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Emerging Markets Explorer

Determined by the flip sides of two coins

Macro: Recoupling but sub-trend growth Theme: Deeper look into flows Strategy: Wary of Q4, brighter 2014 4 October 2013

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CONTENTS
Executive summary: Determined by the flip sides of two coins.......................................................................................................... 3 SEB EM forecasts & track record ............................................................................................................................................................. 4 EM macro: Recoupling but sub-trend growth ....................................................................................................................................... 5 EM assets fell out of bed this summer ........................................................................................................................................ 5 but recovered in September ......................................................................................................................................................... 5 The trigger....................................................................................................................................................................................... 6 and the undercurrents................................................................................................................................................................... 6 The macro impact from the summer sell-off ................................................................................................................................ 7 What next? The main scenario ........................................................................................................................................................ 7 Structural deficiencies exposed ................................................................................................................................................... 8 but partial progress on reforms and reduced vulnerabilities too ............................................................................................ 9 Catch-up potential partly realised slower growth ahead ......................................................................................................... 9 Fed also in the EM driver seat ....................................................................................................................................................... 10 EM GDP growth forecasts .............................................................................................................................................................. 10 Key risks ............................................................................................................................................................................................ 11 Inflation is not the big headache ................................................................................................................................................... 11 Heterogeneous monetary policy outlook .................................................................................................................................... 12 Theme: Deeper look into flows ..............................................................................................................................................................13 Strategy: Wary of Q4, brighter 2014 ..................................................................................................................................................... 15 EM FX drivers ................................................................................................................................................................................... 16 SEB EM FX forecasts ....................................................................................................................................................................... 16 Trading recommendations .............................................................................................................................................................17 Fixed Income: Driven by the tapering ebb and flow................................................................................................................... 19 SEB EM bond basket update.......................................................................................................................................................... 20 Quantitative and technical analysis ............................................................................................................................................. 22 Asia ............................................................................................................................................................................................................ 25 China: What is Liconomics? ........................................................................................................................................................... 25 India .................................................................................................................................................................................................. 26 Indonesia.......................................................................................................................................................................................... 26 Korea................................................................................................................................................................................................. 27 Malaysia............................................................................................................................................................................................ 27 Philippines ....................................................................................................................................................................................... 27 Singapore ......................................................................................................................................................................................... 28 Taiwan .............................................................................................................................................................................................. 28 Thailand............................................................................................................................................................................................ 28 Emerging Europe ..................................................................................................................................................................................... 29 Czech Republic ................................................................................................................................................................................ 29 Hungary ............................................................................................................................................................................................ 29 Poland............................................................................................................................................................................................... 30 Romania ............................................................................................................................................................................................31 Russia ................................................................................................................................................................................................31 Turkey ............................................................................................................................................................................................... 32 Ukraine ............................................................................................................................................................................................. 33 Africa ......................................................................................................................................................................................................... 34 South Africa ..................................................................................................................................................................................... 34 Latin America ........................................................................................................................................................................................... 35 Brazil ................................................................................................................................................................................................. 35 Chile .................................................................................................................................................................................................. 36 Mexico .............................................................................................................................................................................................. 37 EDITORS
Mats Olausson, Chief EM Strategist, +46 8 506 23 262 Sean Yokota, Head of Asia Strategist, +65 65 05 05 05

Disclaimer: See page 38 Contacts: See page 39 Cut-off date: 1 October 2013

CONTRIBUTORS
Per Hammarlund Sandra Heidmann Magnus Lilja

Fredrik Skoglund Dag Muller Karl Steiner Anders Sderberg

Note: Data in graphs are from Macrobond if nothing else is stated. 2

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Executive summary: Determined by the flip sides of two coins


TRADING RECOMMENDATION RECOMMENDATIONS ONS We recommend buying a 5M, 1*2 put spread in EUR/MXN and we reiterate our call to buy CNY NDF vs. USD 1M. We look to buy USD/ZAR on dips and see good relative value in buying INR/IDR as well as going long PLN/CZK.Finally, we look to sell USD/SGD. For the rationale behind each trading recommendations and details, see page 17. MACRO Emerging markets (EM) have been on a rollercoaster ride since early this summer. Significantly however, these developments have been confined primarily to financial markets. The real economy has been more stable. Still, macro developments form part of the background to this summers events and the impact of greater volatility will be seen in real data later on. The sell-off was clearly triggered by an increasing likelihood that the US Fed would begin tapering its asset purchases sooner rather than later. However, four undercurrents also help explain EM underperformance this summer: 1) disappointing growth; 2) lack of structural reforms; 3) positioning; and 4) eyecatching political unrest. The macro impact of the summer sell-off will be negative for EM growth (scarcer, more expensive liquidity) and positive for external balances. While also negative for inflation, this is only a big issue for Indonesia and Turkey. Looking forward, we have an optimistic view on the global economy. EM have lagged this years recovery by developed markets (DM). Importantly, this largely reflects structural deficiencies (demographics and growth models have run their course), especially in the BRICs. In fact, this structural slowdown has been taking place since 2010/11. Despite some reforms (for example, in Mexico, Colombia and Singapore), we do not think the summer crisis has created sufficient crisis awareness to kick-start major changes. So, despite several signs of early recovery in many EM, which in turn support incipient recoupling with DM, the upturn in EM will only generate GDP growth of around 5%, well below their 10 year trend of 6.6%. THEME In our theme article we take a Deeper look into capital flows. The US Feds message in May represented a paradigm shift in the sense that it reversed five years of on hold or additional easing of monetary policy into a first look towards the exit. Markets reacted strongly. Countries with current account deficits were first to be hit as capital flows reversed. However, we also examine deeper capital flow vulnerabilities. While the how and when of tapering remain uncertain, clearly the hunt for quality and yield will be a less potent driver for EM bonds than in recent years. Instead, we expect recoupling of growth, albeit to lower levels than before, to attract capital back to this years underperforming EM equity markets, at far more attractive valuation compared to many DM counterparts. STRATEGY In coming quarters, the outlook for EM assets will largely depend on how investors emphasise the flip sides of two coins. Firstly, will investors focus on tighter liquidity due to Fed tapering or on the strength of the US economy, which is a prerequisite for tapering to happen and which will help global growth returning to trend? Secondly, will they cheer the recoupling of EM growth or rather focus on the lower growth rate and diminished growth advantage over DM? To conclude, we are generally cautious on EM assets in Q4 but expect a better outlook in 2014. We assume the Fed will start tapering in December and, crucially, that it clarifies its intentions and ease the confusion currently restricting risk appetite. Market movements will largely stay within ranges established since early summer. Investors should increasingly diversify between EMs. For now, we recommend a 25% hedging ratio in EM FX.

The flip sides of two coins


Growth

U.S.
Tapering

Summer 2013
Sub-trend growth Recoupling

EM
3

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SEB EM forecasts & track record


SEB EM FX forecasts for eop 01-okt-13 1M Q4 13 4,20 298 25,9 4,43 43,4 37,5 32,7 3,17 225 19,5 8,20 2,05 10,20 2,25 13,00 505 6,08 6,08 7,80 12000 65,0 1100 3,30 44,0 1,30 32,7 30,2 1,33 103 Q1 14 4,15 295 25,8 4,38 42,1 36,8 32,4 3,19 227 19,8 9,00 1,98 9,80 2,20 12,70 500 6,02 6,02 7,80 11500 64,5 1080 3,25 43,8 1,28 32,5 30,0 1,30 105 Q2 14 4,15 295 25,5 4,33 41,6 36,5 32,4 3,23 230 19,8 9,10 1,98 9,80 2,20 12,50 495 5,98 5,98 7,80 11200 63,5 1070 3,20 43,5 1,26 32,0 29,7 1,29 107 Q3 14 4,10 295 25,5 4,30 41,7 36,8 32,8 3,23 232 20,1 9,20 2,05 10,20 2,25 12,40 490 5,94 5,94 7,80 11000 63,0 1060 3,20 43,0 1,24 31,5 29,4 1,27 109 Q4 14 4,05 295 25,2 4,27 41,4 37,0 33,4 3,27 238 20,3 9,30 2,10 10,50 2,30 12,30 490 5,90 5,90 7,80 11000 60,0 1050 3,20 42,5 1,22 31,0 29,2 1,24 110

Vs. EUR
PLN HUF CZK RON RUB RUB/BASKET 4,22 297 25,7 4,45 43,8 37,4 32,3 3,11 219 19,0 8,18 2,01 10,00 2,22 13,09 505 6,12 6,11 7,75 11315 62,3 1074 3,23 43,3 1,25 31,1 29,5 1,36 98,0 4,25 300 25,8 4,45 44,1 37,8 32,7 3,15 222 19,1 8,20 2,05 10,20 2,25 13,20 508 6,10 6,10 7,80 12000 63,5 1150 3,20 43,0 1,28 32,5 30,2 1,35 100

Vs. USD
RUB PLN HUF CZK UAH TRY ZAR BRL MXN CLP CNY CNH HKD IDR INR KRW MYR PHP SGD THB TWD EUR/USD USD/JPY

SEB EM policy rates forecasts for eop 01-okt-13 EMEA Poland 2,50 Czech 0,05 Hungary 3,60 Turkey 1W repo 4,50 Turkey O/N borrowing 3,50 Turkey O/N lending 7,75 S. Africa 5,00 Romania 4,25 Russia 1W repo 5,50 LatAm Brazil Chile Mexico Asia China lending China deposit Korea India Indonesia Malaysia Philippines Thailand Taiwan Source: Bloomberg, SEB

4Q13 2,50 0,05 3,20 4,50 3,50 8,25 5,00 3,75 5,25

1Q14 2,50 0,05 3,00 4,50 3,50 8,25 5,00 3,75 5,00

2Q14 2,50 0,05 3,00 4,50 3,50 8,25 5,00 3,75 5,00

3Q14 2,75 0,25 3,00 5,00 3,50 8,25 5,00 4,00 5,00

4Q14 3,00 0,50 3,00 5,50 3,50 8,25 5,00 4,50 5,00

9,00 5,00 3,75

9,50 4,50 3,75

9,50 4,50 3,75

9,50 4,50 3,75

9,50 4,50 4,00

9,50 4,75 4,25

6,00 3,00 2,50 7,50 7,25 3,00 3,50 2,50 1,88

6,00 3,00 2,50 7,75 8,00 3,00 3,50 2,75 1,88

6,00 3,00 2,50 7,75 8,00 3,00 3,75 2,75 1,88

6,25 3,25 2,50 7,50 8,00 3,25 3,75 3,00 1,88

6,25 3,25 2,50 7,50 7,50 3,25 3,75 3,00 2,00

6,75 3,75 2,50 7,25 7,25 3,75 4,50 3,50 2,25

EM FX recommendations track record # of recommendations Hit ratio 2008 11 72,7% 2009 14 50,0% 2010 11 54,5% 2011 8 50,0% 2012 12 58,3% 2013 6 50,0% Total 62 56,5% Average P&L per year 2008-2012 Average P&L per recommendation 2008-2012

