Emerging Markets 2013 Outlook - Deutsche Bank

Global

7 December 2012

Emerging Markets 2013 Outlook

EM Struggling to Stand Out

Deutsche Bank Securities Inc.

Note to U.S. investors: US regulators have not approved most foreign listed stock index futures and options for US investors.

Eligible investors may be able to get exposure through over-the-counter products. DISCLOSURES AND ANALYST CERTIFICATIONS

ARE LOCATED IN APPENDIX 1. MICA(P) 072/04/2012.

Research Team

Marc Balston

(+44) 20 754-71484

Robert Burgess (+44) 20 754-71930

Gustavo Cañonero (+1) 212 250-7530

Drausio Giacomelli (+1) 212 250-7355

Michael Spencer

(+852 ) 2203-8305

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7 December 2012 EM Monthly

Page 2 Deutsche Bank Securities Inc.

Key Economic Forecasts

2012F 2013F 2014F 2012F 2013F 2014F 2012F 2013F 2014F 2012F 2013F 2014F

Global 2.8 3.1 3.9 3.3 3.3 3.5 0.0 -0.3 -0.4 -4.1 -3.7 -3.0

US 2.1 1.9 3.1 2.1 2.4 2.6 -3.2 -3.5 -3.6 -7.2 -6.3 -5.3

Japan 1.6 0.2 0.3 -0.1 -0.6 1.7 1.0 1.2 1.6 -10.2 -9.8 -7.8

Euroland -0.4 -0.2 1.1 2.5 1.8 1.7 0.4 0.5 0.7 -3.2 -2.6 -2.0Germany 0.8 0.3 1.5 2.0 1.7 1.6 6.1 5.3 5.0 0.0 -0.5 -0.1France 0.1 -0.1 1.2 2.3 1.7 1.6 -2.5 -2.9 -2.7 -4.8 -3.6 -2.8Italy -2.1 -0.7 0.5 3.4 2.1 1.7 -0.5 0.3 0.2 -2.6 -2.0 -2.1Spain -1.4 -1.3 1.0 2.5 1.8 1.4 -2.9 -2.1 -1.2 -6.7 -5.3 -4.0Netherlands -0.9 0.0 1.2 2.9 2.5 1.8 8.0 7.0 6.0 -4.4 -3.5 -2.9Belgium -0.2 0.1 1.2 2.6 1.7 1.7 0.0 0.5 1.0 -3.6 -3.5 -2.9Austria 0.4 0.3 1.2 2.4 1.8 1.8 2.0 1.5 1.0 -2.7 -2.6 -2.5Finland 0.2 0.1 1.1 3.2 2.5 1.9 -1.5 -1.0 -0.5 -0.5 -0.8 -0.7Greece -6.6 -4.1 1.4 1.3 0.5 0.2 -6.0 -4.0 -3.0 -9.2 -8.4 -6.2Portugal -2.9 -0.7 1.3 2.9 1.1 1.1 -2.0 -1.0 0.0 -5.6 -4.5 -3.3Ireland 0.2 0.8 1.9 2.2 1.7 1.5 2.0 2.5 3.0 -8.3 -8.0 -6.1

Other Industrial CountriesUnited Kingdom -0.3 1.0 1.8 2.8 2.3 1.9 -2.3 -2.1 -1.8 -7.1 -7.2 -5.4Sweden 1.0 1.5 2.2 1.4 1.7 2.0 6.2 5.4 5.2 -0.5 0.5 1.0Denmark -0.2 1.2 1.6 2.3 2.0 2.0 5.5 5.0 5.0 -4.5 -3.0 -2.0Norway 3.5 2.0 2.5 1.0 2.0 2.0 15.0 14.0 13.0 11.0 10.5 10.0Switzerland 1.0 1.5 1.7 -0.6 0.3 0.5 10.5 10.0 9.5 -0.3 -0.4 0.0Canada 2.2 2.3 3.0 1.8 2.4 2.3 -2.6 -1.9 -1.3 -1.7 -1.5 -0.9Australia 3.6 2.4 3.4 1.8 3.0 2.8 -3.5 -4.5 -4.1 -3.0 0.1 0.1New Zealand 2.3 2.1 2.4 1.1 1.5 2.2 -5.1 -5.1 -5.4 -4.3 -3.0 -1.1

Emerging Europe, Middle East & Africa 3.0 3.5 3.9 5.2 5.6 5.1 1.9 1.6 0.6 -0.6 -0.7 -0.6Czech Republic -0.8 1.0 3.4 3.3 2.5 2.1 -1.8 -1.6 -1.7 -3.5 -3.2 -2.7Egypt 1.6 3.4 5.0 8.9 8.3 8.8 -3.1 -3.3 -2.9 -10.8 -10.0 -8.0Hungary -1.3 0.0 1.6 5.7 4.1 3.5 0.9 1.5 0.9 -3.0 -2.9 -2.8Israel 3.3 2.9 3.6 1.8 2.3 2.3 -0.8 -0.6 -0.3 -4.0 -3.5 -3.0Kazakhstan 5.5 6.0 6.2 5.4 6.2 6.4 6.7 5.8 5.2 5.1 5.3 4.8Poland 2.2 1.6 2.3 3.8 2.6 2.3 -3.4 -3.0 -3.7 -3.6 -3.5 -2.9Romania 0.8 2.5 3.5 3.4 4.6 3.9 -4.0 -4.0 -4.0 -2.8 -2.5 -2.0Russia 4.0 4.3 4.2 5.2 7.4 6.1 4.3 3.4 1.5 0.1 0.0 0.2Saudi Arabia 5.6 3.7 3.4 4.5 3.8 3.2 27.1 24.9 21.2 15.3 13.1 9.5South Africa 2.3 2.7 3.6 5.6 5.8 5.7 -6.4 -4.6 -3.5 -5.0 -4.7 -3.6Turkey 3.0 4.8 5.0 9.0 6.9 6.5 -6.5 -7.5 -8.2 -2.4 -2.0 -1.8Ukraine 2.0 4.0 3.9 1.5 6.0 5.5 -6.2 -4.2 -4.4 -2.5 -1.8 -1.6United Arab Emirates 2.4 2.7 2.8 0.7 0.4 1.4 11.2 13.6 14.3 5.6 4.8 3.4

Asia (ex-Japan) 5.9 6.7 7.4 3.8 3.9 4.2 1.7 1.0 0.7 -2.9 -2.7 -2.3China 7.7 8.2 8.9 2.6 3.0 3.5 2.7 2.0 1.6 -1.6 -1.3 -1.0Hong Kong 1.3 2.5 4.5 4.0 2.5 1.7 -1.5 -1.5 -0.5 1.1 1.2 1.7India 4.6 6.8 7.1 7.5 6.6 6.3 -3.5 -3.4 -3.3 -8.0 -7.5 -7.3Indonesia 6.3 6.3 6.5 4.1 5.3 6.3 -1.8 -2.0 -2.0 -2.7 -2.3 -2.2Korea 2.1 2.5 4.4 2.2 2.6 3.1 3.9 2.5 1.2 0.0 -0.8 0.1Malaysia 4.8 5.0 6.0 1.7 1.7 2.4 5.5 5.5 7.1 -5.0 -4.5 -4.0Philippines 6.3 5.5 5.0 3.3 4.6 5.0 4.0 4.6 5.0 -1.5 -1.0 -1.0Singapore 2.5 3.0 4.5 4.7 4.0 3.0 11.1 9.5 9.6 6.6 7.4 6.9Sri Lanka 6.2 7.0 7.5 7.5 7.0 6.3 -5.0 -3.5 -3.8 -6.2 -6.5 -6.2Taiwan 1.1 3.0 4.3 1.9 1.3 2.2 9.6 6.1 3.8 -2.8 -2.9 -1.7Thailand 5.7 3.9 4.9 3.0 3.1 3.6 1.7 2.1 2.3 -3.5 -3.0 -1.9Vietnam 4.9 5.2 5.8 9.3 9.4 11.4 3.6 -1.9 -0.6 -6.0 -5.5 -4.5

Latin America 2.8 3.7 3.9 8.0 7.9 8.0 -0.9 -1.4 -1.4 -2.0 -2.3 -1.8Argentina 1.6 2.1 1.9 23.8 26.5 26.5 1.4 2.0 1.9 -3.0 -3.1 -3.4Brazil 1.0 3.5 4.2 5.4 5.3 5.8 -2.4 -2.6 -2.7 -2.3 -2.0 -1.7Chile 5.1 4.7 4.9 3.1 2.8 3.0 -2.4 -1.7 -1.2 0.2 -0.5 0.2Colombia 4.3 4.4 5.0 3.3 3.0 3.0 -2.9 -3.0 -3.2 -1.8 -1.6 -1.4Mexico 3.8 3.5 3.7 3.9 3.7 3.6 -0.4 -1.1 -1.3 -2.2 -2.0 -1.9Peru 6.3 6.0 6.2 3.6 2.6 2.5 -3.2 -3.4 -2.7 1.8 1.8 1.7Venezuela 4.2 5.0 2.1 26.1 23.3 22.2 6.3 2.6 3.3 -3.0 -9.2 -4.3

Memorandum Lines: 1/

G7 1.3 1.2 2.1 1.9 1.8 2.2 -1.3 -1.4 -1.4 -6.2 -5.6 -4.6Industrial Countries 1.2 1.0 2.0 1.9 1.8 2.1 -1.1 -1.2 -1.1 -5.7 -5.1 -4.1Emerging Markets 4.7 5.4 6.0 4.9 5.0 5.1 1.2 0.7 0.3 -2.2 -2.1 -1.8BRICs 5.7 6.8 7.3 4.3 4.6 4.7 1.0 0.5 0.0 -2.8 -2.6 -2.3

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

Real GDP (%) Consumer Prices (%, pavg) Current Account (% GDP) Fiscal balance (% GDP)

Source: Deutsche Bank


Deutsche Bank Securities Inc. Page 3

Table of Contents

Emerging Markets and the Global Economy in the Month Ahead

We expect a compromise to defer much of the fiscal cliff and avert recession. Although markets should anticipate a benign outcome, a final deal may take time and growth may only gradually pick up steam. EM economies should be able to grow a little faster in this environment and we are particularly constructive on China. As DM economies begin to recover, EM countries that are unable to undertake difficult reforms may struggle to stand out against an improving global backdrop. We expect EMFX outperformance under this backdrop and diminished yet positive returns in EM credit.... .............................................................................. 11

This Month’s Special Reports

Rates in 2013: The Cliff and Beyond In the following months, the dominant common factor in EM rates will be the “fiscal cliff.” In our view, US politicians will eventually reach a bargain into 2013. This more benign scenario should pave the way for curves to more closely price country-specific fundamentals rather than global risks... ................................................... 20

FX in 2013: Gaining Ground In 2012, we believe that EMFX should rally if the global economy does recover. We expect differentiation to play a major role in valuation in the year ahead as we do not expect global growth to strengthen enough to overcome idiosyncratic risks... .............................................................................................................................. 28 Sovereign Credit in 2013: Less Gas in the Tank 2012 was a remarkable year for EM sovereign credit, with unexpectedly strong performance, driven primarily by spread compression. 2013 is highly unlikely to deliver comparable returns, but we believe that there is still scope for further spread compression. Our baseline scenario sees the EMBI Global ending 2013 at a spread of around 225bp. This is coupled with 10Y UST yields rising to around 2.75%, which should yield a total return of just below 5%.. ..................................................................................................................................................... 36

On the Likelihood of EM Diminishing Economic Performance EM countries currently under-performing their own history are also facing long term structural challenges. Thus, unless progress in reforms is meaningful, higher interest rates could be demanded to contain inflation and maintain currency stability, while growth could be the main collateral damage of status quo policies. Argentina, Brazil, India, South Korea, South Africa, and Russia appear as the most vulnerable countries in this regard. Other EM economies, however, are expected to continue delivering strong growth and stable inflation, implying further differentiation within the asset class... ....................................................................................... 51

EM Performance: Growth and Asset Rebalancing Dismal growth and accommodative policies provided the ideal background for a stellar year for global fixed income assets in 2012, but we expect a gradual rebalance away from fixed income overweight to growth-centric products such as equities and EMFX (and commodities) conditional on an orderly resolution of the US fiscal cliff. ............................................................................................................................................................... 61

EM Vulnerability Monitor Our EM vulnerability monitor suggests that EMEA remains by far the most vulnerable region, especially in terms of external and fiscal risks. We see vulnerabilities as highest of all (and rising) in Ukraine but also still elevated in Egypt and Hungary. Asia has by far the lowest external vulnerability and, like Latin America, little in the way of fiscal problems... ................................................................................................................................. 66 Theme Pieces ..................................................................................................................................................... 160



Summary Views – LatAm Economic Outlook Main Risks Strategy Recommendation

Argentina Page 72

The economy seems to be finally recovering but at a rather slow pace as increasing state interventionism keeps threatening frail confidence. Meanwhile, the last US court decision prevented technical default for now, but legal uncertainty remains. Expectation of increased soybean exports is buying time, but policy flexibility, in particular in the exchange rate, is becoming inevitable. A likely resistance will only worsen the outlook ahead while an intransigent legal position could bring back real debt payment problems.

Continued exchange rate rigidity and strong state interventionism could block any solid recovery process. Negative US court ruling could still trigger technical default on debt. Expansionary policies could further worsen the inflationary and competitive situation, exacerbating financial repression and negative growth.

Remain neutral on ARS and underweight on the local curve. Neutral external debt – we see balanced risk/reward in the current prices, but would still defensively positioned favoring local law bonds (hold to maturity on long Bonar 13s) and EUR Pars. GDP Warrants do not look attractive.

Brazil Page 76

Despite all the measures implemented by the authorities to stimulate the economy, GDP grew a much weaker-than-expected 0.6% QoQ in 3Q12, prompting us to cut our 2012 GDP growth forecast to 1.0% from 1.5%. While we still expect the stimulus measures to pave the way for faster growth in 2013, uncertainty about the global recovery, strong government intervention in the economy, and a lower statistical carryover have led us to cut our 2013 growth forecast to 3.5% from 3.8%. In this environment, we expect further monetary and fiscal easing.

The economy remains vulnerable to further deterioration in the global economic and financial conditions. The ad hoc measures to stimulate certain economic sectors and a myriad of capital controls and trade barriers could raise uncertainty and impair investment, undermining long-term growth. The combination of low interest rates and weak currency could stoke inflation in the future.

x Shift to long BRL/JPY. Enter Jul’14 DI receiver after taking profits on Jan’14/Jan’17 steepener, and maintain long NTNB ‘45. Underweight external debt. Take profit in short 10Y basis and cash curve flatteners (41s vs. 21s).

Chile Page 80

The economy rapidly recovered from the deceleration experienced in Q311 and continues to grow above potential. Concerned by some inflationary pressures and the uncertain global environment, the Central Bank of Chile (BCCh) continues to follow a wait-and-see approach.

Tradable inflation could add to already-elevated non-tradable inflation. A sharp deceleration in China could negatively affect copper prices, intensifying the negative external shock.

Maintain 1x2 USD/CLP put spread and enter short EUR/CLP. Take profits on 1Y1Y CLP/CAM payer and enter long 10Y rates (CLP/CAM or BTP) vs UST.




Colombia Page 82

Inflation is well anchored, while economic activity has softened since 3Q12. The likely approval of an investor-friendly tax reform could elicit a significant inflow of funds from abroad, thus strengthening the currency.

A relapse in economic activity in the US, and/or a softening of external terms of trade as a result of a global slowdown.

Remain neutral COP after closing at a loss long USD/COP. Take profits on TES ’24 and enter 1Y COP/IBR receiver. Remain neutral on external debt.

Mexico Page 84

Annual headline inflation is declining since September, and it is approaching the ceiling of the target range, thus providing some breathing room to the Central Bank. Economic activity is softening relative to 1H12. Banxico holds a very soft tightening bias but it is likely to maintain the tasa de fondeo unchanged. The outlook for the approval of structural reforms has improved, thus opening the door for spread compression and higher potential growth.

Mostly external, mainly a sharp drop in US economic activity because of fiscal cliff-related issues, and/or heightened global financial turmoil prompted by a disorderly adjustment in Europe. Domestically, stubborn inflation pressures fueled by supply shocks.

Take profits on 1x2 USD/MXN put spread and enter short USD/MXN. Take profits on 2Y TIIE-US spread and long MBonos 5Y and buy MBonos (or TIIE) 20Y vs UST 20Y. Overweight external debt and enter UMS ‘40s vs. Brazil ‘41s. Take profit in 2s5s CDS curve flatteners.

Peru Page 88

GDP growth has gradually accelerated and it is now at near potential rates. Inflation has converged towards the target range and it will likely drop further during 2013. The Central Bank’s FX intervention strategy to lower currency volatility and prevent sharp PEN appreciation is to continue.

A weakening in global growth that would reduce demand for Peruvian exports and lower external terms of trade. Further delays in the resolution of social conflicts and postponements of investment projects in the mining sector.

Enter short USD/PEN and remain neutral in local rates. Stay neutral on external debt, and favor 10Y sector of the curve (19s and 25s).

Uruguay Page 90

Economic growth has decelerated this year on the back of the temporary shutdown of ANCAP, but it is set to recover, albeit gradually, in 2013. Inflationary pressures have been very persistent and will likely continue in 2013, preventing the Central Bank from easing its monetary policy stance – regardless of lax monetary policies at the global level. A positive net currency balance should maintain the UYU well supported.

Deterioration in terms of trade fueled by global downturn. Further increase in inflation that would require additional monetary tightening. Political stalemate and conflicts over economic policy mix ahead of 2014 elections.

Enter long UYU ’18. Neutral external debt and favor long end of the global curve.




Venezuela Page 92

After this year’s strong GDP expansion, we expect a deceleration in 2013, on the back of much needed fiscal tightening. Inflation may increase as some repressed prices will have to be adjusted. President Chavez’ recent return to Cuba for further cancer treatment has rekindled the possibility of a political transition.

Weakening of oil prices as a result of a global slowdown. Acceleration of inflation in the event of supply shortages. Policy radicalization during the new chavista administration.

Overweight external debt. Favor the Republic to PDVSA, especially at the long end. We favor 5-10y sector of the Sovereign curve (especially 18Ns and 22s) and 17Ns on PDVSA (but hold switching to PDV 35s from 37s). Also hold 2s5s CDS curve steepeners.



Summary Views – EMEA

Economic Outlook Main Risks Strategy Recommendation

Czech Republic

Page 94

Ongoing fiscal austerity and a still-weak external environment will mean the resumption of a meaningful growth dynamic is unlikely in 2013. But with fiscal and external vulnerabilities low and the banking sector in decent shape, fundamentals still remain sound.

Political risks will linger an early election is possible in 2013. This would most likely mean an opposition win and a looser fiscal stance. We see potential for a downgrade to the rating outlook if political noise intensifies.

Stay Long PLN/CZK in spot FX, target 6.30, stop @ 5.95. Neutral on rates for now.

Hungary

Page 98

Policy unpredictability has left a very poor investment climate and a structural weakening in Hungary’s growth dynamic. Hungary is the only CEE country where we do not expect the economy will have returned to the pre-crisis level of output by the end of our forecast horizon in 2014.

PM Orban’s likely appointment of a government minister as the new NBH Governor risks significant concerns over NBH independence, the future of the inflation targeting mandate and a possible move to unorthodox monetary policy.

Recent trend channel in EURHUF to remain intact, implying a trading range of 275-300. Receive 2Y IRS, target 5.00. Underweight on sovereign credit

Israel

Page 102

Growth is running a little below trend but should accelerate from mid-2013 as global recovery takes hold. Inflation is well-anchored around the middle of the 1 3% target band.

Sentiment is weak and fiscal consolidation is looming. Growth could therefore disappoint (though there is room to cut policy rates if necessary). Geopolitical risks, especially tension with Iran, have the potential to hit investor confidence.

On a pullback to 3.85, go short USD/ILS again. Initial target 3.70, with a trailing 1% stop loss. Receive 5Y IRS at 2.65%, target 2.40% with a stop loss at 2.75%.

Poland

Page 104

Poland is facing its worst growth outlook in a decade with domestic demand under pressure and an increased reliance on a fragile external environment. But as the slowdown comes after 3 years of outperformance on growth and with contained medium-term vulnerabilities we maintain an overall constructive view on Poland.

The change to Poland’s debt rule, which introduces an average fx rate and removes liquid funds, risks undermining the credibility of the fiscal consolidation efforts, particularly as it does not change the preference for a strong year-end fx rate.

Long 3m EUR/PLN put with strike @ 3.99. Stay long PLN vs CZK. Neutral on rates for now. Underweight sovereign external debt.



Summary Views – EMEA

Economic Outlook Main Risks Strategy Recommendation

Romania

Page 108

A fragile but improving growth outlook is secured by fiscal and external buffers and a well capitalized banking system. The authorities are likely to sign another precautionary IMF/EC deal to ensure the structural reform effort continues.

Politics will remain a significant risk as President Basescu and PM Ponta struggle to cooperate and another impeachment attempt is likely.

Expect a gradual drift lower in EUR/RON, target 4.35 (stop 4.5850). Overweight sovereign credit.

Russia Page 112

Growth slowed down in 2012, but set to rebound in 2013 driven by investments.

Persistent capital outflows, extreme tightening of the monetary conditions and a drop in oil prices remain key risks.

Target 34.10 in the dual basket, stop revised to 35.35 (35.90). Long Apr 21, target 6.50%. Neutral sovereign credit.

South Africa

Page 116

The economy is set for further weakness in domestic growth as it lags global growth by up to five quarters.

The deterioration in the current account deficit in the short term, coupled with concomitant exchange rate pressure, could derail our call for further policy easing next year.

Stay short ZAR vs TRY, while USD/ZAR is likely to be driven by swings in risk appetite (within a wide range, floor around 8.50, ceiling 9.25). Stay received 2Y IRS, target 4.90. Underweight sovereign credit.

Turkey Page 120

Growth is picking up marginally while rebalancing continues and inflation is declining more rapidly than envisaged with the evaporation of last year’s supply shocks and falling food prices.

Continued vulnerability of overall macro conditions to volatility in capital inflows in both directions.

Stay long TRY vs ZAR, targeting 5.25, with a revised stop @ 4.80. Constructive Jan 22s, target 6.50%. Overweight sovereign external debt.

Ukraine Page 124

Multiple challenges include the need to bring the IMF programme back on track and resuscitate the lackluster growth momentum

Deterioration in external position exerting downward pressure on the currency

UAH to remain under pressure. We recommend an underweight exposure on sovereign external debt.



Summary Views – Asia Economic Outlook Main Risks Strategy Recommendation

China

Page 126

We expect GDP growth to recover modestly to 8.0% in H1 of 2013 and reach its potential of around 8.5%yoy in H2. The back-loaded trajectory of growth recovery is led mainly by corporate investment after shaking out excess capacity, but also reflects the export acceleration in H2 2013. For 2013 as a whole, we expect the nominal growth rate of gross capital formation (GCF) to accelerate to 11.5% in 2013 from 9% in 2012, export growth to rise to 10% in 2013 from 8% in 2012, and consumption growth to remain largely steady. .

The key downside risk to our 2013 China forecast is worse-than-expected external demand due to, e.g., the US “going over its fiscal cliff” and/or oil price shocks from the Middle East. A 1.6ppt downgrade in G2 GDP growth will likely reduce China’s GDP growth by 1ppt and delay our expected China recovery by about three quarters. The main upside risk to our 2013 projection is better-than-expected fiscal revenue performance, which may allow stronger-than-expected government capex in areas such as subway and light rail construction.

We are cautious on duration as growth recovery and supply risk on the credit market likely will drive up long-dated rates. Our favored trades in 2013: (a) put on 2Y/5Y Repo NDIRS/IRS curve steepeners at 15bps; (b) pay outright 5Y Repo NDIRS/IRS when 5Y retraces to around 3.3%; (3) on the cash curve, we recommend Shibor floaters and think 10Y CGBs at above 4% are attractive to buy.; (4) sell 1Y USDCNH forward. Downside surprises to economic growth, credit events in the bond market and delay of financial liberalization reforms are key risks to our view.

Hong Kong

Page 132

Recovery is dependent on stronger growth in the US, EU and China (combined), which is unlikely before mid-2013. Inflation is likely to continue to decline as property prices stabilize.

“Fiscal cliff” or other external shocks remain the key risk to the outlook. Rising property prices would keep inflation high leading to a “stagflationary” environment.

We recommend put on 5Y/10Y Hi/Li basis curve flattener at 15bps and long only investors should consider switching out of 10Y EFNs to 10Y GBHK for about 30bps pickup in yield.

India

Page 134

Conditions may well be set for a modest recovery in 2013, driven by a pick-up in external demand, flat commodity prices, monetary policy easing, some recovery in investment, better quality public spending, and resilient consumption.

India remains vulnerable to inflation and exchange rate risks, coupled with external shocks and domestic political turbulence.

Overweight duration. Add to risk on any back up to 8.25% on 10Y yields.

Indonesia

Page 138

It may not be smooth sailing in 2013 as rising wages push up inflation, worsening external balances continue to weaken the currency, and a lacklustre outlook for commodities weakens a key engine of growth. Strong consumption and investment sentiments may persist, however, as policy is likely to remain pro-cyclical, given election related considerations.

The key risk is over-heating of the domestic economy, including excess of lending or price increase in real estate, inefficient investment boom, and worsening currency mismatch on balance sheet of corporates that have dollar payables and rupiah receivables.

Market weight on duration; collect NDF hedges on dips.

Malaysia

Page 142

Fiscal policy has supported growth in 2012, but as exports recover from mid-2013 we expect fiscal policy to be tightened.

“Fiscal cliff” could plunge Malaysia back into recession, leading to rate cuts and FX weakness.

Look to accumulate duration on any election related steepening of MGS curve.



Summary Views – Asia Economic Outlook Main Risks Strategy Recommendation

Philippines

Page 144

Growth continues to surprise to the upside and the economy is beginning to overheat. While it is becoming more export-sensitive, we think inflationary pressures are likely to continue to build, forcing BSP to raise rates and let the peso appreciate.

Inflation risks are weighted to the upside by strong GDP growth and rising global food prices.

Stay short USD/PHP

Singapore

Page 146

A mild recovery in the US and China could pave the way for an improved outlook in the coming year.

Inflation could remain stubbornly high, affecting competitiveness and posing challenges to monetary policy.

Be short SGD NEER, look to buy back the SGD on pullbacks to mid-band.

South

Korea

Page 148

Recovery in South Korea’s GDP growth assumes a timely resolution of the US fiscal cliff, while weak domestic demand depressed by falling housing prices and rising tax expenditure warrants further monetary easing.

Further QE by the Fed and BoJ points to tighter prudential regulation in South Korea against hot money inflows.

We see a bearish steepening bias in the Korea rates in 2013, although the possibility of a BOK rate cut could lead to a short-lived rally in 1Q.

Sri Lanka

Page 152

Post a disappointing 2012, we expect macro conditions to turn somewhat favorable in 2013, especially in the latter half of the year.

Supply side shocks could prevent inflation from moderating sufficiently, thereby complicating monetary policy decisions, while revenue slippage could force the authorities to cut back aggressively on growth-critical capital spending to meet the ambitious budget deficit target.

Taiwan

Page 154

Recovery in exports necessary for rebound in GDP growth amid weakening domestic demand.

The US fiscal cliff challenge poses the greatest risks to our growth outlook for Taiwan.

We are more positive on the TWD on improving cyclical indicators, a rising current account surplus, and potentially less official resistance to gains. We await some retracement in the NDF negative carry before going short USD/TWD.

Thailand

Page 156

Thailand faces a volatile growth trajectory due to last year’s floods and requires recovery in exports to sustain growth in 2013.

The US fiscal cliff poses downside risks, while a rapid increase in credit warrants caution.

Front end steepness in the IRS curve cannot be explained by outlook on policy rates or the fixing. Receive 2Y1Y IRS.

Vietnam

Page 158

A weak banking and challenging external environment point to a limited recovery in GDP growth in 2013.

While aggressive monetary easing poses inflation risks, bank reform represents contingent liabilities for the government.



Emerging Markets and the Global Economy in the Month Ahead

We expect a compromise to defer much of the fiscal cliff and avert recession. Still, it may take a while before a durable solution to the US fiscal outlook is agreed. Although markets should anticipate a benign outcome, growth may only gradually pick up steam.

Europe is also likely to start growing into 2013, albeit only very slowly. Its recovery will be a fragile one: while systemic risks have been greatly reduced, event risks remain high and concentrated in core countries.

EM economies should be able to grow a little faster in this environment and we are particularly constructive on China, which has probably already turned the corner.

As DM economies begin to recover, however, investors may begin to look more discerningly at EM. Countries that are unable to undertake difficult reforms may struggle to stand out against an improving global backdrop.

We expect EMFX outperformance as global economy recovery lifts trade and capital flows from currently depressed levels. Country-specifics should continue to play an important role both for EM and also for base currencies. We favour EUR and JPY funding over the USD.

In Asia, our favorite currencies are CNH, KRW and PHP. In LatAm, MXN is our top pick, but we also hold bullish positions in CLP (vs. EUR), PEN (vs. USD), and BRL (vs. JPY). In EMEA, we are most bullish in RUB, TR, and PLN. For tail hedges, we like long 3Mx3M FVAs in MXN, ZAR, KRW and TRY.

-Even if the "cliff" is avoided, the easing cycles may not be over yet in Brazil, Colombia, South Africa, and Hungary, where we still favor short-end receivers. In addition the very long end of Mexico and Russia should continue to benefit from reforms and lower inflation. As growth gains more solid footing, we may see overshooting vs. UST in markets such as Israel, Peru, and possibly Turkey.

We foresee EMBIG spreads at 225bp in 2013 for a total return near 5%. Regarding country allocation, we recommend an overweight exposure to Turkey, Romania, Venezuela, Mexico and Indonesia. We recommend an underweight exposure to South Africa, Brazil, Chile, Hungary and Ukraine.

We expect the bond-CDS basis to move lower in 2013 as the outperformance of bonds eases. We

expect this to be most pronounced in Brazil and Russia.

We expect a low start for the year for the global economy on lingering fiscal drag and uncertainty. The risks of a delayed or insufficient compromise in the US remain uncomfortably high, but we expect the outlook for the year to brighten as uncertainty is resolved and a credible framework to put US debt dynamics on a sustainable path is reached into 2013. As US private sector finances are already on a stronger footing, the housing market seems poised to improve further, and reduced uncertainty should finally unleash delayed business investment, we expect activity to accelerate into 2H13. We are particularly constructive the outlook for China, where a possible acceleration in reforms (both in the rural and business sectors) could improve resource allocation (and thus productivity), and free up cheap labor so as to contain costs. This combination should prove beneficial to global trade and capital flows, and thus supportive of the rebalance in global portfolio away from fixed income into more growth-sensitive assets such as equities and currencies – but respecting the slow start we foresee.

Global growth seems poised to continue at multi-speed, with Europe and Japan as clear laggards. This is likely to remain the case also within Europe, where systemic risks seem now contained, but event risks remain large as they have escalated to core countries. These are unlikely to dissipate before elections and before EU sovereigns and societies convincingly show they can persevere on fiscal restraint without growth (we don’t expect the Eurozone to grow in 2013). Growth differentiation should also remain the norm in EM, where more resilient economies and reduced output gaps seem poised to raise inflation risks. Better policies have been rewarded and, while increased global trade should benefit most EM countries, boosting investments that could elevate growth and alleviate capacity constraints may prove elusive for large economies such as Brazil, India, and also South Africa.

US: Fiscal cliffhanger and beyond The outlook for the US economy next year remains unusually uncertain pending the resolution of the fiscal cliff. Three weeks away from the year-end deadline, the outcome of negotiations between the Obama administration and the Republican Party is little clearer. Each side has rejected the other’s initial proposals and we will inevitably see further brinkmanship over the next few weeks.



Our base case remains that a compromise will be reached by the end of the month, with the payroll tax cuts and extended unemployment benefits allowed to expire but most of the other elements of the cliff kicked further down the road. The resulting 1 to 1½% of GDP of fiscal tightening (broadly similar to the fiscal drag we have seen this year) would still allow the economy to expand by about 2%, and accelerating as uncertainty is reduced, which should facilitate a recovery in business spending. Under this scenario, we would also expect the Fed to continue to purchase longer-term US Treasuries and mortgage-backed securities at roughly the current pace ($85bn a month) through much of the year.

US fiscal cliff resolution: baseline scenario

0

100

200

300

400

500

600

700

Fiscal cliff in current law

Avoided Actual cliff

USD bn

$650bn(4.2% GDP)

$470bn(3.0% GDP)

$180bn(1.2% GDP)

Payroll tax cuts, extended

unemployment insurance allowed to expire, ACA high income taxes will come into effect

Source: US Congressional Budget Office, Deutsche Bank

If such a compromise is also accompanied by agreement on a credible framework for putting the US public finances onto a sustainable footing over the long term, laying the groundwork for a so-called “Grand Bargain” to be hammered out later in the year, the resulting reduction in uncertainty and boost to confidence would likely result in stronger growth than in our base case. In the absence of a credible framework agreement, however, a downgrade by the rating agencies would be highly likely.

There is also a nontrivial risk that political gridlock, or perhaps a tactical gambit by the Obama administration, sees the US goes over the fiscal cliff. This would likely tip the economy into recession and threaten global recovery. The CBO estimates that the economy would contract by 0.5% and the unemployment rate would rise to 9.1%. The impact would be concentrated in the first half of the year, when real GDP would contract at an annual rate of 2.9% before growing by 1.9% in the second half of the year. The recession could be deeper than this, however, depending on the impact on investor and business confidence, which is not factored into the CBO estimates.

Impact of fiscal cliff on real GDP and employment

Source: US Congressional Budget Office, Deutsche Bank

Europe: a fragile recovery We expect a return to modest growth in the euro area next year. The economy is in recession and has likely slowed further this quarter. Germany, which had remained relatively resilient, has shown increasing signs of weakness: GDP growth decelerated to 0.2%QoQ in the third quarter and will likely turn negative this quarter. But the conditions for a moderate turnaround are falling into place. Fiscal austerity will continue but the degree of contraction is set to ease: the cyclically-adjusted budget balance for the region is set to tighten by 1.0% of GDP next year compared with tightening of 1.4% of GDP in 2011 and 2012. Similarly, we expect the pace of deleveraging in the private sector to slow and the resulting positive credit impulse will help to support domestic demand. Stronger growth in the US and China in the second half of next year will also provide an external fillip. This should facilitate a moderate recovery with the euro area growing by about 1% on an annualized basis over the second half of next year.

Euro area: very mild recovery from 2013Q2

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

Q1 12 Q2 12 Q3 12 Q4 12F Q1 13F Q2 13F Q3 13F Q4 13F

France

Eurozone

Germany

QoQ%

Forecast

Source: Haver Analytics, Deutsche Bank

This will be a fragile recovery, however, and there are multiple potential pressure points in the year ahead:



The commitment to provide additional debt relief to Greece is a welcome step forward. The debt burden remains unsustainable and further relief will ultimately be necessary. But it has bought time and signaled the willingness of European governments to do whatever it takes (short of notional haircuts) to keep Greece in the euro area.

Market pressure may ultimately be needed to persuade the Spanish government to swallow its pride and seek support from the ESM. For now at least, investors seem reluctant to bet against potential ECB intervention. And the relationship between the centre and the regions has become even more complicated following the strong showing by separatists in recent Catalan elections, which will complicate negotiation of any MoU. But we think a request for assistance remains only a matter of time.

Italian elections in the spring are another source of potential volatility. Implementing and completing the structural reforms initiated by the Monti government is essential for public debt sustainability. It is unclear whether a stable majority can be secured, although the centre-left’s lead in opinion polls is increasing and the chance of Monti continuing to play a role in the new government is receding.

France may also face market pressure if the government fails to tackle declining competitiveness. The recently announced “competitiveness pact” (fiscal devaluation) is positive but the government has yet to take on labor market deregulation. We think France will deliver albeit hesitantly

On balance, we think Europe will remain prone to periods of market stress but these will be more country-specific and less systemic than in the past. The ECB’s willingness to provide unlimited support to countries under certain conditions has been a major factor in reducing systemic risk. But strong political support for the euro project in core countries (demonstrated in the Greek agreement) and resolve in the periphery to continue implementing tough adjustment programs (with the carrot of ECB support) have also been key. Progress on building the institutional architecture (banking union and fiscal integration), however, has lagged and is unlikely to accelerate at least until after the German elections in September 2013.

Most Europeans still support the single currency

For

Against

20

25

30

35

40

45

50

55

60

65

70

Spring 2006

Spring 2007

Spring 2008

Spring 2009

Spring 2010

Spring 2011

Spring 2012

Support for the euro (% respondents)

Source: European Commission Standard Eurobarometer, Deutsche Bank

EM: Struggling to stand out Our base case, in which Europe begins to grow and US growth accelerates to about 2½% in the second half of next year, is a moderately constructive one that should facilitate an increase in growth in EM from 4.7% this year to 5.4% in 2013.

China will likely lead the way. It will take another two or three quarters for the corporate sector to shakeout its excess capacity but rising capacity utilization and stronger profitability will eventually drive a recovery in corporate investment Exports will also benefit from stronger external demand. Overall therefore, we see growth in China picking up to around 8% in the first half of the year and 8½% in the second half -- with upside risks if higher tax revenues create from for stronger public investment.

As core markets begin to recover, however, investors will likely begin to look more discerningly at EM. The gloss has already started to come off the growth story in some cases and a number of EM countries unable to undertake difficult reforms may struggle to stand out against an improving global backdrop. Later in this EM Monthly, we therefore consider where the growth outlook remains robust and where performance could disappoint.



China: back-loaded recovery next year

5

6

7

8

9

10

11Q1 11Q3 12Q1 12Q3 13Q1 13Q3 14Q1 14Q3

Actual DB forecast% YoY

Source: CEIC, Deutsche Bank

We remain optimistic about the medium-term outlook for China. We don’t subscribe to the idea that growth will slow sharply as a result of chronic overinvestment. Infrastructure spending has been substantial but has not obviously created excess capacity – the power and transportation sectors, for example, would appear still to need significant investments to provide services to the whole population. Similarly, we think demographic constraints are not as great as believed once one allows for productivity growth in agriculture, which will release additional surplus labor. Productivity performance has also been good and, by allowing for the reallocation of capital away from SOEs to the more efficient private sector, financial liberalization should enable this good performance to be maintained without an increase in the share of investment in the economy. On balance, we think China should be able to grow at rates of around 8½% for the next few years, though this is contingent on further progress on structural reforms, something that we believe will be forthcoming with the leadership transition now out of the way.

China: likelihood of reforms in next 3-4 years Most likely reforms Possible reforms Least likely reforms

Resource pricing reform Personal income tax reform SOE reform

Interest rate liberalization Hukou reform Property tax

Capital account liberalization Rural land reform Central-local relations

Greater exchange rate flexibility Budget transparency

VAT reform De-monopolization

Resource/environmental tax reform Pension reform

Increase in social spending


The prognosis for other large EMs is less encouraging. In Brazil, despite a series of measures to stimulate the economy, GDP grew by a much weaker-than-expected 0.6% (QoQ) in the third quarter, prompting us to cut our growth forecast for this year to 1.0% from 1.5%. We have also revised down our forecast for 2013 to 3.5% from

3.8%. This disappointing performance has also raised deeper questions about Brazil’s growth model. Low investment and an ageing population are the main structural constraints facing the economy. The government’s strategy of boosting public and private consumption and devaluing the currency has simply translated into sharply rising unit labor costs and declining competitiveness. On this path, we would expect the economy’s trend rate of growth to decelerate to 3½% or below from an estimated 4½% in recent years.

Brazil: low savings constrain investment

10

12

14

16

18

20

22

Domestic saving

Investment

% of GDP

Source: IBGE, Deutsche Bank

Growth in Russia has held up relatively well at around 4% over the last 2-3 years. But deeper structural reforms will be needed if the economy is to grow faster and reduce its reliance on oil and gas, which still account for about one-fifth of economic activity. Better macroeconomic management, including a more flexible exchange rate and a new fiscal rule linking spending to long-term average oil prices, should help to keep inflation in check and reduce the volatility of growth. Weak governance and a difficult business environment, however, continue to deter investment. Population ageing will also bite sooner in Russia than in other EMs. Rather than increasing relatively low retirement ages, however, the government plans to divert contributions to private pension funds back into the public sector. We view the switch as negative for the long term health of the public finances and potentially also damaging for local capital market development.

In India, a combination of stubbornly high inflation and sharply decelerating growth could point to a decline in trend growth. Investment has also been weak, contributing little to growth in recent quarters. The government has begun to take corrective measures, including opening up the key retail and aviation sectors to foreign investment. And the economy may enjoy something of a bounce in the coming year anyway, even in the absence of further reforms, on the back of stronger external demand and a weaker exchange rate. If the economy is to return to growth rates of 8% or above, however, a second push on reforms will be necessary,



including further fiscal consolidation, and investment and financial liberalization.

Population ageing hits sooner in Russia

2000

2010

2020

2030

2040

2050

2060

Russia China Brazil India

Exit year

Exit year shows the point at which countries exit the "demographic window " when the proportion of working age population is most prominent, defined (by the UN) as the period when the propotion of children falls below 30 percent and proportion of people over 65 is still below 15 percent.

Source: UN, Deutsche Bank

The picture among other EMs is mixed. Argentina’s populist model is approaching the limits of its ability to deliver continuing growth. Failure to tackle long-standing structural weaknesses, particularly in the labor market, will continue to limit expansion in South Africa. Rapid ageing and high household debt threaten to constrain growth in South Korea. Elsewhere, the outlook is brighter. Sound policies continue to deliver strong and stable growth in Chile. Colombia and Peru are now following a similar path. With a young population and low debt levels, Turkey also has room to grow, though higher private savings are needed to finance investment.

In looking more discerningly at EM in the coming year, investors will of course want to pay attention to traditional macroeconomic and financial vulnerabilities that can derail EM performance. Our updated EM Vulnerability Monitor presented later in this EM Monthly suggests that EMEA remains by far the most vulnerable region, especially in terms of external and fiscal risks. We see vulnerabilities as highest of all (and rising) in Ukraine but also still elevated in Egypt and Hungary. Asia has by far the lowest external vulnerability and, like Latin America, little in the way of fiscal problems.

EM Vulnerability Monitor (2012)

Cur

rent

acc

ount

FX re

serv

es

Exte

rnal

deb

t

FX v

alua

tion

Ove

rall

Ove

rall

Ove

rall

bala

nce

Publ

ic d

ebt

Mat

urin

g de

bt

FX D

ebt

Ove

rall

Loan

:dep

osits

Cre

dit g

row

th

Cre

dit l

evel

Fore

ign

clai

ms

Ove

rall

Ope

nnes

s

Ove

rall

EMEA Czech Rep

Egypt

Hungary

Israel

Kazakhstan

Poland

Romania

Russia

South Africa

Turkey

Ukraine

Asia China

India

Indonesia

Korea

Malaysia

Philippines

Taiwan

Thailand

LatAm Argentina

Brazil

Chile

Colombia

Mexico

Peru

Venezuela

= medium vulnerability = high vulnerability

arrows indicate degree of change in indicator since last year

External FinancialFiscal

= low vulnerability


Strategy: Growth and Asset Reallocation

Dismal growth and broad-based policy accommodation have underpinned yet another stellar year for global fixed income. EM and HY credit markets have outperformed so far in 2012, trailed by EM local fixed income (chart). In contrast with 2011, spread compression has accounted for a substantial share of total return – a result of abundant liquidity, upgrades, and relative scarcity of high quality yield assets. Looking ahead, these double-digit returns are unlikely to repeat in 2013 given the more limited room for spread tightening and the repricing of the USTs we expect. Credit selection, especially across high-yielders, will become more relevant for performance.



Performance profile in “risk-off” mode

-4% 0% 4% 8% 12% 16%

EMBI-G

HY

DB-EMLIN

S&P

EU Eq

EM Eq

IG

DB-EMLIN (hedged)

EMFX (Total Return)

UST

EMFX Spot

Com'dty

YTD asset returns


EM local markets have once again benefited from additional easing, but – barring the adverse “cliff” scenario – we see limited room for further accommodation. In contrast, the outlook seems brighter for EMFX, which has shown remarkable resilience given this year’s poor economic performance. As the now depressed global trade and capital flows are lifted by the better growth prospects we foresee, the combination of spot gains and carry should push total returns toward low double-digit territory. Local currencies could also benefit from a likely rebalance in global flow of funds that in 2012 have been largely skewed toward fixed income funds.

The year of fixed income inflows

-5

0

5

10

15

20

25

30

35

40

Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12

EMD-HC EMD-LCDM HY EM EquityDM Equity US IGUS Govt

Cumulative Inflows, 2012 YTD to end of Novemeber (% of AUM)

Source: Deutsche Bank, EPFR

Overall, we expect a gradual rebalance away from the defensive (fixed income overweights) that marked the year 2012 to growth-centric products such as equities and

EMFX, and commodities in 2013, conditional on an orderly resolution of the US fiscal cliff early in the year1.

EMFX: Gaining ground2 We are confident that the usual EMFX-growth nexus remains intact. If the global economy does recover as we expect, EMFX should follow. Encouragingly, EMFX has posted a respectful – yet more differentiated – performance in 2012 despite being the main shock absorber in a quite eventful year. EMFX spot returns – led by Asia and EMEA – are closing the year about 2% up vs. the USD. EM currencies did lag US equities, but we believe that this stems from the favorable impact of QE on stocks vs. the USD, which is ending the year flat vs. the EUR. When we compare EMFX performance with equities – now arguably a better proxy of global growth than US equities – the correlation has remained strong. Moreover, the closer relation between Chinese GDP and EMFX in recent years should prove beneficial as China growth picks up.

EMFX follows its relevant macro drivers

6%

7%

8%

9%

10%

11%

75

80

85

90

95

100

105

110

115

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12

China GDP (YoY, rhs) EMFX (spot) SPX CRY

Source: Deutsche Bank, Bloomberg.

The outlook for EMFX obviously hinges on the resolution of the “cliff”. But in light of recent performance, the bar for EMFX to rally in 2013 seems low. Investment, credit, trade, and capital flows are so depressed that trend growth in the US – on reduced uncertainty – would likely suffice to trigger a turnaround. That said, potential USD strength and reflux of capital back into developed markets (at least in the margin) may weigh on EM currencies. Altogether, we expect EMFX to recover some lost ground but not to retrace fully to 2011 highs.

We expect differentiation to play a major role in valuation in the year ahead. The EUR/USD was an important driver

1 For a more in-depth discussion on the performance perspective for EM assets, see EM Performance – Growth and Asset Rebalance, a special report included in this Outlook. 2 For more in-depth analysis see the separate outlook piece in this publication.



of EMFX/USD fluctuations earlier in the year, but this should fade as US and China economies recover. The chart below shows that the EUR/USD “common factor” role of early 2012 has already eased. We expect this to remain the norm if the “cliff” is avoided and see EUR funding as way to position for growth differentials in favor of the US and event risks that appear largely concentrated in Europe later in 2013.

Return attribution: EUR/USD factor wanes

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

CZK HUF ILS BRL RUB PLN COP CLP ZAR MXN TRY PEN

R2 (April-2011 to Jan-2012)

R2 (Feb-2012 to Nov-2012)

R-Square (%) of USD/EMFX vs. EUR/USD


Regionally, we believe that LatAm has most to benefit from the recovery in China and the US we foresee. In the region, MXN is our top pick, but we also hold bullish positions in CLP (vs. EUR), PEN (vs. USD), and BRL (vs. JPY). Fundamental valuation appears to be a lesser concern at current misalignment levels. Although EMEA FX seems slightly cheaper (chart), the growth, EUR/USD, and commodity prospects for the region are also dimmer. Still, valuation is appealing in RUB, TRY, and PLN on higher oil prices, re-rating, and – for all of them – carry-to-vol. In Asia our favorite currencies are CNH (on possible band widening), and KRW, PHP (where basic balances and valuation remain very supportive).

Fundamental valuation: A mild plus for EMEA .

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

EMEA

Asia

LatAm2011 2012


Intervention should be an ongoing concern, especially in Asia, Brazil, Turkey, but also in the Andeans. Nevertheless, with inflation and trade flows gaining momentum, the balance of risk should gradually change with authorities eventually giving in to more appreciation.

As for “cliff” tail protection, we believe that EMFX vols are an appealing hedging vehicle given their depressed levels and high sensitivity to risk especially in distressed environment. In particular, we like long 3Mx3M FVA in MXN, ZAR, TRY and KRW.

EM Rates: The Cliff and Beyond3 The following months could see considerable changes in the outlook for rates in EM and also in global markets. The imminence of a dominant common factor such as the “cliff” has clustered the forward paths of most EM curves around those of the US and EU curves (Brazil being the notable exception). If the US avoids the “cliff” as we expect, global reflation should proceed.

In our baseline scenario, this means 10Y US yields at 2.75%, and the SP500 at 1,500 by the year end. Under this backdrop, EM capacity constraints should become more visible and EM curves should start to price more closely country-specific fundamentals. Until the uncertainty around the “fiscal cliff” is resolved, however, EM rates will likely remain depressed.

This balance of risks bodes for selective defensive receivers in the near. If the “cliff” scenario materializes we believe that EM central banks will again ease to defend growth. The chart below summarizes selected central bank responses to our negative scenario of a 2%+ recession in 1H13. This would support receiving n the front end in Brazil, Chile, Mexico, South Africa, and Israel, despite the already depressed level of monetary policy rates in most of these economies.

Although EM curves have often times steepened in response to sell-offs in global markets, the performance of the past years has been more aligned with the typical behavior seen in developed fixed income markets. Accordingly, we would expect longer tenors to follow lower US yields (1-1.25% under our adverse scenario) should the adverse scenario materialize. Considering the scaled market response observed after the US downgrade in 2011, 10Y receivers in Mexico, Brazil, Colombia, and Chile, in particular, would be the most attractive receivers in the longer tenors of EM curves (bottom panel of the chart below).

3 See the rates outlook piece in this publication for more in-depth analysis.



Picking short-end receivers under the “cliff”

BR

MX CL

IS

ZA

CZ

HU

PL

TR

CO

BR

MXCL

IS

ZA

CZ

HU

PL

TR

CO

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

-300 -200 -100 0 100 200

Baseline

With Fiscal Cliff

Curve roll (6M2Y-2Y , in bps)

(DB end-2013 forecasts) - Market (bps)

receivers

payers

TRY PLN

HUFCZK

ZARILS

MXN

USD

EURBRL COP

CLP

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

-140 -120 -100 -80 -60 -40 -20 0

z-score, 10Y

Normalized move, 10Y


Even if the “cliff” scenario is ruled out we still see value in selected receivers given the slow start for the global economy we foresee. Indeed, the easing cycles may not be over yet in Brazil and Colombia, and we expect 50bp of cuts in South Africa while Hungary may cut even more than already priced. The very long end of Mexico should also continue to benefit from reform momentum – a factor that should support the long end of Russia as inflation targeting gains credibility.

Past the “cliff threat”, we believe that the global economy will eventually gain momentum. At that point, the balance of risks should change significantly as rates reflect better fundamentals. As the chart below shows, several EM yields are well below “fair” under our baseline scenario. Rates in Turkey, Poland and Peru stand out as having undershot considerably our “fair” values. Mexico, Chile, Colombia and Russia look mildly rich, but they would still outperform US fixed income (first panel). Possible contagion risk from higher US yields could also take a toll on EM rates. From this perspective, Israel and Mexico seem most exposed to US rates repricing (second panel below).

Comparing market and “fair” yields

-300

-250

-200

-150

-100

-50

0

50

100

BRL CLP COP MXN PEN CZK HUF ILS PLN RUB TRY ZAR

1Y 2Y Fwd - 1Y 2Y Fair


Fwd - Fair (bps)

CZK

MXN

ILS

PLN

CLP

HUF

RUB

BRL

ZAR

PENCOP

TRY

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

0 0.1 0.2 0.3 0.4 0.5 0.6

R2 Local Slope x US Slope

R2 Local Level x US Level


Focusing on relative asset allocation, we see value in both linkers vs. nominal bonds, and local vs. (offshore) global debt. We believe that inflation premia are low, particularly when contrasted with inflation risks in Brazil, and Turkey. In addition, local bonds are becoming more attractive vis-à-vis their global counterparts. In Brazil, high yield differential and pull-to-par has reduced the time it takes to offset the IOF burden; in Chile the introduction of GDNs should provide an additional boost to the local curve; and in Colombia, the imminent tax reform could lower the entry cost for foreign investors

Technically, we believe that, except for Turkey, Ukraine, and Hungary, supply risk seems contained given better growth prospects and increased foreign demand. In our view, the risk of a potential rotation out of bond funds into equities could be tamed by still attractive interest rate differentials and currency upside. However, given the high correlation between EM and global bond fund flows, such relocation could still disrupt EM local markets.



Sovereign Credit: Less Gas in the Tank 2012 was a remarkable year for EM sovereign credit, with unexpectedly strong performance, driven primarily by spread compression. 2013 is highly unlikely to deliver comparable returns, but we believe that there is still scope for further spread compression. Our baseline scenario sees the EMBI Global ending 2013 at a spread of around 225bp. This is coupled with 10Y UST yields rising to around 2.75%, which should yield a total return of just below 5%.

Motivating our expectation for further spread compression in EM are two factors: (a) a modest further spread compression in DM credit markets, supported by improving economic growth and higher UST yields (see first chart below) and (b) outperformance of EM vs. DM, making up for the relative lack of outperformance (in spread terms) over the past four years (see second chart below).

Credit spreads can be modeled reasonably well on

the basis of growth and risk-free rates

0

100

200

300

400

500

600

1993 1998 2003 2008 2013

Moody's Baa spread

Model spread

Model projection

Spread over USD swaps, bp

Model: Log(Spread)= -0.094 x G7 GDP growth (past 2q annualized, %) -0.093 x 10Y US Swap yield (%) -0.04 x Fed Funds (%) + 5.75

Source: S&P, Moody’s, Fitch, Deutsche Bank (for 2013 forecast)

Given our constructive, but relatively benign outlook for EM sovereign credit, we believe it should remain an important, core part of investors’ portfolios. Furthermore, given that under our baseline scenario we anticipate a constructive environment for risk in Q1 and likely continued supportive technical environment, we would recommend investors begin the year with a small overweight exposure.

However, it is hard to deny that the risk-reward is becoming increasingly skewed and we would hesitate to say that an overweight exposure is advisable if the investment horizon is for the whole year.

In terms of country-specific recommendations, we recommend an overweight exposure to Turkey, Romania, Venezuela, Mexico and Indonesia. We recommend an underweight exposure to South Africa, Brazil, Chile, Hungary and Ukraine.

We expect the bond-CDS basis to move lower in 2013 as the outperformance of bonds eases. We expect this to be most pronounced in Brazil and Russia.

The rationale behind all these recommendations, and others, are discussed at length in the special report Sovereign Credit Outlook for 2013, later in this publication.

Market pricing now lags the rating agencies’

assessment of EM sovereign credit quality

9

12

15

2003 2005 2007 2009 2011

Agency Rating

Market-Implied Credit Quality

Credit Quality Index (BBB=9 , BB=12 etc.)

For an explanation of the methodology behind the ‘market-implied credit quality’ please see the appendix to the Sovereign Credit Outlook for 2013 later in this publication. Source: Deutsche Bank

Drausio Giacomelli, New York, +1 212 250 7355

Robert Burgess, London, +44 20 7547 1930

Marc Balston, London, +44 20 7547 1484



Rates in 2013: The Cliff and Beyond

The following months could see considerable changes in the outlook of EM rates, as the imminence of a dominant common factor such as the “cliff” has clustered the dynamics of EM curves around the US and EU paths.

In our view, after painful negotiations, US politicians will eventually reach a bargain into 2013, which will suffice to avert a recession and reduce fiscal uncertainty for the better part of the year ahead. This more benign backdrop should pave the way for curves to more closely price country-specific fundamentals rather than global risks.

We see limited value in receiving rates under the resolution scenario, but under a sluggish start of the global economy, the easing cycles may not be over yet everywhere (in particular Brazil, Colombia, South Africa, and Hungary). The very long end of Mexico should also continue to benefit from reform momentum – a factor that should support the long end of Russia as inflation targeting gains credibility. In any case, we recommend receiving against US rates.

The steep fiscal adjustment that the “cliff” entails in the alternative scenario, and the likely knock on global, could likely trigger preemptive cuts as EM central banks which have repeatedly revealed their preference to defend growth vs. fighting inflation. Our preferred receivers in this case would be �Brazil, Chile, Mexico, South Africa, and Israel. EM would eventually bull-flatten, but EM slopes would likely lag the US flattening.

We see a slow start for the global economy, but believe that the outlook could brighten significantly as uncertainty is resolved along the way. As growth gains more solid footing, we may see overshooting vs. UST in markets such as Peru, Turkey, and possibly Israel.

The ”Cliff” and Beyond.

The following months could see considerable changes in the outlook for rates in EM and also in global markets. The imminence of a dominant common factor such as the “cliff” has clustered the dynamics of EM curves’ forwards around the US and EU paths as the chart below shows. With the exception of Brazil, EM curves are priced to evolve in line with global markets in the foreseeable future despite the significant differences across EM economies, their better growth potential, and higher inflation risks.

Under our baseline scenario, the 10Y US yields would end the year at 2.75% with SP500 at 1,500 (and above 3% and 1,600, respectively, if a “Grand Bargain” is reached). This more benign backdrop should pave the way for curves to more closely price country-specific fundamentals rather than global risks. However, in the near term, the fact that EM central banks still have room to cut substantially under the more adverse scenario of a sharp recession in the US (and likely globally), EM curves should remain depressed and highly correlated with the US curve.

In the following sections we discuss the strategy implications for these alternative scenarios. Although a sharp recession early in the year as a result of going over the fiscal cliff is less probable in our view, we tackle this risk first as this is the largest and most imminent event risk ahead. Then we move to our benchmark scenario for the remainder of the year – a more benign one that assumes this hurdle is cleared.

A glacial pace of normalization priced in (1Y forward paths)

-100

-50

0

50

100

150

200

250

300

BRL

CLP

COP

MXN

TRY

ILS

ZAR

USD

-80

-60

-40

-20

0

20

40

60

80

100

CZK

PLN

HUF

EUR




First, the cliff-hanger

There is little room for most EM central banks to cut beyond what is already expected by the market under our baseline scenario. Hungary (as long as the currency remains stable), Brazil (amid subdued recovery), Colombia, and South Africa still offer some value in the short end. But in most cases markets appear to be pricing too much monetary easing already. However, the steep fiscal adjustment that the “cliff” entails and the likely knock on effects to Europe, Japan, China, and overall EM economies of a sharp recession in the US would trigger preemptive cuts as EM central banks have repeatedly revealed their preference to defend growth vs. fight inflation. We doubt these preferences would change under a renewed bout of global distress.

We estimate what could be the reaction of selected EM central banks under the assumption of a 2.5% US recession in 1Q13. Despite the already depressed levels, we find still significant value in receiving 2Y rates across EM curves. Brazil, for external but also domestic reasons, would offer most value, according to our estimates (chart). Domestic vulnerability would also amplify the blow in South Africa, although the more resilient Mexico, Chile, Colombia, and Israel also stand out as attractive receivers under this scenario. Our estimate for Chile would look particularly conservative should the global economy face a more protracted slowdown, since the country’s economy would likely be one of the last to turn.

Picking short-end receivers under the “cliff”

BR

MX CL

IS

ZA

CZ

HU

PL

TR

CO

BR

MXCL

IS

ZA

CZ

HU

PL

TR

CO

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

-300 -200 -100 0 100 200

Baseline

With Fiscal Cliff

Curve roll (6M2Y-2Y , in bps)

(DB end-2013 forecasts) - Market (bps)

receivers

payers


EM curves are also quite flat already and in several cases long-term yields barely compensate for inflation risk. Still, as we believe that the US 10Y swaps could drop to 1-1.25% under the worst case scenario, there is room for EM curves to rally further. We believe that having to face the “cliff” would be very detrimental to creditworthiness and we use the recent US downgrade (a consequence of

politician’s failure to agree on similar issues) during the summer of 2011 as a benchmark. The chart below shows the normalized move in yields (scaled to account for the differences in the levels of yields then and now) and the 1Y z-scores of these rates as an additional gauge for how low these rates already are. When we run this event analysis for 2Y rates, the results are similar to the ones obtained above, although Chile stands out as the best receiver (not shown).

Looking for 10Y receivers in EM, Mexico, Brazil, Colombia, and – particularly – Chile look most appealing (chart). Turkey also stands out, but at -3 standard deviations from last year’s mean and the risk of FX pass-through, we see better defensive trades in the former countries. Only Poland would out-rally the US, but the curve is already quite flat historically. From a curve positioning standpoint, note that EM curves eventually bull-flattened (more significantly so in Mexico and Colombia) as growth dominated risk concerns.

Picking long-end receivers under the “cliff”

TRY PLN

HUFCZK

ZARILS

MXN

USD

EURBRL COP

CLP

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

-140 -120 -100 -80 -60 -40 -20 0

z-score, 10Y

Normalized move, 10Y

TRY

PLNHUF

CZKZAR

ILS

MXNUSD

EURBRL

COP

CLP

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

-60 -50 -40 -30 -20 -10 0 10 20

z-score, 2Y10Y slope

Normalized move, 2Y10Y slopeSource: Deutsche Bank

Brazil, Chile, Mexico, South Africa, and Israel are our favorite receivers over the “cliff”. Regarding the shape of the curve, EM would eventually bull-flatten, but EM slopes would likely lag the flattening in US yields.



Avoiding the Cliff: Normalization begins

In our view, after painful negotiations, US politicians will eventually reach a bargain into 2013. Although this bargain may not be “grand”, it should suffice to avert a recession and reduce fiscal uncertainty for the better part of the year ahead. Lower uncertainty, finally more investment, and protracted monetary accommodation should lift activity prospects, but ongoing fiscal contraction and deleveraging should continue to weigh on growth. We thus expect gradual reflation in 2013 that is consistent with orderly repricing of inflation risks and monetary policy across global markets. However, as we discuss later in this piece, this process may gain momentum as uncertainty is reduced and growth picks up so that potential technical dislocations may well occur along the normalization path we foresee.

We see limited value in receiving rates under the resolution scenario. However, given the slow start for the global economy we foresee, the easing cycles may not be over yet in Brazil and Colombia. We also expect 50bp of cuts in South Africa while Hungary may cut even more than already priced. The very long end of Mexico should also continue to benefit from reform momentum – a factor that should support the long end of Russia as inflation targeting gains credibility. But even in these cases, we would recommend receiving the long end of these curves vs. paying US rates.

Looking further down the road, if our baseline scenario materializes and the global economy does gain momentum into 2H13, the balance of risks should change significantly. In this case, EM central banks’ pro-growth bias and more prevalent capacity constraints in EM will likely be tested later in the year. Not only nominal curves are trading in many cases at (or close to) record minimum levels (as in Peru and Colombia) but real rates are also hovering well below long-term historical equilibrium levels (chart). This has fueled domestic demand as most output gaps are closed, labor markets are tight, and non-tradable inflation has been quite persistent.

EM real rates variation near, or at, rock bottom

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

BRL CLP COP MXN ILS TRY ZAR

Actual Avg

10Y Real rates


So far, most EM central banks have downplayed inflation risks, justifying their actions on the elevated uncertainty of the external scenario. Contained tradable inflation and strong currencies have helped in many cases counteract domestic inflationary pressures. But this balance of risks seems poised to change if the US manages to avert the “cliff.” The central banks of Brazil and Turkey are natural candidates to be tested later on, but they may also be more resistant to react, thus fueling inflation expectations, as we discuss below in the linkers session.

We assess these reflation risks from two perspectives:

1. The market risk contagion from the repricing in UST we foresee;

2. The natural repricing of macroeconomic factors.

UST contagion The chart below shows the r-squares of the regression of the first two factors of our Nelson-Siegel decomposition of EM curves vs. 10Y and 2Y/10Y US swaps (the respective proxies for level and slope). Czech Republic, Israel, Mexico, Poland, and Chile dynamics are more closely aligned with US rates and thus, in principle, most sensitive to US repricing. Accounting for the level of rates, linkages with core countries, and stages in the business/monetary cycles, we believe that Mexico, and Israel should be most exposed to reflation in core rates.



Assessing sensitivity to US yields (10Y and 2Y/10Y)

CZK

MXN

ILS

PLN

CLP

HUF

RUB

BRL

ZAR

PENCOP

TRY

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

0 0.1 0.2 0.3 0.4 0.5 0.6

R2 Local Slope x US Slope

R2 Local Level x US LevelSource: Deutsche Bank

The macro angle From a macroeconomic perspective, we use as a reference our model of local interest rates, which can provide us both “fair” curves as well as implied macroeconomic variables.4 In particular, we focus on the combination of policy (benchmark) interest rates, output gaps, consumer inflation, curve dynamics, and their intrinsic relationships. The findings of our model are summarized below and shown in the chart.

4 The methodology used in this piece is similar to the one presented in “EM Rates: Reassessing Macro Risks”; EM Monthly June 2012, to forecast the joint dynamics of local curves and a set of relevant macroeconomic variables. To facilitate this analysis, local curves are in turn decomposed into its main factors using Nelson-Siegel (NS) methodology. A crucial assumption of the model is that the joint dynamics of curve and macro factors is properly captured with a Vector Auto Regression (VAR) representation. Given current values of the variables, the estimated VAR can be used to project the estimated path of the variables in the model (that is, we are able to obtain conditional expectation of future values given the actual information). The shortcoming of this approach is that even if we knew some of the future values in the variables included in the VAR, it was not possible to incorporate that information into the VAR forecasts. In this piece we address that issue by relying in an additional econometric technique -Kalman filter. By using this filter, which follows the same VAR dynamics, we can predict values of some of the components of the VAR assuming that the remaining components follow a pre-determined path . For instance, we are able to forecast the macro variables assuming a determined path for the NS factors. In our case, we determined the implied path of certain macroeconomic variables by assuming that yield curves will converge to the respective forward curve. In some sense, we recover the implied macroeconomic variables which are consistent with the current term structure of interest rates.

Comparing market and “fair” yields

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0

50

100

BRL CLP COP MXN PEN CZK HUF ILS PLN RUB TRY ZAR



Fwd - Fair (bps)


Brazil seems close to fair, but – with growth risks biased to the downside, in our view – we still see room for receiving (assuming that the more accommodative monetary policy response of this central bank will not change).

The Chile curve will likely outperform US rates as they eventually adjust to 2.75%+ as it is already hovering near “fair”. The same applies to Colombia.

In MXN, the model points to rates close to fair from a fundamental standpoint. This should allow the spread in the long end vs. US yields to compress further as reforms materialize. The same applies to Russia.

Polish rates have undershot and thus bode for paying later in 2013. CE3 rates in general have undershot.

South African rates are slightly above fair and should thus also outperform US rates, while Turkish rates are depressed vs. “fair” and exposed to more aggressive repricing as growth gains momentum later on. The same applies to Peruvian rates.

To conclude, we see a slow start for the global economy, but believe that the global outlook could brighten significantly as uncertainty is resolved along the way. We thus see value in selected receivers during this slow start, but would either receive vs. paying US rates where valuation and domestic fundamentals bode for flattening (such as in Mexico, and Russia). As growth gains more solid footing, we may see overshooting vs. UST in markets such as Peru, Turkey, and possibly Israel. In sum:

Receive front end in Brazil, Colombia, Hungary, and South Africa early in 2013.

Keep core receiver in the long end of Mexico, Chile, Colombia, and Russia vs. paying US rates.



As growth firms, position for reflation via short-end payers in Israel, and Mexico and longer tenors in Turkey, Poland, and Peru.

Asset selection

In the following sections we look in more detail at the choice between outright vs. curve trades, nominal vs. real bonds, and onshore vs. offshore bonds.

Lost in translation: Implementation via curve trades One important lesson from the recent years and 2012 in particular is that translating directional views via curve trades has become less effective, since the relationship between curve levels and slopes has either changed or become unstable. The chart below shows the r-squares of slopes vs. both the short end (as a proxy of monetary policy) and the long end (as a proxy of reflation).

(Dis)Connecting 2Y/10Y slopes and levels

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

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

vs 10s vs 2s

Source: Deutsche Bank. R-squares of 2Y/10Y slopes vs. 10Y and 2Y yields in weekly changes in 2012.

For the “do nothing” central banks (those who have kept interest rates roughly unchanged over the past year such as Mexico and the majors), the 10Y sector has better captured reflation (via bear-steepening) and deflation risks (via bull-flattening). The relatively high r-squares suggest that – in those cases – curve trades could still effectively translate directional views (as these central banks are unlikely to do anything in the near term).

However, for the more active central banks, historical correlations have collapsed over the past year. Changes in policy reaction functions, bond fund flows, and the more difficult separation of structural vs. cyclical shocks underpin this instability.

As these seem unlikely to change anytime soon, one important takeaway from 2012 is to avoid translating directional views via curve trades – especially where central banks have been more active.

Nominal vs. Inflation-linked bonds The acceleration in food prices in particular of 3Q has lost steam. Subdued growth and base effects suggest that inflationary pressure will ease into 2013. But as the table below shows, inflation premium is relatively low under our baseline scenario. Obviously, if reflation gains momentum in 2013 and the Fed phases out QE, real rates will rise, thus weighing on duration. However, since our goal is to compare nominal vs. inflation-linked bonds, we focus on inflation risk and inflation accrual.

In our assessment, inflation premia are low, particularly when contrasted with inflation risks in Brazil, and Turkey, where we favor linkers vs. nominal bonds as a core trade. As the table below shows, inflation expectations are often times running below market breakevens – possibly due to the recent deceleration in prices.

Nominal bonds vs. linkers: Value and risk assessment B/E

Inf. Prem.

Proj. Infl. (DB)

Proj. Accr.Infl.

MoM YoY Min. Max. 1Y 2Y 2Y 2Y 3M 3M

BRL 0.59% 5.45% 2.5% 6.5% 5.00% 5.20% 5.45% 0.25% 1.36% 1.36%

CLP 0.56% 2.92% 2.0% 4.0% 2.40% 2.70% 2.56% -0.14% 0.65% 1.07%

COP 0.16% 3.06% 2.0% 4.0% 3.10% 3.15% 3.11% -0.04% 1.29% 0.80%

MXN 0.51% 4.60% 2.0% 4.0% 3.80% 3.70% 3.87% 0.17% 1.81% 1.81%

ILS -0.19% 1.83% 1.0% 3.0% 2.20% 2.30% 2.25% -0.05% 0.16% 0.37%

TRY 1.96% 7.80% 3.0% 7.0% 6.65% 6.24% 4.54% -1.70% 2.28% 4.32%

ZAR 0.64% 5.61% 3.0% 6.0% 6.00% 6.20% 5.85% -0.35% 0.74% 1.37%

Expected Inflation

Headline Inflation

Target


The main risk to being long linkers is the depressed level of real rates, but we should expect central banks to tolerate more inflation (especially in Brazil and Turkey) while they gather stronger signs that the recovery we foresee is on solid footing. This is not the case in Chile, where real rates are hovering near relative historical highs and inflation premium remains subdued.

More idiosyncratically, one important risk to consider in Brazil is further administrative measures to contain prices. But with non-tradable inflation running above 8%, commodity prices in BRL hovering near the highs of the past 4 years, and expanding fiscal accounts, the risk of a rise in inflation above 7% (even if temporary) is significant. In Chile, tight labor markets and the risk of oil prices back above USD100 as we foresee also bode for more defensive trades, while, in Turkey, we fear that monetary policy may have turned loose too soon.

On-shore/off-shore Search for yield has pushed global bonds to historical lows in some cases – in absolute terms and when compared to local bonds. In the case of Brazil, the combination of high yield differential and pull-to-par has



reduced the time it takes for local bond investments (net of 6% IOF) to breakeven with Global BRL bonds to just about 18 months (in the case of Global ’22 vs. NTNF ’21).

The high spread has also triggered Global Depository Notes (GDNs) programs for Chile, which could increase foreign participation in that market and thus compress the hefty yield differential between local bonds and the CLP Global (approximately 170bp) – well in excess of taxation. Regarding taxation, if Colombia does reduce the burden for foreigners to a flat 14% income tax, local TES spread vs. Global COP (still 180bp at the TES ’24 benchmark) would continue to compress.

Technicals: The magnification risk

To finalize, we note that supply risk seems overall contained as financing needs are likely to drop next year on better growth prospects. As the chart bellows shows, however, in Turkey, Ukraine, and Hungary supply will increase significantly and bear watch. In Peru and Colombia, governments may increase local funding at the expense of foreign funding so as to contain FX appreciation. However, external demand in Peru and also in Colombia (if taxation is reduced as we expect) should outweigh these risks.

