

90%2001

2012

2013

2014

Source: ONS

The rise in agricultural prices caused by the drought is putting even more pressure on inflation. The IPCA consumer price index surged a higher-than-expected 0.92% MoM in March, the highest monthly inflation for the month since 2003. Consequently, the 12-month IPCA accelerated to 6.15% in March from 5.68% in February, reaching the highest level since July 2013. Food prices were mostly responsible for the jump in inflation, as they rose 1.92% due to the effect of adverse weather conditions on agricultural output. Wholesale agricultural prices jumped 5.58% MoM in March, according to FGV’s IGP-DI inflation index. However, inflation is widespread, as attested by the

10 April 2014



71% diffusion index and 9.1% YoY surge in service prices. While food prices may unwind recent gains in the next months as climate conditions improve, they hit the economy when core inflation and inflation expectations were already quite high, so the effects of the supply shock could be quite persistent. We have raised our 2014 IPCA forecast to 6.3% from 6.0%. For 2015, given high inertia and the potential impact of a re-alignment in regulated prices, we have also revised our IPCA forecast to 5.9% from 5.5%.

Brazil: IPCA consumer price index

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0 YoY%

Source: IBGE, DB forecasts

Despite high inflation, the BCB has signaled that the monetary tightening cycle is coming to an end. The COPOM raised the SELIC overnight rate by 25bps to 11.0% at the beginning of the month, in line with market expectations. However, the BCB surprisingly altered its communiqué, removing a phrase that indicated the “continuation” of the adjustment in interest rates, and adding that the committee would monitor the macroeconomic situation until the next meeting, a phrase that had been used in the past to signal a change in policy stance. We interpreted such changes as a signal that the BB wants to end the cycle as soon as possible. Nevertheless, due to higher-than-expected inflation, we now expect another 25bp hike in May. The BCB would then pause and wait until after the October elections to resume hiking rates, probably at the beginning of 2015. Thus, we raised our year-end SELIC rate forecast to 11.25% from 11.00%. For the end of 2015, we revised our forecast to 12.25% from 12.0%.

The fiscal results posted so far this year are not very encouraging. The public sector posted a consolidated primary fiscal surplus of BRL2.1bn in February, down from BRL19.9bn in January due to seasonal factors, but higher than our forecast of a BRL1bn surplus and the market consensus forecast of a BRL0.4bn deficit. The surplus was also better than the BRL3.0bn deficit posted in February 2013. The main surprise, as it happened in January, was the better-than-expected BRL5.8bn surplus posted by local governments (and respective state-owned companies), which offset the

BRL3.7bn deficit posted by the central government and federal enterprises. The primary surplus totaled BRL22.1bn in 2M14 (2.73% of the period’s GDP), compared to BRL27.2bn in 2M13 (3.66% of the period’s GDP), reflecting a large decline in the federal government’s surplus (especially in January, when spending was larger than usual due to postponements at the end of 2013, and the February federal surplus was boosted by BRL2.9bn in dividend payments from government enterprises). At the federal level, spending continues to grow much faster than revenues (15.5% vs. 9.6% in 2M14 nominal terms). An important question is whether the local governments will manage to maintain such good results during the year, given that we will have elections in October and the states have much more leeway to spend due to their raised debt limits. In 12 months, the consolidated primary surplus rose to 1.76% in February from 1.66% in January. We are keeping our 2014 consolidated primary surplus forecast at 1.5% of GDP for now, although we do not rule out the possibility that the government meets the 1.9% of GDP target by resorting to extraordinary revenues again.

Brazil: Federal Spending (% o GDP)

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5% % of GDP

Payroll

Current and capital spending

Social security

Source: STN

The trade balance continues to disappoint. After posting deficits in January and February, the trade balance registered a small surplus of USD112mn in March. The trade deficit rose to USD6,072mn in 1Q14 from USD5,157mn in 1Q13. The numbers are even worse than they look, as the 1Q13 deficit was boosted by oil imports that were actually inherited from 2012. Excluding oil, according to our estimates, the trade balance shifted from a USD1.3bn surplus in 1Q13 to a UDS0.7bn deficit in 1Q14. Average exports fell 4.1% YoY in 1Q14, led by automobiles (-24.0% YoY, reflecting a decline in shipments to Argentina) and sugar (-19.9% YoY). Imports fell 2.2% YoY, led by oil (-12.0% YoY), non-durable consumer goods (-3.1% YoY) and capital goods (-2.7% YoY). In terms of export destination, the good news was the 22.1% surge in exports to China, while the bad news was the 14.4% drop in shipments to Argentina and the 13.3% decline in exports to Europe. In light of these data and recent

10 April 2014



BRL appreciation, we have lowered our 2014 trade surplus forecast to USD3bn from USD7bn. Consequently, we have raised our 2014 current account deficit forecast to USD80bn (3.6% of GDP) from USD75bn.

The BRL has appreciated significantly despite the S&P downgrade. Ratings agency Standard & Poor’s downgraded Brazil’s sovereign rating to BBB- from BBB in March, citing concerns about fiscal policy and slow economic growth. Since then, however, the BRL has appreciated significantly and reached the strongest level since October 2013. We believe the market reaction can be explained by several reasons: 1) the downgrade had already been priced in; 2) other emerging market currencies have rebounded as well, reflecting the (so far) smooth implementation of QE tapering in the US and decline in risk aversion; 3) high local rates and a decline in FX volatility have contributed to raise foreign capital inflows into fixed-income instruments; 4) opinion polls have showed a decline in President Dilma Rousseff’s approval rating, suggesting that another candidate could win the election in October and pave the way for better economic policies next year; and 5) the BCB has continued to place and roll over existing FX swaps, suggesting that the authorities are probably satisfied with the disinflationary effect of the FX appreciation. In March, the BCB rolled over 75% of the USD10.1bn in swaps due in April, creating expectations that it would do the same regarding the USD8.7bn due in May. However, the BCB surprised market participants by indicating that it could roll over 100% of this maturity. The seemingly change in strategy occurred at the same time that inflation accelerated due to the surge in agricultural prices, hence the conclusion that the government may be taking advantage of the BRL appreciation to limit the increase in interest rates required to curb inflation. While appreciation will help contain inflation, it will also delay the current account deficit adjustment, rendering the country more vulnerable to volatile international capital flows, especially if international interest rates rebound strongly. It is also important to highlight that the FX swap program will expire at the end of June, when the outstanding stock will reach approximately USD100bn, making it more difficult for the BCB to renew it. Thus, we still expect the BRL to be weaker at year-end than now. However, in light of the smooth reaction to monetary policy changes in the US and our expectation of higher domestic interest rates due to higher inflation, we lowered our year-end currency forecast to BRL2.40/USD from BRL2.50/USD. For the end of 2015, we are keeping our forecast at BRL2.55/USD for now.

José Carlos de Faria, São Paulo, (5511) 2113-5185

Brazil: Deutsche Bank forecasts

2012 2013 2014F 2015F

National IncomeNominal GDP (USDbn) 2,253 2,242 2,249 2,269

Population (m) 199 201 203 204

GDP per capita (USD) 11,306 11,159 11,101 11,111

Real GDP (YoY%) 1.0 2.3 1.7 1.4

Private consumption 3.2 2.3 1.8 1.3

Government consumption 3.3 1.9 1.2 1.4

Gross capital formation -4.0 6.3 -0.5 1.4

Exports 0.5 2.5 3.0 4.0

Imports 0.2 8.4 2.0 3.0


CPI (YoY%, eop) 5.8 5.9 6.3 5.9

CPI (YoY%, avg) 5.4 6.2 6.4 6.0

Money base (YoY%) 8.3 7.6 7.0 6.5

Broad money (YoY%) 5.3 11.2 8.0 6.0


Consolidated budget balance -2.5 -3.2 -4.0 -3.6

Interest payments -4.9 -5.1 -5.5 -5.6

Primary balance 2.4 1.9 1.5 2.0


Merchandise exports 242.6 242.2 243.0 257.0

Merchandise imports 223.2 239.6 240.0 245.0

Trade balance 19.4 2.6 3.0 12.0

% of GDP 0.9 0.1 0.1 0.5


% of GDP -2.4 -3.6 -3.6 -3.6

FDI 65.3 64.0 60.0 70.0


FX rate (eop) BRL/USD 2.04 2.34 2.40 2.55


Government debt (gross) 58.8 57.2 58.6 61.0

Domestic 55.9 54.1 55.6 58.2

External 2.9 3.1 3.0 2.9


in USDbn 440.6 485.1 505.1 530.1


General

Industrial production (YoY%) -2.5 1.1 2.0 1.5

Unemployment (%) 5.5 5.4 5.7 6.1

Financial Markets (EOP) Current 2Q14 3Q14 4Q14Selic overnight rate 11.00 11.25 11.25 11.25

