November 2010

Emerging Markets: Capital Flows & Current Account Balances

Notwithstanding the failure of the G20 finance ministers and central bank governors to agree a set of targets for where current accounts ought to go, Citi analysts think there are good reasons to expect current account balances in Emerging Markets (EM) to deteriorate over time: surpluses are likely to fall, and deficits are likely to rise, in many countries. Deteriorating current account balances in EM might give rise to a debate about whether we‟re headed for another round of EM crises. This would be a valid debate, but Citi analysts think the risks are pretty low in the short run.

September 2010

Emerging Markets: Capital Flows & Current Account Balances

Capital flows to EM are being driven by powerful „push‟ factors, Citi analysts believe, particularly in the form of i) negative real interest rates and

ii) the expectation of further increases in US liquidity if the Federal Reserve‟s balance sheet undergoes further expansion. At the same time, they

note that powerful „pull‟ factors are drawing capital flows towards EM in the form of a large and widening differential in GDP growth rates

between EM and the developed markets, alongside a widening interest rate differential. Many countries are struggling against the currency

appreciation that results from these push and pull factors, with the result that official FX interventions are accelerating, together with a greater

willingness to experiment with controls on capital inflows.

Policy responses to large capital inflows seem destined to continue for the foreseeable future, and from that point of view, Citi analysts therefore

continue to expect real and nominal exchange rates to strengthen in EM; reserves to keep growing; and capital controls to remain a dominant

theme on policymakers‟ agendas. Yet they think that one consequence of these large capital flows that has been under-analysed is the impact

that they are likely to have on current account balances in emerging markets.

But why should current accounts deteriorate? There are two different ways of thinking about the relationship between a country‟s current

account and its capital inflows, say Citi analysts. One view is that capital flows are subsidiary to the current account: in other words, capital flows

enter an economy in order to finance whatever spending decisions that are made autonomously by firms, households and the government,

where these spending decisions give rise to an external financing requirement. Another view is that the current account is subsidiary to the

capital account. In other words, the sheer availability of external financing creates deficits, by facilitating spending decisions that otherwise could

not have been undertaken. Or another way of putting it: countries‟ deficits widen to the point that can be financed by available capital inflows. In

Citi analysts‟ opinion, this is probably for two main reasons: i) because capital inflows cause the real and nominal exchange rate to strengthen,

and so the trade balance deteriorates; and ii) because external financing has (historically at least) been available at lower yields than domestic

financing, which has tended to bias financing decisions towards external markets whenever they are open.

The basic idea is that current accounts balances ought to deteriorate – surpluses are likely to shrink, deficits are likely to rise – as capital flows

increasingly find a home in emerging economies. To some extent this process is already at work, and a number of big EM current account

balances have deteriorated in recent quarters: China, India, Brazil and Turkey have all seen their current accounts worsen. With the possible

exception of Turkey, whose current account deficit now exceeds 6% of GDP, the current account deterioration that we have seen has been

pretty modest, in Citi‟s opinion. One way of explaining this is that policymakers still have a “fear of deficits”, largely thanks to the role that big

current account deficits have played in emerging markets crises over the past 30 years.

Nonetheless, Citi analysts think there is plenty of room for this “fear of deficits” to diminish, for three main reasons. In the first place, real

exchange rate appreciation has accelerated recently, and currency strength may in the end bias spending decisions towards imports. A second

reason why current accounts are likely to deteriorate has to do with the composition of GDP growth and the evolution of credi t markets. With

domestic spending growth now leading GDP growth in a number of the large EM economies – China, Brazil, India, and Turkey for example – this

means that there may be more spill over to imports. Meanwhile, a changing composition of GDP growth is echoed by what is happening in credit

markets in some countries. Domestic credit growth in Brazil, in India, in Turkey, Indonesia and China is either high or rising, or both. Of course

credit trends are connected to the shifting composition of GDP growth in these countries, but they do at least reinforce the idea that emerging

current account balances should continue to deteriorate.