Supply risk contained – with notable exceptions

Bul

Cro Cze

Est

Hun

Lat

Lit

Pol Rom

Tur Isl

Saf

Ukr

Rus

Arg

Brz

Chl

Col

Mex

Ven

Chn

Hkg

IndIdn

Kor

MysSgp

0

4

8

12

16

20

0 4 8 12 16 20

Gross financing needs 2013 (% GDP)

Gross financing needs 2012 (% GDP)Source: Deutsche Bank

Another important risk to consider is the potential rotation out of bond funds into equities should growth pick up. EM bond flows are highly correlated with global flows and this could take a toll on the long end of EM curves, in particular. As the chart below shows, foreign holdings continue to hover around historical highs. The still attractive interest rate differential and currency upside suggest that this risk should be limited, however.

Foreign holding hovering near historical highs

BR

CZ

HU

ID

KR

MXMY

PL

RU

TR

ZA

TH

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

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


Drausio Giacomelli, New York, +1 (212) 250 7355 Mauro Roca, New York, +1 (212) 250 8609 Guilherme Marone, New York, +1 (212) 250 8640 Jose Vieira-Filho, New York, +1 (212) 250 593



Appendix: Rates Strategy Summary

Country View Strategy Risks

China We are cautious on duration as growth recovery

and supply risk on the credit market likely will drive

up long-dated rates.

Pay 2Y/5YCurve steepeners on Repo IRS curve at

15bps; pay outright 5Y Repo NDIRS/IRS when 5Y

retraces to 3.3%; Shibor floaters offer relative

value to fixed rate bonds; buy 10Y CGB at above

4%

Downside surprises to economic growth, credit

events in the bond market and delay of financial

liberalization reforms

Hong Kong Capital inflow will continue in 2013 and liquidity

injection by the HKMA will keep the front-end Hibor

fixing relatively low; Long-end of the Hi/Li basis

curve is too steep by historical standard.

Put on 5Y/10Y Hi/Li basis curve flattener at 15bps;

switch out of 10Y EFNs to 10Y GBHK for about

30bps pickup in yield;

Long-dated corporate liability hedging is a key risk

to our flattening view on Hi/Li basis curve.

India We are constructive on duration going into 2013 on

the back of expectations of policy easing and

benign technicals. But we suggest active and

opportunistic currency hedging because INR will

likely remain volatile.

Overweight on bonds, add to risk on back up in 10Y

yields to 8.25%

Higher than expected slippage on the fiscal gap

Indonesia Carry is the biggest attraction to own duration.

Technicals are still broadly constructive, with

supply in check, and BI buying to likely provide exit

in a sell off.

But we are wary of getting overweight at current

levels, particularly given the risk of potential

reduction in spot liquidity in the event of any global

macro stress

Marketweight. Use any cheapening in NDF points

to add to hedges.

Stronger than expected global recovery

Malaysia Ample liquidity, high real rates & lower supply

outlook for 2013 will keep yields supported. A

relatively hawkish stance by BNM and flat curve

shape means any rally in yields will be short lived.

0-5Y part of the MGS curve could stay supported

even though the 5Y-10Y part could steepen on UST

sell off and/or election related risk

Pay 5Y swap spreads below +10bp. Target:+30bp Global macro situation deteriorates causing swaps

to outperform bonds.

Philippines The cyclical tailwinds will get less favorable in

2013, as BSP reverses some of its monetary

easing. However, the strength of onshore liquidity

technicals, and a re-rating of the sovereign's credit

fundamentals will likely force yields to grind lower

still, and for the curve to further bull flatten early in

2013.

Modest overweight. Bearish steepening in the US yield curve

Singapore Insurers, banks and offshore demand will keep

SGS supported even if UST yields start selling off.

The beta of SGS yields to UST yields could be a lot

lower than it has been in the past. Given the

uncertainity around the fiscal cliff, SGS curve is

likely to sell off only post Q1

Receive 5Y5Y IRS in Singapore vs US(Target:

+30bp)

Timeline for RBC2 implementation is extended

South Korea We expect s bearish steepening bias in the KTB

and IRS curves with a target of 3.40% for 10Y KTB

yields in 2013 although a probable BOK rate cut

could lead ot a short-lived rally in 1Q. Demand

from on and offshore investors is likely to be

slower. Furthermore, duration supply will increase

despite similar gross and net issuance of KTBs.

Pay the dips in swaps in the event of a BOK cut.

Favor conditional steepeners.

Going over' the US fiscal cliff could lead to a

substantial monetary easing and in turn a rally in

bonds.

Thailand Bond markets could continue to be under supply

pressure however a dovish stance by BoT will

prevent rates from selling off much. Bond curve

could remain steep unless PDMO cuts down local

currency issuance. Front end of the IRS curve is

too steep.

Receive 2Y forward 1Y IRS at 3.25% (Target: 3%) Global macro rebounds causing the market to

expect rate hikes in the near/medium term.

Taiwan We are neutral on duration for now as the market

is more likely to consolidate after the recent rally

and recent data points to improvement in

economic activities;

Pay 5Y TWD NDIRS outright at 1.00%; Put on

2Y/5Y NDIRS steepener at 14bps;

Spillover from G3 economic growth deceleration

and CPI falling faster than expectation.




Appendix: Rates Strategy Summary Cont’d


Czech Domestic and German economic backdrop

remains gloomy. Political risks could drag CZK

yields higher.

Neutral for now. A strong sell off in Bunds will be a clear risk.

Egypt Cautiously optimistic about economic and financial

market performance in 2013 given the 22m SBA

with the IMF, who noted objectives of declining

inflation, improving competitiveness and increasing

reserves.

Neutral for now, but we have a bullish bias in EGP

assets for 2013.

There remain significant risks ahead: tight funding,

risks to recovery in tourism / FDI due to

geopolitical risks, and

remaining important steps for progress in political

transition.

Israel The subdued growth, low inflation and weak

backdrop means we attach some probability to

the scenario of another 25bp rate cut in Q1 in

Israel.

We recommend being received in 5Y ILS at 2.65%,

with a target of 2.40% and a stop at 2.75%.

Resumption of geopolitical risks. Specifically an

Israeli strike on Iranian nuclear facilities - though

our base case remains that the likelihood of this

happening is low.

Poland Given a poor GDP reading in Q3 and inflation

expected to fall back into NBP's target range in

Q1, we now see a floor in the policy rate of 3.25%

by the end of 2013.

We think the swap curve fairly reflects the balance

of risks in monetary policy (curve priced for

roughly 120bps of cuts) and remain sidelined in

swaps for now.

YoY CPI dropping meaningfully below 3% could

lower the bar for a more front loaded and deeper

easing cycle than what is currently priced.

Russia Constructive OFZs. Non-residents are under

positioned, yields remain attractive vs. our

assessment of external vulnerabilities and we

expect inflation to slow in 2013.

Long Apr21 OFZs at 6.90%, target 6.50% and with

a stop loss at 7.20%.

A sharp turn in risk sentiment or an unexpected

rise in inflation would be risks to the trade.

South Africa We stick to our view that the SARB could cut rates

by 50bps in Q1. We think SARB remain concerned

with the uncertainty and lack of confidence in the

South African economy. Core inflation remains

subdued for now.

Continue receiving 2Y target 4.90 and with a stop

at 5. 30. We are also constructive the shorter

tenor bonds - specifically the R203s.

A pick up in core inflation, rand weakness and a

resumption of wage induced strikes are risks to

our view.

Turkey Attractive back end yields, a solid fiscal position

and improved macro economic indicators (decline

in CA deficit, inflation and higher ROC for local

banks) are positive factors for Turkey's ratings

prospects.

Long Jan22s at 6.80, target 6.50. Heightened political tension could see a spike in

TRY yields.

Argentina The stay order granted by the Appeals court

produced an expected recovery in all Argentinean

assets, including local ones.

Remain underweight on the local curve. Expansionary policies could further worsen the

inflationary and competitive situation, exacerbating

financial repression and negative growth.

Brazil The recent weaker than expected economic data

releases is fueling expectations of additional

monetary easing.

Enter Jul’14 DI receiver after taking profits on

Jan’14/Jan’17 steepener, and maintain long NTNB

‘45.

The combination of low interest rates and weak

currency could stoke inflation in the future.

Chile After suffering a temporary spike due to volatile

prices, inflation is expected to decline considerably

during the last quarter.

Take profits on 1Y1Y CLP/CAM payer and enter

long 10Y rates (CLP/CAM or BTP) vs UST.

Tradable inflation could add to already-elevated non-

tradable inflation

Colombia TES bonds have rallied to historical lows as the tax

reform advanced in Congress and the central bank

continued to ease monetary conditions.

Take profits on TES ’24 and enter 1Y COP/IBR

receiver.

A softening of external terms of trade as a result

of a global slowdown.

Mexico The passage of that reform together with a

positive message from the entering government

regarding the remaining ones is helping the curve

to recover.

Take profits on 2Y TIIE-US spread and long

MBonos 5Y and buy MBonos (or TIIE) 20Y vs UST

20Y.

Stubborn inflation pressures fueled by supply

shocks.

Peru The local curve continued to grind lower, with the

front end sinking well below the reference interest

rate under no expectations of monetary easing in

the near future.

Remain neutral in local rates. Further delays in the resolution of social conflicts

and postponements of investment projects in the

mining sector.

Uruguay Uruguayan linkers offer not only an attractive

source of diversification but also sizable carry.

Enter long UYU ’18. Further increase in inflation that would require

additional monetary tightening. Political stalemate

and conflicts over economic policy mix ahead of

2014 elections. Source: Deutsche Bank



FX Outlook: Gaining Ground EMFX has posted a respectful performance this year

despite being the natural shock absorber in a quite eventful year. Although trailing well behind fixed income, EMFX spot returns are likely to close the year about 2%

Going forward we believe that EMFX should rally if the global economy does recover. While performance is conditional on the resolution of the “cliff”, the prospects of growth will likely suffice to trigger a turnaround.

Potential USD strength and potential reflux of capital back into developed markets might however weigh on future EM currencies. Altogether, we expect EMFX to recover some lost ground but not to retrace fully to 2011 highs.

We expect differentiation to play a major role in valuation in the year ahead. The EUR/USD was an important driver of USD/EMFX performance earlier in the year, but we expect it to be less so as US and China economies recover.

Consequently, if the cliff is avoided we expect EUR funding as way to position for growth differentials in favor of the US and event risks that appear largely concentrated in Europe later in 2013.

Finally, intervention should be an ongoing concern, especially in Asia, Brazil, Turkey, but also in the Andeans. That said, with inflation and trade flows gaining momentum, authorities might eventually reduce the pace of interventions.

In Asia, our favorite picks are CNH, KRW and PHP. In LatAm, MXN is our top pick, but we also hold bullish positions in CLP (vs. EUR), PEN (vs. USD), and BRL (vs. JPY). In EMEA, we are most bullish in RUB, TRY, and PLN. For tail hedges, we like long 3Mx3M FVAs in MXN, ZAR, KRW and TRY.

A brighter outlook

Although EMFX spot performance in 2012 has paled in comparison with fixed income (both local and credit), it has managed to break into positive territory in a year marked by dismal global growth, depressed trade and capital flows, substantial monetary easing, and large event risks. We expect a gradual improvement in these underlying conditions in 2013 – an improvement that may gain momentum into the second half of the year. Accordingly, we expect to see some rotation away from fixed income funds into equities and currencies that should support more substantial appreciation (though still within the limits of continued deleveraging in developed

countries). This better backdrop and higher inflation pressures should also contain interventionism. As we expect the US to pull ahead of its G3 peers, we favor EUR and JPY as funding currencies. In this scenario our recommendations for EMFX are:

In Asia, our favorite picks are CNH, KRW and PHP.

In LatAm, we favor MXN is our top pick, but we also hold bullish positions in CLP (vs. EUR), PEN (vs. USD), and BRL (vs. JPY).

In EMEA, we are most bullish, RUB, TRY, and PLN.

Taking stock: A resilient buffer EMFX has posted a respectful performance this year despite being the natural shock absorber in a quite eventful year. Although trailing well behind fixed income, EMFX spot returns – led by Asia and EMEA – are likely to close the year about 2% up. Investors have been concerned about EMFX’s substantial underperformance vs. the SP500 (12% up), but we believe these concerns are overdone. US equities’ valuation has been distorted by successive rounds of QE so that commodity prices now seem more accurate proxies for global growth. Accordingly, we find that EMFX has continued to perform in line with the global activity (actually outperforming commodities). As the chart below shows – EMFX has also tracked one of the main drivers of both global activity and commodities: China GDP growth. The usual EMFX-growth nexus seems thus intact. If the global economy does recover as we expect, EMFX should rally.

EMFX follows its relevant macro drivers

6%

7%

8%

9%

10%

11%

75

80

85

90

95

100

105

110

115


China GDP (YoY, rhs) EMFX (spot) SPX CRY

Source: Deutsche Bank, Bloomberg.

Looking beyond the aggregated numbers, increased dispersion of returns has been another important aspect of performance this year. As global growth has been too weak to lift the asset class, country-specifics have often times dominated. These included economic resilience, politics, monetary policy and IMF involvement, and their



impact has been quite large. The chart below shows FX performance vs. global market factors such as equities, credit, and commodities. The residuals (the “valuation” axis) capture performance net of global drivers and, as shown, they are quite disperse.

Dispersion in returns; carry trades lag

BRL CLP

COPMXN

PENCZK

HUF

PLN

RUB

TRY

ZAR

ILS

IDR

INR

KRW

SGD

THB

PHP

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

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

3M Carry

Valuation (-: undervalued +:overvalued)Source: Deutsche Bank

Idiosyncratic shocks have benefitted HUF, TRY, and also the more resilient economies of Chile and Mexico within LatAm. In contrast, adverse policies and politics have heavily affected popular carry trades as currencies as ARS, BRL and ZAR had YTD depreciations of 13%, 11% and 8% respectively. However, despite the underperformance of several carry trades, interest differentials have continued to contribute substantially to total returns. All in, only the USD/BRL, USD/ZAR, and USD/IDR ended the year in negative territory at 5%, 4%, and 2% up, respectively.

The case for a brighter EMFX outlook Ultimately, it all hinges on a benign resolution of the “cliff”. In our assessment, and in light of recent performance, the bar for EMFX to rally in 2013 is low. Investment, credit, trade, and capital flows are so depressed that trend growth in the US – on reduced uncertainty – would likely suffice to trigger a turnaround. Despite central banks’ concerns about another “tsunami” of inflows into EM currencies on additional QE, the chart below shows that EM capital accounts have decelerated almost as much as in 2008. Moreover, global trade is growing at low single digits vs. the mid-teen growth rates of 2010. This depressed external backdrop is, in our view, the main reason why some central banks have been successful with FX intervention. But should the still uncertain horizon clear, we believe that the combination of stronger capital and trade flows, and also domestic economies should not only tame exporters’ demands but also policymakers’ ability to lean against the wind.

Capital flows and trade at a turning point

-150

-100

-50

0

50

100

150

200

-100

-80

-60

-40

-20

0

20

40

60

80

100

Mar-01 Sep-02 Mar-04 Sep-05 Mar-07 Sep-08 Mar-10 Sep-11

EM Imports + Exports

EM Cap. Account

EM Imports + Exports YoY (USD bn) EM Cap. Account YoY (USD bn)


In addition to the level, the composition of growth should be an important driver of performance. The deceleration in Asia, and particularly in China, has acted as an amplification mechanism to the downward spiral of trade and capital flows. Moreover, it has disproportionately affected commodity prices which in turn have acted as a drag on LatAm FX, in particular. As the chart below shows, the EM share in world GDP has grown to already high levels – a trend that will stay as EM/DM growth differentials are sustained. Accordingly, intra-EM trade has also become a lot more important. The rebound in China we foresee (with only gradual transition to a more consumer-based model) should boost trade, commodities, and especially LatAm FX in 2013. In contrast, with parliamentary elections at the core of the EU (Italy and Germany), and fiscal contraction at the periphery, it is unlikely that growth in Europe could depart considerable from zero. As the US likely pulls ahead and Japanese authorities resort to increased monetary accommodation, we expect USD strength vs. both the EUR (to 1.20-1.25) and JPY (to 85-90). Therefore, those are our favorite funding currencies.

EM growing more important for EMFX




Potential USD strength and potential reflux of capital back into developed markets (at least in the margin) may weigh on EM currencies. Moreover, as we do not expect global growth to strengthen enough to overcome idiosyncratic risks, performance should remain disperse. Altogether, we expect EMFX to recover some lost ground but not to retrace fully to 2011 highs.

Assessing differentiation The EUR/USD was an important driver of EMFX/USD performance earlier in the year, but we expect it to be less so as US and China economies recover. With important elections ahead, Europe will remain eventful, but systemic risks have been largely contained – especially if the US and China do recover. The chart below shows that the EUR/USD “common factor” role of early 2012 has eased, as the euro has explained a lot less of EMFX dynamics. We expect this to remain the norm if the “cliff” is avoided and see EUR funding as way to position for growth differentials in favor of the US and event risks that appear largely concentrated in Europe later in 2013.

Return attribution: EUR/USD factor wanes

0%

10%

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30%

40%

50%

60%

70%

80%

90%

100%

CZK HUF ILS BRL RUB PLN COP CLP ZAR MXN TRY PEN

R2 (April-2011 to Jan-2012)

R2 (Feb-2012 to Nov-2012)

R-Square (%) of USD/EMFX vs. EUR/USD


As mentioned above, we believe that LatAm has most to benefit from the recovery in China and the US we foresee. Despite being in different parts of the cycle, countries in the region are enjoying strong domestic demand on the back of abundant credit and tight labor markets. Consequently, inflation risks are mounting. Policies have hurt confidence and investment in Brazil, but improving external conditions could still go a long way in boosting growth. This boost could also be particularly beneficial for the more opened Mexico and Chile. After all, there is still significant slack in the tradable sectors across the region (and across EM in general). Naturally, commodity exporters would benefit the most and the chart below indicates that the positive impact on their current accounts can actually be quite substantial.

Chinese boost to exporters’ current accounts

R² = 0.5736

R² = 0.0227

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

5% 7% 9% 11% 13% 15%

Commodity Exporters

Commodity Importers

Aggregate Current Account (USD Millions)

China GDP GrowthSource: Deutsche Bank

Intervention should be an ongoing concern, especially in Asia, Brazil, Turkey, but also in the Andeans. But with inflation and trade flows gaining momentum, the balance of risk should change. In both the Philippines and Korea, the strength of basic balances will remain quite supportive. Even if authorities worry about losing competitiveness, we believe that they would be unable and eventually unwilling to fight the medium term trend, and they would at best attempt to slow the moves.

Fundamental valuation seems a lesser consideration at current levels across EMFX. Although EMEA FX seems slightly cheaper, the growth, EUR/USD, and commodity prospects for the region are also dimmer. Even the mildly ZAR undervaluation could be offset if unfavorable productivity and mining outlooks are factored in the model. According to our long-term valuation model, LatAm and Asia FX are hovering near “fair”. We find large overvaluation (near double-digits) only in Argentina and Singapore (and less so in Korea).

Fundamental valuation: A mild plus for EMEA .

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

EMEA

Asia

LatAm2011 2012




Hedging EMFX tail risks Monetary accommodation has been quite effective in taming FX vols despite unfavorable external conditions. Except for the rally during the European stress, EMFX vols have drifted lower. In addition, FX spot and vols returns have become less correlated as idiosyncratic factors predominated (chart). Since we don’t see any meaningful tightening in liquidity conditions in 2013, EMFX vols should stay low – barring a “cliff” sell-off. QE has been an effective tool to tame vols.

7911131517192123252729313335

30%

40%

50%

60%

70%

80%

90%

Dec-07 Sep-08 Jun-09 Mar-10 Dec-10 Sep-11 Jun-12

Aggregate Correlation Avg. 3M Realized Vol. (rhs)Avg. 3M Imp. Vol (rhs)

QE2 QE3QE1

BRL

CLP

COP

MXN

ILS

RUBTRY

ZARKRWIDR

INR

THB

TWD

SGD

PHPCZK

HUF

PLN

-2.5

-2

-1.5

-1

-0.5

0

-1 -0.9 -0.8 -0.7 -0.6 -0.5 -0.4 -0.3 -0.2 -0.1 0

carry/vol ,long 3Mx3M FVA

3M implied vol z-score,1Y


However, we look for tail protection as the likelihood of going over the “cliff” seems uncomfortably high. At these levels and given their high sensitivity to risk, EMFX vols are an appealing hedging vehicle. Accordingly, as the second panel shows, not only vols are depressed, but curves are also flat, thus reducing the carry burden of long positions. In addition, vols tend to become more sensitive to global risks in a distressed environment (proxied by EUR/USD vols above 10 in the first and second panels below). Both correlations and their economic significance (using EMFX vols vs. EUR/USD vols in changes) tend to increase under higher vol. Using this metric to select the best “cliff” hedges, MXN, TRY, ZAR and KRW are the best longs (through long 3Mx3M FVAs) given both the magnitude of the “pick-up” in sensitivities and correlations to EUR volatility.

Selecting the most sensitive vols to a surge in risk

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

THB

ILS

PHP

CZK

TWD

INR

IDR

SGD

COP

CLP

PLN

HU

F

BRL

RUB

KRW

TRY

MXN ZA

R

EUR Vol<10 EUR Vol>10

Betas of EMFX 3M vol vs. EUR 3M vol (1 year history, 2d changes)

0%

10%

20%

30%

40%

50%

60%

THB

IDR

BRL

CZK

INR

ILS

PHP

RUB

TWD

COP

HU

F

SGD

CLP

PLN

KRW

ZAR

MXN TR

Y

EUR Vol<10 EUR Vol>10

Rsq of EMFX 3M vol vs. EUR 3M vol (1 year history, 2d changes)


Our recommendations

Asia: Our favorite currencies in the region are CNH, KRW and PHP. We expect a slow grind lower in USD/CNY fixings, particularly as inflation is set to fall even further early into next year, but the likelihood of band widening bodes for significant further gains in spot (best captured via being short USD/CNH 3M forwards). Meanwhile, basic balances remain very supportive both the Philippines (vs. USD) and Korea. (vs. a mix of USD and JPY). We also recommend tactical short USD/INR in anticipation of renewed portfolio inflows. Although bouts of illiquidity are a reason for caution, we maintain a core long carry position in USD/IDR. Should the US go over the “cliff”, KRW, MYR, and SGD seem most stretched and exposed, in our view.

LatAm: MXN is our top pick, but we also hold bullish positions in CLP (vs. EUR), PEN (vs. USD), and BRL (vs. JPY). In the case of Mexico, a combination of US reflation and reforms (and thus increased FDI and portfolio flows) should support appreciation vs. the USD. In CLP, a tight labor market and monetary policy, rising commodity prices, and



increased risk of intervention only below 570 pave the way for further gains. In Peru, near-potential growth, and a likely mining investment boom that could bring USD50bn over the next three years should push the peso to more even stronger levels (vs. long-term fundamentals’ “fair” value). Rising commodities and external demand should also support a rangebound BRL with risks biased to mild appreciation.

EMEA: We favor RUB, TRY, and PLN. With no or very limited output gaps real rates should remain in positive territory and support for these currencies. The Ruble and the Lira also benefit from a favorable trend in the external balances, as well from their most attractive vol-adjusted carry across EM FX. We look for further gains in TRY vs. ZAR and EUR and RUB vs. the basket. Stay positioned for a sustained upward trend in PLN vs. CZK.

Our favorite tail hedges are long 3M/3M FVAs in MXN, ZAR, TRY, and KRW.

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

Mauro Roca, New York, +1 (212) 250 8609 Guilherme Marone, New York, +1 (212) 250 8640

Henrik Gullberg, London, +44 (20) 754-59847



Appendix: FX Strategy Summary


China USD/CNY fixings have stabilized, despite spot

consistently trading at bottom end of the policy

band. Signs of a trough in China have been

encouraging, with recent data boosting hopes of a

recovery. However we expect only a slow grind

lower in USD/CNY in the coming months with

inflation set to slow further. Authority rhetoric also

suggests inclination to engineer significant gains is

weaker. Interestingly, band-widening talk has risen,

which cd enable spot gains even w/o fixing gains.

* Short 12M USD/CNH forwards vs. NDFs

* Short 3M USD/CNH forwards

CNH liquidity conditions remain tight, spot retraces

higher towards the fixing

Hong Kong Rising capital inflows (into property mkts, H-

shares) on the back of QE3 and stabilization in

China have driven USD/HKD to the strong-side of

the convertibility undertaking, compelling HKMA to

intervene. We do not think HKMA will change its

USD peg, prefering macro-prudential measures to

control inflows.

Neutral HKMA surprises with a policy change

India Rupee volatility has risen significantly. INR

appreciation prospects remains contingent on

India attracting foreign capital to finance her wide

current account deficit. There is scope for a

portfolio flow renewal on an increase in FII debt

quotas, bond inflows ahead of the RBI easing

cycle, foreign interest in govt disinvestments

and/or further tax incentives for FIIs. However

inflows will need to be significant and sustained for

the rupee to recover.

Short USD/INR via RKO puts Weak/reversal in portfolio flows, fiscal deficit

overshoot leads to sovereign rating downgrade

Indonesia The IDR has bucked the regional trend,

depreciating by 6% this year. Despite a strong

pickup in bond inflows and resilient FDI inflows,

Indonesia's basic balance has remained vulnerable

with the trade account in deficit and outflows

related to MNC profit repatriation. USD illiquidity

onshore resulting from pent-up corporate demand

for USD and exporters' preference to keep USD

offshore has also led to upside USD/IDR pressure.

BI has however been supplying USD to slow the

upward grind.

* Buy USD/IDR NDFs on negative dips in implied

yields

Trade account returns to surplus and onshore

USD liquidity eases

Malaysia The historically high-beta MYR has disappointed

post-QE3. Despite robust domestic growth,

attractive yield differentials and a more laissez-

faire central bank USD/MYR downside has been

muted. The trade balance has been hurt by

declining palm oil prices, and strong imports

growth. MYR gains could remain constrained due

to resident outflows by local asset managers and

corporates, and by political overhang ahead of

elections.

Neutral

Philippines The PHP has been the best performing Asian ccy

YTD, supported by strong BoP, growth

fundamentals and reform momentum. Despite the

implementation of macroprudential measures and

rate cuts, USD/PHP has continued to break to

new lows. The defensiveness of BSP's stance

remains key, as natural BoP flows point to

continued gains.

Short USD/PHP BSP implements strict capital controls and/or

limits onshore NDF activity, hurting sentiment

towards PHP




Appendix: FX Strategy Summary Cont’d


Singapore MAS surprised by keeping policy unchanged at

their Oct MPC reflecting their concerns about

inflation. The sharp post-MPC rally in SGD brought

S$NEER to the top of the policy band (2% p.a.

slope assumption) where official resistance has

been cited. The risk-reward is thus asymmetric

with SGD gains limited to basket crawl, while

losses could extend to 4% within the band.

Short SGD NEER forwards SGD continues to crawl higher within the band

South Korea KRW outperformance has been led by a rising CA

surplus, USD sales by underhedged exporters and

bond inflows. While momentum has slowed on

pickup in FX intervention and macroprudential

measures (reduction in banks' FX derivative limits),

bounces in spot have been muted and short-lived.

Authorities are more concerned about the pace of

won gains, rather than levels, and are thus likely

only to slow not halt the medium-term won

uptrend.

Short KRW vs. USD and JPY Harsh capital controls/Tobin tax are imposed

Thailand Thailand's trade balance remains finely balanced,

dipping into deficit in Oct. The govt and BoT also

remain concerned about the exports recovery with

exports growth forecasts having been

downgraded. We thus expect BoT will keep THB

gains in check to support exports and in keeping

with their policy of allowing the THB to move in line

with regional FX.

Neutral A stronger rebound in exports allowing BoT to be

more accommodative of THB gains.

Taiwan TWD is a highly procyclical currency: with returns

closely tied to exports growth, and the economy

leveraged to US/China growth. The signs of a turn

in the exports cycle and the pickup in China PMIs

are thus encouraging. The current account

uptrend is also supportive and equity flows have

turned higher. However, negative carry in NDFs

remains a deterrent.

Short USD/TWD when implied yields are >-1% (3-

6M)

NDFs remain depressed driven by a pick up in local

asset managers' hedging flows on their overseas

investments

Czech Bearish. CZK has no carry, inflation and activity is

moderating and CNB has signalled that a weaker

currency is the next policy step.

PLN/CZK is currently close to the low end of the

trend channel from the past 12mths. Target 6.30,

stop 5.95.

CZK has a slightly lower EUR/USD beta than PLN,

meaning aggressive moves in the euro might hurt

the zloty more than the koruna.

Egypt Stabilisation in FX reserves, CA deficit not widening

further and a chance of an IMF deal mean the

outlook for the pound is slightly less bearish.

3m NDF currently at 6.35, should be capped at

6.40. Stay neutral.

Capital outflows in response to a political unrest/no

IMF deal.

Israel While we remain constructive on the ILS medium-

term, we are uncomfortable going long at current

levels given ILS has gained almost 5% vs the USD

over the past 3 weeks (top performing EM

currency).

On a pullback to 3.85, go short USD/ILS again.

Initial target 3.70, with a trailing 1% stop loss.

Geopolitics/Sharp correction higher in oil. BoI

continuing to reduce rates due to external

concerns.

Kazakhstan With inflation remaining below the NBK's target of

6-8%, the Bank will be comfortable allowing

gradual depreciation of the tenge going into the

new year.

Expect a further 2-3% depreciation in the TWI KZT

over the next couple of months.

Sharp correction in oil/RUB from current levels

would increase the risk of another devaluation.

Poland Cautiously constructive. The rates mkt is already

pricing in aggressive policy easing (100-125bp next

12mths), suggesting that PLN will continue to be

driven primarily by risk sentiment.

Long PLN via 3m EUR/PLN puts with strike at

3.99. Long PLN/CZK, target 6.30.

A relatively high EUR/USD beta means aggressive

moves in the euro might hurt the zloty more than

peers.

Romania The NBR’s tolerance for FX weakness has

diminished and in a overall stable risk environment

this is likely to result in a gradual drift lower in

EUR/RON.

Maintain the target 4.35 over the next couple of

months, with a stop @ 4.5850.

Escalation of Eurozone debt crisis and Eurozone

bank deleveraging.




Appendix: FX Strategy Summary Cont’d


South Africa USD/ZAR to settle in new broad 8.50-9.25 range.

Risk-on/off to determine where within the range.

Deterioration in the external balances and the

increasing likelihood for SARB policy easing are

consistent with ZAR underperformance vs peer

currencies.

Short ZAR vs TRY. Target 5.30, with a revised stop

at 4.80 (4.60).

Foreign bond holdings and a high EUR/USD beta

imply potential for exaggerated moves in risk

on/off scenarios.

Turkey A continued improvement in the C/A balance and

the sovereign rating upgrade from FITCH have

seen TRY breaking the low end of the range. This

trend is likely to persist going forward.

Capture the relative improvement in the TRY vs

ZAR C/A balance. Stay short ZAR vs TRY. Target

5.25, with a revised stop at 4.80 (4.60).

Risk deterioration and/or the CBT responding to the

slight improvement in inflation expectations by

reducing the LOWER band of the o/n rates

corridor.

Ukraine Bearish. FX reserves continue to shrink, growth is

weak and the CA is expected to widen and the IMF

programme remains frozen over the government’s

refusal to hike domestic gas prices.

Target a continued upward trend in UAH vs USD

peg.

Heightened risk aversion post elections and an

accelerated decline in reserves could trigger a

devaluation.

Argentina Fundamentals drivers point toward further

depreciation, but even when the central bank

balance sheets is rapidly deteriorating due to fiscal

financing, the monetary authority has ample room

to continue managing the FX parity.

Remain neutral on ARS. Continued exchange rate rigidity and strong state

interventionism could block any solid recovery

process.

Brazil The BRL suddenly broke away from the tight range

it had been trading for the previous four months.

Long BRL/JPY. The economy remains vulnerable to further

deterioration in the global economic and financial

conditions.

Chile In the short-run, important growth differential

would continue to push the currency toward

appreciation.

Maintain 1x2 USD/CLP put spread and enter short

EUR/CLP.

A sharp deceleration in China could negatively

affect copper prices, intensifying the negative

external shock.

Colombia We think that the threat of FX intervention caps

any potential upside.

Remain neutral COP after closing at a loss long

USD/COP.

A relapse in economic activity in the US.

Mexico The MXN had another month of erratic behavior

but it now seems poised to benefit from potential

reforms.

Take profits on 1x2 USD/MXN put spread and

enter short USD/MXN.

Mostly external, mainly a sharp drop in US

economic activity because of fiscal cliff-related

issues, and/or heightened global financial turmoil

prompted by a disorderly adjustment in Europe.

Peru After reacting to the change in official intervention

strategy, and exhibiting greater volatility, the

currency seems to be setting back into former

dynamics.

Enter short USD/PEN. A weakening in global growth that would reduce

demand for Peruvian exports and lower external

terms of trade.




Sovereign Credit in 2013: Less Gas in the Tank

2012 was a remarkable year for EM sovereign credit, with unexpectedly strong performance, driven primarily by spread compression. 2013 is highly unlikely to deliver comparable returns, but we believe that there is still scope for further spread compression.

Our baseline scenario sees the EMBI Global ending 2013 at a spread of around 225bp. This is coupled with 10Y UST yields rising to around 2.75%, which should yield a total return of just below 5%.

Motivating our expectation for further spread compression in EM are two factors: (a) a modest further spread compression in DM credit markets, supported by improving economic growth and higher UST yields (b) outperformance of EM vs. DM, making up for the relative lack of outperformance (in spread terms) over the past four years.



We recommend an overweight exposure to Turkey, Romania, Venezuela, Mexico and Indonesia.

We recommend an underweight exposure to South Africa, Brazil, Chile, Hungary and Ukraine.

We expect the bond-CDS basis to move lower in 2013 as the outperformance of bonds eases. We expect this to be most pronounced in Brazil and Russia.

Taking stock

Sovereign credit has been the best performing asset class in 2012… As we discuss in “EM Performance: Growth and Asset Rebalance”, 2012 has been another strong year for global fixed income assets, especially the “yield products”. EM sovereign credit has been simply the best performing among all liquid asset classes. EMBI-Global returned about 17% year to date, outperforming US and Global HY

credits, due in part to its longer duration and improving fundamentals.

...with spread compression contributing the bulk of the returns Unlike 2011, when EM sovereign credit benefited tremendously from lower US yields, spread compression contributed the bulk of the returns in 2012, as shown in the graph below. YTD, the spread of EMBI-Global has tightened by 140bp (current level: 286bp), while 10Y UST tightened by about 15bp.

Return attributions for EM sovereign credits (2012

YTD)

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

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

VE

HU EG TR UA PE

PH PL

RU UY

ZA PA ID CO BR EC MX

CL

MY

BG LB CN AR

Spd Return

Yield Return

UST Return

Total returns, YTD 2012

Note: returns are computed for DB-EMSI sub-indices Source: Deutsche Bank

EMEA was the winner among regions, while BB

among rating brackets

0%

6%

12%

18%

LatAm EMEA Asia

DB-EMSI Regional Sub-index Total Returns, YTD

0%

5%

10%

15%

20%

A BBB BB B

DB-EMSI Rating Sub-index Total Returns, YTD


In general, higher yielding and longer duration credits have performed better, given that most part of the year has been dominated by bullish flows, but idiosyncratic factors have also played a big role in the relative country performances (more on this below). After all, 2012 has been an eventful year in EM. Venezuela and Hungary were the best performers, while Argentina was the worst. There was also a clear regional bias as EMEA, which had underperformed in 2011 (on the back of the eurozone crisis), was the outperformer among the regions. Clearly, this was due to the significant reduction of systemic risk in Europe. Among ratings brackets, BB credits were the



best performers, with notable contributions from Hungary, Turkey, and the Philippines.

EM credit has certainly benefited from 'search for yield'... The significant amount of inflows into EM hard currency funds, driven mainly by the relative attractiveness of yield products as a result of a combination of abundant liquidity, historically low core rates, and relative scarcity of investable fixed income assets, have been the main catalysts behind the impressive performance of EM sovereign credit. YTD, hard currency funds have received a record 40.4% AUM in inflows, far outpacing that of USD and Global HY (22%), US IG (15%), and EM local currency debt (19%).

EM hard currency debt had the best inflows among all

asset classes in 2012

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35

40

45

EMD-HC DM HY EM Blend EMD-LC US IG US Govt EM Equity

DM Equity

YTD inflows into varying asset classes per EPFR survey, % AUM

Source: EPFR

...but continued improvement in fundamentals also played a role There is no doubt that EM sovereign credit has benefited from the ‘search for yield’ phenomenon, but the fact that flows into EM hard currency debt measured by %AUM were almost double that of the amount going into global HY funds would suggest that investors were disproportionately attracted to EMD. The continued improvement in fundamentals, coupled with the fact that the valuations remain attractive on a relative basis, has likely contributed to the attraction.

Interestingly, despite the extraordinary inflows and high total returns, we still find the valuation of the EM sovereign credit market to be attractive on a relative basis. In fact, we find that market pricing reflects little of the improvement in fundamentals which have occurred over the past four years. In the appendix of this article, we introduce the concept of market-implied credit quality. This allows the evolution of the spread of EM sovereigns (at the index level) to be mapped into a credit rating, based on the pricing in the US and European corporate credit markets. This measure is shown on the chart below, along with the rating agency assessment of credit

quality. It is clear that while the average rating has improved by almost a whole notch in the past three years, the market-implied credit quality has simply oscillated around a constant level (equivalent to BB). Indeed, this divergence has reached an extent that the market perception of the credit quality of EM is weaker than that of rating agencies.

The trend improvement in EM credit quality has been long-standing, broken only by the 2008-09 crisis. We expect it to continue into 2013 and we expect EM sovereign upgrade events to outpace downgrade events.

Market pricing now lags the rating agencies’

assessment of EM sovereign credit quality

9

12

15

2003 2005 2007 2009 2011

Agency Rating




The trend of more upgrades than downgrades

continues

40%

30%

20%

10%

0%

10%

20%

30%

40%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 13

Proportion of upgrades

Proportion of downgrades


In the table below we present what we believe are the most likely rating changes to expect in 2013 (among the major EM sovereigns).



Projected rating actions by the main agencies in 2013 Country Rating Agency Current Rating New Rating

Upgrades Turkey SP BB BB+Indonesia SP BB+ BBB-Philippines FITCH BB+ BBB-China MOODY Aa3 Aa2Romania SP BB+ BBB-Brazil MOODY Baa2 Baa1Colombia SP BBB- BBBMexico SP BBB BBB+Peru SP BBB BBB+Peru MOODY Baa2 Baa1

Downgrades India SP BBB-u BB+South Africa FITCH BBB+ BBBSouth Africa MOODY Baa1 Baa2Hungary FITCH BB+ BBHungary MOODY Ba1 Ba2Ukraine SP B+ B-Ukraine FITCH B B-


Idiosyncratic factors continued to be key As mentioned previously, 2012 has been an eventful year in the EM markets. The significant reduction of EU risk premium pushed EMEA credit spreads to post-Lehman lows. Hungary – despite its weak fundamentals, negative perception on its policy framework, and lack of progress in obtaining official support from the IMF/EU – has been one of the best performers in EMEA in 2012, second only to Venezuela. The latter has been fuelled by hopes for a regime change, though it was subsequently dampened by the sound victory by President Chavez in the October presidential election. Turkey and the Philippines, both being BB credits, are also among the better performers supported by fundamentals’ improvements and strong local sponsorships. On the negative side, Argentina was damaged first by pesification fears in its local law debt and then by the adverse US court ruling on the pari-passu case of NML vs. Republic that brought the credit to the brink of default.

Cash has significantly outperformed CDS throughout

2012

-20

0

20

40

60

-0.1

0

0.1

0.2

0.3

0.4

0.5

Nov-11 Feb-12 May-12 Aug-12 Nov-12

Average 10Y Basis/Bond Spread (l.h.s)Average 10Y Basis (r.h.s)

Average of model par bonds on major EM curves excluding VE, AR, UA and HU

Basis/Bond Spread Basis


Cash bonds have outperformed CDS Given that the significant outperformance of EM sovereign credit has been mostly driven by technical factors, especially the historical amount of inflows and the hunt for yield assets, cash bonds have steadily outperformed CDS throughout 2012. There have been two episodes of interruptive corrections to this trend, one occurred in September and the other in November, both coinciding with weaker technicals on the cash side due to slowing inflows and a surge in issuances. This market repricing of CDS/bond basis (see graph below) is more pronounced at the 10Y sector, owing to bull flattening of cash curves (5s10s) and bull steepening of the CDS curves. Even after the recent correction, basis remains elevated (especially in terms of percentage of basis over bond spreads), and we are inclined to favor CDS over cash with the premise that the level of inflows is unlikely to be reproduced in 2013 (more on this later).

Issuers, including new borrowers, have rushed to the market EM sovereign issuers have sold $87bln of global bonds so far in 2012, not including global Sukuk placements, breaking the record set in 2009 ($84bln). The historically low level of yields has certainly enticed issuers to the market to take advantage of the low financing rates and it is worth noting that there are also a large number of first-time issuers in 2012 among EM sovereigns, such as Angola, Bolivia, and Zambia. One other reason for the larger amount of issuances in 2012 was the higher-than-usual external debt payments (principal and interest), about $63bln in total. The largest issuer was Poland, who sold almost $10bln worth of bonds, followed by Russia ($7bln). The Venezuela complex, surprisingly, had no issuances in 2012 by the Republic, and only $3bln by PDVSA.

Outlook for 2013

Credit spreads still have (some) room to tighten… Given the importance of credit spread compression for the high total returns in 2012, an obvious first question when considering 2013 is whether there is any potential for further compression. When we factor in our baseline assumptions in terms of economic growth and risk-free rates, we believe that there is.

In very broad macro terms, credit spreads should theoretically be driven by two primary factors: the business cycle and risk free rates. Taking this as a framework, we find that a very simple model can do a surprisingly good job of fitting credit spreads over the long term. We model the spread of BBB US corporates as an exponential function of the G7 economic growth rate, 10Y US swap rates and the Fed funds rate. Using quarterly



data from the past eighteen years this model has an R2 of 84% and the coefficients are significant at a 99% confidence level for growth and 10Y yields and at 95% for Fed funds.

Credit spreads can be modeled reasonably well on

the basis of growth and risk-free rates

0

100

200

300

400

500

600

1993 1998 2003 2008 2013

Moody's Baa spread

Model spread

Model projection

Spread over USD swaps, bp

Model: Log(Spread)= -0.094 x G7 GDP growth (past 2q annualized, %) -0.093 x 10Y US Swap yield (%) -0.04 x Fed Funds (%) + 5.75


A key advantage of this parsimonious model is that the independent variables are all ones which we forecast and which we often use to describe our baseline macroeconomic outlook.

Our economics colleagues are expecting economic growth to pick up in 2013, particularly in the second half. Their forecast for G7 growth in H2 is 2.45%. In conjunction, our US fixed income colleagues expect to see 10Y yields at 2.75% by the end of the year as the strengthening economy allows the Fed to cease asset purchases, although fed funds are not changed. With these as inputs our model indicates a BBB spread of 190bp. This represents a 60bp tightening in the model estimate over 2013, although it is only 10bp tighter than the current level. Making some allowance for the current ‘richness’ to model, we would assume a baseline forecast of 175bp.

…with outperformance by EM on the back of continued improving fundamentals The above estimate of credit spreads is based on US corporates as a benchmark for the credit market, but what of EM sovereigns? As we discussed earlier, the EM sovereign market is currently priced in line with BB+ credits, a level it has traded around for the past four years. We assume that the improvement in credit quality (as reflected by the rating agencies) will continue at the same pace in 2013 (approx. 0.3 notch change in the aggregate

per year), but that the relative cheapness of EM will diminish (a further 0.2 notches in terms of implied credit quality). This aggregate 0.5 notch improvement in the market-implied credit quality is worth approximately 25bp in spread terms on the index. Added to the 25bp decline in BBB spreads gives us a baseline assumption for the EMBI Global Diversified of 225bp.

…and a similar supply/demand picture as in 2013 but likely more subdued level of inflows We project about $87bln gross issuances by EM sovereigns in 2013, about the same level as in 2012 so far this year, and in comparison with the total repayment (principal and interest) amount of $66bln. This results in about $20bln of net supply, just $3bln lower than 2012. Thus, the supply picture looks similar to 2012. We note, however, our issuance projections probably represent the upper limit. One of the reasons for the historical amount of sovereign issuances in 2012 was the historically low

2013 sovereign issuer repayments and project net

supply

-2000 0 2000 4000 6000 8000

PolandVenezuela

RussiaMexicoTurkey

HungaryUkraine

BrazilIndonesia

QatarRomaniaSlovakia

Czech RepublicEgypt

LithuaniaPhilippines

SerbiaSlovenia

South AfricaUAE

BahrainCroatia

IsraelBelarus

ChileJordanLatvia

LebanonMalaysiaMorocco

NigeriaSenegal

South KoreaThailand

Sri LankaTunisiaGhana

BangladeshColombia

Costa RicaGuatemalaMacedonia

PeruAruba

BulgariaUruguay

Repayment

Est. Net Supply

2013 repayment and expected net issuances by EM




level of yields and many sovereigns simply took the opportunity to come to the market even though they actually did not have a real financing need. While yields will likely remain at a low level in 2013, some issuers may have already pre-financed during 2012. In addition, there is a fair chance for projected issuances for some countries, such as Egypt, Ghana, Jordan, Macedonia, Morocco, Nigeria, and Senegal, to not materialize.

In terms of fund flows, as we argue in EM Performance: Growth and Asset Rebalance, a special report included in this same EMM, we expect a gradual rebalance away from the defensive (fixed income overweights), which marked 2012, into growth-centric products such as equities and EMFX (and commodities) in 2013. Obviously, this is conditional on an orderly resolution of the US fiscal cliff early in the year. Therefore, one potential threat to the performance of EM Sovereign credit is the reversal of significant inflows into fixed income funds in 2012, redirecting flows to equities under our baseline (or better) scenario in terms of growth and fiscal cliff. Given this, we believe fund flows into EMD fund in 2013 will unlikely reproduce the same levels as in 2012, creating some relatively weaker, though still supportive, technicals environment for EM sovereign credits.

So, while we do not anticipate the same extent of spread tightening in 2013 as we saw in 2012, there is room for some compression. Given the relatively modest move in spreads, the impact of the UST yield on total returns will likely be very important. Furthermore, considering the acute degree of uncertainty with respect to US fiscal policy, it is useful to expand upon the baseline scenario we just discussed and to examine some alternative scenarios.

UST yield will likely be repriced higher, but only moderately Throughout 2012, 10Y UST yields have mostly been trading below 2% and have touched the 1.4% historical lows in July. Risk aversion due to the Eurozone sovereign credit crisis during the spring and summer of 2012 was the main reason behind the repricing toward lower yields for the Treasuries, but the Fed’s accommodative policies and concerns about the US fiscal cliff have helped the 10Y rate anchor at the current level of 1.6%.

The historically low level of US Treasuries, combined with the similarly low level of rates in both the Eurozone and Japan, helped promote the portfolio reallocation to yield assets, benefiting EMs tremendously in 2012. Going forward, the UST yield forecast for 2013 will be largely a function of the outcomes of the fiscal cliff negotiations, as

well as the Fed’s policy5. Below, we discuss the range of scenarios centering on the US fiscal cliff and we project EMBI returns under these scenarios based on Deutsche Bank’s forecast of UST yields and our forecast of EMBI spreads.

Baseline scenario: a compromise on the cliff that results in a fiscal drag of 1.5% of GDP, reduction of private sector savings-investment balance to offset this fiscal drag, average growth for 2013 of 2%, and the Fed following Twist 2 with QE4 in Treasuries (about $40bln a month, taking out about 60% of coupon Treasury net issuances in 2013) 6 . The medium-term view held by Deutsche Bank’s US rate strategists is for a modest step higher in yields, with 10y Treasuries pushing toward 2.25% and moving even higher toward 2.75% during the second half of the year as the Fed ceases asset purchases.

As discussed, under this scenario, we expect a further tightening of EMBI-global spread to 225bp, reflecting tighter global credit spreads and improving credit quality of EM sovereigns in aggregate. This scenario should yield a respectable total return in the index of just under 5%.

Alternative (less likely) scenario of lower UST yield will likely ensue in the event of an unmitigated fiscal cliff, combined with a failure of the private sector to accommodate fiscal tightening, a failure of the Fed to provide adequate monetary support, or as a result of a number of more technical, demand side factors that could force yields lower if liquidity growth (due to additional monetary support by the Fed, BoJ, and even the ECB) outstrips growth in investable assets. Under this scenario, 10s could move closer to 1% and 30s to 2.25%.

Assuming a fairly sharp contraction in growth in 2013 our model indicates that BBB spreads should be around 320bp, the EMBI spread at about 430bp. In this scenario the EMBI-Global total return will likely be around 0%, although the path to that point will most likely see substantially negative returns during the year.

Under the scenario of a grand bargain over the cliff negotiation, the Fed will likely scale down its accommodative policies by mid-year and this should result in a higher 10Y UST yield toward 3%.

5 Our US economists and rate strategists believe QE4 will likely be in the store, which will help keep yields at the front end to the intermediate sector (5Y) anchored, and likely a steepening of 5s30s. 6 See Fixed Income Weekly, DB Global Markets Research, 30 November 2012.



In this case, the EMBI spread could tighten to the 200bp area (but still wider than the all-time low of the 150bp level observed in 2007) and we believe total return for the index will be 4.75%.

See the table below for a summary of these scenarios and projected EMBI returns7.

Key US macro forecasts and associated EMBI return

projections


Beyond these, there are many other scenarios in terms of the combination of US Treasury yields and EMBI spreads, shown in the table below. If there is a substantial widening in EMBI spreads, driven by, for instance, outflows from the asset class, but at the same time a widening of UST yields, then this will represent the worst case scenario for EMBI returns (see the right-lower corner in the table below). We see this as very unlikely because if outflows are driven by portfolio reallocation to riskier assets (equity for instance), then the spread widening will most likely be moderate because the macro scenario will be a benign. So, in the table below, we have grayed out the combinations which, in our view, are unlikely.

Total return projections of EMBI-G under varying

scenarios of spreads and UST yields

160 190 220 250 280 310 340 370 400 430 460

1.00% 17.9% 16.1% 14.2% 12.4% 10.6% 8.8% 6.9% 5.1% 3.3% 1.5% -0.4%

1.20% 16.7% 14.8% 13.0% 11.2% 9.4% 7.5% 5.7% 3.9% 2.0% 0.2% -1.6%

1.40% 15.4% 13.6% 11.8% 9.9% 8.1% 6.3% 4.5% 2.6% 0.8% -1.0% -2.8%

1.60% 14.2% 12.3% 10.5% 8.7% 6.9% 5.0% 3.2% 1.4% -0.4% -2.3% -4.1%

1.80% 12.9% 11.1% 9.3% 7.4% 5.6% 3.8% 2.0% 0.1% -1.7% -3.5% -5.3%

2.00% 11.7% 9.9% 8.0% 6.2% 4.4% 2.5% 0.7% -1.1% -2.9% -4.8% -6.6%

2.20% 10.4% 8.6% 6.8% 5.0% 3.1% 1.3% -0.5% -2.3% -4.2% -6.0% -7.8%

2.40% 9.2% 7.4% 5.5% 3.7% 1.9% 0.1% -1.8% -3.6% -5.4% -7.2% -9.1%

2.60% 7.9% 6.1% 4.3% 2.5% 0.6% -1.2% -3.0% -4.8% -6.7% -8.5% -10.3%

2.80% 6.7% 4.9% 3.0% 1.2% -0.6% -2.4% -4.3% -6.1% -7.9% -9.7% -11.6%

3.00% 5.5% 3.6% 1.8% 0.0% -1.8% -3.7% -5.5% -7.3% -9.2% -11.0% -12.8%

3.20% 4.2% 2.4% 0.6% -1.3% -3.1% -4.9% -6.7% -8.6% -10.4% -12.2% -14.1%

Baseline Full cliff Grand bargain

10Y

US

T Y

ield

EMBI-Global Spreads


Combining all of these macro scenarios, we have reasons to continue to be constructive on Sovereign credit,

7 We note that this is a simplistic view of the market. In fact, under each of these scenarios, the path to the end projections vary and the levels of macro variables (including Treasury yields) could be different during the 1H13 and 2H13.

especially given its defensive nature. However, on the other hand, the likely repricing higher of US Treasuries (albeit moderately so) will be less supportive for low spread credits (sub-125bp), given the thinner valuation cushion. Helping mitigate this risk is the fact that there will likely continue to be scarcity in risk-free rate assets, so that even very low spread credit products will continue to attract investor attention.

What of EM specific performance? The concept of market-implied credit quality introduced in the appendix (market-implied credit quality) also provides us with an interesting tool to quantitatively relate macroeconomic fundamentals to sovereign credit spreads.

The model which maps fundamentals to ‘credit quality’ has four factors: CPI, FX reserves, public sector external debt and government effectiveness (a World Bank index). Taking our bottom-up forecasts for each country, for the first three factors and applying them to the model gives us a projected shift in implied credit quality over the coming year. We also assume a small degree of mean-reversion in the model residuals (approx. 10% of the difference per year, based on the empirical evidence) and a small aggregate outperformance of EM versus DM as discussed earlier. In the table below we present these three components of the change in implied credit quality.

Model-based, relative spread changes

Change in Predicted

implied-credit quality Spread chgForecast delta

Reversion to model

EM vs DM Log bps

China +0.75 +0.25 -0.20 +0.14 +9Chile +0.19 +0.24 -0.20 +0.04 +2Brazil -0.12 +0.40 -0.20 +0.01 +1Colombia -0.67 +0.34 -0.20 -0.10 -10Mexico -0.32 +0.24 -0.20 -0.05 -5Poland +0.39 +0.10 -0.20 +0.05 +6Bulgaria 0.00 +0.28 -0.20 +0.01 +1Malaysia +1.24 -0.57 -0.20 +0.09 +10Peru -0.21 +0.23 -0.20 -0.03 -4Uruguay +0.23 +0.10 -0.20 +0.02 +3Panama 0.00 -0.11 -0.20 -0.06 -6Philippines +0.81 +0.12 -0.20 +0.13 +16South Africa +0.29 +0.11 -0.20 +0.04 +5Russia +0.21 +0.17 -0.20 +0.03 +5Indonesia +0.33 +0.33 -0.20 +0.08 +13Turkey -0.16 -0.13 -0.20 -0.09 -17Hungary +0.06 -0.48 -0.20 -0.11 -31El Salvador 0.00 -0.24 -0.20 -0.08 -27Egypt +0.54 -0.01 -0.20 +0.06 +23Ukraine +1.08 -0.41 -0.20 +0.09 +49Venezuela -0.00 +0.11 -0.20 -0.02 -14Argentina +0.60 -0.63 -0.20 -0.04 -37 Source: Deutsche Bank



We also translate the aggregate change into a predicted spread change for each credit.

While the model is a useful tool for quantifying the impact of (some) macro factors, it is only one input to guide our views on country-specific performance. We do note the model results for Ukraine, South Africa and Mexico. In Ukraine, our macro forecasts point towards a clear deterioration in 2013, only partly mitigated by the fact that the market is already ‘cheap’ to fundamentals. In South Africa we also see a weakening, albeit much more modest. However, this weakening is on the back of several quarters of weakening which has not been reflected by the market. In contrast, our forecasts for Mexico point towards an improvement in credit quality, leading to an anticipated outperformance in spreads. These results help to reinforce our recommendations on these credits (underweight, underweight and overweight respectively) as we discuss below.

Strategy recommendations



In terms of strategic country allocations, we would identify the following countries as providing compelling reasons for being over-/under-weight.

Strategic overweights

Turkey. Despite rallying strongly in recent months, the pricing of Turkey’s external debt still implies a weaker level of credit quality than is implied by fundamentals, according to our simple model. The decline in inflation and the continued rise in FX reserves which we anticipate for 2013 also point towards further improvement in credit quality. The rating agencies’ current assessment of Turkey’s fundamentals is more cautious, but 2013 could see some catch-up in this regard. If S&P or (more likely) Moody’s were to follow suit and raise Turkey to investment grade in 2013 it could provide a significant positive catalyst.

Romania. Romania was a strong performer in 2012, but without the political distractions it could have been even stronger. With these distractions likely to recede in 2013 we expect the focus to return to the relatively healthy fundamentals and that this will foster ongoing outperformance in spread terms. We find that Romania’s combination of CPI, FX reserves, public sector external debt and ‘government effectiveness’ point to a credit quality score of 9.4 – i.e. between BBB and BBB- on the rating agencies’ scale. In contrast, the market-implied credit quality is 12.1 (BB). If Romania were to converge just half-way towards its fundamentals-implied level it would imply a 70bp tightening.

Venezuela. The complex is our main strategic overweight among EM high yielders in 2013. The prospect of regime change has been the main catalyst behind the outperformance in 2012. President Chavez’ decisive victory in October’s election has cast a shadow to this perception, but we believe the united opposition behind Capriles will remain in strong contention in the event a new election is called due to President Chavez’s health condition, which many believe is deteriorating given the recent announcement of his traveling to Cuba for an extended period of cancer treatment. Valuation is very attractive as Venezuela is the only major sovereign credit in EM outside of Argentina that still offers double-digit yields (“the only game in town”). In addition, oil prices look supportive, and - if the US overcomes the “cliff” as we foresee – a dynamics with tightening spreads and widening UST yield clearly favors high-yielding credits such as Venezuela. The main risk to our view is if the government will put forth a referendum plan to modify presidential succession rules.

Indonesia. Despite that Indonesia joined the investment grade club in the beginning of 2012, its performance was subsequently hurt by poor political dynamics that caused the government to fail in pushing through the hike of domestic gas prices, and by deterioration of both its fiscal and external accounts. Large amount of sovereign and quasi-sovereign issuances also constrained the performance of the credit. In 2013, however, the external environment will likely be more supportive, and Indonesia’s buoyant domestic economy will likely keep it credit improvement path on track. We expect S&P, the only major ratings agency still having the credit at BB+, to upgrade Indonesia to investment grade in 2013. We expect a partial convergence in Indonesia’s credit spread to the Philippines, as well to its EM high grade peers in LatAm, such as Brazil.



Mexico. We see good reasons to be optimistic about Mexico’s chance to break out of the LatAm low beta pack on the positive side in 2013. First, the enhanced political capital by the new administration has raised prospects of further progress on the structural reform front. In addition to the recently approved labor reform, a revenue-increasing fiscal reform will mostly likely be implemented next year, potentially adding revenue of 1% of GDP. At the same time, the chance for the much coveted energy reform has also significantly increased, which would induce a sharp rise in foreign inflows. The renewed drive for reforms will make Mexico well positioned to enjoy a long period of relatively high and stable growth with low inflation and compressing spreads. This view is also consistent with our implied credit quality model in terms of an improvement in credit quality, driven by (among other factors) lower public debt ratio, leading to an anticipated outperformance in spreads. Finally, spreads of the UMS bonds are slightly wider than its regional peers, especially relative to Brazil (+15-20bp).

Strategic underweights

South Africa. If we were to simply group EM countries into those on a clear positive trajectory, those on a more uncertain (or even negative) trajectory, we would have to put South Africa in the latter camp. Furthermore, it seems that the market may be slow to acknowledge the deterioration. Over the past three years our model of credit quality indicates a deterioration of 1.5 rating notches, based on fundamentals. This results primarily from higher public sector external debt and a modest weakening in ‘government effectiveness’. The market meanwhile has effectively reflected no change in credit quality. We recommend an underweight exposure.

Brazil. Ad-hoc policies have not been effective to support growth so far it seems. Even though various stimulus measures will induce a gradual recovery in 2013, risk for further disappointments remains, so is the risk of continued fiscal slippage. Despite all that, Brazil bonds spreads remain the tightest among its regional peers, due in large part to technical factors, as Brazil has featured negative supplies over the past year even before we account for the buybacks conducted by the National Treasury. Technicals will remain supportive, but we see a stalled credit migration path in 2013, lagging its LatAm low beta peers, especially Mexico.

Chile. We favor Chile’s fundamentals, but with its 10Y bonds spread at a mere 70bp, and an environment with likely rising UST yields, carry and total return prospect simply does not look attractive for Chilean bonds.

Ukraine. Our 2013 macro-economic forecasts for Ukraine, when input into our implied credit-quality model suggest that Ukraine faces the largest decline in credit quality across EM sovereigns during the coming year. The combination of rising inflation, falling FX reserves and rising public sector external debt all contribute to this fall. On the positive side, the market-implied credit quality is already a little lower than implied by the model, but we would expect the direction of fundamentals to dominate. 2013 is likely to prove more challenging than 2012. With substantial external redemptions and with increasing pressure on the currency, time is running short to achieve agreements with the IMF (on a new loan agreement), or with Russia (on gas prices) or preferably both. Given the potential for matters to come to a head in the coming months, we recommend beginning the year with an underweight exposure.

Hungary. The bleak picture for Hungary’s macro outlook has been apparently glossed over by the market, but this could change in the first quarter of 2013. The substantial debt financing needs in February and the change in NBH governor in March are likely to bring the risks in the country into focus once again. If demand for EM debt remains as strong as it has been in recent months then Hungary may have little difficulty covering its financing needs, which then buys it considerable time, but if there were to be a lull in demand, then Hungary would be amongst the most vulnerable. As a hedge to this scenario we recommend an underweight.

Other specific cases Argentina – neutral for now, but we are now more

optimistic about the litigation outcome. Litigation risk clearly dominates the consideration of this credit. The stay order granted by the Second Circuit court brought some breathing room for Argentina, and we are also encouraged by the apparent softening in Government’s attitudes, as well as the “signal” we perceive from the Second Circuit Court recent orders that the Court will likely approach the case very carefully, also considering third parties’ arguments. We currently see balanced risk/reward in the market pricings of the bonds. In the near term, potential headlines related to government’s intention to reopen the exchange may provide a mild boost in asset prices; otherwise we believe bond prices will likely trade within a narrow range until we approach the next court hearing scheduled for February 27th next year.

However, given the binary outcome and distressed prices, Argentina may well present the best investment opportunities for investors in 2013. Those



who hold a strong bullish view on the outcome of the court case should be overweight now. We prefer, however, to err on the side of caution for now and wait until there is more clarity on the legal front.

Key long-short country views Mexico vs. Brazil. As we discussed above on both

credits, we expect Mexico to finally break out of the pack with the improved prospects of structural reforms while there is a sizable risk for Brazil’s improvement to be stalled on the back on its disappointing growth dynamics and ad-hoc and inconsistent policies. Mexican bonds are trading at 10-15bp higher spread at the moment but we expect Mexico to trade through Brazil during 2013. We express this view via UMS 40s vs. Brazil 41s (current spread differential: 15bp, target: parity).

Indonesia vs. Philippines. We are constructive on the fundamentals of the Philippines, as the country is having a positive momentum in terms of its political stability, growth dynamics, and credit quality. We expect a ratings upgrade to BBB- by S&P in 2013 so that the credit can officially join the investment grade club, broadening its investor base. However, all these positive developments are already (more than) priced in, and with the strong local sponsorships, Philippines’ bonds spreads are already at the same level as Brazil. On the other hand, Indonesian bonds are still trading substantially (50%) wider than the Philippines. We like both credit stories, but we call for a partial convergence in the relative valuation. We expect Indonesia bonds to tighten by 30bp vs. the Philippines. We express this view via Indonesia ‘42s vs. Philippines ‘37s (current spread differential: 55bp, target: 30bp).

Relative value themes Basis range to likely move tighter – As discussed

above, the outperformance of cash bonds vs. CDS – driven mostly by technicals – has been an important relative value theme in the sovereign credit market in 2012. Going forward, we see the current basis level, even after a mild correction, as being too wide from a valuation point of view. Given our assessment of the likelihood for a reallocation to equities from fixed income assets in 2013, we doubt that the level of inflows into EMD funds seen in 2012 will be sustainable. As such, we believe a correction will take place in the basis, with the basis/bond spread ratio reverting to the 10-20% area from the current range of 30-40%, short-term volatility notwithstanding. This correction will likely be more pronounced in low spread credits, such as Brazil and Russia.

CDS curves – the bull steepening of the CDS curve has been another important theme in 2012 and it has

moved in the opposite direction as bond spread curves (front end), which have flattened. The extent of this steepening had been such that a number of curves reached unprecedented levels of steepness, particularly considering the overall level of spreads. We had recommended a number of dv01-neutral 2s5s curve flatteners to capitalize on a correction to this valuation disconnect, namely in Russia, Brazil, Mexico, and the Philippines. Over the past two months, most of these curves have flattened from peak levels, with exception of the Philippines, which still stands out as offering significantly positive carry+roll down. We hold the 2s5s curve flattener recommendation in the Philippines, while unwinding the others (Russia, Brazil, and Mexico).

The longer segments of CDS curves (e.g., 5s10s) in many cases also appear unusually steep. However, the steepness has not yet reached the point at which carry is eroded. Indeed, given the relatively low level of credit spreads at the short end of curves, the carry offered by some 5s10s steepeners is actually quite attractive8.

There are still a number of 2s5s CDS curves that

feature positive carry/roll for flatteners

BR

COMX

PERU

ZATR

IDPH

PL

BG

RO

-1.0

-0.5

0.0

+0.5

+1.0

+1.5

+2.0

+2.5

-2.0 -1.0 0.0 +1.0 +2.0 +3.0

z-score of 2s5s

Break even (bps per month)Source: Deutsche Bank

Marc Balston, London, (+44) 20 754-71484 Hongtao Jiang, New York, +1 212 250 2524

Contributions by

Srineel Jalagani, Jacksonville, +1 212 250 2060 Winnie Kong, London, (+44) 20 754-51382

8 For a more detailed analysis on our views on CDS curves, see EM Trade Idea: Screening for CDS Curve Flatteners, 14 September 2012, DB Global Markets Research.



Appendix: Market-Implied Credit Quality

Arguably the most important, and difficult, question concerning investment in the sovereign credit market is how to relate market spreads to fundamentals. This question lies at the heart of such questions as: when to be long/short the market? To which countries to be relatively more/less exposed? Where should new issuers price? Over the years we (and others) have addressed this question from a variety of different directions9, however, as yet, we do not have a comprehensive way to answer it.

One of the main challenges with any empirical exercise aiming to relate spreads to fundamentals is the presence of a dominant overall factor in the level of credit spreads. It is quite clear that the correlation between the spreads of different issuers is driven by something beyond any correlation in their fundamentals. This common factor could be considered the overall market pricing of credit risk, which fluctuates over time in response to factors such as risk aversion and supply/demand dynamics in the credit market. Before trying to identify the impact of issuer-specific fundamentals on an issuer’s own credit spread, we first need to extract this factor. In essence we’d like to translate market spreads into a measure of market-implied credit quality which is independent of the overall market pricing of credit risk.

In order to identify the market-implied pricing of credit risk we begin with the assumption that, in aggregate across credit markets, credit rating agencies assessment of credit risk is unbiased. We have observed in the past the log-linear relationship between credit spreads and credit ratings, both in the EM sovereign market and for US and European corporate credits. Indeed, this relationship is clear in our popular illustration of the credit market, shown in the chart below.

We have also observed that over time there is a strong correlation between the level of spreads of EM sovereigns and the level of spreads for comparably rated US and European corporate credits. In the past we have highlighted the spread difference between EM sovereigns and the ‘market-fitted’ level of spreads based on the log-linear relationship between spreads and ratings. This relationship formed the basis of our ‘country-specific spreads’ measure. However, a fair criticism of this approach has always been that it places too much

9 E.g. Fundamentals to Spreads, Jun 2004; Sovereign Ratings – Macro Drivers, December 2009

emphasis on the rating agency assessment of an individual issuer.

EM sovereign credit spreads in the context of the

market pricing of credit risk.

The points on the chart above represent individual EM sovereign issuers; the density plot represents the level of spreads for US+EU corporates. The line is a simple linear regression on the universe of US+EU corporates.Source: Deutsche Bank

An alternative (indeed orthogonal) use of the relationship is to infer a market-implied rating, given the market spread of an issuer and the overall market relationship between spreads and ratings. This approach does not rely at all on the rating agency assessment of individual credits, simply assuming the aforementioned overall lack of bias in their assessments.

The market-implied credit quality is a mapping of an

issuers credit spread into a rating, using the

calibration provided by the corporate credit market

Turkey

Hungary

25

50

100

200

400

1(AAA)

3(AA)

6(A)

9(BBB)

12(BB)

15(B)

Z-Spread

Credit Quality

market-implied=8.4

market-implied=12.5


The chart below illustrates this measure when applied to DB’s EM sovereign bond index. Note that we use a linear



scale for credit quality with a value of 1 being equivalent to AAA, 2=AA+ etc. A higher number is therefore indicative of weaker credit quality. The sign of the measure is therefore analogous to credit spreads.

The market-implied credit quality of EM

9

12

15

2003 2005 2007 2009 2011

Agency Rating




The chart above clearly shows the improvement in the market perception of EM sovereign credit quality over the past decade. Interestingly though, the market-implied credit quality has remained relatively stable over the past four years, oscillating around a level of ‘10’ (equivalent to a rating of BB+). In contrast, rating agencies have continued to upgrade their own assessment of EM sovereigns over the past four years, as highlighted by the second line on the chart above.

Just as we infer the market-implied credit quality of the overall market, we can do the same exercise for individual issuers. The chart below shows this for Russia. Note that for the market spread of individual issuers we are using the sub-index spread from DB’s EM Sovereign USD bond index.

The market-implied credit quality of Russia

3

6

9

12

15

2003 2005 2007 2009 2011

Agency Rating




Using the market-implied credit quality as a dependent variable in empirical analysis Having extracted the market-implied credit quality from market pricing, we can attempt to relate this measure to fundamental and potentially even technical factors. The exercise we undertook in this regard was very similar to the approach we used in our December 2009 analysis10 – namely a panel regression, using a wide variety of potential explanatory variables, which we then pared down to include solely factors which met three key criteria: their coefficients had the correct (intuitive) sign, they were statistically significant and the magnitude of the coefficient was such that they had a material impact on the results.

In the December 2009 analysis, we used actual credit ratings as the independent variable. In this updated exercise we use our new market-implied credit quality. This has the advantage of (a) making the results more relevant from a market perspective and (b) allows us to consider higher frequency data. While in 2009 we conducted the exercise on annual data, this time we use quarterly data.

Four key factors can explain much of the variation in

market-implied credit quality. Credit quality Change for

Variable Coeff. t-stat Impact +1 notch

Govt effectiveness index -3.55 -14.3 -1.93 -0.3

CPI y/y chg +0.21 +9.9 +1.35 +4.7 pp

FX Reserves as % of GDP

-0.12 -10.6 -1.31 -8.6 pp

Public sector external debt as % of GDP

+0.06 +9.8 +1.21 +18.0 pp

* ‘Credit quality impact’ indicates the marginal change in credit quality for a 1stdev change in the given variable, considering the distribution of the variable across the entire panel. Source: Deutsche Bank

Interestingly, just as in 2009, we find that there is a relatively small set of fundamental factors (shown above) which can explain much of the variability of market-implied credit quality between issuers and the variability of a given issuer over time. Also, reassuringly, we find that the same factors dominate – namely CPI, FX reserves and public sector debt levels. We also examined a variety of factors to measure structural differences between countries and we found that one of these had a very significant impact on the model: the World Bank’s ‘Government Effectiveness’ index. This index aggregates a wide range of different surveys and “captures

10 Sovereign Ratings – Macro Drivers, December 2009



perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies” (source: World Bank).

An important difference between our latest analysis and our December 2009 one is that in the previous exercise we included fixed-effects for individual countries. This allowed us to focus on the impact of fundamentals on how credit ratings changed over time, but meant that the analysis was of little value in understanding the inter-country differences in rating, as explained by fundamentals. In our latest analysis we found that we could dispense with fixed-effects for countries and so we use exactly the same coefficients for all countries. Despite this significant reduction in the degrees of freedom of the model, we find that it still explains on average, over time 51% of the variation in market-implied credit quality between countries. Over the past two years the model has explained over 60% of the variation.

While we have not used fixed-effects for countries, we have introduced fixed effects for time. This factor effectively accounts for any systematic difference in the pricing of credit quality between EM sovereigns and our reference market – US+EU corporates. The chart below shows the time series of this factor. It is clear that during the market dislocation at the onset of the financial crisis in 2007-08, EM sovereigns outperformed the US+EU market and hence appeared to be relatively better rated by as much as 4 rating notches (on average). Importantly however, outside of this extreme event, the impact of the time-effect has been minimal, resulting in at most a +/-1 notch impact on the implied credit quality.