3-month rate (%) 10.9 11.2 11.1 11.1

BRL/USD 2.20 2.30 2.35 2.40Source: National Statistics, Deutsche Bank forecasts

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Chile Aa3 (stable)/AA- (stable)/A+ (positive) Moodys /S&P/ /Fitch

Economic outlook: Economic activity remains weak despite February’s mild positive surprise. The current deceleration trend is mostly explained by lackluster investment growth, especially in the mining sector. However, the probable end of the investment cycle in the mining should soon support increased production of copper. Although resilient, private consumption growth has also moderated, yet supported by good labor market and real wage dynamics. This scenario has nevertheless pushed the CB to cut 100bp the policy rate since the beginning of 2013, and further monetary easing remains actually the most likely scenario.

Main risks: Main risks are related to a greater than expected deceleration in China´s growth, and to a worsened business confidence reacting to an aggressive fiscal reform. Given recent weakness in economic activity, the latter might represent the major risk to performance in the months ahead. An accelerated tapering in the US could bring increased volatility in financial markets, although that should have a minor effect an activity.

An ambitious reform despite slowdown

Business climate continues depressed The monthly economic activity proxy (IMACEC) increased on a seasonally adjusted basis by 0.2%MoM in February, or 2.5% in twelve months. The original series advanced by 2.9%YoY, above our expectations of 2.4%YoY. This figure indicates that activity expanded faster than the 1.6%YoY posted during January but far below the 4.4%YoY marked during the same month of the previous year. Worth noting, this February had the same number of working days as February 2013. February activity was driven by the dynamism of the mining sector and retail.

The industrial production index (IPI) advanced by 2.6%YoY in February too, recovering from the contraction of 1.7%YoY recorded in January. The rebound in the industrial index was led by mining that expanded by 6.7%YoY, above the contraction of 2.0%YoY posted in the previous month. This was the result of greater production of copper, climbing 7.6%YoY, despite the 11.4%YoY drop in prices. Manufacturing contracted by 2.0%YoY for the second consecutive month, partly explained by a restructuring in production processes in the products of iron and steel and fertilizers. Services decelerated its pace of growth advancing by only 0.9%YoY, affected by the contraction of 0.1%YoY in electric generation. Meanwhile, demand indicators are confirming some

growth moderation, with real retail sales advancing by 5.3%YoY, and real supermarket sales posting an increase of 3.7%YoY, or below the 6.0% and 7.0% recorded in the previous month, respectively.

The trade balance resulted in a surplus of USD1.7bn during March, or better than anticipated. Exports reached USD7, 323mn during the month, reflecting an increase of 17.8%YoY and 11.7% on the month. Mining exports accounted for 53% of total exports, of which copper, the main exported product representing 49% of total exports increased 30% relative to one year ago. Imports summed USD5,621mn in the same month, falling by 1.42%YoY. Imports of consumption goods came down by 6.4%YoY, likely indicating another moderated figure in private consumption during March. Durables, semi-durables and other imported consumption goods contracted by 11.1%YoY, 1.5%YoY and 5.2%YoY, respectively. Additionally, intermediate goods increased by 2.7%YoY, mainly explained by fuels imports that increased by 26.4%YoY as a consequence of higher oil prices in global markets. Finally, capital goods contracted by 6.7%YoY, with trucks and cargo vehicles, and other machinery falling by 18.5%YoY and 2.3%YoY, respectively.

Unemployment was able to stay unchanged at 6.1% during the moving quarter December-February, even posting a decrease of 0.1pp in the inter-annual comparison. In the last twelve months, labor force and employment advanced at the same pace of 2.7%YoY. For the fifth consecutive month self-employment, which advanced by 9.4%YoY, led job creation, followed by employees that grew by a modest 1.2%YoY. Likewise, during the last twelve months, the sectors that reported the highest contributions to job creation were retail, growing by 8.7%YoY; followed by social services and healthcare that expanded by 12.3%. Conversely, the highest jobs destruction was seen in agriculture, hotels and restaurants, and mining.

Inflation accelerates as anticipated Consumer price index increased by 0.8%MoM during March. Thus twelve month inflation came out at 3.5%YoY, which was above expectations of 3.3%YoY as per Bloomberg’s poll. By the third month of the year accumulated inflation is now running at 1.5%. Items reporting the highest incidences were education (4.9%MoM, 5.3%YoY), followed by food and non-alcoholic beverages (0.8%MoM, 5.7%YoY), and clothing and footwear (1.4%MoM, -5.6%YoY). These three categories jointly added 0.559pp to March inflation, explaining 75% of total monthly variation. Conversely, communications was the only tag reporting a negative variation (-0.3%MoM, -1.7%YoY).

10 April 2014



Consumer inflation excluding food and energy, the preferred core measure of the Central Bank, advanced by 0.8%MoM and 2.7%YoY, accumulating an expansion of 1.4% year to date. Central Bank hints more rate cuts to come The Central Bank published its Monetary Policy Report (IPOM) for March, acknowledging a deteriorating outlook. Specifically, the IPOM lowered its growth forecast for this year from its December projection by 75bps, to 3.00%-4.00%. This included a sharp downward revision in investment growth for this year, from 4.1% expected in December to just 1%, noting continued downward surprises in investment performance and the risk of this being protracted. It also incorporated even a subdued prospect for consumption demand. This notwithstanding, the inflation outlook remained stable or anchored to the CB 3% target while trend growth is believed to have remained at around 5%. In light of this scenario, the IPOM monetary comments were extremely balanced, expecting help from a more normal fiscal execution with higher investment expenditures later in the year, although accepting its commitment to conduct monetary policy with flexibility. In our view, the fiscal stimulus might backfire because of negative perception, and that would oblige the CB to step in. An ambitious tax reform amid economic weakness The reform aims at collecting 3% of GDP by 2018, mostly intended to finance the educational reform, a fundamental promise of the recent presidential campaign. President Bachelet indicated that this reform will place Chile´s tax burden in line with other countries member of the OECD and will allow the country to achieve a sustained economic growth by reducing income inequality, which is considered one of the highest in the region. The four objectives of this reform, as stated by Mrs. Bachelet, are 1) to increase taxes to finance permanent education expenses with permanent revenues; 2) to improve income distribution; 3) to create new and better incentives for saving and investment; and 4) to reduce further tax elusion and evasion.

The reform would raise funds in a gradual pace starting with 0.29% of GDP in 2014, 0.82% in 2015, 1.76% in 2016, 2.44% of GDP in 2017. The increase in corporate taxes will also be gradual, with rates going to 21% this year, up to 22.5% in 2015, 24% in 2016, and finally reaching 25% in 2015. Rate reduction in personal taxes from 40% to 35% will be implemented in 2018. The project has also an environmental dimension, charging extra pollution sources. Similarly it taxes more aggressively smoking and alcohol consumption. The question remains whether the private sector would value the potential positive externalities or simply adjust to a bigger tax burden.