And finally, current accounts may deteriorate simply because they have room to do so. Although it has been noted that EM policymakers are shy

when it comes to running large current account deficits, since current account deficits have been associated with currency and banking crises in

the past, Citi analysts think EM policymakers might find themselves more easily convinced that current account deficits are still well short of

levels that give any rise to concerns about external vulnerability. But that is not to say that countries will rush towards running current account

deficits. It is however worth noting that emerging economies‟ ability to sustain current account deficits is considerably bigger than it used to be,

simply as a result of their superior creditworthiness. Of course that will not excuse countries from worrying about unsustainable deficits – Turkey

may be a case in point – but for the most part current accounts have some way to deteriorate before it is time to worry. For investors,

deteriorating current account balances in EM might give rise to a debate about whether we‟re headed for another round of EM c rises. This will

be a valid debate, but Citi analysts think the risks are pretty low in the short run.

Chart 1:

S&P 500 Index Chart 2:

Dow Jones Stoxx 600 Index

United States Policy efforts likely to sustain modest recovery

Evidence that consumer spending expanded at a 2.5% pace in 3Q10

has held off double dip concerns and suggests some upside potential to

growth if financial stability can be restored. Nonetheless, the pickup in

manufacturing has crested and languishing housing markets are

expected to lag recovery next year. Business investment remains a

standout.

A longer and more active support effort from the Federal Reserve (Fed)

plays an instrumental role in Citi‟s forecast of gradually strengthening

recovery over the next year or so. The Federal Open Market Committee

is expected to launch a new round of large-scale asset purchases at its

November meeting. Until recovery shows greater self-sustaining

momentum and financial headwinds are neutralised, Fed policy is likely

to remain accommodative. Clarity over pending tax policy decisions for

2011 may also alter recovery as well as the path of Fed policy next

year.

Citi analysts observe that the 69% recovery of the S&P500 from the

March 9, 2009 is the strongest bear market rebound of the last 80

years. Furthermore, since the Shanghai market has proven to be a

relatively respectable three-month lead indicator for US indices, there is

reason to believe, in Citi‟s opinion, that after a possible early November

pause, US stock prices could re-establish an upward trend well into

1Q11.

Nevertheless, Citi analysts think it is important to highlight some

challenges for 2011, especially entering mid-year, including probable

margin pressures and seasonal weakness. Overall, they see potential

for equities to move higher next year, but caution that the road ahead is

likely to stay uneven and investors may need to stay nimble with

respect to portfolio positioning.

*Denotes cumulative performance Performance data as of 29 October 2010 Source: Bloomberg

-23.63%

14.19%

6.11%3.69%

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0%

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1-Mth YTD 1-Yr 3-Yr*

Euro-Area First ECB rate hike expected only in 3Q11

Available data for 3Q10 suggest divergent GDP performance among Euro

Area member countries. On average, Citi analysts expect slightly below-

trend GDP growth of 0.3% in 3Q10. However, partly due to strikes in some

member countries, the 4Q10 reading is likely to be somewhat weaker than

initially expected. While this does not change our 2010 GDP forecast, the

slower expansion in 2H10 contributes to a downward revision of our 2011

forecast by 0.2 points to 1.1%. Additionally, somewhat slower export

momentum in 2011, caused by the stronger EUR, may cap GDP growth.

Although the European Central Bank (ECB) continues to provide all its

liquidity measures with full allotment, these measures are now less

attractive for banks (maximal funding up to 3 Months for 1%) than they

were a year ago (funding up to 12 Months for 1%). Furthermore, there are

signs that the situation in the banking sector is gradually improving. In this

environment, the ECB is likely to announce the end of the full allotment of

the 3 Month Long-Term Refinancing Operations (LTROs) in December.

Despite the recent appreciation of the EUR and probably somewhat

weaker GDP growth, Citi analysts expect the ECB to start the

normalisation of interest rates with a 25 bps hike around 3Q11.

Citi analysts continue to believe that we have seen a structural change in

the global economy over the past couple of years. As a result, and in a

world with less growth and less credit, those companies with growth and

capital advantages are structurally advantaged for the next few years. This

has been Citi‟s own structural view since the start of 2009.