P&L 22,8% 10,4% 19,5% 17,8% 4,0% 2,1% 76,6% 12,8% 1,24%

SEB GDP forecasts 2010 China 10,4 India 10,6 Indonesia 6,2 EM 7,4 Latvia -0,9 Mexico 5,5 Singapore 14,8 World (PPP) 5,1 South Korea 6,3 Lithuania 1,5 Turkey 9,2 Estonia 3,3 World (nominal) 4,4 Poland 3,9 Romania -1,2 South Africa 3,1 Russia 4,5 OECD 3,1 Brazil 7,5 Ukraine 4,1 Czech Rep. 2,5 Hungary 1,3 Source: IMF, SEB

2011 9,3 7,5 6,5 6,4 5,5 3,9 5,3 3,8 3,6 5,9 8,5 8,3 3,1 4,5 1,9 3,5 4,3 1,8 2,7 5,2 1,8 1,6

2012 7,8 5,4 6,2 4,9 5,6 3,9 1,3 3,4 2,0 3,6 2,2 3,2 2,7 2,0 0,7 2,5 3,4 1,5 0,9 0,2 -1,2 -1,7

2013 7,5 5,0 5,8 4,8 3,5 1,8 2,6 3,2 2,8 3,2 3,7 1,5 2,5 1,5 2,2 2,0 1,7 1,2 2,5 -0,8 -0,8 0,7

2014 7,4 5,6 5,3 5,2 4,8 4,5 4,1 4,0 3,6 3,5 3,3 3,3 3,2 3,1 3,0 2,6 2,4 2,4 2,2 2,0 2,0 1,5

2015 7,0 6,0 5,5 5,4 5,0 4,5 4,0 4,2 3,5 4,5 4,0 3,5 3,5 3,5 3,5 3,0 3,0 2,8 2,7 3,4 2,5 1,8

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EM macro: Recoupling but sub-trend growth


EM economies have underperformed Green shoots point to an incipient recoupling but only to sub-trend growth Structural deficiencies disclosed Inflation is not the big headache Monetary policy will remain heterogeneous
Emerging markets have been on a rollercoaster ride since early this summer. Significantly however, these developments have been confined primarily to financial markets. In each case, the real economy has been more stable. Still, macro developments form part of the background to this summers events and the impact of greater volatility will be seen in real data further down the road.

However, EM currencies received most attention with almost uninterrupted losses vs. the USD of around 10% between early May and late August. Several EM policymakers that only a few months earlier had been fighting the Currency War against excessive appreciation, suddenly found themselves restricting capital outflows and intervening to protect their own currencies.

EM assets fell out of bed this summer


EM financial markets turned sour from May 9 and fell sharply until late June. Stocks (MSCI EM) fell by around 15% but stabilised during July and August.

The countries hardest hit were characterised by having: Hard and local government EM bonds were also hit in May and again in August. The yield on local government bonds (GBI-EM) rose from May 9 by almost 200bps to about 7%. At the same time, the spread vs. US yields widened by about 100bps to 540bps. Large or rising current account deficits Received substantial capital inflows Deteriorating growth fundamentals (structural)

Consequently, the biggest FX losses during May August were incurred by the INR which fell by 18% vs. USD followed by BRL (-16%) and IDR, ZAR and TRY (-12,-13%). THB, MXN, ARS, PHP and MYR all fell by around 8%. Least affected were CNY, KRW, TWD and several CEE currencies.

but recovered in September


As shown in the three graphs above, September brought a sigh of relief for EM assets with stocks recovering about two thirds of the summers losses before falling back again towards the end of the month. Meanwhile currencies reversed around half their earlier losses vs. USD (up 5% by

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September 19 but later gave back about 1.5%-points). Local government bond yields fell by around 50bps (a quarter of their previous rise) while the spread vs. UST dropped by 40bps to 500bps (compared to 440bps in early May) but widened modestly again by the end of September. To draw conclusions regarding the next likely turn on this rollercoaster ride, we need to better understand what caused this turbulence in the first place.

Conversely, most emerging markets continued to decelerate.

The trigger
The sell-off was clearly triggered by the increasing likelihood that the US Fed would begin tapering its asset purchases sooner rather than later. Although an eventual move in that direction was expected, strengthening US data and comments from the Fed apparently came as a surprise to the market. Although it was clear the Fed would carry on expanding its balance sheet until mid-2014 and wait longer still before starting to hike interest rates, the market reaction was tantamount to an immediate reduction in global liquidity. This response makes sense in the way that the expected tapering decision could be seen as a paradigm shift. After spending five years discussing whether monetary policy was sufficiently loose or whether additional stimulus was needed, this was the first time in the cycle that the Fed began to look the other way: towards the exit (even if it will take a long time to get there). However, the impact of the expected reduction in asset purchases on asset markets that presumably had benefited from the Feds balance sheet expansion was uneven. For example, many stock exchanges in developed markets (DM) performed well over the summer, while US corporate bonds reacted mildly. EM assets were beaten more severely. This was no coincidence, in our view.

Source: IIF

Lack of structural reforms. In several economies, not least the BRIC, structural impediments to growth were becoming increasingly apparent. Still, generally decisive policy actions to overcome these challenges did not take place. (We discuss in more detail what is needed and how likely progress is in coming years below). Consequently, growth forecasts were revised downwards instead of up, benefitting DM at the expense of EM whose growth advantage in recent years began to shrink. Positioning. The more tilted market positioning becomes, the greater the risk of a reversal. The less liquid a market is, the greater the likely effect on asset prices. By the early summer of this year, several years of G4 balance sheet expansion had created an environment characterized by 1) historically low yields on DM bonds, 2) supportive risk appetite and 3) investors hunting for yields. The tilted positioning was most evident in several EM where bond markets had received massive inflows since the beginning of 2012. EM stocks had also experienced large inflows but had underperformed since the start of this year. Currencies, meanwhile, were nominally cheap even before the summer but still suffered substantial losses. Overall, positioning in bonds was most vulnerable. It appears likely that many investors began hedging FX risk rather than sell bonds, at least initially. This may explain the damage done to EM currencies. Other flows obviously played an important part. One source of capital inflows that probably fell sharply, or even reversed, when tapering fears were highest is bank loans. Prominent political unrest. The fourth factor that made EM assets vulnerable during the summer was probably the fact that general sentiment surrounding EM had been hurt by political unrest in several countries. Even if street protests in Turkey and Brazil did not overthrow their political leaders and perhaps wont change economic policymaking much, the global media presented eye-

and the undercurrents


Four undercurrents help explain the underperformance by EM this summer: Disappointing growth Lack of structural reforms Positioning Prominent political unrest

Disappointing growth. After the global bounce in economic activity in 2009/10, the world economy entered a long period of deceleration. During the first half of 2013, however, the US and Japanese economies shifted into higher gear while the Euro zone climbed out of recession in the second quarter.

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catching images of violent unrest and instability. Nor were the wave of strikes in South Africa and chaos in Egypt exempt from such coverage.

The macro impact from the summer sell-off


September brought some relief to EM markets (but probably in rather thin volume, especially the immediate response to the FOMC meeting) but the summer sell-off obviously remains fresh in investors minds. Its potential impact continues to be evaluated. As a starting point we think the impact come in three areas: Growth External balances Inflation

to countries such as Brazil, Russia and South Africa. Mainly, there are three countries where we expect inflation to remain more challenging next year: Turkey and Indonesia. However, given our main assumptions regarding global commodity prices, the outlook for currencies etc., inflation will not be so high that it severely distorts economic activity in any major EM. Barring short-term, supply shock driven spikes, double digit inflation is history in most of the EM world.

What next? The main scenario


Summing up so far weve seen a dramatic sell-off over the summer and a partial recovery in September. On the macro side, we expect further pressure on credit driven growth but more competitive exchange rates and few inflationary challenges. What next for EM macro economically? In our view, there are two conflicting, or opposing, stories playing out. Firstly, we have an optimistic view on the global economy moving into 2014 and 2015. Indeed, five years after the Lehman crash, it is finally moving back towards trend growth. We expect worldwide growth in PPP terms to ease from 3.4% to 3.2% in 2013 but to accelerate to 4.0% this and 4.2% next year. Since 2008, EM have lent crucial support during this healing process. They have accounted for around 75% of global growth. With domestic demand rising faster than in DM, the aggregate current account surplus in EM (including Middle Eastern oil exporters) has decreased. Mirroring this, the current account balances of the US and Euro zone have improved to the benefit of their respective economies. Looking forward, we expect the US economy to resume its historical role as a global economic locomotive. Meanwhile, Japan is being given the benefit of the doubt under the Abenomics doctrine, while currently we are seeing the Euro zone taking further faltering steps towards recovery, albeit slowly. The second story to be told is that so far this year, the vast majority of emerging economies have fallen behind developed markets in reversing the deceleration seen since early 2010. Indeed, EM overall have been laggards rather than leaders. While G3 economies substantially improved during the first half of this year, EM generally extended the malaise suffered since the economic bounce in 2009 to four years of almost constant deterioration. After a false start (mostly in Asia) late last year, the aggregate EM manufacturing PMI once again turned downward, hitting a four year low in July. So, EM have decoupled from DM during 2013. Why is this, and will it last?

Growth will be hurt as the uncertainty created by high volatility undermines investment and consumer confidence. More importantly, credit growth will be reduced, due to: the tighter global liquidity, higher nominal interest rates and the withdrawal of domestic liquidity in connection with FX interventions.