The market-implied credit quality of EM

-5

-4

-3

-2

-1

0

1

2

2002 2004 2006 2008 2010 2012

Time factor


Just as the model helps to show how a few fundamental variables can explain the majority of the variability in the

market pricing of EM sovereign credit risk, so it can also show that the same factors explain a large degree of the variation in the credit quality of individual sovereigns over time. On average, across all countries, the model explains just over 50% of the variation. However, for some countries the explanatory power is as good as 70% (e.g. Brazil and Venezuela) or even above 80% (Russia and Peru).

Fundamentals can explain very well the evolution of

the market perception of Russian credit risk

0

2

4

6

8

10

12

14

16

18

Mar-02 Jan-04 Nov-05 Sep-07 Jul-09 May-11

Model MarketRussia, implied credit quality


The chart above shows the results for Russia. At the end of this report we present similar charts for a wide range of sovereigns. Looking into the model further, we can see which of the four fundamental factors have contributed to the improvement in the perception of Russia’s credit quality. The model-implied credit quality is simply the linear combination of these four factors, plus the time factor shown above.

Fundamentals can explain very well the evolution of

the market perception of Russian credit risk

-5

-4

-3

-2

-1

0

1

2

3

4

5

2002 2004 2006 2008 2010 2012

FX%GDP EffIdxPD%GDP CPI

Model components




It is clear from the chart that the growth in FX reserves, and the fall in both inflation and debt have all contributed to the improvement in credit quality, although ‘governance’ as been a marginally negative factor. In recent years, fluctuations in CPI and FX reserves have been important in explaining the fluctuations in implied credit quality.

Further work The fit of the model is surprisingly good and the results are intriguing. Some results clearly make intuitive sense, others can force us to challenge preconceptions. Ideally we would want to look to use a model such as this for a wide range of applications in the sovereign credit market, for instance, identifying relative value, forecasting and pricing new issuers. However, at present the model is a little too parsimonious to use aggressively in this form. For instance, the degree of uncertainty inherent in any ‘predictions’ from the model are likely substantially larger than the predicted changes themselves.

However, we are confident that this approach can form the basis for more comprehensive models of the sovereign credit market. The important thing is that we have a measure (implied credit quality) which we can successfully relate to macroeconomic factors and which can also be related directly back to sovereign spreads.

Marc Balston, London +44 20 7547 1484 Winnie Kong, London +44 20 7545 1382



Market- and Model-Implied Credit Quality of EM Sovereigns

0

3

6

9

12

15

18

21

02 04 06 08 10 12

ModelMarket

Brazil

0

3

6

9

12

15

18

02 04 06 08 10 12

ModelMarket

Colombia

0

3

6

9

12

02 04 06 08 10 12

ModelMarket

Mexico

0

3

6

9

12

02 04 06 08 10 12

ModelMarket

Poland

0

3

6

9

12

15

18

21

02 04 06 08 10 12

ModelMarket

Bulgaria

0

3

6

9

02 04 06 08 10 12

ModelMarket

Malaysia

0

3

6

9

12

15

18

02 04 06 08 10 12

ModelMarket

Peru

0

3

6

9

12

15

18

02 04 06 08 10 12

ModelMarket

Uruguay

0

3

6

9

12

15

02 04 06 08 10 12

ModelMarket

Panama

0

3

6

9

12

15

18

02 04 06 08 10 12

ModelMarket

Philippines

0

3

6

9

12

02 04 06 08 10 12

ModelMarket

South Africa

0

3

6

9

12

15

18

02 04 06 08 10 12

ModelMarket

Russia

0

3

6

9

12

15

18

02 04 06 08 10 12

ModelMarket

Indonesia

0

3

6

9

12

15

18

21

24

02 04 06 08 10 12

ModelMarket

Turkey

0

3

6

9

12

15

18

02 04 06 08 10 12

ModelMarket

Hungary

0

3

6

9

12

15

02 04 06 08 10 12

ModelMarket

El Salvador

0

3

6

9

12

15

02 04 06 08 10 12

ModelMarket

Egypt

0

3

6

9

12

15

18

21

24

02 04 06 08 10 12

ModelMarket

Ukraine

0

3

6

9

12

15

18

21

24

02 04 06 08 10 12

ModelMarket

Venezuela

0

3

6

9

12

15

18

21

24

02 04 06 08 10 12

ModelMarket

Argentina




Appendix: Credit Strategy Summary Cont’d Country View Strategy Risks

Czech Domestic and German economic backdrop

remains gloomy. Political risks could drag CZK

yields higher.

Neutral for now. A strong sell off in Bunds will be a clear risk.

Egypt Cautiously optimistic about economic and financial

market performance in 2013 given the 22m SBA

with the IMF, who noted objectives of declining

inflation, improving competitiveness and increasing

reserves.

Neutral for now, but we have a bullish bias in EGP

assets for 2013.

There remain significant risks ahead: tight funding,

risks to recovery in tourism / FDI due to

geopolitical risks, and

remaining important steps for progress in political

transition.

Israel The subdued growth, low inflation and weak

backdrop means we attach some probability to

the scenario of another 25bp rate cut in Q1 in

Israel.

We recommend being received in 5Y ILS at 2.65%,

with a target of 2.40% and a stop at 2.75%.

Resumption of geopolitical risks. Specifically an

Israeli strike on Iranian nuclear facilities - though

our base case remains that the likelihood of this

happening is low.

Poland Given a poor GDP reading in Q3 and inflation

expected to fall back into NBP's target range in

Q1, we now see a floor in the policy rate of 3.25%

by the end of 2013.

We think the swap curve fairly reflects the balance

of risks in monetary policy (curve priced for

roughly 120bps of cuts) and remain sidelined in

swaps for now.

YoY CPI dropping meaningfully below 3% could

lower the bar for a more front loaded and deeper

easing cycle than what is currently priced.

Russia Constructive OFZs. Non-residents are under

positioned, yields remain attractive vs. our

assessment of external vulnerabilities and we

expect inflation to slow in 2013.

Long Apr21 OFZs at 6.90%, target 6.50% and with

a stop loss at 7.20%.

A sharp turn in risk sentiment or an unexpected

rise in inflation would be risks to the trade.

South Africa We stick to our view that the SARB could cut rates

by 50bps in Q1. We think SARB remain concerned

with the uncertainty and lack of confidence in the

South African economy. Core inflation remains

subdued for now.

Continue receiving 2Y target 4.90 and with a stop

at 5. 30. We are also constructive the shorter

tenor bonds - specifically the R203s.

A pick up in core inflation, rand weakness and a

resumption of wage induced strikes are risks to

our view.

Turkey Attractive back end yields, a solid fiscal position

and improved macro economic indicators (decline

in CA deficit, inflation and higher ROC for local

banks) are positive factors for Turkey's ratings

prospects.

Long Jan22s at 6.80, target 6.50. Heightened political tension could see a spike in

TRY yields.

Argentina The stay order granted by the Appeals court

produced an expected recovery in all Argentinean

assets, including local ones.

Remain underweight on the local curve. Expansionary policies could further worsen the

inflationary and competitive situation, exacerbating

financial repression and negative growth.

Brazil The recent weaker than expected economic data

releases is fueling expectations of additional

monetary easing.

Enter Jul’14 DI receiver after taking profits on

Jan’14/Jan’17 steepener, and maintain long NTNB

‘45.

The combination of low interest rates and weak

currency could stoke inflation in the future.

Chile After suffering a temporary spike due to volatile

prices, inflation is expected to decline considerably

during the last quarter.

Take profits on 1Y1Y CLP/CAM payer and enter

long 10Y rates (CLP/CAM or BTP) vs UST.

Tradable inflation could add to already-elevated non-

tradable inflation

Colombia TES bonds have rallied to historical lows as the tax

reform advanced in Congress and the central bank

continued to ease monetary conditions.

Take profits on TES ’24 and enter 1Y COP/IBR

receiver.

A softening of external terms of trade as a result

of a global slowdown.

Mexico The passage of that reform together with a

positive message from the entering government

regarding the remaining ones is helping the curve

to recover.

Take profits on 2Y TIIE-US spread and long

MBonos 5Y and buy MBonos (or TIIE) 20Y vs UST

20Y.

Stubborn inflation pressures fueled by supply

shocks.

Peru The local curve continued to grind lower, with the

front end sinking well below the reference interest

rate under no expectations of monetary easing in

the near future.

Remain neutral in local rates. Further delays in the resolution of social conflicts

and postponements of investment projects in the

mining sector.

Uruguay Uruguayan linkers offer not only an attractive

source of diversification but also sizable carry.

Enter long UYU ’18. Further increase in inflation that would require

additional monetary tightening. Political stalemate

and conflicts over economic policy mix ahead of

2014 elections. Source: Deutsche Bank



On the Likelihood of EM Diminishing Economic Performance

Recent economic performance has disappointed in some of the major economies in EM. In some cases, policy improvement and/or structural reforms seem warranted, but lack of political enthusiasm for those changes does raise concern.

Using a simple panel regression from the major EM countries, we find that countries like Argentina, Brazil, China, India, South Korea, Czech Republic and South Africa are underperforming their own recent histories once all proper factors are accounted for, including the global economic cycle. Furthermore, most of these countries face increasing expectations that under-performance will continue over the next few years.

In Latin America, Argentina and Brazil are clear examples of consumption boom cycles that are reaching their peaks, with lackluster investment pickup being insufficient for a technology upgrade to compensate for increasing production costs. In Brazil, this is being exacerbated by the decreasing pace of credit expansion after the initial accommodation to a more stable and lower nominal equilibrium.

In Emerging Europe/Africa, South Africa is witnessing an important shock in labor market stability that could have meaningful effects in the long term. Meanwhile, Russia’s economic performance does seem to be fine but mostly helped by significant oil gains in the short term while facing the worst demographic profile of the EM universe.

The story in Asia also seems mixed, with bad population dynamics shaping South Korea policies and welfare allocation, while more traditional development bottlenecks are the constraints to growth in India. China, in our view, remains the greatest hope in the region, particularly with the new leadership; however, this is increasingly contingent on further progress on the structural reform front.

In sum, structural challenges are likely to represent a toll to economic growth in the major EM countries in the years to come. This might imply that unless progress in reforms is meaningful, higher interest rates could be demanded in some of the key EM markets to contain inflation and to maintain currency stability, while growth could be the main collateral damage of status quo policies. Argentina, Brazil, India, South Korea, South Africa, and Russia appear as the most vulnerable countries in this regard. Other EM economies, however, are expected to continue

delivering strong growth and stable inflation, implying further differentiation within the asset class.

Introduction

EM economic growth has continued to outperform G7 growth as pictured in the chart below. Nonetheless, there are some signs that such extraordinary growth of the past has already reached a peak while the developed world is likely to slowly recover from the ashes of the crisis. Indeed, growth this year in EM is likely to be 320bps slower than prior to the 2008 global crisis. The same comparison reveals a slowdown of 95bps in the case of G7 economies.

EM economic outperformance in retrospective

0

1

2

3

4

5

6

7

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Trend GDP growth

G7 EM

%


This situation, however, seems much more troublesome in some key countries of the EM world. For example, this is particularly noticeable by looking at the landmark BRICs. Brazil’s growth this year is likely to reach 1.0% at best, a pale performance compared to the average 4.5% between 2005 and 2007. The difference is 450bp in the case of Russia. The contrast is even more extreme in India and China, where this gap is around 500bp. It is worth noting, however, that there is hardly any underperformance in countries like Chile, Colombia, Mexico, Peru, Poland, Turkey, Indonesia, Malaysia, and the Philippines, to list a few of the resilient emerging economies of the last few years.

In the lines below we will analyze the factors behind the near economic future and implications for the future. We first show what historic relationships are predicting for different countries once corrected by the proper explanatory factors. This helps us to identify relative winners and losers in recent years. Second, we categorize some of the common drivers or eventual suspects behind the current economic outlook. Third, we relate the



empirical patterns with our macroeconomic view for the most important countries and project the outlook ahead. Finally, we map this view with potential asset price implications.

Recent economic performance in EM

In order to test performance deviation from the prevailing “norm”, we run a panel data regression on economic fundamentals and external factors. The economic fundamentals are product per worker, the real effective exchange rate, net commodity exports as share of GDP, total international trade as share of GDP, foreign direct investment as share of GDP, total investment in each country as share of GDP, and the unemployment rate. These series were included with one lag to avoid any type of spurious correlation with GDP growth (endogenous variable bias). Likewise, we do not include fiscal and monetary stances to prevent short-term contradicting effects. The external factors include the terms of trade, regional growth (excluding each country growth), and US, EU, and Japan GDP growth. The data sources were ILO, IMF, Haver, and national statistics. These series were included contemporaneously. The estimation method was OLS corrected by the variance-covariance information, taking full advantage of the panel structure. The results are presented below.

GDP growth explained by fundamentals (OLS

regression)

Bold represents significant at 10% confidence

Source: ILO, IMF, Haver, National Statistics, Deutsche Bank

The equation is relatively straightforward, containing only state variables and sources of shocks that could affect economic growth. Of the state variables, the most important (statistically significant at 5% confidence) seem to be the level of investment and labor productivity, the

level of the real exchange rate, and the composition and size of international trade. All have the desired signs except the size of international trade, whose effects are highly correlated to the transmission of external shocks and should be analyzed all together. The external shock variables are all found to be statistically significant and with the right sign, with the exception of US growth. The latter probably also demonstrates the strong correlation with G3 growth.

The table below shows our projected growth rates for 2012 arising from the previous equation. They are compared to our own forecasts for this year. On average, there is 8% overestimation of our projected growth for the countries listed below. However, this relatively good fit hides important extreme cases. For example, according to the regression, historical correlations suggest Czech Republic growth this year should be 266% higher than we are forecasting. Similarly this number is 174% for Argentina, 237% for Brazil, 43% for South Korea, 32% for South Africa, and 44% and for India and China, respectively. On the contrary, the regression seems to suggest forecasted growth in the Philippines, Poland, and Turkey is actually much better than what history can predict.

2012 GDP growth forecasts vs implied by regression Implied

DB Forecast Regression Underperformance

Arg 1.60 4.38 174%Bra 1.00 3.37 237%Chi 5.10 4.58 -10%Col 4.30 4.78 11%Mex 3.80 3.55 -7%Per 6.30 5.22 -17%

Chn 7.70 9.87 28%Ind 4.60 6.63 44%Ido 6.30 5.18 -18%Kor 2.10 3.00 43%Mal 4.80 3.89 -19%Phi 6.30 3.34 -47%

Cze -0.80 1.33 266%Pol 2.20 1.77 -20%Soa 2.30 3.04 32%Tur 3.00 2.37 -21%Rus 4.00 3.25 -19%SoA 2.30 3.04 32%


Interestingly, the model projection indicates that some of the estimated underperformers in 2012 actually have been underperforming history for the last two years, namely Brazil, China, the Czech Republic and South Africa. Similarly, the model has been underestimating growth in Turkey for the last few years. Thus, these results seem to suggest that economic growth disappointment in some countries is unusual for the historical relationship observed in the last decade. However, this disappointment is showing some degree of persistence in

Sample (adjusted): 1999 2011. Cross sections:17 Obs: 221Cross-section weights (PCSE) standard errors & covariance (d.f. corrected)

Coefficient Prob.

Product per Worker (-1) 0.000 0.005Real Effective Exchange Rate (-1) -0.021 0.028Credit/GDP (-1) 0.002 0.706Net Commodity Exports/GDP (-1) 0.086 0.001Exports+Imports/GDP (-1) -0.016 0.002FDI/GDP (-1) 0.007 0.357Total Investment/GDP (-1) 0.209 0.000Unemployment Rate (-1) 0.016 0.736Terms of Trade 0.010 0.046Regional Growth 0.445 0.000USA Growth -0.272 0.051EU Growth 0.293 0.072Japan Growth 0.311 0.006Dummy Latam -0.176 0.901Dummy Asia 0.321 0.831Dummy Emea 0.159 0.926

Weighted StatisticsR-squared 0.665Adjusted R-squared 0.641S.E. of regression 2.455



recent years, as least for some of the major countries, like Brazil and China.

It is worth noting that the results shown for 2012 indicate that higher investment and weaker exchange rate than the sample average helped to project positive growth this year. On the contrary, the trade composition and size, together with all other external factors, represented drags on the EM economies in 2012. As an approximation to explain this year’s disappointment, it is fair to suggest that strong currency and low level of investments are actually hurting countries like Argentina, Brazil, South Africa, and the Czech Republic. The latter is also affected by fiscal consolidation, not well captured in the regression. In the case of China and India, a strong currency seems also exacerbating low external and regional growth and their own linkages in international trade and investment. Finally, in the case of South Korea, there does not seem to be a clear candidate for underperformance other than the extreme precautionary stance by some local consumers and investors, a weak external demand, and high commodity prices.11

A crack on the BRIC

The simple forecasting exercise done above seems to corroborate the market’s diminishing expectations for growth in the main economies, as reflected by equity performance and growing analyst pessimism. Below, we address current concerns on the landmark BRIC group and provide our own assessment. In sum, we do acknowledge serious challenges in these economies and we are not optimistic regarding the respective countries rapidly addressing these issues. Nonetheless, we remain more constructive on the Chinese outlook than many market players seem to be, partly because we also foresee progress on the reform front.

Brazil: searching for a new growth model On November 27 we published a detailed analysis of Brazil’s medium term challenges.12 There, we concluded that the current economic slowdown has a strong cyclical component linked to the challenging global environment. However, we also noted that Brazil´s low investment rate together with an aging population is the main structural constraint. Unfortunately, the official policy, based on boosting public and private consumption and devaluing the currency, is not the most efficient to promote growth with this background. Indeed, this explains Brazil´s record increase in unit labor costs in the last few years, as

11 These results are in line with our previous warning about performance in EM, as documented in two pieces: Ever Emerging Markets, published on October 2010, and Unit Labor Cost and Performance in EM, published on May 2012. 12 Brazil: In Search of a New Growth Model

consumption booms not accompanied by pickup in investment and productivity translate to worsening competitiveness indicators. Thus, the natural outlook under the status quo is to expect trend growth to move downwards from an estimated 4.5% in recent years, to something like 3.5% or even below.

Brazil: saving and investment

10

12

14

16

18

20

22

Domestic saving

Investment

% of GDP

Source: IBGE

There are a number of factors affecting Brazil´s growth perspective. First, the Brazilian economy will probably not enjoy the strong tailwinds provided by the commodity “supercycle” of the last ten years again. Second, Brazil seems to be moving away from the so-called “three pillars” of macroeconomic policy (floating exchange rate, fiscal discipline, and inflation targeting) that supported growth in the 2004-10 period, risking the credibility of the economy´s nominal anchor and potentially creating a damaging inflation problem in the future. Although fiscal solvency is not at risk, the combination of conventional and off-balance-sheet fiscal expansion could aggravate the problem. Third, and related to the Central Bank’s new set of goals, Brazil might be confronting the boundaries on credit penetration that was critical to fuel economic strength in the last few years. Fourth, structural reforms that started under the F. H. Cardoso administration (1995-2002) and that were complemented by the Lula da Silva government (2003-2010) also played a crucial role in Brazil´s stellar performance in the last decade or so but the prospect for further reforms appear dim. 13 Fifth, Brazil has failed to foster higher saving and investment in the country.

Taking for granted that the new reality ahead involves less euphoria from the commodity world and the softening of the authorities´ economic prudence, one valid question is whether Brazil´s credit boom is over. We do not believe so, despite the fact that household debt and the debt service burden have already reached 44% and 22% of disposable income, respectively. These numbers are

13 For a deep discussion on each of these factors please see our report cited in footnote 1.



almost twice as high as a few years ago, but the credit penetration process might be far from exhausted. First of all, interest rates are still falling but this has not yet been fully reflected in the debt service burdens. Second, Brazil´s mortgage market is still relatively small, just 5.5% of GDP, due to many years of high interest rates, financial instability, and financial short-sightedness. Thus, the continuation of low rates and financial stability is very likely to fuel further growth in this market. Needless to say, the main risk to such an outlook is the one stemming from more “unorthodox” policies by the current administration, as discussed above.

Investment, reaching at its peak only 19% of GDP, is Brazil´s main constraint to high growth. There are several reasons for that. One very important reason is the government’s efforts to limit the rate of return on private investment projects and the reliance on corporate taxes to fund the public sector. Brazil’s total tax burden of approximately 34% of GDP is among the highest among emerging markets. A complex tax system heavily dependent on several cumulative indirect taxes is difficult to manage and undermines the competitiveness of the local industry. Another factor is the weak regulatory framework for long-term investment. A clear reflection of that is the low level of infrastructure growth. The country invests approximately 2.0% of GDP in infrastructure, which is barely enough to compensate for depreciation and keep up with population growth.

The government’s fiscal problems have taken a toll on infrastructure investment over the years. Given the large share of mandatory spending (legal earmarking, social security, welfare, personnel, etc.) in the federal budget, the easiest way for the government to reduce its budget deficit has been by curbing investment. Furthermore, public investments require careful planning and compliance with strict legal and environment rules. Another problem is that investments of government-owned companies sometimes conflict with other government goals. For example, the ability of oil company Petrobras to invest has been damaged by the government’s reluctance to raise gasoline prices to avoid higher inflation.

Other factors affecting investment decisions negatively are the low level of savings, partly associated with the tax structure, and Brazil’s generous public social security system. Another is Brazil’s low ability in stimulating human capital. Although Brazil spends a relatively large share of GDP on public education, it continues to lag behind in performance, which calls into question the efficiency of government spending. In OECD’s Program for International Student Assessment (PISA) test, for example, only three countries scored lower than Brazil, which was at the bottom of its income tier.

Thus, Brazil could expect to increase investment demand by reforming the tax regime or the social security system; however, the likelihood of such a change is rather low. Furthermore, although saving tends to increase with per capita income, the aging population and the decline in real interest rates conspire against an increase in private saving as well.

Notwithstanding, there is probably significant room for higher public investment given fiscal dynamics and declining real interest rates. But barring significant structural reforms, this is still an optimistic scenario. First, there is a risk that the primary surplus could decline faster than we are assuming. As noted, the reduction in interest rates means that the net public debt can remain stable at lower levels of primary fiscal surplus. Second, public spending is strongly endogenous, mainly due to widespread budget earmarking, which makes spending move in tandem with revenues. Third, Brazil’s aging population and resulting increase in the old-age dependency ratio will increase the pressure on the social security system and the demand for public healthcare.

To put all these problems into perspective, we describe a hypothetical positive scenario in which an increase in government and external savings gradually allow investment to rise to 23% of GDP. We assume that private saving remains unchanged at 19% of GDP, while public saving declines to zero, and the current account deficit climbs to 4.2% of GDP over ten years. All the improvement in government saving comes from lower interest rates, as government consumption remains steady at 21% of GDP. We assume total factor productivity growth of 1% per year, which seems to be consistent with recent history. We introduce a declining rate of labor force growth, in line with forecasts provided by the United Nations. Even this scenario does not prevent potential growth from slowing to 3.5% from 3.9% in ten years, mainly because of the likely deceleration in labor force growth.

For all the reasons discussed above, the government policy of boosting public and private and consumption and devaluing the currency is not the most efficient to promote growth, in our view. The excessive emphasis on consumption undermines saving and therefore investment. For a given level of private sector saving, the more the government consumes, the larger must be the external saving (current account deficit) to enable the same amount of investment. If domestic demand grows faster than supply and net imports do not rise, inflation may rise to restore equilibrium.

The authorities will likely succeed in stimulating some investment in the near term through tax cuts, a significant amount of subsidized credit, and new concessions for the private sector. In the long run, however, the frequent changes in taxes, capital controls, and regulation could



have the contrary effect on entrepreneurs’ “animal spirits.” The plan to reduce electricity prices by forcing utility companies to cut prices in exchange for their concessions is an example of how interventionist policies could raise uncertainty and hurt private investment.

Russia: improved macro-management but investment lags Growth in Russia has been relatively steady at 4% this year. While this is 75bps better than our regression-based estimates would have suggested, it is disappointing relative to the 7% growth rates achieved on average in the decade prior to the last crisis. We expect (Brent) oil prices to remain around $110-115bbl over the next two years, which should continue to support growth of around 4%. But deeper structural reforms will be needed if the economy is to grow substantially faster than this and to diversify away from oil and gas, which still account for about one-fifth of economic activity.

The good news is that better macroeconomic management should help to reduce the volatility of growth. The rigid exchange rate peg in place prior to the last crisis has been abandoned and much greater exchange rate flexibility has been introduced as the rouble band has been widened to +/- 10%. This has given the Central Bank greater control over domestic liquidity conditions, which should in turn help to meet inflation targets of 5-6% in 2013 and 4-5% in 2014. Fiscal policy has been mildly countercyclical but not consistently so. The budget for 2013-15, however, is based on a new fiscal rule that ties spending to a long-term moving average of oil prices with any excess revenue going to the oil savings funds. If consistently implemented, this will help to insulate the budget from swings in oil prices.

Russia: weak governance scores

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Voice / accountability

Political stability /

absence of violence

Government effectiveness

Regulatory quality

Rule of Law Control of corruption

RussiaGovernance score

Stronger

Weaker

Columns indicate range of scores for other emerging markets

Source: World Bank, Deutsche Bank

Progress on structural reforms has been less impressive. Russia finally joined the WTO in August after decades of negotiation and this should be helpful in terms of improved market access and introducing greater

competitive pressure. But the investment climate needs to be improved to enable the economy to take full advantage of this and stem chronic capital outflows at the same time. Russia scores poorly relative to its EM peers on most governance indicators and it ranks 112th out of 185 countries in the World Bank’s assessment of the ease of doing business. Privatization would help. The government intends to privatize most (non-strategic) state-owned companies but implementation has been slow.

Finally, Russia needs to deal with the challenges of an ageing population, which will bite sooner than in the other BRICs, as shown in the chart below. The IMF estimates that maintaining replacement rates for public pensions at current levels would add 7% of GDP to spending by 2050. Rather than raising retirement ages, which are relatively low by international standards, at 55 for women and 60 for men, the government plans to address the deficit by diverting contributions to private pension funds back into the public sector from 2014 onwards. We think the additional revenues accruing to the government are unlikely to be fully saved and view the switch as negative for the long-term health of public finances and potentially damaging for local capital market development.

Population ageing hits sooner in Russia

2000

2010

2020

2030

2040

2050

2060

Russia China Brazil India

Exit year

Exit year shows the point at which countries exit the "demographic window " when the proportion of working age population is most prominent, defined (by the UN) as the period when the propotion of children falls below 30 percent and proportion of people over 65 is still below 15 percent.

Source: UN, Deutsche Bank

India: in need for a second push toward reforms India has seen a sharp decline in growth in recent years, from over 8% just a couple of years ago to well below 6% this year. However, the decline in growth rate has not opened up a large output gap, with supply constraints causing inflation to remain in the 7-9% range. This has led to widespread skepticism about the economy's potential rate of real GDP growth, which was estimated to be over 8% by the IMF and the Planning Commission of India only a couple of years ago. Indeed, in its recent communication, the Reserve Bank of India has suggested that the potential rate of growth may well be no more than 7-7.5%.



The notion that trend growth has declined is reinforced by the fall in India's investment growth rate, with fixed capital formation contributing nearly zero to growth in recent quarters. High input costs and wage demand, regulatory uncertainty, rising cost of capital, tight liquidity, and crowding out by the government's substantial fiscal deficit have all contributed to this outcome.

India is also increasingly vulnerable to global demand and price shocks, the former because trade/GDP has been rising and the latter because domestic prices have begun to reflect international prices to a greater degree. This rise in vulnerability needs to be dealt with through greater economic flexibility, such as automatic price adjustment of fuel products and a more flexible FX regime.

Faced with slowing economic momentum and its adverse social and political implications, the government of India has begun to take corrective measures, which may revive growth prospects and productive capacities. A much belated move toward fiscal consolidation has started, regulations have been relaxed to open up key sectors (including retail and aviation) to foreign direct investment, and the Central Bank has signaled its keenness to ease monetary policy in early 2013 as inflation pressure abates somewhat. There may be a constructive case to be made that growth has bottomed and an investment-led recovery is around the corner, but for that a second push toward reforms is necessary, including investment and financial liberalization, fiscal consolidation, and efficiency enhancements. 14

India: debt sustainability hinges critically on strong

growth

30

40

50

60

70

80

90

2004 2006 2008 2010 2012 2014 2016 2018 2020

Baseline public sector debt 1/

Real GDP growth is at baseline minus one standard deviation

% of GDP

Source: Government of India, Deutsche Bank. 1/ Combined Central and State level debt.

Further fiscal consolidation is certainly a key to the resumption of stronger economic growth. In the decade between 2002 and 2011, India’s sovereign debt/GDP ratio declined from 82% to 68%, helped by an economy that grew rapidly, reduced the fiscal deficit, and kept a lid on interest costs. With real economic growth averaging 8%, revenues grew robustly, displaying some buoyancy,

14 For a couple of recent research papers discussing these issues please see India GDP Growth, issued on 29 November 2012 and India´s Debt Sustainability and Growth Outlook, published on 30 November 2012.

resulting in a remarkable improvement in the fiscal position. But the situation has been considerably more challenging since the global crisis, with a combination of commodity price volatility and weakening economic growth causing a substantial amount of fiscal slippage. The primary fiscal deficit in the past four years has been in the range of 3-4% of GDP. The trajectory of the debt/GDP path has begun to flatten, even though the gap between real GDP growth and real interest paid on debt remains substantial. The chart above shows the projected trajectory of debt rations under the assumption of economic growth remaining at 7% and the same ratio if growth fails move away from the 5% pace.

China: still constructive but contingent to further reforms Investors appear to have had a progressively more bearish view of China’s potential growth rate over the past seven or eight years, since well before the Global Financial Crisis. The ‘structural’ factors weighing on growth appear numerous: demographics, over-investment, slower growth in China’s trade partners, and doubts about productivity growth. 15 On the over-investment thesis, we’ve offered arguments in the past that China’s infrastructure spending has not created obvious excess capacity – the power and transportation sectors would appear to need significant investments to provide services to the whole population, although telecommunications infrastructure seems well advanced – and interest rate liberalization offers the prospect for more efficient investment in the non-government sector in the years ahead.16 So the main drag on investment demand – at least on the growth implications of investment – is likely to come from a decline in residential investment. Our colleague Jun Ma estimates this is worth a drag of about 1.2% off growth.17

The external drag on growth, from slower US/EU demand growth, is another source of “structural” decline that we acknowledge. Over 2004-2007 US/EU combined GDP growth averaged 2.8%. We would expect that in the medium term this growth rate could be halved. That’s worth about a 2% reduction in China’s growth rate relative to the pre-crisis years. Note that export growth today of about 5% YoY is about one-third what we think could be the new trend growth rate in exports over the medium term. So the US/EU recovery should boost Chinese GDP growth from the 7.6% QoQ(saar) we estimate for Q3 by

15 For a full discussion on China´s medium term prospect, please see “Demographics and GDP Growth in China” published in the Global Economic Perspectives, on November 16, 2012. 16See “The State of Infrastructure in Asia,” Global Economic Perspectives, Oct 12, 2012 and “China’s Financial Revolution,” Global Economic Perspectives, on April 20, 2012. 17See Jun Ma, “Lower Growth, Better Structure,” China Macro Strategy, on September 16, 2010.



more than one percentage point. So, after having grown 12.1%p.a over 2004-07, slower growth in residential investment and exports can be expected to take trend growth in China down to about 9%.

The other parts to the ‘structural’ slowdown thesis typically come from demographic pressures and productivity growth. However, we believe there is compelling evidence that the demographic constraint on growth is not as great as believed. Furthermore, we also believe that productivity growth is likely to remain high or not decline at least.

Trend as “potential” GDP growth in China

4

6

8

10

12

14

16

18

92 94 96 98 00 02 04 06 08 10 12

Actual Trend%yoy

Sources: CEIC and Deutsche Bank

The academic literature on the labor surplus question finds no evidence for a sudden increase in real wages in the early or mid-2000s, when it was supposed to have begun. Instead, a conventional neoclassical labor market emerges in which migrant workers must be paid a premium to their reservation wage – what they would earn as farmers. So the fact that urban wages rose rapidly in 2010 doesn’t necessarily mean there was a shortage of labor. If migrants’ wages fell in 2009 while food prices were rising – and given that for the first time migrants realized urban jobs were not secure – it would have been necessary to raise migrants’ wages much higher than usual in 2010 to restore the proper incentive to migrate.

Attempts to ‘count’ surplus workers must, in our view, allow for productivity growth in agriculture – this sector will not always be stuck with ancient technologies if China is to become an advanced economy. And even a very loose reckoning of the amount of labor that could potentially be shed if agriculture were suddenly modernized suggests that there may still be more potential migrants than have migrated over the past thirty years.

Regarding productivity growth in China, it appears to have maintained a remarkably good record. Conventional measures of total factor productivity growth show it to be consistently higher than in other Asian economies and rising over time. To be sure, capital accumulation has also

been an important contributor to Chinese growth, and Brandt and Zhu’s (2010) demonstration of the distortions caused by the capital subsidy given to the SOEs is compelling and consistent with investors’ experience.18 We state their key result slightly differently: it is possible that financial liberalization, which evidence suggests is already underway, by allowing for the reallocation of capital away from the SOE sector to the private sector, could allow productivity growth to be maintained without an increase in the investment/GDP ratio.

Productivity growth in China

-2

-1

0

1

2

3

4

5

6

7

"G4" Japan NIEs China India

'07-'80 '80-'90 '90-'00 '00-'07%

Sources: ADB and Deutsche Bank

So we come back to financial reforms. The state sector continues to dominate capital accumulation, accounting for more than 50% of fixed investment, but is clearly less efficient than the non-state non-agricultural sector. We argued in our 20 April report, China’s Financial Revolution, that financial sector reform fundamentally alters China’s growth model and offers prospects for a more efficient allocation of capital. Brandt and Zhu (2010) are able to put that into concrete growth terms. They estimate that had capital been allowed to flow freely between the state and non-state sectors, TFP growth during 1978-2007 would have been 0.82% higher than the 3.92% they estimated. Put another – and compelling – way, “absent capital market distortions, China could have achieved the same growth performance without any increase in the aggregate investment rate”.

In our view, a combination of labor-shedding investment in agricultural production, allowing for continued migration of surplus farm workers into the private industrial and services sectors, combined with financial liberalization, allowing a more efficient allocation of capital in favor of the private sector, could allow Chinese GDP growth to continue at a faster rate than investors expect for many more years. If these two reforms are pursued, and we believe both have already begun in recent years, then our

18 Brandt, Loren and Xiaodong Zhu, “Accounting for China´s Growth” IZA Discussion Paper N0 4764, February 2010.



current estimate of potential GDP growth in China of 8.5% looks like a very reasonable medium-term baseline scenario.

Other worrisome outlooks

As we noted, there are also other important emerging economies facing the end of the easy harvest of low hanging changes fostering performance. Argentina is a very good example of a country in Latin America that is facing the limits of policy continuity. South Africa is another important emerging economy that is struggling to grow amid growing labor conflicts despite significant increases in real wages in the last few years. In Asia, South Korea is threatened by an aging population and high leverage.

Argentina: facing the time decay of unsustainable policies Argentina currently resembles the end of cycle of the typical populist policies, which, after being able to deliver very strong growth, failed to create business incentives to invest. 19 Exhausted resources in the case of Argentina were exacerbated by policy mistakes, accelerating the time decay of the populist approach in recent months. Thus, after producing an average growth of around 8% annually for the last eight years, we expect the economy to advance hardly above 1% this year and 2% in the years to come. A faster pace of growth will only be achievable after a significant change in policies, meaningfully reducing state intervention in private sector business and promoting investment. This is unlikely to occur until we witness a change in political leadership in the country, which could start happening after the mid-term elections in October next year. Argentina´s richness in commodity production, low leverage, and relatively educated population provide the proper background for a much faster pace of growth after policies move in the right direction.

South Africa: to underperform unless reforms are enacted Growth in South Africa is set to reach 2.4% this year, about 0.6ppts basis points below our regression-based estimate. On the face of it, this underperformance is easy to explain with recent labor unrest resulting in significant production losses and directly knocking about 0.5ppts off growth this year.

While recent labor disputes have mostly died down, we think the South African economy will continue to underperform over the next few years, with annual growth rates struggling to get much above 4%. Fiscal space is

19 A description of the cycle and perspectives can be found in Argentina: The limits of Policy Continuity, published on August 9, 2011.

limited and interest rates are already at historic lows. More vigorous structural reforms will therefore be needed to support growth.

The labor market is certainly the place where reforms are warranted. Despite a sharp deceleration in economic growth and high levels of unemployment, real wages in the formal sector have continued to increase rapidly in recent years, well above productivity growth. Generous public sector pay settlements and strong union bargaining power have facilitated these increases. This has eroded competitiveness and employment growth, which has been among the worst in EM since the crisis. Recent strikes will lead to more of the same, i.e. high wage settlements and job losses. We see little prospect of a turnaround here and, if anything, a risk of greater militancy as unions compete more aggressively for membership among disaffected workers.

Regulation and fiscal consolidation are also good candidates for progress on reform. Infrastructure has suffered from years of underinvestment. The resulting transport bottlenecks and electricity shortages have discouraged other investment, including the natural resources sector, which has been unable to take full advantage of the boom in commodity prices. Investment in infrastructure is being ramped up but the bulk of the increase in public spending in recent years has gone toward the wage bill and progress is slow.

Finally, the education system remains a longer-term drag on growth. Funding levels and enrollment rates are adequate. But the system delivers poor returns, with South Africa ranking towards the bottom of most international literacy, numeracy, and science tests.

South Korea: population dynamics and welfare concerns South Korea faces a few but critical structural challenges that weigh on its long-term growth outlook. First, it has one of the fastest ageing populations among OECD members. Although by increasing women's participation in the work force (which is currently very low at below 50%), South Korea could counter the demographic challenges, it has yet to eliminate persistent negative cultural and corporate practices that depress women's participation. Second, Korean households are heavily indebted, with debt-to-income ratios higher than those of US households , which weighs on the housing market and thereby depresses private consumption via the wealth effect. At the same time, with an inadequate welfare system, nearly half of the elderly live in relative poverty and they depend on loans to maintain self-employment. 20

20 For a detailed discussion on South Korea immediate challenges, see South Korea: A Country Divided, issued on November 16, 2012.



Although South Korea enjoys a very low unemployment rate of around 3%, the headline number is rather deceiving as about 30% of workers are self-employed, and depend heavily on loans to remain liquid. Although South Korea has increased its R&D expenditure, the services sector’s productivity – where two thirds of workers are employed – remains below that of manufacturing, resulting in a wage gap of about 50% against the manufacturing sector wage.

Economic democratization remains at the top of South Korea’s national agenda amid growing economic polarization, prompting all candidates in the coming Presidential election to commit to welfare spending increases. However, there are no concrete policies in this regard.

The more encouraging stories Not all emerging economies are struggling to maintain their strong pace of growth. Chile’s exemplary policy making continues to deliver very stable and very strong economic growth. Colombia and Peru appear to be simply following the Chilean path and steady FDI is rewarding the policy choice. These Latin American countries have been blessed by commodity resources, but they have also followed the right policy track. The latter is critical to understand the success of these economies. Good policies have also helped Mexico to withstand the global shock, Actually, Mexico is the new focus for hope in the region as a new administration is starting to push for long-awaited reforms with much more conviction than in the past; there is a chance to further improve business conditions in the country. Indeed, further demonstrating that resources are not the only reason for hope, improved performances by Philippines and Turkey are potentially grooming them to be the new darlings of the EM, although risks remain as we discuss in the line below.

Chile, Colombia, and Peru: collecting from good policies These three relatively open economies have shown in the last few months how strong economic fundamentals could buffer a weak global cycle. Indeed, the resilience of these three economies has been remarkable. The reason is relatively straightforward: policy making has been dedicated to minimizing distortions and maximizing comparative advantages. The process is relatively mature in the case of Chile, with already more than 25 years of solid performance. The process is more recent in Colombia and Peru but we are growing more confident that the policy path is going to remain unchanged. Indeed, the last elections in these countries have simply helped confirm the society preference for reasonable and text book economic policy making. This confirmation was probably more important in the case of Peru as the new government elected last year was perceived to be too

extreme and a real threat to policy continuation, but concerns were proven unfounded after more than a year in power. Thus, helped by policy continuity and strong economic fundamentals, we expect these countries to continue delivering solid growth in the 4.5%-5.0% range for Chile and Colombia, and 6.0%-6.5% for Peru.

Mexico: time for long awaited reforms? Amid ongoing concerns about possible negative external shocks, the outlook for much needed and long promised structural reforms in Mexico appears to have improved. A labor reform bill was approved in Congress on November 13, even before incoming President Enrique Peña Nieto was sworn in. The core of the reform is to streamline hiring and firing process, making domestic labor market more flexible. According to official estimates, the bill could reduce unemployment rates on a permanent basis by some 1%. The congressional approval, which was obtained with votes from PAN and PRI parties and the opposition from the leftist PRD, represents a powerful signal of legislative coordination between the two largest parties in Congress, a rather uncharacteristic feature of Mexican politics. It reduces the possible political cost to be borne by Peña Nieto, and it opens the door for additional legislative cooperation in other areas. We expect a fiscal reform bill to be discussed during 1H13. It will likely be geared towards increasing the tax base and streamlining the tax code. The tax changes are to result in a revenue increase to lower dependence of fiscal accounts on oil-related receivables. Currently oil related revenues hover around 35% of the total fiscal take, and the fiscal reform will probably aim at eventually lowering that figure to less than 30%. As there is significant common ground on fiscal issues between PAN and PRI, we see this reform as a likely event next year. Energy deregulation, on the other hand, may be the tallest order of the new administration. Private participation in the energy sector is forbidden by Art. 27 of Constitution. A full, deep energy reform requires constitutional changes, which can only be done via a qualified two thirds congressional majority. We do not rule out some progress on energy reform, but believe a complete deregulation of the sector is not the most likely scenario. If full energy reform fails to pass, emphasis will continue on existing joint ventures between Pemex and private companies, which since inception have been fairly marginal, possibly because private capital commitments are unlikely to occur without a more solid constitutional framework.

Philippines: some reasons for hope The Philippine economy has grown much faster than expected over the past year or so and one wonders whether this might reflect a higher potential growth rate. Over the past five years, exports of information technology and business services have grown from less than 1% of GDP to nearly 5%. Recently, FDI into



manufacturing industries has pushed non-electronic exports up 10%. The current account is solidly in surplus and foreign investors are looking more positively at the Philippines.

The election of President Aquino in 2010 has been cited as a watershed event, ushering in a more determined effort to clean up government and improve governance. While hard to quantify, we note how frequently investors and businesspeople in the Philippines credit this administration's efforts in improving governance as a key reason for their confidence.

However, to maintain the momentum, progress with fiscal reforms is needed. Stronger growth has allowed the government to achieve its fiscal targets ahead of schedule -- we forecast a deficit of only 1.5% this year. But this has been achieved largely via expenditure restraint. The main fiscal challenge remains to raise the revenue/GDP ratio, which has been declining broadly for twenty years. Thus, an administrative reform may not be enough.

Turkey: dealing with volatility Turkey is likely to grow by about 3% this year, some 60 basis points faster than our model would have predicted. Indeed, the economy is one of the few in EMEA to have enjoyed a vigorous recovery following the global financial crisis, with output now 12% above its pre-crisis level despite a deep recession in 2008-09.

We think the economy can continue to grow at a reasonable clip, probably averaging 4½-5 percent over the next few years. Unlike its emerging European neighbors, there is no pressing need for fiscal consolidation: public debt levels are already low at 38% of GDP and falling. Leverage in the private sector is also relatively low. Private credit, for example, is about 45% of GDP (compared with an EM average of about 65% of GDP), which suggests scope for further financial deepening.

Demographics are also favorable with a relatively young population.21 Participation in the labor market is still low (especially among women), at about 53% of the working-age population compared with an average of about 66% in other emerging markets. So Turkey has not yet taken full advantage of this demographic dividend. Improvements in education would help in deploying this ample pool of labor more fully in higher value-added sectors in manufacturing and services.

Saving rates are low, declining further in recent years to 13%, which will likely constrain investment and/or see continued reliance on foreign savings. Public savings have increased as a result of sustained fiscal discipline, but this

21 Turkey entered its “demographic window” (i.e., the period when the proportion of children falls below 30 percent and proportion of people over 65 is still below 15 percent) in 2002 and does not exit the window until 2040.

has been more than offset by a decline in private savings. The government has introduced measures to encourage private savings (e.g., incentives to contribute to private pension schemes). But locking in low and stable inflation and reducing the economy’s susceptibility to boom-bust cycles (see below) would also help.

Our concerns in Turkey have less to do with the level of growth and more with its volatility, which has been high by EM standards (and similar to Russia, which has been driven by swings in oil prices). We think this is likely to continue. The current account deficit has narrowed but is set to remain over 7% of GDP over the next two years. With maturing external debt of well over 10% of GDP, this leaves Turkey heavily reliant on external financing flows and sensitive to changes in risk sentiment.

Asset implications Structural challenges are likely to represent a toll to economic growth in the major EM countries in the years to come. This might imply that unless progress in reforms is meaningful, higher interest rates could be demanded in some of the key EM markets to contain inflation and to maintain currency stability, while growth could be the main collateral damage of status quo policies. Argentina, Brazil, India, South Korea, South Africa, and Russia appear as the most vulnerable countries in this regard.

With less need for further reforms or positive expectations about the prospects for reforms other countries in EM are expected to continue delivering strong economic growth and stable inflation and exchange rates. As noted we will include in this category Chile, Colombia, Peru, Mexico, Poland, Turkey, China, Hong Kong, Indonesia, and Malaysia, among others.

Indeed, the current global picture populated by leveraged economies in the center and low interest rates for long as a consequence, might offer an important buffer for emerging markets to continue performing in economic and credit terms. Although this would be contingent to fiscal solvency not deteriorated by domestic policies, as it could happen in some EMEA countries, or as noted in a country like India if current fiscal consolidation were to fail.

Thus, our analysis above simply highlights the growing risks against performance in some of the key emerging markets. But at the same time it suggests that given the existing global backdrop, emerging economies will continue to attract interest for investment and some countries could actually keep outperforming. Therefore, market participants will have to be increasingly selective from now on.

Gustavo Cañonero, New York, (1) 212 250 7530 Robert Burgess, London, (44) 20 7547 1930

Michael Spencer, Hong Kong, (852) 2203 8305



EM Performance: Growth and Asset Rebalancing

The year 2012 was characterized by the resurgence of the European debt crisis and the subsequent placement of central bank backstop mechanisms. Dismal growth and accommodative policies provided the ideal background for another stellar year for global fixed income assets.

EM credit posted the best performance this year, as spreads have compressed substantially, benefitting from abundant liquidity and a relative scarcity of high quality yield assets. However, double-digit return is unlikely to repeat in 2013 given limited room for spread tightening and likely repricing of the USTs.

EM local markets once again benefited from continued accommodative monetary policies. However, the performance was contaminated by volatilities introduced by swings in EMFX. Going forward, performance of EM local debt mostly hinges on the rebound of EM currencies. If the US overcomes the “cliff,” as we foresee, local currency debt will likely outperform EM credit in 2013.

We expect a gradual rebalance away from the defensive (fixed income overweights) that marked 2012, to growth-centric products such as equities and EMFX (and commodities) in 2013, conditional on an orderly resolution of the US fiscal cliff early in the year.

As has been the case over the years, outperformance in 2013 will likely hinge on whether to overweight growth-sensitive assets or not, rather than on the relative allocation between EM and DM (which remains overly light EM, in our view).

2012: A Year of Fixed Income

Dismal growth and accommodative policies provided the ideal background for another stellar year for global fixed income. Slow progress in Europe, the looming fiscal cliff, and the accompanying collapse in global trade dragged EM economies along and triggered a renewed wave of monetary easing across the globe. Credit markets benefitted not only from the search for yield but also from EU policies aimed at securing low funding cost for the region’s sovereigns and banks.

Consequently, fixed income assets – led by credit products – have posted the best performance so far this year (see the chart below). In line with what we anticipated at the end of last year22, these have largely

22 See EM Performance: Grass is Grayer on the Other Side, a special report include in the 2012 Outlook.

outperformed the more growth-sensitive assets such as commodities and FX – a pattern that was amplified by lower demand from China and the substantial relocation away from equities into fixed income funds23. In contrast with what we expected, however, the deeper slowdown in global activity enhanced rather than diminished total fixed income returns.

Differentiation has also been substantial and, consistent with the theme that the “Grass is grayer on the other side” 24 , EM assets, especially credit, have once more provided exceptional value for investors. Stronger fundamentals have supported EM credit outperformance over developed markets’ IG and HY.

Performance profile in “risk-off” mode

-4% 0% 4% 8% 12% 16%

EMBI-G

HY

DB-EMLIN

S&P

EU Eq

EM Eq

IG

DB-EMLIN (hedged)

EMFX (Total Return)

UST

EMFX Spot

Com'dty

YTD asset returns


EM Credit: Stellar, but with less gas left in the tank EMBI-Global’s more than 17% YTD gain, the highest among liquid asset classes, is skewed toward high-yielders and EMEA. In addition, and unlike in 2011, spread compression rather than UST accounted for most of these gains (see the following chart). Technicals have played an important role, as EM assets are relatively scarce for global funds in search for yield. But fundamental developments have also remained supportive, with 18 ratings upgrades vs. 12 ratings downgrades so far this year. The average rating of sovereign issuances in 2012 is BBB, the best since 2005 (except 2009 when the market was open for only high grade issuers).

23 Inflows into fixed income asset classes, including US Bonds Funds (Treasury, Agencies, Mortgages, Munis, and IG credit), Global HY funds (US and Non-US) and EM debt funds, attracted inflows of 14%, 21% and 29% AUM respectively, in comparison with inflows of 6.4% AUM in EM equities and outflows of -0.5% AUM from DM equities, according to EPFR. 24 See the same article aforementioned.



Return attributions: spread compression the main

contributor; EMEA and high-yielders at the top

-20%

-10%

0%

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20%

30%

HU VE

EG TR UA PE

PH

RU PL

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PA EC ID ZA CO BR

MX

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LB CN AR

Spd Return

Yield Return

UST Return

Total return, YTD 2010


Looking ahead, we expect fundamentals, technicals, scarcity, and search for yield to support further spread compression, but this will likely be partially offset by the higher UST yields we foresee (2.75% by year-end). We also expect the wide dispersion in returns across countries to carry on to 2013 as global (common) factors ease. In addition, we foresee a substantial rotation across countries and regions. So far this year, Hungary and Venezuela have been the best performers with Argentina on the opposite extreme. Regionally, EMEA (the laggard of 2011) has outperformed on contained systemic risk in Europe. However, as EU deleveraging weighs on these economies, we believe EMEA credits are more vulnerable than their peers in LatAm and Asia in 2013.

EMEA and BB credits posted the best returns within

EM

0%

6%

12%

18%

LatAm EMEA Asia

DB-EMSI Regional Sub-index Total Returns, YTD

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A BBB BB B

DB-EMSI Rating Sub-index Total Returns, YTD


There were also notable positive ratings migration stories in a couple of credits, most notably in Indonesia, which was (in our view) prematurely upgraded to investment grade, but failed to post a strong performance on its subsequent deterioration in both fiscal and current accounts, and large amount of issuances by the sovereign and quasi-sovereign issuers. Turkey also benefitted from some rebalancing in its BoP and stable fiscal accounts. In contrast, fundamentals in Hungary have continued to deteriorate while the EU prospect improved. In South Africa, the mining strikes and deterioration of fundamentals prompted a downgrade by S&P.

Local markets: A brighter outlook for EMFX Local fixed income returns stemmed from carry and duration, as FX spot performance has been lacklustre – though still slightly positive in aggregate. In 2012, the vast majority of EM monetary authorities lowered their policy rates and the magnitude ranged from 25bp to 375bp. Although there is room for further easing in a few cases (and more so should the US face a recession), we expect EM policy rates on average to hover around these levels for most of 2013 (see table below). Under our baseline scenario, there is little room for Central Banks to cut beyond what is priced. Most EM curves are trading near historically flat levels and inflation risks priced in breakevens are close to “fair”, suggesting that the contribution from duration will likely be negative in 2013.

Forecasts of EM policy rates and 5Y rates in 2013 Policy Rate 5Y Rate Policy Rate 5Y Rate

Brazil 7.25% 9.23% Hungary 5.25% 6.09%Chile 5.50% 5.36% Israel 2.25% 3.56%Colombia 5.00% 5.66% Poland 3.75% 4.72%Mexico 4.50% 5.81% Russia 8.00% 7.42%Peru 4.25% 4.96% Turkey 6.25% 9.31%Czech Republic 0.05% 1.09% South Africa 4.50% 6.28%


Mild dollar strength, depressed growth, and subdued commodity prices have weighed on EMFX in 2012. The deceleration in Asia (and particularly in China) was particularly damaging to trade and capital flows, as well as commodities (whose performance has since been more closely aligned with EMFX). If the US overcomes the “cliff” as we foresee, EMFX spot would finally add to returns in 2013 and more than offset rates risks and possible USD strength. Regarding local fixed income risk, we believe that EMFX – as the closest proxy for global risks among EM assets – should continue to account for most of the volatility in local return (see chart below)25.

EMFX: The main source of local markets volatility

95

100

105

110

115

Dec-11 Mar-12 Jun-12 Sep-12

DB-EMLIN DB-EMLIN (hedged) EMFX Total Return


25 As we discuss in our Rates Outlook, local fixed income supply risk seems subdued, although a potential outflows from global fixed income funds could weigh heavily on the long end of EM curves.



2013 Outlook: Growth and Asset Rebalance

Outlook and risks We expect a gradual rebalance away from the defensive (fixed income overweights), which marked 2012, into growth-centric products such as equities, EMFX, and commodities in 2013. Obviously, this is conditional on an orderly resolution of the US fiscal situation early in the year.

Under our baseline scenario of a moderate fiscal drag of 1.5% and 2% US growth, our equity strategists see a 12% risk premium already built in S&P 500 and investors very underweight26

Cumulative fund flows into fixed income and equity

asset classes in 2012 (% AUM)

-5

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5

10

15

20

25

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35

40

Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12

EMD-HC EMD-LCDM HY EM EquityDM Equity US IGUS Govt

Cumulative Inflows, 2012 YTD to end of Novemeber (% of AUM)


One potential threat to the performance of fixed income assets is the reversal of massive inflows into fixed income funds in 2012, redirecting flows to equities under our baseline (or better) scenario in terms of growth. The fact that some money recently taken away from US Equities has been redirected to EU Equities may bring some comfort, but we note that such inflows were a mere reflux of earlier losses on the Eurozone crisis. Our baseline of gradual recovery should tame these risks, but if the economy gains momentum later on the situation may change.

Sovereign Credit: Value & defensive status appeal In order to repeat this year’s 17% return, the EMBI-Global yield would need to compress by about 150bp to the all-time lows of 2007 (also 150bp) – assuming UST yield unchanged at around 1.60%. If UST yield drops to 1%, spreads would still need to tighten to 200bp, 40bp tighter

26 Asset Allocation – To Year End: Five Considerations, Binky Chadha et al., 23 November 2012, DB Global Markets Research.

than the post-Lehman low of 240bp, to match the 17%. These are unlikely scenarios, in our view.

Under our baseline macro scenario, 10Y UST yield would move to 2.75% in 2013, which is still not high enough to attract substantial flows away from credit assets, in our view. In addition, growth recovery and improving credit quality among EM credits would support a moderate spread tightening to 225bp (about 60bp tighter than the current level). Under this scenario, the EMBI-G would return about just under 5%.

The following table illustrates additional scenarios in terms of combinations of EMBI-G spreads and UST yields. For consistency, we rule out (in gray) the scenarios with a combination of substantial spread tightening and UST yield compression. However, we do envision scenarios where EMBI-G spreads rise moderately (possibly on outflows into equities) and UST sells off. In our assessment, the “risk-on” scenario could be more damaging for EM credit, as a possible “cliff-driven” recession would be accompanied by further accommodation and increased demand for defensive trades (long higher quality credits), as we have seen over the past few years.

EMBI-Global total returns under varying scenarios of

UST yields and EMBI spreads


Within sovereign credit, depressed UST yields do not bode well for IG credits on a relative basis. Meanwhile, idiosyncratic factors should continue to drive performance across high-yielders. In addition, in terms of regional bias, given that there appears to be little ‘Eurozone’ risk premium currently in prices in EMEA credits, we believe they look vulnerable to a repricing. We favor LatAm and Asia credits on relative basis. See our Sovereign Credit Outlook for details on our strategy recommendations.

Local currency debt: Reflation vs. appreciation As we move past the cliff, we foresee an acceleration of growth both in EM and in DM later in the year. In addition, we expect China’s recovery to reach a lower plateau.



Moreover, as the US is likely to pull ahead of Europe after fiscal uncertainty is resolved, potential USD strength may also weigh on EM currencies. Altogether, despite our constructive outlook for the year, we expect EMFX to partially retrace to 2011 highs to just break into low double-digit total returns27.

Therefore, if this benign scenario for EMFX materializes, we foresee EM local currency debts outperform EM credit in 2013, even though investors may continue to favor the defensive feature offered by credit while uncertainty remains elevated. Regionally, we believe that LatAm has most to benefit on our predicted recoveries in China and the US, stronger domestic conditions, and rising inflation risks.

Final remarks: Long-term in perspective

As we discussed in last year’s outlook assessment piece (EM Performance: Grass is grayer on the other side), simple portfolio maximization analysis indicates that global investors remain substantially under-invested in EM. “Optimal” allocations to EM, throughout sub-periods of bull and bear markets, tend to exceed by a large margin those reported by global asset allocation surveys.

The performance of local and hard currency debt has differed dramatically across bull and bear markets, however. Qualitatively, 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. The inclusion of 2012 data in our exercise has not changed this conclusion (see the charts below). As it has been the case over the years, the key decision to make in 2013 is whether to overweight growth-sensitive assets or not rather than whether to overweight EM or not. As we noted, investors remain overly light in EM, according to simple efficient portfolio frontier analysis.

27 The return will be around 16% if EMFX fully retraces to 2011 highs (12% spot return + about 4% carry)

EM expands the portfolio frontier

EMBI-G

EMLIN-U

EMLIN-H

EMFX (total return)

EMEQIG

HY

Comdty

SPX

UST

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8%

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Average weekly returns (past 6Y)

Annualized weekly return volatility (past 6Y)

EMBI-G

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EMEQ

IG

HY

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

Average weekly returns (past 4Y)

Annualized weekly return volatility (past 4Y)

Note: The past 6 years of data comprise bullish years, followed by crisis and subsequent recovery, while the past 4 years cover the entire post-Lehman period, consisting of both bullish and bearish years Source: Deutsche Bank.

A closer look at historical asset performance also suggests that double-digit returns in credit are unlikely unless credit spreads are initially relatively high or US yields rally aggressively (see charts below). The backdrop is different now. After years of re-rating, EM investment grade sovereigns now account for 60% of our external debt index. In addition, US real rates are in negative territory already. In the case of local markets, history indicates that FX-hedged returns have been remarkably stable at about 5% over the past decade with fluctuations mildly tracking global policy rates. We have no reason to expect any departure from this norm, as we expect policy rates to hover around current levels in 2013. As the charts below show, however, EMFX has tended to rebound strongly after years of poor performance (as observed in 2003, 2004, and 2009). Again, as we discussed in the previous section, local markets (equities, FX, but not duration) seem the fruitful allocation of resources in the year ahead should the US escape the “cliff”.



Asset performances of past 10 years Year

Return Vol Ret/Vol Return Vol Ret/Vol Return Vol Ret/Vol S&P UST CRB2003 25.7% 18.0% 1.4 5.5% 2.4% 2.3 17.0% 3.7% 4.6 26.4% 2.3% 23.8%2004 11.7% 6.7% 1.7 7.7% 2.9% 2.7 13.0% 4.4% 3.0 9.0% 3.5% 15.7%2005 10.7% 2.4% 4.5 7.2% 1.9% 3.8 6.0% 4.7% 1.3 3.5% 2.8% 19.1%2006 9.1% 4.5% 2.0 6.4% 2.6% 2.5 5.2% 5.9% 0.9 10.4% 3.1% -7.4%2007 6.1% 7.6% 0.8 4.8% 2.6% 1.8 12.9% 5.8% 2.2 3.9% 9.0% 16.7%2008 -10.9% 6.3% -1.7 5.4% 7.1% 0.8 -10.2% 12.7% -0.8 -38.5% 14.1% -40.0%2009 28.2% 16.6% 1.7 5.5% 4.2% 1.3 16.5% 9.4% 1.8 23.5% -3.8% 31.8%2010 12.0% 5.6% 2.1 8.6% 2.8% 3.1 8.1% 7.4% 1.1 12.8% 5.8% 15.4%2011 7.9% 5.2% 1.5 4.3% 3.0% 1.4 -5.2% 8.5% -0.6 0.0% 8.8% -8.3%2012 17.6% 3.6% 4.9 7.2% 2.1% 3.5 5.2% 5.4% 1.0 10.3% 4.1% -2.6%

Average 11.8% 7.6% 1.9 6.3% 3.2% 2.3 6.9% 6.8% 1.4 6.1% 5.0% 6.4%Corr. w/ S&P 52.0% 28.0% 61.5%

w/ UST -7.8% 11.0% -36.2%w/CRB 36.0% 30.5% 58.6%

EMBI Global EM Local Bonds (FX-Hedged) EMFX (total return) Other asset return

Note: Correlation with S&P, UST, and CRB index returns are calcuated using weekly

returns.

-15%

-10%

-5%

0%

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15%

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25%

30%

35%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

EMBI Global EM Local Bonds (FX-Hedged) EMFX (total return)

EM asset returns, past 10Y

Source: Deutsche Bank, Bloomberg

Hongtao Jiang, New York, +1 212 250 2524

Jack Zhang, New York, +1 212 250 0664 Drausio Giacomelli, New York, +1 212 250 7355



EM Vulnerability Monitor

We update our assessment of the underlying vulnerabilities of EM economies. Our approach is based on a range of macroeconomic and financial indicators that we think capture a country’s susceptibility to an economic crisis.

EMEA remains by far the most vulnerable EM region, especially in terms of external vulnerabilities and fiscal risks.

We see vulnerabilities as highest and rising in Ukraine, where we have seen a sharp deterioration in external balances and increasing reliance on riskier forms of borrowing to finance the budget deficit. Very low foreign reserves suggests that time is running out to address these problems.

Risks are also high in Hungary and Egypt though these are little changed over the past year. Poland and Romania have made further progress in reducing their macroeconomic vulnerabilities, though bringing down debt levels will be a long haul. Disappointing growth and the impact of strikes has pushed up risks to moderate levels in South Africa.

Asia has by far the lowest external vulnerability and, like Latin America, little in the way of fiscal problems. India remains perhaps of greatest concern given its high fiscal deficits and high and now rising government debt levels, albeit comfortably financed domestically.

On the financial side there are interesting differences between regions. EMEA banking systems are less liquid reflecting their greater dependence on external funding, though this is being slowly (and painfully) addressed as western European banks have reduced (or at least stopped expanding) their presence in the region. Debt stocks are generally highest in Asia, but credit growth has recently been highest in Latin America.

Introduction

Last year, we introduced a framework for assessing the underlying vulnerabilities of EM economies.28 We update this assessment here with the latest data with estimates for 2012 and include three new countries (Peru, Taiwan, and Venezuela) in the exercise.29 Our approach is based on a range of indicators that we think capture a country’s

28 See “Survival of the Fittest” (EM Monthly, December 2011). 29 The estimates for 2012 used in this note may differ slightly from the DB forecasts presented elsewhere in this EM Monthly.

susceptibility to an economic crisis. Specifically, we look at the following indicators:

External sector: current account balance, external debt, exchange rate valuation, and foreign reserve adequacy.30 Our estimates of exchange rate valuation are taken from our behavioral equilibrium exchange rate model introduced earlier this year (see “Presenting our EM FX Model: A Fundamental Analysis” in our May 2012 EM Monthly). Where these estimates are not available, we revert to the deviation between the real effective exchange rate and its (HP-filtered) trend.

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).

Financial sector: loan-to-deposit ratios, the pace of private credit growth (average over the last two years), the level of private credit, and foreign bank claims on the economy (to capture risks from deleveraging by stressed banks in core markets).

Openness: we include a simple measure of openness to capture sensitivity to the global growth cycle.

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 six years. Taking the current account balance as an example, the 60th and 80th percentiles of the distribution correspond with deficits of 1.9% of GDP and 3.6% of GDP. Countries with deficits exceeding these levels are assigned medium and high risk ratings respectively for this indicator.

We then aggregate the scores to come up with a vulnerability rating for each sector. 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.

30 We use reserves as a percent of risk-weighted liabilities as our preferred measure of reserve adequacy. For details on its construction, see “Reserve Adequacy in EMEA” (EM Monthly, November 2011).



Assessment

Below we summarize the main results, our current overall vulnerability rankings, and the evolution of these overall rankings over the last six years.

External vulnerabilities

The relatively greater external vulnerabilities built up over several years in EMEA show up clearly on the basis of this metric. The stock of external debt remains much higher on average in EMEA than in Latin America and Asia. The resulting debt repayments have left many countries with chronically large external financing needs despite relatively moderate (albeit higher than in Latin America or Asia) current account imbalances. In a few cases, however, we have also seen current account positions deteriorate sharply over the last year, notably South Africa, where strikes have hit mining exports. In South Africa’s case, however, the resulting vulnerability is tempered by a low level of external debt, which leaves its external financing needs for next year at a relatively moderate 10% of GDP.

External risks are most acute in Ukraine, where the current account has widened sharply as steel exports have remained weak while higher gas prices have pushed up the energy import bill. Capital inflows are weak and reserves have also fallen to critically low levels. The deterioration in the terms of trade for Ukraine has also pushed the pegged exchange rate into overvalued territory. Elsewhere, current account deficits in Poland and Romania are only a little above our “high-risk threshold” and the resulting high overall rating probably overstates by a notch the external risks in these cases.

External vulnerabilities in Latin America and Asia are much lower. Argentina’s exchange rate is overvalued and foreign reserves are relatively low but the government will continue to resort to administrative measures to address any emerging external pressures, although at a cost of lower economic growth. The Colombian peso also appears as overvalued from a historical standpoint, but it has been strong for few years already, funded by strong FDI, and has not prevented the economy from growing strongly. Reserve coverage in Venezuela remains relatively low but the country still enjoys current account surplus of more than 3.5% of GDP and has external resources outside the central bank for more than 50% of the reserves reported.

Current account positions in Asia remain strong although in most cases they are declining. Indeed, for the first time in several years, small deficits have emerged in Indonesia and Thailand. But overall, courtesy of years of surpluses and FX reserves accumulation, external vulnerabilities in Asia are generally very low.

External vulnerabilities Overa ll

% GDP Risk % Risk % GDP Risk % Risk RiskEMEA Czech -1.9 Low 148.5 Med 45.6 Med -0.2% Low Med. Egypt -3.1 Med 56.6 High 14.2 Low -0.3% Low Med. Hungary 1.6 Low 160.8 Low 135.0 High -4.8% Low Med. Israel -0.7 Low 222.3 Low 44.1 Med -1.1% Low Low Kazakh 6.7 Low 107.6 High 66.2 High 1.6% Med High Poland -3.9 High 161.7 Low 70.3 High -7.9% Low High Romania -4.0 High 171.7 Low 82.2 High -1.7% Low High Russia 4.3 Low 221.0 Low 26.6 Low 4.1% Med Low South Africa -5.7 High 131.1 Med 29.1 Low 1.3% Low Med. Turkey -7.3 High 127.7 Med 41.2 Med -1.9% Low High Ukraine -6.2 High 67.1 High 75.5 High 2.6% Med High

Asia China 2.7 Low 168.7 Low 10.4 Low 3.2% Med Low India -3.2 Med 320.8 Low 21.0 Low -2.2% Low Low Indonesia -1.8 Low 175.8 Low 24.8 Low -1.1% Low Low Korea 3.3 Low 153.8 Low 37.1 Med 6.3% High Med. Malaysia 5.5 Low 167.5 Low 26.2 Low 1.0% Low Low Philippines 4.0 Low 415.5 Low 25.3 Low 0.3% Low Low Taiwan 10.2 Low 303.4 Low 30.8 Low -4.2% Low Low Thailand -0.1 Low 328.8 Low 34.3 Low 5.3% High Low

LatAm Argentina 1.4 Low 117.9 Med 26.3 Low 12.1% High Med. Brazil -2.2 Med 270.1 Low 18.3 Low 3.5% Med Low Chile -2.4 Med 138.4 Med 39.2 Med -1.7% Low Med. Colombia -2.9 Med 179.1 Low 21.6 Low 6.6% High Med. Mexico -0.4 Low 150.5 Low 19.1 Low -3.7% Low Low Peru -3.2 Med 417.0 Low 25.3 Low 2.1% Med Low Venezuela 2.6 Low 66.7 High 19.8 Low 4.5% High Med.

Med. threshold -1.9 150.4 35.4 1.5%High threshold -3.6 117.9 47.7 4.3%

Current account Reserve cover Ex terna l Debt FX Va luation


Fiscal vulnerabilities Fiscal risks are also more prominent in EMEA than in the other two emerging regions. Egypt remains the most fiscally vulnerable country in our EM universe because of its double-digit deficit, high public debt, and high rollover needs. Similarly, despite its relatively moderate fiscal deficits, Hungary’s remains a high risk given its high debt, rollover risks, and large FX exposure.

Risks have diminished in Poland, where the government has delivered fiscal consolidation and reduced its overall deficit from 8% of GDP in 2010 to less than 4% of GDP this year. Romania is still scored as a high risk but is on track to follow Poland in moving to a medium risk ranking if it delivers a further modest improvement in the budget balance next year.

Disappointing growth has squeezed South Africa’s public finances, pushing risks from low to medium according to our scorecard. Risks in Ukraine are also rising where the government has sharply increased its reliance on FX-denominated financing, which has accounted for about 60% of its issuance over the past year.

In Asia, India remains of greatest concern with continued high fiscal deficits and relatively high and now rising government debt/GDP, although this debt is comfortably financed domestically. Persistently slightly high deficits in Malaysia have pushed debt up above 52% of GDP and the government is again promising deficit reduction in the coming year. The Philippines has made significant progress on fiscal consolidation, cutting the deficit in half in two years although this has been mainly due to



expenditure reduction rather than revenue increases. The Philippines’ relatively high foreign debt remains a concern although an increasing share of this is peso-denominated.

Fiscal risks in Latin America are little changed over the past year. Risks are moderate in Brazil given its relatively high level of public debt, a little over one-quarter of which is rolled each year, but this is mostly local debt in local currency, minimizing the potential payment risks considerably. Likewise Venezuela has a relatively large deficit and hard currency debt, but they do not seem to present any serious risk: the large deficit is in its majority financed in local currency and the hard currency debt is still relatively low for a government that produces an exportable flow (oil) for about 20% of GDP every year.

Fiscal vulnerabilities Overa ll

% GDP Risk % GDP Risk % GDP Risk % GDP Risk RiskEMEA Czech -3.5 Med 44.5 Med 9.0 Med 7.9 Low Med. Egypt -10.8 High 84.4 High 21.2 High 20.5 High High Hungary -3.0 Low 79.3 High 13.8 High 37.0 High High Israel -3.6 Med 71.9 High 5.7 Low 12.6 Med Med. Kazakh 5.1 Low 12.6 Low 1.3 Low 2.3 Low Low Poland -3.6 Med 54.1 Med 8.1 Med 15.7 Med Med. Romania -3.6 Med 40.5 Med 8.7 Med 20.4 High High Russia 0.1 Low 8.7 Low 1.2 Low 2.5 Low Low South Africa -5.0 Med 41.0 Med 1.4 Low 3.6 Low Med. Turkey -2.4 Low 38.3 Low 7.6 Med 10.1 Low Low Ukraine -2.5 Low 36.0 Low 7.2 Med 34.1 High Med.

Asia China -1.5 Low 19.0 Low 6.9 Med 0.1 Low Low India -8.0 High 64.4 High 4.4 Low 3.0 Low Med. Indonesia -2.7 Low 24.9 Low 1.2 Low 10.3 Low Low Korea 0.0 Low 35.7 Low 3.3 Low 0.1 Low Low Malaysia -5.0 Med 52.6 Med 3.4 Low 1.9 Low Med. Philippines -2.0 Low 54.4 Med 8.1 Med 26.6 High Med. Taiwan -2.8 Low 44.2 Med 4.2 Low 0.7 Low Low Thailand -3.5 Med 37.5 Low 6.3 Low 0.4 Low Low

LatAm Argentina -3.0 Low 19.1 Low 3.5 Low 0.0 Low Low Brazil -2.0 Low 57.7 High 15.8 High 1.8 Low Med. Chile 0.2 Low 6.6 Low 0.9 Low 1.6 Low Low Colombia -1.9 Low 38.9 Low 4.6 Low 7.6 Low Low Mexico -2.2 Low 35.3 Low 8.8 Med 8.5 Low Low Peru 1.0 Low 23.4 Low 2.1 Low 11.1 Med Low Venezuela -6.7 High 37.5 Low 1.2 Low 30.3 High Med.