From an equity perspective, this has driven Citi to focus on those

companies with strong balance sheets and Emerging Market (EM)

exposure within UK and European equity markets.

*Denotes cumulative performance Performance data as of 29 October 2010 Source: Bloomberg

-31.53%

12.25%

4.75%2.40%

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Chart 3:

MSCI Asia Pacific Index

Chart 4:

MSCI Emerging Markets Index

*Denotes cumulative performance Performance data as of 29 October 2010 Source: Bloomberg

*Denotes cumulative performance Performance data as of 29 October 2010 Source: Bloomberg

Japan Economy expected to maintain moderate uptrend

The economy is slowing amid a renewed slowdown in the major trading

partners, a tapering-off of positive impacts from the government‟s policy

measures and the yen‟s appreciation. The expiration of the

government‟s subsidies is likely to cause marked volatility until the

2Q11. Citi analysts expect negative GDP growth in 4Q10 as auto sales

and production are plunging. Nonetheless, the economy is expected to

maintain a moderate upward trend thanks to much slower but still

positive growth in exports and a pickup in private capex on the back of a

strong rebound in profits.

The Bank of Japan (BoJ) decided on additional easing measures

including the new asset purchase program amounting to ¥5 trillion in

early October. While the BoJ is poised to expand the size of asset

purchases depending upon economic and financial developments, Citi

analysts are sceptical that the new measures will have a meaningful

impact on financial conditions and economic activity.

Asia Pacific Rising inflation pressures

Exports have rebounded in many Asian economies while domestic

demand remains resilient. However, inflation pressures are rising.

Ample liquidity amid high capital inflows are expected to complicate

monetary policy.

The Bank of Korea and Bank of Thailand paused in October given

concern on currency strength, while Bank Indonesia has been

increasingly dovish. Citi analysts think tighter regulations on capital

inflows are inevitable – Thailand has started, and Korea is likely to

follow soon.

Over the medium term, Citi analysts believe growth outperformance and

higher interest rates in Asia versus the developed world could

potentially attract further capital inflows, supporting Asian currencies –

particularly the Indian Rupee (INR) and Korean Won (KRW).

Emerging Markets CEEMEA and Latam currencies continue to remain supported

Despite raising the growth outlook in Poland and Kazakhstan, Citi

analysts have cut their 2010 GDP growth forecast for CEEMEA1

– from

4.5% to 4.2% – on Russian and Romanian economic

underperformance. Policy rate hikes are expected in 4Q10 in Israel and

Poland on the back of surprising strength in economic recovery and

deteriorating inflation prospects.

Meanwhile, the strengthening of Latam currencies has intensified since

September, triggering varied responses across the region. Citi analysts

expect that Quantitative Easing 2 (QE2) may have a positive impact on

Latam currencies and fixed income assets as they are likely to benefit of

improved risk appetite.

In particular the Brazilian Real (BRL) and Mexican Peso (MXN) are

likely to continue benefiting while Citi expects the Russian Ruble (RUB)

and Polish Zloty (PLN) to outperform their peers over the medium term

in CEEMEA.

Citi analysts are more cautious about Latin America‟s near-term

economic outlook due to the pressures from a slowing global economy

– in particular China and the US. However, the region‟s GDP growth is

expected to continue to outperform that of the developed countries.

Within Latin America, they are overweight Brazil.

As for CEEMEA equities, despite attractive valuations and robust

earnings growth, the biggest risks include potential commodity price

declines, currency volatility and links to developed Europe. Within

CEEMEA, Citi analysts are overweight Russia, Poland and Egypt.

1. CEEMEA is the collective term for Central and Eastern Europe, Middle East

and Africa.

2.81%

11.75%

20.94%

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2.41%

9.56%11.08%

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1-mth YTD 1 Year 3 Years*

Chart 5:

Currencies (vs US Dollar on 1 month)

*Denotes cumulative performance Performance data as of 29 October 2010 Source: Bloomberg

Currencies

Trend weakness in the USD is likely to continue although there are risks

of disappointment on Fed action. Citi analyts forecast Trade-Weighted

USD at 75.06 in a 3 months period.