This will be particularly important in countries where credit growth has been crucial for growth, such as Brazil, Indonesia and Turkey. External balances. Those countries whose currencies were hardest hit during the summer (INR, BRL, IDR, ZAR, TRY and MXN) all run current account deficits. In some, such as Mexico and Brazil, these have largely been offset by FDI inflows. In others, such as Turkey and South Africa, FDI inflows have only partly covered deficits, leaving such countries to rely on shorter term (and more vulnerable) capital inflows. At any rate, the weakening of their currencies can certainly be seen as a welcome boost to competitiveness and a helping hand in reducing these external imbalances. The flip side of the coin is that a weaker currency will push inflation higher. Inflation. Although global inflation remains at a historically low level, several EM central banks are struggling to get inflation down to their target range. The sell-off in their currencies this summer will make their task even more challenging given the worsening outlook for imported inflation. Still, we think many of them will manage to meet their targets by next year as commodity prices and global inflation remain subdued, and domestic growth sluggish. This applies

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Structural deficiencies exposed


To a large extent, the reason for recent underperformance is to be found in structural deficiencies. Indeed, the structural slowdown in EM has been going on since 2010/11. Firstly, the demographic trend has for long been supporting EM economies. In conjunction with intensified structural reforms as well as globalisation 10-15 years ago, vast amounts of labour could enter the market, contributing to rapidly rising economic growth. Among the BRIC, however, the demographic trend is turning in China and Russia with dependency ratios beginning to increase going forward. In Brazil, this will happen in only a few years while India will continue to benefit from supportive demographics for a couple more decades. Secondly, EM have excelled over the past decade or so, but the growth models of several key economies, especially the BRIC, have now run their course. Their strategies have been quite different and it is, perhaps, a coincidence that they have all lose steam at the same time. The Brazilian success story since President Lula took office in 2003 was actually based on the market oriented reforms of his predecessor Cardoso (including fiscal responsibility and a disinflation oriented central bank). Lula harvested the benefits of these reforms supported by a global environment that included rising demand and higher commodity prices. Apart from some well-designed social initiatives, however, the pace of reform slowed. Instead, additional growth impetus resulted largely from expansionary policies and more credit, especially from public sector banks. However, this route is becoming exhausted, with debt service costs as a share of disposable income having risen from 16% to 22% over the last eight years. External debt to GDP remains modest at about , but increasing global interest rates will still make the problem worse. Strong credit growth has spurred domestic demand and imports, while exports and industrial production have so far been less dynamic. The infamous costo Brazil reflects many of the challenges facing that part of Brazilian industry that is exposed to international competition. The Russian economy is a basket case of the Dutch disease. While spectacular, improvements during the 1990s and 2000s were largely based on improving terms of trade. Admittedly, the switch from Yeltsin to Putin brought greater administrative order, while the 2003 tax reform was a success. However, many strong fundamentals (external balances, debt ratios, FX reserves) would look dramatically worse if natural

resource extraction industries were excluded. Much of the rest of the economy is weak and without ever-rising oil/gas prices or productivity enhancing structural reforms, the economy would be destined to settle for much slower growth than for several years. India benefited like everybody else from the big export boom in the 2000s but has structurally fallen short in three areas, which prevents India from growing at 10% like rest of Asia in the early stage of economic development. First, Indias labor laws are still too restrictive to dominate low end, labor intensive manufacturing. Chinas rising wages are opening up this sector for India to enter but India has not capitalized because they continue to support small manufacturers. Second, India has not efficiently used the rise in savings accumulated from strong export market. Most Asian economies build infrastructure using their savings but in India, the government uses those savings and distributes them as cash handouts to win votes. They increase consumption short term but reduce long term growth potential. Third, India still has not learned to control inflation. Part of the problem is that food supply chain is undeveloped and cause erratic swings in WPI, which makes monetary policy more difficult to control. In turn, this led India to cut interest rates too aggressively in 2009 and too late to hike in 2010 and 2011, which has left inflation expectations more entrenched. Fortunately, the new RBI governor Rajan understands these challenges and is addressing them from his first meeting and tackling the inflation issues. China needs to shift its growth dependence from investments and exports towards domestic, private, consumption, not least in services. This strategy lies at the core of its current 5-year plan, which began in 2011. It has also been fully confirmed by the new political leadership which seems prepared to pursue the course even at the price of substantially slower (but higher-quality) growth. The demographic situation is also catching up with reality as the one-child policy is taking its toll and urbanization is more than half way complete. More importantly, increase in labor can only lead to higher growth if there are jobs and the slower global growth and export environment makes demographics less powerful. Overall, the shift in strategy is clearly necessary, even at the cost of lower growth, as it will help deflate bubbles that might burst later. The sharp increase in leverage in the Chinese economy (especially in the less regulated shadow banking system) in recent years has received plenty of attention lately since consequences for the rest of the world could be large. An important difference compared to many other crises, however, is that Chinas credit boom has been inflated by domestic loans. The ripple effect through financial linkages should therefore be smaller. On the other hand, the country has become the second largest global economy, and a crisis would certainly not go unnoticed either by capital goods

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exporters or EM commodities providers. An additional worry would be the extent to which China would see itself as forced to bring home money heavily invested abroad during the past 10 years (during which period FX reserves have increased tenfold to USD 3.5tn).

but partial progress on reforms and reduced vulnerabilities too


There are also encouraging signs of progress in designing and implementing structural reforms. Mexico is the most shining example but Colombia and Singapore are also seen as strong reformers. Further, several countries, not least in Eastern Europe and the CIS have progressed well up the World Banks list of countries ranked based on Ease of Doing Business and are now rated more highly than many developed economies. Similarly, many CEE economies that suffered most from their close trade and financial connections with Western Europe have seen their domestic economies tighten their belts. As a result, their former current account deficits have either fallen sharply or even become surpluses. Overall, however, we are not particularly optimistic on structural reform initiatives and implementation going forward. Firstly, the EM crisis of this summer could have created the sort of crisis awareness that is often needed for politicians to overcome hurdles and challenge vested interests to push through reforms that may bring long term gains but short term pain. However, the crisis was largely financial while the real economy were the wider electorate operates has seen rather fewer changes in recent months. Secondly, several large EMs have elections scheduled for the next year including: South Africa India Indonesia Brazil Turkey General General Presidential Presidential Local Presidential General General May May July October 5 March 30 August 28 June 13, 2015 April

approximately 7% going forward is obviously a big contributor to this trend. This deceleration is, however, probably welcome as it reduces the risks of a sharper setback in the future. However, China alone does not explain the poorer aggregate EM growth outlook. The reasons are more broadly based. This reflects emerging markets growing up in the sense that the lowest hanging fruit of trade integration and productivity improvements have already been harvested. Consequently, the marginal return on new investments in EM is lower today than 10 years ago. EM have substantially caught up DMs. Going forward, the next step will be more challenging. The potential, however, remains vast. A key question is whether investors regard slowing EM growth compared to the last decade as a disappointment and turn their backs, or whether they adopt more realistic expectations, acknowledging that EM growth still remains double that in DMs and more sustainable. The jury may still be out on this call but it seems fair to say that the underperformance of EM assets this summer probably reflects the former interpretation. Our guess, however, is that the realisation of slower EM growth than before is largely discounted in prices now. However, while forecasts will probably continue to adjust lower for a while, we are already fairly close to ending downward revisions of EM growth. This assumption obviously depends on several assumptions, mainly as follows: OECD growth will double from 1.2% this year to 2.4% next, and further increase to 2.8% in 2015. For further details, see Nordic Outlook published at the end of August. Emerging markets will benefit from such growth with a lag. Decoupling of growth during the first half of this year will gradually give way to recoupling going forward. The wild card is the Feds journey towards exiting its supportive monetary policy, and how it will affect global liquidity and risk appetite. Here we take a more balanced view looking forward.

Hungary

We do not expect the electoral cycle to be conducive to structural reforms.

The green shoots of the second trend are already evident in China and several CEE economies. Indeed, most EM manufacturing PMIs have bounced upward during the past couple of months after hitting a four-year low in July,

Catch-up potential partly realised slower growth ahead


All this implies that even though developed markets are picking up speed, EM will not return to their 10year trend growth rate of 6.6% but instead remain at around 5%. The slowdown in the large Chinese economy from a peak of 14% in 2007 to

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Septembers PMI readings looked promising in the emerging world. Hungary was the outperformer advancing to 54.5 (prior 51.8) but the reading is rather volatile. Turkey rose to 54, which was a 40 month high, up from 50.9 in August. The increase was due to an increase in domestic demand, hence, suggesting that the current account deficit may widen further. Poland improved to 53.1 and Czech Republic dropped slightly to 53.4, both still in expansionary territory. Moreover, there were some countries with less positive news for September; S Africa plummeted to 49.1 after 56.5 in August due to labor unrest and constrained productivity, and Brazil edged higher and
printed 49.9 from Augusts 49.4 marking the third consecutive month below 50, but the first upward move for 2013. Generally, a rather promising picture for the

EM countries that are more dependent on the recovery of the German economy.

These factors may well continue to dampen risk appetite for a while. Nevertheless, we assume that Congress will agree on a budget and lift the debt ceiling in a way that does not obstruct the continuing recovery of the US economy. If so, the Fed will probably start tapering in December. We assume it will communicate its intentions in a way that reduces uncertainties going into 2014. There is, of course, a risk that market concerns once again revive as questions emerge regarding the length of time the Fed will roll over maturing Treasury and mortgage securities, when it will abandon its zero interest rate policy and how fast it will normalise conditions. In our main scenario, we do not expect these bouts of uncertainty to escalate to levels seen earlier this summer. Consequently, the main impact of US monetary policies on EM macroeconomic conditions will be negative for growth, positive for external balances and modestly negative for inflation. Despite, considerable uncertainty regarding the Feds behaviour right now, arguably the messages it sent in May and September define the issues. In May, we learnt that many Fed members have increasing doubts as to whether the benefits of continued quantitative easing outweigh the costs. The market reacted to this and by early September 10 year US Treasury yields had risen to 3% from 1.6% in May. In the two week leading up to the September FOMC meeting, the market took a few small steps back from its hawkish expectation. Furthermore, as Larry Summers withdrew his candidacy, it now looks increasingly likely the next Fed Chairman will be a woman; Janet Yellen. At the margin, this will ensure the Fed remains slightly more dovish than not. Obviously, the Fed will respond to incoming data. Consequently, we believe the central bank will adopt tighter (or less loose) policies only if longer term market rates have not run ahead of themselves and if the recovery stays on course. Conversely, if the US economy were to fail to meet expectations, the Fed would maintain its stimulus measures for longer. Therefore, the flip sides of this coin will affect EM in opposing ways. This summer, which began with very depressed US yields, the market focused entirely on the negative effect of the paradigm shift to a decreasingly stimulative monetary policy. In future, we expect its reactions to the Fed to be more balanced with a negative tilt until tapering begins in December and a more sanguine response next year. However, it deserves to be repeated that the Feds journey towards the exit is likely to remain an important source of volatility for EM assets for quite some time.

Fed also in the EM driver seat


As we have discussed, expected Fed tapering was the trigger for this summers EM sell-off. Tighter global liquidity will dampen growth prospects in EM, especially those with credit driven growth models and highly dependent on external capital. We now expect tapering to start in December and to be finished by mid-2014. This is also the consensus view. The decision not to start tapering in September surprised the market in a big way. Importantly, the positive market reaction proved very short-lived. We think there were two reasons for this; the Fed left the market feeling very confused, and renewed uncertainties about US fiscal policies (the approach of a new budget year with no budget agreement and the debt ceiling expected to be reached by October 17).

EM GDP growth forecasts


A modest pick-up in growth in most EM appears to be taking place. For reasons already considered, previous highs will not be revisited. In the 10 years to 2012, EM growth averaged 6.6% (including both the super-cycle and the Great Recession). Going forward, we expect EM

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aggregate growth to reach 4.8% this year, 5.2% next year and 5.4% in 2015.

Euro zone recovery has caused some modest increases in some CEE countries.

