em outlook 2012

Global

6 December 2011

Emerging Markets 2012 Outlook

Survival of the Fittest

Deutsche Bank Securities Inc.

All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 146/04/2011.

Research Team

Marc Balston (+44) 20 754-71484

Robert Burgess (+44) 20 754-71930

Gustavo Cañonero (+1) 212 250-7530

Marcel Cassard (+44) 20 754-55507

Drausio Giacomelli (+1) 212 250-7355

Michael Spencer (+852 ) 2203-8303

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Special ReportsRates in 2012: Identifying Pockets of Value

FX in 2012: The Vehicle to Trade Global Risk Sovereign Credit in 2012: Diminished Returns; Country Selection Key

EM: Survival of the Fittest EM Performance: The Grass is Grayer on the Other Side

EM Technicals in 2012: Structurally Sound; Cyclically Vulnerable A Closer Look at Real-Money Positioning

IMF Financing: Possibilities and Limitations EMEA Domestic Debt: Supply and Demand in Focus

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Key Economic Forecasts

2010F 2011F 2012F 2010F 2011F 2012F 2010F 2011F 2012F 2010F 2011F 2012F

Global 5.0 3.6 3.2 3.7 4.1 3.6 0.5 0.2 0.0 -5.1 -4.5 -3.8

US 3.0 1.8 2.3 1.6 3.3 3.2 -3.2 -3.1 -2.7 -8.8 -8.5 -6.2

Japan 4.1 -0.4 0.5 -0.7 -0.3 -0.3 3.6 2.2 1.9 -8.7 -8.8 -9.1

Euroland 1.8 1.6 -0.5 1.6 2.7 1.9 -0.5 -0.7 -0.3 -6.3 -4.2 -3.6

Germany 3.6 2.9 0.0 1.1 2.5 2.0 5.6 5.4 5.1 -4.3 -1.3 -1.4

France 1.4 1.6 -0.3 1.7 2.2 1.8 -1.8 -2.8 -2.6 -7.1 -6.0 -5.4

Italy 1.3 0.5 -1.1 1.6 2.7 2.3 -3.5 -3.8 -3.0 -4.6 -4.0 -2.5

Spain -0.1 0.6 -0.9 2.0 3.1 1.3 -4.6 -3.9 -3.3 -9.3 -6.8 -6.0

Netherlands 1.6 1.9 -0.5 0.9 2.5 2.0 6.7 7.0 8.0 -5.1 -3.4 -3.5

Belgium 2.3 1.9 -0.6 2.3 3.4 2.0 2.4 2.0 2.0 -4.1 -3.9 -5.0

Austria 2.3 2.8 -0.5 1.7 3.6 2.1 2.9 2.5 2.5 -4.4 -3.2 -3.2

Finland 3.6 2.9 0.0 1.7 3.3 2.3 3.0 2.0 2.0 -2.5 -1.5 -1.5

Greece -3.5 -5.3 -3.0 4.7 3.1 1.3 -11.8 -9.0 -7.0 -10.6 -9.5 -6.6

Portugal 1.4 -1.5 -2.9 1.4 3.6 2.5 -9.8 -8.0 -6.5 -9.8 -6.5 -6.4

Ireland -0.4 1.5 0.2 -1.6 1.2 1.5 -0.7 0.0 0.5 -31.3 -10.5 -9.1

Other Industrial Countries

United Kingdom 1.8 1.1 1.3 3.3 4.5 3.2 -2.5 -2.5 -2.4 -10.3 -8.2 -6.9

Sweden 5.4 4.1 1.3 1.3 2.7 2.0 6.3 6.5 6.0 -0.1 1.9 3.0

Denmark 1.7 1.4 1.2 2.3 2.6 1.9 5.5 5.8 5.6 -5.3 -1.6 -0.8

Norway 0.3 2.2 1.3 2.4 1.6 1.8 12.3 12.8 13.8 10.6 9.1 10.8

Switzerland 2.7 2.0 1.0 0.7 0.7 0.7 15.6 13.8 13.5 0.8 1.0 1.3

Canada 3.2 2.1 2.5 1.8 3.0 2.5 -3.1 -3.2 -3.1 -3.4 -2.1 -1.8

Australia 2.7 1.6 2.9 2.8 3.4 3.0 -2.7 -2.1 -1.6 -4.1 -3.3 -1.4

New Zealand 1.7 2.0 2.6 2.3 4.4 2.5 -3.4 -3.8

Emerging Europe, Middle East & Africa 4.4 4.4 3.3 6.5 6.3 5.8 1.2 1.6 0.7 -3.7 -1.0 -1.3

Czech Republic 2.2 1.8 0.0 2.3 2.0 3.3 -3.3 -4.0 -3.7 -4.8 -4.3 -3.8

Egypt 5.1 1.8 3.0 10.1 8.9 9.0 -2.0 -2.6 -2.4 -8.1 -9.5 -8.5

Hungary 1.2 1.4 -0.8 4.7 4.1 4.7 1.1 0.6 0.3 -4.3 1.9 -3.2

Israel 4.8 4.5 2.8 2.6 2.3 2.3 2.9 -0.4 -1.4 -3.7 -3.3 -3.5

Kazakhstan 7.3 6.6 5.5 7.8 8.0 7.0 3.1 10.4 8.4 1.5 2.0 2.5

Poland 3.9 4.2 2.3 3.1 4.0 2.4 -4.6 -4.5 -4.4 -7.8 -5.5 -4.3

Romania -1.3 1.8 1.9 8.0 3.5 3.2 -4.2 -3.6 -4.1 -6.4 -4.4 -3.1

4.0 4.5 4.6 8.8 7.1 7.0 4.8 5.9 4.1 -3.9 0.2 -0.4

Saudi Arabia 4.1 5.7 3.7 5.4 5.5 4.5 14.9 18.4 14.5 5.2 9.7 7.3

South Africa 2.8 3.1 3.2 3.5 6.4 6.0 -2.8 -3.1 -3.7 -6.6 -5.5 -5.4

Turkey 8.9 7.0 2.3 6.4 9.2 6.4 -6.6 -9.4 -8.4 -3.6 -1.5 -1.5

Ukraine 4.2 4.5 3.9 9.1 6.5 9.0 -2.0 -2.7 -3.1 -5.0 -2.5 -2.5

United Arab Emirates 3.2 3.7 3.5 1.7 1.6 2.4 8.0 10.1 10.3 3.6 8.2 7.4

Asia (ex-Japan) 9.5 7.3 6.9 5.4 4.8 3.7 3.5 2.6 1.9 -2.2 -2.9 -2.9

China 10.3 9.1 8.3 4.6 3.8 2.8 5.2 4.0 3.4 -1.7 -2.0 -2.0

Hong Kong 7.0 5.3 3.0 2.9 6.0 4.3 6.2 5.5 4.8 4.2 1.6 1.2

India 10.0 7.0 7.5 9.4 7.5 6.0 -3.1 -2.9 -3.1 -4.7 -8.1 -7.4

Indonesia 6.1 6.5 6.3 7.0 4.0 6.5 0.8 0.5 -0.2 -0.6 -1.1 -1.4

Korea 6.2 3.7 3.4 3.0 4.1 3.2 2.8 2.3 0.7 -0.2 1.6 0.3

Malaysia 7.2 5.0 4.3 2.1 3.4 2.1 11.5 11.4 9.9 -5.6 -4.2 -5.0

Philippines 7.6 3.5 3.0 3.1 4.7 4.0 4.2 4.5 3.4 -3.5 -2.9 -3.2

Singapore 14.5 5.0 3.0 4.6 5.3 1.2 22.2 19.1 18.5 5.1 8.0 6.6

Sri Lanka 8.0 8.0 7.5 6.8 4.1 7.6 -2.9 -5.6 -4.9 -8.0 -7.0 -7.0

Taiwan 10.9 4.4 3.0 1.2 1.0 0.6 9.2 8.6 7.6 -3.7 -3.2 -3.4

Thailand 7.8 1.8 3.9 3.0 4.1 3.3 4.6 0.0 -1.9 -1.1 -3.7 -4.9

Vietnam 6.8 5.9 5.6 11.7 18.6 10.8 -4.2 -3.8 -5.1 -6.5 -5.3 6.0

Latin America 6.3 4.1 3.6 8.4 8.2 8.2 -0.9 -0.9 -1.3 -2.4 -2.0 -1.8

Argentina 9.2 7.3 3.1 25.2 23.1 25.4 0.8 0.8 -0.5 -1.5 -2.3 -1.5

Brazil 7.5 3.0 3.3 5.9 6.4 5.3 -2.3 -2.2 -2.6 -2.5 -2.1 -1.6

Chile 5.2 6.0 4.2 3.0 3.7 2.9 1.9 -1.1 -1.7 -0.3 0.8 0.2

Colombia 4.3 5.5 5.0 3.2 3.7 3.4 -3.7 -3.2 -2.7 -3.9 -3.3 -3.2

Mexico 5.5 3.9 3.3 4.4 3.4 3.4 -0.6 -0.7 -1.0 -2.8 -2.1 -2.3

Peru 8.8 6.8 5.9 2.1 4.4 3.5 -1.6 -1.4 -1.7 -0.7 0.1 -0.2

Venezuela -1.4 3.9 4.0 27.2 28.0 27.0 4.6 6.9 2.5 -1.9 3.7 -3.7

Memorandum Lines: 2/

G7 2.9 1.5 1.3 1.4 2.6 2.4 -1.0 -1.3 -1.1 -7.7 -7.0 -5.6

Industrial Countries 2.7 1.5 1.2 1.5 2.7 2.3 -0.9 -1.1 -0.9 -7.3 -6.4 -5.1

Emerging Markets 7.7 6.1 5.5 6.2 5.7 5.0 2.2 1.7 1.1 -2.6 -2.3 -2.3

BRICS 9.1 7.3 7.0 6.3 5.3 4.4 2.5 2.0 1.4 -2.7 -3.0 -2.9

Current Account (% GDP) Fiscal balance (% GDP)

1/ CPI (%) forecasts for developed markets are period averages.

2/ 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.

Real GDP (%) Consumer Prices (%, eop) 1/

6 December 2011 EM Monthly


Table of Contents

Emerging Markets and the Global Economy in the Year Ahead

The coming year is clearly going to be a difficult one for the world economy; however, this resilience will not be uniform

across EM. Given the headwinds, 2012 may well prove to be a case of ‘survival of the fittest’. We expect the tug of war

between structural and tactical drivers of 2011 to extend into 2012 – particularly during the first months of the year,

when the future of Europe may be decided. .................................................................................................................... 11

This Month’s Special Reports

Rates in 2012: Identifying Pockets of Value EM receivers performed well after a rocky start. In our 2012 outlook, we analyze those country specific effects using a

model which integrates macro-monetary policy interactions and local curve dynamics. Under our benchmark scenario

the ‚fair‛ curves are relatively close to forward curves. ..................................................................................................... 22

FX in 2012: The Vehicle to Trade Global Risk During 2011, EMFX played the role of shock absorber with a large share of returns attributed to global drivers. External

factors should remain the main drivers of EM currencies in 2012. .................................................................................... 30

Sovereign Credit in 2012: Diminished Returns; Country Selection Key Given the circumstances, 2011 has been another strong year for EM sovereign credit. We highlight how country

selection (as opposed to simple beta-management) has been a key factor in portfolio selection in 2011. With this in mind,

we devote much of this year’s outlook to a thorough examination of specific country factors (pricing, macro and

technical). ............................................................................................................................................................................ 37

EM: Survival of the Fittest We present a framework for assessing relative vulnerabilities across EM using external, fiscal, financial, and growth

sensitivity indicators. EMEA dominates our list of the most vulnerable countries. Other regions look safer though risk

from rapid credit growth (Asia) and commodity dependency (LatAm) bear watching. ................................................. 46

EM Performance: The Grass is Grayer on the Other Side We see the distribution of returns will likely continue to favor fixed income vs. growth-sensitive assets. Though returns

are diminishing, EM still seems too important a source of carry and value to drop from investors’ priority list – either in

risk-on or risk-off modes. In addition, if returns are less appealing in EM, the opportunities in global markets seem even

less so. ................................................................................................................................................................................ 53

EM Technicals Outlook in 2012: Structurally Sound; Cyclically Vulnerable A broad set of metrics suggest that structurally global investors are still under-allocated to EM. However, valuation, lack

of depth, and market access suggest that the pace of strategic inflows will be considerably slower going forward when

compared with 2003-2007. ................................................................................................................................................. 58

A Closer Look at Real-Money Positioning EM local currency funds have grown by a factor of almost 3.5x over the past four years, increasing their impact on the

behaviour of local markets. In this article we examine the rise of these funds and also introduce a new analysis of the

country positioning of such funds. ...................................................................................................................................... 63

IMF Financing: Possibilities and Limitations We review the various options on the table for boosting the financial firepower of the IMF, concluding that an increase

in bilateral loans is the proposal most likely to fly. The need for a bigger IMF is primarily to deal with the euro crisis. We

think the IMF already has enough in its locker to deal with likely EM needs. ..................................................................... 71

EMEA Domestic Debt: Supply and Demand in Focus Since Q32011, forced deleveraging has caused some foreign investors to either cut or hedge their holdings of local

currency government debt. This note presents detailed estimates of the supply/demand dynamics of each EMEA market

in 2012. We flag opportunities and threats from the perspective of technicals. ................................................................ 76

Theme Pieces .................................................................................................................................................................. 184



Summary Views – LatAm

Economic Outlook Main Risks Strategy Recommendation

Argentina

Page 84 The government seems to be

ready to combine some fiscal

consolidation with tighter FX and

price controls, and labor union

persuasion aiming at managing a

soft landing to a 5% growth

pace. Nonetheless, inflation

stability together with FX

sustainability will demand an

even weaker economy. The

sooner the government accepts

that reality, the smoother the

expected economic path ahead.

A likely resistance will only

accelerate economic slowdown,

and short term inflation.

Further confirmation of

current policy continuity

could only preserve an on-

going currency run and a

severe capital flight. Lack of

investment amid fiscal

expansion, together with

unfriendly policies, could

maintain high inflation,

reinforcing fears of potential

financial stress. The current

pace of real appreciation is

leading to a rapid and sharp

deterioration of external

accounts, while strong fiscal

spending is adding stretch to

difficult financing.

Remain neutral in the currency, but

the front-end of the NDF curve

offers attractive carry for those

willing to sustain elevated risk.

Continue avoiding the CER curve

which offers unfavorable

FX/inflation breakeven. Badlar-

linked bonds are more attractive

for those seeking local peso

exposure. Stay neutral on external

debt but be conservative on

duration, favor credit to Warrants

and favor global bonds (especially

the Global 17s) over local law

bonds. In addition we recommend

long basis on Global 17s vs. 5Y

CDS.

Brazil

Page 88 The government has showed that

it intends to use all possible

instruments to prevent a strong

economic deceleration by easing

monetary policy aggressively,

revoking some ‚macro-

prudential‛ measures, and

introducing fiscal measures to

stimulate consumption.

Therefore, we expect the

economy to grow slightly above

3% in 2012 despite the bleak

global outlook. Although inflation

is poised to decelerate in the

next months due to the recent

economic slowdown and lower

commodity prices, it will likely

remain above 5% due to high

inertia and aggressive monetary

easing.

The government’s initiative to

aggressively ease monetary

policy to prevent a significant

economic slowdown could

damage its credibility and

lead to permanently higher

inflation, especially if not

accompanied by the

promised fiscal austerity. The

large increase in the

minimum wage and

mounting pressure on the

government to increase

investment in infrastructure

do not bode well for fiscal

restraint in 2012. The BRL

remains vulnerable to lower

commodity prices.

Take profits on long 1M USD/BRL

FVA and enter zero-cost 1M

USD/BRL put spread Take profits

on Jul ’12- Jan ’17 steepener and

enter Jan ’13- Jan15’ flattener.

Stay neutral on external debt and

continue to favor 41s and 40s (to

call) vs. 21s. In addition, we favor

short basis at the 10Y sector as a

tactical trade.

Chile

Page 92 The economy continues to

decelerate along an unbalanced

path, with domestic demand still

growing at a higher pace than

supply. Nevertheless, albeit

some surprises, domestic

inflationary pressures are still

subdued. A weakening CLP and

tight labor markets have so far

had little impact on inflation. The

Central Bank of Chile (BCCh) is

increasingly considering easing

monetary conditions to

counteract negative effects from

the external scenario.

Domestic demand could

adjust faster than expected

due to uncertainty in external

conditions. A slowdown in

global growth and a potential

deceleration in China could

affect copper prices. There

could be some form of

contagion from a credit event

in Europe due to the links

between local and Spanish

banks.

Maintain short EUR/CLP. Shift

from 2Y to 5Y breakeven inflation

and enter 2s5s CLP/CAM

steepener. Underweight sovereign

credit, and buy 5Y CDS vs. Brazil

as a defensive trade.



Summary Views – LatAm


Colombia

Page 94 Economic activity keeps growing

robustly, while inflation has risen

temporarily, fueled by food

prices. BanRep has begun to hike

the policy rate again, and will

continue to do so in 2012. The

fiscal accounts are improving on

the back of tax collection

outperformance.

Higher inflation because of

stronger commodity prices

and/or domestic demand

pressures. Overheating and

bubbles prompted by a credit

boom. A relapse in the US

economy, destination of

more than one third of the

country’s exports.

Remain on the sidelines waiting for

better entry levels to get exposure to

COP. Close 2s3s COP/IBR steepener

and receive 5Y COP/IBR (or TES Jun

’16) against 5Y USD swap. Stay

overweight external debt and favor

shorter-end of the curve, where we

favor off-the-run 19s and 20s over

the benchmark 21s.

Mexico

Page 98 Headline inflation has accelerated

but core remains well behaved,

very near the medium term target.

Economic activity surprised on the

upside during 3Q11, and will

decelerate very gradually over the

coming months. The negative

output gap will not close until 2012.

Banxico is unlikely to cut the

funding rate unless the currency

appreciates back towards pre-US

downgrade levels.

A relapse in US economic

activity. Higher inflation

because of strong

commodity prices and/or

higher pass-through from

depreciation. Volatility of

political origin ahead of next

year’s presidential elections.

Take profits on long MXN/CZK and

enter short CAD/MXN. Take profits

on 5Y TIIE payer and enter 2s10s

TIIE flattener vs. 2s10s USD swap

steepener. Neutral external debt.

The old 19s remain significantly

rich to the curve.

Peru

Page 102 GDP growth is to be near 7% this

year, slowing down very gradually

towards 6% in 2012. The inflation

spike is likely to be temporary,

but it will prevent monetary

easing for now. Structural excess

demand for dollars is to maintain

the currency well supported.

Higher inflation because of

food prices. Weaker fiscal

and external performance

because of softer mining

prices, if global growth

falters.

Maintain long 3M USD/PEN NDF

and remain neutral on rates.

Increase to overweight external

debt, take profit in the 37s to 19s

switch and now favor the long end

of the curve.

Uruguay

Page 104 Economic growth is decelerating

gradually, converging towards

trend levels, although risk of the

projections is on the upside given

the pipeline of investment

projects. Inflation remains well

above the ceiling of the target

range, preventing any monetary

easing for the time being.

A drop in commodity prices.

A further acceleration in

inflation. Weaker growth in

the country’s main trading

partners.

We favor UYU ’18 as a buy and

hold strategy due to elevated carry

and diversification.

Venezuela

Page 106 Economic activity is picking up

speed, following the contraction

of the past two years and beating

expectations. The recovery should

continue next year on the back of

very expansive fiscal and

monetary policies, ahead of the

presidential elections. Inflation

remains the highest across the

EM universe.

Lower oil prices as a result of

softer global growth or a

financial disruption in Europe.

Further acceleration in

inflation because of food

prices and/or pressures from

very loose fiscal policy.

Volatility of political origin

before next year’s

presidential elections.

Increase to a small overweight,

favoring the Republic over PDVSA.

On Venezuela, 28s look the most

attractive. On PDVSA, we continue

to favor the 13s (for carry-oriented

investors) but also consider moving

to the mid-end of the curve where

we favor the 22s. In addition, while

we continue to recommend long

basis on the sovereign curve (24s

vs. 10Y being the best trade at the

moment), we also like PDVSA 22s

vs. Venezuela 10Y CDS.



Summary Views – EMEA


Czech

Republic

Page 110

The combination of a weak

labour market, ongoing fiscal

austerity and an expected

recession in Euroland leaves a

significant risk of recession in

Czech Republic. But with the

public debt/GDP ratio sub 40%

and C/A deficit financing the

most secure in the region, the

medium-term fundamentals

remain strong.

Germany is by far Czech

Republic’s largest export partner

accounting for 22% of GDP in

exports. A more protracted

recession in Germany leaves

significant downside risk for the

Czech economy and could well

push the CNB into a rate cut.

2s10s IRS set to

steepen.Neutral on rates.

Neutral on EUR/CZK

Egypt

Page 114 The economy is likely to gain

strength in FY2011/12 with

political transition, base effects

and greater access to external

financing.

Occasional setbacks in political

progress and delay in

implementation of a

comprehensive economic plan

in coordination with and funding

from multi-lateral institutions

could lead to a much weaker

growth performance.

Neutral EGP. Political stability

and resumption of talks with

IMF will hold the key.

Hungary

Page 118 We expect Hungary to tip back

into recession in 2012. Fiscal

drag is set to increase in line with

the government’s commitment

to stick to a 2.5% of GDP fiscal

deficit while rate hikes, FX

weakness and rising deleveraging

will all severely constrain growth

for some time ahead. With the

expected recession in Euroland

net trade will be unable to offset

the negative domestic

environment.

Likely policy conflicts between

the authorities and the IMF/EU

risks prolonged program

negotiations which could mean

continued pressure on the

currency, a larger hiking cycle

and further rating downgrades.

It could also mean a very

difficult backdrop to meet

external refinancing needs.

NBH to provide ceiling in

EUR/HUF. Sell vega neutral

3m/6m straddles in EURHUF.

Underweight sovereign credit.





Israel

Page 122 The divergence between strong

domestic absorption and faltering

net exports is set to dwindle,

pointing to a marked loss in

growth momentum. Inflation is

expected to behave benignly,

providing room for further easing

if needed, although housing

dynamics and ILS will also play an

increasingly important role. The

C/A is set to turn negative and

remain in deficit throughout the

forecast horizon, while fiscal

consolidation arrives with a delay.

The geopolitical risk premium is

set to remain elevated given

multiple sources of concern. A

more rapid than needed

deceleration in housing prices

may lead to financial stability

risks and complicate rate

outlook.

Favour tactical shorts in EUR/ILS

above 5.10. Receive 2Y IRS

Kazakhstan

Page 126 Growth is picking up and

inflationary pressures are on the

rise.

The key vulnerability remains in

the banking sector, with

negative implications for

recovery in loan growth.

Maintaining a relative

preference for KZT NDFs vs

their UAH counterparts. Neutral

on sovereign credit (CDS).

Poland

Page 128 A Poland’s larger and less export-

orientated economy compared

with elsewhere in CEE should

outperform again in 2012. While

growth will undoubtedly slow

there is little risk of recession. The

pace of slowdown alongside zloty

performance, the inflation outlook

and the fiscal stance will all

determine the scope for rate cuts

in 2012. We see this as unlikely

before Q3.

Any evidence that the new

government lacks commitment

to fiscal austerity could quickly

put pressure on yields and see

the rating outlook revised to

negative. The discussed

methodology changes to

calculation of the debt rule, if

used as a substitute for fiscal

reform, would be a big negative

in this regard.

We recommend a 1y EUR/PLN

put, with a and strike at 4.25 for

2% of EUR notional.Receive 1Y

XCCY basis as a hedge but

outright purchase of POLGBs

will be attractive in H2 201.

Overweight sovereign credit.

Romania

Page 132 A precautionary IMF/EU SBA in

place until 2013 combined with

the government’s intention to

increasingly tap the Eurobond

market ahead of large external

redemptions in 2013/14 should

help to ensure reform fatigue is

avoided and the structure of

growth continues to improve.

Despite a very difficult external

backdrop we see upside risks to

our growth projection from

stepped up absorption of EU

funding and reform of loss-

making SOEs.

Fiscal slippage in the run up to

the Q4 general election risks

pushing the IMF/EU program off

track and would limit scope for

further monetary easing. It

could also put pressure on the

ratings.

Neutral FX. Overweight

sovereign external debt.





Russia

Page 136 Growth accelerating on the back

of high consumption and fixed

investment growth.

Recurring capital outflows and a

drop in oil prices remain key

risks.

Short NOK/RUB, for a move

back down to 51 flat. OFZs

likely to perform in 2012.

Overweight sovereign credit.

South Africa

Page 140 The much weaker growth base in

Q2 and Q3 makes for

encouraging rebound potential in

growth into 2012. We do not

expect a recession locally, as we

estimate this probability between

10-15%. Household demand is

expected to be the main growth

driver in 2012.

Deteriorating global growth,

negative repercussions for

terms of trade could severely

harm corporate profits. From

these risks stem employment

losses, which will offset the

benefit of lower commodity

prices on inflation.

Buy a 1y digital EUR/ZAR put

struck at 10 for roughly 25% of

EUR notional. ZAR curve set to

steepen. Underweight

sovereign credit.

Turkey

Page 144 Rebalancing in the economy

continues with domestic demand

slowing down gradually and

imports losing momentum.

Inflation will continue to rise in

the short term due to FX pass-

through and higher food prices.

A harder landing is on the cards

given the large exposure to

short-term funding from

international banks, balance

sheet effects of a weaker

currency and volatility in capital

inflows.

Having hit the target on long

TRY/HUF, we recommend

playing the range in USD/TRY.

Buy a DnT with strikes at 1.70

and 1.90. Add exposure to Jan-

20 bonds if the economy

responds to the ongoing

tightening. Overweight


Ukraine

Page 148 Growth has been robust but is set

to soften on the back of rising

macroeconomic

Hryvnia weakness on the back

of the deteriorating balance of

payments remains a risk

The negative skew of risks

warrant a bearish position in

NDFs. Underweight sovereign

external debt.



Summary Views – Asia


China

Page 150

For 2012, we expect the economy

to be featured by 1) disinflation, 2)

initial growth deceleration followed

by a recovery, and 3) policy easing

in 1H followed by a more cautious

stance towards the end of the year.

We maintain our 2012 GDP growth

forecast at 8.3% (down from 9.1%

in 2011), with a qoq trough in Q1

(at 6.4% saar, slightly deeper than

our earlier projection of 6.8%) and

a sequential recovery from Q2. For

2013, we expect GDP growth to

recover to 8.6% largely on stronger

export growth. On policies, we

expect 2-3 more RRR cuts in the

coming 6-9 months, which should

permit average monthly RMB

lending to rebound to RMB800-

900/month in 1H, and annual

lending to reach around RMB8.4tn

in 2012. We expect the fiscal

deficit-to-GDP ratio to remain

largely unchanged at 2-2.2% in

2012. Fiscal priorities in 2012

should include public housing,

completion of on-going

infrastructure projects, SMEs,

services, and consumption.

The two most important shocks

to the economy in the coming

months are property FAI

deceleration and export

slowdown. We expect property

FAI growth to slow from the

current 25 30%yoy to 15%yoy in

the first few months of 2012.

We expect export growth to

decelerate from the current

15%yoy to 8-9% in 1Q 2012.

We favor Repo swap NDIRS/IRS

and Shibor swap 2x5 NDIRS/IRS

steepeners to express our view

that interbank liquidity will ease

markedly in the coming 6-9

months. We retain our bullish

view on the CGB cash bonds.

Expect a slower pace of RMB

appreciation in 2012.

Hong Kong

Page 156

Growth in Hong Kong continues to

follow the lead of the US and EU

economies. This means markedly

slower growth in 2012 but a likely

return to reasonably robust growth

in 2013

A disorderly resolution of the

sovereign debt crisis in Europe

would likely be translated into a

deep recession in Hong Kong.

We see upside risk on Hibor -

Libor basis in Q1 next year

driven by corporate liability

hedging demands.

India

Page 158

Assuming no big collapse in global

financial markets, the Indian

economy ought to grow by 7-7.5%

in 2012, supported by rate cuts

from RBI around mid-2012

Worsening of twin deficits could

prevent inflation from moderating

to mid single-digit levels, which

could complicate RBI’s monetary

policy decision, especially if

growth were to slow sharply at

about the same time

Pay steepeners on the OIS

curve (1Y/2Y) to position for the

turn in the cycle. Risk to INR

gets more digital next year, with

policy intervention a key factor.

Indonesia

Page 164

Building on the momentum built

over the past couple of years,

Indonesia steps into 2012 with

well-anchored consumer and

business confidence, which could

allow the economy to grow by over

6% at a year when global growth

will likely slow sharply.

Inflation could rise sharply on the

back of electricity and fuel price

adjustments, and as demand

remains strong. Rupiah could

come under pressure if global

liquidity crunch and risk aversion

continue. Bond yields could rise

for the same reason.

Increase underweight as 10Y

yields close in on 6%.



Summary Views – Asia


Malaysia

Page 166

Slower export growth will weigh on

investment spending and

consumption cushioned by

continued easy monetary and fiscal

policies.

The main risks lie abroad,

especially the possibility of a

deeper recession in Europe.

Vulnerability to bond market

outflows keeps us cautious on

rates (with a steepening bias)

and neutral on MYR.

Philippines

Page 168

Growth has slowed owing to a

weakening of external demand, but

domestic demand is likely to hold

up as inflation declines, while

consumer and business sentiment

remains resilient.

External demand could be

weaker than expected if the

crisis in Europe deepens further.

Modest overweight on duration

into 2012. Peso to be more

resilient than regional FX.

Singapore

Page 170

Slower global growth means much

slower growth in Singapore in

2012, but sharply lower inflation as

well.

Singapore is Asia’s most export-

sensitive economy, so macro risk

derives mainly from the US and

Europe.

SGS has strong technicals but

rich valuations. Expect the yield

curve to flatten in 2012. Trade

SGD NEER in a range.

South

Korea

Page 172

We see South Korea’s growth to

follow the G2 cycle, reporting a

below trend growth of 3.4% in

2012, followed by a notable

rebound to 4% in 2013.

The sovereign debt crisis in

Euroland pose serious downside

risks to growth.

We look for further steepening

on the KTB curve. Concerns

about lack of reinvestment

demand from offshore fund

investors should reduce, which

is supportive of 2Y-3Y segment.

Sri Lanka

Page 172

Real GDP growth likely to

moderate to 7.5% in 2012 (from

8% in 2011), led by a negative base

and weak external demand.

There is a non-trivial risk that the

ongoing fiscal consolidation

process suffers a setback, in the

event of any external shock, that

threatens to lower growth below

7% in 2012.

Taiwan

Page 178

With exports at 74% of GDP, we

see weak G2 growth of 1% in

2012, vs. 1.7% in 2011, guiding

Taiwan’s growth lower to 3.0%

from 4.4% in the same period.

Risks to our rates outlook remain

to the downside amid the

sovereign debt crisis in Euroland.

We believe TWD interest rate

swap curve is unlikely to break

its recent range in the next three

months unless CBC surprises

the market with cuts in the

policy rates. We recommend to

hold paying the belly in TWD

2x5x10 notional neutral butterfly

position.

Thailand

Page 180

We see GDP growth rebounding to

3.9% in 2012 from 1.8% in 2011,

supported by reconstruction

activities. The latter and weak

exports, however, point to a

current account deficit of 1.9% of

GDP in 2012.

Risks to growth remain to the

downside due to fragile external

conditions and implementation

risks to reconstruction plans.

Bond and swap curves to

steepen driven by valuations,

supply concerns and a more

dovish outlook on monetary

policy.

Vietnam

Page 182

We expect a modest slowdown in

GDP growth, to 5.6% in 2012 from

5.9% in 2011, as lower inflation

and rates counter the negative

impact of weaker external demand.

The banking system remains

under pressure, posing downside

risks to growth and the dong.



Emerging Markets and the Global Economy in the Year Ahead

The coming year is clearly going to be a difficult one

for the world economy. Nevertheless, if, as we

expect, the US economy can continue to tick over at

even a little below trend and China can avoid a hard

landing, this will provide a moderately constructive

backdrop for most of EM. We thus think that EM can

grow at about 5½% in aggregate next year.

However, this resilience will not be uniform across

EM. Whereas we think much of Asia and Latin

America are relatively well placed to weather the

current storm, public and private balance sheets are

generally weaker in EMEA, which is also more

directly exposed to the euro crisis through stronger

economic and financial linkages.

Given the headwinds, 2012 may well prove to be a

case of ‘survival of the fittest’ and with this in mind

we introduce a new framework for assessing relative

vulnerabilities across countries in the EM universe.

We expect the tug of war between structural and

tactical drivers of 2011 to extend into 2012 –

particularly during the first months of the year, when

the future of Europe may be decided. Valuation

supports EM credit, local rates, and FX – particularly

under the risk of some financial repression in the

developed world. Structurally, flows should also

continue to benefit EM, as global investors remain

under-allocated.

In EMFX is most vulnerable to global risk and stands

to benefit more from EU progress. We favor the more

‚US-centric‛ MXN in LatAm, and RUB on persistently

high oil and inflows. Add ZAR tactically only vs. AUD

and HUF while EU uncertainty remains high despite

underperformance. We position for further

appreciation in RMB and PHP.

In rates, value is less than in FX, but fundamentals

support receivers in Mexico, Brazil (for now),

Colombia, Israel, and bonds in Russia, Poland, and

modestly so in the Philippines, but underweight

Indonesia. We favor steepeners in Chile, China,

Korea, and Thailand.

In sovereign credit we expect 2012 to be another

year of modest returns in which country selection

holds the key to outperformance. We recommend

overweight exposure to Venezuela, Colombia, Poland,

Russia, and Turkey; underweight exposure to

Hungary, Ukraine, Chile, and South Africa.

The survival of the fittest

Lower debt tolerance was a trademark of 2011. What

once seemed to be largely an EM trait has become

widespread and likely to constrain the financing of many

DM countries, despite their much deeper credit markets.

Adapting to this new reality will require protracted debt

reduction and thus years of fiscal responsibility, possible

financial repression in some cases, and – as the market

stress even in lower-debt economies such as Spain has

shown – structural reforms to boost potential growth and

improve debt dynamics. The possible outcomes have

become more binary given scarcer financing. But under

our baseline scenario of EU crisis resolution that we

expected to start to be delineated in weeks to come, the

US avoiding recession, China soft-landing, and with EM’s

more vulnerable ‚periphery‛ too small to pose a

significant systemic risk for the asset class, we expect

growth in (the less indebted) EM to outperform by almost

4.5ppts the industrial economies (table).

Summary Growth and Inflation Forecasts

2010F 2011F 2012F 2010F 2011F 2012F

Global 5.0 3.7 3.2 3.7 4.1 3.6

US 3.0 1.8 2.3 1.6 3.3 3.2

Japan 4.1 -0.4 0.5 -0.7 -0.3 -0.3

Euroland 1.8 1.6 -0.5 1.6 2.7 1.9

EEMEA 4.4 4.4 3.3 6.5 6.3 5.8

Russia 4.0 4.5 4.6 8.8 7.1 7.0

Asia (ex-Japan) 9.5 7.6 7.1 5.3 4.5 3.8

China 10.3 9.1 8.3 4.6 3.8 2.8

India 10.0 8.0 8.0 9.5 7.5 6.0

Latin America 6.3 4.1 3.6 8.4 8.2 8.2

Brazil 7.5 3.0 3.3 5.9 6.4 5.3

Memorandum Lines: 2/

G7 2.9 1.5 1.3 1.4 2.6 2.4

Industrial Countries 2.7 1.5 1.2 1.5 2.7 2.3

Emerging Markets 7.7 6.2 5.6 6.2 5.6 5.0

BRICS 9.1 7.5 7.2 6.4 5.3 4.4

1/ CPI (%) forecasts for developed markets are period averages.

2/ 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.

Real GDP (%) Consumer Prices (%, eop) 1/

Source: Deutsche Bank

More than a debt crisis year, however, 2011 has

highlighted that – at its very core – this is a governance

crisis. It has been governance and thus capacity to react

that has differentiated performance across the highly

indebted Ireland vs. its peripheral peers, the Fed vs. the

ECB and the also highly indebted US vs. Europe. The

failure of the super-committee has recently reminded us

that we should not underestimate the governance issues

the US faces either, but time is of essence and those are

less pressing and more back-loaded than in the EU. Not

only does the US face better initial growth conditions and

demographics, more flexible markets, a less leveraged

banking sector and a population that largely supports a



compromise between the parties, but it has better control

over its monetary policy. Accordingly, despite the

challenges faced by the US and also some emerging

economies, 2012 will be largely driven by EU political

decisions.

Encouragingly, after successive attempts at building

backstops against contagion, we believe that the EU

authorities’ mindset has finally evolved to what we believe

is the fittest policy to resolve this crisis: More integration.

They will face an uphill battle against numerous

institutional constraints – both fiscal and monetary. But

the tolerance for muddling through is now limited and we

believe that the tone of the year will be dictated by the

progress EU authorities make in the first few months of

2012 and a more concerted action seems now underway.

As governance cannot be quickly built, market pressure

seems to us the most credible incentive device and thus

poised to linger. Therefore, this is unlikely to be a bright

year for growth but a year where growth prospects could

brighten somewhat later on as a stronger fiscal pact is

forged in the EU and political (and fiscal) uncertainty is

resolved in the US.

EU: The long and winding road to resolution

We expect material progress toward resolution rather

than dissolution of the EU in 2012. With the crisis deeply

rooted in core countries, widespread recession underway,

and relentless market pressure, EU authorities seem now

committed to tackle the region’s Achilles heel: the lack of

fiscal framework that is consistent with monetary union. It

would be naïve to expect them to take such a task in

stride as treaty changes cannot be delivered fast, but the

EC summit on December 8th-9th should present a positive

blueprint for action. Ideally, the EU should be able to

change national budgets in line with the euro stability, but

DB believes that authorities will pursue a less ambitious

proposal where judicial actions – in addition to financial

sanctions – could be used to enforce a beefed up Stability

and Growth Pact. Whether this would appease markets is

questionable, as the EU would still need to deliver a crisis

resolution framework to deal with the potential offenders.

From a timing perspective, however, it is more important

in preventing the escalation of this crisis that this blueprint

is enough to persuade the ECB to step up its securities

purchases1.

A concerted action from governments and monetary

authorities was instrumental in changing market

sentiment in the post-Lehman debacle and we believe

1 Italy’s response has been impressive in such a short period of time,

although obviously incomplete. The acceleration in pension reform and

expected correction in fiscal accounts underway should encourage the

ECB to help.

that concerted action is needed – and likely – once again.

The coordinated action to ease dollar funding shortages

was a first step in this direction and there have been

indications that more is underway. That France and

Germany endorsed greater fiscal integration is also

welcomed, but this needs to reach critical mass within the

EU (we believe it will). As the risk that the EU crisis goes

global has risen, G-20 economies (and Germany in

particular) seem open to increasing the IMF’s firepower

via bilateral loans, although likely conditional on increased

ECB participation. Judging by the original support

(EUR500bn from EFSF and EFSM, and EUR250bn from

the IMF), DB estimates that the combined IMF/EFSF pool

would have to increase by EUR425-650bn to cover up to

three years of funding needs for Italy, Spain, and Belgium

after discounting for commitments and bank capitalization

contingencies. Assuming the original IMF/EFSF ratio

holds, this would require additional USD825bn. Given the

pending maturities across both banks and sovereigns this

concerted action is needed fast.

What should we expect from the ECB? With European

banks facing EUR450bn in maturities in 1H12, 2Y and 3Y

LTRO extension seem more likely now. But it is important

that the eligibility criteria for collateral are eased. This

could be accomplished via the reopening the facility for

non-euro paper that was discontinued this year.

Alternatively, the ECB could accept lower-rated paper,

although this could face more resistance. Regardless, we

expect the ECB to cut 25bp in December with a risk of a

50bp. Most important is that it accelerates its SMP as

discussed above, although we doubt it would commit to

large amounts a la Fed. In principle, given the risks to the

transmission of monetary policy and price stability it

should be ready to do so, but it will likely await for the

‚green light‛ from fiscal authorities and possibly move

more aggressive during 1Q when maturities peak.

ECB balance sheet to grow further

0

5

10

15

20

25

0

50

100

150

200

250

May-10 Sep-10 Jan-11 May-11 Sep-11

Weekly purchases (rhs)

Cumulative (lhs)

ECB government bond purchases, EURbn

Stage 1:

Greece crisis

Stage 2:

Ireland crisis

Stage 3:

Portugal crisis

Stage 4:

Ita/Spn




Even if significant progress is made early on it is very

unlikely that the EU could avoid a recession of a least 1ppt

peak-to-through. Fiscal tightening is pervasive, monetary

policy has little room to maneuver, and – with banks

forced to increase their capital ratios – there is less

smoothing in private consumption and investment that

could offset reduced public demand. As a silver lining

when compared with post-Lehman performance, an

already depressed starting point in the cyclical and

stronger external demand could ease the fall

An outright contraction in euro area GDP in 2012

GDP, % yoy

2010 2011F 2012F 2013F

Germany 3.6 2.9 0.0 1.0

France 1.4 1.6 -0.3 1.2

Italy 1.2 0.5 -1.1 0.7

Spain -0.1 0.6 -0.9 0.8

Netherlands 1.6 1.9 -0.5 1.2

Belgium 2.3 1.9 -0.6 1.2

Austria 2.3 2.8 -0.5 1.2

Finland 3.6 2.9 0.0 1.4

Portugal 1.4 -1.5 -2.9 0.4

Greece -4.4 -5.3 -3.0 0.1

Ireland -0.4 1.5 0.2 1.4

EA-17 1.8 1.6 -0.5 1.0 Source: Deutsche Bank

US: Avoiding recession

In the US, 2012 is likely to be another year of sluggish

recovery with growth in the vicinity of 2.5% and with only

modest improvement in the labor market – assuming

authorities control the EU crisis. The recent data have

reinforced the view that the US can decouple from the

likely recession in Europe, with the latest ISM near 53 –

led by new orders at 57. The cyclical components of

demand remain near historical lows thus limiting

downside, but we expect real estate contribution to

growth to accelerate no earlier than in 2013. Home prices

are already nearing the bottom (we see just 4% downside

through 2014), but economic conditions indicate that the

depressed rate of household formation (about half the

historical norm), the overhang of vacant homes and the

still high pace of foreclosures (despite some retrenchment

in recent months) will remain a drag in 2012 2 . The

government’s renewed efforts to ease refinancing (HARP)

will possibly double the participants, but they will remain

marginal. A large-scale program involving principal write-

downs could be a lot more effective, but this is unlikely to

gain much political support ahead of elections.

2 See ‚US Housing Dormant for 2012, Global Economic Perspectives,

December 1st, 2011.

PMIs have decoupled most recently

35

45

55

65

00 01 02 03 04 05 06 07 08 09 10 11

Index, > 50

increasing

35

45

55

65

IndexISM composite index of US (ls)

Euro area PMI: composite output (rs)

Correlation:

Jan'00 - Jul'07 = 0.52

Aug'07 - present = 0.91


The outlook is brighter for consumer durables and

business investment, although less so for the latter as it is

already close to historical average. Altogether, our models

suggest that pent-up consumer and business spending

should more than offset the 1-2% of fiscal drag we pencil

in for the year even under ‚current policies‛ 3 (chart).

Obama’s American Jobs Act (AJA) could offset this drag,

but given the chasm between Democrats and

Republicans we expect the latter to concede on only what

they believe is enough not to be blamed for a double-dip

and this would amount to possibly extending payroll tax

cuts and unemployment benefits. Still, this could reduce

the amount of fiscal drag next year by 1ppt of GDP (to

1%). Inflation is likely to ease a bit from levels that have

been elevated by commodity price increases to remain

relatively subdued – excluding food and energy. But with

US yields already about 100bp depressed vs. what recent

data implies and the outlook for prices far off deflation

territory, Fed actions should continue to be more effective

at attenuating the transmission of EU shocks through the

banking system and easing dollar funding shortage.

3 The CBO’s ‚current law‛ projections assume the expiration of payroll tax

cuts, extended unemployment benefits, AMT patch, and ‚Doc Fix‛ in 2012

and Bush tax cuts in 2013. These account for a substantial part of the

deficit reductions under the CBO ‚current law‛ scenario with the rest

stemming from the winding down of the stimulus package. As no

meaningful tax reform is expected ahead of elections, we expect many of

the Bush tax cuts, the ‚Doc Fix‛, and the AMT patch to be extended (the

‚alternative policy scenario‛), with possible extension also of the payroll

tax reduction and unemployment benefits.



No scope for further easing for now

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

10

20

30

40

50

60

70

80

90

100

110

03 04 05 06 07 08 09 10 11

US Surprise Index

UST 10y (LHS)


Although we cannot ignore risks to our scenarios for fiscal

policy and housing it is the EU crisis that poses the most

pressing and potentially most damaging threat. And since

the US is a relatively closed economy – the main risk is

financial contagion. From a pure trade perspective, 1ppt

drop in EU growth would reduce US GDP growth by only

0.1ppt, according to DB estimates. The impact estimated

via simple macro models such as OECD’s is similar, but it

would increase to 0.3ppt if we assume 10% euro

depreciation in line with the 1ppt drop in EU growth – still

far from recession territory.

The financial linkages seem a lot more important. First, the

stock markets are highly correlated and about 15-20% of

S&P500 revenues stem from Europe. Second, consumer

and business confidence surveys correlations have been

very high over the past decade and more so since 2007 –

although we have seen a marked drop since mid-summer.

The same applies to PMIs, although with an even stronger

de-coupling recently. Third, and possibly most damaging,

US banks’ exposure to Europe could be high. BIS and

DTCC data indicates that total claims and other next

exposure to GIIPS amounts to USD230bn – about 40% of

the tier-1 capital of the four largest US banks.

However, DB’s US banks team believes that the actual

exposure could be substantially less than the BIS data

indicates. The Fed survey shows that almost two-thirds of

the respondents reported 0-5% of their C&I loans booked

to Europe and less than 10% had substantial exposure (of

20% of more – see chart).

SLO survey points to lower exposure than BIS data

Exposure of US banks to European economies in their C&I

books

0

10

20

30

40

50

60

70

0-5% 5-10% 10-20% 20-50% 50% - more

%

0

10

20

30

40

50

60

70

%

Source: Deutsche Bank; SLO survey respondent exposure to Europe via C&I loans

China: Soft landing underway

In our assessment, the main risk to Chinese growth is

internal and related to the prospects for the property

market. Chinese property investors have never seen a

bear market for real estate, but they seem to be

responding to lower prices by buying rather than waiting

for even lower prices and recent transaction volumes

appear to be picking up. This is important, because

developers still need to work off the overhang of unsold

properties stemming from hikes in transactions taxes,

credit tightening, and quantity constraints on purchases

during 2011. Also encouraging, inflation is easing on

favorable base effects and also on weaker demand (both

foreign and domestic) and we expect it to drop below 4%

by the end of the month. Accordingly, the 50bp cut in

reserve requirements should be just the beginning of a

cycle with 2 or 3 more cuts over the next 2-3 quarters. An

easing of credit growth restrictions in a heavily bank-

intermediated economy will likely be positive for growth

and reassures us that a "hard landing" scenario -- and that

probably means different things to different people -- is

unlikely.

We forecast that growth will slow to 8.3% in 2012 from

9.1% in 2011, with slight downside risk to that 2012

forecast under our baseline scenario for Europe. The

health of the banking system in China does raise

concerns, especially when regulators concede that 25% -

30% of the loans to local government financing vehicles

are not being serviced by the original borrower (they don't

say whether they are not being serviced at all or just being

covered by someone else). However, as the government

owns the banks and the borrowers the decision to declare

a loan nonperforming boils down to politics. In practice,

the government appears to have decided to absorb most

of the nonperforming local government loans, thus

transferring the losses away from banks. This said, the

post-Lehman massive credit stimulus is now viewed as a

mistake, so that policy expansion should be moderate –



especially with growth at a robust 8%+ pace. We expect

fiscal stimulus of the order of 1% of GDP or less in the

form of tax cuts and increased social welfare spending.

EM: Policy flexibility and resilience to shocks

The coming year is clearly going to be a difficult one for

the world economy. Nevertheless, if, as we expect, the

US economy can continue to tick over at even a little

below trend and China can avoid a hard landing, this will

provide a moderately constructive backdrop for most of

EM. We thus think that EM can grow at about 5½% in

aggregate next year, well below recent peaks for sure but

substantially above the 2% growth rate registered in 2009

during the last synchronized global recession.

EM’s Favorable Public Debt Dynamics

EM

DM

25

45

65

85

105

125

145

165

185

205

225

2006 2010 2014 2018 2022 2026 2030

(% GDP)

We assume: (i) primary balances are held

constant at this projected 2012 levels; (ii) real

GDP grows at trend rates; and (iii) the

differential between real interest and real

growth rates in each country is 0 until 2015

and 1.0 thereafter.

Source: Haver Analytics, IMF, Eurostat, Deutsche Bank

However, this resilience will not be uniform across EM.

Whereas we think much of Asia and Latin America are

relatively well placed to weather the current storm, public

and private balance sheets are generally weaker in EMEA,

which is also more directly exposed to the euro crisis

through stronger economic and financial linkages.

Reflecting this, we have downgraded our forecasts for

EMEA much more aggressively than for other emerging

regions over the last few months (chart). Within EMEA,

the current crisis is weighing most heavily on the

economies of Central and Eastern Europe: we have

revised down our growth forecast for this region by an

average of 2.5%, even more than our revision for the euro

area, and we expect Hungary to fall back into recession

next year.

Downgrades to DB growth forecasts since July

-2.5

-2

-1.5

-1

-0.5

0

US Eurozone EMEA Asia Latin

America

Change in 2012 GDP growth forecast, ppts


Later in this EMM, we therefore present a new framework

for assessing relative vulnerabilities with a view to

identifying the most likely pressure points within EM over

the coming year. It suggests that EMEA is facing

something of a quadruple whammy. First, while current

account balances have improved in the last few years and

central banks have been able to build bigger buffers of

foreign reserves, the large stock of external debt

accumulated during the middle of the last decade, much

of it in foreign currency still leaves the region with large

external burden. Second, sharply weaker growth in the

last two or three years has taken a heavy toll in the public

finances leaving many with the ‚DM problem‛ of having

to tighten policy into the face of a downturn. Third, the

rapid expansion of western European banks throughout

much of the region has left many countries exposed to

deleveraging by foreign banks as they seek to meet

additional capital requirements. And fourth, the region’s

economies are mostly relatively small and open with high

trade and financial exposures to the euro area, leaving

them relatively more exposed therefore to a recession in

Europe even leaving aside the other vulnerabilities noted

above.

Not surprisingly, therefore, EMEA dominates our list of

the most vulnerable countries. Five countries (Hungary,

Ukraine, Romania, Poland, and Egypt) show up as highly

vulnerable, though for different reasons. Egypt’s

underlying vulnerabilities, for example, are fiscal first and

external second. Ukraine’s risks are mostly external.

Hungary’s vulnerability reflects a combination of risks in all

four areas. Poland’s risk rating is probably a notch too high

according to this mechanical exercise, though it does

underscore that the economy does have macro

imbalances that have yet to be fully addressed. Romania

remains vulnerable but has done a lot of the hard yards in

terms of fiscal adjustment and is poised to move to a

lower risk category.



EMEA’s high external debt levels

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

LV

AH

UF

ES

TB

UL

CR

OK

ZT

UK

RLTU

RO

NP

LN

ILS

CZK

TR

YR

US

ZA

RE

GY

KO

RM

YS

TH

AID

NTA

IIN

RC

HN

CH

LA

RG

ME

XP

EN

CO

LB

RZ

Short term

Medium and long term

Region median

2010 gross external debt,% GDP

Source: Haver Analytics, BIS, Deutsche Bank

In Asia, years of current account surpluses and sound

fiscal policy have helped to underpin the region’s

resilience. India’s large government deficits are a

persistent worry, though this has to be placed alongside

manageable debt levels (61% of GDP) funded almost

entirely onshore and we think the government will resume

its consolidation efforts once global threats to growth

recede. The main pockets of concern are on the financial

side. Domestic credit expansion has been overly rapid

not only in China in 2009 but also in a many other

economies over the past two or three years. China, Korea,

Malaysia, and Thailand have high credit/GDP ratios

indicating significant potential debt burdens in the private

sector in a slowing growth environment. While the focus

of investors today is, perhaps rightly, on the external risks

to the region, we think domestic debt levels – and

possibly falling asset prices – are a significant risk to some

Asian economies.

Latin America went through a painful and meaningful

external, fiscal, and financial crisis in the 90s and today´s

resilience cannot be understood without that reference.

Forced fiscal adjustments, together with some structural

reforms, and overly conservative financial regulation have

allowed the region to converge to a relatively safe status.

This has permitted growth to become vigorous and

sustained with the helped of steady rise in commodity

prices, the region´s comparative advantage. Lack of

investment and increasing dependency on commodities is

probably the major drawback of this experience.

Increasing complacency regarding long term fiscal

rigidities with spending concentrated in current spending

in cases like Argentina, Brazil, Colombia, even Mexico, are

probably the main yellow light. Strong growth

sustainability and steady alleviation of poverty and social

conflicts remains the main challenge ahead.

Overall vulnerability map

Cu

rre

nt

acco

un

t

FX

re

se

rve

s

Exte

rnal d

eb

t

FX

valu

ati

on

Ove

rall

Ove

rall b

ala

nce

Pu

blic d

eb

t

Matu

rin

g d

eb

t

FX

De

bt

Ove

rall

Lo

an

:de

po

sit

s

Cre

dit

gro

wth

Cre

dit

le

ve

l

Fo

reig

n c

laim

s

Ove

rall

Gro

wth

be

ta

Ov

era

ll

EMEA

Czech Rep

Egypt

Hungary

Israel

Kazakhstan

Poland

Romania

Russia

South Africa

Turkey

Ukraine

Asia

China

India

Indonesia

Korea

Malaysia

Philippines

Thailand

LatAm

Argentina

Brazil

Chile

Colombia

Mexico

Risk ratings as follows: = low = medium = high

External Fiscal Financial


The flexibility that countries have to respond to weaker

global growth by easing policies partly reflects these

relative vulnerabilities. Outside of EMEA, most countries

should have room to at least let their automatic fiscal

stabilizers operate. In EMEA, however, even this room is

constrained in most cases – Russia and Turkey being two

notable exceptions. Pretty much all of Central and Eastern

Europe, for example, is looking to tighten fiscal policy into

a downturn.

Monetary easing is in any event likely to continue to be

the first line of defense for much of EM. Here, we think

reaction functions will continue to vary reflecting central

banks’ differing degrees of tolerance for exchange rate

weakness. At one of the spectrum is Brazil, where the

central bank will likely view recent depreciation as

correcting overvaluation and in that sense acceptable. It

has also cut rates by 150bps since August and we

anticipate a further 150bps in easing to come. Israel is

also in the middle of a mini-easing cycle and we think

there is one more cut to come there. Others are more

constrained by the impact of FX weakness on inflation

and/or domestic balance sheets. Turkey, for example, cut

rates in August in response to global developments but

was forced to change course in late October when the lira

continued to weaken, despite significant FX intervention,



and this started feeding through into inflation (9.5% in

November). Hungary, which has the largest stock of FX

liabilities in EM, also had to hike last month by 50bps to

prop up investor confidence and will likely have to hike

further. Others, such as Mexico, Poland, and South Africa

are likely to stay on hold for the next few months in this

environment. Inflationary concerns, however, would likely

become secondary if a sharper than anticipated global

slowdown threatens to push some of these countries

towards recession, and we could see a larger group of

countries cutting rates.

Strategy: Facing a binary scenario with a

smaller cushion

Defensive trades outperformed in 2011, boosted by the

drop in global rates. External debt was again the best

vehicle to capture the rally in US Treasury bonds, trailing

UST total returns closely as shown in the table below.

Spreads did widen during the year, but EM external debt

was nevertheless supported by its higher quality (that

benefited from ‚flight to quality‛) and the overall negative

correlation between spreads and UST yields. Hedged local

currency debt also performed well, but the rally in local

rates was hindered by EM central banks need to rein in

inflation after three quarters of solid growth and inflation

pass-through from weaker currencies. Not surprisingly,

equities and currencies lagged on stretched valuations,

higher risk aversion, and lower growth.

Asset performances in the past ten years Year

Return Vol Ret/Vol Return Vol Ret/Vol Return Vol Ret/Vol S&P UST

2003 25.7% 18.0% 1.4 5.5% 2.4% 2.3 10.8% 5.4% 2.0 26.4% 2.3%

2004 11.7% 6.7% 1.8 7.7% 2.9% 2.7 14.2% 6.1% 2.3 9.0% 3.5%

2005 10.7% 2.4% 4.4 7.2% 1.9% 3.8 -0.9% 7.1% -0.1 3.5% 2.8%

2006 9.1% 4.5% 2.0 6.4% 2.6% 2.5 4.5% 7.8% 0.6 10.4% 3.1%

2007 6.1% 7.6% 0.8 4.8% 2.6% 1.8 13.7% 6.5% 2.1 3.9% 9.0%

2008 -10.9% 6.3% -1.7 5.4% 7.1% 0.8 -10.1% 15.5% -0.6 -38.5% 14.1%

2009 28.2% 16.6% 1.7 5.2% 4.2% 1.2 16.0% 12.1% 1.3 23.5% -3.8%

2010 12.0% 5.6% 2.1 8.6% 2.8% 3.1 6.5% 6.9% 0.9 12.8% 5.8%

2011 7.2% 5.2% 1.4 4.3% 3.0% 1.4 -4.4% 8.9% -0.5 -0.8% 8.8%

Average 11.1% 8.1% 1.4 6.1% 3.3% 1.9 5.6% 8.5% 0.7 5.6% 5.1%

Correla- w/ S&P 58% 47% 68%

tion w/ UST 47% 40% -6%

GBI-EM (FX -Hedged) EMFX (spot and ca r ry ) Other assets returnEMBI Globa l

Note: EMFX (spot and carry) is derived from GBI_EM unhedged and hedged returns.

Correlation with S&P and UST returns are calcuated using monthly returns. Source: Deutsche Bank

In contrast with the situation a year ago, EM equities and

EM FX are now a source of value for the year ahead. As

we show in the 2012 outlook pieces for EM rates and

currencies in this publication, there are still some

interesting pockets of value in receivers, but the

weakness of many currencies has already taken them into

overshooting territory. As the table below shows, higher

prospective returns are now skewed towards unhedged

local markets exposure – obviously assuming an eventual

resolution of the crisis in Europe. External debt would

likely avoid losses under less upbeat scenarios, but

returns would be rather diminished and lower than FX-

hedged local debt as the UST cushion is now small.

A simplistic projection of EM FI asset returns under

various scenarios of UST and S&P

Intercept UST S&P Carry*

EMBI Global 448.3 -50.3 0.14 4.36

GBI EM (Hedged) 165.3 -11.5 0.01 1.44

EMFX (spot and carry)** 70.9 1.3 0.06 3.49

Current

Level

10Y UST Yield 2.07

S&P 1247

Fitted Level Return Level Return Level Return

EMBI Global 569 556 -2.2% 578 1.6% 570 0.2%

GBI EM (Hedged) 174 175 0.7% 177 1.7% 175 1.0%

EMFX (spot and carry) 171 158 -7.7% 174 2.1% 182 6.6%

* For EMBI/GBI-EM, a UST-weighted time drift term is used in the regression to capture carry;

For EMFX, a time drift term is used. (Regression is based on 2Y history)

** Proxied by the ratio of GBI-EM Unhedged and GBI-EM Hedged

Bearish

Scenario

Neutral

Scenario

Bullish

Scenario

1.50

1000

2.07

1247

3.00

1350


We expect the tug of war between structural and tactical

drivers of 2011 to extend into 2012 – particularly during

the first months of the year, when the future of Europe is

been decided. Valuation supports EM credit, local rates,

and FX – particularly under the risk of some financial

repression in the developed world. Structurally, flows

should also continue to benefit EM, as global investors

remain under-allocated and EM continued to expand the

‚efficient frontier‛ during both ‚risk on‛ and ‚risk off‛

years 4 . However, EM’s still limited depth has kept it

vulnerable to bouts of deleveraging as we repeatedly saw

throughout 2011 and we expect this weakness to persist

into 2012.

A concerted effort from policymakers a la 2008 could

bring a significant relief rally for EM currencies, equities

and high-yielders. But as the institutional constraints are

more entrenched in Europe, implementation risks are

high. We thus favor trades that would perform well under

a scenario where risks become more EU-centric as more

comprehensive back-stops are built and EU gradually

strengthens its institutional framework. Under this

scenario, we expect LatAm and Asian currencies to

outperform EMEA FX, with more US-centric currencies

such as the MXN to outperform, and – with a soft-landing

in China and no disruption in global flows – the RUB to

benefit from high oil prices. As tail risk is contained, we

see room for flatter curves and favor box trades vs. the

UST, while – in credit – we continue avoid central Europe

and, in RV, favor long basis in Venezuela.

4 See ‚EM Flows: Structurally sound, tactically exposed” included in this

publication.



Rates: Concentrating on pockets of value

High interest rate differentials, some additional monetary

accommodation, and contained risk still bode for receiving

(locally-funded) rates in EM, although risk-reward is less

compelling than in 2011. For a good part of the year EM

monetary policy flexibility was limited by robust growth

momentum and residual inflationary pressures stemming

both from the rally in commodities of 1H11 and weaker

currencies later in the year. Since then both growth and

inflation have eased, but FX pass-through risks may

continue to hinder a more dovish monetary stance in

several emerging economies, including most of LatAm

(though less so for Brazil’s CB) and also in Turkey, South

Africa, and Hungary – to name a few. But this should not

last long, as below potential growth settles in as

inflation/pass-through are peaking or close to peak. The

integrated analysis of macroeconomic prospect for the

region and valuation indicates that front-end receivers in

Israel, Colombia, and Poland (where we expect 75bp of

cuts in the year) stand out – although the Polish CB seems

comfortably on hold for now. Valuation is now less

compelling in Brazil, despite the gradual 150-200bp of

easing we expect.

Short-end opportunities to receive and curve trades

Source: Deutsche Bank. Model estimate minus forward curve yields.

FX, technicals and credit risk will continue to weigh on the

shape of EM curves – particularly in EMEA, but we expect

rates to reach lower levels and some term premium to be

priced out. More defensive relative value vs. the US

(where we believe risk is biased to higher yields in the

long end) seems attractive in Mexico and Colombia (and

also Israel – see chart below). Valuation is most

compelling in Mexico’s long-end, where positioning is also

relatively light, and US-related credit risks are lower. The

Turkish curve also stands out as too steep from our

valuation perspective, and technicals are light (we favor

gradually adding to Jan20 bonds). Inflation pressures

seem to be easing, but investors may want to wait for

more clarity on FX policies before building positions. FX

risk remains particularly important for Hungary, where

more bear-flattening seems likely before IMF re-

engagement (or not). In contrast, the Chilean curve should

continue to reflect more closely fundamentals and as such

it is prone to bull-steepen, in our view5. We see room for

rates in the 5-10Y sector in South Africa to drop during the

year, but the reliance on foreign demand to absorb heavy

issuance renders the long-end too sensitive to risk and

thus less attractive for box trades vs. the US for now. We

see better risk-reward in Mexico.

Barring a full-fledged credit crunch as in 2008, bank

deleveraging should in principle take a bigger toll on

EMEA markets. In Poland, adding cross-currency basis as

a hedge could mitigate such risks for long government

bonds (as we recommend). In the less EU-centric Russia,

however, the prospect of Euroclearable OFZs should

benefit these bonds while cross-currency swaps already

price a quite cautious global backdrop.

Searching for RV trades vs. UST: COP, MXN, ILS lead

MXN

CLP

COP

TRY

ZARILS

CZK

HUFPLN

-10-8-6-4-202468

1012

0 0.5 1 1.5

3M 10s receiver carry (bp)

Z-score of 10s differentials to USD curve (6M history)

USD Carry


In Asia, the outlook for rates is less constructive. Curves

across the region are rich and flat. Furthermore, we may

see less support from offshore investors in 2012 on less

compelling currency outlook, and better valuation in other

parts of EM. Although some reversal of the policy

tightening we saw in Asia this year is in order, the longer



end may underperform. We look for steepening from a

combination of some mean reversion in long end and

more from overshoot in the front end, particularly China,

India, Korea, and Thailand. We still favor receiving Hibor-

Libor basis. On cash bonds, underweight Indonesia,

overweight Philippines, and stay neutral on Malaysia and

Thailand.

As we discuss in more detail in the rates outlook piece,

technicals remain an important potential source of

dislocation and we look for defensive trades via

swaptions. Our search indicates that best risk-reward is

found in Turkey, ZAR, and CZK swaps (chart).

Selected defensive trades in EM swaptions


EMFX: Repository of value, but proxy for global risk

In a year of relentless external shocks, EMFX played its

role as a buffer and performed broadly in line with global

equities and the ebbs and flows of risk (chart). This is

unlikely to change in 2012, in our view. EM carry tended

to be negatively correlated with spot returns and only IDR,

RUB, and the managed ARS delivered a positive

combination of carry and total returns. Regionally, EMEA

currencies did underperform LatAm and Asia FX, but the

worst performer of the year was the rand (the traditional

proxy for global equities and commodities instead of usual

suspects such as CE3 FX). Accordingly, global variables

(such as equities, US yields, and commodities) have

gained considerable importance in explaining EMFX

dynamics more globally since 2008. At this critical

juncture in the crisis we expect EM currencies should

remain broadly a vehicle to trade global risk.

EMFX follows global risk

0.9

1

1.1

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov

LatAm

EMEA

Asia

Cumulative Total Return in 2011


Value has been restored, but risks remain asymmetric.

The chart below shows positioning and valuation

(indicated as deviations from long-term ‚fair‛ value

determined by. relative productivity, external prices,

openness, and NFAs) 6 . Most currencies are trailing

fundamentals and positioning is also very light. Since,

inflation targeting has secured mean-reversion in EMFX

with few exceptions (notably Argentina) and positioning is

supportive, there is room for retracement both tactically

and fundamentally. However, as EM currencies have

become a proxy for global factors and they are also

susceptible to non-residents’ hedging of their local

investments, the downside risk should the EU crisis

escalate could easily outweigh their potential to retrace.

If our baseline scenario materializes and the crisis

becomes more EU-centric and contained, we could see a

substantial EMFX recovery in 2012. Accordingly, we favor

currencies where valuation and technicals are favorable,

but the drivers of risk are less EU-centric and more

dependent on the outlook for the US/China and

oil/commodities such as MXN, and RUB. We expect

investors to avoid high current account deficits and thus

expect the TRY to trade in a wide range despite attractive

valuation and would buy ZAR only against some

protection for EU/global risks such as AUD, and HUF. We

also position for PLN undervaluation more defensively via

1Y EUR/PLN 4.25 puts. We expect the BRL to benefit on

relief rallies, but the combination of high inflation and the

central bank’s battle to compress carry limits its

attractiveness. We prefer MXN (and also COP) in the

region.

6 See the FX outlook piece in this publication for an outline of the model

and further discussion.



More value and lighter positioning

ARS

BRL

CLP

COPMXN

PEN

HUF

PLN

ILS

RUB

TRY

ZAR

KRWIDR

INR

TWD

SGD

PHP0

1

2

3

4

5

6

-0.15 -0.1 -0.05 0 0.05 0.1

Positioning (+ long USD/ - short USD)

Valuation (+ overvaluation/- undervaluation)


Asia FX valuations and growth differentials are still

supportive (though less so than before), but current

accounts are likely to moderate next year, the policy cycle

is turning, and currencies such IDR remain too exposed to

bond outflows for limited upside. We expect the RMB to

continue to appreciate but at a smaller pace than in 2011,

and will feature early in the sequencing of policy easing in

China. We favor keeping a core long in RMB (via 1Y

NDFs), and remain positive on the low beta currencies

with strong current account support such as PHP. We

favor trading SGD NEER on a range basis, and would look

to add on dips within 100bp of the lower bound of the

corridor. Intra-Asia, we like TWD as the funding currency.

We search for defensive trades across EMFX by favoring

high retracement (over the past 100 business days) and

high long USD or EUR call skews via call spreads. The

chart below highlights the best so defined risk-reward

trades: BRL, HUF, CZK, and KRW.

Selected defensive trades in EMFX options


Credit: Diminished returns; country selection key

Given the circumstances, 2011 has been another strong

year for EM sovereign credit. Although the total return has

not been high, there are very few asset classes which

have produced a better performance. In hindsight, a key

factor behind the overall performance of the asset class

was the diversity of performance within it. Indeed, 2011

was unusual in that alpha dominated beta for EM

sovereign credit as the chart below illustrates7.

Differences in yield and volatility did not explain

relative country performance in 2011

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

2011

YTD

2010200920082007200620052004

Rating change Yield (at start)

Volatility (prev yr) All three combined

Explanatory factors for relative country performance,

R2


In this respect, we expect 2012 to bring more of the same

behavior and so our outlook for the market (discussed in

more depth in the separate special report) is geared

toward trying to identify the potential ‘winners and losers’

for 2012. Overall however, we expect EM sovereigns to

benefit from more upgrades than downgrades in the year

ahead.

7 For each calendar year (and 2011 YTD) we regressed the annual returns

of each country against three different factors: (a) the yield of each

country at the start of the year, (b) the volatility of the country in the

previous year and (c) the net change in rating notches during the year.



We expect 2012 to be another year in which upgrades

dominate for EM sovereigns

40%

30%

20%

10%

0%

10%

20%

30%

40%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

Proportion of upgrades

Proportion of downgrades


The main exogenous source of risk for EM sovereign

credit remains the crisis in the eurozone. However, while

2011 saw the can being ‘kicked down the road’ (albeit by

progressively shorter distances), we believe that 2012 will

bring greater resolution. Muddling through is unlikely to

be an option for much longer, suggesting a fairly binary

set of possible outcomes with respect to asset price

performance. In the positive scenario (some form of fiscal

union and ECB intervention) risk appetite should be

strong, benefiting EM sovereign debt. However, the likely

continued weakness in the global economy, exacerbated

by ongoing bank deleveraging, will mean that

vulnerabilities will remain for some EM countries. The

negative scenario (the eurozone crisis deepens and fears

of a break up of the currency union and/or sovereign

defaults escalate) would be hugely disruptive for global

markets and for global capital flows. In such a scenario we

would expect all vulnerable EM sovereigns to sell off

substantially. In positioning to defend against such a

scenario, we would argue that it would be better to be

underweight (or short) the more vulnerable credits with

lower yields (e.g. Ukraine and Hungary) than the traditional

highest beta credits (Argentina and Venezuela). This

approach towards defending against the crisis scenario

results in a rough barbell approach to risk allocation.

In terms of the overall return outlook for the asset class

we are not optimistic that we will see much better than

mid-single digit returns in 2012. The only scenario which

could bring an upside to this would be one in which

spreads compress, but UST yields remain anchored at

their current low levels. Ultimately however, we see an

environment in which very few asset classes offer a

compelling value/risk proposition and in this environment

EM sovereign credit may well prove to be the least ugly

sister.

For 2012, our strategic country recommendations are

to be overweight exposure to Venezuela, Colombia,

Poland, Russia, and Turkey; underweight exposure to

Hungary, Ukraine, and South Africa.

We also recommend buying Chile 5Y CDS vs. Brazil

as a defensive trade.

In terms of relative value we recommend Venezuela

24s vs.10Y CDS, PDVSA 22s vs. Venezuela 10Y CDS.

Argentina Global 17s vs. 10Y CDS

Drausio Giacomelli, New York, +1 212 250 7355

Robert Burgess, London, +44 20 7547 1930

Marc Balston, London, +44 20 7547 1484



Rates in 2012: Identifying Pockets of Value

EM receivers performed well after a rocky start.

Country specifics have remained the dominant driver

of returns, but the importance of global factors

increased in 2011.

In our 2012 outlook, we analyze those country

specifics effects using a model which integrates

macro-monetary policy interactions and local curve

dynamics. We restrict our analysis to two potential

scenarios: the benchmark given by our country

forecasts and a more pessimistic alternative due to

potential events in Europe.

Under our benchmark scenario the ‚fair‛ curves are

relatively close to forward curves. Nevertheless, we

identify some interesting opportunities. The short-

dated tenors of Colombia, Poland, and the long-end

of Mexico and Israel stand out as opportunities to

receive, steepeners seem most attractive in Chile and

Poland, while Peru yields seem too low and the

Turkish curve poised to bear-flatten.

Interestingly, while the analysis under the more

pessimistic scenario produces some changes in

valuation, the most attractive opportunities seem to

be robust to a greater slowdown in economic activity.

Nevertheless, under the bearish scenario technical

issues could pose a greater risk. In analyzing real

money exposure for specific countries we find that

EMEA in general appears more vulnerable than

LatAm. South Africa and Hungary stand out in EMEA,

while Brazil appears more vulnerable in LatAm.

Turkey, Peru, and –to lesser extent – Colombia and

Mexico, could benefit from lean positioning.

Taking Stock of Recent Performance

EM receivers had a relatively good performance despite

the rocky start of 2011, when US growth expectations

were revised up and UST yields sold off sharply. With the

exception of HUF, cumulative returns for EM receivers

(which we compute by rolling 1M10Y forward-starting

swap) turn marginally positive already in February. It still

took a few months for receivers to renter positive

territory, with LatAm outperforming primarily on to closer

connection with the more accommodating Fed, while, in

EMEA, CZK outperformed on its closer linkages with

Bunds. Overall, the initial level of yields had little to do

with total return, with low yielders benefiting from the

dramatic repricing of yields across the US and EU.

EM receivers: Back-loaded returns

-100

-50

0

50

100

150

200


USD LatAm EMEA

Accumulative Total Return in 2011


Country specifics have remained the dominant source of

returns, but the share of EM rates returns that can be

attributed to the performance in DM assets increased in

2011 vs. recent years. After controlling for EMFX, weekly

returns of long duration strategies were highly correlated

with global assets such as UST, S&P500 and CRY on a

disaggregated level. For buy-and-hold 10Y receiver swaps

strategies, global factors account for approximately 20%

of the weekly non-overlapping returns, compared to 14%

for the year of 2008, and 10% for the last 5 years (with

PLN and ZAR the exceptions). The results above also carry

on to relative curve trades such as buy-and-hold 2s10s

flatteners. As the chart above suggests, this increased

correlation probably owes to the wide swings in core

rates that seem more likely to repeat under a scenario of

more rapid resolution of the crisis in Europe

Diminishing importance of carry

* Negative Carry are not shown

** Crisis Period: from Sep 2008 to Dec 2009

0%

100%

200%

300%

400%

USD BRL MXN CLP TRY ZAR ILS CZK HUF PLN

crisis 2011 5Y

Carry Return/Absolute Spot Variation


In contrast with EMFX and equities, EM rates

performance remains largely driven by domestic factors,



with cross-country residuals displaying a low degree of

correlation. Over the past five years, the first principal

component of the individual returns -after controlling for

global macro drivers- is responsible for only 30% of the

total variation, indicating a low degree of cross country co-

movement. In order to assess the outlook for EM local

rates, we thus look in more depth into individual drivers of

curve valuation for hints about potential performance

during next year.

EM rates performance mainly idiosyncratic

* Crisis Period: from Sep 2008 to Dec 2009

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

USD EUR JPY GBP BRL MXN CLP TRY ZAR ILS CZK HUF PLN

crisis

2011

5Y

Source: Deutsche Bank. Percentage of co movement of first component of PCA.

Outlook for 2012

The front-loaded sell-off of 2011 seems unlike to repeat in

2012 unless EU authorities move fast toward fiscal

integration. Although we expect progress toward a

stronger fiscal pact and crisis containment, EU authorities

have rather moved reactively and slowly. It seems too late

to avoid recession in the region and it would be naïve to

expect major breakthroughs on US fiscal policy and

housing overhang ahead of elections. Although progress

seems in order with a more concerted and focal action,

economic growth seems poised to decline. The US could

still avoid recession, while China experiences a soft

landing, but EM will continue to decelerate. The possible

outcomes of this crisis have become more binary,

however, and we consider an alternative scenario where

another credit crunch materializes, China slows down

more than expected, and EM central banks are forced to

act more aggressively amid heightened risk aversion.

Assessing valuation in binary scenarios

We build on a model which integrates macro-monetary

policy interactions and local curve dynamics. The

methodological discussion is summarized in the box at the

end of this piece and the results are presented in the

charts below. The chart shows the difference between

our estimated curves under two different scenarios for

several LatAm and EMEA countries and their respective

forward curves. The baseline scenario is given by our

economists’ forecasts presented in the respective country

sections of this publication. The alternative, more

pessimistic, scenario assumes a larger slowdown in

activity triggered by credit crunch, contagion and the

associated reduction in inflation.8

We find that under our benchmark scenario the simulated

curves are relatively close to forward curves.

Nevertheless, we identify some interesting opportunities

across both short and long tenors.

The short end:

We find little value on the front-end (1Y) of most

curves (see chart); in particular the forward valuation

in the short tenors of the local curves in Mexico,

Brazil, South Africa or Czech Republic are broadly

consistent with our own forecasts. The market has

already discounted enough monetary easing in Brazil

(-150bp), and it seems difficult that the Bank of

Mexico would engage in an aggressive monetary

easing by cutting much more than the 25bp already

discounted by the market. In EMEA, the SARB has

already signaled it will remain on hold.

The short-dated tenors of Colombia, Poland, and to

lesser extent Israel, seem more attractive. In

Colombia, this is consistent with our view that the

market has been too aggressive in pricing potential

tightening of monetary conditions. Although we

believe that the central bank will continue its recently

initiated hiking cycle, it should pursue a more gradual

path than currently discounted by the market. In

Poland, the NBP is pointing to 2H cuts (75bp, in our

view), but these could be advanced depending on

extent of the slowdown in the EU and PLN

weakness. We are more constructive in Israel, where

the latest minutes and inflation numbers pave the

way for two more cuts.

In Peru and Turkey pricing is relatively tight in short

tenors, suggesting a bias to pay in these countries. In

the case of Peru, a managed exchange rate, local

pension system support and foreign sponsorship

have helped the local curve to remain immune to

increasing volatility in external markets. In Turkey, the

corridor blurred the policy rate as the instrument of

monetary policy and we prefer to focus on the longer

end of the curve.

8 In particular, we assume a departure from our forecasts of -2% and -1%

for the output gap and inflation respectively.



Simulated curves vs. forwards


The long end:

We find more value at longer tenors (10Y) of some

curves under our benchmark scenario. The best

opportunities appear in Mexico and Israel, where

premium seems to have overshot fundamentals the

most. In contrast, there are some curves which have

not incorporated enough risk premia, in our view,

such as in Brazil, Chile, Peru, Poland, and Czech

Republic. Accordingly, while steepeners appear as

attractive in Chile and Poland (swaps), and to lesser

extent, Brazil and Russia, flatteners seem most

attractive in Mexico and Israel.

Interestingly, while the analysis under the more

pessimistic scenario produces some changes in valuation,

the most attractive opportunities seem to be robust to a

greater slowdown in economic activity. The front-end of

the Colombian curve stands out in terms of offering value

to receive under that scenario, while the Mexican and

Israeli curves continue to be the best options in the long

end. Steepeners in Chile also become more attractive

under a sharper slowdown – in line with typically

aggressive central bank responses.

Positioning: A lingering source of risk

Following two years of steady inflows, EM Local Debt

saw significant outflows starting last September (although

moderate as a percentage of assets under management).

Still, positioning bodes for caution as it looks elevated in

several markets -in some cases near historical highs. The

chart below shows the latest figures and the distribution

of foreign holdings of domestic debt.

Encouragingly, the past year’s tame investor reaction to

rising risk has revealed remarkable resilience to repeated

bouts of global deleveraging. Fundamentals such as low

growth, controlled inflation, and high interest rate

differentials likely played an important role, with local debt

flows showing considerable more stability than EM

equities flows. That central banks have been ready to

provide plentiful liquidity should also remain reassuring for

local investors. Accordingly, foreigners remained

committed even throughout the most serious episode of

risk aversion (September), when disruptions to USD

funding of European banks acted as a channel of

contagion to EM. It appears that most funds chose to

hedge their exposure to FX via NDFs rather than unwind

their bond positions. This should stay the norm barring a

major setback in Europe.



Inflows have been on an exponential trend (USD bn)

TH

ZA

TR

RU

PL

MY

MX

KR

ID

HU

CZ

BR

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0% 5% 10% 15% 20% 25% 30% 35% 40%

Foreign Holdings of Domestic Government Debt (latest data)

Foreign Holdings of Domestic Government Debt on 31-Aug-08


In our view, fundamentals and the binary risks we foresee

continue to support long rates and inflows into bonds at

the expense of equities – the pattern of the past years

that we doubt will change at least while growth is

depressed in the US and the EU is in recession. However,

local markets inflows have been sensitive to bouts to risk

aversion (proxied by the VIX) despite the structural forces

discussed above.