Gradual normalisation of ECB policy still supports EUR upside near

term (1.45 in 0-3 months). However, adverse growth effects from higher

EUR and renewed investor focus on periphery problems call for some

retracement longer out.

Fed QE2 to keep downward pressure on USD/JPY, but Ministry of

Finance / Bank of Japan are likely to try to slow Yen appreciation.

Elsewhere in G10, SEK and NOK offer best fundamental value. AUD

and NZD likely participate in further USD weakness, although the risks

of a sharp correction in both currencies have been growing, according

to Citi analysts.

Citi analysts think that UK fiscal tightening should keep upward

pressure on EUR/GBP.

In the emerging world, Citi analysts expect further currency appreciation

due to QE2, renewed risk appetite and, for some, higher commodity

prices.

In EM Asia, CNY appreciation against the USD is likely to continue. This

should help to offset policy attempts to resist appreciation elsewhere in

the region. Citi analysts expect upside in most other Asian currencies.

Risk appetite should continue driving CEEMEA FX higher. A weaker

USD and higher commodity prices are key supports for Latam

currencies despite strong rallies earlier this year.

General Disclosure “Citi analysts” refers to investment professionals within Citi Investment Research and Analysis, Citi Global Markets (CGM) and voting members of the Global Investment Strategy Committee. Citibank N.A. and its affiliates / subsidiaries provide no independent research or analysis in the substance or preparation of this document. The information in this document has been obtained from reports issued by CGM. Such information is based on sources CGM believes to be reliable. CGM, however, does not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute CGM's judgment as of the date of the report and are subject to change without notice. Opinions expressed herein may differ from the opinions expressed by other businesses or affiliates of Citibank N.A. This document is for general information purposes only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or currency. No part of this document may be reproduced in any manner without the written consent of Citibank N.A. Information in this document has been prepared without taking account of the objectives, financial situation, or needs of any particular investor. Any person considering an investment should consider the appropriateness of the investment having regard to their objectives, financial situation, or needs, and should seek independent advice on the suitability or otherwise of a particular investment. Investments are not deposits, are not obligations of, or guaranteed or insured by Citibank N.A., Citigroup Inc., or any of their affiliates or subsidiaries, or by any local government or insurance agency, and are subject to investment risk, including the possible loss of the principal amount invested. Investors investing in funds denominated in non-local currency should be aware of the risk of exchange rate fluctuations that may cause a loss of principal. Past performance is not indicative of future performance, prices can go up or down. Some investment products (including mutual funds) are not available to US persons and may not be available in all jurisdictions. Investors should be aware that it is his/her responsibility to seek legal and/or tax advice regarding the legal and tax consequences of his/her investment transactions. If an investor changes residence, citizenship, nationality, or place of work, it is his/her responsibility to understand how his/her investment transactions are affected by such change and comply with all applicable laws and regulations as and when such becomes applicable. Citibank does not provide legal and/or tax advice and is not responsible for advising an investor on the laws pertaining to his/her transaction.

Currencies

Positive on High-grade and High-yield corporate

debt

US Treasuries

Flight-to-quality sentiment has had an impact on US treasuries; current

valuations are unattractive in Citi‟s view.

US Corporates

Potential opportunities in quality US corporate debt at the lower end of the

investment grade spectrum, given the recent sell-off, particularly in the

financial, metals and mining sectors. Meanwhile, high-yield spreads are

anticipated to continue grinding tighter over time as positive technical

factors and improving fundamentals support performance.

Euro Bonds

Investors can find value in sovereigns that have been impacted by

concerns in the periphery, but are unlikely to default, such as Italy and

Belgium (despite continued political risks). Citi analysts prefer maturities in

the 10 to 15 year range, which has the most attractive carry opportunities.

Emerging Market Debt

Citi analysts favour Asian and Latin American sovereign credits as

improved market liquidity and healthy risk appetite persist.

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Euro GBP JPY