Emerging Markets Outlook Emerging markets analysis Jul 9, 2015 - - PDF document

Emerging Markets Outlook

Emerging Markets FX Provides advice, analysis and foreign exchange products to clients within emerging markets. For further information, call +46 8 700 90 20 Analyst: Hans Gustafson +46 8 700 91 47 Emerging markets outlook Is published four times a year and is forecasting currency developments for selected emerging market countries with a time horizon of 3 months.

Political risks dominate the headlines

Emerging markets analysis — Jul 9, 2015

Emerging market currencies face many challenges right now. Economic growth is low and worries run high about the future of the eurozone. The political situation in Greece has been turbulent, and at the time of writing tough negotiations are underway with the EU. Uncertainty whether Greece can keep the euro as its currency is very high. The outcome of the negotiations also affects expectations about the eurozone in general. We see little risk that economic turmoil will spread to emerging markets. In the short term, however, there is a strong risk that negative sentiment will apply downward pressure to emerging market

• currencies. In the longer term the currencies could fjnd support if

the central banks, led by the ECB and perhaps the Fed, are forced to act and increase liquidity. Macroeconomic development in China is of much greater importance to several of the currencies we follow. Right now the Chinese markets are plunging. While the real economic impact shouldn’t be overstated, it’s still a factor in an environment with weak growth in China and uncertainty in Europe. The Chinese central bank will continue to stimulate to ease the impact of the tumbling stock market and support the economy. We expect these measures to reduce the risk of an overly negative outcome. On the other hand, demand from China will remain low, which is negative for the currencies in Asia and Brazil. Political uncertainty has also increased in countries such as Turkey and Poland. In Turkey the governing AKP party lost its majority for the fjrst time and the leftist Kurdish party HDP cleared the 10% threshold. It now remains to be seen whether a new election will be called or if a coalition government is formed. The parties are far apart. Regardless of the outcome, the political map has been rewritten, creating considerable uncertainty about economic policy. As a result, the risk that Turkey enters a period of political turbulence and a further weakening of its currency is high. Even in otherwise stable Poland, political uncertainty has increased after the latest presidential election, which was won by opposition candidate Andrzej Duda. There is a stronger likelihood therefore of a change in government after parliamentary elections this fall. His Law and Justice Party has promised to spend more on families and repeal the decisions to raise the retirement age and increase taxes on banks. Though this will put pressure on the zloty, it will be partly offset by Poland’s strong economic development. Another risk is that the US central bank, the Federal Reserve, will begin to normalize its monetary policy this fall. Higher interest rates in the US and a stronger dollar are negative for countries with large dollar loans such as Brazil, Turkey, Indonesia and Mexico.

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Forecast EUR/RUB in 3 months 67.58 (today 63.59) Forecast EUR/PLN in 3 months 4.30 (today 4.23)

Currency forecast vs. the euro Currency forecast vs. the euro The zloty is supported by relatively high growth and strong public fjnances. However, political uncertainties before the autumn parliamentary elections and political risks in the euro zone linked to developments in Greece are negative factors. We are therefore moderately negative to the zloty in the coming months. Political uncertainty has increased in Poland after the recent presidential election, which was won by opposition candidate Andrzej Duda. The election outcome has increased the likelihood of a change in government after parliamentary elections this fall. The market is concerned that a new government led by the president’s party, Law and Justice, will implement more expansive, populist and less market-friendly

• policies. Law and Justice has promised to spend more on

families, repeal the decision to raise the retirement age and return to a defjned-benefjt pension system. The latter two promises would be very negative, since Polish demographics are among the most challenging in the world given its rapidly growing old-age dependency ratio. The banking sector also potentially faces the cost of having to convert loans in Swiss franc to zloty. The risk of deteriorating public fjnances and a lower credit rating shouldn’t be blown out of proportion,

• however. Economic conditions are strong. The current account

defjcit has been reduced, the government budget has been strengthened and infmation pressure is very low. In addition, fjscal rules domestically and in the EU place a cap on the government debt. Growth prospects for Poland are good. GDP rose by 3.4% on an annual basis in the fjrst quarter and the June PMI indicates continued strength going forward. The biggest risk for growth is a turbulent Grexit.