The exposure z-score indicates how ‘over-/under-

weight’ funds are at present

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

BR ZA MY TH KR HU MX CO RU CZ ID PL EG RO PE IL TR

Oct 11

Prev. Mth

Exposure Z-score*

*-Avg exposure vs benchmark, relative to 12mth MA, divided by StDev of monthly

change in exposure


In order to assess which curves seem more exposed to

short-term disruptions, we have developed an approach

that allow us to monitor these funds average exposure

relative to the country’s weight in the benchmark as well

as the relative strength of these funds appetite for a

specific country.9 In our assessment, we find that EMEA

in general appears as more vulnerable than LatAm.

South Africa and Hungary stand out in EMEA as most

vulnerable, while Brazil more vulnerable in the LatAm. In

the case of South Africa – where the curve was most

obviously dependent on external factors – the local

investor base seems to be persistently underweight when

yields for back-end bonds fall below (8.5-9%), leaving the

role of supporting the market to foreign investors. In a

scenario, where foreign inflows are more timid next year,

the curve would steepen and ASW will widen.

In the case of Hungary, we are concerned that non-

resident holdings have not adjusted enough in line with

the riskier profile as it falls into economic recession in

2012 (our base case scenario). Non-resident holding are

only 7% below their recent peak, despite a downgrade to

sub-investment grade by one rating agency. More

negative news, such as disappointments in IMF

negotiations could accelerate foreigner’s exit from that

market. Brazil stands out in terms of positioning in the

LatAm region and it could be contrasted with the situation

in Mexico. While appetite in Brazil should remain strong

amid easing, the outlook could change should the

currency weaken substantially (not our baseline scenario).

At the other end of the scale, we believe that Turkey

benefits from a high carry and low positioning, and

therefore an improvement in fundamentals is likely to be

met with strong inflows. Peru and, to lesser extent,

Colombia and Mexico, could benefit from lean positions.

The buyers v sellers index gives an impression of the

relative strength of appetite for different countries

-0.5

-0.4

-0.3

-0.2

-0.1

0

+0.1

+0.2

+0.3

+0.4

+0.5

ZA TH RU BR KR CO CZ HU RO MX MY TR PL PE IL ID EG

Oct 11

Prev. Mth

Buyers v sellers index, 3m MA*

*-Number of funds actively increasing exposure minus number of funds actively

decreasing exposure, divided by the total number of funds


9 For details on the methodology: please see “A Closer Look at Real-

Money Positioning”, inside this publication



Defensive trades in swaptions

As protection for potential bouts of deleveraging we look

for high payout ratios in put spreads after normalizing for

the different degrees of responses during the 2008 crisis.

The chart below shows the resulting ‚normalized‛

ranking: ZAR, CZK and TRY offer a combination of steep

skew and significant upside move in the underlying rate

making those curves the most desirable ones to place

defensive trades in the back end. We build these curves

by fixing the difference between high and low strike at

25bp. The payout ratio monotonically increases with the

volatility skew, but to make these positions we take the

2008 as the benchmark year for a shock. We thus

normalize the move in rates by the realized standard

deviation (a 5bp move in ILS would correspond to a 10 bp

move in TRY, for instance).

TRY, ZAR, and CZK stand out as defensive trades


Conclusion and recommendations:

The situation remains fluid, but while valuation is not

particularly appealing fundamentals and the risk bias

favors receivers in EM. In this piece we look at valuation

in more detail and highlight the most attractive pockets of

value. Interestingly, these opportunities seem to be

robust to our more pessimistic scenario characterized by

lower economic growth and inflation. Our top

recommendations in LatAm and EMEA are:

LatAm: In Argentina, stay out of local curves but

favor Badlar linkers in relative terms. In Brazil, take

profits on July ’12-Jan ’17 DI steepener and enter Jan

’13-Jan ’15 flattener. Enter a 2s5s CLP/CAM

steepener in Chile. In Colombia close 2s3s IBR/COP

steepener and enter a 5Y receiver, either in IBR/COP

or TES Jun ’16, against 5Y USD swap payer. Take

profits on 5Y TIIE payer in Mexico, and enter a box

trade of 2s10s TIIE flattener against 2s10s USD swap

steepener

EMEA: In Israel receive 2Y IRS. In Poland receive 1Y

XCCY basis as a hedge. Receive 1Y EURPLN cross-

currency basis. In Czech Republic take profit on

2s10s

Drausio Giacomelli, New York, +1 (212) 250 7355

Mauro Roca, New York, +1 (212) 250 8609

Guilherme Marone, New York, +1 (212) 250 8640

Lamine Bougueroa, London, +44 (20) 7545 2402



Appendix: Modeling local curves

To determine how the different curves could behave in

these distinct scenarios we use a dynamic model of the

term structure of interest rates based on macroeconomic

fundamentals (see “EM Rates: Modeling Curve Dynamics

under Macroeconomic Shocks,” EM Special Publication,

November 18th 2011). Our methodology can be

characterized by a series of steps.

First, we parameterize the yield curve using a Nelson-

Siegel decomposition. This approach consists in

projecting the entire yield curve on three latent factors,

which could be associated with the level, slope, and

curvature, respectively (see chart). One of the advantages

of this approach is that the relationship between the

different tenors of the yield curve and these latent factors

has a closed form representation which can be used to

reconstruct the entire yield curve from these three factors

at any point in time.

Since we are ultimately interested in exploring the

behavior of the yield curve under different

macroeconomic conditions, in a second step we estimate

an econometric model (Vector Auto-Regression, VAR) of

the latent factors and some selected macroeconomic

variables). Following a basic New Keynesian

representation we characterize the economy by a

measure of prices (YoY consumer price inflation), a

measure of activity (the deviation of GDP or IP from its

trend), and the stance of monetary policy (the policy

interest rate).

Finally, from the estimated relationships between the

variables in the VAR, we can forecast the interest rate

curves under certain assumptions regarding the future

evolution of the macroeconomic variables or determine

what would be the dynamic response of each of these

variables –or the entire term structure of interest rates- to

a shock in any other variable (that is, we obtain the

corresponding impulse response functions). We can then

compare the simulated curves with forward curves to

assess if there is some value under our assumptions.

In summary, our methodology allows analyzing the

behavior of the term structure of interest rates by

exploiting the dynamic feedback mechanism between the

latent factors, -representing the yield curve- and some key

macroeconomic variables. The latter influence the position

and shape of the curve, but the curve also influences the

evolution of the macro variables.

What Nelson-Siegel factors capture

4

5

6

7

8

4

5

6

7

8

Nov-06 Jul-07 Mar-08 Nov-08 Jul-09 Mar-10 Nov-10 Jul-11

NS LEVEL CLP/CAM 10Y, lhs%

-4

-2

1

3

5

7

-100

0

100

200

300


CLP/CAM 2s10s, lhs NS SLOPEbp

-5

-3

-1

1

3

5

7

9

-20

0

20

40

60

80


CLP/CAM 2s5s10s NS CURVATUREbp




Appendix: Rates Strategy Summary

Country View Strategy Risks

China We believe the risk of an RRR cut before the year-

end is rising to 30% from 0% and we expect short-

term rates to fall towards 3% over the next two

months.

We take profit on the 2Y/5Y steepeners Upside surprises on CPI which could delay

monetary easing

Hong Kong Hibor - Libor basis to remain stable towards the

year-end

Looking to receive Hibor-Libor basis position USD strengthens against EM currencies

India Concerns about further fiscal slippages to add to

issuance will keep cash bonds under pressure,

unless we see RBI easing liquidity through OMOs

or a cut in CRR. That might not come till the CB

gets more evidence of a sharp growth slowdown,

or at least an easing in inflation because of base

effects into end year. Timing is critical in receiving

the front end of OIS curve, given the steep

negative carry.

Neutral A very weak Q3 (calendar 2011) growth number.

Indonesia Mostly a tail risk trade at these levels. The

fundamentals of the Indonesia story have not

changed, but we don’t like the timing of the rate

cut by BI, or indeed that the CB has been the only

significant buyer of duration in the last couple of

months.

Stay underweight Squeeze on under allocated investors if risk tone

improves, especially as supply winds down into

end year

Malaysia The policy outlook could arguably turn more dovish

in the coming months, but with a large supply

calendar in 2012, the markets would need strong

appetite again from offshore investors, in the

absence of interest from local players.

Neutral. Return of appetite for EM exposure among global

investor portfolios.

Philippines Except for its traditional EM like character

because of shallow markets, there is little to fault

the rates backdrop in Philippines - comfortable

inflation outlook, improving fiscal picture, strong

BOP and low concentration of risk with offshore

investors.

Modest overweight. Spike in food inflation because of spillover from the

Thai flood situation.

Singapore With the MAS not having eased as aggressively as

expected, richness in front end of the curve could

persist for a while on weak macro conditions.

Neutral Upside surprise to economic data.

South Korea Steepening bias on KTB curve driven by rolling over

pressure from the concentration of KTB

redemption in December. Modest steepening view

on KRW 2Y-5Y IRS curve.

DV01 neutral 3Y/10Y KTB steepener through 3Y

and 10Y KTB futures at 36bp with a target of 50bp.

An early monetary easing tends to flatten the IRS

curve.

Thailand The flood situation is likely to remain a drag on the

supply outlook for this market. Any dovish turn in

the policy outlook could end up impacting belly of

the curve more, given the low level of yields in the

front end.

Pay 5Y/10Y steepeners, target 60bp. BOT cuts rates sharply in response to a

worsening flood situation.

Taiwan The front-end of the IRS curve likely will remain

anchored but 5Y/10Y has room to flatten.

Maintain 2Y/5Y/10Y butterfly spread paid position

at -7bp

Deterioration in exports and growth causing CBC

to turn dovish.

Czech Czech economy to be impacted by the Eurozone

slowdown. Central bank to remain dovish

Neutral at current levels A reversal in risk appetite that would hurt the

Krona

Egypt Significant deterioration in the political outlook

since the reinstatement of emergency rule.

Balance of payment difficulties likely to persist

causing pressure on the level of FX reserves

We do not favour being invested in EGP or T-bills

until we see more clarity on the political situation

Resumption of demonstrations asking for a faster

pace of reforms, leading to capital outflows

Israel Disinflation trend to persist due to macro and

micro elements. BoI likely to continue monetary

easing policy

Receive 2Y IRS. Expect curve to bull steepen Middle East political uncertainty

Poland Our and market expectations Cuts have been

pushed back to Q3 2011. Growth to decelerate but

remain positive in 2012. Inflation to start slowing

after Q1 2012

Receive 1Y XCCY basis as a hedge. Outright

purchase of POLGBs will be attractive in H2 2012

The negative impact of the Eurozone crisis on

banks operating in Poland (liquidity risk)




Appendix: Rates Strategy Summary Cont’d


Russia Strong fiscal performance. Year-end inflation

target (7%) likely to be met, but capital outflows

maintaining rates at a high level

Neutral in rates. Bullish bias on OFZ market A sudden fall-out in global growth would have

negative consequences for oil

South Africa SARB to stay on hold for a prolonged period.

Inflation outlook dependent on ZAR

Expect rates to trade in range consistent with

5y5y in (8.40-9%). Front-end rates are well

anchored, while the back-end is dependent on ZAR

performance. 2s10s set to steepen

Large scale foreign outflows from bond and

equities, caused by global risk aversion

Turkey CBT trying to juggle multiple goals, but with

inflation being its top priority at this stage. De

facto tightening of monetary policy to help

rebalancing the economy

Receiver bias at the back-end Roll-over risks for local banks short term external

debt

Argentina With real yields in low double digits CER-linked

bonds do not offer an attractive return for foreign

investors.

In relative terms, we continue to favour Badlar

linkers, which benefit from nominal instability.

Liquidity could dry very rapidly

Brazil The market is widely expecting that BCB will

continue reducing rates aggressively during 1Q12

(150bp to 9.5%).

We recommend taking profits on our July ’12-Jan

’17 DI steepener recommendation and position for

a setback in short-term rates with a Jan ’13-

Jan’15 DI flattener.

With domestic and external activities trending

lower, the risks to this scenario are still biased to

the downside due to BCB’s increasing focus on

growth.

Chile As the economy continues to decelerate, the

BCCh seems closer to ease monetary conditions.

As a consequence, we recommend shifting the 2Y

breakeven inflation position to the 5Y sector and

entering a 2s5s CLP/CAM steepener.

The cuts could help to build up additional risk and

inflation premium in the belly of the curve.

Colombia The local curve has been anticipating the on-going

tightening cycle for some weeks.

Closing 2s3s IBR/COP steepener and entering a 5Y

receiver, either in IBR/COP or TES Jun ’16, against

5Y USD swap payer .

Risks are biased to the downside for short-term

rates, as the slowdown in global growth may drag

on domestic activity and reduce some inflationary

pressures.

Mexico Local rates have been following the movements in

the exchange rate.

We take profits in our 5Y TIIE payer

recommendation and switch to a box trade of

2s10s TIIE flattener against 2s10s USD swap

steepener .

The reduction of risk appetite.

Peru The local curve, supported by favorable technicals

and a stable currency, has shown extraordinary

resilience to external events.

With the curve now trading at relatively low levels,

the risk/reward of the position looks less

attractive, even at shorter tenors.

Higher than expected inflation might force the

Central Bank to rise rates.




FX in 2012: The Vehicle to Trade Global Risk

During 2011, EMFX played the role of shock absorber

with a large share of returns attributed to global

drivers. It ended the year as one of the worst

performer across the major global asset classes. In

line with increased risk aversion, ex-ante carry tended

to be a poor indicator of ex-post performance.

External factors should remain the main drivers of EM

currencies in 2012. More attractive valuation will have

to overcome the ebbs and flows of external prices,

portfolio flows, and risk appetite. For its liquidity and

role as a shock absorber, EMFX should continue to be

the preferred vehicle EM investors have to express

their views on the global economy and the prospect

for the EU crisis.

Global risks could be amplified by domestic

weaknesses. Even if global risks do not escalate but

linger, the market may start to focus on EM’s

‚periphery‛.

In LatAm we recommend entering zero-cost 1x2

USD/BRL put spreads and short CAD/MXN, while

maintaining short EUR/CLP and long USD/PEN. In

EMEA, we favor shorting EUR/ILS and oil sensitive

NOK/RUB, and entering long PLN/HUF and long ZAR

versus an equally weighted basket of similarly high

betas AUD and HUF.

Taking Stock of Recent Performance

EMFX –after EM equities– ended the year as one of the

worst performer across the major global asset classes10.

In line with perceptions on global growth, EM currencies

performed reasonably well until mid-year, when the EU

crisis and worsened economic data in developed markets

prevailed (chart). In terms of leaders and laggards,

idiosyncratic currencies such as PEN and (the managed)

ARS outperformed their peers while currencies most

linked to global drivers (such as ZAR) lagged – although

country-specifics also amplified external shocks in

currencies such as TRY and INR.

10 See ‚EM performance: The grass is greyer on the other side‛ in this

publication.

EMFX performs in line with global growth and risk

0.9

1

1.1


LatAm

EMEA

Asia

Cumulative Total Return in 2011


In line with increased risk aversion, ex-ante carry tended

to be a poor indicator of ex-post performance with

positive carry normally incurring in negative P&L as shown

in the chart below. Except for the IDR, only managed or

dirty floating currencies such as the RUB, ARS and PEN

delivered positive total return and carry, with only the low

carry PEN posting total return in excess of carry.

Under heightened risk aversion, carry anticipated loss


EMFX played the role of shock absorber and, accordingly,

a large share of the returns could be attributed to global

drivers in 2011. Cross-country did matter with heavy

positioning, stretched valuations, or lack of central bank

support associated with underperformance. But simple

regressions of spot EMFX weekly changes on the

equivalent changes in some relevant global variables (SPX,

UST and CRY) shows that ex-carry, total returns indeed

traded as a global asset in 2011. As the chart below

shows, and as we have highlighted in several reports,

EMFX has become more of a proxy of global risks since

the outset of the 2008 crisis. Except for more tightly



managed RUB, the best performers were the low r-square

currencies (ARS and PEN) while the worst performers

(ZAR, TRY and MXN) were the high r-square pairs.

EMFX as a proxy for global risks

0%

10%

20%

30%

40%

50%

60%

70%

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

crisis 2011 5Y


Outlook for 2012

External fundamentals and technicals should remain the

main drivers of EM currencies in 2012. In contrast with

rates where fundamentals and –to a lesser extent

valuation– are aligned, in the case of EMFX more

attractive valuation will have to overcome the ebbs and

flows of external prices, portfolio flows, and risk appetite.

For its liquidity and role as a shock absorber, EMFX should

continue to be the preferred vehicle EM investors have to

express their views on the global economy and the

prospect for the EU crisis. This and the fact that real

money investors have hedged their local markets

exposure at moments of stress should continue to amplify

external shocks even if speculative positioning is light.

From a tactical perspective, the most pressing issue is

whether the steps to fiscal integration to be announced

later in the week will suffice for the ECB to step up its

purchases. We believe that it will – even if backloaded to

1Q12 –and that additional firepower will be added by the

IMF– conditional on EU’s increased commitment to

resolution of the crisis.

Our scenario thus bodes well for near-term retracement in

EMFX under the view that a more concerted action by

authorities will succeed in containing the escalation of this

crisis and hopefully render it more EU-centric. But as

many parts need to fall in place implementation risk will

run high and we favor trades that could benefit from less

policy-sensitive risks as US growth and China’s soft-

landing supporting commodity prices.

The degree of underperformance vs. financial drivers

presented in the table below provides an indication of

potential retracement and sensitivity to each driver (not

shown) 11. PLN and HUF naturally feature among the most

‚undervalued‛ after the recent correction, but we’d rather

avoid their sensitivity to EU developments. Although the

table below also points to laggards such as the ZAR and

TRY as the pairs that have most room to catch up under

retracement, we would be long ZAR only vs. an equally-

weighted basket of crisis-sensitive HUF and AUD and

avoid currencies with large current account deficits such

as TRY.

We favor currencies such as MXN (vs. USD or CAD), COP,

and RUB (vs. NOK) that are more exposed to US and

commodities (oil) instead. Tactically we would be long

BRL, although – from a longer-term perspective – we find

it less appealing than MXN.

EMFX overshoots drivers, but heterogeneity matters


From a strategic perspective, growth prospects and EM

fundamentals in particular are most relevant and we focus

on macro – rather than financial – variables to asses value.

Accordingly, we estimate ‚fair‛ value using an

econometric model of real effective exchange rates vs.

selected macroeconomic fundamentals such as

productivity, terms of trade, net foreign assets, and trade

openness (see Appendix for further details). Although this

11 The table shows EMFX misalignments vs. a benchmark of financial

drivers such as S&P500 (or VIX), CRY (or the more appropriate metric for

external prices a country faces), EUR/USD and UST or credit risk. The

regressions are specified according to each currency pair



model has more of a medium to long term appeal, and misalignment tends to correct only gradually, the equilibrium values are more representative of EMFX’s true value as currencies do tend to revert to this moving “mean”12.

The results point to some similarities across fundamentals- and financials-based models. This is not surprising when floating currencies trade more closely to fundamentals so that dislocations show in both types of models. But in currencies such as the BRL very high rates and an elevated pace of foreign direct and portfolio investment could set a wedge between financials and fundamentals approaches. Indeed, the BRL appears undervalued according to the short-term financial drivers perspective, but it remains one of the most overvalued EM currencies from a fundamentals standpoint (see chart below). Moreover, as the level of inflation the central bank now accepts combined with its urgency to depress carry suggest that the BRL has become a less appealing currency to hold strategically while policies are not corrected. Currencies such as MXN, ZAR, PLN and TRY appear as undervalued in both set of estimates, but MXN poses the best BoP situation. PLN vulnerability is less than HUF and valuation is more attractive, but we prefer to add more cautious bullish trades via EUR/PLN put spreads.

Undervaluation vs. fundamentals is becoming the

norm


While higher inflation is a long-term concern for the BRL and also for TRY, it is the main concern for the Argentine peso because of the higher rate of inflation in Argentina (about 5 times higher than in Brazil) and lower reserves (less than 1/7th Brazil’s). But with forwards already pricing 20-30% devaluation and FX being an important nominal anchor for the country, this is already in excess of the

12 Inflation targets and batter balance sheets have anchored inflation and rendered nominal EMFX mean-reverting across most emerging countries.

devaluation we foresee. Most countries have accepted some depreciation to reflect worse fundamentals, but in Peru more forceful intervention has already pushed the currency into slight overvaluation territory. The less interventionist and more EU-sensitive EMEA FX naturally concentrates the most undervalued currencies in our sample. From a risk perspective, the chart below shows that the most overvalued currency in our sample (the BRL) has moved closer to fair, but the degree of undervaluation in MXN, PLN or TRY has increased further despite already hovering around depressed levels.

EMFX valuation: Corrections and exaggerations


How risky are EM currencies? Although global risks are dominant they could be amplifying by domestic weaknesses. Moreover, even if global risks do not escalate but linger, the market may start to focus on EM’s “periphery”. The following tables present a set of scores to gauge external and fiscal vulnerabilities across EM countries. Not surprisingly Hungary stands out, although Poland’s and Turkey’s wide current account deficit also raises concerns, although market financing seems a lot more robust than in Hungary. In LatAm, the current account deficits are wider in Brazil and Colombia, but the capital account is expected to provide enough financing. Argentina is the only country in the region where international reserves could begin to matter, particularly if the government insists in using the Central Bank as a financing source to service the debt.



EMEA appears more vulnerable than LatAm

Cu

rre

nt

acco

un

t

FX

re

se

rve

s

Exte

rnal d

eb

t

Ove

rall

Ove

rall b

ala

nce

Pu

blic d

eb

t

Matu

rin

g d

eb

t

FX

De

bt

Ove

rall

Lo

an

:de

po

sit

s

Cre

dit

gro

wth

Cre

dit

le

ve

l

Fo

reig

n c

laim

s

Ove

rall

EMEA

Czech Rep

Hungary

Israel

Poland

Russia

South Africa

Turkey

LatAm

Argentina

Brazil

Chile

Colombia

Mexico

External FinancialFiscal


When observing positioning, valuation, and carry/risk

indicators for EMFX, we find that there is ample

heterogeneity (see Table below). Some currencies like

ARS, BRL or TRY continue to offer relatively high carry but

as a compensation for different types of risks. Valuation is

becoming attractive in several currencies, but BRL and

PEN are clearly overvalued. Risk reversals are relatively

high across EM FX, but those of BRL and MXN are

relatively low with respect with recent history. Positioning

is relatively lean across all EMFX, with PEN, MXN and TRY

standing out in terms of long USD bets.

EM FX Scorecard: An heterogeneous landscape

Technical

ST LT 3M Carry 3M Carry/Vol 3M IV/HV 3M 25D RR* Positioning**

ARS - 2% 28.9% 1.9 4.3 1.5 1.0

BRL -7% 5% 7.6% 0.4 0.8 0.6 2.5

CLP 0% 0% 4.3% 0.2 1.0 1.1 3.5

COP -10% 0% 0.2% 0.0 1.4 1.3 4.0

MXN -7% -10% 2.8% 0.2 0.8 0.5 4.5

PEN 0% 6% 3.1% 0.5 1.6 1.1 5.0

CZK -1% - -0.3% 0.0 1.1 2.4 1.0

HUF -5% -4% 4.3% 0.3 1.0 2.0 0.5

PLN -6% -15% 3.7% 0.3 0.9 1.4 1.0

ILS -3% 3% 0.8% 0.1 1.1 2.5 0.5

RUB -2% -2% 5.4% 0.3 1.0 1.5 1.5

TRY -10% -13% 7.6% 0.5 1.0 1.5 4.0

ZAR -12% -14% 5.4% 0.2 0.9 1.2 2.5

KRW - 4% 2.1% 0.1 1.1 0.8 0.5

IDR - 9% 8.9% 0.6 1.1 1.7 0.5

INR - -4% 7.2% 0.6 1.1 1.8 0.5

THB - 3% 3.4% 0.5 1.0 1.7 -

TWD - -2% -3.0% -0.4 1.1 1.2 2.0

SGD - -4% -0.2% 0.0 0.8 0.8 1.0

PHP - -2% 1.2% 0.1 1.0 1.2 0.5

ST: Short-term valuation model based on financial drivers

LT: Long-term valuation model based on macroeconomic fundamentals

Carry/vol: Ratio of expected carry and implied volatility

IV/HV: Ratio of implied and historical volatility

25D RR: 1-year z-score of 25D risk reversal

Positioning: Latam, z-score of official data; EMEA and Asia, dbSelect Positioning Indicator

Valuation Return Risk


Considering all the potential risks and the heterogeneity of

the asset class, it is worth asking which currencies offer

the best defensive trades. To answer this question we

look at those liquid pairs with higher USD call spread

payout ratios and which have retraced the most during the

last 100 days (see chart). We find that BRL, KWR and CZK

stands out.

Top trade recommendations:

LatAm: Enter zero-cost 1x2 USD/BRL put spreads, and

maintain short EUR/CLP and long USD/PEN. Take profits

on long MXN/CZK and switch to short CAD/MXN.

EMEA: Short EUR/ILS and oil sensitive NOK/RUB. Enter

long ZAR versus an equally weighted basket of similarly

high betas AUD and HUF and long PLN/HUF.



Identifying defensive trades


Drausio Giacomelli, New York, +1 (212) 250 3755

Mauro Roca, New York, +1 (212) 250 8609

Guilherme Marone, New York, +1 (212) 250 8640

Appendix: Our Model of Equilibrium REER

We base our assessment of fundamental valuation of EM

FX in an econometric model of the real effective exchange

rates (REER). More specifically, our model can be framed

into the class of Behavioral Effective Exchange Rate

(BEER) models.

Following the extensive literature on exchange rate

valuationi, the value of the exchange rate is determined in

this model by a few relevant macroeconomic variables.

We choose these variables with the aim of both capturing

the main determinants of exchange rate valuation and

maintaining a parsimonious model for tractability

purposes. In particular we use the following variables:

- Productivity differential (ratio between domestic and

foreign total factor productivities). This is a proxy for

relative productivities of the tradable and non-tradable

sectors, capturing the well known Balassa-Samuelson

effect (a higher productivity differential produces a relative

appreciation of the currency). ii

- Net Foreign Assets (ratio between net foreign assets

and GDP). This variable captures the potential inter-

temporally financing of the current account with net

holdings of foreign assets. iii

- Terms of trade. This variable captures the positive

income and wealth effects resulting from an improvement

in the relative price of exports.

- Openness, (ratio of the sum of imports and exports and

GDP). This variable not only captures the sensitivity of the

exchange rate to disequilibrium in the domestic economy

and its external sector but also is very sensitive to

structural breaks resulting from regime changes or crisis.

To estimate the model we follow a cointegration

approach, following and Granger and Engle.iv We apply it

to a panel covering more than a decade of monthly data –

from January 2000 to October 2011- for 20 EM countries.

The panel approach allows us to exploit the information in

the cross-section of countries to overcome the relative

short duration of macroeconomic time series of EM

countries. However, this forces all countries in the panel

to share regression coefficients, neglecting some relevant

diverse characteristics. We chose a balanced approach by

estimating regional panels for LatAm, EMEA and EM Asia;

this allows us to exploit intra-regional similarities without

being subject to inter-regional differences. Moreover, we

allow the coefficient of openness to be country specific as

this variable –as explained above- captures several

idiosyncratic effects.

iMacDonald, Ronald, 1998."What determines real exchange

rates?: The long and the short of it," Journal of International

Financial Markets, Institutions and Money, Elsevier, vol. 8(2), pp.

117-153, June; Obstfeld, Maurice & Rogoff, Kenneth, 1995.

"Exchange Rate Dynamics Redux," Journal of Political Economy,

University of Chicago Press, vol. 103(3), pages 624-60, June;

Sebastian Edwards & Miguel A. Savastano, 1999. "Exchange

Rates in Emerging Economies: What Do We Know? What Do We

Need to Know?," NBER Working Papers 7228, National Bureau of

Economic Research, Inc.i ii Bela Balassa, 1964."The Purchasing-Power Parity Doctrine: A

Reappraisal," Journal of Political Economy, University of Chicago

Press, vol. 72, pp. 584. iii

Philip R. Lane & Gian Maria Milesi-Ferretti, 2006."The External

Wealth of Nations Mark II: Revised and Extended Estimates of

Foreign Assets and Liabilities,1970-2004," The Institute for

International Integration Studies Discussion Paper Series 126. iv Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and

Error Correction: Representation, Estimation, and Testing,"

Econometrica, Econometric Society, vol. 55(2), pp. 251-76,

March.



Appendix: FX Strategy Summary


China Authorities have yet to signal worries of a slow

down in economic activity. Monetary policy

remains focus on stabilizing inflation and

authorities are allowing gradual appreciation of the

RMB.

Sell 1Y USD/CNY NDF with trailing stop-loss of

1.5%.

Positioning unwind extends; authorities pushing

spot higher in retaliation to US protectionists

measures

Hong Kong We do not think HKMA will change its USD peg in

the near-term. HKD has been trading in line with H-

shares, and we suggest watching signs of policy

easing in China, which would be a catalyst for a

renewed rally in H-shares and HKD.

Neutral HKMA surprises with a policy change

India India runs a huge C/A deficits and is dependent on

foreign inflows to fund its deficits. Weak market

sentiment limits portfolio inflows, while RBI is not

showing effort to stabilize its currency through FX

intervention.

Bearish. Negative risk sentiment due to external factors or

domestic corporate governance issues.

Indonesia Recent move by the central bank to cut interest

rates, as well as hints of more cuts ahead, could

dampen foreign bond inflows somewhat. However

FDI and C/A inflows remain strong and should

provide support for the IDR.

Neutral Sharp acceleration in inflation or global risk

aversion causing heavier bond outflows.

Malaysia The MYR has a high beta to global sentiments. A

bullish mid-term view is still warranted given the

strong C/A and growing FDI inflows, though a

stabilization in risk sentiment is needed before the

MYR resumes its uptrend.

Neutral Weak growth environment causing BNM to be

more defensive on FX.

Philippines BoP underpinned by steady growth in remittances

and outsourcing inflows. Seasonals are turning

favourable for the peso and remittances are likely

to pick up ahead of the year-end festive period.

Positive, with a 3M target of 42.5 Oil / food price shocks dragging down the BoP.

Singapore With SGD NEER spot and forwards still trading

below the mid-band, there remains scope for SGD

to appreciate vs. the basket. However, the beta of

SGD to external drivers is exceptionally high and

SGD is thus vulnerable to swings in the euro and

global risk.

Neutral A sharp slowdown in economic growth leading

MAS to shift to a neutral policy

South Korea Positive on valuations and strong C/A surplus.

External contagion and a tightening of USD funding

remains a key risk, but BoK is likely to intervene

more actively if spot attempts to break the 1200

level.

Neutral Heightening of geopolitical tensions, tightening of

USD funding and capital controls.

Thailand Recent severe flooding in Thailand is likely to

dampen economic activity and investor sentiment.

BoT may not cut rates in the near-term, but is

likely to prevent outperformance of the THB

relative to regional currencies to provide some

support for exporters.

Neutral A more severe slowdown in global demand leading

to weaker demand for Thai exports.

Taiwan The beta of Taiwan's growth to G2 demand is

high. CBC is likely to limit TWD appreciation to

support exports in a weak growth environment.

Prefer to use TWD as a funding currency for intra-

Asia carry trades.

A sharp slowdown in exports growth leading CBC

to intervene more aggressively.

Czech Few catalysts for downside in EUR/CZK. CZK has

become a cheap hedge against Euro woes - this is

unlikely to change in the short term. Sidelined for

now.

Neutral Significant slowdown in the key German export

market and continued euro related risk aversion

will hurt the koruna.

Egypt Political stability and resumption of talks with IMF

will hold the key.

Neutral on USD/EGP. Political risk after the planned election due to end

in Jan '12 and swings in global risk appetite. Source: Deutsche Bank



Appendix: FX Strategy Summary Cont’d


Israel Escalation of the ongoing conflict with Iran,

continued social unease over living costs as well

as a further deterioration in the trade balance, we

do not find risk-rewards in being long ILS spot quite

as attractive anymore.

Tactical sellers of EUR/ILS at levels above 5.10. Increased geo-political tensions in the Middle East

and expectations for further rate cuts will

undermine ILS.

Kazakhstan Domestic backdrop improving. Neutral but should outperform neighbouring UAH

NDFs

Sharp correction oil prices and sustained risk

aversion.

Poland Cautiously constructive. This is based on strong

economic momentum, sticky inflation and

commentary towards the hawkish side from NBP

and positive developments on the fiscal front.

Longer term valuation is attractive.

Long PLN/HUF (target around 72). Long 1y vanilla

EUR/PLN put at 2% of EUR notional.

Emergency hikes from NBH and the fact that PLN

has to some degree become a hostage of the

Eurozone crisis.

Romania Despite an improving macro backdrop, we do not

see meaningful catalysts for a significant sell off in

EUR/RON in a risk positive scenario. Upside in

EUR/RON should be limited by NBR intervention.

Neutral. Generalised risk aversion and lower oil prices.

South Africa Remains default risk-on/off choice, regardless of

fundamentals (limited gross external financing

requirements and attractive LT valuation). Fate of

the rand will be determined by European rather

than domestic factors.

Our preference remains to express constructive

ZAR views through relative value trades. We

recommend long ZAR versus an equally weighted

basket of similarly high betas AUD and HUF.

Otherwise, buy a 1y digital EUR/ZAR put struck at

10 for 25% of EUR notional.

ZAR currently has one of the highest EUR/USD

betas, meaning it might suffer more in any risk led

sell off.

Turkey Is one of the worst performing EM currencies,

having lost 19% vs USD and 21% vs EUR. Going

forward, we expect the lira to stay rangebound

between 1.75-1.90.

Trade ranges, or alternatively, but a short dated

DnT with strikes at 1.70 and 1.90.

Global recession fears and the consequential

drying up of financing flows would hurt the lira.

Ukraine The three most important factors for the UAH are

gas price negotiations with Russia, risk appetite in

macro markets and domestic economic and

political developments. The risks to all three are

negative in our view.

Bearish NDFs. One positive that could emerge is reduction in gas

price charged by Russia. Press reports that this

could be up to 40% (i.e. to $225/mcm from

$355/mcm in 3Q '11) - saving Ukraine $500m/y.

Argentina The government will find it increasingly difficult to

avoid any meaningful depreciation due to the

combination of worrisome levels of capital flight

and double digit inflation.

We recommend avoiding exposure to the NFD

curve, but some investors may find attractive the

elevated carry in the front-end.

Elevated risks and low liquidity

Brazil The BRL –as other liquid EM currencies- has

suffered from increased volatility on the back of

developments in core markets.

Positioning for potential short-term retracement

with zero-cost 1x2 USD/BRL put spreads.

Carry is expected to decrease further as the

central bank continues easing monetary conditions

aggressively with a focus on economic activity.

Chile During next year, the CLP will continue to be

affected by the continuous revisions of

expectations regarding global growth and copper

prices.

Maintain a short EUR/CLP position The main short-term risks are related to the direct

and indirect effects of a potential escalation in the

European crisis.

Colombia Fundamentals keeps improving the medium-term

prospects for the COP.

We remain on the sidelines, waiting for better

entry levels at the beginning of next year.

The currency could also suffer from a more

challenging global environment.

Mexico MXN was one of the currencies which suffered

the most from recent market volatility.

Taking profits in our long MXN/CZK

recommendation and switching to short

CAD/MXN.

Swings in risk aversion originating from the

external enviroment.

Peru The successful Central Bank intervention in the FX

market has shielded the PEN from the recent

volatility in global financial markets.

We recommend maintaining 3M USD/PEN NDF. The risks, in our view, are biased toward

depreciation.




Sovereign Credit in 2012: Diminished Returns; Country Selection Key

Given the circumstances, 2011 has been another

strong year for EM sovereign credit. Although the

total return has not been high, there are very few

asset classes which have produced a better

performance.

In this article we highlight how country selection (as

opposed to simple beta-management) has been a key

factor in portfolio selection in 2011. With this in

mind, we devote much of this year’s outlook to a

thorough examination of specific country factors

(pricing, macro and technical).

For 2012 our strategic recommendations are to be

overweight exposure to Venezuela, Colombia, Poland,

Russia, and Turkey; underweight exposure to

Hungary, Ukraine, Chile and South Africa.

Given the circumstances, 2011 has been another strong

year for EM sovereign credit. Although the total return has

not been high, there are very few asset classes which

have produced a better performance. In hindsight, a key

factor behind the overall performance of the asset class

was the diversity of performance within it. Indeed, 2011

was very much a year in which alpha dominated beta for

EM sovereign credit.

In this respect, we expect 2012 to bring more of the same

behaviour and so we devote much of this outlook toward

trying to identify the potential ‘winners and losers’ for

2012. We examine a variety of factors in determining the

appropriate country selection. These factors cover market

pricing, macro fundamentals and technicals (supply,

demand and positioning).

The main exogenous source of risk for EM sovereign

credit remains the crisis in the eurozone. However, while

2011 saw the can being ‘kicked down the road’ (albeit by

progressively shorter distances), we believe that 2012 will

bring greater resolution. Muddling through is unlikely to

be an option for much longer, suggesting a fairly binary

set of possible outcomes with respect to asset price

performance. In the positive scenario (some form of fiscal

union and ECB intervention) risk appetite should be

strong, benefiting EM sovereign debt. However, the likely

continued weakness in the global economy, exacerbated

by ongoing bank deleveraging, will mean that

vulnerabilities will remain for some EM countries. The

negative scenario (the eurozone crisis deepens and fears

of a break up of the currency union and/or sovereign

defaults escalate) would be hugely disruptive for global

markets and for global capital flows. In such a scenario we

would expect all vulnerable EM sovereigns to sell off

substantially. In positioning to defend against such a

scenario, we would argue that it would be better to be

underweight (or short) the more vulnerable credits with

lower yields (e.g. Ukraine and Hungary) than the traditional

highest betas (Argentina and Venezuela). This approach

towards defending against the crisis scenario results in a

rough barbell approach to risk allocation.

In terms of the overall return outlook for the asset class

we are not optimistic that we will see much better than

mid-single digit returns in 2012. The only scenario which

could bring an upside to this would be one in which

spreads compress, but UST yields remain anchored at

their current low levels. Ultimately however, we see an

environment in which very few asset classes offer a

compelling value/risk proposition and in this environment

EM sovereign credit may well prove to be the least ugly.

Taking Stock of 2011

Sovereign credit has outperformed yet again in 2011…

As we discuss in EM Performance: grass is greyer on the

other side, 2011 has been another year of outperformance

of EM assets and, in particular, sovereign credit. The total

return of the EMBI Global is higher than US IG (despite

EM having a lower average rating) and only slightly lower

than that of USTs (see the graph below).

During a year of heightened risk aversion, EM Sovereign

Credit seems fairly close to being a ‘safe-haven’.

2011 YTD performances of major asset classes


…but it can’t be ignored that yet again USTs were a

significant contributor to performance

Clearly, EM credit once again benefited from lower US

yields. The graphs below show the UST rally has



accounted for most of the positive total returns of DB-

EMSI constituents. With the notable exceptions of

Ukraine, Egypt, and Argentina, the stellar performance of

USTs has more than offset the widening in spreads. The

best performers have been, not surprisingly, low-beta,

high-quality LatAm credits. Only in Venezuela were yields

(and carry) high enough to more than compensate for the

widening in spread seen in 2011.

Sovereign credit: UST more than offsets wider

spreads

-5%

0%

5%

10%

15%

20%

EC UY PE PA MX CO VE BR PH ID EM ZA CL LB RU SV HU TR PL BG UA EG AR

Total Return UST Contribution

YTD Total Return and UST Contributions

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

VE QA MX CO PE BR PH PA LV ZA IL KZ MY RU ID CZ RO HU PL TR BG UA AR HR SK

5Y CDS Total Returns, YTD


However, this simple picture of a year dominated by

lower UST yields and wider credit spreads is misleading.

The reality was more complex. 2011 was very much a

year of two halves as the chart below illustrates. For the

first seven months of the year, spreads were tightly

range-bound, while USTs rallied. Then, in late July,

spreads dramatically broke out of that range as the

combination of fiscal concerns in the US and financing

concerns in Europe both lead to a sharp increase in risk

aversion.

The chart below highlights that the level of spreads for

EM sovereigns has remained closely in-line with the level

of spreads for equivalently rated US corporates for much

of the past two years. Does this mean that EM

sovereigns are at fair value and hence offer little upside

vs. corporate credit? We think not, for two reasons.

First, credit markets are currently pricing two fairly distinct

markets: corporates and financials, with the latter priced

significantly wider than the former, at the same rating.

While the chart above represents the blend of these two

markets, we believe that it is more appropriate to

compare EM to the corporate market alone, since the

majority of EM sovereigns do not suffer from the same

pressures that have led to the re-pricing of financials

(excess leverage and uncertain funding costs).

The second reason for us to believe that EM sovereigns

continue to offer value over and above US corporates is

because we continue to see an underlying positive rating

migration in the asset class. As we discuss later, we

expect upgrades to continue to outpace downgrades by a

significant degree during 2012. Such migration leads EM

to outperform, even if the relative level of spreads at a

given rating remains constant.

2011 has been a year in which ‘alpha’ has dominated

inter-country returns

Historically, EM sovereign credit has been a market

dominated by ‘beta’. During most calendar years, a large

degree of the variation in the returns of different countries

can be explained simply by market ‘beta’. This beta can

be reflected in the yield and volatility of the individual

components.

However, 2011 has been far from the norm in this respect

as the chart below shows. For each calendar year (and

2011 YTD) we regressed the annual returns of each

country against three different factors: (a) the yield of

each country at the start of the year, (b) the volatility of

the country in the previous year and (c) the net change in

rating notches during the year.

EM Sovereign spreads have been highly correlated

with the US corporate credit market

200

250

300

350

400

450

Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11

Median for US/EU corporates* EM Sovereigns

Libor spread, bp




Differences in yield and volatility did not explain

relative country performance in 2011

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

2011

YTD

2010200920082007200620052004

Rating change Yield (at start)

Volatility (prev yr) All three combined

Explanatory factors for relative country performance,

R2


It is clear that in most years the beta factors alone (yield

and volatility) can explain a large degree of the variation in

inter-country returns. However, in 2011 (just as in 2006)

these factors have explained virtually none of the

variation. On the other hand, the ratings changes which

have occurred explain a significant proportion of the

variation. Indeed, with the exception of the years in which

beta dominates, ratings are a consistently significant

factor in explaining the return variation.

It may seem to be stating the obvious that changes in

credit ratings can explain return variation. However, given

the scepticism regarding the value of the ratings and

given that the agencies certainly have a tendency to lag

the market, it is nevertheless an interesting result which

justifies examining possible rating changes for the year

ahead.



2011 was again a year in which upgrades outpaced

downgrades – particularly during the second quarter when

the pace of sovereign upgrades in EM reached its highest

level in almost four years. More recently the actions have

been more balanced, with Egypt, Hungary and Venezuela

all suffering downgrades, but we remain optimistic for

2012.

Looking across the major EM sovereign credits, we

believe that upgrades could be expected for Argentina,

Brazil, Colombia, Peru, Russia, Turkey and Indonesia. On

the other hand we believe that Hungary and Ukraine are

both likely to suffer further downgrades.

Most countries face higher than usual external debt

payments in 2012

Since the 2008 financial crisis, external issuance by EM

governments and private sector entities has been

extremely strong, breaking the records set pre-crisis. For

governments, the increased issuance has been to finance

looser fiscal positions and has arisen due to many new

borrowers tapping the market for the first time. For

corporates the increase in bond issues as been in part to

substitute for the contraction in bank lending as

developed market banks have reduced their balance

sheets. We expect both the factors to continue to

influence issuance and hence we expect the pipeline of

issuance to remain robust.

An additional reason to expect issuance to remain high in

2012 is that the majority of EM sovereigns are facing

higher than usual external debt payments (principal and

interest) in 2012. As the chart below shows, for some

countries the repayments in 2012 are up to 2-4 times the

average amount in the prior three years. Upgrades have generally outpaced downgrade, but it

is clear that the agencies remain very active

0%

5%

10%

15%

20%

25%

05 06 07 08 09 10 11 12

Downgrades

Upgrades

Rolling 3-mth ratings changes (as a % of number of rated sovereign

EM issuers)




40%

30%

20%

10%

0%

10%

20%

30%

40%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

Proportion of upgrades

Proportion of downgrades




These payments (approx. USD60bn in total for 2012) can

be seen as both positive and negative. For the market as

a whole they should be a positive factor, as we would

expect a large proportion to be recycled. However, for

the individual countries facing higher gross external

financing needs, they are potentially a negative factor.

Those countries which have deep, flexible domestic

markets should be less susceptible to this pressure, since

they should be able to be more flexible in the external

borrowing plans.

Ultimately, whether it is a positive or negative factor likely

comes down to the net issuance by individual countries.

We illustrate this indirectly in the chart below. The chart

shows (a) the estimated gross borrowing per country

assuming that the net issuance is the same as the

average of the past three years, and (b) our own estimates

of gross issuance. The difference between the two bars

is effectively the difference in the net issuance between

what we expect (or what has been stated by officials) and

what has been the average outcome over the past three

years.

The chart highlights that many of the larger EM borrowers

are cutting back on net issuance, while there is expected

to be a substantial increase in net issuance by the smaller

countries and less frequent borrowers.

Notable exceptions to this are Hungary, Ukraine, UAE (in

which we include both Abu Dhabi and Dubai) and Russia.

For the former two the financing needs which drive the

issuance expectations are more pressing. If the market is

not conducive to the significant amount of issuance

implied for Hungary and Ukraine then they will need to

find alternative sources or make further fiscal

adjustments.

If all countries in the chart below were to issue the gross

amounts indicated in the chart, the total amount of

issuance would be USD75-85bn (75bn based on the blue

bars, 85bn based on the grey bars)

Most countries face higher than usual external debt

payments in 2012, some as much as 2-4x higher

VN

VE

UY

UA

AE

TR

LK

KR

ZASI

SK

CS

RU

RO

QA

PL

PHPE

PA

PK

MA

MX

MY

LT LB

JM

IL

IQ

ID

HU

GHGA

SV

EG

EC

DO

CZ

HR

CO

CN

CL

KY

BG

BR

BH

AR

8bn

4bn

2bn

1bn

500mm

250mm

125mm

50mm

8bn4bn2bn1bn500mm250mm125mm50mm

2012 Payments = 3Y Avg

2012 Payments 2x/0.5x Avg

2012 Payments 4x/0.25x Avg

External debt payments in 2012 (principal and interest), USD

Average annual external debt payments (2009-11), USD


Despite the market turmoil in recent months, EM

issuance in 2011 has been close to last year’s record

0

20

40

60

80

100

120

140

2004 2005 2006 2007 2008 2009 2010 2011

Corporate

Financial

Sovereign

Gross external issuance, USD equivalent bn

Jan-Nov (Full year outcome is indicated by error bars)


Gross borrowing in 2012 projections vs. estimates

based on past 3Y average

* The estimated gross issuance is compiled from a variety of sources (official

statements, budgets, comments from government officials and, in some cases

conjecture based on our assessment of needs). Source: Deutsche Bank



Dedicated investors have cut exposure to the ‘high

betas’

According to the latest data on investor positioning (end-

Oct), investors have cut back on exposure to the higher

yielding sovereign credits in EM. In another article in this

report13 we introduce a new approach to analyzing data on

dedicated fund exposures. In this approach we have two

measures to assess the potential impact of dedicated

funds: (a) Positioning (evidenced by a z-score measure of

the fund exposure relative to the reference benchmark,

and (b) An ‘appetite’ index which measures the relative

proportion of funds in the sample which have been

actively adding to their exposure to a given country,

versus those that have been reducing.

The chart below illustrates the positioning score. Note

that exposure to Argentina, Hungary, Ukraine and

Venezuela are all at the far right, with z-scores in the -1

to -3 range14, indicating that the exposure of dedicated

funds is well below the average level of the past two

years. Meanwhile, funds have increased exposure to a

number of the smaller, less-liquid credits.

Understanding how dedicated funds are positioned with

respect to individual countries can help to shed light on

how the bonds of those countries might react to a shock

(positive of negative). If positioning is biased toward over-

or under-weight then we would expect the response to a

shock to be similarly biased (overweight leading to a

negative bias and vice versa). In addition to this indicator

of current positioning, we also like to understand whether

13 A Closer Look at Real-Money Positioning

14 A z-score of 1 implies that for exposure to return to the 2Y average level

(relative to the benchmark) then the required change in exposure would be

1 standard deviation of the historical monthly changes.

investors have been actively15 adding/reducing exposure

to a given country. In order to do this we construct an

index which represents the net proportion of funds in the

sample which have added exposure. This index is

computed for each country, for each month. The chart

below shows the three month moving average for each

country.

Appetite has recently been strong for core IG

sovereign credits

-0 .3

-0 .2

-0 .1

0

+ 0 .1

+ 0 .2

+ 0 .3

+ 0 .4

Z A :

R S

:

:

M X

B R :

P L

:

:

T R

C L :

C O

:

:

T N

M Y :

R U

:

:

V N

P K :

P H

:

:

A R

U Y :

K R

:

:

P E

E G :

B G

:

:

V E

P A :

G H

:

:

H U

S V :

U A

:

:

ID

O c t 1 1

P re v . M th

B u y e rs v s e lle rs in d e x , 3 m M A *

* -N u m b e r o f fu n d s a c t iv e ly in c re a s in g e x p o s u re m in u s n u m b e r o f fu n d s a c t iv e ly

d e c re a s in g e x p o s u re , d iv id e d b y th e to ta l n u m b e r o f fu n d s


The chart indicates that fund managers have been adding

exposure to the core investment grade credits (BR, MX,

ZA, PL) along with Serbia (which issued a Eurobond in late

September). At the other end of the spectrum, funds

have been actively reducing exposure to Indonesia,

Ukraine and El Salvador.

For further detail on these exposure indicators – along

with time series of both indicators for all countries –

please see the companion article in this report.

Survival of the Fittest

The headline theme of this 2012 outlook has been

‘Survival of the Fittest’, a theme on which we elaborate in

another of the special reports16 in this publication. In this

special report we introduce a set of indicators to capture

the relative vulnerability of each country to four key risks:

external risks, fiscal risks, financial risks and exogenous

risks. Given that the avoidance of risks is central to asset

allocation within a credit portfolio, such indicators should

be very relevant for our assessment of relative country

exposures.

15 We distinguish between active changes in exposure and passive

changes, the latter arising from relative price movements. See the

accompanying article for further discussion of this distinction. 16

See: EM: Survival of the Fittest

Dedicated funds have reduced exposure to high beta

credits

-4 .0

-3 .0

-2 .0

-1 .0

0 .0

1 .0

2 .0

3 .0

4 .0

R S :

C L

:

:

P K

V N :

P E

:

:

P A

B G :

S V

:

:

P L

M X :

B R

:

:

C O

T R :

P H

:

:

Z A

M Y :

U Y

:

:

T N

G H :

R U

:

:

V E

E G :

U A

:

:

ID

H U :

K R

:

:

A R

O c t 1 1

P re v . M th

E x p o s u re Z -s c o re *

* -A v g e x p o s u re v s b e n c h m a rk , re la t iv e to 1 2 m th M A , d iv id e d b y S tD e v o f m o n th ly

c h a n g e in e x p o s u re




Unsurprisingly, EMEA dominates the list of the most

vulnerable countries. Five countries (Hungary, Ukraine,

Romania, Poland, and Egypt) show up as highly

vulnerable, though for different reasons. Egypt’s

underlying vulnerabilities, for example, are fiscal first and

external second. Ukraine’s risks are mostly external.

Hungary’s vulnerability reflects a combination of risks in all

four areas. Poland’s risk rating is probably a notch too high



imbalances that have yet to be fully addressed. Romania

remains vulnerable but has done a lot of the hard yards in

terms of fiscal adjustment and is poised to move to a

lower risk category.

Outside of EMEA, only Malaysia makes it on to our list of

countries with medium risk ratings mainly reflecting the

high level of foreign bank claims on the country (which

may be overstated) and moderate concerns about the

country’s public finances.


reforms, and overly conservative financial regulation in

response to a severe external crisis in the 90s have

allowed LatAm to converge to a relatively safe status.

Increasing dependency on commodities is probably the

major short term vulnerability. Complacency regarding

long term fiscal rigidities with spending concentrated in

current spending is probably the main yellow light for the

medium term.

Strategy Recommendations

As discussed in the introduction, we expect country

selection rather than simple beta-management to be key

to portfolio outperformance in 2012. To help identify the

potential ‘winners and losers’ for 2012, we compare a

variety of factors, based largely on the preceding

discussion. These factors cover market pricing, macro

fundamentals and technicals (supply, demand and

positioning).

On the following page we present a simple scorecard of

the factors which influence our views. We divide these

factors into three groups:

Market Factors

Yield and Spread. As discussed earlier, in most years

yield differences alone can explain a large degree of

the variation in country returns. While we do not

expect 2012 to be such a ‘beta’ year, but

nevertheless yield remains an important factor in our

selection.

Market-implied rating (z-score). While the ‘yield’ is a

useful static, absolute measure of the value offered

by a credit, it conveys little in the way of relative

value, either to other credits, or relative to itself over

time. To address this we also look at the market-

implied rating of the credit (as a deviation from the

actual rating) and also a z-score of this market-implied

rating deviation. For example, in the scorecard below,

Turkey has a market-implied rating deviation of -0.7

(meaning that the market prices-in an average 0.7

notch rating improvement across the three agencies).

However, the z-score of this deviation is +1.8,

meaning that the current deviation represents a much

smaller deviation than the past 1-year average.

Macro fundamentals

Vulnerability indicators. As discussed, we present the

four vulnerability indicators which are described in the

article ‘EM: Survival of the Fittest’.

Forecast rating changes: We present forecasts of

likely rating changes over the coming year, based on

the expectations of our economics team. A value of

one indicates a one-notch change by all three

agencies. A value of 1/3 would indicate a one notch

change by a single agency.

Technicals

Real-money positioning and appetite. As discussed

previously, we look at two indicators based on the

exposures of dedicated real-money funds. The

positioning indicator is a z-score of the current

average exposure deviation, versus the average

deviation of the past two years. The ‘appetite’

indicator is a measure of the net proportion of funds

in the sample which have been actively adding (or

reducing) exposure to the country.

Supply/demand (gross payments and expected net

issuance). We show the gross payments due from

each credit; what this amount represents as a

multiple of the average payments from the past three

years and also the expected net issuance by the

country.

To highlight the positive and negative factors we highlight

appropriate values in the score card. For most indicators

we highlight the top and bottom four values in each

column. For rating changes we highlight all values. For

the vulnerability indicators we highlight the values

corresponding to ‘medium risk’ and ‘high risk’ according

to the methodology discussed in the accompanying

report.

On the basis of these indicators, and also considering

additional subjective factors (such as political risk etc.) we

arrive at the following investment recommendations.



Strategic overweights

Venezuela

Though Venezuela presents a clear case of credit

deterioration and features some of the worst

technical conditions due to large amount of net

issuances, valuation looks extremely attractive, and in

our view, has not sufficiently priced in the chance for

a relatively peaceful transition of power to the

opposition in 2012 (meaningfully large than 50% in

our view), which will likely lead to a significant (albeit

gradual) shift of political and economic policy down

the road. The main risk is the potential volatility during

the election process and doubt on whether the

transition of power will be done peacefully. For this

reason, we would keep only a small overweight in the

near terms.

Colombia

Colombia presented a prominent case of ascension in

the credit standing in 2011, with significantly

improvement of the country’s political and economic

environment over the past few years reaping benefits

as it joined the investment grade club. It remains

marginally more risky in comparison with its regional

high grade peers according to our vulnerability

indicators, but the positive trend and marginally better

valuation are keys to our strategic overweight

recommendation on Colombia in 2012.

Russia

On all the ‘domestic’ vulnerability indicators, Russia is

clearly one of the least vulnerable countries in EMEA.

External vulnerability is however significant, a

consequence of its heavy reliance on oil exports.

Valuation, rating outlook and fund positioning are all

favourable and although net issuance may be

substantial, this would only take place in the context

of a very supportive market. 2012 is an important

year for Russia with likely WTO accession and the

passage of elections. While we are not very

optimistic that the return of Putin to the Kremlin will

spur reform, we believe that the market currently

prices an excessive risk premium.

Turkey

While we remain concerned about the direction of

monetary policy and the risks of a hard landing for the

economy, from a sovereign credit perspective Turkey

looks fairly positive. Given the healthy primary

surplus, moderate debt stock and low real rates, the

credit spreads on bonds of well above 300bp seems

incongruous. Certainly some premium is warranted

given the aforementioned risks, but Turkey’s debt

dynamics are considerably less vulnerable than in the

past. Relative to the EM sovereign market as a whole

Turkey credit is cheap on a historical basis.

Poland

On the scorecard, the picture for Poland is mixed. It

is rated as high risk on the vulnerability indicators,

real-money investors are modestly overweight and

repayments are high. On the flip side, we expect net

issuance to be negative, which would be a substantial

change from prior years and, perhaps most

importantly, it has cheapened considerably in recent

months. In fact, the extent of the change in the

market-implied rating is similar to that of Ukraine,

Hungary and Argentina, which we think is wholly

unjustified. Furthermore, as we discuss in ‘EM:

Country Scorecard Market Factors Macro fundamentals Technicals Recommendation

DB F'cst

Yield Z-Spd Market-Implied Vulnerability Rating Chg Real-Money Funds Supply Exp.

% bp Rating Z-Score Ext. Fisc. Fin. Exo. Up Dwn Pos'n App. Pmts Net Iss.

Latin America

Argentina 11.8 1037 +3.0 +2.4 0.15 0.13 0.25 0.20 0.7 -3 -2 4.2 0.9x -4.2 Neutral Argentina

Brazil 3.5 162 -3.5 +0.0 0.15 0.38 0.25 0.58 0.7 +1 +22 5.6 1.2x -2.6 Neutral Brazil

Chile 2.3 68 -3.9 -2.5 0.15 0.00 0.50 0.70 +4 +13 0.8 3.6x -0.8 U/W Chile

Colombia 3.6 174 -3.4 -1.0 0.15 0.25 0.25 0.66 0.3 +1 +12 1.9 1.4x +0.1 O/W Colombia

Mexico 3.6 168 -3.0 -1.4 0.00 0.13 0.13 0.85 +1 +27 3.4 0.7x +0.1 Neutral Mexico

Peru 4.5 222 -1.8 -0.2 n.a. n.a. n.a. n.a. 0.3 +2 -7 1.4 1.9x +0.6 Neutral Peru

Uruguay 4.6 221 -3.2 -1.2 n.a. n.a. n.a. n.a. -0 -4 0.4 0.8x -0.4 Uruguay

Venezuela 14.0 1219 +5.4 -1.3 n.a. n.a. n.a. n.a. -1 -9 2.5 0.9x +4.0 O/W Venezuela

EMEA

Egypt 7.2 509 +0.5 +0.5 0.50 1.00 0.00 0.26 -7 0.1 0.3x +1.9 Neutral Egypt

Hungary 7.5 566 +4.5 +2.1 0.30 0.75 0.63 1.31 0.3 -2 -10 3.2 1.3x +1.8 U/W Hungary

Poland 4.3 282 +3.3 +2.4 0.60 0.63 0.38 0.62 +1 +19 6.6 2.2x -0.6 O/W Poland

Russia 4.4 260 +0.8 +0.6 0.00 0.00 0.13 1.75 1.0 -1 +4 3.8 0.7x +3.2 O/W Russia

South Africa 3.8 197 -0.2 +0.7 0.45 0.25 0.25 0.59 +0 +34 1.5 2.4x +0.5 Neutral South Africa

Turkey 5.2 340 -0.7 +1.8 0.45 0.13 0.25 1.49 0.3 +0 +13 5.3 1.0x -0.8 O/W Turkey

Ukraine 9.6 814 +2.9 +2.6 0.75 0.25 0.38 3.36 1.0 -2 -20 1.1 1.0x +1.9 U/W Ukraine

Asia

Indonesia 4.2 244 -2.7 -0.1 0.00 0.00 0.00 0.07 0.7 -2 -22 1.6 1.2x +1.7 Neutral Indonesia

Malaysia 3.3 172 -0.5 +0.6 0.15 0.25 0.50 1.22 +0 +6 0.1 0.1x -0.1 Neutral Malaysia

Philippines 4.1 209 -4.5 -0.8 0.00 0.63 0.00 0.64 +0 -1 1.7 0.5x +0.6 Neutral Philippines Source: Deutsche Bank



Survival of the Fittest’ we feel that the vulnerability

indicators are overly harsh on Poland as they do not

take account of some key offsetting features.

Strategic underweights

Hungary

Hungary appears as the most vulnerable of all EM

countries on the vulnerability indicators and while

valuation and positioning are supportive, we do not

believe they are sufficient to offset the risks. 2012 is

set to be particularly challenging given the

government’s need to raise a substantial amount on

the external bond market. If this is not forthcoming,

then an agreement with the IMF seems critical.

However, to secure such an agreement would likely

require a radical change of approach from the

government and we are not convinced that this

government would be willing to stomach such a

change.

Ukraine

Unsurprisingly, Ukraine comes out poorly on the

vulnerability indicators, but valuation and positioning

are supportive. Our primary concern is the tightness

of financing conditions raising the risk of credit

problems in the coming year. The treasury continues

to struggle to execute its domestic borrowing plan

and is reliant on the NBU for financing. Net claims of

the NBU on the central government have more than

doubled since the end of May, reaching approx.

USD8bn. A deal with Russia on gas prices would

certainly be positive, but we are not convinced that it

would be sufficient to mitigate the risks and reverse

sentiment.

South Africa

The combination of increased gross issuance ahead,

coupled with the fact that dedicated investors are

already relatively overweight the credit persuades us

to be cautious. Furthermore, as our vulnerability

indicators highlight, SA is not entirely immune to the

risks which characterise much of EMEA.

Chile

Despite its solid fundamentals, the tight credit

spread, financial risk (albeit moderate) as shown in

our vulnerability indicators, and the likely lack of

support from the USTs in 2012 mean risk is biased

towards lower returns. In addition, real money

investors have been significantly overweight Chile,

creating a non-supportive technical condition. We

look to buy Chile CDS as a defensive trade.

Further, we note that while the scorecard as a very useful

reference that influences our views, it does not capture all

the aspects we need to consider in order to make a

comprehensive decision on our country positioning

recommendations, especially those that are qualitative in

nature. We take exceptions to what the scorecard

suggests to us regarding:

Argentina

Strategically, we recommend a neutral position on

Argentina in 2012 even though the scorecard

suggests overweight. In our view, Argentina’s main

vulnerability lies in the erosion of investors’

confidence (caused by the risk of medium term

economic crisis in the absence of policy change)

coupled with significant capital flight. In addition, in

terms of technicals, Argentina’s large negative net

issuance is more indicative of lack of a conventional

market based means of financing (for well

documented reasons) rather than presenting good

technicals.

Indonesia and the Philippines

Even though the vulnerability indicators look positive

for Indonesia, its underperformance in September

and October suggests that Indonesia remains very

sensitive to a weakening of risk sentiment due to the

lack of a strong local bid (unlike in the Philippines). In

our view, this lack of defensive prevents us from

holding a strategic overweight recommendation on

Indonesia, despite its solid and improving macro

fundamentals. In fact, we have recently been

underweight Indonesia. However, we would now

take the opportunity of Indonesia’s underperformance

to cover underweight and move to neutral tactically.

In terms of the Philippines, while we acknowledge

the weakness apparent in its fiscal vulnerability

indicators, the strong investor sponsorship for its

external debt more than compensate this shortfall.

We hence recommend a strategically neutral

exposure to the Philippines.

Marc Balston, London, 44 207 547 1484

Hongtao Jiang, New York, 1 212 250 2524



Appendix: Credit Strategy Summary


Hungary Clearly one of the most vulnerable credits in CEE.

External financing could be challenging in 2012

absent a new IMF program.

Underweight cash A short position is likely to be costly in a general

market rally, but the risk-reward still justifies the

position.

Kazakhstan With plenty of opportunities in the Russian

sovereign/quasi-sovereign space there is little

reason to take exposure in Kazakhstan at present

Neutral.

Poland Recent underperformance provides the potential

for outperformance should the new government

deliver a credible fiscal plan. Poland is one of the

few EM credits with the potential to deliver a

positive catalyst.

Overweight. The newly re-elected government fails to deliver a

credible fiscal adjustment.

Romania Risks to economic performance are mounting, but

the government’s commitment to fiscal

adjustment and its good relationship with the IMF

should stand the country in good stead to weather

potential storms ahead.

Overweight Renewed pressure on eurozone sovereigns.

Russia Valuation, rating outlook and fund positioning are all

favourable and although net issuance may be

substantial, this would only take place in the

context of a very supportive market.

Overweight With the budget assumption for oil now raised to

$93bbl (Urals), the risk from a drop in oil prices

has risen.

South Africa Increased gross issuance ahead, coupled with the

fact that dedicated investors are already relatively

overweight the credit persuades us to be cautious.

Underweight Increase issuance, to the extent that it leads to a

higher benchmark weight, could limit the

downside.

Turkey Turkey sovereign credit is the cheapest it has been

in three years, relative to EM. Concerns over

monetary policy have diverted attention from

strong fiscal performance.

Overweight. Shorten duration to capitalize on the

very flat cash curve. 2015s represent the 'sweet

spot'.

Turkey weathered the 2008-09 crisis well, but the

current unconventional policy mix risks sacrificing

those gains.

Ukraine Sources of financing are diminishing, Little

likelihood of IMF disbursement; eurobond issuance

is hard to imagine and even domestic issuance is

proving challenging.

Remain underweight. A volte-face on domestic gas prices and/or some

leeway from Russia on the Gazprom contract

could ease the pressure,

Argentina The external risk environment in 2012 is unlikely to

be supportive for Argentina, and we remain

doubtful there will be any meaningful policy

changes. But attractive valuation looks attractive.

Stay neutral, favor global bonds (especially the

Global 17s) over local law bonds. Long basis on

Global 17s vs. 5Y CDS.

A surprise shift to market friendly policies takes

place and renders our conservative approach a

losing proposition.

Brazil Though fiscal performance appears to be on track

in 2011, we project it to underperform budget in

2012.

Stay neutral and continue to favor 41s and 40s (to

call) vs. 21s. Sell basis (10Y vs. 21s).

Notional Treasury does not resume buying back

legacy bonds, causing 5Y sector to underperform;

Brazil taps long end of the curve, causing further

steepening.

Chile Despite its solid fundamentals, its tight spread and

the likely lack of support from the USTs in 2012

mean risk is biased towards lower returns.

Underweight and look to buy CDS as a defensive

trade.

Colombia Macro momentum remains strong and valuation is

still marginally more attractive valuation relative to

its LatAm low beta peers.

Stay overweight and favor shorter-end of the

curve

Historically, a higher beta credit than regional

peers - whether this has changed is yet to be

tested

Mexico Valuation does not look attractive, but Mexico is

among the credits having the lowest risk on our

vulnerability indicators. Improving US economic

activity is also supportive.

Neutral. The old 19s remain significantly rich to the

curve.

Sharper than expected slowdown in the US and

lower oil prices.

Peru While we value Peru’s stability drawn from its

fundamental strength, valuation also looks

marginally more attractive in comparison with

Brazil and Mexico.

Increase to overweight, take profit in the 37s to

19s switch and now favor the long end of the

curve.

Policy risk remains given President Humala’s

political background, though it will unlikely be a

serious concern in the near term.

Venezuela Attractive yields, high oil prices, and medium-term

prospects for political change will continue to play

in Venezuela' favor relative to its high-yielding

peers.

Increase to a small overweight, favoring Republic

over PDVSA. Stay long basis on the sovereign

curve (24s vs. 10Y), and also long PDVSA 22s vs.

Venezuela 10Y CDS.

Volatility of political origin




EM: Survival of the Fittest

We present a new framework for assessing relative

vulnerabilities across EM in a systematic manner

using external, fiscal, financial, and growth sensitivity

indicators.

EMEA dominates our list of the most vulnerable

countries. Five countries (Hungary, Ukraine, Romania,

Poland, and Egypt) show up as highly vulnerable,

though for different reasons. Egypt’s underlying

vulnerabilities, for example, are fiscal first and external

second. Ukraine’s risks are mostly external. Hungary’s

vulnerability reflects a combination of risks in all four

areas.

Poland’s risk rating is probably a notch too high



imbalances that have yet to be fully addressed.

Romania remains vulnerable but has done a lot of the

hard yards in terms of fiscal adjustment and is poised

to move to a lower risk category.

Outside of EMEA, only Malaysia makes it on to our

list of countries with medium risk ratings mainly

reflecting the high level of foreign bank claims on the

country (which may be overstated) and moderate

concerns about the country’s public finances.

Forced fiscal adjustments, together with some

structural reforms, and overly conservative financial

regulation in response to a severe external crisis in

the 90s have allowed LatAm to converge to a

relatively safe status. Increasing dependency on

commodities is probably the major short term

vulnerability. Complacency regarding long term fiscal

rigidities with spending concentrated in current

spending is probably the main yellow light for the

medium term.

EM resilience faces a stern test

The coming year is going to be a difficult one for the

world economy. Much of Europe will likely be in recession

and the US will do well to grow at anywhere close to

trend. Together, Europe and the US are now expected to

grow by 0.9% in 2012 compared with our forecast of

2.6% back in July. Reflecting this, we have downgraded

our forecasts for EM over the last few months, primarily in

EMEA, whereas we continue to think Asia and Latin

America will be less severely affected. Within EMEA, the

current crisis is weighing most heavily on the economies

of central and eastern Europe: we have downgraded our

growth forecast for this region by an average of 2.5%,

even more than our revision for the euro area, and we

expect Hungary to fall back into recession next year.

Downgrades to DB growth forecasts since July

-2.5

-2

-1.5

-1

-0.5

0

US Eurozone EMEA Asia Latin

America

Change in 2012 GDP growth forecast, ppts


EM resilience is clearly being tested, though we continue

to think that growth will remain well above that in DM at

an aggregate level. EM and DM cycles have become

increasingly correlated over the last 10-20 years as EM

economies have become more integrated with global

economic and financial markets – i.e. cyclical coupling.

Once we strip out the cycle, however, trend growth rates

have moved firmly in favour of EM and we would expect

this positive differential to remain intact next year. This is

illustrated in the chart below – if there is one chart that we

have got more mileage out of than any other it is this one,

so we repeat it here for one last time this year.17

Cyclical coupling and trend decoupling

EM ex. China

trend

DM Trend

EM ex. China

cycle

DM cycle

-6

-4

-2

0

2

4

6

1980 1985 1990 1995 2000 2005 2010

Growth (%)

Source: IMF, Deutsche Bank

The reasons for this EM resilience have been widely

discussed elsewhere. We think a big factor has been

improved economic policies, which have in turn allowed

17 See also ‚EM: Trend Decoupling but Cyclical Coupling‛ in our July

EMM.



many EM economies to reduce debt and accumulate

substantial foreign reserves. This is most clearly visible in

the public finances (see chart below) where a combination

of more prudent fiscal management and rapid growth –

helped in some cases by financial repression and very low

domestic real interest rates – have brought government

debt levels down to comfortably sustainable levels across

much of EM. These stronger public and private balance

sheets should leave much of EM relatively well placed to

weather the current economic storm.

Simulated public debt paths

EM

DM

25

45

65

85

105

125

145

165

185

205

225

2006 2010 2014 2018 2022 2026 2030

(% GDP)

We assume: (i) primary balances are held

constant at this projected 2012 levels; (ii) real

GDP grows at trend rates; and (iii) the

differential between real interest and real

growth rates in each country is 0 until 2015

and 1.0 thereafter.

Source: Haver Analytics, IMF, Eurostat, Deutsche Bank

This resilience is not uniform, however, across EM

regions or countries. Public and private balance sheets are

generally weaker in EMEA, for example, which is also

more directly exposed to the euro crisis through stronger

economic and financial linkages. Growth in Latin America

has remained more robust but the region remains heavily

reliant on commodities and would suffer if commodity

prices fell sharply in response to slower global growth.

Asia has for some time been the star performer within EM

and we would expect this to continue into 2012.

Nonetheless, very rapid credit growth and rising property

prices could quickly turn and present problems in a lower

growth environment.

We have highlighted each of these and other potential

weaknesses several times in our research throughout the

year. Here we assess them in a more systematic manner

with a view to identifying the most likely pressure points

within EM. We present a new framework for assessing

relative vulnerabilities across EM and then draw some

conclusion for each emerging region.

Assessing Vulnerability

We provide a structured and objective assessment of the

underlying vulnerabilities of EM economies. Our

assessment is based on a range of measures that we

think capture a country’s susceptibility to an economic

crisis. Specifically, we look at the following indicators:

External sector: current account balance in percent

of GDP, external debt in percent of GDP, exchange

rate valuation (REER vs HP trend), and foreign

reserves as a percent of risk-weighted liabilities. The

latter is our preferred measure of reserve adequacy

(see Reserve Adequacy in EMEA in our November

EM Monthly for more details).

Fiscal sector: overall fiscal balance, public debt, debt

maturing in the next year (to capture rollover risk), and

foreign currency denominated debt (to capture

exchange rate risk) – all measured in percent of GDP.

Financial sector: loan-to-deposit ratios, the pace of

private credit growth (average over the last two

years), and the level of private credit in percent of

GDP. We also include a measure of foreign bank

claims on the economy (in percent GDP), using the

BIS consolidated banking statistics, which includes

exposure through local subsidiaries. Our aim here is

to capture the potential risk from deleveraging by

stressed banks in core markets.

Exogenous shocks: we include our growth betas, i.e.

the elasticity of economic growth with respect to

growth in the US and Europe.

These indicators are then given a risk rating – low,

medium, or high – depending on whether or not they

exceed certain thresholds. Our thresholds are relative

rather than absolute insofar as they are based on the

distribution of observations for each indicator across our

EM universe over the last five years. Taking external debt

as an example, the 60th and 80th percentiles of the

distribution correspond with 38.3% of GDP and 52.8% of

GDP. Countries with external debt above these levels are

assigned medium and high risk ratings respectively for

this indicator.

We then aggregate the scores within each sector to come

up with vulnerability ratings for each of one (i.e. external,

fiscal, financial, and exogenous). These sector ratings are

in turn then combined to result in a single overall

vulnerability rating. In doing so, we attach a higher weight

(40%) to the external sector, followed by the fiscal sector

(30%), financial sector (20%), and exogenous sector

(10%) reflecting our judgment on the relative importance

of these variables in precipitating an economic crisis in an

EM context.

Below we summarize the main results, our current overall

vulnerability rankings, and the evolution of these overall

rankings over the last five years.

External vulnerabilities

Our external vulnerability indicators immediately point to

relatively greater risks in EMEA, with only Israel and

Russia within the region ranking as low risk overall on this

metric. This is driven primarily by the region’s relatively



high external debt levels, which in some cases are higher

now than they were going into the last crisis because of

deep recessions and currency depreciations resulting in

an increase in the valued of foreign-currency denominated

debt.

Current account balances in EMEA have strengthened as

a result of import compression but remain elevated in

Poland and, especially, Turkey. Reserve cover has also

improved in recent years but remains low relative to our

preferred risk-weighted measure of liabilities in South

Africa and Ukraine. Egypt’s reserves are also very low

halving more than halved since the start of the year. Egypt

is also the only county where we see hints of exchange

rate overvaluation.

Overall, the high risk countries according to this metric are

Egypt, Poland, and Ukraine. This may perhaps overstate

the risks in Poland somewhat, where the current account

is moderately high but comfortably financed by EU funds

and FDI. Similarly, the risks posed by Hungary’s extremely

large external debt level and Turkey’s very large and

largely short-term financed current account deficit are

probably not fully captured by these metrics.

Outside of EMEA, the picture is more comfortable with no

countries in LatAm or Asia rated as having high overall

external risks. There are a few pockets of vulnerability,

such as India’s current account deficit, relatively low

reserve coverage in Malaysia, and a moderately high

external debt level in Chile and relatively large (by regional

standards) current account deficit in Colombia although

fully financed by FDI. Chile´s external debt is, however,

largely compensated by high value of exports and one of

the most solid fiscal fundamentals globally as we will note

in the following section.

Fiscal vulnerabilities

Public finance risks are a little more evenly distributed

across the three regions but again EMEA emerges as

most vulnerable. Egypt’s chronic fiscal problems come

out quite clearly, with its double-digit deficit, public debt,

and rollover risks the highest in our EM universe. Despite

its relatively moderate deficit, Hungary is also highly

vulnerable because of its high debt, rollover risks, and

large FX exposure. Poland is again perhaps rate too

harshly on our metric – it is close to the edge of some of

our thresholds, and we would expect it to move to a

lower risk category should fiscal consolidation proceed

along the lines outlined by Prime Minister Donald Tusk

last month.

External vulnerabilities Overa ll

% GDP Risk % Risk % GDP Risk % Risk Risk

EMEA

Czech -3.1 Med. 132.3 Med. 48.2 Med. -1.4% Low Med.

Egypt -2.6 Med. 92.6 High 14.9 Low 1.6% Med. High

Hungary 0.6 Low 163.2 Low 146.0 High -2.1% Low Med.

Israel 1.0 Low 182.0 Low 46.8 Med. -2.2% Low Low

Kazakh 8.1 Low 125.1 Med. 83.8 High -2.6% Low Med.

Poland -5.0 High 146.8 Low 63.5 High -3.2% Low High

Romania -3.7 Med. 229.3 Low 75.2 High 0.5% Low Med.

Russia 5.9 Low 221.3 Low 27.3 Low -2.0% Low Low

South Africa -2.8 Med. 111.6 High 20.8 Low -2.5% Low Med.

Turkey -9.1 High 131.0 Med. 36.4 Low -10.0% Low Med.

Ukraine -2.7 Med. 97.0 High 81.1 High 0.2% Low High

Asia

China 4.4 Low 198.0 Low 4.4 Low 0.3% Low Low

India -3.4 Med. 338.3 Low 13.7 Low -0.6% Low Low

Indonesia 0.4 Low 189.7 Low 23.7 Low -0.3% Low Low

Korea 1.1 Low 146.7 Low 32.1 Low 5.4% High Low

Malaysia 9.4 Low 129.0 Med. 28.7 Low -1.1% Low Low

Philippines 4.5 Low 431.2 Low 32.2 Low -1.3% Low Low

Thailand 3.5 Low 349.4 Low 21.8 Low -1.6% Low Low

LatAm

Argentina 0.8 Low 138.2 Med. 30.9 Low -0.3% Low Low

Brazil -2.2 Med. 243.5 Low 17.1 Low -1.7% Low Low

Chile -1.1 Low 149.1 Low 43.1 Med. -0.5% Low Low

Colombia -3.2 Med. 188.0 Low 22.4 Low -1.9% Low Low

Mexico -0.7 Low 146.5 Low 19.8 Low -1.1% Low Low

Med. threshold -2.0 142.1 38.3 1.1%

High threshold -3.7 120.7 52.8 3.1%

Current account Reserve cover Ex terna l Debt FX Valuation

Source: Haver Analytics, Deutsche Bank

In Asia, the risks are highest in the Philippines reflecting

its moderately large public debt, over half of which is

denominated in foreign currency, with relatively significant

amount (12% of GDP) falling due in the next year. Aside

from Egypt, India’s fiscal deficit is the largest in EM at

about 8% of GDP although this has so far been

comfortably financed domestically.

In LatAm, there are a couple of amber warnings in Brazil

given it high rollover needs and moderately large debt

stock, and in Colombia reflecting its moderate deficit and

relatively high FX exposure. Brazil´s relatively large primary

surplus (3.2% of GDP estimated for this year and 2.5%

projected for 2012) together with full dominance of local

market-local currency debt significantly mollifies the fiscal

risk although short term duration is still meaningful. A

balanced primary result in Colombia also helps to

moderate its fiscal risk but the combination of medium

size deficit and debt makes the country the most

vulnerable among the largest economies in the region

from a fiscal stand point.

Financial sector vulnerabilities

The picture in the financial sector is even more varied.

Loan-to-deposit ratios are typically higher in EMEA,

especially in Hungary and Ukraine, reflecting the

wholesale and external funding model of many banks in

the region. Loans are typically more than fully covered by

deposits in Asia and LatAm, however, with the notable

exceptions of Korea, Chile, and Colombia.



Fiscal vulnerabilities Overall

% GDP Risk % Risk % GDP Risk % Risk Risk

EMEA

Czech -4.3 Med. 39.9 Low 6.5 Low 6.0 Low Low

Egypt -9.5 High 76.2 High 18.6 High 18.5 High High

Hungary -2.9 Low 75.9 High 13.7 High 32.3 High High

Israel -2.8 Low 71.1 High 8.6 Med. 13.8 Med. Med.

Kazakh 2.7 Low 12.9 Low 0.9 Low 1.0 Low Low

Poland -5.5 High 56.7 Med. 8.4 Med. 12.7 Med. High

Romania -4.4 Med. 34.0 Low 9.2 Med. 21.8 High Med.

Russia 0.2 Low 11.7 Low 1.1 Low 2.7 Low Low

South Africa -5.5 High 36.1 Low 0.9 Low 3.3 Low Med.