Med. threshold -3.1 40.5 6.6 11.0High threshold -5.0 57.7 9.6 17.7

Overa ll ba lance Pub lic debt Maturing debt FX debt

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

Financial sector vulnerabilities Risks in the financial sector are generally moderate or low across most of EM. Many emerging European economies are still recovering from the collapse of earlier credit booms and this is reflected in low credit growth across much of the region. Debt stocks are highest in Asia while external bank obligations are highest in EMEA.

In EMEA, credit growth has been highest in Turkey and Russia over the past couple of years, albeit from low starting levels in both cases. Loan-to-deposit ratios have also risen in both cases. This pushes Russia from a low to medium risk rating. The main financial vulnerability for the region, though, remains its reliance on external liquidity to fund credit. Foreign bank claims are worryingly high in Egypt, Hungary, Romania and the Ukraine.

In Asia, credit growth in China has decelerated notably since 2009-10, though the relatively high level of credit extension sees the country retain its medium-risk rating. The only change in the overall financial vulnerability rating in the region is in India, where sustained moderate credit growth in recent years has just tipped the level of credit extension in the country into our medium-risk bucket. Korea’s relatively high loan-to-deposit ratio and level of credit extension together with moderately high foreign bank claims on the country continue to give it a high risk rating.

In Latin America, loan-to-deposit ratios remain unusually high in Chile and Colombia though other indicators (e.g. capital ratios and nonperforming loans) suggest that the sector remains sound. Foreign bank claims on Chile are also high (mostly Spanish banking groups), which explains the country’s high overall financial vulnerability rating, though there is little sign of foreign banks cutting their credit lines or reducing their presence through local affiliates. Credit growth in Brazil remains relatively rapid and the level of credit extension can no longer be considered low; but so far there is little indication that credit growth has translated into significant vulnerabilities in the financial sector.

Financial vulnerabilities:

Overa ll% Risk % Risk % GDP Risk % GDP Risk Risk

EMEA Czech 0.77 Low 5.9 Low 55.2 Low 90.4 High Med. Egypt 0.48 Low 5.4 Low 29.4 Low 15.4 Low Low Hungary 1.21 Med -2.4 Low 51.3 Low 82.1 High Med. Israel 0.99 Low 5.3 Low 125.3 High 9.0 Low Med. Kazakh 1.29 Med 10.1 Low 32.7 Low 9.1 Low Low Poland 1.09 Med 9.8 Low 51.1 Low 58.3 High Med. Romania 1.16 Med 5.2 Low 38.5 Low 56.5 High Med. Russia 1.19 Med 20.9 Med 45.2 Low 11.3 Low Med. South Africa 1.11 Med 6.8 Low 74.7 Med 30.8 Med Med. Turkey 1.07 Med 34.8 High 44.4 Low 29.3 Med Med. Ukraine 1.42 High 5.9 Low 55.8 Low 19.3 Low Med.

Asia China 0.79 Low 16.0 Low 121.8 High 9.4 Low Med. India 0.77 Low 18.7 Med 59.4 Med 18.4 Low Med. Indonesia 0.81 Low 24.5 Med 30.6 Low 13.7 Low Low Korea 1.33 High 4.8 Low 122.4 High 30.6 Med High Malaysia 0.88 Low 13.0 Low 117.7 High 53.1 High Med. Philippines 0.64 Low 14.4 Low 36.2 Low 16.1 Low Low Taiwan 0.61 Low 6.4 Low 127.9 High 32.6 Med Med. Thailand 0.98 Low 15.8 Low 116.0 High 27.7 Low Med.

LatAm Argentina 0.76 Low 40.1 High 17.0 Low 12.4 Low Med. Brazil 0.78 Low 22.4 Med 77.4 Med 21.2 Low Med. Chile 1.60 High 13.2 Low 74.1 Med 56.1 High High Colombia 1.85 High 20.0 Med 36.6 Low 13.3 Low Med. Mexico 0.75 Low 12.2 Low 41.0 Low 32.1 Med Low Peru 0.90 Low 17.9 Med 27.0 Low 28.6 Med Med. Venezuela 0.62 Low 34.9 High 21.7 Low 10.1 Low Med.

Med. threshold 1.05 17.3 58.4 27.8High threshold 1.33 25.4 96.6 51.4

Loan/depos it Cred it g rowth Cred it LevelForeign bank

c la ims

Source: Haver Analytics, BIS, Deutsche Bank

Openness We also include (with a small weight) the degree of openness in each country to give a sense of their likely exposure to an exogenous shock in the form of a drop in external demand in developed markets (e.g. a US recession should they go over the fiscal cliff). This



introduces an additional risk element for a few very open economies, namely Czech Republic, Hungary, Malaysia, Taiwan, and Thailand, where exports are well over 60% of GDP. This is confirmed in our estimates of the sensitivity of growth in Asia to changes in US and European growth, which is highest for these more open economies. It also corroborates Latin American relative isolation from global factors, with the exception of Mexico that is closely linked to the US economy.

Openness of EM Economies

Medium threshold

High threshold

0

10

20

30

40

50

60

70

80

90

HU

NC

ZEKA

ZU

KRP

OL

RO

UR

US

ZAF

ISR

TUR

EGY

MYS TA

ITH

AKO

RC

HN

IDN

PH

LIN

D

MEX

CH

LVE

NP

ERA

RG

CO

LB

RA

Exports (% GDP)


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. The ratings for each individual indicator, and the evolution of the overall ratings over the last six years, are shown in the vulnerability maps (“warning lights”) at the end of this note.

As last year, the vulnerability ratings are high overall for Hungary, Ukraine, Romania, Poland, and Egypt. In the cases of Poland and Romania, however, vulnerabilities are declining and further progress on fiscal consolidation and/or an improvement in external balances will see their risk ratings fall to medium. The other countries in EMEA are rated as medium risks, with the exception of Russia, which is the only country in the region that we rate as low risk.

Outside of EMEA, we see medium risks in India (fiscal), Korea (financial), and Malaysia (fiscal and financial). In Latin America, we see signs of medium risks in Brazil (fiscal and financial) and Venezuela (moderate risks in all sectors), but relatively under control.

In terms of changes, Czech Republic has moved from a high to medium overall risk rating over the last year following a further improvement in its current account

balance. Overall risks have increased from low to medium in South Africa (weaker external and fiscal balances), India (higher level of private credit), Malaysia (higher level of private credit and fiscal deficit), Chile (higher current account deficit and lower foreign reserve coverage, but from low and manageable levels), and Venezuela (larger exchange rate overvaluation, fiscal deficit, and credit growth).

Clearly, there are several factors that this exercise does not capture. The low vulnerability rating for Argentina according to this metric, for example, does not adequately capture the unsustainable nature of the country’s economic model. Similarly, we do not attempt to capture here vulnerabilities to specific shocks, such as significant changes in commodity prices.

Overall vulnerability scores

Medium risk threshold

High risk threshold

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

UKR

RO

MH

UN

PO

LEG

YC

ZETU

RZA

FKA

ZIS

RR

US

KOR

MYS IND

THA

TAI

PH

LC

HN

IDN

VEN

CH

LB

RA

CO

LP

ERA

RG

MEX

Growth Fin Fisc Ext

Overall vulnerability score


Conclusions

EMEA remains by far the most vulnerable region, especially in terms of external vulnerabilities and fiscal risks. We see vulnerabilities as highest and rising in Ukraine, where we have seen a sharp deterioration in external balances and increasing reliance on riskier forms of borrowing to finance the budget deficit. Very low foreign reserves suggests that time is running out to address these problems.

Risks are also high in Hungary and Egypt though these are little changed over the past year. Poland and Romania have made further progress in reducing their macroeconomic vulnerabilities, though bringing down debt levels will be a long haul. Disappointing growth and the impact of strikes has pushed up risks to moderate levels in South Africa.

Asia has by far the lowest external vulnerability and, like Latin America, little in the way of fiscal problems. India remains perhaps of greatest concern given its high fiscal



deficits and high and now rising government debt levels, albeit comfortably financed domestically.

On the financial side there are interesting differences between regions. EMEA banking systems are less liquid reflecting their greater dependence on external funding, though this is being slowly (and painfully) addressed as western European banks have reduced (or at least stopped expanding) their presence in the region. Debt stocks are generally highest in Asia, but credit growth has recently been highest in Latin America.

Robert Burgess, London, (44) 20 7547 1930

Gustavo Cañonero, New York, (1) 212 250 7530 Michael Spencer, Hong Kong, (852) 2203-8305



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FX valuation

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Credit growth

Credit level

Foreign claims

Overall

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Argentina B3/B-/CC Moodys /S&P/ /Fitch

Economic Outlook: The economy seems to be finally recovering but at a rather slow pace as increasing state interventionism keeps threatening frail confidence. Meanwhile, the last US court decision prevented technical default for now, but legal uncertainty remains. Expectation of increased soybean exports is buying time, but policy flexibility, in particular in the exchange rate, is becoming inevitable. A likely resistance will only worsen the outlook ahead while an intransigent legal position could bring back real debt payment problems.

Main Risks: Continued exchange rate rigidity and strong state interventionism could block any solid recovery process. Negative US court ruling could still trigger technical default on debt. Expansionary policies could further worsen the inflationary and competitive situation, exacerbating financial repression and negative growth.

Strategy Recommendations: Remain neutral on ARS and underweight on the local curve. Neutral external debt – we see balanced risk/reward in the current prices, but would still defensively positioned favoring local law bonds (hold to maturity on long Bonar 13s) and EUR Pars. GDP Warrants do not look attractive.

Macro view

Saved by the Appeals court… The Court of Appeals' decision on Wednesday November 28 to grant Argentina the right to revise the District court order of November 21 could be viewed as a reasonable verdict, as the previous week´s ruling and its potential collateral damage do seem to warrant further analysis. However, this ruling was just the opposite decision of what was largely expected after what appeared to be a decisive ruling by Judge Griesa the previous week. Therefore whilst the Appeals court in its October 26th ruling seriously put into question fairness and highlighted the undesired effects on third parties resulting from Judge Griesa February injunction31, Mr. Griesa's basic repetition of such an injunction on November 21 made everybody think that there was something else at stake.

At Thanksgiving eve, it looked like Judge Griesa was attempting to say that this was not a standard case. Instead, his rulings implied that US Justice administrators felt challenged by explicit disobedience from Argentina. As such, it was expected that the Appeals court would

31 As we analyzed the very same day in our “Argentina: Another Holdout Victory, Yet Unenforceable".

have made a truly “institutional" response, thereby supporting its fellow Judge32. To everybody´s surprise, however, and no doubt to Judge Griesa´s, the Appeals court not only gave Argentina a new opportunity to discuss the enforcement of the pari-passu clause, but also introduced a new party into the case: the exchange bond holders, whose self defense should also help Argentina to request a softening of the court sentence. Therefore, we find ourselves in a similar situation to the one we saw on October 26, when uncertain (and undesirable to some) consequences were explicitly introduced by the Appeals court ruling.

In many respects, only lawyers can say what is next. However, the most recent developments suggest that fairness and an awareness of the possible undesirable effects to third parties are back on the radar screen. In any event, this legal battle remains highly unpredictable. This notwithstanding, it is safe to say that the US courts will not block debt service on exchange bonds this December.

In the meantime, the government’s apparent change in attitude in its last appeal request33 could have now a new opportunity to be supported by acts. As noted, the government´s potential offer to reopen the exchange swap or modify the lock law meant initially probably too little and too late given the US courts apprehension regarding Argentina’s outlaw position of the past. Nonetheless, given the last gesture by the Appeals court, this could well become another useful strategy for Argentina to confirm: being more flexible regarding the holdouts, the de facto recognizing some rights to their claims (or pari-passu). It cannot be a better time for the government to convey an irrefutable sign to help the Appeals court’s difficult task. It would be the government‘s best opportunity to confirm that its last offer was not simply opportunistic. The Argentine administration´s genuine concern after Judge Griesa last ruling could be a reason for hope. However, multiple domestic problems, including the application of the media law this week, and the coming Congress recess might be good excuses to boycott an immediate and efficient delivery of a positive response.

…but still challenged by reality Fitch’s decision to downgrade the country's debt ratings, albeit right before the last sentence from the Second Circuit court, perfectly reflects the yet challenging reality ahead. Fitch decided to cut the Republic debt rating to CC

32As discussed the following day on our piece, “Argentina: The Worst Possible Outcome for Now" 33 Commented in “Argentina: Time to Compromise?”, issued on Tuesday Nov 27.



from B for Argentina’s international law bonds and to B- from B for Argentina's local law bonds.

The coming mid-December deadline imposed by the IMF for Argentina to present a credible plan to normalize the report of economic and social statistics is another evidence of the troubles ahead. The government is reporting some progress on that subject but the credibility is not exactly on its side. Meanwhile the Fund is losing its tolerance although it is still questionable what type of punishment it could enforce.

A comprehensive and national strike following a massive demonstration by the middle class also provided the local thermometer of the government’s on-going test. On November 21, a national labor strike was called by the opposition General Labor Confederation (CGT-Azopardo) and the Argentine Trade Union (CTA), two of the three existing major labor unions; the third union remains supportive of the government. The strike was decided in reaction to the government's rejection to increase the floor for income tax payment deduction on wage earnings. Last revised 20 months ago, this boundary has been eroded by 25% annual inflation since then. The organizers were also protesting against a number of government policies as well, like indiscriminate high taxes for agriculture production, increased debt with pension system, the failure to comply with 82% minimum pension payment, etc. The mobilizations affected most of the means of transportation in the city and the province of Buenos Aires. Indeed, the strike was relatively successful, as much of the productive activities in the country were significantly affected. Worth recalling, this was the second massive social demonstration during November; on November 8th thousands of people of all age groups, but mostly representing middle class, marched in the major cities of the country also protesting against some policies in place like the strict capital and trade controls and the official plan to seek a constitutional reform to permit President CFK a potential third term election.

The need to announce a long awaited increase in electricity and gas for households and commerce despite declining political support for the government also reveals the few degrees of freedom enjoyed by the current administration. Late last week the Minister of Planning, Julio de Vido, announced the introduction of fixed amount surcharges in the electricity and gas bill that go from ARS4 to ARS300 bi-monthly per household. Minister De Vido clarified that for the majority of the population, some 70%, the increase will simply represent the lowest amount. According to the Minister this money will fund a new fund of energy development. Thus nothing from these fare increases is going to be received by the private companies providing the services.

A deteriorating fiscal situation despite some spending control is another reflection of the policy constrains facing

the government. The Treasury office reported that the September primary surplus was ARS 534mn, pushing the nominal deficit to ARS 2589mn. Worth noting this result was achieved with the help of profits from the Central Bank for ARS 1937mn and from the social security system ANSES for ARS 1837mn. Nonetheless, the primary surplus this September was 19% higher than last year, paled to private sector inflation estimates surrounding 24%. Likewise this result occurs despite a significant deceleration in spending to 19.8% YoY or similar to the deceleration of revenues. However the spending performance included a 2% YoY fall in capital spending. Thus fiscal deterioration continues as expected, with this year total deficit likely to reach 3.0% of GDP once capital gains from BCRA and ANSES are excluded.

As noted, the time decay of current policies is only accelerating and gathering opposition voices.34 This trend is likely to continue despite some hopes for economic recovery, as interventionist policies keep threatening a fragile consumer and business confidence, necessary for a solid rebound. In this regard, the passing of the new capital market law by Congress is unlikely to improve the business climate. Although the law is basically introducing better defense mechanisms for minority shareholders, the fact that ANSES (social security administrator) is a de facto minority owner in most of the major companies in the country does create some concerns for further intervention by the state on private matters.

Meanwhile, green shoots are fueling some hope, but... Economic data in recent weeks have improved mildly, suggesting that at least the economy is back to a recovery path, albeit lackluster and still far from robust. The monthly proxy of economic activity for September was up barely 0.1% YoY but 0.3% MoM s.a. This was much weaker than what market analysts expected (1.7% YoY) and also lower than the 1.4% YoY pace recorded in August. September activity level brings estimated GDP growth so far this year to 2.1%, somehow confirming that it is very unlikely that growth will accelerate enough in the fourth quarter of 2012 to exceed the warrant payment trigger of 3.26% for the year. As noted, recent poor performance has been reflecting a weak demand from Brazil, the income erosion of high inflation, but more importantly, the negative effect that increasing capital and import restrictions adds on investors’ confidence, investment appetite, and overall business mood. Preliminary evidence during the month of October seems to suggest some improving trends. The official indicator of industrial output was up 2.2% YoY in October, and 4.7% MoM seasonally adjusted. Such a performance was a positive surprise after the -4.4% YoY and -1.7% MoM sa

34 For an early analysis on that please see our “Argentina: The Limits of Policy Continuity” issued back in August 2011.



recorded the previous month. Despite this number, average industrial growth year to date remains negative 0.9% YoY. Worth noting that the private think tank FIEL released its own industrial production for October, reporting a 2.4% YoY fall, but a 1.8% MoM sa rebound. Construction activity however suffered another setback in October, after some positive signs in September. Also according to INDEC, construction fell 0.3%MoM seasonally adjusted and 5.2% YoY. Based on this latest reading, construction has accumulated a 2.5% fall so far this year. Private sector estimates point to a faster drop in the year, around 10%, while construction permits were still falling, 18.3% YoY in September, suggesting that the sector might not have touched bottom yet. Based on current restrictions on dollar transactions and their direct impact on the real estate and construction activities, we would expect depressed levels in this particular sector to remain even if a generalized rebound were to be confirmed. Indeed, real estate effective transactions have continued to shrink, at least those reporting for the city of Buenos Aires by the School of Notaries. Real estate transactions in the city capital in October were 35% lower than last year. This seems to reflect an improvement against the worst 47% fall in September, but October last year was already starting to show subdued transactions levels due to the dollar restrictions. Sales indicators are not yet signaling any clear trend either, with both shopping and supermarket sales in October showing hardly any change once properly deflated by private sector estimates of inflation. Not even wages kept the good growth pace registered in recent months, with the September general wage index calculated by the INDEC advancing 1.35% MoM compared to 2.14% in August, or 24.7% vs 25.7% YoY. This year is the first since 2009 were salary increases are lower than estimated inflation and this is likely to remain the case in 2013. Indeed, many of the salary negotiations were concluded by August and the next few months labor income will likely show lower growth than inflation. The latter could be another important drag on the economy as it was in the second quarter of this year. Although much more backward looking, unemployment rate, according to INDEC, came out at 7.6% in 3Q12, 30bps higher than consensus expectations and also above prior quarter’s figure of 7.2%. This reading is also the highest rate since 2Q2010. The official release reported that 906,000 urban residents are jobless and 1,059m are underemployed. During the period the employment rate increased to 43.3% from 42.8% implying that the increase in unemployment was mostly due to increase in the labor supply. During this year labor creation is running at half the pace the average growth of labor supply. Another worrisome fact reported by the official data is that some employment stability is overshadowing the reduction of 1.9% YoY in working hours. Reflecting a longer term

problem, a study by the private think tank IERAL reported that since 2008 private sector employment increased by 4% YoY against 18% in the public sector. These numbers had been 35% and 10% between 2003 and 2007. Tax collection in November, after relatively good October revenue, added some encouragement, advancing by 28%YoY in nominal terms or similar to the pace in October. This number, however, somehow reflects a rebound from a low September collection that was up only 20% YoY. Taxes related to economic activity (VAT, income, fuels and financial transactions) went up more than 30%YoY in nominal terms during November-October, after remaining subdued in September. This could be a confirmation of better activity indicators, although collection growth remains hardly positive in real terms. Meanwhile, consumer confidence in November pictured the fragile state of expectations around. According to the survey collected by Di Tella University, consumer confidence went down by 1.7% in November, after showing a rebound of 2.8% MoM in October. The index however remains negative 24.7% on the year.

Direct and indirect proxies of economic growth

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

-20%

-15%

-10%

-5%

0%

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10%

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20%

EMAE, YoY 3m MA

IPI FIEL, YoY 3m MA

Tax Revenue (CPI adj), YoY 3M MA, rhs

Source: Economic Ministry, Central Bank, and Deutsche Bank Research

Unfortunately inflation has remained on the high side despite a relatively weak economy, becoming a severe burden for income and economic growth. Preliminary indications from private sector estimates for the month of November confirms the pace of inflation remaining at around 1.9%MoM, from 1.6% average in June-September, with the YoY reaching 24.6% or 20bps higher than last month. We continue to see inflation in the 24%-26% range this year and next even with the economy advancing at a much slower pace than before. High inflation is due to increased protectionism, depreciating non-official exchange rate, and the lack of any credible anti-inflationary institution in the country.

Also not that encouraging, the Brazilian recovery is disappointing. Furthermore, Brazil´s growth next year is likely to be more driven by services than manufacturing. Finally, abundant rains and the recent fall in soybean prices is forcing everybody to revise downwards next year expected positive shock from agriculture.

Gustavo Cañonero, New York, (212) 250 7530



Investment strategy FX: Managed depreciation to continue. While high frequency economic data is reflecting some signals of an incipient recovery, structural challenges remain in place. In particular, after a year of FX controls, the managed depreciation path, regardless of some recent steepening, still falls short of double digit inflation. Fundamentals drivers point toward further depreciation, but even when the central bank balance sheets is rapidly deteriorating due to fiscal financing, the monetary authority has ample room to continue managing the FX parity. It is difficult that the government would let the currency move faster than currently priced by NDFs. On the other hand, and considering the reduced premium and potential risks on the credit, we do not find attractive to receive carry via a short USD/ARS positions. Rates: Waiting for the next shock. The stay order granted by the Appeals court produced an expected recovery in all Argentinean assets, including local ones. The reaction of the blue-chip swap spread to the legal challenges on the external debt is a reminder of the risk facing foreign investors to position in local instruments. Looking ahead, the lack of progress in the improvement of statistics and the potential reprimand from the IMF could have some negative effects on CER-adjusted paper. Nevertheless, local bonds should remain less volatile than external credit while the legal issues are not solved. . We continue to recommend foreign investors to remain underweight on the local curve, but the elevated blue-chip swap spread gives an attractive cushion for a carry trade in the short-end of the curve. Credit: Neutral. The stay order granted by the Second Circuit court brought some breathing room for Argentina, and we are also encouraged by the apparent softening in Government’s attitudes. We currently see balanced risk/reward in bonds. In the near term, potential headlines related to government’s intention to reopen the exchange may provide a mild boost in asset prices; otherwise bond prices will likely trade within a narrow range until we approach the next court hearing (February 27th 2013). Given the binary nature of the event, we continue to recommend a defensive strategy, favouring short dated local law bonds and EUR Pars for their limited downside. We hold Bonar 13s to maturity. Regarding GDP Warrants, we think they are expensive given our bearish view on medium term growth and the current legal uncertainty (need to pay 5-6pts for future coupon payments starting in December 2014 at the earliest). On the CDS curve, 6M (11pts) currently reflects only 18% probability of default– a bit too low in our view.

Mauro Roca, New York (+1) 212 250 8609 Hongtao Jiang, New York (+1) 212 250 2524

Argentina: Deutsche Bank forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 445 496 519 577Population (m) 40.5 41.0 41.5 41.9GDP per capita (USD) 11,089 11,099 12,520 13,775 Real GDP (YoY%) 7.0 1.6 2.1 1.9 Priv. consumption 8.0 4.2 1.9 1.9 Gov't consumption 10.9 5.0 6.0 3.0 Gross capital formation 13.0 -11.1 0.5 1.5 Exports 5.4 -5.2 5.2 3.5 Imports 19.3 -9.4 5.0 3.5 Prices, Money and Banking CPI (YoY%, eop) (*) 23.1 24.7 28.1 25.4CPI (YoY%, avg) (*) 24.4 23.8 26.5 26.5Broad money (M2) 33.0 28.0 25.0 22.0Bank credit (YoY%) 33.4 28.0 25.0 22.0 Fiscal Accounts (% of GDP) Budget surplus -2.9 -3.0 -3.1 -3.4 Gov't spending 30.5 30.7 30.9 31.1 Gov't revenue 27.7 27.6 27.8 27.7Primary surplus -0.9 -1.1 -1.2 -1.4 External Accounts (USD bn) Merchandise exports 84.3 82.4 92.8 95.8Merchandise imports 73.9 68.9 75.9 80.3Trade balance 10.4 13.6 16.9 15.6 % of GDP 2.3 2.7 3.2 2.7Current account balance 0.6 7.2 10.5 10.8 % of GDP 0.1 1.4 2.0 1.9FDI (net) 5.6 4.5 3.6 2.9 FX reserves (USD bn) 46.4 43.0 44.5 44.7FX rate (eop) ARS/USD 4.31 4.96 5.94 7.12 Debt Indicators (% of GDP) Government debt 20.7 19.1 18.6 17.0 Domestic 5.6 6.8 7.2 6.6 External 15.1 12.3 11.4 10.4Total external debt 31.7 26.3 24.8 22.5 in USD bn 141.0 130.3 128.9 129.8 Short-term (% of total) 36.4 39.9 40.4 40.0 General Industrial production (YoY) 4.6 1.2 2.7 2.5Unemployment (%) 7.1 7 5 8.0 8.5 Financial Markets (EOP) Current 3M 6M 12MOvernight rate 9.8 13.5 16.5 17.53-month Baibor 12.8 15.0 19.0 21.0ARS/USD 4.84 5.10 5.35 5.87Source: DB Global Markets Research, National Sources



Brazil Baa2(pos)/BBB/BBB Moody’s/S&P/Fitch

Economic outlook: Despite all the measures

implemented by the authorities to stimulate the economy, GDP grew a much weaker-than-expected 0.6% QoQ in 3Q12, prompting us to cut our 2012 GDP growth forecast to 1.0% from 1.5%. While we still expect the stimulus measures to pave the way for faster growth in 2013, uncertainty about the global recovery, strong government intervention in the economy, and a lower statistical carryover have led us to cut our 2013 growth forecast to 3.5% from 3.8%. In this environment, we expect further monetary and fiscal easing.

Main risks: The economy remains vulnerable to further deterioration in the global economic and financial conditions. The ad hoc measures to stimulate certain economic sectors and a myriad of capital controls and trade barriers could raise uncertainty and impair investment, undermining long-term growth. The combination of low interest rates and weak currency could stoke inflation in the future.

Strategy recommendations: Shift to long BRL/JPY. Enter Jul’14 DI receiver after taking profits on Jan’14/Jan’17 steepener, and maintain long NTNB ‘45. Underweight external debt. Take profit in short 10Y basis and cash curve flatteners (41s vs. 21s).

Macro view

GDP grew a much weaker-than-expected 0.6% QoQ, prompting us to lower our 2012 growth forecast to 1.0% from 1.5%. Growth in 3Q12 was much lower than the market consensus forecast of 1.2% QoQ, which was also the increase projected by the Central Bank’s IBC-Br monthly GDP proxy. In our view, the main surprises were the lack of growth in the services sector (0.0% QoQ) and the larger-than-expected decline in investment. In the case of services, the main highlight was the 1.3% QoQ fall in financial intermediation and insurance services, the sector’s worst performance since the 2.9% decline posted in 4Q08, when the economy was rocked by the Lehman Brothers bankruptcy. The financial sector’s contribution to GDP may have been underestimated because its measurement was affected by a sharp decline in interest rates and bank spreads. Consequently, once spreads stabilize at lower levels, continuation of the process of credit penetration should lead to an increase in the contribution of the financial sector to GDP. The other sectors of the economy had very good performance: the industrial sector grew 1.1% QoQ and agricultural GDP rose 2.5% QoQ. On the demand side, the main surprise was the fifth consecutive quarterly decline in investment,

of 2.0% QoQ. Feeble investment contrasts with the 0.9% QoQ increase in private consumption, which has remained strong due to low unemployment, rising labor income, and government incentives. Public sector consumption climbed 0.1%QoQ (also less than expected), exports of goods and services inched up 0.2% QoQ, and imports plunged 6.5% QoQ. The contribution from the external sector was thus positive, although the sharp decline in imports (the strongest since 1Q09) may have been influenced by the postponement of oil imports that will be accounted for in 4Q12. The silver lining was a decline in inventories on the order of 0.2% of annual GDP, which bodes well for expansion in the next quarter. We have also seen some positive signs of economic expansion in 4Q12: industrial production grew a seasonally-adjusted 0.9% MoM in October, consumer confidence in the services and retail sectors has somewhat improved, and investment seems to be recovering as a result of subsidized loans provided by government banks. Moreover, unemployment remains at record low levels, which continues to provide an important support for domestic demand. Thus, we forecast growth of approximately 1.0% QoQ in 4Q12. However, given the lower-than-expected 3Q and downward revision of 2Q GDP to 0.2% from 0.4% QoQ, we lowered our 2012 forecast to 1.0% from 1.5%.

Brazil: GDP

90

110

130

150

170

190

GDPInvestmentConsumption

1995=100

Source: IBGE

We still expect GDP to accelerate in 2013, but have lowered our growth forecast to 3.5% from 3.8%. We expect household consumption to remain on a trend of steady growth and expand 3.5% next year, supported by low unemployment, higher wages, and a gradual recovery in consumer credit. We also expect faster public spending, as the government has cut its primary fiscal surplus this year and does not have strong incentives to raise the surplus back to 3.1% of GDP in 2013, mainly because lower interest rates have reduced the primary



surplus required for fiscal solvency. The main question, in our view, is how investment will react. On the one hand, the frequent changes in regulations, taxes, and capital controls have raised uncertainty and could have a negative long-term effect on investment. On the other hand, we still expect a short-term rebound due to expectations of a somewhat less uncertain global environment (although Europe’s woes will probably not go away, we expect the US to overcome the “fiscal cliff”), lower domestic interest rates, increased supply of subsidized loans by public banks, government stimulus measures (e.g., reduction in payroll taxes and energy costs), and an increase in the pace of infrastructure investments related to the 2014 FIFA World Cup and 2016 Olympic Games. Therefore, although our previous forecast of 7% growth in investment next year was perhaps too optimistic35, we still project a rebound of 5%. The revision in investment had already led us to cut our 2013 growth forecast from 4.2% to 3.8% at the end of November. The release of 3Q12 GDP, however, added an additional complication, as it reduced the statistical carryover effect (i.e., how much annual GDP would grow without any growth at the margin in each quarter) for 2013 from an estimated 1.4% to 1.1%. Consequently, we further reduced our 2013 GDP forecast to 3.5% from 3.8%. For 2014 – a year when Brazil will host the FIFA World Cup and have presidential elections – we also cut our forecast slightly to 4.2% from 4.5%.

Low unemployment and a gradual recovery in credit will support consumption next year. Brazil’s seasonally-adjusted unemployment rate stood at 5.4% in October, very close to the series record low of 5.3%. Although job creation has decelerated due to the overall slowdown in economic growth, slower labor force growth has contributed to maintaining low unemployment. In 2010, for example, employment grew 3.5% and the labor force expanded 2.0%. In 2012, employment will probably rise 1.8%, but the labor force will also slow to 1.3%. We expect the unemployment rate to remain roughly stable at 5.5% in 2013. The credit market remains sluggish. Although consumer non-performing loans stopped growing in May, they have been roughly stable at the relatively high level of 7.9% since then, leading private banks to lend more cautiously despite the government’s strong pressure for more lending and lower rates. Credit expansion has been mainly concentrated in public banks, which have managed to raise their market share from 42% in October 2011 to 47% in October 2012. As the economy continues to recover, however, we expect delinquency to start declining slowly in the coming

35 For more details, please refer to our report, Brazil: In Search of a New Growth Model, of 27 November 2012.

months, paving the way for faster credit expansion in 2013.

Brazil: Non-Performing Loans

0.0

1.5

3.0

4.5

6.0

7.5

9.0

ConsumersCorporates

%

Source: BCB

We expect consumer prices to climb 5.5% in 2012 and 5.2% in 2013. We raised our 2012 IPCA consumer price index forecast slightly to 5.5% from 5.4%, taking into account the latest price data. Next year, although our revised GDP growth forecast should contribute to lower inflation next year, we now expect a weaker exchange rate to have the opposite effect. Therefore, we are keeping our 2013 IPCA forecast at 5.2%. We are also assuming that the government will raise gasoline prices by approximately 8% in 2013. An important assumption behind our forecast is that the government will manage to implement its plan to cut electricity prices by 20% on average next year, saving 50bps off the IPCA (although some companies have not accepted the government’s offer, we believe the authorities could compensate for it by cutting some taxes). Another important factor will be the smaller minimum wage increase (8.5% versus 14.1% in 2012), which should moderate somewhat the pace of increase of service prices (although they will likely continue to grow faster than headline inflation due to low unemployment). Should inflation accelerate more than expected, the government could implement additional measures, such as a reduction in taxes on food staples, which could shave approximately 50bps off the IPCA, according to very preliminary estimates. For 2014, we forecast inflation of 5.6%

We now expect the Central Bank to resume cutting interest rates in 2013. While we expect inflation to remain above the official inflation target of 4.5% in 2012, 2013 and 2014, we believe the Central Bank authorities are satisfied with inflation between 4.5% and 5.5% and are currently much more concerned about the slow pace of economic recovery. We expect the COPOM to resume cutting interest rates in March 2013, when inflation will likely decelerate due to the reduction in electricity prices expected to take place in February. We now forecast three rate cuts of 25bps, and therefore cut our year-end SELIC rate forecast to 6.50% from 7.25% for 2013. We



do not expect the Central Bank to raise rates until 2Q14, and lowered our SELIC forecast for the end of 2014 to 8.25% from 9.00%. Even if global economic conditions and the domestic economy improve faster than we expect, we believe the government would introduce “macro-prudential” measures (mainly credit restrictions) to curb inflation, thus postponing eventual rate hikes.

Brazil: Expected inflation, Focus survey

4.2

4.6

5.0

5.4

5.8

2012 20132014 4.5% target

%

Source: BCB

Fiscal easing should also help the economy recover. Due to the deceleration in economic growth and increase in subsidies and social security payments, the public sector’s consolidated primary fiscal surplus declined to BRL88.2bn in 10M12 from BRL118.6bn in 10M11. The central government’s surplus fell to BRL64.1bn from BRL85.7bn, while the surplus posted by states and municipalities slipped to BRL22.9bn from BRL30.8bn. In 12 months, the consolidated primary surplus declined to 2.25% of GDP in October, reaching the lowest level since August 2010, and further distancing itself from the 3.1% target set for the whole year. The federal government has formally announced that it will deduct BRL25.6bn (0.6% of GDP) spent on investment projects from its surplus target of 2.2% of GDP. The local government’s current primary surplus of 0.6% of GDP is also below the 0.9% target set for the whole year, so we cut our 2012 primary surplus forecast to 2.3% from 2.6%. For 2013, we also lowered our forecast to 2.3% from 2.5%, as we expect the government to introduce more fiscal stimulus measures to boost GDP growth.

Weaker-than-expected GDP growth does not bode well for the currency, and we now forecast a weaker BRL. After trading within a narrow range between BRL2.00/USD and BRL2.05/USD for a few months, the currency seems to have shifted to a weaker level around BRL2.10/USD in November. The BRL depreciated on growing market speculation that the government was interested in weakening the currency to help the local industry and provide more stimulus for the economy to recover. The Central Bank did not intervene to slow the depreciation until the BRL reached BRL2.115/USD (which

happened after Finance Minister Guido Mantega stated that the currency was “not in a totally satisfactory place”), suggesting that the authorities were comfortable with the currency around BRL2.10/USD. As the currency continued to depreciate and breached BRL2.12/USD, the Central Bank stepped up its intervention through FX swaps and dollar repurchase lines (selling USD in the spot market and agreeing to repurchase them at a later date). Moreover, the government reversed a measure enacted earlier this year restricting advanced prepayment export loans, and reduced the maturity of external bonds and loans subject to the 6% IOF tax from two years to one year (the fourth change so far this year). The government seems to be taking advantage of the weaker BRL to relax some of the capital controls and minimize their negative effect on exports and corporate financing, at the same time that the Central Bank is trying to improve liquidity in the FX market (officials have mentioned an increase in the demand for dollars due to the seasonal increase in profit remittances). We believe the Central Bank is concerned about the possible effect of a weaker BRL on inflation, but probably cares more about the speed of devaluation than about the level of the currency. All in all, in light of the weaker-than-expected GDP numbers, we raised our year-end currency forecast to BRL2.10/USD from BRL2.00/USD. We expect the currency to weaken further to BRL2.15/USD in 1Q13 and gradually regain some ground as economic growth recovers. While we still believe higher inflation in 4Q13 could prompt the authorities to be more flexible and accept a somewhat stronger currency, we changed our currency forecast for the end of 2013 to BRL2.05/USD from BRL1.90/USD. Nevertheless, we believe the risk to this forecast remains skewed toward a weaker BRL.

Brazil: BRL/USD

1.70

1.75

1.80

1.85

1.90

1.95

2.00

2.05

2.10

2.15

Source: Bloomberg Finance, L.P.

José Carlos de Faria, São Paulo, (5511) 2113-5185

Investment strategy FX: Intervention uncertainty. The BRL suddenly broke away from the tight range it had been trading for the previous four months. Besides external factors, the main



culprit was confusing signals from the government. First, the Ministry of Finance showed some support for a weaker currency, and then the central bank did not intervene when the currency broke formerly perceived boundaries. This was later reversed with forceful direct intervention by the central bank and some unwinding of IOF taxation to allow for some currency appreciation. With the dust beginning to settle, the BRL now seems poised to trade on a wider range, but the central bank has sent important signals that it is not willing to risk on the inflation front by allowing for a fast depreciation. On our view, the incipient economic recovery, and a marginally improved external environment, could provide some support for the currency, maintaining the attractiveness of the BRL as a carry trade -regardless of potential monetary easing. We recommend shifting to long BRL/JPY as a low-vol carry trade (entry: 39.58, target: 40.39, stop: 39.18). Rates: Maintain receiver bias. After bringing the SELIC rate to minimum levels, the BCB paused at its last meeting and signaled a prolonged period of constant interest rates. But the recent weaker than expected economic data releases is fueling expectations of additional monetary easing. Facing a relatively benign inflation scenario –assuming some flexibility regarding the 4.5% inflation target- in our view the risks are markedly biased to continue receiving short-term rates. After having taken profits in DI Jan14/Jan17 steepener, we recommend receiving DI Jul17 when we expect a tightening cycle may begin (entry: 7.07%, target: 6.75%, stop: 7.22%). Additionally, we recommend maintaining exposure to real rates which could benefit from both additional easing and rising inflation expectations. Maintain long NTNBs 45 (current: 3.95%, entry: 4.01%, adjust target: 3.77%, tighten stop: 4.05%). Credit: Underweight. Ad-hoc policies have not been effective to support growth so far it seems. Even though various stimulus measures will induce a gradual recovery in 2013, risk for further disappointments in growth remains, so does the risk of continued fiscal slippage. Despite all that, bonds spreads remain the tightest among its regional peers, due in large part to technical factors, as Brazil has featured negative supplies over the past year even before we account for the buybacks conducted by the Treasury. Technicals will remain supportive, but we see a likely stalled credit migration path for Brazil in 2013, lagging its LatAm low beta peers, especially Mexico. We recommend an inter-credit switch of UMS 40s vs. Brazil 41s. In relative value, the shape of the global curve has corrected and we recommend taking profit in curve flattener of 41s vs 21s. We have also taken profit in short 10Y basis (10Y vs. 21s). However, we continue to hold dv01-neutral 5s10s CDS curve steepeners with positive carry/roll down (current: 39bp, target: 45bp).

Mauro Roca, New York, (212) 250-8609 Hongtao Jiang, New York, (212) 250-2524

Brazil: Deutsche Bank Forecasts 2011 2012F 2013F 2014F

National Income Nominal GDP (USDbn) 2,475 2,187 2,302 2,595Population (m) 195 197 198 200GDP per capita (USD) 12,687 11,113 11,601 12,969

Real GDP (YoY%) 2.7 1.0 3.5 4.2 Private consumption 4.1 3.1 3.5 4.2 Government consumption 1.9 3.1 3.8 3.9 Gross capital formation 4.7 -3.0 4.8 7.0 Exports 4.5 -1.5 2.0 4.0 Imports 9.8 -1.0 4.0 8.0

Prices, Money and Banking CPI (YoY%, eop) 6.5 5.5 5.2 5.6CPI (YoY%, avg) 6.6 5.4 5.3 5.8Money base (YoY%) 9.3 7.0 9.0 10.0Broad money (YoY%) 6.2 4.2 6.5 9.0

Fiscal Accounts (% of GDP) Consolidated budget balance -2.6 -2.3 -2.0 -1.7 Interest payments -5.7 -4.6 -4.3 -3.7 Primary balance 3.1 2.3 2.3 2.0

External Accounts (USDbn) Merchandise exports 256.0 242.0 260.0 284.0Merchandise imports 226.3 223.0 240.0 268.0Trade balance 29.8 19.0 20.0 16.0 % of GDP 1.2 0.9 0.9 0.6

Current account balance -52.5 -53.0 -60.0 -70.0 % of GDP -2.1 -2.4 -2.6 -2.7

FDI 66.7 63.0 65.0 70.0FX reserves (USDbn) 352.0 379.0 389.0 394.0FX rate (eop) BRL/USD 1.88 2.10 2.05 2.05

Debt Indicators (% of GDP) Government debt (gross) 54.2 58.1 56.6 55.5 Domestic 51.5 55.6 54.3 53.2 External 2.6 2.5 2.4 2.3

Total external debt 16.3 19.4 19.3 17.9 in USDbn 404.1 424.1 444.1 464.1 Short-term (% of total) 11.6 11.0 11.0 11.0

General (YoY%) Industrial production (YoY%) 0.3 -2.5 3.5 3.0Unemployment (%) 6.0 5.5 5.5 5.3

Financial Markets (EOP) Current 3M 6M 12MSelic overnight rate 7.25 7.00 6.50 6.503-month rate (%) 7.1 6.7 6.6 6.6BRL/USD 2.08 2.15 2.10 2.05



Chile Aa3/A+/A+ Moodys/S&P/Fitch

Economic outlook: The economy rapidly recovered

from the deceleration experienced in Q311 and continues to grow above potential. Concerned by some inflationary pressures and the uncertain global environment, the Central Bank of Chile (BCCh) continues to follow a wait-and-see approach.

Main risks: Tradable inflation could add to already-elevated non-tradable inflation. A sharp deceleration in China could negatively affect copper prices, intensifying the negative external shock.

Strategy recommendations: Maintain 1x2 USD/CLP put spread and enter short EUR/CLP. Take profits on 1Y1Y CLP/CAM payer and enter long 10Y rates (CLP/CAM or BTP) vs UST.

Macro view Some nascent deceleration... The economy started the last quarter of the year on a strong footing. The BCCh reported that the index of economic activity (IMACEC) rose by 6.7%YoY in October, the highest annual rate of the year. This figure undoubtedly shows that the economy kept growing above potential, but it is worth noticing that this number is also biased to the upside due to seasonal effects - this year 0ctober has three more business days than last year. In fact, on a seasonally adjusted basis the index decreased 0.5% MoM, consistent with the deceleration in the margin already insinuated in August. Furthermore, the cyclical trend expanded by 4.3%YoY, the lowest pace of the year.

The national accounts for 3Q12 already showed a GDP growth of 5.7% YoY with a seasonally adjusted basis, growth of 1.4% QoQ. In this case, the period had five working days less than 2011 with a negative calendar effect of 1pp. Domestic demand kept showing strong dynamism -it grew by 8.0% YoY, above the 6.8% YoY recorded during the previous quarter. The increase in demand was driven by consumption and investment which jumped by 5.9%YoY and 13.3%YoY respectively. On the external front, exports declined by 3.4%YoY while imports increased by 2.5%YoY. On a sectoral basis, financial services reported the highest rate of growth (9.5%YoY), followed by retail (8.6%YoY) and construction (7.9%YoY). Conversely, fishing and manufacturing suffered contractions of 5.8%YoY and 0.3%YoY respectively. Finally, mining and personal services were the sectors that contributed the most with 0.8pp.

The bottom line is that the economy is still growing at a very strong pace in the absence of any slack in non-

tradables or labor markets (which could become sources of inflationary pressures) but some incipient adjustment is already occurring at the margin.

The gradual deceleration in economic growth is associated with the small increase in unemployment of the last couple of months. The unemployment rate for the August/October moving quarter increased to 6.6% from 6.5%, in contrast with expectations of a 6.4% decline. This quarterly increase was the result of labor force growing faster than employment (0.4%QoQ versus 0.3%QoQ respectively). This is consistent with the recent evolution of wage inflation. Nominal wages and labor costs increased respectively by 0.4%MoM (6.2% YoY) and 0.5%MoM (6.7% YoY) in September, reflecting a small decline with respect to the annual rates of the previous month. The labor market remains tight, and it is a potential source of inflationary pressures, but the latest figures are already pointing to some softening of labor demand.

…with a still benign inflation scenario. The latest figures showed that consumer prices increased by 0.6% MoM (2.9% YoY) MoM during September, considerable above consensus expectations. Nevertheless, the monthly increase on core measures was smaller than in the previous month, showing that an important part of the increase could be attributed to volatile prices. As a consequence, the spike on prices could be transitory, and should not pose a threat to a .benign short run inflation scenario. Apart from subdued inflation in the last part of year, an elevated comparative base would help to bring headline inflation even lower.

The results the latest BCCh’s survey on economic expectations of economists and financial analysts, are in accordance with this relatively stable scenario. The median for the expected inflation in 12M, 2Y and for the end of 2014 remain anchored at the 3.0% inflation target. Regarding activity, expectations are that GDP will grow by 5.2% in 2012 and gradually decrease to 4.8% in 2014. Consistently, survey participants are expecting the board of the BCCh to keep the monetary policy rate unchanged at 5.0% during the policy horizon. In summary, regardless of the challenging external scenario expectations are that the economy will continue to evolve along a (more) balanced path.

BCCh maintains neutrality Private agents’ expectations are broadly consistent with those of the monetary authority. The minutes of the last monetary policy meeting, held on November 13th, showed that the only option under consideration by the board was to maintain the policy interest rate (TPM)



unchanged at 5.0%, while arguments against a change in any direction were presented. A hike was discarded because due to some indication of moderation in some indicators, regardless of the potential inflationary pressures which could originate in the dynamism of domestic demand. On the other hand, preventive easing against the risk of a worsening external scenario was also rejected due to less probable materialization of tail risks. Nevertheless, the Board members pointed that external risks, namely the weak situation in the Eurozone, and the possibility of a fiscal contraction in United States, are still important. In this context, just China presented a more positive outlook according to its latest activity figures, but this was in contrast with the recent decrease in commodity prices (particularly copper). It is worth noticing that Board members argued that the observed deceleration in credit growth shows that the banking sector is already providing some restrain to domestic demand expansion. The bottom line is that all Board members continue to feel comfortable with the current level of interest rates which they see as neutral.

Mauro Roca, New York, (212) 250-8609

Investment strategy FX: Toward less supportive fundamentals. An interesting fact in the latest central bank minutes was the repetitive mentioning of the deterioration of the current account due to elevated growth in domestic demand amid a slowdown in global demand. In our view, this will be a key variable to monitor due to its potential effects on the currency. Apart from fluctuations in global demand, the evolution of the terms of trade –tied to copper prices- would play an important role. In the short-run, important growth differential would continue to push the currency toward appreciation. We recommend maintaining exposure with zero cost 1x2 USD/CLP put spreads to limit potential downside. For the year ahead we favor short EURCLP (entry: 626, target: 605, stop: 637). Rates: Shifting to receivers. After suffering a temporary spike due to volatile prices, inflation is expected to decline considerably during the last quarter. Even when the economy is growing above potential and labor markets remain tight, the central bank has sent a strong signal that the policy interest rate will remain unchanged in the near term. While we expect that interest rates will eventually rise during next year, we recommend to tactically take profits on our 1Y1Y CLP/CAM payer recommendation, and wait for better entry levels (current: 5.25%, entry: 4.95%) and shift to receive at longer maturities (10Y) vs UST due to the potential effects of GDNs amid still strong fundamentals. We continue to see value in real rates with a medium term horizon but they could suffer in the short-term since base effects could produce an important decline on headline inflation in the next couple of months.

Mauro Roca, New York, (212) 250-8609

Chile: Deutsche Bank forecasts 2011 2012F 2013F 2014F

National income

Nominal GDP (USDbn) 223.0 256.4 278.5 300.9

Population (m) 17.1 17.6 17.8 18.0

GDP per capita (USD) 13,036 14,562 15,625 16,732

Real GDP (YoY%) 6.2 5.1 4.7 4.9

Priv. consumption 8.2 6.3 5.6 5.9

Gov't consumption 6.2 4.3 4.1 3.8

Investment 16.8 7.2 7.5 8.2

Exports 7.3 3.5 4.2 5.4

Imports 14.2 5.9 5.5 5.5

Prices, money and banking CPI (Dec YoY%) 4.4 2.1 3.2 3.0

CPI (Avg. YoY%)s 3.3 3.1 2.8 3.0

Broad money 19.6 20.3 22.3 21.2

Credit 10.9 12.8 12.5 11.0

Fiscal accounts (% of GDP) Consolidated budget balance 0.8 0.2 -0.5 0.2

Government spending 21.9 21.2 21.6 21.8

Government revenues 22.7 21.4 21.1 22.0

External Accounts (USDbn) Exports 80.9 77.5 79.2 82.7

Imports 70.5 73.1 74.0 75.3

Trade balance 10.4 4.4 5.2 7.4

% of GDP 4.7 1.7 1.9 2.5

Current account balance -3.8 -6.1 -4.6 -3.5

% of GDP -1.7 -2.4 -1.7 -1.2

FDI 11.4 13.5 15.0 17.0

FX reserves 40.0 41.0 42.0 42.0

FX rate (eop) USD/CLP 520 495 515 510

Debt indicators (% of GDP) Government debt 7.3 6.6 6.2 6.0

Domestic 5.1 4.7 4.5 4.5

External 2.2 1.8 1.7 1.5

Total external debt 39.7 39.2 34.9 32.1

in USDbn 98.6 100.5 97.1 96.5

Short-term (% of total) 18.9 18.6 15.1 14.5

General Industrial production (YoY%) 4.0 4.6 4.2 4.4

Unemployment (%) 7.0 7.1 7.6 7.8

Financial markets (end) Current 3M 6M 12M

Overnight rate (%) 5.00 5.00 5.00 5.50

6-month rate (%) 4.97 4.95 5.05 5.27

USD/CLP 479 498 510 512Source: Deutsche Bank Global Markets Research, National Source



Colombia Baa3 (stable)/BBB- (pos)/BBB- (stable) Moodys/S&P/Fitch

Economic outlook: Inflation is well anchored, while

economic activity has softened since 3Q12. The likely approval of an investor-friendly tax reform could elicit a significant inflow of funds from abroad, thus strengthening the currency.

Main risks: A relapse in economic activity in the US, and/or a softening of external terms of trade as a result of a global slowdown.

Strategy recommendations: Remain neutral COP after closing at a loss long USD/COP. Take profits on TES ’24 and enter 1Y COP/IBR receiver. Remain neutral on external debt.

Macro view Interest rate cut On November 23, BanRep announced the reduction of the reference rate by 25bp to 4.50%, surprising the market. The decision was reached by simple majority. The medium term inflation target remains at 3%, with an admissible deviation band of 100bp. The rate cut was made preemptively, to help the economy reach its potential GDP growth rate of 4.8% in 2013. BanRep believes that the main macro risks facing the Colombian economy are from abroad, but at the domestic level, growth has decelerated since 3Q12. The Bank expects a recovery in consumption during next year, as well as robust investment fueled by low interest rates and aggressive programs of public works. We expect no more cuts for now, as expected inflation appear to be well anchored, and annual inflation is indeed likely to be below the 3% mark at the end of this year.

COP to remain strong More often than not in recent years, COP has been under appreciation pressure, on the back of strong terms of trade and FDI inflows. We believe that those factors will remain place in 2013. Furthermore, the likely approval of the fiscal reform proposal submitted to Congress a month ago may result in additional appreciation. The reform is geared towards fostering employment in formal labor markets and modifying the tax code to make the system more progressive. It also includes a reduction in the income tax rate on foreign fixed investment investors to 14% from the current 33%, a move that, if confirmed, would give rise to significant portfolio inflows that are likely to push yields lower but also to exert additional appreciation pressures. It remains to be seen whether the probable COP strengthening would elicit an offsetting policy reaction on the part of BanRep and/or the Finance Ministry, especially considering that in the past the

authorities have made it clear that they believe that sudden and sharp appreciation is not desirable. Economic activity gradually softening DANE reported that industrial production contracted by 1.3% YoY during September, significantly worse than expectations of a 0.6% increase. During the first nine months of the year, industrial output rose by 0.8% YoY. Economic activity indicators are showing that the Colombian economy entered into a soft patch since the past two to three months. The labor market, however, has behaved well, as DANE reported that the open unemployment rate at the national level dropped to 8.9% in October from 9.9% in the previous month. We expect output to expand by about 4.3% this year and to continue growing at a similar pace in 2013, slightly below potential.

The Hague Court ruling The Hague’s International Court of Justice ruled in the 11-year old border conflict between Colombia and Nicaragua, giving sovereignty over seven small islands to Colombia but increasing the territorial sea under Nicaraguan jurisdiction. Nicaragua was the winner of the ruling, as the expansion of its territorial sea benefits the country from additional fishing and possibly offshore hydrocarbon resources. President Santos indicated that the ruling was flawed and that Colombia will appeal it, and announced emergency economic measures for the San Andres' residents, whose main source of revenue is fishing, and that could be immediately affected by the ruling. His popularity, however, took a beating after the ruling, dropping 15 points to 45% in November according to the Semana magazine poll. It is not yet clear what the policy options for Colombia are, although the recent meeting between Santos and Nicaraguan President Daniel Ortega suggests that the country will probably try to launch a bilateral negotiation about fishing rights of the islanders.

Peace negotiations update The second phase of the bilateral peace negotiations between the government and the FARC guerrillas began last month in Havana. Humberto de la Calle, the chief negotiator from the government’s team, said the authorities are “moderately optimistic” and remain confident that “FARC will tell the Colombian people whether they are willing to reach concrete and realistic agreements to become part of the formal political system, without weapons”. Finance Minister Mauricio Cardenas has indicated that in the event the negotiations result in a full peace accord, Colombia’s potential GDP growth could climb to 6% to 7% in the coming years. de la Calle said the agenda to be discussed is based on the original plan, which includes issues related to agricultural development, political participation, end of the armed conflict, anti-drug



trafficking, and treatment of the victims of the conflict, but that the negotiations will not include any concessions from the Colombian society to the FARC, or any government policies or the development model of the country. The government reiterated that there will be no cease of military actions during the negotiations. Meanwhile, the FARC announced a unilaterally cease fire between November 20 and January 20, including civil, military and infrastructure targets.

Fernando Losada, New York, (212) 250-3162

Investment strategy FX: At the risk of intervention. After experiencing some volatility during the last couple of months, the currency sustained a surprising interest rate cut and it is not trading close to the crucial 1800 level. While economic data has not been particularly supportive of a stronger COP and the government announced its intention of substituting external financial with local issuance, expectations about the impending fiscal reform –which will make less costly for foreigners to enter the local market- and central bank measures to ease seasonal liquidity shortages, may have played a role in breaking the weakening trend. Nevertheless, we think that the threat of FX intervention caps any potential upside. With the economy still struggling to recover and the central bank signaling the end of the easing cycle, we think the government could have problems in accepting a stronger currency. We recommend closing at a loss long 3M USD/COP position (current: 1813, entry: 1829) and remaining neutral. Rates: Shorter duration. TES bonds have rallied to historical lows as the tax reform advanced in Congress and the central bank continued to ease monetary conditions. The prospects for the local bonds are undoubtedly favorable, even when the government has announcement a relative supply shift away from external financing. But at current levels, we recommend taking profits in our long TES ’24 recommendation (current: 5.82%, entry: 6.18%) and receiving in the short-end (1Y) of the IBRCOP swap curve for further pricing of monetary easing (entry: 4.45%, target: 4.22%, stop: 4.61%).

Credit: Remain neutral. 2012 has been a year for Colombia to complete its convergence to its regional peers, both in terms of credit quality and credit spread. Currently, its bond spreads are broadly in line with that of Brazil, Mexico, and Peru, and its fundamentals remain solid. Colombia remains on a positive path in terms of its ratings migration but a dramatic improvement is not expected. Valuation does not look attractive, especially in light of a potential repricing higher of UST yields in 2013 under a benign macro scenario, but Colombia should nevertheless be featured in a defensive oriented portfolio at a weight close to the benchmark.

Mauro Roca, New York, (212) 250-8609 Srineel Jalagani, New York, (212) 250-2026

Colombia: Deutsche Bank Forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 265.1 295.0 321.7 348.3Population (mn) 49.3 50.4 51.0 51.7GDP per capita (USD) 5,377 5,854 6,309 6,737 Real GDP (YoY%) 5.9 4.3 4.4 5.0 Priv. consumption 6.0 4.1 4.2 5.0 Gov’t consumption 3.0 3.9 4.0 3.8 Gross capital formation 12.0 10.0 10.0 11.0 Exports 25.0 13.0 13.0 12.0 Imports 28.0 20.0 19.0 17.0 Prices, Money and Banking CPI (Dec YoY%) 3.7 2.9 3.0 3.1CPI (avg%) 3.4 3.3 3.0 3.0Broad Money 19.0 16.0 14.0 15.0Bank credit 21.0 16.0 13.0 15.0 Fiscal Accounts (% of GDP)

Consolidated budget balance -2.0 -1.8 -1.6 -1.4

Interest payments 3.1 3.1 3.0 2.9

Primary Balance 1.1 1.3 1.4 1.5 External Accounts (USD bn)

Exports 56.9 64.0 69.0 75.0

Imports 54.7 62.0 69.0 76.0

Trade balance 2.2 2.0 0.0 -1.0

% of GDP 0.8 0.7 0.0 -0.3


% of GDP -2.6 -2.9 -3.0 -3.2

FDI 14.8 12.0 14.0 14.0

FX reserves 32.3 39.0 48.0 55.0

COP/USD 1939 1800 1750 1750

Debt Indicators (% of GDP)

Government debt 39.3 38.9 38.5 38.1

Domestic 27.5 27.6 27.5 27.6

External 11.8 11.3 11.0 10.5


in USDbn 60.0 64.0 66.0 70.0

Short-term (% of total) 8.0 7.0 7.0 7.0 General

Industrial production (YoY%) 6.0 6.0 7.0 8.0

Unemployment (%) 10.0 9.9 9.5 9.3 Financial Markets (eop) Current 3M 6M 12M

Overnight rate (%) 4.5 4.5 4.5 4.5

3-month rate (%) 5.3 5.3 5.3 5.3

COP/USD 1812 1790 1780 1750Source: DB Global Markets Research, National Sources



Mexico Baa1 (stable) / BBB (stable) / BBB (stable) Moody’s/S&P/Fitch

Economic: Annual headline inflation is declining since

September, and it is approaching the ceiling of the target range, thus providing some breathing room to the Central Bank. Economic activity is softening relative to 1H12. Banxico holds a very soft tightening bias but it is likely to maintain the tasa de fondeo unchanged. The outlook for the approval of structural reforms has improved, thus opening the door for spread compression and higher potential growth.

Main Risks: Mostly external, mainly a sharp drop in US economic activity because of fiscal cliff-related issues, and/or heightened global financial turmoil prompted by a disorderly adjustment in Europe. Domestically, stubborn inflation pressures fueled by supply shocks.

Strategy recommendations: Take profits on 1x2 USD/MXN put spread and enter short USD/MXN. Take profits on 2Y TIIE-US spread and long MBonos 5Y and buy MBonos (or TIIE) 20Y vs UST 20Y. Overweight external debt and enter UMS ‘40s vs. Brazil ‘41s. Take profit in 2s5s CDS curve flatteners.

Macro view 3Q12 GDP growth below expectations The government’s statistics office INEGI reported that 3Q12 GDP rose by 3.3% YoY, 0.45% QoQ on a seasonally adjusted basis. The figures came out below expectations of 3.6%, and clearly showing a deceleration relative to 1H12, when it had expanded by 4.7% (revised upwards from 4.3%).

Mexico: GDP growth (% YoY)

-8

-6

-4

-2

0

2

4

6

8

2005 2006 2007 2008 2009 2010 2011 2012F 2013F

Source: Banco de Mexico, Deutsche Bank

The annual increase was driven by the industrial sector, which rose by 3.6%. Services increased by 3.3% while primary activities was the laggard, expanding by 1.7%.

For the entire year, and even if GDP growth decelerates further towards some 3% in 4Q12, the rate of expansion will be very near 4%. INEGI also reported the IGAE economic activity index for September, which came out way below expectations at 1.3% YoY versus forecasts of 3.2%. This deceleration is probably behind Banxico’s hesitancy to tighten monetary policy despite the spike in headline inflation.

Tasa de fondeo unchanged again On November 30, Banco de Mexico left the target overnight rate unmodified at 4.5%, as expected by the market, and for the 41st consecutive month. In the press release that accompanied the decision, Banxico highlighted that economic activity at the global level continues to show signs of weakness, and that the possibility of a hard fiscal tightening in the US in 2013 is affecting domestic demand in the US. In addition, generalized weakness persists in the Eurozone. Regarding China, the Bank noted the recent recovery in growth after the deceleration observed during the previous months. In Mexico, economic activity continues to expand although at a more moderate pace. The output gap is close to nil, while the labor market is recovering gradually. Banxico believes that the balance of growth risks facing Mexico has deteriorated slightly.

Mexico: Inflation rates (% YoY)

2

3

4

5

6

7

8

9

10

CPI Core Food


On the inflation front, Banxico continues to argue that there was an inflection point in September, so that annual rates are trending downwards since then. The Bank is now expecting annual inflation to be below the 4% ceiling of the target range by year-end, a meaningful revision since the previous month and some 15bp lower than market expectations. Banxico also highlighted that inflation in services, which it believes better reflects the domestic determinants of inflation, is currently running at historically low levels. The Bank expects to see a



decreasing trend in global inflation due to the world deceleration and a corresponding softening in commodities prices. All in all, the press release had a more dovish tone than in recent months, reinforcing our view that Banxico will remain on hold during 2013. We expect headline inflation to be at the ceiling of the target range by year-end, but to grind lower since 1Q13, thus providing the Central Bank room for maneuver and to maintain the policy stance unmodified. In addition to the improving expected domestic inflation scenario, we continue to be of the idea that the global context of extremely lax monetary policy in developed countries suggests that Banxico should not be in a hurry to hike the tasa de fondeo.

Mexico: Expected inflation for 2012 (% YoY)

3 .5

3 .6

3 .7

3 .8

3 .9

4 .0

4 .1

4 .2


FCL renewed The Finance Ministry confirmed that the International Monetary Fund approved the renewal of the USD73bn flexible credit line for two years. On November 5, the authorities had requested the renewal of the line with the idea of keeping the funds as strictly precautionary. The decision was made jointly between the outgoing and incoming economic teams. Combining the resources in the FCL with the current stock of Banxico’s international reserves, Mexico has more than three times the reserve war chest that it had in 2009, when the strategy to increase dollar assets was launched as a way to reduce the country’s external vulnerability.

October’s trade deficit larger than expected The trade accounts showed a deficit of USD1.65bn in October, versus expectations of an imbalance worth USD553m according to Bloomberg’s poll. Total exports rose 13% YoY to USD33.92bn during the month, despite oil exports dropping by 4.1% YoY. Imports increased by 16.4% YoY to USD35.56bn, mainly fueled by intermediate products, up 17.3% YoY, and capital goods, up 26.1% YoY. Trade figures in Mexico have a strong seasonal pattern, with larger imbalances towards the latter part of the year, so a deficit was not surprising although the magnitude was. This was the largest monthly deficit of

the year, and roughly three times as large as that of October 2011. Year to date, however, the trade accounts have been in surplus for USD471m, versus a deficit of USD906m during the same period of 2011. In the latest quarterly inflation report, Banxico projected that the trade accounts for the year would be close to balanced, but chances are that there could be a small annual deficit of up to USD1bn. Still, we do not see Mexico’s external accounts as any reason for concern – the projected current account deficit for 2012 will probably be below 0.5% of GDP, and more than fully covered by FDI inflows. The external imbalance is likely to widen in 2013, with the current account deficit possibly climbing above the 1% of GDP mark, but we project that the dollar amount will remain below FDI flows. In addition, Mexico continues to have virtually unrestricted access to international capital market financing, so that the moderate increase in the external deficit should not represent any reason for concern.

Mexico: External accounts (USDbn) 2011

2011 2012

Current account -9 .2 -6.7 -2 .6 Rece ipts 399.0 296.1 315.1 Outlays 408.2 302.8 317.7

Capita l account 44.3 35.6 33.2 L iabilities 60.5 42.6 57.3 Debt 14.3 6.5 6.6 Fore ign inv estm ent 46.2 36.2 50.7 D irect 20.8 15.8 13.0 Portfolio 25.4 20.4 37.7 Equity -6 .2 -3.7 4.0 F ixed incom e 31.7 24.1 33.7 Assets -16.3 -7.1 -24.2

Errors and omissions -6 .7 -5.3 -12.0Change in international reserves 28.9 24.4 19.4Valuation ad justment -0 .4 -0.7 -0 .8

Jan-Sep


Slight increase in unemployment rate The official statistics office INEGI reported that October's open unemployment rate was 5.04%, above expectations of 4.90% as per Bloomberg’s survey and 3bp above September’s print. On a seasonally adjusted basis, the jobless rate was 4.83%, 15bp above the previous month's level. The underemployment rate came out at 8.70%, 60bp below relative to the mark of one year ago. INEGI also reported that nominal GDP expanded by 8.2% YoY during 3Q12, as a result of a 3.3% increase in real GDP and a 4.7% increase in the GDP deflator. Primary activities currently represent 3.7% of GDP, the industrial sector makes up 36.2% and services represent 60.1%.

Labor reform approved Last month, Congress approved the labor reform bill with the support from the PRI, PAN, Green Party and Nueva Alianza parties, and the opposition from the leftist PRD and Labor parties. The initiative is geared towards increasing flexibility in the country’s labor market, as it



introduces new contractual forms such as temporary and trial agreements, as well as providing a legal basis for outsourcing. It also establishes caps on severance payments. The final version of the bill excluded the chapter on freedom of union choice that was the main source of friction between PAN and PRD lawmakers. The initiative is a welcome development that should help improve Mexico’s productivity. It also provides early evidence of political coordination between the PRI and PAN parties, something that would be crucial for the future endorsement of other reforms such as fiscal and energy. The congressional approval of the bill provide a very favorable start to President Enrique Peña Nieto, as the new administration will benefit from the impact of the reform without having to pay any political cost for it, as the initiative was approved before the new government took office.

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

Under new management President Peña Nieto was sworn in on December 1st, thus bringing the PRI back to power after two six-year terms of PAN rule. Luis Videgaray, one of the leaders of Peña’s campaign and former finance minister of Mexico State, was appointed new finance minister, replacing Jose Antonio Meade who will be the new foreign affairs minister – thus giving a clear sense of policy continuity between the outgoing and incoming administrations. Ildefonso Guajardo, another close aide of Pena Nieto, will be Economy Secretary. New interior minister Miguel Angel Osorio said the new administration will push for fiscal, education and telecommunications reforms first. Videgaray also said that the fiscal reform is a priority, and added that the deregulation of the energy industry will also be sought after next year. Immediately after the inauguration ceremony, a letter of compromise to endorse necessary structural reforms was signed by all major political parties, an early signal that next year could be the time when significant progress on the reform front is made. We expect a fiscal overhaul to be implemented in 2013, and possibly some opening up of the energy sector.

Videgaray announced that his team will be completed with Fernando Aportela as deputy finance minister, Miguel Messmacher (former finance ministry’s chief economist) as undersecretary of revenue, and Fernando Galindo as undersecretary of spending.

We believe that there is significant common ground between PRI and PAN regarding the need for a fiscal overhaul, which should include action on the areas of expansion of tax base and streamlining of the corporate income tax. While it appears politically difficult to completely eliminate the pool of VAT-exempt items, a reduction of said pool to a list of truly basic goods could be possible. On the corporate tax front, changes to the tax code and a unification of the system after the 2009 reform may be needed. Given the low tax collection generated by Mexico, when government’s revenues depend strongly on oil, we believe that a successful fiscal reform should be geared towards creating additional revenues of at least a couple of percentage points of GDP over the coming years.

During the electoral campaign and also after being elected, Peña Nieto has been very adamant about the need for an energy reform. The President’s drive, coupled with what appears to be a favorable political climate towards reforms, suggests that the chances of some action on the energy reform front are higher than in the past. The mere fact that a deep deregulation of the sector requires a constitutional reform, however, gives as pause about the realistic chances of approval of such changes, as the initiative would require virtually unanimous approval from PRI and PAN lawmakers, assuming that the political left will oppose it.

Even in the absence of energy reform, but assuming that the fiscal overhaul takes place during 1H13, we would expect markets to react positively, with a likely compression of the long end of the yield curve via a reduction in country-specific risk. The magnitude of said compression will depend on the nature of the reforms. If not only the fiscal changes but also an energy reform is endorsed by Congress, we would expect sovereign spreads to contract by well over 100bp and, in addition, the currency to appreciate meaningfully because of the expected significant increase in FDI inflows to the hydrocarbons sector.


Investment strategy FX: Betting on reforms. The MXN had another month of erratic behavior but it now seems poised to benefit from potential reforms. A cleaner positioning adds to known attractive valuation. Meanwhile, realized and implied USD/MXN volatility are still around minimum levels. The fiscal cliff hurdle still needs to be cleared, but the decline of European tail risks could pave the way for an appreciation



trend. The labor reform showed that the government could struggle to materialize its agenda as fast as the market expects, but the positive momentum could have a positive impact on the currency in the near term. A free-floater central bank which may have to toughen its tone to fight potential inflationary pressures will continue to favor the carry trade. We recommend taking profits in our bullish zero cost 1x2 USD/MXN put spread (current: 0.3%) and shifting to a more aggressive short USD/MXN (entry: 12.93, target: 12.75, stop: 13.11) regardless of some noise ahead of the fiscal cliff deadline. Rates: Room for spread compression. As we expected, the curve suffered a bear steepening during the previous month due to uncertainties affecting the external scenario, the associated MXN weakening and the delays in approving the labor reform. But the passage of that reform together with a positive message from the entering government regarding the remaining ones is helping the curve to recover. While we maintain our reservations regarding the depth and timing of those potential reforms –particularly the crucial energy reform- we think that the current political capital and mandate of the new government would help to maintain alive expectations for reform. As a consequence we think that there is a room for some spread compression to the US –particularly if the US recovery gains speed after clearing the fiscal cliff- in the long-end of the curve. We recommend taking profits in 2Y TIIE-US receiver (current: 464, entry: 471) and Mbonos 5Y (current: 5.03%, entry 5.11%) and entering Mbono (or TIIE) 20Y against UST 20Y (entry: 400bp, target: 375bp, stop: 415bp). Credit: Overweight. �We see good reasons to be optimistic about Mexico’s chance to break out of the LatAm low beta pack on the positive side in 2013. First, the enhanced political capital by the new administration has raised prospects of further progress on the structural reform front. In addition to the recently approved labor reform, a revenue-increasing fiscal reform will mostly likely be implemented next year, potentially adding revenue of 1% of GDP. At the same time, the chance for the much coveted energy reform has also significantly increased, which would induce a sharp rise in foreign inflows. The renewed drive for reforms will make Mexico well positioned to enjoy a long period of relatively high and stable growth with low inflation and compressing spreads. Finally, spreads of the UMS bonds are slightly wider than its regional peers, especially relative to Brazil (+15-20bp). We recommend an overweight exposure (vs. underweight Brazil), and expect the spread differential between UMS 40s and Brazil 41s to converge to parity from the current 15bp. We also recommend taking profit in the 2s5s dv01-neutral CDS curve flatteners. After some 10bp flattening, the slope looks fair as carry and roll down for a flattener has turned negative.