Poland

High growth and strong public fjnances Political uncertainty

Russia

Political unwillingness to strengthen the ruble Weak growth and global isolation We remain negative to the ruble. Economic growth is weak and there is a political distaste for a stronger ruble. Future refjnancing of foreign currency loans will require a high risk premium in the form of a low ruble as long as the global fjnancial markets are closed to Russia. The Russian ruble turned lower and was the weakest emerging market currency in the second quarter. This is only natural against the backdrop of continued fjghting in Ukraine and weak economic development. After Russian GDP fell by an annual rate of 2.2% in the fjrst quarter, the Ministry of Finance estimates that the slowdown accelerated in April with GDP down 4.2% compared with the same period in 2014. The decline in industrial production also accelerated in May and fell by 5.5% on an annual basis. The EU extended sanctions against Russia at the end of June when the confmict in eastern Ukraine escalated and Russia violated the Minsk ceasefjre. Russia countered by extending its import restrictions. This means that demand from abroad will remain weak and high infmation pressure will continue. Consumer prices rose 15.3%

• n an annual basis in June. The high infmation rate is putting

a stranglehold on domestic spending. Real wages are down about 7% and retail sales about 10% at annual rates. The central bank cut the benchmark rate by 100 basis points to 11.5% at its June meeting. The political signals clearly suggest that the Russian leadership is uncomfortable with a stronger

• ruble. In fact, the fjnance minister took part in the April 30

policy rate meeting, which is highly unusual.

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Forecast EUR/TRY in 3 months 3.05 (today 2.98) Forecast EUR/ZAR in 3months 14.06 (today 13.89)

Currency forecast vs. the euro Currency forecast vs. the euro The South African rand dropped to a new record low against the dollar in June. We expect the rand to further weaken against the dollar against the backdrop of weak growth, falling commodity prices, structural problems in the mining industry and a high sensitivity to a stronger dollar. The Turkish lira fell to a new low against the dollar after the

• election. Turkey is economically vulnerable due to slow growth,

high infmation and large dollar loans. Exports have slowed in

• 2015. Coupled with political uncertainty, this raises the risk of

a further depreciation of the lira. GDP improved slightly in the fjrst quarter with growth at 2.1%

• n an annual basis, against 1.2% in the last quarter of 2014. On

the other hand, South Africa is plagued by structural problems and weak demand, which are stifming growth. Electricity

• utages are driving up prices and slowing production. They

are also hurting net exports, since companies are increasingly importing inputs rather than deal with domestic producers and the possibility of blackouts. Domestic demand is being held in check by a weak labor market and high infmation. Unemployment is the highest since 2005. The weak demand is clearly refmected in car sales, which fell signifjcantly in May. Besides these problems, there is a strong risk of a strike in the gold sector. The central bank has recently signaled that it is prepared to raise its benchmark rate. Two members voted for a 25 bp rate hike at the May policy rate meeting. According to the central bank’s latest monetary report, available resources are rapidly shrinking and the potential growth rate has fallen to 2-2.5%. The increase in core infmation is 5.7%, close to the upper limit set by the central bank. Infmation has stayed close to the upper limit for some time. We therefore expect the central bank to take a more hawkish stance to reduce infmation expectations going forward. Turkey’s recent election left the governing AKP party without a majority for the fjrst time and lifted the leftist Kurdish HDP party above the 10% threshold. Turkey is now entering a period of great political uncertainty and instability after having been governed by a single party for 13 years. The AKP now has to try to form a coalition government. This won’t be easy, since the parties are far apart. A minority government is a possibility, but so is a new election. The election results were a major setback for President Erdogan and his authoritarian

• leadership. Plans to amend the constitution and strengthen

the president’s power are now on the backburner. Uncertainty about future policy is tempered by the increased possibility that the central bank will set a more independent monetary

• course. Economic growth has been slowed by weak investment

and exports. GDP rose 2.3% on an annual basis in the fjrst quarter, compared with a gain of 2.6% in the last quarter of

• 2014. At the same time the infmation rate has continued to rise.

Consumer prices climbed 7.2% on an annual basis in June and are still far above the central bank’s 5% target. The current account defjcit has shrunk but has left the Turkish economy highly vulnerable to a stronger dollar and global disruptions.