Turkey -1.5 Low 39.7 Low 9.5 Med. 10.7 Low Low

Ukraine -2.5 Low 39.3 Low 5.1 Low 26.1 High Med.0.0 Low 0.0 Low

Asia

China -1.5 Low 19.6 Low 6.1 Low 0.1 Low Low

India -8.1 High 61.2 Med. 3.2 Low 4.2 Low Med.

Indonesia -1.1 Low 26.0 Low 1.2 Low 10.9 Low Low

Korea 0.0 Low 34.4 Low 2.2 Low ... Low Low

Malaysia -4.9 Med. 55.2 Med. 2.9 Low 2.0 Low Med.

Philippines -2.8 Low 58.2 Med. 11.5 High 32.9 High High

Thailand -3.3 Low 36.0 Low 6.5 Low 6.3 Low Low

LatAm

Argentina -2.3 Low 21.8 Low 6.0 Low ... Low Low

Brazil -2.1 Low 56.6 Med. 16.8 High ... Low Med.

Chile 0.8 Low 7.4 Low 2.4 Low 2.2 Low Low

Colombia -3.3 Low 39.3 Low 3.9 Low 14.0 Med. Low

Mexico -2.1 Low 35.2 Low 8.7 Med. 9.2 Low Low

Med. threshold -3.4 41.5 7.4 12.0

High threshold -5.5 62.2 10.3 17.7

Overall balance Public debt Maturing debt FX debt

Source: Haver Analytics, IMF, Bloomberg LLP, Deutsche Bank

Many emerging European economies are still recovering

from the collapse of earlier credit booms and this is reflect

in low credit growth across much of the region. Turkey is

an exception where credit has been growing at an annual

average rate of 35% over the past two year, albeit from a

relatively low base. Credit is growing more rapidly in Asia

and LatAm, especially in Argentina, Brazil, and China. The

stock of outstanding credit is also quite high in China, now

at well over 100% of GDP.

One particular concern right now is that European banks

might look to reduce their exposures to EM as part of

efforts to meet capital requirements. The total risk

exposure of foreign banks is about 45% of GDP on

average in EMEA and about 26% of GDP in Asia,

reflecting the relatively greater role of European bank

subsidiaries in central and eastern Europe. Outside of

Europe, Malaysia (inflated a little bit by the offshore

banking business in Labuan), South Korea, Thailand, and

Chile have moderately high ratios of international bank

claims to GDP.

Overall, this metric suggests that the biggest risks lie in

Chile, Malaysia, Korea, and Hungary, though there are

moderate vulnerabilities in almost all countries. One

indicator that we did not include here was non-performing

loans because we think they way these are measured

varies greatly from country to country, making

comparisons difficult. If we had included a measure,

however, this would have bumped up our risk ratings for

Ukraine and, especially, Kazakhstan. Likewise, it is

questionable that high foreign claims make Chile

vulnerable as long as any other economic fundamentals

remain rock solid.

Financial vulnerabilities:

Overa ll

% Risk % Risk % GDP Risk % GDP Risk Risk

EMEA

Czech 0.81 Low 4.2 Low 73.2 Med. 105.9 High Med.

Egypt 0.48 Low 3.7 Low 30.8 Low 18.3 Low Low

Hungary 1.45 High -0.8 Low 78.1 Med. 101.4 Med. High

Israel 1.05 Low 6.1 Low 130.2 High 11.7 High Med.

Kazakh 1.25 Med. 0.0 Low 47.5 Low 18.7 Low Low

Poland 1.17 Med. 7.7 Low 51.9 Low 64.3 Low Med.

Romania 1.20 Med. 3.1 Low 56.3 Low 71.6 Low Med.

Russia 1.14 Med. 6.3 Low 0.0 Low 13.1 Low Low

South Africa 1.13 Low 3.2 Low 75.3 Med. 33.5 Med. Med.

Turkey 0.97 Low 35.3 High 41.9 Low 28.6 Low Med.

Ukraine 1.56 High 1.5 Low 62.9 Med. 25.5 Med. Med.0.0 Low 0.0

Asia

China 0.77 Low 19.5 Med. 117.7 High 10.1 High Med.

India 0.00 Low 18.1 Med. 56.9 Low 17.5 Low Low

Indonesia 0.72 Low 17.3 Low 27.8 Low 14.7 Low Low

Korea 1.36 Med. 3.9 Low 121.2 High 34.7 High High

Malaysia 0.90 Low 11.9 Low 116.6 High 59.1 High High

Philippines 0.61 Low 10.4 Low 33.7 Low 17.9 Low Low

Thailand 1.03 Low 10.5 Low 102.1 High 28.0 High Med.

LatAm

Argentina 0.72 Low 29.5 High 15.2 Low 10.7 Low Med.

Brazil 0.70 Low 22.2 Med. 71.8 Med. 24.1 Med. Med.

Chile 1.41 High 3.7 Low 66.7 Med. 56.6 Med. High

Colombia 1.70 High 14.6 Low 31.8 Low 12.6 Low Med.

Mexico 0.74 Low 6.1 Low 38.1 Low 35.8 Low Low

Med. threshold 1.1 17.8 59.4 30.3

High threshold 1.4 25.5 94.3 56.8

Loan/deposit Cred it g rowth Cred it Level

Foreign bank

c la ims

Source: Haver Analytics, BIS, Deutsche Bank

Exogenous shocks

We next assess the exposure of countries to an

exogenous shock in the form of a drop in external demand

in developed markets. Our measure for this is the growth

elasticity of each EM economy with respect to growth in

the US and Euro area. These ‚growth betas‛ are derived

as the coefficient estimates of regressions of a country’s

GDP on PPP-weighted US and Euro area GDP growth.

Within EMEA, five countries (Ukraine, Russia, Romania,

Turkey, and Hungary) have growth betas in excess of one,

pushing for above one regional average. Worth noting, the

impact of a synchronized global slowdown could be

higher than our growth betas – which capture the average

relationship over the last decade or so – would suggest.

During the last crisis, for example, the average drop in

output in EMEA was about 8-9%, compared with 5.4% in

the Euro area and 5.0% in the US.

In Asia, not surprisingly the growth betas are highest in

the economies with the largest export sectors. So

Singapore and Hong Kong – not included in this study

because their roles as financial centers exaggerate their

apparent vulnerability to financial shocks – have growth

betas in excess of 1.5. Taiwan also has a beta of around

1.5. So in the chart below the economies that appear

highly sensitive in a pan-EM perspective -- namely

Malaysia, Thailand, and South Korea – are actually in the

middle of the pack in Asia in terms of concerns about

imported growth shocks. Growth betas for three of the

region’s largest economies, China, India, and Indonesia,

are small as their large populations and relatively smaller

penetration of export sectors into the economy insulate

them to a considerable extent. We reckon these countries

are less sensitive to European growth than the US is



despite the fact that in China exports to Europe comprise

about one-third of total exports.

In Latin America, in addition to the well known case of

Mexico, there is also relatively high dependence on US/EU

growth in Chile and Colombia, as expected given their

openness, but also because of the importance of the

commodity complex in their economies. This

notwithstanding, the region is becoming increasingly

dependent on Asia flows and commodity prices. This is

today the most important channel of contamination from a

global problem for Latin America. In Argentina, domestic

policies during the last eight years or so have allowed a

fairly independent performance of its economy relative to

the global scenario, something that is unlikely to continue

now that most of the financing buffers it initially had are

almost fully utilized.

EM Growth Betas

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

UK

R

RU

S

RO

M

TU

R

HU

N

MYS

TH

A

KO

R

KA

Z

CZ

E

ME

X

ISR

CH

L

CO

L

PH

L

PO

L

ZA

F

BR

A

CH

N

EG

Y

AR

G

IND

IDN

Betas to 1pp change in US/Eurozone growth


Overall vulnerability ratings

Combining each of these sectors, and attaching relatively

more weight to the external and fiscal sectors, we

construct an overall vulnerability score or rating for each

country. This is shown in the chart below together with

the contributions from each particular sector. Based on

the discussion above, it will come as no surprise to find

that EMEA dominates our list of most vulnerable

countries. Five countries (Hungary, Ukraine, Romania,

Poland, and Egypt) show up as highly vulnerable, though

for different reasons. Egypt’s underlying vulnerabilities, for

example, are fiscal first and external second. Ukraine’s

risks are mostly external. Hungary’s vulnerability reflects a

combination of risks in all four areas. As we noted above,

our sense is that Poland’s risk rating is probably a notch

too high according to this mechanical exercise, though it

does underscore that the economy does have macro

imbalances that have yet to be fully addressed.

Outside of EMEA, only Malaysia makes it on to our list of

countries with medium risk ratings mainly reflecting the

high level of foreign bank claims on the country (which

may be overstated) and moderate concerns about the

country’s public finances.

Overall vulnerability scores

Medium risk

threshold

High risk

threshold

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

HU

N

UK

R

RO

M

PO

L

EG

Y

TU

R

CZ

E

ZA

F

MY

S

ISR

KA

Z

BR

A

IND

KO

R

PH

L

CO

L

CH

L

AR

G

RU

S

TH

A

CH

N

ME

X

IDN

Growth Fin Fisc Ext

Overall vulnerability score


The graphic below summarizes these findings with a more

visual map, including every single indicator used for an

easier and comprehensive comparative analysis

Overall vulnerability map C

urr

ent

acco

unt

FX

re

se

rve

s

Exte

rnal d

eb

t

FX

valu

ati

on

Ove

rall

Ove

rall

bala

nce

Pub

lic d

eb

t

Matu

ring

de

bt

FX

De

bt

Ove

rall

Lo

an:d

ep

osit

s

Cre

dit

gro

wth

Cre

dit

le

ve

l

Fo

reig

n c

laim

s

Ove

rall

Gro

wth

be

ta

Ove

rall

EMEA

Czech Rep

Egypt

Hungary

Israel

Kazakhstan

Poland

Romania

Russia

South Africa

Turkey

Ukraine

Asia

China

India

Indonesia

Korea

Malaysia

Philippines

Thailand

LatAm

Argentina

Brazil

Chile

Colombia

Mexico


External Fiscal Financial


Having constructed our vulnerability measures, we can

also track how these have evolved over time. Below we

show the evolution of the overall ratings for each sector

and for the overall (cross-sector) rating from 2007-11.

Three things emerge clearly from this graphic:



While EMEA is currently clearly the most vulnerable

region, these vulnerabilities were actually even higher

prior to the last crisis in most cases – i.e. it was no

accident that many EMEA economies suffered their

own crisis in 2008-09

Some countries, however, have become more

vulnerable recently, at least in some respects. Egypt

is the obvious example, primarily reflecting its much

weaker reserve position but also some deterioration

in the current account. Fiscal risks have also become

greater in Poland and South Africa as fiscal deficits

have widened sharply; and also in Ukraine as debt

levels increased sharply.

The relatively high financial exposure of countries in

Asia (China, Korea, Malaysia) or LatAm (Brazil, Chile,

Colombia) seems to have persisted over time despite

relatively strong external and fiscal fundamentals,

which should moderate the potential relative risk in

this regards. This notwithstanding, we feel domestic

debt levels – and possibly falling asset prices – are a

significant risk to some economies in Asia.

Evolution of vulnerability ratings (2007-2011)

20

07

20

08

20

09

20

10

20

11

20

07

20

08

20

09

20

10

20

11

20

07

20

08

20

09

20

10

20

11

20

07

20

08

20

09

20

10

20

11

EMEA

Czech Rep

Egypt

Hungary

Israel

Kazakhstan

Poland

Romania

Russia

South Africa

Turkey

Ukraine

Asia

China

India

Indonesia

Korea

Malaysia

Philippines

Thailand

LatAm

Argentina

Brazil

Chile

Colombia

Mexico


External Fiscal Financial Overall


Conclusions

EMEA: facing a quadruple whammy

We have consistently highlighted the relatively greater

vulnerability of EMEA among emerging regions to a

renewed downturn in core developed markets. Indeed the

region faces something of a quadruple whammy right

now with significant weakness across each of the areas

that we have looked at.

First, current account balances have improved in the last

few years and central banks have been able to build

bigger buffers of foreign reserves. But the large stock of

external debt accumulated during the middle of the last

decade still leaves the region with large external burden.

Much of this borrowing took place in foreign currencies –

Swiss franc mortgages in Hungary (20% of GDP) being

just one example – the local currency burden of which is

now being inflated as those currencies come under

pressure. With these debts needing to be serviced on an

ongoing basis, many countries still face large external

financing needs even as their current account positions

have improved. This is particularly true of Hungary and

Ukraine, which have gross external financing needs of

30% of GDP or above in 2012 despite a moderate current

account deficit in Ukraine and a small surplus in Hungary.

If the difficulties facing Hungary and Ukraine are partly a

reflection of past external deficits, Turkey’s external

vulnerabilities are largely a reflection of the large current

account deficit (9% of GP) it is running now. Much of this

is financed through short term flows. Egypt’s problems

are different again with political uncertainty precipitating a

withdrawal of capital from the country and foreign reserve

coverage to fall to the lowest level in EM.

Three of these countries may well need to tap the IMF for

financial support next year. Ukraine already has an IMF

program (of which USD 12bn or 6.5% of GDP is

potentially still available) but is currently looking first to

Russia for cheaper gas prices to reduce its external

financing needs. Hungary is seeking the reassurance of a

precautionary IMF program although negotiation on the

policy condition has not yet started and could well be

difficult. Egypt had reached agreement in principle on a

USD 3bn (1.2% of GDP) arrangement with the IMF but

has yet to proceed with the deal for political reasons. We

don’t think Turkey will need to turn to the IMF but the risk

there is that a squeeze on capital inflows would

precipitate a sharp slowdown in domestic growth and a

weaker lira.

Second, as in many developed countries, sharply weaker

growth in the last two or three years has taken a heavy toll

in the public finances. In some cases, such as Egypt and

Hungary, fiscal positions were relatively weak to begin

with. Elsewhere, they are almost entirely a reflection of

the fiscal response to the crisis. Poland and South Africa,

for example, enjoyed strong budget positions going into

the last crisis and were therefore able to ease fiscal policy

aggressively. They have, perhaps understandably, been

slow to unwind this easing but may now find themselves

having to either tighten policy into a downturn (as Poland



plans to do) or at least unable this time around to ease

policy to prop up growth.

Third, the buildup of foreign currency debt was probably

largely a reflection of relatively high and volatile inflation in

some cases, leading to a large spread between domestic

and foreign interest rates. But the availability of foreign

currency loans was also facilitated by the rapid expansion

of western European banks throughout much of the

region. This has left many countries exposed to

deleveraging by foreign banks as they seek to meet

additional capital requirements imposed by the European

Banking Authority. These requirements are largest for

Greek, Italian, and Spanish banks, which may be a

concern for Romania and Hungary (as well as Croatia,

Serbia, and Bulgaria outside our sample) where Greek and

Italian banks are most active. But other banks may also be

reluctant to maintain their exposures in the region.

Germany’s Commerzbank, for example, has indicated that

it will temporarily suspend new lending outside of

Germany and Poland. Austria’s central bank has also

imposed limits on new lending in CEE by the subsidiaries

of Austrian banks. And countries without strong parent-

subsidiary ownership linkages are also unlikely to be

immune. Turkish banks, for example, have substantially

increased their short term external borrowing in the last

couple of years (from foreign banks) and may face some

difficulties in rolling these loans.

Fourth, EMEA’s economies are mostly relatively small and

open markets with high trade and financial exposures to

the euro area and US. Even leaving aside the

vulnerabilities discussed above, it would leave countries

such as Hungary and Czech Republic – where exports to

the euro area account for about 40% of GDP - relatively

more exposed therefore to a recession in Europe.

There are, however, some pockets of resilience within

EMEA. With its current account surplus, large stock of

reserves, and low debt levels, Russia faces few of the

macro vulnerabilities of the rest of the region. Its

weaknesses are largely structural in nature though, as the

experience in 2008-09 reminds us, growth and the rouble

would come under pressure in the event of a significant

weakening of oil prices. The same is also true of

Kazakhstan, though the banking sector remains a potential

source of weakness. Israel’s macroeconomic

fundamentals are also generally strong and the main risks

are geopolitical in nature.

Asia: risks from rapid credit growth bear watching

Years of current account surpluses and sound fiscal policy

contribute to a picture of a region that is relatively less

vulnerable than EMEA for example. With the exception of

Korea’s real exchange rate – the apparent overvaluation of

which has likely been eliminated with the 6% depreciation

since September – Asia’s external vulnerabilities are

modest. Even India’s current account deficits – usually

3% of GDP or less – raise only an amber warning. Once

upon a time it was considered normal for emerging

economies to import capital.

And while India’s chronic large government deficits –

often more than 7% of GDP for the state and central

governments combined – are a persistent worry it has to

be placed alongside the manageable debt/ GDP ratio of

about 61% of GDP funded almost entirely onshore. We

don’t think policymakers are complacent, but deficit

reduction has been difficult over the past few years and

we expect that as global threats to growth recede in 2013

and beyond, the government will return to its pre-global

financial crisis trend of falling deficits.

Where this vulnerability exercise raises worries for Asia –

concerns which we have raised before – is on the financial

side. Domestic credit expansion has been overly rapid

not only in China in 2009 but also in a many other

economies over the past two or three years. The

economies of China, Korea, Malaysia, and Thailand have

high credit/GDP ratios indicating significant potential debt

burdens in the private sector in a slowing growth

environment. While the focus of investors today is,

perhaps rightly, on the external risks to the region, we

think domestic debt levels – and possibly falling asset

prices – are a significant risk to some Asian economies.

LatAm: Commodity dependency remains the main risk

Latin America went through a painful and meaningful

external, fiscal, and financial crisis in the 90s and today´s

resilience cannot be understood without that reference.


reforms, and overly conservative financial regulation have

allowed the region to converge to a relatively safe status.

This has permitted growth to become vigorous and

sustained with the helped of steady rise in commodity

prices, the region´s comparative advantage. Lack of

investment and increasing dependency on commodities is

probably the major drawback of this experience.

Increasing complacency regarding long term fiscal

rigidities with spending concentrated in current spending

in cases like Argentina, Brazil, Colombia, even Mexico, are

probably the main yellow light. Strong growth

sustainability and steady alleviation of poverty and social

conflicts remains the main challenge ahead.

Robert Burgess, London, (44) 20 7547 1930

Gustavo Canonero, New York, (1) 212 250 7530

Michael Spencer, Hong Kong, (852) 2203 8305



EM Performance: The Grass is Grayer on the Other Side

The year 2011 was marked by relentless crises in the

EU, damaged confidence, and faltering political

leadership that kept the global economy flirting with

recession for most of the year. Looking across all

asset classes, the most growth-sensitive ones have

underperformed fixed income in 2011 – a trend we

expect to extend into 2012.

EM Credit benefitted from lower US yields, but we

believe UST is unlikely to repeat its contribution to the

total returns in 2012.

EM rates have benefited from easier monetary

policies, but depreciation of the currencies has offset

gains. So the prospect for local markets hinges on

EM currencies and thus, on the resolution of the EU

crisis – the sooner the better.

We see three main takeaways from recent history

that are relevant for the year ahead: 1) the distribution

of returns will likely continue to favor fixed income vs.

growth-sensitive assets such as equities and EMFX –

especially in Q1 or H1; 2) returns are diminishing; 3)

EM still seems too important a source of carry and

value to drop from investors priority list – either in

risk-on or risk-off modes.

That said, if returns are less appealing in EM as they

used to be, the opportunities in global markets seem

even less so. Looking beyond bouts of deleveraging

and flight-to-quality, developed markets may set an

even-lower bar for EM in the years ahead.

Taking Stock: Lessons from 2011

The year 2011 was marked by relentless crises in the EU,

damaged confidence, and faltering political leadership that

kept the global economy flirting with recession for most

of the year. Backward-looking performance has often

times been a very poor predictor of future returns, but as

we write, the shocks that buffeted global markets in 2011

seem very likely to persist well into 2012. In particular, we

see three main takeaways from recent history that are

relevant for the year ahead: 1) the distribution of returns

will likely continue to favor fixed income vs. growth-

sensitive assets such as equities and EMFX – especially in

Q1 or H1; 2) returns are diminishing; 3) EM still seems too

important a source of carry and value to drop from

investors priority list – either in risk-on or risk-off modes.

In the sections below we shed more light on these.

The outperformance of the defensive

Not surprisingly, the chart below shows that the most

growth-sensitive assets underperformed fixed income – a

trend we expect to extend into 2012. Total returns were in

single digits, except for EM equities, which dropped about

17%. We have highlighted in recent Monthly publications

that EM FX has become more of a proxy for global risks

than EM specifics. This has weighed significantly on local

markets performance, and it seems unlikely to change

soon. In contrast, credit has benefited from the rally in

UST, but this is unlikely to repeat. Altogether, the stage

seems set for fixed income to outperform once more – at

least in the beginning of the year, but total returns seem

poised to shrink for long-only defensive investors.

2011 YTD performances of major asset classes

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

UST

EMBI-G

IG

GBI-EM (hedged)

HY

GBI-EM

G10 FX Carry Basket

S&P

EM FX (Spot & carry)

Com'dty

FX Carry Basket

EMFX Spot

EM Eq

YTD returns of various asset classes

Source: Deutsche Bank; MSCI EM, JPMorgan, Bloomberg Finance LP

EM credit benefitted not only from lower US yields but

also from the negative correlation between spreads and

yields during a good part of 2011, which compressed total

return volatility and boosted Sharpe ratios. How much did

the rally in UST contribute to total returns? The chart

below shows that the UST rally has accounted for most of

DB-EMSI constituents’ positive total returns year-to-date.

With the notable exceptions of Ukraine, Egypt, and

Argentina, the stellar performance of the USTs have more

than offset the widening in spreads.

The best performers have been, not surprisingly, low-

beta, high-quality LatAm credits. Only in Venezuela, yields

(and carry) were high enough to more-than-compensate

for the widening in spread seen in 2011. Looking ahead,

the good news is that spreads are higher and thus, offer

an additional buffer for shocks. The bad news is that UST

is unlikely to repeat its contribution to total returns in

2012. All in all, it seems more likely that EM hard currency

returns will be reduced going forward either by the limited

room for yield compression or potential re-pricing up of

UST as developed markets deal with their debt crises.


Sovereign credit: UST more than offsets wider

spreads

-5%

0%

5%

10%

15%

20%

EC UY PE PA MX CO VE BR PH ID EM ZA CL LB RU SV HU TR PL BG UA EG AR

Total Return UST Contribution

YTD Total Return and UST Contributions

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

VE QA MX CO PE BR PH PA LV ZA IL KZ MY RU ID CZ RO HU PL TR BG UA AR HR SK

5Y CDS Total Returns, YTD


EM rates have also benefited from easier monetary

policies, but depreciated currencies have offset gains

(chart below). The chart above shows that hedged returns

held up well near 5%, while EMFX returns (with carry)

were in line with the poor SP500, but outperformed

Deutsche Bank’s global FX (dynamic) carry basket,

commodities, and EM equities. EMFX will likely remain a

drag while the global economy flirts with recession and

EM rates are already relatively low. In fact, real rates are

negative in Asia, near zero in EMEA, and still positive in

LatAm – but relatively low. EM central banks are still

dealing with residual inflation (from FX pass-through and

commodities), but the inflation outlook is brightening. Still,

only in LatAm we see room for easing – though not

aggressive. Altogether, the prospect for local markets

hinges on EM currencies and thus on the resolution of the

EU crisis – the sooner the better.

EMFX: The major drag for local currency debt

85

90

95

100

105

110

90

95

100

105

110

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11

GBI-EM

DBI-EM (FX-hedged)

EMFX (Spot and Carry)

YTD Returns


Diminished returns

The performance in 2011 was driven by adverse market

conditions but also by years of re-pricing of EM risk. As

the chart below suggests, double-digit returns in external

debt seem now confined to post-crisis recovery years.

After years of re-rating, EM investment-grade sovereigns

account for half of Deutsche Bank’s external debt index.

This, relatively low spreads and real rates in the US near

zero point to lower returns ahead. In the case of local

markets, the downtrend in total returns (FX + rates) still

seems less pronounced, but this is overshadowed by FX

volatility. In fact, FX-hedged returns have been remarkably

stable around 5% over the past decade, with fluctuations

mildly tracking global policy rates.

Asset performances of past ten years Year

Return Vol Ret/Vol Return Vol Ret/Vol Return Vol Ret/Vol S&P UST

2003 25.7% 18.0% 1.4 5.5% 2.4% 2.3 10.8% 5.4% 2.0 26.4% 2.3%

2004 11.7% 6.7% 1.8 7.7% 2.9% 2.7 14.2% 6.1% 2.3 9.0% 3.5%

2005 10.7% 2.4% 4.4 7.2% 1.9% 3.8 -0.9% 7.1% -0.1 3.5% 2.8%

2006 9.1% 4.5% 2.0 6.4% 2.6% 2.5 4.5% 7.8% 0.6 10.4% 3.1%

2007 6.1% 7.6% 0.8 4.8% 2.6% 1.8 13.7% 6.5% 2.1 3.9% 9.0%

2008 -10.9% 6.3% -1.7 5.4% 7.1% 0.8 -10.1% 15.5% -0.6 -38.5% 14.1%

2009 28.2% 16.6% 1.7 5.2% 4.2% 1.2 16.0% 12.1% 1.3 23.5% -3.8%

2010 12.0% 5.6% 2.1 8.6% 2.8% 3.1 6.5% 6.9% 0.9 12.8% 5.8%

2011 7.2% 5.2% 1.4 4.3% 3.0% 1.4 -4.4% 8.9% -0.5 -0.8% 8.8%

Average 11.1% 8.1% 1.4 6.1% 3.3% 1.9 5.6% 8.5% 0.7 5.6% 5.1%

Correla- w/ S&P 58% 47% 68%

tion w/ UST 47% 40% -6%

GBI-EM (FX -Hedged) EMFX (spot and ca r ry ) Other assets returnEMBI Globa l

Note: EMFX (spot and carry) is derived from GBI_EM unhedged and hedged returns.

Correlation with S&P and UST returns are calcuated using monthly returns.

-20%

-10%

0%

10%

20%

30%

2003 2004 2005 2006 2007 2008 2009 2010 2011

EMBI Global

GBI-EM (FX-Hedged)

EMFX (spot and carry)

EM asset returns, past 10Y

Source: Deutsche Bank, Bloomberg Finance LP



FX-hedged returns have provided higher Sharpe ratios

than hard currency, but total returns in external debt have

been almost twice as high since 2003. Returns in external

debt are matched only by unhedged local markets returns

in this period, but at a cost of higher volatility. Deciding

whether to allocate more to external debt or local markets

naturally depends on the prospects for US equities and

rates. From a valuation perspective, EMFX has more to

offer as it has lagged other assets. However, with global

growth likely to pick up only in 2013, FX will more likely

weigh on returns into 2012.

In order to provide some insight to the prospective and

constraints to the performance of sovereign credit and

local markets (and the relative performances between

them), we run a multiple regression of the asset

performances on S&P and UST for last two years, and

project their returns in 2012 based on three scenarios:

a bearish scenario under which 10Y UST yield

tightens to 1.5% and S&P drops to 1000

a neutral scenario where both UST and S&P remains

around the current levels

a bullish scenario under which 10Y UST yield rises to

3% and S&P rises to 1350

A simplistic projection of EM FI asset returns under

various scenarios of UST and S&P

Intercept UST S&P Carry*

EMBI Global 448.3 -50.3 0.14 4.36

GBI EM (Hedged) 165.3 -11.5 0.01 1.44

EMFX (spot and carry)** 70.9 1.3 0.06 3.49

Current

Level

10Y UST Yield 2.07

S&P 1247

Fitted Level Return Level Return Level Return

EMBI Global 569 556 -2.2% 578 1.6% 570 0.2%

GBI EM (Hedged) 174 175 0.7% 177 1.7% 175 1.0%

EMFX (spot and carry) 171 158 -7.7% 174 2.1% 182 6.6%

* For EMBI/GBI-EM, a UST-weighted time drift term is used in the regression to capture carry;

For EMFX, a time drift term is used. (Regression is based on 2Y history)

** Proxied by the ratio of GBI-EM Unhedged and GBI-EM Hedged

Bearish

Scenario

Neutral

Scenario

Bullish

Scenario

1.50

1000

2.07

1247

3.00

1350


The table above shows that both credit and FX-hedged

local markets would perform poorly under both the

bearish scenario (suffering from lower growth and higher

risk aversion) and the bullish scenario (suffering from

higher rates). Not surprisingly, EMFX (spot and carry) will

perform the best under the bullish – and even the neutral

scenario – given that they have sold off the most and

hence will have more to offer if there is a bounce in the

market. On the flip side, given its high beta to equities,

EMFX would take a big hit if S&P sold off 20% from

current level. That said, we note that the approach we

take here is very simplistic. Our aim here is to provide a

simple perspective, rather than deriving precise

quantitative implication from this exercise.

Nevertheless, the main point is that it will be hard for

credit to perform well without the support of USTs, and

likewise for local market without the contributions of FX

exposure.

The grass is greyer on the other side

Despite overall solid balance sheets and increased

investor interest18, EM performance has been hostage to

bouts of de-leveraging typical of riskier assets. This and

the prospect of diminished returns cast doubt on whether

EM could still expand the investment frontier. Despite its

obvious limitations, we rely on standard portfolio

optimization to shed some light on asset allocation, as it

remains the workhorse in the industry19. We obviously

avoid deriving precise quantitative implications from such

an exercise, as this would be futile under so much

uncertainty and data limitations. Instead, we look at

different periods and asset sets that could help identify

performance patterns. A subset of our results is

presented in the charts below and in the appendix.

The past decade has seen extreme bull and bear markets,

but throughout these adverse and pro-risky markets EM

assets have most often participated in the optimal

portfolios and in shares that tended to exceed by a large

margin those reported by global asset allocation surveys20.

In hindsight, the main decision was not whether to have

EM in size in the portfolio, but whether to concentrate in

hard currency or local currency exposure – or whether to

position aggressively or defensively. Qualitatively, rather

than displaying the theoretical capital market line, global

asset allocation seemed to span ‚clusters‛ of more

defensive assets (mainly fixed income and higher grade

credit) and more bullish growth equities/EM currencies.

18 According to DB’s Institutional Investor Survey, EM ranks highest in the

list of investors’ intentions to add exposure (see ‚2011 Institutional Survey,

John Haugh, DB Cross Rate Sales, Pensions") 19

The shortcomings range from estimating returns and their distribution

amid structural breaks and shocks, non-normality, skew, non-zero and

time-varying serial and cross-correlation in returns. It is important to note,

however, that these do not necessarily bias EM’s ‚optimal‛ share

downwards (see Non-Normality of Market Returns: A Framework for Asset

Allocation Decision Making, in The Journal of Alternative Investments,

Winter 2010, V12, 3 for examples. 20

See EM Technicals Outlook: Structurally sound; cyclically vulnerable

included in this publication.


Efficient frontier: EM present on both ends

EMBI-G

GBI-EM

GBI-EM-H

EMFX (spot)

EM Eq

IG

HY

Comdty

SPX

UST

0%

2%

4%

6%

8%

10%

12%

14%

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

8Y

6Y

4Y

2Y

2Y (w/o UST)

Average weekly returns

Annualized weekly return volatility

Note: The lines represent frontiers calculated based on return data for

various historical periods to date; the dots are past 8Y returns vs. volatility.

GBI-EM-H is the fx-hedged version of the GBI-EM index. Source: Deutsche Bank

The past eight years of data comprise more bullish years,

while the past four years have been mostly crisis years

with short-lived rebounds. Accordingly, EM played an

important role in expanding the frontier. As growth

prospects dimmed and risk aversion surged over the latter

years, the ‚optimal‛ set shrunk. But rather than dropping

out of the portfolio, local markets gave way to a strong

participation of hard currency debt. Note that the past two

years have seen an increase in risk-adjusted returns for

lower-risk portfolios that seem atypical. The frontier does

not shrink significantly once we exclude UST from the

optimization because the rally in UST continues to be

captured by credit (high and low grade).

Focusing on the past two years, which seem a more likely

reference for the near future, the chart below shows that

external debt appears on the portfolio frontier for higher

risk tolerance portfolios (it takes 100% of the weight at

6.65% return volatility, the end point of the efficient

frontier). The total return was boosted by the rally in UST

and this is unlikely to repeat – at least in the similar

magnitude. But the rally in UST has been the main driver

of returns across all the competing assets (for the more

defensive allocation cluster that we show) so that the net

effect on portfolio is moot. Note from the chart above that

– for the more bullish ‚optimal‛ portfolio composition –

EM equities and local markets (unhedged) allocations

dominate US equities and commodities. From a

fundamentals and valuation standpoint, we believe EM

could still figure prominently in ‚optimal‛ portfolios for

both defensive and more bullish allocation ‚clusters‛.

External debt as a defensive trade

EMBI-G

GBI-EM

GBI-EM-H

EMFX (spot)

EM Eq

IGHY

Comdty

SPX

UST

-4%

-2%

0%

2%

4%

6%

8%

10%

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

Average weekly returns (past 2Y)

Annualized weekly return volatility(past 2Y) Source: Deutsche Bank

Concluding remarks

A dim growth prospect suggests that optimal portfolios

will likely remain skewed toward fixed income – at least in

the beginning of 2012. After two doses of QE, fixed

income returns are unlikely to repeat the performance of

2011. From a portfolio perspective, ‚optimal‛ allocation

weights of EM assets have been consistently above

average holdings in global portfolios, according to

institutional investors’ surveys, despite diminishing

returns – both in risky and defensive portfolios over the

past eight years. From a fundamentals and valuation

standpoint, EM currencies seem broadly undervalued,

sovereign and corporate balance sheets tend to be

healthier than their developed markets counterparts, and

EM remains an important source of carry, nevertheless.

If returns are less appealing in EM as they used to be, the

opportunities in global markets seem even less so.

History has shown that debt overhang has often times

been accompanied by negative real rates in many

countries after World War II 21 . Financial repression

accounted for roughly 20% of tax revenues in the sample

of countries facing debt overhang and around 2% of GDP

(3-4% in the US and UK, and 5-6% in Italy). Looking

beyond bouts of deleveraging and flight-to-quality,

developed markets may set an even lower bar for EM in

the years ahead.

Drausio Giacomelli, New York, (1) 212 250 7355

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

Jack Zhang, New York, (1) 212 250 0664

21 See Reinhardt and Rogoff: Growth in a Time of Debt, 2009.



Appendix A: Asset average returns and volatility for past 8Y, 6Y, 4Y and 2Y periods

Return and Risk are based on weekly return

(annualized)

Return Risk Return Risk Return Risk Return Risk

EMBI* 9.1% 10.0% 8.7% 10.9% 8.9% 13.0% 9.5% 6.6% * JPMorgan EMBI Global Total Return Index

GBI-EM ** (Unhedged) 11.7% 12.0% 10.7% 13.0% 7.8% 14.6% 6.6% 11.2% ** JPMorgan GBI-EM Global Diversified Composite

GBI-EM ** (Hedged) 6.3% 3.7% 6.0% 4.1% 5.8% 4.7% 6.2% 3.0% *** JPMorgan EM Currency Index

EMFX *** 0.8% 8.1% -0.1% 9.0% -3.0% 10.2% -3.3% 8.9%

EM Equity 13.1% 26.3% 8.8% 28.8% -3.6% 31.4% -1.2% 23.3%

US IG 5.3% 4.9% 6.1% 5.2% 6.8% 5.9% 7.5% 4.5%

Glolbal HY 7.4% 7.7% 7.6% 8.6% 7.9% 10.4% 9.0% 5.8%

CRB 5.0% 19.7% 1.0% 20.6% -0.2% 23.3% 7.8% 18.3%

SPX 3.0% 19.2% 1.2% 21.5% -2.3% 25.0% 5.6% 18.7%

US Treasury Total Return 5.3% 4.5% 6.2% 4.7% 6.2% 5.3% 6.8% 4.2%

8Y 6Y 4Y 2YAsset

Appendix B: Portfolio weights on efficient frontiers

8Y History

Asset

EMBI 0% 0% 0% 0% 0%

GBI-EM (Unhedged) 0% 32% 61% 91% 0%

GBI-EM (Hedged) 48% 1% 0% 0% 0%

EMFX 0% 0% 0% 0% 0%

EM Equity 0% 0% 0% 0% 100%

US IG 0% 0% 0% 0% 0%

Glolbal HY 9% 17% 8% 0% 0%

CRB 1% 0% 0% 0% 0%

SPX 0% 0% 0% 0% 0%

US Treasury 42% 50% 31% 9% 0%

Port. Return 6.0% 7.7% 9.4% 11.1% 13.1%

Port. Risk 2.9% 4.9% 7.7% 10.8% 26.3%

Portfolio Composition

6Y History

Asset

EMBI 0% 0% 0% 0% 0%

GBI-EM (Unhedged) 0% 18% 45% 72% 100%

GBI-EM (Hedged) 43% 0% 0% 0% 0%

EMFX 0% 0% 0% 0% 0%

EM Equity 0% 0% 0% 0% 0%

US IG 0% 0% 0% 0% 0%

Glolbal HY 10% 20% 10% 1% 0%

CRB 1% 0% 0% 0% 0%

SPX 0% 0% 0% 0% 0%

US Treasury 46% 63% 45% 27% 0%

Port. Return 6.2% 7.3% 8.3% 9.4% 10.7%

Port. Risk 3.1% 4.1% 6.3% 9.3% 13.0%


4Y History

Asset

EMBI 0% 6% 28% 51% 100%

GBI-EM (Unhedged) 0% 0% 0% 0% 0%

GBI-EM (Hedged) 42% 9% 0% 0% 0%

EMFX 0% 0% 0% 0% 0%

EM Equity 0% 0% 0% 0% 0%

US IG 0% 0% 2% 20% 0%

Glolbal HY 9% 25% 27% 24% 0%

CRB 2% 0% 0% 0% 0%

SPX 0% 0% 0% 0% 0%

US Treasury 48% 59% 42% 4% 0%

Port. Return 6.1% 6.7% 7.4% 8.1% 8.9%

Port. Risk 3.5% 4.2% 6.0% 8.9% 13.0%


2Y History

Asset

EMBI 0% 0% 14% 38% 100%

GBI-EM (Unhedged) 0% 0% 0% 0% 0%

GBI-EM (Hedged) 41% 21% 0% 0% 0%

EMFX 0% 0% 0% 0% 0%

EM Equity 0% 0% 0% 0% 0%

US IG 0% 0% 0% 0% 0%

Glolbal HY 8% 32% 40% 41% 0%

CRB 0% 0% 0% 0% 0%

SPX 5% 2% 0% 0% 0%

US Treasury 45% 45% 46% 21% 0%

Port. Return 6.7% 7.4% 8.1% 8.7% 9.5%

Port. Risk 2.3% 2.6% 3.3% 4.4% 6.6%





EM Technicals in 2012: Structurally Sound; Cyclically Vulnerable

A broad set of metrics encompassing institutional

guidelines, relative amounts outstanding, basic

portfolio allocation, and the structural indications from

EPFR flows suggest that global investors are still

structurally underweight EM

However, valuation, lack of depth, and market access

suggest that the pace of strategic inflows will be

considerably slower going forward when compared

with 2003-2007.

In sovereign credit, we expect an increase in gross

issuance in 2012 due to higher financing need in a

few countries and higher than usual principal and

interest payment. Venezuela will clearly present the

largest amount of net supplies, while Brazil, on the

other hand, will likely have the largest amount of net

redemptions.

In local markets, a major pressure point will be

foreign investor positioning, which remains close to

historical highs. We see risks of outflows as highest

in Hungary and to a much lesser extent Poland.

Otherwise, Hungary stands out having the largest

financing requirement increases (from 10% to

14.5%), while Egypt features the largest absolute

financing need (30.5% of GDP).

EM corporates have surpassed sovereigns in

issuance by a large margin and the primary market

activities have become quite resilient to the ebbs and

flows of global capital markets, thanks in part to the

higher quality and relatively low leverage amongst the

issuers.

The strong strategic inflows of 2003-2007 have given way

to more gradual allocations that at times have been

dwarfed by bouts of risk aversion. As we discuss in more

detail below, emerging economies are likely to command

an increased share in global portfolios for several years

from a structural standpoint, but the combination of less

appealing valuation and lingering risk aversion bodes for

gradual inflows at best amid likely surges in deleveraging

in 2012.

Tactically, after months of risk reduction EM technicals

seem positive not only structurally but also from a

(shorter-term) cyclical standpoint. The chart below shows

speculative FX data – a timely gauge for leveraged

positions – hovering near historical lows. However, light

speculative positioning (be it in FX forwards or options,

and CDS or swaps) is a partial metric that ignores

potential unwinding of real investments in EM that have

built over the years. In 2011 investors initially hedged core

EM positions (thus pushing speculative positioning into

light territory) to eventually capitulate on relentless market

pressure. Therefore, despite light speculative positions

EM FX in particular remains vulnerable to bouts of

deleveraging as we saw in 2011 should the global

economy enter recession and risk aversion surge again. In

the following sections we shed more light into the various

(structural and cyclical) aspects of EM technicals.

EMFX positioning is very light

-1

0

1

2

3

4

5

ARS BRL CLP COP MXN PEN

2-Nov-11 25-Nov-11 2-Dec-11

FX Spec. Positioning Z-scores (2Y)

Light


Structural under-allocation faces capacity constraints

Are global investors still under-allocated to EM? The

evidence indicates that – structurally – they are.

Incidentally, the latest DB Institutional Survey22 indicates a

strong positive bias towards EM assets, both equities and

debt – as shown in the graph below. For example,

according to the anticipated allocation changes for the

next 12 months, the percentage of funds looking to add

EM Debt vs. those looking to reduce is 28% vs. 3%.

However, there is really no simple answer to the question

above given the difficulties in reliably estimating current

vs. ‚optimal‛ portfolio allocations. We thus look at a

broad set of metrics encompassing institutional

guidelines, relative market size, basic portfolio allocation

benchmarks, and structural drivers for EPFR flows.

22 See 2011 Institutional Survey, John Haugh, DB Cross Rate Sales,

Pensions. The report presents a survey of 101 institutional asset owners,

taken between Mid-July and end of August 2011.



DB survey: String bias towards EM assets

Source: Deutsche Bank 2011 Institutional Survey

a) Benchmark indices: One common institutional

guideline takes the form of benchmark indices23.

In the case of equities, anecdotal evidence points

to an average allocation to EM equities just above

5% - still a fraction of the almost 14% share of

EM in the MSCI. Moreover, long-term growth

differentials in favor of EM point to an increasing

share in the MSCI.

In the case of fixed income, anecdotally (from our

survey) we believe that EM’s share in global

portfolios is less than 3%, while the latest IMF

survey shows it is less than 5%24. This is still a

small number when compared with EM’s

debt/GDP and it’s almost 50% share in global

GDP (according to the latest IMF estimate, using

PPP exchange rates). However, while increasing

allocations to equities faces adverse market

conditions, investing in EM fixed income is

hindered by numerous accessibility hurdles – a

constraint that will likely be lifted only gradually.

Accordingly, foreign investors have favored the

most accessible markets such as CE3, Mexico,

and South Africa so that technicals actually look

heavy in these casesi.

b) Portfolio allocation: Although the standard

model is plagued by non-normality, serial, and

cross-correlation in returns, it remains the

workhorse in the industry. As we show in a

separate article in this publication25, EM tends to

figure prominently in global ‚optimal‛ portfolios

that also include global equities, high-yield, high-

23 From a fundamentals standpoint, savings ultimately match investments,

so that assessing whether investors are under-allocated hinges on their

preferences and the relative performance characteristics of investable

assets. Since the determination of the optimal portfolio is no easy task,

investors often times resort to benchmarks. Although benchmark indices

can be a useful reference, they are rather static and detached from market

incentives. In fact, since weighs increase when assets appreciate or

indebtedness rises, index weights and prospective returns tend to be

negatively correlated. 24

See September’s Global Financial Stability Report 25 See EM Performance: grass is greyer on the other side

grade, and US bonds, and global FX or

commodities. Although the ‚optimal‛ portfolio

shares obviously depend on risk tolerance,

(typical) moderate risk portfolios often post

‚optimal‛ EM allocations well in excess of the

weights in global portfolios discussed in the

previous paragraph. Whether this will hold is

questionable, as valuation is now less appealing.

But – from a long-term perspective – the pull

factors (such as EM’s superior carry and balance

sheets) will likely still compare favorably with

developed markets push factors such as balance

sheets, growth prospects, and possible financial

repression26.

EM expands efficient frontiers

EMBI-G

GBI-EM

GBI-EM-H

EMFX (spot)

EM Eq

IG

HY

Comdty

SPX

UST

0%

2%

4%

6%

8%

10%

12%

14%

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

8Y

6Y

4Y

2Y

2Y (w/o UST)

Average weekly returns

Annualized weekly return volatility


c) Fundamental drivers of EM flows. Since

portfolio analysis is rather static, we model EM

portfolio inflows (using EPFR data since 2004;

weekly and monthly) aggregated by local currency

debt fund (LC), hard currency (HC), and equities.

The results for LC and HC debt based on standard

CCAPM are presented in the tables below. Our

results indicate that EM flows respond to

fundamentals and risk in line with intuition: 1) A

surge in risk aversion is associated with

substantial outflows; 2) Higher yield differentials

between local currency debt vs. hard currency

debt favors inflows into the former vs. outflows

from the latter; 3) inflation weighs on local

markets inflows, while growth differentials are

most relevant for equity inflows (not shown in the

table); 4) flows are most vulnerable to risk and risk

26 See Reinhardt and Sbracia, 2011



aversion (proxied by the VIX), as we discuss in

more detail below 27.

EM flows supported by fundamentals

Dependent Var.: LC (AUM%) Dependent Var.: HC (AUM %)

Variable Coeff. t-stat. Variable Coeff. t-stat.

C 4.72 2.4 C 12.27 5.4

Ln(VIX) -1.83 -3.7 Ln(VIX) -2.43 -6.1

Yield diff 0.53 2.6 EM yield -0.42 -2.8

EM inflation -0.19 -1.5 UST yield -0.53 -3.2

R-squared 59% R-sq. 64%

Adjusted R-sq 55% Adjusted R-sq. 51%

S.E. of regr. 0.79 S.E. of regr. 0.39

F-statistic 14.53 DW stat 1.71

DW stat. 1.94

Sample: 2004-2011, monthly Source: Deutsche Bank, EPFR

d) Receding home bias. Missing in the portfolio-

based approaches we use is the prevalence of

home bias in international allocation decisions28.

Home bias has been falling, however. As it seems

inversely related to GDP/capita, it has been on a

downward trend (see the graph below). Since

financial assets are still concentrated in developed

markets, this trend should benefit EM allocations.

Home bias ratios trend down

0.5

0.6

0.6

0.7

0.7

0.8

0.8

0.9

0.9

1.0

1.0

Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07

Emerging Market Developed Market

Home Bias Trend

Note: the figure plots the simple mean home bias ratios over time, with numbers taken

from Solnik and Zuo, 2011, A Global Equilibrium Asset Pricing Model with Home

Preference Source: Solnik and Zuo, 2011

27 Although the sensitivity to VIX shown is higher for hard currency flows,

this is because of the additional variables included in the local flows

regression (such as FX vols and local yield variance) that reduce the

elasticity of local flows to VIX. The dynamics version shown below

indicates - in line with intuition and anecdotal evidence - that local markets

investments are more sensitive to surges in risk aversion. 28 See Karen k. Lewis, International Home Bias in International Finance and

Business Cycles, 1998. The paper suggests that domestic investors hold a

substantially larger proportion of their wealth portfolios in domestic assets

than standard portfolio theory would suggest. In the absence of this home

bias, investors would optimally diversify away domestic output risk.

Assessing risks of reversals and EM capacity

The analysis above supports continued strategic inflows,

but it also highlights the sensitivity of these flows to bouts

of risk aversion. One natural by-product of the dynamic

modeling of these flows (on weekly data) is the impulse

response to a shock in VIX. As the chart below shows, the

response of flows to shocks is remarkably quick appearing

in the data already the week after shock. The impulse

responses we obtain from the dynamic version of the

regressions above show that they peak one week after

the shock and then gradually revert over the following

months.

The reversion is faster in hard currency (HC) than in local

markets (LC) and the impact of shocks to LC also tends to

be higher than shocks to HC funds. The chart below

shows the response to 10-point increases in the VIX - the

most important source of risk for flows. Although the

sensitivity to one point deviations in variables such as

growth, yield differentials, and inflation are comparable to

the VIX, the potential changes in the VIX are much larger.

Altogether, from a tactical standpoint, risk remains the

most important driver of flows dynamics. In addition, the

data patterns we have observed suggest that the VIX

threshold for outflows is around 30.

EM flows are quite sensitive to surges in the VIX

-1.8

-1.6

-1.4

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

1 2 3 4 5 6 7 8 9

Impact of a 10-point rise in VIX on AUM %

LC response to VIX shock

HC response of to VIX shock

weeks following surge in VIX

DB research, EPFR

Although not destabilizing, these fund outflows amplify

market pressure, highlighting that – despite the

improvement of the past decade – emerging markets

remain relatively shallow. Therefore, although EM

performance would warrant larger allocations in global

portfolios, EM’s sheer lack of depth already poses

capacity constraints. While investable EM fixed income

markets hovers below USD1.5trn, global mutual funds

alone amount to USD26trn – followed by similar stocks in

pension funds and insurance companies. With Sovereign

Wealth Funds contributing with almost USD5trn, private

wealth funds hovering above USD42trn, and alternative

investments possibly adding USD10trn (o.w.USD2trn in



hedge funds), a mere percentage point relocation into EM

would amount to one-third of its equity capitalization or

about all the investable fixed income pool29.

In sum, although fundamentals and institutional guidelines

indicate that global investors remain under-allocated to

EM, valuation, lack of depth, and market access suggest

that the pace of strategic inflows will be considerably

slower going forward when compared with 2003-2007.

A closer look at EM: Amortization and supply

Having discussed tactical and structural drivers of

technicals from EM at large, we now assess specifics for

sovereign credit, local markets and EM corporate credit in

2012, mostly from the perspective of supply vs. demand.

In sovereign credit, external issuance by EM governments

has been very strong post 2008 crisis, peaking in 2010,

but even in 2011 it has remained close to the 2010 high.

We expect issuance in 2012 to remain elevated (and most

likely above 2011) given the higher than usual external

debt payments (principal and interest, in total of

USD60bn). We project total principal and interest

repayment to cover over 70% of our projected gross

issuances across the major countries, in comparison with

the average 65% of the past three years. See the graph

below. This suggests an increase in total gross issuance

to $80bln from the average of $70bln of the past three

years, mostly due to significant increase of issuances by

Venezuela, Russia, UAE, and also due to a substantial

increase in net issuance by the smaller countries and less

frequent borrowers (e.g. Gabon, Ghana, and Egypt).

Project net supply by major EM governments in 2012

Net supply = projected gross issuances - total principal and interest payments

(bonds only)

Argentina: repayment include estimated warrant payments (excl. public holdings)

issunce projection is $2bln local law bonds

Venezuela: excludes PDVSA interest payments

UAE: include both Abu Dhabi and Dubai

-6000

-3000

0

3000

6000

AE VE CZ UA HU ID RO RU PE PH ZA CO MX LT PL LB TR BR AR

2012 hard currency bonds net supplies

DB research

29 Note that EM pension funds and mutual funds are among those with

highest growth rates, thus adding an important source of demand to this

equation. See OECD, ICI, The City UK, and Towers Watson statistics for

more information.

Among the countries, Venezuela is clearly the credit with

the largest amount of net supply, and the number above

does not even include PDVSA. Ukraine and Hungary are

two issuers with pressing financing needs. They could

place bonds only if market conditions are conducive; so

that external support (e.g. the IMF) may be required to

solve the liquidity problem they are facing. For Argentina,

we pencil in $2bln of local law bonds supply (likely to be

placed with the Anses), with the remainder of financing

gap ($3.5bln) to be likely filled with the use of Central

Bank reserves and loans with the Banco Nacion. The large

amount of negative net supply in Argentina is a double-

edged sword: on the one hand it suggests that investors

will get large redemptions, but on the other hand it is

indicative of demand constraints and lack of market-based

means of financing. Brazil’s large amount of negative net

supply, on the other hand, indeed represents a very

positive technical condition30.

Total public borrowing requirements are little

changed in 2012 from 2011 for most countries

BG

HRCZ

HU

LT

LUPL

RO

TR

IL

ZA

UA

RU

AR

BR

CL

CO

MX

VE

CN

IN

ID

KR

MY

SGPH

TH

0

5

10

15

0 5 10 15

2012 Gross Financing Requirement (% of GDP)

2011 Gross Financing Requirement (% of GDP)

Note: Data source for most countries is the IMF, with notable exception of Brazil,

Venezuela, Korea, and the Philippines, for which we get the amount of debt maturing

from Bloomberg. Source: Deutsche Bank, IMF

Data on local markets amortization schedule is scarcer.

We thus look at total public borrowing requirements and

investor positioning in selected markets for potential

pressure points. Based on IMF projections, the total gross

financing requirements will change little in 2012 compared

to 2011 (see the graph above). Countries that stand out

include Hungary, whose financing requirement increases

to 14.5% from 10%. Hungary has initiated talks with IMF

with the aim of accessing a precautionary credit line.

30 For a more detailed discussion on the supply/demand outlook as well as

other aspects of the technical conditions on Sovereign credit, please see

‚Sovereign Credit in 2012: Diminished returns; country selection key‛ in

this Monthly publication



Egypt features the largest financing need (30.5% of GDP),

but for scaling purposes it is not shown in the graph.

For EMEA local markets, 2012 is likely to see a marginal

increase in net issuance, but the growth in volume is likely

to be in line with GDP and the increase is concentrated in

states that enjoy a comfortable fiscal position (Turkey,

Russia)31

the typically high financing needs in Brazil.

Otherwise, in local markets, a major pressure point will be

foreign investor positioning. Foreign investors have been

remarkably resilient even in markets (such as Hungary)

that have been hit hardest by the turmoil in the EU. As the

chart below shows, non-residents share of local currency

government debt markets is at an all time high in Poland,

Russia, South Africa, Turkey, and Hungary. The recent

years have been a reminder that these positions can be

unwound once risk aversion surges and – despite its

resilience – we see foreign positioning as vulnerability for

these markets. Risk is highest in Hungary and to a much

lesser extent Poland. On the other hand the likely

introduction of Euroclearable government bonds in Russia

is supportive in attracting inflows.

Foreign ownership of local fixed income still high


Corporates: The rising of the asset class is on track

It is no news that corporates have surpassed sovereigns

in issuance by a large margin (chart). For EM corporate,

the significant increase in bond issues after the 2008 crisis

has been in part to substitute for the contraction in bank

lending as development market banks have reduced their

balance sheets. In addition, the past few years have

shown that corporate issuance has become quite resilient

to the ebbs and flows of global capital markets. Dedicate

mandates are still minor when compared to sovereign and

31 See ‚EMEA Local Debt Supply and Demand in Focus‛ in this Monthly

publication for more details.

now local markets, but EM corporates bonds outstanding

already amount to about two-thirds of the HY and more

than 15% of IG.

Corporate-Sovereign supply gap likely to widen

19.0

59.072.6

55.5 57.6 63.050.4

57.3

83.794.1

122.0

176.4189.7

94.9

229.5

295.7286.5

245.3

0.00

50.00

100.00

150.00

200.00

250.00

300.00

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

10

YT

D

20

11

YT

D

USDbn

Sovereign Corporate


Higher quality and relatively low leverage also played a

role in explaining this resilience. Average corporate cash /

short term debt ratio is above 2x in LatAm and in

CEEMEA and has been growing in the past quarters. At

the same time, corporate net leverage has been declining

steadily in both LatAm and CEEMEA (see the graph

below), leaving the corporate sector in robust shape to

face a downturn in economic and financing activity.

Low leverage tames risk of reversals


Drausio Giacomelli, New York, 1 212 250 7355

Hongtao Jiang, New York, 1 212 250 2524



A Closer Look at Real-Money Positioning

EM local currency funds have grown by a factor of

almost 3.5x over the past four years. One of the

implications of this rise is that such funds have an

increasing impact on the behaviour of local markets.

In this article we examine the rise of these funds and

the impact it has had on cross-correlation within EM

local markets.

We also introduce a new analysis of fund positioning,

which we believe will serve as a useful tool for

gauging relative technicals across EM local markets.

The past few years have seen a dramatic rise in the

amount of funds managed according to dedicated, global

EM bond mandates. This rise has been particularly

significant for EM local currency debt funds; the AUM of

such funds has gone from USD24bn at the end of 2007 to

USD82bn32.

Recently however, inflows to EMD funds have stalled and

after over two years of consistent inflows, the past two

months have brought outflows. Within this article we

discuss some of the implications of the rise of local

currency funds. We also introduce a new approach for

assessing the relative position and appetite of real money

investors with respect to individual countries within both

local currency and hard currency funds.

EM Local Currency Bond Fund Flows

-5,000

-4,000

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11

0

10

20

30

40

50

60

70

80

90

100

Inflows, USD mm AUM, USD bn

Source: EPFR Global

32 This is according to data provided by EPFR Global which tracks primarily

publicly listed funds. The actual number is likely substantially larger, as we

discuss later.

Foreign holdings of several local currency markets has

mirrored the growth of global local currency funds...

0

50

100

150

200

250

300

350

400

450

Jan 08 Jan 09 Jan 10 Jan 11

Index of foreign holdings of domestic currency government bonds

USD-equivalent value, end 2007=100

Brazi

Indonesia

Malaysia

Mexico

AUM of EM Local

Currency Bond Funds

Brazil

Source: Haver, Bloomberg LLP, BIS, Country Sources, DB Global Markets Research

One of the consequences of the rise of the global local

currency funds is of course that foreign investors now

hold fairly substantial proportions of the outstanding stock

of many local currency debt markets. By comparing the

data from the countries themselves on foreign holdings

with the flow data from EPFR we can build a picture of

the impact of the global funds on the rise in foreign

holdings. As the chart below shows, there is a striking

correlation in the holdings of a number of major local

markets with respect to the AUM of local currency funds.

It is remarkable that since the end of 2007, the percentage

increase in the stock of foreign holdings for all four

countries (Brazil, Mexico, Indonesia and Malaysia) and of

the total AUM of global local currency funds is in each

case in the range 200-250%.

...and the impact of the fund growth can also be seen

in many other markets

0

50

100

150

200

250

300

350

400

Jan 08 Jan 09 Jan 10 Jan 11

Index of foreign holdings of domestic currency government bonds

USD-equivalent value, end 2007=100

Korea

Turkey

Poland

Hungary

AUM of EM Local

Currency Bond FundsS. Africa

Source: Haver, EPFR, Bloomberg LLP, BIS, Country Sources, DB Global Markets Research



While not all countries have seen a percentage rise in

foreign holdings comparable to that of the four shown

above, a number of others also reflect the same pattern of

inflows. A likely reason why these particular countries

have seen a smaller percentage increase is that each of

these markets had significant proportions of foreign

investors prior to the recent rise of the global local

currency funds.

One of the implications of this remarkable rise of global

local currency funds is that markets which were once

almost entirely independent of one another are now being

linked by a common factor: the behaviour of the local

currency fund managers and in particular, the in/out flows

that they are experiencing.

The impact of this increasingly common factor can be

seen by looking at the average of all pair-wise correlations

of the returns of individual local markets. The chart below

shows the history of this cross-correlation, along with the

cross-correlation of (a) the FX component of the returns of

each market and (b) the fixed income component of the

returns. Most striking is the recent rise in the intra-FI

cross-correlation, coincident with the period of sharp

outflows shown in the first chart of this article.

Cross-correlation among EM local currency fixed

income has recently jumped higher

0

0.1

0.2

0.3

0.4

0.5

0.6

Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

Total USD Return

FI Return

FX Return

Cross-correlation (60d mov.avg of 5d returns)

Source: DB Global Markets Research

As global fund flows are of greater importance in

determining the behaviour of local currency bond markets,

the appetite of fund managers for different countries is

likely to have an increasingly impact, as they represent a

far larger share of holdings in each market. For this

reason, understanding how such funds are positioned

with respect to individual countries should be valuable.

For a number of years we have analysed such positioning

data for external debt funds, but only recently has the

coverage of local currency funds within the sample 33

reached a point at which we feel it is sufficiently

representative as to be able to provide meaningful

insights. While widening our analysis of local currency

fund positioning, we have also enhanced the way we

analyse the data.

We believe that there are two important factors to

consider when judging what the data on exposures tells

us about the technical position for a given country:

How are funds positioned relative to their respective

benchmark and how does this relative exposure

compare with history?

What has the recent appetite been for the country in

question? Have funds generally been adding or

reducing exposure?

For fund exposures we focus on how the exposure

deviation varies over time

Local currency fund exposure to Hungary

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

Jul10 Oct10 Jan11 Apr11 Jul11 Oct11

Benchmark

Avg Portfolio

Weight, %

-3.00

-2.50

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

Jul10 Oct10 Jan11 Apr11 Jul11 Oct11

Avg Fund Exposure

12m MA

MA +/- 1StDev*

Avg Exposure vs. benchmark

*The standard deviation measure used for the bands is based on the monthly changes

in the average exposure vs. benchmark.

Source: EPFR Global, DB Global Markets Research

33 We use data provided by EPFR Global on fund country exposures. This

data is provided on a monthly basis and at present covers USD28bn AUM

of hard currency funds and USD25bn AUM of local currency funds.



For the first question, the analysis is relatively

straightforward. We simply take the average exposure of

the funds and compare this to the appropriate

benchmark 34 weight for the asset class. Since not all

funds will be benchmarked to the specific indices we use,

we do not place great emphasis on the absolute

difference between the exposure and the benchmark;

rather we focus on how that difference has evolved over

time.

The charts above illustrate this for the exposure of local

currency funds to Hungary. The first chart shows the raw

data: the average exposure of the funds and the weight of

the country in the benchmark. The second chart shows

the difference, along with the 12-month moving average

of the difference. These charts highlight the relevance of

looking at the deviation over time. The average fund

exposure has historically been below the benchmark

weight, but the deviation has been relatively stable

between 1-2pp below.

Notice that in the chart above, the relative rise in the fund

exposure which occurred in Q2 of this year was entirely

due to the reduction in the benchmark weight, not

because funds were actively increasing exposure. This is

clearly an important distinction and leads us to the second

factor we examine.

To answer the second question, for each fund in the

sample we examine the changes in country exposures

from one month to the next and estimate the extent to

which those changes are (a) passive – i.e. would have

34 For the local currency funds we use JP Morgan’s GBI-EM Broad

Diversified weights from Bloomberg. For the hard currency funds we use

our own EM USD Sovereign Index (which is very similar in composition to

JP Morgan’s EMBI Global Diversified and other similar constrained market

cap indices for EM sovereign USD bonds).

occurred due to relative price movements, without any

trading activity and (b) active – i.e. resulted from active

trading. We then examine the whole sample of funds and

see what proportion of the funds actively added exposure

and what proportion reduced exposure. We call the

difference between these two the ‘buyers v sellers index’.

The chart below illustrates this for Hungary and clearly

shows that funds were, on balance, actively reducing in

Q2.

Having constructed the relative weight and the buyers v

sellers index, we now have a pair of simple metrics with

which to compare fund exposure and appetite for

different markets. For the positioning we take the

difference between the average deviation from the

benchmark and the 12-month average, divided by the

standard deviation of the monthly changes of the

deviation.

The exposure z-score indicates how ‘over-/under-

weight’ funds are at present

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5


Oct 11

Prev. Mth

Exposure Z-score*


change in exposure


The chart clearly shows that funds are currently most

‘overweight’ with respect to Brazil and South Africa, while

Turkey is the biggest ‘underweight’.

For the comparison of recent ‘appetite’ we compare the

3-month moving average of the buyers vs. sellers index

for each country, as shown below.

Our buyers v sellers index illustrates the appetite for a

country among benchmarked real-money investors

-1.0

-0.5

0.0

0.5

1.0

Jan 10 Jan 11 Jan 12

Hungary - buyers v sellers index

* A value of +1.0 indicates that all funds in the sample added exposure during the given

month. A value of -1.0 indicates that all funds in the sample reduced exposure.




The buyers v sellers index gives an impression of the

relative strength of appetite for different countries

-0.5

-0.4

-0.3

-0.2

-0.1

0

+0.1

+0.2

+0.3

+0.4

+0.5

ZA TH RU BR KR CO CZ HU RO MX MY TR PL PE IL ID EG

Oct 11

Prev. Mth

Buyers v sellers index, 3m MA*

*-Number of funds actively increasing exposure minus number of funds actively

decreasing exposure, divided by the total number of funds


This shows that funds have been most consistent in their

appetite for South Africa; while there have been few

countries which have seen consistent selling pressure in

the past few months. The chart above also shows a sharp

change in the appetite for Colombia, from selling to

buying. This can be seen more clearly by looking at the

underlying index, as shown below:

Detailed country-specific charts (such as these) are

included in the Appendix

-7.4-7.2-7.0-6.8-6.6-6.4-6.2-6.0-5.8-5.6-5.4-5.2


Colombia - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Colombia - buyers v sellers index


The following pages contain charts like those shown

above for Colombia for all countries in the analysis. In

addition, we include similar analyses for the exposure of

hard currency funds. The interpretation of these is

discussed in the Sovereign Credit Outlook article within

this report.

Finally, we mentioned at the outset that the total amount

of assets managed by global EM local currency funds is

likely to be considerably larger than the USD80bn figure

indicated by EPFR. One way to gauge the order of

magnitude of the true figure is to compare the average

country weights of fund managers with the total stock of

foreign holdings in each market, as reported by the

various national sources (as shown below). If all the

foreign holdings in each market were held within global

local currency funds and if the country weights in our

sample is reflective of the overall market, then the points

on the chart below would all lie on a straight line, the

slope of which would reflect the total AUM of the funds.

As it is, a portion of the holdings are certainly not

managed within such funds, but this analysis nevertheless

allows some approximation to be made for the possible

size of this family of funds. The chart below would

suggest that there may be as much as USD200bn

managed in such funds.

The total size of the global local fund universe may be

as much as USD200bn

TH

ZA

TR

RU

PL

MY

MX

KR

IDHU

EGCZ

BR

$400bn

$300bn

$200bn

$100bn

0

20

40

60

80

100

120

0 5 10 15 20

Foreign Holdings of Domestic Government Debt (USD bn)

Average % allocation within Global Local Currency EMD Funds

Source: Haver, Bloomberg LLP, BIS, Country Sources, DB Global Markets Research

Marc Balston, London, (44) 20 7547 1484



Exposures of Local Currency EM Bond Funds

0

2

4

6

8

10


Brazil - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Brazil - buyers v sellers index

-7.4-7.2-7.0-6.8-6.6-6.4-6.2-6.0-5.8-5.6-5.4-5.2


Colombia - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0



0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0


Czech Republic - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Czech Republic - buyers v sellers index

-0.2

0.0

0.2

0.4

0.6

0.8

1.0


Egypt - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Egypt - buyers v sellers index

0

1

2

3

4

5


Hungary - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0



0.0

0.5

1.0

1.5

2.0

2.5

3.0


Indonesia - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Indonesia - buyers v sellers index

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4


Israel - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Israel - buyers v sellers index

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0


South Korea - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


South Korea - buyers v sellers index

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0


Mexico - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Mexico - buyers v sellers index

-6

-4

-2

0

2


Malaysia - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Malaysia - buyers v sellers index

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8


Peru - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Peru - buyers v sellers index

-3

-2

-1

0

1

2


Poland - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Poland - buyers v sellers index

0.0

0.2

0.4

0.6

0.8

1.0


Romania - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Romania - buyers v sellers index

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0


Russia - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Russia - buyers v sellers index




Exposures of Local Currency EM Bond Funds (cont...)

-6

-5

-4

-3

-2

-1

0


Thailand - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Thailand - buyers v sellers index

0

2

4

6

8


Turkey - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


Turkey - buyers v sellers index

-2

-1

0

1

2

3


South Africa - avg exposure vs b'mark

-1.0

-0.5

0.0

0.5

1.0


South Africa - buyers v sellers index




Exposures of Hard Currency EM Bond Funds

0

2

4

6

8


Argentina - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Argentina - buyers v sellers index

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2


Bulgaria - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Bulgaria - buyers v sellers index

-6

-4

-2

0

2


Brazil - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Brazil - buyers v sellers index

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4


Chile - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Chile - buyers v sellers index

-3

-2

-1

0

1


China - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


China - buyers v sellers index

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6


Colombia - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0



-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4


Egypt - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Egypt - buyers v sellers index

-0.4

-0.2

0.0

0.2

0.4


Ghana - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Ghana - buyers v sellers index

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6


Hungary - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0



-0.5

0.0

0.5

1.0

1.5

2.0

2.5


Indonesia - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Indonesia - buyers v sellers index

-9

-8

-7

-6

-5

-4


South Korea - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


South Korea - buyers v sellers index

-8

-6

-4

-2

0

2


Mexico - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Mexico - buyers v sellers index

-3

-2

-1

0

1

2


Malaysia - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Malaysia - buyers v sellers index

-1.6

-1.4

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0


Panama - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Panama - buyers v sellers index




Exposures of Hard Currency EM Bond Funds (cont)

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4


Peru - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Peru - buyers v sellers index

-4.0

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0


Philippines - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Philippines - buyers v sellers index

-0.4

-0.2

0.0

0.2


Pakistan - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Pakistan - buyers v sellers index

-1.8

-1.6

-1.4

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2


Poland - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Poland - buyers v sellers index

-0.4

-0.2

0.0

0.2


Serbia - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Serbia - buyers v sellers index

-2

0

2

4

6

8

10

12


Russia - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Russia - buyers v sellers index

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8


El Salvador - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


El Salvador - buyers v sellers index

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05


Tunisia - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Tunisia - buyers v sellers index

-6

-5

-4

-3

-2

-1


Turkey - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Turkey - buyers v sellers index

0.0

0.5

1.0

1.5

2.0

2.5


Ukraine - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Ukraine - buyers v sellers index

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8


Uruguay - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Uruguay - buyers v sellers index

-2

-1

0

1

2

3


Venezuela - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Venezuela - buyers v sellers index

-0.6

-0.4

-0.2

0.0


Vietnam - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


Vietnam - buyers v sellers index

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8


South Africa - avg exposure vs benchmark

-1.0

-0.5

0.0

0.5

1.0


South Africa - buyers v sellers index




IMF Financing: Possibilities and Limitations

The IMF currently has EUR 285bn in its locker for new

lending. This would be enough to provide newly-

launched Precautionary and Liquidity Lines for both

Italy and Spain (up to EUR 138bn), though we have

doubts about whether they would qualify for this

instrument. It would not be enough to cover a fund

arrangement for Italy (EUR 292bn) proportionate in

size to that put together for Greece

Various options have been proposed for increasing

the IMF’s financial firepower, including voluntary

contributions to an IMF special structure, pooling

European SDR allocations, or ECB lending to the IMF.

There are political and technical drawbacks with each

of them.

A further increase in bilateral contributions to the IMF

would seem more viable, though this would rule out

using the additional resources to buy bonds or lend to

the EFSF. Non-European countries will also want to

see greater clarity regarding Europe’s financial

commitment before they go down this route.

Were it not for the potential calls from the euro area,

the IMF already has enough firepower to meet the

probable needs of emerging market countries. The

requests are most likely to come from emerging

Europe, where a toxic combination of relatively

weaker fundamentals and higher exposures to the

euro area have left several countries facing

difficulties. Four countries in the region (Poland,

Romania, Serbia, and Macedonia) already have IMF

arrangements in place. Ukraine also has an

arrangement although this has been dormant for the

past year because Ukraine has not yet met the

requisite policy conditions (e.g. raising gas tariffs).

Hungary has also requested a program, though these

negotiations could well be difficult.

The IMF’s Financial Firepower35

The IMF’s resources come from two principal sources: (i)

the capital subscriptions (or ‚quotas‛) made available by

each member country – with the size of a country’s quota

determined mainly by its economic size; and (ii), IMF

borrowing, typically from its stronger member countries.

35 The IMF’s financial resources and transactions are denominated in

Special Drawing Rights, the value of which are based on a basket of

currencies including the dollar, euro, yen and pound sterling. The dollar and

euro amounts quoted in this note are based on exchange rates as of

November 22 (1 USD = SDR 0.639; 1 EUR = SDR 0.865) but might vary a

little with exchange rate movements.

These resources have expanded significantly in response

to the 2008-09 crisis:

IMF quota resources are in the process of being

doubled to approximately EUR 575bn. This increase is

still working its way through the domestic approval

process among the IMF’s member countries. The aim

is to get this done by October 2012, though there is a

risk that this date could slip, not least given the need

for US congressional approval the increase.

In the meantime, the credit lines available to the IMF

from stronger countries have been boosted to about

EUR 428 billion. The amount available to the IMF is, in

practice, rather less than this. Some creditor

countries could themselves run into balance of

payments difficulties and the IMF sets aside a portion

of these credit arrangements to reflect this risk.

Greece, Ireland, and Portugal, for example, participate

in these arrangements; but their portion of these

credit lines is effectively unavailable to the IMF. When

the quota increase becomes effective, the intention is

to scale back the borrowing arrangements

correspondingly.

That currently gives the IMF about EUR 620bn of total

resources, of which about EUR 590bn comes from quotas

and borrowing arrangements in roughly equal measure.

This compares with total resources of EUR 244bn in

December 2007 prior to the last crisis.

However, the amount the IMF has to lend to countries is

significantly less than this, primarily reflecting: (i) its

holdings of non-usable currencies (e.g. Zimbabwe dollar);

(ii) the amounts it has already lent or has committed to

lend (including precautionary arrangements or credit lines);

and (iii) a prudential balance or safety margin. Once all this

is factored in, that leaves the IMF with some EUR 285bn

available for new lending.

Potential lending to Europe

The IMF has a variety of lending facilities through which it

can lend to its member countries:

At one end of the spectrum is the Flexible Credit Line

(FCL) designed to provide to large upfront financing

to countries with very strong fundamentals and a

clear track record of implementing good policies.

Critically, for those countries that qualify, there are no

strings attached in the sense that disbursements



under an FCL are not phased or conditional on a

country meeting certain policy understandings as is

Current IMF quotas (EUR bns)

Euro area 63.8 Selected others

Austria 2.4 Brazil 4.9

Belgium 5.3 Canada 7.4

Cyprus 0.2 China 11.0

Estonia 0.1 Japan 18.1

Finland 1.5 Mexico 4.2

France 12.4 Russia 6.7

Germany 16.8 UK 12.4

Greece 1.3 US 48.7

Ireland 1.5

Italy 9.1

Luxembourg 0.5

Malta 0.1

Netherlands 6.0

Portugal 1.2

Slovakia 0.5

Slovenia 0.3

Spain 4.7


the case under a traditional IMF-supported program.

There is no cap on the amounts made available,

which are based on an assessment of a country’s

potential financing need. But we can get a sense of

what is ‚normal‛ from the three countries that

currently have such arrangements, Mexico (1500% of

its quota), Poland (1400%), and Colombia (500%).

Somewhere in the middle is the IMF’s new

Precautionary and Liquidity Line, introduced earlier

this week.36 This is intended for countries with sound

fundamentals and policy track records, but which face

moderate vulnerabilities and do not qualify for the

FCL. Access is limited to 500% of quota up front and

up to a total of 1000% after 12 months subject to

satisfactory progress in addressing remaining

vulnerabilities. There is also a short-term liquidity

window under which countries could access between

250% and 500% of quota. We do not think there will

be much demand for this, with countries that qualify

for the PLL likely to prefer the longer 12-24 month

arrangement.

To give a sense of how much the IMF could lend to

Europe, using its existing instruments and given its

current firepower, we show some illustrative program

36 This is very similar to the Precautionary Credit Line (PCL), which it

replaces: Macedonia is currently the only country that has a PCL. Aside

from the new short-term liquidity window, the only other material change

is that a country can now request a PLL when it has an actual balance of

payments need versus potential need under the old arrangements. In

practice, however, defining whether a country faces an actual or potential

balance of payments need is not a precise exercise. We think it unlikely

that the distinction was much of a barrier to countries accessing the PCL.

sizes for Italy and Spain in the table below. Were it to

qualify for a PLL, for example, Italy would be able to

access up to EUR 91bn. The corresponding amount for

Spain would be EUR 47bn. In both cases, only half of

these amounts would be available upfront. The IMF would

be able to finance these amounts, totaling EUR 138bn,

from within its existing EUR 285bn available for new

lending.

It would be more difficult for it to accommodate programs

significantly larger than this. If, for example, Italy were to

request a ‚Greek-size‛ program (i.e. 3200% of quota), this

would amount to EUR 292bn, which would entirely wipe

out the IMF’s new lending capacity. The Irish and

Portuguese programs were a little smaller than this at

about 2300% of quota, which in Italy’s case would

amount to EUR 210bn. This is within the IMF’s new

lending capacity but would leave it with little (EUR 75bn)

to meet the needs of other potential borrowers, such as

Spain, let alone emerging markets that are facing

difficulties in the current environment. Hungary, for

example, has already indicated its intention to seek

another arrangement with the IMF.

Illustrative IMF program sizes (EUR bns)

Italy Spain Total

PLL (1000% of quota) 91 47 138

of which available immediately: 46 23 69

Traditional program (3200% of quota) 292 149 440

Traditional program (2300% of quota) 210 107 316


It is debatable whether Italy or Spain would qualify for the

PLL. The IMF has, for example, indicated that the PLL is

intended for ‚crisis bystanders‛. The qualification criteria

(see box below) involve some subjective judgments. But

we think that both Italy and Spain need to undertake large

macroeconomic and structural policy adjustment, which

would appear to rule them out as PLL candidates. If that is

the case, then they would need to seek more traditional

programs with their more intrusive (and politically

unpalatable) policy conditionality.



IMF Precautionary and Liquidity Line

Qualification requires that a country: (i) has sound

economic fundamentals and institutional policy

frameworks; (ii) is implementing—and has a track record

of implementing—sound policies; and (iii) remains

committed to maintaining such sound policies in the

future.

The criteria used to assess whether a country qualifies for

the PLL are: (i) external position and market access; (ii)

fiscal policy; (iii) monetary policy; (iv) financial sector

soundness and supervision; and (v) data adequacy. While

requiring strong performance in most of these areas, the

PLL permits access to precautionary resources to

members that may still have moderate vulnerabilities in

one or two of these areas.

Countries suffering any of the following problems at

approval cannot access the PLL: (i) sustained inability to

access international capital markets; (ii) the need to

undertake large macroeconomic or structural policy

adjustment; (iii) a public debt position that is not

sustainable in the medium term with a high probability; or

(iv) widespread bank insolvencies.

Source: IMF and based on the qualification criteria for the Precautionary Credit Line.

Options for increasing IMF firepower

There has already been some discussion, notably among

the G20 at the Cannes Summit, of further increasing the

financial firepower of the IMF. G20 Finance Ministers will

return to these issues when they meet in the new year.

Mirroring its primary sources of funds, there are two basic

ways in which to increase the general resources that the

IMF has available to lend:

A further increase in IMF quota subscriptions. This

seems unlikely, with the last increase still winding its

way through a lengthy and cumbersome approval

process. It was also not among the options

mentioned by G20 leaders in their Cannes

communiqué.

Additional increases in IMF borrowing. There are a

variety of ways in which this could be done. The IMF

could, for example, borrow from the private sector

although it has never done so. The IMF’s current

borrowing takes place primarily through a multilateral

agreement, the "New Arrangements to Borrow"

(NAB). The quickest way, however, is through

bilateral agreements with individual countries. This is

the route that was followed after the last crisis. These

bilateral commitments were then folded into an

expanded NAB.

Our reading of the G20 meetings a few weeks ago was

that while the BRICS and others were reluctant to lend

directly to the EFSF, they were open to the idea of

providing support through the IMF, not least because the

IMF would then bear the credit risk. No firm pledges were

made, though the table below (showing the current

breakdown of bilateral credit lines to the IMF through the

NAB) shows the amounts that countries eventually

stumped up following the last crisis.

The US seems less enthusiastic about increasing the size

of the IMF. In his statement to G20 Finance Ministers in

mid-October, for example, Secretary Geither note that,

‚The IMF has a substantial arsenal of financial resources,

and we would support further use of those existing

resources to supplement a comprehensive, well-designed

European strategy alongside a more substantial

commitment of European resources‛.

Ultimately, however, the main stumbling block was an

unwillingness outside the euro area to commit resources

to a bigger IMF while the financial commitment from

Europe was itself unresolved.

A number of other proposals potentially involving the IMF

in providing financial support to Europe have been floated.

We go through these below and offer our views on

whether they are likely to work or garner much support.

Increased IMF Special Drawing Rights (SDRs).