Mauro Roca, New York, (212) 250-8609 Hongtao Jiang, New York, (212) 250-2975

Mexico: Deutsche Bank Forecasts 2011 2012F 2013F 2014National Income Nominal GDP (USD bn) 1045 1131 1233 1328Population (mn) 111 112 114 115GDP per capita (USD) 9,449 10,079 10,836 11,516 Real GDP (YoY%) 3.9 3.8 3.5 3.7 Priv. consumption 4.0 3.6 3.4 3.5 Gov't consumption 1.5 3.5 3.5 3.5 Investment 4.6 4.0 5.0 8.0 Exports 21.0 13.0 12.0 12.0 Imports 19.0 16.0 15.0 15.0 Prices, Money and Banking CPI (Dec YoY%) 3.8 4.0 3.5 3.5CPI (avg%) 3.4 3.9 3.7 3.6Broad Money 11.0 12.0 10.0 10.0Credit 11.0 12.0 10.0 10.0 Fiscal Accounts (% of GDP) Consolidated budget balance -2.4 -2.2 -2.0 -1.9

Primary Balance -0.2 0.1 0.0 0.0 External Accounts (USD bn) Exports 349.7 363.0 393.0 440.0

Imports 350.8 364.5 400.0 455.0

Trade balance -1.1 -1.5 -7.0 -15.0

% of GDP -0.1 -0.1 -0.6 -1.1


% of GDP -0.4 -0.4 -1.1 -1.3

FDI 19.5 20.0 21.0 27.0

FX reserves 142.5 163.0 176.0 190.0

MXN/USD (eop) 13.00 12.95 12.50 12.40

Debt Indicators (% of GDP) Government debt 35.2 35.3 35.8 35.7

Domestic 25.4 25.8 26.5 26.7

External 9.8 9.5 9.3 9.0


in USDbn 206.0 216.0 225.0 230.0

Short-term (% of total) 20.0 19.0 18.0 17.0 General Industrial production (YoY%) 4.4 4.0 5.0 5.0

Unemployment (%, avg) 5.6 5.2 5.0 4.9 Financial Markets (end

)Current 3M 6M 12M

Overnight rate (%) 4.5 4.5 4.5 4.5

3-month rate (%) 4.3 4.4 4.5 4.5

MXN/USD 12.92 12.80 12.60 12.50

Source: DB Global Markets Research, National Sources



Peru Baa2 (pos)/BBB (pos)/BBB (neutral) Moody’s/S&P/Fitch

Economic outlook: GDP growth has gradually

accelerated and it is now at near potential rates. Inflation has converged towards the target range and it will likely drop further during 2013. The Central Bank’s FX intervention strategy to lower currency volatility and prevent sharp PEN appreciation is to continue.

Main risks: A weakening in global growth that would reduce demand for Peruvian exports and lower external terms of trade. Further delays in the resolution of social conflicts and postponements of investment projects in the mining sector.

Strategy recommendations: Enter short USD/PEN and remain neutral in local rates. Stay neutral on external debt, and favor 10Y sector of the curve (19s and 25s).

Macro view November inflation well below expectations The official statistics unit INEI reported that the headline index at the national level dropped by 7bp MoM, 2.66% YoY. On a YTD basis, the figure was 2.48%, so it is clear that the annual figure will be below 3% by year-end. That is, the annual rate is already inside the official target range again. Prices of food and beverages dropped by 43bp MoM and those of transportation fell by 47bp MoM. In the Lima Metropolitan area, the index dropped by 14bp, so that the annual rate is now 2.66%. On a YTD basis, the index rose by 2.38%. The figure was significantly below expectations of a 0.1% MoM increase, and it validates the Central Bank's claim that the spike in inflation of earlier this year had been cause by temporary supply factors that did not require an increase in the policy rate.

We expect no changes to the reference rate, which has remained at 4.25% since May 2011, in the near future. It must be noted, however, that the Central Bank has tightened financial conditions three times this year via increases in mandatory reserve requirements, which suggests that the gradual acceleration in the growth pace through the year may have warranted a preemptive action on the part of the monetary authority. Chances are good that in the event of needed changes to the policy stance, the monetary authority will continue modifying the encajes at the margin, before altering the reference rate. The very active intervention in the currency market is also expected to continue, as appreciation pressures are unlikely to abate given the favorable prospects for FDI.

GDP continues to expand at near potential rates INEI reported that GDP expanded by 6.5% YoY during 3Q12, in line with expectations, and at a clip that is very

close to the potential of the economy. The construction sector led the increases, expanding by 19.3% YoY, followed by financial services at 8.9% and retail activity at 6.2%. Rising investment has fueled a construction boom so far this year, as the sector has risen by over 16% YoY during the first nine months of 2012. GDP growth accelerated during 3Q12, after a 6.2% YoY expansion of 1H12, and appears to be converging towards its cruising speed, which we believe is the fastest across LatAm. Thus, we expect Peru to be the top growth performer in the region over the short and medium term. On the fiscal front, the outlook is very robust, as the consolidated public sector surplus is expected to be near 2% of GDP.

Trade surplus above expectations INEI reported that exports reached USD3.86bn and imports totaled USD3.4bn in September, which resulted in a trade surplus of USD460.9m, above expectations of USD200m as per Bloomberg’s poll. Exports dropped by 2.5% YoY, explained by a drop in both traditional and non-traditional products by 1.7% and 5.6%, respectively. Conversely, imports climbed by 10.5% YoY, mainly explained by the 15.5% jump in imports of raw materials and intermediate products. We expect the trade surplus to be shy of USD5bn this year, down from USD7.7bn in 2011, mainly because imports increased at a faster pace than exports. The current account imbalance, in turn, will likely widen by a large margin towards some USD6bn, or 3% of GDP, and to remain at relatively high level until 2014, when it should begin to decline. Contrary to what was observed in recent years, FDI inflows are expected to fall short of the current account deficit, although we do not expect any urgency for the country to finance its external obligations. International reserves have increased at a fast pace in 2012 and could reach the USD60bn by year-end. Regarding issuance, we do not rule out the possibility that the Republic could tap international markets with a benchmark global bond next year, something that was hinted by the economic authorities in recent weeks.

The political backdrop The social conflicts around some mining projects, which resulted in the postponement of the Minas Conga undertaking in the Cajamarca region, represented an important test for the administration of President Ollanta Humala. The government has maintained a pro-business stance, walking a fine line between attending grassroots’ demands and providing reassurance to investors. So far the strategy has worked, as business confidence has remained buoyant and consumer confidence has also been resilient, in both cases recovering from the 2011 lows. The solid performance of private investment was



accompanied by a recovery in public investment, which had lagged last year. The delay in the implementation of some large investment projects, however, is likely to be monitored by market participants, and any further negative development on that front could result in a deceleration in investment. An additional issue to follow is the reappearance of Shining Path guerrillas, especially regarding any possible strategy to attack infrastructure.

Gustavo Cañonero, New York, (212) 250-7530 Fernando Losada, New York, (212) 250-3162

Investment strategy

FX: Returning to the sluggish appreciation trend. After reacting to the change in official intervention strategy, and exhibiting greater volatility, the currency seems to be setting back into former dynamics. Important FDI flows continue to gradually strengthen the currency, while the central bank tries to mop up excess USD supply. The PEN is becoming one of the most overvalued currencies in the region while carry is not particularly attractive. Nevertheless, as capital flows are not expected to decelerate in the near term, we recommend entering short USD/PEN (entry: 2.58, target: 2.53, stop: 2.62%).

Rates: Tighter and tighter. The local curve continued to grind lower, with the front end sinking well below the reference interest rate under no expectations of monetary easing in the near future. It is not difficult to argue that the curve does not offer much value –if any- at current levels, but good technical conditions and a supportive currency could continue to push local yields even lower. For the moment, we recommend to maintain a neutral exposure, waiting for better entry levels.

Credit: Neutral. Strong growth and solid debt dynamics should continue to support Peru’s positive credit migration path, and we expect a 1-notch upgrade of its credit rating to BBB+/Baa1 by S&P and Moodys in 2013. Technicals are supportive as Peru will have negative supply in 2013 and investors have reduced their exposure since September based on country weights data compiled by EPFR. Valuation, however, does not look attractive in light of the tight credit spread and likely rising UST yields in 2013. The 10-30Y section of the global curve is the flattest among its peers; we favor 10Y sector of the curve (19s or 25s) over the long end (37s or 50s).

Mauro Roca, New York, (212) 250-2975 Srineel Jalagani, New York, (212) 250 2026

Peru: Deutsche Bank Forecasts

2011 2012F 2013F 2014FNational Income Nominal GDP (USDbn) 170.7 192.7 207.7 224.4

Population (mn) 29.7 30.0 30.5 31.0

GDP per capita (USD) 5,747 6,422 6,811 7,239

Real GDP (YoY%) 6.9 6.3 6.0 6.2

Priv. Consumption 5.0 5.0 5.0 5.3

Gov't consumption 8.1 9.0 10.0 10.0

Investment 11.0 16.0 15.0 14.0

Exports 23.0 12.0 13.0 12.0

Imports 30.0 17.0 12.0 12.0

Prices, Money and Banking ( %)

CPI (YoY%) 4.7 2.8 2.5 2.5

CPI (avg%) 3.4 3.6 2.6 2.5

Broad money 12.0 15.5 13.0 13.0

Credit 14.0 16.0 15.0 15.0

Fiscal accounts, % of GDP

Balance 1.8 1.8 1.8 1.7


Primary surplus 3.0 2.9 2.9 2.7

External accounts (USDbn) Exports 44.8 46.0 52.0 61.0

Imports 37.1 42.0 46.0 52.0

Trade balance 7.7 4.0 6.0 9.0

% of GDP 4.5 2.1 2.9 4.0


% of GDP -2.0 -3.2 -3.4 -2.7

FDI 5.5 4.5 5.0 5.5

FX reserves (USDbn) 48.9 60.0 65.0 70.0

FX rate PEN/USD (eop) 2.70 2.61 2.63 2.65


Domestic 9.5 9.8 10.0 10.3

External 13.4 13.6 13.7 13.4


in USDbn 45.6 48.8 52.9 56.0


General Industrial prod (%) 6.0 6.3 6.5 7.0

Unemployment (%) 7.3 6.9 6.8 6.9

Financial Markets (eop) Current 3M 6M 12M Policy rate (interbank o/n) 4.25 4.25 4.25 4.25

6-month rate 4.35 4.40 4.40 4.40

PEN/USD 2.58 2.60 2.61 2.63Source: DB Global Markets Research, National Sources



Uruguay Baa3 (positive)/BBB- (stable)/BB+ (positive) Moodys /S&P/ /Fitch

Economic Outlook: Economic growth has

decelerated this year on the back of the temporary shutdown of ANCAP, but it is set to recover, albeit gradually, in 2013. Inflationary pressures have been very persistent and will likely continue in 2013, preventing the Central Bank from easing its monetary policy stance – regardless of lax monetary policies at the global level. A positive net currency balance should maintain the UYU well supported.

Main Risks: Deterioration in terms of trade fueled by global downturn. Further increase in inflation that would require additional monetary tightening. Political stalemate and conflicts over economic policy mix ahead of 2014 elections.

Strategy Recommendations: Enter long UYU ’18. Neutral external debt and favor long end of the global curve.

Macro view November inflation above expectations Consumer prices rose by 0.35% MoM, 9.03% YoY in November, versus expectations of a 0.20% increase as per Bloomberg’s poll and of no monthly inflation according to the Central Bank’s survey. The annual rate dropped by 8bp relative to October, but it has averaged 8.93% during the last three months, remaining sharply above the 6% ceiling of the target range and suggesting that the Central Bank has no room to ease monetary policy for now and that the currency, barring a negative external development, should remain well supported. Year to date, inflation has been 8.27%. In November, prices of food and beverages rose by a relatively tame 0.31% Mom, but annual food inflation is still in double digits at 10.68%. Other item groups whose annual price increases are above the 10% mark include housing, education and restaurants and hotels. We expect inflation to remain above the target during next year, although dropping slightly from the 2012 figures.

Inflation has remained elevated for over a year. Despite the monetary lassitude observed at the global level, the Central Bank tightened monetary policy by increasing the reference rate 75bp to 8.75% at the end of last year, and given the persistence of inflationary pressures, it hiked again n September by an additional 25bp. Higher interest rates did not deliver the expected results, so that the authorities have recently shifted their priorities towards the implementation of alternative, somewhat heterodox policies to stem price pressures. They include the negotiation of price guidelines with supermarket chains, the establishment of price caps for selected items, the

temporary reduction of fuel prices, and the delay in price adjustments of public services. The mere fact that inflation was again higher than expected in November suggests that further monetary tightening, in addition to the new measures, should not be ruled out. Uruguay stands out as one of the very few countries in LatAm where the monetary tightening cycle started last year and it may well continue into 2013.

GDP growth to accelerate next year The negative impact of the temporary shutdown of the ANCAP oil refinery will be reflected in softer GDP growth during the current year, that we project to be near 3.7% - down from 5.7% in 2011. Industrial production, however, is showing early signs of a recovery, so that we project slightly more robust economic expansion rates in the latter part of the current year and during 2013. We believe, however, that given the external context of subdued growth, Uruguay will not be able to expand at the fast pace observed during the 2010-11 period over the short and medium term. While gross domestic investment behaved well so far this year, expanding by about 18%, consumption growth decelerated to around 6% and exports remained flat. On the external front, we believe that the trade deficit will be near USD2.3bn this year, just wider than what was observed in 2011. The current account deficit, in turn, is expected to be near USD1.7bn, or roughly 3% of GDP, and to remain at that level in 2013. Similarly to recent years, FDI inflows are projected to surpass the current account imbalance by a large margin, thus providing support for the currency and allowing for further accumulation of international reserves. FDI could increase substantially if the so-called Uruguay Round II, a program of exploration and exploitation contracts for offshore hydrocarbon areas already awarded to four large multinational oil companies, results in rapid discoveries. We expect the exchange rate to be near UYU19.50/USD by year-end and to depreciate towards UYU20.20/USD in 2013.

New issue and liability management Last month, the Republic sold USD853m worth of global bonds due 2045 to yield 4.125%, the lowest in the country’s history. The transaction was part of a large liability management transaction, as USD500m of the proceeds was used to repurchase existing obligations with cash and USD353m was utilized in a debt swap. The total amount of eligible bonds, which have maturities ranging from 2013 to 2036, was USD5.018bn. It must be noted that since July, Uruguay has two investment grade ratings, thus already qualifying for several benchmark indices. We expect the sovereign to be rated at the



investment grade status by all three major agencies since early 2013.

We project an overall fiscal imbalance of nearly 2% of GDP this year, above the 1.7% official target, because of energy cost overruns due to the severe drought in the early part of the year and higher transfers. We forecast a gradual decline in the fiscal deficit in 2013 towards 1.5% of GDP, fairly in line with the latest official projections. Current trends suggest that the gross public debt/GDP ratio should be near 42% during this year and next, some 14 percentage points down from the level of 2009, which had been inflated by the weak GDP figure amid the global economic downturn.

Fernando Losada, New York, (212) 250 3162

Investment strategy

Local markets: An attractive source of carry. Uruguayan linkers offer not only an attractive source of diversification but also sizable carry. Inflation is likely to continue showing important persistence regardless of the on-going tightening cycle which has brought nominal rates to the upper simple digits. Additionally, the currency should continue to be well supported by external fundamentals and the incipient recovery. To complete the picture, the recently recovery of the investment grade status is an adamant to the solid credit on the back of improving policy institutions. The caveat is that scarce liquidity extends the appropriate holding horizon. We recommend positioning on the front-end of the linkers curve via long UYU ’18 (entry: 2.10%, target: 1.75%, stop: 2.30%) as a buy-and-hold source of carry.

Credit: Neutral. We are constructive on the fundamentals, and believe a positive ratings migration will continue in 2013 with Fitch to likely upgrade the credit to investment grade. Scarcity value and smart liability management also support the global curve. However, market has largely reflected all these positive developments as Uruguay’s credit spread is now almost at par with that of Brazil. Technicals are supportive as we project negative net supplies in 2013 and lightened positioning amongst investors (as of the end of October according to country weights data compiled by EPFR). We favor long end of the global curve which have underperformed on the back of liability management, and also for better liquidity.

Mauro Roca, New York (+1) 212 250 8609 Hongtao Jiang, New York (+1) 212 250 2524

Uruguay: Deutsche Bank forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 46.7 54.1 58.5 62.7Population (mn) 3.3 3.3 3.4 3.4GDP per capita (USD) 14,224 16,406 17,218 18,433 Real GDP (YoY%) 5.0 3.7 4.1 5.0 Consumption 8.0 6.0 5.0 5.5 Gross capital formation 18.0 18.0 15.0 15.0 Exports 27.0 1.0 8.0 10.0 Imports 30.0 13.0 15.0 18.0 Prices, Money and Banking CPI (Dec YoY%) 8.6 8.9 7.6 6.5Broad Money 23.0 22.1 18.0 17.0 Fiscal Accounts (% of GDP)

Consolidated budget balance -1.1 -1.5 -1.3 -1.0


Primary Balance 1.9 1.4 1.5 1.8 External Accounts (USD bn)

Exports 12.8 13.1 14.1 15.3

Imports 12.7 13.4 15.0 16.6

Trade balance 0.1 -0.3 -0.9 -1.3

% of GDP 0.2 -0.6 -1.5 -2.1


% of GDP -2.8 -3.0 -3.1 -3.2

FDI 5.6 5.4 5.6 5.5

FX reserves 10.3 12.8 14.0 15.0

UYU/USD 20.0 19.5 20.2 21.1



Domestic 14.3 14.3 15.0 15.0

External 28.3 27.9 27.0 26.8


in USDbn 15.0 15.5 16.1 16.5

Short-term (% of total) 5.0 5.0 5.0 5.0 General

Unemployment (%) 6.0 5.7 5.5 5.4 Financial Markets (end

)Current 3M 6M 12M

Overnight rate (%) 9.0 9.0 9.0 9.0

3-month rate (%) 6.0 6.0 6.0 6.0

UYU/USD 19.4 19.7 19.8 20.1 Source: DB Global Markets Research, National Sources



Venezuela B2 (stable)/B+ (stable)/B+ (negative) Moodys/S&P/Fitch

Economic Outlook: After this year’s strong GDP expansion, we expect a deceleration in 2013, on the back of much needed fiscal tightening. Inflation may increase as some repressed prices will have to be adjusted. President Chavez’ recent return to Cuba for further cancer treatment has rekindled the possibility of a political transition.

Main Risks: Weakening of oil prices as a result of a global slowdown. Acceleration of inflation in the event of supply shortages. Policy radicalization during the new chavista administration.

Strategy Recommendations: Overweight external debt. Favor the Republic to PDVSA, especially at the long end. We favor 5-10y sector of the Sovereign curve (especially 18Ns and 22s) and 17Ns on PDVSA (but hold switching to PDV 35s from 37s). Also hold 2s5s CDS curve steepeners.

Macro View November inflation above expectations Consumer prices at the national level rose by 2.3% MoM, 18.1% YoY, above expectations of a 2% MoM increase. During the first 11 months of the year, inflation was 16%, so that the annual rate will come out well below the 22% target for the year. Annual inflation rose by 11bp relative to October, the first increase since November 2011 when it had reached 27.6%. Behind the impressive drop in the annual rate observed during the current year there is evidence of some repressed prices because of official caps, a problem that will have to be dealt with in 2013 to avoid supply shortages. Therefore, we expect inflation to accelerate again next year towards the mid 20s level. 3Q12 GDP growth fairly in line with expectations GDP expanded by 5.2% YoY during 3Q12, the eighth consecutive trimester of expansion. During the first nine months of the year, the economy expanded by 5.5%. In 3Q12, the oil economy rose by 1.1% YoY, while the non-oil sector expanded by 5.4%. Financial services was the fastest rising sector, expanding by 35.9%, followed by construction at 12.6%, which was fueled by the Housing Mission. The fast pace of growth of economic activity so far this year was fueled by a very expansive fiscal and monetary stance. The consolidated public sector deficit could well be in the double digit range this year, while M1 has increased by over 50% YoY as of late November. We expect the government to implement a gradual fiscal tightening during 2013, after the December gubernatorial elections, to avoid a spiraling of inflation. The spending reduction is to result in softer economic growth. On the financing front, we expect the government to increase the pace of issuance in foreign currency relative to the

somewhat tame 2012. We project combined issuance of the Republic and PDVSA for at least USD7bn, possibly with PDVSA leading the way and with most of the dollar issuance targeted to fueling the Sitme currency system. Meanwhile, the authorities will keep tapping the abundant domestic banking liquidity for regular financing purposes. Devaluation Despite the implicit message of no devaluation during 2013 embedded in next year's budget proposal, we expect the authorities to engineer devaluation next year. This is so because devaluation is needed to restore fiscal equilibrium, as oil-related revenues represent the main source of funds for the administration. We believe that the most likely scenario is one similar to previous devaluation episodes, with Cadivi and Sitme rates weakening by some 50%, and the parallel rate possibly appreciating as the "official" markets absorb the pressure that is currently exerted on the free market rate. We are of the idea that in order to generate a fiscal benefit, the basic official rate that channels the bulk of oil flows needs to be adjusted. The political succession issue Last month, after several days of absence from public appearances, President Chavez announced that he would continue his anti-cancer treatment in Cuba. He received authorization from the National Assembly to remain outside the country until January 10, when he has to return to Caracas for the ceremony of inauguration of the new term. Chavez said he will receive hyperbaric oxygenation treatment, a therapy to help relieve bone and tissue damage caused by radiation. In the last year and a half, Chavez has been absent from Venezuela a dozen times, travelling to Cuba for treatment of his ailment. After the October 7 presidential elections, Chavez' presence in the media dropped significantly. He has not made any public appearance since November 15, however, which led to market talk about a possible relapse in his condition. Chavez' announcement puts the issue of his illness, and the possible succession, back in the front burner. According to the Venezuelan Constitution, if the President has to step down from office during the first four years of his term, he is replaced by the Vice President who in turn has to call new elections within a month. If the replacement takes place during the last two years of the six-year presidential term, the Vice President takes over the presidency but completes the term. In the absence of a change to that constitutional norm, Chavez' announcement will increase the perception that a regime change is indeed possible next year, something that should be supportive for Venezuelan asset prices. It is still uncertain whether the government will put forth a referendum plan to modify the Constitution in order for



Vice President Nicolas Maduro to be able to complete the upcoming term without new elections. The chavista coalition does not hold a two thirds majority in the National Assembly to vote for such a constitutional reform, so that the changes would have to be implemented via an alternative way. Meanwhile, this new development also makes the December 16 gubernatorial elections very significant, as a strong showing by the opposition candidates could solidify the notion that a regime change is likely in the event a new presidential election is called next year. Chief among the state governor elections is that of Miranda, where Henrique Capriles Radonski, former presidential candidate from the opposition coalition, will face former Vice President Elias Jaua. Early polls give Capriles a very ample margin of advantage over Jaua, of more than 20 percentage points. A solid victory by Capriles would convey the message that he remains a referent of the opposition and a likely candidate to defeat the chavismo were Chavez have to step down from office in the near future.


Investment Strategy Credit Markets: Overweight. The complex is our main strategic overweight among EM high yielders in 2013. The prospect of regime change has been the main catalyst behind the outperformance in 2012. President Chavez’ decisive victory in October’s election has cast a shadow to this perception, but we believe the united opposition behind Capriles will remain in strong contention in the event a new election is called due to President Chavez’s health condition, which many believe is deteriorating given the recent announcement of his traveling to Cuba for an extended period of cancer treatment. Valuation is very attractive as Venezuela is the only major sovereign credit in EM outside of Argentina that still offers double-digit yields (“the only game in town”). In addition, oil prices look supportive, and - if the US overcomes the “cliff” as we foresee – a dynamics with likely tightening of credit spreads and widening of UST yield clearly favors high-yielding credits such as Venezuela. The main risk to our view is if the government will put forth a referendum plan to modify presidential succession rules. In relative value, risk premium of PDVSA vs. Republic is below 100bp at the front end (5-10Y sector) and negative at the long end. We hence favor the Republic (especially at the long end), where we believe the ‘18Ns or the’ 22s offer the most attractive risk-reward. For a more bullish position, the ‘31s are the cheapest bonds at the long end. On PDVSA, we continue favor ‘17Ns but hold ‘37s to ‘35s switch. Finally, we continue to hold dv01-neutral 2s5s CDS curve steepeners (current: 125bp, target: 160bp).

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

Venezuela: Deutsche Bank Forecasts 2011 2012F 2013F 2014FNational Income

Nominal GDP (USD bn) 328 436 542 578Population (mn) 29 30 31 31GDP per capita (USD) 11,300 14,621 17,775 18,941 Real GDP (YoY%) -1.5 4.2 5.0 2.1 Priv. consumption -1.9 4.0 5.0 2.5 Gov't consumption 2.1 5.9 6.0 3.0 Investment -6.3 4.4 14.0 3.0 Exports -12.9 4.7 2.0 6.0 Imports -2.9 15.4 15.0 8.0 Prices, Money and Banking CPI (Dec YoY%) 27.2 27.6 18.5 25.0CPI (avg%) 28.2 26.1 23.3 22.2Broad Money 26.0 51.1 50.0 25.0Credit 18.0 48.3 30.0 10.0 Fiscal Accounts (% of GDP) Consolidated budget balance -1.9 -3.0 -9.2 -4.3Interest payments 2.6 3.0 3.2 3.3Primary Balance 0.7 0.0 -6.0 -1.0 External Accounts (USD bn) Exports 65.8 94.0 100.0 105.0Imports 38.6 45.0 58.0 55.0Trade balance 27.2 49.0 42.0 50.0 % of GDP 8.3 11.2 7.7 8.7Current account balance 15.0 27.4 14.0 19.0 % of GDP 4.6 6.3 2.6 3.3FDI -2.0 2.0 0.0 1.0FX reserves 30.3 29.9 26.0 27.0VEF/USD 4.30 4.30 4.30 6.00 Debt Indicators (% of GDP) Government debt 34.5 35.8 37.5 40.0 Domestic 11.0 14.6 16.5 18.0 External 23.5 21.2 21.0 22.0Total external debt 25.9 23.2 19.7 20.3 in USDbn 84.9 101.0 107.0 117.0 Short-term (% of total) 22.0 22.0 22.0 22.0 General Industrial production (YoY%) -1.3 1.9 2.4 2.0Unemployment (%) 8.5 8.2 8.1 8.2 Financial Markets (eop) Current 3M 6MOvernight rate (%) 0.0 4.0 8.03-month rate (%) 14.5 15.0 15.5VEB/USD 4.30 6.30 6.30Source: DB Global Markets Research, National Sources



Czech Republic A1(stable)/AA-(stable)/A+(stable) Moody’s/S&P/Fitch

Economic Outlook: Ongoing fiscal austerity and a still-weak external environment will mean the resumption of a meaningful growth dynamic is unlikely in 2013. But with fiscal and external vulnerabilities low and the banking sector in decent shape, fundamentals still remain sound.

Main Risks: Political risks will linger an early election is possible in 2013. This would most likely mean an opposition win and a looser fiscal stance. We see potential for a downgrade to the rating outlook if political noise intensifies.

Strategy Recommendations: Stay Long PLN/CZK in spot FX, target 6.30, stop @ 5.95. Neutral on rates for now.

Macro View Another difficult year ahead. Czech Republic’s robust medium-term fundamentals are unlikely to shine through in 2013. A combination of ongoing fiscal austerity, dismal economic sentiment, a still-weak external environment and a soft labour market all point firmly to another year of very weak growth ahead. That said, factors such as a solid public sector balance sheet, secure financing of the C/A deficit, a banking sector with the lowest LTD ratio in the region, a relatively high household savings rate leave and an absence of fx mismatches are all sufficient buffers to ensure that there are no big pressure points for 2013. Moreover, we continue to expect a return to trend-like growth in 2014 and view the slowdown as cyclical rather than structural. Domestic politics will remain noisy with a Presidential election scheduled for Q1 and the lingering possibility of a general election before the scheduled 2014 date - which the opposition CSSD would most likely win. Ratings changes are not that likely but we do not rule out a reduction in the rating outlook to negative should political noise intensify and start to impede policymaking.

With the highest exports / GDP ratio in CEE at 75% and the highest share of exports destined for Germany, the Czech economy performed badly throughout 2012. The Q3 GDP reading at -0.3% QoQ was worse than in Hungary with the CZSO citing domestic factors as the reason behind the decline. Czech Republic has recently reported what is the worst IP reading in the region this year (September at -7.1% YoY), a more protracted swing in the C/A versus elsewhere as imports collapsed faster than exports and a YTD decline in the PMI which is larger than seen in Poland or Hungary.

The exposure to Europe is a significant part of the problem in Czech but the government’s very strong commitment to fiscal austerity despite the continued downward revisions to the growth outlook is undoubtedly exacerbating the weakness in the domestic economy. PM Necas has raised the possibility of easing back on austerity but his threat of resigning if the 2013 austerity bill failed to pass in Parliament makes it unlikely that this will happen anytime soon. Standard monetary policy options are extinguished and there is no obvious factor that could provide a material boost to growth in 2013.

Czech Republic: The level of output is unlikely to

reach the pre-crisis peak in 2013

75

80

85

90

95

100

105

110

115

Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12

Peak = 100

Czech (-2.3%)Hungary (-6.5%)Poland (no recession)Romania (-4.8%)

Source: Haver Analytics, DB Global Markets Research

Our latest projections are for a 1% expansion in GDP growth in 2013 which will reverse the expected decline of 0.8% in 2012. A return to a more trend-like growth rate of 3.4% in 2014 will then mean a that the Czech economy finally reaches the pre-crisis level of output. The latest CNB projections are more pessimistic with 2013 and 2014 GDP growth projected at only 0.2% and 1.9% respectively.

Fiscal overkill set to continue. The eventual passing of the 2013 austerity package after an initial veto in the Senate secures another year of fiscal overkill in Czech Republic. The package includes a 1pp VAT hike on both the preferential and standard VAT rate, the introduction of a 7% tax on those earning more than CZK100,000 per month, an increased excise tax on tobacco, abolition of the existing tax rebate on fuel for farmers, an increase in the real estate tax – and on the expenditure side a lower indexation of pension and an extension of the 2012 spending restraints. The package is intended to ensure the country remains on track to achieve a medium-term structural deficit target of 1% of GDP by 2015 and a balanced budget by 2016. The package was initially



approved by the Cabinet in May when the GDP projections from the Ministry of Finance stood at 0.2% for 2012 and 1.3% in 2013. The November Fiscal outlook published by Ministry of Finance now expects a GDP contraction of -1.0% and growth of 0.7% for 2013 but as yet there have been no changes to the substance of the package.

Czech Republic: Another sizeable austerity package

will come into effect in January CZKbn

7% additional solidarity personal income tax 1.8

Abolition of basic allowance for working pensioners 2.0

Reduction of flat-expense deductions for self-employed 3.5

Increase of withholding tax against tax havens to 35% 0.6

1 pp increase in VAT to 15% and 21% 19.6

Abolition of "green diesel" for agricultural producers 1.6

Higher tax on tobacco 0.1

Abolition of health insurance ceiling 1.8

Increase in real estate tax 1.8

Profit transfer from Lesy CR state company 4.0

Sales of emission permits 2.9

REVENUE MEASURES 39.8

Lower indexation of pensions 9.5

Freezing of wages for state employees 5.5

Abolition of housing benefit subsidy 0.8

Lower subsidies on renewable energy resources 2.0

Lower subsidy to SFDI state fund 0.2

EXPENDITURE MEASURES 18.0

TOTAL REVENUE AND EXPENDITURE MEASURES 57.8

% of GDP 1.4

Fiscal impulse to GDP in percentage points* -0.8Source: CNB

The 2012 fiscal deficit excluding one-off items looks likely to meet the authorities’ 3.2% of GDP target (despite some delay of EU payments earlier in the year) and the authorities target a further narrowing to 2.9% in 2013 (based on a 0.7% GDP growth assumption) and 2.7% in 2014. One risk to the accruals-based EC fiscal data for 2012 (to be released in April/May) is the recent approval of the Church Restitution bill. This is estimated to add 1.5% of GDP to the headline deficit at the time of introduction through financial settlement/compensation to the churches from the 1948 property-related injustices. The most recent Ministry of Finance estimate of the deficit is therefore 5% of GDP (which includes an additional 0.3% of GDP in delayed reimbursement of EU funds). The impact on the cash-based deficit is however minimal with the CZK59bn in financial compensation paid over a 30-year period and CZK75bn relates to the return of assets.

One factor to note in 2013 is the introduction of a 2nd pillar pension system which will eat into government revenues. The Ministry of Finance assumption is for a low 10% participation rate, equating to just CZK6bn. While there is a risk that these estimates are too low the long-term

future of the new system is uncertain given the pledge by the opposition to dismantle it if they come to power.

The combination of a modest (cash based) fiscal deficit and a cash reserve at CZK140bn leaves more than 50% coverage in what should be a roughly CZK250bn gross public sector financing requirement in 2013. The fiscal position should therefore look fairly comfortable in 2013 with the debt/GDP ratio still one of the lowest in the EU.

A very secure external position. The ongoing weakness in domestic demand in 2013 will also be reflected in the external outlook. The C/A deficit narrowed by 2/3rds in Q1-Q3 2012 to stand at just 1.0% annualized as imports have dropped faster than exports. This has taken its toll on the export-orientated manufacturing sector with IP slumping in tandem with trade growth. The larger income deficit has also narrowed through recent months reflecting lower dividend payments and profit repatriation in line with the poor health of the Czech economy. We expect the modest external deficit to be maintained through 2013 with the external backdrop remaining fairly weak and domestic conditions not supportive of a resumption in imports (moreover given the large imported component of exports there is a high correlation between the two series). The recent rise in private sector savings plus the government’s commitment to ongoing fiscal consolidation also suggests the C/A deficit will remain contained in the coming quarters.

Czech Republic: A reasonable large, but stable, gross

external financing requirement EURbn 2006 2007 2008 2009 2010 2011 2012F 2013F

Gross Financing Req. 17.9 19.8 22.3 27.8 27.8 29.9 32.9 30.6

C/A (deficit = negative) 2.4 5.7 3.3 3.5 5.9 4.5 2.9 3.2

Amortisation (MLT) 3.1 2.4 3.7 4.9 5.3 7.7 8.6 8.6

Amortisation (ST) 12.4 11.7 15.3 19.4 16.6 17.7 21.4 18.8

Financing 17.9 19.8 22.3 27.8 27.8 29.9 32.9 30.6

Non-debt creating 3.5 7.3 2.5 3.3 5.0 3.8 4.3 4.0

FDI (net) 3.2 6.5 1.4 1.4 3.7 3.2 3.0 3.0

EU capital inflows 0.4 0.8 1.1 1.9 1.3 0.6 1.3 1.0

Debt creating 15.9 12.2 21.3 28.4 25.1 25.9 30.0 26.6

Sovereign Eurobonds 0.3 0.0 2.0 2.2 2.0 0.0 2.8 2.0

Foreign purchases of CZGBs 0.1 0.5 -1.0 3.3 4.3 0.1 0.0 1.3

Banks + corporates 15.5 11.7 20.3 22.9 18.9 25.8 27.2 23.2

Errors & omissions -1.4 0.9 0.1 -1.7 -0.7 -0.4 -1.1 0.0

Reserves (+ = decrease) -0.1 -0.6 -1.5 -2.2 -1.6 0.6 -0.2 0.0

Gross Financing Req.

% of GDP 14.5 13.6 16.6 18.0 18.0 20.5 20.6 18.2Source: Bloomberg Finance LP, CNB, DB Global Markets Research

We expect the C/A deficit to continue to be majority financed via reinvested earnings (a subcomponent of FDI). Exposure to non-resident investment into local securities will likely remain an insignificant financing item given the very low yields (non-resident holdings are around 13% of total). The overall gross external financing requirement is



expected to remain broadly unchanged from 2011/2012 at close to 20% of GDP with the improved C/A outlook swamped by still-high short-term external debt repayments (around one-third of which is trade finance). The banks + corporates component of our financing table therefore accounts for most of the 2013 financing needs with the remainder expected to come via modest FDI and EU inflows. We expect one sovereign Eurobond issue as although there are no redemptions in 2013 a continuation of the Ministry of Finance strategy to tap the market once per year will likely continue.

A move to FX intervention in 2013 is uncertain. The CNB extinguished its standard monetary policy toolkit in 2012 by taking the policy rate to a historic EM low of 0.05% and reducing the deposit-lending corridor to just 20bps. The CNB has also for the first time given forward guidance with the November statement noting that “rates will remain at this level over a longer horizon until inflation pressures increase significantly”. The CNB Board has said on numerous occasions that fx intervention will be the next tool to be used to loosen monetary conditions and have made it clear that any other measures such as actions to narrow the gap between the policy rate and 3m PRIBOR, or to ease back on the Bank’s liquidity draining operations (9% of GDP), have been ruled out at this stage.

The CNB have not however guaranteed that fx intervention will be used at all. Our impression from a recent visit to Prague is that it is not likely in the near-term and would be contingent on a material undershoot on monetary-policy-relevant (MPR) inflation versus the November CNB forecast and CZK appreciation from the 24.9/EUR baseline for the koruna. The currency is currently weaker than the baseline and the most recent CPI and MPR readings are slightly above the CNB target and unlikely to drop back sharply in the coming months.

In the event that an fx intervention program is announced in 2013 we expect this would be a very transparent daily fx purchase program with the monthly reserves releases noting exactly how much of the increase is due to intervention. In terms of how much depreciation the CNB may want to see we update our monetary conditions index for Czech Republic and use 3:1 weights for the interest rate: exchange rate ratio in line with an earlier CNB report (the 3:1 ratio means a 33bps rate cut is equivalent to a 1% depreciation in the REER). Our MCI shows that monetary conditions have remained fairly restrictive this year despite the drop in the policy rate and are significantly tighter than in Q4 2008 due largely to fx appreciation. If the CNB pushed the currency 3% weaker (to 26/EUR) this would be equivalent to 100bps in rate cuts and using the sensitivities presented in the last inflation report would add 0.1pp to CPI in each of the next

four quarters. This should bring the CNB’s 2013 CPI expectation to around 2.7%, versus the 2.0% target.

Czech Republic: A 3:1 MCI points to fairly restrictive

monetary conditions given the macro weakness

0.0

1.0

2.0

3.0

4.0

5.0

6.0

-3

-2

-1

0

1

2

3

4

Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12

MCI (3:1), lhs

Policy rate (%), rhs

Accommodative monetary conditions

Restrictive monetary conditions

Source: Haver Analytics, DB Global Markets Research (A 3:1 MCI means that interest rate moves account for 2/3rd of the move in the MCI and the exchange rate for 1/3rd)

The November re-appointment by President Klaus of Hampl and Tomsik as Vice Governors at the CNB removes any personnel uncertainty for 2013. No new appointments will now be made until early 2014 with the term of the hawkish Zamrazilova the next to expire although she will be eligible for reappointment. It is difficult to determine which Board members are pushing for fx intervention and who may vote against this but we expect this will become increasingly clear in the next few months.

Czech Republic: No changes ahead on the CNB Board

next year Members of the CNB Board Term ends

Governor Miroslav Singer 30th June 2016

Vice-Governor Mojmir Hampl 30th November 2018

Vice-Governor Vladimir Tomsik 30th November 2018

Board Member Kamil Janacek 30th June 2016

Board Member Lubomir Lízal 12th February 2017

Board Member Pavel Rezabek 12th February 2017

Board Member Eva Zamrazilova 28th February 2014Source: CNB

High chance of a 2013 general election. The very fragile coalition between ODS-TOP09-LIDEM is expected to create further noise in 2013 following the very poor resigned recently and a wider Cabinet reshuffle is expected fairly soon. The likelihood of the coalition surviving until the scheduled 2014 general election is fairly low. This leaves some uncertainty on fiscal policy as the opposition Socialist party (CSSD) is firmly ahead in all recent opinion polls and is expected to win the next election. Protracted political noise which distracts attention away from policymaking and leaves significant uncertainty over



the fiscal outlook could well lead to a downgrade to the stable outlook on Czech Republic’s rating. S&P currently rates Czech Republic one notch above Fitch and Moody’s but all three are on stable outlook.

Caroline Grady, London, 44 207 545 9913

Investment Strategy

FX: A large output gap and a very restrictive fiscal plan mean it falls on monetary policy to provide support for the economy. Also, core CPI remains subdued, and pipeline price pressures as well, dragging headline lower, and combined with the large output gap this would suggest the CNB will monitor the risk of further disinflation closely in the new year, in turn suggesting the risk of FX intervention will not go away. On balance, high export dependence, plenty of spare capacity and fiscal consolidation are all factors continuing to impede growth, underlining the need for monetary policy to remain or even become more expansionary, in turn undermining the appeal of the CZK. We remain short CZK vs PLN, for a move to 6.30 (stop 5.95).

Henrik Gullberg, London, +44 20 7545 9847

Rates:. A depressed growth backdrop and subdued monetary policy relevant inflation mean policy is likely to stay accommodative. However, given that the outright level of rates is so low (CNB policy rate at 0.05%, 5Y IRS at 0.91% at time of writing), we do not see a great deal of value in being long rates at the current juncture. Instead, we think tactical payer positions might make sense in CZK. We recommend waiting for two catalysts before establishing such positions. The first is continuation of any negative political noise in CZK – specifically the risk that the coalition government might fall and secondly the possibility of outlook downgrades by ratings agencies. Carry & roll dynamics are not prohibitive for payer positions across the curve and we would recommend paying 5Y (negative carry & roll of 1bps/m) as a way to express this view.

Siddharth Kapoor, London, +44 20 7547 4241

Czech Republic: Deutsche Bank Forecasts 2011 2012E 2013F 2014F

National Income Nominal GDP (USD bn) 202.8 205.9 211.6 210.7Population (mn) 10.5 10.6 10.6 10.6GDP per capita (USD) 19257 19511 20008 19888

Real GDP (%) 1.7 -0.8 1.0 3.4Priv. consumption -0.6 -2.8 0.0 2.9Govt consumption -1.7 -1.0 -0.4 1.2Investment -1.3 -0.9 1.0 3.5Exports 11.0 5.0 7.2 7.8Imports 7.5 4.5 7.3 7.5

Prices, Money and Banking (eop) CPI (YoY%, eop) 2.4 2.4 2.9 2.1CPI (YoY%, pavg) 1.9 3.3 2.4 2.1Broad money (M2) 5.3 4.5 5.4 7.5

Fiscal Accounts (% of GDP) Consolidated budget balance -3.3 -3.5 -3.2 -2.7

Revenue 40.1 39.5 40.0 40.8 Spending 43.4 43.0 43.2 43.5

Primary balance -1.9 -2.1 -1.7 -1.2

External Accounts (USDbn) Exports 138.7 135.1 144.8 146.6Imports 133.4 127.2 136.3 138.7Trade balance 5.3 7.9 8.5 8.0% of GDP 2.6 3.8 4.0 3.8

Current account balance -6.2 -3.6 -3.3 -3.5% of GDP -3.1 -1.8 -1.6 -1.7

FDI (net) 4.4 3.9 4.0 5.0FX reserves (USDbn) 35.2 36.7 37.2 37.7CZK/USD (eop) 19.7 18.7 21.0 20.9CZK/EUR (eop) 25.6 25.2 25.2 24.0

Debt Indicators (% of GDP) Government debt 40.8 44.3 44.0 43.6 Domestic 29.8 31.6 31.9 31.7 External 11.0 12.7 12.1 11.9

Total external debt 46.3 45.5 44.0 43.4in USD bn 93.9 93.7 93.0 91.5

General (% pavg) Industrial production (% YoY) 6.7 2.0 4.1 7.3Unemployment 8.5 8.6 8.2 8.0

Financial Markets (eop) Current 3M 6M 12MCNB policy rate (%) 0.05 0.05 0.05 0.05CZK/EUR 25.2 25.2 25.2 25.2CZK/USD 19.5 19.2 19.7 21.0

Source: Haver Analytics, CEIC, DB Global Markets Research



Hungary Ba1(neg)/BB(stable)/BB+(neg) Moodys/S&P/Fitch

Economic Outlook: Policy unpredictability has left a

very poor investment climate and a structural weakening in Hungary’s growth dynamic. Hungary is the only CEE country where we do not expect the economy will have returned to the pre-crisis level of output by the end of our forecast horizon in 2014.

Main Risks: PM Orban’s likely appointment of a government minister as the new NBH Governor risks significant concerns over NBH independence, the future of the inflation targeting mandate and a possible move to unorthodox monetary policy.

Strategy Recommendations: Recent trend channel in EURHUF to remain intact, implying a trading range of 275-300. Receive 2Y IRS, target 5.00. Underweight on sovereign credit

Macro View Another bleak year ahead. The continuation of unpredictable policies through 2012 and a strategy that looks to be fiscal austerity at all costs leaves a very dismal outlook for 2013 and probably beyond. The introduction of a financial transactions tax (FTT) from January and numerous other tax increases suggests the investment climate is unlikely to improve and the capital stock will start to erode. Banking system profitability is set to remain poor and deleveraging will continue due to reluctance to lend, weaker creditworthiness for corproates and households, limited appetite for credit and an ongoing pullback in external funding. An IMF/EU deal is unlikely and we expect that authorities will change their stance and return to the Eurobond market probably early in Q1. Hungary’s institutional framework will be questioned by the appointments of a new NBH Governor and Deputies in H1 which is likely to see a current/former Minister appointed to the role. Further ratings downgrades are likely and we do not expect Hungary to return to the pre-crisis level of output throughout our forecast horizon.

The Q3 GDP reading of -0.2% QoQ (sa) marked the third consecutive negative GDP reading and leaves a YTD contraction of -1.7%. This is by far the worst in the CEE region and comes despite the sizeable auto production facilities which came on stream during the year. A slightly better backdrop in Europe in 2013 (with our growth expectation here at -0.2% versus -0.4% in 2012) and better base effects on exports should provide some support to growth in the coming year. Nevertheless, in contrast to Czech Republic we view the weak growth dynamic as a structural, rather than cyclical, decline due to the very poor investment climate and numerous adverse

policies targeted at the banking sector. KSH reported a moderation in the decline in investment in the third quarter to -2.1% YoY in Q3 leaving the overall decline in investment at 18% since Q1 2008. The composition of investment shows large investment in the auto industry offset by deeper declines in investment in sectors such as construction and finance. FDI is negative, domestic conditions are poor and there seems little reason to expect any material improvement in the investment ratio from the current all-time low of 16%.

Hungary: The auto (manufacturing) sector is the only

sector where investment growth is positive

30

40

50

60

70

80

90

100

110

120

130

Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12

Total investmentConstructionManufacturingFinance/Insurance

Source: KSH

Medium-term growth outlook has deteriorated. The continued policy unpredictability and the negative impact that the structure of fiscal adjustment is likely to have on medium-term growth dynamics were the key factors cited in the recent S&P downgrade. The NBH have also repeatedly highlighted the likely adverse impact of government policies on medium-term growth. The NBH will release its next set of forecasts in late December and Governor Simor has already pointed to the possibility of a downgrade to the 2013 GDP growth projection from the current 0.7%. Our own forecast now stands at zero for 2013 with a better export performance the main driver behind the improvement in growth from an estimated -1.3% in 2012. Domestic factors are expected to remain unsupportive due to an ongoing decline in real incomes while economic sentiment and the labour market outlook will remain very weak. The introduction of the 0.2% FTT in January adds significant uncertainty into the forecasts as the hit on bank profitability may tighten credit even further while the tax base could narrow as activity tries to move into the grey economy (there is a higher rate payable on cash withdrawals at 0.3% and a cap of the tax paid per transaction to try to prevent this). Corporates and households may also opt to transact through foreign



banks to the extent possible. There are also risks with the telecoms tax and new road tolls that there will be efforts made to avoid these.

More worrying is the longer term outlook. Declining investment and the unpredictable operating environment for corporates will hurt the growth potential over a multi-year horizon. Weaker growth will also make the government’s goal of debt reduction harder to achieve. Hungary is the only economy in CEE where we do not expect the level of output to have reached the pre-crisis peak by the end of our projection horizon in 2014.

Unwavering commitment to exit the EDP. Hungary’s desire to exit the EU’s Excessive Deficit Procedure and avoid another threatened suspension of (politically sensitive) EU funds will continue to shape the fiscal stance in the year ahead. The government is targeting a 2.7% fiscal deficit for 2013 (from what they expect to be the same in 2012) and a further narrowing to 2.2% in 2014. The additional fiscal adjustment measures for 2013 announced since April amount to a whopping 5% of GDP (two fiscal packages in October totalling 2.5% of GDP, another 0.2% in November and 2% of GDP announced in April as part of Szell Kalman 2.0) but this ignores the impact on growth and includes uncertain revenue increases which suggests the net effect is probably much less. The measures continue to be skewed towards the revenue side with the FTT, a higher income tax on the energy sector (from 11% to 31%) a permanent banking sector levy (still based on 2009 balance sheets), higher taxes on the insurance sector, the introduction of a road toll and a higher utilities tax all in store for 2013. This comes after a 2pp hike in VAT in 2012, the introduction of a telecoms tax, a hike in excise taxes, a higher gambling tax and a tax on unhealthy foods.

Hungary: Fiscal adjustment is skewed towards the

revenues rather than lower spending

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.030

35

40

45

50

55

60

2002 2004 2006 2008 2010 2012F 2014F

% GDPRevenue ExpenditureBudget balance (rhs)

Source: European Commission

The autumn forecasts from the EC produced the desired result with projections for a sub 3% fiscal deficit for 2012

and 2013. The EC’s 2013 projection was however 0.2pp above the government’s 2.7% target which the EC attributes to assumed slippages in savings measures, compensation of the expected 2012 loss of the NBH, and a more conservative GDP baseline of 0.3% versus the 0.9% assumed by the government. The EC’s publication of a 3.5% deficit projection for 2014 prompted the government to announce the previously temporary bank levy will now become permanent.

We see an IMF/EU deal as unlikely. The ongoing reliance on taxes and failure on the part of the authorities to address other well documented IMF concerns on the structural of the fiscal adjustment rules out any near-term IMF/EU program for Hungary. Not only would the authorities have to demonstrate a meaningful shift in the fiscal stance (which is unlikely ahead of the 2014 general election) they would also need to promote the IMF/EC as partners. The very unhelpful advertising campaign against the IMF is set to stop but this is the removal of a very negative tactic rather than introducing something positive.

Hungary: The sovereign faces a EUR4.2bn

redemption peak in February

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

T-bills (EUR5.5bn) HGBs (EUR4.1bn)

IMF (EUR4.5bn) Eurobonds (EUR1.6bn)

EURbn

Source: Bloomberg Finance LP, IMF

We expect an early 2013 Eurobond. The absence of an IMF/EU deal meant 2012 passed with zero external issuance despite plans to issue EUR4bn. We expect the government will change track fairly soon and issue a Eurobond without an IMF/EU agreement particularly with the February peak in the 2013 sovereign redemption profile at EUR4.2bn (a combination of a Eurobond, an IMF repayment and rollover of local T-bills and T-bonds). Sovereign repayments stand at 14.8% of GDP (or EUR15.8bn) for 2013 with a 2.7% of GDP fiscal deficit also requiring financing. At EUR4.5bn IMF repayments are higher than in 2012 (EUR3.8bn) with the component due directly from the government is also higher (EUR3.8bn versus EUR3.3bn in 2012). An absence of early Q1 Eurobond would mean a sharp run down in the government’s cash buffer (currently EUR6.1bn) plus a continuation of the 2012 strategy of stepped-up issuance



on the local market (net issuance in 2012 was around 3x that projected in the 2012 debt management outlook). Assuming ongoing access to the local market Hungary can therefore survive without external issuance but the liquidity position could become very tight.

Hungary’s overall gross external financing requirement is expected to remain the highest in CEE at 30% of GDP in 2013 and not much changed from 2012. The C/A is expected to remain in surplus of around 1% of GDP but this is swamped by maturing loan obligations. Banks will therefore continue to be the largest financing component but we expect some change in the structure in that another year of very high non-resident purchasing of HGBs (which amounted to EUR4bn in 2012) is unlikely given the share already stands at 42% of total.

NBH succession leaves significant uncertainties over 2013 monetary policy. The ending of the six-year terms for Governor Simor and his two Deputy Governors will mean a very different MPC in 2013. PM Orban will make all three appointments and for the first time leave the NBH with a Monetary Council entirely nominated by the government (previously the Governor choose the Deputies plus two of the four external members). Potential successors will face a salary that is around 70% lower than in 2010 and the possibility of a repeat of government criticism against MPC decision. This will mean any private sector appointments are unlikely leaving a current / former Minister as the most likely option. As the NBH law allows for the Governor to hold the position twice there is also the possibility of a return of former Governor Jarai (2001-2007 Governor), particularly given his close links to Fidesz. It is also possible that there are 5 new appointments rather than 3 with the latest version of the NBH law stating that the Monetary Council most consist of between five and nine members whereas the previous law stated it should be seven. The government committed not to appoint a third Deputy under Simor’s terms so there is nothing standing in the way of a 3rd Deputy after March 2nd.

Hungary: A new NBH Governor and Deputies in 2013 Members of the Monetary Council Term ends

Governor András Simor 2nd March 2013

Deputy Governor Ferenc Karvalits 26th March 2013

Deputy Governor Júlia Király 2nd July 2013

MPC Member Andrea Bártfai-Mager 20th March 2017

MPC Member János Cinkotai 20th March 2017

MPC Member Ferenc Gerhardt 20th March 2017

MPC Member Gyorgy Kocziszky 20th March 2017Source: NBH

The discussion on potential candidates has centred on Economy Minister Matolcsy, Minister Varga (currently head of the IMF/EU negotiating delegation although there are no negotiations) and former State Secretary Karman. The operational independence of the NBH will very likely be questioned following the appointment but this will not be a legal issue.

The future of the inflation targeting mandate could also be questioned further under an Orban-appointed Governor. This has already happened with the four external members appointed in 2011 outvoting the Governor and Deputies for rate cuts which were not backed up by forecasts from the research department. The MPC have already acknowledged that in addition to the inflation outlook and risk perceptions the reaction function now includes the growth outlook. With the December IR likely to see the GDP projections revised down and the forint and risk perceptions continuing to hold up we therefore expect continued 25bps rate cut in each of the next several meetings. Barring any substantial pressure on the currency we now see the policy rate at 4.5% by end 2013.

Hungary: We expect the NBH will continue to focus

on weak growth rather than high inflation

Previous Latest Change Previous Latest Change2012 5.3 5.8 0.5 -0.8 -1.4 -0.62013 3.5 5.0 1.5 0.8 0.7 -0.1

Inflation forecasts (% YoY) GDP forecasts (%)

Source: NBH (from the September Inflation Report)

Another worry is a move to non-standard monetary policy under a new Governor. There has been some discussion over NBH spending cuts such as a reduction in NBH liquidity draining operations, removal of the interest payment on commercial bank reserve requirements and the possible use of NBH reserves to repay the IMF/EC. The current NBH law does not allow for central bank financing of the government but the government could potentially change the law.

Keep an eye on the Together 14 coalition. The recent return to politics by former PM Bajnai and formation of an opposition coalition, Together 14, will be important to watch ahead of the 2014 general election. As things stand the opposition remains fragmented and does not pose a real threat to Fidesz winning re-election. That could change with a recent poll suggesting Together 14 would easily pass the 5% threshold needed to enter parliament and put support at 13% versus just 19% for Fidesz.




Investment Strategy

FX: Near-term direction in the HUF vs the majors will continue to be determined by general risk sentiment and EUR/USD, rather than NBH policy. However, given the prospects of an MPC entirely appointed by the government in 2013, further rate cuts are all but certain, and with headline inflation trending higher mainly due to supply side factors (currently 6% YoY), this is likely to result in a gradual FX underperformance vs the rest of the region. Indeed, history clearly shows that a sustained NBH rate cutting cycle at a time when the ECB largely is staying put has typically resulted in HUF underperformance (Mar’05-Jun’06, Jun’07-Feb’08, Mar’10-Jul’10). In addition to further rate cuts/negative real rates, the lack of an IMF loan deal is further restricting the appreciation potential in HUF. Indeed, even assuming a higher EUR/USD (DB sees 1.35 Q1), we see EUR/HUF remaining in a broad 275-300 range over the next 3-6 months, consistent with the trend/pattern over the past 10-11 years, which clearly shows HUF in a range until a more significant sell-off, after which the Hungarian unit always settles into a ‘new and higher’ range vs the EUR.


Rates:. Market currently prices roughly 100bps of cuts over 2013. According to our economists the NBH base rate could go to 4.5% - lower than what is currently priced. This drives our principle bias to be received in the front end. The advantage of receiving 2Y outright is that this is the most direct way of trading our view vs market pricing of NBH policy. Long 2Y positions are negative carry (-10bps/3m), but we think this is adequately compensated by the realised volatility of the 2Y part of the curve, In other words, the carry & roll vs realised vol ratio is around low (below -0.3). The main risk to this trade is the direct correlation with broader equity and risk sentiment. Therefore, we recommend trading this with relatively tight stops. We recommend being long 2Y at 5.50, with an initial target of 5.00 and with a s/l at 5.65..


Credit: Underweight. The bleak picture painted above for Hungary’s macro outlook has been apparently glossed over by the market, but this could change in the first quarter of 2013. The substantial debt financing needs in February and the change in NBH governor in March are likely to bring the risks in the country into focus once again. If demand for EM debt remains as strong as it has been in recent months then Hungary may have little difficulty covering its financing needs, which then buys it considerable time, but if there were to be a lull in demand, then Hungary would be amongst the most vulnerable. As a hedge to this scenario we recommend an underweight.

Marc Balston, London, +44 20 7547 1484 Winnie Kong, London, +44 20 7545 1382

Hungary: Deutsche Bank Forecasts 2011 2012E 2013F 2014FNational Income Nominal GDP (USD bn) 139.8 132.4 135.6 142.6Population (mn) 10.0 10.0 9.9 9.9GDP per capita (USD) 13996 13290 13642 14377

Real GDP (YoY%) Priv. consumption 1.6 -1.3 0.0 1.6 Gov’t consumption -0.2 -0.9 0.0 2.4 Gross capital formation -2.4 -2.9 0.2 1.8 Exports -5.5 -5.5 -3.5 2.0 Imports 8.4 4.2 6.4 7.5

Prices, Money and Banking CPI (YoY%, eop) 4.1 5.5 4.0 3.5CPI (YoY %, pavg) 3.9 5.7 4.1 3.5Broad money (M3) 5.9 4.7 5.3 6.3

Fiscal Accounts (% of GDP)

ESA 95 fiscal balance 4.2 -3.0 -2.9 -2.8 Revenue 53.5 44.5 44.3 44.4 Expenditure 49.3 47.5 47.2 47.2

Primary balance 8.4 0.8 0.9 1.0

External Accounts (USDbn)

Exports 104.8 105.0 110.9 112.4Imports 100.1 99.2 105.3 107.1Trade balance 4.7 5.8 5.6 5.2 % of GDP 3.3 4.4 4.2 3.7

Current account balance 1.3 1.2 2.1 1.1 % of GDP 0.9 0.9 1.5 0.9

FDI (net) 0.2 0.4 0.5 0.4FX reserves (USD bn) 45.4 37.9 35.4 35.3HUF/USD (eop) 243.0 217.3 219.5 231.1HUF/EUR (eop) 315.0 280.7 280.0 271.6


Government debt 80.8 78.2 77.5 76.2 Domestic 38.9 40.8 39.5 38.7 External 41.9 37.3 38.0 34.4

Total external debt 130.9 130.0 128.6 130.0 in USD bn 182.9 172.1 174.4 185.4 Short-term (% of total) 18.5 16.8 17.7 17.7

General (YoY%)

Industrial production 5.8 0.2 3.2 5.4Unemployment 11.0 11.2 11.2 11.0

Financial Markets (eop) Current 3M 6M 12M

Policy rate (2-week depo) 6.00 5.25 4.75 4.50HUF/EUR 283.0 280.0 280.0 280.0HUF/USD 216.2 217.5 224.0 233.3 Source: NBH, Haver Analytics, DB Global Markets Research.



Israel A1(stable)/A+(stable)/A(stable) Moodys/S&P/Fitch

Economic Outlook: Growth is running a little below

trend but should accelerate from mid-2013 as global recovery takes hold. Inflation is well-anchored around the middle of the 1-3% target band.

Main Risks: Sentiment is weak and fiscal consolidation is looming. Growth could therefore disappoint (though there is room to cut policy rates if necessary). Geopolitical risks, especially tension with Iran, have the potential to hit investor confidence.

Strategy Recommendations: On a pullback to 3.85, go short USD/ILS again. Initial target 3.70, with a trailing 1% stop loss. Receive 5Y IRS at 2.65%, target 2.40% with a stop loss at 2.75%.

Macro View Growth has softened though not yet as much as sentiment indicators would have suggested. GDP growth decelerated 2.9% QoQ (saar) from 3.1% in the first half of the year. The composite State of the Economy index weakened further in October and is expanding at its weakest rate since the first half of 2009, when the economy was pulling out of the post-Lehman recession (chart). Sentiment indicators are consistent with further deceleration. The manufacturing PMI has been below 40 for the past three months. Business and consumer confidence (CBS surveys) strengthened in October but remain very weak.

Israel: economy decelerates

-5

0

5

10State of Economy index (3mma/3mma) GDP% annualized


Growth may therefore decelerate a little further in the next quarter or two. Fiscal consolidation will add to the drag on growth: we expect the government to pass a moderately restrictive budget, delivering fiscal consolidation of about 1% of GDP over the next two

years, following the election early next year. Growth should pick up gradually in the second half of next year, however, as global recovery takes hold, reaching 2.9% for the year as a whole.

Monetary policy is already accommodative but there is scope for further easing should growth disappoint. Policy rates have been cut by 125bps to 2.0% over the last year or so, bringing real rates to zero. Given the benign inflation outlook, however, there is scope to ease further if necessary (e.g. should domestic activity data disappoint further or external risks increase). Despite recent increases in excise duties and a 1 percentage point increase in the rate of VAT, the headline rate decelerated to 1.8% YoY in October and the “core” measure (excluding housing, fruit, and vegetables) is even lower at 1.3%. Inflation expectations are also well anchored around the mid-point of the Bank of Israel (BoI) 1-3% target range.

The deterioration in the external balance is likely to reverse over the next year. The current account balance has swung from a surplus of close to 5% of GDP in September 2010 to a modest deficit of just over 1% of GDP (annualized) over the first half of the year. This is partly a reflection of the more moderate slowdown in Israel relative to its trading partners. But it likely also reflects the surge in investment over the past year or two associated with, among other things, a new semiconductor plant. Exports should now start to benefit from this new capacity. The start of natural gas production from the Tamar field, slated to begin at some stage next year, will also help to cut the economy’s substantial energy import bill. We would therefore expect the current account deficit to peak at about 0.8% of GDP this year before strengthening gradually thereafter.

Policy continuity is likely following next month’s elections. According to the latest Haaretz-Dialog poll, Prime Minister Netanyahu’s Likud-Beiteinu is expected to win 39 seats in elections to be held on January 22. This would make it comfortably the largest party in the 120-member Knesset and enable it to lead a coalition alongside other religious-right leaning parties, which are expected to win an additional 30 seats. As such, we would expect little change in the overall direction of economic policies.

The economy has generally proven quite resilient to geopolitical risks though they will almost inevitably again have an impact on market sentiment at some stage this



year. Tensions with Hamas have subsided for now following the recent ceasefire but the risk of further hostilities remains significant. More worrisome from a market perspective would be an Israeli strike on Iranian nuclear facilities though our base case remains that the likelihood of this happening is low.

Robert Burgess, London, 44 207 547 1930

Investment Strategy

FX: While we remain constructive on the ILS medium-term, we also remain uncomfortable going long ILS at current levels, with the Israeli unit expensive on our financial fair-value metrics after having gained almost 5% vs the USD over the past 3 weeks (top performing EM currency). However, any pullback to 3.85 or above we would view as a good entry level to go short yet again. The constructive medium-term outlook for the shekel is primarily justified on our expectation for the C/A balance to swing back into surplus, but also on a belief that the BoI will maintain short-end real rates in positive territory, as well as some of the most attractive longer-term valuation across EM FX. On a pullback to 3.85, go short USD/ILS again. Initial target 3.70, with a trailing 1% stop loss. Ultimately we expect the move lower to extend to around 3.50.


Rates: The weak economic backdrop - GDP growth deceleration, weak survey data and soft inflation - means we attach some probability to the scenario of another 25bp rate cut in Q1 '13. Looking further out, however, we think that the BoI is close to the end of their rate cutting cycle. Although it is natural to switch attention to payers on expectations of future hikes, recent history suggests there might still be value in receiver positions. To get a sense of perspective on this we plotted the realised path of the front end of the curve (1y) together with what was being implied by the curve from each point forward (i.e. 3m1y, 6m1y, 1y1y and so on). In the case of Israel, we find that the forwards are always upward sloping, regardless of which cycle we are in. In other words, receiver positions typically perform well in periods of rate reductions and monetary policy stasis and payers generally tend to perform in periods of policy tightening (as shown by hiking cycle in Dec '10). We recommend receiving 5Y at 2.65, with a short term target of 2.40 and a stop at 2.75. This position has positive carry and roll of 10bps/3m.


Israel: Deutsche Bank Forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 243.7 237.3 255.2 278.7Population (mn) 7.8 7.9 8.0 8.2GDP per capita (USD) 31,390 30,031 31,726 34,032

Real GDP (YoY%) 4.6 3.3 2.9 3.6 Priv. consumption 3.8 3.1 3.0 3.6 Gov’t consumption 2.9 3.1 2.1 2.0 Gross capital formation 16.0 4.0 1.5 5.0 Exports 5.5 2.0 5.0 6.3 Imports 11.1 4.0 4.0 6.0

Prices, Money and Banking CPI (YoY%, eop) 2.2 2.1 2.3 2.3CPI (YoY %, pavg) 3.5 1.8 2.3 2.3Broad money (M2) 10.5 6.8 6.3 7.1

Fiscal Accounts (% of GDP) Budget balance (excl. credit) -3.3 -4.0 -3.5 -3.0 Revenue 27.4 27.1 27.4 27.6 Expenditure 30.7 31.1 30.9 30.6

Primary balance 0.0 -0.7 -0.2 0.2

External Accounts (USDbn) Exports 64.2 61.0 66.2 72.8Imports 72.0 72.4 77.5 83.6Trade balance -7.8 -11.4 -11.3 -10.9 % of GDP -3.2 -4.8 -4.4 -3.9

Current account balance 1.9 -2.0 -1.5 -0.7 % of GDP 0.8 -0.8 -0.6 -0.3

FDI (net) 8.3 4.5 4.0 4.0FX reserves (USD bn) 74.9 77.0 80.8 85.4ILS/USD (eop) 3.81 3.85 3.70 3.63ILS/EUR (eop) 4.94 5.20 4.44 4.17


Total external debt 42.6 42.8 39.8 36.4 in USD bn 103.9 101.5 101.5 101.5 Short-term (% total) 43.8 42.5 42.5 42.5

General (YoY%) Industrial production 2.5 4.0 3.5 4.3Unemployment 7.0 7.1 6.8 6.6


BoI Policy rate 2.00 2.00 2.00 2.25ILS/USD 3.83 3.83 3.79 3.71ILS/EUR 5.00 5.09 4.89 4.50 Source: BoI,CBS, Haver Analytics, DB Global Markets Research.



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

Economic Outlook: Poland is facing its worst growth

outlook in a decade with domestic demand under pressure and an increased reliance on a fragile external environment. But as the slowdown comes after 3 years of outperformance on growth and with contained medium-term vulnerabilities we maintain an overall constructive view on Poland.

Main Risks: The change to Poland’s debt rule, which introduces an average fx rate and removes liquid funds, risks undermining the credibility of the fiscal consolidation efforts, particularly as it does not change the preference for a strong year-end fx rate.

Strategy Recommendations: Long 3m EUR/PLN put with strike @ 3.99. Stay long PLN vs CZK. Neutral on rates for now. Underweight sovereign external debt.

Macro View The weakest growth outlook in a decade. Poland is facing its weakest growth outlook in a decade. The combination of much reduced public investment, an earlier run down in household savings, a soft labour market, a greater reliance on exports and a still-fragile external environment all point firmly to very weak growth momentum in 2013. The NBP easing cycle is expected to continue as inflation finally heads towards target but the support to growth will likely be fairly muted. Any fiscal policy response is constrained by an ongoing need to reduce the budget deficit which has remained large versus others in the region. But that said, vulnerabilities look reasonably contained with fiscal and external financing comfortable (particularly given pre-financing and the likely renewal of the FCL), a healthy banking sector and much more moderate exposure to fx mismatches versus Hungary and Romania. Moreover, the economy is slowing from multi-year outperformance versus the rest of the region.

The Q1-Q3 YTD outturn on GDP growth at 1.1% is significantly better than elsewhere in CEE but down by around two-thirds versus recent years. The Q3 reading of 0.4% QoQ (sa) was double that of Q2 but the focus has centred on the slump in the YoY rate to what is the lowest since Q2 2009 at 1.4% (nsa). The structure of GDP has rotated away from what was previously a domestic-led growth story to what is now entirely export led. This is however due to imports falling faster than exports rather than an improvement in exports. The weak export growth has been reflected in a very sharp slowdown in new orders and IP with the latest readings the worst since 2009. The sharp declines in H2 2012 should set up a more favourable base for 2013 but near-term data will continue to look poor.

A 2.2% reading is achievable for 2012 GDP growth but for 2013 our projected 1.6% is lower than the 2009 outturn and has significant downside risks. Our assumed improvement in exports may disappoint and the destocking cycle may continue longer than we expect. In addition, the starting point for 2013 growth will be weak. That said, at 1.6% Poland is still likely to be the fastest growing CEE economy in 2013 but with the margin of outperformance much reduced.

Poland: The Polish slowdown comes after three years

of significant outperformance on growth

-24 -20 -16 -12 -8 -4 0 4 8 12 16Greece

PortugalItaly

HungaryRomania

SpainIreland

DenmarkFinlandN.lands

UKCzechFrance

BelgiumAustria

GermanySwedenPoland

Real GDP growth (2009 -2012)

Source: Haver Analytics, DB Global Markets Research

Fiscal targets unlikely to be met. The government’s response to the economic slowdown has so far involved a moderate relaxation of the fiscal deficit targets and a multi-year, off-budget investment plan. The 2013 Budget Act is based on an optimistic GDP assumption of 2.2% and will mean either additional consolidation measures or, more likely, subsequent revision for a wider deficit.

Data on the general government balance are released once a year leaving little to go on for 2012 other than the latest estimates from the authorities for a 3.4% of GDP deficit (versus 5.0% in 2011). For 2013 the authorities target another 0.3pp narrowing in the deficit to 3.1% with the state budget projected at 2.1% of GDP or PLN35.6bn. Consolidation measures include a continuation of the freeze in personal income tax thresholds which raises the effective tax rate, an ongoing freeze on public sector wages, the continuation of a temporary spending rule which limits budgetary expenditures to CPI + 1pp, ongoing fiscal rules for local governments and the introduction of another stage in Poland’s European Emissions Trading System which is expected to bring in additional revenues. 2013 will also be the first year where the higher retirement age for men and women starts to be phased in.



Even if we assume an overshoot of the deficit target in 2013 the financing position looks comfortable. Around 20% of next year’s financing needs have already been covered and the PLN145bn Ministry of Finance estimate for the 2013 gross borrowing requirement is a fairly modest 8.6% of GDP and lower than in 2012 (PLN109.6bn is planned in domestic financing and PLN35.4bn in foreign financing).

Poland: A lower gross financing requirement in 2013

26.9

102.9

6.2

37.9

114.2

16.4

45.7

84.1

15.2

0

20

40

60

80

100

120

Net Borrowing Requirements

Repayment of domestic debt

Repayment of foreign debt

2011 (Total = PLN136.1bn)



PLN bn

Source: Ministry of Finance

Debt rule is relaxed. Poland’s efforts at continued fiscal consolidation despite a weaker growth dynamic are offset somewhat by the recent changes to the country’s Public Finance Act. The changes will be introduced on January 1st (and impact the 2012 debt data to be released in May) and will relax the debt thresholds for mandatory fiscal consolidation. Poland’s definition of public debt - which excludes the road bonds issued by BGK and based on an end of year exchange rate - will not change but should this break the 55% threshold new calculations will be made before triggering a VAT hike and other unspecified consolidation. Foreign currency denominated public debt will be recalculated using an average exchange rate and debt stock will be reduced by the “liquid funds” in the Ministry of Finance account which are to be used for financing the state budget in the following year.

The change to an average exchange rate would have cut the debt/GDP ratio by 1.6pp in 2011 and by a larger 2.6pp in 2008. For 2012 this would increase debt GDP by around 0.4pp with the average zloty rate currently 1.5% weaker than the eop rate versus EUR, and weaker by 3.5%, 2.3% and 6.8% versus the USD, CHF and JPY eop rates respectively (based on the debt data as of Q2 and fx rates through December 5th). The liquid funds balance is only available for 2012 and 2013 and stands at PLN3.2bn and PLN7.1bn respectively. This cuts 0.2% and 0.4% of GDP from the 2011 and 2012 debt stock and therefore offsets the impact a weaker average exchange on the 2012 data. As Poland’s existing public debt series using an eop exchange rate will continue to be published the preference for a stronger currency at year end will remain.