Gustavo Cañonero, New York, (212) 250 7530

Chile: Deutsche Bank forecasts 2012 2013F 2014F 2015FNational income

Nominal GDP (USDbn) 266.3 284.8 279.8 295.6Population (m) 17.4 17.6 17.7 17.9GDP per capita (USD) 15,300 16,219 15,795 16,544 Real GDP (YoY%) 5.4 4.1 3.6 4.1 Priv. consumption 6.0 5.6 4.5 4.9 Gov't consumption 3.7 4.2 3.9 4.0 Investment 12.2 0.4 4.5 7.0 Exports 2.3 3.5 3.3 5.9 Imports 6.9 1.3 3.0 6.5 Prices, money and banking CPI (YoY%, eop) 1.5 3.0 3.0 3.0CPI (YoY%, avg) 3.0 1.9 3.5 3.0Broad money (YoY%, eop) 7.6 14.9 10.1 8.0Credit (YoY%, eop) 13.5 10.2 11.7 10.0 Fiscal accounts (% of GDP) Consolidated budget balance 0.6 -0.6 -0.8 -0.6 Government spending 21.5 21.5 22.2 23.5 Government revenues 22.1 20.9 21.4 22.9 External Accounts (USDbn) Exports 78.0 76.7 79.9 86.0Imports 75.6 74.5 80.0 82.7Trade balance 2.4 2.2 -0.1 3.3 % of GDP 0.9 0.8 0.0 1.1Current account balance -9.1 -9.5 -9.8 -9.8 % of GDP -3.4 -3.3 -3.5 -3.3FDI 6.2 9.3 14.0 15.6FX reserves -0.4 0.3 43.5 42.0FX rate (eop) USD/CLP 479 524 565 540 Debt indicators (% of GDP) Government debt 6.9 6.5 6.0 5.7 Domestic 4.6 4.4 4.5 4.3 External 2.4 2.1 1.5 1.4Total external debt 44.2 45.9 46.8 44.4 in USDbn 117.6 130.7 130.9 131.2 Short-term (% of total) 18.9 15.1 14.5 14.5 General Industrial production (YoY%) -1.7 2.3 4.0 4.1Unemployment (%) 6.0 6.1 6.3 6.0 Financial markets (eop) Current 2Q2014 4Q20141Q2015Overnight rate (%) 4.00 3.75 3.50 3.50

6-month rate (%) 3.7 3.7 3.8 3.8

USD/CLP 547 555 565 550

Source: DB Forecasts and, National Statistics

10 April 2014



Colombia Baa3 (positive)/BBB (stable) /BBB (stable) Moodys /S&P/ /Fitch

Economic outlook: The release of activity numbers for 2013 confirmed the trend evidenced since the third quarter pointing to a continued recovery. The closing of the output gap and the acceleration in prices (albeit still below the middle of the target range) implies that the beginning of the hiking cycle is near. However, the announcement of the rebalancing of model portfolios from foreign investors positively impacted the TES, IBR, and USDCOP markets. Just six weeks before the Presidential elections, Santos does not seem to have a strong lead in polls.

Main risks: Coincident indicators of economic activity have been sending mixed signals on the strength of the recovery in the first quarter of 2013. The rally in the currency and the local debt and swap yield curve could retrace if the government announces the long awaited reform on the calculation of the minimum benchmark return from local pension funds.

Rebalancing expectations

Growth confirmed recovering trend in 4Q-2013 Economic activity measured by GDP was at a 4.3% annual rate in 2013, led by investment (4.9% YoY) and exports (5.3% YoY). The sectors that evidenced stronger growth rates were construction (9.8%), services (5.3%), and agriculture (5.2%), the last one mostly explained by the positive shock in the sector from higher coffee prices and a recovery in production that contributed by growing at a 22.3% YoY rate. Manufacturing posted the second consecutive year of decline (-1.2% YoY).

Energy and mining sector grew by 4.9% YoY, after an increase in oil of 7.8% and gas of 11%. Environmental penalties and strikes in the coal sector during 2013 hurt mining activity, falling by 4.2%. For 4Q-2013, GDP grew at a 4.9% annualized rate, with respect to the same period in 2012. This growth rate shows a confirmation in the acceleration of economic activity after the slowdown experienced in the first half of the year, when growth was about 2.5%.

….but the jury is still out on 1Q-2014

Releases of coincident index of activity are sending mixed signals on the strength of the recovery in the first two months of 2014. Retail sales showed strength in February, growing at an annualized rate of 6.5% higher than the 4% averaged in 2013.

However, the consumer confidence index fell in February to the level evidenced in February and March of 2013, when the economic cycle was only starting to turn. In our opinion, the heated political debate ahead of the Congressional elections and its effect on public opinion could have been related to this sudden drop from a five-month growth trend. External demand retraced as well in January and February after falls in mining, industrials, and agricultural sectors. On the supply side, economic activity shows that electricity demand and coffee production evidenced strong growth levels in February.

On the other hand, manufacturing stagnated, a behavior that has persisted for the last two years. However, the behavior of the different economic sectors has been heterogeneous. While there are sectors growing at a rapid rate, others are falling and this is not related to the tradability of the goods produced. The willingness of BanRep to react more aggressively to currency appreciation has been muted because of this particularity in manufacturing given that it is not clear that the source of the fall in activity is driven by the lost competitiveness from real exchange rate appreciation. The majority of sectors in manufacturing, however, keep showing negative growth rates.

Manufacturing annual growth rate by sector

-40% -30% -20% -10% 0% 10% 20% 30% 40%

Motor Vehicles Parts & Accessories

Motor Vehicles & Motors

Carpentry Parts & Pieces for Construction

Spinning, Knitting & Finished Textile Prods

Basic Steel & Iron Industries: Smelting

Clothing Articles, Tailoring

Printing Activities

Publishing Activities

Footwear

Mfg of Fruits, Vegetables, Oils & Fats

Plastic Products

Nonmetallic Mineral Products

Starch and Mill Products

Mfg excl Coffee Threshing

Manufacturing

Ceramic Products for Nonstructural Use

Other Textile Products

Glass & Glass Products

Other Manufacturing Industries

Basic Chem Substances,Synth/Artificial Fibers

Manufactured Metal Products

Petroleum Refinery

Other Food Products

Radio/TV/Communication Equip & Products

Coffee Threshing

Source: Deutsche Bank and Haver Analytics

BanRep waiting to pull the trigger on hiking cycle Inflation continued increasing in March, printing at 0.39%, driving the annual figure to 2.51% and the three month result to 1.52%, evidencing a marked acceleration from the fourth quarter of 2013 when food

10 April 2014



price negative shocks drove the annual rate below the lower range of the target. The sectors with the largest increases were communications, food, and health, while education and entertainment contributed negatively to the headline result. We expect the hiking cycle to start in July, delivering three 25bps hikes that would drive the policy rate to 4.0% by year end. In our opinion, inflation expectations remain well anchored and the strength from private sector demand is still not clear, precluding a stronger response from monetary policy.

Rebalancing triggered rally but PF reform remains as a risk The effect of the rebalancing of widely tracked indices for offshore investors in local debt markets across EM triggered a massive rally in the COLTES, IBR, and USDCOP markets. This change and the effect in the COLTES market are widely discussed in our theme piece: Implications of increase in foreign participation in Colombian debt market. The estimated inflows would amount to between USD 8 bn and USD 10 bn until foreign investors end the repositioning. The expected lowering of the withholding tax rate for foreign investors from 14% to below 5%, which was mentioned by the public credit office, would attract more inflows.

However, in our view, the main risk in the months ahead is from the government bringing back to the table the reform on the methodology to calculate the minimum return for pension funds. In a first draft discussed last year, the exposure to foreign currency denominated assets in the benchmark portfolio would increase to 20%. As the graph below shows, an increase from the current level (16.3%) would imply an increase of exposure of around USD 4 bn. While the tax reform would need to be approved by Congress, a daunting task for a fresh re-elected President Santos with low political capital, the pension fund reform will only need a regulatory change from the Ministry of Finance.