Countries hold SDRs as part of their reserve assets and

are able, through the IMF, to exchange them for the freely

usable currencies of other IMF members (e.g. dollars or

euros). The IMF can create SDRs – it is (roughly) the IMF

equivalent of printing money. There have only ever been

three such SDR allocations. The last allocation of EUR

186bn in 2009 was by far the largest and the first since

1981. Some countries converted their allocations into

usable currencies which they then spent. Ukraine, for

example, used its allocation to pay Russia for gas

supplies; and Serbia used its allocation to finance its

budget. For the most part, however, countries held on to

their allocations.37

The problem with this as a means of providing financial

support to Europe is that SDRs are allocated in proportion

to a country’s quota. So for every EUR 10bn that would

get allocated to, say, Italy, the US would receive EUR

53bn because its quota is over five times the size of

Italy’s. It would be technically possible to have an SDR

allocation just for Europe, but it’s hard to see why other

countries would agree to this.38

37 Total SDR sales between the allocation in August 2009 and June 2011

were only about EUR 8bn. 38

There was a special one-time allocation of EUR 25bn in which some

countries received more than their quota share. But this part of efforts to



Pooling Euro area SDRs. There has been some

discussion of the euro area countries pooling their SDR

allocations, which could then be used to provide capital

for the EFSF. The current SDR holdings of the euro area

are about EUR 52bn, not insubstantial but certainly no

panacea in terms of increasing the size of the EFSF. Our

understanding is also that Germany does not support the

proposal.39

The IMF’s New Arrangements to Borrow (EUR bns)

Country commitments :

Eurozone 108.0 EM 66.4

Aust 4.1 Brazil 10.1

Bel 9.1 Russia 10.1

Cyp 0.4 India 10.1

Fin 2.6 China 36.1

Fra 21.6

Ger 29.3 Other EM 35.1

Gre 1.9 Chile 1.6

Ire 2.2 Israel 0.6

Ita 15.7 Hong Kong 0.4

Lux 1.1 Korea 7.6

Net 10.5 Kuwait 0.4

Por 1.8 Malaysia 0.4

Spa 7.7 Mexico 5.8

Philippines 0.4

Other DM 218.1 Poland 2.9

Australia 5.1 Saudi Arabia 12.9

Canada 8.8 Singapore 1.5

Denmark 3.7 South Africa 0.4

Japan 76.2 Thailand 0.4

New Zealand 0.7

Norway 4.5 Total 427.6

Sweden 5.1

Switzerland 12.6

UK 21.6

US 79.8


IMF administered accounts or trusts. In addition to its

general resources, the IMF has a number of administered

accounts and trusts that have been established to meet

specific purposes.40 The main requirement is that such

accounts need to be consistent with the purposes of the

IMF. One option would therefore be set up such an

account or trust for Europe, to which others could then

contribute financial resources. The IMF could then either

rebalance the IMF and address some obvious inequities, including the fact

that some members (those joining after 1981) had never received an SDR

allocation. 39

It is also not clear how using these SDRs as capital for the EFSF would

square with the IMF’s arrangements for ensuring that SDRs can be

converted into freely usable currencies. 40

Trusts (largely financed by donors) have been used to enable the IMF to

lend money to low-income countries on concessional terms or to provide

debt relief. Administered accounts have been used to enable countries to

finance technical assistant. Spain also used an administered account to

provide financing to Argentina alongside its IMF program in 2000-01.

lend these resources to euro area countries or, potentially,

buy bonds and/or lending to the EFSF.

We think this is unlikely to happen for three reasons: (i)

other countries will be reluctant to support a vehicle that

is designed solely for the benefit of Europe; (ii)

contributing countries rather than the IMF would still bear

the credit risk from such loans; and (iii) in contrast to the

extension of credit lines to the IMF (discussed above),

country contributions to an administered account or trust

could not be included as part of the contributing country’s

foreign reserves.

IMF as a conduit for ECB financing. This is essentially

the same option as above but simply involving the ECB.

As such, it could be a way of getting round the EU treaty

restrictions that have so far precluded larger ECB bond

purchases or lending to the EFSF. It would likely therefore

be subject to the same (German) objections.

Summary of options for IMF financing Loans to IMF

genera l resources

account

Loans to an IMF

administered

account/ trust SDR Allocation SDR Poo ling

Approval IMF board decision

(simple majority).

Funding from donor

country need to be

approved at the

national level (See

below).

IMF board decision

(simple majority).

Funding from donor

country need to be

approved at the

national level (see

below).

IMF board decision

with 85% majority

Country decision as to

how to use the

reserves (could be

national Treasury or the

national central banks).

Amount In 2009 EUR 428bn of

additional funding was

committed initially as

bilateral loans

subsequently folded

into an expended NAB

Only a few examples

in the past (e.g. loan

from Spain to

Argentina).

In 2009 increased the

SDR allocation by

EUR189bn

The current SDR

holdings of the EUR

area amount to

EUR52bn

Conditions Usual IMF procedure.

Loans will have

preferred creditor

status

Has to be‛ consistent

with the purpose of the

IMF‛. Could be more

flexible than IMF

General Resources: i.e.

does not need to be

limited to loans to IMF

member states nor

does it have to enjoy

preferred creditor

status.

Country decision as to

how to use the

reserves (could be the

central bank or the

fiscal authority). For

instance, Ukraine in

2009 exchanged its

SDR for hard currency

via the IMF and used

the proceeds to pay

Russia for gas

supplies

Not clear, but

presumably could be

rolled into the EFSF or

have EFSF like

procedure. ECB will

need to agree to

exchange the SDRs

against euros

Funding In most countries it is

the national Treasury

that provides the loan,

but the net debt is

unchanged as there is

a claim against the

IMF. In the case of

Germany, it is the

Bundesbank that

provides the loan,

without an impact on

the net debt position of

Germany.

The source could be

either national central

banks or national

Treasuries. May have

an impact on the net

debt position of the

lender

De facto money

printing by the IMF. In

accounting terms, the

national central banks

have increased

reserves and against it

a long term liability to

the IMF that never gets

called unless the

country exits the IMF

De facto money

printing by the ECB

Comments Non-EU countries have

withheld their support

pending further

financial commitment

from Europe.

Have more flexibility

than General Resources

usage. Not clear

however that non-EU

countries will agree to

take directly the credit

risk of the recipient

country. May also lead

to the loans being

accounted as debt in

the national accounts

A generalised SDR

issuance implies that

the US would receive a

disproportionate

amount of SDR relative

to Spain and Italy that

would presumably

need the funds. Also,

there is no

conditionality

automatically attached

to the use of the SDR.

Small amount

available.

Assessment Most likely outcome.

Can be agreed by the

next G20 meeting in

February. Would need

Bundesbank Approval

Less market friendly

than administered

account as the IMF

seniority may

complicate the return

to market for program

countries.

Unlikely and inefficient.

Would need to be

combined with SDR

pooling to be material.

Lacks conditionality for

using the funds. Not

clear why

Germany/ECB would

agree to this vs. other

alternatives.

Unlikely and too small

to matter. Not clear

why Germany/ECB

would agree to it vs.

other alternatives




Implications for EM

The current debate about increasing the financial

firepower of the IMF is largely about giving it sufficient

resources to increase its lending operations in the euro

area. Its current resources are adequate to handle the

most likely requests for financial assistance from EM,

though these resources would certainly be stretched if

one or two larger emerging markets, particularly Brazil but

also Turkey, were to request financial assistance (e.g. in

the form of Flexible Credit Lines or Precautionary and

Liquidity Lines).

The requests are most likely to come from emerging

Europe, where a toxic combination of relatively weaker

fundamentals and higher exposures to the euro area have

left several countries facing difficulties. Four countries in

the region (Poland, Romania, Serbia, and Macedonia)

already have IMF arrangements in place as a financial

safety net. Ukraine also has an arrangement although this

has been dormant for the past year because Ukraine has

been unable to meet the conditions required (e.g. higher

domestic gas tariffs) for further disbursements of financial

support.

Current IMF programs for EM

Type Amt (USD bn) % Quota

Colombia Flexible Credit Line 6.1 500

Macedonia Precautionary Credit Line 0.3 314

Mex ico Flexible Credit Line 74.0 1304

Poland Flexible Credit Line 30.0 1135

Romania Precautionary Standby 4.8 300

Serb ia Precautionary Standby 1.5 200

Sri Lanka Standby Arrangement 2.6 400

Ukra ine Standby Arrangement 15.6 729


Hungary has announced that it is seeking a precautionary

financing package with the IMF (and EU). The government

has indicated that it would like an insurance-type

arrangement (i.e. upfront access with little or no policy

conditionality). But our assessment is that they are more

likely to get a traditional Precautionary Standby

Arrangement (like Romania and Serbia) – see also the

Hungary section later in this EM Monthly for a more

detailed discussion of our views on this issue, including

some of the potential policy sticking points in the

negotiations.

Other countries in south eastern Europe (e.g. Croatia)

could also be candidates for IMF financial assistance in

this environment. Outside of Europe, Egypt’s external

position remains under significant pressure with reserves

more than halving since the revolution earlier this year.

The government had reached preliminary agreement on a

USD 3bn Standby Arrangement with the IMF but stopped

short of going forward with the arrangement for political

reasons.

Robert Burgess, London, (44) 20 7547 1930



EMEA Domestic Debt: Supply and Demand in Focus

2011 was a positive year for fiscal performance in

most EMEA countries. In most instances fiscal

targets were exceeded and debt issuance programs

progressed without interruption. A performance that

contrasts with the situation prevailing in developed

markets and more specifically Eurozone countries.

2012 is likely to see a marginal increase in net

issuance in our view, but the growth in volume is

likely to be in line with GDP and the increase is

concentrated in states that enjoy a comfortable fiscal

position (Turkey, Russia)

EMEA countries have been cautious in managing

their debt issuance plan, often front-loading issuance

(Poland, Hungary), pre-funding for 2012 (Poland) and

preserving healthy cash balances (Poland, South

Africa). Hungary has initiated talks with IMF with the

aim of accessing a precautionary credit line.

EM local currency debt funds continued to see strong

inflows, but the momentum has been lost in the

second half of the year as Eurozone worries forced a

derisiking across financial markets.

Appetite for local currency debt has seemed at times

indiscriminate (Hungary) and excessive (Poland, South

Africa). Non-residents share of local currency

government debt markets is at an all time high in

Poland, Russia, South Africa, Turkey, Hungary

We see risks of outflows as highest in Eastern

Europe: Hungary and to a much lesser extent Poland.

On the other hand the likely introduction of

Euroclearable government bonds in Russia should

attract inflows

In the following note we take stock of the lessons

learned in 2011 and address the specifics of each

market in terms of supply/demand over 2012

Inflows have been on an exponential trend (USD bn)


…modest outflows despite a negative performance


Foreigner positioning is at new highs in most markets

TH

ZA

TR

RU

PL

MY

MX

KR

ID

HU

CZ

BR

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0% 5% 10% 15% 20% 25% 30% 35% 40%

Foreign Holdings of Domestic Government Debt (latest data)

Foreign Holdings of Domestic Government Debt on 31-Aug-08


2011: Lessons from a volatile year

A combination of factors arguably made EM Local debt

appear to be the ideal asset class in which to invest in

2011. The global backdrop was characterized by low

expectations for global growth/inflation which should be

supportive for rates However, investors in DM rates

products were faced with new risks: the potential

negative impact of successive rounds of QE on the USD,

financial repression via the imposition of negative real

yields and the emerging risk of default in several Eurozone

names. As such EM, enjoyed better fiscal fundamentals,

and seemed to offer an ideal investment environment.

The asset class has for example attracted much more

inflows than EM equities.



Despite a positive start to the year, performance turned in

the third and fourth quarter as DM troubles caught up

with EM investors via the USD funding channel. The

spread of Greek crisis to other Eurozone assets made US

money market funds reluctant to fund European banks,

thereby triggering a scramble for USD funding which

penalized EM FX. The impact was severe enough to cause

fears of FX pass-through into inflation. Turkey and Russia

were forced to allow money market rates to rise. As a

result the benchmark index has delivered a negative

performance (at time of writing -3%).

Some investors would have been reassured that outflows

were relatively modest at (-2.5% of total assets) and the

trend reversed quickly, compared to EM hard currency.

However, anecdotal evidence suggests that bond

investors themselves were at least partly responsible for

the weak EM FX performance in an attempt to hedge

bond holdings via a more liquid instrument. The low risk of

default and the absence of client redemptions make it

hard to justify the transaction costs of an outright

reduction in bond holdings. This form of ‚synthetic

outflows‛ via FX hedging or even over-hedging (whereby

investors attempt to hedge both FX and duration exposure

via FX) can lead to higher rates with central banks forced

to react to FX weakness to reduce the FX-pass through to

inflation It therefore seems to us that even in the relatively

supportive environment of 2011, weak technicals did play

a role in the negative performance for the year.

At the start of 2012, Turkey looks to be the largest

underweight position, while South Africa is the biggest

overweight in EMEA.

In the following section, we analyse on a country by

country basis the supply/demand picture for 2012 and

compare this to the existing positioning.

Local debt performance turned in September

-6

-4

-2

0

2

4

6

8

10

01/11 04/11 07/11 10/11

EM LC Index

EM LC Index Hedged

Year to date total returns (%)


FX positioning turned sharply since September


Turkey is the most underweight position

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5


Oct 11

Prev. Mth

Exposure Z-score*


change in exposure


Hungary: an arduous 2012

Fiscal: Our economists expect GDP growth of -0.8% for

2012 after an expected 1.4% outturn for 2011. The

government has penciled in 2.5% of GDP fiscal deficit in

2012, which we believe is too optimistic and expect the

deficit to be close to 3.2%.

Supply: Favourable risk appetite in the first half of the year

allowed Hungary to issue significantly more than planned

at the end of 2010. Indeed, in 2011, gross issuance in

Hungarian bonds was approximately HUF 1.7tn versus

HUF 1.5tn planned. In 2012, DB forecasts a 3.2% deficit

in Hungary from a 1.9% surplus in 2011 which translates

to an increase in net financing need by approximately HUF

360bn. However, we expect gross issuance next year to

increase only by HUF 220bn to HUF 1948bn as

redemptions are set to fall to a low of HUF 738bn. We

assume zero net issuance in the external debt market. We

expect Hungary to look to issue EUR 4-4.5bn in external

debt in 2012, almost unchanged from 2011. This financing



is intended to cover repayment to the IMF and

redemptions in the Eurobond market. Such issuance will

clearly be susceptible to the external environment. If the

market is not conducive to such issuance then this could

result in higher domestic issuance to compensate

Demand: We were surprised by the resilience of demand

for HGBs despite three factors: 1/ Worsening outright and

relative performance of Hungarian bonds since August. 2/

Deterioration of the economic prospects in the Eurozone

3/ Investor unfriendly government measures that

culminated in the loss of investment grade status.

A probable explanation is that demand was supported by

benchmarked investors who adopted an overall

underweight position but not a deep underweight

considering the cost of carry.

The government’s cancellation of USD 4.5bln of bonds

held by pension funds was a one off event in 2011.

However, going forward the disappearance of yearly

transfers (amounting to 8 % of GDP) to those funds will

imply either a further increase in non-residents take up or

an increase in banks share. Both instances imply higher

yields at the back-end of the curve.

Foreigners compensated for pension funds forced exit


Poland: Gross issuance increases, but net

issuance falls

Fiscal: We expect the current state budget which targets

sub-3% of GDP fiscal gap to be revised, since the growth

estimate at 4% does not take into account the increased

likelihood of weak economic performance in the

Eurozone. Having said that, the pre-financing already

executed in 2011 (10% of issuance needs) and MinFin’s

ample cash buffer (2.8% of GDP), reduce roll-over risks on

the domestic debt front in 2012. One source of worry is

the current talk of redefinition of the 55% debt/GDP

constitutional limit from Gross to Net, since that may

herald more fiscal drift in the future.

Supply: In the financing outlook for 2012, it is worth

highlighting the increase in redemptions in T-bonds in

2012 from PLN 101bn in 2011 to PLN 123bn in 2012. The

deficit for 2012 is expected to remain approximately the

same at PLN 35bn. Hence, gross issuance in Polish T-

bonds is expected to reach PLN 123bn in 2012 versus

PLN 100.5bn in 2011. Issuance in the external debt

market is estimate by MinFin to remain the same at PLN

24.1bn gross issuance. Overall, the issuance program

plans to increase the proportion of domestic debt

issuance denominated in zloty from 61% in 2011 to 70%

in 2012.

Demand: The reduction in government transfers to

pension funds and rather timid demand for banks which

preferred to allocate their balance sheet to higher margin

loan demand, have left the treasury reliant on external

financing to cover the sharp increase in net issuance. We

are concerned that a deepening of the Eurozone crisis

would cause foreigners to reduce exposure and the bond

curve to steepen further.

Increased reliance on external funding

0%

10%

20%

30%

40%

50%

60%(External + foreign held PLN debt)% of state debt




… has led to a widening of ASW41


South Africa: Stable issuance plan

Fiscal: According to the Medium Term Budget Policy

Statement (MTBPS) the Treasury sees a narrowing of the

fiscal gap from current 5.5% to 3.3% of GDP by

2014/2015.

Supply: The borrowing requirement was revised higher by

R 9bn, R 20bn and R 27bn over the next 3 years.

However, the bond markets were not rattled by this

development as the announcement was made that cash

balances will be used to finance these additional

shortfalls. Consequently, this means that net issuance in

T-bonds in FY 2012 is set to be approximately R 135bn,

the same as FY 2011. Net issuance in T-bills too is

expected to remain unchanged at R 22bn. Therefore, we

do not expect any immediate change to the weekly fixed-

rate (R 2.1bn every Tuesday), and inflation-linked bonds (R

800mn every Friday) auctions that are held currently.

However, it is likely that if the global markets recover,

issuance at the back-end is stepped up again.

Demand: A striking feature of the market has been the

increase in foreigner holdings compared to pre-2007. It is

clear that this was linked to the huge increase in issuance

over the past two years and the lack of willingness/ability

of the domestic investor base to increase purchases at

the same pace as supply. In the case of the PIC, the

largest domestic pension fund, it seems that preference

lies either with linkers or higher yielding Parastatal debt.

Mutual funds have also lagged in terms of demand due to

the positive performance of equities. The local domestic

base continues to hold an insular view of the market that

states that long-term yields should settle around 8.5-9%

(inflation of 5.5-6% + real yields of 3% + term premium).

41 The columns represent the annual 10-90% range, the dash shows the

annual median and the square is the latest value

This contrasts with the bullish view expressed by foreign

investors who have been more focused on the lack of

global inflationary pressures and the high yield

differentials offered by exposure to South Africa. South

Africa is currently the largest overweight for real money

investors42, which suggests reducing positions at times

where rates rally away from the ‚local bid‛ level and

where risks of outflows from EM local debt are high.

The share of non-resident holders is at the highs

0%

5%

10%

15%

20%

25%

30%

35%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11

Share of non-residents in the local bond market


Turkey: Comfortable fiscal position

Fiscal: The primary surplus and overall budget deficit is

projected to be close to 2% of GDP and below 1% of

GDP, respectively in 2011.

Supply: Net issuance in the domestic market in Turkey is

set to significantly increase in 2012 to reach TRY 37.5bn

from TRY 22bn in 2011. This is despite domestic bond

redemption falling to TRY 81.6bn next year from TRY

97.1bn in 2011. In the FX market, the Treasury plans to

issue bonds almost at the same levels as 2011(both gross

and net), hence keeping net issuance in external market at

under TRY 1bn. The increase in net issuance in the

domestic market is being caused by a lower primary

budget balance next year (2%) from 2.5% in 2011

Demand: Foreign investors have increased their

underweight position in Turkey due to the uncertainty

created by the complex monetary policy strategy

conducted by the CBT. In a scenario of a controlled

economic slowdown, that helps rebalancing the economy,

Turkish paper could see a large bid from non-residents.

While the main risks lie in the local banks ability to roll

42 See 'A Closer Look at Real-Money Positioning' also in this

report.



over about USD 32 bln in short-term debt, mostly owed to

European banks.

Tight TRY liquidity has cheapened bonds


Russia: Likely to see a surge in foreign

participation

Fiscal: Russia seems in line to post a 0.2%/GDP fiscal

surplus, thanks to higher than expected oil prices. The

overall performance for next year will be extremely

dependent on oil prices, but MinFin predicts an increase

in the non-oil budget deficit to 11%/GDP from 10.2%

Supply: MinFIn tends to be extremely flexible and

opportunistic in conducting its bond issuance plan. We

expect an average of RUB 20 bln/ week supply with an

average maturity of 7Y.

Demand: Preparations for enabling Euroclearability of OFZ

bonds has entered its final stages. We expect this to

increase foreign demand for OFZ paper, particularly that

Russia’s weight in the benchmark index has become

significant. Based on the success of Russia’s first RUB

Eurobond earlier this year, it is possible to envisage that

foreigners could take up 20% of new issuance. To put

things in perspective, their share has consistently

averages below 5% in the past few years.

The domestic debt market is growing rapidly

0

10

20

30

40

50

60

70

y/y % growth in outstanding RUB debt


Israel: Net issuance increases as fiscal backdrop

gets challenging

Fiscal: In 2011, domestic the deficit continued to remain

above the seasonal path and is likely to exceed the

Ministry of Finance's working target of 2.9% by c0.4pp to

reach 3.3% of GDP (that is ILS 28.2bn). DB economics

attribute this to a weakening domestic demand and

possibility of higher spending in light of public protests. In

2012, growth is set to moderate and we expect the deficit

to worsen to 3.5% percent of GDP which translates to

approximately ILS 32bn as the budget deficit. This should

increase net issuance in the Israeli government paper

market from ILS 7.2bn in 2011 to ILS 11bn in 2012.

Supply: Repayment to the market in 2012 is likely to be

ILS 46.7bn, ILS 5.1bn lower than 2011. However, an

increase in the deficit offsets the fall in redemptions and

hence gross issuance in 2012 is projected to be only

marginally lower at ILS 57.6bn. Net issuance consequently

increases from ILS 7.2bn in 2011 to ILS 11bn in 2012, a

52% rise.

Demand: Foreign involvement in bonds has remained low

at 4% of the total market. We see this as a supportive

factor for adding exposure.

Lamine Bougueroua, London, (44) 20 7545 2402

The author of this report would like to thank Raj

Chatterjee, an employee of CIB Centre, a wholly owned

subsidiary of Deutsche Bank, for his contribution to this

piece



Appendix 1: Historical Monthly DV01 issuance

South Africa Turkey

0.0

0.4

0.8

1.2

1.6

2.0

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

USD mm

-

1.0

2.0

3.0

4.0

5.0

Jan06 Jan07 Jan08 Jan09 Jan10 Jan11

USD mm



Hungary Poland

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80


USD mm

0

1

2

3

4

5


USD mm





Appendix 2: Expected issuance program

Expected issuance in EMEA (% of projected GDP)

0%

2%

4%

6%

8%

10%

12%

14%

16%

2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F

Gross Issuance % GDP

Net Issuance % GDP

HU PL

ZA TR

IL RU


Expected issuance in EMEA (absolute amounts)

0

20

40

60

80

100

120

2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F

Gross Issuance (USD bn)

Net Issuance (USD bn)

HU

PL ZA

TR

IL RU




Appendix 3: 2012 Local bonds redemption schedule

bonds (local currency bn)

CZ

HU

IL

PL

RU

ZA

TR

Source: Global M arkets Research

0.00.0 0.0 0.014.8

0.0

0.0 0.0393.0

12.30.0 12.2 4.4

13.6 8.9 11.9 5.6 0.5 18.3

4.4 1.3 11.6 11.7 0.0 0.0

0.0 0.0 44.0 181.0

1.30.0

0.0 0.00.0 0.0 26.5

45.0 0.0 0.0 44.0 45.0

25.514.8 0.0 0.0 0.0 26.7

0.0 0.0 0.0

4.1 6.4 0.8

0.0368.6 0.0 0.0

DecJan Feb Mar Apr

0.0 0.0 0.0 0.0 0.045.3 70.3 0.0

0.0

Sep Oct NovJul Aug

0.0

0.5 16.5 7.3

2012 redemptions

May Jun

0.0 0.00.0 0.0

13.9

0.0

0.0 42.1

0.0 8.52.7 2.4 5.1 4.5



Argentina B3/B-/B Moodys /S&P/ /Fitch

Economic Outlook: The government seems to be

ready to combine some fiscal consolidation with

tighter FX and price controls, and labor union

persuasion aiming at managing a soft landing to a 5%

growth pace. Nonetheless, inflation stability together

with FX sustainability will demand an even weaker

economy. The sooner the government accepts that

reality, the smoother the expected economic path

ahead. A likely resistance will only accelerate

economic slowdown, and short term inflation.

Main Risks: Further confirmation of current policy

continuity could only preserve an on-going currency

run and a severe capital flight. Lack of investment

amid fiscal expansion, together with unfriendly

policies, could maintain high inflation, reinforcing

fears of potential financial stress. The current pace of

real appreciation is leading to a rapid and sharp

deterioration of external accounts, while strong fiscal

spending is adding stretch to difficult financing.

Strategy Recommendations: Remain neutral in the

currency, but the front-end of the NDF curve offers

attractive carry for those willing to sustain elevated

risk. Continue avoiding the CER curve which offers

unfavorable FX/inflation breakeven. Badlar-linked

bonds are more attractive for those seeking local

peso exposure. Stay neutral on external debt but be

conservative on duration, favor credit to Warrants and

favor global bonds (especially the Global 17s) over

local law bonds. In addition we recommend long

basis on Global 17s vs. 5Y CDS.

Macro view

Time for policy fine tuning

On November 24th, a month after her landsliding re-

election victory, President Cristina Fernandez de Kirchner

(CFK) addressed businessmen at the closing of the

Industrial Chamber´s (UIA) Annual Conference. In this

speech, CFK appeared setting the guidelines for her new

four year mandate that starts on December 10th,

acknowledging the need to improve policies fostering

investment while containing inflation. CFK also stated that

her government does not like extraordinary rents from

business and that growth, not inflation, should be the

target of a proper national policy. Nonetheless, the overall

pro-business tone of the speech was a welcome change

as well as the focus on inflation and investment.

A few days earlier, Economy Minister Amado Boudou and

Planning Minister Julio de Vido announced further

subsidies removal to the once announced at the beginning

of the month. From December 1st, subsidies will be cut

to big companies in the fuel sector, natural gas

production, bio-fuels and agrochemicals industry. Mr.

Boudou noted that, as a consequence, government

spending will be reduced by ARS 3.468mn. Subsidies cuts

will also be extended on January 2012 to high income

homes and, according to authorities, this will represent an

extra ARS1500mn saving. Additionally, Mr. De Vido

announced the creation of a register for those consumers

that voluntarily want to renounce to subsidies on water,

gas and electricity consumption. The cuts announced are

still symbolic for the size of subsidies in place (at best

10%-15% of an estimated total subsidy bill of 4% of

GDP), but the government is at least recognizing that

subsidies cannot longer be extended or increased.

The ‚prudent‛ set of policy initiatives even included a

number of comments asking for moderation in wage

demands. Furthermore, President CFK explicitly rejected

the convenience of a rule based distribution of corporate

profits to the worker force to be discussed in Congress,

as lobbied by labor unions. CFK argued that not all

companies are in the same situation and such a

discussion should be a negotiation between interested

parties without intervention of the Congress. For many

these remarks were a clear warning message to labor

union leaders that seem ready to increase confrontation

with the government, as demonstrated in the recent

conflict in the state owned airline.

On the other extreme, the government further reinforced

constrains on dollar buying by individuals or corporations.

The local newspapers still report that approvals from the

tax authority have remained in the 20%-30% of requests.

In addition, the Central Bank and the government have

been persuading corporation and banks to postpone any

potential demand for dollars, from imports and trade

finance, to transfers abroad in any concept. As a result the

CB has been able to stop the heavy drain of dollars of

previous weeks but creating a new source of capital flight:

dollar deposit withdrawals. As of November 18th the CB

reported the fall of some USD2.2bn of dollar deposits in

the system during the month or 15% of the total held

before the last FX measures were introduced. This flow is

believed to have slowed down in recent days but the

system is still losing an estimated USD200mn a week. All

this notwithstanding, Argentina is projected to have

already experienced USD24bn of foreign asset formation

in the first eleven months of the year, representing more

than 5% of GDP.

The inflation/FX threat

As discussed previously, we believe policy continuity

does face a strong challenge. In the very short term,

capital flight is still the main threat to stability. A simple

solution, in our minds, calls for a faster pace of currency

depreciation and tighter monetary and fiscal policies. The



faster depreciation rate seems a possibility but the

authorities are revealing strong fear to float, probably

misled by past experiences of currency moves in the

country. More importantly, it is still unclear whether the

government will accept tight policies. Needless to say, the

absence of more conservative policies could only

accelerate capital flight and economic slowdown. In the

end, a weaker economy would allow for a necessary

convergence between inflation and depreciation rate. The

question is whether policy hesitation would push for

inflation acceleration before a recession is generated or

smooth the slowdown process. In the medium term, the

challenge is about sustainable growth. In our view,

without a more-friendly policy set up for private sector

investment, Argentina might grow at a much slower pace

than in the last few years with embedded volatility.

The next few days might reveal some indications about

the government’s true understanding of the problems and

its will to fix them. The very first reaction was not exactly

encouraging, as the authorities simply decided to move to

much tighter capital controls as a way of moderating hard

currency accumulation. This decision does not only reveal

the risk of extreme policy preferences in some key policy

makers; it also made it evident that there is not a single

individual in charge of economic policy. The President

appears to be making the final calls even in technical

matters. We still believe that the confirmation of Minister

Boudou’s leadership in fiscal and monetary policy

decisions would be a positive development. In this regard,

the naming of current Secretary of Finance Lorenzino as

the new Minister of Finance could signal a vote of

confidence for Minister Boudou, who is believed to favor

pragmatism over blind policy continuation. In the last few

days, however, Minister Boudou´s looked more detached

from economic policy initiatives, while new candidates are

emerging, like re-elected Tucuman governor Jose

Alperovich, who could be a less technical choice for the

task but yet a successful entrepreneur.

The very first recognition that subsidies will have to be

revised represents a welcomed leap forward.

Implementation risks are huge and a real improvement

will demand solid conviction to confront clear political

costs. The absence of tighter monetary policy is rather

disappointing though. Private banks have started to offer

higher interest rates to preserve their clients as a stable

source of funding, but the Central Bank is still pushing

short term rates low, in the 10% range, or unacceptably

low to compete with 23% inflation or any consistent

exchange rate expectation.

We hope the government will take advantage of the tighter

controls to let the currency move more in line with inflation

expectations (20% a year or so), which in our view is the

main reason behind the growing demand for the dollars. If

accompanied by the CB validation of short-term rates in a

similar range, we believe this could be enough to eventually

stop the capital flight. More international reserve losses

seem inevitable at this stage, but stability could be regained

over time with clear policy signals.

Alternatively, the CB could keep the currency in the current

path, or at a much slower depreciation rate, while

maintaining all controls or even tightening some of them

further. This could place the authorities in a dead end,

where reserves could be going away from the banks and

the Central Bank, while standard policies could be

becoming increasingly ineffective to re-create credibility in

the short term.

Given all the considerations above, and relatively high

international reserve levels at USD46bn, we foresee a

gradual slide of the peso during the next few months.

Afterwards, the real economy will likely help to close the

gap between expected inflation and currency depreciation,

as a recession will be the likely outcome of increased

control tightening. It is worth recalling, Argentina’s private

and public sectors have very little external debt (USD128bn

gross debt or 30% of GDP, or less than the USD180bn in

external assets held by residents), thus it only takes a small

depreciation or a significant economic slowdown to

rebalance the dollar flows of the country without triggering

major balance sheets or real problems like in the past.

On the positive side, La Nacion newspaper reported last

week feedback from three European countries that are

expecting to see progress on Paris Club debt after the new

Minister of Finance is named. The report suggested that a

deal could include a 4 year payment plan with a large initial

disbursement. An important caveat: officials consulted by

the newspaper noted that the potential benefit in terms of

FDI could be very limited given increasing trade and capital

restrictions in Argentina. As of now, we should be very

cautious on any Paris Club deal mainly because of

increased hard currency scarcity. Argentina can only avoid

the IMF involvement by canceling the debt (even in

installments given some US support). Government officials

argued that FDI flows would largely compensate the initial

disbursement but that seems rather difficult in the current

circumstances. La Nacion is talking about USD6.0bn initial

disbursement which would add to the USD6.0bn dollar

financing gap Argentina will face in 2012, as discussed in

detail below.

The 2012 outlook

In the next few months, we foresee a rapid deceleration

of the economy, in line with expectations that the

government will keep tight controls on the current and the

capital account of the balance of payments for the time

being. Exchange rate flexibility is likely to be gained only

after the economy is weaker and inflationary pressures

are subsiding. Thus, we anticipate a gradual slowdown in

the pace of economic growth towards a less than 3% YoY

range by the last quarter of 2012, from 6%-6.5%

currently. In addition, a weak economy, together with an



‚expensive‛ peso, would only make more evident the

worrisome fiscal and external dynamic, forcing reduced

fiscal spending and weaker imports to eventually help

equilibrate those trends. Whether the government can

avoid the temptation to try help the economy with fiscal

expansion is the pending question mark. Fiscal expansion

with tensions in the FX market and inflation could only

exacerbate the problem, just deepening the economic

slowdown. In other words, risks to our 2012 growth

forecasts are biased to the downside.

Thus, under a muddling through scenario, the lower

economic growth will allow inflation not to accelerate

much despite increasing pace of peso depreciation and

tariff increases, but still remaining around 25% YoY.

Similarly, this will permit the trade balance to remain high

enough to avoid a major deterioration in the current

account. Furthermore, helped by different barriers to

import and transfer money abroad, the current account

could end up with a deficit of less than 0.5% of GDP in

2012. In this regard, it is worth looking at recent trade

numbers, where imports growth is decelerating rapidly

(29%-27% YoY in September-October from around 40%

in previous months).

Notwithstanding a relatively small external imbalance

projected for next year, financing it could be a real

challenge, in particular if we continue to see some level of

capital flight. The latter is unavoidable as stricter controls

will simply foster misreporting of trade transactions and

the seeking of any possible loophole to transfer dollars

abroad. We estimate international reserves will fall by

USD7.2bn this year, mostly explained by USD25.6bn

capital formation abroad, and despite increased private

sector net financing for more than USD6.0bn. Based on

current trends, reserve loss could be similar next year if

capital flight were to slow from this year peak to

USD15.0bn average of the last few years. The table below

shows the main drivers of the balance of payment

forecasts for next year.

A full flavor of the potential scarcity of dollars next year is

only completed once public sector financing is added to

the picture. The table below summarizes this financing

task, netting out government holdings and also multilateral

re-financing, both expected to provide a full rollover.

Thanks to Central Bank reserves and advances, the

government basically had more resources than needed in

2010 and this year, fostering the accumulation of reserves

at the treasury. This could not prevent this year that

international reserves at the Central Bank are estimated to

be falling by more than USD7.0bn by the end of this year.

This situation becomes even more critical in 2012, as the

Central Bank will not have excess reserves to allocate for

government debt payments. It is worth noting that excess

reserves are defined as international reserves at the

Central Bank that exceed money base at the current

exchange rate.

Balance of payment forecast (USD mn)

2010 2011 2012

Current account 3,081 3,713 (2,194) % GDP 0.84% 0.85% -0.47%

External debt amortization 47,596 50,874 56,537 Public 5,342 5,277 6,775

Private 42,254 45,597 49,762

Debt new issues 54,920 55,773 56,175

Public 3,234 2,960 3,656

Private 51,686 52,813 52,519

BCRA (2,910) 3,500 1,500

Net FDI 5,372 6,298 7,055

Net portfolio flows (11,410) (25,650) (15,000)

Errors and valuation (2,700) - -

Change in Reserves 4,157 (7,240) (7,000) Source: Economic Ministry, Central Bank, and Deutsche Bank Research

After the election, there are probably no severe political or

institutional obstacles to the government’s continued use

of Central Bank reserves after changing the existing

legislation. Nonetheless, any additional fiscal use of CB

international reserves is going to directly affect the net

international reserve level. In the past, ample trade

surpluses and moderated capital flight have allowed the

CB to compensate reserve losses from fiscal financing

with true trade surplus. In the months to come, the trade

balance is unlikely to be large enough to prevent a further

decline in international reserves. Thus, this evident

weakening of the CB balance sheet could create another

powerful motive for capital flight to continue or even

accelerate unless policy changes are implemented.

Financing constrains might be biding soon (USD mn)

2010 2011 2012

Net amortizations 4,775 4,859 4,758

Net interest payments 2900 3100 3338Warrants (exc. Public holdings) - 1,543 2,106

Total financing needs 7,675 9,502 10,202

Primary surplus (exc. BCRA & ANSES profits) 139 (2,731) (1,606)

%GDP 0.0% -0.6% -0.3%BCRA & ANSES profits 6,256 5,821 4,902

Net financing needs 1,279 6,412 6,906

BCRA reserves 9,500 9,877 -

BCRA advances 2,549 3,464 1,500

Banco Nacion 1,612 2,667 -

Financing gap (12,382) (9,596) 5,406

Source: Economic Ministry, Central Bank, and Deutsche Bank Research

As we noted repeatedly, public sector financing in

Argentina is greatly simplified by high inflation, as it

provides relatively cheap (short term!) financing sources

as long as money demands remain stable. This,

unfortunately, does not solve the dollar financing

conundrum that demands improved policies, and/or a

weaker economy, or a weaker currency in real terms.

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



Investment strategy

FX: Managing a difficult trade-off. The pressure on the

currency continues to increase but the central bank seems

engaged in avoiding any meaningful depreciation. Amid

increasing volatility in global financial markets, the ARS

has weakened approximately 1% per month during the

last 2 months. In our view, the government will find

increasingly difficult to continue with this strategy due to

the combination of worrisome levels of capital flight and

double digit inflation. Additionally, the bleeding of

international reserves has accelerated after the

implementation of the latest FX measures. The freely

available reserves -those in excess of the monetary base

at the current exchange rate- have now disappeared. If the

government insists in using the central bank as financing

source, the pressures in the currency will continue to

mount. Nevertheless, the NFD curve is already pricing a

depreciation of 30% in 12M, which might be excessive.

Due to elevated risks and low liquidity we recommend

avoiding exposure to this curve, but some investors may

find attractive the elevated carry in the front-end (1M

offers 31% implied yield versus 3% depreciation).

Rates: Not longer attractive. With real yields in low

double digits, a compensation for inflation which does not

reflect macroeconomic dynamics, and expected high

depreciation of the currency, CER-linked bonds do not

offer an attractive return for foreign investors. Additionally,

the risks affecting the currency are amplified for the blue-

chip swap. Apart from potential government measures

affecting this transaction, liquidity could dry very rapidly. In

relative terms, we continue to favour Badlar linkers, which

benefit from nominal instability. The recent withdrawal of

deposits made evident that the central bank will find

increasingly difficult to contain nominal interest rates.

Credit: Neutral. The external risk environment in 2012 is

unlikely to be supportive for Argentina, and we remain

doubtful there will be any meaningful policy changes.

What prevent us from being underweight are the

attractive valuation and the risk of squeeze as reaction to a

positive headline. We stay long Boden 12s (hold to

maturity) for carry, and overall are conservative on

duration. In addition, extending duration on the local law

curve (via placing bonds to Anses) will likely one of the

main financing vehicles for the government in 2012 due to

declining reserves, and this will not be supportive to the

long end of the local law curve from a technical

perspective. We favour the Global 17s over the local law

bonds (switching from Boden 15s). We also recommend

buying basis on Global 17s vs. 5Y CDS. Finally, we remain

of the view that GDP Warrants are no more than a

leverage beta pay over credit, and as such, the global

bonds arguably offers superior risk/reward.

Mauro Roca, New York, (1) 212 250 8609

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

Argentina: Deutsche Bank forecasts

2010 2011E 2012F 2013F

National Income

Nominal GDP (USD bn) 368 439 475 491

Population (m) 40.1 40.5 41.0 41.5

GDP per capita (USD) 9,169 10,936 11,576 11,854

Real GDP (YoY%) 9.2 7.3 3.1 2.9

Priv. consumption 9.0 8.9 2.8 2.7

Gov't consumption 9.4 13.2 7.5 5.0

Gross capital formation 15.5 12.2 4.0 3.6

Exports 14.6 5.4 7.1 6.0

Imports 34.0 19.3 9.7 7.2

Prices, Money and Banking CPI (YoY%) (*) 25.2 23.1 25.4 22.6

Broad money (M2) 28.0 33.0 28.0 22.0

Bank credit (YoY%) 37.8 33.4 28.0 22.0

Fiscal Accounts (% of GDP)

Budget surplus -1.5 -2.3 -2.0 -1.5

Gov't spending 30.0 31.6 31.3 31.1

Gov't revenue 28.4 29.3 29.3 29.6

Primary surplus 0.0 -0.6 -0.3 0.2

External Accounts (USD bn)

Merchandise exports 68.1 85.1 87.8 92.5

Merchandise imports 56.5 75.0 83.8 89.5

Trade balance 11.6 10.1 4.0 3.0

% of GDP 3.2 2.3 0.8 0.6

Current account balance 3.1 3.7 -2.2 -1.7

% of GDP 0.8 0.8 -0.5 -0.3

FDI (net) 5.4 4.3 3.4 2.8

FX reserves (USD bn) 52.2 44.9 37.9 33.4

FX rate (eop) ARS/USD 3.98 4.35 5.21 6.24

Debt Indicators (% of GDP)

Government debt 23.8 21.8 22.3 23.6

Domestic 9.8 9.0 9.2 9.8

External 13.9 12.8 13.0 13.8

Total external debt 35.0 30.9 29.7 29.3

in USD bn 128.6 135.7 141.1 143.8

Short-term (% of total) 35.5 35.9 42.0 42.0

General

Industrial production (YoY)

(nominal) 8.7 4.6 3.1 2.9

Unemployment (%) 7.3 7.1 7.5 7.5

Financial Markets (EOP) Current 3M 6M 12M

Overnight rate 10.3 13.5 17.0 19.5

3-month Baibor 12.8 14.7 18.5 20.5

ARS/USD 4.28 4.51 4.76 5.17 Source: DB Global Markets Research, National Sources



Brazil Baa2(pos)/BBB/BBB Moody’s/S&P/Fitch

Economic Outlook: The government has showed

that it intends to use all possible instruments to

prevent a strong economic deceleration by easing

monetary policy aggressively, revoking some ‚macro-

prudential‛ measures, and introducing fiscal

measures to stimulate consumption. Therefore, we

expect the economy to grow slightly above 3% in

2012 despite the bleak global outlook. Although

inflation is poised to decelerate in the next months

due to the recent economic slowdown and lower

commodity prices, it will likely remain above 5% due

to high inertia and aggressive monetary easing.

Main Risks: The government’s initiative to

aggressively ease monetary policy to prevent a

significant economic slowdown could damage its

credibility and lead to permanently higher inflation,

especially if not accompanied by the promised fiscal

austerity. The large increase in the minimum wage

and mounting pressure on the government to

increase investment in infrastructure do not bode well

for fiscal restraint in 2012. The BRL remains

vulnerable to lower commodity prices.

Strategy Recommendations: Take profits on long

1M USD/BRL FVA and enter zero-cost 1M USD/BRL

put spread Take profits on Jul ’12- Jan ’17 steepener

and enter Jan ’13- Jan15’ flattener. Stay neutral on

external debt and continue to favor 41s and 40s (to

call) vs. 21s. In addition, we favor short basis at the

10Y sector as a tactical trade.

Macro view

We expect the Brazilian economy to grow 3.0% in

2011 and 3.3% in 2012. The economy decelerated

significantly in 3Q11, reflecting tighter fiscal and monetary

policies, as well as contagion from Europe’s never-ending

debt crisis. The slowdown was particularly strong in the

manufacturing sector, as industrial production dropped a

seasonally-adjusted 0.8% QoQ in 3Q11 even after falling

0.6% QoQ in 2Q11. The sector has also been hurt by an

increase in competition from imported goods (mainly due

to the strong BRL), and its malaise is attested by the

steady decline in business confidence (the FGV index of

business confidence dropped 12% between December

2010 and November 2011) and capacity utilization (which

reached 83.3% in November, the lowest level in two

years). Due to weak industrial production, we estimate

that GDP dropped a seasonally-adjusted 0.2% in 3Q11.

We expect a mild recovery in 4Q11 (+0.3% QoQ) due to

the incipient effect of the monetary easing and the recent

measures to stimulate consumption, but are keeping our

2011 GDP growth forecast unchanged at 3.0%. In 2012,

the economy will face a challenging international

environment with a recession in Europe and tighter global

credit conditions. Thus, although we believe that

additional monetary and fiscal easing and the unwinding

of the ‚macro-prudential‛ restrictions on credit will help to

keep consumption afloat, we expect investment to

decelerate further. The recent drop in domestic

production and imports of capital goods already reflects a

slowdown in investment. Another problem is that,

according to our calculations, the GDP growth carryover in

2012 will be only 0.3%, compared to 1.1% in 2011. In

other words, if GDP remains unchanged at 4Q11 levels

during the whole year, it will grow only 0.3% in 2012.

Therefore, we expect the economy to grow 3.3% in 2012,

which would be much less that the government’s target

of 5.0%, but not a bad result considering the uncertain

global scenario.

Brazil: Capacity utilization and business confidence

76

78

80

82

84

86

88

70

80

90

100

110

120

Business confidence

Capacity utilization (RHS)

%

Source: FGV

Although the labor market remains tight, job creation

has decelerated, and we expect a gradual increase in

unemployment. Brazil’s unemployment rate fell to 5.8%

in October from 6.0% in September, dropping below our

6.0% forecast. On a seasonally-adjusted basis, according

to our calculations, the unemployment rate dropped back

to 5.9% (the all-time low) from 6.1%. Nevertheless, the

drop in unemployment was mainly caused by a 0.1%

MoM drop in the labor force, as new jobs rose only 0.1%

MoM. Job creation rose 1.5% YoY, the lowest year-on-

year rate since December 2009. Furthermore, average real

earnings remained unchanged in October even after

dropping a hefty 1.8% MoM in September. Consequently,

real earnings fell 0.3% YoY, the first drop since January

2010. While the deceleration in real earnings reflects the

slowdown in job creation, it can also be explained by high

inflation, and the latest wage negotiations suggest that

wages could recover some ground in the following



months. However, we believe this scenario is consistent

with a very gradual increase in unemployment, which we

expect to rise to 6.4% in 2012 from 6.1% in 2011. The

persistence of a relatively low rate of unemployment will

likely provide important support for domestic

consumption.

Brazil: Job creation and labor force growth

-1%

0%

1%

2%

3%

4%

5%

6%

7%

Labor force

Jobs

YoY

Source: IBGE

Brazil: Credit delinquency

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

Consumers

Corporates

Source: BCB

Credit growth has decelerated, prompting the

government to revoke some of the ‚macro-

prudential‛ measures. Total bank loans grew 0.8% MoM

in October, the slowest MoM increase since January

2011. Although October’s poor performance was probably

influenced by the strike of bank employees, credit

origination has decelerated significantly this year,

especially in the area of consumer financing. Consumer

credit origination rose a hefty 6.4% MoM in October, but

the increase was led by expensive facilities such as

overdraft loans and credit cards, mainly due to the bank

strike that reduced the supply of other consumer loans,

according to the Central Bank. However, the increase in

expensive revolving credit lines might also reflect an

increase in non-performing loans, which climbed to 7.1%

in October, the highest since February 2010. Since

unemployment is one of the main determinants of credit

delinquency and we expect it to rise gradually, we believe

that NPLs have not peaked yet (although the fast decline

in interest rates tends to mitigate this effect). Fearing the

effect of the slowdown in credit growth on consumption,

the government revoked some of the macro-prudential

measures enacted last year, reducing the capital

requirements on payroll debit-loans, car loans, and

personal loans of up to 36 months, scrapping the

minimum 20% credit card balance payment obligation

that was scheduled to become effective in December,

and cutting the IOF tax on consumer loans to 2.5% from

3.0%. Moreover, the government reduced taxes on

domestic appliances and low-income housing, and

eliminated the 2% IOF tax on foreign portfolio investment

in equities to stimulate the stock market.

Brazil: IPCA weight revision

Old IPCA New IPCA

Food at home 15.0% 15.0%

Tradables (ex-food) 20.4% 25.2%

Services 24.8% 22.3%

Other non-tradables 10.8% 10.4%

Administered prices 29.0% 27.1%

Source: IBGE, DB Global Markets Research

We still see inflation above 5% next year despite the

changes in the IPCA methodology. The IPCA consumer

price index rose 7.0% YoY in October, confirming that 12-

month inflation peaked at 7.3% in September, as we had

expected. Although 12-month inflation remains

significantly above the target of 4.5% and even above the

6.5% ceiling of the inflation target’s tolerance band, we

expect it to decline further in the coming months due to

the base effect, the economic slowdown and a drop in

commodity prices. We expect the IPCA to climb 6.4% this

year, just slightly below the top of the band. For 2012, we

have lowered our IPCA forecast slightly to 5.3% from

5.5% due to the changes in the index weighting structure

that will take place in February 2012. This week, the

official statistics agency IBGE announced a revision to the

IPCA methodology that will essentially reduce the weight

of services to approximately 22% from 25%, (mainly due

to a surprisingly large drop in the weight of school fees,

and despite a relatively small increase in the weight of

housing rentals), and raise the weight of tradable goods

(excluding food) roughly to 25% from 20% (led by a

significant increase in the relative importance of

automobiles). The change could be relevant because

service prices have been rising well above the headline

inflation (9.0% YoY in October), reflecting the strength of

domestic demand and the tight labor market. Thus,

although we remain concerned about the potential

inflationary effect of the hefty 13.6% minimum wage

increase programmed for January 2012, we estimate that

the new weighting structure will shave off approximately

20bps from our IPCA forecast. On the other hand, we



note that the increase in the weight of tradable goods in

the index might somewhat raise the exchange rate pass-

through to inflation.

We still do not see inflation returning to 4.5% next

year, but continue to expect more rate cuts ahead.

Europe’s sovereign debt crisis and the change in the IPCA

methodology have contributed to stabilize inflation

expectations, offsetting the negative effect of the

surprising 50bp interest rate cut in August. The Central

Bank repeated the dosage in October and November,

reducing the SELIC rate to 11.0%. The authorities also

indicated that they plan to maintain the same pace of rate

cuts for now, claiming that ‚a moderate adjustment in

rates is consistent with convergence of inflation to the

target.‛ We continue to forecast that three additional

50bp rate cuts will lower the SELIC rate to 9.5% by April

2012, although we believe the risk is tilted to the

downside, considering our revisions to GDP growth and

inflation forecasts. Moreover, given the increasingly

tighter liquidity conditions produced by Europe’s crisis,

we would not be surprised if the Central Bank reduces

reserve requirements on bank deposits. This week, the

government relaxed the rules for banks to sell their loan

portfolios, so as to help small and mid-sized banks. That

said, we believe interest rates will drop below their

equilibrium level and will eventually rise again after the

global economy recovers. We expect the Central Bank to

initiate a new tightening cycle in 2Q13, raising the SELIC

rate back to 11.0% by the end of 2013.

We expect the government to meet its full primary

fiscal surplus target of 3.15% of GDP in 2011, but

project a smaller surplus for 2012. As tax collection has

risen more than expected this year (mainly due to high

inflation and a tax amnesty program), the government

raised this year’s primary fiscal surplus target by 0.25% of

GDP (BRL10bn) to 3.15% of GDP. The Finance Minister

also pledged to meet next year’s primary surplus target of

3.1% of GDP without resorting to accounting adjustments

(i.e., without deducting PAC investments from the primary

balance). Nevertheless, we project a primary surplus of

2.7% of GDP for 2012. Barring the introduction of a new

tax, government revenues could decelerate more than

expected due to slower GDP growth (the budget

assumed real GDP growth of 5.0% for 2012). Moreover, it

is not clear whether the government will be able to keep a

lid on public spending. This year’s moderation has been

achieved mainly by compressing public investment, which

is probably not sustainable in the medium term due to the

growing demand for infrastructure investment and

projects related to the 2014 World Cup and 2016 Olympic

Games. Furthermore, the generous 13.6% minimum

wage increase scheduled for 2012, the ‚Brasil Maior‛

stimulus program, and the ‚Amendment 29‛ (which aims

to increase mandatory spending on healthcare) could all

cost approximately BRL60bn (1.4% of GDP) next year,

while the latest tax cuts announced to stimulate

consumption could cost as much as BRL8bn. That said,

we cannot discard the possibility of another positive

surprise in fiscal performance next year, which could

make it easier for the Central Bank to ease monetary

policy without fueling inflation.

While risk of currency depreciation remains high due

to global environment, we continue to assume a

relatively benign scenario for the currency. We have

kept year-end BRL forecast at BRL1.80/USD for 2011 but

raised it to BRL1.80/USD from BRL1.75/USD for 2012 due

to the potential negative effects of the European crisis on

global growth, commodity prices, and credit supply. The

good news is that the BRL continues to benefit from a

slow increase in the current account deficit and huge

volume of foreign direct investment (FDI). This year’s

trade surplus has been surprisingly strong and will likely

reach USD29bn, mainly due to high commodity prices.

Although exports will probably suffer as commodity prices

decline, we expect imports to decelerate as well due to

softer domestic demand. We still forecast a sizeable trade

surplus of USD20bn for 2012, and therefore project a

modest increase in the current account deficit, from an

estimated USD53bn (2.2% of GDP) in 2011 to USD64bn

(USD2.6% of GDP) in 2012. In the financial account, the

main highlight has been the massive inflow of foreign

direct investment, which we estimate will reach USD64bn

in 2011. We expect FDI to drop to USD52bn in 2012 due

to the bleak global outlook, and believe the risk is tilted to

the downside given that approximately 60% of the FDI

this year originated from Europe. Critical risks to the BRL

lie in the external credit crunch and in the existing large

stock of foreign portfolio investment, especially the

USD129bn in local bonds (as reported by the Central Bank

for October), which include a large amount owned by

Japanese retail investors. Nevertheless, the Central Bank

has a strong incentive to intervene in the FX market to

avoid excessive BRL weakness. Since the authorities’

main priority is to cut interest rates, a strong depreciation

of the BRL could become a problem because of its

potential inflationary effect. This view is reinforced by the

Central Bank’s intervention in September, by offering FX

swaps when the currency traded above BRL1.90/USD,

and by the recent decision to scrap the 2% IOF tax on

foreign portfolio investments in the stock market. Since

the Central Bank currently owns approximately USD350bn

in international reserves (compared with USD207bn in

September 2008), the authorities have plenty of

ammunition to intervene in the spot market as well. In the

worst-case scenario, the government might even revoke

the 1% IOF tax on FX derivatives.

José Carlos de Faria, São Paulo, (5511) 2113-5185



Investment strategy

FX: Position for short-term retracement. The BRL –as

other liquid EM currencies- has suffered from increased

volatility on the back of developments in core markets.

This has favored our long 1M FVA position, which has

reached its target. The better tone in risk sentiment after

the coordinated action by main central banks, and the

potential intervention of the Central Bank of Brazil (BCB) in

the FX market, could help BRL to recover. However,

behind the short-term overshooting, the currency is still

overvalued from a more fundamental perspective.

Additionally, carry is expected to decrease further as the

central bank continues easing monetary conditions

aggressively with a focus on economic activity. Moreover,

both the trade balance and current account are expected

to deteriorate amid a reduction in FDI flows. As a

consequence, we recommend positioning for potential

short-term retracement with zero-cost 1x2 USD/BRL put

spreads, but maintaining a neutral stance at longer

horizons.

Rates: Stretched valuation in short-term receivers. The

market is widely expecting that BCB will continue

reducing rates aggressively during 1Q12 (150bp to 9.5%).

With domestic and external activities trending lower, the

risks to this scenario are still biased to the downside due

to BCB’s increasing focus on growth. Nevertheless, the

risk/reward of short-term receivers is not longer attractive

with this stretched valuation. As a consequence we

recommend taking profits on our July ’12-Jan ’17 DI

steepener recommendation and position for a setback in

short-term rates with a Jan ’13- Jan’15 DI flattener (entry:

65bp, target: 40bp, stop: 80bp).

Credit: Stay neutral. We believe 2012 will likely be

another year of outperformance of high quality, low beta

credits such as Brazil, but we prefer Colombia and Peru.

Though fiscal performance appears to be on track in 2011,

we project it to underperform budget in 2012. Though not

our baseline, risk remains that the aggressive monetary

easing could damage Central Bank’s credibility and lead to

permanently higher inflation, especially if the promised

fiscal austerity does not materialize. Technical condition

looks supportive given Brazil’s $5.5bln principal and

interest repayment in 2012 (vs. our issuance projection of

<=3.0bln), especially if Brazil’s Treasury returns to the

market and resume buying its legacy bonds. In terms of

positioning in the global curve, we believe 10s30s looks

excessively steep (among LatAm low betas) while 5s10s

still looks too flat; we continue to favor the barbell

strategy of 41s and 40s to call vs. 21s. In addition, we

believe 10Y basis (vs. 21s) should continue to tighten,

especially if the recent positive market tone continues.

Mauro Roca, New York, (212) 250-8609

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

Brazil: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income

Nominal GDP (USDbn) 1,626 2,090 2,388 2,425

Population (m) 191 193 195 197


Real GDP (YoY%) -0.3 7.5 3.0 3.3

Private consumption 4.1 7.0 4.7 4.2

Government consumption 3.7 3.3 2.1 2.8

Gross capital formation -6.7 22.0 5.5 2.6

Exports -6.7 22.0 5.5 2.6

Imports -10.3 11.5 4.0 3.0

Prices, Money and Banking

CPI (YoY%) 4.3 5.9 6.4 5.3

Money base (YoY%) 4.6 19.5 10.0 10.0

Broad money (YoY%) 7.0 17.0 8.0 10.0


Consolidated budget balance -3.3 -2.5 -2.1 -1.6

Interest payments -5.3 -5.3 -5.2 -4.3

Primary balance 2.0 2.8 3.2 2.7

External Accounts (USDbn)



Trade balance 25.3 20.2 29.0 20.0

% of GDP 1.6 1.0 1.2 0.8

Current account balance -24.3 -47.6 -53.0 -64.0

% of GDP -1.5 -2.3 -2.2 -2.6

FDI 25.9 48.5 64.0 52.0

FX reserves (USDbn) 239.1 288.6 350.6 360.6

FX rate (eop) BRL/USD 1.74 1.67 1.80 1.80


Government debt (gross) -9.0 -9.8 -12.4 -11.9

Domestic 62.0 54.8 56.6 54.6

External 58.5 51.8 52.8 50.9


in USDbn 277.6 350.4 407.4 432.4


General (YoY%)

Industrial production (YoY%) -7.4 10.5 0.5 2.0

Unemployment (%) 8.1 6.7 6.1 6.4

Financial Markets (EOP) Current 3M 6M 12M

Selic overnight rate 11.00 10.00 9.50 9.50

3-month rate (%) 10.6 9.8 9.4 9.6

BRL/USD 1.80 1.80 1.80 1.80



Chile Aa3/A+/A+ Moodys/S&P/Fitch

Economic Outlook: The economy continues to

decelerate along an unbalanced path, with domestic

demand still growing at a higher pace than supply.

Nevertheless, albeit some surprises, domestic

inflationary pressures are still subdued. A weakening

CLP and tight labor markets have so far had little

impact on inflation. The Central Bank of Chile (BCCh)

is increasingly considering easing monetary

conditions to counteract negative effects from the

external scenario.

Main Risks: Domestic demand could adjust faster

than expected due to uncertainty in external

conditions. A slowdown in global growth and a

potential deceleration in China could affect copper

prices. There could be some form of contagion from

a credit event in Europe due to the links between

local and Spanish banks.

Strategy Recommendations: Maintain short

EUR/CLP. Shift from 2Y to 5Y breakeven inflation and

enter 2s5s CLP/CAM steepener. Underweight

sovereign credit, and buy 5Y CDS vs. Brazil as a

defensive trade.

Macro view

Latest figures confirm the declining trend in activity…

Recently, the Central Bank of Chile published the quarterly

report of the national accounts. It showed that GDP

increased by 4.8% YoY (0.6% s.a. QoQ) during 3Q11,

considerably below the 9.9% and 6.6% observed during

the first two quarters of the year (which were

nevertheless favored by a low comparative base). As in

the previous quarters, domestic demand continued to

show important dynamism. It increased 9.4% YoY on the

back of growth in investment in machinery and equipment

(31.5%), construction (9.8%), and private consumption

(7.5%). All sectors exhibited positive performance, with

the exception of the crucial mining sector, which

decreased by 6.5% due to a reduction of ore grades,

strikes and the impact of adverse climate conditions. In

contrast, fishing was the sector showing the highest

dynamism, increasing 59.4% YoY due to the control of the

virus ISA that affected the production of salmon and

created a low comparative base effect.

Preliminary figures for the last quarter seem to confirm

this trend. The Institute of National Statistics (INE)

reported that, in October, industrial production and sales

declined by 0.8% YoY (-3.2% MoM sa) and 0.6% YoY (2.2

MoM sa) respectively, markedly below consensus

expectations of 4.1% and 2%. This differs from previous

months, during which the mining sector was the main

culprit of disappointing figures, the slowdown was now

noticeable in several sectors. The sectors with the biggest

contraction were oil refining, clothing and wood products,

which jointly contributed with -1.3pp to the index. In

contrast, mining increased by 2.9% YoY mainly driven by

higher production of copper (from 462k to 467k metric

tons) and, to a lesser extent, of gold and molybdenum.

Domestic demand growth also suffered some

deceleration, with retail sales increasing by 8.6% YoY, in

line with expectations but below the 9.6% observed in the

previous month. Consequently, the supply-demand

growth imbalance continues to widen.

Regarding the external sector, the current account

showed a deficit of USD2.9bn (4.9% of GDP) during

3Q11, in contrast with the balanced level of 3Q10. This

decline was more than compensated by important capital

inflows of USD4.5bn. During October, there was a

positive contribution from the trade balance, which

increased to USD837mn The accumulated surplus has

reached USD10.8bn during 10M11, representing a

decrease of 7.31% YoY. The recovery in the trade balance

was the result of a much larger decline in imports

(10.75% MoM) than in exports (2.46% MoM). The

relatively good performance of exports was in part

explained by a recovery in copper exports, which

increased 6.86% MoM, or 24.35% YoY, to USD3.5bn.

…but the labor market remains tight…

Regardless of declining activity, the unemployment rate

for the August-October moving quarter decreased to

7.2% from 7.4% in the previous measuring period.

Following the trend observed during the year, the decline

in the unemployment rate was explained by a larger

increase in employment (3.5% YoY) than in the labor force

(3.1% YoY).

…and inflation surprised to the upside

The latest inflation data available showed a surprising

increase in prices during October (0.5% MoM), which

drove the index to 3.7% YoY. Nevertheless, as the spike

could be partially attributed to a one off effect in some

items (meat), the inflation outlook is still relatively benign.

Seasonal factors should help to decrease headline

inflation during the last part of the year. In fact, the

surprise in inflation had a muted effect on inflation

expectations. According to the latest BCCh survey, the

median monthly inflation forecast remained at 0.1% for

the month of November while expectations for annual

inflation continued to be anchored at the 3% inflation

target from 12 months onwards.

BCCh still has room to wait

At the latest monetary policy meeting, the BCCh decided

to maintain the policy interest rate (TPM) unchanged at

5.25% for a fifth consecutive month. The minutes of that

meeting showed that it also evaluated a 25bp reduction.

The monetary authority believed that the easing of

monetary conditions would have been a preventative

move against an increasingly adverse external



environment. However it acknowledged that such a

decision could have led the market to believe that it was

more concerned about the external outlook. Moreover,

the Board agreed that there was considerable uncertainty

regarding the potential effects of the worsening external

environment in the domestic economy. In contrast, the

Board considered that the alternative of keeping the

interest rate unchanged, but conveying a dovish tone,

would give more time to evaluate those effects. It was

agreed that the risk of this alternative was to fall behind

the cycle due to the lagged effects of monetary policy.

However this risk was tempered by the elevated

dynamism of domestic demand, a closed output gap and

tighter labor market conditions. Additionally, the Board

considered that a more aggressive policy could later

compensate for a delayed implementation. Finally, the

Board hinted to an increasing probability of an imminent

cut during the next months, probably after the revised

monetary policy views have been published in the next

inflation report (IPOM).


Investment strategy

FX: At the tone of global growth. During next year, the

CLP will continue to be affected by the continuous

revisions of expectations regarding global growth and

copper prices. A soft landing of China and the finalization

of the rule-based intervention could benefit the CLP and

counteract the potential setback from reduction in carry

due to monetary easing. The main short-term risks are

related to the direct and indirect effects of a potential

escalation in the European crisis. We recommend

maintaining a short EUR/CLP position (entry: 690, target:

660, stop: 685)

Rates: Position for further steepening. As the economy

continues to decelerate, the BCCh seems closer to ease

monetary conditions. While enough easing is already

priced in the short-end of the local curve (150bp during

9M11) we think the cuts will be more frontloaded.

Additionally, they could help to build up additional risk and

inflation premium in the belly of the curve. We therefore

recommend shifting the 2Y breakeven inflation position to

the 5Y sector (entry: 2.8%, target: 3.1, tighten stop: 2.6%)

and entering a 2s5s CLP/CAM steepener.

Credit markets: Underweight. Despite its solid

fundamentals, the tight credit spread, financial risk (albeit

moderate) as shown in our vulnerability indicators, and the

likely lack of support from the USTs in 2012 mean risk is

biased towards lower returns. In addition, real money

investors have been significantly overweight Chile,

creating a non-supportive technical condition. We look to

buy CDS as a defensive trade at good levels, and

recommend buying Chile CDS vs. Brazil as a defensive

trade with asymmetric payoff (more limited loss under a

bullish scenario vs. the large gain under a bearish

scenario).


Hongtao Jiang, New York, (212) 250 2524

Chile: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National income

Nominal GDP (USDbn) 204.0 224.1 230.4 242.3

Population (m) 16.9 17.1 17.3 17.5


Real GDP (YoY%) 5.2 6.0 4.2 3.9



Investment 18.8 13.8 8.2 7.4

Exports 1.9 6.5 4.3 4.8

Imports 29.5 9.2 5.8 5.5

Prices, money and banking

CPI (Dec YoY%) 3.0 3.7

2.9 3.2

Broad money 10.9 12.6 11.2 11.8

Credit 25.3 13.5 12.8 12.5

Fiscal accounts (% of GDP)

Consolidated budget balance -0.3 0.8 0.2 -0.5

Government spending 22.7 21.9 21.2 21.6

Government revenues 22.4 22.7 21.4 21.1


Exports 71.0 81.5 82.0 83.0

Imports 55.2 71.0 72.0 74.0

Trade balance 15.9 10.5 10.0 9.0

% of GDP 7.8 4.7 4.3 3.7

Current account balance 3.8 -2.4 -3.9 -4.6

% of GDP 1.9 -1.1 -1.7 -1.9

FDI 6.4 11.4 13.5 15.0

FX reserves 27.9 40.0 41.0 42.0

FX rate (eop) USD/CLP 468 505 510 525

Debt indicators (% of GDP)


Domestic 6.9 5.6 5.2 5.0

External 2.2 1.8 1.7 1.5


in USDbn 86.7 94.0 95.0 96.0


General

Industrial production (YoY%) 3.8 4.1 3.2 3.0

Unemployment (%) 7.1 7.0 7.2 7.6

Financial markets (end)

period)

Current 3M 6M 12M

Overnight rate (%) 5.25 4.75 4.25 4.25

6-month rate (%) 4.56 4.17 4.01 4.11

USD/CLP 515 500 490 510 Source: Deutsche Bank Global Markets Research, National Source



Colombia Baa3 (stable)/BBB- (stable)/BBB- (stable) Moodys/S&P/Fitch

Economic outlook: Economic activity keeps growing

robustly, while inflation has risen temporarily, fueled

by food prices. BanRep has begun to hike the policy

rate again, and will continue to do so in 2012. The

fiscal accounts are improving on the back of tax

collection outperformance.

Main risks: Higher inflation because of stronger

commodity prices and/or domestic demand

pressures. Overheating and bubbles prompted by a

credit boom. A relapse in the US economy,

destination of more than one third of the country’s

exports.

Strategy recommendations: Remain on the

sidelines waiting for better entry levels to get

exposure to COP. Close 2s3s COP/IBR steepener and

receive 5Y COP/IBR (or TES Jun ’16) against 5Y USD

swap. Stay overweight external debt and favor

shorter-end of the curve, where we favor off-the-run

19s and 20s over the benchmark 21s.

Macro view

BanRep hikes reference rate

On November 25, Banco de la Republica raised its target

interest rate by 25bp to 4.75%. The decision was not a

complete surprise, as market forecasts were fairly evenly

divided between no hikes and a 25bp increase. The press

release that accompanied the decision highlighted that the

policies implemented in Europe to deal with the debt

crisis have yet to yield results, and that the emerging

market consensus is that the US will grow at a moderate

pace for a protracted period. Commodity prices, however,

remain high and continue to benefit producers in the EM

world. The Bank also acknowledged that in Colombia,

domestic demand continues to expand at a very robust

pace, so that the optimistic growth prospects presented

earlier this year continues to be valid. That is, the Bank

expects the economy to grow by about 5.5% in 2011.

Bank credit keeps growing at a very fast pace, especially

consumer credit which is expanding at roughly three

times the pace of nominal GDP, while housing prices are

at historically high levels. BanRep admitted that inflation

during the past two months exceeded its expectations,

leading to an upward revision in short term projections.

For next year, however, the Bank remains confident that

the temporary shocks to inflation will recede and that the

annual rate will converge towards the target range. It

pointed out, however, that stronger than expected

domestic demand pressures represent an inflationary risk

for the coming months. On the growth front, the risks are

mainly external, i.e. represented by a disorderly

adjustment in Europe.

Colombia: COP and policy interest rates

1500

1700

1900

2100

2300

2500

2700

2

3

4

5

6

7

8

9

10

11

Repo rate (% pa) COP spot (rhs)

Source: Banco de la República, Deutsche Bank

The tone of the communiqué was measured, suggesting

that BanRep may hike the reference rate some more

although proceeding in a rather gradual fashion. We

indeed expect the Central Bank to proceed with caution in

the coming months, hiking the target rate by some 50bp

to 75bp more during 2012, possibly pausing in between

rate movements. Over time, we believe the Central Bank

will adjust its monetary policy stance to reach short term

real interest rate levels nearing 200bp. In the press

conference that followed the announcement, BanRep’s

authorities hinted that the hike ‚was enough for now‛.

Inflation on a temporary high

Increases in consumer prices accelerated in September

and October, coming out above expectations and

resulting in annual inflation that is now a shade above the

ceiling of the target band. BanRep has indicated that this

is a temporary phenomenon, associated with seasonal

increases in food prices, and that it remains confident that

in 2012 inflation will converge towards the 3% medium

term target again. Food and beverages are the fastest

rising items of the index, having increased by 6.6% yoy

through October, on the back of weak supply because of

heavy rains in agricultural areas. Meanwhile, core prices

continue to behave well, remaining at or below the

medium term target. We expect annual inflation to end

the current year just below the ceiling of the band, and to

drop further in 2012, although we see the convergence



towards 3% as a significant challenge. This is so because

Colombia will be among the fastest growing economies in

the region next year too, with a robust performance of

domestic demand, and with credit expanding fast. In

addition, concerns about financial developments in

industrialized countries have increased risk aversion,

prompting currency weakness, which if maintained over

time could contaminate domestic prices.

Colombia: Inflation rates (% yoy)

-2

0

2

4

6

8

10

12

14

16

CPI CPI food

Source: DANE, Deutsche Bank

Lowest unemployment rate in a decade

The official statistics office DANE reported that the urban

jobless rate (for the country’s 13 largest cities) came out

at 10.2% in October, the same level as in the previous

month and above market expectations of 9.9% as per

Bloomberg’s poll. The nationwide unemployment,

however, was 9.0%, significantly below the 9.7%

registered in September and the lowest since 2001. The

figure represents not only good economic news but also

another political for President Juan Manuel Santos, who

had set the goal of driving unemployment to the single

digit range during his administration. Santos indeed

celebrated the release and pointed out that this record is a

great accomplishment ‚considering the unfavorable

external scenario where economies like United States,

Europe and Asia have seen their unemployment rates

increasing‛. According to DANE, Colombia has 2.13m

unemployed workers, a reduction of 129,000 people

relative to a year ago, while the occupied population is

now at 21.5m. So far this year, the unemployment rate

has dropped even though the participation rate has

increased, which means that job creation is outstripping

labor supply. We expect the open unemployment rate to

continue dropping in 2012, with the nationwide figure

reaching 9%.

Colombia: GDP and unemployment

9

10

11

12

13

14

15

0

1

2

3

4

5

6

7

8

9

Jan

-07

May-0

7

Se

p-0

7

Jan

-08

May-0

8

Se

p-0

8

Jan

-09

May-0

9

Se

p-0

9

Jan

-10

May-1

0

Se

p-1

0

Jan

-11

May-1

1

Se

p-1

1

GDP Unemployment Source: DANE, Deutsche Bank

IP and retail sales below expectations

The official statistics office DANE reported that industrial

production rose by 5.2% yoy in September, below

expectations of a 5.9% increase according to

Bloomberg’s poll. Industrial sales expanded by 5.9%,

while employment in the industrial sector increased by

1.6%. During the first nine months of the year, industrial

output grew by 4.9% yoy. DANE also reported that retail

sales rose by 8.1% yoy in September, below expectations

of an 11.3 increase, and the lowest print since April 2010.

Despite these softer than expected figures, we project

that the Colombian economy will grow by more than 5%

this year, while inflation is temporarily above the ceiling of

the target band.

Colombia: IP and retail activity (% yoy)

-15

-10

-5

0

5

10

15

20

25

Jan

-08

Ap

r-0

8

Ju

l-0

8

Oct-

08

Jan

-09

Ap

r-0

9

Ju

l-0

9

Oct-

09

Jan

-10

Ap

r-1

0

Ju

l-1

0

Oct-

10

Jan

-11

Ap

r-1

1

Ju

l-1

1

Sales IP Source: DANE, Deutsche Bank

Trade balance in September

The official statistics unit DANE reported a trade deficit of

USD337m in September, below consensus expectations

of a USD90m deficit as per Bloomberg’s poll. The

accumulated surplus year-to-date reached USD3236m,

which represents a 131% increase vis-à-vis the same

period from previous year. During the month, total



imports increased by 29% yoy. Regarding exports,

traditional products rose by an impressive 56.3% yoy, on

the back of strong sales of oil and oil derivatives, while

those of non-traditional products rose by 6.3% yoy. As a

result, total exports increased by 36.2% yoy. We expect

the trade surplus to shrink by year-end, as demand for

imports is typically strong during the latter part of the

year, and to contract further in 2012, as imports are

propped up by strong economic activity. Trade dynamics

will be impacted by the recently approved FTA with the

US, expected to become fully operational by 2013. In the

meantime, the US Congress approved the renewal of the

special trade preferences known as APTDEA retroactively

to February 2011 when they had expired, and until 2013

when they will probably be rendered unnecessary by the

enactment of the FTA. By virtue of the agreement, more

than 5,000 items of the tariff code that are currently levied

at 5% or above will face gradually decreasing tariffs,

converging to zero within the next two decades.

The current account balance, on the other hand, is

expected to continue showing a relatively large deficit

because of the unfavorable services balance. We project it

to be near 3% of GDP this year and next. As it has been

the case in recent years, FDI flows are expected to be

larger than the current account deficit over the forecast

period, thus suggesting no urgency whatsoever on the

external financing side. In addition, we are also of the idea

that Colombia would be in an optimal position within

LatAm to gain access to multilateral financing, if so

desired, in the event of a worsening of international

conditions. Public external debt amortization is to remain

below the USD2bn per year mark, almost half of which is

bilateral and multilateral.

Fiscal performance gradually improving

Because of the faster than initially expected growth of

economic activity, tax receipts are likely to come out

above budgeted levels during the current year by about

5%. During the first nine months of the year, VAT

collection and income tax receipts rose by 41% yoy a

piece, while the financial transactions tax revenue

increased by 76% yoy. This has resulted in a reduction in

planned domestic debt sales this year, and will also lower

TES issuance for 2012. We project this year’s

consolidated public sector deficit to be just above 3% of

GDP, instead of official estimates from early this year that

put it at 4.1%, as tax outperformance is to be in the order

of COP6trn (1% of GDP). This will be the case, in our

view, even if the authorities bring forward some expenses

originally slated for 2012, such as some pension outlays.

For 2012, we project such deficit to drop further towards

3% of GDP, as tax collection and compliance continue on

an upswing. Over the medium term, fiscal performance

should also benefit by the series of reforms approved by

Congress this year, something that should also increase

the chances of sovereign rating upgrades down the road.

Colombia: Tax outperformance in 2011

Actual

(COPtrn) % yoy

Internal 54.04 49.4 70.06 77.1

Income 27.74 40.6 32.00 86.7

VAT 18.37 41.1 31.69*

Financial transactions 3.68 76.3 4.04 91.3

Wealth 4.13 294.2 2.33 177.4

Stamp 0.11 -59.5 0.20 54.7

External 11.62 35.1 3.52

Total 65.66 46.7 73.78 89.0

* Domestic and external VAT receipts.

Jan-Sep 2011

Budgeted

for 2011

% of

budget

Source: DANE, GlobalSource, , Deutsche Bank

On Santos’ possible reelection bid

During a conference at the London School of Economics,

President Juan Manuel Santos said that ‚if he achieves

most of the goals of his administration‛ during the four

years of his mandate, he would prefer not to run for

reelection. He added that in the event of a reelection bid,

the process should be smoother than in the previous

political cycle, as no constitutional reform would be

necessary this time around. Thus, Santos did not close the

door to the possibility of a reelection, something that is

unlikely to be ruled out especially considering that his

popular support is currently at an all time high of well over

80%. Santos’ popularity is being supported by the good

economic performance of the country, especially in a

difficult international context, and the recent strikes on the

FARC, with several guerrilla leaders taken down.

Meanwhile, the local media reported that the relationship

between Santos and former President Alvaro Uribe is

somewhat strained, and that Uribe may support former

Finance Minister Oscar Ivan Zuluaga as presidential

candidate in 2014. It is, however, too early to determine

what the eventual political strategies will be, but it

appears that Santos is currently in a position of substantial

strength and would become a very powerful candidate for

reelection if so desired – and conveying a message of

policy continuity to the market. Santos met with British

Prime Minister David Cameron and Foreign Affairs

Minister William Hague, who highlighted Colombia’s

continued commitment to improve security and Santos’

compromise to avoid human rights abuses. Hague also

indicated that the bilateral goal is to double trade volumes

by 2015. Labor Party lawmakers, in turn, complained

about Colombia’s human rights record and requested the

British government to prioritize the guarantees to the

rights of labor union leaders in Colombia over bilateral

trade goals.

Fernando Losada, New York, (212) 250-3162



Investment strategy

FX: Constructive on fundamentals but beware of

short-term risks. Fundamentals keeps improving the

medium-term prospects for the COP, but the usual end-of-

year scarcity of USD in the local market create some

pressure on short-term points, increasing the volatility

during the next weeks. The favorable trade and fiscal

performance observed during this year is expected to

continue during 2012, and strong FDI flows will more than

compensate a growing deficit in the current account. The

latest activity and inflation data suggest that Banrep will

continue to tighten monetary conditions early into next

year. Together with lean positioning, the recovery in carry

could act as important short-term driver. Nevertheless, the

recent underperformance of the COP is an reminder that

the currency could also suffer from a more challenging

global environment, particularly as technical factors play a

role at the turn of the year. As a consequence, we

recommend remaining on the sidelines, waiting for better

entry levels at the beginning of next year.

Rates: Enough tightening priced in. The local curve has

been anticipating the on-going tightening cycle for some

weeks. With 75bp of additional tightening already priced

in, we consider that the risks are biased to the downside

for short-term rates, as the slowdown in global growth

may drag on domestic activity and reduce some

inflationary pressures. Nevertheless, we find that the belly

of the curve may offer more value, particularly relative to

core rates. We recommend closing 2s3s IBR/COP

steepener and entering a 5Y receiver, either in IBR/COP or

TES Jun ’16, against 5Y USD swap payer (swaps, entry:

440bp, target: 410bp, stop: 455bp).

Credit: Stay overweight. We keep Colombia at

overweight on the back of its strong macro momentum,

evidenced in its robust domestic driven growth as well as

the improvement in fiscal performance and debt

dynamics; marginally more attractive valuation relative to

its LatAm low beta peers; and supportive technicals.

Colombia will likely have (in a worst case) flat net issuance

in 2012 (maximum USD2bn external issuance met with

almost the same amount in principal and interest

payments). On the global curve, while the bonds at the

long end are trading almost flat to their counterparts on

peer curves, the shorter end still has room to catch up;

we favor the 19s and the off-the-run 20s over the 21s,

whose 20bp richness to the curve due to benchmark

premium looks somewhat excessive.