South Africa

Major structural problems High vulnerability to a stronger dollar

Turkey

High political uncertainty Weak growth and high sensitivity to a stronger dollar

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Forecast EUR/MXN in 3 months 17.28 (today 17.53) Forecast EUR/BRL in 3 months 3.65 (today 3.59)

Currency forecast vs. the euro Currency forecast vs. the euro We are cautiously positive to the Mexican peso going forward. It has a fairly low valuation and growth appears to be

• strengthening. The biggest risks are that demand from the US

won’t pick up or that the Fed raises interest rates so quickly that the fjnancial markets are jolted. The Mexican peso is currently trading at the lowest level ever against the dollar. Its depreciation is due to considerably lower terms of trade and weak exports. The real effective exchange rate is now nearing the lows of 2009, following the Lehman

• crisis. Exports have slowed and were down about 9% in May
• n an annual basis, which in itself indicates that the peso isn’t
• undervalued. Exports prices have plunged and in May were

down 14.7%, while import prices fell 3.6% on an annual basis. As a result, terms of trade are the lowest in over fjve years. On the other hand, we are cautiously positive that the economy is strengthening. Consumer spending has accelerated thanks to a strong labor market, lower electricity prices and the elimination of several phone fees. We expect demand from the US to strengthen this fall. This is positive for export growth, since about 80% of total exports go to the US. The stabilization of oil prices means that energy reforms can now

• continue. The fjrst auction of shallow water oil fjelds will take

place on July 15, with 26 oil companies taking part. A second auction will be held on September 30 and a third on December

• 15. If they are successful, the investments will provide a major

boost to growth in coming quarters. In light of weak economic growth, high infmation and big challenges to improve public fjnances, we see a risk that the Brazilian real will weaken further. The combination of tight economic policy and weak exports has increased political acceptance of a weaker currency. On the other hand, high short-term interest rates will limit any rapid drop in the real. Economic development in Brazil is very weak. The economy is struggling with stagfmation, a big increase in unemployment and further rise in infmation. GDP fell 1.1% on annual basis in the fjrst quarter and industrial production has been in a negative trend since the start of 2014. The infmation rate rose to 8.5% in May, the highest level in over 10 years. As a result, the central bank is expected to announce more rate

• hikes. Economic policies are very tight, as refmected by a 14.4%

annualized drop in imports in May and lower retail sales in the fjrst half of 2015. The Petrobras corruption investigation continues to spread, adding to the political uncertainty and restraining investments and growth. This in turn leaves less room to improve the budget. Furthermore, president Rousseff’s popularity is record low. There is a big risk that the target of a 1.2% primary surplus won’t be reached in 2015. Moreover, it isn’t unlikely that the 2016 surplus target of 2% will be delayed until 2017. This, coupled with an increased current account defjcit in 2015, means that the risk of a credit downgrade remains. Falling commodity prices have hurt terms

• f trade. This motivates a low valuation of the Brazilian real,

which in real terms is trading at levels last seen in 2009.

Brazil

High policy rate Many diffjcult challenges

Mexico

Low valuation and stronger demand from the US Weak growth and low carry

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Forecast EUR/IDR in 3 months 15042 (today 14783) Forecast EUR/KRW in 3 months 1264 (today 1257)

Currency forecast vs. the euro Currency forecast vs. the euro We expect the Korean won to continue to fall against the backdrop of weak growth and historically low short-term interest rates. This is probably a welcome development from the standpoint of South Korean politicians and exporters. Furthermore, the won isn’t cheap measured by its real effective exchange rate. The rupiah is currently trading at a record low against the

• dollar. In spite of this, it doesn’t have a low valuation in real
• terms. We are negative to the rupiah against the dollar in the

coming quarter against the backdrop of weak demand from Asia and the risk of a stronger dollar. The central bank cut its benchmark rate by 25 bp to a new record low of 1.5% at its meeting on June 11. This was the fourth rate cut since mid-2014. The reason for the cut was the slide in exports and possible negative effects on consumption

• f the MERS outbreak in South Korea this spring. The economy

has been greatly impacted by the epidemic, which forced people to stay home instead of going out and spending. Tourism has also been impacted negatively. Economic growth has weakened since spring 2014. GDP rose by 2.4% on an annual basis in the fjrst quarter, compared with 3.9% in the same period in 2014. At the same time exports have dropped every month in 2015. Exports were mainly affected by weak spending in the EU. The weaker euro makes it more expensive for Europeans to import at the same time that production in Europe becomes more competitive. Weak demand from Russia put a major dent in auto exports. The PMI fell to 46.1 in June, indicating continued weak manufacturing activity. The infmation rate was only 0.7% in June, far below the central bank’s lower infmation target of 2%. The central bank has previously been reluctant to monetary easing due to concerns about high levels of household indebtedness. The Indonesian rupiah reached a new low against the dollar in early June on the heels of slow economic growth, a large current account defjcit and general lack of global investment in emerging markets in anticipation of a rate hike by the