Pension fund system positioning (Jan - 2014)

Source: Deutsche Bank and Superintendencia Financiera

Armando Armenta, New York, (212) 250 0664

Colombia: Deutsche Bank forecasts 2012 2013F 2014F 2015F

National Income

Nominal GDP (USD bn) 370.3 378.2 405.0 428.9

Population (m) 46.0 47.0 47.0 48.0


Real GDP (YoY %) 4.2 4.3 4.5 4.3


Gov't consumption 5.1 5.2 5.2 5.0

Gross capital formation 5.7 5.6 6.2 8.0

Exports 5.3 4.0 3.5 3.2

Imports 8.0 7.0 6.5 6.0


CPI (Dec YoY %) 2.4 1.9 3.0 3.6

CPI (avg %) 3.2 2.0 2.7 3.3

Broad Money 17.0 15.0 14.5 14.0

Bank Credit 18.2 13.0 14.0 12.0




Primary Balance 0.3 0.1 0.2 0.2


Exports 59.6 69.0 75.0 76.8

Imports 54.1 69.0 76.0 80.0

Trade balance 5.6 0.0 -1.0 -3.1

% of GDP 1.5 0.0 -0.2 -0.7


% of GDP -3.2 -3.4 -2.7 -3.0

FDI 15.7 15.0 14.5 15.0

FX reserves 37.5 42.0 44.0 46.0

COP/USD 1768 1950 1970 2050


Central Government debt 36.1 35.0 35.5 34.0

Domestic 25.7 27.5 26.0 25.0

External 10.4 12.0 9.5 9.0


in USDbn 79.1 85.0 90.0 95.0


General

Industrial production (YoY %) 2.4 -2.6 -1.5 2.0

Unemployment (%) 9.6 9.5 8.2 7.8

Financial Markets (end period)

Current 2Q2014 3Q2014 4Q2014

Overnight rate (%) 3.17 3.18 3.20 3.75

3-month rate (%) 3.18 3.20 3.55 3.80

COP/USD 1935 1950 1960 1970Source: Deutsche Bank and National Sources

10 April 2014



Mexico A3 (stable)/BBB+ (stable)/BBB+ (stable) Moody’s/S&P/Fitch

Economic outlook: Recent indicators confirmed that the Mexican economy started 2014 growing slowly. Moreover, the pattern of growth so far seems similar to that of 2013: falling construction and flat non-autos manufacturing. On top of that, services contracted on a monthly basis, suggesting that it may lose some of the resilience of 2013. On the other hand, recent releases on exports, manufacturing and consumer confidence, suggest that activity may accelerate in the coming months. Notwithstanding such incipient indicators, the balance of risks for economic activity in 2014 has deteriorated slightly due to the slow start, so we now expect GDP to grow 3.0%YoY this year.

Main risks: We see downside risks to economic activity limited going forward. The US cyclic upturn and government spending in infrastructure should start delivering some extra growth later in the year, but it did not happen yet in 1Q2014. On the political front, the process of reforms is moving slowly but we expect secondary laws for the pending constitutional changes to be passed before the end of the month.

A disappointing first quarter

But some indicators are positive The monthly GDP-proxy for January confirmed that the economy started 2014 growing more slowly than expected. Activity grew 0.1%MoM with seasonally adjusted figures, 0.8%YoY. The latter figure was below expectations of 1.4%YoY. Subpar growth was partly explained by an unexpected drop in primary activities, 2.6%MoM and 1.7%YoY, driven by weak performance of agriculture.

Economic activity global index (%)

-2

-1

1

2

3

4

5

2012

/07

2012

/08

2012

/09

2012

/10

2012

/11

2012

/12

2013

/01

2013

/02

2013

/03

2013

/04

2013

/05

2013

/06

2013

/07

2013

/08

2013

/09

2013

/10

2013

/11

2013

/12

2014

/01

%MoM

%YoY

Source: INEGI

On top of this, industrial output grew moderately at 0.5%MoM and 0.7%YoY and services contracted 0.1%MoM, yet increasing 1%YoY. These results looked even more worrisome if analyzed in detail. In the industrial sector, growth in January was largely explained by motor vehicles and parts, which had the biggest production on record for that month (probably a rebound from a drop in December), while the rest of manufactures remained essentially flat (likely due to the effects of weather on US orders). Likewise, construction activity fell on a monthly basis, suggesting that it had not bottomed out yet, contrary to our previous expectation. Furthermore, services seem to be losing the resilience shown in 2013.

IP and components (Jan12=100)

90

95

100

105

110

115

120

2012

/01

2012

/02

2012

/03

2012

/04

2012

/05

2012

/06

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

TotalConstructionManufacturingMotor vehicles and parts

Source: INEGI

It is worth mentioning that construction activity not only did not bottom out, but its component expected to start recovering faster in 2014 actually posted a large drop. Infrastructure construction fell 8.1%MoM in January using seasonally-adjusted data, thus reflecting not only that a pipeline of major projects is not there yet but that activity failed to resume normally at the beginning of the year.

Recovery of infrastructure construction has been elusive so far, but we maintain our view that it is likely to grow faster in the second semester of this year. Even if it does not gain traction due to major flagship projects, such as fast trains or airports, we expect at least a recovery based on more traditional projects that do not require important technical works or expropriations to get rights of way, such as extensions or renovation of roads.

10 April 2014



Construction and components (Jan12=100)

89

91

93

95

97

99

101

103

105

2012

/01

2012

/02

2012

/03

2012

/04

2012

/05

2012

/06

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

2013

/01

Total

Buildings

Infrastructure

Source: INEGI

While economic activity in early 2014 has been weaker than expected, some indicators for February and March suggest that part of that may be due to the combined effects of weather in the US and the fiscal program for 2014, which may have started to vanish:

The trade balance posted a surplus of USD$976.3m in February as total exports grew 4.7%YoY. This came out as result of stronger non-oil exports (6.3%YoY) and a moderate drop of 5.1%YoY in oil exports. It is also worth noticing that the resulting accumulated balance in the trade account is a deficit of USD$2.2bn by the second month of the year, lower than a deficit of USD$2.7bn last year. This is particularly important since the capacity of EMs to finance its current account is likely to be scrutinized more closely going forward.

Manufacturing activity is likely to keep recovering in March according to two early indicators. First, the HSBC Manufacturing PMI indicator was 51.7 in March (SA, prior 52.0), above the 50-point threshold that implies an expansion of activity. Similarly, the seasonally-adjusted IMEF manufacturing index stood at 52.7 in March (prior 50.4). Both indicators anticipate stronger readings for manufacturing activity in March and suggest that the effects of weak numbers in the US related to weather may be over.

Consumer confidence improved significantly in March with respect to the previous month, 4.7%MoM. This increase adds to the recovery shown by consumer confidence in February, when a 5-month streak that started in late 2013 was broken. This result is explained by improvements in all of the five components of the consumer confidence index (mainly that on the perceived capacity to purchase durable goods, up 21.4%MoM). Results for February and March suggest that, as the year goes by and the new taxes are assimilated, consumer confidence is likely to recover. This scenario may be further

improved as increased credit availability due to the financial reform reinforces the perceived capacity of households to purchase durable goods in the second semester of 2014. Nevertheless, this indicator has to be taken with caution as the retail sales numbers for February and March offered a mixed picture of no clear recovery yet.

On top of those incipient positive indicators, two key elements of growth in 2013 have remained in place consistently throughout the first quarter of 2014:

Domestic sales, exports and production of autos and light trucks have remained strong this year, particularly in March. Total domestic sales stood at 85.7k units a rise of 3.5%YoY. With this result, domestic sales in the last 12 months remain above the million-unit threshold and close to the highest readings in the last 5 years. Similarly, exports displayed a strong performance are were 230.8k units in March, up 12.9%YoY, accumulating total exports of nearly 2.5m units in the last 12 months. Accordingly, total production continued to grow strongly in March, reaching 277k units, 16.3%YoY and the highest production for that month on record. We expect motor vehicles to remain the main source of IP growth in 2014, as it was in 2013.

The labor market has maintained a positive trend this year. The unemployment rate for January 2014 came at 5.05%, below 5.42% a year before. Similarly, 125k formal jobs were created in the first two months of the year, a remarkably good figure given the overall weakness that remains in economic activity. In fact, there is strong evidence that labor markets have developed some resilience with respect to downturns of economic activity.

Formal jobs creation and economic activity (%YoY)

0%

1%

2%

3%

4%

5%

6%

0

100

200

300

400

500

600

700

800

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

Jobs net creation (thousands)

Jobs net creation (%YoY)

Growth (%YoY)

Source: INEGI and IMSS

Notwithstanding some positive indicators for February and March and its implications for the second semester of the year, the generalized weakness of economic activity in January makes the balance for growth in 2014 slightly more negative. Even if activity accelerates

10 April 2014



later in the year, recent data suggests that it will be more slowly than originally expected. Therefore, we have revised our growth forecast for 2014 to 3.0%YoY, slightly down from our previous estimate of 3.1%YoY. In this regard, it is worth mentioning that a generalized downward revision of growth expectations for 2014 has taken place, so about 80 basis points have been subtracted from the consensus in the last 8 months.