Colombia: Deutsche Bank Forecasts 2010 2011F 2012F 2013F

National Income

Nominal GDP (USD bn) 243.3 267.4 293.4 319.7

Population (m) 45.8 49.3 50.4 50.4


Real GDP (YoY%) 4.3 5.5 5.0 5.0




Exports 18.0 25.0 21.0 18.0

Imports 20.0 28.0 22.0 20.0


CPI (Dec YoY%) 3.2 3.7 3.4 3.2

Broad Money 8.1 13.5 13.0 13.0

Bank credit 10.0 12.0 15.0 15.0



Interest payments 3.3 3.3 3.2 3.1

Primary Balance -0.6 0.0 0.0 0.1


Exports 39.8 55.0 63.8 75.0

Imports 40.7 53.5 63.6 76.0

Trade balance -0.9 1.5 0.2 -1.0

% of GDP -0.4 0.6 0.1 -0.3


% of GDP -3.7 -3.2 -2.7 -2.7

FDI 9.1 10.0 11.0 11.0

FX reserves 28.4 34.0 40.0 44.0

COP/USD (eop) 1908 1890 1850 1830



Domestic 26.5 27.5 27.9 27.9

External 12.0 11.8 11.5 11.5


in USDbn 55.0 60.0 66.0 66.0


General


Unemployment (%) 11.0 10.0 9.3 9.0

Financial Markets (eop) Current 3M 6M 12M

Overnight rate (%) 4.8 5.0 5.3 5.3

Three-month rate (%) 5.0 5.2 5.6 5.6

COP/USD 1946 1880 1870 1850 Source: DB Global Markets Research, National Sources



Mexico Baa1 (stable) / BBB (stable) / BBB (stable) Moodys/S&P/Fitch

Economic Outlook: Headline inflation has

accelerated but core remains well behaved, very near

the medium term target. Economic activity surprised

on the upside during 3Q11, and will decelerate very

gradually over the coming months. The negative

output gap will not close until 2012. Banxico is

unlikely to cut the funding rate unless the currency

appreciates back towards pre-US downgrade levels.

Main Risks: A relapse in US economic activity.

Higher inflation because of strong commodity prices

and/or higher pass-through from depreciation.

Volatility of political origin ahead of next year’s


Strategy recommendations: Take profits on long

MXN/CZK and enter short CAD/MXN. Take profits on

5Y TIIE payer and enter 2s10s TIIE flattener vs. 2s10s

USD swap steepener. Neutral external debt. The old

19s remain significantly rich to the curve.

Macro view

Inflation edging upwards towards year-end

November’s fortnight inflation came out above

expectations at 0.97% mom. Core inflation was higher

than expected at 0.27%, but non-core soared by 3.41%

because of high agricultural prices and adjustments to

energy prices, as the summer season fares were phased

out. When measured with the fortnightly index, annual

inflation is now running at 3.44%, 30bp above the

previous month’s print.

Mexico: Inflation rates (% yoy)

2

3

4

5

6

7

8

9

10

CPI Core Food

Source: Banco de Mexico, Deutsche Bank

These developments, coupled with the fact that the

currency remains extremely weak and that 3Q11 GDP

came out stronger than expected, prevents easing on the

part of Banxico for the time being. We expect headline

inflation to be around 3.4% and core to near 3.2% by

year-end, and we also expect similar levels for headline in

2012 and slightly lower core, possibly at 3%.

GDP growth well above expectations

The official statistics office INEGI reported that GDP

expanded by 4.5% yoy during 3Q11, significantly above


Bloomberg’s poll. On a qoq seasonally adjusted basis,

GDP expanded by 1.34%. The outperformance was

helped by a substantial 8.3% yoy, 11.8% qoq jump in

agriculture. Manufacturing, in turn, rose by 4.6% yoy. The

2Q11 figure was revised slightly downwards by 10bp to

3.2% yoy. GDP has expanded by 4.1% yoy during the first

nine months of the year, so that even if the growth pace

slows down in 4Q11 as we expect, the figure for the

entire year will be at least 3.8%. Amid global financial

turmoil and steady but slow growth in the US, we project

that economic activity growth will be weaker in 2012,

possibly just below the 3.5% mark.

Mexico: Actual and expected GDP (% yoy)

-8

-6

-4

-2

0

2

4

6

8

2005 2006 2007 2008 2009 2010 2011F 2012F


Tasa de fondeo unchanged

On December 2, the last monetary policy of the year,

Banxico left the tasa de fondeo unchanged at 4.5%, in line

with expectations. The Bank highlighted that the financial

crisis in Europe has worsened, and that the chances of a

recession in the area next year have increased, while the

concerns about the health of some European banks have

increased volatility in international financial markets.

Banxico also pointed out that despite some recently

released positive economic indicators in the US, structural

problems persist, including unemployment and high

household leverage, with the additional difficulty

generated by the lack of political agreement towards a

sustainable fiscal path. Banxico sees heightened risks for

growth in the US, something that was corroborated by the



Fed’s downward revision of its GDP growth forecasts for

2011 and 2012, and the indication that monetary policy

will remain very accommodative at least through 2013.

Those subdued growth prospects suggest that

commodity prices may weaken and that inflation in

developed markets will soften.

In Mexico, Banxico acknowledged that although general

economic activity continues to expand, the industrial

sector has softened, reflecting weaker external demand.

Credit and labor markets still show signs of slack capacity,

and the negative output gap will take longer to close.

Banxico argued that the balance of risks for growth has

deteriorated but the balance of risk for inflation is neutral,

as inflation could fall because of weaker domestic and/or

external demand but it could increase as a consequence

of the currency depreciation and/or the movement in

some agricultural prices. In the previous monetary policy

meeting, Banxico had said that the balance of inflation risk

had improved, so the new statement can be construed as

marginally more hawkish. The Bank also reiterated the last

paragraph of the previous communiqué, pointing out that

depending on the impact of the global deceleration on the

Mexican economy and ‚in the context of great monetary

lassitude in developed countries‛, it may become

necessary to relax monetary policy in the future, but also

indicating that it remains vigilant of any possible impact of

the depreciation on inflation. All in all, the statement was

consistent with the 3Q11 inflation report, where Banxico

said to expect both headline and core to remain within the

3.0%/4.0% interval over the foreseeable future, and that

the current monetary policy stance is neutral, with

inflation expectations well anchored in spite of the recent

currency slide. Thus, we continue to be of the idea that in

order for Banxico to cut rates in 1Q12, we would need to

see a stronger exchange rate, possibly trading with a 12

handle, inflation edging downwards from current levels,

and some further signs of economic deceleration.

The new old FX intervention policy

On November 29, the Exchange Commission announced

the suspension of the monthly auctions to buy dollars, in

view of the sharp weakening of the currency observed in

previous weeks. The November 30 auction was called off.

In addition, Banxico rekindled the daily dollar auction

mechanism that has been used several times in the past.

The Bank will offer up to USD400m every day the

currency depreciates by at least 2% overnight. This move

confirms that Banxico is worried about the possible

impact of the depreciation on inflation, especially since

the last two inflation releases came out above

expectations, and with preliminary evidence that prices of

tradable goods are increasing faster than initially

expected. True to its tradition, Banxico will intervene in

the currency market via a transparent rule-based

mechanism rather than on a discretionary basis. The

instrument, which had been used two years ago when the

global financial turmoil was on the rise, is geared towards

providing liquidity to the fx market to reduce currency

volatility. It must be noted that the Bank is in a far stronger

position to intervene at the present juncture than in 2008-

09, as international reserves are twice as high as in 2007,

even before counting the IMF’s contingent financing. The

announcement of the contingent dollar auctioning

mechanism was made at the same time of the

coordinated action of the US Federal Reserve and five

other major central banks, thus resulting in a stronger

impact on the peso, provided support for the peso, which

appreciated by some 28 centavos in the three days that

followed the news to MXN13.54/USD.

Mexico: Exchange rates and international reserves

70

80

90

100

110

120

130

140

150

11.4

11.9

12.4

12.9

13.4

13.9

14.4

Exchange rate (MXN/USD) Reserves (USDbn, rhs)


External accounts show comfortable situation

Through October, the accumulated trade deficit was just

below USD1bn. Given the seasonal behavior of the trade

accounts, we expect the imbalance to increase through

December, although remaining below the USD4bn mark.

The current account deficit, in turn, is also expected to

remain subdued at no more than USD7bn. For next year,

we expect those imbalances to increase to USD7bn and

USD10bn, respectively, on the back of lower export

growth given the weak prospects for the US. Similarly to

what has been the case in recent years, the external

imbalance does not pose any risk for the Mexican

economy, as the current account deficit will be more than

covered with FDI inflows alone, which we expect to hover

around the USD20bn per year during 2011-12. Given our

balance of payments projections, we expect a further

accumulation of international reserves next year, although

at a slower pace than in 2011.

2011 growth and inflation up in latest Banxico poll

The latest Banxico expectations survey showed market

participants revising their GDP growth forecasts for the

current year to 3.87%, 15bp above the previous month’s

poll. It was the first time in the past six months that the

growth projection is revised upwards, in what was a result



of the higher than expected figure observed during 3Q11.

For 2012, GDP is expected to expand by 3.25%. Headline

inflation, in turn, was revised upwards to 3.36%, 6bp

above the October projection, also reflecting the recent

acceleration in prices and possibly the weakening of the

exchange rate, a phenomenon that is lasting more than

initially expected. The currency is now expected to be at

MXN13.32/USD by year-end, 36 centavos weaker than in

the previous poll. Regarding the tasa de fondeo, the

majority of survey participants projected no change during

this year, while one third of them expect to see monetary

easing during 1H12, and close to half of the respondent

project tightening since 2013.

Retail sales, unemployment better than expected

The National Institute of Statistics INEGI reported that

retail sales increased by 4.7% yoy in September, beating

expectations of a 3.1% increase as per Bloomberg’s poll.

Employment in the retail sector increased by 2.8%, while

average wages dropped by 1.5%. Wholesale activity, in

turn, rose by 6.3% yoy. INEGI also reported that

unemployment was 5.0% in October, way below

expectations of 5.7%. On a seasonally adjusted basis, the

jobless rate was 4.8%. These figures reaffirm the view

that fears about a quick and sharp deceleration of

economic activity were overblown. Instead, the real

economy is holding up pretty well, and the deceleration

expected for next year will proceed gradually.

Mexico: Industrial production and unemployment

3

4

5

6

7

90

100

110

120

130

IP (Jan 09=100) Unemployment (%, rhs)

Source: INEGI, Deutsche Bank

Peña Nieto likely PRI presidential candidate

Senator Manlio Fabio Beltrones from the opposition PRI

party announced his decision to step down from the race

to become a presidential candidate ahead of next year’s

election. Beltrones trailed former Mexico State Governor

Enrique Peña Nieto by a very large margin in all surveys,

but his decision definitely cleared the way to define Peña

as the party candidate. In a press release, Beltrones

indicated that his decision was ‚not a sacrifice, but rather

a contribution to help the PRI secure the victory in 2012‛.

He went on to say that the slim victory obtained by the

PRI in the recent Michoacan State election and the early

announcement of a coalition candidate by the leftist

parties suggest that the PRI also has to rally around a

consensus leader as soon as possible. Indeed former

Mexico City mayor and presidential candidate Andres

Manuel Lopez Obrador had edged current mayor Marcelo

Ebrard in a PRD party poll, with AMLO thus becoming the

presidential candidate from the left. Peña thanked

Beltrones via Twitter, acknowledging his ‚professionalism

and contribution towards PRI unity‛, and registered

formally as a presidential candidate. Beltrones’ decision

renders any primary election mechanism within the PRI

unnecessary, as the party will most likely line up behind

Peña, who in different national polls appears to be at least

ten percentage points ahead of any candidate from the

ruling PAN or the leftist PRD parties.

Las month, Peña addressed a group of investors in New

York, indicating that in the event of being elected next

year, his government program will have the following

priorities: (i) maintenance of macroeconomic stability as a

necessary (albeit not sufficient) condition for growth; (ii)

fostering competition in all markets; (iii) promoting Mexico

as a regional energy powerhouse; (iv) opening up of the

oil sector to private participation; (v) increase of

investment in human capital, modernization of educational

system; (vi) increase in bank penetration and credit

creation as a proportion of GDP; (vii) improvement in

physical infrastructure; (viii) implementation of a new

universal social security system, which will include health

coverage, unemployment insurance and pensions; (ix)

deepening of integration with the US, (x) implementation

of an integral fiscal reform; and (xi) implementation of

sector-specific promotion policies. He indicated that

economic policies geared towards accelerating growth

and reducing poverty will be the cornerstone of his

administration. His presentation was well suited for both

domestic and international investors, although he did not

provide details of implementation of each policy, as the

venue and the time constraint did not allow it. Regarding

the energy sector, he indicated that the public sector will

continue to have full ownership of the country’s natural

resources, which suggests that his plan may include a

twist to the existing arrangement of incentive contracts

for private firms, but with no changes to the constitutional

constraints on private participation in the sector.

Regarding security, he said the decision of the

administration of President Felipe Calderon to combat

organized crime was correct, although he added that

under his government he would try to increase the

operational force of the security forces, both expanding

the police and emphasizing intelligence activities.




Investment strategy

FX: Intervention may reduce volatility. MXN was one of

the currencies which suffered the most from recent

market volatility. Nevertheless, the recently announced

rule-based intervention by Banxico (will offer USD400mm

whenever the currency weakens by more than 2% in a

day) was successful in curbing the MXN depreciation and

may help to reduce its volatility. The effectiveness of the

intervention could be increased due to the important MXN

undervaluation and extreme short positioning MXN is

clearly undervalued both from a short-term perspective

based in recent evolution of financial drivers and from a

much longer valuation based on macroeconomic

fundamentals. Additionally, in our view it will be difficult

that Banxico eases monetary conditions unless the

currency appreciates considerably. We continue to find

attractive maintaining exposure to the peso, even when

acknowledging the potential risks posed by the external

environment. We recommend taking profits in our long

MXNCZK recommendation and switching to short

CADMXN (entry: 13.38, target: 13.10, stop: 13.50); this

cross still offers some positive carry while offering

protection against US risks.

Rates: Position to capture risk premium. Local rates have

been following the movements in the exchange rate. As

Banxico does not seem ready to ease monetary

conditions, at least until the currency appreciates further,

the short-end of the curve offers little value. Nevertheless,

the medium and long term sectors of the curve could

benefit from reduced exchange volatility due to Banxico’s

intervention and from a potential improvement in risk

appetite. After reaching the target, we take profits in our

5Y TIIE payer recommendation and switch to a box trade

of 2s10s TIIE flattener against 2s10s USD swap steepener

(entry: -15bp, target: 25bp, stop: -35bp). This trade could

benefit from the reduction in risk premia in Mexican rates

but also from some normalization of US rates.

Credit: Increase to neutral from underweight. Mexican

external debt has performed broadly in line with its LatAm

low beta peers, but an improving US economic activity

(especially relative to the rest of the world) in a way

removes a source that might negatively impact Mexico’s

debt dynamics. Valuation does not look attractive, but

Mexico is among the credits having the lowest risk on our

vulnerability indicators (see the special piece: EM: Survival

of the Fittest). On the UMS curve, a correction to the

mispricing of the 8.125% 19s (19Os) has taking place but

it remains significantly rich to the curve and should be

avoided; we continue to favor the 5.95% 19s (19N).



Mexico: Deutsche Bank Forecasts 2010 2011F 2012F 2013F

National Income Nominal GDP (USD bn) 995 1041 1121 1199

Population (m) 109 111 112 114


Real GDP (yoy%) 5.5 3.9 3.3 3.5


Gov’t consumption 3.4 1.5 2.9 3.0

Investment 4.0 4.6 4.0 5.0

Exports 25.0 21.0 11.0 12.0

Imports 24.0 19.0 10.0 12.0

Prices, Money and Banking CPI (Dec yoy%) 4.4 3.4 3.4 3.4

Broad Money 13.0 11.0 12.0 10.0

Credit 9.0 11.0 12.0 10.0

Fiscal Accounts (% of GDP) Consolidated budget balance -2.8 -2.1 -2.3 -2.0

Primary Balance -0.5 0.1 0.0 0.0


Exports 297.0 341.2 362.0 395.0

Imports 300.1 345.0 369.0 404.0

Trade balance -3.1 -3.8 -7.0 -9.0

% of GDP -0.3 -0.4 -0.6 -0.8


% of GDP -0.6 -0.7 -1.0 -1.2

FDI 18.0 19.5 20.0 21.0

FX reserves 113.6 140.0 161.0 180.0

MXN/USD (eop) 12.34 13.00 12.80 12.80

Debt Indicators (% of GDP) Government debt 34.4 35.2 35.3 35.8

Domestic 24.4 25.4 25.8 26.5

External 10.0 9.8 9.5 9.3


in USDbn 192.0 206.0 216.0 225.0


General

Industrial production (yoy%) 6.0 4.4 4.0 5.0

Unemployment (%, avg) 5.3 5.6 5.4 5.2


Overnight rate (%) 4.5 4.3 4.0 4.0

3-month rate (%) 4.4 4.2 4.0 4.0

MXN/USD 13.54 12.80 12.60 12.60 Source: DB Global Markets Research, National Sources



Peru Baa3 (pos)/BBB (neutral)/BBB (neutral) Moody’s/S&P/Fitch

Economic outlook: GDP growth is to be near 7%

this year, slowing down very gradually towards 6% in

2012. The inflation spike is likely to be temporary, but

it will prevent monetary easing for now. Structural

excess demand for dollars is to maintain the currency

well supported.

Main risks: Higher inflation because of food prices.

Weaker fiscal and external performance because of

softer mining prices, if global growth falters.

Strategy recommendations: Maintain long 3M

USD/PEN NDF and remain neutral on rates. Increase

to overweight external debt, take profit in the 37s to

19s switch and now favor the long end of the curve.

Macro view

3Q11 GDP in line with expectations

GDP expanded by 6.5% yoy during 3Q11, slightly below


Bloomberg’s poll. This was the fifth consecutive quarter in

which growth slows down. The Central Bank has recently

upgraded its 2011 GDP growth forecast to 6.8% from

6.3%. In order to reach 6.8%, the economy should grow

by 4.8% yoy during 4Q11, something that looks feasible.

Although domestic spending appears to be holding up

well, the authorities have announced a stimulus plan to

offset a possible further deterioration in external

conditions. Currently, said plan stands at nearly 2% of

GDP, but Economy Minister Castilla hinted that it could be

increased if deemed necessary. We expect to see slower

growth next year, although Peru should still be among the

strongest performers in LatAm, expanding by almost 6%.

November inflation above expectations

INEI reported that consumer prices rose by 0.43% mom,

4.64% yoy, well above expectations of a 0.30% increase

as per Bloomberg’s survey. Year to date, prices increased

by 4.46%. Prices of food and beverages continue to lead

the increases. The Central Bank has argued that the spike

in inflation is a temporary phenomenon that will dissipate

next year, while core inflation remains better behaved at

3.50% and inflation excluding all food and energy items is

running at 2.50%, suggesting that there is no evidence of

substantial demand pressures. The increase in inflation

observed since June, however, has been very significant,

which suggests that next year’s figures could also be a bit

higher than initially thought, near 3.5%.

Policy rate unchanged for now

The Central Bank left its reference rate unchanged at

4.25% in October, in line with expectations. The decision

was made as the Bank acknowledged that aggregate

expenditure is growing at a slower pace than earlier in the

year, and also because of the higher risks stemming from

the international financial turmoil. While the Bank has

repeatedly indicated its concerns about a deteriorating

global environment, the inflation spike suggests that the

authorities have little to ease monetary policy at the

present juncture. We indeed expect the policy rate to

remain unchanged through 2012, as current levels

represent real short term rates that are well below 1%.

External accounts in good shape

September’s trade surplus reached USD656m, on track to

reach almost USD7bn this year. The current account

deficit, in turn, is to be below 1.5% of GDP. We project

similar figures for the next couple of years, with the

current account imbalance remaining below 2% of GDP

and more than covered by FDI inflows. We also project a

further accumulation of reserves, albeit at a somewhat

smaller pace than in the past two years.

Humala’s first 100 days – a mixed review in the polls

After 100 days in office, President Ollanta Humala’s

approval rate is still high at 56% but it has dropped from

more than 70% when he took office, according to a poll

conducted by local consultant Apoyo. He lost six points in

the last month alone. Those supporting him indicated that

he is promoting change to improve the country, that he is

fulfilling his campaign promises, and that he cares about

the poor. Those who disapprove of him mentioned that he

is not sticking to his campaign agenda, that he does not

generate confidence, and that there is evidence of

corruption in his government. First Lady Nadine Heredia is

the public figure with the highest popularity at 63%, even

surpassing the President. Prime Minister Salomon Lerner

received only 33% backing, while Economy Minister

Miguel Castilla reached 37% and Congress Chairman

Daniel Abugattas got 42%. Vice Presidents Marisol

Espinoza and Omar Chehade (currently under investigation

and suspended from his post) did not fare well, with

support of 34% and 8%, respectively. In terms of specific

areas of government work, the Humala administration

obtained a mixed review, with good marks regarding the

fight against poverty and the promotion of investment and

employment, while the efforts towards solving social

conflicts, fight drug trafficking and combat corruption

were disapproved.

Fitch upgrade

On November 10, Fitch ratings announced its decision to

upgrade Peru’s foreign currency issuer default rating (IDR)

and country ceiling to BBB from BBB-. The local currency

IDR was raised to BBB+ from BBB. The decision

represents an implicit endorsement for President Ollanta

Humala, as the agency indicated that the upgrade reflects



‚reduced uncertainty regarding macroeconomic policy

continuity and changes to the fiscal contribution of the

mining sector‛. Fitch said that the ratings are supported

by a strong net external creditor position, high and

increasing international reserves, and low external debt.

The vulnerabilities are mainly the high dependence on

commodities and the high degree of dollarization. Fitch

highlighted the commitment of the new administration to

a conservative fiscal stance and a credible monetary

policy, and the rapid and successful negotiation to

increase the fiscal contribution of the mining industry,

which reduced regulatory uncertainty. We believe

upgrades from other rating agencies are likely next year.

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


Investment strategy

FX: Risks are biased toward depreciation. The

successful Central Bank intervention in the FX market has

shielded the PEN from the recent volatility in global

financial markets. However, as the currency continues to

trade close to multiyear high levels, the intervention has

helped to increase the currency overvaluation. While the

central bank will likely continue to intervene aggressively

to smooth the currency movements and capital flows may

still be favorable, the risks, in our view, are biased toward

depreciation. Next year, the currency will receive less

support both from economic growth and terms of trade.

We recommend maintaining 3M USD/PEN NDF (entry:

2.72, target: 2.80, stop: 2.68).

Rates: Remain neutral. The local curve, supported by

favorable technicals and a stable currency, has shown

extraordinary resilience to external events. With rates

trading at relatively low levels and the central bank with

little room to ease monetary conditions, the curve does

not offer much value. We recommend remaining neutral

on local rates, waiting for better entry levels to get

additional exposure.

Credit: Increase to overweight. Fundamentals remain

strong, anchored by robust growth, even though there is a

mild deterioration in fiscal and external accounts due to

weaker global demand for mining exports. While we value

Peru’s stability drawn from its fundamental strength,

valuation on the curve also looks marginally more

attractive in comparison with Brazil and Mexico. On the

global curve, the 19s/37s slope has significantly

steepened and we hence recommend taking profit in the

37s to 19s switch. We now find better value at the long

end of the curve.


Hongtao Jiang, New York, (212) 250 2524

Peru: Deutsche Bank Forecasts

2010 2011F 2012F 2013F

National Income


Population (m) 29.3 29.7 30.0 30.5


Real GDP (YoY%) 8.8 6.8 5.9 5.5

Priv. Consumption 6.0 6.5 5.5 5.0


Investment 22.4 11.0 10.0 10.0

Exports 2.5 24.0 10.0 10.0

Imports 23.8 31.0 17.0 12.0


CPI (YoY%) 2.1 4.4 3.5 3.2

Broad money 25.4 12.0 13.5 13.0

Credit 20.3 14.0 15.0 15.0

Fiscal accounts, % of GDP

Balance -0.7 0.1 -0.2 -0.4

Government spending 20.0 19.9 20.5 21.0

Government revenue 19.3 20.0 20.3 20.6

Primary surplus 0.6 0.8 0.4 0.3

External accounts (USDbn)

Exports 35.6 44.7 48.5 51.1

Imports 28.8 38.0 45.0 49.0

Trade balance 6.8 6.7 6.5 6.0

% of GDP 4.6 4.0 3.7 3.2


% of GDP -1.6 -1.4 -1.7 -1.9

FDI 5.7 5.5 5.1 5.0


FX rate PEN/USD (eop) 2.80 2.72 2.85 2.90



Domestic 10.3 9.5 9.8 10.0

External 13.8 13.4 13.6 13.7


in USDbn 41.0 45.6 48.8 52.9


General

Industrial prod (%) 8.3 6.0 6.3 6.0

Unemployment (%) 7.6 7.3 7.0 6.9


Policy rate (interbank o/n) 4.25 4.25 4.25 4.25

6-month rate (interbank) 4.50 4.50 4.50 4.50

PEN/USD 2.71 2.75 2.80 2.85 Source: DB Global Markets Research, National Sources



Uruguay Ba1 (stable)/BBB- (stable)/BB+ (stable) Moodys/S&P/Fitch

Economic Outlook: Economic growth is decelerating

gradually, converging towards trend levels, although

risk of the projections is on the upside given the

pipeline of investment projects. Inflation remains well

above the ceiling of the target range, preventing any

monetary easing for the time being.

Main Risks: A drop in commodity prices. A further

acceleration in inflation. Weaker growth in the

country’s main trading partners.

Strategy Recommendations: We favor UYU ’18 as a

buy and hold strategy due to elevated carry and

diversification.

Macro View

Inflation remains well above expectations

Consumer prices rose by 0.42% mom, 8.40% yoy in

November, above expectations of a 0.30% increase as

per the Central Bank’s poll. Annual inflation jumped 52bp

relative to October. With the exception of entertainment,

all item groups posted price increases during the month,

led by apparel that rose by 1.47%. Prices of food and

beverages increased by 0.30% mom, 8.92% yoy. Inflation

has been fueled by high prices of commodity imports and,

in spite of the substantial monetary tightening

implemented this year, to the tune of 150bp, it remains

well above the ceiling of the official target that spans from

4% to 6%. Producer prices are increasing at double digit

pace, suggesting that both demand and supply factors are

playing a role in the acceleration of consumer prices. This

suggests that despite any concerns about global

economic growth and/or softening commodity prices in

the months ahead, the Central Bank has no room to ease

monetary policy at the present juncture. The next

monetary policy meeting is scheduled for December 29.

We expect the policy rate to remain unchanged at 8%

through next year.

Economic activity continues to expand

GDP rose by 5.7% yoy during 1H11, significantly below

the 8.4% increase observed during 2010. We expect the

slowdown to continue during 2H11, so that the annual

figure is likely to come out at around 5%. This weakening

trend is also behind our expectation of no more interest

rate hikes in the coming months, despite the evidence of

inflation pressures. The index of leading indicators

produced by local think tank Ceres continued to indicate

an expansion through September, which suggests that

economic activity will most likely grow during 2H11.

Ceres leading index has risen for 28 consecutive months.

Ceres diffusion index, in turn, is currently at 89%, which

indicates that most of the variables that are part of the

leading index continue to move forward. We project the

economy to grow at near trend levels of less than 5% pa

over the next couple of years, although we acknowledge

that the risk of the forecast is on the upside, as Uruguay

remains a significant attractor of strategic foreign

investment which, given the size of the economy, could

have an outsized impact on growth performance. In

addition, a recently approved public-private partnership

law could also have a beneficial effect on infrastructure

investment. Unemployment has averaged 6.1% so far this

year, which compares favorably with the 6.7% of 2010

and the 7.3% of 2009. We believe that the jobless rate

could continue dropping towards the high 5% level during

the next two years.

External sector dynamics

The current account deficit has widened this year and is

expected to surpass the 2% of GDP mark. The increase in

that imbalance will probably continue over the next couple

of years. Demand for imports is strong, fueled by private

consumption and investment, while exports are likely to

grow at a slower pace as the real exchange rate continues

to appreciate. The currency weakened since September

2011, in unison with most other EM currencies, and is

likely to end the year at nearly UYU20/USD, after

averaging UYU18.8/USD during 3Q11. The exchange rate,

however, has been on a major appreciation trend since

the beginning of 2009, on the back of stronger

fundamentals and robust capital inflows. Although we

expect the nominal rate to trade slightly above 20 going

forward, we estimate that the real effective exchange rate

is currently some 15% stronger than its average of the

past decade. Given that inflation will probably remain

above the ceiling of the target band during the next two

years, chances are good that the real appreciation will not

be corrected any time soon. In the event of excessive

short term currency volatility because of external

concerns, the Central Bank is in a strong position to

intervene successfully, as international reserves are

currently above the USD10bn threshold, more than triple

the level of 2007.

Although the external deficit is expected to increase, we

believe that it will be more than covered by FDI inflows,

which will contribute to maintaining the capital account of

the balance of payments in a surplus position. In May

2011, a consortium of foreign firms started the

construction of yet another pulp mill worth USD1.9bn, the

largest ever private FDI transaction in the country’s

history. According to the Finance Ministry, the project

should have a direct positive impact on GDP growth of

some 0.8% during 2011 and 2012, and 2% pa when it

becomes fully operational.

Public sector finances

In the 12 months to August 2011, the consolidated public

sector primary surplus was equivalent to 1.9% of GDP. As

the interest bill on public debt remained at 3% of GDP,



the overall deficit was just above 1% of GDP. We expect

the imbalance to increase towards 1.5% of GDP by year-

end, and to remain around those levels during 2012-13.

Gross public sector debt currently stands just below 60%

of GDP, of which 35% of GDP is external. We project

these ratios to fall further in 2012-13, although at a much

smaller pace than in recent years (gross debt/GDP was

over 100% in 2003). In July, S&P raised the country’s

foreign currency issue rating to BBB-, and Fitch did at the

same time to BB+. The upgrades were justified by the

track record of sound policy design and implementation,

and the evidence that the fiscal and monetary policy mix

was not changing after the administration of President

Jose Mujica took over.


Investment Strategy

Rates: Linkers are attractive as a buy and hold proposition.

While Uruguayan linkers suffer from reduced liquidity, the

attractive carry and good prospects for the carry make

them an attractive proposition to buy and hold. In our

view, inflation expectations will remain elevated as

inflation remains above the upper band of the target.

Additionally, while high inflation continues to appreciate

the currency which is arguably already overvalued, the

central bank will likely intervene to stop any sharp

depreciation of the currency. Finally, as shown by the

recent credit rating upgrades, the credit will remain solid

on the back of sound policy design. As a consequence,

we believe that short duration linkers –like the UYU ‘18s-

could be an interesting source of carry while offering an

attractive diversification opportunity.


Uruguay: Deutsche Bank Forecasts 2010 2011F 2012F 2013F

National Income


Population (mn) 3.4 3.4 3.4 3.4


Real GDP (YoY%) 8.0 5.0 4.8 5.0

Consumption 10.1 8.0 7.5 8.0


Exports 23.0 27.0 25.0 24.0

Imports 24.1 30.0 28.0 28.0


CPI (Dec YoY%) 6.9 8.1 6.5 6.0

Broad Money 31.0 23.0 18.0 17.0




Primary Balance 1.7 1.9 1.8 1.8


Exports 10.7 12.0 11.0 11.0

Imports 9.9 11.7 9.8 9.8


% of GDP 1.9 0.6 2.4 2.3


% of GDP -1.1 -2.2 -2.4 -2.7

FDI 2.4 2.5 2.5 2.5

FX reserves 7.7 10.5 11.6 13.0

UYU/USD 19.9 20.0 21.0 22.0



Domestic 7.5 10.1 9.9 9.7

External 33.9 33.9 33.1 32.3


in USDbn 14.6 15.1 15.6 16.1


General

Unemployment (%) 6.9 6.0 5.9 5.7


Overnight rate (%) 8.0 8.0 8.0 8.0

3-month rate (%) 4.5 5.0 5.0 5.0

UYU/USD 19.8 20.0 20.5 21.0

Source: DB Global Markets Research, National Sources



Venezuela B2 (stable)/B+ (stable)/B+ (stable) Moodys/S&P/Fitch

Economic Outlook: Economic activity is picking up

speed, following the contraction of the past two

years and beating expectations. The recovery should

continue next year on the back of very expansive

fiscal and monetary policies, ahead of the presidential

elections. Inflation remains the highest across the EM

universe.

Main Risks: Lower oil prices as a result of softer

global growth or a financial disruption in Europe.

Further acceleration in inflation because of food

prices and/or pressures from very loose fiscal policy.

Volatility of political origin before next year’s


Strategy Recommendations: Increase to a small

overweight, favoring the Republic over PDVSA. On

Venezuela, 28s look the most attractive. On PDVSA,

we continue to favor the 13s (for carry-oriented

investors) but also consider moving to the mid-end of

the curve where we favor the 22s. In addition, while

we continue to recommend long basis on the

sovereign curve (24s vs. 10Y being the best trade at

the moment), we also like PDVSA 22s vs. Venezuela

10Y CDS.

Macro View

GDP growth well above expectations

GDP expanded by 4.2% yoy during 3Q11, surpassing

expectations of a 3.1% increases according to

Bloomberg’s survey. Earlier on, President Hugo Chavez

had hinted that the economy grew by 3.5% during the

period, but the actual number was even stronger than his

initial estimate. Thus, GDP has risen by 3.8% during the

first nine months of the year (0.2% for the oil sector and

4.1% for the non-oil economy), and it is now on track to

expand by about 4% during 2011 – well above

expectations. Financial services led the increases with a

15% increase, while the construction sector jumped by

10%. The communications sector increased by 7.9% and

mining by 7.6%. The oil economy expanded by 0.3%

during the quarter, a small contribution in spite of the very

high crude prices, which according to Finance Minister

Jorge Giordani is due to the compliance with the OPEC

quotas. Giordani added that the government will target

5% GDP growth in 2012, something that we see as a very

tall order, especially considering that global growth will be

weak and that 2011 figures will represent a higher

comparison point, making fast growth more difficult to

achieve. As the administration will face a crucial

presidential election, however, chances are that fiscal and

monetary policy will take on a very expansive stance,

preventing economic activity from decelerating much. It

remains to be seen, however, whether that policy impulse

will be sustainable over time, especially in the absence of

changes to the policy mix that could provide further

stimulus to the demand for investment.

Venezuela: GDP growth is picking up (% yoy)

-8

-6

-4

-2

0

2

4

6

8

10

12

Source: BCV, Deutsche Bank

Highest inflation across EM

As of the end of October, annual inflation as measured by

the national index was running at 26.8%, while the old

Caracas index showed a 27.7% increase, posting the fifth

consecutive month of increases. Inflation has not been

below the 23% mark since December 2007. The

government established an informal target of 22% to 24%

for the current year, which will likely be surpassed,

especially considering that there could be additional

adjustments to regulated prices while public spending

continues to grow at a fast pace. Core inflation was

running at 27.7% as of October, i.e. head to head with the

general index, which suggests that inflationary pressures

are broad based and will probably be persistent rather

than temporary. For next year, we expect inflation to

remain very high, fueled by very loose fiscal and monetary

policies, combined with an uncertain supply reaction given

the recent implementation of the new price and cost

control norms. Year to date, M2 increased by 41%, even

surpassing inflation, and we expect the rapid rise in

liquidity to continue at least until the November elections.

The bank credit portfolio, in turn, rose by 35%. According

to the Superintendency of Banks, however, the non

performing remains very low at 1.8% of total.



Venezuela: Inflation rates (% yoy)

0

10

20

30

40

50

60

Jan-0

6

Jun-0

6

Nov-0

6

Apr-

07

Sep-0

7

Feb-0

8

Jul-08

Dec-0

8

May-0

9

Oct-

09

Mar-

10

Aug-1

0

Jan-1

1

Jun-1

1

CPI Food

Source: Bloomberg News, Deutsche Bank

New price and cost controls law enacted

A new law that regulates prices across the board became

effective last month, allowing the government to establish

caps on prices of some 15,000 goods and services. A

small group of personal hygiene products had their prices

frozen effective immediately, and going forward all firms

will have to report their cost structure to the authorities in

order for ‚fair‛ prices to be calculated by the government.

Companies will also have to provide information about

their domestic and foreign suppliers, as well as

technological transfers that affect costs. The norm does

not establish any methodology to determine when profits

are ‚excessive‛, although Commerce Minister Edmee

Betancourt hinted that 10% would be a ‚reasonable‛

figure. Official inspectors will work inside firms to monitor

production and cost. Thus, it has become evident that

President Chavez is to toughen his rhetoric against the

corporate world. Before announcing the new law, he

accused local firms of ‚behaving like big monopolies …

that dominate and ransack people‛. Given the high

ongoing inflation rate, the government’s strategy is to

shift its policies towards a stricter control mode to

prevent further price increases ahead of next year’s

election.

The strategy, however, is risky for the chavismo, as the

implementation of a full price control strategy is

logistically difficult, and if the government toughens the

rules in excess for the private sector, shortages will

probably appear, which would take a toll on economic

activity and could backfire and lower popular support for

the administration. Central Bank Director Armando Leon

provided a cautionary note about the law. Leon warned

that exerting control over the 500,000 items traded in the

Venezuelan economy would be ‚absurd‛, and that the

new norm could represent ‚a straitjacket‛ for the

economy. Enforcement of the new regulation would

require some 40,000 inspectors nationwide, he said. Leon

highlighted the challenges such policy entails, as possible

delays in providing permits for companies to produce may

result in supply bottlenecks and eventually in inflationary

pressures – that is, it could backfire.

Oil prices provide ample external support

The very robust prices of the Venezuelan crude mix have

provided ample support for the country’s balance of

payments. During the first 11 months of the year, said

price averaged USD100/barrel, up 42% yoy. According to

our calculations, at current oil prices, Venezuela is to

generate a current account surplus equivalent to some

USD15bn this year, which should result in a notional

increase in international reserves of around USD22bn.

Such increase, however, is not reflected in the reserves

being held by the Central Bank, as the government’s

strategy continues to be the establishment of an

‚optimal‛ reserve level and the transfer of any excess to

other official entities, mainly the Fonden development

fund. During the first nine months of the year, the

government’s exchange bureau Cadivi authorized

USD22.9bn worth of imports at the official exchange rate

of VEF4.30/USD, a 7.2% yoy increase. The supply of

dollars was completed with what was processed via

Sitme and what provided by the Central Bank. It must be

noted that the implicit parity exchange rate that results

from the ration between M2 and reserves was over

VEF14/USD in November.

Venezuela: Nominal and real exchange rates

70

75

80

85

90

95

100

105

110

4.0

4.2

4.4

4.6

4.8

5.0

5.2

5.4

5.6

5.8

6.0

Official rate Sitme rate Real exchange rate (2000=100), rhs

Source: IIF, Deutsche Bank

New PDVSA issue

State owned oil Company PDVSA announced the issuance

of USD2.394bn worth of dollar denominated bonds

maturing on November 17, 2021. The bonds will pay a 9%

semi-annual coupon and will be amortized in three equal

installments on November 2019, November 2020 and

November 2021. The securities are not registered in the

US and are being offered outside the US only. The



company reported that USD1.256bn will be exchanged for

the PDVSA bonds due 2013 currently being held by the

Central Bank. In addition, USD564m of the new bonds will

be placed directly with the Central Bank. The remaining

USD574m should in principle be sold to the market, but

the company did not provide any other specifics about the

transaction. The proceeds of the bond sale are to be used

for ‚general corporate purposes and for contributions to

social projects and programs‛. A few weeks ago, Energy

Minister and PDVSA head Rafael Ramirez had denied that

the company would issue new debt this year, but it could

well be the case that he was referring to issuance to the

market. Before the company’s announcement, there had

been market talk about PDVSA tapping the dollar market

with some USD3bn issue, so that the smaller amount,

coupled with the fact that a large portion of the securities

will be sold directly to the Central Bank, and then leak to

the market more gradually, provided some relief.

Cemex reaches accord with Venezuelan

government The Venezuelan government reached an agreement with

Mexican cement company Cemex to compensate the firm

for the nationalization of its assets in the country. The

local media reported that Cemex initially valued its

Venezuelan assets at USD1.3bn, but the accord was for

USD600m, of which USD240m will be paid immediately

and the rest in four USD90m installments in the form of

PDVSA securities. In August 2008, the government had

seized the three plants of the company in Venezuela, and

both parties were in the process of arbitration with the

World Bank’s ICSID since 2009. Cemex reported that the

agreement was subscribed by its subsidiaries in the

Netherlands and the Socialist Cement Corporation, which

represented the Venezuelan government. Since 2008, the

cement industry is under full government control. It is not

clear whether the agreement with Cemex represents a

blueprint for other agreements with companies currently

in arbitration with the Venezuelan government. If so,

future agreements could represent a marked increase in

PDVSA liabilities.

Electoral campaigns heating up

Last month, the leading opposition politicians held their

first televised debate ahead of February 2012’s primary

election to choose a coalition candidate to run against the

chavismo. The candidates were Miranda Governor

Henrique Capriles Radonski, currently at the top of the

opposition polls, former Chacao Mayor Leopoldo Lopez,

Zulia Governor Pablo Perez, former Caracas Mayor Diego

Arria and independent legislator Maria Corina Machado.

Polls conducted by the local media immediately after the

debate showed that Machado and Arria had the strongest

performances in the debate, although the event did not

feature any substantial crossfire among the candidates,

who instead wanted to convey a message of unity and

need for regime change. The debate was praised by the

local media as a successful democratic event in which the

opposition rallied around the ideas of the need for

institutional change, the fight against corruption, the

improvement of security and education, and the need to

reduce poverty.

The debate appears to have prompted multiple reactions

within the ruling chavista coalition. First, President Chavez

criticized the opposition leaders as elitist and hinted that

he may decide ‚to stay in office for much longer, until

2041‛. Later on, former education minister and chavista

coalition leader Aristobulo Isturiz announced a new

nationwide political strategy in support of Chavez

reelection. The coalition plans to create so called

‚vanguard patrols‛ to drum up support for Chavez,

starting in Caracas, then in Miranda and Aragua, and later

on in the western part of the country. Asturiz said the plan

is to put together, in this first stage, some 1,900 patrols in

Caracas, Miranda, Aragua and Vargas, which would

include 380,000 activists. We indeed expect the

government to implement a more aggressive electoral

campaign since the beginning of 2012, including not only

a very expansive fiscal policy but also targeted criticism at

the opposition candidates with the most robust showings

in the surveys.

The latest poll conducted by Alfredo Keller and Associates

showed that President Chavez’s popular support

recovered from the drop observed in the early part of the

year, reaching 57% versus the 37% of 2Q11, mainly

because of the positive reading of the population about

the Housing Mission and also because of sympathy

reaction prompted by Chavez’ illness. The survey was

conducted during July, August and September among

1,200 Venezuelans nationwide. The poll also shows that

the perception that the main problems of the country have

not been resolved still continues. 85% of the survey

participants believe that security was worsened, while

69% indicated that cost of living has increased, 68% said

drug trafficking has increased, 64% complained about

corruption, and 63% argued that unemployment has risen.

That is, while the poll suggests that Chavez has regained

popular backing, it also highlights that the population

wants policy changes, which leaves the door open for a

good showing of the opposition in the October 2012

elections. In the event that Chavez cannot run for

reelection next year, the poll shows that Vice President

Elias Jaua would be the strongest contender within the

chavismo, with 34% of the preferences, followed by

Barinas Governor (and the President’s brother) Adan

Chavez and Former Interior Minister Nicolas Maduro. On

the opposition front, Capriles and Lopez are at the top of

the preferences, followed by Perez and Machado, with



Arria trailing by a very large margin. Interestingly,

according this poll Chavez leads all opposition candidates

by at least 17 percentage points when he faces an

atomized opposition, but loses against a coalition

candidate by 51% to 39%.

Fernando Losada, New York, (1) 212 250-3162

Investment Strategy

Credit Markets: Increase to a small overweight.

Venezuela has been one of the best performers in terms

of cash bond total returns and the best performer in terms

of CDS total returns in EM in 2011, thanks in large part to

the hopes of a potential regime change down the road

and high level of carry.

While continued deterioration of the credit quality and

poor technicals due to massive amount of issuance will

undoubtedly continue to constrain spread performance of

Venezuelan assets, we believe market has been

underpricing the probability of a relatively peaceful

transition of power to the opposition at end of 2012. This,

together with attractive valuation and continued high oil

prices, form the main basis for our overweight

recommendation. However, due to potential risk of

political uncertainty, we would keep the size of

overweight relatively small.

The recent PDVSA 21s issuance was done in a less

disruptive fashion than expected. Consequently, PDVSA

has outperformed the sovereign in recent days. At current

levels, we are more in favor of the Sovereign curve,

where 10Y sector continue to offer the best value (24s

being currently the cheapest). Towards the longer end,

the 28s look attractive. We continue to recommend long

basis at the mid section of the curve, now favoring 24s vs.

10Y CDS. We have previously favored the 26s, which

have outperformed and now look expensive to the curve.

On PDVSA, while we continue to favor the 13s for carry-

oriented investors as there is little credit risk before the

maturity of this bond (the maturity of the 13s have also

been partially financed through the swap with the Central

bank in the issuance of the 21s), we would also

considering moving out to longer end of the curve where

we find the 22s attractive. Finally, we recommend PDVSA

22s vs. Venezuela 10Y CDS (notional ratio 1 x 0.85) at the

par-equivalent basis of almost -600bp, with excellent carry

of 47bp in 3M breakeven.

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

Venezuela: Deutsche Bank Forecasts 2010 2011F 2012F 2013F

National Income


Population (mn) 29 30 31 31


Real GDP (YoY%) -1.4 3.9 4.0 3.0

Priv. consumption -1.7 3.5 3.5 3.0


Investment -6.0 1.0 1.0 1.0

Exports -12.4 13.0 8.0 6.0

Imports -4.6 10.0 11.0 6.0


CPI (Dec YoY%) 27.2 28.0 27.0 25.0

Broad Money 26.0 46.0 40.0 18.0

Credit 18.0 35.0 30.0 10.0




Primary Balance 0.7 0.6 -0.5 0.1


Exports 65.8 94.0 85.0 85.0

Imports 38.6 45.0 58.0 55.0

Trade balance 27.2 49.0 27.0 30.0

% of GDP 8.3 11.2 5.2 5.0

Current account balance 15.0 30.0 13.0 14.0

% of GDP 4.6 6.9 2.5 2.3

FDI -2.0 2.0 0.0 0.0

FX reserves 30.3 30.0 30.0 30.0

VEF/USD (eop) 4.30 4.30 5.20 6.50



Domestic 11.0 14.6 16.5 18.0

External 23.5 21.2 20.3 22.0


in USDbn 84.9 101.0 113.0 120.0


General


Unemployment (%) 8.5 8.3 8.0 8.1

Financial Markets (end

period)

Current 3M 6M 12M

Overnight rate (%) 0.2 2.0 8.0 12.0

3-month rate (%) 14.5 15.0 15.5 17.0

VEB/USD 4.30 4.30 4.30 5.20 Source: DB Global Markets Research, National Sources



Czech Republic A1(stable)/AA-(stable)/A+(pos) Moody’s/S&P/Fitch

Economic Outlook: The combination of a weak

labour market, ongoing fiscal austerity and an

expected recession in Euroland leaves a significant

risk of recession in Czech Republic. But with the

public debt/GDP ratio sub 40% and C/A deficit

financing the most secure in the region, the medium-

term fundamentals remain strong.

Main Risks: Germany is by far Czech Republic’s

largest export partner accounting for 22% of GDP in

exports. A more protracted recession in Germany

leaves significant downside risk for the Czech

economy and could well push the CNB into a rate cut.

Strategy Recommendations: 2s10s IRS set to

steepen.Neutral on rates. Neutral on EUR/CZK

Macro View An imported recession in 2012. As the most open

economy in EMEA alongside Hungary, Czech Republic

faces a very difficult 2012. Growth stalled in Q3 in what

was the worst growth performance in CEE, and with little

room for fiscal or monetary stimulus and a deteriorating

growth outlook in Euroland the next several quarters are

also likely to report zero or negative growth. The currency

has also come under pressure from the stress in

European financial markets and the plans for a sovereign

Eurobond in H2 2011 did not materialize. But despite the

immediate spillover from European woes the

fundamentals of the Czech economy remain the most

solid in the region. Needed fiscal adjustment and debt

reduction is much less than elsewhere and the structure

of C/A financing the most secure. The medium-term

outlook remains robust.

The zero QoQ and 1.5% YoY reading (sa-wda basis) for

Q3 GDP compares with a consensus expectation of 0.2%

QoQ and 1.6% YoY and a CNB forecast of 1.7% YoY. It is

also disappointing given the only 0.1% QoQ reading in

Q2. Although full components are not yet released the

CZSO press release from the flash estimate noted that a

slowdown in domestic demand was compensated by

positive developments in external demand with net trade

remaining as the only component reporting positive

growth. We expect that some of the underperformance in

Q3 GDP versus the 0.5% QoQ reading for Hungary and

1.9% QoQ reading for Romania is due to the temporary

boost from agriculture which benefitted these economies

due to the larger agriculture sectors in these countries.

The level of the PMI remained the highest in CE3, trade

momentum held up better than elsewhere, albeit much

reduced from Q2, and households were not impacted by

a strong Swiss franc through the quarter. It is also the

case that direct banking sector linkages with the most

stressed European countries are smaller than in Hungary

or Poland and the sector-wide LTD ratio is at a

comfortable 80% so pressure on financing should also

have been much less.

The stalling in growth through Q3 came with a declining,

but still expansionary, PMI with a 53.0 average for Q3.

Nevertheless, this was a 3.7 point drop from Q2 and the

largest quarterly decline since Q1 2009 when the

economy reported its largest quarterly GDP contraction on

record (-3.6% QoQ). A decline in new orders was by far

the largest contributor to the drop in the PMI through Q3

with declines in output, inventories and employment

being much smaller factors during recent months. The

trend continued in the October and November PMI

readings and pushed the November PMI to a 27-month

low of 48.6 and the first sub 50 reading since October

2009. On the domestic demand side the worst quarterly

reading on retail sales since Q1 2010 combined with a

drop back in the pace of credit extension versus earlier in

the year will both have added to the negative domestic

demand contribution through the quarter. Confidence has

also continued to decline with consumer confidence now

back close to the Q1 2009 lows.

Czech Republic: Consumer confidence has dropped

back close to the Q1 2009 lows

-35

-30

-25

-20

-15

-10

-5

0

5

10

-40

-30

-20

-10

0

10

20

30

Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11

Industrial

confidenceConsumer

confidence (rhs)

% balance (seasonally adjusted)

Source: Haver Analytics, DB Global Markets Research

The January 2012 hike in the preferential VAT rate from

10% to 14% and ongoing fiscal consolidation efforts in an

attempt to achieve a sub 3% fiscal deficit by 2013 point to

further weakness in domestic demand for 2012.

Combined with our expectation of three quarters of

negative growth in Euroland (with our 2012 Euroland GDP

growth forecasts recently revised down to -0.5% from

+0.4% previously) we have now revised down our 2012

GDP forecasts for Czech Republic and also nudged down



2011 estimates due to the recent poor performance. We

now expect 2011 GDP growth at 1.8% (from 2.0%

previously) with a positive carryover and enough

momentum through H1 to produce a reasonable growth

reading despite a poor H2. For 2012 we now expect GDP

growth of zero (and therefore in line with our forecast for

Germany) versus 1.6% in our earlier forecasts with the

contribution to growth from external trade now much

reduced and most of the growth coming in the second

half of the year. The latest CNB forecast stands at 1.2%

and Ministry of Finance projection at 1.0%. Our revised

forecasts still see Czech Republic returning to pre-crisis

levels of output in 2012 but now in H2 (as of Q3 2011

output remained 0.6% below the peak compared with

5.3% in Hungary and 5.8% in Romania). Our baseline is

for a shallow recession through the first half of 2012 with

the risks to our forecasts remaining skewed to the

downside.

One complicating factor for our growth projections is the

upcoming release of the revised quarterly national

accounts data back to 1995. The annual revisions were

released in September and saw the level of nominal GDP

raised by around 4% relative to earlier estimates and 2010

real GDP growth revised up to 2.7% from 2.2%

previously. Depending on how the quarterly profile is

distributed this could push up our 2011 and 2012 growth

projections. Nevertheless, given the weak backdrop the

risks still remain skewed to the downside.

Fiscal deficit is narrowing slowly. The Finance Ministry

has recently revised down its 2012 GDP growth

assumption to 1.0% from 2.3% in its May Fiscal Outlook.

The earlier plans for a maximum 3.5% of GDP deficit in

2012 and 2.9% in 2013 have however been retained with

lower revenue estimates being offset by revisions to

spending plans (the point forecast is for a 3.2% fiscal

deficit forecast for 2012). With the lower growth outlook,

the planned narrowing in the headline deficit requires an

average 0.7pp improvement in the structural position in

each of the next several years to achieve the targeted

medium-term structural deficit of less than 1% of GDP.

The 2012 fiscal adjustment switches to the revenue side

after the spending side measures of 2011 which included

a 10% reduction in the public sector wage bill,

reduction/cancellation of benefits and reduction in current

and investment spending. 2012 will see a rise in the

preferential VAT rate from 10% to 14% (expected to

result in increased revenues of CZK27bn) with revenues

intended to plug the gap created by the establishing of a

second pillar pension system as of 2013. YTD

performance looks broadly on track with data through

November showing the state deficit at 93.2% of the

CZK135bn full-year target. This is however worse than the

86% in November 2010 and therefore leaves less of a

buffer going into year end. On the wider general

government deficit the government has initially targeted a

4.6% of GDP deficit for 2011 but has suggested this could

be as low as 3.7%. Assuming no overshoot on the state

budget this would still need a material improvement in the

local government budget to be realistic. We do not expect

the deficit targets to be achieved but nevertheless see

slow, steady consolidation.

Czech Republic: The EC expects only a small

improvement in the deficit in 2012

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

2007 2008 2009 2010 2011F 2012F

Autumn 2011

Sprine 2011

Headline budget balance (% GDP)

Source: European Commission

The Ministry of Finance has yet to release its Debt

Management Outlook for 2012 but the Finance Minister

has said the gross borrowing requirement would be

around CZK226bn (5.7% of GDP) and therefore up from

the CZK219.5bn for 2011 (and based on the planned

CZK105bn state budget deficit). Czech Republic does not

face any sovereign Eurobond redemptions in 2012 but we

expect the authorities will issue the Eurobond announced

for H2 2011 with the remainder of the financing from

domestic issuance.

C/A financing likely to remain comfortable. We do not

expect much change in the C/A dynamics in 2012 with the

income outflows from the high presence of foreign-

owned companies continuing to offset the trade surplus.

While we have modified our export assumption the very

high correlation between export and import growth in

Czech Republic (reflecting the high import content of

exports) points to a largely neutral impact on the trade

balance from a drop back in export demand. The C/A

deficit stands at an annualized 3.8% of GDP through

September with the trade surplus at 4.0% of GDP and the

deficit on the income line at 11.1% of GDP. A weaker

macro environment will likely reduce corporate profitability

and dividend outflows and potentially reduce the headline

C/A deficit. This will be offset by lower reinvested

earnings on the capital account (the main financing item of



the Czech C/A) and leave a stable structure of C/A

financing.

While the weaker export demand is expected to neutralize

on a BoP basis it is not neutral on economic growth. The

export-oriented manufacturing sector will take a hit from

weaker end demand in Germany which accounts for

32.5% of total exports versus the next largest export

partners which are Slovakia at 8.8%, Poland at 6.3%,

France at 5.4% and the UK at 4.8%. As a share of GDP

exports to Euroland are the highest in CEE at 43.5% with

exports to Germany accounting for 22.3% of GDP. Our

chart below shows export ratio across CEE and Hungary

is the highest in the region but with a lower share to

Euroland (and Germany) than in Czech Republic.

Czech Republic: Exports to Euroland are around 43%

of GDP (versus 39.5% of GDP for Hungary)

0

10

20

30

40

50

60

70

80

HUF CZK LTL BGN LVL PLN RON

US

Rest of the world

Japan

Euroland

% GDP


Policy rate likely to remain unchanged until 2013. In

line with the deteriorating domestic and external backdrop

the Czech National Bank (CNB) has sounded increasingly

dovish in recent policy meetings. Vice Governor Tomsik

voted for a 25bps rate cut to 0.5% at the November 3rd

CNB Board meeting and the previously more hawkish

Board members (Zamrazilova and Janacek) have recently

voted to leave rates unchanged. Governor Singer had said

even before the November ECB rate cut that CNB rates

could go down, as well as up, from there but we view rate

cuts as unlikely in practice. October inflation was reported

at a higher-than-expected 2.3% YoY versus a 2.1% CNB

forecasts and a 2% target. The CZK-denominated CRB

food index reported an average monthly increase of 1.0%

through July-September after an average decline of -0.9%

from March-June and given the lags through to headline

CPI there could be more bad news in the pipeline

particularly given a ~5% depreciation in the currency since

August. The CPI outlook is dominated by that January VAT

hike and will push up CPI to outside the 2% +/-1pp buffer.

While the CNB will probably concentrate on their measure

of monetary-policy-relevant inflation which should remain

close to the 2% target, the VAT hike should still be

enough to rule out any rate cut. That inflation expectations

remain above target on both a one- (2.8%) and three-year

(2.2%) horizon also decreases any change of a rate cut.

With Janacek, Rezabek and Zamrazilova stating their

preference for stable rates it is also unlikely that Tomsik

could gather enough support to push through a rate cut.

Czech Republic: One of the seven CNB Board

members voted for a rate cut in November

Nov-11 Sep-11 Aug-11 Jun-11 May-11 Mar-11

Policy ra te (%) 0.75 0.75 0.75 0.75 0.75 0.75

M. Singer H H H H H H

M. Hampl H H H H H H

V. Tomsik -25 H H H H H

K. Janacek H H +25 +25 +25 -

P. Rezabek H H H H H H

E. Zamrazilova H H +25 +25 +25 +25

L. Lízal H H H H H H Source: CNB

The November PMI points to the possibility of rate cuts

with the CNB reducing the policy rate in the past with the

PMI at a higher level. The difference now is the level of

rates as at 0.75% the CNB rate is at a historic low and it is

debatable whether another cut could stimulate growth.

Czech Republic: PMI points to scope for rate cuts

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

30

35

40

45

50

55

60

65

Nov-03 Nov-05 Nov-07 Nov-09 Nov-11

PMI (lhs)

change in policy rate


As the CNB did not follow the ECB with its summer rate

hikes we do expect they will follow on the way down

either. Our Euroland economists expect the ECB rate back

at 1% by January and to remain there until 2013. This

would take the differential in the policy rates back to the -

25bp of mid 2010 – mid 2011 and with rate cuts from the

CNB unlikely we expect the differential will remain at -

25bps. Despite this negative interest rate differential the

solid medium-term fundamentals including a stronger

public sector balance sheet than elsewhere in CEE, an

absence of near-term downward pressure on the

sovereign rating and less concern over deleveraging from

foreign parent banks given the 80% LTD ratio and the



banking systems status as a net external creditor, our bias

remains for medium-term appreciation of the koruna.

Caroline Grady, London, (44) 207 545 9913

Investment Strategy

FX: Over the medium term, CZK is supported by relatively

sound fundamentals, a credible central bank and the fact

that real income convergence is well ahead of price

convergence (vs Germany). Given CNB's strong focus and

historical track record of controlling inflation, over the

longer term price convergence will continue to primarily

take place through a stronger koruna (and not through

higher inflation). The shorter term outlook is less

favourable. The short point is that the koruna lacks

meaningful catalysts and impetus to rally in the near term.

Given its location (next to the Eurozone), the CZK will,

rightly or wrongly, likely continue to be used as a 'cheap'

hedge against Eurozone worries (the market being paid

gamma in considerable size in late summer is telling in

this context). Depressed economic activity, lack of

inflation momentum and fears of a sharp Eurozone

slowdown mean that the CNB have little room to hike the

already low base rate to 0.75%. Remain sidelined for the

short term.

Henrik Gullberg, London, (44) 20 7545 4987

Siddharth Kapoor, London, (44) 20 7547 4241

Rates: Neutral on rates The IRS curve has steepened

slightly in the 2s10s part since our recommendation (from

87 to 94bp). The trade was linked to expectations of a

weaker CZK, causing an increase in inflation expectations.

However, we believe this trade has become consensus as

seen from the reduction in foreign holding of CZK bonds

and the build up of long gamma trades in EURCZK. We

prefer to close our trade recommendation, and await

better levels. We expect monetary policy to remain

accommodative throughout 2012, but the rates curve

could remain stable with very little scope for policy rates

to move either to the upside or downside.


Czech Republic: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income


Population (mn) 10.5 10.5 10.5 10.6

GDP per capita (USD) 18187 18266 14423 15214

Real GDP (%) -4.0 2.2 1.8 0.0


Govt consumption 2.6 -0.1 -1.3 0.2

Investment -15.6 5.4 3.1 1.5

Exports -11.4 17.8 6.4 5.1

Imports -10.5 17.6 5.8 5.8

Prices, Money and Banking (eop)

CPI (YoY%) 1.0 2.3 2.0 3.3

Broad money (M2) 4.2 3.3 4.4 5.6



Revenue 40.1 40.5 40.6 41.1

Spending 46.0 45.3 44.9 44.9


Exports 98.4 118.0 134.9 137.7

Imports 93.8 115.2 130.7 133.8


% of GDP 2.4 1.5 2.7 2.4


% of GDP -2.5 -3.3 -4.0 -3.7

FDI (net) 1.9 5.1 3.5 3.9


CZK/USD (eop) 18.5 18.7 19.2 17.8

CZK/EUR (eop) 26.4 25.0 25.0 24.0



Domestic 23.9 24.7 27.4 29.2

External 10.5 12.9 13.5 14.0


in USD bn 89.2 95.4 98.0 100.1

General (% pavg)

Industrial production (% YoY) -14.6 10.2 6.2 3.5

Unemployment 8.1 9.0 8.6 8.6


period)

Current 3M 6M 12M

CNB policy rate (%) 0.75 0.75 0.75 0.75

CZK/EUR 25.3 24.8 24.5 24.0

CZK/USD 18.8 19.0 19.6 17.8

Source: Haver Analytics, CEIC, DB Global Markets Research



Egypt B1 (negative)/B+ (negative)/BB (negative) Moody’s / S&P / Fitch

Economic Outlook: The economy is likely to gain

strength in FY2011/12 with political transition, base

effects and greater access to external financing.

Main Risks: Occasional setbacks in political progress

and delay in implementation of a comprehensive

economic plan in coordination with and funding from

multi-lateral institutions could lead to a much weaker

growth performance.

Strategy Recommendations: Neutral EGP. Political

stability and resumption of talks with IMF will hold

the key.

Macro View

The revolutionary spirit is back and elections are

underway…

The revolutionary spirit has rejuvenated as again

reformists have gathered at and remained in Cairo’s Tahrir

square in thousands for several days pushing for

continued ‚change‛ demanding more democracy and

less military. While this could ultimately lead to more progress towards a more democratic regime, it has

resulted in bloodshed as the military regime cracked down

on the protestors with very little in the way of

concessions. The Supreme Council of the Armed Forces

(SCAF) accepted the resignation of the cabinet, promised

to speed up the presidential election (to mid 2012 versus

the widely anticipated year-end previously) and indicated

their reluctance to govern once the electoral cycle is

completed. Neither the promises nor the appointment of

yet another elderly political veteran, Kamal Ganzouri, who

served under Mubarak as PM for three years, as PM to

form a national salvation government prevented the

reformists from continuing with their demonstrations.

The SCAF committed to holding parliamentary elections

as originally scheduled and the process went relatively

smoothly in the first leg on November 28-29 with almost

no violence and strong voter participation expected to be

above 70%.

…but the reformists still have major concerns

And yet it seems, and as local and international media

report, the reformists are not as keen on parliamentary

elections being held on time as they are on ensuring free

elections and adopting of a fully democratic constitution

stripping the military of any supra-national powers.

Following a number of changes in the interim government

and occasional tension between the SCAF and the

reformists, the pace of political progress seemed to have

slowed down since March or so with the former

becoming more retrograde. The SCAF took a number of

steps that could allow the Moslem Brotherhood and the

remnants of the old regime to dominate the political

scene going forward (particularly the minimalist approach

to changing the electoral law – see below), alienating the

liberals. In the summer the SCAF did accept the liberal’s

proposal of a preliminary blueprint of basic rights and

principals and yet it added clauses giving it a permanent

political role.

The SCAF has refused to step down and cede power to a

civilian government as some reformists have demanded

and the police have responded to unrest with force as

over forty people have died. The events of the past couple

of weeks seem to be a replay of that several months ago

before the ousting of President Mubarak and yet we

understand that the opinion on the ground may be split

with some groups against protests viewed as being

destructive during the elections. The SCAF indicated that

it would be willing to let a national referendum decide on

whether the military regime should continue to lead the

political transition or not.

The economy is under greater pressure…

Political instability resulted in intense pressure on the

EGP, which fell to its weakest point against the USD in six

years. This and the downgrading of the sovereign to B+

by S&P while maintaining a negative outlook prompted

the CBE to hike its policy rate by 100bps (the overnight

deposit rate to 9.25% from 8.25%) to shore up

confidence. The CBE’s international reserves (inclusive of

FX deposits at commercial banks) have more than halved

since the start of the year to $20bn leading to a

significantly weaker reserve coverage of external

obligations (a SCAF official indicated that reserves may

decline to $15bn by end-January due to external

obligations). Talks with the IMF for a program have been

Egypt: Interest rate corridor and nominal exchange

rate

6.0

7.0

8.0

9.0

10.0

11.0

12.0

13.0

14.0

Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11

5.2

5.3

5.4

5.5

5.6

5.7

5.8

5.9

6

6.1Deposit Rate (lhs)

Lending Rate (lhs)

EGP/USD (rhs)

%

Source: Haver Analytics and Deutsche Bank Global Markets Research



on and off, and only a fraction of the bilateral funds

previously pledged by some Arab nations (mainly Saudi

Arabia) has been received. External and budgetary

financing are the two fundamental pressure points for the

economy going forward and restoring growth will be

difficult in the absence of financial assistance in the

months ahead, particularly with continued weakness in

revenues from tourism and FDI, and limited non-resident

interest in EGP assets. Continued instability may also

weigh in on confidence of locals and escalation of

violence could have negative implications for growth in

the same manner it did in the period preceding the

military takeover early this year when the economy was

brought to a standstill would widespread supply

bottlenecks.

…the expected broad coalition government may have

difficulty in delivering reforms

Parliamentary elections started on November 28 in 9

provinces and the process will be finalized by early-

January with voting for the remaining states scheduled for

mid-December and early January. The parliamentary

elections are a relatively complex process. For the 498

seats in the Parliament, one-third of the candidates will be

elected based on a single district scheme (voters select

candidates with no party affiliation who must win a simple

majority to be elected) and two-thirds will be elected

according to proportional representation (voters pick

among party candidates and each party gains seats in

proportion to its share of votes). The former scheme

favors local strongholds of the Mubarak era and for the

latter the competition will be fierce with several parties

entering the race. And yet the system overall seems to

favor well-entrenched larger parties with well-established

networks across the country while marginalizing the

relatively new and small parties that have yet to have the

opportunity and the time to organize nationwide.

While the results are difficult to project as there is no

precedent or polls, the newly adopted system is unlikely

to yield a single-party majority government in the

upcoming elections. And yet the Moslem Brotherhood

(MB) is widely expected to win the largest number of

seats with the remnants of the old regime, the reformist

bloc and the old Wasd party being represented leading to

a rather fragmented parliament. This is expected to result

in the formation of a broad national unity coalition

government, which may not be so effective for

policymaking going forward. We reiterate our view that

Egypt is fundamentally different and there is much to

cheer about with public opinion now being important in

political decisions. And yet progress is likely to be slow

next year with a fragmented parliament, the preparation of

a new constitution and the presidential election now set

for mid-2012 (could be delayed in our opinion given that

formation of the government is likely to take us well into

the first half of the year).

The post election period may see rising tensions between

the SCAF and MB. There are a number of contentious

issues including the MB’s opposition to the military's

desire to prevent civilian oversight of the military budget.

Additionally splits in the MB and the conservative camp in

general may not be a surprise as there are several groups

with varying views on Islamic rule, and how it should

written into the constitution. The reformists and the

revolutionaries are also likely to be unsatisfied with the

election results, the continued strong presence of the

military and slow progress towards a free and democratic

state. Weakness in the economy in our opinion requires

external assistance and the implementation of a cohesive

economic plan in coordination with multi-lateral

institutions. Otherwise political backlash is likely and the

government must be able to prioritize politically painful

economic reforms, which may be a difficult task given its

likely fragmented make up.

Cem Akyurek, Istanbul, (90) 212 317 0138

Egypt: FX reserves

0

5

10

15

20

25

30

35

40

45

50

Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

CBT deposits at

banks

CBT Official reserves


Egypt: Non-resident T-bill holdings

Non-resident's share in outstabding T-bills

0

5

10

15

20

25

Jan-10 Jul-10 Jan-11 Jul-11

%




Investment Strategy

FX: Neutral on USD/EGP. Political stability will hold the

key to much of EGP's fate over the course of the next

year. The complex electoral system means it may be

difficult to predict the precise breakdown of parliament

until the end of staggered voting on January 11. Even if

the current elections (at the time of writing) proceed

smoothly, maintaining order and democracy will be key

for the country and the currency. Political instability will

also have implications for Egypt's sovereign rating - as

S&P downgraded Egypt's rating by one notch last week.

The domestic economy has also struggled - the budget

deficit has been widening, and foreign reserves have

continued to drop into November. Any resumption of talks

with the IMF for a $3bn loan would be a clear positive for

capital flows, and therefore for the pound.



Egypt: Deutsche Bank Forecasts

2008/09 2009/10 2010/11F 2011/12F

National Income


Population (mn) 76.8 78.6 80.5 82.3


Real GDP (YoY%) 4.7 5.1 1.8 3.0



Gross capital formation -9.1 6.5 -3.9 7.6

Exports -12.8 -1.9 3.7 1.2

Imports -17.7 -1.7 7.5 4.9


CPI (YoY%) 9.9 10.1 8.94 9.0

Broad money (M2Y) (YoY%) 8.4 10.4 10 12

Bank credit (YoY%) 5.1 8.2 3..0 15



Interest Payments 4.4 5.4 5.2 5.5

Primary balance -1.8 -2.7 -4.3 -3.5



Merchandise imports 50.3 49.0 51 52.0

Trade balance -25.2 -25.1 -27.6 -27.7

% of GDP -13.3 -11.5 -11.2 -10.5

Current account balance -4.4 -4.3 6.5 -4.5

% of GDP -2.3 -2.0 -2.6 -1.7

FDI (net) 6.8 5.8 6 10.0


FX rate (eop) EGP/USD 5.59 5.70 5.95 6.20


Government debt 81.1 79.4 86 88.0

Domestic 67.4 67.4 76 76.0

External 13.7 12.0 10 12.0


In USD bn 31.5 33.7 34 36.0


General (YoY %)

Industrial production -2.0 5.0 0 7.0


Financial Markets (end)

period)

Current 3M 6M 12M

CBE deposit rate 8.25 8.25 8.25 9.25

CBE lending rate 10.25 10.25 10.25 10.25

EGP/USD 6.01 6.20 6.30 6.20

EGP/EUR 8.20 8.40 8.40 8.68 Source: DB Global Markets Research, National Sources



This page is left blank intentionally



Hungary Ba1(neg)/BBB-(neg)/BBB-(neg) Moodys/S&P/Fitch

Economic Outlook: We expect Hungary to tip back

into recession in 2012. Fiscal drag is set to increase

in line with the government’s commitment to stick to

a 2.5% of GDP fiscal deficit while rate hikes, FX

weakness and rising deleveraging will all severely

constrain growth for some time ahead. With the

expected recession in Euroland net trade will be

unable to offset the negative domestic environment.

Main Risks: Likely policy conflicts between the

authorities and the IMF/EU risks prolonged program

negotiations which could mean continued pressure

on the currency, a larger hiking cycle and further

rating downgrades. It could also mean a very difficult

backdrop to meet external refinancing needs.

Strategy Recommendations: NBH to provide ceiling

in EUR/HUF. Sell vega neutral 3m/6m straddles in

EURHUF. Underweight sovereign credit.

Macro View

Recession now unavoidable. Hungary’s November U-

turn to request a precautionary assistance package from

the IMF/EU reflects the exceptionally fragile macro

outlook. Moody’s has now downgraded the sovereign to

sub investment grade and S&P/Fitch could well follow in

Q1 if the negotiations with the IMF/EU prove problematic.

The policy stance is not supportive of growth with the

NBH recently embarking on a hiking cycle despite the high

probability of a recession and the government’s

commitment to a 2.5% fiscal deficit target for next year

implying a now much tighter structural position than

originally expected. Accelerated deleveraging also leaves

a substantial downside risk to the growth outlook.

The higher-than-expected 0.5% QoQ and 1.4% YoY Q3

GDP reading was a rare piece of good news in Hungary.

Q2 GDP was also revised upwards to 0.2% QoQ from an

earlier reported zero reading and Q1 was revised up to

0.5% QoQ from 0.3% (which was previously revised

down from an initial 0.7% reading). KSH have yet to

publish the full components but said that the Q3

performance was mainly due to agriculture and industrial

exports. The bumper summer harvest is likely to be only a

temporary boost to growth however and it is very unlikely

that the 0.5% QoQ reading will be repeated in the coming

quarters. Domestic demand growth is likely to turn

negative from Q4 during an acceleration in deleveraging

following the September announcement of the

discounted early repayment option on mortgages and

protracted currency weakness through Q4 pushing

monthly mortgage repayments higher. A January VAT hike

and further benefit cuts will start to impact growth from

Q1. Any boost to growth from external demand is also

likely to be much reduced from earlier in 2011 given our

expectation of recession in Euroland from Q4. September

trade momentum showed some pick up (the 0.8%

reading for exports on a 3m/3m basis was the first

positive reading since May) after a very weak summer but

it is unlikely that this will be sustained. Latest data on new

orders show a modest improvement after the negative

readings during the summer but we the trend remains

downward. The combination of a high growth beta with

Euroland and deteriorating domestic conditions point

firmly to a Hungarian recession in 2012.

Hungary: Growth beta with Euroland is very high

y = 1.5593x + 3.6383

R² = 0.8763

-30

-20

-10

0

10

20

-27 -18 -9 0 9

Hungary

IP

(S

A, %

YoY)

Euroland IP (SA, % YoY)


The extent of the domestic demand contraction next year

will partly depend on the take-up rate on the discounted

early repayment scheme and the resulting losses faced by

the banking sector. Our impression is that the banking

sector currently work with a maximum take-up

expectation of 20% and data released so far put this at

8% between application and repayments. The additional

measures still being discussed between the banking

association and the government could increase this

baseline however as the government has indicated on

various occasions that it would like to see the early

repayment option available to as many households as

possible. The very negative operating environment for

foreign banks in Hungary after the bank levy, pension

system reform, 3-year fix on mortgage payments and the

discounted early repayment scheme also leaves a risk that

foreign parents opt to significantly reduce exposure to

Hungary. There is no evidence of this so far but it leaves

substantial downside risks to our macro projections. Any

IMF/EU program could be an important policy anchor for

next year and combined with implementation of the Szell

Kalman plan would be supportive for the medium-term



growth outlook. However it is unlikely to materially change

the growth dynamics for 2012. We do not however

expect anything similar to the very deep recession of

2008/09 with the worst of the flow adjustment now done

and fundamentals undoubtedly improved.

We now expect GDP growth of -0.8% for 2012 after an

expected 1.4% outturn for 2011. The NBH is likely to

revise down its 0.6% projection for 2012 when the

updated Inflation Report is released in late December

while the Economy Ministry recently mention a 0.5-1%

expectation versus the 1.5% published in September. For

2013, a reduced pace of deleveraging, improvement in

household balance sheets from a stronger forint and a

more supportive external backdrop should all bring growth

back to positive territory but probably still lagging on any

regional comparisons.

IMF/EU negotiations likely to face significant conflicts

over policy. Hungary’s announcement that it is seeking a

precautionary financing package with the IMF/EU was a

surprise to us given recent statements by the government

to the contrary. The initial announcement from the

Hungarian authorities mentioned ‚a new type of

cooperation with the IMF‛ and subsequent comments by

Economy Minister Matolcsy suggested Hungary would

like a FCL (flexible credit line) but would probably have to

seek a PCL (precautionary credit line) or a precautionary

SBA (stand-by arrangement). The PCL facility was

replaced with the PLL (precautionary and liquidity line) on

November 23rd so we do not yet have any example of

countries using the facility. Nevertheless, as the

qualification criteria are similar to those for an FCL and

based on a track record of a sustainable external position,

favourable market access, sound fiscal and monetary

policy, financial sector soundness and supervision with

moderate vulnerabilities in ‚one or two‛ of these areas‛

we do not think Hungary would be eligible. Hungary’s

external and fiscal vulnerabilities are protracted in our view

which suggests a precautionary SBA is the most likely

option similar to that currently in place in Romania and

Serbia.

In terms of the potential EC component, we expect this

would also be similar to Romania with a precautionary

deal under the BoP assistance programme available to

non-Euro Area member states. Out of the EUR50bn funds

allocated to this program a total of EUR13.25bn has been

disbursed to Hungary, Latvia and Romania and the

EUR1.4bn committed in precautionary assistance to

Romania in March 2011 was the first time the EC had

been involved in providing precautionary financial

assistance.

Hungary: We see a precautionary SBA as the most

likely IMF program option for Hungary Program

typeCr iter ia Condit iona lit y Likelihood Count r ies

FCL

Very strong economic

fundamentals and

institutional policy

framework

No ex-post conditions and all

resources available under the credit

line can to tapped at any time,

disbursements not phased or

conditioned on particular policies

None

Poland,

Colombia,

Mexico

PLL/PCL

Sound fundamentals and

policies and good track

record of policy

implementation

Combines pre-qualification (similar to

FCL) with more focused ex-post

conditions that aim to address

moderate vulnerabilities (actual or

potential BoP needs). Access limited

to 500% of quota up front and

1000% after 12 months

Very low Macedonia

Precaution-

ary SBA

For countries facing

potential (very large)

financing needs subject

to relevant IMF policies

Specific conditionality with

quantitative conditions and structural

measures. Regular program reviews,

exceptional high access on a case-by-

case basis

HighRomania,

Serbia

Source: IMF, DB Global Markets Research (likelihood reflects DB view)

The difficulty for the authorities with a precautionary

SBA/BoP assistance programme is the likely strict

conditionality and adjustment program that would be

required. Recent policies such as the discounted early

repayment scheme on mortgages, the abolishing of the

2nd pillar pension system, the bank levy, the crisis taxes on

retail/telecoms/energy and the government’s leaning of

the independence of the NBH, constitutional court and

revamp of the fiscal council to leave it largely powerless

are all unlikely to sit well with the international lenders.

The ECB’s very negative published opinion in early

November that the discounted mortgage repayment

option will weaken banking sector stability and the sectors

ability to lend, have adverse spillovers to the economy, hit

banks capital positions at a time when ability to

recapitalize is much reduced, put pressure on the forint,

increase country risk premia, put upward pressure on

domestic interest rates, weaken growth and dent investor

confidence due to increased legal uncertainty is an

example of this unhappiness. It is not yet clear whether

the EC will challenge the legality of the policy although a

spokesperson for the EC reputedly announced that

Hungary has until February to respond to complaints from

European banks about the scheme. It is difficult to see

how the EC could agree to any precautionary assistance

with this law still in place and it would be politically

difficult for PM Orban to now reverse this. Some of the

temporary revenue raising measures are probably easier

to reach a compromise on provided the authorities

commit to phasing these out, but even this could take

time to negotiate.

Our understanding is that Hungary had penciled in

EUR4bn (euro equivalent) in external issuance for 2012

and therefore unchanged from 2011. This financing is

intended to cover EUR3.2bn to the IMF (total principal

repayments to the IMF are EUR3.8bn but the remainder is



due from the NBH) and two Eurobonds totaling

EUR1.4bn. The government has some buffer from

EUR1bn in its account at the NBH plus any proceeds from

the sale of pension assets. Without drawing down FX

reserves Hungary cannot however avoid coming to the

Eurobond market. Should Fitch or S&P also cut Hungary’s

sovereign rating to sub investment grade (which would

become increasingly likely if IMF/EU negotiations are

prolonged) this could also impact the ability to issue.