• Fed. Foreign holdings of Indonesian bonds are already large,

which makes the currency sensitive to major shifts in global

• portfolios. GDP slowed in the fjrst quarter of this year and

grew only 4.7% on an annual basis, compared with 5.0% in the previous quarter. Continued weakness in commodity markets and sluggish domestic demand were the reasons for the lower growth rate. Exports have trended downward since mid-2011. Infmation is high despite the weaker growth. On an annual basis consumer prices rose 7.2% in May, the highest level this year. The price rise wasn’t driven by demand but by higher administrative costs and food prices. The government eliminated gas subsidies in early 2015, which together with the recent rise in oil prices directly impacts overall prices. Oil prices have risen about 40% since bottoming out in January. We therefore expect the central bank to keep its benchmark rate unchanged. The rupiah is highly sensitive to risks in the global fjnancial markets.

South Korea

Large reserves and strong external balance Weak external demand and low carry

Indonesia

Weak demand from Asia Large current account defjcit

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Forecast EUR/INR in 3 months 70.31 (today 70.40) Forecast EUR/CNY in 3 months 6.76 (today 6.88)

Currency forecast vs. the euro Currency forecast vs. the euro The Chinese leadership has been busy this year taking measures to stabilize the economy, and more recently the stock market. The central bank has cut interest rates four times since November 2014. Reserve requirements for banks have been loosened three times this year. Initially the aim was to stabilize the weak property market. The last time the focus shifted to the plunging stock prices. Chinese stock markets had been hibernating for years, then came to life last November when the central bank started its monetary stimulus with a rate cut. Stocks accelerated this spring, with several Chinese exchanges more than doubling in value in about a half-year. This happened at the same time that economic growth continued to slow. We expect the plunging stock prices to have little impact on the real economy. The stock gains were too short to create any wealth effects and few households own stocks in China. In addition, the central bank will continue to provide support to soften the blow. The highly indebted provinces have received help to reduce their interest expenses by exchanging old, high interest rate loans with short maturities for longer bond loans at a lower interest rate. The banks have to absorb the higher cost but at the same time can get cheap funding from the central bank with the new bonds as collateral. We expect further stimulus to stabilize the economy this year. Economic growth has been somewhat of a disappointment in 2015 and the strong growth expectations following the change in government in 2014 have now been tempered. In fact, the government never promised rapid changes. The aim of its reform agenda is to raise growth in the long term. India needs major infrastructure investments. Investment has been weak, however, as has credit growth. The latter is the lowest in about 10 years – despite that the central bank has cut its benchmark rate by 75 bp in 2015. The banks have not cut lending rates for their borrowers to quite the same extent. The infmation rate has fallen signifjcantly since the second half

• f 2014 on a broad basis. This is due to better control over food

prices, overcapacity in the manufacturing sector and a more stable currency. The price decline has been even more evident at the wholesale level, where prices have fallen on an annual basis every month since November 2014. In May they fell 2.4%, the lowest annual rate in about 40 years. Weak domestic demand suggests that infmation will remain low and stay below the central bank’s target of 6% for 2016. We therefore expect further rate cuts to stimulate credit growth and speed up the necessary investments. Exports have declined since last December, which together with low infmation pressure suggests a weaker currency. The renminbi has been unusually stable against the dollar since mid-March. We expect continued stability for the rest of 2015 as China prepares to further internationalize the renminbi and eventually make it fully convertible. We suspect, however, that China need to implement additional fjnancial reforms before it can be included in the IMF’s currency basket of Special Drawing Rights (SDR). The rupee has trended lower against the dollar for the last

• year. We suspect that India’s leaders are happy with this,

since exports are weak and could need support from a weaker

• currency. The risks are on the downside if the government

won’t be able to get key reforms passed by the Senate or that risk sentiment weakens signifjcantly in connection with a rate rise in the US.

China

Politicians prepare the renminbi for full convertibility Weak growth and stock market turbulence

India

Tight monetary policy Weak recovery

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