Expected GDP growth (%YoY)

3.0

3.2

3.4

3.6

3.8

4.0

4.2

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

2015

Source: Banxico survey

Inflation has continued to drop faster than expected and it came out below expectations in March, due to the combined effect of a fall in prices of food and beverages, a seasonal price drop in key agriculture products, and a slower growth of government-controlled prices. This result put annual inflation at 3.76%YoY. Thus, the inflation outlook for 2014 kept improving and annual inflation is now comfortably within the target range of monetary policy.

CPI inflation (%YoY)

2.0

2.5

3.0

3.5

4.0

4.5

5.0

2012

/02

2012

/04

2012

/06

2012

/08

2012

/10

2012

/12

2013

/02

2013

/04

2013

/06

2013

/08

2013

/10

2013

/12

2014

/02

CPI Core

Source: INEGI

Now with a clearly improving inflation outlook and increasing growth concerns, the possibility of a policy rate hike by the Central Bank this year has diminished

significantly. Even if economic activity accelerates later in the year and annual inflation runs above 4% for some time in 2H2014 (as expected due to seasonal factors), a supportive stance for the monetary policy seems the most likely prescription going forward. The combination of subpar growth and contained inflation makes the current monetary policy position as the most likely scenario for the remainder of this year, so we now expect the next hike in 1Q2015.

Monetary policy in 2014 and 2015 (%)

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

Jan-

11

Apr

-11

Jul-1

1

Oct

-11

Jan-

12

Apr

-12

Jul-1

2

Oct

-12

Jan-

13

Apr

-13

Jul-1

3

Oct

-13

Jan-

14

Apr

-14

Jul-1

4

Oct

-14

Jan-

15

Apr

-15

Jul-1

5

Oct

-15

Policy rate (actual and forecast)

Short-term exante real interest rate

Source: Banxico, Bloomberg Finance LP and DB research

Secondary laws likely to be approved soon The process of reforms that started last year with a series of constitutional changes has kept moving slowly in the secondary laws phase. This should be an increasing concern as the end of the first period of Congress sessions approaches (April 30). If secondary laws are not processed in the current period, there is a risk of serious delays, as the possibility of calling for an extraordinary period of sessions is somewhat limited.

Among the constitutional reforms that require secondary laws to be processed in Congress, the proposals for the economic competition and telecommunications bills have been submitted, not for the energy reform. Our view of the legislative process in the coming weeks is the following:

Regarding the competition bill initiative, the private sector has complained repeatedly about the discretionary powers of the new anti-trust commission to impose sanctions and the poor protection of the companies’ right to a due process. We expect these issues to be addressed by Congress in the near future, so the secondary laws on competition will be passed after some adjustments to the original proposal before the end of this month.

The initiative for telecommunications and broadcasting was sent to Congress in March, well past the deadline of December 9, 2013 established in the constitutional reform. As expected, the

10 April 2014



proposal has been criticized by different companies and analysts. The main criticism to the proposal, similar to that leveled against the rulings of the regulator last month, is that it imposes obligations to dominant players that do not allow them to get an adequate return on their investments, fundamentally on the telecommunications side. On the political side, PRI (ruling party) and PRD (left-wing party) have taken sides in favor and against the proposal, respectively, while PAN (right-wing party) seems divided about it. Given the economic and political issues at stake in the telecommunications reform, we expected this to be a heated discussion characterized by bitter criticisms. Precisely because of the inflamed discussion and the remote possibility of reaching a consensus among economic and political actors, we anticipate that the government and Congress will not let the environment to deteriorate further by extending the legislative process beyond the end of the current period of sessions. In that scenario, the secondary laws should be approved before the end of April.

The secondary laws for the energy reform have not been submitted to Congress. Submission is likely to have been delayed mainly by the conflict between PAN and the government that followed the uncovering of a fraud involving a major contractor of PEMEX. This problem clouded the energy sector in the last weeks and the implied case of corruption created frictions between PRI and PAN, so the latter asked to postpone the discussion of the secondary laws. Nevertheless, this issue seems to be losing steam gradually, so the broad political consensus built around the energy reform is likely to prevail by the end of the month. In this scenario, the energy secondary laws are likely to be approved without further delay. In our view, the opposite case would be too costly for the government and the ruling party. Even if an extraordinary period of sessions of Congress is convened in the coming days, failure to pass the secondary laws of the flagship reform of this Administration before the natural deadline (the current period) would cast considerable uncertainty about the timing of the reform going forward. This may give the opponents of the reform in the left some time to gain strength and may also lower the generalized mood about the ongoing reform process. To avoid this scenario, Congress may opt for an express approval process, similar to the steps followed in the constitutional part of the energy reform.

Alexis Milo, Mexico City, (52 55) 5201-8534

Mexico: Deutsche Bank Forecasts 2012 2013 2014F 2015F

National Income

Nominal GDP (USD bn) 1177 1238 1326 1426

Population (m) 117 119 121 124


Real GDP (YoY%) 3.8 1.1 3.0 3.7



Investment 5.5 -0.1 3.9 4.7

Exports 4.2 1.4 3.1 3.8

Imports 6.0 2.0 4.5 5.1


CPI (Dec YoY%) 4.1 4.0 4.0 3.7

CPI (avg %) 4.1 3.8 4.1 3.8

Broad Money 10.8 11.5 11.0 12.0

Credit 12.0 10.0 15.0 19.0



Primary Balance -0.6 -0.9 -1.9 -1.5


Exports 371.4 376.6 388.3 403.0

Imports 371.2 378.6 395.7 415.8

Trade Balance 0.2 -2.0 -7.4 -12.8

% of GDP 0.0 -0.2 -0.6 -0.9

Current Account Balance -14.1 -22.3 -27.8 -31.4

% of GDP -1.2 -1.8 -2.1 -2.2

FDI 15.4 13.0 22.0 30.0

FX Reserves 163.5 186.5 205.0 225.0

MXN/USD (eop) 13.0 13.0 12.9 12.8



Domestic 23.1 24.4 25.0 25.2

External 10.6 11.2 11.5 11.6

Total External Debt 19.3 20.3 21.8 23.4

in USD 227.2 250.2 289.3 334.5

Short term (% of total) 19.0 18.0 17.0 19.0

General

Industrial Production 2.8 0.9 2.7 3.3


Financial Markets (end i d)

Current 1Q14 2Q14 4Q14Overnight rate (%) 3.50 3.50 3.50 3.50

3-month rate (%) 3.80 3.90 4.00 4.25

MXN/USD 13.20 13.20 12.90 12.80

Source: DB Global Markets Research, National Sources

10 April 2014



Peru Baa2 (positive)/BBB+ (stable)/BBB (neutral) Moodys /S&P/ /Fitch

Main risks: A widening of the trade deficit due to

the fall in copper price could be exacerbated by lower than forecasted targets in production in the coming months. The effect of a failure of external demand to the domestic economy would imply a significant drop in economic activity and the already high current account deficit could continue increasing. This would be accompanied by a slowdown in FDI responding to lower commodity prices and tighter liquidity conditions.

All eyes on copper

Activity below average while inflation remains in check Economic activity decelerated in January when the rate of growth of the GDP monthly index fell to 4.2% from the 6.1% observed in the same month one year ago. The result for GDP was explained by a sharp deceleration in primary sectors activity to 3.9% from double digits numbers in the last two months of 2013, as well as a fall in the non-primary sector to a growth level of 4.3%, lower than the average for the past year which was 5.86%. However, coincident indicators suggest acceleration to a rate of growth above 5% in February, as was stated by Central Bank President Velarde.

The National Institute of Statistics INEI reported that consumer prices in the Lima Metropolitan area increased by 0.52%MoM and by 0.55%MoM at the national level in March. These figures were mainly driven by an increase in education expenses (2.47%MoM), and housing, fuel and electricity (0.49%MoM), jointly adding 0.40 percentage points of the monthly rate. Accumulated inflation for the last twelve months reached a value of 3.54%YoY for the national indicator, as the chart below shows, and 3.38%YoY for the Lima Metropolitan area. The three month rate reached 1.32% at the national level. In turn, wholesale prices increased by 0.52% during the month.