Hungary: External financing for 2012 remains fairly

onerous

EURbn 2007 2008 2009 2010 2011F2012F

Gross Financ ing Req. 34.4 45.1 39.3 37.4 37.3 36.3

C/A (deficit = positive) 7.2 7.8 0.2 -1.1 -0.6 -0.3

Amortisation (MLT) 10.0 14.8 19.4 18.8 13.4 12.2

Amortisation (ST) 17.1 22.5 19.7 19.6 24.6 24.3

Financ ing 34.4 45.1 39.3 37.4 37.3 36.3

Non-debt creating 0.9 3.7 0.9 2.2 3.7 2.7

FDI (net) 0.2 2.7 -0.2 0.4 1.3 1.0

EU capital inflows 0.7 1.0 1.1 1.7 2.4 1.7

Debt creating 33.6 51.4 44.1 39.4 33.7 33.6

Sovereign Eurobonds 1.2 1.8 1.0 1.4 4.0 4.0

Multilateral financing 6.9 7.5

Foreign purchases of HGBs 4.1 0.2 -3.4 0.4 5.5 3.0

Banks + corporates 28.3 42.5 39.0 37.7 24.2 26.6

Errors & omissions -1.6 -2.9 -0.3 -1.2 0.0 0.0

Reserves (+ = decrease) 1.5 -7.0 -5.5 -3.0 0.0 0.0

Gross Financ ing Req.

% of GDP 34.1 42.4 42.3 38.0 36.0 34.1 Source: DB Global Markets Research

NBH could just as easily hike or cut rates. Success and

timing in securing even a precautionary multilateral

financing packing combined with developments in Europe

will both have an important bearing on the monetary

policy outlook. Three months of protracted currency

weakness combined with a widening of CDS back to all

time highs prompted a 50bps rate hike from the NBH at

the November policy meeting despite acknowledgement

by Governor Simor that the Bank’s 0.6% GDP growth

forecast for 2012 now looked too optimistic. The

statement said explicitly that further rate hikes may be

necessary if inflation and risk perceptions remain

‚persistently unfavourable‛ which suggests that it would

take a fairly significant turnaround in the currency and CDS

to prevent further hikes. The sharp turnaround in the forint

after the coordinated announcement by the major central

banks to address pressure on global money markets

could, if sustained, be enough to prevent another rate hike

but it remains to be seen whether this rally can last. The

policy anchor and likely improvement in confidence from a

successor IMF/EU package would likely have a positive

and probably more lasting impact on the currency and risk

appetite and could open the door for rate cuts. In a

scenario where the forint is trading back sub 300/EUR and

CDS drops back from the November highs the summer

discussion on the timing of rate cuts, rather than hikes,

should come back on to the agenda.

Hungary: The decision to hike by 50bps in November

was unanimous Nov-11 Oct-11 Sep-11 Aug-11 Jul-11 Jun-11 May-11 Apr-11 Mar-11

Policy ra te (%) 6.5 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0

András Simor +50 H H H H H H H H

Júlia Király +50 +25 +25 H H H H H H

Ferenc Karvalits +50 H H H H H H H H

Andrea Bártfai-Mager +50 H H H H H H H H

János Cinkotai +50 H H H H H H H H

Ferenc Gerhardt +50 H H H H H H H H

Gyorgy Koczizsky +50 H H H H H H H -

Source: NBH

Our call for the policy rate sees only another 50bps in

tightening to take the policy rate to 7%. We expect this

will be delivered in the December/January MPC meetings

with the peak in CPI to come in January following the

scheduled 2pp VAT hike. On the basis that Hungary does

not end up in a situation of very protracted IMF

negotiations we expect the combination of a reversal of

the recent forint weakness and confirmation of the

weaker growth backdrop to prompt a reversal of the

recent hikes. We see the policy rate back at 6% by late

2012.

Political commitment to fiscal consolidation is an

important MT positive. The government’s commitment

to fiscal consolidation has been an important positive in an

otherwise negative environment. The government plan for

a 2.5% of GDP fiscal deficit in 2012 could prove too

optimistic in a recession environment but we do not

expect that any overshoot would be large. The initial

budget calculations were based on a 1.5% GDP growth

assumption but with the inclusion of HUF300bn or 1% of

GDP in reserves (split between a general reserve, a

reserve to cover higher interest costs and an additional

safety reserve) to provide buffer room in a deteriorating

environment. The budget is a combination of revenue and

expenditure side measures and split between 1.56% of

GDP (HUF455bn) from projected savings in the structural

reform plan (83% of that announced in structural reforms

earlier in the year) and another HUF656bn or 2.25% of

GDP from the recently announced balance improving

measures (such as 2pp VAT hike and increase in

employee social security contributions). While fiscal

policy will prove to be a drag of growth in 2012 from the

direct impact of various measures progress on

implementation of the structural reform plan is

nevertheless an important medium-term positive.




Investment Strategy

FX: We have highlighted Hungary's vulnerabilities to the

Eurozone through a number of channels such as the FX

loan stock, high external debt and substantial refinancing

needs, (EMEA Daily Compass 2nd and 3rd Nov). After

NBH's 50bp hike on 29th Nov, the key question for the

HUF remains the timing and magnitude of further hikes.

The rates markets are currently pricing in 50bp of hikes by

Mar '12. The risk remains that the NBH may be forced to

take more forceful measures (similar to the 300bp hike in

'08). Further rate hikes being currency constructive will

depend on a number of factors, such as further

downgrades (following the downgrade by Moody's to Ba1

on Nov 25th) and how that will impact on the huge foreign

holdings of domestic government debt. Providing some

protection, meanwhile, is the surplus in the C/A and the

fact that state finances compare well with the Eurozone.

However, given its vulnerabilities EUR/HUF's risk beta will

remain high. Expect aggressive rate hikes [if necessary] to

limit the upside in EUR/HUF to around 320.



Rates: Favour HUF to rates Trading the Hungarian curve

has become akin to trading a credit product, with little

correlation to growth and inflation dynamics. The NBH has

decided to counteract the impact of higher risk aversion

with higher policy rates, with the primary aim being to

reduce CHF/HUF volatility and maintain financial stability.

Negotiations with the IMF have added a level of

complexity to the outlook. Our long held view that HUF

would perform better than rates has held true, and we

expect this to be the case over 2012, particularly vs PLN.

One risk Hungary faces is that of more accelerated

outflows from its bond market, where foreigners

represent 40% and local pension funds are expected to

not roll-over their assets following the end of government

transfers. In that scenario ever more aggressive hikes

could materialize.


Credit: Underweight. Among the Central European

credits, Hungary remains the most vulnerable to a further

deterioration in the external environment. 2012 is set to

be particularly challenging given the government’s need to

raise a substantial amount on the external bond market. If

this is not forthcoming, then an agreement with the IMF

seems critical. However, to secure such an agreement

would likely require a radical change of approach from the

government and we are not convinced that this

government would be willing to stomach such a change.


Hungary: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income


Population (mn) 10.0 10.0 10.0 10.0


Real GDP (YoY%) -6.7 1.2 1.4 -0.8

Priv. consumption -5.8 -2.0 -0.3 -0.7

Gov’t consumption 2.2 -0.6 0.1 -0.1

Gross capital formation -8.0 -5.6 1.5 -2.8

Exports -9.6 14.1 6.2 3.9

Imports -14.6 12.0 6.0 3.5


CPI (YoY%) 5.6 4.7 4.1 4.7

Broad money (M3) 3.4 3.0 7.5 4.5


ESA 95 fiscal balance -4.5 -4.3 1.9 -3.2

Revenue 46.1 44.6 51.0 43.3

Expenditure 50.5 48.9 49.1 46.5

Primary balance 0.1 -0.1 5.8 0.6


bn)

Exports 79.4 92.3 105.3 106.3

Imports 76.2 88.0 100.1 101.8


% of GDP 2.5 3.3 3.6 3.4

Current account balance -0.3 1.4 0.9 0.4

% of GDP -0.2 1.1 0.6 0.3

FDI (net) -0.2 0.6 1.7 1.5


HUF/USD (eop) 189.0 208.2 230.8 216.8

HUF/EUR (eop) 270.7 278.6 300.0 280.0



Domestic 42.0 42.4 40.1 41.2

External 36.4 37.8 36.2 33.4


in USD bn 188.9 182.1 210.0 189.7

Short-term (% of total) 14.3

17.9 16.0 16.1

General (YoY%)

Industrial production -17.3 10.3 5.2 2.1

Unemployment 9.8 11.1 11.1 11.3


Policy rate (2-week depo) 6.5 7.0 6.5 6.0

HUF/EUR 304.7 295.0 290.0 280.0

HUF/USD 226.7 226.9 232.0 207.4

Source: NBH, Haver Analytics, DB Global Markets Research. Fiscal and debt forecasts reflect the

pension reform which will mean a one-off transfer of around 10% of GDP as of end May 2011.



Israel A1(stable)/A+(stable)/A(stable) Moody’s/S&P/Fitch

Economic Outlook: The divergence between strong

domestic absorption and faltering net exports is set

to dwindle, pointing to a marked loss in growth

momentum. Inflation is expected to behave benignly,

providing room for further easing if needed, although

housing dynamics and ILS will also play an

increasingly important role. The C/A is set to turn

negative and remain in deficit throughout the forecast

horizon, while fiscal consolidation arrives with a delay.

Main Risks: The geopolitical risk premium is set to

remain elevated given multiple sources of concern. A

more rapid than needed deceleration in housing

prices may lead to financial stability risks and

complicate rate outlook.

Strategy Recommendations: Favour tactical shorts

in EUR/ILS above 5.10. Receive 2Y IRS

Macro View

2011 was another year of economic success. Israel has

been one of the best performing economies in 2011 with

growth remaining well above the trend for the second

year in a row. The labour market has improved markedly

as unemployment reached its historical nadir (5.5%)

following an acute 2pp leapt during the course of global

recession. 2011 also saw an unanticipated one-notch

upgrade by S&P (to A+) thanks to improved macro policy

flexibility/credibility, a healthy banking sector, robust

external performance and ongoing fiscal consolidation,

confirming strong fundamentals of Israeli economy vis-à-

vis the rest of EMEA. Event risks, however, were also on

the rise year-to-date. The geopolitical/security backdrop

deteriorated noticeably with ongoing unrest in neighboring

countries, strained relations with Turkey and an elevated

possibility of military action against Iran more recently.

Local sentiment also turned sour owing to social protests

over the high cost of living. The latter has complicated the

fiscal outlook but was conducive to improved inflationary

conditions in the second half of the year which prompted

a timely monetary response by the Bank of Israel (BoI).

Growth is set to moderate notably in 2012 although a

hard landing is not in the cards. Recent economic

activity data were still resilient but signals of a

forthcoming shift from ‘normalization’ to ‘a general

slowdown’ in headline growth have intensified.

Preliminary Q3 2011 GDP growth was higher-than-

expected at 3.4%QoQ (saar), following a revised down

3.5% previously and 4.7% in Q1. While the headline

number looks relatively resilient, composition of growth

insinuates a looming softening. Putting robust fixed

investments aside, stock-building was very strong at

5.2%QoQ (saar) while private consumption continued to

soften and accounted for only 0.1pp of 0.8% quarterly

gain.

Israel: Growth is set to moderate notably in 2012

-4

-3

-2

-1

0

1

2

3

4

5

6

-6

-4

-2

0

2

4

6

8

10

04 05 06 07 08 09 10 11F 12F 13F

GCFGovt cons.Pvt cons.Net exportsReal GDP (rhs)

pp contr. QoQ (saar)

F o recast

Source: Haver Analytics, CBS, DB GM Research

Israel: C/A turns sour with record high trade deficit

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

2005 2006 2007 2008 2009 2010 2011F 2012F 2013F

Merchandise trade IncomeTransfers ServicesC/A balance

% of GDP

Source: Haver Analytics, BoI, DB GM Research

The negative contribution of net exports accelerated to -

1.1% following -0.8% seen in the previous period. Both

exports and imports receded over the quarter but the

extent of contraction in the former (-16.9%QoQ (saar)

versus -7.6%) was considerably larger, reflecting impact

of weak external sector. The latter is likely to be an

overhang on growth in 2012 as well given that exports

destined to US and Europe account for c25% of GDP and

DB now expects a recession to the tune of -0.5% in

Euroland. The divergence between strong domestic

absorption and faltering net exports is also set to dwindle.

The BoI’s latest Companies Survey revealed a fairly

downbeat output growth expectations in most industries

already in the final quarter of 2011 with manufacturing

companies specifically mentioning weakening domestic

market as one of the causes. This insinuates growth in

private consumption and fixed investments will likely



decelerate in 2012 on the back of elevated uncertainty,

dented confidence and constrained funding supply. We

now expect headline GDP growth to moderate by around

1.8pp to 2.8%YoY next year before converging to its trend

of 3.8% in 2013. Risks are tilted to the downside given

the forthcoming global slowdown.

It is also worth noting that current account is likely to turn

negative – already by end-2011 and throughout the

forecast horizon – for the first time since 2002. This is

mainly due to a marked acceleration in the trade deficit

emanating from the combined impact of export

underperformance and strong import growth. While

higher commodity prices played a role behind the latter, a

46.2%YoY rise in investment good imports year-to-date

suggests resilient domestic absorption was also an

important contributor. The expected deterioration in the

current account is commensurate with empirical studies

showing that countries experiencing a natural resource

discovery (natural gas in Israeli case) are likely to

spend/borrow more in the near term (in anticipation of

higher future income) before the advent of initial receipts

(probably in mid-2013 although a delay is more likely than

not) while surplus C/A figures are set to arrive consistently

once major fields (Tamar and Leviathan) become fully

operational (probably by the middle of decade).

Inflation seems under control for now. Headline

inflation already receded below BoI’s upper band (3%) in

Q3 and seems likely to remain within target rate at least

until end-2012, barring any external/ geopolitical or

administrative price (such as higher electricity tariff)

shocks. Many factors are behind this favourable outlook.

On top of anchored real wages and stable global

commodity prices, mass public protests over high cost of

living seem to have paved the way for a welcome quasi-

structural change in private (and to some extent public)

pricing behavior, reflected mostly in retail cuts on basic

goods. Subsequently, market-derived 12-month inflation

expectations retreated significantly from 3.8% in February

to 1.7% in mid-November. Secondly, the housing

component, a main driver of headline CPI since late 2008

given its +20% weight in the basket, is expected to

moderate given improved supply and demand conditions.

Finally, weakened FX pass-through is likely to cap any

upward pressure stemming from weaker ILS. According

to the latest BoI calculations, a 1% rise in USD/ILS (i.e.

depreciation) is envisaged to lift up housing component by

only 0.1pp in the short term versus 0.7pp estimated in the

previous decade (as the share of rental contracts

denominated in USD has dropped to only 5% from over

85% previously).

Fiscal backdrop will be under close scrutiny. The 2-year

combined budget bill sets deficit ceilings of 3.0% (of

GDP) and 2.0% for 2011 and 2012, respectively. Yet, a

slippage in both cases seems highly likely. Although the

cumulative budget deficit (excluding net credit) in the first

ten months of 2011 stood at a somewhat manageable

ILS14.1bn (1.6% of GDP) compared to annual target set at

ILS25.2bn, domestic revenues were 2.7% lower than the

seasonal path consistent with 3.0% ceiling mainly owing

to a continued slowdown in indirect tax receipts. This

suggests Ministry of Finance’s working target estimated

at 2.9% (just below 3.0% ceiling) will likely be overshot by

c0.4pp. Possibility of higher spending in light of public

protests and moderating growth (4.0% penciled in budget

forecast against our and BoI’s estimates standing at 2.8%

Israel: …with better conditions in housing…

-15

-10

-5

0

5

10

15

20

254

6

8

10

12

14

16

18

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Months of supply (inverted, t-3, LHS)

House prices, YoY% (RHS)

Forecast


Israel: Inflation seems to be under control…

-2

-1

0

1

2

3

4

5

6

-2

-1

0

1

2

3

4

5

6


Transportation & Comm.HousingFood (excl, fruit & veg.)Headline CPI (YoY%, rhs)

pp contribution YoY%pp contribution YoY%

Forecast


Israel: …and low FX pass-through

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

1 2 4 6 8

%

pp

co

ntr

ibuti

on to

head

line

Quarters

Clothing T&C

Dwelling maintenance Housing

Total CPI (RHS)

Note: The chart exhibits cumulative response of CPI (and its components) to a 1% depreciation in ILS

(against the USD) ; Source: BoI calculations, DB GM Research



and 3.2%, respectively) point to high likelihood of a

consecutive slippage in budgetary balances next year;

although - in absolute terms - fiscal deficit will remain fairly

manageable compared to developed world and many

other EM peers. Meanwhile, a meaningful drop in

government debt/GDP ratio is now likely to arrive in 2013

once revenue side resumes its strong growth with

improved economic activity (and also partially on the back

of arrival of gas receipts while impact may be felt more in

2014-15 given grace period in place). Separately,

Netanyahu government's earlier plans to trim

income/corporate taxes gradually by 2016 have been

shelved with approval Trajtenberg Committee’s long-

awaited recommendations which envisaged social

spending of around ILS30bn over the forthcoming five

years financed mainly through cuts in defense spending

(to the tune of ILS2.5bn in 2012) and tax changes/hikes

Monetary policy to remain focused on growth.The

newly formed 6-member Monetary Committee (MC)

delivered its first cut in November following its inception a

month earlier. This was the second cut in the last three

months as concerns over negative spillovers from a

faltering global backdrop intensified. As has been the case

throughout the hiking cycle (125bps) earlier in the year,

the Bank will continue to base its rate decisions on (i)

domestic inflation (including inflation expectations); (ii)

growth in Israel and globally; (iii) monetary policies of

major central banks; (iv) the trade weighted ILS; and (v)

housing prices while weight of these parameters will

continue to be dynamic. For now, growth concerns seem

to have taken precedence given ongoing (forthcoming)

global (domestic) slowdown, and will likely remain as the

main driver at least in the first quarter of 2012. Policy

action by major central banks comes next in terms of

importance as any additional monetary accommodation

will likely be perceived as a strong signal for further

downturn in global economy and also due to

repercussions for the shekel. This is followed by inflation

dynamics (and inflationary expectations) which seems

fairly tamed for now. Housing prices and ILS appear to be

placed to the very end of this implicit ranking although this

is subject to change in 2012. Accordingly, the penultimate

paragraph of BoI’s latest communiqué, which reads as

‘…lower rates, together with the recent weakening of the

effective exchange of ILS, are expected to help Israel’s

economy deal with the difficulties confronting it’, implicitly

signals, in our view, that further (and noticeable) ILS

weakening in the coming period could be seen as an

alternative to additional rate cuts. Additionally, Governor

Fischer has cited his concern about the possibility of a

more rapid than needed deceleration in residential prices

and underlining the necessity to slowdown the pace of

marketing of land for construction, particularly given that

banking system’s overall exposure to real estate/housing

sector (accounting c44% of total loan book) is significant.

Combined altogether and given slowly-bleeding nature of

sovereign debt crisis in the Euro zone), we expect the BoI

to reduce rates by another 25bps to 2.50% in early 2012

followed by steady rates until mid next-year. This will

mean that monetary conditions remain accommodative

for most of 2012 but a delicate balance will be maintained

in the housing market at the same time by not overly

stoking the demand side (or by letting housing prices drop

precipitously). The precarious external outlook

necessitates a data-dependent stance by the Bank more

than ever, hinting that rate risks are tilted to the downside.

Apart from a deeper global slowdown, downward risks

(on growth and the ILS) will again emanate from

geopolitical backdrop. Although some part of noticeable

ILS weakness seen in the shekel since September is due

to poor risk appetite, weaker external balances, and

(expectations of) lowered yield support; rising geopolitical

risks (i.e. ongoing turmoil in Syria, regime change in

Egypt, stalemate in peace talks with PA, strained relations

with Turkey and more recently possibility of military action

against Iran) also played a significant role. Geopolitical

strains are unlikely to soften in 2012 given elevated

uncertainty over the end-game in Syria and the positioning

of any new administration in Egypt. Any direct

Israel: Housing market will remain spotlight

Public

sector; 9.0%

Retail sector;

11.8%

Corporate

sector (ex-

commerical

real estate

loans);

35.3% Commercial

real estate

loans; 15.5%

Mortgages;

28.4%

Total

exposure to

real estate/

housing

sector;

43.9%

% in total bank credit


Israel: Fiscal consolidation is to arrive with a delay

60

67

74

81

88

95

102-6

-5

-4

-3

-2

-1

0

04 05 06 07 08 09 10 11F 12F 13F

Government debt (RHS)

Fiscal deficit [excluding net credit, inverted]

% of GDP




confrontation with Iran (which is not our main working

assumption) will likely be accompanied by notably easier

monetary conditions by BoI while record-high FX reserves

will provide some (limited) comfort. ILS is still expected to

strengthen, mainly in the second half of the year, thanks

to unscathed macro fundamentals (i.e. credible macro

policy mix, healthy banking system, net external asset

position). Yet, projected C/A deficits and a lower yield

support (than expected) could put a cap on any

meaningful appreciation cycle. Any adverse geopolitical

development has also a potential to reverse the envisaged

path for the shekel.

Kubilay Ozturk, London, (44) 207 547 8806

Investment Strategy

FX: Continuing tensions with Iran (and rising possibility of

military action), continued social unease over living costs,

the negative trade balance in October and the

outperformance in the ILS vs peer currencies over the

past 3-6 months mean we do not currently see

risk/reward strongly favouring long ILS positions.

However, it is worth noting that price action in EUR/ILS

has been remarkably resilient over the last few months,

with the pair largely back to pre-August levels. To put this

move in perspective, EUR/ZAR has rallied by over 18%

over the same period, EUR/HUF by 16% and EUR/PLN by

over 12%. This suggests that being short EUR/ILS is a

lower beta or ‘defensively bullish’ way to express a

constructive EM view. In terms of positioning, we have

seen a marked reduction in the ILS position on dbSelect -

the ILS position is, in fact, shorter than it has been for

more than 12 months. We prefer to be tactical sellers of

EUR/ILS above 5.10, for an eventual move down towards

the pre-August lows at around 4.80.



Rates: Receive 2Y IRS We take comfort from the latest

MPC meeting minutes and expect two further cuts. The

BoI inflation forecast of 1.6% y/y in 12m is consistent with

immediate cuts, but the BoI feels that waiting may give it

a better opportunity to act effectively. The current 2s10s

slope is fair to the level of Telbor, based on historical

regression, however the 10Y is rich to one of its key

macro drivers (US economic surprise index). For this

reason, we decide to take profit on our recommendation

to receive 10Y IRS and instead recommend receiving 2Y

with a target of 2.4 and s/l at 2.9 (current 2.72). The

carry/roll on this trade is positive by 4bp/3m

Lamine Bougueroua, London, (44) 207545 2402

Israel: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income


Population (mn) 7.5 7.6 7.8 7.9


Real GDP (%) 0.8 4.8 4.5 2.8


Govt consumption 2.4 2.5 2.9 2.5

Investment -4.1 13.6 15.3 4.0

Exports -12.6 13.4 4.6 3.6

Imports -14.0 12.6 10.6 5.2


CPI (YoY%) 4.0 2.6 2.3 2.3

Broad money (M2) 13.5 3.6 2.9 1.2


Budget balance (excl credit) -5.1 -3.7 -3.3 -3.5

Revenue (incl credit) 37.7 38.9 41.1 40.0

Spending (incl credit) 42.7 42.3 43.7 42.9

Primary balance (incl credit) -2.1 -0.5 -0.1 -0.4


Exports 46.3 56.1 60.3 63.3

Imports 46.0 58.0 68.8 74.6

Trade balance 0.3 -1.9 -8.5 -11.3

% of GDP 0.2 -0.9 -3.5 -4.6


% of GDP 3.6 2.9 -0.4 -1.4

FDI (net) 2.7 -2.8 2.3 1.0


ILS/USD (eop) 3.79 3.52 3.75 3.65

ILS/EUR (eop) 5.42 4.72 4.88 4.93



Domestic 63.4 61.8 61.3 61.0

Foreign 14.4 12.7 12.2 12.3


in USD bn 93.3 106.0 117.7 125.3

General (% pavg)




BoI policy rate (%) 2.75 2.50 2.50 3.00

ILS/USD (eop) 3.79 3.80 3.72 3.65

ILS/EUR (eop) 5.05 4.94 4.65 4.93

Source: DB Global Markets Research, BoI



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

Economic outlook: Growth is picking up and

inflationary pressures are on the rise.

Main risks: The key vulnerability remains in the

banking sector, with negative implications for

recovery in loan growth.

Strategy outlook: Maintaining a relative preference

for KZT NDFs vs their UAH counterparts. Neutral on

sovereign credit (CDS).

Macro outlook

The macroeconomic conditions in Kazakhstan remained

relatively favourable in 2011 despite global financial

volatility as evidenced in sovereign credit rating upgrades.

In November 2011 S&P upgraded Kazakhstan’s sovereign

credit rating to BBB+ (outlook stable), citing rising exports

and the sustainability of high growth rates of 6% until

2014. The agency referred to the combination of a strong

current surplus, prudent fiscal policy and high FDI inflows

among the factors underpinning the upgrade. At the same

time, the agency also pointed to vulnerabilities, centering

on the country’s banks’ holdings of foreign debt, which

remains significant at 24% of total liabilities of the

financial sector. Overall, the increase in the sovereign

credit rating should be supportive for capital inflows and

the currency, though in the short term these positive

factors may be dented by lingering uncertainty and risk-

aversion in global financial markets. The S&P upgrade was

shortly followed by an upgrade from Moody’s, also in

November 2011.

One of the key strengths of the Kazakh economy is the

attainment of high growth rates, which is projected by the

government to reach 7% in 2011 and to stay at 6-7% in

the medium term. At the same time, the government is

targeting inflation in the range of 6-8% in each of the next

five years, a target that lacks ambition on the disinflation

front. It also reflects the greater predilection of the

National bank of Kazakhstan to keeping the exchange rate

stable versus the dollar, with the head of the National

Bank, Grigory Marchenko declaring that the monetary

authorities would not allow the tenge to appreciate

beyond KZY/USD145 in 2011. The continued commitment

to exchange rate stability may harbor upside risks for

inflation in a high oil price environment, with 2011 inflation

likely to come towards the upper end of the 6-8% range

targeted by the monetary authorities.

One of the main points of vulnerability in Kazakhstan’s

economy remains the banking sector, which continues to

face the challenges of slow lending dynamics and weak

asset quality. The latter is exerting pressure on margins

and profitability, which is coming on top of the already

significant problems inherited by the sector from the

downturn experienced in 2007. The authorities are

targeting the sale of majority stakes held by Samruk-

Kazyna in BTA, Temirbank and Alliance under a debt

restructuring program, but in November 2011 the Head of

the National Bank of Kazakhstan, Grigory Marchenko,

declared that it may take longer (beyond 2013) to sell off

these banks due to the volatility in Europe’s financial

markets.

On the political front, Kazakhstan is to hold snap

parliamentary elections on January 15-16 which are likely

to result in a reduction of the monopoly of the ruling Nur

Otan party. We do not expect to see an escalation in

political risks in the near term, with the longer-term

vulnerability being the uncertainty over the succession to

the 71-old leader, Nursultan Nazarbayev.

Kazakhstan: Inflation and GDP growth

0

2

4

6

8

10

12

14

16

18

20

2003 2004 2005 2006 2007 2008 2009 2010 2011F 2012F 2013F

Real GDP (YoY%) CPI (Dec/Dec)

Source: National authorities, Deutsche Bank

In the fiscal sphere, expenditure restraint has helped to

lower the vulnerability of the budget to a downturn in oil

prices. In 2011 Kazakhstan’s fiscal surplus could reach

close to 2% of GDP compared to a surplus of 1.4% of

GDP in 2010. In November, the parliament adopted the

budget plan for 2012-2014, which is based on

conservative oil price assumptions and envisages a

budget deficit of 2.6% of GDP in 2012, which is to

progressively decline to 1.5% of GDP in 2013 and 1.3% of

GDP in 2014. Outlays are projected to rise by 6-7% in

nominal terms in 2012, with transfers to the budget from

the National Fund of Kazakhstan projected at KZT1.2tr. As

of September 2011 the assets of the National Fund

reached nearly USD40bn.

Yaroslav Lissovolik, Moscow, (7) 495 933 9247

Ilya Piterskiy, Moscow,( 7) 495 933 92 30



Investment strategy

FX: Correlation patterns suggest that the main drivers for

KZT NDFs are the ruble, equity sentiment and oil. While it

is difficult to be constructive on risk assets over the

coming year, it is worth pointing out that the domestic

backdrop of Kazakhstan seems to be improving. Firstly,

the Fitch upgrade to 'BBB' (positive outlook) was a plus

for the currency, combined with a strong government

GDP forecast for 2012 (to 6.9% from 7%), stabilization in

FX reserves (to $32.6bn) and the continuing current

account surplus in Q3 '11 (vs. a deficit in Q3 '10) and a

gradual decline of inflation to 5.4% YoY in October (vs.

5.9% in September) bode well for the currency. Further,

the latest assets of the National Oil fund show another

increase, suggesting that we are unlikely to see sharp

moves in the KZT. We recommend staying sidelined for

now, but express a relative preference for KZT NDFs vs

their UAH counterparts.



Credit markets: Little has changed regarding our

fundamental view on Kazakhstan that selling sovereign

CDS protection offers a good medium-term risk-reward.

However, the weaker global environment and increased

risks in the domestic banking sector argue that the risk-

reward profile of such a position is currently unattractive.

We recommend remaining on the sidelines for the time

being.


Kazakhstan: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National income


Population (m) 16.1 16.4 16.6 16.8

GDP per capita (USD) 8 689 9 832 11 055 12 503

Real GDP (%) 7.3 6.6 5.5 6.0



Investment 2.0 9.0 10.0 10.0

Exports 1.9 12.9 2.5 11.2

Imports 0.9 25.4 5.6 -7.7

Prices, money and banking (eop)

CPI (YoY %) 7.8 8.0 7.0 6.5

Broad money (M3) 15.7 13.0 14.0 12.0

Private credit 0.0 9.0 9.0 11.0


State budget balance 1.5 2.0 2.5 3.1

Revenue 25.3 26.3 26.6 27.0

Spending 23.8 24.3 24.1 23.9

External accounts

(USDbn)

Exports 60.8 86.5 92.8 102.6

Imports 32.0 43.3 48.9 48.1

Trade balance 28.9 43.3 43.8 54.5

% of GDP 20.6 26.8 23.9 26.0


% of GDP 3.1 10.4 8.4 11.6

FDI (net) 2.8 8.0 8.0 8.0

FX reserves (USDbn)

OIL

28.3 38.0 54.0 70.0

KZT/USD (eop) 147.4 147.0 145.0 143.0

Debt indicators (% of

GDP)

Total public debt 15.7 19.0 14.7 10.1


in USD bn 110.0 136.0 148.0 169.4

General (% pavg)

Industrial production (%

YoY)

10.0 6.2 5.8 6.0

Financial markets (eop)

period)

Current 3M 6M 12M

NBK policy rate (%) 7.0 7.0 7.0 7.0

KZT/USD (eop) 147.6 147.0 146.6 146.5 Source: Official statistics, Deutsche Bank Global Markets Researc



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

Economic Outlook: A Poland’s larger and less

export-orientated economy compared with elsewhere

in CEE should outperform again in 2012. While

growth will undoubtedly slow there is little risk of

recession. The pace of slowdown alongside zloty

performance, the inflation outlook and the fiscal

stance will all determine the scope for rate cuts in

2012. We see this as unlikely before Q3.

Main Risks: Any evidence that the new government

lacks commitment to fiscal austerity could quickly put

pressure on yields and see the rating outlook revised

to negative. The discussed methodology changes to

calculation of the debt rule, if used as a substitute for

fiscal reform, would be a big negative in this regard.

Strategy Recommendations: We recommend a 1y

EUR/PLN put, with a and strike at 4.25 for 2% of EUR

notional.Receive 1Y XCCY basis as a hedge but

outright purchase of POLGBs will be attractive in H2

201. Overweight sovereign credit.

Macro View

Still one of the strongest economies in Europe. Donald

Tusk has now been sworn in for a second term as Polish

PM leading a successor PO-PSL coalition. In his first

speech to Parliament Tusk set out a fairly ambitious fiscal

reform agenda which includes various changes to the

pension system, elimination of tax breaks, healthcare

reform and a pledge to step up deregulation. The

commitment to fiscal reform comes as Poland feels the

impact of the financial stress in Western Europe via

ongoing depreciation of the zloty but has otherwise been

relatively immune despite its own still-high fiscal deficit.

The government’s new four-year mandate and a better

economic backdrop then elsewhere in Europe to

implement fiscal reform suggests market tolerance

towards any perceived lack of commitment in Poland is

likely to be limited.

Poland statistics office reported a robust 1.0% QoQ

reading for Q3 GDP (seasonally adjusted) and 4.2% YoY

(non-seasonally adjusted) versus a consensus expectation

of 4.0% YoY. This is down only slightly from the upwardly

revised 1.2% QoQ reading for Q2 (previously reported at

1.1%) and other than Romania’s agriculture-induced

bumper 1.9% QoQ reading is comfortably the strongest

growth reading in Europe. The detailed components show

a pretty robust composition of growth albeit with some

evidence of a slowing in the domestic momentum.

Domestic demand accounted for 3.2pp out of the 4.2%

YoY GDP reading with the contribution from restocking

the lowest since Q4 2009 at 0.4pp. The components

showed the quarterly pace of consumer spending slowing

to just 0.6% from 1.0% in Q2 with the YoY rate

moderating to a still-strong 3.0%. Fixed investment

slowed as expected given the lower public investment

spending with the quarterly pace of growth at 1.4% and

therefore the lowest since Q3 2009. On a YoY basis

growth in investment now stands at 8.5% and is the

highest in the post-crisis period but more reflective of

gains in previous quarters rather than in Q3 itself. On a

YoY basis the contributions to growth from private

consumption and investment were reported at 1.8pp and

1.6pp respectively which is the lowest contribution from

consumer spending since Q4 2009. On the external side

net trade added 1.0pp to growth, the highest contribution

since Q4 2009 and the only meaningful boost to growth

from net trade in recent quarters. This masks the fact that

exports reported a sluggish 0.4% QoQ gain while import

growth turned positive after a negative reading in Q2.

Poland: Growth has eased back but remains strong

and the composition is robust

0

1

2

3

4

5

6

7

8

-15

-10

-5

0

5

10

Q3-06 Q3-07 Q3-08 Q3-09 Q3-10 Q3-11

Inventories GFCF

Govt Cons Pvt Cons

Net Exports Real GDP (rhs)

pp contribution % YoY

Source: Haver Analytics, DB Global Markets

Going forward we continue to expect the pace of GDP

growth to moderate. Investment should continue to

decelerate on the back of reduced public investment and

an uncertain global backdrop while consumer spending

will start to reflect lower wage growth in both nominal

and real terms and deteriorating employment prospects.

The planned fiscal consolidation will also weigh down on

domestic demand components as benefits are cut further

and spending freezes are expanded while it is unlikely that

reform of retirement schemes will offset these measures

in the near term. While Poland has a much smaller export

sector compared with Hungary or Czech Republic, exports

will still feel the impact of further weakness across

Western Europe which currency weakness (and therefore

competitiveness gains) will not be able to offset. A

continued normalisation in the boost to growth from the

restocking cycle will also dampen growth in the coming



year. A better-than-expected Q3 GDP pushes our 2011

growth estimate to 4.2% but we have nudged down our

2012 forecast to 2.3% versus 2.6% previously. We now

expect a lower contribution from both domestic demand

and net trade with the high base from the very solid

performance in 2011 also making YoY comparisons now

more difficult. Our 2.3% forecast is lower than the 3.2%

NBP projection and the likely 2.5% Ministry of Finance

forecast but still leaves Poland as easily one of the

strongest economies in Europe.

Fiscal financing looks secure for 2012. The combination

of a VAT hike, introduction of a spending rule, reduction in

the contributions to the private pension funds and cuts to

various benefits are expected to produce a narrowing in

Poland’s general government budget deficit from -7.8% in

2010 to 5.5% in 2011. Data on the narrower state budget

through October show the deficit at PLN22.5bn and

therefore on track to come in considerably below the

planned PLN40.2bn with outperformance on both the

revenue and spending sides. The government continues

to target a sub 3% general government deficit for 2012

with PLN35bn or 2.3% of GDP on the state budget.

Savings from the deficit rule for local governments, the

spending rule, reduced pension contributions and

elimination of some early retirement options are all

assumed to achieve this. The state budget is still under

revision however given the earlier 4% GDP growth

assumption for 2012 and unlike Hungary there is no

explicit reserves buffer in the budget and there has not

been any real discussion of additional measures to keep

the budget on track. Budgetary space afforded by

outperformance on the state budget in 2011 could provide

some buffer but this is unlikely to be enough. A sub 3%

fiscal deficit by 2012 was too optimistic even in a better

macro environment and we continue to expect the deficit

outturn to be in excess of 4% of GDP.

Poland: Gross borrowing requirement larger in 2012

65.4

105.7

8.7

35.7

103

6.2

47.3*

114.3

13.9

0

20

40

60

80

100

120

140

Net Borrowing

Requirements

Repayment of

domestic debt

Repayment of

foreign debt

2010 (Total:

PLN 179.8bn)

2011 (Total:

PLN 144.9bn)

2012 (Total:

PLN 175.5bn)

PLN bn

Source: Ministry of Finance (*state budget deficit of up to PLN35bn)

Nevertheless, the fiscal financing outlook looks relatively

secure. The authorities have announced a PLN175.5bn

(EUR39bn) gross borrowing requirement for 2012 with

intended financing split between PLN146.1bn in domestic

financing and PLN29.4bn in foreign financing. Poland has

already started pre-financing for 2012 on both the

domestic and external side (Ministry of Finance officials

said this was 10% by end November) and the government

has a substantial cash buffer (EUR10.5bn) at its disposal.

The 2012 pre-financing also suggests comfort by the

Ministry of Finance that Poland is not in danger of

breaching its 55% debt/GDP limit despite the recent zloty

weakness. Some 27% of public debt is denominated in

foreign currency (and predominantly euros) and with

debt/GDP at 53.7% as of Q2 (4-quarter rolling basis) on a

PLN rate of 3.99/EUR there have been increasing

concerns about breaking 55%. But with debt issuance

front-loaded in H1 and the combination of a slower than

expected easing in GDP growth plus slightly higher

inflation, we do not expect the threshold will be breached.

Public debt data are only available through June but using

the recent Ministry of Finance projection of debt/GDP at

53.8% based on EUR/PLN at 4.35 we see the tipping

point at 4.75/EUR for 2011 (data will be released in May

2012).

Recent comments that Poland may look to change the

calculation method for public debt to use an annual

average, rather than year end, exchange rate should be

viewed with caution. That a single exchange rate point can

have an important bearing on future fiscal policy does not

make much economic sense (triggering the 55% limit

would mean a 1pp temporary VAT hike and unspecified

measures to ensure the fiscal deficit is on a declining path

and the debt/GDP ratio is expected to decline). But the

worry will be that Poland uses a methodology change as a

substitute for fiscal reform. The bigger risks in our view is

the accompanying comments that Poland would also like

to see the debt definition changed to net, rather than

gross, debt. The EUR10.5bn in PLN and FX liquidity held

by the Ministry of Finance as of end October is equivalent

to 2.8% of GDP and would therefore open up significant

room to manoeuvre on fiscal policy before the debt limit

was reached. The ratings agencies have yet to comment

on the proposals but we expect these will be viewed

decidedly negatively.

C/A financing more vulnerable. Despite the ongoing

worries on the fiscal side, Poland’s larger vulnerabilities

for the coming year are on the external side in our opinion.

At an expected 4.5% of GDP in 2011 the C/A deficit is the

largest in CEE and has the weakest financing mix. NBP

data show the deficit at EUR12.5bn through September,

of which EUR7.8bn stems from the trade deficit and

EUR11.8bn from deficit on investment income line with a

partial offset from services and transfers surpluses. Both

FDI and EU transfers components cover around 30% each

with the much larger source of financing coming from

inflows into debt securities. This stands at EUR8.75bn



YTD, with another EUR1.6bn in foreign inflows into equity,

and covers 70% of the deficit YTD. The September BoP

data reported the first (small) monthly outflow on the debt

securities component which corresponds with the start of

the zloty weakness. The overall BoP reported a shortfall

for the month and a corresponding fall in reserves which

is not explained by foreign debt repayments. The

combined debt and equity inflow amounted to 5.6% of

GDP in 2010 versus a headline C/A deficit of 4.6% of

GDP. This is now down to 3.7% of GDP on an annualised

basis versus a C/A deficit at 4.5% of GDP. Should these

flows drop back further this could mean continued

pressure on the zloty as it is difficult to see where any

financing offset could come from. We view Poland’s

USD30bn precautionary flexible credit line arrangement as

only a tentative source of strength. The arrangement is in

place until January 2013 but Poland’s decision to treat the

FCL as precautionary means this is not included in the

NBP’s EUR64.1bn in FX reserves. Any request to trigger

the facility would therefore be a very public sign of

weakness and we see this as likely only in a very worst

case scenario where the sovereign cannot issue.

Rate cuts pushed out to Q3. Governor Belka recently

described the ongoing zloty weakness as a ‚temporary

headache‛ and the Bank, along with various other Polish

officials, have said the move is out of line with Poland’s

fundamentals. As our chart opposite shows, the

weakness has largely been in tandem with the stresses in

Western Europe and has come in the absence of any

negative developments on the macro side. The NBP have

confirmed direct intervention on four occasions now with

their public stance that they are not targeting a particular

level of the zloty but instead acting against destabilisation

in the FX market. FX reserves have dropped by

EUR240mn since the start of intervention to stand at

EUR64.15bn at end October but this is clouded by

valuation effects and public flows making it difficult to

disentangle exactly the intervention size. Nevertheless,

with reserves less than 100% of ST debt and one of the

lowest in EMEA as a share of GDP we reiterate our view

that intervention is likely to be contained.

With inflation currently way above the NBP’s 2.5% target

(4.3% YoY for October) pass-through from currency

weakness is an increasing concern. The monthly gains in

the October food and petrol price components were

higher than elsewhere in CEE pointing to some immediate

pass-through from the zloty weakness and given

continued depreciation through October and November

(albeit smaller than the 5% decline in September) upside

risks remain for the forthcoming inflation prints. The input

price component of the November PMI was unchanged

from October at a five-month high which may cap some

of the concerns on pass-through while the EC survey on

selling price expectations also dropped in November after

a sharp jump in October.

Poland: Zloty weakness has been in tandem with

stresses in Western Europe

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

3.8

3.9

4.0

4.1

4.2

4.3

4.4

4.5

4.6


EURPLN

Italy 10Y Government

Bond (%, rhs)

Source: Bloomberg Finance LP

The NBP’s November Inflation Report saw a 0.4pp

upward revision to the Bank’s inflation projections for both

2012 and 2013 and the GDP growth projections lowered

marginally. With CPI expected to remain above target

through the entire forecast horizon the NBP are likely to

maintain their relatively hawkish stance for some time

ahead. Further zloty weakness will also rule out any

change to a dovish stance and we expect the Bank will

also want to be sure of the government commitment to

fiscal consolidation before hinting at any easing in

monetary policy.

Poland: NBP now expects inflation to remain above

its 2.5% target through the entire forecast horizon

Previous Latest Change Previous Latest Change

2011 4.0 4.0 0.0 4.0 4.1 0.1

2012 2.7 3.1 0.4 3.2 3.1 -0.1

2013 2.4 2.8 0.4 2.9 2.8 -0.1

Inflation forecasts (% YoY) GDP forecasts (%)

Source: NBP

Despite the ongoing zloty weakness and recent

announcement of tax increases on diesel and tobacco the

inflation profile will still improve from January as the 2011

VAT hike drops from annual comparisons. CPI will move

back within the 2.5% +/-1pp buffer by Q2 but it will not

drop back to the 2.5% midpoint target 2013. The

combination of still-strong domestic momentum and a

higher inflation profile suggests our earlier expectation for

the NBP to move to a rate cutting cycle from March 2012

now looks too soon. We now expect the NBP will remain

firmly in wait-and-see mode for at least the next six

months with the first rate cut unlikely before Q3.




Investment Strategy

FX: Strong momentum in the domestic economy

continued in Q3, with the GDP report showing that

currency weakness is not entirely negative, as it makes

exports more competitive (net exports added 1% to Q3

growth). Inflation has been sticky, and commentary from

NBP has remained hawkish, suggesting that the

aggressive re-pricing of policy seen in August is unlikely to

materialise. The consolidation plan following the elections

was well received by OECD - who expect the government

deficit to be cut to 2.9% of GDP in '12 (previously 3.8%).

Finally, valuation is attractive on our longer term valuation

metric and combined with credible fiscal consolidation

and continued support from official authorities to keep

EUR/PLN contained (also to keep debt/GDP below 55%)

we are cautiously constructive. Near-term there are still

substantial risks, with the PLN hostage to the Eurozone

crisis and also taking over as the default European risk-off

hedge to some extent if NBH starts hiking rates. On

balance, we recommend a 1y EUR/PLN put struck at 4.25

for an indicative cost of 2%.



Rates: Receive 1Y XCCY basis as a hedge but outright

purchase of POLGBs will be attractive in H2 2012 The

negative FX performance and robust economic growth

has led us to reduce our expectations for rate cuts in H1

2012. Real money funds have been consistently

underweight through the year, at least partly due to the

current stigma associated with European names. Any

further negative developments could lead to a tightening

of USD funding and a rise in the interbank fixing. At

present, we see more upside in bearish positions such as

receiving the 1Y EURPLN cross-currency basis. In H2, as

more progress is achieved in resolving the Eurozone issue

and the inflation outlook likely moderates, we would be

looking to increase exposure via bonds.


Credit: Overweight. The next few months are a critical

period for Poland with respect to fiscal policy – likely the

key determinant for relative performance of the credit in

the near term. While we are cautious in our expectations

of what the re-elected government will deliver, we believe

the market reflects an even more cautious view and

hence we see the risks being skewed towards tighter

spreads. Certainly there are few credits in EMEA which

have such a potential to provide a positive surprise in the

near term. We change our recommend to overweight

from neutral.


Poland: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income


Population (mn) 38.1 38.1 38.1 38.1


Real GDP (YoY%) 1.6 3.8 4.2 2.3



Gross capital formation -1.4 -2.2 6.2 4.0

Exports -6.8 10.2 7.0 6.4

Imports -12.4 11.6 6.2 6.0


(eop

CPI (YoY%) 3.5 3.1 4.0 2.4

Broad money (M2) 8.1 7.8 10.2 10.0


ESA 95 budget balance -7.3 -7.8 -5.5 -4.3

Revenue 37.2 37.5 39.5 39.6

Expenditure 44.5 45.3 45.0 43.9



Exports 142.1 165.7 191.2 188.2

Imports 149.7 177.5 208.5 203.8

Trade balance -7.6 -11.8 -17.3 -15.6

% of GDP -1.8 -2.5 -3.3 -3.2


% of GDP -4.0 -4.6 -4.5 -4.4

FDI (net) 8.5 3.6 2.8 2.7


PLN/USD (eop) 2.86 2.96 3.38 3.04

PLN/EUR (eop) 4.10 3.97 4.40 4.10



Domestic 36.8 38.4 38.6 38.5

External 13.1 14.4 14.4 14.7


in USD bn 281.1 312.2 327.8 333.3


General (YoY%)


Unemployment 11.0 12.1 12.1 12.0


Policy rate (14 day repo) 4.50 4.50 4.50 4.00

PLN/EUR 4.49 4.33 4.25 4.10

PLN/USD 3.33 3.33 3.40 3.04

Source: Haver Analytics, NBP, DB Global Markets Research.



Romania Baa3(stable)/BB+(stable)/BBB-(stable) Moodys/S&P/Fitch

Economic Outlook: A precautionary IMF/EU SBA in

place until 2013 combined with the government’s

intention to increasingly tap the Eurobond market

ahead of large external redemptions in 2013/14

should help to ensure reform fatigue is avoided and

the structure of growth continues to improve.

Despite a very difficult external backdrop we see

upside risks to our growth projection from stepped

up absorption of EU funding and reform of loss-

making SOEs.

Main Risks: Fiscal slippage in the run up to the Q4

general election risks pushing the IMF/EU program

off track and would limit scope for further monetary

easing. It could also put pressure on the ratings.

Strategy Recommendations: Neutral FX.

Overweight sovereign external debt.

Macro View Domestic factors point to upside risks to the growth

outlook. We see Romania’s recovery as one of the most

secure in the region for the coming year. While growth is

likely to be relatively slow after a bumper Q3 and continue

to be reliant on exports, the composition of growth is

expected to be the most balanced for many years. That

the IMF/EU precautionary stand-by arrangement (SBA) is

active through Q1 2013 should also help to avoid any

policy slippage in the run up to the general election due by

November. Fundamentals have continued to improve,

reflected in the positive assessment by the IMF in its

recent program review which commended the authorities

for making ‚good progress in implementing program

policies in a very difficult external environment‛. That the

sharp fiscal policy adjustments are now in the past also

reduces the fiscal drag on the 2012 growth outlook

compared with the past two years. Despite our

expectation for a 2012 recession in Euroland we see the

risks to our growth forecasts for Romania to the upside

with the potential for a sizeable step-up in absorption of

EU funding and positive spillover from growth-enhancing

structural reforms. Romania’s smaller export share (35.8%

of GDP) compared with Czech Republic (79.3%) and

Hungary (86.5%) also helps while a public debt/GDP ratio

of sub 40% also limits spillover from European debt

worries.

At 1.9% QoQ and 4.4% YoY Romania’s Q3 GDP reading

was by far the strongest in CEE and is the fastest pace of

quarterly growth since seasonally-adjusted data are

available (Q1 2009). On a YoY basis the 4.4% reading is

the highest since Q3 2008 and up sharply from the 1.4%

YoY reading in Q2 with the July 2010 austerity measures

now out of annual comparisons. INSEE have yet to

publish the GDP components for Q3 but we expect

agriculture provided by far the largest contribution to

growth given the bumper harvest through the quarter. IP

growth picked up to 5.7% through Q3 following a sharp

deceleration in Q2 and we expect exports will also show a

move up after merchandise exports (value basis) reported

a return to positive territory at 4.2% for Q3 versus Q2

after a -5.1% reading for Q2. On the domestic side,

monthly retail sales data suggests a still weak consumer

with growth remaining in negative territory for almost

three years now (3mma YoY basis) albeit with the

September 2012 reading the strongest for a year. Credit

growth remains weak with net new credit extension to

the private sector largely unchanged YTD versus a year

ago although this should be neutral, rather than negative,

for domestic demand. On a FX-adjusted basis credit

growth stands at 6% YoY as of September and positive in

real terms for three consecutive months now. The outlook

for any meaningful revival in credit growth is severely

limited however given capital raising requirements faced

by foreign parent banks. But with the Vienna initiative for

Romania renewed in early 2011 we do not expect any

protracted reduction in exposure by the largest foreign-

owned banks in the coming year.

Romania: At 1.9% QoQ in Q3 GDP Romania reported

by far the strongest growth in CEE

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11

RomaniaEurolandCzechHungaryPoland

Real GDP (SA, % QoQ)


As the boost from a strong harvest could continue to

support growth through Q4 on a QoQ basis and the

bumper Q3 has now lifted the base to ensure a strong

final quarter reading in YoY terms, our previous 0.9% GDP

expectation for 2011 now looks too low. We revise this up

to 1.8% while for 2012 we leave our 1.9% growth

expectation unchanged despite our now weaker Euroland



baseline (-0.5% from +0.4% previously). We have

however adjusted the composition of GDP for next year

with a lower export assumption and higher domestic

demand growth. Our revised forecasts see a gradual pick-

up in consumer spending with wage growth much

improved in both real and nominal terms and acceleration

in investment growth from efforts to improve absorption

of allocated EU funding (the EUR6bn or 4.7% of GDP

included in the budget for EU transfers is a record high).

To the extent that the fiscal dynamics allow for a further

reversal of the 2010 public sector wage and pension cuts

this would be another upside for growth in the coming

year. The continuation of regular program reviews by the

IMF/EU and the authorities desire to increasingly tap the

Eurobond market ahead of large IMF repayments in 2013

and 2014 should also help to ensure reform fatigue does

not set in and the impressive track record of policy

implementation during the past two years continues.

Targeting a sub 3% fiscal deficit in 2012. The

government’s commitment to a sub 3% fiscal deficit for

2012 (which would be the first such reading since 2007) is

impressive particularly given the election calendar. The

recently approved 2012 budget is based on an IMF-agreed

1.8% GDP growth assumption and sees the

expenditure/GDP ratio dropping for the third consecutive

year and the revenue/GDP ratio increasing. We do not see

a 3% deficit as unachievable. Romania has already passed

all the necessary legislation to ensure continued fiscal

consolidation (the fiscal responsibility law, the unitary

wage law, the public finance law and the pension reform

law) and is committed to reduce the overall wage bill to

below 7.2% of GDP from 9.2% in 2009. The EUR6bn

assumption on EU transfers looks optimistic at first glance

but with the EU budget period ending in 2013 time is

running out to absorb the remaining funding allocation and

with just a 5% co-financing requirement (versus 15%

normally) there is a large incentive to do so. The IMF/EU

focus on loss-making SOEs and clearing of arrears, if

achieved, should also prove to be a support to growth and

indirectly to the budget. The authorities have also set out

a timeline for IPOs and for new management structures at

the largest loss-making enterprises with the intention of

making the companies cash-flow positive. The success of

the IPO pipeline will however depend on the broader

macro environment with the unsuccessful sale of the

country’s largest energy company, Petrom, in July

evidence of this. With an expected pick-up in growth next

year and continued narrowing of the headline deficit the

structural budget deficit should also narrow again next

year. The latest EC projections see a 2.6% of GDP

structural budget deficit for 2012 which would amount to

a 6.5pp reduction in the structural deficit since the peak in

2009. This compares with 2.1pp for Czech Republic,

0.5pp for Hungary and 3.5pp for Poland. The ~1pp

improvement for next year is smaller than the adjustments

made during the past two years which also supports our

view on an improvement in domestic demand for the

coming year.

Modest rate cuts look likely. A moderate loosening in

the monetary policy stance is also expected to provide

some support to growth in 2012. The NBR announced an

earlier-than-expected move to an easing cycle with a

25bps rate cut in early November. The rate cut was the

first since May 2010 and came after a significant

improvement in headline inflation with the November CPI

reading at 3.5% YoY, versus 8.4% in May, the adjusted

CORE2 readings at 2.7% and 4.8% YoY for October and

May respectively (CORE2 excludes administered prices,

volatile prices and tobacco and alcohol). While some of

the improvement reflects a better base as the July 2010

VAT hike has now dropped out of annual comparisons the

5.7% decline in the food price component (37.5% of the

total index) between May and September was also a

significant factor. The sharp disinflation pushed real rates

sharply higher and was offset only partly by a weaker leu

according to our monetary conditions index.

Romania: Further cuts in the policy rate will reverse

some of the recent increase in real rates

-4

-2

0

2

4

6

8

110

120

130

140

150

Oct-05 Oct-07 Oct-09 Oct-11

%

Dec

2000=100dbREER (lhs)

Real policy rate (rhs)

Source: Haver Analytic, DB Global Markets Research

The NBR policy statement from November said that the

cut in the policy rate was intended to ensure adequate

real broad monetary conditions and that the NBR would

maintain a prudent approach to monetary policy. The NBR

statement also mentioned a ‚gradual reduction‛ in real

broad monetary conditions going forward and highlighted

the importance of domestic savings and ‚appropriate

remuneration of bank deposits‛. These comments

combined with the Bank’s acknowledgement that the

medium-term risks to the inflation outlook are to the

upside suggest 2012 rate cuts are likely to be modest and

we expect a total of 75bps in rate cuts through the next

twelve months. This would leave the policy rate at 5.25%

and real rates around 2%. We expect the timing of rate

hikes to be fairly spread out as the NBR assesses the



impact of the recent cut in heating subsidies (estimated to

add up to 0.5pp to headline CPI) as well as any spillover

impact from the recent increase in industrial gas prices.

The updated Inflation Report from November sees the 3%

+/-1pp target being achieved for both 2011 and 2012 (the

NBR has only once met its target in the past) but with

three main risks around the outlook namely; a weaker

external environment leading to a currency depreciation,

possible upward pressure on public sector wages in 2012

due to the general election and administered price hikes.

Romania: Liquidity operations have been stepped up

in case of any funding squeeze

-40

-30

-20

-10

0

10

20

30

40

50

60

Nov-07 Nov-08 Nov-09 Nov-10 Nov-11

RON bn

Net OMO

Source: NBR, DB Global Markets Research (chart shows monthly aggregate)

Aside from the inflation trajectory, scope for rate cuts will

also be dependent on banking sector stability in the face

of further stress in European financial markets as well as

RON performance. The NBR has stepped up its weekly 7-

day repo operations during recent months with the

RON6.25bn repo tender on November 21st the largest

since early 2010. That commercial bank holdings of

government securities now stand at 10.4% of GDP versus

just 1.3% of GDP in September 2008 significantly

improves bank’s access to repo liquidity as government

securities are the bulk of eligible collateral. If banks facing

a liquidity squeeze do not have sufficient eligible collateral

to use the repo window the NBR also has an option to

extend emergency liquidity with a broader range of

collateral. The list is not made public however and would

be done on a case-by-case basis. These short-term

liquidity facilities are complemented by a deposit

guarantee fund which has the power to take over

distressed banks temporarily in order to avoid any fire sale

until a private sector buyer can be found. Despite the high

share of Greek parent banks in Romania and the move up

in NPLs to 14.2% as of September 2011 from 11.7% a

year earlier the banking system is nevertheless generally

viewed as resilient with a 13.4% capital adequacy ratio as

of end September, adequate provisioning and all banks

above the 10% regulatory minimum. In addition, there has

not been any obvious pressure on deposits.

External position looks comfortable, albeit with some

widening in the C/A deficit. Romania’s external position

should also continue to show improvement during the

coming year although made difficult by a very weak

backdrop in Europe and a likely pick-up in import demand

given the expected improvement in domestic demand.

Latest data on exports show a turnaround from the

summer lows but it is difficult to determine the extent this

will be sustained although data on new export orders have

also rebounded from the summer slump. A very strong

performance at the beginning of 2011 should mean that

annual growth in exports and imports is only marginally

down from the 28.5% and 20.4% of 2010 securing a

further reduction in the trade deficit to around 4.5% of

GDP from a high of 13.7% in 2008. Recent divestments

by two of Romania’s main exporters will also hurt export

growth next year although production increases by Ford

as well as investment announcements from other

multinational corporates could offset this to some extent.

Romania faces the problem that the only offset to the

trade deficit, namely the transfers surplus, could well

decline further in line with fiscal austerity and recession in

Italy, the main source of remittances. Nevertheless, at

around 5% of GDP the C/A deficit should be comfortably

financed and we do not foresee any BoP funding gap that

would put pressure on the RON.

Romania: External financing will increase in 2012 but

looks easily manageable

EURbn 2007 2008 2009 2010 2011F 2012F

Gross Financ ing Req. 36.0 45.1 39.2 31.3 35.7 38.5

C/A (deficit = positive) 17.0 16.2 4.9 5.0 4.7 5.5

Amortisation (MLT) 6.5 8.5 13.1 12.3 14.6 13.5

Amortisation (ST) 12.5 20.5 21.3 14.1 16.4 19.4

Financ ing 36.0 45.1 39.2 31.3 35.7 38.5

Non-debt creating 8.1 9.9 4.2 2.5 2.2 4.2

FDI (net) 7.3 9.3 3.6 2.2 1.6 2.2

EU capital inflows 0.8 0.6 0.6 0.2 0.6 2.0

Debt creating 32.6 33.5 35.2 31.5 33.4 34.3

Sovereign Eurobonds 0.8 1.0 1.5 3.0

Multilateral financing 10.9 6.2 2.1

Banks + corporates 32.6 32.7 24.3 24.3 29.9 31.3

Errors & omissions -0.2 1.7 1.0 0.9 0.0 0.0

Reserves (+ = decrease) -4.5 0.0 -1.1 -3.5 0.0 0.0

Gross Financ ing Req.

% of GDP 28.9 32.3 33.4 25.7 27.9 28.5 Source: DB Global Markets Research

Despite the expected move wider in the C/A deficit and

slightly higher amortization than in 2011 the overall gross

external financing requirement looks manageable. The

bulk of the financing remains with the private sector but

with the IMF/EU anchor remaining in place we expect



sufficient financing will be maintained. On the sovereign

side, the government faces a total of EUR2.6bn in

redemptions in 2012 with EUR1.9bn in repayments to the

IMF (with principal payments of EUR0.6bn, EUR0.6bn and

EUR0.2bn due in August, November and December

respectively) and a EUR700mn Eurobond due in May. The

authorities have a EUR7bn EMTN program in place and

have announced plans to issue their first USD-

denominated Eurobond soon. With EUR5bn due to the

IMF in 2013 and EUR4.6bn due in 2014, Romania’s

presence on the Eurobond market will likely increase in

2012 in order to pre-finance for later years. We see

potential for S&P to join Fitch in bringing Romania’s LT

foreign currency sovereign rating back to investment

grade during the coming year provided the government

sticks with its fiscal commitments.


Investment Strategy

FX: Romania's macro outlook is improving. Domestic

factors are pointing towards upside risks to growth, the

C/A deficit at around 4% does not pose a material threat

to the RON and the government's sub 3% fiscal deficit

target does not look unachievable. It is worth noting that

with 35% of exports to Europe, Romania is not as

exposed to Europe as Czech Republic (around 80%) or

Hungary (87%). From a strategy point of view, however,

we see a lack of catalysts for RON volatility. In risk

positive scenarios we see investors preferring higher

yielding and more 'default' risk currencies such as the

ZAR. In risk negative scenarios we do not foresee the leu

getting hit as aggressively as for example HUF, and of

course of the threat of intervention from the NBH.



Credit: Overweight. Risks to economic performance are

mounting, but the government’s commitment to fiscal

adjustment and its good relationship with the IMF should

stand the country in good stead to weather potential

storms ahead. At 430bp, Romania 5Y CDS exaggerates

the risks; we recommend an overweight exposure to the

credit. The main risk to this position is renewed pressure

on eurozone sovereigns. Romania spreads are already

20bp tighter than Italy and while this is arguably justified

given the country’s relative debt dynamics, it will likely

constrain how much Romania spreads could tighten.


Romania: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income


Population (mn) 21.4 21.4 21.4 21.4


Real GDP (%) -7.1 -1.3 1.8 1.9

Priv. consumption -9.6 -1.8 2.3 4.0

Govt consumption 1.2 -3.2 1.5 3.5

Investment -25.3 -13.1 6.5 9.5

Exports -5.0 14.3 8.9 9.2

Imports -21.4 12.4 10.0 13.0


CPI (YoY%) 4.8 8.0 3.5 3.2

Broad money (M2) 8.3 6.2 5.6 5.3


General budget balance -8.5 -6.4 -4.4 -3.1

Revenue 32.1 34.4 34.6 35.1

Spending 40.6 40.8 39.0 38.2



Exports 40.3 51.8 61.7 64.6

Imports 49.8 60.0 69.7 73.6

Trade balance -9.5 -8.2 -8.0 -9.0

% of GDP -5.8 -5.0 -4.5 -5.2


% of GDP -4.2 -4.2 -3.6 -4.1

FDI (net) 4.9 3.1 2.3 2.9


RON/USD (eop) 2.95 3.20 3.31 3.07

RON/EUR (eop) 4.23 4.28 4.30 4.15



Domestic 18.4 22.7 21.8 22.0

External 11.6 15.2 17.2 17.1


in USD bn 112.5 123.7 133.5 139.6

General (% pavg)




period)

Current 3M 6M 12M

NBR policy rate (%) 6.00 5.75 5.25 5.25

RON/EUR 4.36 4.26 4.23 4.15

RON/USD 3.24 3.28 3.38 3.07

Source: NBR, DB Global Markets Research. The NBR classifies the IMF lending under

monetary authorities rather than government external debt.



Russia Baa1(stable)/BBB(stable)/BBB(positive) Moody’s/S&P/Fitch

Outlook: Growth accelerating on the back of high

consumption and fixed investment growth.

Main risks: Recurring capital outflows and a drop in

oil prices remain key risks.

Strategy recommendations: Short NOK/RUB, for a

move back down to 51 flat. OFZs likely to perform in

2012. Overweight sovereign credit.

Macro outlook

The outlook for 2012 is clouded by the volatility in global

financial markets, which impacts Russia through higher

capital outflows as well as elevated risks of a decline in oil

prices. To some degree the scale of capital outflows may

moderate in 2012 with a reduction in political uncertainty

and some of the positive developments in Russia’s

investment climate, most notably the accession to the

WTO. The latter is likely to be largely sealed by Russia at

the WTO Council on December 15, 2011, with the

approval of the accession package and full-fledged

accession taking place in mid-2012.

We believe that growth has scope to accelerate further in

2012 on the back of higher expansion in fixed investment.

At the same time there may be upside risks to inflation

due to the effects of rouble weakness in H2 2011 as well

as higher fiscal spending ahead of the presidential

elections. Given DB’s positive oil price outlook for 2012,

the current account is likely to continue to exhibit a strong

surplus, while in the fiscal sphere a moderate deficit may

emerge at the federal level. The escalation in fiscal

commitments (most notably in the defense sector) may

sustain the level of the non-oil budget deficit at high

levels, leaving the federal budget vulnerable to declines in

oil prices.

Growth outlook: investment likely to accelerate

The key economic indicators for October reveal the

persistence of high household consumption growth rates

and emphatic acceleration in fixed investment growth. In

October household consumption (as proxied by retail

sales) increased by 8.8% YoY, which is only moderately

lower than the 9.2% YoY reading registered in the

preceding month. The surge in household consumption

was mostly driven by higher outlays on non-food goods –

while in January-October 2011 food retail sales increased

by 2.5% YoY, the corresponding figure for non-food

goods amounted to 10.4%. The high rate of growth in

consumption took place despite the rise in unemployment

from 6% in September to 6.4% in October and real

disposable income rising by a moderate 0.4% YoY in

October. The volatility in the exchange rate sphere may

have still favoured spending on non-food goods as a way

to preserve rouble savings. The recent acceleration in

household consumption growth suggests that in 2011

growth could reach nearly 7%, which significantly

exceeds government projections.

Fixed investment growth reached 8.6% in October, which

is higher than the 8.5% and 6.5% seen in September and

August respectively. In January-October 2011 fixed

investment growth reached 5.3% and is on course to

reach or exceed the government’s 6% projection for

2011. One of the drivers behind the acceleration in fixed

investment growth is construction, which expanded by

8.2% YoY in October after posting a 4.8% YoY increase in

the preceding month. We continue to see construction as

one of the key potential drivers of higher fixed investment

in the remainder of this year as well as in 2012. Our view

is that fixed investment growth is likely to benefit in 2012

from a combination of lower capital outflows, further

recovery in construction as well as the implementation of

large-scale infrastructure projects associated with the

preparations for APEC summit in 2012 and Sochi Winter

Olympics in 2014. Starting from next year a notable

increase in infrastructure spending is also projected for

the 2018 Soccer World Cup.

Russia: fixed investment and household consumption

-20

-15

-10

-5

0

5

10

15

20

25

2003 2004 2005 2006 2007 2008 2009 2010 2011F 2012F 2013F

Consumption growth, %, real Investment growth, %, real

Source: Rosstat, Deutsche Bank

According to the Ministry of Economy, the government

could revise up its GDP growth estimate for 2011 from

4.1% to 4.2-4.5%. For 2012-2014, the ministry projects

the GDP growth would stabilize around 4% with inflation

gradually decelerating to 4–5%. Overall, the ministry’s

possible GDP growth outlook is in line with our projection

of 4.5% for 2011, given a significant acceleration in fixed

investment growth in recent months as well as the

resilience of high rates of growth in household

consumption. At the same time compared to the official

forecast of less than 4% GDP growth in 2012, we are

more optimistic in assessing the scope for growth in fixed



investment, while also expecting a relatively strong

increase in household consumption on the back of the

pre-electoral boost to social outlays.

Fiscal policy: medium-term concerns on the spending

front

According to the Ministry of Finance, Russia’s federal

budget posted a RUR269bn surplus in October, putting

YTD surplus at RUR1.4tr. The accelerating surplus was

mainly due to higher-than-YTD average revenues

(RUR1,028bn in October vs. monthly average of

RUR913bn in the first nine months of 2011), while

expenditures were slightly above average at RUR759bn.

For the first ten months of 2011, the federal surplus figure

stands at 3.2% of GDP, though this is likely to decline to

less than 1% of GDP by the end of the year due to a

seasonal surge in spending in December, which this year

is likely to be exacerbated by electoral pressures. The

Ministry of Finance estimates that Russia could post a

budget surplus of 0.2% of GDP in 2011, which is in line

with our projections for this year.

Russia: Federal budget parameters

Government forecast DB forecast

% of GDP 2011* 2012 2013 2011 2012 2013

State budget balance -1.3% -1.5% -1.6% 0.2% -0.4% 0.6%

Revenue 19.3% 20.1% 19.6% 21.9% 20.2% 20.0%

Expenditure 20.7% 21.6% 21.2% 21.7% 20.6% 19.4%

Urals oil price, USD/bbl 100 97 101 109 112 117

* - most recently the government forecasted a 0.5% federal budget surplus in 2011

Source: Minfin, Deutsche Bank

Despite the strong fiscal performance this year, there are

mounting concerns regarding to possibility of high fiscal

outlays in the medium-term due to the already high social

commitments assumed by the government ahead of the

2011-2012 elections, the rising outlays on defense as well

as the projected increases in spending on infrastructure.

In fact outlays as a share of GDP are projected to rise by

the Ministry of Finance from 20.8% of GDP in 2011 to

21.1% of GDP in 2012. The rise in spending commitments

will result in a further increase in the vulnerability of the

budget to a downturn in oil prices – current projections of

the Ministry of Finance assume an increase in the non-oil

budget deficit from 10.3% of GDP in 2011 to nearly 11%

of GDP in 2012.

Monetary policy: lower inflation prioritized

One of the main achievements in the macro sphere for

Russia in 2011 has been the attainment of the lowest

inflation rate since 1992, which by the end of the year

may reach around 7%. Greater focus on inflation the part

of the CBR, which was accompanied by greater exchange

rate flexibility, was a crucial factor in improving Russia’s

inflation track-record. Improved focus on inflation was also

complemented by the effects of capital outflows, which

served to lower the pace of growth in M2 money supply.

According to the CBR, Russia’s M2 money supply

declined by 0.5% after rising by 2% in September. Since

the beginning of the year the rise in M2 money supply

amounted to 6.8%, while the 12-month growth rate

decelerated to 20% by the end of October after reaching

31% at the end of last year. According to earlier

statements of the Head of the CBR Sergey Ignatiev the

deceleration in the money supply has been driven by the

sizeable budget surplus as well as the CBR’s tight

monetary policy. In the remainder of this year the growth

in the money supply will get a boost from the end of the

year budget spending increase, which may persist into Q1

2012 due to electoral factors. For 2012-2014 the CBR

expects growth in the money supply of 13-20%. Despite

the slowdown in the growth in the money supply,

inflationary pressures are building up in recent periods on

the back of the effects of rouble depreciation.

Russia: Main parameters of the monetary programme

In RUBbn unless

otherwise mentioned

Scenario 1

2011 2 012 2 013

Monetary base 7 099 7 713 8 672

Net international

reserves, USDbn 495 480 462

Net domestic assets (7 991) (6 922) (5 401)

Net credit to the broad

government (5 529) (5 202) (4 801)

Net credit to banks (90) 679 1 865

Scenario 2

2011 2 012 2 013

Monetary base 7 099 8 058 9 137

Net international




government (5 529) (5 698) (6 159)

Net credit to banks (90) 250 1 092

Scenario 3

2011 2 012 2 013

Monetary base 7 099 8 264 9 452

Net international




government

(5 529) (6 589) (7 864)

Net credit to banks (90) 116 565


We expect the rouble nominal rate next year to appreciate

versus the dollar towards Rb/USD28, given DB’s high oil

price forecast as well as the possibility of net capital

inflows in the second half of 2012 – in line with our and



government’s expectations. Provided the CBR continues

to target low inflation and allow greater exchange rate

flexibility we believe that inflation may stabilize around 7%

in 2012, though upside risks associated with high fiscal

spending may be significant. Still, given that in 2012 we

expect both inflation and growth rates to remain close to

2011 levels, we do not expect significant swings in policy

rates. During its November meeting the CBR ruled to

keep key policy rates on hold and noted in its statement

that the current level of interest rates is consistent with

balancing inflationary and growth slowdown risks.

BOP: breaking the streak of capital outflows

One of the key negative developments in 2011 was the

persistence of net capital outflows from Russia, which

largely deprived the economy of the benefits of a

favourable high oil price environment. The government

projects net private capital outflows of 80 bn dollars in

2011, which implies that capital outflows in November -

December are projected to reach 16 bn dollars. According

to government estimates the scale of outflows in

November was significantly lower than in September-

October, possibly reaching around 10 bn dollars. For 2012

the government projects net outflows of 20 bn dollars,

while in 2013-2014 the Ministry of Economy expects net

inflows, with the trend towards inflows likely to emerge in

H2 2012 according to the Ministry. We share the view

that inflows are likely to materialize next year and believe

that there is scope for net inflows in 2012 on the back of

improvements in the investment climate, though much

will continue to depend on global factors.

As regards the current account, the high oil price

environment (as projected by DB for 2012) as well as the

moderation in the growth in imports (partly coming on the

back of a weaker rouble) are likely to result in the

persistence of a relatively high surplus of more than 4% of

GDP. In the medium-term the expansion in imports may

be given additional impetus by WTO accession as well as

imports of capital goods to support the efforts of the

authorities to develop infrastructure.

Politics: Putin to come back as President

The main political event of 2012 will be the presidential

elections scheduled for March 2012, though the main

intrigue regarding the outcome of the elections has largely

been resolved after earlier this year current President

Dmitry Medvedev called for Prime Minister Putin to run

for presidency. In November, support for Putin declined

remained at 67% compared to 66% in October, and

Medvedev’s remained stable at 62%. The new popularity

rating of Putin is close to an all-time low of 60% since the

start of his presidency in 2000-2001. The sizeable decline

in the popularity ratings of the ruling party and the Putin-

Medvedev tandem may be in part a pent-up demand for

greater changes with respect to improvements in

governance and the reduction in red tape. Despite the

notable decline in the popularity ratings of Vladimir Putin,

we expect Putin to secure his third presidential term in the

first round of the presidential elections with more than

50% of the vote.

Russia: : Putin and Medvedev approval ratings

50

55

60

65

70

75

80

85

90

2007 2008 2009 2010 2011

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

Source: Levada Centre, Deutsche Bank

As regards the parliamentary elections scheduled for

December 4, the popularity of the ruling United Russia

party declined in November. The Levada-center poll

conducted at the end of November showed that support

for United Russia tumbled 7ppt to 53%, which is an all-

time low for the two past electoral cycles (in the fall of

2007, support for the party stood at nearly 70%). At the

same time, support for the communists increased from

17% to 20%, and for LDPR it grew from 11% to 12%,

with notable gains also observed for Yabloko and Justice

Russia. The eventual outcome of the elections is likely to

be a simple (rather than a constitutional) majority for the

ruling United Russia party, with the nationalistic LDPR

party possibly securing close to 15% of the vote, which

may enable the Kremlin to retain the possibility of

securing constitutional majority on key issues, since LDPR

tends to support the Kremlin in the Duma.

While the results of both parliamentary and presidential

elections are predictable and do not suggest a significant

departure from the current political framework, the decline

in the popularity ratings of Putin and the ruling United

Russia party may be of some concern with respect to the

commitment of the new government to pursuing reforms

in a post-electoral setting. In particular, further declines in

the popularity of the authorities may constrain the scope

for some of the more difficult reforms such as pension

reform or increases in regulated tariffs. There is also a risk

of greater proclivity towards higher fiscal spending in the

social sphere as a way to limit further declines in

popularity ratings.


Ilya Piterskiy, Moscow, (7) 495 933 92 30



Investment strategy

FX: Economic uncertainty, lack of transparency, fears of a

Euro recession and political uncertainty point to outflows

of around $80bn. Capital flight is likely to diminish going

into the March elections and also likely to moderate in

response to the WTO finally approving Russian

membership after 18 years of negotiations - FinMin's

latest estimate is for outflows to slow to $20bn in 2012.

RUB will continue to be highly sensitive to oil prices, but

the budget plan for next year is based on crude at $95 on

average (Urals), which does not seem unrealistic (DB

Commodities forecasts Brent to average $115/barrel in

‘12). On balance, the outlook for capital flows, WTO

membership, oil price assumptions, the fact that FX

remains a key tool for the CBR to counter price pressures

as well as the fact that the RUB basket is still trading well

above not just pre-2008 crisis levels, but also 7% above

the levels prior to the Aug/Sep sell-off, imply there is

scope for RUB outperformance. Short 'oil' pair NOK/RUB,

for a move down to the around 51 with s/l at 54.


Siddharth Kapoor, (44) 20 7547 4241

Rates: OFZs likely to perform in 2012. Despite a strong

fiscal performance, record low inflation and high oil prices,

Russia was not immune to the effects of global risk

aversion. Large capital outflows caused a liquidity

tightening, despite a record increase in Repo funding by

the CBR. Russian rates are already pricing a sufficiently

cautious global scenario and we prefer to take profit on

our 2s5s flattener (initiated at 75bp, current 35bp). The

prospect of Euroclearability for OFZs as early as June

2012 is likely to lead to inflows from foreign investors (we

estimate this at about USD 9bln), since the only RUB

sovereign Eurobond, issued this year, is trading close to

90bp tight to OFZ. Therefore, we expect bonds to have a

positive performance in 2012. An easing of 3M Mosprime

levels would be a signal to receive rates


Credit: Overweight. WTO accession and the passage of

elections make 2012 an important year for Russia. While

we are not very optimistic that the return of Putin to the

Kremlin will spur reform, we believe that the market

currently prices an excessive risk premium.


Russia: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National Income

Nominal GDP (USD bn) 1 480 1 757 2 027 2 282

Population (m) 141.9 141.8 141.7 141.6


Real GDP (YoY %) 4.0 4.5 4.6 4.9


Govt consumption 1.4 2.7 -0.7 -1.2

Investment 6.0 7.0 8.0 7.0

Exports 11.1 0.2 4.0 4.0

Imports 25.4 6.1 9.0 10.0


CPI (YoY %) 8.8 7.1 7.0 6.8

Broad money 28.5 20.0 20.0 20.0

Credit 13.0 21.0 17.0 18.0


State budget balance -3.9 0.2 -0.4 0.6

Revenue 18.2 21.9 20.2 20.0

Expenditure 22.1 21.7 20.6 19.4

Primary surplus -3.5 0.7 0.1 1.1

External Accounts

(USDbn)

Exports 400 505 519 541

Imports 249 310 360 421

Trade balance 151 195 159 120

% of GDP 10.2 11.1 7.8 5.2


% of GDP 4.8 5.9 4.1 1.9

FDI (net) -10.5 10.0 12.0 12.0

FX reserves (USD bn) 479 520 590 654

RUR/USD (eop) 30.5 28.2 28.0 28.4



Domestic 4.6 5.9 7.1 7.3

External 2.8 2.0 2.0 2.0


in USD bn 483 480 510 570

General (% pavg)

Industrial production (% YoY) 8.2 5.2 5.4 5.4



Policy rate (refinancing rate) 8.25 8.00 8.00 8.00

RUR/USD 30.7 28..2 28.1 28.0 Source: Official statistics, Deutsche Bank Global Markets Research



South Africa A3 (negative)/BBB+ (stable)/BBB+ (stable) Moodys/S&P/Fitch

Economic Outlook: The much weaker growth base

in Q2 and Q3 makes for encouraging rebound

potential in growth into 2012. We do not expect a

recession locally, as we estimate this probability

between 10-15%. Household demand is expected to

be the main growth driver in 2012.

Main Risks: Deteriorating global growth, negative

repercussions for terms of trade could severely harm

corporate profits. From these risks stem employment

losses, which will offset the benefit of lower

commodity prices on inflation.

Strategy Recommendations: Buy a 1y digital

EUR/ZAR put struck at 10 for roughly 25% of EUR

notional. ZAR curve set to steepen. Underweight

sovereign credit.

Macro View

Risks to global economic growth are tilted to the

downside, despite global efforts to limit deeper growth

contagion from the EU. Concerns have surfaced that the

domestic economy’s significantly weaker-than-expected

growth performance this year means that we could be a

lot closer to another recession. We believe these

concerns are misplaced. We do not foresee significant

risk of recession in the economy next year; indeed, we

estimate the likelihood to be between 10-15%. Our

reasons are outlined below. This analysis is supplemented

with base and bear case scenarios for those key business

cycle indicators that are considered to be timely signals of

recession risks. In short, substantial slippages need to

occur in global growth, commodity prices, and, by

extension, corporate profits, to raise the probability of

recession to higher levels of conviction.

A weaker global economy...: Our European colleagues

have cut near-term growth expectations to -0.5% from

0.4% for 2012, as downside risks to the sovereign debt

crisis are developing into the baseline view. Though we

acknowledge the risks, DB still remains of the view that a

euro break-up is not on the cards. The US is expected to

grow even if the euro area contracts. Asian growth should

remain generally resilient, though with some momentum

loss in the near term. We maintain a fairly robust outlook

for EM growth, but remain cautious of increasing

downside risks. Within this context we remain cautiously

optimistic on South Africa, expecting growth of 3.2% next

year from 3.1% in 2011 (revised from 3.3%).