Moreover, the EC will continue to publish their wider definition of debt (56.3% at end 2011) leaving the benefits of the relaxed rule limited to the avoidance of a potential VAT hike.

Poland: An average rather than eop fx rate would

increase the debt/GDP ratio in 2012

53.9

54.2

35

40

45

50

55

60

65

2004 2005 2006 2007 2008 2009 2010 2011 Q2 12

Public debt on eop FX rates (as published)Public debt on pavg FX rates (calculated)Debt threshold (PFA)

% GDP

Source: Ministry of Finance, DB Global Markets Research

A narrower C/A deficit ahead. The weak domestic backdrop and ongoing fiscal consolidation effort is becoming increasing evident in the external position. The Q1-Q3 C/A deficit was almost one third smaller than in 2011 to stand at an annualized 3.1% of GDP versus the 2011 reading of 4.3%. Moreover, the September data reported the first monthly trade surplus since January 2005 and only the third since 1997. The YTD export level is just 4% smaller than imports which means a more sustained trade surplus is possible in Poland although not yet our base case given the weakness in end market demand. Nevertheless, we do not expect C/A deficits in excess of 4% of GDP to return in Poland in the next two years, particularly as investment spending (both public and private) is now more subdued and the earlier run down in private savings is unlikely to continue.

Poland: Non-resident inflows increased by EUR8bn

(2% of GDP) in 2012

40

60

80

100

120

140

160

180

200

Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12

Non-resident holdings (T-bills + T-bonds)

PLNbn

Source: Ministry of Finance

While a lower C/A deficit reduces Poland’s external financing needs we continue to have concerns on the



composition of deficit financing. Non-resident inflows into the local debt market totalled EUR8bn through the first 10 months of 2012 covering most of the EUR9bn C/A deficit and taking the share of the non-resident holdings to 35%. A sharp turnaround in risk sentiment leaves significant short-term vulnerabilities for Poland and would be very quickly evident in the currency. The broader financing position nevertheless remains comfortable due to continued EU inflows and FDI. In addition, the likely announcement of an extension of Poland’s USD30bn FCL also provides a significant external buffer.

Inflation should finally hit the target in early 2013. The sharp drop in activity data secured two 25bps rate cuts in November and December despite inflation remaining significantly above the 2.5% target. The easing cycle will undoubtedly continue through 2013 but with the depth more dependent on the slowdown in inflation rather than growth. The combination of much weaker domestic demand, a drop back in commodity prices, a stable / appreciating zloty and very favourable base effects in the coming months suggests inflation will start to look much better in 2013 and we expect the target will be met in Q1. Domestic utility prices should also help the inflation outlook with Poland’s largest gas company, PGNiG, submitting a request to the regulator for a 10% cut in household prices from January 1st and a 3% cut for industry. The cut has yet to be confirmed but assuming this is implemented it will cut 0.2pp from CPI given the 2.6% weight of gas in Poland’s CPI basket. The possible absence of an electricity price hike in early 2013 would also lower CPI by another 0.2-0.3pp versus our baseline. PPI is already down sharply with the latest 1.0% YoY reading the lowest since April 2010. In addition, the input price component of the PMI has dropped back while both industry price selling expectations and 12-month-ahead consumer price trends are finally moving lower.

Poland: Both industry and consumer price

expectations are moving lower

-10-505101520253035

0

10

20

30

40

50

60

Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12

12-month-ahead consumer price trends

Industry selling price expectations (rhs)


We now see a 3.25% floor in the policy rate. The recent MPC statements provide little guidance on the likely

extent of the easing cycle noting only that rate cuts will continue if the incoming data confirm a “protracted” slowdown and should the risk of “increase in inflationary pressure remain limited”. Governor Belka has made it clear that another cut will come in January but ruled out a front-loaded easing cycle saying that the situation is not critical. The preference for positive real rates has been repeated stressed during past months and suggests that the policy rate will follow inflation lower.

Poland: MPC want to keep real rates positive

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Nov-04 Nov-06 Nov-08 Nov-10 Nov-12

% Avg real rate since permanent IT introduced in Jan 2004Ex-ante real rates

Ex-post real rates

Source: Haver Analytics, DB Global markets Research

The most recent MPC voting split is from the October meeting. Governor Belka was out outvoted at this meeting in a 5-4 split with mega doves Bratkowski and Chojna-Duch voting for a cut for a third consecutive month and Zielinkska-Glebocka joining them. MPC members such as Gilowska, Kazmierczak, Winiecki, Rzonca and Glapinski are traditionally hawkish but as CPI could well drop below target we no longer expect they will stand in the way of continued rate cuts.

Poland: A divided MPC Dec-12 Nov-12 Oct-12 Sep-12 Jul-12 May-12 Apr-12 Feb-12 Jan-12

Policy ra te (%) 4.25 4.50 4.75* 4.75* 4.75* 4.75 4.50 4.50 4.50

Marek Belka -25 H H +25 H H H

Andrzej Bratkowski -50 -50 -50 H H H H

Elżbieta Chojna-Duch -50 -50 -25 H H H H

Zyta Gilowska - - - +25 +25 H H

Adam Glapiński H H H +25 +25 H H

Jerzy Hausner H H H +25 H H H

Andrzej Kaźmierczak H H H +25 +25 H H

Andrzej Rzońca H H H +25 H H H

Jan Winiecki H - H +25 H H H

Anna Zielińska-Głębocka -25 H H +25 H H H

Source: NBP *Bratkowski and Chojna-Duch voted for 25bps as well as 50bps cuts

Three more 25bps rate cuts would take the policy rate to the post-Lehman low of 3.5% and could be reached as soon as Q2. We do not see this as a floor for the policy rate and revise our call for another 100bps in cuts in 2013 to take the policy rate to 3.25%. Risks are skewed towards great easing.

Caroline Grady, London, +44 207 545 9913



Investment Strategy

FX Strategy: The NBP has turned decidedly more dovish over the past month, having revised down GDP forecasts more than anticipated and with the CPI projection largely in line with the target over the policy horizon. However, we stick to the view that for PLN this will have very limited implications. This view is partly based on that the rates market is already priced for an aggressive 100-125bp of further rate cuts over the next 12 months, not necessarily consistent with an economy with no output gap and a central bank which continues to be focused on the real rates development. Moreover, correlation patterns show that PLN is currently disconnected with relative rate spreads and is driven largely by risk sentiment (S&P 500). Position for downside in EUR/PLN over the next 3-6 months (3m EUR/PLN put, with a strike 3.99 costs an indicative 0.20% of notional, spot ref: 4.12). Also, stay long PLN vs CZK, with the next target 6.30, and with the stop @ 5.95.


Rates Strategy: Despite the deteriorating economic picture (DB Economics now expecting a floor in policy rates of 3.25%, we do not find POLGBs an attractive investment option. Why? Firstly, we think the level of yield (both FX hedged and unhedged) are not particularly attractive relative to EM peers and vs PLN's external, fiscal and financial vulnerabilities. Moreover, our research indicates that non-residents are not under-positioned in PLN debt either - non-residents currently own around 35% of POLGBs and slightly over 20% of the total local debt market (in line with EMEA average). Finally, we note that most of the liquid bonds on the POLGB curve are negative carry. Given that we think the swap curve fairly reflects the balance of risks in monetary (curve priced for roughly 120bps of cuts over next year), we prefer to stay sidelined in the swaps space for now.


Credit: Underweight. Being overweight Poland was one of our key recommendations during the first half of 2012; we saw it as the best way to capitalise on the unwinding of contagion from the eurozone sovereign crisis. With that contagion now fully unwound, our focus shifts to country-specifics fundamentals. The deteriorating growth outlook and likely shortfall on the fiscal balance paint a very different picture from a year ago. Our model of fundamentals-driven credit quality suggests that among the high grade EM sovereigns, Poland’s credit quality is likely to deteriorate more than most in 2013. We recommend an underweight exposure.


Poland: Deutsche Bank Forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 514.9 497.7 547.3 536.1Population (mn) 37.9 37.6 37.6 37.5GDP per capita (USD) 13569 13223 14573 14308

Real GDP (YoY%) Priv. consumption 4.3 2.2 1.6 2.3 Govt consumption 2.6 1.2 0.6 2.2 Gross capital formation -1.7 0.5 1.0 1.2 Exports 8.6 4.0 1.5 4.0 Imports 7.8 3.6 8.0 9.2

Prices, Money and Banking

CPI (YoY%, eop) 4.6 2.9 2.5 2.5CPI (YoY%, pavg) 4.3 3.8 2.6 2.3Broad money (M2) 12.5 10.0 8.4 9.6

Fiscal Accounts (% of GDP) ESA 95 budget balance -5.1 -3.6 -3.5 -2.9 Revenue 38.5 39.5 39.0 39.8 Expenditure 43.6 43.1 42.5 42.7


External Accounts (USD bn)

Exports 193.9 185.0 202.4 202.1Imports 208.0 196.5 213.0 215.6Trade balance -14.1 -11.5 -10.6 -13.5 % of GDP -2.7 -2.3 -1.9 -2.5

Current account balance -22.1 -17.1 -16.6 -20.0 % of GDP -4.3 -3.4 -3.0 -3.7

FDI (net) 9.1 3.9 5.8 5.6FX reserves (USD bn) 86.8 92.2 87.9 86.0PLN/USD (eop) 3.44 3.04 3.18 3.30PLN/EUR (eop) 4.46 4.10 3.82 3.80


Government debt 53.5 54.2 53.6 53.4 Domestic 36.5 36.7 36.4 36.1 External 16.9 17.5 17.2 17.3

Total external debt 62.5 70.6 68.3 73.6 in USD bn 321.9 351.5 373.6 394.8 Short-term (% of total) 25.4 24.9 24.8 25.0

General (YoY%)

Industrial production 7.0 2.8 2.3 4.7Unemployment 12.4 12.3 12.0 11.8


Policy rate (14 day repo) 4.25 3.50 3.50 3.25PLN/EUR 4.12 4.03 3.96 3.82PLN/USD 3.15 2.99 3.05 3.18 Source: Haver Analytics, NBP, DB Global Markets Research.



Romania Baa3(neg)/BB+(stable)/BBB-(stable) Moodys/S&P/Fitch

Economic Outlook: A fragile but improving growth

outlook is secured by fiscal and external buffers and a well capitalized banking system. The authorities are likely to sign another precautionary IMF/EC deal to ensure the structural reform effort continues.

Main Risks: Politics will remain a significant risk as President Basescu and PM Ponta struggle to cooperate and another impeachment attempt is likely.

Strategy Recommendations: Expect a gradual drift lower in EUR/RON, target 4.35 (stop 4.5850). Overweight sovereign credit.

Macro View A better macro performance and a potential rating upgrade. 2013 should prove to be a better year for Romania. Political noise should be much reduced after three governments, an impeachment referendum against the President and a general election in 2012, while the difficult base effects of the past few quarters now turn more favourable paving the way for better macro data. We expect the authorities will also secure another IMF/EU precautionary SBA which should help to achieve continued progress on structural reform and bring Romania on to a higher growth trajectory. We expect S&P will finally join Moody’s and Fitch and bring Romania back to investment grade in the year ahead. The biggest risk is still politics however with President Basescu’s term not due to expire until 2014 and a poor track record on relations between the President and PM.

The 2012 growth outturn disappointed versus our expectations going in to the year. In our 2012 EM Outlook publication we projected 1.9% of GDP but instead only 0.8% now looks likely to have been achieved. This is a poor outturn considering the statistical carry-over from 2011 growth was 0.5pp. A significantly worse backdrop in Europe versus our earlier expectations combined with a much better outturn in 2011 were the main reasons for the disappointing performance, although protracted political noise that diverted attention away from policymaking and a drought impacting the fairly large agriculture sector also had an important impact. The 1% of GDP reduction in foreign bank exposure to Romania in each of the past four quarters combined with a very sharp slowdown in net new lending also suggests deleveraging has been a constraint on growth through 2012.

The Q3 GDP reading of -0.5% QoQ was the worst in Europe barring Portugal (-0.8% QoQ) and the Netherlands

(-1.1%) and much worse than seen elsewhere in CEE. Romania’s much larger agriculture sector (around 6% of GDP) was undoubtedly a factor but dismal activity in construction and the manufacturing sector have also taken their toll. Similar to elsewhere in the region new export orders have slumped in Romania with the Q1-Q3 average growth at -2.6% YoY, compared with +20.3% during the same period a year earlier, and IP growth has also collapsed in tandem. The combination of a slightly better dynamic in Western Europe in 2013 and simply a more favourable base effect should mean YoY comparisons improve in 2013 but any return to 2011-style growth rates is however unlikely.

Romania: Q3 GDP was one of the worst in Europe

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

LV EE LT FR BG HU IT CZ ES RO PT NL

Flash Q3 GDP

Bloomberg consensus

% QoQ

Source: Haver Analytics, Bloomberg Finance LP

Better dynamics in the labour market should also help Romania in the year ahead. Two public sector wage hikes in 2012 completed the reversal of the 25% wage cut in 2010 while allowing the authorities to maintain their commitment to the IMF to keep the wage bill below 6.7% of GDP. Private sector employment growth is positive, albeit negated somewhat by a low participation rate, and the new Labour Code in place since May 2011 should continue to promote job creation during the coming years via the measures to improve labour market flexibility and reduce the informal work force.

Despite some improvement in the domestic demand dynamic with deleveraging set to continue, and real incomes under pressure from the move back up in inflation, we expect net trade will continue to be the main driver of growth through the coming quarters. After a downwardly revised 0.8% projection for 2012 GDP growth we expect 2.5% growth in 2013 and a still-subdued 3.5% in 2014. This should nevertheless take Romania back to its pre-crisis level of output.



Another successor IMF/EU deal likely. The outlook for a very modest recovery in growth with ongoing downside risks from the external environment has prompted the authorities to indicate preference for a third successive stand-by arrangement in 2013. Romania has a “good” track record under the current (precautionary) program according to the IMF with performance criteria fully met in each review with the exception of arrears. The most recent Article IV notes that another IMF program would depend on the overall track record on the current program as well as the external environment. This reflects comments made by President Basescu’s office following the IMF/EC visit in early November that Romania had been advised that several structural reforms are lagging behind and that existing commitments must be met before any successor agreement could be signed. This very likely refers to the limited progress on privatization with the targeted dates for the privatization of Hidroelectrica and Romgaz pushed out and the progress on the sale of Oltchim and Transgaz also fairly poor.

Romania: History of IMF lending arrangements*

FacilityDate of Arrangement

Date of Expiration / Cancellation

Amount Agreed

Amount Drawn

Amount Outstanding

SBA Mar 31, 2011 Mar 30, 2013 3.7 0.0 0.0SBA May 04, 2009 Mar 30, 2011 13.6 12.5 11.9SBA Jul 07, 2004 Jul 06, 2006 0.3 0.0 0.0SBA Oct 31, 2001 Oct 15, 2003 0.4 0.4 0.0SBA Aug 05, 1999 Feb 28, 2001 0.5 0.2 0.0SBA Apr 22, 1997 May 21, 1998 0.4 0.1 0.0SBA May 11, 1994 Apr 22, 1997 0.4 0.1 0.0SBA May 29, 1992 Mar 28, 1993 0.4 0.3 0.0SBA Apr 11, 1991 Apr 10, 1992 0.5 0.4 0.0

EURbn

Source: IMF *table here shows only IMF lending, the 2009 package totalled EUR20bn with contributions from the EC and WB.

We expect the quantitative and structural targets under a new program are likely to be similar to those currently in place. Structural benchmarks would likely include further liberalization of energy prices, moving ahead with the currently slow privatization effort (including secondary public offerings), health sector reform and measures to improve the absorption of EU funds and the investment climate more generally. The quantitative performance criteria would most likely again include targets on the fiscal deficit, net foreign assets and arrears. In the situation where Romania does not agree a new program the country will move on to post-program monitoring which would entail six monthly reviews. It should not raise any concerns regarding financing as the current program was never drawn on and we do not project any financing shortfall for 2013. It may however bring in to question the government’s commitment to continued structural reform.

The best fiscal effort in Europe after Greece. Romania’s commitment to achieving a sustainable fiscal position has been impressive in the past several years. The cash based

deficit looks on track to achieve a 2.2% of GDP deficit in 2012 and sub 3% on an ESA95 basis. This will leave Romania with the second largest fiscal adjustment in the EU27 after Greece in the past three years with a significant part of this coming via a lower wage and pension bill. The target for the 2013 cash deficit is for a further reduction to -1.8% of GDP and a structural adjustment of 0.5% of GDP in 2013 and 2014 to achieve the medium-term objective of a structural fiscal deficit of 0.7% of GDP.

Romania: A 7.7pp reduction in the cyclically adjusted

fiscal balance in the past 3 years is the best in Europe

after Greece

7.7

-4

-2

0

2

4

6

8

10

12

14

EL RO LV PT IE LT UK

SP BG

PO CZ

SKEU

-27

FR SV BE IT NE

CY

HU

MT

DE

AU FI ES LU DK

SW

Change in Cyclically Adjusted Balance (2009-12, % of GDP)


Numerous structural reforms including a Fiscal Responsibility Law, Local Public Finance Law, Unitary Pay Law, Pension Reform Bill and a new Labour Code have all been implemented during the past year or two but several important reforms still remain. Achieving a financially viable health care system is a priority for 2013 as is strengthening of tax collection, reducing arrears, restructuring SOEs, reform of the energy and transport sectors and moving ahead with privatization. Implementing these reforms should ensure the good track record on fiscal consolidation is sustained and would help to bring Romania on to a higher growth path.

A relatively comfortable external position. Similar to elsewhere in CEE the combination of very weak domestic demand meant an improvement in the C/A position through 2012 with the Q1-Q3 deficit around 1/4th smaller than a year earlier. Romania has however fared worse than others with exports (-0.5% YoY YTD) slumping more sharply than imports (0.1% YoY) with the result that the trade deficit has actually widened slightly. The improved C/A position is therefore a result of a lower income deficit and a modest improvement in the services and transfers surplus which is partly related to effort to improve absorption of EU funds.



While export growth should improve modestly in 2013 we do not expect that Romania will achieve much below a 4% C/A deficit in the coming years. The push to absorb EU funds before the 2007-2013 budget allocation ends suggests public investment spending should increase while private sector investment should benefit from a better domestic and external environment. The financing of a ~4% C/A deficit should be relatively comfortable with FDI (a large part of which is inter-company loans) accounting for about 40% coverage while EU inflows and banking / corporate loans making up the remainder.

Romania: Gross external financing needs should drop

slightly in 2013 EURbn 2006 2007 2008 2009 2010 2011 2012F 2013F

Gros s Financ ing Req. 21.7 36.0 45.1 39.2 31.9 37.0 39.4 38.8

C/A (deficit = positive) 10.2 17.0 16.2 4.9 5.5 5.9 5.4 6.2

Amortisation (MLT) 5.3 6.5 8.5 13.1 12.3 14.7 15.1 15.3

Amortisation (ST) 6.3 12.5 20.5 21.3 14.1 16.4 18.9 17.4

Financ ing 21.7 36.0 45.1 39.2 31.9 37.0 39.4 38.8

Non-debt creating 8.7 8.1 9.9 4.2 2.5 2.6 4.2 5.0

FDI (net) 8.7 7.3 9.3 3.6 2.2 1.8 2.2 2.5

EU capital inflows 0.0 0.8 0.6 0.6 0.2 0.7 2.0 2.5

Debt creating 18.8 32.3 36.8 37.1 33.1 34.9 33.8 31.8

Sovereign Eurobonds 0.8 1.0 1.5 4.0 4.0

Multilateral financing 10.9 6.2 2.1

Banks + corporates 18.8 32.3 36.1 26.3 26.0 31.4 29.8 27.8

Errors & omissions -0.6 0.2 -1.7 -1.0 -0.2 0.4 0.9 0.0

Reserves (+ = decrease) -5.2 -4.5 0.0 -1.1 -3.5 -0.9 0.6 2.0

Gros s Financ ing Req.

% of GDP 22.2 28.9 32.3 33.2 25.7 27.1 28.7 25.3Source: Bloomberg Finance LP, NBR, DB Global Markets Research

In terms of the overall external financing position our table above shows a slight drop back in the financing need in 2013 in line with the lower short-term debt rollover. Sovereign redemptions on the 2009 IMF/EC/WB loan nevertheless step up sharply (a total of EUR4.8bn due to the IMF in 2013 versus EUR1.5bn in 2012) and we assume that around EUR2bn of this will be covered directly out of reserves. The EUR4bn in Eurobond issuance seen in 2012 could well be repeated to smooth a later repayment spike despite no sovereign Eurobond redemptions in 2013 and only EUR1bn due from the Ministry of Finance to the IMF.

NBR stands ready to hike rates. A difficult inflation outlook combined with the desire to avoid the 2012 currency weakness will determine the monetary policy stance during the coming quarters. The NBR have indicated they will raise rates if pressure on the currency remains and Governor Isarescu has made it clear that managing liquidity is the Bank’s preferred method of controlling the currency for now. Any reduction in the still-high reserve requirements on leu and fx-denominate liabilities is off the table.

The NBR’s task of balancing the need for a tighter monetary stance with the still-fragile growth outlook is made more difficult in 2013 by a drop in the inflation target to 2.5% +/-1pp, from 3.0% +/-1pp in 2012. The 2012 target is out of reach due to a combination of a spike in food prices, a hike in electricity and gas prices and the earlier currency weakness. We expect the inflation dynamic will however improve through 2013 particularly with the end 2013 base effects now more favourable. Our expectation for modest leu appreciation in 2013 (due to a continuation of the RON4-6bn limit on 1-week repo operations) will also help keep a lid on price growth. With a gradual improvement in inflation we expect rates to remain on hold at 5.25% through the foreseeable quarters with the concerns over growth outweighing the concerns over inflation.

Romania: NBR projections are that the 2013 inflation

target will only just be met

Q3-12 Q4-12 Q1-13 Q2-13 Q3-13 Q4-13 Q1-14 Q2-14Target 3.0 2.5

Forecast 5.3 5.1 5.1 5.6 3.9 3.5 3.1 3.2

NBR baseline inflation projections (% YoY)

Source: NBR

First Deputy Governor Georgescu expected to return to the NBR Board in 2013. The current NBR Board were (re)appointed to the job in October 2009 and with the 5-year term running until 2014 no changes in personnel are expected for 2013.The one exception is the return of 1st Deputy Governor Georgescu whose term was temporarily suspended in 2012 so he could act as Ministry of Finance until the December election. It is hard to know whether this will make much difference though with voting records not made available and no discussion of voting preferences in the press.

Romania: Deputy Governor Georgescu will return to

the NBR Board in 2013 Members of the NBR Board (2009-2014) Term number

Governor Mugur Isarescu 4th term

1st Deputy Governor Florin Georgescu* 2nd term

Deputy Governor Bogdan Olteanu 1st term

Deputy Governor Cristian Popa 3rd term

Member Marin Dinu 1st term

Member Nicolae Danila 1st term

Member Virgiliu Stoenescu 2nd term

Member Agnes Nagy 3rd term

Member Napoleon Pop 2nd termSource: NBR, DB Global Markets Research

Domestic politics to remain the biggest risk in 2013. The heightened political tensions through much of 2012 should not be as protracted in 2013 but will likely not disappear completely. We do not rule out another



impeachment attempt against President Basescu or continued bickering between PM Ponta and Basescu. But with the dent in USL popularity after the unsuccessful impeachment attempt in July the government may be more cautious second time around. Nevertheless, political noise risks diverting attention away from policymaking and potentially jeopardising any successor IMF program.


Investment Strategy

FX: NBR reserves have remained largely stable in recent months as the NBR has primarily focused on limiting repo operations as a tool for currency adjustment. Given that refinancing requirements to a large extent will fall on the NBR over the course of the next 12 months, verbal rather than actual intervention, liquidity management and stable [rather than higher] rates are likely to be the Bank’s main tools in stabilizing inflation expectations, which have crept up slowly in recent months in line with higher core inflation. The bottom line, the NBR’s tolerance for FX weakness has diminished and in an overall stable risk environment this is likely to result in a gradual drift lower in EUR/RON. Maintain the target from the EM Monthly on Nov 8th @ 4.35 over the next couple of months, with a stop @ 4.5850.


Credit: Overweight. Romania was a strong performer in 2012, but without the political distractions it could have been even stronger. With these distractions likely to recede in 2013 we expect the focus to return to the relatively healthy fundamentals and that this will foster ongoing outperformance in spread terms.

We do not include Romania in our market-implied credit quality model, but we can nevertheless input its fundamental variables into the model to see what level of credit quality they imply. We find that Romania’s combination of CPI, FX reserves, public sector external debt and ‘government effectiveness’ (as reported by the World Bank) point to a credit quality score of 9.4 – i.e. between BBB and BBB- on the rating agencies’ scale. In contrast, the market-implied credit quality is 12.1 (BB). If Romania were to converge just half-way towards its fundamentals-implied level it would imply a 70bp tightening. We recommend an overweight exposure.


Romania: Deutsche Bank Forecasts 2011 2012F 2013F 2014F

National Income Nominal GDP (USD bn) 190.1 177.5 194.5 199.1Population (mn) 21.4 21.4 21.3 21.3GDP per capita (USD) 8877 8304 9114 9350

Real GDP (%) 2.5 0.8 2.5 3.5Priv. consumption 1.0 1.8 3.5 4.0Govt consumption -3.4 2.1 3.5 4.7Investment 6.2 4.0 6.8 7.5Exports 10.5 2.5 7.0 8.5Imports 11.5 1.9 8.5 10.3

Prices, Money and Banking CPI (YoY%) eop 3.1 4.9 3.8 3.8CPI (YoY%) pavg 5.8 3.4 4.6 3.9Broad money (M2) 6.2 5.9 8.0 7.6

Fiscal Accounts (% of GDP) General budget balance -5.5 -2.8 -2.5 -2.0 Revenue 32.3 33.3 33.5 33.8 Spending 37.8 36.1 36.0 35.8


External Accounts (USDbn) Exports 63.0 59.7 63.7 64.9Imports 73.4 68.9 74.5 75.8Trade balance -10.3 -9.2 -10.7 -10.9% of GDP -5.4 -5.2 -5.5 -5.5


FDI (net) 2.6 2.8 3.1 3.5FX reserves (USDbn) 42.3 42.3 41.3 42.8RON/USD (eop) 3.34 3.32 3.50 3.65RON/EUR (eop) 4.32 4.48 4.20 4.20


Total external debt 72.3 82.6 79.1 81.8in USD bn 137.5 146.6 153.8 162.8

General (% pavg) Industrial production (% YoY) 6.3 1.3 3.0 4.1Unemployment 5.1 4.9 4.8 4.6

Financial Markets (end Current 3M 6M 12MNBR policy rate (%) 5.25 5.25 5.25 5.25RON/EUR 4.53 4.41 4.34 4.20RON/USD 3.46 3.37 3.39 3.50

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(stable) Moody’s/S&P/Fitch

Outlook: Growth slowed down in 2012, but set to

rebound in 2013 driven by investments.

Main risks: Persistent capital outflows, extreme tightening of the monetary conditions and a drop in oil prices remain key risks.

Strategy recommendations: Target 34.10 in the dual basket, stop revised to 35.35 (35.90). Long Apr 21, target 6.50%. Neutral sovereign credit.

Macro outlook

Despite the lingering uncertainties in global financial markets, we believe Russia’s economy may show some improvement in the macroeconomic sphere. In particular, we see growth staying broadly stable compared with 2012, with consumption being supported by higher growth in fixed investments. In the monetary policy sphere, the expected reduction in inflationary pressures may prompt the CBR to ease its monetary policy stance somewhat. In the fiscal sphere, the new budget rule, which enters into force from the next year, will serve to contain the growth in outlays. Finally, on the structural reform front, the lack of momentum could persist, as pension reform and other measures are delayed until after 2013.

Growth: investment to continue to lead the way Russia’s growth decelerated in 2012, but was broadly in line with the growth performance exhibited in 2010-2011, when it averaged around 4%. The relatively stable growth performance stood out against the backdrop of high capital outflows, which undermined the growth in fixed investments and, to a large degree, neutralized the positive effects on growth from high oil prices. Notwithstanding the large-scale capital outflows in 2012, the growth in fixed investments was still relatively high, at more than 9% in January-October 2012. At the same time, consumption in H2 2012 started to decelerate, which was likely due, in part, to the sharp acceleration in inflation following regulated tariff increases in mid-2012.

We expect the investment-led pattern of growth to persist in 2013, with consumption growth likely to gravitate to the 5-6% range. The key factors underpinning our positive outlook on fixed investment growth in 2013 include the following.

�Higher share of fiscal outlays being reallocated from current/social outlays towards infrastructure – given that Russia completed the electoral cycle in 2012, the pressure to spend more in the social sphere is likely to moderate.

�Large-scale infrastructure projects: 2013 Universiade in Kazan, 2014 Sochi Olympics and 2018 World Cup.

�Moderation in capital outflows: we expect net capital outflows to moderate to USD20bn, compared with nearly USD70bn expected in 2012 – one of the key drivers for the improvement in capital flows is the moderation in the volatility of global financial markets, as developed economies stabilize their growth paths.

�Construction likely to continue to recover from a very low base – housing construction is likely to accelerate in key regions, including Moscow city’s new area.

�We expect inflation to moderate, which should lead the CBR to ease its monetary policy stance, resulting in lower rates and greater scope for investment growth.

Russia’s investment-consumption growth of GDP

-15

-10

-5

0

5

10

15

-30

-20

-10

0

10

20

301Q

2003

2Q20

033Q

2003

4Q20

031Q

2004

2Q20

043Q

2004

4Q20

041Q

2005

2Q20

053Q

2005

4Q20

051Q

2006

2Q20

063Q

2006

4Q20

061Q

2007

2Q20

073Q

2007

4Q20

071Q

2008

2Q20

083Q

2008

4Q20

081Q

2009

2Q20

093Q

2009

4Q20

091Q

2010

2Q20

103Q

2010

4Q20

101Q

2011

2Q20

113Q

2011

4Q20

111Q

2012

2Q20

12

Priv. consumption Investment GDP

Source: Ministry of Finance, Deutsche Bank

In terms of other sources of growth, household consumption is likely to face headwinds, given the CBR’s efforts to effect a slowdown in the growth in consumer lending. The likely slowdown in fiscal outlays in the social sphere after the 2012 elections may result in lower growth in real disposable income and reduced momentum in consumption growth. Among the factors that we see as supporting consumption next year are low unemployment of 5-6% and a decline in inflation. Net exports are likely to be less supportive, as the current account surplus is likely to contract on the back of the rise in imports. Government spending is also less likely to be the main engine of growth, as the government recalibrates its policy after the electoral cycle, although if there is indeed a greater investment/infrastructure component in total state spending, this would generally render fiscal policy more growth-oriented.

Fiscal policy: challenging year ahead Russia’s 2012 federal budget posted a RUR80.2bn surplus (1.4% GDP) in October, putting the YTD surplus at RUR1.01tr, or 1.4% of GDP. Overall this year, the normal



budget cyclicality has been shifted towards the spring, due to the fiscal layout being based on the pre-election promises, implying more uniform spending throughout the year. In 2012, vs. 2011, the thrust of government spending was in social spending, defense and infrastructure. Despite this, the budget managed to approach November with 25% unutilized expenditure, vs. almost 30% in 10M11, implying less fiscal stimulus by the end of the year.

On the revenue side, on a ytd basis, the budget managed to perform relatively well due to slightly higher oil prices (+3% to Brent) and the substantial depreciation of the rouble (+7.3% to RUB/USD). Subsequently, the government revisited the budget assumptions on average Urals and the rouble, adjusting them from USD115/bbl and RUR/USD29.2, respectively, to USD109/bbl and RUR/USD 31.2, resulting in a projected budget deficit at 0.07% of GDP. On the back of higher oil prices, we expect the budget to balance at 0.1% of GDP this year.

In 2013-2015 as in 2012, the emphasis for budget spending will be on social outlays, national defense and national security, while spending on education and health care will decline. Special attention will be given to supporting the industries that are vulnerable to the WTO accession. On the privatization front the fiscal authorities expect to receive RUB427.7bn, RUB330.8bn and RUR591.5bn in 2013, 2014 and 2015, respectively. Overall, we believe that, given our positive long-term oil price outlook, the federal budget will be broadly balanced in 2013-2015, with the surplus increasing marginally from 2016.

Russia: Federal budget parameters Govt forecast DB forecast

2012 2013 2014 2012 2013 2014

Inflation, eop %yoy 7.0 5.5 5.0 7.0 6.4 5.9 Urals oil price, USD/bbl 109.0 97.0 101.0 111.4 111.5 107.0 Budget rule, USD/bbl - 91.0 92.0 - - - RUR/USD, pavg 31.2 32.4 33.0 31.1 30.5 30.7 Revenues, % GDP 21.31 19.30 19.00 21.20 20.40 19.40 Expenditures, % GDP 21.39 20.10 19.20 21.10 20.40 19.20 Fiscal Balance, % GDP -0.07 -0.80 -0.20 0.10 0.00 0.20 Source: Ministry of Finance, Economic Expert Group, Deutsche Bank

Starting from 2013 the government is introducing a new budget rule, which will serve to contain the growth in outlays during periods of high oil prices. According to the Cabinet, in accordance with the rule the budget is based on an oil price rule that assigns oil revenues to the budget at an average oil price over the last five years (currently, it stands at USD97/bbl). The budget rule will then include increasingly more years, reaching a 10-year moving average by 2018. The amount of expenditure is limited to the amount of revenue based on the budget rule +1%; the rest will be directed to the Reserve fund. When the Fund reaches 7% of GDP, the remaining amount will be

directed to the National Wellbeing fund and to infrastructure spending on a 50:50 basis. As a result, the fiscal authorities expect budget revenues to be at 19.3% and expenditures at 20.1% of GDP. The budget deficit is projected at 0.8% of GDP, while the non-oil budget deficit should decrease to 9.7% of GDP, from 10.5% of GDP in 2012. For 2014 and 2015, the non-oil deficit is expected to decrease further, to 8.7% of GDP and 8.4% of GDP, respectively.

Monetary policy: inflation targeting underway Russia’s monetary sphere continued to advance from low levels of inflation in H1 2012, due to tariff freezes, reaching the record low level of 3.6% in spring, although it surged to 6.6% in September. In part, recent developments in the monetary sphere were attributed to the transmission of the Central Bank of Russia (CBR) target from the exchange rate to inflation. In July, the CBR continued widening the policy band for the dual currency basket from 6 rubles to 7 rubles, and lowered regulatory amount of accumulated reserves needed to that shift the range by 5 kopeks from USD500m to USD450m.

Russia: exchange rate policy

-2 500

-2 000

-1 500

-1 000

-500

0

500

30

32

34

36

38

40

42


RU

R/B

AS

KE

T

US

Db

n

RUR/BASK rate Band Range CBR interventions on the domestic FX market, USDmn (RHS)

Source: Bloomberg Finance L.P., CBR, Deutsche Bank

On the policy front in 2012, the CBR continued to forge ahead with widening the exchange rate band – in particular in July, the CBR continued to widen the policy band for the dual currency basket, from 6 rubles to 7 rubles, and lowered the regulatory amount of accumulated reserves needed to shift the range by 5 kopeks, from USD500m to USD450m.Along with changes on the exchange rate front, the CBR continued to enhance its refinancing tools: in April, the CBR introduced a one-week auction depo rate, at 4.75%, while one-month depo auctions have been suspended; in June, the CBR cut the FX swap rate to 6.5%, while, in September, the monetary authorities lifted the key interest rates by 25bps in order to lower inflationary pressures in the economy.

As for the policy outlook for 2013-2015, the main target for the CBR is to effect a transition to a free-floating exchange rate by 2015, which should gradually widen the exchange rate band on the one hand; on the other hand, the monetary authorities have set consumer price growth as the main objective for monetary policy. The target



ranges for inflation in 2013-2015 are set at 5-6% in 2013 and 4-5% in 2014-2015.

The monetary authorities are also going to enhance the refinancing tools for better liquidity regulation, with the aim of the CBR being the tightening of the policy rate band. Recently, CBR officials have declared that the CBR aims to change the liquidity provision policy mechanism by substituting the fixed rates of repos, FX swaps, loans secured by non-marketable assets and guarantees with terms of more than one month to the floating rates (RUONIA+ some margin). Overall, we believe the commitment of the CBR is to transmit its monetary policy to lowering inflation rather than targeting the rouble.

On the economic outlook, the CBR has prepared three scenarios for economic development, based on three oil price trajectories: USD73-78/bbl, USD97-104/bbl, USD121-130/bbl. According to these scenarios, M2 growth may reach 9-18% in 2013. Capital outflows are expected to reach USD35bn and USD10bn in the first two scenarios, respectively, while, in the third scenario, the flows are to be balanced. Our own projections are closer to the upper estimates of the authorities in view of our relatively more optimistic outlook on oil prices and capital inflows.

We expect the rouble nominal rate versus the dollar to reach RUR/USD30.6, given Deutsche Bank’s high oil price forecast (USD111/bbl) as well as the possibility of net capital inflows on the back of euroclearability of Russia’s financial instruments as well as the amelioration of the global economic scene. On the inflation front, we see inflation subsiding from levels of almost 7.0% by the end of 2012 to 6.4% in 2013, on the back of a slowdown in money supply, credit growth and lower volatility in the rouble exchange rate. Accordingly, we believe that there may be scope for a moderate reduction in rates next year, though it is unlikely to progress much as the inflation levels are still likely to be somewhat higher than those targeted by the authorities.

BOP: capital flows seek better investment climate Resembling the pattern of 2011, capital outflows did not contract significantly this year, standing at USD61bn in 10M12, on the back of the risk-off mode in global markets following concerns about the European debt crisis. Both the monetary and fiscal authorities have been downgrading their projections of outflows this year, from USD10-25bn to USD65-70bn. For 2013-2015, the Ministry of Economy expects outflows in 2013 to be zero, and inflows in 2014 and 2015 to be USD30bn and USD40bn, respectively. Meanwhile, the Ministry of Finance sees further scope for continued capital outflows in 2013-2014.

We believe the capital outflows are likely to be in line with the authorities’ estimates; however, we are more

constructive on the upside risks given privatization, and measures towards the enhancement of the business climate in Russia. Our analysis suggests that there is a strong correlation between the growth in capital outflows and the deceleration in fixed investment growth. We note that the growth in fixed investment reacts to net capital outflows with a lag of 3-4 months. Thus, a deceleration in capital outflows next year may potentially improve Russia’s GDP performance via the acceleration in fixed investment growth.

Russia: Fixed assets investments vs capital flows

-30

-20

-10

0

10

20

30

-60

-40

-20

0

20

40

60

2007 2008 2009 2010 2011 2012Net capital flows, other sectors, USDbn Net capital frows, banks, USDbnFixed assets investments, real, % yoy (RHS)

Source: Rosstat, CBR, Deutsche Bank

On the current account side, the positive balance has been benefiting from high oil prices so far this year, and amounted to USD79bn in 10M12 vs. USD80bn in 10M11. Both Russia’s monetary and fiscal authorities expect the CA balance to be USD83-84bn this year, given official forecasts for the Urals oil price at USD109/bbl. As for 2013-2015, in the baseline scenario – Urals at USD97/bbl-USD104/bbl in 2013-2015 – the authorities are forecasting a surplus of USD22-31bn in 2013, USD8-20bn in 2014 and USD-12bn-3.8bn in 2015.

Given our positive long-term oil price outlook, we remain constructive on the CA balance, which we expect to deteriorate towards 2015, but less sharply than the government forecasts. We estimate the CA surplus at USD83.0bn this year, USD74.4bn in 2013 and USD36.1 in 2014. We believe downside risks to our scenario are associated with a further deterioration of external market conditions, especially growth-related issues in Europe and China. Russia’s WTO accession in August 2012 is unlikely to have a significant effect on trade flows in the very near term, given the prevalence of transition period in Russia’s set of WTO commitments. In the medium term, one of the factors propping up import growth is likely to be the growth in investment and the rise in imports of capital goods to sustain the infrastructure effort.

Yaroslav Lissovolik, Moscow, 7 495 933 9247



Investment strategy

FX: The constructive RUB story is largely intact. The NSD recently acquired the license enabling them to open nominal holder's accounts, meaning OFZs will be Euroclearable from the next 1-2 months. This in turn opens the door for significant inflows going forward, and combined with a more stable global growth outlook this is likely to lead to a reduction in net capital outflows. Moreover, inflation at 6.5% YoY is running well above the CBR’s 5-6% YoY target, and with the Bank repeatedly in recent months having reiterated its aim to continue moving towards inflation targeting, rates will have to stay relatively elevated. Apart from policy support, and the prospect of stronger inflows, the RUB remains cheap compared with equity sentiment and CDS. Technically, the trend channel from the beginning of June to date is firmly established and suggestive of a next leg lower. Target 34.10, stop revised to 35.35 (35.90).

Henrik Gullberg, London, 44 20 7545 9847 Rates: We expect OFZs to continue their rally into 2013 for three reasons. Non-residents are under positioned in RUB debt (12%) vs the broader EMEA average (20%) - we estimate that Euroclearability could lead to inflows of around 15-20% of the total size of the market. Secondly, we believe the global demand for local currency fixed income/yield will become more nuanced - from this perspective, we think RUB yields stack up well when compared to Russia's external, fiscal and financial risks. Importantly, we think the level of RUB yields vs Russia's vulnerabilities are more favourable in comparison to other EMs (HUF and ZAR back end offers similar yield but the quality of yield does not rank as well on our metrics). Finally, we expect inflation to slow in 2013, which we think will be supportive for local debt. Long Apr21 at 6.90%, target 6.50%, stop loss at 7.20%.

Siddharth Kapoor, London, 44 20 7545 2402

Credit: Neutral. The outlook for Russia is constructive, but we do not see any clear catalysts which could prompt a market re-rating of the credit. Our model of implied credit quality from fundamentals fits Russia’s market-implied credit quality extremely well (R2 of 0.85) and at present it suggests that the market is a little rich to fundamentals. The difference isn’t sufficient to motivate an underweight exposure, but we think it does argue against being overweight at this point.

Marc Balston, London, 44 20 7547 1484

Russia: Deutsche Bank forecasts 2011 2012F 2013F 2014F

National Income

Nominal GDP (USDbn) 1852.4 1920.9 2189.0 2407.8

Population (m) 143.0 143.1 143.2 143.2

GDP per capita (USD) 12954 13428 15292 16820

Real GDP (yoy %) 4.3 4.0 4.3 4.2


Govt consumption 1.5 0.6 -0.1 -0.3

Investment 8.0 6.0 7.0 7.2

Exports 0.4 5.3 6.2 6.0

Imports 20.3 9.0 8.5 8.0

Prices, Money and Banking (eop)

CPI (YoY%) eop 6.1 7.0 6.4 5.9

CPI (YoY%) ann avg 8.4 5.2 7.4 6.1

Broad money 22.6 17.0 20.0 20.0

Credit 21.0 22.0 18.0 18.0


State budget balance 0.8 0.1 0.0 0.2

Revenue 20.9 21.2 20.4 19.4

Expenditure 20.1 21.1 20.4 19.2

Primary surplus 1.3 -0.3 0.5 0.7


Exports 522.0 518.0 550.0 573.0

Imports 323.8 380.0 435.0 464.0

Trade balance 198.2 138.0 115.0 109.0

% of GDP 10.7 7.2 5.3 4.5

Current account balance 98.8 83.0 74.4 36.1

% of GDP 5.3 4.3 3.4 1.5

FDI (net) 10.0 24.0 18.0 14.0

FX reserves (USDbn) 498.6 520.0 530.0 550.0

RUR/USD (eop) 32.2 30.5 30.6 30.8


Domestic 4.8 6.7 6.9 7.1

External 2.0 2.0 2.1 2.2


in USDbn 480.0 510.0 608.5 662.2

General (% pavg)

Industrial production (%) 5.2 3.5 3.6 3.4

Unemployment 6.8 6.0 6.2 6.1


Policy rate (refinancing 8.25 8.25 8.00 8.00

RUR/USD 30.8 30.5 30.5 30.6Source: Official statistics, Deutsche Bank Global Markets Research



South Africa Baa1 (negative)/BBB (negative)/BBB+ (negative) Moody’s/S&P/Fitch

Economic Outlook: The economy is set for further

weakness in domestic growth as it lags global growth by up to five quarters.

Main Risks: The deterioration in the current account deficit in the short term, coupled with concomitant exchange rate pressure, could derail our call for further policy easing next year.

Strategy Recommendations: Stay short ZAR vs TRY, while USD/ZAR is likely to be driven by swings in risk appetite (within a wide range, floor around 8.50, ceiling 9.25). Stay received 2Y IRS, target 4.90. Underweight sovereign credit.

Macro View

In last month’s edition we discussed some of the key issues facing the economy next year. In a nutshell, we see greater headwinds to domestic demand, which partly stems from the reverberations of the negative supply shock this year. By the time this publication goes to print, we would have received data for Q3 and historical revisions of national accounts data, which may result in adjustments to our forecasts for next year. This note therefore highlights some broad brushstroke themes for next year, and do not contain any changes to our existing view.

Growth at a tipping point: The domestic economy has been characterised by two primary themes over the last two-three years, firstly, increased synchronisation with developed economies, and secondly, a positive terms of trade (ToT) shock which underpinned a significant upturn in household demand. This period was also accompanied by a significantly overvalued exchange rate of up to 25% at times, which managed to keep inflation and the import bill contained until recently. The combination of these trends has resulted in significant margin expansion for corporates, hence corporate cash buffers still imply good growth prospects down the line, improved business confidence permitting. However, around the end of 2011, the cyclical windfalls of an upturn in global demand since 2009, a strong commodity boom and overvalued exchange rate have all reached their turning points, resulting in a huge blowout in the current account deficit. The ripple effects will now begin to exert greater pressure on the domestic economy, whilst possibly weakening the exchange rate further in the process.

Against the backdrop of these dominant trends, we unpack some of the main themes we identify for 2013: 1) The cyclical squeeze: the beginning or the end? 2)

Prospects for ToT gains; 3) Current account deficit digression or compression; 4) Exchange rate: toast, or dripping roast?; 5) Ratification for more policy easing.

The cyclical squeeze: the beginning or the end? The cyclical downturn in developed markets over the last few quarters directly affects GDP via the export channel. Domestic growth lags those of developed economies by between three and five quarters. Rising homegrown issues, coupled with the catch-up phase suggest spillover effects could last for several quarters given broader ramifications for employment, confidence, and capex spend. South Africa could therefore lag the upturn expected in most of our trading partner countries. To be sure, growth in the US and Europe will be modestly better than 2012, but risks are probably skewed to the downside in 1H13. The Eurozone should gradually recover from recession in 2H13 whereas, the underlying US economy recovery, excluding fiscal cliff concerns, is relatively resilient. On balance, meaningful growth catalysts from an export perspective are still largely elusive as even China will only reach trend growth in 2H13. South Africa’s growth ties with DM economies strengthened since 2008 (see below). On the basis of historical cycles, GDP growth has on average reached a trough around five quarters after the G7 growth has bottomed. This would imply improving momentum in GDP from around 2H13 as the G7 growth appears to have bottomed in 1Q12.

South Africa: Rolling correlation between SA and

global growth

-80%

-40%

0%

40%

80%

1998 2000 2002 2004 2006 2008 2010 2012US Japan EurozoneG7 China

5-year rolling correlation

Source: Deutsche Bank, I-Net Bridge

The chronological order of recovery in national accounts data, would reflect improvement in export volumes and household demand (expected by 3Q13), however, fixed investment and inventories will lag this turning point by a



further four quarters (i.e. 2Q14). We expect inventory accumulation to slow or even contract next year, which serves as a drag on growth.

Prospects for terms of trade gains: From a commodity perspective (60% of exports vs 20% of imports), DB has a constructive view on the outlook for prices in 2013, particularly as the underperformance in industrial metals should normalise alongside a recovery in global demand. In turn, as we head into next year the main drivers of precious metal prices, gold in particular, such as expectations of QE4, a weak dollar and US downgrade risks, will remain intact in our view. These dynamics could provide a modest lift to commodity export prices, which held up well over the last few quarters (as illustrated below). However, the potential for significant headway in SA export prices may be tempered by non-commodity prices in the export basket (c.40% of the export basket), which are predominantly manufactured goods. These prices are mostly a function of SA’s global export competitiveness and global demand. In light of significant increases in domestic unit labour costs where growth of nearly 7% was reported earlier this year, an improvement in export competitiveness in the near term remains unlikely. Overall, export prices will probably track sideways to modestly higher from here, but will fail to offset the increases in import prices, which are also at the mercy of a much weaker exchange rate.

South Africa: Export prices* fail to keep pace with

rising import costs

100

120

140

160

180

200

220

240

260

2002 2004 2006 2008 2010 2012Export prices: non-commoditiesExport prices: commoditiesImport prices: all

Index

* We use PPI export and import indices as proxies for a inputs into terms of trade. Source: Deutsche Bank, StatsSA

Current account deficit digression or compression: Though relative price movements matter a great deal for income generated by terms of trade, export volumes are equally important, which as established above should gain traction from 3Q next year. On balance, income effects from a modest recovery in terms of trade and export volumes are likely to be much lower from 3Q12 onwards,

but could improve in 2H13. As illustrated below, the gap between GDI (GDP augmented by ToT) and GDP measures the income windfall from ToT. Historically, positive income effects have led to excess domestic demand growth (i.e. GDE > GDP), and vice versa if income effects compressed or declined. Our expectation of a gradual easing in GDE next year may be on the optimistic side if we consider the sharp fall in ToT income effects. This argument forms the basis of our expectation for a narrowing in the CAD to more sustainable levels, as imports adjust to inline with export purchasing power (dictated by ToT) and domestic demand.

South Africa: Income gains from terms of trade are

negative over next 3 quarters, will compress GDE

-4

-2

0

2

4

1994 1999 2004 2009 2014

GDI-GDP GDE-GDP (lagged two quarters)

% pointsDBe

Source: Deutsche Bank, SARB

Exchange rate: toast, or dripping roast? We are not overly bullish on the currency, given the risk of structural concerns, but we do see scope for some improvement next year. Concerns over the fiscal cliff and ongoing reduction in tail risks facing the euro has seen EUR/USD improve to the top-end of DB’s forecast range of 1.35 (2012 eop), which will likely be maintained into the first quarter of next year. This trend, alongside diminishing labour unrest as we head into the holiday period has seen the rand improving modestly. We expect this trend to continue within an environment still characterised by recurring risk-on, risk off markets.

At current levels, we still see a considerable political risk premium in the rand (see below), based on our fundamental rand model, which takes into account the trade deficit, dollar under/overvaluation, relative equity performance in EM vs DM and real bond yield differentials between SA and DM. These indicators would suggest a trading level of close to R8/USD in 2H12, which is why we think conditions will have to deteriorate dramatically for the rand to break above 9/USD (not our base view). We thus maintain that a firmer outlook for the rand in 2013, based on the following few factors:



South Africa: Rand valuation based on fundamentals

7.5

7.5 7.3

6.97.0

6.7

7.2

7.6

7.7

8.1

8.3

8.8

7.1

7.6

7.2 7.1

6.46.5

7.4

7.8

7.6

8.17.9

8.0

6.2

6.7

7.2

7.7

8.2

8.7

9.2

2010 2011 2012 2013

Spot dollar-rand Fundamental rand model

• Marikana• CAD rises to -6.4%• Moody's downgrades• Mass sacking of miners

• S&P downgrades• Transport strike flares up• Hedging of renewable capex projects• Hedging of bond positions by long only accounts

Source: Deutsche Bank, Bloomberg Finance LP

After a period in which the focus fell on hedging downside risks to risky assets, the risk-reward profile has now shifted away from hedges towards risk on trade, which remains a 2013 structural house view.

Violent labour clashes are unlikely to be repeated within the next year, but poor social conditions will remain at the forefront of ongoing labour protests. As most workers in the mining sectors are migrants, the fierce tension illustrated before will have dissipated by the time they return to their posts next year. Labour protests usually have a predictable rhythm, which seasonally picks up from July each year. We expect focus on the 2014 National Elections in 2H13 to create an opportune time for labour issues to flare up again, but these could be contained in respect of much reduced employment growth prospects and possibly increased focus by the ANC.

Global capital flows could well shift from bonds back to equity markets as relative growth plays shift back in gear. For South Africa to capitalise on this trend, it would require a firmer global growth environment which could see a return in appetite for stocks that look attractive from a valuation perspective.

Admittedly, several issues will conspire against a swift compression in the risk premium.

The outcome of the Mangaung ANC Elective conference is still very much a concern for markets even though it appears that President Zuma may be re-elected for a second term. We expect the announcement around Dec 20th, following a four-day build up where the president will make one of his most important speeches yet. Further ahead, the growing factionalism within the ANC increases the risks of continued policy drift next year and reduces the likelihood of an internal campaign for self correction within the ANC, in our view. Ratings agencies, particularly Moody’s, are unlikely to take easy to growing policy inertia in this scenario.

South Africa: Cumulative net inflows into bonds and

equities

-40

0

40

80

120

160

200

240

2010 2011 2012

Rbn

Cumulative bond inflowsCumulative equity inflows


Further sovereign downgrades are most likely in Q1. Fitch is likely to make its pronouncement early next year, while Moody’s could also strike again, though the timing here is less certain.

We expect a tentative blowout in the CAD before compressing further into 2013. Indeed, based on preliminary trade data, and zar movements in Q4, the CAD is most likely to have an 8% handle (the first since 1976) in Q4, despite the fact that seasonal trends should help to contain the import bill.

Ratification for more policy easing: Against the backdrop of weaker growth fundamentals next year, an undesirable current account deficit position and above-target inflation (by mid-2013), the SARB will find itself in a constricting policy bind. Upside risks to inflation is more likely to be a short-term phenomenon than a lingering concern, in our view. Though the SARB still needs to adopt the new CPI weights in its forecast (due by March), we believe they will still maintain a forward looking approach, despite the potential for further and short-lived deterioration in inflation. On our profile, CPI peaks at around 6.7% by mid-year, but drops back to within the target band over the forecast horizon. Given the confluence of risks in the short-term, the rand exchange rate and the CAD are two intricately linked factors that have become more ingrained in their decision making process. We see the latter as an increasing risk to the timing of our rate cut call, as huge CAD pressure may still linger in March, when we believe the next cut will occur. However, against the backdrop of weakness in EM growth, which some central banks have responded to by cutting rates further, we see greater chance of another strike by the SARB than no cut at all.

Danelee Masia, South Africa, 27 11 775 7267



Investment Strategy

FX: While labour unrest has abated over the past couple of weeks, and while the mining output level could recover somewhat from November/December onwards, the medium-term trend level of activity (investment) in the sector is likely to have been adversely affected. This suggests a continued structural deterioration in the external balances, on top of the certain deterioration in the Q3/Q4 C/A balances, and following the deterioration already witnessed over the preceding six months. Whether or to what extent this will be reflected in the ZAR vs the majors in the new year will depend to some extent on global risk sentiment, but deterioration in the external balances and the increasing likelihood of SARB policy easing are consistent with ZAR underperformance vs peer currencies. Stay short ZAR vs TRY, for a move to 5.20 (stop @ 4.85). In USD/ZAR the prospect of some ‘normalisation’ in the mining industry, and a more supportive global risk environment, could see the risk sensitive ZAR returning to around 8.40, which we would see as good levels to establish fresh longs in USD/ZAR.

Henrik Gullberg, London, 44 20 7545 9847

Rates: We like to keep receivers in the front end of the swaps (2Y) and bond curve (R203) in South Africa. As our economists discuss, it is not the level of borrowing costs but rather uncertainty and lack of confidence that the SARB will respond to. Core CPI is contained and the risks around headline CPI remain risks as opposed to reality. We think risk/reward remains favourable in short end receivers. Firstly, a rate cut is not fully priced by the market, meaning shorter tenors are likely to rally as and when expectations of rate cuts increase. Secondly, both the 2Y IRS and the R203s are positive carry, the latter being the 'sweet spot' in terms of realised vol adjusted carry & roll. Finally, correlations show that the short end of the swaps & bond curve is less correlated with USD/ZAR than the longer end of both bond and swap curves.

Siddharth Kapoor, London, 44 20 7547 4241

Credit: Underweight. If we were to simply group EM countries into those on a clear positive trajectory, those on a more uncertain (or even negative) trajectory, we would have to put South Africa in the latter camp. Furthermore, it seems that the market may be slow to acknowledge the deterioration. Over the past three years our model of credit quality indicates a deterioration of 1.5 rating notches, based on fundamentals. This results primarily from higher public sector external debt and a modest weakening in ‘government effectiveness’. The market meanwhile has effectively reflected no change in credit quality. We recommend an underweight exposure.

Marc Balston, London, 44 20 7547 1484 Winnie Kong, London, 44 20 7545 1382

South Africa: Deutsche Bank Forecasts 2011 2012F 2013F 2014F

National Income Nominal GDP (USD bn) 413 395.7 435.0 462.5Population (mn) 50.5 51.0 51.5 51.9GDP per capita (USD) 8183 7755 8449 8904 Real GDP (YoY%) 3.1 2.3 2.7 3.6 Priv. consumption 5 3.5 3.1 3.6 Gov't consumption 4.5 4.1 4 3.9 Gross capital formation 4.4 5.5 3.8 4.6 Exports 5.9 0.0 1.2 3.9 Imports 9.7 6.0 2.3 5.1 Prices, Money and Banking CPI (YoY%, eop) 6.1 5.6 6.2 5.5CPI (YoY%, ave) 5 5.6 5.8 5.7

Fiscal accounts, % of GDP (fiscal years) Budget surplus -4.5 -5 -4.7 -3.6 Expenditures 32.7 32 32 31.2 Revenues 27.7 27 27 27.6Primary surplus -2.2 -2.2 -1.8 -0.9 External Accounts (USD bn) Exports 103.1 93.2 101.5 114.0 Imports 101.7 104.5 106.2 114.8 Trade balance 1.4 -11.2 -4.7 -0.8 % of GDP 0.3 -2.8 -1.1 -0.2 Current account balance -13.8 -25.4 -19.8 -16.2 % of GDP -3.3 -6.4 -4.6 -3.5 FDI(% of GDP) 1.6 0.2 0.3 0.5 FX reserves (USD bn) 50.5 51 53 54.5 USD/ZAR (eop) 8 8.2 8.1 9 EUR/ZAR (eop) 10.5 11.07 9.72 10.35

Debt Indicators (% of GDP) (fiscal years) Government debt 40.1 41.0 42.7 42.7 Domestic debt 35.8 37.8 40.0 40.0 External debt 4.3 3.3 2.7 2.7Total external debt 26.1 28.9 24.8 23.3 In USDbn 108.0 115.0 108.0 109.0 413 41.0 42.7 42.7Financial Markets (eop) Current 3M 6M 12M Policy rate 5 4.5 4.5 4.5 3-month rate (Jibar) 5 4.6 4.6 4.6 10-year rate 6.62 6.5 6.7 7.2 EUR/ZAR 11.46 11.04 10.6 9.7 USD/ZAR 8.8 8.2 8.2 8.1




Turkey Ba1 (positive)/BB (stable)/BBB- (stable) Moody’s / S&P / Fitch

Economic Outlook: Growth is picking up marginally

while rebalancing continues and inflation is declining more rapidly than envisaged with the evaporation of last year’s supply shocks and falling food prices.

Main Risks: Continued vulnerability of overall macro conditions to volatility in capital inflows in both directions.

Strategy Recommendations: Stay long TRY vs ZAR, targeting 5.25, with a revised stop @ 4.80. Constructive Jan 22s, target 6.50%. Overweight sovereign external debt.

Macro View

Macro adjustment continues much to the joy of the markets … Rebalancing in the economy continues with gold exports continuing to provide a bonus to the adjustment in the current account deficit (CAD). Disinflation has also received a nice bonus from the rapid fall in food prices over the past couple of months. In the mean time most indicators are pointing to a mild pick up in economic activity in 4Q compared to 3Q with private sector expenditure looking to expand at a moderate pace. Given

this macro background with improvement on all fronts and notwithstanding rising geo-political risks (mainly the recent escalation of tension between Turkey-Syria), the markets continued to set new records. The yield curve continued to shift down with long term and short term rates falling below the 7% and 6% levels. The short end has collapsed by about 700bps since the start of the year on the back of CBT’s aggressive lowering of policy rates (hybrid policy rate) and recent momentum is also owed to elevation to investment grade by Fitch and expectations

of other agencies to upgrade in the months ahead. Over the past two months banks’ local bonds holdings have declined by TRY5bn with a matching rise in the holdings of non-residents, elevating the share of the latter in outstanding TRY bonds to an all time high of 23% (15% at the start of the year). Despite underperforming many EM currencies over the past twelve months, TRY has remained high in the carry trade rankings thanks to still relatively higher nominal rates. We also note a significant improvement in the Sharpe ratio over the past three months (relative to other EM currencies as well) and that comes on the back of lower FX volatility driven in part by the CBT’s flexibility in managing short term rates to stabilize the exchange rate. Needless to say the swap curve has also collapsed with short term and long term rates now at around 4.7% and 5.4% levels.

The equity market also reached its all time high mainly on the back of non-resident inflows. The financials component has been the main catalyst with bank shares rising rapidly on the back of portfolio gains, as the ISE-100 has outperformed the MSCI EM index significantly since April. While rates and equities have clearly outperformed in a significant way, hard currency debt has also performed well and CDS spreads have been more than halved since the start of the year with continued momentum in the past two months similar to the recent improvement in the local bond market. …with gold exports continuing to provide a “bonus” to CAD adjustment… The CAD has been adjusting more rapidly than our expectations, which is basically due to the bonus provided by the gold balance. The CAD has adjusted by an

Turkey: Local government bond yield curve declined

dramatically

5.0

6.0

7.0

8.0

9.0

10.0

11.0

3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 8Y 9Y 10Y

Nov-19 Oct-24

Dec-03 Jan-01

Local Bonds Yield Curve (2012)

Source Bloomberg and Deutsche Bank Global Markets Research

Turkey: TRY carry ranking has remained high

02468

1012141618

ARS CLP TRY COP PLN HUF PEN MXN PHP KRW

Top 10 carry returns (short USD over the past 12 months)

Source Bloomberg and Deutsche Bank Global Markets Research



estimated 2.6pp from the end-2011 level of 10% of GDP through September to 7.3%. The main contributor, non-energy component, swung from a 3% deficit to a 0.4% surplus while the energy deficit increased by 0.8pp (to 7.7% of GDP). Just about 1pp of the decline in CAD is due to the swing in the gold balance from a 0.6% deficit to a 0.4% surplus.

Our start of the year projection for the CAD was $59bn (7.2% of GDP) and the 12-month figure by October has declined to an estimated $53.5bn. Export growth is outpacing import growth by a wide margin after adjusting for gold exports and energy imports (flat and -8.6% YoY, respectively, on average over the past three months). The adjustment story has been more of an import collapse on the back of sharp slowdown in domestic demand and lagged effects of real exchange rate depreciation seen last year (despite a marked recovery in 2012, the trade weighted real exchange rate is still 9% below its peak at the start of last year). With continued weakness in imports the 2012 CAD number could fall to about $52.5bn, which will be an estimated 6.5% of GDP. We are projecting an increase in CAD next year on the back of acceleration in domestic demand and assuming that the gold bonus disappears. And yet the widening is expected to be gradual particularly if oil prices remain at current levels. PM Babacan acknowledged that the gold exports predominantly correspond to gold purchases by Iran (subsequently taken home) using TRY payments received for natural gas exports to Turkey. In a sense Turkey’s natural gas imports have been financed by depletion of its gold stock. We think the “bonus” will evaporate as the current scheme is a violation or circumvention of sanctions on Iran and it is just a matter of time before it may be terminated. …and the food component of CPI providing the “bonus” for disinflation…

As recently as October, the CBT had revised its year-end CPI forecast up by 1.2pp to 7.4% on the back of a number of fiscal measures implemented (tax and price hikes). With food prices declining very rapidly the CBT argues now that the year-end number will be significantly lower perhaps closer their pre-October forecast of 6.2%.

November MoM CPI at 0.38% was significantly lower than market consensus mainly on the back of a surprisingly negative MoM in food (0.21% decline versus last year’s 3.42% increase). Food YoY dropped to 4.1% in November from 10.5% in September, which decreased headline CPI by 1.6pp during this period. The remaining portion of the 2.8pp decline in CPI since September basically came from the decline in tobacco component to 0.97% from 18.8% (-0.9pp contribution) and the house ware component to 5.9% from 8.2% (-0.05pp contribution). The former is basically due to last year’s tax hike falling out of the YoY numbers (we may see taxation of tobacco in the months ahead) and the latter can be largely attributed to strength in TRY. We also not that core inflation (mainly excluding food and energy has declined to 5.7% in November from 6.1% last month and 6.7% in September. The seasonally adjusted numbers point to a 4.2% annualized figure on average over the past three months. All in all, supply shocks of last year have evaporated and CPI has returned to its pre-shock(s) level in July of last year (6.3%). We note that the post-supply shock normalization in CPI seems to have occurred relatively rapidly compared to similar past episodes indicating that second round effects have been largely muted. That is very good news and yet longer term inflation expectations have been stuck basically around 6.2%, which may be an obstacle for further disinflation to the 5% end-2013 target unless economic activity remains subdued for a longer period. That said stable FX and oil prices should stabilize CPI at around current levels (possibly lower for the next 2-

Turkey: Equities have outperformed MSCI EM

80

90

100

110

120

130

Dec-09 Jul-10 Feb-11 Sep-11 Apr-12 Nov-12

3Yr avg

Source: Bloomberg and Deutsche Bank Global Markets Research

Turkey: Non-energy CA is in surplus

-11.0%

-9.0%

-7.0%

-5.0%

-3.0%

-1.0%

1.0%

3.0%

2008-03 2009-06 2010-09 2011-12

CADGold BalanceCAD excl energy

as % of GDP

1

Source: Turkey Data Monitor, CBT and Deutsche Bank Global Markets Research



3 months) barring a reversal of the downward trend in food. We have revised our year-end forecast to 6.4% (from 7.2%) while preserving our 2013 estimate at 6.4%. …while the CBT is looking to make sure that “everything” is under control The CBT has been happy with the adjustment in CAD and the deceleration in credit growth from a financial stability perspective and the recent acceleration in disinflation should give them more comfort for further easing of monetary policy, underway since May. Most indicators including new orders, capacity utilization and industrial production are showing that growth in 3Q is similar or marginally weaker than that seen in 2Q (2.9% YoY), and that there is at best a mild recovery in 4Q. With growth looking to be below potential, the CBT would like to provide greater accommodation. The upper band of the interest rate corridor has been cut to 9% last month from 12.5% at mid-year leading to decline in credit rates. But credit growth has continued to decelerate in both consumer and commercial segments and while the CBT

indicates that current rate of expansion (15%) is more or less appropriate, we believe that they would like to see some momentum going forward. But at the same time the CBT wants to make sure that a rapid increase in capital inflows does not cause a commensurate expansion in credit growth and domestic demand, endangering both financial stability and disinflation similar to last year. As such the CBT indicated that it would cut the lower band and the one-week repo rate in response to massive inflows. We have seen some strengthening in inflows as reflected by price action across markets and yet in our opinion conditions have yet to ripen for the CBT to prioritize repelling inflows and for changing their policy mix in an aggressive way. Thus we are likely to see a gradualist approach with more cuts in the upper band to provide some stimulus while the pace of cuts in the lower band, if at all, will be conditional to

developments abroad and risk appetite rather than domestic data (we have penciled in a 100bps cut in the lower band through 1Q based on our base case of a partial “cliff” in the US and continued QE).

Our overall assessment of monetary policy is unchanged and in a recent piece (“Recapitulating MP: Easier said than done”) we discussed the evolution of monetary policy (framework, tools and objectives) in detail and presented our views on strengths and weaknesses. Our main points were: i) The CBT took on greater responsibility in smoothing out the repercussions of volatile capital inflows by amending its inflation targeting framework in a number of ways. The process is ongoing, and at times it is hard to keep track of changes as it relates to new tools being tried out, objectives shifting around, and most importantly communication style and content changing very frequently. ii) The extreme discretion the new framework provides to the CBT makes it a bit difficult to the see the progression of the monetary framework and what its “ruling anchor” will be going forward. iii) The new monetary mix may have been helpful in soft-landing but we think we owe much of the orderly adjustment this year to the rapid turnaround in risk appetite and capital inflows. iv) Recently CBT added another weapon to its arsenal to cope with the macro affects of volatile capital inflows, the reserve option mechanism (ROM), which allows the banks to hold a portion of their TRY reserve requirements in FX. It is more of a tool for smoothing out the effects of volatile capital inflows on domestic credit expansion thereby complementing the corridor in minimizing the bad side affects of risk on/risk off periods. v) The CBT will continue to monitor market conditions for optimal timing of further easing of short term rates particularly the lower band.

Cem Akyurek, Turkey, +90 212 317 0138

Turkey: The decline in food prices supported CPI

disinflation

0

5

10

15

20

2010-01 2010-07 2011-01 2011-07 2012-01 2012-07

CPI Food

Source: Turkey Data Monitor and Deutsche Bank Global Markets Research

Turkey: Short term rates

0

2

4

6

8

10

12

14

Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12

O/N Borrow ing O/N Lending

1W repo Hybrid policy

Source: Turkey Data Monitor, CBT and Deutsche Bank Global Markets Research



Investment Strategy

FX: CBT governor Basci has communicated that policy going forward will be shaped to a greater extent by the inflation outlook. Also, the adjustment in the external balances has continued unabated, with exports outperforming imports despite the unfavourable external environment (in the 3 months up to October even exports to the EU rose by 20%). Add to that the sovereign rating upgrade from FITCH, and the backdrop is much more supportive of the TRY, allowing the highest risk-adjusted carry in FX, attractive valuation and light positioning to underpin the Lira to a greater extent. We remain long TRY vs ZAR, targeting 5.25, with a revised stop @ 4.80 (4.60). We also continue to see value in positioning for downside in USD/TRY over the next few months. A 3m USD/TRY put with a strike @ 1.75 costs an indicative 0.30% of USD notional (spot ref: 1.7850).


Rates: We continue to be constructive on the back end of bond curve for three reasons. Firstly, TRY yields are attractive in comparison with EM peers (both FX hedged and unhedged). Turkey's latest MTP suggested the country's impressive fiscal position will be sustained over the next three years. Finally, we think the decline in the CAD, an increase in the ROC (reducing vulnerability of local banks) and a decline in inflation could be positive factors when Moody's considers upgrading Turkish debt. We note that foreigners are not over-positioned in local debt (holdings are in line with EMEA average). Buy Jan 22s at 6.80, target of 6.50, and s/l at 7.05. We are neutral the front end for now, given what is expected (some market participants expecting for 50bps for Dec 18th meeting) and our view that the scope for meaningful/sustained rate reductions by the CBT is limited (see EMEA Compass “Lira worth a TRY regardless of CBT” 20th Nov 12 for more details on this view)


Credit: Overweight. Despite rallying strongly in recent months, the pricing of Turkey’s external debt still implies a weaker level of credit quality than is implied by fundamentals. The decline in inflation and the continued rise in FX reserves which we anticipate for 2013 also point towards further improvement in credit quality. The rating agencies are somewhat ‘behind the curve’ with respect to Turkey’s fundamentals, but 2013 could see some catch-up in this regard. If S&P or (more likely) Moody’s were to follow suit and raise Turkey to investment grade in 2013 it could provide a significant positive catalyst. We recommend an overweight exposure.


Turkey: Deutsche Bank Forecasts

2011 2012F 2013F 2014F National Income Nominal GDP (USD bn) 772.0 813.6 893.1 972.6Population (mn) 73.9 74.3 74.5 74.6GDP per capita (USD) 10447 10950 11988 13038

Real GDP (YoY%) 8.5 3.0 4.8 5.0Priv. consumption 7.7 2.0 5.0 5.0Gov't consumption 4.5 1.6 2.9 1.0Gross capital formation 18.3 4.2 9.8 12.4Exports 6.5 11.3 11.1 12.0Imports 10.6 5.2 15.8 17.0

Prices, Money and Banking CPI (YoY%) eop 10.5 6.4 6.5 6.5CPI (YoY%) ann avg 6.5 9.0 6.9 6.5Broad money (M2Y) (YoY%) 14.9 13.0 13.0 16.0Bank credit (YoY%) 25.0 14.0 16.0 18.0

Fiscal Accounts (% of GDP) Consolidated budget balance -1.3 -2.4 -2.0 -1.8Interest Payments 3.4 3.5 3.2 3.0

Primary balance 2.1 1.1 1.2 1.2

External Accounts (USD bn) Merchandise exports 143.5 161.1 174.1 194.6Merchandise imports 232.9 229.5 256.8 292.1Trade balance -89.4 -68.42 -82.7 -97.5% of GDP -11.6 -8.4 -9.3 -10.0


FDI (net) 13.4 13.0 15.0 15.0FX reserves (USD bn) 78.3 95.0 102.0 107.0FX rate (eop) USD/TRY 1.89 1.80 1.85 1.88

Debt Indicators (% of GDP) Government debt 40.0 38.3 35.2 32.2Domestic 27.9 27.6 25.2 22.2External 12.1 10.7 10.0 10.0

Total external debt 40.1 39.2 36.4 35.0In USD bn 309.6 318.0 325.0 340.0Short-term (% of total) 27.5 28.3 29.2 30.0

General (YoY%) Industrial production 9.2 3.0 4.8 5.0Unemployment 9.8 9.0 9.0 8.8

Financial Markets (end) Current 3M 6M 12MPolicy rate 5.75 5.25 5.25 5.25Benchmark bond rate (comp.) 5.75 6.2 7.00 7.20USD/TRY 1.7841 1.8000 1.800 1.850




Ukraine B1(negative)/B+(negative)/B(stable) Moody’s/S&P/Fitch

Outlook: Multiple challenges include the need to

bring the IMF programme back on track and resuscitate the lackluster growth momentum

Main risks: Deterioration in external position exerting downward pressure on the currency

Strategy recommendations: UAH to remain under pressure. We recommend an underweight exposure on sovereign external debt.