In our opinion, the Central Bank will continue with the expansionary monetary policy stance evidenced in 0.5 percentage points decreases in the PEN reserve requirements. On its most recent meeting the BCRP decided to keep the monetary policy rate unchanged at 4.0%, a decision we expect to be repeated in the next meeting. This policy rate is assessed by the BCRP as adequate and compatible with a projected inflation of 2% for 2014 and 2015. However, the monetary authority is expecting inflation to remain close to the upper limit of the target range.

Copper prices continued subdued in international markets. The prospect for this industrial metal, that

constitutes around 23% of the country’s total exports are not as promising. As the graph below shows, the decrease in the price was not temporary and is expected to continue due to an increase in global supply and a decrease in demand from Chinese importers. Compared to the average price for most of 2013, the fall has been around 7.5%, a considerable amount given the weight on the economic recovery that the material’s exports has for the coming year.

Copper price (USD cts. per pound)


The BCRP has forecasted a widening of the trade deficit during the first half of 2014 due to the drop in the price of copper. The expected recovery in the second half of the year The BCRP forecasts a recovery in the second half of the year driven by the reversion in prices and a higher supply of products in mining and fishing sectors. For the entire year the monetary authority anticipates a trade surplus of USD450mn. As the graph below shows further deterioration in exports would continue widening the trade balance as well as the overall current account in the rest of the year.

Current account and Trade Balance

Source: Deutsche Bank and Haver Analytics

10 April 2014



Pension funds and USDPEN stability One of the reasons that market participants attach to the stability of the USDPEN rate is the continued intervention in the foreign exchange market from the Central Bank. However, another main reason of the stable horizon in the currency is that pension funds, a major market participant in the FX market, are already heavily exposed to foreign currency. This causes than in risk-off events even as other EM currencies tend to depreciate, the Peruvian sol would remain stable at current levels. The latest numbers show that more than 60% of exposure to foreign currency denominated assets which precludes the possibility of large increase in demand of foreign currency in the local market.

Pension funds foreign currency exposure

Source: Deutsche Bank ans Asociacion AFP

Cabinet confirmation interrupted The latest spat in the country’s domestic policies was evidenced during the confirmation of the cabinet that was delayed for over three days. Even though the opposition members of Congress did not vote against it, by abstaining to vote they delayed the process. The event shows how popularity of President Humala and his political power has continued decreasing in the latest months.

Armando Armenta, New York, (212) 250 0664

Peru: Deutsche Bank forecasts 2012 2013F 2014F 2015F

National Income Nominal GDP (USDbn) 196.9 194.3 202.4 225.2

Population (mn) 30.0 30.5 31.0 31.5


Real GDP (YoY%) 6.3 5.2 6.0 6.5

Priv. Consumption 6.5 5.0 6.0 6.2


Investment 11.0 6.0 9.0 9.5

Exports 14.0 10.0 10.5 12.0

Imports 23.0 12.0 15.0 15.0

Prices, Money and Banking (YoY%)

CPI (YoY%) 2.7 3.0 2.5 2.7

CPI (avg%) 3.7 2.5 2.7 2.9

Broad money 16.5 15.0 16.0 16.0

Credit 16.0 15.0 15.5 17.0

Fiscal accounts, % of GDP

Balance 2.1 1.0 0.6 0.5


Primary surplus 3.2 1.7 1.5 1.3

External accounts (USDbn) Exports 45.2 52.0 60.0 62.0

Imports 39.8 46.0 52.0 55.0

Trade balance 5.4 6.0 8.0 7.0

% of GDP 2.7 3.1 4.0 3.1


% of GDP -3.1 -5.0 -4.3 -4.5

FDI 12.2 11.0 10.9 12.5


FX rate PEN/USD (eop) 2.55 2.80 2.92 2.87


Domestic 9.8 10.0 10.4 9.5

External 13.6 13.7 12.7 11.6


in USDbn 48.8 52.9 56.0 62.2


General Industrial prod (%) 10.3 9.0 10.0 11.0

Unemployment (%) 6.9 6.8 6.9 6.8

Current 1Q2014 2Q2014 4Q2014Policy rate (interbank o/n) 4.00 4.00 4.00 4.50

3-month rate 4.90 4.90 5.00 5.00

PEN/USD 2.80 2.82 2.86 2.90

Source: DB Global Markets Research, National Sources

10 April 2014



Venezuela Caa1 (negative)/B (negative)/B+ (negative) Moody’s/S&P/Fitch

Economic outlook: Economic authorities have taken pragmatic measures to solve the dire economic conditions and stop the exacerbation of the crisis. The launch of SICAD 2 provides a long awaited devaluation and a flexibilization of the exchange rate regime, a major source of economic instability. Monetary and fiscal tightening measures have been announced. The government and the opposition parties have agreed to start a negotiation process to alleviate the political crisis with the mediation of UNASUR and the Catholic Church. However, the removal from office and incarceration of opposition political leaders will make an agreement difficult.

Main risks: The economic situation characterized by rampant inflation, heightened scarcity, shortage of hard currency and imports, continues. It will take a while for economic authorities to reduce the vulnerability to negative shocks. The opposition appears divided and it is possible that in case some leaders make an agreement to stop demonstrations, some protestors might not follow them exacerbating the negative economic situation.

Sending signals in the right direction

Pragmatism trumps radicalism among economic authorities Economic conditions continued deteriorating in the last month as the squeeze in imports has worsened scarcity and inflation. We expect the slowdown in economic activity to be evidenced in a negative growth rates in real GDP for the last quarter of 2013 and accelerating the decline in the first quarter of 2014. As our theme article on the Breakeven Oil Prices shows, the current account surplus that the country has enjoyed is in peril if there is an unexpected fall in oil prices of around 10%, a possibility that cannot be discarded.

The long awaited adjustment measures that had been delayed for political reasons started with the announcement and launch of operations of the SICAD 2 system. This reform implies a partial, albeit large, devaluation of the currency, one of the causes of the exacerbation of domestic and external imbalances.

The expectations of market participants of a large devaluation were exceeded and in the first two weeks the exchange rate has been hovering around 50 VEF/USD. This system complements the official exchange rate, that continues to be fixed at the at 6.3 VEF/USD to be used for around 80% of imports, while the remaining 20% would be divided between imports at the SICAD exchange rate (around 11.3 VEF/USD),

and at the SICAD 2 rate. This market will provide sellers of hard currency, like PDSVA and corporations that need to obtain bolivares, a more depreciated exchange rate when compared to the 6.3 VEF/USD that they had to sell dollars at, during most of 2013, and even to the average 11.5 VEF/USD that they have been able to obtain since January 2014. Public banks and the Central Bank will also need to supply dollars and dollar denominated bonds to feed the supply and maintain the exchange rate in the future. Moreover, the private sector that has been deprived of foreign currency due to the delays and limitations in quantity of the SICAD system will also be able to obtain access for dividend repatriation and imports of goods and services. With these numbers the weighted exchange rate for imports amounts to around 23.53 VEF/USD, implying close to a 140% annual devaluation.

The details of the system, as of now, do not limit the amount of dollars demanded. However, given the large quantity of pent-up demand for hard currency, even at the 50 VEF/USD rate, we expect the system to apply quantitative restrictions to some degree in the future. In the meantime, the black market exchange rate that had been hovering at around 85 VEF/USD has decreased to 66 VEF/USD recently. Even though the volumes awarded through the system have been low, as the table below shows, the reform implies a step in the right direction and a signal of a change in the helm of the economic team. A more credible adjustment would imply a devaluation of the VEF/USD 6.3 rate and the SICAD (around 11 USD/VEF) that still are grossly overvalued, and settling at the SICAD 2 rate of around 30 VEF/USD. This could be achieved implicitly by rebalancing the amount of imports and hard currency awarded through each of the systems.

SICAD 2 after two weeks of operations Date Exchange Rate Total Daily

(Bs./US$) USD M

March 24, 2014 51.9 5.60

March 25, 2014 51.6 37.80

March 26, 2014 51.4 39.40

March 27, 2014 51.6 103.70

March 28, 2014 50.9 101.00

March 31, 2014 49.8 47.10

April 1, 2014 49.2 n.a.