Key risks
We see four key risks to our scenario: Rapid exit by the Fed US economy dips on failure to resolve fiscal issues Renewed Euro zone debacles Spike in oil prices

As we forecast OECD GDP to double to 2.4% next year, EM will expand at approximately 2x rather than 3-4x that of DM seen in recent years. Our country by country forecasts are as follows:
SEB GDP forecasts 2010 China 10,4 India 10,6 Indonesia 6,2 EM 7,4 Latvia -0,9 Mexico 5,5 Singapore 14,8 World (PPP) 5,1 South Korea 6,3 Lithuania 1,5 Turkey 9,2 Estonia 3,3 World (nominal) 4,4 Poland 3,9 Romania -1,2 South Africa 3,1 Russia 4,5 OECD 3,1 Brazil 7,5 Ukraine 4,1 Czech Rep. 2,5 Hungary 1,3 Source: IMF, SEB 2011 9,3 7,5 6,5 6,4 5,5 3,9 5,3 3,8 3,6 5,9 8,5 8,3 3,1 4,5 1,9 3,5 4,3 1,8 2,7 5,2 1,8 1,6 2012 7,8 5,4 6,2 4,9 5,6 3,9 1,3 3,4 2,0 3,6 2,2 3,2 2,7 2,0 0,7 2,5 3,4 1,5 0,9 0,2 -1,2 -1,7 2013 7,5 5,0 5,8 4,8 3,5 1,8 2,6 3,2 2,8 3,2 3,7 1,5 2,5 1,5 2,2 2,0 1,7 1,2 2,5 -0,8 -0,8 0,7 2014 7,4 5,6 5,3 5,2 4,8 4,5 4,1 4,0 3,6 3,5 3,3 3,3 3,2 3,1 3,0 2,6 2,4 2,4 2,2 2,0 2,0 1,5 2015 7,0 6,0 5,5 5,4 5,0 4,5 4,0 4,2 3,5 4,5 4,0 3,5 3,5 3,5 3,5 3,0 3,0 2,8 2,7 3,4 2,5 1,8

Clearly, the first risk has the greatest effect on EM (firstly financially, then later in the real economy) which is why we have devoted a large part of this report to the subject. If Congress fails to agree a budget or to lift the debt ceiling, the locomotive of the global economy would falter. While EM would be hurt, the Fed would probably adjust its monetary policy stance in such a way as to at least partly offset the impact. In Europe, Greece is expected to restructure yet more of its debt, although as this is already discounted by the market we expect little accompanying market turbulence. It is nevertheless, a clear risk. The Italian political situation and challenges in Portugal also threaten improved Euro zone sentiment with potential ripple effects far beyond it. The Russian initiative on Syrias chemical weapons appears to make further progress, defusing the immediate risk of directly involving other countries in the civil war. Still, the situation is, of course, far from resolved and the political situation in large parts of the Middle East remains fragile. A sharp (and lasting) rise in oil prices could wreck the incipient recovery in oil importing EM and also harm oil exporters, due to the negative impact on risk appetite and the global outlook in general.

Inflation is not the big headache


This summers sell-off in May EM currencies has refocused attention on inflation risks. Overall, however, the dampened outlook for commodities and for global inflation

In line with our analysis above, we have made the largest downward revisions to our estimates in countries that are most vulnerable to tightening in global liquidity, due either to high external financing requirements or an exhausted growth model, which is dependent on credit growth, or both. We have, for instance, lowered our Brazilian GDP forecast for next year from 4.0% to 2.5%, and for Turkey from 5.0% to 3.3% compared to our EM Explorer report in February. Despite reducing our Chinese projection, the country remains the fastest growing major country. Meanwhile, positive momentum attributable to the

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implies that inflation itself will remain under control in most EM. Indeed, only in Indonesia and Turkey do we expect it to remain troublingly high. Currently, inflation is above target also in Brazil, Russia and South Africa though it will probably fall within their target ranges by next year. In some countries such as Chile and the Czech Republic, the problem is instead that inflation is too low compared to its target.

SEB EM policy rates forecasts for eop 01-okt-13 EMEA Poland 2,50 Czech 0,05 Hungary 3,60 Turkey 1W repo 4,50 Turkey O/N borrowing 3,50 Turkey O/N lending 7,75 S. Africa 5,00 Romania 4,25 Russia 1W repo 5,50 LatAm Brazil Chile Mexico Asia China lending China deposit Korea India Indonesia Malaysia Philippines Thailand Taiwan Source: Bloomberg, SEB

4Q13 2,50 0,05 3,20 4,50 3,50 8,25 5,00 3,75 5,25

1Q14 2,50 0,05 3,00 4,50 3,50 8,25 5,00 3,75 5,00

2Q14 2,50 0,05 3,00 4,50 3,50 8,25 5,00 3,75 5,00

3Q14 2,75 0,25 3,00 5,00 3,50 8,25 5,00 4,00 5,00

4Q14 3,00 0,50 3,00 5,50 3,50 8,25 5,00 4,50 5,00

Heterogeneous monetary policy outlook


Since this summers events have hit markets differently and economies are in different states of development, monetary policy responses have differed too. To prevent, or at least limit additional currency weakness, three policy tools have been deployed in a number of countries: Policy rate hikes have occurred in Brazil, Turkey, India and Indonesia Interventions. Brazil has been most active with swap market interventions of USD 45bn even before its USD 60bn intervention program began. Russia, India and Indonesia have each bought around USD 15bn in local currency and Turkey USD 10bn, while Ukraines currency defence erodes its reserves. Capital controls on outflows have been implemented in India, Indonesia and Ukraine, while restrictions on inflows have been dismantled in Brazil.

9,00 5,00 3,75

9,50 4,50 3,75

9,50 4,50 3,75

9,50 4,50 3,75

9,50 4,50 4,00

9,50 4,75 4,25

6,00 3,00 2,50 7,50 7,25 3,00 3,50 2,50 1,88

6,00 3,00 2,50 7,75 8,00 3,00 3,50 2,75 1,88

6,00 3,00 2,50 7,75 8,00 3,00 3,75 2,75 1,88

6,25 3,25 2,50 7,50 8,00 3,25 3,75 3,00 1,88

6,25 3,25 2,50 7,50 7,50 3,25 3,75 3,00 2,00

6,75 3,75 2,50 7,25 7,25 3,75 4,50 3,50 2,25

Meanwhile, central banks in countries that have suffered less damage this summer have seen scope to cut policy rates; Poland, Czech Republic, Hungary, Romania and Mexico. Given our growth and inflation forecasts, we expect this heterogeneous approach to continue. Our policy rate forecasts are as follows:

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Emerging Markets Explorer

Theme: Deeper look into flows


Background

20 15 10 5 0 -5 -10

Current Account as % of GDP

Here is how we see capital flows impact emerging markets. Emerging markets are less developed and the uncertainty brings higher risk. The last five years have shown that parts of developed markets are risky too and indeed this has been reflected in market prices. To compensate for the higher risk, emerging markets provide higher growth or higher yield relative to developed markets. Higher growth translates into higher earnings for equity investors and higher income for debt and credit investors that allow them to continue paying interest on their borrowings. The higher yields compensate debt investors with higher interest payments. Recently, emerging markets stopped delivering on both. Since 2011, growth in emerging markets have been declining and providing less relative growth to developed markets. More recently, with US yields at less depressed levels and potential for a continued rise, EM yields have to compete harder to attract investors. Investors dont like this dynamic and are taking capital out of emerging markets.
12% 10% 8% 6% 4% 2% BRICS real GDP % yoy

Adjustment needed However, we think flows need to be adjusted to get the complete picture and be able to project the consequences going forward. First, we should focus on the basic balance instead of the current account. In the initial sell-off, markets are focused on the short term flows. However, as weve already had a taste of emerging market sell off, markets will focus on longer term issues. We would start focusing on the basic balance, which includes the current account and foreign direct investment (FDI). FDI are longer term, sticky investment and will not depart like short term equity, bond and lending flows and buffer economies from outflows. The chart below shows the basic balances. Much of the ranking remains the same but the main differences are that, many of the economies have a surplus when FDIs are included. The most notable economies with improvements are Israel, Czech Republic, Brazil, and Colombia.
20 Basic Balance (Current Acccount + FDI) % of GDP

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

15 10 5

Source: CEIC, Macrobonds, Bloomberg, SEB

Differentiation by current account position Emerging market performance has been hit overall but there are divergences. And market commentators have focused on the current account in the balance of payments. Current account deficit economies need constant capital inflow to fund the economy and keep the currency stable. In times of capital outflow and risk aversions, they are hit more than the current account surplus economies. The chart below shows that the ones that were hit most are concentrated on the right in places like Turkey, South Africa and India.

0 -5 -10 Sing. Norway Taiwan Israel Malaysia China Russia Phils Hungary Czech Col. Peru Sweden Korea EU Brazil Mexico Thailand Indonesia Chile Romania India Poland S Africa Turkey

Second, on capital flows, we should focus less on debt flows and more on equity flows. The hunt for yield based on the quality balance sheets was the big emerging market theme since the beginning of Feds Quantitative Easing. Now with US providing higher yields with a better economic outlook, the hunt for yield should slow and with it debt flows. We should return to the pre-QE era where emerging market attracted equity inflow from a growth perspective. Much of emerging markets are still export dependent and a healthier US economy and a bottoming in

Sing. Norway Taiwan Sweden Malaysia Russia Korea Phils China Hungary EU Israel Mexico Thailand Czech Indonesi Brazil Chile Peru Col. Romania Poland India S Africa Turkey

Source: CEIC, Macrobonds, Bloomberg, SEB

Source: CEIC, Macrobonds, Bloomberg, SEB

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Emerging Markets Explorer

Europe will lead to a bounce in growth and again attract equity flows. The shift in focus to equity from debt flows will have regional consequences. Asia had benefited greatly in the QE era since it has the best balance sheet with low public debt and attracted large debt inflows. The chart below shows the average portfolio investment flows as a percentage of GDP since 2010 and Asian economies in red are concentrated mostly to the left with the large inflows. On the other hand, Eastern Europe suffered from the poor balance sheets and Latin America sat in between. This will likely reverse and Eastern Europe should outperform Asia.
5 Portfolio Investment % of GDP avg since Jan 2010

-5

-10

Furthermore, the debt to equity shift will make it difficult for EM currency appreciation. In nominal amount, debt investments are much larger than equity investments and have a bigger impact on the currency. Also, currency volatility will likely increase since debt investment is more sticky and longer term compared to equity (bigger the investment, more commitment). In summary, the currency investment conclusions are to be long the equity dependent currencies. In Asia, those are India and Taiwan. In Emerging Europe, Turkey, Russia, Poland and South Africa typically have equity sensitive currencies while in Latin America, Brazil tops the field followed by Mexico.

Malaysia Poland Phils Col. Korea Turkey Israel Hungary Brazil Czech Thailand India Indonesia Romania S Africa Mexico China Russia Peru Chile Taiwan Sing.