Macro outlook

Ukraine’s economic conditions in H2 2012 encountered headwinds, with electoral pressures on the domestic front compounded by volatility in global markets. As a result, GDP declined by 1.3% yoy in 3Q12 along with a deterioration in the BOP position. Accordingly the new government will face several challenges next year: real sector decline, deterioration in BoP, and significant pressures on the Hryvnia to depreciate. The government will also face sizeable redemption (USD6.4 is due to the IMF alone) and will need to conduct gas supply negotiations with Russia.

On the political front on 3 December, President Viktor Yanukovich dismissed Mykola Azarov’s cabinet, with the members of the government continuing to serve their positions until the formation of the new cabinet. According to the Ukraine media, quoting the former prime minister, Azarov had asked for the dismissal himself, given that he was elected as the deputy of the new Rada. The candidacy of the new prime minister is to be submitted by the President before 12 December, with the candidate requiring majority of the votes in the legislature (more than 225). At this stage, the current head of the NBU, Sergey Arbuzov, is one of the main candidates for the post of Ukraine’s Prime Minister, with Azarov also has chances to be re-elected as the Prime Minister. Both these candidates are from the pro-Yanukovich camp, suggesting that the overall course of policies of the new government is unlikely to stray too far away from those of its predecessor.

In the real sector, GDP growth sharply declined to 1.1% yoy in 9M12 from 2.5% in 1H12 on the back of weak industrial and agricultural production that were down 2.2% yoy and 4.6% yoy, respectively. October saw some relief in industrial production (-1.4% yoy in 10M12), while agriculture plummeted to -5.1% yoy. Recently, the government reiterated its GDP growth forecast at 3.5% for 2012. As for 2013, the government sees the GDP growth rate at 3.4% yoy and projects pavg inflation at 4.8% yoy. We remain more constructive on the growth

figures for 2013 and believe that growth will resume from 2H13, when we expect the economic activity in Europe to revive. We believe that growth will amount to 2% yoy this year and 4% yoy next year.

Next year will be important for Ukraine in terms the debt refinancing. The country should redeem almost USD8bn in 2013-2014 each year in foreign obligations, with the largest payments to be undertaken with respect to the IMF. Ukraine is scheduled to pay to the Fund USD6.4bn in 2013 and USD4.2bn each year in 2014-15. One of the key gateways to bridging the financing gaps in the coming years will be a new IMF programme. The Fund’s conditionality includes the reform of the financial sector, liberalization of heating tariffs for the population and greater exchange rate flexibility. We believe that in a post-election environment the measures undertaken by the government on these key conditions may succeed in bringing the IMF programme back on track.

On the monetary front, inflation has been decelerating so far this year which has resulted in a slight deflation at -0.3% yoy in 10M12 on the back of heating tariffs freeze and the unchanged official exchange rate. Next year we expect the end of period inflation rate to rise on the back of further modest depreciation in the currency and increases in gas tariffs which feature prominently in IMF’s conditionality with respect to Ukraine. We expect inflation at 6% yoy by December. In the fiscal sphere, the authorities are projecting a deficit of 1.65% of GDP that is predicated on the assumption of 3.4% yoy growth rate and pavg inflation is 4.8% yoy. Overall, we believe that the budget deficit may be broadly in line with official projections.

On the exchange rate front, the recent efforts to maintain the Hryvnia rate undertaken by the NBU were to oblige exporters to sell 50% of revenues that cooled down the market and the hryvna strengthened from USD/UAH8.30 to USD/UAH8.10 by the end of November. The weak point of the NBU is low reserves which dropped by 15% from USD31.36bn in January to USD26.81bn in October. We expect the measures undertaken by the NBU to have a temporary effect in stabilizing the currency and a longer term solution will need to be predicated on a structural reform effort supported by the Fund. In the base case, we expect the hryvna to maintain the current level of USD/UAH8.2 by the end of this year, and then depreciate to the USD/UAH8.4 level in 2013 with notable downside risks prevailing in the near term.

Yaroslav Lissovolik, Moscow, 7 495 933 9247



Investment strategy

FX: As we pointed out in the last EM Monthly, the situation continues to deteriorate with growth weakening, FX reserves shrinking, and social spending accelerating. This continues to undermine the government’s ability to withstand internal and external shocks and obtain external financing (repayments due to the IMF will rise sharply to USD6bn in 2013). The C/A deficit, meanwhile, is already hovering close to record levels and is expected to widen further over the next couple of quarters. Emergency measures like the recently passed law giving the NBU the right to oblige exporters to convert 50% of foreign currency revenues into hryvnas for periods of up to six months had an instant impact on the UAH, but as soon as NBU head Arbuzov said the measure probably would be cancelled ahead of schedule, downward pressures on the UAH resumed. The bottom line is that with external financing needs high and reserves diminishing, the government will have to continue working with the IMF on the Stand-By Program. Until that is in place the UAH will remain pressurized. Expect the gradual drift higher seen over the past 12 months to continue, suggesting 8.25-8.30 by the end of year.

Henrik Gullberg, London, 44 20 7545 9847

Sovereign Credit: Underweight. Ukraine has managed to muddle through 2012, supported by the relatively benign external environment in the second half of the year. Their success in raising external financing has bought them some time, but 2013 is likely to prove more challenging. With substantial external redemptions over the next two years and with increasing pressure on the currency, time is running short to achieve agreements with the IMF (on a new loan agreement), or with Russia (on gas prices) or preferably both. Given that the IMF is unlikely to have changed its view on the need to hike domestic gas tariffs, it is difficult to foresee any agreement with the fund before the end of the winter heating season.

Our 2013 macro-economic forecasts for Ukraine, when input into our implied credit-quality model suggest that Ukraine faces the largest decline in credit quality across the EM sovereigns we cover during the coming year. The combination of rising inflation, falling FX reserves and rising public sector external debt all contribute to this fall. On the positive side, the market-implied credit quality is already a little lower than implied by the model, but we would expect the direction of fundamentals to dominate.

Given the potential for matters to come to a head in the coming months, we recommend beginning the year with an underweight exposure.

Marc Balston, London, 44 20 7547 1484 Winnie Kong, London, 44 20 7545 1382

Ukraine: Deutsche Bank forecasts 2011 2012F 2013F 2014F

National Income Nominal GDP (USDbn) 164.8 178.2 193.5 216.7

Population (m) 45.5 45.3 45.1 45.0

GDP per capita (USD) 3 622 3 934 4 290 4 816

Real GDP (yoy %) 5.2 2.0 4.0 3.9


Govt consumption -2.4 2.5 -1.2 -1.0

Investment 21.9 5.9 8.0 7.5

Exports 2.2 -6.2 9.0 8.9

Imports 16.8 7.3 9.6 9.2

Prices, money and banking (% YoY, eop)

CPI (Dec YoY%) 4.6 3.6 6.0 5.0

Broad money 14.0 13.0 12.5 14.0

Credit 18.0 16.0 13.0 18.0


State budget balance -1.8 -2.5 -1.8 -1.6

Revenue 24.1 23.5 22.9 22.3

Expenditure 25.9 26.0 24.7 23.9


Exports 69.5 64.0 74.0 75.6Imports 83.3 81.6 88.3 89.3Trade balance -13.8 -17.6 -14.3 -13.7% of GDP -8.4 -9.9 -7.4 -6.3


FDI 6.6 6.7 4.3 4.5FX reserves (USDbn) 31.8 27.6 28.4 30.7UAH/USD (eop) 8.0 8.1 8.2 8.2



Domestic 13.2 16.1 16.6 16.7

External 22.8 18.9 18.4 18.5


in USDbn 126.2 134.5 146.3 164.0

General (% pavg)

Industrial production (%) 8.0 1.4 5.8 5.2

Unemployment 8.5 7.8 7.4 7.2


Short-term interest rate 7.5 7.5 7.5 7.5

UAH/USD 8.18 8.20 8.20 8.20Source: Official statistics, Deutsche Bank Global Markets Research



China Aa3(Pos)/AA-/A+ Moody’s/S&P/Fitch

Economic outlook: We expect GDP growth to recover modestly to 8.0% in H1 of 2013 and reach its potential of around 8.5%yoy in H2. The back-loaded trajectory of growth recovery is led mainly by corporate investment after shaking out excess capacity, but also reflects the export acceleration in H2 2013. For 2013 as a whole, we expect the nominal growth rate of gross capital formation (GCF) to accelerate to 11.5% in 2013 from 9% in 2012, export growth to rise to 10% in 2013 from 8% in 2012, and consumption growth to remain largely steady.

On macro policy stance for 2013, we expect the GDP growth target to be set at 7.5%, CPI inflation target at 3-3.5%, M2 growth target at 13-14%, and the fiscal deficit/GDP ratio set at around 1.3% (vs. 1.6% in 2012). We think the PBOC may begin to raise interest rates by the end of 2013 or early 2014 when inflation pressure intensifies. We forecast a 2.5% RMB appreciation against the USD in the coming 12 months.

Structural reforms in areas such as resource pricing, VAT, interest rate and capital account management, and social spending will likely witness significant progress in 2013. These reforms are positive for gas, water, power, refined oil, transport, health and education sectors.

For 2014, our baseline forecast is that GDP growth will continue to accelerate to 8.9%, with growing concern over the risk of economic overheating. The key drivers for growth acceleration include a global economy recovery and accelerating corporate and government investments. The PBOC and NDRC may have to tighten policies when overheating occurs.

Main risks: The key downside risk to our 2013 China forecast is worse-than-expected external demand due to, e.g., the US “going over its fiscal cliff” and/or oil price shocks from the Middle East. A 1.6ppt downgrade in G2 GDP growth will likely reduce China’s GDP growth by 1ppt and delay our expected China recovery by about three quarters. The main upside risk to our 2013 projection is better-than-expected fiscal revenue performance, which may allow stronger-than-expected government capex in areas such as subway and light rail construction.

Strategy recommendations: We are cautious on duration as growth recovery and supply risk on the credit market likely will drive up long-dated rates. Our favored trades in 2013: (a) put on 2Y/5Y Repo NDIRS/IRS curve steepeners at 15bps; (b) pay

outright 5Y Repo NDIRS/IRS when 5Y retraces to around 3.3%; (3) on the cash curve, we recommend Shibor floaters and think 10Y CGBs at above 4% are attractive to buy.; (4) sell 1Y USDCNH forward. Downside surprises to economic growth, credit events in the bond market and delay of financial liberalization reforms are key risks to our view.

Back-loaded growth recovery in 2013

We maintain our 8.2% GDP growth forecast for 2013. On a quarterly basis, our updated yoy and qoq GDP growth forecasts are shown in the following figure.

Yoy and qoq annualised GDP growth forecasts yoy% qoq%, saar

2011Q1 9.7% 9.1%

2011Q2 9.5% 10.0%

2011Q3 9.1% 9.5%

2011Q4 8.9% 7.8%

2012Q1 8.1% 6.6%

2012Q2 7.6% 7.4%

2012Q3 7.4% 9.1%

2012Q4F 7.7% 8.5%

2013Q1F 7.9% 8.2%

2013Q2F 8.2% 8.2%

2013Q3F 8.4% 8.6%

2013Q4F 8.5% 9.0%

2014Q1F 8.7% 9.2%

2014Q2F 9.1% 9.5%

2014Q3F 9.0% 8.5%

2014Q4F 8.8% 8.0%Source: NBS and DB forecasts

Yoy real GDP growth forecasts

6.0%

7.0%

8.0%

9.0%

10.0%

2011

Q1

2011

Q2

2011

Q3

2011

Q4

2012

Q1

2012

Q2

2012

Q3

2012

Q4F

2013

Q1F

2013

Q2F

2013

Q3F

2013

Q4F

2014

Q1F

2014

Q2F

2014

Q3F

2014

Q4F

Source: DB estimates, CEIC



We believe Q3 of 2012 was the trough of yoy GDP growth and a Q4 recovery is already underway. Since September, several positive changes have contributed to a modest acceleration in IP growth. First, raw material prices begin to recover from mid-September, ending a 5-month long inventory destocking process. In October and November, the raw material inventory index in the PMI report continued to improve. Second, demand recovered modestly in the past two months, with the new orders sub-index (partly reflecting end-user demand) rising to an average of 50.8 in October-November, up from an average of 49.2 in Q3. Third, the growth of ytd total social financing (TSF) accelerated sharply to 23%yoy in October, up from a 0% yoy change in the first half of 2012. The stock of TSF grew at 19% in recent months, up from 16% in the middle of 2012. These, together with a 20.5% yoy rise in manufacturing profit growth in October, suggest that financing has become less of a constraint for corporate investment. Based on these trends, we expect Q4 GDP growth to rise to 7.7%yoy from Q3’s 7.4%.

Growth of stock of total social financing, yoy%

15%

20%

25%

30%

35%

Jan-

10

Apr

-10

Jul-1

0

Oct

-10

Jan-

11

Apr

-11

Jul-1

1

Oct

-11

Jan-

12

Apr

-12

Jul-1

2

Oct

-12

Source: DB estimates, CEIC

For 2013, we expect a modest recovery of GDP growth to around 8.0% in H1, before it reaches the potential of around 8.5% in H2. This projection of a back-loaded recovery reflects both the domestic and external factors. On the domestic front, we believe it will take another two to three quarters for the corporate sector to shakeout the excess capacity and normalize the manufacturing sector’s capacity utilization rate. By Q3 next year, the improved capacity utilization rate and higher profitability will begin to drive an acceleration of corporate investment. We believe that the reduction of excess capacity started from the beginning of 2012, when listcos’ capex growth fell to 7% yoy. Note that listcos’ capex growth slowed even further (to zero) in Q3. At the current pace, capacity growth is already slower than demand for capacity, and excess capacity should largely be absorbed by mid-2013.

On the external front, DB’s forecast shows that G2 (US and EU) GDP growth will likely remain subdued in H1 of 2013 (estimated at 0.8%yoy), due partly to the impact of fiscal cliff in the US, before recovering to 1.4%yoy in H2 of 2013, driven mainly by capex growth. Therefore, China’s export growth will likely be relatively weak in H1 but stronger in H2. Specifically, we expect China’s export growth to rise from 8% in H1 to 12% in H2.

G2 GDP growth and China export growth forecasts,

quarterly yoy

0

5

10

15

20

25

30

0.0

0.5

1.0

1.5

2.0

2.5

Mar

-11

Jun-

11

Sep-

11

Dec

-11

Mar

-12

Jun-

12

Sep-

12

Dec

-12

Mar

-13

Jun-

13

Sep-

13

Dec

-13

G2 YoY (lhs)

China exports, yoy% (rhs)

Source: Deutsche Bank, CEIC

Sensitivity of China’s GDP growth to US fiscal cliff

The Wall Street Journal’s CEO Council listed the US fiscal cliff as its biggest concern for the global economy, with the “concern index” for fiscal cliff having risen to 73% at end-November, compared with Euro crisis (12%) and China slowdown (8%). The fiscal cliff is a combination of expiring benefits and new measures set to come into place at the start of 2013. The US economy faces a USD650bn cliff on Jan 1 2013; “going over” the cliff risks economic instability and would send the US into recession. To avoid ‘going over’ the cliff, Congress (currently under divided control between Democrats and Republicans) must agree to extend some of the tax breaks or prevent some of the spending cuts. Our US economists expect the following as the central scenario that can avoid a recession:

A deal to reduce the cliff to around USD180bn or 1-1.5% of GDP;

The debt ceiling to be lifted at some point in H1 2013 if not raised as part of agreement to delay fiscal cliff.

However, political deadlock or insufficient compromise cannot be ruled out. A deadlock risks triggering a potentially disruptive US sovereign downgrade, a sharp fall in US equities, and a significant deceleration (or decline) in US GDP growth.



For China, the key question is how a negative scenario of the US fiscal cliff resolution may affect Chinese exports and GDP growth. Assuming that in the negative scenario of “going over the fiscal cliff”, a resolution to the fiscal cliff is reached only by mid-year, but QE is increased and continues into 2014. In this case, US GDP will likely fall in the first half of 2013, but recover in H2. For 2013 as a whole, US GDP growth will likely be close to zero vs. DB’s baseline forecast of 2.4%. Also assume that the US growth deceleration cuts European GDP growth to -1% via its spill-over effect. Thus, G2 GDP growth in the negative scenario will be -0.5%, compared with our baseline forecast of 1.1%. Based on the historical correlation between G2 GDP and Chinese export growth, we estimate that the negative scenario of US fiscal cliff would knock off China’s export growth by about 9ppts. This will in turn reduce China’s GDP growth by about 1ppt.

Our quantitative analysis shows that the 2ppt GDP growth deceleration in 2011-2012 have led to overcapacity that requires a 1.5 year-long adjustment process of capacity reduction. Therefore, another 1ppt fall in demand as % of GDP should potentially require another nine month extension of the adjustment period. In other words, the negative scenario that we assumed for US fiscal cliff may delay China’s growth recovery by about three quarters compared with our baseline forecast.

Upside risk to our growth forecast: fiscal spending

In our baseline forecast, the 0.5ppt rise in GDP growth in 2013 is explained by the modest acceleration in export growth (by 2ppts) and modest increase in corporate investment growth (by 2ppts), by assuming monetary and fiscal policies are largely neutral. However, we do believe that the main upside risk to our baseline growth forecast is that stronger-than-expected fiscal revenue will allow higher-than-budgeted government capex. Based on our GDP forecast and historical correlation between GDP and fiscal revenue, we found that next year’s fiscal revenue growth will likely reach 16%, up from this year’s 11%.

The outperformance of revenue growth than expectation will likely permit additional government spending of RMB500bn next year beyond the approved budget, after taking into account some allocation to the fiscal reserve fund. This means that government’s fiscal spending, especially capex, will likely exceed the original budget and provide some upside momentum to gross capital formation next year. In a sense, this extra government spending is equivalent to a pro-cyclical fiscal expansion. Assuming that the fiscal multiplier is one, RMB500bn in fiscal expansion should boost GDP growth by 0.8ppts, if the fiscal deficit/GDP ratio is set at 1.6% in 2013, unchanged from 2012. If we assume 2013 fiscal deficit

will be set at the more likely 1.3% of GDP, then the fiscal expansion could boost GDP by 0.5%.

Macro policy outlook for 2013

The National Economic Work conference to be held in December should set the targets for GDP growth and inflation, and outline the monetary and fiscal policy stance (not in quantitative terms) for 2013. We expect the GDP growth target to be set at 7.5% and CPI inflation target at 3-3.5%. We think the government will continue to label 2013’s monetary policy as “prudent” and fiscal policy as “proactive”. The M2 growth target may be later released via informal talks by senior officials from the State Council or the PBOC. The fiscal deficit target will be finalized only at March’s National People’s Congress.

We expect the M2 growth target be set at 13-14%, 2-3 ppts higher than the likely nominal GDP growth rate (12%, based on 8% real GDP growth and 3% inflation). A 13% number will be viewed by us as a bit conservative, while 14% will be slightly expansionary. On the fiscal front, history tells us that when the economy is recovering the government will likely tolerate a small decrease in the absolute amount of the fiscal deficit (e.g., from RMB800bn in 2012 to RMB750bn in 2013). This implies that the fiscal deficit/GDP ratio will likely fall from 1.6% in 2012 to 1.3% in 2013. Nevertheless, as we pointed out earlier, the cyclically-adjusted fiscal stance may still be quite expansionary in 2013, as revenue growth in 2013 may accelerate by as much as 5ppts (equivalent to RMB600bn).

As for specific monetary policy instruments, we expect an modest increase in benchmark interest rates towards the end of 2013, as inflation will likely rise from the current 2% to about 4% by end-2013, due to the increase in food prices and higher PPI. If food inflation is benign in 2013, then the PBOC may delay its rate hike to 2014. We are not looking for a change in RRR policy as BOP surplus seems to have resumed and liquidity injection via FX reserve accumulation and open market operations will probably be sufficient to maintain the needed growth of M2.

Monthly CPI forecasts, yoy%

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan-

10M

ar-1

0M

ay-1

0Ju

l-10

Sep-

10N

ov-1

0Ja

n-11

Mar

-11

May

-11

Jul-1

1Se

p-11

Nov

-11

Jan-

12M

ar-1

2M

ay-1

2Ju

l-12

Sep-

12N

ov-1

2Ja

n-13

Mar

-13

May

-13

Jul-1

3Se

p-13

Nov

-13




On the exchange rate, we forecast a 2.5% RMB appreciation against the USD in the coming 12 months. This is more bullish than our expectation a few months earlier (we expected a 1.5% appreciation) due to: 1) GDP growth outlook has improved, and we are more confident that China can achieve 8.2% GDP growth in 2013; 2) net capital inflow has resumed; 3) the recovery of the global economy in 2013 will mean that most EM currencies tend to appreciate vs. the USD.

More aggressive reforms and anti-corruption efforts from 2013

Contrary to the perception of many western observers who believe the new party leadership is conservative and risk averse, our view that the new leaders will likely accelerate the pace of economic reforms and take more aggressive steps to fight corruption. Several indications from the past two weeks reinforce our expectations: First, Li Keqiang, who is expected to be the next premier, stressed that “reform is the biggest dividend for China”, indicating that full efforts will be made to speed up economic reforms; Second, party secretary Xi Jinping and anti-corruption chief Wang Qishan repeatedly said that “If unchecked, corruption will cause the collapse of the party and fall of the state.” In a recent consultation meeting convened by Wang Qishan, the proposal of public disclosure of officials’ wealth has become a highlight.

In the economic field, we classify reforms into three categories according to our assessment of their probabilities in the coming 3-4 years:

Likelihood of economics reforms in the coming 3-4

years Most likely reforms Possible reforms Least likely reforms

Resource pricing reform Personal income tax reform SOE reform

Interest rate liberalization Hukou reform Property tax

Capital account liberalization Rural land reform Central-local relations

Greater exchange rate flexibility Budget transparency

VAT reform De-monopolization

Resource/environmental tax reform Pension reform

Increase in social spending


We believe that the most likely reforms include resource pricing reform, interest rate liberalization, capital account liberalization, increased exchange rate flexibility, VAT and resource tax reform, and an increase in social spending from the budget. These reforms have largely become a consensus in the government; technical preparation is most advanced; pilot programs have been run with generally successful results; and opposition from interest groups is relatively less organized.

We classify personal income tax reform, Hukou reform, rural land reform, budget transparency, de-monopolization, and pension reform as desirable but will take somewhat longer than those in the first category. This is largely because at the policy research level there are still many competing proposals on technical design, there remains political and ideological concerns (especially on land reform and transfer of SOE shares to the pension system), and interest groups opposing reforms are relatively more vocal (e.g., on de-monopolization and aspects of income tax reform).

We believe SOE privatization, property tax, and central-local fiscal relations are most difficult and therefore the least likely to take place in the coming few years. These reforms are subject to most ideological obstacles, perceived political risks and strongest opposition from interest groups, and have the least technical readiness.

We used our dynamic CGE model (DBCGE) to simulate the impact of the most likely reforms on 135 specific industries. The key results are:

The top beneficiaries are natural gas manufacturing and distribution with a 14.4ppts increase in pre-tax margin, water sector (+8.7%), Petroleum processing (+6.6%), Education (+5.8%), Health (+4.1%) and Electricity (+1.4%). Higher resource prices contribute largely to resource sectors’ benefit since higher prices of their products improve these sectors’ revenue and profit sustainability. Sectors like education, health and telecom benefit from reasons such as less tax burden post VAT reform, higher fiscal expenditure in these fields and higher consumption share of GDP.

At the same time, sectors, mostly heavy industry ones, will be slightly hurt as higher resource prices incur higher costs and thus lower margins for them. Chemicals, non-ferrous and ferrous metal mining see a moderate decline in their gross margins compared with the basecase without the reforms. In addition, a higher resource and environmental tax rate also causes net profit to shrink a little.



Impact of reforms on sector’s pre-tax margin (ppt

change from baseline) -7% -2% 3% 8% 13%

Manufacture of gasWater

Refined oilEducation

HealthElectricity

BankingMedicine products

TelecomUrban public transport

Real estateTourism

InsuranceRailway transport

OilCoal

Steel industryChemical raw materials

Mining of non-ferrous metalMining of ferrous metal

Banking *(including interest rate liberalization)


Watching out for overheating in 2014

In this note, we also briefly present our projection of China’s 2014 GDP growth. We expect a further acceleration of GDP growth to 8.9% in 2014. Despite a gradual deceleration of growth potential due to changes in demographic factors – based on our model, structural factors such as demographics will likely lower China’s growth potential by 0.2-0.3ppts per year between 2008 and 2018 – we believe several cyclical factors will continue to push up GDP growth rate in 2014, or at least in the first half of 2014. These factors include:

First, stronger global demand will lift China’s export growth. Our global forecast shows that G2 GDP growth will accelerate sharply to 2% in 2014 from 1.1% in 2013. This reflects the partial success of fiscal consolidation and rising credit growth in Eurozone, as well as the recovery in confidence after the resolution of the US fiscal cliff. Given that EM growth has very high correlation with G2, it is likely that global GDP growth may rise by 1ppt in 2014 as a result. This implies that China’s export growth may accelerate to 15% in 2014 from 10% in 2013.

Second, domestic investment growth will enjoy an upward momentum. As discussed before, we expect China’s corporate sector to accelerate its investment in H2 next year on stronger profitability. This capex-led recovery tends to generate higher PPI and further improve profitability, and therefore create further incentives for companies to invest. In addition, better-than-expected fiscal revenue will allow the government to invest more, generating a passive fiscal stimulus to the economy. The combination of a corporate capex-led recovery and a de facto fiscal expansion will probably result in an overheating of the economy.

As for the timing of the potential economic overheating, our best guess is that GDP growth may exceed 9%yoy and CPI inflation getting closer to 4%yoy at the end of 2013 or early 2014. If that occurs, the PBOC will likely tighten monetary conditions by withdrawing liquidity from the banking system and raising interest rates. The NDRC may also begin to slow the pace of project approvals. This may lead to a deceleration of growth in the second half of 2014.

Jun Ma, Hong Kong, +852 2203 8308

Investment strategy

Fixed income strategy: We are cautious on duration as growth recovery and supply risk on the credit market likely will drive up long-dated rates. Interbank liquidity should remain stable as monetary policy will shift toward neutral in H1; however, we see upside risk on Shibor fixing with the implementation of the new capital requirement next year; Supply risk is predominantly from local government bond financing and credit market financing

Our favored trades in 2013: (a) put on 2Y/5Y Repo NDIRS/IRS curve steepeners at 15bps; (b) pay outright 5Y Repo NDIRS/IRS when 5Y retraces to around 3.3%; (3) on the cash curve, we recommend Shibor floaters and think 10Y CGBs at above 4% are attractive to buy.; (4) sell 1Y USDCNH forward. Downside surprises to economic growth, credit events in the bond market and delay of financial liberalization reforms are key risks to our view.

Liquidity outlook: We expect monetary policy to shift towards neutral in H1, as such policy interest rate environment will be kept stable in H1 and interbank liquidity to remain ample to support money supply growth at 14%YoY and about 9trn new loan growth.

We believe there are four key drivers of the bear steepening bias on CNY rates market in 2013:

Upside risk to uncollateralized interbank funding: The implementation of the new capital rule from the start of 2013 suggests upside risk on Shibor fixing. Base on our theoretical analysis, Shibor fixing can be adjusted upward by at least 50bps.

Local government bond supply risk: we forecast net local government bond supply of RMB 400bn, up from 250bn in 2012 (60% YoY growth) to finance infrastructure spending.

Credit market supply risk: The trend of financing via the credit market will continue to substitute bank loans, and



we forecast net funding by non-FI corporations to reach CNY 3trn next year, up from about CNY 2trn in 2012.

Potential launch of domestic Certificate of Deposit products(CD) in the interbank market which will help improve the pricing of commercial banks’ deposits, pushing forward domestic interest rate liberalization.

Despite low supply risk of CGB bonds as we forecast the central government’s net financing need in 2013: at around CNY 550-600bn -roughly the same as in 2012, there are two key risks of long-dated CGB yield and Repo rates to break the upside are (a) sustained upward trend of growth recovery; (b) UST selloff; (c) upside surprises on CPI. We expect 10Y CGB yield and 5Y Repo IRS will remain range bound in Q1, and likely will grind higher towards 4% sometime in H1 next year.

CNH market: Robust outlook in 2013: We expect policy makers will focus on addressing offshore liquidity supply concerns by further liberalizing capital accounts. We expect the following policy development: (a) A potential increase of RMB QFII quota to RMB 270bn from RMB 70bn currently. (b) Three new measures to broaden the sources of offshore RMB liquidity supply under capital accounts :(i) RMB cross-border lending should surge and more regions are likely to join the pilot program of RMB cross-border lending by the onshore MNCs. Hard to see substantial fiscal consolidation in 2012; (ii) Regulators may consider allowing offshore participating banks to access the onshore interbank market for short-term collateralized or uncollateralized funding. (iii) We expect an upward adjustment of the RMB daily conversion limits for Hong Kong residents (currently RMB 20k). (c) There are likely to be appointments of RMB clearing banks in Taiwan, Singapore and possibly London, and RMB fixed income trading and other RMB business will become operational in Taiwan in the near future.

On the market development in 2013, we expect RMB trade settlement volume to increase by 30% next year to RMB 4tr. With potential growth of the RMB business in other offshore centres (Taiwan, Singapore and London), we expect daily offshore RMB trading volume to rise to USD 2.5-3bn. In terms of development in the RMB business in other regional centres outside Hong Kong, we expect the aggregate offshore RMB deposit base to reach RMB 1.25tr and net issuance of offshore RMB bonds/CDs to reach RMB 210bn (RMB 340bn gross issuance) in 2013.

Linan Liu, Hong Kong, +852 2203 8709

China: Deutsche Bank forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 7270 7986 9078 10539Population (mn) 1348 1355 1362 1369GDP per capita (USD) 5393 5894 6665 7698

Real GDP (YoY%)1 9.3 7.7 8.2 8.9 Private consumption 9.0 8.4 8.8 8.8 Government consumption 9.9 8.4 9.0 8.5 Gross capital formation 10.0 7.5 8.5 10.0 Export of goods & services 12.6 7.0 8.0 12.0 Import of goods & services 14.0 7.8 9.5 13.5

Prices, Money and Banking CPI (YoY%) eop 4.1 2.0 4.0 3.5CPI (YoY%) ann avg 5.4 2.6 3.0 3.5Broad money (M2) 13.6 14.5 13.5 14.0Bank credit (YoY%) 15.8 15.1 13.5 14.0

Fiscal Accounts (% of GDP) Budget surplus -2.0 -1.6 -1.3 -1.0 Government revenue 22.7 22.7 23.2 23.4 Government expenditure 24.7 24.3 24.5 24.4Primary surplus -1.3 -0.9 -0.6 -0.3

External Accounts (USD bn) Merchandise exports 1898.6 2031.5 2234.7 2569.8Merchandise imports 1743.5 1856.8 2088.9 2433.6Trade balance 155.1 174.7 145.8 136.3 % of GDP 2.2 2.2 1.6 1.3Current account balance 201.7 214.7 180.0 165.0 % of GDP 2.8 2.7 2.0 1.6FDI (net) 170.4 140.0 100.0 70.0FX reserves (USD bn) 3270.0 3300.0 3500.0 3700.0FX rate (eop) CNY/USD 6.30 6.22 6.06 5.91

Debt Indicators (% of GDP) Government debt2 19.4 19.0 18.1 17.0 Domestic 18.9 18.5 17.6 16.5 External 0.5 0.5 0.5 0.5Total external debt 9.6 10.4 10.2 10.4 in USD bn 695.0 830.0 930.0 1100.0 Short-term (% of total) 70.0 65.0 60.0 60.0

General (YoY%) Fixed asset inv’t (nominal) 23.8 19.0 21.0 23.0Retail sales (nominal) 17.1 14.2 14.8 15.2Industrial production (real) 13.9 10.0 11.0 12.5Merch exports (USD nominal) 20.3 8.0 10.0 15.0Merch imports (USD nominal) 24.9 5.5 12.5 16.5

Financial Markets Current 3M 6M 12M1-year deposit rate 3.00 3.00 3.00 3.2510-year yield (%) 3.55 3.60 3.70 4.00CNY/USD 6.22 6.23 6.17 6.06 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



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

Economic outlook: Recovery is dependent on

stronger growth in the US, EU and China (combined), which is unlikely before mid-2013. Inflation is likely to continue to decline as property prices stabilize.

Main risks: “Fiscal cliff” or other external shocks remain the key risk to the outlook. Rising property prices would keep inflation high leading to a “stagflationary” environment.

Strategy recommendations: We recommend put on 5Y/10Y Hi/Li basis curve flattener at 15bps and long only investors should consider switching out of 10Y EFNs to 10Y GBHK for about 30bps pickup in yield.

Macro view

Recovery is dependent on foreign demand. As an entrepot – goods and services trade is 450% of GDP and 97% of merchandise exports are re-exports – Hong Kong cannot help but be driven by global demand. Slowing growth in the US and Europe has reduced demand for Chinese exports trans-shipped through Hong Kong while slowing growth in China has reduced demand for imports through Hong Kong. So, after a strong rebound from the GFC – GDP growth rose from a trough of -7.8% in 2009Q1 to a peak of 7.9% a year later – growth has slowed over the past two years to only 1.0%ytd. Put more starkly, the last six quarters has seen cumulative growth in seasonally adjusted GDP of only 1.2%.

GDP growth in Hong Kong and its main trade partners

HK = 1.92 x G2&CH - 2.5R² = 0.74

-10

-5

0

5

10

15

-4 -2 0 2 4 6 8

HK GDP, %yoy

"G2" & CH GDP, %yoy

Sources: CEIC and Deutsche Bank. “G2” is the US and European Union, “CH” is China. Growth rates are PPP-weighted averages..

We expect this anaemic growth will continue for another 6 – 9 months. While we think Chinese growth will gently rise, growth in the US and Europe will likely decline for another couple of quarters. Only around mid-2013 do we expect growth in the “advanced” economies to strengthen. Thereafter, as the chart above suggests,

growth in Hong Kong can be expected to rise much more quickly than in its trade partners. In the near term, however, this “high beta” nature means that Hong Kong is also highly exposed to downside risks from, e.g., the US “fiscal cliff”.

Current account falls into deficit The most interesting development in Hong Kong since the GFC has been the deterioration in its current account position. Hong Kong last ran an annual current account deficit in 1997, but Q2 saw a USD1.2bn deficit, only the second quarterly deficit since 1997. We now expect that the current account will remain in deficit for the rest of the year and forecast a deficit of 1.5% of GDP this year and next.

Hong Kong’s current account balance

-5

0

5

10

15

20

25

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

4Q ma Quarterly% of GDP


We don’t think of this as “structural” in the sense so often used by investors: i.e., “permanent”. We expect the deficit will peak in the first half of next year and then decline gradually thereafter, disappearing during 2014. It’s a close call whether the current account balance for 2014 will be a small deficit, as we forecast, or a surplus.

What’s behind this deteriorating current account balance is a decline in the savings rate and rising public and private investment. We see these both as mainly cyclical developments. Households are dipping into their savings and the government’s surplus has declined as growth has slowed. The ageing population would tend to depress savings as well, but we think cyclical factors are probably more important these days. On the investment front, rising property investment and the government’s infrastructure projects are both driving investment/GDP upwards. Over the medium term, we expect both influences will weaken while household savings may rise. While the current account deficit may be primarily a cyclical phenomenon, we do not expect a return to the 10% or higher surpluses observed during 2004-07.



Gross savings and investment in Hong Kong

15

20

25

30

35

40

84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Saving Investment% of GDP


Inflation has fallen from 5.8% to 3.8% over the past year and if the government’s efforts to rein in property prices succeed then inflation will likely fall below 2% over the coming 18 months even if food price inflation picks up. These developments should bring more balance to the currently very bullish HKD sentiment.

Michael Spencer, Hong Kong, +852 2203 8305

Investment strategy

Fixed income strategy: Flattening risk on Hi/Li basis curve

The pace of capital inflow, UST performance and corporate funding activities will be key drivers of HKD rates in 2013.

Capital flow to equities, CNH assets and other investment market is likely to continue in 2013, and the pace of such inflows will be determined by fundamental outlook of the Greater China economy.

USDHKD spot will tend to gravitate towards the strong end of the convertibility zone and further liquidity injection by the HKMA is more likely to push EF bills yield lower and cap the front-end of the Hibor fixing.

Sizable prefunding by HK corporations is expected to be completed before the end of this year, and with corporate liability flows likely to lighten up next year, we think the long-end of the Hi/Li basis curve is poised to flatten. We recommend put on 5Y/10Y Hi/Li basis flattener at 15bps.

The relative cheapness of long-dated GBHK(10Y) vs. EF notes can be explained by liquidity premium and the fact that short positions on GBHK bonds are not allowed. However, for long only investors, we think it offers an attractive entry to switch out of EF notes to GBHK at 30bps pickup in yield.

Linan Liu, Hong Kong, +852 2203 8709

Hong Kong: Deutsche Bank Forecasts

2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 248.7 263.1 282.8 305.1Population (mn) 7.1 7.2 7.2 7.3GDP per capita (USD) 34973 36692 39135 41878 Real GDP (YoY%) 4.9 1.3 2.5 4.5 Private consumption 8.2 3.7 4.2 6.6 Government consumption 2.2 3.2 2.1 2.0 Gross fixed investment 7.5 8.4 7.6 4.9 Exports 4.1 0.7 1.9 5.6 Imports 4.6 1.5 2.7 6.2 Prices, Money and Banking CPI (YoY%) eop 5.7 3.1 2.8 0.7CPI (YoY%) ann avg 5.3 4.0 2.5 1.7Broad money (M3) 12.9 10.5 8.8 7.0HKD Bank credit (YoY%) 0.4 5.4 4.1 5.0 Fiscal Accounts (% of GDP)1 Fiscal balance 3.9 1.1 1.2 2.0 Government revenue 22.9 20.0 19.2 19.5 Government expenditure 19.0 18.9 18.0 17.5Primary surplus 3.9 1.1 1.2 1.7 External Accounts (USD bn) Merchandise exports 438.3 457.4 476.1 514.2Merchandise imports 447.4 491.6 517.6 562.8Trade balance -9.1 -34.3 -41.6 -48.7 % of GDP -3.7 -13.0 -14.7 -16.0Current account balance 16.2 -3.4 -3.9 -1.9 % of GDP 6.5 -1.5 -1.5 -0.5FDI (net) 9.3 -2.7 -2.7 -2.7FX reserves (USD bn) 285.4 281.3 277.3 281.8FX rate (eop) HKD/USD 7.78 7.75 7.80 7.80 Debt Indicators (% of GDP) Government debt1 3.2 3.9 4.5 5.0 Domestic 2.6 3.4 4.1 4.6 External 0.6 0.5 0.5 0.4Total external debt 391.8 399.2 327.1 295.0 in USD bn 974.6 1050.0 925.0 900.0 Short-term (% of total) 73.5 70.0 70.0 72.0 General Unemployment (ann. avg, %) 3.5 3.3 3.1 2.5 Financial Markets Current 3M 6M 12MDiscount base rate 0.50 0.50 0.50 0.503-month interbank rate 0.30 0.30 0.30 0.3010-year yield (%) 0.58 0.68 0.75 0.80HKD/USD 7.75 7.77 7.80 7.80 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Fiscal year ending March of the following year.



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

Economic outlook: Conditions may well be set for a

modest recovery in 2013, driven by a pick-up in external demand, flat commodity prices, monetary policy easing, some recovery in investment, better quality public spending, and resilient consumption.

Main risks: India remains vulnerable to inflation and exchange rate risks, coupled with external shocks and domestic political turbulence.

Strategy recommendations: Overweight duration. Add to risk on any back up to 8.25% on 10Y yields.

Ending 2012 on a weak note

July-Sep real GDP growth was 5.3%, marginally lower than the 5.5% outturn in the previous quarter. The average growth in the first three quarters of 2012 was 5.4%, symptomatic of a sideways moving economy.

Agricultural sector GDP growth was just 1.2% (down from 2.9% in Apr-June), broadly reflecting the adverse impact of the 10% decline in Kharif (summer) output owing to a poor monsoon. Industrial sector GDP growth also remained weak in July-Sep (+1.2%yoy vs. +0.8%yoy), though showing some modest improvement from the previous quarter, led by mining (1.9% vs. 0.1%) and manufacturing (0.8% vs. 0.2%). Electricity production growth however moderated sharply to 3.4%yoy, from 6.3% in the previous quarter. Services sector growth slowed further to 7.1%yoy (from 7.4% in April-June), primarily led by a less robust construction sector GDP outturn compared to the previous quarter (6.7% vs. 10.9%). Trade/hotels/transport sector growth improved somewhat (5.5% vs. 4.0%), while slowing in case of community/social/services (7.5% vs. 7.9%) and financing/insurance/real estate (9.4% vs. 10.8%).

Growth trend

-4

0

4

8

12

0

2

4

6

8

10

12

14

2005 2006 2008 2009 2010 2012

Real GDP, lhsNon-farm sector, rhsAgriculture, rhs

% yoy% yoy


The expenditure side GDP data, which is generally volatile and unreliable, showed that the economy grew by only 2.8%yoy in July-Sep, lower than 3.9%yoy in the previous quarter. We note that investment growth improved in the present quarter (4.1% vs. 0.7%), while moderating slightly in case of private consumption (3.7% vs. 4.0%) and government consumption expenditure (8.7% vs. 9.0%).

National accounts summary 2012 Jan-March Apr-June July-Sep

GDP, production side 5.3 5.5 5.3

Agriculture 1.7 2.9 1.2

Industry 0.7 0.8 1.2

Services 7.5 7.4 7.1

Non-farm sector 5.9 5.9 5.8

GDP, expenditure side 5.6 3.9 2.8

Consumption exp. 5.8 4.7 4.4

Private 6.1 4.0 3.7

Government 4.1 9.0 8.7

Gross Fixed Capital Formation 3.6 0.7 4.1

Exports 18.1 10.1 4.3

Imports 2.0 7.9 6.6Source: CSO, Deutsche Bank

The latest GDP data marks the third successive quarter of sub-6% growth which was last seen during the post crisis period of 2008 (Dec’08-June’09). With growth expected to stay below 6% in Oct-Dec as well, we think the overall FY12/13 real GDP growth outturn is unlikely to be better than 5.5%. Consequently, we cut back our real GDP forecast for FY12/13 by 50bps to 5.5%.

GDP forecast % yoy FY10/11 FY11/12 FY12/13E FY13/14E

Real GDP 8.4 6.5 5.5 6.5

Agriculture 7.0 2.8 1.7 3.0

Industry 6.8 2.6 2.1 3.8

Services 9.2 8.5 7.3 7.9

Expenditure side GDP

Consumption exp. 8.1 5.4 5.1 6.0

Private 8.1 5.5 4.7 6.3

Government 7.8 5.1 7.5 4.4

Investment 7.5 5.5 2.9 8.7

Exports 22.7 15.3 7.6 10.6

Imports 15.6 18.5 4.8 10.0Source: CSO, Deutsche Bank



A modest recovery likely in 2013

After a challenging year, during which growth slowed to 5½%, the exchange rate came under repeated bouts of weakness, inflation remained stubbornly over 7%, policy reforms took place in fits and starts, and coalition politics became more challenging, India can look forward a somewhat easier 2013, in our view. Already, markets have become positioned in favor of an economic recovery. Are these optimistic sentiments justified?

We have written for long that India’s low-hanging fruits of reform have been harvested, and the path ahead needs tougher, durable measures to create sustainable growth. The liberalization measures of the past yielded strong growth from 2003 to 2008, but since then the economy has become increasingly volatile, with both output and prices reflecting wide ranging structural bottlenecks, as well as regulatory and governance related constraints. The economy needs a second push, including investment and financial liberalization, fiscal consolidation, and efficiency enhancements.

India is also increasingly vulnerable to global demand and price shocks. The former is due to trade/GDP rising steadily over the past decade (trade/GDP rose to 43% from 21.5% between 2001 and 2011) and the latter because domestic prices have begun to reflect international prices with a greater degree of frequency. This rise in vulnerability needs to be dealt through greater economic flexibility, such as automatic price adjustment of fuel products and a more flexible FX regime.

Since September, when fuel prices were raised and some FDI liberalization measures were announced, consensus has shifted to rising expectations of sustained policy measures to deal with the factors flagged above. Foreign investors, in particular, have expressed optimism about India, bringing in USD26.1bn so far this year. A key question is if reforms were not to sustain due to political developments, to what extent would the market and the economy suffer in the coming year?

Clearly reforms would be helpful to ensuring a lasting economy, and the authorities do look committed to delivering some key measures. But we think a case can be made for a near-term economic bottom even without major initiatives. Below we lay out our case for a modest recovery in 2013; the recovery would be supported greatly if major initiatives were to boost investment and consumption, but could take place in any case, in our view.

External factors First, the exchange rate could be a support for exports next year. The Indian rupee is, on a year-on-year basis, about 25% weaker against the US dollar and about 30% weaker against the Chinese Yuan. Our view of the balance payments pressures suggests this weakness to persist through next year. Given the relative inelasticity of import demand with respect to the exchange rate, we are not expecting a major correction in the current account, but we think it is reasonable to expect India’s export oriented companies to enjoy a bigger margin and improved competitiveness as a result of the rupee’s depreciation.

Additionally, demand for India’s exports could well pick up next year. Given India’s rising correlation with global demand, it is heartening to see improving PMI readings in both China and the US. With leading indicators suggesting a broadly positive and stable outlook in these two economies, India is bound to benefit. Additionally, India’s marginal gains in trade in recent years have come from strong demand in the ASEAN and middle-eastern regions, where economic activity will likely remain robust. Consequently, we are expecting a more positive contribution from net exports in 2013.

Beta to G-2 growth

-6

-4

-2

0

2

4

3

5

7

9

11India, left India, forecastG2, right G2, forecast

%yoy %yoy

Source: CEIC, Deutsche Bank. Note: A quarterly data regression of India’s real growth against ppp-weighted G2 growth, for the sample period 2006Q1 to 2011Q4, obtains a beta coefficient of 0.4, estimated with a statistical significance at 1% level and an adjusted R-squared of 0.61.

Fiscal While the fiscal position would benefit greatly from tax and expenditure side reforms (the laundry list is long, ranging from reforms of the Goods and Services Tax and the Direct Tax Code, market based pricing of fuel products, improvement in revenue administration, and better expenditure management), one does not have to wait for these measures to expect an improvement next year. First, the authorities don’t have any option but to come up with a plan for fiscal consolidation, given the pressure from ratings agencies and chronic weakness in revenue collection.



Second, ongoing institutional progress to replace broad-based subsidies (through price controls) by cash transfers will take further root next year, helping demand but reducing inefficiency at the same time.36

Third, the authorities have been strategizing a “quality vs. quantity” trade-off for plan (or capital) expenditure. The idea (already in place for the remainder of this fiscal year’s budget execution process) is to cut back on a number of capital projects to improve the fiscal situation, but concurrently expedite key, growth-critical projects. In the coming year, we would expect such an approach to help reduce fiscal impulse on one hand, while helping improve the fiscal multiplier on the other.

Consumption Even if the economy were to get no more than meager policy support next year, chances are consumption will remain strong. Labor market surveys suggest both rural and urban wages continue to rise by 15-20%, reflecting a labor market made tight by skill mismatches and public transfers. Demand for consumer goods, gold, and real estate, therefore, looks likely to persist.

Both consumption and investment would be boosted as and when the Reserve Bank of India becomes comfortable with the inflation situation and begins easing monetary policy. In its late October policy statement, the central bank expressed uncertainty about the inflation outlook, but at the same time stressed that it would be in a position to ease policy early in the new-year. If food and fuel prices, locally and globally, remain flat, the RBI may well get a chance to fulfill its goal, thus providing support to growth. Additionally, owing to a variety of measures, including OMOs and cuts in the CRR, liquidity has eased from the beginning of the year and would likely ease further next year, helping funding conditions.

Risks We have presented a constructive scenario above, one that is consistent with growth reaching 6.5% in FY13/14 even if major policy initiatives were to not take place. Of course the list of risks around this scenario is large. Below we highlight 4 key ones:

36 In this context, note that under the Aadhaar program, a 12-digit unique identification (UID) number is being issued to all Indian residents. The UID number is stored in a centralized database and linked to basic demographics and biometric information. This would allow individuals’ bank accounts, linked to the UID, to receive targeted public cash transfers aimed at supporting the poor’s minimum consumption level.

Banking system asset quality. Asset quality has worsened over the past year, and would remain a drag on banks’ ability and eagerness to lend. If rates don’t come down considerably and asset quality does not stop deteriorating, bank finance crunch could be unavoidable.

INR weakness and its impact on inflation and corporate sector balance sheet. This year’s substantial depreciation of the rupee could cause delayed pass-through, undermining a topping out of inflation. Corporations that have borrowed externally without hedging could have considerable difficulties with debt servicing owing currency mismatch on their balance sheets.

Politics. With the 2014 general election looming, and a fragile coalition and emboldened opposition undergoing all sorts of maneuvers, the risk of sound economic management being sacrificed to political expediency is not trivial.

Ratings. If growth disappoints for two more quarters, the currency remains under pressure due to a stubborn current account deficit, and the FY13/14 budget turns out to be unimpressive and not credible, then the risk of a sovereign rating downgrade will rise sharply. This could affect India’s economy and financial sector stability.

So far this year, locals have been short India, be it by selling equities (USD9.1bn) or acquiring gold. During the same period, foreigners have been substantial net buyers of equities and debt (USD26.1bn). Much of the foreign buying has been driven by external factors such as zero interest rate and anemic growth in industrial economies, as well as search for value in India. Will the Indian economy turn sufficiently next year to bring back the locals? We think there is a reasonable case to in favor of a bottoming of growth and a return of the local investor. Much is at stake, as no recovery can be sustained, with or without reforms, if the local population is not invested in the economy’s goals and aspirations.

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



Investment strategy

We are constructive on duration in India going into 2013, on the back of expectations for monetary easing by RBI, and benign technicals. But we would suggest active and opportunistic hedging of the currency risk as INR will likely remain volatile for a while longer.

Net issuance of government bonds could end up being INR5.1tn in the current fiscal year, as the government is forced to issue debt to finance at least part of the slippage due to lesser than expected revenues on 2G auctions and divestment. For FY2013-14 (beginning April next year), though, supply is unlikely to increase significantly (less than 3% year-over-year in both gross and net terms).

Bank demand continues to be key for the market, and has been exceptionally strong in FY13, inspite of concerns about fiscal slippage, and disappointment with RBI’s easing measures thus far. The banking system has run up its SLR to close to 30% of NDTL (see graph), even as the stipulated minimum has been cut to 23%. Every 1% increase translates into INR700bn of additional demand for bonds. With the economy still likely to grow at below potential for the next few quarters, we doubt if a demand for investment credit would force a significant unwind or slowdown in the bank bid. And if it did, we would hazard that RBI steps in more aggressively to plug the gap as it manages the systemic liquidity. The liquidity gap has averaged INR740bn (>1% of NDTL) this year, which has led the markets to consistently price in OMOs and CRR cuts, and acted as a backstop to any cheapening. We don’t think liquidity will ease significantly next year either, but the bond curve should be able to bull steepen on the back of policy rate cuts by RBI in late Q1, strong bank demand and possibility of further OMOs and CRR cuts.

Banking system SLR asset holdings around30% of

NDTL now

20%

25%

30%

35%

40%

45%

J-02 O-02 J-03 A-04 J-05 O-05 J-06 A-07 J-08 O-08 J-09 A-10 J-11 O-11 J-12

Minimum SLR requirements

SLR holdings (adjusted for LAF)

Per cent of NDTL


Sameer Goel, Singapore, +65 6423 6973 Arjun Shetty, Singapore, +65 6423 5925

India: Deutsche Bank Forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 1830 1805 2080 2421

Population (mn) 1200 1218 1236 1255

GDP per capita (USD) 1525 1482 1683 1929FY11/12 FY12/13 FY13/14 FY14/15

Real GDP (YoY %), FY 6.9 5.0 6.7 7.2

Real GDP (YoY %), CY 7.9 4.6 6.8 7.1

Private consumption 5.4 4.7 6.3 6.3

Government consumption 5.8 6.8 5.5 3.7

Gross fixed investment 5.5 2.8 7.5 9.5

Exports 19.4 10.3 9.4 12.7

Imports 22.5 4.9 7.7 10.4

Prices, Money and Banking

WPI (YoY%) eop 7.7 7.4 6.6 6.9

WPI (YoY%) avg 9.5 7.5 6.6 6.3

Broad money (M3) eop 15.9 13.0 17.0 16.0

Bank credit (YoY%) eop 16.1 14.7 18.3 17.0

Fiscal Accounts (% of GDP)1

Central government balance -5.8 -5.5 -5.0 -4.8

Government revenue 8.9 9.4 10.0 10.4

Government expenditure 14.7 14.9 15.0 15.2

Central primary balance -2.5 -2.4 -2.0 -1.8

Consolidated deficit -8.3 -8.0 -7.5 -7.3

External Accounts (USD bn)

Merchandise exports 306.8 309.9 344.0 381.8

Merchandise imports 475.3 484.8 533.3 586.6

Trade balance -168.4 -174.9 -189.3 -204.7

% of GDP -9.2 -9.7 -9.1 -8.5


% of GDP -3.4 -3.5 -3.4 -3.3

FDI (net) 21.8 22.0 25.0 25.0

FX reserves (USD bn) 291.4 295.9 306.7 311.7

FX rate (eop) INR/USD 53.3 53.0 52.0 51.0



Domestic 65.5 64.2 63.1 61.6

External 3.4 3.4 3.4 3.3


in USD bn 334.9 385.2 439.1 505.0


General

Industrial production (YoY %) 2.7 -2.1 3.5 5.1

Financial Markets Current 3M 6M 12M

Repo rate 8.00 7.75 7.50 7.00

3-month treasury bill 8.16 7.90 7.60 7.20

10-year yield (%) 8.17 8.00 7.80 7.50

INR/USD 54.5 53.0 52.3 52.0 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 Baa3/BB+(Pos)/BBB- Moody’s/S&P/Fitch

Economic outlook: It may not be smooth sailing in 2013 as rising wages push up inflation, worsening external balances continue to weaken the currency, and a lacklustre outlook for commodities weakens a key engine of growth. Strong consumption and investment sentiments may persist, however, as policy is likely to remain pro-cyclical, given election related considerations.

Main risks: The key risk is over-heating of the domestic economy, including excess of lending or price increase in real estate, inefficient investment boom, and worsening currency mismatch on balance sheet of corporates that have dollar payables and rupiah receivables.

Strategy recommendations: Market weight on duration; collect NDF hedges on dips.

Macro view

Can the imbalances persist for yet another year? Indonesia has had a relatively smooth 2012; far smoother than could have been expected at the beginning of the year when inflation seemed to be rising, foreign investor sentiment was brittle, external imbalances were worsening, and a long-pending decision to raise fuel prices threatened macro and political stability.

Considering the year was characterized by a major setback with regard to the fuel price indecision, a sharp worsening of the trade and current account balances, a steadily weakening currency, weak demand for commodity exports, numerous reports of labor unrest and wage increase, and no clarity on the dynamic of the next Presidential election, the fact that there were no lasting episodes of financial market correction, corporate or banking sector fragility, and unfavorable surprise on growth or inflation is indeed remarkable.

What explains this resiliency, and can the same expected in 2013? One key driver of the better-than-expected outcome is, in our view, confidence. Indonesian household and businesses are riding on waves of optimism about the future, factoring in a lasting period of economic and political stability. They see robust demand and easy financing conditions ahead, and hence are comfortable in making medium-and-long-term consumption and business decisions accordingly. This high degree of confidence has unleashed a positive feedback loop, under which consumer demand for goods

and services remained strong through the course of the year, which allowed businesses to keep producing, hiring, and paying without worry, which in turn helped reinforce the outlook for income and employment which is crucial in supporting demand.

It is conceivable that this dynamic could have been unraveled during the course of the year due to a major external or domestic shock. In the event, shocks were muted at best. There were no major spikes in global fuel prices that could have exacerbated the fiscal situation or forced the authorities to raise fuel prices. Commodity sector weakened, but not so much to cause a major spill over to the rest of the economy. The trade deficit worsened, and the rupiah weakened, but not to the degree to create severe external debt service difficulties. Global funding conditions were exceptionally easy, and foreign investors’ relentless search for yield kept them interested in Indonesia’s financial assets. Finally, and perhaps equally importantly, despite demand being very strong, food inflation remained muted, there were no discernible pass-through from a weak rupiah to the CPI, and rising wages did not push up inflation expectations.

We are doubtful, however, that these risks would remain as muted in 2013 as they were this year. In fact, if anything, the risks could be more pronounced next year as prevailing imbalances, be it export weakness or excessive demand for subsidized fuel, are compounded. We are therefore concerned that next year would be more challenging than this year. Below we highlight 3 key risks for period ahead.

Current account and the rupiah Indonesia’s trade balances have worsened through the course of this year, and the trend is likely to persist next year with an unclear export outlook (both quantity demanded and price) but likely persistence in the strength of imports. Consequently, the current account will likely remain in deficit territory, and pressure on the rupiah will continue, especially if the financing of the deficit becomes problematic time to time.

Many observers dismiss Indonesia’s current account deficit as a major source of worry, arguing that the deficit is of “good quality” as it reflects, to some extent, rising capital goods imports. We have misgivings about this line of reasoning for several reasons. First, the deficit is also a function of excessive demand for fuel products owing to the wasteful fuel subsidy policy. Since the authorities are not keen to raise fuel prices, the pull on



imports will become stronger next year in line with not just domestic demand but smuggling as well.

Second, much of the so-called capital goods being imported are related to expanding capacity of the consumer goods sector, such as auto and retail. If the imports were going mostly to building infrastructure, including roads, bridges, ports, power generation and so on, we would have been more sanguine. But what we see are imports of fuel, machinery, and transportation goods mostly geared toward responding to exceptionally strong consumption needs. While expanding the domestic productive capacity of consumption goods is welcome, the resulting trade deficit is not as productivity boosting and "good" investment-oriented as one would read at first glance.

The worsening of the trade balance will be compounded by large negative balances on the service and income accounts, as in recent years. As a result, we expect the current account deficit to move to 2.5% of GDP in 2013, if not higher. This would mean capital and financial accounts would have to continue to run sizeable surpluses to keep the balance of payments in stable territory. Indonesia has had a good run lately in attracting FDI and portfolio investments, but it is not clear if a the flows can be sustained or enhanced in the coming year to adequately support the ever widening financial need of the current account. In this context, one cautionary example is that of India, which has seen its current account deficit worsen in recent years due to strong import demand of fuel and gold, and as financing of the deficit has been affected time to time, the currency has seen a substantial rise in volatility. Our concern is Indonesia is beginning to follow the same pattern.

We therefore see a strong chance of a steady weakening of the rupiah in the period ahead, which could have adverse implications for investor sentiment and inflation. While the currency’s weakness did not cause with either risk to manifest in 2012 does not mean the same can be the case next year. As the rupiah heads toward 10,000 to the USD, the psychology of the market is bound to be affected, forcing Bank Indonesia to resort to intervention yet again. Note that with respect to the rupiah, the central bank has undergone a major change of rhetoric in the past year, from adamantly wanting to stabilize the exchange rate to anchor inflation expectations and financial market sentiment to gradually accepting a weak exchange rate was an inevitable consequence to worsening of the external balances. Nevertheless, more intervention can be expected as and when the rupiah heads toward 10,000. As far as inflation implications are concerned, by mid-2013 the exchange rate will be 10% weaker on a yoy basis, and

hence the risk of some exchange rate pass-through to prices would be high, in our view. Considering how strong demand has been so far and will likely be next year, producers will have little incentive to absorb the higher import costs.

Commodity sector weakness Mining and oil/gas related manufacturing make up 15% of Indonesia’s GDP, while commodities make up over half of exports. There is no doubt that the bull run in coal, palm oil, copper, and gas has been a major support for the Indonesian economy in recent years. Strength in mining has revitalized remote corners of the country, brought in substantial foreign direct investment (highest among all sectors), helped boost the value of commodity companies, and pushed up wages, enhancing welfare.

We don’t expect a dramatic weakening of investment and activity in the mining sector in 2013, but a flat commodity price outlook is a source of concern. Mining sector’s value added has weakened in recent quarters, although overall GDP growth has remained over 6%. The question is if the economy can continue to perform robustly if commodity sector weakness were to persist in 2013. We think that overall growth may not suffer much, but mining would indeed be a bigger drag, especially if wage cost continues to rise and export prices remain flat or on a downtrend.

Regulatory uncertainty and rising nationalism could become an issue for investment in mining next year (building on recent developments, where court rulings and regulatory developments have been discouraging for foreign investors), but there are signs that authorities would be pragmatic in dealing with this if the outlook were to worsen. With signs of recovery in China accumulating, there is reason to hope that the mining and commodity exports outlook could recover next year, thus helping the economy. We however don’t expect a surge in commodity demand even under an optimistic scenario, given our view on the type of recovery likely in store for China. Indonesia may well have to deal with the prospect that the commodity super cycle that amply supported its economy in recent years may well be a thing of the past, necessitating heavier lifting from other parts of the economy.

Inflation and wage-price linkage Inflation has been a surprising source of comfort in 2012, although conditions were set for prices to rise considerably. Fuel prices were slated to rise, global food price outlook appeared adverse, economic growth was strong, companies had wage cost rising, and supply side bottlenecks did not seem to be abating fast enough to keep pace with demand.



Despite that, CPI inflation will likely end the year close to 4%, well below Indonesia’s past trend. The much anticipated fuel price increase did not take place this year, and we think it is highly unlikely that administrative prices will be raised in 2013 (with the possible exception of an electricity tariff hike). There was minimal pass-through from rupiah’s modest weakness, and other than a few items in the CPI, there was little sign of producers raising prices appreciably during the course of the year.

But the biggest surprise was with regard to food prices. Given the strength of demand, it would have been reasonable to expect food prices to rise in line with past trend, when episodes of strong demand were associated with double-digit inflation of rice and noodles, in particular. What transpired was a remarkably muted price movement during most of the year, helping bring down overall inflation substantially.

A good harvest was helpful, but is not an adequate explanation of the price situation, in our view. We believe that the supply side has undergone substantial improvement in recent years, and the proliferation of modern retail stores (mini-marts) has helped with inventory and supply chain management, as well as more uniform and competitive pricing of food products in particular and retail products in general. This is indeed a favorable development, but for supply to keep pace with the type demand surge going on in Indonesia, chances are periods of price hike are inevitable, and we see some of that taking place in 2013.

Beyond food and fuel, we expect the rupiah’s weakness and strong demand to contribute to higher core inflation next year. With minimum wages rising by 44% early next year, and widespread reporting of strong wage growth in major sectors across the country, wage-push inflation also appears unavoidable, in our view. We have heard arguments that since wages are a small part of the cost structure of many companies, the risk of wage to price spill-over is small. This is an unconvincing thesis, in our view. Cross-country evidence suggests strong link between wages and prices, and we don't expect Indonesia to be an exception to this empirical regularity. How would Bank Indonesia deal with rising inflation next year? We think that it would maintain its view that the link between interest rate and inflation (and inflation expectations) is weak in Indonesia, and therefore there is no case to be made to raise rates pre-emptively. Indeed, we think the central bank believes keeping rates as low as possible could unleash an investment boom that would create capacity and thus reduce inflation impulse. This rather unorthodox view has taken hold in

recent years, as reflected by the communication of senior officials of the central bank.

We have seen Bank Indonesia take some modest measures this year to tighten liquidity and made the policy interest rate corridor narrower, but the authorities’ bias clearly is on macro-prudential measures. Targeted approaches to dealing with the real estate or foreign exchange market seem to be the strategy of choice. Unless rupiah weakness and/or rising inflation forces the central bank's hand—and we don't see this scenario play till the very end of 2013--the policy status quo will prevail, in our view.

Outlook Unless the risks flagged above accumulate swiftly early next year, the present climate of strong demand along with a slight deterioration of external balances could continue for a number of quarters. In our baseline forecast, therefore, we see growth remaining over 6% next year, inflation rising and rupiah weakening steadily, and both fiscal and monetary policies continue to be pro-cyclical. In our view, the seeds of a boom-bust cycle are in place, but that does not mean we expect major market dislocation in 2013 in our central thesis. One or two major external or domestic shocks would be needed for that dynamic to be unleashed, but we are not expecting a particularly turbulent 2013.

Having established that, we are concerned about the attractiveness of Indonesia’s financial assets. Unless hedged, local currency investments, whether equities or bonds, look less appealing than they did a year ago. The fact that the country is undergoing a consumption boom is well priced in, so the question is will Indonesia surprise on the upside to keep investors interested next year. We see that as a tall task, but we also recognize that in a world of anemic growth, Indonesia’s buoyant domestic economy is somewhat of a rare phenomenon. Hence we don't worry too much about investors shunning Indonesia in 2013. But since the authorities need investment as much as investors need to invest, maintaining macro stability and continuing to improve the legal, regulatory, and governance environment are as important as ever.

Taimur Baig, Singapore, +65 6423 8681



Investment strategy

Carry continues to be the biggest attraction to own duration in Indonesia. Technicals are still broadly constructive, with supply mostly in check, and Bank Indonesia’s bond buying to likely provide exit in a sell off. But we remain wary of getting overweight at current levels, particularly given the risk of potential reduction in spot liquidity in the event of any global macro stress. We stay market weight on duration, and will look to cheapening in NDF points to build hedges.

Given the narrowing of fiscal gap targeted for 2013, and likely continued reliance on multi-currency borrowings, local issuance won’t be particularly onerous next year. Equally though, buffer from carry over financing will be lesser in 2013 because of larger fuel subsidy payouts this year.

Offshore has again emerged as the key demander. It has likely covered bulk of its underweight in the last couple of months, but yields remain attractive in the global QE context. ~75% of offshore holdings are with index funds and LT buy-and-hold investors, and bulk are in >10Y tenor.

Offshore ownership - % of total, and tenor breakdown

10%

15%

20%

25%

30%

35%

40%

0%

25%

50%

75%

100%

0-1 >1-2 >2-5

>5-10 >10 % of total (right)

Source: Deutsche Bank, DMO

With absolute level of yields significantly below hurdle rates, local real money investors are interested only in the very back end of the curve.

BI buying continues to provide exit for street duration. The DMO’s ‘bond stabilization framework’ too should reduce tail risks for holders of duration, but it doesn’t preclude significant cheapening of the market.

The key threat to the market is from re-pricing in the front end of the curve as BI is forced to narrow the FASBI corridor, and step up its OMOs, likely ahead of a hike in benchmark policy rates.

Sameer Goel, Singapore, +65 6423 6973

Indonesia: Deutsche Bank forecasts

2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 846.3 885.8 955.0 1092.3Population (mn) 243.7 246.6 249.6 252.6GDP per capita (USD) 3473 3592 3826 4324 Real GDP (YoY%) 6.5 6.3 6.3 6.5 Private consumption 4.7 5.3 5.0 5.0 Government consumption 3.2 3.6 4.4 5.0 Gross fixed investment 8.8 10.0 8.7 8.7 Exports 13.6 2.2 6.0 7.0 Imports 13.3 4.7 5.1 6.0 Prices, Money and Banking CPI (YoY%) eop 3.8 4.2 6.0 6.5CPI (YoY%) ann avg 5.4 4.1 5.3 6.3Core CPI (YoY%) 4.3 4.5 5.5 5.0Broad money (M2) 16.4 15.0 15.0 16.0Bank credit (YoY%) 24.7 25.0 22.0 22.0 Fiscal Accounts (% of GDP) Budget surplus -1.1 -2.7 -2.3 -2.2 Government revenue 15.3 15.6 15.6 15.5 Government expenditure 16.3 18.2 17.9 17.7Primary surplus 0.9 -0.7 -0.3 -0.2 External Accounts (USD bn) Merchandise exports 200.8 194.7 205.4 217.7Merchandise imports 166.0 182.3 197.0 210.7Trade balance 34.8 12.4 8.5 7.0 % of GDP 4.1 1.4 0.9 0.6Current account balance 1.7 -20.6 -25.4 -28.6 % of GDP 0.2 -2.3 -2.7 -2.6FDI (net) 11.5 12.4 12.0 16.0FX reserves (USD bn) 110.2 106.1 93.6 85.4FX rate (eop) IDR/USD 9068 9640 9900 9700 Debt Indicators (% of GDP) Government debt 26.0 24.9 24.5 24.2 Domestic 15.0 14.1 13.5 13.2 External 11.0 10.8 11.0 11.0Total external debt 23.6 24.8 24.2 22.5 in USD bn 200.0 220.0 240.0 260.0 Short term (% of total) 18.5 20.5 20.8 21.2 General Industrial production (YoY%) 7.0 8.0 8.0 9.0Unemployment (%) 7.0 6.8 6.5 6.0 Financial Markets Current 3M 6M 12MBI rate 5.75 5.75 5.75 6.0010-year yield (%) 5.34 5.50 5.70 5.80IDR/USD 9640 9715 9790 9900 Source: CEIC, DB Global Markets Research, National Sources



Malaysia A3/A-/A-

Economic outlook: Fiscal policy has supported growth in 2012, but as exports recover from mid-2013 we expect fiscal policy to be tightened.

Main risks: “Fiscal cliff” could plunge Malaysia back into recession, leading to rate cuts and FX weakness.

Strategy recommendations: Look to accumulate duration on any election related steepening of MGS curve.

Macro view

Whither Malaysia?. Malaysians will go to the polls some time in the next six months. We think a lot more is at stake in the election than just the margin of victory of the winning party. Since the Asian Financial Crisis, the Malaysian economy has been transformed, and not in a good way. In 2000, Malaysia accounted for 10% of regional exports; exports of goods and services were 115% of GDP. But since then, its share of regional exports has fallen to just over 5%.

Malaysia’s share of gross emerging Asian exports

5

6

7

8

9

10

11

12

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

%


Malaysia’s competitiveness as an exporter seems to have declined over the past decade and it is from that perspective that we approach the government’s Economic Transformation Program, which promised to reinvigorate private investment. For the decline in export competitiveness was, in our view, a consequence of the sharp drop – by more than 20% of GDP – in private fixed investment during the Asian Financial Crisis. The drop in investment opened up a huge current account surplus – averaging 12.5% of GDP since 2000 and never less than 7.9% – but this was not a reflection of strength.

Gross domestic savings and investment

15

20

25

30

35

40

45

50

55

87 89 91 93 95 97 99 01 03 05 07 09 11

Savings Investment% of GDP


As the private investment effort stagnated the government initially tried to make up for the decline. Government investment as a share of total investment rose from about 22.5% in 1997 to 45% in 1999 and peaked at 60% in 2002. While this undoubtedly supported growth, it did so at a cost: since 1999 the government has run fiscal deficits averaging 4.5% of GDP and the government debt/GDP ratio has risen from 33% to about 53%. We think this fiscal support has just about run its course: if the government is unable to reduce its deficit, ratings downgrades loom, which could complicate its effort to reinvigorate private investment.

Government share of investment and consumption

10

20

30

40

50

60

70

89 91 93 95 97 99 01 03 05 07 09 11

Investment Consumption%


2013 outlook has policy rebalancing when exports revive While exports are “only” 89% of GDP versus 104% a decade ago, clearly they are still highly influential in driving activity in Malaysia. Malaysian GDP is highly correlated (0.7) and “high beta” (1.2) with US&EU GDP growth. The next two or three quarters, are unlikely to offer any improvement in the lackluster external environment: Malaysia’s real exports of goods and services have increased by a cumulative 1.6% over the



past eight quarters. When US&EU growth does pick up – around mid-2013 – then private demand will recover in Malaysia. Inflation has fallen steadily since the government slowed down the pace of subsidy cuts last year, reaching 1.3% in Sept/Oct from 3.4% a year earlier. Bank Negara Malaysia has refrained from cutting rates because fiscal support has sustained growth in the economy. We think rate cuts are an option in response to an external shock – a “fiscal cliff” shock could push GDP in Malaysia down by 2% or more – or as part of a rebalancing of stimulus away from fiscal towards monetary easing. But mainly, we look for 2013 to be a year in which external demand strengthens enough that the government is able to pursue with renewed vigor its drive to improve Malaysia’s competitiveness.