April 2, 2014 49.0 n.a.

April 3, 2014 49.1 n.a.

April 4, 2014 49.0 n.a.

April 7, 2014 49.1 n.a.

April 8, 2014 49.1 n.a. Source: Deutsche Bank

10 April 2014



Monetary and fiscal policy should tighten The adjustment brought by SICAD 2 should be considered as a down payment on a myriad of reforms going from fiscal and monetary policy to the Law on Fair Pricing and the Labor Immobility Law that have been crippling productivity and fueled scarcity. On the monetary policy front, the excess liquidity in the financial system should be drained. The graph below shows that excess reserves as a percent of base money has decreased after measures to absorb liquidity through open market operations and an increase of the reserve requirement. However, these figures should be taken cautiously as they coincide with a seasonal drop in liquidity related to tax payments.

In the fiscal front a hike in gasoline prices has been brought to the table, as well as an increase in wealth taxes. However, a change in the high level of expenditure that has characterized the economy for the last decade and a half seems difficult.

Excess Reserves of Banking System (% Base Money)

Source: Deutsche Bank and Banco Central de Venezuela

Solution to the political crisis remains challenging As we went to press, the government and the opposition parties had agreed on the mediation of UNASUR and the Catholic Church to the political crisis. The opposition is demanding that the government cedes some political power by electing members of the Supreme Justice Tribunal and the National Electoral Council, as well as a pardon to the political prisoners, among other demands. The radical factions of Chavismo and the opposition will continue to resist any kind of agreement. However, we expect stabilization in the political situation and a continuation of the Maduro administration amid continued protests in the coming month.

Armando Armenta, New York, (212) 250-0664

Venezuela: Deutsche Bank Forecasts 2012 2013F 2014F 2015F

National Income Nominal GDP (USD bn) 381 449 699 486Population (mn) 30 31 31 31GDP per capita (USD) 12,918 14,722 22,564 15,693 Real GDP (YoY%) 5.6 1.5 0.5 3.5 Priv. consumption 7.0 5.0 3.5 5.0 Gov't consumption 6.3 2.7 3.0 7.0 Investment 23.3 1.0 2.5 8.0 Exports 1.6 3.0 0.1 4.0 Imports 24.4 7.0 8.0 10.0 Prices, Money and Banking CPI (Dec YoY%) 20.1 56.5 55.0 60.0CPI (avg%) 23.8 40.0 55.0 57.0Broad Money (%YoY) 60.1 65.0 50.0 45.0Credit 49.0 55.0 45.0 50.0 Fiscal Accounts (% of GDP)



Primary Balance -15.5 -11.5 -5.0 -8.0 External Accounts (USD bn)

Exports 98.0 92.0 95.0 98.0

Imports 58.0 55.0 50.0 60.0

Trade balance 40.0 37.0 45.0 38.0

% of GDP 10.5 8.2 6.4 7.8


% of GDP 3.7 1.6 2.0 3.1

FDI 0.0 0.0 1.0 1.5

FX reserves 29.9 21.7 25.0 30.0

VEF/USD 4.30 6.30 6.30 15.0


Domestic 15.6 15.5 17.5 22.0 External 22.4 19.1 12.3 17.9


in USDbn 98.4 99.6 100.9 101.8

Debt Service (USD bn) 8.6 13.0 14.0 13.7 General

Industrial production (YoY%) 2.4 1.0 2.0 2.5

Unemployment (%) 8.0 8.3 8.5 8.0 Financial Markets (end period) Current 1Q2014 2Q2014 4Q2014

Overnight rate (%) 20.6 25.0 25.0 25.0

3-month rate (%) 14.5 15.5 15.5 17.0

VEF/USD 6.30 6.30 6.30 6.30

(*) Includes PDVSA external debt Source: DB Global Markets Research, National Sources

10 April 2014



Theme Pieces

March 2014 Bailing Out Ukraine Russia Macro Implications of Increased Geopolitical

Risks EMFX:“Good EM/Bad EM” Tail Opportunities Central Europe: a Good EM Story Is the Philippine Peso a (CA) Deficit Currency? India’s Heterogeneous State Finances LMAP – The Next Generation

February 2014 Vulnerabilities, Policy Inaction, and Stigma in the

Recent EM Sell Off Divergent Pricing of Local and External Sovereign

Bonds India: CPI Target Means Higher Rates for Longer Asia Vulnerability Monitor Inside Fragile EM: Trip Notes from Turkey and South

Africa

January 2014 The Durability of Current Account Adjustment in

Central Europe Can DTCC Positioning Data Predict EMFX? Argentina GDP Warrants: More Attractive

Risk/Reward than Bonds

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

November 2013 China: Economic Benefits of TPP Entry EM Rates: Trading Pre-Taper Anxiety Chile's Presidential Election from a Regional

Perspective Inflation Drivers in EMEA The Mystery of Russia's Deteriorating Current

Account Balance Charting Malaysia's BoP Position

October 2013 EM Allocation: Strategic vs. Tactical Sovereign Credit - Fundamentals Re-pricing and

Credit Differentiation Balance of Payment Sensitivities in Latin America Towards free trade across the Pacific Outlook and Implications of Mexico´s Fiscal and

Energy Reforms Greece: GGBs and Warrant, updated and term

structure of risk

September 2013 Emerging Value in Sovereign Credit Brazil: External Adjustment and FX Intervention Latin America: Challenged by US Tapering and Time

Decay Russian Growth: a View from the Regions Poland – A Deeper Look at Pension Reform

July 2013 Foreign Ownership of EMEA Government Debt: an

Update Introducing EM Sovereign Credit Valuation Snapshot India: Battling Vulnerability

June 2013 Capital Flows to EM: Ample but (Mostly) Not

Alarming EMEA Gov’t Debt: Who Holds it (and Will They Keep

It)? EM Credit: Coping with the End of Easy Money EM Rates: Restoring Value LatAm FX: Roadmap to USD Strength and Weakness Brazil: QE Tapering Requires Plan B

May 2013 EM: Boundaries to QE Hype Analyzing the Inflation Bonus from Elusive Growth Venezuela: Time to Take a More Defensive Position Breakeven Oil Prices Greece: GDP Warrants Revisited

April 2013 EM Growth : Unevenly Elusive Brazil: Is CDS Overbought? EM Rates: At an Inflection Point

March 2013 Inflation Targeting: What Target? Mexico: Reforms Are Drawing Nigh Venezuela – Chavismo, The Sequel Ukraine Muddles Through, For Now Argentina: The Sense Of A Legal Ending Revisiting Market-Implied Credit Quality

10 April 2014



Contacts

Name Title Telephone Email Location

EMERGING MARKETS

Balston, Marc Regional Head, EMEA 44 20 754 71484 [email protected] London

Cañonero, Gustavo Regional Head, LatAm 1 212 250 7530 [email protected] Buenos Aires

Evans, Jed Head of EM Analytics 1 212 250 8605 [email protected] New York

Giacomelli, Drausio Head of EM Research 1 212 250 7355 [email protected] New York

Jiang, Hongtao Head of EM Sovereign Credit 1 212 250 2524 [email protected] New York

Spencer, Michael Regional Head, Asia 852 2203 8305 [email protected] Hong Kong

Ortiz, Nellie Global Research 1 212 250 5851 [email protected] New York

LATIN AMERICA

Armenta, Armando Andean Economist 1-212 250 0664 [email protected] New York

Faria, Jose Carlos Senior Economist, Brazil 5511 2113 5185 [email protected] Sao Paulo

Marone, Guilherme EM Derivatives and Quant Strategist 1 212 250 8640 [email protected] New York

Milo, Alexis Senior Economist, Mexico 5255 5201 8534 [email protected] Mexico

Shtauber, Assaf EM Strategist 1 212 250 5932 [email protected] New York

EMERGING EUROPE, MIDDLE EAST, AFRICA

Burgess, Robert Head of Economics, EMEA 44 20 754 71930 [email protected] London

Grady, Caroline Senior Economist 44 20 754 59913 [email protected] London

Gullberg, Henrik EMEA FX Strategist 44 20 754 59847 [email protected] London

Kalani, Gautam Economist, Central Europe 44 20 754 57066 [email protected] London