Source: CEIC, Macrobonds, Bloomberg, SEB

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Emerging Markets Explorer

Strategy: Wary of Q4, brighter 2014


In coming quarters, the outlook for EM assets will largely depend on how investors emphasise the flip sides of two different coins, as follows: 1. US growth: a. Strong US economic data are good for global and EM growth and generally positive for EM assets. b. However, robust US figures may also encourage the Fed to begin tapering earlier/faster, which would be bad for EM assets. 2. EM growth: a. Green shoots of recovery in many EM suggest growth is recoupling. b. However, this upturn may only reach sub-trend growth rates due to structural impediments, primarily in BRICs.

scenario, this means that actual tapering can take place in a more orderly manner (After all, the market will then have spent around six months focused on and worrying about it). As it occurs, US yields will increase only slightly further and reach 3.15 in the 10-years segment by the end of 2014. In this environment, the market will have a better chance to refocus on the global, more synchronised recovery, which will reach trend levels for the first time in several years. EM growth and what the market will emphasise: Whether investors will cheer the recoupling of EM growth to the recovery taking place in DM since 1H13 or focus disappointedly on the failure of EM growth to return to trend, may crucially depend on psychological factors. Both stories will probably be true simultaneously; the question is which story will be told, and listened to? If general sentiment is supportive, the recoupling story may well win out. However, if bears seize control, the focus will more likely be on sub-trend growth and structural challenges. So, having spent the summer in the lower/left corner of the matrix, where-to from here? As outlined, fear of tapering (and worries about US fiscal policies) will remain dominant during Q4. Moving into next year, however, we think a shift will take place towards the lower/right corner of the matrix; more focus on EM recoupling as the Fed clarifies its intentions and US fiscal issues are resolved. Potentially, a period of focus on strong US growth and EM recoupling could follow. But the surprise effect of recoupling will not last too long and with more, potentially destabilising, steps to follow on the Feds (long) route towards the exit, we dont expect the top/right corner to characterise 2014. We draw the following strategic conclusions from the analysis above: 1. Generally cautious on EM in Q4 better outlook 2014. Generally speaking, EM assets will remain vulnerable during Q4. On balance, heading into 2014, flip side influences should support a more conducive environment for them. We expect a debt to equity shift in capital flows.

The flip sides of two coins


Growth

U.S.
Tapering

Summer 2013
Sub-trend growth Recoupling

EM

The matrix: This summer, investors certainly emphasised the potential impact from Fed tapering while the EM story that was told was focused entirely on the continued deterioration in growth and the structural reasons behind it. Hence, we found ourselves solidly in the lower/left corner of our matrix above. The nirvana for EM assets would be if investors anxiety about Fed tapering eases and focus instead turns to the strong US recovery while simultaneously the recoupling of EM economies takes precedence over sub-trend growth expectations. That is represented by the top/right corner of the matrix. US growth and what the market will emphasise: As discussed in this report, we see several risks to both global and US growth going forward. However, in our main scenario, we believe most of these problems to be overcome and US GDP growth to accelerate handsomely from 1.6% y/y this year to 3.3% and 3.7% respectively in the next two years. However, we expect the market to remain anxious over tapering until it starts and crucially the Fed clarifies its intentions, both of which we believe will occur in December. In our

2. Range-bound trading creates opportunities. In coming months, most markets are likely to be bounded by market pricing before tapering worries began in May and when market stress peaked in late August. Rather than extrapolate market movements, they should seek opportunities as such boundaries are approached, albeit with discrimination. 3. Diversification. Old and familiar correlations and trading patterns have changed rather dramatically in recent months. For example, the correlation between EM FX vs. USD and

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Emerging Markets Explorer

risk appetite broke down in late 2012, while between EM FX vs. USD and EUR/USD this breakdown occurred in May this year. Meanwhile, since last spring the correlation to US yields changed sign and became very strong, only to weaken again following the September FOMC meeting. Also, while several Asian currencies have performed worse than during previous periods of market stress, many CEE currencies have been remarkably stable. This reflects recent diverse trends in industrial production, exports and current accounts. By implication, there are plenty of potential gains to be had from diversification. The strength of recovery will be crucial. Also, can a stronger cyclical recovery take hold or will structural deficiencies restrict growth? How strong is the economys dependence on credit expansion and external financing? Where have valuations improved and where not? Differences in these areas create often attractive intra-EM relative trading opportunities.

SEB EM FX forecasts
Accordingly, currencies most at risk during the rest of this year are KRW, IDR, THB and INR, with expected nominal depreciation of about 5% vs. the USD. By the end of 2014, we forecast currency gains, excluding carry, of about 6% for MXN and 3-4% for CNY, INR, IDR and CLP vs. the USD. Among the EUR-traded crosses, we see a nominal upside of about 4% for PLN and RON by the end of next year. As a rule of thumb, in determining appropriate hedging of EM currency exposures in coming months, we recommend a 25% hedging ratio for all major EM regions, based on: recent improvements in positioning and valuation our main scenario, and risks to it and the potential damage to EM currencies that may be inflicted if this happens.

EM FX drivers
The balance between EM FX currency drivers in our scenario will change in time. Consistent with the conclusion we drew based on our reasoning regarding the flip sides of both coins, more defensive drivers will dominate during Q4, while factors that appeal more to risk seeking investors may be preferred heading into 2014. As a result, we expect focus in the near-term to be on: weak/deteriorating current account balances high external financing requirements, and reliance on credit driven growth.

This recommended hedging ratio is largely consistent with our last report, though for Emerging Europe we have reduced our previous 50% hedge to bring it more into line with other regions. Our forecasts for EM currencies in coming quarters are as follows:
SEB EM FX forecasts for eop 01-okt-13 1M Q4 13 4,20 298 25,9 4,43 43,4 37,5 32,7 3,17 225 19,5 8,20 2,05 10,20 2,25 13,00 505 6,08 6,08 7,80 12000 65,0 1100 3,30 44,0 1,30 32,7 30,2 1,33 103 Q1 14 4,15 295 25,8 4,38 42,1 36,8 32,4 3,19 227 19,8 9,00 1,98 9,80 2,20 12,70 500 6,02 6,02 7,80 11500 64,5 1080 3,25 43,8 1,28 32,5 30,0 1,30 105 Q2 14 4,15 295 25,5 4,33 41,6 36,5 32,4 3,23 230 19,8 9,10 1,98 9,80 2,20 12,50 495 5,98 5,98 7,80 11200 63,5 1070 3,20 43,5 1,26 32,0 29,7 1,29 107 Q3 14 4,10 295 25,5 4,30 41,7 36,8 32,8 3,23 232 20,1 9,20 2,05 10,20 2,25 12,40 490 5,94 5,94 7,80 11000 63,0 1060 3,20 43,0 1,24 31,5 29,4 1,27 109 Q4 14 4,05 295 25,2 4,27 41,4 37,0 33,4 3,27 238 20,3 9,30 2,10 10,50 2,30 12,30 490 5,90 5,90 7,80 11000 60,0 1050 3,20 42,5 1,22 31,0 29,2 1,24 110

Vs. EUR
PLN HUF CZK RON RUB RUB/BASKET 4,22 297 25,7 4,45 43,8 37,4 32,3 3,11 219 19,0 8,18 2,01 10,00 2,22 13,09 505 6,12 6,11 7,75 11315 62,3 1074 3,23 43,3 1,25 31,1 29,5 1,36 98,0 4,25 300 25,8 4,45 44,1 37,8 32,7 3,15 222 19,1 8,20 2,05 10,20 2,25 13,20 508 6,10 6,10 7,80 12000 63,5 1150 3,20 43,0 1,28 32,5 30,2 1,35 100

Vs. USD
RUB PLN HUF CZK UAH TRY ZAR BRL MXN CLP CNY CNH HKD IDR INR KRW MYR PHP SGD THB TWD EUR/USD USD/JPY

Towards the year end, after the Fed has begun modest tapering and also resolved much of the current confusion, the market should gradually refocus on: recovering growth improved valuations light positioning capital flows (mainly equities) and carry (to some extent).

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Trading recommendations
Buy CNY NDF vs USD 1M We currently have this position in our SEB Asia FX Portfolio. We like CNY for three reasons. First, we still find it undervalued. According to our Fundamental Equilibrium Exchange Rate valuation model, we find CNY to be undervalued by about 2% in REER terms. Over the longer time horizon, we still find CNY undervalued by almost 17%. Second, with the recovery in exports to US, China will be reluctant to accumulate as much FX reserves as in the past and slowdown. FX appreciation is one solution. Third, hot money inflows will be slowly increasing as RMB denominated assets such as property continue to perform well. We prefer NDF instead of CNH since the policy rate is less susceptible to Fed policy.
20 15 10 5 0 -5 -10 -15 PHP -20 TWD SGD KRW CNY THB -3.3 -4.5 -7.1 Overvalued INR MYR -9.9 -15.9 IDR JPY REER change needed for macro adjustment (%) 12.4 8.8 Undervalued 6.0 2.0 1.5

280 260 240 220 200 180 160 140 05

INR/IDR 3M NDF

06

07

08

09

10

11

12

13

Look to sell USD/SGD SGD has very strong fundamentals with a large current account surplus, low foreign inflow positioning and strong investment. Most importantly, they are following a similar strategy to China where they want to live with lower growth but with higher quality. One policy has been to limit immigration to improve wages of local residents, which will lead to steady inflation pressures. Singapore uses the currency to control monetary policy and will continue to do so. Currently, SGD is still expensive and we prefer to buy on dips towards fair value of the NEER on risk off events.
123 122 121 120 119 118 117 116 115 114 113 112

SGD NEER

Source: CEIC, SEB

Look to buy INR/IDR These two currencies run current account deficits and their performance have been hit this year. We like INR better since it has fewer chances of inflation pressures. India hiked fuel prices faster and we think Indonesia has 3-6 months before inflation peaks whereas the central bank thinks it has already peaked. Our experience from 2005 tells us that Indonesia has strong secondary effects when fuel prices are hiked. Next, we think India is three months ahead in its current account adjustment relative to Indonesia. Lastly, India has been more transparent and flexible in the spot currency market, which will make it easier for bargain hunters to enter India. In Indonesias case, spot USD/IDR is still unclear and deters investors from re-entry.

Buy 1*2 put spread in EUR/MXN The Mexican peso tops the list of our favoured currencies. Three factors stand out in its support looking forward. First, the progress on reforms will continue which gradually reduces bottle-necks in the economy and lifts potential growth. It also distinguishes the country in an intra-EM comparison since we expect rather modest structural improvements elsewhere. Also, fundamentals are good for a start. Second, Mexico is the EM country that most directly will benefit if our optimistic scenario for the US economy materialises. Third, positioning has become very favourable.

Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13

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would look for a move towards 10.40 with a stop at 9.50, below the post September-FOMC low. Buy PLN/CZK on dips The Polish economy is revering up with influences from improvements not least in Germany. This has helped turning the current account into surplus in recent months. The sharp slowdown has been cyclical in nature and we think the domestic economy will gradually kick in as well to support a return to decent growth next year. The Czech export industry too is gaining strength but the domestic economy remains weaker. Further improvement reduces the odds that the CNB actually uses FX interventions (to buy EUR/CZK) at least if inflation start rising from its current very low level.