Domestic growth artificially depressed in Q2 and Q3:

Economic growth improved in Q3 to 1.4% qoq saar but at

a more sluggish pace than we had expected (DBe 2.5%).

This mediocre growth performance is an extension of the

soft patch that had started in Q2 (1.3% from 4.6% in Q1)

and from unsustainable growth momentum in the

manufacturing sector late 2010. While there has been a

series of one-off events (eg. strikes and production

stoppages) that weighed more heavily on the mining,

manufacturing and agriculture sectors, the weakness was

not entirely due to local factors.

However, we expect positive growth momentum going

forward, and expect household demand to become the

dominant growth driver next year. That said, risks to this

view are likely to increase if global growth falls below 3%

next year. At global growth below 3%, the risks of weaker

commodity prices, which trigger potentially deeper

destocking in China, will have negative ramifications for

the economy. As it stands, our export exposure to Europe

leaves us vulnerable to a more meaningful slowdown next

year. This has raised several questions over the likelihood

of the economy falling into recession next year.

Before examining recession probabilities, below we briefly

discuss our main arguments against recession risks:

Financial conditions are less stringent for consumers

than during the crisis period: We explore the main

financial vulnerability metrics in the Figure below. The

heat map depicts the highest vulnerability in shades of

red, with yellow and greener shades showing neutral to

low levels of vulnerability. On average, the household

vulnerability index43 in 2Q11 was close to 2006 levels, the

midst of the previous boom period, but with the key

difference that employment, financial markets’

performance, house price growth and real disposable

income were much stronger in 2006 (one- to two standard

deviations above the long-term mean). Whereas

employment growth generally lags the economic cycle,

there has been very modest improvement in 2011, which

we believe could be sustained next year. The overall

financial position of households is also in a far healthier

state than in 2008, when most indicators were more than

two standard deviations away from the long-term mean

(negative). Therefore, the envisaged slowdown in

household demand to 3.3% next year, from DBe of 4.2%

in 2011, is mostly a result of high base effects,

consolidating net wealth, and rising inflation. We do not

believe that any of these key consumer metrics could

deteriorate significantly, without a new negative catalyst.

43 Scores are assigned based on the indicator’s deviation from its long-

term mean, with the highest score of 25 indicating extreme vulnerability,

and zero, low vulnerability. These scores are normalised to a total out of

100.



South Africa: Household vulnerability heat map

Ave. Max Min LatestScore

2006

Score

2008

Score

20102Q11

Outlook

*

Debt-serivce-income

ratio (%)9.4 12.7 6.9 6.9 10 21 9 5 Stable

GDP growth

(qoq saar %) 3.1 6.7 -5.9 1.3 9 15 13 15 Positive

Employment

(non-farm - yoy %)2.9 13.9 -4.1 2.0 4 15 16 10 Stable

Financial assets

(yoy %)12.5 28.7 -12.9 15.5 5 18 10 10 Stable

House price (yoy %) 7.2 16.1 -3.5 1.9 5 15 14 15 Stable

Inflation (yoy %) 6.2 13.2 3.5 4.6 10 21 8 10 Negative

Insolvencies (yoy %) 22 137 -43 -36 10 21 6 5 Stable

Net wealth-to-debt ratio

(%)366 414 319 357 10 14 14 15 Stable

Household debt

(yoy %)13.7 27.3 2.0 6.7 20 13 8 10 Stable

Disposable income

(yoy %)3.6 8.3 -4.9 3.8 6 18 10 10 Stable

Savings-income ratio

(%)-0.6 -0.1 -1.3 -0.2 16 19 9 5 Stable

Average score (total

out of 100)38 69 42 40

Historical 2006-2011 Average

*The outlook is based on the expected movement in the score relative to the current quarter.

Source: Deutsche Bank, SARB, StatsSA, I-Net Bridge

Replacement needs exist for previously overextended

indebted households: We proxy pent-up demand as the

trough-to peak increase in the ratio of durable goods to

total HCE in the first two years after a recession. On this

basis, we saw the strongest increase in the durable goods

ratio to HCE on record between 2Q09 and 2Q11. Most of

this demand probably originated from higher income

earners supported by rising net wealth. In light of signs of

improving bad debt records, which we believe is mainly a

middle-to low income constraint; there is scope for more

replacement demand in our view. In addition, any upside

from modestly higher loan growth in the property market

should count as a bonus.

Several cyclical components of GDP are still

suppressed: The typical downward adjustments in

economic activity arise in the cyclical components of GDP

– eg investment in residential property, transport- and

machinery equipment and durable and semi-durable

goods, and business inventories. Of these indicators, only

spending on durable and semi-durable goods and

investment in transport has really recovered over the past

few years. Residential and machinery and equipment are

still at rock bottom levels44, which mean there is very little

downside pressure to growth that could arise from these

indicators

Strong corporate balance sheets: Robust corporate

profit growth in 2011, reaching 13.6% yoy in Q3 should

bring gross corporate savings to the best levels in thirty

years. Corporate profits usually slow sharply ahead of a

recession, which is typically the reason for a dramatic

downsizing of the workforce. But corporates are much

leaner in this cycle. Profit per private sector worker is

44 See EM Monthly: South Africa, 8 December 2010.

currently nearly one-and-a-half times the size at the start

of 2008. Barring much weaker global growth,

retrenchments should be light in comparison with the

2008 cycle, as corporates have not employed excessively

since then.

Monetary policy has room to manoeuvre: In the event

that recession risks do rise, the Bank has the option to cut

interest rates. Even in the absence of further monetary

policy relaxation, real rates are likely to decline further next

year to between -1 and -2%, which remains a tailwind for

consumer demand.

Export growth is more geared to EMs than before: A

point often missed in the context of export vulnerability is

that despite the importance of DMs in the export basket

(c. 55% of total rand exports), these economies only

account for 30-40% of export growth, versus 80-90%

eight years ago. Though quite cyclical at times, China’s

portion of the EM growth share has reached more than

50%. We remain constructive on the Chinese economy,

despite the modest momentum loss over the next few

quarters.

South Africa: EM a strong force behind export growth

-45

-30

-15

0

15

30

45

2003 2004 2005 2006 2007 2008 2009 2010 2011

Emerging markets ex China

China

Advanced economies ex Europe

Europe

% contribution to exports yoy

Source: Deutsche Bank, IMF

Downside risks remain: From these arguments, we view

downside risks to corporate profits, and commodity prices

(terms of trade) – which could scupper our growth call for

next year should these really disappoint. We believe that

terms of trade gains this past year-and-a half has been an

important cyclical driver of corporate profits, and do see

scope for moderation. However, as indicated below,

these indicators will have to fall dramatically in order to

materially weaken the growth dynamic. Should the global

economic recovery take a turn for the worse, in which

case corporates will battle to push rising costs through

the system, corporate profit margins will come under

pressure. The negative knock-on impact this will have on

employment should offset the benefit of lower

commodity prices on inflation, in our opinion.



Turning to our recession probability gauge, we

estimate a very low probability of recession next year

of between 10-15%. These estimates (from models 2 and

3 in the Figure below) are based on the base view of

slowing, but not contracting growth, barring the G7

leading indicator. Using the benchmark leading indicator

of the SARB (model 1) we estimate a 45% probability of

recession in early 2012, if we assume the index level

remains stable next year. In defence, we have to say that

the SARB leading indicator has given three false signals of

recession risks over the last three decades, and hence

prefer models 1 and 2, which also have stronger

forecasting capabilities (second figure below). For the

leading indicator, we find firm levels of conviction at 70%

and above, which is worth monitoring closely.

South Africa: Recession probability model* inputs and

assumptions

2011

YTD Base Prob. Bear Prob.

1. SARB leading indicator (yoy %) 2.9 0 45% -5.5 85%

2. Model incorporating DM growth 15% 99%

Real money supply growth 1.8 0 -2

Insolvencies (number) 731 450 1050

Yield curve (10yr-jibar) 2.9 2.8 4.7

G7 leading indicator (yoy %) 2.9 -1 -4

3. Model incorporating corporate

profits/commodities 10% 95%

Real money supply growth 1.8 0 -2

Yield curve (10yr-jibar) 2.9 2.8 4.7

Real corporate profit growth (yoy %) 7.6 3.7 -1.1

Terms of trade (yoy %) 5.7 1.2 -4.5

2012 forecast assumptions

*Based on a binary response model using maximum likelihood techniques.

Source: Deutsche Bank, SARB, I-Net Bridge

South Africa: Estimated probabilities of recession

0%

50%

100%

1984 1989 1994 1999 2004 2009

Probability range from recession models

Downswing

Recession probability: leading indicator

Est.

Bear

Base


The bear case scenario, which we attach a low probability

to, is consistent with events linked to systemic contagion

in banking and financial markets, and a deeper downturn

in advanced economies. The bear case scenario provides

guidance of trends that have historically been associated

with economic downturns. We tweaked the yield curve to

incorporate a bearish scenario of stagflation, in which

case we think the SARB could react to by cutting interest

rates by 100 basis points, thus initiating a much steeper

yield curve than what would normally be the case for

economic downturns.

Implications for the C/A deficit: a function of savings:

All in, we expect a modest widening in the current

account deficit to 3.7% in 2012, from 3.1% this year. Only

part of this widening is attributed to a deteriorating trade

balance. This is in contrast to the string of surpluses this

year that had been supported by a widening in the savings

investment gap, stemming from healthy operating

surpluses and terms of trade gains. However the very

modest improvement in private investment spending of

late, coupled with a larger fiscal deficit has begun to

counter prospects of a sustained low C/A deficit.

... and private sector investment: While insufficient

demand and underlying political concerns, according to

the Bureau for Economic Research 4Q Manufacturing

survey, are amongst the main reasons for reduced

investment intentions, this sentiment is not evenly shared

amongst industries. An important feature from the survey

is that most manufactures, however, are not looking to

invest in additional capacity, replacement investment or

inventories over the next twelve months, which seem to

suggest that imports may not necessarily be buoyed.

Indeed, only retail-orientated industries seem somewhat

positive in for the next year, but their contribution to total

investment is less than 15% and they are smaller than the

larger capital-based industries. We therefore maintain our

view of fixed investment spending growth of c. 3% next

year.

Plus government dissaving: Our expectations of a fiscal

deficit of 5.4% of GDP (vs NT est. Of 5.2%) next year,

implies that corporate and households will have to save

more for the C/A to remain under control. We think this is

unlikely. On the public side, downside risks to the

Treasury’s existing growth forecasts of 3.4% in 2012

should mean that fiscal consolidation could be

challenging. These factors could be less constructive for

the bond and rand market.

With a weaker rand as the upshot: Our revised rand call

of 8.2, 8.4 and 7.9/USD in 3m, 6m and 12m time

incorporates our view of a weaker terms of trade dynamic

as discussed in this note. Though the rand will be

susceptible to risk events in either direction, our house

view of a stronger dollar in 1H12, coupled with the

potential underperformance in EM equities, implies that

the rand should be range-bound between 7.80 and 8.60

over this period. In times of risk on trades, the rand could

test 7.50/USD, in our view. Though balance of payments

risks should be largely contained, South Africa’s net

redemptions of R9.7bn worth of foreign bonds in 2012

could make the rand vulnerable during risk-off periods.

Monetary policy held hostage: Finally, our long-held

view of an inflation episode in 2012, which appears to



have become a consensus view, should mean lower rates

for longer and a slower adjustment when the need arises.

We expect the onset of a 150bps cycle starting in

November next year, in three 50bps increments.

Danelee Masia, South Africa, (27) 11 775 7267

Investment Strategy

FX: Has sold off 21% vs USD and 22% vs EUR YTD, and

is the worst performing currency in EM. It is worth

remembering that in 2009/10, ZAR was among the top

performing EMFX, and again was preceded in 2008 by

being one of the worst performing. Rand remains very

much the default risk-on/off choice, regardless of solid

fundamentals such as very limited gross external financing

requirements (less than 10% of GDP) and a relatively

attractive long-term valuation. This would suggest that the

fate of the rand will be determined by European rather

than domestic factors. Our preference remains to express

constructive ZAR views through RV, where the macro risk

component is reduced. More favourable geographic

location (vs Hungary) warrants a ZAR/HUF rate closer to

the upper 1SD band away from the mean over the past 10

years, suggesting scope for a 10% move towards 31.

Alternatively, buy a 1y digital EUR/ZAR put struck at 10 for

roughly 25% of EUR notional - giving a risk/reward of 4:1.



Rates: Curve set to steepen The SARB is unlikely to ease

monetary policy in the first half of the year despite the

ongoing slowdown in the global economy. At the same

time, the reliance on continuous non-resident interest to

absorb the heavy pace of issuance means that the back-

end performance has become linked to the unpredictable

developments in Europe. Our analysis suggests that the

curve is too flat to fair value. At times of risk-aversion, the

local bid for bonds became apparent only at levels

corresponding to 5Y5Y higher than 9%, while the same

point is unlikely to move lower than 8.40% without a

resumption of expectations for monetary easing.


Credit: Underweight. The combination of increased

gross issuance ahead, coupled with the fact that

dedicated investors are already relatively overweight the

credit persuades us to be cautious. Furthermore, as our

vulnerability indicators highlight, SA is not entirely immune

to the risks which characterise much of EMEA. In addition

to moving back to underweight from neutral, we also

close our recommendation to sell 5Y CDS protection, vs.

Brazil.

Marc Balston, London,( 44) 20 7547 1484

South Africa: Deutsche Bank Forecasts

2010 2011FF

2012F 2013F National Income

Nominal GDP (USD bn) 364.6 411 404 444

Population (mn) 50.0 50.5 51.0 51.5


Real GDP (YoY%) 2.8 3.1 3.2 3.8




Exports 4.7 1.7 -2.4 8.5

Imports 9.6 5.3 0.9 6.9


CPI (YoY%, eop) 3.5 6.4 6 6.4

Fiscal Accounts (% of GDP) (fiscal years)

Budget surplus -6.6 -5.5 -5.4 -5

Expenditures 33.8 32.6 32.1 31.4

Revenues 27.2 27.1 26.7 26.4

Primary surplus -4.3 -2.9 -2.7 -1.9


Exports 85.4 101.1 92.4 104.3

Imports 81.6 98.8 94.3 105.0

Trade balance 3.8 2.3 -1.9 -0.7

% of GDP 1.1 0.6 -0.5 -0.2


% of GDP -2.8 -3.1 -3.7 -3.7

FDI(% of GDP) 0.3 1.5 0.5 1.5

FX reserves (USD bn) 43.8 50.5 55 58

USD/ZAR (eop) 6.6 8.0 7.9 8.3

EUR/ZAR (eop) 8.8 10.3 10.7 10.4

Debt Indicators (% of GDP) (fiscal years)


Domestic debt 33.5 36.9 38.5 39.5

External debt 3.6 3.4 3.3 3


In USDbn 83 85.5 88.7 97.6


Policy rate 5.5 5.5 5.5 6

3-month rate (Jibar) 5.6 5.6 5.6 6.1

10-year rate 7.8 8.5 8.2 8.5

EUR/ZAR 10.8 10.4 10.5 10.7

USD/ZAR 8.1 8.2 8.4 7.9 Source: DB Global Markets Research, National Sources



Turkey Ba2 (positive)/BB (positive)/BB+ (stable) Moody’s / S&P / Fitch

Economic Outlook: Rebalancing in the economy

continues with domestic demand slowing down

gradually and imports losing momentum. Inflation will

continue to rise in the short term due to FX pass-

through and higher food prices.

Main Risks: A harder landing is on the cards given

the large exposure to short-term funding from

international banks, balance sheet effects of a weaker

currency and volatility in capital inflows.

Strategy Recommendations: Having hit the target

on long TRY/HUF, we recommend playing the range

in USD/TRY. Buy a DnT with strikes at 1.70 and 1.90.

Add exposure to Jan-20 bonds if the economy

responds to the ongoing tightening. Overweight


Macro View

Revising our growth outlook given that risks are much closer to becoming a reality

Since last month, conditions in Europe seem have

worsened and that has been reflected by the significant

downward revision of growth forecasts for the region for

next year. This will impact Turkey mainly through three

channels. First, exports to the region are likely to remain

weak, a hindrance to the already weak recovery in external

demand. The share of exports to the EU have declined

significantly over the past four years and continued

weakness in the area will be a drag on export recovery

unless exports to other markets gain strength (see chart

below). The expected sharp de-levering in EU banks will

have implications for local banks despite the relatively

limited organic ties between the local and European

banking sectors. Local banks’ exposure to short-term

financing from international banks had increased

significantly over the past two years reaching a total of

$57bn in September (including FX credits received and

deposits of international banks at local banks – showing

no signs of weakness yet). Arguably the size of this

exposure at 16% of the outstanding credit stock may be

not be extremely large, but nevertheless short term funds

received from international banks have played a greater

role in financing local credit expansion over the past two

years. While the rise in such exposure has increased

rapidly, deposit growth has remained relatively flat as the

loan to deposit ratio increased to about 100% from just

below 80% two years ago. Some large banks have rolled

over sizable syndication borrowings in November at

reasonable spreads (100bps) and yet conditions (price and

availability) are likely to deteriorate in the months ahead.

We also note that prolonged risk off sentiment is likely to

affect other sources of capital inflows. The vulnerability of

the capital account surfaced in August, as the balance

was close to zero with the current account deficit (CAD)

being financed entirely by decline in reserve assets. The

September figures showed a recovery with sizable

inflows from the usual suspects, the errors and omissions

component, short term borrowing and drawdown of FX

assets held abroad by local banks. Given that the CAD will

decline but remain elevated, its financing will continue to

be a source of vulnerability in the year ahead.

Finally, weakening expectations is likely to have some

negative impact on the economy. Confidence surveys are

showing some weakness although with some mixed

results as the PMI has climbed back to over the 50-mark

in September-October. And yet CBT and TUIK surveys are

showing a decline in export orders, consumer confidence

has taken a downturn over the past three months and

future demand for durable goods has declined sharply

following the strength seen during most of 2010-2011.

Turkey: Export growth and share of exports to EU

-50%

-30%

-10%

10%

30%

50%

70%

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

40%

42%

44%

46%

48%

50%

52%

54%

56%

58%

60%

Exports YoY (lhs)

Exports to EU as % of

to tal (rhs)

Source: Turkey Data Monitor and DB Global Markets Research

Turkey: Banking loans, deposits and ST external

financing

-60

-40

-20

0

20

40

60

80

100

120

Jan-05 Feb-06 Mar-07 Apr-08 May-09 Jun-10 Jul-11

ST External Financing (YoY)

Loans (YoY)

Deposits (YoY)




Looking at recent developments in the balance of FX

deposits of retail at domestic banks, we can argue that

confidence in TRY is also not so strong. Typically retail has

sold FX at times of pressure on the exchange rate working

as a stabilizer (particularly since 2007). Indeed during the

weakening of the currency in 1H2011 (partly driven by the

CBT’s policy mix), locals sold over $10bn and yet they

have hesitated to sell in the recent weakening episode (in

fact have re-built their FX deposits at times of occasional

limited appreciation).

Recent developments have led us to revise our growth

outlook. For the current year the pace of deceleration in

economic activity has been slower than our expectations.

Industrial production (IP) had more momentum than our

projections expanding by 7.5% YoY in 3Q following the

7.9% YoY 2Q number. Growth in imports of capital goods

declined in 3Q parallel to our expectations and yet

remained robust (30% YoY) indicating continued strength

in private sector investments. On the other hand, the

slowdown in consumption appears to in line with our view

based on the developments in leading indicators. We have

revised our current year GDP growth to 7% from 6%

previously.

For next year, we had emphasized the probability of a

harder landing compared to our original GDP growth

projection of 3.2% for some time. With risks now much

closer to becoming a reality and given the downward

revision to EU growth, we have reduced our 2012 GDP

growth projection to 2.3%. We expect that domestic

demand will slowdown significantly next year as

rebalancing in the economy will continue. We project the

contribution of domestic and external demand to growth

to be 3.1pp (9.5pp in 2011) and -0.8pp (-2.6pp in 2011),

respectively.

Credible policies are crucial for protection against risks, and while fiscal policy continues to provide an anchor…

In our opinion ultimately the severity of financial contagion

from the eurozone and the credibility of domestic policies

in maintaining investor confidence will be the key

determinants of the pace of growth deceleration going

forward. Fiscal policy remains to be Turkey’s strongest

anchor in this respect. The primary surplus and overall

budget deficit is projected to be close to 2% of GDP and

below 1% of GDP, respectively in 2011. The government

has done relatively well in constraining growth in non-

interest expenditure to about 10% YoY through October

while revenues have increased by a strong 18% YoY in

part due to collection of receivables (mainly tax arrears).

The government may revise the projections of its medium

term economic plan (MTP) released in October depending

on global developments as hinted by some authorities.

We reckon that the 4% GDP growth projection may be

reduced while noting that Deputy PM Babacan has

reiterated that fiscal policy will not be used to mitigate

downside risks to growth and that the budget targets will

remain as is. The pace of convergence in the current

account deficit (CAD) to more reasonable levels is also a

key factor in bolstering investor confidence. Following a

sharp recovery in September, momentum in import

growth declined in October as the YoY expansion was

halved to 15% compared to the average 31% in the

previous three-month period. The YoY expansion in capital

Turkey: Monthly balance of payments

-12000

-7000

-2000

3000

8000

13000

Jul-10 Nov-10 Mar-11 Jul-11

Current Account Balance

Capital Account Balance

$mn


Turkey: GDP and IP

-25

-20

-15

-10

-5

0

5

10

15

20

Mar-05 Jun-06 Sep-07 Dec-08 Mar-10 Jun-11

GDP YoY IP YoY

Source: CBT, Reuters and DB Global Markets Research

Turkey: Interest rate corridor and benchmark bond

0

2

4

6

8

10

12

14

May-10 Sep-10 Jan-11 May-11 Sep-11

ON Borrowing ON Lending

1-Week Repo Benchmark Bond

ON M arket

Source: CBT, Reuters and DB Global Markets Research



goods and consumer goods fell slightly into the negative

territory (in part due to base effects), which is an early

indication of weakening private sector investment and

growth in 4Q as well as a more rapid pace of adjustment

in CAD in the next several months.

…monetary policy needs to be brought back to basics

Large capital inflows driven by monetary expansion in

developed economies, appreciation of the TRY (loss of

competitiveness), rapidly growing CAD and bank credit,

and to some extent tame inflation were the reasons

behind the CBT’s decision to lower its one-week repo

rate, widen the interest rate corridor (mainly by lowering

the overnight borrowing rate) and increase reserve

requirements back in December. The result was a

significant weakening of the TRY and gradual weakening

in loan growth with some help from measures by the

banking sector authority. The conditions have reversed

since October and monetary policy has responded but not

by a complete reversal of the policy tools used back in

December as the CBT logic would call for, but through the

initiation of yet another unorthodox dimension of an

already unorthodox monetary policy mix. Overnight

lending rate has been increased and reserve requirements

have been decreased while the one-week repo rate held

constant. Since then the CBT manages the volume of one

week repo funding to ensure that market overnight rates

are sufficiently high (closer to the 12.5% upper band of

the corridor) to stabilize the exchange rate. In the mean

time a number of changes on reserve requirement rules

(decline in TRY reserve requirements, allowing the banks

to hold a greater share of TRY requirements in FX and

gold) have increased liquidity and allowed the CBT to

decrease its total funding of the banks (see chart above).

The CBT has traded exchange rate stability for interest

rate volatility as the latter has fluctuated significantly

depending on the strength, or lack thereof, pressure on

the TRY (see chart above). We believe that adding more

durability to the policy stance by raising the repo rate

would go a long way in bolstering confidence in monetary

policy. Importantly, since loan rates have already

increased significantly due to higher and more volatile

cost of funds, adjusting the repo rate is unlikely to tighten

policy further but the return to basics and a more

transparent policy framework will enhance credibility and

provide better protection towards continued volatility in

markets.

In recent communication the CBT argued that the net

effect of accomodative repo rates, contractionary liquidty

and prudential measures, and neutral fiscal policy is

disinflationary. The CBT believes that they have already

done the necessary tightening to bring inflation down to

5% next year following the temporary rise. Governor

Basci recently argued that tighter liquidity conditions and

stability in the exchange rate (indicating that the 25%

depreciation will have caused close 4pp pass-through)

should facilitate the convergence in headline inflation to

the target also given that the CBT does not expect

consumption tax increases next year of the kind seen in

2011 (on tobacco and other selected items). While

inflation will continue to increase in the balance of the

year due to the expectation of a spike in unprocessed

food prices in November and lagged FX pass-through, the

CBT argues that CPI will start its decent in January next

year. We note that, and as acknowledged by the CBT, the

CBT’s year-end inflation is likely to be significantly higher

than the forecast presented in the October inflation report.

In our opinion continued monetary experimentation may

lead to greater risks in an environment of rising inflation,

persistent troubles in the EU and volatility in capital

inflows.

Cem Akyurek, Turkey, (90) 212 317 0138

Turkey: CBT funding mix of banks

-

10

20

30

40

50

60

70

80

Oct-11 Oct-11 Oct-11 Nov-11 Nov-11 Nov-11

O/N

1-w eek repos

Source: CBT and DB Global Markets Research

Turkey: Reserve Requirements and CBT funding of

banks

-90000

-70000

-50000

-30000

-10000

10000

30000

50000

70000

Nov-10 Mar-11 Jul-11 Nov-11

Required

Reserves

CBT Funding of

Banks

Increase in

CBT funding

TRY bn




Investment Strategy

FX: The lira is one of the worst performing currencies this

year, having lost 19% vs the USD and 21% vs EUR.

Despite the u-turn from the CBT on Oct 26th and their

subsequent attempt to beef up TRY the lira remains very

weak. We expect the lira to be broadly range-bound with

the upside limited at around 1.90 by CBT

intervention/policy and expectations (at least as expressed

by the CBT in the latest minutes) that the CA adjustment

will become more visible in the coming months due to

domestic demand weakening and loan growth

deceleration. At the same time the downside in USD/TRY

should be confined to around 1.75. Part of this stems

from the fact that downside risks to growth have

increased but also that any narrowing of the C/A deficit is

likely to be gradual and from high levels. Our long

TRY/HUF (14 Oct) trade has worked well (target hit Nov

14), returning 9%. At current levels we recommend

trading the ranges in USD/TRY. Otherwise, buy a DnT with

strikes at 1.70 and 1.90 costing roughly 30% of USD

notional - giving a risk reward of roughly 3:1.



Rates: Add exposure to Jan-20 bonds if the economy

responds to the ongoing tightening. We estimate that

Turkey is real money manager’s largest underweight. This

is explained by the complex policy mix being pursued by

the CBT and the current rise in inflationary pressures. On

the other hand, a slowdown in the global economy could

help Turkey’s rebalancing and some leading indicators of

inflation have already slowed down. We expect that by

the end of Q1, some investors may be ready to increase

exposure to Turkey, particularly if longer dated bonds

continue to trade close to 10% and if oil levels do not rise

further than current levels.


Credit: Overweight. While we remain concerned about

the direction of monetary policy and the risks of a hard

landing for the economy, it is undeniable that from a

sovereign credit perspective Turkey looks fairly positive.

Given the healthy primary surplus, moderate debt stock

and low real rates, the credit spreads on bonds of well

above 300bp seems incongruous. Certainly some

premium is warranted given the aforementioned risks, but

Turkey’s debt dynamics are considerably less vulnerable

than in the past. Relative to the EM sovereign market as a

whole Turkey credit is cheap on a historical basis. We

maintain an overweight recommendation.


Turkey: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income


Population (mn) 72 73.7 74.0 74.3


Real GDP (YoY%) -4.7 8.9 7.0 2.3




Exports -5.4 3.7 7.2 11.1

Imports -14.4 20.7 14.9 11.5


CPI (YoY%) 6.5 6.4 9.2 6.4

Broad money (M2Y) (YoY%) 11.8 21.9 18.5 13.0

Bank credit (YoY%) 10.8 39.0 25.0 10.0



Interest Payments 4.4 4.4 4.0 4.0

Primary balance -1.1 0.8 2.5 2.5




Trade balance -24.8 -56.4 -85.0 -91.1

% of GDP -4.0 -7.7 -11.2 -11.9


% of GDP -2.3 -6.6 -9.4 -8.4

FDI (net) 6.1 7.2 9.5 13.0


FX rate (eop) USD/TRY 1.52 1.54 1.85 1.85



Domestic 32.9 30.1 27.9 27.0

External 12.1 12.1 12.1 12.0


In USD bn 271.1 265.0 309.6 300.0


General (YoY%)



Financial Markets (end)

period)

Current 3M 6M 12M

Policy rate 5.75 5.75 5.75 7.00

Benchmark bond rate (comp.) 10.95 10.75 10.50 11.50

USD/TRY 1.8500 1.8500 1.850 1.850

Source: DB Global Markets Research, National Sources



Ukraine B2(stable)/B+(stable)/B(stable) Moody’s/S&P/Fitch

Economic Outlook: Growth has been robust but is

set to soften on the back of rising macroeconomic

risks. Inflation pressure should also ease.

Main Risks: Hryvnia weakness on the back of the

deteriorating balance of payments remains a risk

Strategy Outlook: The negative skew of risks

warrant a bearish position in NDFs. Underweight


Macro outlook

In the macroeconomic sphere the key vulnerability relates

to the widening current account deficit, which in January-

October 2011 reached USD 7 bn compared to USD 1.4 bn

in the same period of 2010. According to the NBU one of

the reasons for this apart from high fuel import costs is a

USD 6 bn YoY increase in imports of capital equipment

and machinery, partly due to the development of

infrastructure associated with Euro-2012. The rising capital

outflows amid a growing current account deficit led to a

USD 0.8 bn decline in the forex reserves to USD 34.2 bn

by the end of October as well as pressure on the Hryvnia.

According to the head of the NBU Sergey Arbuzov greater

exchange rate volatility could emerge in 2012 in case BoP

conditions were to deteriorate further. At the same time

Arbuzov noted that until the end of 2011 the Hryvnia

exchange rate would remain stable. At this stage we

retain our projection of a stable Hryvnia exchange rate for

2012, though we do note the intensification of downside

risks, which will be partly also a function of the volatility in

global financial markets and competitive pressures

coming from the dynamics in the rouble.

Despite the rising external accounts risks, Ukraine’s GDP

growth accelerated towards the end of the year boosted

by higher household spending, agricultural production and

fixed investment growth. According to preliminary figures

GDP growth accelerated to 6.6% YoY in Q3 2011

compared to 3.8% YoY in Q2 2011, and 5.5% YoY in the

first 10 months of 2011. The government is projecting

Ukraine’s GDP growth to reach 4.7% in 2011. For 2012

the government has downgraded its projection from 5.5%

to 4%. We have also downgraded our projection to 3.9%

for 2012 on the back of rising macroeconomic risks.

The key gateway to addressing the issue of

macroeconomic stability for Ukraine is the resuscitation of

the IMF stand-by programme, which is currently seen as

one of the key anchors for the country’s economy. One of

the key preconditions for this is the increase in regulated

tariffs on gas for households. The October IMF mission to

Kiev failed to reach an agreement, though consultations

continue. Most recently IMF officials signalled that the

main outstanding conditionality item related more to the

fiscal position of Ukraine and the budget for 2012 rather

than increases in gas tariffs per se. The line taken by

Ukraine’s government representatives is that the

necessity for increases in gas tariffs will be eliminated in

case Ukraine secures a gas tariff discount from Russia,

which would in itself be a significant factor in improving

the financial position of Naftogaz. While it is not clear

whether this creates scope for some concession to

Ukraine on the issue of gas tariff increases, we do see the

possibility of the IMF programme coming back on track in

the first half of 2012, especially if a deal with Russia on

lower gas prices is secured.

In this respect in November Ukraine's media reported that

Russia and Ukraine have agreed to reduce the gas price

by nearly half to USD220-230/mcm from USD355/mcm in

3Q11 and an estimated USD400/mcm in 4Q11 saving

USD500m per month for Ukraine according to PM Nikolai

Azarov. However, according to Russia’s PM

representative, the discussions were still ongoing. A

compromise on the price discount could be attained in

exchange for preferences to Russian investments into

Ukraine as well as the possibility that Ukraine would also

provide access to its gas transportation system. Most

recently Gazprom’s CEO Alexey Miller declared that the

talks could be completed in 2011.

On the political front there are signs of renewed instability

building up around the arrest of ex-PM and a prominent

member of the opposition Yulia Tymoshenko after the

parliament declined to decriminalize her abuse of power

offence. This put further pressure on Ukraine’s

relationships with the EU, with risks that an FTA

agreement between may not be concluded in December.

The tension with the West and the increasing domestic

opposition may further point the current administration

towards assistance from Russia. In this respect a possible

discount in the gas price for Ukraine would serve to

reduce the deficit of Naftogaz without hiking the gas

prices for the population. The latter would be an

unpopular measure ahead of the fall 2012 parliamentary

elections, while the reduction of Naftogaz deficit is

essential for putting the IMF stand-by program back on

track. Overall, political risks are likely to intensify next year

as Ukraine approaches the 2012 parliamentary elections,

which may entail economic costs in the form of elevated

pressure for higher fiscal spending.


Ilya Piterskiy, Moscow, (7) 495 933 92 30



Investment strategy

FX: The three most important drivers of UAH NDFs are

gas price negotiations with Russia, risk appetite and

domestic developments. The risks to these three drivers

remain negative and warrant a bearish position. Press

reports and comments from Azarov on TV have alluded to

gas price reductions up to 40% (to $225/mcm from

$355/mcm in 3Q '11 - saving $500m/y). This would be a

positive, but risks are skewed towards disappointment if

there is no reduction in gas prices or the reduction is not

as high as expected. An announcement is expected by the

end of 2011, and a delay ahead of elections in 2012 it

adds to the negative skew of the risks. The strong

correlation between Russian equities, Oil, VIX and UAH

NDFs suggests that any devaluation pressure is likely to

stem from risk sentiment. Developments on the domestic

political front have worsened with Tymoshenko's arrest

increasingly looking like a political decision - souring

relations with the EU. Economic developments have

surprised to the downside: a worsening current account,

declining reserves and GDP forecasts to 4% (5%

previously) by Ukraine's government do not bode well.


Siddharth Kapoor, (44) 20 7547 4241

Credit strategy: Underweight Financing conditions

continue to tighten and with it the risks of credit problems

in the coming year. The treasury continues to struggle to

execute its domestic borrowing plan and is reliant on the

NBU for financing. Net claims of the NBU on the central

government have more than doubled since the end of

May, reaching approx. USD8bn.

All appears to hinge on Ukraine successfully extracting a

reduction in the price of gas charged by Gazprom, but the

history of such agreements suggest that we shouldn’t be

too optimistic for a generous reduction. External liabilities

in 2012 (principal and interest) will amount to USD 7.5bn.

On top of this will come the cost of gas imports. Given

the pressure, and the fact that it is only a remote

possibility that they are comprehensively eased, we

continue to recommend an underweight exposure.


Ukraine: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National income


Population (m) 45.7 45.5 45.3 45.1


Real GDP (YoY%) 4.2 4.5 3.9 4.0

Priv. Consumption 4.6 5.0 5.2 5.0

Govt Consumption 1.2 -3.2 8.1 -1.2

Investment -1.0 5.6 6.8 8.0

Exports 9.0 9.0 9.0 9.0

Imports 10.0 11.0 10.0 10.0

Prices, money and banking (% YoY, eop)

CPI (Dec YoY%) 9.1 6.5 9.0 8.0

Broad Money 23.1 16.0 14.0 13.0

Credit 8.0 20.0 18.0 16.0


Budget balance -5.0 -2.5 -2.5 -1.8

Revenues 22.0 22.5 23.5 22.9

Expenditures 27.0 25.0 26.0 24.7

External accounts

(USDbn)

Exports 52.1 52.6 57.1 64.1

Imports 60.5 61.0 66.6 66.3

Trade balance -8.4 -8.4 -9.5 -2.2

% of GDP -6.4 -5.8 -5.8 -1.2

Current account balance -2.6 -4.0 -5.1 2.2

% of GDP -2.0 -2.7 -3.1 1.2

FDI 5.7 6.5 7.0 7.0

FX reserves 34.6 32.0 38.0 42.7

UAH/USD (eop) 8.0 7.9 7.9 7.9



Domestic 16.5 16.0 17.2 -26.8

External 23.5 27.0 29.0 29.0


in USDbn 108.5 118.0 122.0 137.0

General

Industrial production

(YoY%) 11.0 8.0 5.4 5.8

Unemployment (%) 9.2 8.5 7.8 7.4

Financial markets (eop) Current 3M 6M 12M

Short-term interest

rate(%) 7.75 7.75 7.75 7.75

UAH/USD 8.0 7.9 7.9 7.9 Source: Official statistics, DB Global Markets Research



China Aa3(Pos)/AA-/A+ Moody’s/S&P/Fitch

Economic Outlook: For 2012, we expect the

economy to be featured by 1) disinflation, 2) initial

growth deceleration followed by a recovery, and 3)

policy easing in 1H followed by a more cautious

stance towards the end of the year. We maintain our

2012 GDP growth forecast at 8.3% (down from 9.1%

in 2011), with a qoq trough in Q1 (at 6.4% saar,

slightly deeper than our earlier projection of 6.8%)

and a sequential recovery from Q2. For 2013, we

expect GDP growth to recover to 8.6% largely on

stronger export growth. On policies, we expect 2-3

more RRR cuts in the coming 6-9 months, which

should permit average monthly RMB lending to

rebound to RMB800-900/month in 1H, and annual

lending to reach around RMB8.4tn in 2012. We

expect the fiscal deficit-to-GDP ratio to remain largely

unchanged at 2-2.2% in 2012. Fiscal priorities in

2012 should include public housing, completion of on-

going infrastructure projects, SMEs, services, and

consumption.

Main Risks: The two most important shocks to the

economy in the coming months are property FAI

deceleration and export slowdown. We expect

property FAI growth to slow from the current

25-30%yoy to 15%yoy in the first few months of

2012. We expect export growth to decelerate from

the current 15%yoy to 8-9% in 1Q 2012.

Strategy Recommendations: We favor Repo swap

NDIRS/IRS and Shibor swap 2x5 NDIRS/IRS

steepeners to express our view that interbank

liquidity will ease markedly in the coming 6-9 months.

We retain our bullish view on the CGB cash bonds.

Expect a slower pace of RMB appreciation in 2012.

Macro View

We maintain our 2012 GDP growth forecast at 8.3%,

but foresee a slightly deeper qoq trough in 1Q than

our earlier projection. We cut our 2012 GDP growth

forecast to 8.3% as early as in August 2011, and has since

maintained this forecast. Despite many changes in DB’s

global economic forecasts and recent developments in

China, we continue to believe our 8.3% annual forecast

remains reasonable.

DB’s European economists downgraded their 2012

Eurozone GDP forecast twice in the past four months.

The most recent revision reduced their 2012 Eurozone

GDP forecast from 0.4% to the current -0.5%. As we

(DB’s China economics team) took a more bearish view

on Europe as early as in August, the recent European

forecast changes only marginally worsened our annual

outlook for China’s export growth. The following table

produces our updated yoy and qoq (saar) GDP growth

forecasts for 2012. The slight change we made is to

further cut our qoq GDP growth forecast for 1Q 2012

to 6.4% from the previous 6.8%, on downward revision

of European GDP forecast in that quarter (we now expect

European GDP to contract 1.6% on qoq saar basis, vs the

previous 0.4% contraction).

China: yoy and qoq GDP growth forecast

yoy % qoq (saar) %

2011Q1 9.7% 8.7%

2011Q2 9.5% 9.1%

2011Q3 9.1% 9.5%

2011Q4F 8.5% 7.3%

2012Q1F 7.7% 6.4%

2012Q2F 7.5% 9.0%

2012Q3F 8.7% 10.0%

2012Q4F 8.7% 9.5%

Source: SSB and DB forecast

Three factors are behind our projection of a sequential

growth trough in 1Q 2012. First, we believe that the

European economy is already in recession and its

economic contraction will like to be worst in 1Q. This

implies that China’s export growth will suffer the most

from European demand weakness in 1Q. Second, China’s

real estate sales have slowed sharply since September

2011, and developers will thus likely rein in their

construction activities. Sequential slowdown in

construction should last until Q1 next year, before

property prices and sales may stabilize. Third, China’s

monetary easing, which began only at the end of

November (as marked by the RRR cut on November 30),

will likely become more visible in 1Q. With a one-quarter

lag, monetary easing should begin to support domestic

demand, especially investment activities, from 2Q.

Note that the qoq GDP growth rates before (and including)

3Q 2011 are estimates from the National Statistical

Bureau (NSB). Our estimates differ from theirs as we use

a different seasonal adjustment methodology. The NSB

uses its own methodology but the agency does not

release its details and original data, and therefore it not

possible to replicate its estimates. We believe its

estimates are problematic as their yoy and qoq growth

rates appear inconsistent. In particular, the NBS estimate

of a sequential acceleration of GDP growth in 3Q of 2011

is contradictory to most other indicators which became

visibly weaker in that quarter– these include the PMI,

monetary and loan growth rates, commodity prices, as

well as qoq change in power consumption. In particular,



the PMI fell to around only 50 in 3Q and during the quarter

monetary conditions appeared to be the tightest in two

years.

Given this difference in methodologies, we ask readers to

take our qoq GDP estimates as indicative (of our view of

the momentum of the economy), rather than something

that could be verified by NBS data releases in the future.

We expect GDP growth to accelerate to 8.6% in 2013.

In this monthly note, we for the first time publish our

forecasts of 2013 economic indicators. We expect GDP

growth to rise to 8.6% in 2013, up from 8.3% in 2012.

This is largely reflecting our view that US and Eurozone

GDP growth will be stronger in 2013 than 2012. The

rationales for this forecast include: 1) the worst part of

bank deleveraging, which causes the contraction of the

real economy, would be in 2012; 2) the fiscal contraction

(measured by the reduction in cyclically adjusted fiscal

deficit/GDP ratio) was as much as 1.4ppts in 2012, but

would improve in 2013. In other words, the impact of

fiscal contraction will become less of drag for the

Eurozone economy in 2013.

Stronger US and Eurozone growth would enhance

Chinese growth via stronger exports. So, for example,

based on historical correlations, a 1% increase in US&EU

growth would increase Chinese export growth by about

6ppts. We thus forecast acceleration of China export

growth from 8% in 2012 to 14% in 2013. In volume

terms, China’s export growth will likely accelerate by

about 3-4ppts. This should translate to a 0.5ppt increase

in China’s GDP growth. However, given that monetary

and fiscal policies will likely become a bit more restrained,

we expect GDP growth in 2013 to accelerate only by

0.3ppts to 8.6%.

Other changes to the key components on the Chinese

economy should largely offset each other in terms of

impact on GDP. For example, we expect some modest

deceleration in real gross capital formation (as the

corporate profit margin will drop due to the long-term

structural trend of higher wage growth), but real private

consumption will likely accelerate a bit on better income

growth and higher government spending on social

services and welfare.

On the latter point, the recent unfortunate school bus

accident in Gansu province is illustrative. This accident,

which killed 21 preschool students, provoked a massive

wave of public criticism (in the form of tens of thousands

of Internet and press commentaries) that put pressure for

the government to improve safety standards. A week

later, the State Council decided to allocate additional

budgetary resources for purchasing school buses that

meet safety standards on a nationwide basis. This case

demonstrates the significant rise in the role of public

opinions in influencing policy making in China, and that the

government will likely have no choice but to increasingly

steer its fiscal priority towards social spending.

China: Macroeconomic Forecasts

2010 2011F 2012F 2013F

Real GDP (YoY%) 10.3 9.1 8.3 8.6

CPI (YoY%) ann avg 3.3 5.3 2.8 3.5

Broad money (M2) 19.7 13.5 16.0 14.5

Bank credit (YoY%) 19.9 15.0 16.0 14.0

Budget surplus (% of GDP) -1.7 -2.0 -2.2 -1.5

FX rate (eop) CNY/USD 6.59 6.30 6.10 5.86

Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0

Retail sales (nominal) 18.4 16.5 14.0 15.0

Industrial production (real) 15.7 13.0 11.5 12.0

Merch exports (USD nominal) 31.3 20.0 8.0 14.0

Merch imports (USD nominal) 38.7 24.0 9.0 16.0

1-year deposit rate (%) 3.50 3.50 3.50 3.50

Source: CEIC and DB forecasts

We expect property FAI growth to slow rapidly in the

first few months of the year. It appears that the

weakening of property investments by developers is

becoming the most serious challenge to the economy in

the coming few months, even more so than export

deceleration. This is because the average property price

in 35 major cities has declined by about 13% in the past

two months according to Soufun, and sales and floor

space started have both decelerated sharply. In terms of

floor space started – a leading indicator of real estate

FAI – its growth fell from 30%yoy in Jan-Aug to only

10%yoy in September and -1% in October. Based on

historical correlation, the deceleration in floor space

started will likely translate into a visible slowdown in real

estate FAI (correlation at 0.5-0.6). We thus expect real

estate FAI growth to decelerate from the 28%yoy in Jan-

September towards 15%yoy in 1Q next year.

Yoy% change in residential floor space started

-50%

0%

50%

100%

150%

200%

250%

Feb-0

8

May-0

8

Aug-0

8

Nov-0

8

Feb-0

9

May-0

9

Aug-0

9

Nov-0

9

Feb-1

0

May-1

0

Aug-1

0

Nov-1

0

Feb-1

1

May-1

1

Aug-1

1

Source: CEIC

Given that real estate sector’s capital formation accounts

for about 10% of GDP, we estimate that a 15ppt nominal



deceleration (or 10% real deceleration) in real estate FAI

could contribute to 1ppt reduction in yoy GDP growth in

Q1 next year. This deceleration trend will only be partially

offset by a modest acceleration in infrastructure FAI.

Assuming that infrastructure FAI will accelerate by 7ppts

(from the current -2%yoy growth to 5%), it would reduce

the impact of real estate FAI slowdown on GDP by

0.3ppts. This results in a net reduction of yoy GDP

growth by about 0.7ppts for 1Q of 2011 (compared with

3Q of 2011).

Export growth will likely slow to 8%yoy in 1Q 2012.

Our European economists are projecting the Eurozone

economy will be in recession for the current quarter and

first half of next year. The trough is projected in 1Q of

2012. The driving forces for further deterioration of

sequential growth in Q1 include bank deleveraging, fiscal

contraction, as well as the negative wealth effect arising

from weaker consumer confidence. However, over the

coming months, we expect some progress of the

Eurozone towards fiscal consolidation, which will permit

the ECB to further loosen monetary policy and support the

debt market, and to help lift market and consumer

confidence. The benefits for the real economy are

expected to kick in from Q2 next year.

Given this European growth trajectory, and a relatively

steady pace of US economic growth (at around 2.5%

annualised rates for most quarters), we expect China’s

qoq and yoy export growth to look like the following:

China export growth forecast, yoy and qoq%

China export (yoy) China export (qoq) EU/US GDP

(qoq saar)

3Q 11 21% 2.5% 1.3%

4Q 11F 15% 1.5% 0.7%

1Q 12F 8% 0.5% 0.3%

2Q 12F 6% 0.7% 0.4%

3Q 12F 6% 2.9% 1.5%

4Q 12F 11% 3.5% 1.9%

Source: DB forecast

According to our estimates, China’s qoq (sa) export

growth will slow sharply to only 0.5% in 1Q next year,

down from 1.5% in 4Q this year. As a result, yoy export

growth will likely decelerate to 8% in 1Q, stay weak for

2Q and 3Q, before recovering in 4Q 2012. For the year as

a whole, we now forecast export growth at 8% (vs

previous expectation of 10%). We also revised down our

import growth forecast by 2ppts to 9%.

Ceteris paribus, the export deceleration will lead to a

reduction in yoy GDP growth by about 1.3ppts in 1Q of

2012 (compared with 3Q of 2011). We expect nearly half

of this deceleration to be offset by the benefits of policy

easing on other sectors.

CPI inflation to drop sharply to 3% in Q2 and 2.8% for

2012 as a whole. We continue to expect CPI inflation to

decline sharply to 4.2% in November and 3.8% yoy in

December, and to 3% in 2Q next year. This reflects the

significant decline in wholesale agriculture prices in the

past two months (by 7-8%) and its gradual pass-through

to retail food prices. Based on historical correlation, the

food component of CPI should fall by at least 5%

cumulatively between the peak September and the next

trough. Even if the power tariffs are raised by 5% and

refined oil prices are raised by 10%, their boost to CPI is

only 0.3ppts, a small fraction of CPI reduction (by 1.5%)

due to a 5% food price drop.

Based on normal seasonality, we assume a 5% rise in

food prices in January and February to reflect the Chinese

New Year effect. Even with this sequential rise in food

prices, yoy CPI inflation will still likely fall to 3% in 2Q and

the full year CPI inflation will likely be at 2.8% for 2012.

Other key assumptions we made in this CPI projection

include a modest decline in PPI in the coming few months,

with a recovery from Q2 next year. For the year as a

whole, we see PPI inflation at about 4%, significantly

lower than the recent peak of about 8%. This projection

is supported by the recent trend of declining input price

index in the PMI report.

Another important contributor to disinflation is the fall in

property prices, which will over time translate to a decline

in the housing component (which includes rents and

imputed rents) of CPI. We estimate that a 10% drop in

physical property prices (soufun property price index) will

eventually – after about 6 months – reduce the housing

component of CPI by 1%.

We expect M2 growth to accelerate to 15-16% for

2012. We expect M2 growth to accelerate marginally to

15-16% next year, up from the current 13%. Experience

tells us that M2 growth is typically set at 2-3ppts above

nominal GDP growth. This time, given the consensus

forecast of 8.5 for real GDP growth and about 3.5% for

CPI inflation, 14% will likely form the bottom for the

discussion for next year’s M2 growth range. However,

arguments for some additional monetary expansion will

likely be made in the coming months – even after the

National Economic Work Conference – to allow 1-2ppt

additional M2 growth in order to offset the global demand

shock and the weakness in the real estate sector. Thus,

the final outcome will likely be 15%-16% for M2 growth.

A M2 growth rate of 15% should be applicable if GDP

growth is running safely above 8%, but 16% is more likely

when yoy GDP growth slips below 8% for two quarters

(which is our forecast). Therefore, although the initial



target for M2 growth could be set at 15%, and eventual

outcome may be 16% next year.

At this moment, we do not see strong reasons why loan

growth will be much different from M2 growth in 2012.

This implies that new RMB lending will be around

RMB8.4tn next year, up from this year’s estimated

RMB7.4tn.

We expect very modest fiscal easing in 2012. Despite the

official rhetoric that fiscal policy will remain pro-active, we

think the reality is that there will be very limited fiscal

expansion in 2012 relative to 2011. Our baseline forecast

is that the deficit-GDP-ratio will rise only slightly to 2.2%

in 2012 (vs 2.0% in 2011). Specifically, we expect total

fiscal deficit to be RMB1.1tn (including RMB300bn for

local government deficit/bond financing) in 2012, vs

RMB900bn in 2011 (including RMB200bn for local

government deficit/bond financing).

Within the fiscal budget for 2012, we expect some

modest tax further cuts to support SMEs, exporters,

consumption, and services. On the expenditure side, we

expect priorities be given to support public housing,

infrastructure (e.g., resumption of railway projects, repair

of reservoirs and dams), social services, and consumption

(e.g., extension of the electronics trade-in policy).

Jun Ma, Hong Kong, (852) 2203 8308

Investment Strategy

Rates. With monetary policy having shifted towards

easing and likely will accelerate in the next 2-3 quarters,

we expect net liquidity inflow to the interbank market to

help bring money market rates to 50-100bps before mid

of 2012. However, in the near-term, the relative stickiness

of the 7D repo fixing rate given the year-end seasonal

liquidity demand, and the extent of liquidity easing being

priced in on the Repo IRS curve argues for the outright

level of CNY IRS curves to be relatively range bound

(within 10-15 bps range). As such we think the risk reward

of outright receiving Repo rates is unfavorable and costly

in carry. We believe Repo swap or Shibor swap curve

steepeners are more suitable for investors sharing our

view. We recommend building Repo IRS/NDIRS or Shibor

IRS/NDIRS 2x5 steepeners at the current market.

We retain our bullish view on CGB cash bonds and 10Y

CGB can rally by 20-30bps over the next quarter. Supply

risk is low in Q1 which should provide good technical

support.

We remain cautious on the onshore credit market and will

wait till credit outlook stabilizes before considering

increasing allocation.

FX. In our opinion, China regards FX as a monetary policy

tool – part of a broader policy toolkit that includes RRR,

interest rates, credit guidance and administrative

measures – for managing inflation. The inflation cycle has

turned in China, and downside risks to exports are

growing. While a major reversal of policy is unlikely, the

government is taking small steps to ease policy, which we

think include a slower pace of RMB appreciation early in

the sequencing of an easing response. We retain a

structurally bullish view on the RMB (tied in to its long

term plan for capital account liberalization, and the need to

reduce its undervaluation), but we expect a cyclical

slowdown in its appreciation path, to nearer 3% by H1

2012. USD/CNY NDFs could however squeeze higher as

the Chinese economy slows in coming months. Possible

overshoots in the NDFs in the coming months should be

seen as better opportunities to re-enter RMB longs.

Linan Liu, Hong Kong, (852) 2203 8709

Dennis Tan, Singapore, (65) 6423 5347



China: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National Income


Population (mn) 1374 1383 1389 1395


Real GDP (YoY%)1 10.3 9.1 8.3 8.6




Export of goods & services 22.0 12.0 6.4 12.5

Import of goods & services 23.0 14.0 7.8 13.0


CPI (YoY%) eop 4.6 3.8 2.8 3.5

CPI (YoY%) ann avg 3.3 5.3 2.8 3.5

Broad money (M2) 19.7 13.5 16.0 14.5

Bank credit (YoY%) 19.9 15.0 16.0 14.0


Budget surplus -1.7 -2.0 -2.2 -1.5


Government expenditure 17.8 24.7 24.7 24.0





Trade balance 183.0 163.8 159.6 144.2

% of GDP 3.1 2.3 2.0 1.5


% of GDP 5.2 4.0 3.3 2.6

FDI (net) 124.9 100.0 70.0 50.0


FX rate (eop) CNY/USD 6.59 6.30 6.10 5.86


Government debt2 20.3 19.4 19.1 18.3

Domestic 19.7 18.8 18.6 17.8

External 0.6 0.6 0.5 0.5


in USD bn 549.0 730.0 830.0 930.0


General (YoY%)

Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0

Retail sales (nominal) 18.4 16.5 14.0 15.0

Industrial production (real) 15.7 13.0 11.5 12.0

Merch exports (USD nominal) 31.3 20.0 8.0 14.0

Merch imports (USD nominal) 38.7 24.0 9.0 16.0

Financial Markets Current 3M 6M 12M

1-year deposit rate 3.50 3.50 3.50 3.50

10-year yield (%) 3.63 3.40 3.30 3.30

CNY/USD 6.35 6.30 6.20 6.13

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



This page is left blank intentionally



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

Economic Outlook: Growth in Hong Kong continues

to follow the lead of the US and EU economies. This

means markedly slower growth in 2012 but a likely

return to reasonably robust growth in 2013.

Main Risks: A disorderly resolution of the sovereign

debt crisis in Europe would likely be translated into a

deep recession in Hong Kong.

Strategy Recommendations: We see upside risk on

Hibor - Libor basis in Q1 next year driven by corporate

liability hedging demands.

Macro View

Slower US&EU growth means slower HK growth.

Hong Kong’s economy eked out 0.3%QoQ(saar) growth in

Q3 after contracting at a 1.4% rate in Q2. The key

message, though, is that when exports of goods and

services are 208% of GDP, external demand will always

be the main driver of growth. And it still seems to be that

US and European demand matters more than Mainland

Chinese demand.45 As exports have stagnated over the

past six months, so too has Hong Kong GDP. And having

downgraded our growth forecast for the US and EU

economies, we have done the same for Hong Kong,

cutting our 2012 forecast from 4.4% to 3.0%. In 2013,

though, as growth in the ‚G2‛ economies is expected to

recover we see Hong Kong’s growth rebounding to 4.5%.

GDP growth in Hong Kong and the G2 (US and EU)

HK = 1.6 x G2 + 1.9

R² = 0.68

-10

-5

0

5

10

15

-6 -4 -2 0 2 4 6

%

%

Sources: CEIC and Deutsche Bank

While export growth has plummeted in recent months –

from 15.1%yoy in Q1 to -0.4% in Q3 in real terms –

private consumption growth has held up surprisingly well,

slowing from 9.7%yoy in Q2 to 8.8% in Q3. But we don’t

45See ‚China is a Weak Engine of Growth for Asia,‛ Global Economic

Perspectives, Sept 10, 2011.

expect this will continue. Our analysis suggests that as

export growth slows and asset prices fall – we expect

Hong Kong property prices could fall 20% next year –

consumption growth is likely to slow significantly.

Private consumption expenditures

-10

-5

0

5

10

15

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

PCE Model%yoy

Sources: CEIC and Deutsche Bank. The “model” is a regression of real PCE growth on real merchandise

export growth, tourist arrivals, the real 3m Hibor yield and real equity price and property price inflation.

Since 1995 the model has an R2 of 0.70.

Inflation to fall gradually in 2012, more quickly in 2013

Because rental inflation only appears in the CPI index with

more than a one-year lag, falling property prices won’t

really show up in lower inflation until 2013. In the interim,

commodity price inflation will be more important. So,

falling food and fuel inflation will likely take inflation down

from 6% at the end of this year to below 4% by mid-

2012. But as food and fuel prices start to rise in the

second half of next year we see inflation rising above 4%

by year-end. But in 2013 even with higher commodity

prices we see the housing effect driving inflation below

1% and perhaps below zero in early 2014.

Expect modest fiscal stimulus The government’s

budget forecast a deficit of HKD32bn in the current fiscal

year. But in the first half of the fiscal year it has run a

deficit of only HKD5.4bn. Only once in the last thirteen

years has the government run a deficit during the Oct –

March period. In the last three years it has run surpluses

averaging HKD78bn during those months. The payout of

the HKD6,000 scheme will undoubtedly reduce the

surplus, but we project a surplus of HKD31bn for the

current fiscal year. Given our US and EU growth

forecasts, we expect only modest fiscal stimulus to be

applied in Hong Kong next year – perhaps a more targeted

cash handout scheme, increased support for those less

well off and possibly a cut in the corporate tax rate – but

we still project a surplus of nearly HKD30bn.




Investment Strategy

Fixed Income Strategy: The dynamic of Hibor - Libor

basis likely will present interesting trading opportunities

next year. We think there are three relevant factors:

a) Q1 is typically seasonally strong funding season and

we expect demand for corporate liability hedging

purpose to push Hi-Li basis higher;

b) Funding activities in the offshore RMB bond market

by HK corporations which then have been swapped

back to HKD Libor, such flows are getting more

active in recent week and will grow if USD funding

market remains challenging next year.

c) The likely slowdown in RMB appreciation at least in

the next 1-2 quarters means less speculative

positioning on the USD/HKD forwards, which will

reduce the risk of further widening in Hi-Li basis.


FX: We think that market speculation of a HKD depeg is

likely to dissipate in 2012. This is because the reflation

tide which has driven a growing debate over the relevance

of the USD peg in recent years is likely to fade. A cyclical

slowdown in China, a more gradual pace of RMB

appreciation, falling inflation and possible property price

declines in both the mainland and in the SAR are factors

that will likely drive speculators to pare back their bets on

a near-term depeg..

HK officials have also repeatedly emphasized that

convertibility of the Chinese currency is a critical

precondition for a repeg to the RMB. While Chinese

authorities are likely to take further steps to allow capital

backflows from the CNH market, China is unlikely to

achieve full convertibility next year. As such the chances

of HKD depeg in 2012 are quite low in our view. We like

buying the 12M USD/HKD outrights, which is trading right

very close to the bottom of its policy band. We also like

buying 1Y risk reversals which are still trading near the

lower end of its historical ranges.


Hong Kong: Deutsche Bank Forecasts

2010 2011F 2012F 2013F

National Income


Population (mn) 7.1 7.1 7.2 7.2


Real GDP (YoY%) 7.0 5.3 3.0 4.5



Gross fixed investment 7.8 4.3 1.2 5.5

Exports 16.8 3.2 2.1 8.8

Imports 17.3 3.3 2.1 9.5


CPI (YoY%) eop 2.9 6.0 4.3 -0.1

CPI (YoY%) ann avg 2.3 5.3 4.6 2.1

Broad money (M3) 7.6 12.2 4.3 4.4

HKD Bank credit (YoY%) -0.4 15.1 6.9 3.9

Fiscal Accounts (% of GDP)1

Fiscal balance 4.2 1.6 1.2 1.5







Trade balance -43.0 -56.2 -58.9 -67.3

% of GDP -19.1 -23.1 -23.0 -24.5


% of GDP 6.2 5.5 4.8 3.8

FDI (net) -7.2 -2.7 -2.5 -3.5


FX rate (eop) HKD/USD 7.76 7.79 7.80 7.80


Government debt1 2.2 2.5 2.9 3.2

Domestic 1.6 2.0 2.3 2.7

External 0.6 0.6 0.5 0.5


in USD bn 803.5 850.0 775.0 800.0


General

Unemployment (ann. avg, %) 4.4 3.5 3.7 3.7


Discount base rate 0.50 0.50 0.50 0.50

3-month interbank rate 0.30 0.30 0.30 0.30

10-year yield (%) 1.35 1.30 1.35 1.35

HKD/USD 7.78 7.80 7.80 7.80


Note: (1) Fiscal year data.



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

Economic Outlook: Assuming no big collapse in

global financial markets, the Indian economy ought to

grow by 7-7.5% in 2012, supported by rate cuts from

RBI around mid-2012

Main Risks: Worsening of twin deficits could prevent

inflation from moderating to mid single-digit levels,

which could complicate RBI’s monetary policy

decision, especially if growth were to slow sharply at

about the same time

Strategy Recommendations: Pay steepeners on

the OIS curve (1Y/2Y) to position for the turn in the

cycle. Risk to INR gets more digital next year, with

policy intervention a key factor.

Questions for 2012

With the current and challenging year almost behind us,

focus now shifts to 2012:

When will the economy trough?

When will the RBI start reversing its current anti-

inflationary stance?

Will the government manage to carry out some

degree of fiscal consolidation?

What is the outlook for the rupee?

What is in the structural reform agenda?

Growth in 2012

For years, one of the appealing characteristics of India for

investors has been its resilient internal growth dynamic,

driven by domestic demand in a somewhat insulated

economy. Our analysis shows that before 2006, the

relationship between India’s growth and that of the US

and Euro Area (G2) was not statistically significant; i.e. the

growth dynamic appeared to be impervious of the G2

cycle. In this regard India used to mimic China.

But as the economy has opened up, it is no longer

shielded from global cyclical movements. The adjoining

chart shows that India’s growth trajectory is not just

mirroring capital flows, but G2 growth as well. The

coefficient estimate on a growth regression with G2

growth on the right hand side is statistically significant in

the post 2005 period, and the explanatory power of the

regression equation is considerable.

India’s economic growth : high correlation with G2

-6

-4

-2

0

2

4

6

5

6

7

8

9

10

11

2005 2006 2007 2008 2009 2010 2011

India, left G2, right%yoy %yoy

Note: A quarterly data regression of India’s real growth against ppp-weighted G2 growth, for the sample

period 2006Q1 to 2011Q2, obtains a beta coefficient of 0.4, estimated with a statistical significance at

1% level and an adjusted R-squared of 0.61.

Source: CEIC, Deutsche Bank Global Market Research

Through the first three quarters of 2011, GDP growth in

India has decelerated, averaging 7.5% as compared to

8.9% growth in the corresponding period in 2010. The

slowdown has been concentrated in the industrial sector,

with growth averaging 4.9%, as against 10.2% in the first

nine months of 2010. Services sector slowdown in

comparison has been relatively modest (8.7% vs. 9.8%),

though downside risks have increased in recent months.

Agricultural sector growth momentum has gained some

traction in 2011 over 2010 (4.9% vs. 2.9%). From the

expenditure side GDP, we note that investment growth

continues to be anemic, while private consumption

growth has also been trending lower. The main supportive

factor to growth has been higher public spending and,

more crucially, net exports.

Given the latest data, we have revised down our FY11/12

growth estimate to 7.0% (from 8.0% earlier), as we see

further intensification of global macro headwinds and

slowdown in domestic demand in the days ahead. We

have also revised down our FY12/13 growth estimate to

7.5% (from 8.0% earlier), which however reflects a

modest recovery relative to the likely 2011 outturn. This is

based on our view that growth momentum would likely

improve from the second half of 2012, helped by (i) a

supportive base effect; (ii) expected rate cuts from RBI

starting from mid-2012; and (iii) a likely improvement in

global market sentiments, helped by belated but

ultimately market stabilizing resolution of the present

Eurozone crisis. However, as the analysis of India’s

growth relationship with G2 shows, our baseline growth

forecast could face downside risks if the US/Euro area

economic growth were to slow appreciably in 2012 than

currently anticipated.



When will RBI start cutting policy rates?

India’s clear and present danger is inflation, which has

been on a trend rise over the past five years or so.

Stubbornly high inflation is a reflection of a number of dis-

functionalities in the economy, which are also some of the

key impediments to India’s stability and prosperity. On the

demand side, high growth rates of GDP (200bps higher in

the past decade than any other period in India’s history)

and real per capita income (rising by 8% annually since

2001) have kept the economy operating at or above its

potential growth rate. Case in point is the dairy industry;

despite production rising by double digit rates in recent

years, milk prices have risen by an annual average of 13%

since 2006 as demand has been outpacing supply. On the

back of strong growth, wages have risen sharply in the

past decade, adding sizeable purchasing power to millions

of Indian households. As household income has risen,

consumption has evolved from basic food items to more

protein-rich items, but the ensuing demand surge has not

been met with an adequate supply response.

CPI and WPI inflation trend

0

2

4

6

8

10

12

14

16

2005 2006 2007 2008 2009 2010 2011

WPI CPI%yoy


On the supply side, key impediments lie in the agriculture

sector, where production growth has been less than 1% a

year in the past decade. There are also substantial

distributional and infrastructure inefficiencies that cause

prices of goods to jump in a disorderly manner in the

event of weather or transportation related shocks. Rising

fiscal deficit and the recent sharp depreciation of the

rupee are also potential threat for inflation going forward.

Despite these concerns, we expect WPI inflation to

moderate to 8% by Dec 2011 from the current 9.7%,

thanks to a favorable base effect in food inflation. Barring

any further food price spike or fuel price hike, WPI

inflation should be down to around 7-7.5% by March and

to 6.5% by June 2012. This should allow RBI to start

cutting interest rates from mid-2012, by a cumulative

100bps through the year (taking repo rate down to

7.50%), in our view. However, the inflation trajectory may

not look as benign as our base case scenario suggests if

supply shocks were to materialize. In such a scenario,

inflation may stay in the 8-8.5% range in the second half

of 2012, instead of the 6-6.5% forecast in our base case

scenario. Given that this would take place amidst a

slowing growth environment and heightened global

uncertainty, the RBI’s monetary management would

clearly become highly challenging, in such a scenario.

Recent depreciation of the rupee is yet another risk to

inflation in the coming months.

WPI inflation forecast – two scenarios

5

6

7

8

9

10

11

2010 2011 2012 2013

Baseline Alternate% yoy

Source: CEIC, Deutsche Bank Global Market Research. Note: Alternate inflation scenario builds in a food

price spike (+3%mom) and a diesel price hike of 5-6%.

Could a CRR cut precede repo rate cut?

In recent months, money market liquidity has tightened

severely, with the existing deficit in the LAF (INR1.2trillion)

being almost twice that of what the RBI would like the

systemic liquidity deficit to be (1% of net demand and

time liabilities, which works out to about INR600bn).

Rupee liquidity conditions could tighten further, if the RBI

were to resort to unsterilized FX intervention to prevent

further sharp depreciation of the rupee.

Net LAF against 1% (+/-) NDTL band, WPI inflation

and cash reserve ratio rate

-2

0

2

4

6

8

10

12

-1500

-1000

-500

0

500

1000

15001 % of NDTL (+)1 % of NDTL (-)Net LAFCRR, rhs

%INR bn




While the RBI could resort to doing more and more open

market operations (OMO) to ease the pressure on rupee

liquidity, we note that the OMO route to improve rupee

liquidity (especially in an environment where FX

intervention could further complicate matters) may prove

to be a time consuming process. A speedier way to infuse

rupee liquidity, thereby creating more flexibility for the

central bank to intervene in the FX market (if the situation

demands), would be to cut the cash reserve ratio (CRR)

rate which currently stands at 6%. Every 1% point cut in

the CRR will increase primary liquidity immediately by

about INR600bn. Indeed, this was the case in the fourth

quarter of 2008, when after the Lehman Brothers

collapse, RBI decided to cut the CRR sharply, while also

intervening aggressively in the FX market.

There are however two main differences with respect to

the 2008-09 period; first, the CRR was at 9%, before the

RBI cut it by 250bps in October 2008 to 6.5% and then by

another 150bps to 5.0% by January 2009. With the CRR

standing at 6% today, the flexibility to cut it is clearly less

(although there is no guideline to stop the RBI from

cutting it). Second, inflation continues to be near double-

digit with little chance of it to moderate to the RBI’s

comfort range of 5-5.5% anytime soon, as compared to

2008/09, when inflation collapsed post 2008, led by a

sharp decline in commodity prices.

Given that inflation and inflation expectations remain high,

RBI therefore may find it difficult to cut the CRR rate

before inflation shows a clear downward trajectory, which

we expect to see only from January onward. Another

possibility could be that the RBI cuts the CRR, justifying

that its move is directed only towards liquidity

management, while its anti-inflationary stance remains

unchanged. This again appears unlikely in the immediate

near-term, though one cannot rule out the possibility of a

100bps cut in CRR, sometime in the first half of 2012.

Is there scope for fiscal consolidation?

The government has not succeeded in reducing the fiscal

deficit since the onset of the 2008 global financial crisis.

While the fiscal stimulus put in place in 2008 helped the

economy, spending has become stickier since then,

making normalization of fiscal policy difficult. Several

social programs have been introduced in recent years,

particularly the rural employment guarantee program (that

gives 100 days of minimum wage to the rural

unemployed), providing substantial impulse to rural

demand while making the fiscal position worse. The

government’s large subsidy programs for food, fuel, and

fertilizer (amounting to about 20% of total spending,

nearly 2.5% of GDP) also add to the adverse fiscal

position and inflated demand.

Expenditure on various subsidies as a % of GDP

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

0.0

0.3

0.6

0.9

1.2

1.5

1.8

FY05 FY07 FY09 FY11

Petroleum, lhs

Fertilizer,lhs

Food, lhs

Total, rhs

% of GDP % of GDP


Building on the slippage of 2011, it is difficult to see

much scope for substantial fiscal consolidation in

2012. The expenditure side of the budget will likely

remain sticky owing to welfare programs such as NREGA

and rising subsidy bill on account of food, fertilizer and oil

(unless global oil prices fall sharply, which is not our base

case scenario). Further, if the Food Security Act is

implemented next year then our estimates suggest that

the food subsidy bill could rise by an additional INR200bn

from the current level.

The revenue side of the budget is likely be weak despite

the slated implementation of the Direct Tax Code, given

likely persistence of weak growth momentum in the next

few quarters. To support the revenue base, excise duties

could be raised on certain items while the services tax net

could be broadened, but this could affect economic

growth adversely on the margin.

The government would clearly like to revive its

disinvestment program to ease financing pressure, but

as the experience of 2011 shows the associated

difficulties; the government has been able to raise only

7% of the budgeted disinvestment target so far in the

current fiscal year.

Despite this, we think that the government will factor in

INR250-300bn proceeds from disinvestment, with an

intention of bringing fiscal deficit down to 4.8% of GDP in

FY12/13 (though upside risks will remain), from a likely

5.2-5.5% of GDP outturn in FY11/12 (as against the

budget estimate of 4.6% of GDP). Consistent with past

trend, this fiscal deficit will be financed primarily through

sizable market borrowings, which will continue to weigh

on bond market sentiments.



Fiscal deficit & market borrowing of the central govt.

0

1

2

3

4

5

2

3

4

5

6

7Gross market borrowing, rhs

Fiscal deficit, lhs

% of GDP INR trn.


Rupee correction: overdue or overdone?

India’s impressive track record with respect to growth and

market potential has brought in foreign capital in recent

years, crucial to the financing of its current account deficit.

This is an important issue, as India’s domestic savings

rate remains in the 32-33% of GDP range, whereas

investment demand has been around 35% of GDP. As a

result a current account of deficit of 2-3% of GDP has

become the norm. It was generally regarded that given

the economy’s high potential rate of growth, there would

be no shortage of foreign flows, and therefore financing of

the current account would continue unimpeded, allowing

even for reserves accumulation and some appreciation of

the exchange rate.

Current and capital accounts

0

2

4

6

8

10

FY07 FY08 FY09 FY10 FY11 FY12F

Current account deficit

Capital account surplus

% of GDP


This thesis is however being challenged. Global risk

sentiments have been poor since 2008, with little respite

in sight. India’s current account deficit has steadily

worsened, primarily owing to high cost of commodity

imports, and financing difficulties were experienced in

2008/09 and again this year. The rupee has come under

pressure lately as the oil import bill has mounted and

portfolio flows have weakened.

Clearly the exchange rate will be vulnerable as the balance

of payments is likely to remain under pressure until

commodity prices correct (we forecast current account

deficit of 3.1% of GDP in 2012, with capital account

surplus just about managing to finance it). Persistent

inflation is yet another complicating factor, reducing the

competiveness of the currency through real exchange rate

appreciation. The rupee therefore has cyclical and

structural headwinds.

Rupee and external flows

-8%

-4%

0%

4%

8%-20

-15

-10

-5

0

2007 2008 2009 2010 2011

(trade balance + net portfolio), lhs

INR/USD (inverted), rhs

USD bn % ch,

mom


Since a large part of the recent rupee depreciation has

been due to India specific issues such as rising trade

deficit and shrinking capital account surplus, an

improvement in those areas could therefore help the

exchange rate stabilize. The central bank and the

government have recently announced some measures to

increase foreign capital flows into the country, which

ought to be helpful on the margin.

The limit for foreign institutional investor’s investment

in government and corporate debt was increased by

USD5bn each.

External commercial borrowing norms were modified

to allow greater capital inflow through this route. i)

All-in-cost ceiling of 3-5 year loans were raised to

350bps above libor (from 300bps earlier); and ii) ECB

raised for rupee expenditure i.e. foreign borrowings

for local activities as opposed to external purchases,

will be required to brought in immediately.

Interest rates on new Non-Resident (External) Rupee

(NRE) term deposits for 1-3 year maturity enhanced

to libor + 275bps (from libor +175bps earlier) while

interest rate of fresh FCNR (B) deposits of all

maturities enhanced to libor + 125bps (from libor

+100bps earlier).



The recent spate of capital liberalization measures

however is unlikely to have an immediate positive impact

on the rupee, especially as global risk aversion and USD

strength continues. The RBI, which has been virtually

absent from the foreign exchange rate market in the last

two years (marking a change in long-standing strategy),

could however play a bigger role. Recent statements of

key RBI officials indicate unwillingness on the part of the

central bank to intervene, but we believe that if markets

were to become disorderly, the RBI would take action,

and indeed, it has a few operational tools to intervene

effectively and credibly.

RBI intervention in FX market vs. USD/INR

-20

-15

-10

-5

0

5

10

15

38

42

46

50

54

2001 2003 2005 2007 2009 2011

USD bnNet purchase (+)/ sale (-) of USD

by RBI, rhsUSD/INR, lhs

Source: CEIC, RBI, Deutsche Bank Global Market Research

We stress that some of the correction of rupee seen in

the past three months was warranted, and further stress

in the global markets could add renewed pressures. But

we are not worried about India seeing some sort of a

balance of payments crisis. Reserves are ample, imports

cannot remain high if exports are slowing, and external

financing markets are functioning better than in 2008.

India’s reserves are ample to prevent a balance of

payments crisis

0

50

100

150

200

250

300

350

400

450

Adequate

coverage

Source: CEIC, Deutsche Bank. Risk weighted liabilities include short term external debt, current account

balance, broad money, portfolio investment, and exports.

Structural agenda

With economic momentum having slowed appreciably in

2011, the pressure on the government has risen to

implement growth-critical reforms. We provide a list

below of some of the important agenda of the

government in the next year, aimed at strengthening the

structural dynamic of the Indian economy.

National Food Security Bill: The Bill proposes free

food grain for the very vulnerable sections of the

society, and food grain at subsidized rates for

households categorized as 'priority' and 'general'

under the targeted public distribution system. While

this will likely increase the food subsidy bill by an

additional INR200bn, thereby straining the fiscal

position, it is also expected to have a positive effect

by supporting private consumption.

Tax reforms: The Direct Tax Code (DTC) is slated to

be implemented from FY12/13 onward. This would

broaden the tax base, while improving incentives for

tax compliance. The Goods and Services Tax (GST) is

unlikely to be fully implemented next year, but some

initial steps toward bringing retail taxes across states

under one common market system will be taken.

Land Acquisition and Rehabilitation Bill: As this bill

becomes an Act next year, land acquisition for

industrial purposes will likely become relatively easy

and less controversial, though it could increase the

overall cost. The benefits are however likely to

outweigh the costs, giving much needed boost to

industrialization and urbanization.

Capital account liberalization: Further liberalization

of the capital account could be expected as the

government is keen to attract capital flows to support

the orderly financing of the current account deficit.

FDI in the aviation sector could be allowed, external

commercial borrowing guidelines could be further

modified, and FII limit for investment in government

and corporate debt could be enhanced further.

Infrastructure investment: To meet its ambitious

goal of investing USD1trillion on infrastructure

between 2012 and 2017, the government would very

likely announce supportive measures (tax benefits,

deregulation, and privatization) that seek to attract

and enhance private investment in the sector.

Taimur Baig, Singapore, (65) 6423 8681

Kaushik Das, Mumbai, (91) 22 6658 4909



Investment Strategy

2012 should present interesting opportunities in India

as RBI starts to unwind part of its liquidity and rates

tightening from the last couple of years, and as INR

likely displays a high beta character to global risk. We

remain of the view that it will be a slow grind on the

former, with the central bank likely to ease its grip in

liquidity before it starts to cut interest rates. The start of

open market operations last week we see as a signal for

the same, and we believe the process would be

supplemented and/or expedited via CRR cuts at some

stage possibly in Q1 2012. While the market has started

to price in a turn in the cycle, the actual overnight fixing is

likely to lag till such time as the liquidity deficit gets

overturned. As such, the carry and timing of a long rates

position is very important. We have thus preferred to

position via 1Y/2Y NDOIS steepeners (and short dated

bonds), with minimal bleed, and with some (arguably less

than optimal) exposure to the likely eventual collapse of

yields in the front end of the curve. We initiated this trade

on 18 November at -55bp mid (current: -44), and believe

the spread will eventually revert towards parity.

INR has been the worst performer in Asia this year, and

among the worst in EMFX as a whole. As the only

significant economy suffering from twin deficits in the

region, it is not surprising that the currency has been

under pressure; though inelasticity of commodity imports

(gold and oil), and a sense of policy paralysis in

government affairs (which has impacted FDI) has

worsened the situation by opening up a gap on the

financing of the current account. From a valuation

perspective, we would note that the drawdown in real

terms on INR (both on bilateral basis vs. USD and in terms

of a broader REER) is still short of the experience in 2008-

09, given India’s high inflation; and that on this metric, an

overshoot in USD/INR to 57-59 levels under conditions of

further global stress is not impossible.

In the short run, we think INR is oversold. The threat of

systemic stability given the sharp recent move in the

currency has forced the authorities into action with policy

measures, which should have a near term positive impact.

However, whether it can sustainably reverse its direction

will depend to a large extent on the state of global risk,

and the ability of policymakers to show consistent

progress on issues which impact business and

investment sentiment. We suspect INR will have

significant digital risk in 2012, and to that effect will need

more active policy intervention.