Investment strategy

Rates: The net issuance of MGS could be sharply lower in 2013 on the back of lower budget deficit, higher proportion of gross issuance in GIIs and over RM38.5bn of maturities of MGS. However, the relatively hawkish stance wof BNM makes it very improbable for the flat MGS curve to rally significantly. Elections are likely to be held in Q1 next year and given offshore owns over 42% of the MGS market, it is likely that some foreign investors lighten up their MGS portfolio in the run up to the elections. We would wait for such opportunities to accumulate duration.

Net issuance of MGS could be sharply lower in 2013

0%

10%

20%

30%

40%

50%

60%

0

5

10

15

20

25

30

35

40

45

50

2010 2011 2012 2013E*

Net issuance of MGSNet domestic borrowings% net financing with MGS

Source: Deutsche Bank, BNM, * Assuming gross issuance in 2013 is split evenly between MGS & GII

We don’t think MGS curve can bear steepen significantly in a risk off environment as local real money has both the size and the appetite to cap any such steepening pressure. The risk to MGS yields continues to be from higher UST yields and even then MGS yields are likely to move higher with a beta of less than 1.

Arjun Shetty, Singapore, +65 6423 5925

Malaysia: Deutsche Bank forecasts 2011 2012F 2013F 2014F

National Income Nominal GDP (USD bn) 288.2 307.8 350.4 394.5Population (mn) 29.0 29.3 29.7 30.1GDP per capita (USD) 9949 10493 11795 13112 Real GDP (YoY%) 5.1 5.3 5.0 6.0Private consumption 7.1 8.4 5.7 6.0Government consumption 16.1 3.3 1.5 3.0Gross fixed investment 6.5 21.0 8.0 4.5Exports 4.2 -0.3 1.6 4.0Imports 6.2 5.4 2.3 4.2 Prices, Money and Banking CPI (YoY%) eop 3.0 1.5 2.1 2.4CPI (YoY%) ann avg 3.2 1.7 1.7 2.4Broad money (M3) 10.9 13.3 8.6 9.0Bank credit (YoY%) 10.6 12.4 10.1 8.5 Fiscal Accounts (% of GDP) Federal government surplus -4.8 -5.0 -4.5 -4.0Government revenue 21.0 21.6 20.5 20.5Government expenditure 25.9 26.6 25.0 24.5Primary fed. gov’t fiscal -2.8 -3.1 -2.7 -2.6 External Accounts (USD bn) Merchandise exports 227.8 227.9 241.3 265.5Merchandise imports 179.4 188.6 198.6 214.4Trade balance 48.4 39.3 42.8 51.0 % of GDP 16.8 12.8 12.2 12.9Current account balance 31.8 16.8 19.3 28.0 % of GDP 11.0 5.5 5.5 7.1FDI (net) -3.2 -3.0 -3.0 -4.0FX reserves (USD bn) 133.6 131.1 126.8 128.1FX rate (eop) MYR/USD 3.14 3.04 2.99 2.93 Debt Indicators (% of GDP) Government debt 51.8 53.1 52.4 52.0 Domestic 49.7 51.2 50.7 50.4 External 2.1 1.9 1.7 1.6Total external debt 29.2 26.3 22.0 18.9 in USD bn 81.0 81.9 77.5 75.2 Short-term (% of total) 40.4 40.3 38.7 42.6 General Industrial production (YoY%) 1.8 2.9 2.1 4.0Unemployment (%) 3.2 3.3 3.3 3.2 Financial Markets Current 3M 6M 12MOvernight call rate 3.00 3.00 3.00 3.003-month interbank rate 3.2 3.2 3.2 3.210-year yield (%) 3.49 3.50 3.55 3.70MYR/USD 3.04 3.03 3.01 2.98 Source: CEIC, DB Global Markets Research, National Sources



Philippines Ba1/BB+/BB+ Moody’s/S&P/Fitch

Economic outlook: Growth continues to surprise to

the upside and the economy is beginning to overheat. While it is becoming more export-sensitive, we think inflationary pressures are likely to continue to build, forcing BSP to raise rates and let the peso appreciate.

Main risks: Inflation risks are weighted to the upside by strong GDP growth and rising global food prices.

Strategy recommendations: Stay short USD/PHP

Macro View

A year of above-trend growth. Third-quarter GDP growth surprised as much to the upside as the initial reading on Q2 (subsequently revised up) did to the downside. The economy expanded at a 5.2%QoQ(saar) pace last quarter to be up 7.1%yoy. After a brief slowdown in mid-2011 the economy has posted four consecutive quarters of above-trend growth.

Actual and trend GDP growth

0

1

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3

4

5

6

7

8

9

10

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

Actual Trend%yoy


Defining potential growth in emerging markets is challenging, especially given how volatile actual growth is. So we measure growth relative to its trend to identify output gaps. By this reckoning, the output gap turned positive in the first quarter of this year, and has widened to about 1.3% of trend GDP in Q3. This is the highest gap observed since the crisis and indeed we estimate that the output gap is at its widest since the Asian Financial Crisis except for 2007.

Likely means higher inflation ahead A positive output gap has historically been associated with rising inflation, measured on a QoQ(saar) basis. Given the importance of food in the CPI basket (39% weight) the mapping from output to inflation is not a close one. But the quarterly inflation impulse has risen from 1.5% in Q1 to 3.5% in Q2

to 4.8% in Q3. We note, however, that so far in Q4 inflation has been surprisingly weak. Importantly, the inflation impulse was much stronger a year ago, so even after three quarters of rising QoQ(saar) inflation, the YoY rate has fallen recently.

Output gap and inflation

CPI = 1.09 x Gap (-2) + 4.7R² = 0.18

0

2

4

6

8

10

12

14

16

-4 -3 -2 -1 0 1 2 3

CPI, %QoQ(saar)

Gap, %


Low real rates encourage faster growth While the central bank struggles with the balance sheet consequences of very high interest rates on its own liabilities compared to short-term money market rates (reverse repo and SDA yields are 3.5% and 3.7% respectively but 3m Phibor yields are 0.8% and 3m Tbill yields are 0.6%) the overall interest rate structure is, in our view, too low for an economy growing as fast as the Philippines. Even though it has declined recently, credit growth is still roughly double nominal GDP growth.

Real lending rate and credit growth

5

10

15

20-2

-1

0

1

2

3

4

5

6

72008 2009 2010 2011 2012

Real rate (lhs) Credit (rhs)% %yoy

Sources: CEIC and Deutsche Bank. Credit to the private sector only.

We expect the benign inflation prints in the last couple of months to prove to be transitory and the stronger inflation momentum to reassert itself. We expect inflation to



average 4% in Q1 next year and rise above 5% by year-end, which should get the BSP tightening policy – raising rates in Q2 and allowing faster PHP appreciation in the meantime. Alternatively, of course, it is possible that the economy’s potential growth rate is higher than our measured trend and that the output gap isn’t as high as we think it is. If so, then policy tightening would be delayed relative to our forecast.


Investment strategy

FX: The Philippines appear to be currently in a ‘virtuous macroeconomic cycle’. The country’s momentum in economic reforms, resilient domestic demand, upswing in the investment cycle, increasing political stability, improving fiscal situation, favorable demographics, potential rating upgrades and attractive yields are likely to drive a further pick up in portfolio inflows in 2013. As such, we see the peso coming under greater appreciation pressure from capital inflows. BSP has been actively trying to slow the peso’s climb using a combination of direct FX intervention, interest rate cuts, non-intervention market tactics (depressing FX implied yields by allowing maturing FX swaps to roll off) and macroprudential measures (e.g. caps on NDF positions at onshore banks, moral suasion on NDF trading, liberalization outflows, etc.). However, BSP will go into 2013 facing greater constraints to FX intervention. First, with a booming economy and flush domestic liquidity, BSP will not be able to keep rates low for long. Second, with low returns on FX reserves, an appreciating peso is driving up sterilization costs and exerting pressure on BSP’s balance sheet. BSP may thus become more reluctant to accumulate reserves, and rely more on macro prudential measures to curb FX gains. BSP may thus become more reluctant to accumulate reserves. Third, BSP’s FX swaps/forward book has almost been fully drawn down, limiting its ability to depress FX yields by not rolling over maturing FX swaps. We have been recommending selling USD/PHP on bounces (see FX Weekly 9 Nov) and like holding shorts, with seasonals working in favor of the PHP into year-end.

Dennis Tan, Singapore, +65 6423 5347

Philippines: Deutsche Bank Forecasts

2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 224.8 252.1 304.6 354.8Population (mn) 95.8 97.6 99.5 101.4GDP per capita (USD) 2346 2582 3062 3500

Real GDP (YoY%) 3.9 6.3 5.5 5.0 Private consumption 6.3 5.8 5.5 5.2 Government consumption 1.0 10.9 4.5 4.5 Gross fixed investment 0.2 8.0 7.6 3.3 Exports -4.2 7.9 5.1 6.3 Imports 0.2 5.2 4.4 6.1

Prices, Money and Banking CPI (eop, YoY%) 4.1 3.8 5.4 3.8CPI (YoY%) ann avg 4.7 3.3 4.6 5.0Broad money (M3, YoY%) 8.5 7.2 8.1 8.0Credit to private sector (YoY%) 13.6 17.1 11.3 10.0

Fiscal Accounts (% of GDP) Fiscal balance -2.0 -1.5 -1.0 -1.0 Government revenue 14.0 14.3 14.1 14.3 Government expenditure 16.0 15.8 15.1 15.3Primary surplus 0.8 1.5 1.4 1.1

External Accounts (USD bn) Merchandise exports 47.2 53.4 58.2 66.0Merchandise imports 62.7 65.2 67.3 74.0Trade balance -15.5 -11.8 -9.1 -8.0 % of GDP -6.9 -4.7 -3.0 -2.3Current account balance 7.1 10.2 14.1 17.8 % of GDP 3.1 4.0 4.6 5.0FDI (net) 1.3 0.8 1.3 1.4FX reserves (USD bn) 75.3 86.1 97.3 110.0FX rate (eop) PHP/USD 43.9 40.7 38.0 36.5

Debt Indicators (% of GDP) Government debt1 56.8 53.7 50.2 47.4 Domestic 31.1 30.4 29.0 27.5 External 25.6 23.3 21.1 19.8Total external debt 27.5 24.9 21.1 18.8 in USD bn 61.7 62.8 64.4 66.8 Short-term (% of total) 11.4 10.8 10.9 12.0

General Industrial production (YoY%) 2.3 7.0 5.6 4.7

Financial Markets Current 3M 6M 12MBSP o/n repo 5.50 5.50 5.75 6.25BSP o/n reverse repo 3.50 3.50 3.75 4.253-month Phibor 1.8 1.8 2.0 2.510-year yield (%) 4.15 4.00 4.20 4.50PHP/USD 40.9 39.8 38.8 38.0 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Incl. guarantees on SOE debt.



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

Economic outlook: A mild recovery in the US and

China could pave the way for an improved outlook in the coming year.

Main risks: Inflation could remain stubbornly high, affecting competitiveness and posing challenges to monetary policy.

Strategy recommendations: Be short SGD NEER, look to buy back the SGD on pullbacks to mid-band.

A multi-speed economy

Singapore’s third quarter national accounts and October trade data release show an economy of two halves. On one side, there are domestic demand oriented activities like construction (+7.7%yoy), transportation (+1.4%yoy), accommodation (+2%yoy), and business services (+3.8%yoy); on the other side lie manufacturing (-0.8%yoy) and trade. The former looks somewhat resilient, while the latter is being affected by weak global demand.

The growth picture looks poor when the GDP data is seasonally adjusted and the qoq percentage change is annualized. The resulting figure of -5.9% should be seen in the context of the fact that the level of output remains around the potential level and the economy is running at full employment, wage growth is robust, liquidity ample, and interest rates at their floor. Of course the fact that there was a broad-based slowdown in the economy's momentum in the third quarter is a source of worry. Unless demand picks up in China and the US in the coming months, anemic economic growth will likely continue in Singapore, but pockets of resiliency will be maintained owing to the mitigating drivers flagged above, in our view.

October's trade data made for mixed reading, with non-oil domestic exports declining by 1.2% on a mom/SA basis. But total trade rose by 3.5%; electronics sector weakness seem to have bottomed out, and non-electronics exports grew robustly. The external environment could well have seen its worst, which would be a helpful springboard for the Singapore economy going into the end of the year.

While economic growth is weak, there is little concern about the health of the economy, which is characterized by full employment, robust wage growth, substantial asset price inflation, abundant liquidity, and a healthy financial sector. While bouts of quantitative easing and debt crisis related uncertainties have caused economic and financial market volatility, in Singapore's case the overall impact has been modest. There is of course no denying that economic fundamentals have been dragged

down by persisting malaise in G3 economies and there is an undercurrent of uncertainty. In particular, global inventory of IT goods remains large, with no clear direction about corporate orders. This is a key source of downside for Singapore's exports. As per the forecasts used by the MAS, economic growth in the period ahead will be below the rate of potential growth (3%), but that is not a source of concern. The central bank's focus is clearly on inflation over growth.

As far as our forecasts, we see growth rising modestly in 2013 to 3%, helped by continued low interest rates and a recovery in industrial country demand. Inflation will remain an issue, averaging around 4%, while the currency will appreciate against a basket of trade-weighted currencies, but remain mostly flat against the US dollar.

“Transitionary” inflation

Singapore is undergoing a multi-year process of economic restructuring, with an aim to raise productivity, reduce reliance on foreign labor, and move up the value chain in production. But this type of restructuring creates transitionary inflation pressures. There is a general sense that some price and wage increases are inevitable.

Inflation, for the first time in many years, is largely a function of non-tradable price increases, especially accommodation and transportation, but there are risks that services costs would also increase given the tight labor market and associated wage growth. The central bank remains convinced that dealing with inflation through the exchange rate channel has been the right thing to do so far; reviews show that as far as imported inflation is concerned, the appreciation channel still works. NEER appreciation also dampens activity indirectly, which ought to have an impact on prices. But it should be noted that going forward, FX appreciation can happen through the real route (as relative prices rise) as opposed to the nominal route (through SGD appreciation). The central bank recognizes the complexity of the situation, and is clearly finding it difficult the appropriate pace of appreciation is difficult.

The Singaporean authorities believe in “monetary policy plus,” which means that in this environment of global low rates and search for yield, monetary policy needs to be complemented with regulatory and administrative measures. In this context, six rounds of measures to tighten the real estate market have had some, if not substantial, impact. The work needed to be done in the real estate market is delicate; the authorities have to



balance the need to prevent over-intermediation against genuine real estate needs of the local population. The government is also addressing supply by pushing up land availability and expediting the construction of public housing. We expect housing prices to rise further in 2013, although the pace of increase will likely moderate. The key risk to the housing market is a turn in global interest rates, something we don’t expect for several more years.

Bottom line: Singapore will continue to experience, for the time being, a tight labor market, strong wage growth, as well as housing and transportation inflation. Since this would push up the real exchange rate to a higher level, it is unlikely that the MAS would pursue policies that would erode competitiveness further. This implies a very slow pace of appreciation of the SGD NEER in the year ahead, notwithstanding the tightening bias maintained by the monetary authority.

Taimur Baig, Singapore, +65 6423 8681

Investment strategy

FX: In recent years, MAS has often surprised by keeping its FX policy tighter than what market observers had expected, suggesting that the central bank has a much higher weight assigned to the price stability objective over growth in their policy reaction function. As discussed earlier, a stronger SGD exchange rate will remain Singapore’s key measure against inflation. There is very little room for MAS to ease policy by lowering the slope of its SGD NEER policy band in 2013 despite sluggish growth, as illustrated by our chart below which plots the relationship between projected inflation and the YoY change in the SGD NEER mid-band under. With spot SGD NEER currently trading very close to the top of its policy band, our bias is to be short the SGD against the basket. We would however look to buy the SGD on pullbacks to levels closer to the mid-band, given our view that MAS will maintain a tightening policy bias.

Trajectory of inflation suggests little scope for easing

Source: Deutsche Bank Research, CEIC

Dennis Tan, Singapore, +65 +6423 5347

Singapore: Deutsche Bank Forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 259.9 270.1 284.8 311.1Population (mn) 5.2 5.3 5.4 5.5GDP per capita (USD) 50137 50840 52562 56563 Real GDP (YoY%) 4.9 2.5 3.0 4.5 Private consumption 4.1 2.5 4.2 5.2 Government consumption 0.9 -1.4 2.8 3.0 Gross fixed investment 3.3 2.7 0.1 1.1 Exports 2.6 1.1 4.1 4.8 Imports 2.4 2.1 3.8 4.5 Prices, Money and Banking CPI (YoY%) eop 5.5 4.4 3.6 3.0CPI (YoY%) ann avg 5.2 4.7 4.0 3.0Broad money (M2) 10.1 10.4 9.7 10.4Bank credit (YoY%) 17.3 12.9 9.8 10.4 Fiscal Accounts (% of GDP) Fiscal balance 8.1 6.6 7.4 6.9 Government revenue 24.2 22.2 21.0 22.1 Government expenditure 16.0 15.6 13.6 15.2 External Accounts (USD bn) Merchandise exports 429.6 433.8 455.4 482.8Merchandise imports 362.2 391.8 415.3 440.2Trade balance 67.4 42.0 40.2 42.6 % of GDP 26.0 15.6 14.1 13.7Current account balance 57.1 29.8 27.1 29.7 % of GDP 22.0 11.1 9.5 9.6FDI (net) 38.9 16.4 8.0 10.0FX reserves (USD bn) 233.4 241.0 251.1 257.8FX rate (eop) SGD/USD 1.30 1.22 1.20 1.19 Debt Indicators (% of GDP) Government debt 106.3 110.8 117.8 123.0 Domestic 106.3 110.8 117.8 123.0 External 0.0 0.0 1.0 1.0Total external debt 230.9 214.7 193.1 190.0 in USD bn 600.0 580.0 550.0 591.0 Short-term (% of total) 75.0 75.0 76.0 77.0 General Industrial production (YoY%) 8.0 -0.2 0.9 3.4Unemployment (%) (eop) 2.1 2.6 2.8 2.6 Financial Markets Current 3M 6M 12M3-month interbank rate 0.38 0.45 0.45 0.7010-year yield (%) 1.31 1.30 1.40 1.50SGD/USD 1.22 1.22 1.21 1.21 Source: CEIC, DB Global Markets Research, National Sources Note: includes external liabilities of ACU banks.



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

Economic outlook: Recovery in South Korea’s GDP

growth assumes a timely resolution of the US fiscal cliff, while weak domestic demand depressed by falling housing prices and rising tax expenditure warrants further monetary easing.

Main risks: Further QE by the Fed and BoJ points to tighter prudential regulation in South Korea against hot money inflows.

Strategy recommendations: We see a bearish steepening bias in the Korea rates in 2013, although the possibility of a BOK rate cut could lead to a short-lived rally in 1Q.

Macro view

Growth to remain below 2.0% until 2H 2013... We expect South Korea’s GDP growth to remain well below its trend, at less than 2.0% until Q2 next year, with a soft patch in Q1 due to the US fiscal cliff risks and as Euroland remains in recession. Once the US fiscal cliff is dealt with, however, we see stronger exports to guide South Korea’s GDP growth higher, above 3.0% in 2H, resulting in annual GDP growth of 2.5% in 2013, up from 2.1% in 2012, before accelerating further to 4.4% in 2014. While facility investment remains highly dependent on exports, fundamentals for private consumption remain challenged, highlighting the importance of a recovery in exports for South Korea’s future growth prospects.

Prolonged weak growth amid weak domestic demand

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-2

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2005 2007 2009 2011 2013

G2 GDP growth (lhs)

South Korea

%yoy%yoy

Forecast


…amid weak domestic demand. High frequency data pointed to weak investment and private consumption at the start of this quarter. In particular, the equipment index fell at a faster pace of 39.6% 3m/3m saar in October vs. 32.4% in September, while retail sales fell 2.0% in October vs. 6.5% growth in September, pointing to a worsening domestic demand growth impulse. The latter remained under pressure amid falling housing prices,

rising tax expenditure and sustained political/policy uncertainties, which weighed on consumer sentiment. According to the household survey, while income rose 4.6%yoy in Q3 2012, household consumption fell 0.7% as household tax expenditure rose 4.4%. Meanwhile, nationwide housing prices fell for the fifth consecutive month in October, by 0.1% mom, resulting in a yoy increase of 0.7%. This is a far cry from the 5.3% increase in 2011. Seoul Southern Gangnam housing prices fell for the nineteenth consecutive month in October by 0.2%mom, leaving the yoy rate at -4.4% in October vs. the 0.2% decline reported last year. Falling housing prices in turn hit private consumption via weak sentiment and a negative wealth impact. According to the latest KOSTAT survey, about 74% of households’ assets were in real estate, compared to US and Japanese households’ 60% and 40%, respectively. Moreover, Korean households have relatively little leeway with a low savings rate of 3% in 2011, down sharply from 9% in 2004, vs. US and Japanese households’ rates of 4.7% and 2.9%, respectively, in 2011.

Falling housing prices and rising tax weigh on PCE

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2008 2009 2010 2011 2012

ExpenditureIncomeNon consumption Housing prices (S Seoul)

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Although financial risks have been reduced, they are still significant… Although the government has adopted housing revival policies, including capital gains tax exemptions, demand dynamics for housing -- such as demographic changes, household indebtedness and poor sentiment -- remained challenging. Note that the population in their 30s and 40s peaked in 2006, while households’ DTI (debt to disposable income) ratio remained above that in the US at 1.34 as of mid-2012, although it did improve from 1.35 in 2011. Moreover, although mortgage rollover risks have been reduced based on the government’s prudential guidance, they are still at significant risk. The share of installment loans rose to 62% in Q1 2012 from below 25% in 2003. However, due to the grace period given to installment loans (which require interest-only payment for some time), the real



share of amortizing loans stood at only about 23%. Moreover, although improving, the fixed rate share of mortgage loans was only about 13% in Q1 2012, vs. 2% in 2003, pointing to high interest rate risks to households’ finances, although that is not an issue at the moment amid falling rates. In response to the policy rate cuts and correction in CD rates, bank lending rates for outstanding loans have fallen by about 50bps this year to 5.5% in October.

Taylor rule suggests the rate could be 50bps lower

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…suggesting further rate cuts may be needed… Sustained weakness in overall growth and falling housing prices amid heavily indebted households suggest that further rate cuts by the Bank of Korea (BoK) may be in order, especially as self-employed and low-income families remain under increasing pressure from debt and the proportion of marginal firms continues to rise. Also, the relatively rapid appreciation of the won has added to this downside risk to the BoK rate. Indeed, according to our Taylor rule model, the BoK rate could be 50bps lower, especially as inflation continued to surprise to the downside. Headline inflation fell to 1.6%yoy (-0.4%mom nsa) in November from 2.1% (-0.1%) in October, as food price inflation declined sharply to 2.7% (-2.5%) in November from 5.0% (-1.5%) in October. Meanwhile, core inflation fell to 1.3% (0.1%) in November from 1.5% (0.0%) in October, amid weak domestic demand. We expect CPI inflation to average 2.6% in 2013 vs. the BoK’s forecast of 2.7%, at the lower end of the BoK’s new medium-term inflation target range of 2.5%-3.5%. However, with a 2013 GDP forecast of 3.2%, vs. our forecast of 2.5%, the BoK may need to see signs of continued weakness in economic data and/or a meaningful deterioration in the US fiscal cliff risks to revise its growth view and cut rates. Also, the BoK may need to coordinate its stimulus measures with the finance ministry to have the maximum impact – and for that, it may need to wait until after the presidential election.

…amid sustained appreciation of the won… A lower policy rate is one of the key elements of a possible policy

framework for managing capital inflows according to the IMF, “when it is consistent with inflation objectives and when overheating is not a concern.” On this note, in response to the increasing risk of a surge in capital inflows, the Korean government has toughened its prudential regulation. In particular, effective 1 December (with one-month grace period), forward contracts at foreign bank branches will be limited to 150% of their equity capital, down from the current rate of 200%, and the cap on currency derivatives holdings of local banks will be lowered to 30% from 40%. Moreover, effective 1 April 2013, financial institutions will also be required to report a detailed breakdown of foreign capital flows by stocks, bonds and derivatives, so that the government can better monitor foreign fund flows and assess risks to the local financial system. With the Fed and the BoJ likely to embark on further quantitative easing, threatening further speculative flows into the Korean financial system, we are not surprised by this decision. Adding to this risk is increasing pressure from Japan’s politicians on the Bank of Japan to embark on aggressive QE, as the country heads towards the general election on 16 December and the current BoJ governor’s term comes to an end in April 2013. In addition, we expect more prudential measures -- including a higher bank levy on non-depository FX debt – to be adopted if and when the stability of the won and local financial system is further threatened. Meanwhile, there is increasing political pressure from the US to allow the won to appreciate, although it is not clear from its own report that the won is “undervalued.” According to the US Treasury report, “the real effective exchange rate of the won was moderately undervalued by between 0 and 10% and the won REER was about 7% below its historical average.” In response to the US government’s call on the Korean government “to limit their foreign exchange intervention to the exceptional circumstances of disorderly market conditions and to commit to greater foreign exchange market transparency including through the publication of intervention data,” the latter noted that it will not publish such data.

Changes in FX debt composition and FX reserves

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…as its defense improves... To prevent a repeat of the won’s volatility in 2008, South Korea has increased its FX reserve holdings to USD322bn in Q3 2012, from USD258bn in Q2 2008, covering 243% of short-term external debt in Q3 2012 vs. 146% in Q2 2008, although the coverage ratio for total external debt improved relatively moderately to 77% from 70% during the same period. Moreover, South Korea and China agreed to use the existing bilateral currency swap line, about USD59bn, for trade settlement between two countries.

However, despite increases in FX reserves, South Korea’s international investment position remained in deficit, at USD102.4bn in Q3 2012, albeit better than USD136.8bn deficit in Q2 2008. Although its assets rose to USD820.7bn in Q3 2012 from USD621bn in Q2 2008, liabilities increased faster to USD923.1bn from USD757.7bn during the same period. This increase in assets was led by increases in FX reserves (as noted above) and FDI assets (to USD190.1bn in Q3 2012 from USD88.8bn in Q2 2008). Meanwhile, portfolio investment liabilities increased notably, to USD555.7bn in Q3 2012 from USD395.6bn in Q2 2008, reflecting increased vulnerability of the won to portfolio flows.

Increasing importance of portfolio flows

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Meanwhile, South Korea saw services account deficit improve since the GFC, led by construction and transportation services. Their surpluses rose to USD11.7bn and USD7.4bn, respectively, in 2011 vs. USD7.9bn and USD4.5bn in 2007. Meanwhile, a weak won has supported the narrowing of South Korea’s travel account deficits, to USD7.4bn in 2011 from USD15.8bn in 2007, as credit rose sharply to USD12.5bn from USD6.1bn during the same period, on the back of sharp increase in tourists, growth of which averaged 12.6% in the last three years vs. 4.7% in 2007, led by tourists from China and Japan. While we see the sharp increase in Chinese tourists as structural, we attribute the increase in Japanese tourists to the sharp depreciation of the won against the yen.

Services account balance improved but at risk

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…while economic democratization warrants higher welfare spending. South Korea’s (relative) poverty is also one of the highest in the OECD. At the same time, Korea’s relatively low unemployment is deceptive; almost 30% of workers are self-employed. Moreover, the labor market is highly inequitable: the gender gap in wage and employment is one of the worst among OECD members. While the population is demanding – and demographic change will anyway require – greater spending in this area, the presidential candidates have not yet explained how they will finance this higher spending. There is a risk that this may translate into higher taxes on the wealthy or corporates. Note that the corporate share of national income has grown at the expense of household income.

Corp income share rose at the expense of households

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Reflecting the government’s fiscal prudence, the finance minister has maintained his insistence that “mobilizing all available fiscal, monetary and financial policy means in a bold move with a large size may have harmful effects,” including a wider budget deficit. Instead, he called for “less costly and more salient policies,” such as cutting business regulation, while the presidential candidates call for tighter oversight of chaebols.

Juliana Lee, Hong Kong, +852 2203 8312



Investment strategy Fixed income strategy: 2013 outlook Although weak growth and muted inflation in Korea economy increase the chance of a BOK cut in 1Q 2013, our moderately positive house view on the US fiscal cliff, and growth in emerging markets suggests that Korea rates will likely increase in 2013. Meanwhile, the fiscal soundness represented by a higher credit rating (S&P AA-, local long term) than that (S&P AA-u, local long term) of Japan will continue to induce offshore demand in the event of a rise in yields. As a result, an increase in the KTB yields would be milder than that in the US Treasury, where we expect a rise of around 80bp until 1Q 2013. Our year-end target for the 10Y KTB yields in 2013 is 3.40% at this stage. Offshore demand for long-dated bonds looks more balance in 2013 than in 2011 and 2012 when strategic offshore investors had start building their Korean bond portfolios. On the local investor side, demand for long-dated KTBs also looks fragile given the negative carry for the institutional investors and the risk of capital loss for retail investors. Despite similar gross and net issuance in KTBs to those in 2012, an increasing DV01 supply due to a larger allocation of 30Y KTBs will likely add to a steepening bias, in our view.

Recommendations going into 2013 We put a modest underweight on KTBs, and would like to pay on dips in the IRS curve with entry levels of 2.70%, 2.80% and 3.0%, respectively, for the 1Y1Y, 5Y and 10Y swaps. The possibility of a BOK in 1H remains high given weak growth and muted inflation. In the event of a BOK rate cut to 2.50%, we recommend investors to use it as an opportunity of placing swap paid positions as suggested above. We also see a steepening bias in the curves but acknowledge that the scope of steepening itself is unlikely to be very enthusiastic. In order to leverage a change in the curve shape, we would look more towards a conditional steepener with swaptions, rather than outright swap steepeners. At present, the terms for premium structures are not very attractive for entering conditional steepeners. In the event of a rise in implied volatilities in the front-end associated with a BOK rate cut, selling a front-end payer and buying a long-end payer (i.e. bearish conditional steepener) could enhance the return on the steepening movement. In the past, the correlation of implied volatilities to underlying rates has usually been negative (i.e. lower rates lead to higher volatilities). This is consistent with our view of pay on dips.

Kiyong Seong, Hong Kong, +852 2203 5932

South Korea: Deutsche Bank forecasts 2011 2012F 2013F 2014F

National income Nominal GDP (USDbn) 1118 1143 1244 1353 Population (m) 49.4 49.8 50.0 50.2GDP per capita (USD) 22630 22966 24889 26950 Real GDP (YoY%) 3.6 2.1 2.5 4.4 Private consumption 2.3 1.6 2.0 2.9 Government consumption 2.1 3.8 2.5 1.9 Gross fixed investment -1.1 -0.1 1.7 4.6 Exports 9.5 3.9 5.3 10.3 Imports 6.5 2.3 4.3 9.5 Prices, money and banking CPI (YoY%) eop 4.2 1.6 2.9 3.1 CPI (YoY%) ann avg 4.0 2.2 2.6 3.1Broad money (M3) 8.3 8.2 9.0 9.5 Bank credit (YoY%) 5.9 5.5 6.0 7.5 Fiscal accounts (% of GDP) Central government surplus 1.5 0.0 -0.8 0.1 Government revenue 23.6 22.9 22.3 22.7 Government expenditure 22.1 23.0 23.1 22.6Primary surplus 2.9 1.4 0.7 1.5 External accounts (USDbn) Merchandise exports 551.8 557.3 598.0 649.8Merchandise imports 520.1 516.4 561.5 624.0Trade balance 31.7 40.9 36.5 25.8 % of GDP 2.8 3.6 2.9 1.9Current account balance 27.2 45.0 30.6 16.5 % of GDP 2.4 3.9 2.5 1.2FDI (net) -15.7 -19.5 -22.0 -20.0FX reserves (USDbn) 306.4 326.2 335.0 337.7FX rate (eop) KRW/USD 1152 1090 1070 1030 Debt indicators (% of GDP) Government debt1 34.6 35.7 35.0 33.2 Domestic 33.8 35.0 34.2 32.3 External 0.8 0.7 0.8 0.9Total external debt 35.6 36.9 34.8 33.2 in USD bn 398.4 421.0 435.0 452.0 Short-term (% of total) 34.2 33.7 32.9 31.4 General Industrial production (YoY%) 7.0 2.5 4.5 7.0 Unemployment (%) 3.4 3.3 3.5 3.4 Financial markets Current 3M 6M 12MBoK base rate 2.75 2.50 2.50 2.7591-day CD 2.85 2.60 2.60 2.8510-year yield (%) 3.04 3.00 3.20 3.40KRW/USD 1082 1090 1080 1070Source: CEIC, Deutsche Bank Global Markets Research, National Sources Note: (1) FX swap funds unaccounted for (2) Includes government guarantees



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

Economic outlook: Post a disappointing 2012, we expect macro conditions to turn somewhat favorable in 2013, especially in the latter half of the year.

Main risks: Supply side shocks could prevent inflation from moderating sufficiently, thereby complicating monetary policy decisions, while revenue slippage could force the authorities to cut back aggressively on growth-critical capital spending to meet the ambitious budget deficit target.

2012 was a difficult year for Sri Lanka

2012 turned out to be a challenging year for the Sri Lankan economy as it had to cope with various macro headwinds ranging from high inflation, low growth, revenue slippage, falling exports and credit momentum, sharp depreciation of the currency and a highly unsupportive global environment. To be true, a large part of the hardship was self-inflicted (which was unavoidable in our view), as the authorities sought to reduce the macroeconomic imbalances accumulated in the past two years through tough administrative and policy measures.

These measures, which were announced in the early part of 2012, seem to have worked well in reducing trade deficit, money supply and credit growth, though at the cost of a perceptible slowdown in GDP growth. According to our forecasts, GDP growth has likely slipped to 6.2% in 2012, from 8.3% and 8.0% respectively in 2011 and 2010. Meanwhile inflation has remained uncomfortably high (CPI inflation touched 9.5% in November) and the weakness in the currency has persisted, despite a marked improvement in the gross official reserves position (currently USD7.1bn, up from the February low of USD5.5bn), thanks to a combination of IMF loan, sovereign bond issuance and some genuine BOP gains.

Inflation still high; credit and M2 growth moderating

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Modest recovery likely in 2013

With 2012 having borne the brunt of the imbalance adjustment, we expect macro conditions to turn somewhat favorable in 2013, especially in the latter half of the year. Of course, if any of the global event risks – fiscal cliff, EU debt sustainability, geopolitical tensions – spin out of control, things could turn decisively negative but that is not our base case scenario. We however expect volatility in global financial markets to persist through 2013, punctuated by policy interventions. In this backdrop, we present the 2013 macro views for Sri Lanka below.

Growth We forecast real GDP growth to improve to 7.0% in 2013, from a likely 6.2% outturn this year. We expect growth to bottom out in the 4Q of 2012, and then chart a sequential recovery from early next year. The recovery is expected to gain traction mainly in 2H‘2013 though, aided by a favorable base effect. We factor in agricultural sector growth of 4.2%yoy (7.8% likely in 2012) and non-farm sector growth of 7.4%yoy (6.0%) to arrive at our baseline forecast of 7.0% real GDP growth for 2013. On the expenditure side GDP, we expect both consumption (6.0%yoy vs. 5.4% in 2012) and investment growth (10.4% vs. 9.1%) to improve in 2013, but net exports to subtract more from GDP than this year (-1.1% vs. -0.9%).

GDP forecast Sectors 2011 2012F 2013F 2014F

Agriculture 1.5 7.8 4.2 4.5

Industry 10.3 8.4 8.5 8.6

Services 8.6 4.8 6.8 7.5

Real GDP 8.3 6.2 7.0 7.5

Memo-item

Non-farm GDP 9.2 6.0 7.4 7.9Source: CEIC, Deutsche Bank

Inflation & monetary policy We expect CPI inflation to moderate to 7% in 2013, from this year’s likely average of 7.5%. After a steady moderation through October, CPI inflation unexpectedly accelerated to 9.5% in November, led by a 2.4%mom spike in food prices. As food items constitute 41% weight in the CPI basket, the trajectory of headline CPI inflation gets readily affected by swing in food prices, and consequently a potential food price shock remains a key risk for Sri Lanka’s inflation outlook going forward. However, barring any supply side shocks, we expect headline CPI inflation to moderate to 6.5-7% by mid-2013 and then head lower towards the 6% mark towards the end of the year.



Based on our inflation projections, we expect the CBSL to start cutting rates from 2Q of 2013. In our view, the central bank has scope to cut the policy rate by a cumulative 75bps, taking the reverse repo to 9.0% by end- 2013. An accommodative monetary policy stance will likely play a key role in reviving the growth momentum, but in our view, the positive impact is likely to be felt more in 2014 than 2013, given the substantial lag with which monetary transmission mechanism works in EM countries.

Fiscal We expect 2013 budget deficit to be 6.5% of GDP, higher than the 5.8% target set by the government. The risk is mainly on the revenue side, where each year the actual collection has fallen short of the budgeted target. For 2013 budget also, the authorities have assumed revenue collection to pick up by 50bps to 14.7% of GDP, from a likely 14.2% of GDP outturn in 2012, contrary to the current trend of revenue/GDP ratio falling steadily each year. Given our growth projection, we expect revenue collection/GDP ratio to be 14% of GDP in 2013, which along with our expenditure estimates (20.5% of GDP, in line with the government projections) should yield a budget deficit outturn of 6.5% of GDP. Of course, the government could cut back on capital expenditure aggressively to meet the headline budget deficit target (as it has done this year), but then such a development would most likely have negative implications for public investment and consequently overall GDP growth.

Fiscal forecast % of GDP 2011 2012 2013,

budget 2013, DB forecast

Total revenue and grants 14.5 14.2 14.7 14.0

Total expenditure 21.4 20.4 20.5 20.5

Recurrent 15.4 14.7 14.6 14.5

Capital and net lending 6.0 5.6 6.0 6.0

Budget deficit -6.9 -6.2 -5.8 -6.5Source: Department of Fiscal Policy, Deutsche Bank

BOP and exchange rate We expect modest appreciation in the Sri Lankan rupee, as the BOP position improves further next year. We forecast the current account deficit to narrow to 3.5% of GDP in 2013, from a likely outturn of 5.0% of GDP in 2012. We expect the overall BOP balance to be positive, by about USD1bn, which should increase the gross official reserves to around USD8.5bn by end-2013. We expect the Sri Lankan authorities to continue their engagement with IMF through an Extended Fund Facility program next year. This, in our view will help to improve investor sentiments and support the exchange rate.

Kaushik Das, Mumbai, +91 22 7158 4909

Sri Lanka: Deutsche Bank Forecasts 2011 2012F 2013F 2014FNational Income Nominal GDP (USD bn) 59.1 58.1 68.0 79.6Population (mn) 20.9 21.1 21.3 21.5GDP per capita (USD) 2830 2755 3194 3702

Real GDP (YoY %) 8.3 6.2 7.0 7.5 Total consumption 13.0 5.4 6.0 6.8 Total investment 14.6 9.1 10.4 11.2 Private 15.9 10.0 11.0 12.0 Government 10.0 6.0 8.0 8.0 Exports 11.0 -7.0 9.5 9.5 Imports 20.0 -2.5 9.0 10.0 Prices, Money and Banking CPI (YoY%) eop 4.9 9.1 6.0 6.7CPI (YoY%) avg 6.7 7.5 7.0 6.3Broad money (M2b) eop 19.1 17.0 16.0 17.5Bank credit (YoY%) eop 34.5 18.0 16.0 17.0 Fiscal Accounts (% of GDP) Central government balance -6.9 -6.2 -6.5 -6.2 Government revenue 14.5 14.2 14.0 13.8 Government expenditure 21.4 20.4 20.5 20.0Primary balance -1.4 -0.9 -1.4 -1.2 External Accounts (USD bn) Merchandise exports 10.6 9.3 10.5 11.8Merchandise imports 20.3 17.6 19.2 22.1Trade balance -9.7 -8.3 -8.7 -10.3 % of GDP -16.4 -14.3 -12.8 -13.0Current account balance -4.6 -2.9 -2.4 -3.0 % of GDP -7.8 -5.0 -3.5 -3.8FDI (net) 0.9 0.9 1.0 1.0FX reserves (USD bn) 5.9 7.4 8.5 10.0FX rate (eop) LKR/USD 114.0 127.0 124.0 119.0 Debt Indicators (% of GDP) Government debt 78.5 78.4 74.9 71.0 Domestic 42.9 43.1 41.2 39.1 External 35.6 35.3 33.7 32.0Total external debt 48.1 52.0 45.6 40.2 in USD bn 28.4 30.2 31.0 32.0 Short-term (% of total) 13.6 13.5 13.5 13.5 General Industrial production (YoY %) 9.1 6.0 7.5 8.0Unemployment (%) 4.2 4.2 4.1 4.0 Financial Markets Current 3M 6M 12MReverse Repo rate 9.75 9.75 9.25 9.00

LKR/USD 128.4 124.5 124.3 124.0 Source: CEIC, DB Global Markets Research, National Sources



Taiwan Aa3/AA-/A+ Moody’s/S&P/Fitch

Economic Outlook: Recovery in exports necessary

for rebound in GDP growth amid weakening domestic demand.

Main Risks: The US fiscal cliff challenge poses the greatest risks to our growth outlook for Taiwan.

Strategy recommendations: We are more positive on the TWD on improving cyclical indicators, a rising current account surplus, and potentially less official resistance to gains. We await some retracement in the NDF negative carry before going short USD/TWD.

Macro view

Taiwan’s recovery depends on G2 growth... Given its relatively large export share of GDP and the performance of exports driving domestic demand, Taiwan’s beta (the elasticity of Taiwan’s GDP growth to G2 GDP growth) remained high at around 1.7 (2003-present). Hence, while we have seen a notable improvement in exports in October, we do not expect a smooth, sustained recovery due largely to the US fiscal cliff risks. We expect the latter to limit the rebound in Taiwan GDP growth to 3.0% in 2013 from 1.1% in 2012, which is largely in line with the DBGAS’s forecast.

Taiwan is one of the most sensitive to G2 growth

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….as domestic demand remains anemic… While export growth impulse continued to strengthen, to 27.8% 3m/3m saar in October from 15.4% in September, domestic demand growth remained anemic. In particular, consumer sales and real machinery and equipment imports fell 3.4% and 23.5%, respectively, in October vs. 1.7% and 15.2% in September, weighing on the leading indicator. The latter indicator rose only 1.6% in October, vs. 1.5% in September, despite the sharp increase in exports. However, once the US fiscal cliff risks are contained, we see risks to growth shifting to the upside due to pent-up domestic demand. As domestic demand

rebounds, following recovery in exports, we see GDP growth accelerating further to 4.3% in 2014.

…with lower inflation calling for rate cuts… CPI inflation fell more than expected to 1.6% in November from 2.4% in October, prompting us to revise down our 2013 inflation forecast by 0.4ppts to 1.3%, in line with the DGBAS forecast of 1.25%. Given our inflation and growth forecast, our Taylor rule model suggests that the monetary policy rate could be about 50bps lower. However, with the real rates at almost zero the Central Bank of China (CBC) remains reluctant. With this in mind, we think that perhaps the risk of fiscal cliff may need to rise further to see the CBC pulling the trigger.

…while measures are taken to ease pressure on the TWD… The CBC has also increased its efforts to prevent hot money inflows, including requiring banks to provide proof of demand before embarking on FX transaction. At the same time, by becoming an offshore yuan center, Taiwan could see the pressure on the TWD ease as yuan deposits are introduced, providing alternative means for exporters to keep their earnings, for example. At the same time, investors’ preference for the TWD in anticipation of exports recovery is hardly surprising, especially given the TWD’s relative stability. The TWD continued to enjoy relative stability, vs. its peers like the KRW, with Taiwan remaining as a net investor to the world. Note that while its international investment assets stood at USD1187.2bn in 2011, Taiwan’s liabilities stood far smaller at USD446.6bn, with portfolio investment assets and liabilities at USD314.9bn and USD195.7bn, respectively.

Net investor to the world, a relatively stable TWD

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…and the government seeks the means to support recovery in investment. Meanwhile, to boost growth, the government is seeking means to support the local stock market and preparing a policy governing investments in planned free trade economic zones, which



will grant free movement of capital, personnel, goods and information in the zones, with special treatment given to foreign companies, including China-based companies. The policy should raise the quota for foreign labor from 40% to 50% and provide tax exemption to international logistic firms. This is critical in light of weak investments. Note that Taiwan saw the investment share of GDP falling sharply to 17% in 2011 from 29% in 2000.

Juliana Lee, Hong Kong, (852) 2203 8312

Investment strategy

FX: We are more positive on the TWD in 2013 given the improvement in cyclical indicators. TWD returns have historically been pro-cyclical, with FX returns tracking exports growth. Although some improvement in exports has been priced into FX, a firmer exports recovery should support further gains. Taiwan’s economy also has one of the highest betas in Asia to US and China growth, and is well-positioned to benefit from their economic recoveries. Taiwan’s current account surplus has also been steadily rising with the goods, services and income balance all improving. Support from these natural inflows has been a significant currency advantage against a backdrop of higher global capital flow volatility. With Taiwan enjoying the second highest current account (as a % GDP) in the region, the TWD should be well-supported in 2013.

CBC could also be less of an obstacle to FX performance, with suggestions that appetite to accumulate reserves may be waning. In recent months, reserves accumulation has fallen significantly as net sterilization costs have turned positive. These constraints could translate either into a) a preference for a more creative policy tool kit to manage FX strength (i.e. macro-prudential measures), or b) a more accommodative stance towards FX strength.

Equity inflows to Taiwan could also accelerate in 2013. Foreign purchases of Taiwanese stocks in 2012 lagged relative to the region. Policy interference – in the form of the capital gains tax legislation – bears much responsibility; however, with the short-term impact of the CGT largely priced, foreigners may cover their underweight on Taiwan stocks in 2013. While the TWD should benefit from foreign equity flows, Taiwan’s net portfolio balance has traditionally been skewed towards outflows. Significantly, outward portfolio investment has picked up lately and was the largest on record in Q3 2012. Hedging flows on the back of outflows have depressed the carry in NDFs into negative territory, reducing the immediate appeal of short USD/TWD NDF positions. We await some retracement in the negative carry (to >-1% in the 3-6M NDFs) before entering USD/TWD shorts.

Mallika Sachdeva, Singapore, +65 6423 8947

Taiwan: Deutsche Bank’s forecasts 2011 2012F 2013F 2014FNational income Nominal GDP (USDbn) 465.1 474.1 501.8 539.4Population (m) 23.2 23.3 23.4 23.4GDP per capita (USD) 20031 20355 21492 23102 Real GDP (yoy %) 4.1 1.1 3.0 4.3 Private consumption 3.1 1.3 2.2 3.0 Government consumption 1.0 0.6 1.0 1.0 Gross fixed investment -5.2 -4.1 3.0 5.2 Exports 4.5 -0.6 3.7 7.6 Imports -1.2 -2.2 2.5 7.2 Prices, money and banking CPI (yoy %) eop 2.0 0.8 2.6 1.7CPI (yoy %) annual average 1.4 1.9 1.3 2.2

Broad money (M2) 6.0 5.0 6.0 7.0Bank credit1 (yoy %) 5.8 4.0 5.5 6.5 Fiscal accounts (% of GDP) Budget surplus -2.2 -2.8 -2.9 -1.7 Government revenue 16.8 16.5 16.5 16.9 Government expenditure 19.0 19.3 19.4 18.6Primary surplus 0.0 -0.5 -0.6 1.6 External accounts (USDbn) Merchandise exports 307.0 300.2 315.0 348.0Merchandise imports 279.2 272.5 298.9 339.9Trade balance 27.8 27.7 16.1 8.1 % of GDP 6.0 5.9 3.2 1.5Current account balance 41.7 45.6 30.4 20.7 % of GDP 9.0 9.6 6.1 3.8FDI (net) -14.7 -15.0 -13.0 -13.0FX reserves (USD bn) 385.5 405.5 422.8 435.4FX rate (eop) TWD/USD 30.3 29.2 28.3 27.5 Debt indicators (% of GDP) Government debt2 42.4 44.3 46.3 46.2 Domestic 40.5 42.4 44.4 44.3 External 1.9 1.9 1.9 1.8Total external debt 28.8 30.8 31.1 28.9 in USDbn 130.0 145.0 155.0 155.0 Short-term (% of total) 80.8 82.8 83.9 83.9

General

Industrial production (YoY%) 5.0 0.3 3.0 6.0Unemployment (%) 4.4 4.3 4.4 4.3

Financial markets Current 3M 6M 12MDiscount rate 1.88 1.88 1.88 1.8890-day CP 0.86 0.83 0.83 0.83 10-year yield (%) 1.14 1.16 1.20 1.25 TWD/USD 29.1 29.2 28.7 28.3 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: Thailand faces a volatile growth

trajectory due to last year’s floods and requires recovery in exports to sustain growth in 2013.

Main risks: The US fiscal cliff poses downside risks, while a rapid increase in credit warrants caution.

Strategy recommendations: Front end steepness in the IRS curve cannot be explained by outlook on policy rates or the fixing. Receive 2Y1Y IRS.

Macro view

Sustained growth requires rebound in exports…The pace of recovery from last year's floods was impressive. Thailand is now well on its way to post very strong growth of around 5.7% in 2012, up sharply from 0.1% in 2011. However, while the impact of last year's floods will render Thailand's growth trajectory rather volatile in the quarters ahead, we see 2013 growth limited to 3.9% vs. the Bank of Thailand’s forecast of 4.6%, as a meaningful recovery in exports is realized only in 2H 2013 following the resolution of the US fiscal cliff risks and as Euroland emerges slowly out of its recession. As it is, weak exports remain a source of concern. In October, export growth momentum worsened, falling 11.5% 3m/3m saar down vs. 9.6% in September.

…to support weakening domestic demand… In contrast to the BoT’s assessment that “the greater–than–expected strength in domestic demand appeared to provide sufficient cushion against the adverse impact of export slowdown,” data suggest weaker domestic demand growth momentum. In particular, private consumption and investment impulse fell 1.1% 3m/3m saar and 7.7% in October vs. 1.3% growth and 3.7% fall reported in September. Consistent with weaker demand, manufacturing production impulse continued to contract by 14.3% in October, albeit better than the 18.1% decline in September.

…amid structural challenges…At the same time, sustained rapid increase in wages highlighted the need for Thailand to improve labor productivity and find a new source of growth, especially amid the economic and political opening of its neighbors. While Thailand saw sustained improvement in labor productivity, it needs to further its efforts in human capital development as it tries to climb further up the value chain. According to the World Economic Forum's Global Competitiveness report, Thailand ranks relatively highly at 38th (out of 118 countries), above Indonesia and the Philippines. However, its competitiveness suffers from an "inadequately educated workforce" among other things, according to the

WEF. Meanwhile, since 2007, Vietnam took the lead over Thailand in textile/footwear exports as the latter moved away from labor intensive production, while the HDD industry went through a serious consolidation, with the number of HDD companies falling from 11 in 2003 to 3 by mid-2012. Like its peers in the region, since the Asian Financial Crisis, Thailand saw a relatively weak, volatile investment growth, which left the facility and construction investment share of GDP sharply lower at 15% and 8%, respectively, in 2011, vs. 22% and 20% in 1996.

…while falling inflation provides room for more rate cuts… Falling inflation provides the Bank of Thailand (BoT) with ample room to maneuver, as it “stand(s) ready to take appropriate policy action as warranted.” In particular, headline inflation fell to 2.7%yoy in November from 3.3% in October, while core stood largely unchanged at 1.9% vs. 1.8% in October. Given our growth inflation and growth forecast, our Taylor rule model suggests that the BoT policy rate could be another 25bps lower. However, robust credit growth warrants caution. Claims on non-financial corporations and other resident sectors continued to rise at a robust rate of 14.8%yoy ytd and 16.9% in October, respectively, after accelerating to 15.6% and 16.9% in 2011 from -0.9% and +13.9% in 2010. Hence, it may need a material deterioration in external outlook to prompt further rate cuts.

Drivers of International investment liabilities

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…as the US fiscal cliff risks threaten the baht’s stability. In our view, a worse-than-expected US fiscal cliff suggests not only aggressive rate cuts but also a weaker baht although Thailand’s FX reserves rose to USD183.6bn in Q3 2012 from USD105.7bn in Q2 2008, more than covering the rise in total external debt to USD127.4bn from USD78.9bn during the same period. Increases in FX reserves supported improvement in Thailand’s international investment position, to a deficit of USD32bn in 2011 vs. USD55.1bn in 2007. On the other hand, Thailand’s portfolio investment liabilities rose



relatively sharply, to USD87.1bn in 2011 from USD63.2bn in 2007, while portfolio assets rose only to USD22.5bn from USD15.2bn during the same period, highlighting the local financial markets and baht’s vulnerability to portfolio flows.

Juliana Lee, Hong Kong, +852 2203 8312

Investment Strategy

Rates: As was widely expected, BoT decided to keep rates on hold in the last MPC meeting for the year. All members unanimously voted to keep rates unchanged, which signals that a more bleak growth outlook will be required for further rate cuts. With inflation surprising sharply to the downside in November and exports likely to stay under pressure in the near term, it is difficult to reason why the front end of the IRS curve could continue to stay this steep. In the last two years, we have seen two episodes when the 1Y/3Y steepened beyond current levels (see chart).The first episode was caused by a massive risk off environment (bull steepening) led by the US downgrade and prospects of default by peripheral European countries. The fixing collapsed by 100bp as USD funding tightened sharply. The second episode was a bear steepening move caused by better-than-expected external data leading the curve to price in rate hikes.

Current steepness of the 1Y/3Y part of the curve is

excessive

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In the near term, we think the market will not expect any rate hikes given a weak global macro environment, contained inflation pressures and a more dovish bias of BoT. With steps taken by global central banks, we do not expect the fixing to fall much from here. We recommend receiving 2Y forward 1Y IRS (carry: 3bp/month) above 3.25% with a target of 3% to play for this normalization in the front end slope. Investors who are cautious about going long duration can put on 1Y/3Y IRS flatteners with a target of +18bp.

Arjun Shetty, Singapore, +65 6423 5925

Thailand: Deutsche Bank Forecasts

2011 2012F 2013F 2014FNational Income Nominal GDP (USDbn) 345.9 365.5 401.2 445.0Population (m) 64.1 64.3 64.5 64.7GDP per capita (USD) 5398 5683 6219 6879 Real GDP (yoy %) 0.1 5.7 3.9 4.9 Private consumption 1.3 5.6 3.6 3.1 Government consumption 1.4 6.4 4.0 1.6 Gross fixed investment 3.3 11.6 6.3 3.6 Exports 9.5 3.5 6.9 11.0 Imports 13.6 6.5 7.1 9.1 Prices, Money and Banking CPI (yoy %) eop 3.5 3.1 3.4 3.3CPI (yoy %) ann avg 3.8 3.0 3.1 3.6Core CPI (yoy %) 2.4 2.1 2.1 2.8Broad money 15.2 10.0 9.0 10.0Bank credit1 (yoy %) 14.2 13.5 10.0 11.0 Fiscal Accounts2 (% of GDP) Central government surplus -2.7 -3.5 -3.0 -1.9 Government revenue 19.1 19.2 18.8 20.2 Government expenditure 21.8 22.7 21.8 22.1Primary surplus -1.6 -2.5 -2.0 0.3 External Accounts (USDbn) Merchandise exports 225.4 227.7 243.5 270.5Merchandise imports 201.9 218.5 233.7 254.9Trade balance 23.5 9.1 9.8 15.6 % of GDP 6.8 2.5 2.4 3.5Current account balance 11.9 4.3 7.4 10.3 % of GDP 3.4 1.2 1.8 2.3FDI (net) -2.4 -2.8 -3.0 -3.0FX reserves (USDbn) 175.1 184.5 195.9 209.2FX rate (eop) THB/USD 31.6 30.7 30.0 29.3 Debt Indicators (% of GDP) Government debt2,3 35.7 37.4 38.2 37.3 Domestic 33.7 35.2 36.3 36.3 External 1.9 2.2 1.9 1.0Total external debt 30.8 34.2 33.7 31.5 in USDbn 106.6 125.0 135.0 140.0 Short-term (% of total) 46.4 55.2 56.3 57.9 General Industrial production (yoy %) -9.3 5.5 4.0 6.5Unemployment (%) 0.7 0.8 0.8 0.7 Financial Markets Current 3M 6M 12MBoT o/n repo rate 2.75 2.75 2.75 3.253-month Bibor 2.87 2.85 2.88 3.4010-year yield (%) 3.60 3.60 3.65 3.80THB/USD (onshore) 30.7 30.7 30.5 30.3 Source: CEIC, Deutsche Bank Global Markets Research, National Sources Note: (1) Credit to the private sector & SOEs. (2) Consolidated central government accounts; fiscal year ending September. (3) excludes unguaranteed SOE debt.



Vietnam B2/BB-/B+ Moody’s/S&P/Fitch

Economic outlook: A weak banking and challenging

external environment point to a limited recovery in GDP growth in 2013.

Main risks: While aggressive monetary easing poses inflation risks, bank reform represents contingent liabilities for the government.

Macro View

Limited growth amid challenging external environment… With the US fiscal cliff risks posing headwinds to exports amid weak domestic demand, we see Vietnam’s growth under pressure at least until Q2 next year. Our expectation of stronger growth of 5.2% in 2013, vs. 4.9% in 2012, rests not only on a recovery in G2 demand for Vietnamese exports but also on progress in local bank reform, which would bring about a rebound in credit growth and therefore stronger domestic demand.

…and weaker domestic demand… While export growth slowed sharply, to 18.4%yoy ytd in November 2012 from 34.7% in November 2011, anemic domestic demand resulted in a sharper slowdown in import growth to 6.8% from 26.4% during the same periods. In fact, reflecting weaker facility investment growth, machinery import growth fell to 5.6%yoy ytd in November, from 13.7% during the same period last year, while retail sales growth fell to 16.8% from 27.3%. In 2011 the investment and consumption share of GDP fell to 35% and 68%, respectively, from 41% and 69% in 2010.

Domestic demand growth needs to recover

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…although the latter keeps the dong stable… Weak imports, in turn, resulted in a trade account surplus of USD14mn ytd in November 2012, vs. USD8.8bn during the same period last year. This is a far cry from USD18.0bn in 2008, the year in which Vietnam suffered severe market consolidation and the dong was devalued by 5.4%. Since 2008, the dong has depreciated by 22.7% against the US dollar. This devaluation pressure, however,

has eased sharply on the back of an improved external account balance.

2008 vs. now 2008 2011 2012F

Inflation 23.1 18.1 9.3

Banking NPL 2.2 3.1 8.8

Loan growth 33.0 24.5 6.5

Domestic credit, % of GDP 94.0 121.0 110.0

External debt, % of GDP 29.8 40.8 40.0

ST External debt, % of FX Reserves 1.0 56.0 32.0

Current account, % of GDP -12.0 0.2 3.6Sources: CEIC and Deutsche Bank

With relatively weaker growth in imports, 11.0%yoy in Q1 2012 vs. export growth of 32.9%, the goods trade account balance stood at USD0.3bn. Supported by a current transfer of USD2.1bn, Vietnam reported a current account surplus of USD3.4bn in Q1 2012, while FDI, portfolio and other investments stood at a net surplus of USD1.6bn, USD0.7bn and USD0.3bn, respectively, in Q1 2012. According to local news reports, Vietnam continued to enjoy positive external balance, with FDI rising to USD7.3bn ytd in November. Improvement in external balance in turn left Vietnam’s FX reserves sharply higher, at USD20bn in July 2012, vs. USD13bn at end-2011, raising its import coverage ratio to 2.1x from 1.4x during the same period.

Improvement in BoP, but weak domestic demand

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…while guiding inflation lower… Lower inflationary pressure also supported the dong’s stability. Headline inflation fell to 6.5%yoy ytd in November, from 18.1% in 2011, a far cry from the 23.1% reported in 2008. While maintaining its growth target of 5.5%, the government lowered its inflation target from 8% to 7%, cementing its commitment to macroeconomic stability. At the same time, however, with expectations of lower inflation, the authorities have called on banks to lower their lending rates. To achieve this end, we expect the State Bank of



Vietnam (SBV) to lower its policy rates and/or the lending and deposit caps. However, we are cautious with respect to aggressive rate cuts, amid a rising inflationary impulse to 14.0% 3m/3m saar in November from 11.4% in October, and ongoing concerns about banks.

…as Vietnam embarks on bank reform. With banks under pressure, credit growth was very low at 3.3%yoy ytd. This was sharply below credit growth of about 35% over the past five years, which resulted in a sharp increase in Vietnam’s domestic credit to GDP ratio to around 120% in 2011 from below 100% in 2007, above Thailand’s 121%. Although credit growth slowed sharply last year, in response to sharp increases in rates and tighter prudential regulations, years of strong credit growth resulted in large non-performing loans. The official NPL ratio stood at 8.82% as of September, excluding about 8% of loans that were rescheduled under SBV’s circular 780 in April.

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The SBV has asked banks to book sufficient provisions for bad debts but we have yet to hear more details on the AMC (Asset Management Corporation), which was set up to support the bank clean-up (to buy distressed assets from banks at a discount and sell them to investors). There are obvious concerns about how the AMC would be capitalized, with or without the government’s explicit guarantee. In late September, Moody’s downgraded Vietnam, noting that bank capitalization requirements may reach more than 10% of GDP and that “the apparent lack of private sector solutions” represented contingent liabilities for the government. In connection, we welcome the government’s recent call for “foreign companies to invest in and take part in the process of restructuring state-owned companies, including banks.” In our view, SOE reform should be an integral part of bank reform. Despite their large share of GDP, at 38%, the SOEs’ contribution to 6.6% GDP growth in the past five years stood only at 1.8%, vs. the non-state and foreign sectors’ contribution of 3.7% and 1.1%, respectively.

Juliana Lee, Hong Kong, (852) 2203 8312

Vietnam: Deutsche Bank Forecasts

2011 2012F 2013F 2014F

National Income Nominal GDP (USD bn) 122.6 138.1 156.1 178.4Population (m) 87.9 88.8 89.8 90.7GDP per capita (USD) 1395 1555 1739 1966 Real GDP (yoy %) 5.9 4.9 5.2 5.8 Private consumption 4.4 3.8 4.3 7.6 Government consumption 7.1 6.5 6.5 8.0 Gross fixed investment -10.4 2.0 7.0 11.3 Exports 10.0 6.0 7.5 12.5 Imports 7.0 1.6 6.5 14.1 Prices, Money and Banking CPI (yoy%) eop 18.1 7.5 10.3 12.9CPI (yoy%) ann avg 18.6 9.3 9.4 11.4Broad money (yoy%) 11.9 7.5 11.0 18.0Bank credit (yoy%) 24.5 6.5 9.0 15.0 Fiscal Accounts1 (% of GDP) Federal government surplus -5.3 -6.0 -5.5 -4.5 Government revenue 28.0 27.5 27.7 28.5 Government expenditure 33.3 33.5 33.2 33.0Primary fed. govt surplus -3.8 -4.5 -3.0 -1.0 External Accounts (USD bn) Merchandise exports 96.9 113.0 130.0 162.0 Merchandise imports 97.7 109.0 133.0 167.0 Trade balance -0.8 4.0 -3.0 -5.0 % of GDP -0.7 2.9 -1.9 -2.8Current account balance 0.2 5.0 -3.0 -1.0 % of GDP 0.2 3.6 -1.9 -0.6FDI (net) 8.0 7.0 6.0 6.0FX reserves (USD bn) 13.3 26.0 28.0 34.0FX rate (eop) VND/USD 21034 20900 21600 22000 Debt Indicators (% of GDP) Government debt 53.0 54.0 54.8 55.8 Domestic 21.0 22.0 22.5 23.0 External 32.0 32.0 32.3 32.8Total external debt 40.8 39.8 39.1 36.4 in USD bn 50.0 55.0 61.0 65.0 Short-term (% of total) 15.0 15.0 16.4 16.9 General Industrial production (yoy%) 6.9 4.3 6.5 7.5Unemployment (%) 4.5 4.7 4.6 4.5 Financial Markets Current 3M 6M 12MRefinancing rate 10.00 9.00 9.00 9.00VND/USD 20845 21000 21300 21500 Source: CEIC, DB Global Markets Research, National Sources Note: (1) Fiscal balance includes off budget expenditure, while revenue and expenditure include only on budget items.



Theme Pieces

November 2012 Argentina: Pricing Litigation EM Options: Gliding Over the Cliff South Africa: Short-Term Gain, Long-Term Pain

October 2012 Stress Testing EM External Resilience EM Rates: Analyzing Sensitivity to US Rates Sovereign Credit: Retracing Basis and Slope EMFX: Switching to Low Volatility Venezuela: Chavez Still Unbeatable Greece: GGB RV – It’s Not About the Yield

September 2012 EM Neutral Rates in the New Norm CDS as a Substitute for Bonds – an Updated Analysis EM Options: Reaping the Carry Screening for CDS Curve Flatteners EMEA: Headwinds from European Bank Deleveraging India: It’s Not All Doom and Gloom

July 2012 Finding Value in Real Rates QE or not QE – Positioning via EM Swaptions Systematic Screening of Sovereign CDS Pair Trades Revisiting Relative Value Between USD and EUR

Denominated Eurobonds Brazil Slowdown, not Bust Financial Stability Issues in EMEA: Turkey and Israel

June 2012 Monetary Stances in EM and their Sensitivity to Shocks EM Rates: Reassessing Macro Risks EM Rates Options: The Tale of Two Tails Winners and Losers from Rupee’s Depreciation Exploring FX/CDS Basis in EM Breakeven Oil Prices

May 2012 Presenting our EM FX Model: A Fundamental Analysis Unit Labor Cost & Economic Performance in EM EM Rates: Capitalizing the Forward Premium Alernative Assessments of Exchange Rate

Misalignments Argentina GDP Warrants: Peaches or Lemons? Brazil, Indonesia and Turkey’s Experiment Brazil: Currency Risk Premium Revisited LatAm Factors: What’s Working, What’s Next

April 2012 Sovereign Credit: CDS Curve Trade Opportunities

EM Rates: Who Cares About Inflation? Update to the Autobahn EM Inflation Analyzer EMEA BOP Snapshot Can Central Banks Curb Carry Trends? LatAm Equity Model Portfolio – Tapping on the Brake

March 2012 Oil, Inflation and Growth in EM Capitalizing on On-shore/Off-shore Risk Premium in EM EMFX Carry: Exploring Cross Hedges in EMFX BRIC Equity: From Growth to Idiosyncratic Drivers Argentina: Requiem for Growth and Warrants

February 2012 Risks to EM from European Bank Deleveraging Sovereign Credit: A More Structured Look at

Technical’s Sovereign Credit: Focus on Basis Anatomy of EMFX Vol A Tale of the Tape: LatAm Equity Scorecards

January 2012 GCC 2012 Economic Outlook 2012 Asia Country Risk Guide 2012 Outlook – Key Themes for LatAm Equities

December 2011 Rates in 2012: Identifying Pockets of Value FX in 2012” The Vehicle to Trade Global Risk Sovereign Credit 2012: Diminished Returns; Country

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

Side EM Technical’s 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

November 2011 Foreign Reserve Adequacy 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

Regulatory Dis



Contacts

Name Title Telephone Email Location

EMERGING MARKETS

Balston, Marc Head of EM Quantitative Research 44 20 754 71484 [email protected] London Cañonero, Gustavo Head of Economic Research LA&EMEA 1 212 250 7530 [email protected] Buenos Aires Evans, Jed Head of EM Analytics 1 212 250 8605 [email protected] New York Giacomelli, Drausio Head of EM Research 1 212 250 7355 [email protected] New York Jiang, Hongtao EM Credit Strategy 1 212 250 2524 [email protected] New York Ortiz, Nellie EM Research 1 212 250 5851 [email protected] New York Parisien, Denis Head of EM Corporates 1 212 250 7568 [email protected] New York

LATIN AMERICA Corfield, Natalia LatAm Corporates 1 212 250 6135 [email protected] New York Faria, Jose Carlos Senior Economist 5511 2113 5185 [email protected] Sao Paulo FIlho, Jose Strategy 1 212 250 5932 [email protected] New York Losada, Fernando Senior Economist 1 212 250 3162 [email protected] New York Marone, Guilherme LA/EM Strategy 1 212 250 8640 [email protected] New York Roca, Mauro Local Markets Strategy & Senior Economist 1 212 250 8609 [email protected] New York Zhang, Jack LA/EM Strategy 1 212 250 0664 [email protected] New York

EMERGING EUROPE, MIDDLE EAST, AFRICA Akyurek, Cem Senior Economist 90 212 317 0138 [email protected] Istanbul Boulos, Tala Corporates 44 20 754 53664 [email protected] London Burgess, Robert Chief Economist 44 20 754 71930 [email protected] London Grady, Caroline Economist 44 20 754 59913 [email protected] London Gullberg, Henrik FX Strategist 44 20 754 59847 [email protected] London Lissovolik, Yaroslav Senior Economist 7 495 967 1319 [email protected] Moscow Kapoor, Siddharth Strategy 44 20 754 74241 [email protected] London Kong, Winnie EMEA Strategy 44 20 754 51382 [email protected] London Masia, Danelee Senior Economist 27 11 775 7267 [email protected] Johannesburg Shilin, Viacheslav Head of EMEA Corporates 44 20754 79035 [email protected] London

ASIA Baig, Taimur Chief Economist, India 65 642 38681 [email protected] Singapore Das, Kaushik Economist 91 22 6658 4909 [email protected] Mumbai Goel, Sameer Head of Asia Rates & FX Research 65 6423 6973 [email protected] Singapore Lee, Juliana Senior Economist 852 2203 8312 [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 Sachdeva, Mallika FX Strategy 65 6423 8947 [email protected] Singapore 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 6423 5347 [email protected] Singapore



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.



Regulatory Disclosures

1. Important Additional Conflict Disclosures

Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

2. Short-Term Trade Ideas

Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com.

3. Country-Specific Disclosures

Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Investment Advisers Association. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless “Japan” or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation.

Risks to Fixed Income Positions

Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates – these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly



important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements.

Hypothetical Disclaimer

Backtested, hypothetical or simulated performance results have inherent limitations. Unlike an actual performance record based on trading actual client portfolios, simulated results are achieved by means of the retroactive application of a backtested model itself designed with the benefit of hindsight. Taking into account historical events the backtesting of performance also differs from actual account performance because an actual investment strategy may be adjusted any time, for any reason, including a response to material, economic or market factors. The backtested performance includes hypothetical results that do not reflect the reinvestment of dividends and other earnings or the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid. No representation is made that any trading strategy or account will or is likely to achieve profits or losses similar to those shown. Alternative modeling techniques or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor guarantee of future returns. Actual results will vary, perhaps materially, from the analysis.

David Folkerts-Landau Managing Director

Global Head of Research

Marcel Cassard Global Head

CB&S Research

Ralf Hoffmann & Bernhard Speyer Co-Heads

DB Research

Stuart Parkinson Chief Operating Officer

Research

Richard Smith Associate Director Equity Research

Asia-Pacific Germany Americas

Fergus Lynch Regional Head

Andreas Neubauer Regional Head

Steve Pollard Regional Head

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Global DisclaimerEmerging markets investments (or shorter-term transactions) involve significant risk and volatility and may not be suitable for everyone. Readers must make their own investing and trading decisions using their own independent advisors as they believe necessary and based upon their specific objectives and financial situation. When doing so, readers should be sure to make their own assessment of risks inherent to emerging markets investments, including possible political and economic instability; other political risks including changes to laws and tariffs, and nationalization of assets; and currency exchange risk. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report.

Foreign exchange transactions carry risk and may not be appropriate for all clients. Participants in foreign exchange transactions may incur risks arising from several factors, including the following: 1) foreign exchange rates can be volatile and are subject to large fluctuations, 2) the value of currencies may be affected by numerous market factors, including world and national economic, political and regulatory events, events in equity and bond markets and changes in interest rates and 3) currencies may be subject to devaluation or government imposed exchange controls which could negatively affect the value of the currency. Clients are encouraged to make their own informed investment and/or trading decisions. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis.

Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the "Characteristics and Risks of Standardized Options," at http://www.theocc.com/components/docs/riskstoc.pdf If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document.

The risk of loss in futures trading, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited.

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Emerging Markets 2013 Outlook - Deutsche Bank