Given our cautious views for EM FX in the near term, we prefer to express our bullish stance on the MXN in the medium term through options, and vs. the EUR. We recommend buying a 5M, 1*2 put spread in EUR/MXN with strikes at 17.50 and 16.50. With our forecasts on USD/MXN and EUR/USD, the 16.50 level will be reached by the end of 1Q14. The all in cost of this is about 1% of notional and the potential net gain is about 4 times the invested amount. Buy USD/ZAR on dips The rand is one of the currencies that has taken a big hit this summer. This is for reasons that continue making it one of the most vulnerable currencies ahead. The country suffers from substantial twin deficits with a C/A deficit in Q2 of 6.5% of GDP and poor trade data as late as August. The September PMI was a cold shower, dropping from 56.5 to 49.1. The outlook for reforms is dimmed by continued unrest on the labour market as well as among trade unions and by the upcoming elections in April next year. Without productivity enhancing reforms, continued high inflation will eventually require a weaker nominal exchange rate to maintain competitiveness.

The CNB has voted twice on the issue but held its powder dry but statements from Governor Singer keeps the possibility very much alive. We think the likelihood of interventions has fallen below 50% but not by much. This trade would immediately benefit if that scenario plays out and the sheer threat of interventions will keep a floor under EUR/CZK. In our main scenario, we dont expect massive movements in PLN/CZK but would regard risk reward as attractive to buy on dips to about 6.0 aiming for a move to 6.20 (in line with our targets during 1Q14) and with a stop at 5.90. The risk to this trade would be a severe liquidity squeeze since EUR/PLN is more vulnerable to the upside than EUR/CZK given Polands still substantial foreign ownership in the bond and equity markets.

The rand is also vulnerable to episodes of liquidity stress since the SARB is unlikely to intervene to lend the rand support. Finally, the technical outlook of USD/ZAR is bullish. We look to buy USD/ZAR on dips to around 9.80 and

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Emerging Markets Explorer

Fixed Income: Driven by the tapering ebb and flow


In our previous EM Explorer published back in February, we argued for the stretched valuations of both local and hard currency bonds in the EM space, with the reasoning that hard currency bonds would be hit harder than local currency bonds under market distortions. Looking back on the performance during the period since our cut-off date of 20 February until today, we conclude that hard currency bonds, measured as EMBI+ sovereign spread versus US treasuries, increased by 83bps compared with 55bps spread change for the local currency GBI EM benchmark over US treasuries.

Source: IIF

Taking the accumulation of assets during 2011 and especially 2012 into account, there is still room for continued outflows from EM fixed income funds near term, should the market become anxious about the tapering impact on risky assets. Liquidity and central banks dominate In the absence of EM self-sustained growth, the asset class will continue to be driven by liquidity and central bank actions. Since the tapering discussion started to surface in May, there has been an increased correlation between US bonds and EM ditto as seen below. While US yields are up by about 80bps, the GBI-EM rates have risen by close to 150bps during the same time.

The market has now corrected to the upper part of the previous years range. So would that mean that it is time to buy the asset class again? Our answer is; not quite yet. Given the current drivers of the market, we are cautiously optimistic on the asset class over the medium term but we see risks of poor performance in the near term. We believe that the timing to add to EM fixed income will come, but not until the Fed clarifies its intentions and reduces the confusion currently in the market. Presumably, this will happen in December. With EM growth showing signs of green shoots, and PMIs in a number of countries on the rise, it looks promising on a stand-alone basis. However the tapering ebb and flow, where the Fed has taken the market by surprise twice since the speech by Ben Bernanke on June 19 and September 18 respectively, makes the market sensitive to the timing of the actual tapering. Flows in red The EM fixed income fund flow statistics show about the fairly steady inflows to the asset class during the last years. However, YTD flows are in red after inflows during the first five months of the year followed by outflows since then.

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Emerging Markets Explorer

We believe that EM yield levels over the medium term will be closely linked to the yield levels of the US Treasuries. Our projection for the 10-year US treasury yield by December 2014 is 3.15%, 50 bps higher than current market pricing. The level correlation between the 5-year US treasury and GBI EM has moved outside its recent correlation range, now being close to 0.9 measured as the rolling 90day level correlation. We believe in continued strong correlation near term, with a risk of spread widening, should the markets start to feel the tapering discussions surface again. Taking a closer look at the short end, the market has not altered its projection for FED funds more than marginally compared to the pricing as of February when we last looked at the projections for the rate using Fed Funds futures.
FED Funds futures Maturity Yield 2013-02-20 Change Sep 13 0,08 0,14 -0,06 Dec 13 0,11 0,15 -0,04 Mar 14 0,12 0,17 -0,05 Jun 14 0,14 0,2 -0,06 Sep 14 0,19 0,25 -0,06 Dec 14 0,24 0,31 -0,07 Mar 15 0,33 0,4 -0,07 Jun 15 0,45 0,47 -0,02 Sep 15 0,59 0,58 0,01 Dec 15 0,81 0,69 0,12

for some reversal of this summers spread widening. This will, however, not take us back to levels from before the summer since the playing field has changed with the paradigm shift of Fed now looking towards the exit. In line with that, and as we explore in the Theme article we expect a shift from bond to equity flows moving forward. Still, yields have risen to attractive levels and fundamental are better than historically. Excluding the EM dummy risk premium EM ratings would be 3.6 notches higher on average, equivalent to AA-, according to an IIF study made in 2011. In addition, better fundamentals leads to a positive credit migration of some EM countries. Given the global outlook still with plenty of resources available and the Fed to stay put until 2015 as we see it, EM fixed income still offers a massive yield pick-up. Combined with strengthening fundamentals in a number of emerging economies, we think the combined yield and currency performance bodes well for the asset class over the medium term.

SEB EM bond basket update


Since our last EM Explorer cut off 20 February our portfolio has delivered a return of -6.6% in USD terms and a slight positive return in local currency, up 0.6%. The local positive development is mainly driven by the performance from Hungary and Mexico. The largest negative contribution comes from Indonesia where we have been wrongly positioned; having 15% weight in the portfolio deducting 0.8% of the total weighted return in local currency. The IDR is also the worst performing currency adding to the negative performance, weakening almost 15% since February. Brazil has also been one of our largest positions in the portfolio, adding to negative performance this time, mainly driven by the currency that lost 11.5% to the USD. We were wrong on this pick as we believed in a stronger BRL. Our position in South Korea added to an overall positive return in local currency. The GBI EM benchmark has rendered a negative return in local currency of -3,8% local return and -8,2% in USD terms.
SEB EM Bond Portfolio February 20 2013 to Oct 1 2013
GBI-EM SEB Rating weight weight S&P (LT-FC) 10% 10% A6% 7.5% BB 10% 7.5% BBB 10% 15% BB+ 0% 10% A+ 10% 15% BB+ 10% 10% A10% 15% BBB 10% 10% BBB 100% BBB Yield 20-Feb 3.6% 5.6% 5.3% 5.9% 2.8% 4.8% 3.1% 9.3% 4.5% 5.2% Yield m~==c=OM 01-Oct `= i~=K rpa=K 3.6% MKNB OKPB OKQB 5.0% JMKPB RKSB RKOB 6.2% JNOKNB NKVB JNMKRB 8.4% JNNKNB JNKPB JNOKPB 2.9% MKQB NKQB NKUB 7.6% JNQKUB JRKPB JNVKPB 3.1% JQKPB NKVB JOKRB 11.4% JNNKRB MKPB JNNKOB 3.8% JPKTB QKMB MKNB 6.3% JTKPB
GBI-EM:

Downside market risks near term Although hard currency spreads have come back up and the VIX is range bound, we are still in the lower part of recent years range for VIX, something that adds to our cautious stance.

Poland Hungary S. Africa Turkey S. Korea Indonesia Malaysia Brazil Mexico Average

MKSB
-3.80%

JSKSB
-8.24%

EM bonds still offer fundamental value Stepping back a bit from the screen, looking at the fundamentals of the EM fixed income as asset class, we would argue that there is long term value and room

Underweighting South Africa and Indonesia, overweighting Hungary and Mexico

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Emerging Markets Explorer

In the new bond basket, we change reference securities in South Africa, Mexico, Turkey and Malaysia. The overall duration of our new portfolio is 3.4 years. We increase weights and our overweight in Hungary, Poland, Mexico and Malaysia, since we like fundamentals and the currency outlook, at least on a relative regional basis. In Hungary we also expect another 60bps cut in policy rate, more than consensus. We remain overweight in Korea but somewhat less since our previous allocation as the won has already outperformed. We have reduced Indonesia from overweight to underweight. We remain underweight in South Africa and have reduced Brazil to market weight given lingering nervousness about tapering. Our new portfolio is presented below:
New SEB EM Bond Basket Oct 1 2013
GBI-EM SEB weight weight Poland Hungary S. Africa Turkey S. Korea Indonesia Malaysia Brazil Mexico Average 10% 6% 10% 10% 0% 10% 10% 10% 10% 15.0% 15.0% 7.5% 10% 7.5% 5% 15% 10% 15% Rating S&P (LT-FC) ABB BBB BB+ A+ BB+ ABBB BBB Yield 01-Oct 3.6% 5.0% 7.0% 8.6% 2.9% 7.6% 3.1% 11.4% 4.6% 5.5% Duration years 2.8 3.6 4.3 3.9 2.8 3.1 4.1 2.8 3.6 3.5

100.0% BBB

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Emerging Markets Explorer

Quantitative and technical analysis


Starting in the quantitative corner: Downtrends in USD/KRW and USD/TWD stand out when screening the EM FX universe for interesting trend trades and deserve further fundamental and technical scrutinizing. USD/IDR and USD/TRY uptrends are overstretched and there is an intensified risk of correction in these particular currencies. Screening for trend trades In order to screen currency pairs for interesting trend trades we apply the three standardized measures: (1) trend-o-meter, (2) stretch-o-meter and (3) vol-ometer. What we are looking for are currencies with a strong trend (high chance of autocorrelation), low stretch (low probability of a correction) and low vol (trademark of a smooth trend).
Top 5 trending currency pairs
CCY USDIDR USDKRW USDPLN USDTWD EURRUB Trend Stretch Vol 3m change 1m change

Another way to assess the trend is the use of linear regression on the aggregated change. The advantage with this approach is that it takes each observation in the 3 month sample into consideration (while the trend-o-meter only use the initial and ending levels), provides both a measure of the strength of the trend (the regression coefficient) and the reliability of the trend (the explanatory power as shown by R2), and is more visual. As can be seen in the charts below a regression approach complement our conclusions regarding the USD/KRW and USD/TWD trends: USD/KRW trend has been stronger (with a daily change of -0.06%) than the USD/TWD trend (0.02%) and it is more reliable as it shows a more persistent pattern (R2 0.8 vs. 0.6). The question is if the fundamental reasons behind the trend still are in play? If so, short USD/KRW is the EM trend trade to seek!
USD/KRW Aggregated change past 3m
0 -0.01 -0.02

1.87 -1.70 -1.32 -1.09 0.96

2.75 -1.23 -0.95 -0.10 1.66

0.65 -0.07 0.05 -0.11 -0.20

12.9% -5.7% -6.8% -1.7% 3.4%

-0.4% -1.9% -3.6% -0.9% -0.6%

-0.03 -0.04 -0.05 -0.06 -0.07 y = -0.0006x + 25.083 R = 0.8006

We screen for the five top trending currency pairs and then evaluate these using the two other measures. USD/IDR has the strongest trend but also a severe stretch making a correction (mean reversion tendency) to probable for a trend trade to be optimal. Furthermore, the vol-o-meter indicates that realized volatility has been higher than usual which tells us that the trend, even if strong, has not been nice and smooth. On this basis we would not consider going long USD/IDR at the moment. The two currencies among the top five trending currency pairs that we find interesting are short USD/KRW and short USD/TWD. Both these currency pairs combine strong trends with relatively low stretches and below average volatility. Furthermore, when comparing their respective 3 months change with the 1 month change they both point in the same direction further, indicating that the trend has not lost momentum. To conclude, the quantitative screen for interesting trend trades show that one should investigate shorting USD/KRW and USD/TWD in more detail, e.g. are there fundamental reasons why these trends should continue and what has technical analysis to offer regarding timing of a trade.