Kong, Winnie EMEA Sovereign Credit Strategist 44 20 754 51382 [email protected] London

Masia, Danelee Senior Economist 27 11 775 7267 [email protected] Johannesburg

Popov, Eugene Head of CEEMEA Corporate Credit 44 20 754 56460 [email protected] London

Porwal, Himanshu EM Corporate Credit 44 121 615 7073 [email protected] Birmingham

Wietoska, Christian Rates Strategist 44 20 754 52424 [email protected] London

ASIA

Agarwal, Harsh Head of Asia Credit Research 65 6423 6967 [email protected] Singapore

Baig, Taimur Head of Economics, Asia 65 6423 8681 [email protected] Singapore

Cheung, Jacphanie Credit Analyst, China Property 852 2203 5930 [email protected] Hong Kong

Das, Kaushik Economist, India, Pakistan, Sri Lanka 91 22 71584909 [email protected] Mumbai

Del-Rosario, Diana Economist, Malaysia Philippines 65 6423 5261 [email protected] Singapore

Goel, Sameer Head of Asia Rates & FX Research 65 6423 6973 [email protected] Singapore

Kalbande, Swapnil Rates Strategist 65 6423 5925 [email protected] Singapore

Kojodjojo, Perry FX Strategist 852 2203 6153 [email protected] Hong Kong

Lee, Juliana Senior Economist, South Korea, Taiwan and Vietnam 852 2203 8312 [email protected] Hong Kong

Li, Lin Economist, China, Hong Kong 852 2203 6187 [email protected] Hong Kong

Liu, Linan Rates Strategist 852 2203 8709 [email protected] Hong Kong

Ma, Jun Chief Economist, Greater China 852 2203 8308 [email protected] Hong Kong

Paranathanthri, Devinda Credit Analyst, Non-property HY 65 6423 5718 [email protected] Singapore

Sachdeva, Mallika FX Strategist 65 6423 8947 [email protected] Singapore

Seong, Ki Yong Rates Strategist 852 2203 5932 [email protected] Hong Kong

Shilin, Viacheslav Credit Analyst, Banks & Sovereigns 65 6423 5726 [email protected] Singapore

Tan, Colin Credit Analyst, IG Corporates 852 2203 5720 [email protected] Hong Kong

10 April 2014



Projected Policy Rates in Emerging Markets

Q2-2014 Q3-2014 Q4-2014

Emerging Europe, M iddle East & Africa

Czech 0.05 0.05 0.05 0.05 0.05 0.50

Hungary 2.60 ↓ 2.50 ↓ 2.50 ↓ 3.00 3.25 4.00

Israel 0.75 0.75 0.75 0.75 ↓ 1.00 ↓ 1.75 ↓

Kazakhstan 5.50 5.50 5.50 5.50 5.50 5.50

Poland 2.50 2.50 2.50 3.00 3.50 4.00

Romania 3.50 3.50 3.50 3.50 3.75 4.50

Russia 7.00 6.50 6.00 6.00 6.00 6.00

South Africa 5.50 6.00 6.00 6.00 6.00 7.50

Turkey 10.00 10.00 10.00 10.00 10.00 10.00

Ukraine 6.50 6.50 6.50 6.50 6.50 6.50

Asia (ex-Japan)

China 3.00 3.00 3.00 ↓ 3.00 ↓ 3.00 ↓ 3.00 ↓

India 8.00 8.00 7.75 7.50 7.50 8.00

Indonesia 7.50 7.50 7.50 ↓ 7.50 ↓ 7.50 ↓ 8.00 ↑

Korea 2.50 2.50 2.50 2.50 2.75 3.50

Malaysia 3.00 3.00 3.25 3.25 3.25 3.50

Philippines 3.50 3.75 4.00 4.00 4.25 4.50

Taiwan 1.875 1.875 1.875 1.875 2.000 2.325

Thailand 2.00 2.00 2.00 2.50 2.50 2.50

Vietnam 6.50 ↓ 6.50 ↓ 6.50 ↓ 6.50 ↓ 7.00 ↓ 10.00

Latin America

Brazil 11.00 ↑ 11.25 ↑ 11.25 ↑ 11.25 ↑ 11.75 ↑ 12.25 ↑

Chile 4.00 ↓ 3.75 ↓ 3.50 ↓ 3.50 ↓ 3.50 ↓ 4.00 ↓

Colombia 3.25 3.50 4.00 ↑ 4.00 4.75 ↑ 5.00

Mexico 3.50 3.50 3.50 3.50 ↓ 3.75 ↓ 4.00 ↓

Peru 4.00 4.00 4.25 4.50 4.50 4.50

↑/↓ Indicates increase/decrease in level compared to previous EM Monthly publication; a blank indicates no change


Q4-2015

Policy Rate Forecasts

Current policy rate Q1-2015

10 April 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

10 April 2014



Regulatory Disclosures

1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

2. Short-Term Trade Ideas

Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com.

3. Country-Specific Disclosures

Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Investment Advisers Association. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless "Japan" or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bankmay engage in transactions in a manner inconsistent with the views discussed herein. Qatar: Deutsche Bank AG in the Qatar Financial Centre (registered no. 00032) is regulated by the Qatar Financial Centre Regulatory Authority. Deutsche Bank AG - QFC Branch may only undertake the financial services activities that fall within the scope of its existing QFCRA license. Principal place of business in the QFC: Qatar Financial Centre, Tower, West Bay, Level 5, PO Box 14928, Doha, Qatar. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Business Customers, as defined by the Qatar Financial Centre Regulatory Authority. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation. Kingdom of Saudi Arabia: Deutsche Securities Saudi Arabia LLC Company, (registered no. 07073-37) is regulated by the Capital Market Authority. Deutsche Securities Saudi Arabia may only undertake the financial services activities that fall within the scope of its existing CMA license. Principal place of business in Saudi Arabia: King Fahad Road, Al Olaya District, P.O. Box 301809, Faisaliah Tower - 17th Floor, 11372 Riyadh, Saudi Arabia. United Arab Emirates: Deutsche Bank AG in the Dubai International Financial Centre (registered no. 00045) is regulated by the Dubai Financial Services Authority. Deutsche Bank AG - DIFC Branch may only undertake the financial services activities that fall within the scope of its existing DFSA license. Principal place of business in the DIFC: Dubai International Financial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as defined by the Dubai Financial Services Authority.

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

10 April 2014



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.

GRCM2014PROD031821

David Folkerts-Landau

Group Chief Economist Member of the Group Executive Committee

Guy Ashton

Global Chief Operating Officer Research

Marcel Cassard Global Head

FICC Research & Global Macro Economics

Richard Smith and Steve Pollard Co-Global Heads Equity Research

Michael Spencer Regional Head

Asia Pacific Research

Ralf Hoffmann Regional Head

Deutsche Bank Research, Germany

Andreas Neubauer Regional Head

Equity Research, Germany

Steve Pollard Regional Head

Americas Research

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Global Disclaimer Emerging markets investments (or shorter-term transactions) involve significant risk and volatility and may not be suitable for everyone. Readers must make their own investing and trading decisions using their own independent advisors as they believe necessary and based upon their specific objectives and financial situation. When doing so, readers should be sure to make their own assessment of risks inherent to emerging markets investments, including possible political and economic instability; other political risks including changes to laws and tariffs, and nationalization of assets; and currency exchange risk.

Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report.

Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the "Characteristics and Risks of Standardized Options," at http://www.theocc.com/components/docs/riskstoc.pdf If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document.

The risk of loss in futures trading and options, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures and options trading, losses may be incurred that are greater than the amount of funds initially deposited.

Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis. Deutsche Bank makes no representation as to the accuracy or completeness of the information in this report. Deutsche Bank may buy or sell proprietary positions based on information contained in this report. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof. This report is provided for information purposes only. It is not to be construed as an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor's home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorized by the BaFin. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and authorized by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One Raffles Quay #18-00 South Tower Singapore 048583, +65 6423 8001), and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without DeutscheBank's prior written consent. Please cite source when quoting.

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