Sameer Goel, Singapore, (65) 6423 6973

India: Deutsche Bank Forecasts

2010 2011F 2012F 2013F

National Income


Population (mn) 1175 1200 1218 1236


FY10/11 FY11/12 FY12/13 FY13/14

Real GDP (YoY %), FY 8.6 7.0 7.5 8.0

Real GDP (YoY %), CY 9.9 7.3 7.3 8.0




Exports 13.9 23.2 16.3 16.2

Imports 11.5 14.1 13.0 14.3


WPI (YoY%) eop 9.4 7.5 6.0 7.5

WPI (YoY%) avg 9.6 9.4 6.3 6.9

Broad money (M3) eop 16.5 16.3 19.0 18.3

Bank credit (YoY%) eop 23.2 15.7 18.7 18.9

Fiscal Accounts (% of GDP)1

Central government balance -4.7 -5.5 -4.8 -4.5



Central primary balance -1.7 -2.5 -1.8 -1.5

Consolidated deficit -7.6 -8.1 -7.4 -7.0




Trade balance -132.2 -150.6 -170.2 -195.7

% of GDP -8.0 -8.0 -8.3 -8.0


% of GDP -3.1 -2.9 -3.1 -3.2

FDI (net) 10.0 25.0 32.5 35.0


FX rate (eop) INR/USD 44.8

44.8

51.5

51.5

48.0

48.0

47.0

47.0



Domestic 61.4 59.0 58.8 58.7

External 3.6 3.2 2.9 2.7


in USD bn 247.0 265.0 300.0 320.0


General

Industrial production (YoY %) 8.1 0.7 8.5 6.5


Repo rate 8.50 8.50 8.50 7.50

3-month treasury bill 8.73 8.00 7.80 7.00

10-year yield (%) 8.71 9.00 8.50 8.00

INR/USD 51.3 50.5 49.5 48.0 Source: CEIC, DB Global Markets Research, National Sources

Note: (1) Fiscal year ending March of following year, consolidated deficit includes state and central

government finances, as well as bonds issued as payments to oil and fertilizer companies on account of

the losses incurred from the provision of subsidies..



Indonesia Ba1/BB+(Pos)/BB+(Pos) Moody’s/S&P/Fitch

Economic Outlook: Building on the momentum built

over the past couple of years, Indonesia steps into

2012 with well-anchored consumer and business

confidence, which could allow the economy to grow

by over 6% at a year when global growth will likely

slow sharply.

Main Risks: Inflation could rise sharply on the back of

electricity and fuel price adjustments, and as demand

remains strong. Rupiah could come under pressure if

global liquidity crunch and risk aversion continue.

Bond yields could rise for the same reason.

Strategy Recommendations: Increase underweight

as 10Y yields close in on 6%.

Sustained growth in a more challenging

environment

It has been a landmark year for Indonesia, characterized

by strong growth, robust investor sentiments, and below

trend inflation. Aided by a buoyant commodity market that

saw earnings from exports rise sharply, Indonesia’s

economic performance in 2011 has been particularly

striking as it has taken place when growth momentum

worldwide has been waning.

Growth will face some headwinds in 2012 if the

commodity markets weaken, but we believe that the

economy could continue to motor ahead, keeping most of

its growth momentum intact, as a virtuous cycle of strong

sentiments fuelling consumption and investment, which in

turn creates employment and income that further

supports sentiments appears to be in place for the time

being. We, therefore, expect growth to exceed 6% in the

coming year, helped by private and public consumption

and investment. Net exports contribution to growth will

likely decline, but that should not constitute more than

0.5% downside to GDP growth, in our view. On the

investment side, we expect continued activities in mining,

transportation, infrastructure, and retail sectors. If land and

labor laws become more transparent and effective, there

would be upside to our investment forecast.

Inflation has been remarkably benign through the course

of 2011 due to (i) about 20% of CPI has been kept fixed as

there have been no upward adjustment in administrative

prices of electricity, fuel, toll road usage, and

transportation, (ii) food prices have been mostly flat or

declining owing to favorable weather and well executed

public procurement and disbursement programs, and (iii)

the stability of food and fuel prices have kept inflation

expectations in core prices in check. Inflation could be 4%

or less at the beginning of 2012.

We however don’t see this trend persisting for long.

Capacities are stretched, wage pressure has risen, and

demand is likely outpacing supply. Against this backdrop,

the government’s policy to keep interest rates ultra-low

encourages a bank lending boom (much of it will likely go

toward financing consumption). The practice of leaving

administrative prices unadjusted is bound to fuel demand-

push inflation. Also, we understand that some electricity

tariff adjustment and fuel price hike are on the cards,

which could unleash an unfavourable inflation dynamic.

Our forecasts see inflation heading above 6% next year.

Bank Indonesia has been unambiguously dovish through

the course of the year and will likely remain so in the first

half of 2012. Our official call is for no further rate cuts, but

if inflation surprises on the downside and global

conditions deteriorate, the central bank will not hesitate to

cut rates, given its track record.

This approach toward supporting growth as first

default could be problematic for the medium term.

The dovish approach to monetary policy pre-supposes

limited feedback from interest rate policy to inflation and

inflation expectations. We don’t subscribe to this idea,

and believe that inflation expectations could readily get

adjusted upward if rate cuts continue while growth

remains relatively strong.

The policy framework of the central bank is also an

important determinant of the exchange rate and bond

yields. This should be a moment for the rupiah and

Indonesia bonds to readily outperform the region, given

the economy’s comfortable external financing position. A

highly interventionist policy, however, has undermined

external investor sentiment by strenuously moderating the

moves in the exchange rate and bond yields.

We expect much of the external financial market

difficulties of 2011 to spill over to 2012. This means

periods of heightened risk aversion and dollar funding

shortage cannot be ruled out. The authorities would likely

need to intervene periodically to ensure that asset price

overshooting does not happen (in either direction) and

payments and settlements take place in an orderly

manner. But the interventions need to be market based,

transparent, and constructive. Some progress in this

direction would ensure financial market stability for years

to come, in our view.




Investment Strategy

Indonesia offers little value at these levels, particularly

on vol adjusted basis, and we stay defensive in our

exposure. But given the breakeven costs, and active

intervention by authorities (both in spot and bond markets),

it is also tough to carry anything more than a small

underweight position in this market. We see it therefore

more as a tail risk trade on both rates and FX, with the

possibility of gapping out in the event global conditions

worsen significantly, and/or policy errors get magnified.

Let’s have a look at the positives to start with, though –

the biggest one being the resilience of the economy’s

growth momentum as highlighted in the section above.

We would also count in this list a disciplined fiscal

strategy (though arguably more a reflection of lack of

spending); a strong cash position for the MOF (which

forms a part of the bond stabilization framework);

improved credit metrics; and a strong probability of

upgrade for sovereign ratings to investment grade by one

or possibly two agencies in 2012.

But with 10Y yields moving again towards 6%, and IDR

hugging 9000, the risk reward is hardly compelling. What

we don’t like in particular is, 1) the timing and quantum of

recent rate cuts by Bank Indonesia, given the backdrop of

a cyclically insensitive economy and possible increase in

inflationary risks again next year; 2) the concentration of

offshore ownership in the bond markets, and possible lack

of a similar level of sponsorship as in previous years; 3)

the dominance of BI as the main buyer of duration in this

market in the last couple of months; and 4) the failure of

BI’s spot intervention in calming market nerves.

Foreign investors own $24bn of government bonds,

equivalent to 30% of outstanding (and arguably double

the proportion of ‘floating stock’), and in the first eight

months of this year, had bought 82% of all net issuance.

They have in the last three months offloaded $3.6bn of

their holdings, 90% of which was picked up by Bank

Indonesia (which now carries a portfolio of $7.2bn). Local

banks picked up another $2.5bn, while other domestic

real money (insurers, pension funds, mutual funds) have

all been net sellers. With the pressure of issuance starting

again in January, the extent of offshore support for this

market will get severely tested again.

Inspite of a rapid build up in its reserves since 2008, we

note that Indonesia’s BOP sensitivity to stress situations

has not necessarily gotten any better. This is because

most of these reserves have been built on the back of a

growing concentration of offshore ownership of

Indonesia’s capital markets. See our Asia FX Strategy

Notes from 27th October for details.


Indonesia: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National Income


Population (mn) 240.8 243.7 246.6 249.6


Real GDP (YoY%) 6.1 6.5 6.3 6.5




Exports 14.9 13.9 8.5 8.5

Imports 17.3 12.8 7.9 7.9


CPI (YoY%) eop 7.0 4.0 6.5 6.6

CPI (YoY%) ann avg 5.1 5.4 5.7 6.5

Core CPI (YoY%) 4.3 4.5 5.5 6.0

Broad money (M2) 15.4 16.0 15.0 15.0

Bank credit (YoY%) 13.0 22.0 20.0 22.0


Budget surplus -0.6 -1.1 -1.4 -1.9







Trade balance 30.6 36.7 31.1 27.1

% of GDP 4.3 4.4 3.4 2.6


% of GDP 0.8 0.5 -0.2 -0.5

FDI (net) 10.7 9.1 9.6 12.0


FX rate (eop) IDR/USD 8991 9100 8950 8700



Domestic 14.7 15.0 14.1 13.5

External 12.3 11.0 10.8 11.0


in USD bn 180.0 200.0 220.0 240.0

Short term (% of total) 18.6 18.5 20.5 20.8

General


Unemployment (%) 7.1 7.0 6.8 6.5


BI rate 6.00 6.00 6.00 6.50

10-year yield (%) 6.25 6.50 6.70 7.00

IDR/USD 9100 9050 9010 8950




Malaysia A3/A-/A- Moody’s/S&P/Fitch

Economic outlook: Slower export growth will weigh

on investment spending and consumption cushioned

by continued easy monetary and fiscal policies.

Main risks: The main risks lie abroad, especially the

possibility of a deeper recession in Europe.

Strategy recommendations: Vulnerability to bond

market outflows keeps us cautious on rates (with a

steepening bias) and neutral on MYR.

Macro view

Surprising strength in Q3, but GDP growth will slow.

We estimate that GDP expanded 3.8%QoQ(saar) in Q3 up

from 2.4% in Q2. Compared to a year ago, growth rose

to 5.8% from 4.3% in Q2. We estimate that exports fell

3.8%QoQ(saar) in the quarter, but this was offset by

surprising growth in private and government consumption

and in investment. Broadly, our expectation is that as

exports continue to decline over the next few months,

domestic demand growth will suffer. While we are far

from forecasting a return to the extreme contractions of

2001 or 2008/09 we think export growth will start 2012 in

negative YoY territory and with a gradual recovery

thereafter the likelihood is that growth will be slightly

negative for the year as a whole. In such an environment,

we expect consumption growth – which has been running

well above long-run average recently – to slow down next

year. Private capital expenditures have historically been

heavily influenced by export growth will almost certainly

slow down in 2012.

Domestic and external demand in GDP

-20

-15

-10

-5

0

5

10

15

20

25

00 01 02 03 04 05 06 07 08 09 10 11

Dom demand Exports%yoy


Still, our forecast of 4.3% growth seems to us to be a

relatively positive one. Note that a backward-looking

estimate of Malaysia’s potential growth rate would put it

at about 4% although Bank Negara’s estimate is about

5%. With US and EU combined growth rising to about

2% in 2012 from about 1% in 2012 we see Malaysia’s

economy growing significantly faster in 2013.

Policies to remain supportive but not very stimulative

In the October budget, the government announced a

mildly contractionary policy – forecasting a deficit next

year of 4.7% of GDP versus 5.4% this year. While there

were lots of measures aimed at boosting demand, the

overall target for government expenditures is slightly

lower than the expected outcome this year. Our forecast

is for expenditures to come in slightly above target,

resulting in a deficit mildly higher than what was budgeted

but more importantly higher than this year’s forecast

deficit. So in that sense we think fiscal policy will be

slightly expansionary in 2012 but not aggressively so. We

think the government is committed to reducing its debt

burden in the medium term.

On the monetary side, while the risks are increasingly

weighted in the direction of rate cuts as inflation falls, we

don’t at this point think the central bank will cut rates. The

real policy rate is still negative today but we expect that

with subsidy cuts likely deferred to the second half of next

year inflation will fall to about 2% by mid-2012 from 3.4%

currently (3.3% excluding price-controlled items). Rate

cuts become possible, in our view, once real interest rates

turn significantly positive but our forecast is that by then

growth will have bottomed out obviating the need for rate

cuts. Clearly, some combination of slower growth and/or

lower inflation relative to our forecasts could change the

interest rate outlook.

Inflation and interest rate forecasts

-4

-2

0

2

4

6

8

10

06 07 08 09 10 11 12

CPI o/n policy rate%





Investment strategy

Rates: In FY12, we expect gross and net issuance of

bonds (MGS/GII) to be MYR89bn and MYR43.5bn

respectively. This is marginally lower compared to FY11.

We continue to be cautious in the MGS market due to its

vulnerability to capital outflows. As of end September,

foreigners had bought over 230% YTD of the net issuance

of MGS on the back of continuous inflows into EM local

currency debt funds. Even though our base case remains

that offshore inflows will continue to support the market

in 2012, systemic risks from Europe could result in these

inflows turning weaker. Given that net supply is roughly

the same next year; the onus will be on local players to

pick up the slack. At such rich levels, locals have not

shown a strong appetite for bonds despite ample liquidity

onshore and growing AUM of pension funds.

The upside risks to yield is mitigated by the dovish outlook

on monetary policy and weak growth prospects, which

could result in the domestic players allocating more

towards bonds compared to risky assets. Therefore, we

think sustained and sharp spike in back end yields are

unlikely even though curves could continue to steepen on

underperformance of the long end of the curve.

FX: We see the MYR as one of the more vulnerable

currencies to a deepening of the European crisis. First, the

ringgit is trading as a high beta currency to global risk

sentiment and the broad USD, in part because the central

bank is less active in smoothing FX volatility. Second, FX-

implied USD funding costs in the local market are at

exceptionally high levels, as asset swapping activities by

MYR bond issuers and investment outflows by locals have

picked up at a time when USD funding has tightened

globally. Third, foreign bond holdings remain at high

levels, and a pickup in EM fund redemptions could drive

further fixed income outflows from Malaysia.

That said, we note quite a couple of positive factors for

the MYR. Malaysia has one of the largest current account

surpluses in the region. Currency valuations are not

stretched, and the MYR REER is trading furthest below

the pre-97 crisis peaks. Exports are likely to slow as

external demand weakens, but the drag to growth from

exports would also be partly offset by the government’s

initiatives to kick start a few mega projects domestically.

Nominal rates differentials should remain in favour of MYR

assets, as BNM does appear to be in a hurry to ease

policy. In sum, our preference is to stay neutral the MYR

until external headwinds subside.

Arjun Shetty, Singapore, (65) 6423 5925


Malaysia: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National Income


Population (mn) 28.3 28.6 29.0 29.4


Real GDP (YoY%) 7.2 5.0 4.3 5.5




Exports 9.9 2.8 -0.2 5.2

Imports 15.1 4.1 -0.9 6.2


CPI (YoY%) eop 2.1 3.4 2.1 2.6

CPI (YoY%) ann avg 1.7 3.2 2.4 2.3

Broad money (M3) 8.3 10.8 11.1 9.3

Bank credit (YoY%) 10.7 10.6 9.7 8.6


Federal government surplus -5.6 -4.2 -5.0 -5.0



Primary fed. gov't fiscal

surplus -3.6 -2.0 -2.8 -2.7




Trade balance 41.8 45.7 41.2 43.3

% of GDP 17.5 16.6 14.4 14.0


% of GDP 11.5 11.4 9.9 9.3

FDI (net) -4.4 -4.0 -3.0 -3.0


FX rate (eop) MYR/USD 3.13 3.15 3.10 3.07



Domestic 51.0 50.3 52.3 53.6

External 2.2 1.9 1.7 1.5


in USD bn 73.4 74.0 70.0 69.8


General


Unemployment (%) 3.3 3.2 3.3 3.3


Overnight call rate 3.00 3.00 3.00 3.00


10-year yield (%) 3.75 3.80 3.80 3.90

MYR/USD 3.13 3.15 3.13 3.10




Philippines Ba2/BB/BB+ Moody’s/S&P/Fitch

Economic Outlook: Growth has slowed owing to a

weakening of external demand, but domestic demand

is likely to hold up as inflation declines, while

consumer and business sentiment remains resilient.

Main Risks: External demand could be weaker than

expected if the crisis in Europe deepens further.

Strategy Recommendations: Modest overweight

on duration into 2012. Peso to be more resilient than

regional FX.

More resilient to face external

headwinds

As expected, the ongoing global slowdown is pulling

down the Philippine economy. The key question is if the

economy could head toward near-zero growth in 2012

due to the drag from the Euro area, and possibly from

China, or if it would display a more resilient outcome. We

think that short of a severe exacerbation of the global

economy and markets, the Philippines should come

across as more resilient in 2012 relative to 2008.

The recently published third-quarter national accounts data

could be an apt illustration of the economy’s

vulnerabilities and strengths. Reflecting a sharp

contraction in trade and poor weather, the economy grew

by 3.2%yoy in Q3 (3.1% in Q2), in line with our forecast

(3.3%). The authorities have estimated that poor weather

subtracted 0.3% from growth in Q3 (agriculture sector

growth moderated to 1.8%yoy in Q3 vs. 8.2% in Q2). The

biggest drag was from the external sector, with exports

(which represent over 50% of GDP) declining by

13.1%yoy, a sharp deterioration from growth of 1.4% in

the previous quarter. With a view to 2012, the outlook will

remain grim for exports, with the Euro area expected to

undergo a recession and China’s domestic economy

slowing.

On the bright side, industrial production appears to have

stabilized owing to strong domestic demand. More

corroboration is found in the expenditure side data, which

show consumption rising by 7.1%yoy, up from 5.5% in

Q2. Investment rebounded strongly during the quarter,

rising by 24.5%yoy (vs. -7.7% in Q2). Within the segment,

growth in durable equipment rose sharply by 9.9% (up

from 1.0% in Q2) and the pace of decline in construction

investment eased to 10.6% in Q3 vs.-21.0% in Q2. With

remittances remaining resilient, the outsourcing sector

gaining momentum, domestic money and credit

conditions highly comfortable, and the government’s

public infrastructure spending program beginning to take

traction, the outlook for domestic demand is considerably

better than was the case in 2008/09.

Our growth forecasts for 2011 and 2012 (3.5% and 3%,

respectively) would have been at least 100bps lower if we

did not take solace from the resiliency of domestic

demand, driven by the factors discussed above. We also

think that public spending would be more supportive

next year as public-private infrastructure spending picks

up and the central bank takes monetary policy easing

measures (at least 50bps in rate cuts in Q1 2012, in our

view). BSP will be comfortable with the money and credit

situation in the economy due to ample liquidity, and hence

is unlikely to pursue policy measures aggressively.

We also expect inflation to ease next year as commodity

prices flatten out and growth falls below the potential

rate. We see considerable base-effect led disinflation in

Q1 2012, which could take inflation down by 100bps

during the quarter. BSP’s 3-5% inflation target is

comfortably achievable, in our view.

We expect remittances to be impacted only mildly in

2012, growing perhaps by 3-4%. Demand for overseas

Filipinos remains strong worldwide, and the 2008 crisis

showed that deployment of workers was not particularly

pro-cyclical. The marginal demand for overseas Filipinos

come from Asia and the Middle-East, where growth

would slow much less than in the industrial countries,

which would likely help.

The peso should be well supported. At a time when

rising risk aversion has caused a tightness in USD liquidity

worldwide, squeezing systems of payments and

settlements, the Philippines is an outlier, with an

exceptionally flush dollar liquidity position (thanks to

steady and sizeable remittance flows). Reserves are

ample to the extent of making the Philippines a net

creditor nation, so the currency is among the least

vulnerable in Asia, in our view.

We think that there are risks to the upside with

respect to our growth forecasts. If agriculture rebounds,

domestic consumption and investment sentiments remain

stable, and public spending gains traction, growth could

well surprise on the upside. By focusing on fiscal

consolidation, pursuing prudent monetary policy, the

Philippine authorities have established a strong macro

framework to deal with adverse economic shocks, and

2012 may well be a year when the economy’s improved

resiliency catches investor attention.




Investment Strategy

Rates: The key differentiating factor this year for the

Philippines was the improvement in fiscal performance.

While we would expect some payback to what was at

least in part a result of postponement of spending, we

should nonetheless see a gradual reduction in the fiscal

risk premium priced into the interest rate curve. Except for

its legacy EM-like nature, characterized mostly by the lack

of depth in the bond market which makes it vulnerable to

global risk sell offs, there is little else to fault in the rates

backdrop for the Philippines as we head into 2012. The

inflation outlook is comfortably benign; with BSP itself

forecasting average CPI in mid to low 3% range for the

next couple of years (food prices arguably are the biggest

risk to this outlook). BSP will likely be early within the

region to cut rates, while the currency remains less

sensitive to interest rate differentials, and more a function

of current account surpluses. The financing picture is

robust – ample domestic liquidity, tapped this year in part

also by two very successful retail issuances. We project

net issuance of FXTBs and retail bonds to in fact dip by

close to 20% year-on-year, with larger redemptions in the

pipeline. And very importantly, there is little immediate

vulnerability to the volatility in capital flows, except in the

case of GPNs. We think yields will grind lower towards

5.5% eventually, with the possibility of an overshoot in

response to BSP rate cuts. We suggest being positioned

modestly overweight on this market going into next year.

FX: The Philippine peso has weathered this year’s market

turmoil better than most Asian currencies – it is one of

only two Asian currencies which are trading up against the

USD year to date (the other being the RMB). Reasons for

the peso’s outperformance include stable growth in

remittances and outsourcing sector inflows, as well as

relatively more resilient portfolio inflows. We think these

factors should help the peso outperform in 2012 as well,

particularly if the Europe-related volatility continues. Our

recent BoP stress test reveals that the peso is one of the

least vulnerable currencies should market conditions turn

more adverse. We also see chances of a pick up in FDI if

the government manages to kick start the Public-Private

Partnership (PPP) infrastructure, given strong interests in

the scheme by foreign investors. Should capital inflows

pick up next year, the BSP may face constrains in FX

intervention, not least because of flush domestic liquidity.

Note that the BSP is the only Asian central bank talking

about relaxing outflows measures and tightening control

measures on inflows at this point. The main risk to this

view is if supply constraints cause commodity prices to

start heading higher again.



Philippines: Deutsche Bank Forecasts

2010 2011F 2012F 2013F

National Income


Population (mn) 92.5 94.8 97.1 99.6


Real GDP (YoY%) 7.6 3.5 3.0 4.5




Exports 21.0 -2.0 2.0 9.0

Imports 22.5 1.4 4.5 10.8

Prices, Money and Banking CPI (YoY%) eop 3.1 4.7 4.0 4.0

CPI (YoY%) ann avg 3.8 4.8 3.8 4.0

Core CPI (YoY%) 3.7 4.2 3.5 4.0

Broad money (M3) 9.8 9.0 9.5 10.0

Bank credit1 (YoY%) 8.9 13.9 12.5 13.0

Fiscal Accounts (% of GDP) National government surplus -3.5 -2.9 -3.2 -3.2



Primary surplus -0.2 0.6 0.1 0.3

External Accounts (USD bn) Merchandise exports 50.7 52.2 51.5 56.1


Trade balance -10.4 -15.5 -17.6 -19.9

% of GDP -5.2 -6.8 -7.2 -7.2


% of GDP 4.2 4.5 3.4 3.3

FDI (net) 1.2 1.3 0.1 0.5


FX rate (eop) PHP/USD 43.9 43.5 42.5 41.5

Debt Indicators (% of GDP) Government debt2 57.6 56.4 55.2 54.0

Domestic 30.4 30.0 30.1 29.8

External 27.3 26.4 25.2 24.2


in USD bn 70.0 72.0 76.0 80.0


General Industrial production (YoY%) 15.6 3.0 6.0 6.0

Unemployment (ILO) (%) 8.1 7.9 7.7 7.7


BSP o/n repo 6.50 6.00 6.00 6.00

BSP o/n reverse repo 4.50 4.00 4.00 4.00

3-month treasury bill 2.89 3.50 4.00 4.55

10-year yield (%) 5.88 5.70 5.50 5.50

PHP/USD 43.8 43.4 43.1 42.5


Note: (1) Deposit money bank credit to the private sector. (2) Incl. guarantees on SOE debt.



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

Economic Outlook: Slower global growth means

much slower growth in Singapore in 2012, but

sharply lower inflation as well.

Main Risks: Singapore is Asia’s most export-

sensitive economy, so macro risk derives mainly from

the US and Europe.

Strategy Recommendations: SGS has strong

technicals but rich valuations. Expect the yield curve

to flatten in 2012. Trade SGD NEER in a range.

Macro View

Asia’s highest-‚beta‛ economy. As export volumes

have stagnated in recent months so too has the economy.

We estimate that exports of goods and services fell

4.5%QoQ(saar) in Q3 after falling 5.3% in Q2 – more than

enough to offsetting the previous two quarters’ growth.

So, not surprising given that exports are more than double

the size of GDP, GDP growth has essentially stalled as

well. While GDP did expand at a 1.9% annualized rate in

Q3, this followed a 6.4% rate of decline in Q2. Given the

volatility of economic data in Singapore even quarterly

forecasts are difficult but we can with great confidence

say that the economy will simply follow where exports

lead. Over the past 15 years the correlation between

growth in (gross) exports and goods and services and

GDP has been 0.87.

Exports of goods and services and GDP

-20

-15

-10

-5

0

5

10

15

20

25

30

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

GDP Exports%yoy


So the key question for Singapore is: what drives

exports? As we argued recently1 it does not appear that

China is yet an important source of final demand for

Singapore’s exports – at least compared with the US and

1See ‚China is a weak engine of growth for Asia,‛ in Global Economic

Perspectives, September 10, 2011.

Europe. So, with Euroland in recession and the US

growing at a stable 2.0% - 2.5% rate we expect to see

slower export growth next year compared with this year

and therefore slower GDP growth. But similarly, the

recovery in Euroland and possibly faster US growth in

2013 should see the Singapore economy bounce back

sharply.

Inflation to fall rapidly in 2012/13 With slower global

growth will come lower inflation. Indeed, the inflation

impulse has already weakened. The 3m/3m seasonally

adjusted rate of change in the CPI is 1.2% versus a YoY

rate of inflation of 5.4%. Global wholesale food prices

have broadly been in decline since April – the YoY change

in the IMF’s food price index has fallen from 33.4% to

1.4% over the past six months. Similarly, crude oil prices

have essentially been stable for the past seven months,

taking the YoY rate of change down from above 50% in

July to about 30% currently. If, as we expect, oil prices

remain stable for the next six months then of course oil

price inflation will vanish.

We are confident that we’ve seen the worst of property

price inflation and that prices may actually decline next

year. However, that won’t necessarily translate into the

CPI. We think the CPI lags market prices by at least six

months, but when property prices fell 24%yoy in mid-

2009 the accommodation component of the CPI for 2009

recorded at most a 3%yoy fall. So, we assume the CPI

measure of accommodation costs stops rising after mid-

2012 but doesn’t decline.

Inflation and interest rates

-2

0

2

4

6

8

06 07 08 09 10 11 12

Inflation 3m SGD Sibor%


Still, as inflation falls – and the risks to our forecast are,

we think, to the downside – real interest rates will rise

sharply, adding further downward momentum to GDP.




Investment Strategy

Rates: For 2012, we estimate a gross issuance of

SGD24.7bn for SGS and 1Y T-bills. Accounting for the

maturities of SGD20.4bn; we expect the net issuance to

be SGD4.3bn which is more or less in line with previous

years. The technicals in this market are very healthy

however valuations do appear rich. Any sustained

improvement in risk sentiment could cause a significant

back up in yields from current levels. However, we still

think that there are factors which lend some degree of

comfort on this front. 1) With over EUR600bn of

refinancing needs for Italy and Spain in 2012, and ECB

reluctant to finance state deficits, systemic risks from

Europe will continue to dampen risk sentiments and keep

a bid on save haven assets 2) Most of the foreign holdings

in SGS are concentrated at the front end of the curve

which means that FX exposure dominates duration

exposure. With SGD NEER close to the bottom of the

band, downside on the currency is ultimately capped by

MAS. 3) Liquidity ratio of banks is close to all time lows

which mean that despite the rich yield levels, banks are

likely to continue buying SGS/T-bills. The risk to this view

could come from a strong rebound in growth in US and/or

a change in stance by ECB on financing state deficits.

Arjun Shetty, Singapore, (65) 6423 5925

FX: The SGD was the top currency pick for the macro

community earlier this year, but it has fallen from grace to

become the worst performing Asian currency after the

INR lately. We think there are a few reasons for SGD’s

underperformance: 1) investors paring back bullish bets

on policy expectations, 2) impact of deleveraging by

European banks, and 3) less active MAS intervention

within a relatively wide band (+/-3% around mid-point).

While the initial weakness in the SGD can be explained by

a washout of speculative positions in late September, we

suspect that deleveraging by European banks have started

to impact the SGD more significantly, given Singapore’s

status as a financial centre. Currencies of countries with a

higher exposure to European banks (i.e. SGD, KRW, PHP,

IDR and MYR) have underperformed this month, while

currencies of countries with a lower exposure (CNY, TWD,

THB) have been more insulated from the European

contagion. This could limit SGD's recent bounce, even

though it is still trading in the lower half of the policy band

(about 1.5% above the bottom band). A slowdown in

global growth and inflation would also increase the

chances of another round of policy easing by MAS in

April. We favor a more range-trading approach to SGD

NEER (within the lower band).


Singapore: Deutsche Bank Forecasts

2009 2010 2011F 2012F

National Income


Population (mn) 5.2 5.3 5.4 5.5


Real GDP (YoY%) 14.5 5.0 2.5 4.8



Gross fixed investment 5.1 0.7 -7.1 -0.1

Exports 19.2 1.4 0.0 6.4

Imports 16.6 1.4 -0.9 6.2


CPI (YoY%) eop 4.6 5.3 1.2 1.0

CPI (YoY%) ann avg 2.8 5.2 2.6 0.9

Broad money (M2) 8.5 10.4 10.6 9.8

Bank credit (YoY%) 9.6 24.7 10.9 1.6


Fiscal balance 5.1 8.0 6.6 7.3






Trade balance 46.8 50.8 51.8 57.1

% of GDP 21.0 19.7 19.5 19.6


% of GDP 22.2 19.1 18.5 20.3

FDI (net) 19.1 19.8 10.0 8.0


FX rate (eop) SGD/USD 1.31 1.30 1.25 1.20


Government debt 105.8 107.2 110.4 113.3

Domestic 105.8 107.2 110.4 113.3

External 0.0 0.0 0.0 1.0


in USD bn 513.6 600.0 580.0 550.0


General


Unemployment (%) (eop) 2.2 2.1 2.6 2.8



10-year yield (%) 1.70 1.75 1.80 1.90

SGD/USD 1.28 1.28 1.27 1.25


Note: includes external liabilities of ACU banks.



South Korea A1/A/A+ Moody’s/S&P/Fitch

Economic Outlook: We see South Korea’s growth to

follow the G2 cycle, reporting a below trend growth

of 3.4% in 2012, followed by a notable rebound to

4% in 2013.

Main Risks: The sovereign debt crisis in Euroland

pose serious downside risks to growth.

Strategy Recommendations: We look for further

steepening on the KTB curve. Concerns about lack of

reinvestment demand from offshore fund investors

should reduce, which is supportive of 2Y-3Y segment.

Macro View

Growth thus far this year has been broadly in line with

expectations, driven by exports… Performance of the

South Korean economy was broadly in line with our

forecast in terms of the headline numbers. A year ago, we

forecasted that the economy would grow by 4.0% in 2011

and it expanded 3.7%yoy ytd in Q3 2011. On the other

hand, there were some notable differences in detail, with

exports outperforming our expectations and domestic

demand proving to be weaker than our forecast noted a

year ago. In particular, we saw export growth of

11.9%yoy ytd in Q311, vs. our earlier forecast of 6.3%

growth for the whole year, while private consumption

expanded 2.7% and investment contracted 1.7% in 2011,

vs. our forecasts of 3.4% and 4.3%, respectively, noted a

year ago. The contraction in overall investment was largely

due to construction investment.

GDP growth supported by domestic demand

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

2007 2008 2009 2010 2011F 2012F 2013F

Net exports Stocks

Investment Govt

PCE GDP

% contribution to growth


Slowing G2 demand points to weaker South Korea

growth in 2012… Looking forward, we see weaker G2

growth, at 1% in 2012 vs. 1.7% in 2011, guiding South

Korea’s export growth lower, to 5.5% in 2012 from 10.6%

in 2011, with the net trade contribution to growth falling

to 1.0% from 2.0% in the same period. In comparison, we

expect private consumption to remain relatively stable,

supported by lower inflation, contributing 1.2% to overall

growth in 2012, vs. 1.3% in 2011. Meanwhile, we expect

recovery in construction to guide overall investment

higher, expanding 2.8% in 2012, after contracting 1.3% in

2011. As a result, we see investment adding 0.7% to

overall growth in 2012, after subtracting 0.4% in 2011,

while private consumption contribution should fall slightly,

to 1.2% in 2012 from 1.3% in 2011.

Export growth to slow…

30

35

40

45

50

55

60

65

-40

-30

-20

-10

0

10

20

30

40

50

2004 2005 2006 2007 2008 2009 2010 2011

SK exports

US ISM (rhs)

%yoy Index


…guiding facility investment lower… Facility

investment growth continued to fall relatively sharply, to

1.4% in Q311, despite a relatively stable export growth of

9.5% in the quarter. In light of the slowdown in 2011, we

expected further weakness in facility investment growth

to be limited to 1.7% in 2012, down from 5.4% in 2011,

especially as the operation ratio remains high at 104.3 in

October. This would add 0.2% to overall growth in 2012,

vs. 0.5% in 2011. On the other hand, we do not expect a

notable pick up in facility investment in 2012 amid weak

export growth and poor business sentiment. The latter

continued to fall in December, to its lowest level since

early 2009, led by concerns about export weakness and

inventory accumulation.

…weighing on facility investment growth

-30

-20

-10

0

10

20

30

40

2002 2004 2006 2008 2010

Facility Investment

Exports

%yoy




...while private construction investment recovers… In

contrast, we expect construction investment to expand

2.3% in 2012, after contracting 6.3% in 2011, adding

0.3% to growth in 2012, vs. -1.0% in 2011, as the

government seeks to increase housing in response to

rising rental prices. Construction investment fell 7.6% in

the first three quarters of this year, after contracting 1.4%

in 2010, led by weakness in residential building.

…while housing construction to recover

-30

-20

-10

0

10

20

30

40

2002 2004 2006 2008 2010

Non-residential Building Construction

Residential Building Construction

%yoy


...in response to rising rental prices… While purchasing

prices have moved sideways in Seoul, rental prices

continued to move upward, as households hold off on

home purchases, expecting a notable fall in housing prices

ahead. As households opted for rent, the jeonse (rental)

prices continued to rise, constituting 50.5% of purchasing

prices in October 2011, after bottoming at 38.2% in

January 2009.

…in response to rising rental prices

50

55

60

65

70

75

2001 2003 2005 2007 2009 2011

Jeonse to Purchase Price

%


Housing prices (rental this time) remain a source of

concern for the authorities. They continue to face a

difficult task of limiting rental price inflation by providing

more supply while preventing a sharp correction in the

housing market. We expect a more decisive policy

response on the issue in 2012. Furthermore, government

measures to alleviate households debt burden pose

upside risks to our private consumption growth outlook.

Private consumption growth to slow, modestly…

Payrolls continued to expand in October, by 1.7%yoy

3mma, supporting private consumption despite high

inflation. Private consumption rose 2.7% in the first three

quarters. Looking forward, we see private consumption

growth to weaken further, to 2.4% in 2012 from 2.6% in

2011, as a result of weaker payrolls gain. On the other

hand, we also see falling inflation to support real wage

income growth, which stood at -3.4%yoy in Q311, as

inflation averaged 4.3%. We note that consumer

sentiment improved in November, as a result of

anticipation of falling inflation and interest rates. In

particular, consumer inflation expectation fell to 4.1% in

November from 4.2% in October.

…amid persistent payrolls gain

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

-6

-4

-2

0

2

4

6

8

2005 2006 2007 2008 2009 2010 2011

PCE

Employment (rhs)

%yoy %yoy 3mma


…supported by falling inflation... The trend in CPI

inflation remains downward, at 4.0%yoy 3mma in

October, vs. 4.3% in September. This fall was led by food

price inflation, which fell to 6.4% from 9.1% in the same

period. We note that the Korean Statistical Information

Service (KOSTAT) rebased the consumer price index in

November to better reflect recent economic and social

changes and introduce established international standards

and advanced statistical techniques. The KOSTAT deleted

eight items from the basket, including Korean costume,

camcorder, electronic dictionary and gold ring. As a result,

the new series left headline CPI inflation 0.4ppts lower, at

4.0%yoy ytd in October.

Inflation to fall

0

1

2

3

4

5

2009 2010 2011 2012

CPI Forecast%yoy




Looking ahead, we expect inflation to fall to 3.4% in 2012

from 4.0% in 2011, as a result of moderation in food price

inflation and below-trend growth. We note that the IMF

food price inflation has fallen 11.3%yoy 3mma in October,

after reaching its recent peak of 34.3% in April,

suggesting that imported food inflation will be limited.

Meanwhile, our commodity analysts expect little change

in oil prices in 2012 – only 3.5% increase in Brent oil

prices from this year.

Taylor rule model in line with our rate call

1

2

3

4

5

6

00 01 02 03 04 05 06 07 08 09 10 11 12

Actual Forecast Taylor%


…points to no rate change by the Bank of Korea until

2H 2013... Weaker growth and falling inflation point to no

rate change by the Bank of Korea (BoK) in 2012. We do

not expect rate hikes by the BoK until mid-2013. Given our

growth and inflation projection, our Taylor rule model

suggests that the BoK rate is where it should be.

Moreover, risks to rates remain to the downside, as

conditions in the G2 economies – Euroland in particular –

remain precarious, at best. Moreover, given Korean

households’ high gearing ratio (worse than their

counterparts in the US), lower rates would reduce the

household debt servicing burden. The fifth percentile

(lowest) income group’s debt servicing ratio stood at

20.4%, vs. the nation’s average of 11.5% in 2010.

Debt servicing ratio by income group

11.5

20.4

14.7

12

9.4 9.1

0

5

10

15

20

25

Total 1st quintile 2nd 3rd 4th 5th

%

Sources: OECD, Bank of Korea

…while the sovereign debt crisis in Europe check the

won’s gain. Despite large current account surpluses, the

won remained vulnerable to the sovereign debt crisis in

Europe. In response to the sharp increase in risk aversion,

capital outflows rose sharply in September, rendering the

won 10.4% weaker against the US dollar. In particular,

while South Korea’s current account surplus widened to

USD3.1bn in September, up from USD0.3bn in August, its

capital account deficit rose to USD4.7bn in September

from USD1.7bn in August, due to deterioration in ‚other

investments‛. The latter reported a net outflow of

USD17.1bn in September vs. a net inflow of USD4.6bn in

August, as a result of outflows of trade credit, FX loans

and deposits. In contrast, portfolio investment rebounded

in September, registering a net inflow of USD1.8bn vs. a

USD2.9bn outflow in August. FX reserves fell to

USD303.4bn in September, from USD312.2bn in August,

as a result. On a positive note, the Korean authorities

expanded FX swap lines with their Chinese and Japanese

counterparts, resulting in their increase to about

USD125bn combined.

Capital flow weighs on the won…

-20

-15

-10

-5

0

5

10

15

20

2008 2009 2010 2011

Fgn net purchase of debt securities

Fgn net purchase of equity securities

Fgn other investment

USDbn


We note that South Korea’s current account surplus

widened further in October, to USD4.2bn from USD2.8bn,

driven by the goods account. Meanwhile, the financial

account, excluding reserve assets, reported a surplus of

USD4.3bn in October vs. the USD17.2bn deficit reported

in September, as other investments stood at a surplus of

USD2.96bn in October vs. a deficit of 16.8bn in

September. Looking forward, we see the sovereign debt

crisis in Euroland and deleveraging by its banks to

continue to weigh on the won for the early part of 2012,

especially as South Korea’s current account reports a

deficit, temporarily in Q1, due to seasonal effects.

However, as mentioned earlier, with a much larger FX

reserve of USD311bn in October (225% and 79% of

short-term and total FX debt outstanding in Q311), and

USD125bn of FX swaps, we see limited volatility in the

won in 2012.



…despite the positive fundamental

-5

-3

-1

1

3

5

7

-50

-30

-10

10

30

50

70

2007 2008 2009 2010 2011

Trade Balance (rhs)ImportsExports

USD bn%yoy 3mma


Juliana Lee, Hong Kong, (852) 2203 8305

Investment strategy

Local rates: Given the strong technicals, we maintain our

moderate bullish steepening view with a target on 10Y

KTB yields of 3.75% by year end. Concerns over lack of

reinvestment demand from offshore investors have

reduced, which is supportive of 2Y-3Y segments. We also

see December KTB issuance plan of KRW6.5tn as an

indicator of the likely KTB issuance pattern in 2012, with

increased allocations towards the 10Y and 20Y KTBs,

given large maturities in 2014 (KRW56.6tn). Asian central

banks remain key on the demand side, having bought

USD9.9bn (net) till September this year. It is less than

certain if they would buy an equivalent amount in 2012. To

that extent, we think swaps would outperform bonds,

especially in the long-end. The risk on BOK is skewed

towards the possibility of a rate cut if global conditions

worsen. With milder RRR regulation, the spread between

the 91D CD rates and the policy rate could also gradually

tighten towards the year's low of 23bp. This will likely

cause swaps to outperform bond equivalents, which

would be more pronounced in the long end as rolldown

and carry for the front-end swap receivers is expensive.

The risk to this view could be radical household measures

aimed at shifting more household debt into fixed rate

loans. Such measures would reduce the interest from

banks to receive long end swaps.

FX: The won’s high beta to global risk sentiment appears

to be the only reason to be underweight this currency at

this juncture. Even so, we note that the won is now less

sensitive to global USD funding conditions, not least

because Korean FIs have reduced their dependence on s/t

external funding in recent years. A strong current account,

cheap currency valuations, a positive carry and growing

foreign demand for Korean bonds are reasons to retain a

core medium-term bullish view on the currency.

Kiyong Seong, Hong Kong, (852) 2203 5932

South Korea: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National income

Nominal GDP (USDbn) 1015 1115 1165 1280

Population (m) 48.8 48.9 49.0 49.1


Real GDP (YoY%) 6.2 3.7 3.4 4.0



Gross fixed investment 7.0 -1.3 2.8 3.5

Exports 14.5 10.6 5.5 9.8

Imports 16.9 7.6 4.4 8.7


CPI (YoY%) eop 3.0 4.1 3.1 4.3

CPI (YoY%) ann avg 2.9 4.0 3.4 3.5

Broad money (M3) 9.5 8.0 8.5 9.0

Bank credit (YoY%) 3.4 6.8 7.0 7.0


Central government surplus 1.4 1.6 0.3 0.3







Trade balance 41.9 32.1 14.9 20.1

% of GDP 4.1 2.9 1.3 1.6


% of GDP 2.8 2.3 0.7 1.2

FDI (net) -19.4 -11.0 -10.0 -13.0


FX rate (eop) KRW/USD 1135 1120 1080 1050


Government debt1 35.2 34.7 34.2 33.9

Domestic 34.3 33.9 33.4 33.1

External 0.9 0.8 0.8 0.8


in USD bn 359.4 395.0 288.0 286.0


General


Unemployment (%) 3.7 3.4 3.4 3.3

Financial markets Current 3M 6M 12M

BoK base rate 3.25 3.25 3.25 3.25

91-day CD 3.60 3.60 3.60 3.70

10-year yield (%) 3.80 4.00 4.10 4.20

KRW/USD 1143 1130 1100 1080 Source: CEIC, Deutsche Bank Global Markets Research, National Sources

Note: (1) FX swap funds unaccounted for. (2) Includes government guarantees..



Sri Lanka B+(Pos)/BB- S&P/Fitch

Economic Outlook: Real GDP growth likely to

moderate to 7.5% in 2012 (from 8% in 2011), led by

a negative base and weak external demand.

Main Risks: There is a non-trivial risk that the

ongoing fiscal consolidation process suffers a

setback, in the event of any external shock, that

threatens to lower growth below 7% in 2012.

Growth to moderate to 7.5% in 2012

Through 2011, the Sri Lankan economy has shown

exceptional resilience, despite a highly unsupportive

global environment and severe flooding in early part of the

year, which affected domestic agricultural production

substantially. Notwithstanding these adversities, the

economy will likely record 8% real GDP growth in 2011

(same as in 2010), aided by an acceleration in non-farm

sector growth to 9.0%, up from 8.2% in 2010. But will Sri

Lanka manage to record 8% growth for the third year in a

row in 2012? We think it is unlikely. Our estimates show

that non-farm growth momentum in Sri Lanka is likely

to moderate in 2012 (to about 7.8%), led by a negative

base and weak external demand, which should drag

overall growth to around 7.5% (the government expects

growth to be around 8.5-9.0% in 2012). In contrast,

agricultural sector growth is likely to be supportive,

bouncing back from a low base of this year. Note that our

base case growth forecast of 7.5% assumes an orderly

resolution to the present debt crisis in EU. However, if the

EU crisis were to unfold in a disorderly fashion, downside

risk to growth could rise appreciably, through the trade

and confidence channel. In such a scenario, the central

bank would cut rates aggressively and the government

would likely compromise on its fiscal consolidation goal to

ramp up public spending, in an effort to prevent growth

from heading below the 7% mark.

Resilient growth despite various adversities

0

2

4

6

8

10

12

2007 2009 2010 2011

Real GDP Non-farm GDP% yoy

Source: CEIC, CBSL, Deutsche Bank

Inflation to stay in mid single digits

CPI inflation moderated to 4.7% in November, after

peaking at 8.8% in April of this year. We forecast CPI

inflation to moderate further, led by lower food inflation

and stable fuel prices, to end the year around 4.0%, which

should lead to an annual average inflation rate of 6.7% for

2011 (up slightly from 6.2% in 2010). Core inflation should

also moderate to around 4.5% by year-end. The inflation

trajectory should remain favorable through the first half of

2012 as well, after which CPI inflation should rise to touch

7.5% by end-2012. Overall, we expect inflation to

average 5.5% in 2012, barring any supply shocks.

This benign inflation trajectory should have allowed the

Central Bank of Sri Lanka (CBSL) to cut interest rates to

support growth, especially in an environment, where the

government is expected to continue with its fiscal

consolidation process and given potential growth risks

due to heightened global uncertainty. But broad money

supply (20.7%yoy) and bank credit growth (34.4%yoy)

remains exceptionally high, indicating strong demand side

pressures. Perhaps owing to this, the CBSL Governor

Ajith Cabrral recently described the current monetary

policy stance as ‚appropriate‛, thereby signaling that

the central bank is not yet ready to cut the policy rate or

the reserve ratio immediately.

But we think that there is a possibility for this stance

to change in the first quarter of 2012, as i) inflation

moderates further in the coming months; ii) credit growth

eases; iii) 4Q 2011 GDP growth falls below 8%; and iv)

global conditions worsen. Consequently, we factor in two

25bps rate cuts, each in the first and (early) second

quarter, which should take the reverse-repo rate to 8% by

mid-2012, from the current 8.50% levels.

Colombo CPI and core CPI inflation forecast

0

2

4

6

8

10

12

2009 2010 2011 2012

CPI CPI proj.

Core CPI Core CPI proj.

% yoy

Source: CEIC, CBSL, Deutsche Bank



Fiscal consolidation will be challenging

We think the 2012 budget deficit target of the Sri Lankan

government (6.2% of GDP) is slightly on the optimistic

side. While the expenditure target seems broadly

reasonable, we think the government is overestimating

likely revenue outturn, based on its expectation of 8.5-

9.0% real GDP growth for 2012, which is unlikely in our

view. Further, while the various expenditure targets look

realistic in line with the past trend, there is a non-trivial risk

that those targets could be breached, in the event growth

starts slowing sharply. In such a scenario, the Sri Lankan

authorities could decide to sacrifice the fiscal targets by

boosting expenditure, to give impetus to growth. Given

these various risks, our base case scenario therefore

builds in a budget deficit forecast of 7.0% of GDP

(unchanged from 2011 levels), with further upside risks

likely, if global conditions worsen. Consistent with our

budget deficit forecast, we expect the debt-GDP ratio to

edge lower to 75.1% in 2012, from a likely 78.5% in 2011.

Deutsche Bank vs. Government forecast for 2012

% of GDP 2010 2011 2012 DB

forecast

2012 budget

forecast

Total revenue and grants 14.9 14.3 14.3 15.0

Total expenditure 22.9 21.4 21.3 21.2

Recurrent 16.7 15.6 14.8 14.7

Capital and net lending 6.1 5.8 6.5 6.5

Budget deficit -8.0 -7.0 -7.0 -6.2

Source: Department of Fiscal Policy, Deutsche Bank

Rupee likely to appreciate in 2H 2012

Post the devaluation of the rupee by 3% on 21 November,

the LKR is currently trading at 113.9 levels versus the

dollar, as against 110.4 previously. The central bank

governor has assured market participants that there

will be no further sharp depreciation of the rupee in

the immediate future, although risks remain, in our

view. We expect the rupee to depreciate further to 114.5

levels by mid-2012 as dollar strength intensifies in the

coming months. However, there could be a bigger

depreciation risk to the rupee if the BOP position worsens

significantly from our baseline forecast (we forecast

current account deficit to be 4.9% of GDP in 2012, and

overall BOP surplus to be 0.8% of GDP ), led by a severe

external shock. Without an external shock, we expect the

rupee to reverse course in the second half of 2012, and

appreciate to 112.5 levels by end-Dec 2012.

Kaushik Das, Mumbai, (91) 226658-4909

Sri Lanka: Deutsche Bank Forecasts

2010 2011F 2012F 2013F

National Income


Population (mn) 20.7 20.9 21.1 21.3


Real GDP (YoY %) 8.0 8.0 7.5 8.0

Total consumption 8.6 8.6 8.2 8.3

Total investment 8.0 9.2 8.7 10.0

Private 7.0 9.0 8.0 10.0

Government 12.0 10.0 11.0 10.0

Exports 9.0 12.0 10.0 11.0

Imports 10.0 13.0 11.5 12.0


CPI (YoY%) eop 6.8 4.1 7.6 6.3

CPI (YoY%) avg 6.2 6.7 5.6 6.7

Broad money (M2b) eop 15.8 19.0 15.6 15.5

Bank credit (YoY%) eop 24.9 28.2 15.4 13.4


Central government balance -8.0 -7.0 -7.0 -6.5







Trade balance -5.2 -7.4 -8.0 -9.6

% of GDP -10.5 -12.8 -12.4 -12.7


% of GDP -2.9 -5.6 -4.9 -5.2

FDI (net) 0.4 0.8 0.8 1.0


FX rate (eop) LKR/USD 111.0 113.9 112.5 111.0



Domestic 45.8 44.3 42.4 40.3

External 36.1 34.2 32.7 31.2


in USD bn 21.4 24.0 26.0 28.0


General

Industrial production (YoY %) 10.4 3.8 7.6 7.4

Unemployment (%) 4.9 4.8 4.7 4.5


Reverse Repo rate 8.50 8.25 8.00 8.00

LKR/USD 113.9 114.2 114.5 112.5 Source: CEIC, DB Global Markets Research, National Sources



Taiwan Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic Outlook: With exports at 74% of GDP,

we see weak G2 growth of 1% in 2012, vs. 1.7% in

2011, guiding Taiwan’s growth lower to 3.0% from

4.4% in the same period.

Main Risks: Risks to our rates outlook remain to the

downside amid the sovereign debt crisis in Euroland.

Strategy Recommendations: We believe TWD

interest rate swap curve is unlikely to break its recent

range in the next three months unless CBC surprises

the market with cuts in the policy rates. We

recommend to hold paying the belly in TWD 2x5x10

notional neutral butterfly position.

Macro View

Weak exports to depress growth in 2012… We see

Taiwan’s GDP growth slowing to 3.0% in 2012 from 4.4%

in 2011, as export growth remains weak. After soaring to

25.7% in 2010, we see export growth slowing to 5.0%

this year and 4.2% next year. In 2012, we see Taiwan’s

growth coming under further pressure, as G2 (US/EU)

growth should slow sharply, to 1.0% from 1.7% this year.

As for the growth dynamics, we see Taiwan’s growth

bottoming at 1.7% in Q1 2012, as export growth troughs.

The latter will also push private consumption growth

lower, to 2.6% in 2012 from 3.1% in 2011, further

depressed by negative wealth effects of lower stock

prices. Note that the securities share of households’ total

assets (including fixed assets) stood at 18.6% (in 2009).

We note that consumer sentiment continued to decline in

November 2011 to 80, below the 12mma of 84.9, after

peaking in August at 87.

GDP growth to bottom in Q1

-30

-20

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0

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20

30

40

50

-10

-5

0

5

10

15

2007 2008 2009 2010 2011 2012 2013

GDP (lhs) GDP Forecast

Exports Exports forecast

%yoy%yoy

Source: CEIC and Deutsche Bank

On average, we see private consumption contribution to

growth falling to 1.4% in 2012 from 1.7% in 2011, while

the net trade contribution also declines to 2.6% from

3.6% in the same period. The latter in turn points to

sustained weakness in investments in 2012, providing no

support to growth in 2012, albeit better than the -0.6% in

2011. Meanwhile, we believe inventory destocking will

likely continue to weigh on growth, by 1.1% in 2012 vs.

0.3% in 2011.

Net export contribution to growth to fall

-10

0

10

20

2007 2008 2009 2010 2011F 2012F 2013F

PCE Govt Investment

Stocks Net exports GDP



The Central Bank of China to stay on the sidelines

until 2H 2013, with risks to the downside. We expect

CPI inflation to ease modestly in 2012 to 0.9% from 1.3%

in 2011, as food price inflation eases and oil price increase

remains limited. We note that the IMF food price inflation

has fallen 11.3%yoy 3mma in October, after reaching its

recent peak of 34.3% in April, suggesting that imported

food inflation will be limited. Meanwhile, our commodity

analysts expect little change in oil prices in 2012 – only

3.5% increase in Brent oil prices from this year. Moreover,

housing price inflation continued to fall in 2011, as has

credit growth, after peaking in April 2011 at 8.7%yoy

3mma. While we expect no rate change by the CBC until

2H 2013, we see risks to our rates outlook to the

downside amid falling inflation and weak growth.

Inflation to fall modestly

-3

-2

-1

0

1

2

3

4

2009 2010 2011 2012

CPI Forecast%yoy


Meanwhile, low rates and weak exports point to only a

limited appreciation of the TWD in 2012. Weak exports



suggest a narrower current account surplus of 7.6% of

GDP, although still high compared to its peers. Moreover,

although risks to growth, rates and the TWD remain to the

downside due to the sovereign debt crisis in Euroland, we

see a relatively stable TWD – compared to the KRW, for

example – as Taiwan remains a net investor to the world.

We also note that its FX reserve of USD393.3bn in

October stood more than three times its total external

debt of USD124.6bn (in Q211).


Investment strategy

Rates. We believe TWD interest rate swap curve is

unlikely to break its recent range in the next three months.

A potential near-term catalyst is any surprise cuts in the

policy rates, which could be justified if domestic growth

slowdown is a more material threat than the upside risk

on inflation.

Currently the market is pricing in the scenario that CBC

will remain on hold for the next 12 months, which is in line

with our expectation. We are less convinced on the

directional risk on the IRS curve in the near-term and we

prefer to maintain our TWD 2Y/5Y/10Y butterfly spread.

FX. We think gains in TWD will lag regional currencies in

2012 and thus prefer to use it as a funder for intra-region

trades. The main argument is that Taiwan’s exports

growth has slowed considerably, and that central bank’s

FX policy has tended to be motivated by cyclical factors.

The Taiwanese government is the first in the region to

have announced an economic stimulus package, including

measures to help the exports sector. With headwinds to

exports still growing and layoffs (unpaid leave for workers)

on the rise, we think CBC is likely to intervene more

actively to slow gains in the currency to provide support

for the exports sector. One key risk for the TWD in 2012

is the presidential elections. A change in political

leadership could potentially slow economic integration

with the mainland, a key economic development that has

provided significant support to Taiwan’s economic activity

and BoP (exports, tourism inflows, freight and passenger

transportations services, etc.) in recent years.


DennisTan, Singapore, (65) 6423 5347

Taiwan: Deutsche Bank’s forecasts

2010 2011F 2012F 2013F

National Income


Population (m) 23.2 23.2 23.3 23.4


Real GDP (YoY%) 10.9 4.4 3.0 4.4


Government consumption 1.8 -0.4 1.0 1.4

Gross fixed investment 23.4 -3.1 -0.3 3.7

Exports 25.7 5.0 3.9 9.1

Imports 28.2 0.2 0.6 9.6


CPI (YoY%) eop 1.2 1.0 0.6 1.9

CPI (YoY%) annual average 1.0 1.3 0.9 1.1

Broad money (M2) 4.5 6.0 6.0 7.0

Bank credit1 (YoY%) 5.3 5.8 4.0 6.0


Budget surplus -2.4 -3.2 -3.4 -2.3







Trade balance 26.5 25.4 22.5 20.3

% of GDP 6.1 5.3 4.8 4.0


% of GDP 9.2 8.6 7.6 6.7

FDI (net) -9.1 -15.0 -13.0 -13.0


FX rate (eop) TWD/USD 30.3 30.0 29.0 27.5


Government debt2 40.5 43.3 46.2 47.5

Domestic 38.7 41.4 44.3 45.6

External 1.9 1.8 1.9 1.8


in USDbn 101.6 130.0 145.0 155.0


General


Unemployment (%) 5.0 4.4 4.4 4.4

Financial markets Current 3M 6M 12M

Discount rate 1.88 1.88 1.88 1.88

90-day CP 0.80 0.80 0.80 0.80

10-year yield (%) 1.32 1.25 1.30 1.30

TWD/USD 30.1 30.0 29.7 29.0

Source: CEIC, Deutsche Bank Global Markets Research, National Sources

Note: (1) Credit to private sector. (2) Including guarantees on SOE debt



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

Economic Outlook: We see GDP growth rebounding

to 3.9% in 2012 from 1.8% in 2011, supported by

reconstruction activities. The latter and weak exports,

however, point to a current account deficit of 1.9% of

GDP in 2012.

Main Risks: Risks to growth remain to the downside

due to fragile external conditions and implementation

risks to reconstruction plans.

Strategy Recommendations: Bond and swap curves

to steepen driven by valuations, supply concerns and

a more dovish outlook on monetary policy.

Macro View

Growth to rebound sharply ahead, as the country

rebuilds… Natural disasters continued to pressure

Thailand’s production this year. Although far from home,

Japan’s earthquake earlier this year rendered Thailand’s

manufacturing production weaker than it otherwise would

have been in 1H, due to supply chain disruptions. This

quarter the manufacturing sector saw its worst downturn

on record, due to the floods. According to the latest data,

manufacturing production fell 35.4%mom (35.8%yoy) in

October, after contracting 4.1% in September. For the

quarter, we see the economy contracting 4.5%qoq (down

2.2%yoy) in Q4. In contrast, we see a strong start to

2012, with the qoq growth rebounding to +3.6% in Q1, as

reconstruction efforts gain their full momentum. As the

economy moves further into the year, however, we see

growth momentum slowing to around 1% in Q4. As a

result, we see qoq growth of 2.4% in 2012, vs. the 0.5%

contraction we forecast for 2011, while the yoy growth

surging to 9.9% in Q412, supported by favourable base

effects.

Domestic demand drives growth in 2012

-10

-5

0

5

10

2007 2008 2009 2010 2011F 2012F 2013F

PCE Govt

Investment Stocks

Net exports GDP



…but limited by weak exports… As Thailand rebuilds

itself, also supported by credit support, wage hikes and

rice price guarantees, we see domestic demand

expanding at a faster pace, with its contribution to growth

increasing to 3.8% in 2012, from 2.2% in 2011. In

contrast, we see a relatively weak export growth of 5.4%

in 2012 vs. 8.3% in 2011, as G2 growth falls to 1.0% in

2012 from 1.7% in 2011. With import growth relatively

stable, supported by stronger domestic demand for

capital goods, we see net trade becoming a drag on

growth, by 0.2% in 2012, after contributing 1.2% in 2011.

Meanwhile, we expect a modest positive contribution to

growth from inventory restocking.

…while the Bank of Thailand stays on the sidelines

until Q3, as inflation eases. The Bank of Thailand (BoT)

delivered a 25bps rate cut as the flood’s effect was

deemed ‚more widespread and severe.‛ The BoT

expects the economy to expand 1.8% in 2011, vs. its

earlier forecast of 2.6%. While the extent of the rate cut

was less than our forecast of 50bps, the BoT’s tone was

dovish, noting that ‚the MPC would remain vigilant in

monitoring developments in the global economy, as well

as progress on domestic restoration efforts and stand

ready to take appropriate actions.’ The BoT sees GDP

growth of 4.8% in 2012, sharply higher than our forecast

of 3.8%. We see weaker G2 growth; 1.0% in 2012 vs.

1.7% in 2011, to weigh on Thailand’s export growth.

Hence, with growth disappointing, we see the BoT

delivering another 25bp rate cut in Q112, as inflation

continues to ease.

Inflation moderates and stay within the target range

-6

-4

-2

0

2

4

6

2009 2010 2011 2012

CPI forecast%yoy


We see inflation continuing to trend downward in 1H

2012, bottoming in June at 3.5%yoy 3mma, then move

more or less sideways, ending the year at 3.6%. On

average, we see headline inflation falling to 3.7% in 2012

from 4.1% in 2011. We see food price inflation easing

further in 2012, as the flood effect drops out of the data

and as the Brent price increase is limited to 3.5% in 2012

(the latter calculation derived from our commodity



research forecast). Given the inflation dynamics and weak

growth, we see the BoT remaining on the sidelines until

2013, after one more rate cut in Q112. We note that the

BoT will be targeting headline inflation of 1.5-4.5% in

2012, vs. core inflation of 0.5-3.0% in 2011. With the BoT

on hold, we see no notable support for the baht until 2H

2012, as stronger domestic demand vs. exports result in a

current account deficit of 1.9% of GDP in 2012.


Investment Strategy

Rates: For FY12 (Oct-2011 to Sep 2012), the MoF plans to

issue THB540bn of bonds(including T-bills and linkers)

which is close to 20% higher than the issuance last year.

On a net basis, the issuance will be up nearly 40% YoY.

On a slightly positive note, the entire increase in gross

issuance comes from the introduction of the new 3Y

benchmark and T-bills. Therefore we note duration of

supply is not as concerning as the headline numbers

suggests.

However, there are still a few reasons why bond investors

should be cautious going into 2012: 1) The above

issuance plan was announced before the budget deficit

got revised upwards from THB350bn THB400bn due to

floods. In fact the deficit number could still be revised

higher as the damage due to floods has been much more

severe than initially anticipated. 2) Roughly 50% of the net

issuance in FY11 was bought by foreigners. Given the

possible impact on currency due to sharply slowing

exports and systemic risks emanating from Europe,

inflows into EM debt funds could be more muted next

year compared to FY2011.

We would like to point out that onshore liquidity remains

abundant and AUM of insurers and pension funds

continues to grow at double digit rates. In fact, Thailand is

one of the few countries in Asia, where domestics have

continued to buy aggressively despite rich levels of the

curve. The question then becomes, how much could be

the increase in supply. This would depend on how

aggressively the administration plans to implement the

reconstruction projects and how it plans to finance it.

FX: Thailand is likely to see temporary weakness in the

BoP due to recent nation-wide floods which have severely

disrupted exports and tourism activities. Imports are likely

to rise in the near-term to meet shortages in domestic

supplies, while FDI plans are likely to be put on hold. As

such, the buffer from current account flows against capital

outflows has weakened. However, we expect BoT to

maintain stability or limit gains in the THB to provide some

support to the exports sector during the recovery phase. Arjun Shetty, Singapore, (65) 6423 5925


Thailand: Deutsche Bank Forecasts

2010 2011F 2012F 2013F

National Income


Population (m) 63.9 64.2 64.5 64.8


Real GDP (YoY%) 7.8 1.8 3.9 4.8




Exports 14.7 8.3 5.5 11.0

Imports 21.5 8.6 7.5 11.8


CPI (YoY%) eop 3.0 4.1 3.3 4.1

CPI (YoY%) ann avg 3.3 3.9 3.7 3.7

Core CPI (YoY%) 0.9 2.4 2.7 2.7

Broad money 8.0 8.0 8.0 9.0

Bank credit1 (YoY%) 8.4 8.0 8.5 9.0

Fiscal Accounts2 (% of GDP)

Central government surplus -1.1 -3.7 -4.9 -3.2







Trade balance 32.2 15.7 8.7 21.1

% of GDP 10.1 4.5 2.3 3.4

Current account balance 14.8 0.1 -7.3 5.5

% of GDP 4.6 0.0 -1.9 0.9

FDI (net) 1.0 -4.5 3.1 2.2


FX rate (eop) THB/USD 30.6 31.0 30.5 29.5


Government debt2,3 35.2 35.9 39.5 38.8

Domestic 33.0 34.9 38.2 37.7

External 2.2 1.1 1.3 1.1


in USDbn 100.6 115.0 125.0 135.0


General

Industrial production (YoY%) 15.4 -7.0 10.0 7.0

Unemployment (%) 1.1 1.1 1.0 1.0


BoT o/n repo rate 3.25 3.00 3.00 3.00

3-month Bibor 3.30 3.05 3.10 3.10

10-year yield (%) 3.40 3.50 3.80 3.80

THB/USD (onshore) 31.0 31.0 30.9 30.5 Source: CEIC, DB Global Markets Research, National Sources

Note: (1) Depository institutions credit to the



Vietnam B1(Neg)/BB-(Neg)/B+ Moody’s/S&P/Fitch

Economic outlook: We expect a modest slowdown

in GDP growth, to 5.6% in 2012 from 5.9% in 2011,

as lower inflation and rates counter the negative

impact of weaker external demand.

Main risks: The banking system remains under

pressure, posing downside risks to growth and the

dong.

Macro View

Weaker exports to leave overall growth weaker, at

5.6% in 2012 from 5.9% in 2011… Year-to-date, the

economy expanded 5.8%yoy in Q3 2011, down from

6.5% in the same period last year. We expect growth to

remain under pressure in Q4, compared to 2010, leaving

the growth at 5.9% in 2011 compared to 6.8% in 2010.

This weaker growth is the consequence of

macroeconomic imbalances which resulted in high

inflation and weakness in the dong. To address these

issues, the authorities have adopted various tightening

measures, including raising rates and credit tightening.

We discussed their efforts in detail in our report ‚Vietnam:

Seeking sustainable growth‛ published on 4 November.

Weaker growth…

0

1

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3

4

5

6

7

8

9

-15

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-5

0

5

10

15

20

2007 2008 2009 2010 2011F 2012F 2013F

Net trade Changes in Stock

Investment Private Cons

Govt Cons GDP (rhs)

%% contribution to growth


As for 2012, we expect weak external demand – we see

G2 growth falling to 1.0% in 2012 from 1.7% in 2011 -- to

guide Vietnam’s growth lower, to 5.6% from 5.9% this

year. That is, we expect net trade to become a heavier

drag on growth, at 2.1% in 2012 vs. 1.7% in 2011. In

contrast, we see domestic demand growth remaining

relatively stable, with its contribution to growth

moderating slightly, to 6.8% in 2012 from 7.1% in 2011.

…while inflation falls… We expect headline inflation to

fall to 12.7% in 2012 from 18.7% in 2011, led by food.

The latter rose 23.3%yoy ytd in November 2011, leading

the headline inflation to 18.7% this year, from 9.2% in

2010. Note that food constitutes 32.5% of the CPI basket

in Vietnam. In 2012, we expect a reversal of this trend,

with lower food price inflation guiding overall inflation

lower, further pressed by below-trend growth.

Note that the IMF world food price index rose at a sharply

lower pace of 11.3%yoy 3mma in October compared to

its recent peak of 34.3% in April. Meanwhile, our

commodity analysts expect little change in oil prices in

2012 – only 3.5% increase in Brent oil prices from 2011.

We expect inflation to continue to trend downward,

bottoming below 11% in Q4 2012, providing the SBV

sufficient room to maneuver.

…and lower inflation to prompt rate cuts

0

5

10

15

20

25

30

2006 2007 2008 2009 2010 2011 2012

Refinancing rate

Headline inflation

%

Forecast


…prompting the State Bank of Vietnam (SBV) to

deliver rate cuts in 2012… In response to lower inflation

and weak growth, we expect the SBV to deliver 300bps

rate cuts in 2012, leaving the refinancing rate at 12% by

end-2012. We expect the SBV to stop short of guiding the

policy rate below inflation, to keep the economy on the

path of sustainability and balanced growth. Note that the

National Assembly passed a resolution on socioeconomic

plans which target GDP growth of 6.5–7.0% in 2011–

2015, compared to its earlier target of 7.5–8.0%, while

targeting a headline inflation of 5.0–7.0% in the same

period.

Meanwhile, we reiterate the importance of reforming the

banking sector, as it would play a key role in stabilizing the

economy and its currency. Although those efforts may

bring on bouts of volatility and thereby pose downside

risks to growth, we believe that the negative impact is

likely to be short term in nature. We again highlight the

importance of preparing for a more dramatic consolidation

of the banking sector, thereby reducing systemic risks and

pursuing restructuring of the state-owned enterprises.



Needless to say, the stability of the banking system is

critical in the dong’s stability.

External imbalances to continue

-3

-2

-1

0

1

2

3

4

-60

-40

-20

0

20

40

60

80

2004 2005 2006 2007 2008 2009 2010 2011

Trade Balance (rhs)

Exports

Imports

%yoy 3mma USD bn


…while the dong continues to weaken, albeit

relatively modestly… We expect a relatively weaker

external demand to result in a larger current account

deficit in 2012, albeit at a below five-year average of

6.57%, at 5.0% of GDP. However, we expect falling

inflation to ease the pressure on the dong, limiting its

depreciation against the US dollar to about 5.0% in 2012.

As noted earlier, the dong’s fragile stability rests much on

the Vietnamese public, not foreigners, as Vietnam remains

a highly dollarized economy. We also expect the

Vietnamese authorities to continue to monitor FX market

activities closely to curb grey market activities. Risks to

our FX outlook remain to the downside, due to the

sovereign debt crisis in Euroland and sustained pressure

on the domestic banking system.

Dong remains under pressure, but limited

15,000

16,000

17,000

18,000

19,000

20,000

21,000

22,000

2008 2009 2010 2011

Reference rate

Spot rate

VND/ USD



Vietnam: Deutsche Bank Forecasts

2010 2011F 2012F 2013F

National Income


Population (m) 86.9 87.9 88.8 89.8


Real GDP (YoY%) 6.8 5.9 5.6 6.5




Exports 16.0 10.0 5.5 9.0

Imports 15.4 9.4 6.2 8.5


CPI (YoY%) eop 11.7 18.6 10.8 13.5

CPI (YoY%) ann avg 9.2 18.7 12.7 13.0

Broad money (M3) 25.0 19.0 22.0 25.0

Bank credit (YoY%) 27.0 15.0 17.0 18.0

Fiscal Accounts1 (% of GDP)

Federal government surplus -6.5 -5.3 -6.0 -5.0



Primary fed. govt surplus -5.2 -3.8 -4.5 -2.5




Trade balance -5.2 -5.5 -8.0 -7.0

% of GDP -5.0 -4.7 -6.0 -4.7


% of GDP -4.2 -3.8 -5.1 -4.0

FDI (net) 7.0 7.0 6.0 7.0


FX rate (eop) VND/USD 19500 21100 22200 23000



Domestic 21.0 21.0 22.0 22.5

External 31.1 32.0 32.0 32.0


in USD bn 43.6 50.0 55.0 61.0


General


Unemployment (%) 4.3 4.5 4.5 4.5


Refinancing rate 15.00 14.00 13.00 12.00

VND/USD 21011 21100 21500 22200


Note: (1) Fiscal balance includes off budget expenditure, while revenue and expenditure include only on

budget items.



6 D

ece

mb

er 2

01

1

E

M M

onth

ly

Theme Pieces

November 2011

Foreign Reserve Adwquacy in EMEA

Africa’s Frontier Markets: Growing Up

Clustering Patterns in EMFX

Argentina – FX&Rates Outlook Amid Tighter Capital

Controls

Venezuela – Analyzing Negative Basis Trades

October 2011

Inflation Pass-through, Monetary & FX Policies in EM

Trading Tails in EM: Leaders & Laggards

Asian Growth is Slowing, That’s All

Em Corporates: Preserving Value

Equities—Latam factors: What’s Working, What’s Next

September 2011

EM and the Global Slowdown

EMEA: Still Vulnerable to an External Financing Squeeze

Introducing the EM Rates Volatility Report

A Primer on Asia Interest Rate Options

GCC Macro Updates: Still Resilient

Financial Condition Indicators in Latin America

Argentina: The Limits of Policy Continuity

Latam Equities: Stress Testing

July 2011

EM Trend Decoupling but Cyclical Coupling

CEE: Examining Contagion from Peripheral Europe

EMFX: Revisiting the Vol Dispersion Trade

EM Exchange Rate Fundamentals

Venezuela: Sailing on Uncharted Waters

June 2011

Sovereign Credit- Trading the Soft Patch

EMFX: Favoring EUR Funding

Dislocations in EM Swaption Vols

Revisiting the Credit Impulse in EMEA

EMEA: Updating Our Breakeven Oil Price Estimates

Is Indonesia the Next Brazil?

Brazil Equities – Navigating Through Choppy Waters

May 2011

Perceived Inflation Asymmetries and Rate Anomalies

Reacting to Core Vs Headline Inflation in EMEA

Assessing CDS Curve Dynamics in EM

EM Rates: How Much Carry is Left?

The Pressure Cooker in Asia – Bubbling Away

LatAm Factors – What’s Working, What’s Next?

April 2011

LatAm Rates: Is There Any Value Left?

Monetary Policy in EMEA: Who’s (Running) Hot and

Who’s Not

Peru: Countdown to Presidential Elections

In Vogue: Reserve Requirements in Turkey and Russia

In a Sideways Market: Buy LatAm Dividend Elite

March 2011

High Oil Prices: Winners and Losers Updated

Hedging the Non-Linear Effects of Oil Prices

Sovereign Credit: CDS as Substitute for Bonds

Macro Repercussions of MENA Crisis

Oil Spike: Ways to Play the Spike in LatAm Equities

February 2011

EM Rates: Repricing the Cycle and Commodities Risk

Is Inflation in EMEA Back?

Introducing Sovereign Credit Relative Value Monitor

A Closer Look at Ruble Fixed Income

Colombia: Introducing COP/IBR Interest Rate Swaps

Impact of Technical Rotation: Too Much Ado

Latam Equities: Tactics to Combat EM Outflows into

US

January 2011

EM Inflation Acceleration: The Commodity Fuel Once

Again

Argentina CER Bonds: Seitch from Duration to Carry

GCC 2011 Outlook

2011 Outlook: Key Themes for Latam Equities

The Year of the Rub

December 2010

Outlook for EM Rates

Outlook for EM FX

Outlook for EM Sovereign Credit

Perspectives on the Capital Flows to EM

EM Sovereign Risks in 2011 ( and Beyond)

EMEA Domestic debt – 2011 Supply and Demand

Global EM Equities – Evolving Structural Drivers

2011 Latin America Equity Market Target

November 2010

A Detailed Examination of Local Currency Debt

Returns

Surveying Onshore/Offshore Relative Pricing in EM

EM Sensitivity to Greater Renminbi Flexibility

Responding to Capital Flows in EMEA

Asia Rates: Supply to Force Greater Differentiation in

2011

October 2010

Ever Emerging Markets

Lessons From a decade of Outperformance

Revisiting EMEA External Positions

Argentina: Not Yet Time to Take Profit

Asian Equity Volatility – The World’s Cheapest Buy?

CEE: Food Inflation Ahead

Regulatory Dis



Contacts

Name Title Telephone Email Location

EMERGING MARKETS

Balston, Marc Head of EM Quantitative Research 44 20 754 71484 [email protected] London

Brown, Latashia EM Strategy 1 212 250 5774 [email protected] New York

Cañonero, Gustavo Head of Economic Research LA&EMEA 1 212 250 7530 [email protected] Buenos Aires

Cassard, Marcel Global Head - Macro & Fixed Income Research 44 20 754 55507 [email protected] London

Evans, Jed Head of EM Analytics 1 212 250 8605 [email protected] New York

FIlho, Jose LatAm Strategy 1 212 250 5932 [email protected] New York

Giacomelli, Drausio Head of EM Strategy 1 212 250 7355 [email protected] New York

Jiang, Hongtao EM Strategy 1 212 250 2524 [email protected] New York

Parisien, Denis Global Head of EM Corporates 1 212 250 7568 [email protected] New York

Zhang, Jack EM Strategy 1 212 250 0664 [email protected] New York

LATIN AMERICA

Faria, Jose Carlos Senior Economist, LA 5511 2113 5185 [email protected] Sao Paulo

Losada, Fernando Senior Economist, LA 1 212 250 3162 [email protected] New York

Marone, Guilherme EM Strategy 1 212 250 8640 [email protected] New York

Roca, Mauro EM Strategy & Senior Economist 1 212 250 8609 [email protected] New York

Menusso, Marcelo Head of LatAm Corporates 1 212 250 6135 [email protected] New York

EMERGING EUROPE, MIDDLE EAST, AFRICA

Akyurek, Cem Senior Economist, EMEA 90 212 317 0138 [email protected] Istanbul

Bougueroua, Lamine EM Strategy, EMEA 44 20 7545 2402 [email protected] London

Boulos, Tala EMEA Corporates 44 20 754 53664 [email protected] London

Burgess, Robert Chief Economist, EMEA 44 20 754 71930 [email protected] London

Grady, Caroline Economist, EMEA 44 20 754 59913 [email protected] London

Gulberg, Henrik Economist,EMEA 44 20 754 59847 [email protected] London

Lissovolik, Yaroslav Senior Economist, EMEA 7 495 967 1319 [email protected] Moscow

Kapoor, Siddharth EMEA Strategy 44 20 754 74241 [email protected] London

Masia, Danelee Senior Econom st, EMEA 27 11 775 7267 [email protected] Johannesburg

Ozturk, Kubilay Economist, EMEA 44 20 7547 8806 [email protected] London

Shilin, Viacheslav Head of EMEA Corporates 44 20754 79035 [email protected] London

ASIA

Baig, Mirza FX Strategy 65 6423 5930 [email protected] Singapore

Baig, Taimur Chief Economist, India 65 642 38681 [email protected] Singapore

Goel, Sameer Head of Asia Rates & FX Research 65 6423 6973 [email protected] Singapore

Das, Kaushik Economist 91 22 6658 4909 [email protected] Mumbai

Lee, Juliana Senior Economist 852 2203 8312 [email protected] Hong Kong

Leung, Mickey EM Economics 852 2203 8307 [email protected] Hong Kong

Liu, Linan Rates Strategy 852 2203 8709 [email protected] Hong Kong

Ma, Jun Chief Economist, China 852 2203 8308 [email protected] Hong Kong

Seong, Ki Young Rates Strategy 852 2203 5932 [email protected] Hong Kong

Shetty, Arjun Rates Strategy 65 6423 5925 [email protected] Singapore

Spencer, Michael Chief Economist, Asia Pacific 852 2203 8305 [email protected] Hong Kong

Tan, Dennis FX Strategy 65 643 5347 [email protected] Singapore

mailto:[email protected]



Appendix 1

Important Disclosures

Additional information available upon request

For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see

the most recently published company report or visit our global disclosure look-up page on our website at

http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.

Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the

undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in

this report. Drausio Giacomelli

Deutsche Bank debt rating key

CreditBuy (‚C-B‛): The total return of the Reference

Credit Instrument (bond or CDS) is expected to

outperform the credit spread of bonds / CDS of other

issuers operating in similar sectors or rating categories

over the next six months.

CreditHold (‚C-H‛): The credit spread of the

Reference Credit Instrument (bond or CDS) is expected

to perform in line with the credit spread of bonds / CDS

of other issuers operating in similar sectors or rating

categories over the next six months.

CreditSell (‚C-S‛): The credit spread of the Reference

Credit Instrument (bond or CDS) is expected to

underperform the credit spread of bonds / CDS of other

issuers operating in similar sectors or rating categories

over the next six months.

CreditNoRec (‚C-NR‛): We have not assigned a

recommendation to this issuer. Any references to

valuation are based on an issuer’s credit rating.

Reference Credit Instrument (‚RCI‛): The Reference

Credit Instrument for each issuer is selected by the

analyst as the most appropriate valuation benchmark

(whether bonds or Credit Default Swaps) and is detailed

in this report. Recommendations on other credit

instruments of an issuer may differ from the

recommendation on the Reference Credit Instrument

based on an assessment of value relative to the

Reference Credit Instrument which might take into

account other factors such as differing covenant

language, coupon steps, liquidity and maturity. The

Reference Credit Instrument is subject to change, at the

discretion of the analyst.

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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

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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.

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 Securities 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‛ is specifically designated in the name of the entity.

Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from

time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may

engage in transactions in a manner inconsistent with the views discussed herein.

Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any

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Risks to Fixed Income Positions

Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay

fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in

interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the

maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in

inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to

receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets

holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency

conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are

also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be

mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates – these are

common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the

actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly

important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate

reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs

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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.

David Folkerts-Landau Managing Director

Global Head of Research

Guy Ashton

Head

Global Research Product

Marcel Cassard

Global Head

Fixed Income Research

Stuart Parkinson

Associate Director

Company Research

Asia-Pacific Germany Americas Europe

Fergus Lynch

Regional Head

Andreas Neubauer

Regional Head

Steve Pollard

Regional Head

Richard Smith

Regional Head

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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

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em outlook 2012

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