USD/TWD Aggregated change past 3m


0

-0.005

-0.01 y = -0.0002x + 6.686 R = 0.6035

-0.015

-0.02

-0.025

FX-o-meter descriptions The trend-o-meter is the standardized three month change where a positive (negative) score indicates that the EM currency has depreciated (appreciated) and the score is expressed in standard deviations. It assumes that a stronger trend indicates a higher probability that the trend will continue. The stretch-o-meter provides a measure for the strength of mean reversion tendencies which is standardized between currency pairs (making direct comparison possible). The larger the stretch score the larger is the probability that mean reversion tendencies will set in and

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Emerging Markets Explorer

drive a currency towards its longer term average (in this case its one year moving average).
Stretch-o-meter
USDCNH USDCNY USDKRW USDPLN USDHUF USDHKD USDTWD EURCZK EURRON USDSGD EURHUF EURPLN USDRUB USDTHB USDBRL USDPHP USDMXN USDCLP USDZAR USDMYR USDINR EURRUB USDUAH USDTRY USDIDR -3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3

In the following we share some key conclusions from our team Technical Analysts:
USD/KRW to test 1,050 area in medium-term

Region with intensified risk of correction

The vol-o-meter is our third measure for currency pairs. It measures how current realized volatility deviates from the average/normal realized volatility. A negative (positive) score indicates that current volatility is lower (higher) than normal. The measure serves as a warning signal when contemplating investing in a trend. A positive vol score indicates that the risk is high and that one has to be prepared for swings in the P/L. Also the lower the vol score the smoother and in one a sense the stronger the trend.
Vol-o-meter
USDCNY USDUAH USDCNH USDHKD EURHUF EURRUB USDTWD EURCZK USDHUF USDKRW USDRUB USDPHP EURPLN USDZAR USDPLN EURRON USDCLP USDTHB USDMXN USDSGD USDMYR USDTRY USDBRL USDINR USDIDR -1.0 -0.5 0.0 0.5 1.0

Short-term, USD/KRW is impulsively trending lower having already fallen back below the yearly moving average band. Recent violation below 1,082 adds to the already present medium-term downside in a technical environment that already supports the won. Provided it remains below 1,0951,110, or even 1,127, we favor further downside targeting 1,054-1,048. In fact, the 2011-2013 wave structure suggests levels as low as 1,009 are possible. The Korean KS11 stock market index (2,010) is holding above a previously violated medium-term trendline but has yet to break key resistance at 2,042-2,057. When it does, it should represent yet another bullish factor for the won.
USD/INR is set to move higher from medium-term equilibrium position

In the medium-term, USD/INR was severely overstretched only a few weeks ago. The market rally has paused and neutralized previous strained short- to medium-term conditions. The correction down to the rolling 21 week high/low average or "Base line" (aka "Tenkan-Sen") has returned the pair to medium-term equilibrium, both supporting (because over time it is increasing) and attracting during correctional moves. A short-term move back above 64.65-65.25 would strongly argue for a fresh high above 68.80 then moving closer to a 2008-2011 261.8% Fibo projection point at 78.20 as a topside beacon.

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Emerging Markets Explorer

USD/BRL should turn higher from its 50% retracement ref

The real trades like the rupiah, though the market managed to extend USD/BRL losses slightly below the rolling 21week high/low average, albeit with no greater success in maintaining the break. Now, the previous medium-term stretch is fully neutralized. If buyers are encouraged by support at the 50% retracement ref, they should soon be able to break back above minor resistance currently at 2.3150. A move back below 2.18 would call for an alternative route closer to 2.1375 before moving upward. In the short-term, the Brazilian BOVESPA index (53,785) is showing signs of exhaustion near its medium-term dynamic resistance (at market). Falling back under 54,110 on a weekly close would increase downside risks considerably, probably adversely affecting the currency. Russian rouble faces new headwinds The Russian rouble basket (37.52) has rebounded sharply from its rolling 21week high/low average. The high weekly close (27/9) may once again start challenging its recent 38.31 high. A move above this point would refocus medium-term attention on a 2012-2013 "Equality point" at 39.00. The Russian IRTS Equity index (1,433) risks having completed a Jun-Sep 3-wave correction. Below 1,401 would make this more likely, while a move under 1,285 would substantially increase the risk of a break below a long-term key ref at 1,200. Being hardly rouble positive, this would in turn have a significant and far reaching negative effect.

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Emerging Markets Explorer

Asia
China: What is Liconomics?
From Freakonomics to Abenomics, now the term Liconomics is making the rounds in markets and media. Similar to Abenomics in Japan coined by Prime Minister Abes economic policy, Liconomics is named after Chinas Premier Li Keqiangs economic policy. Unlike Abenomics, Liconomics is not an official term endorsed by Li and was concocted by the investment community. Liconomics is roughly framed around three pillars, which are 1) limited leverage 2) limited stimulus and 3) structural reform. In our view, Liconomics isnt a paradigm shift in Chinas economic policy but a small step away from the stop and go economy. The 7% floor in growth will be firmly protected but this time well only get a light tap on the pedal if the economy starts heading below the 7.5% target. The magic 7 Before we begin, Liconomics needs to be put into context of the GDP growth target and the floor. In June interbank rates spiked where 7 day repo rate jumped from around 4% to almost 11% (for more details see Is China risk on the rise?, China Tracker 20 June 2013). Spikes in interest rates happen often but this time, the spike was more extreme, lasted longer and the government did this deliberately to teach banks a lesson to better manage risk. The government was getting serious about inflicting short term pain to improve long term growth. With a 7.5% growth target for 2013, how much pain are the authorities willing to take? Unofficial comments from Li state that the floor on growth is 6.9%. Former President Hu Jintao set a goal in 2010 to double the size of GDP by 2020 and China needs to grow by 6.9% to meet that goal. China sets long term goals and those dont change with a new administration. In addition, Li believes that when the economy grows below 7% as China saw in 2008-09 the adverse impact on employment becomes too strong. 7% or 6.9% looks to be the floor and the pain threshold.
16 15 14 13 12 11 10 9 8 7 6 5 00 01 02 03 04 05 06 07 08 09 10 China Real GDP % yoy 4qtr mvavg

The pillars of Liconomics With that in mind, we can better understand the three pillars of Liconomics. The first pillar on limited leverage should not mean deleverage but to slow the pace of leverage. For example, this years bank credit target was set at 13.5% but as of June we are already averaging 14.8%yoy. Our estimate of total social financing, which includes bank and non-bank loans (e.g. corporate bond issuances and trust loans) shows credit growth averaging even higher at about 22%yoy. Liconomics will bring credit growth towards the target of 13.5% instead of contracting it. We are too close to the growth floor for deleveraging.
40 35 30 25 20 15 10 05 06 07 08 09 10 11 12 13 % yoy Bank Loans Total social financing estimate

The second pillar of limited stimulus does not mean shock therapy. The 7% floor will be protected. Instead, Liconomics will move away from the old habits of over stimulating the economy when growth falls below the 7.5% target. So in todays context, Li will provide small measures to support the economy such as the one announced today to exempt small companies from value-added and business taxes. Third, Li will focus on economic restructuring while growth is not at the floor. Li has mentioned several areas of focus. First, he wants to control Chinas volatile food inflation. Much of Chinas inflation is food related from things like pork and feed, which inflates CPI and forces the authorities to tighten aggressively. Li will focus on agricultural reforms to smooth out food inflation. Second, he wants to redirect investments. Over-capacitated industries such as steel and cement will get credit rations and construction on railroads, highways and urban redevelopment will get more funding. Third, consumption should be another driver of growth but again with a shift in focus. The consumption focus used to be autos but that will shift to building more information related products such as 4G hand phones and the network infrastructure. Fourth, Li wants to streamline administration of the government and delegate power away from the central government to local and provincial levels. This will limit mass stimulus channeled from the central government. The government will allow ownership and operating rights for things like railways to local governments and private investors. The key here is to reiterate that restructuring will only occur while growth is above the 7% floor, which to us means little appetite for pain and slows the restructuring process.

Li's 7% floor 11 12 13

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Summary Chinas economy is often characterized as riding a taxi in Hong Kong. The driver slams on the gas when the light is green, accelerates to a couple of inches away from the car in front and slams on the breaks. Liconomics isnt a paradigm shift in Chinas economic policy but a step away from the stop and go economy. So now that growth is slowing below the 7.5% target, we wont get a pedal to the metal response but a light tap on the gas. We are forecasting no major acceleration in the Chinese economy for the next two years and see only a 7.5% growth for 2013 and 7.4% for 2014 under Liconomics. The economy is again running on all engines. We see 3 drivers to the Chinese economy a) external demand through exports b) domestic demand measured through construction and c) monetary policy. They were all turning lower in the first half of the year but all three are again turning up. First, exports had been decelerating since authorities have clamped down on over billing of exports to take advantage of RMB appreciation. However, this impact is waning and with improved outlook in Europe and US, exports took a bounce higher in July and August and we expect it to continue. Second, the biggest change we saw was in domestic demand where our SEB China Construction Indicator had turned down, signalling a slowdown. However, this has turned in July/August and we are seeing some specific relaxing of property measures (e.g. Wenzhou). Property prices continue to rise about 0.8% a month. Lastly, monetary contraction appears to be ending. The liquidity crunch in interbank market has subsided and interest rate sensitive non-bank lending has stabilized. Hence with 3 out of 3 drivers stabilizing, we think the risk for growth is to the upside going forward.
50 % yoy 3mma 40 30 20 10 0 -10 -20 07 08 09 10 11 12 13 SEB China construction indicator

have to once again resort to currency intervention and accelerate CNY appreciation. We still find CNY undervalued by about 2% short term and 17.7% in the long run. Lastly, Chinas real rates have risen with US real rates and CNY should outperform other Asian currencies. We think NDF will outperform CNH in a period of USD strength and global deleveraging from higher US Treasury yields. CNH underlying performance such as bonds is weakening and with an open capital account for CNH products, it will sell-off more than the fixing sensitive NDF market. We have a short USD/CNY 1 month NDF position in our Asia FX Portfolio.

India
India is and has been about the current account deficit and inflation. They are showing signs of bottoming. The slowdown in the domestic economy are finally reducing imports and the current account deficit should start shrinking. Inflation pressures are back on the rise but the former IMF Chief Economist and new RBI governor Raghuram Rajan has come in with a hawkish note and surprisingly hiked interest rates to reduce Indias entrenched inflation expectations. Short term, these policies are negative for growth and equity markets. However, this should at least stabilize the currency and hopefully inflation where in 6 months time, RBI can finally reduce interest rates and get the economy growing again.
5 0 -5 -10 -15 -20 -25 03 04 05 06 07 08 09 10 11 12 13 Trade Balance ex oil bn USD

Indonesia
Macro: The cyclical growth has peaked. Indonesia benefited from a clean balance sheet allowing for credit growth that generated domestic demand. However, credit growth will slow as the central bank is forced to hike interest rates to prevent capital outflow and rise in inflation from fuel price hikes by 44%. This combination of tighter policy and higher fuel prices is positive long term but short term will crimp economic activity. Indonesia is likely taking the cue from India where combination of subsidized fuel and current account deficit can lead to a sudden capital outflow and destabilize the economy. FX: The spot market, which was stable from central bank intervention, is slowly moving upwards with the NDF market. IDR NDF weakened due to risk aversion and

FX: USDCNY fixing, set by the policymakers have been stable. We think the currency is acting as a nominal anchor of stability while the authorities reform the domestic financial market, which increases volatility in interest rates, credit growth and equity markets. In addition, the pick up in exports mean that China will

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investors hedging their FX exposure of their bond holdings. The NDF now provides attractive yields to go long IDR but we remain sidelined since we think inflation can surprise to the upside from the removal of fuel subsidies and scare foreign bond investors again. The central bank will have to react and we expect 50bps more hikes in the next 6 months from BI to protect the currency.
45 40 35 30 25 20 15 10 5 0 03 04 05 06 07 08 09 10 11 12 13 Loan grow th % yoy

scheduled for April of 2014. The government already plans to implement fiscal stimulus to cushion the fall in consumption. If the fiscal stimulus is not enough, Bank of Japan is ready to implement more monetary easing if the inflation and growth outlook weakens. This type of policy stance by Japan becomes headwinds for Korean assets to outperform. At least, it calls for a reduction in the strong equity inflows weve seen in the last 2 months. We think rest of Asia and emerging markets will either catch up to Korea or Korea will start under-performing. We dont recommend chasing the move lower in USD/KRW.
130 120 110 100 90 80 Production Inventory Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Korea 2010=100

Korea
Macro: If Mr. Bernanke is right and the US economy recovers, this should help Korea and exports. However, the domestic recovery will be slower because of Koreas high private debt. Korea has one of the highest private debt levels in the world. The high debt is the result of relying on credit to sustain a high growth level. With everyone leveraged up, trend domestic growth will likely fall since Korea has limited room to borrow and grow. In addition, Korea will likely have lower inflation. FX: Koreas performance across asset classes has been resilient in the last two months, while many in emerging markets have suffered. Is Korea the new safe haven? We dont think so for two reasons. First, we think the current account surplus will likely fall. The favorable current account position came from improved trade balance from exports recovering faster than imports. We think this happened because Korea has relatively higher inventory relative to production, which allowed exports to grow without importing inputs. However, in the coming months, we expect inventories to decrease from continued increase in demand, raise import growth and narrow the trade surplus. Second, we think the Japanese Yen will continue to weaken and the Nikkei will march higher and again compete for capital flows. Japan continues to run very loose monetary policy and they are ready to do more fiscal and monetary stimulus with any blip in the equity market or growth outlook. We are already seeing the commitment by the Japanese authorities with the proposed increase in the consumption tax

70 60

Malaysia
Malaysias economy will go through a mild slowdown from fiscal contraction. Prime Minister Najib gave cash handouts to influence the last election and now those impacts will weigh on growth. We would also watch for him to pass unfavourable but positive long term economic measures. He raised the fuel prices by almost 10% this month, which is a start. Over the medium term, we expect Najib to continue with his liberalization plans and especially help the equity market. Malaysias equity market is often expensive since domestic funds and public institutions buy and hold Malaysian stocks, which make foreigners reluctant to buy as it is over-priced and discourages Malaysian companies from aggressively increase profitability. With domestic institutions divesting, that will force more foreign inflows and should lead to more efficient Malaysian companies. MYR has been hurt from USD strength and rising US yields. It has also been hit from rapid reduction in the current account surplus. However, with the export outlook improving, Chinas domestic demand recovering and fuel price hikes to limit imports, we think MYR can outperform in Asia.

Philippines
Philippines had grabbed the attention of many investors from strong performance in the equity, bond and currency market. Low inflation, abundant global liquidity and credit growth was helping domestic demand. Philippines has also recently received a rating upgrade to investment grade by

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Emerging Markets Explorer

S&P and Fitch and becomes another support for PHP. We are worried short term about PHP since interest rates are very low and unlike Indonesia, the central bank is not turning hawkish to prevent capital outflow.

and reduce the need for currency appreciation. In this environment of USD strength and capital outflow, TWD will weaken but relative to other currencies such as KRW, We think TWD can outperform.
30 25 20 15 10 5 0 -5 -10 06 07 08 09 10 11 12 13 Credit% yoy 3mma Taipei Property prices

Singapore
Singapore looks to be turning better. Exports and growth have finally turned where 2Q GDP accelerated to 3.8%yoy from 0.2%. Inflation has eased from over 5% in the middle of 2012 to below 2%. Inflation is mostly housing and autos (autos are inflated by increased auction price to own a car) and for housing, more cooling measures have been introduced such as increasing stamp duty on home purchases by 5-7 percentage points. Singapores inflation was outpacing its trading partners but it has converged. We think Singapore will join China and choose to sacrifice high growth for a stronger currency. Growth is recovering but will not reach the previous levels of close to 10% and settle around 4-5%. Inflation has eased but will likely pick up since strict immigration policies will keep underlying inflation in tact. SGD NEER is trading 120bp above mid and looks too expensive currently but we would recommend buying on dips.
8 6 4 2 0 -2 08 09 10 11 12 13 CPI % yoy Singapore Asia Average

Thailand
Similar to Philippines, Thailand has caught investor interest from a stellar equity performance in 2013. This made sense since Thailand was experiencing a) a V shaped recovery early in the year post the floods b) fiscal boost from a minimum wage hike and reduction in the corporate tax rate to 23% from 30% and c) light foreign positioning since Thailand only started receiving flows post the election of Prime Minister Yingluck Shinawatra in July 2011 that that removed the political uncertainty. However, the currency has lagged the equity performance since the floods required increase in imports for reconstruction and hurt the trade balance and periodically put Thailand in a current account deficit. Going forward, we think THB will be the more vulnerable currency in the region since it has very little support from the current account and deleveraging can lead to capital outflow. We would change our minds if the central bank started to sound more hawkish but that has yet to happen.
70 60 50 40 30 20 10 0 -10 -20 -30 -40 07 % y oy 3mma bn USD Trade Balance (RHS) Ex ports (LHS) Imports (LHS) 7 6 5 4 3 2 1 0 -1 -2 -3 -4

Taiwan
Taiwan should benefit from an export recovery in the US heading into year end and the tech heavy equity market should receive foreign inflow and the economy should continue to recover. Unlike Seoul, Korea, Taipei property prices are still growing around 8%yoy and credit growth is above 10%yoy. The domestic economy is strong considering exports are still at the early stages of a recovery. TWD has a two step appreciation process in a cycle. Appreciation at the beginning of the cycle is slow while inflation is low and accelerates towards the end of the cycle once interest rate hikes are well underway. We think the approach will be similar this time around. Inflation is currently running low as the effects of a one time boost in energy prices in early 2012 wear off

08

09

10

11

12

13

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Emerging Europe
Czech Republic
During Q2, the Czech Republic ended its 18 month long recession, mainly due to improved exports. We expect growth will continue to pick up from -0.8% this year to 2.0% in 2014. The Czech Republic depends on external demand to maintain growth, and has strong trade ties with Western Europe. The trade balance has improved significantly so far this year, due to the recovery of the Euro zone. However, domestic demand is weak, dampened by fiscal austerity. In the shortterm, the market will focus on the upcoming early election on October 25-26. Polling data suggest the Social Democrats are likely to win the election. They have already indicated they will loosen fiscal policy in 2014. The election follows the collapse of the previous government and the failure to form a replacement. With its 2013 financing requirements covered, the Czech government bond is safer than its peers.

drops below 25.50 or the deflation threat increases. We expect the EUR/CZK to trade around 25.90 by the end of the year, and at 25.50 in 12 months.

Hungary
The Hungarian growth outlook began to improve last spring with monthly indicators supporting further gains with improvements in both industrial production (2.5% y/y in July) and retail sales (1.2% y/y in July). Further, exports are benefiting from stronger sentiment throughout Europe. Private consumption also appears to be increasing and real wages are starting to rise. The National Bank of Hungary (NBH) now forecasts growth to be 0.7% y/y (after previously expecting 0.6%) this year and 2.1% y/y (1.5%) in 2014. We project growth to be 0.7% 2013 and 1.5% in 2014. The banks decision to raise its GDP growth projections is partly due to an extension of the Funding for Growth Scheme (FGS) implemented earlier this year, as investments have decreased from 24% to 17% of total GDP. By extending the fund, the NBH will increase resources available to SMEs with HUF2000bn in Stage II, after paying out HUF500bn during Stage I (Initial Trial), totalling around 8.5% of GDP. The facility provides loans to SMEs at an annual interest rate of 2.5%, representing a two-thirds discount to the normal rate. However, it remains unclear what share will be applied to real new investments rather than subsidizing pre-planned economic activity. It is also unclear whether inadequate demand for credit, or lack of opportunities compelled private sector investment. Consequently, despite the slightly less negative climate for Hungary, there is still work to be done - in particularly with parliamentary elections scheduled next year (probably in April). The FX-mortgage relief plan is also of interest as the election approaches. However, the public appear sceptical as to whether or not politicians can be trusted on this issue. Still, investors and banks appear positive to the scheme. Currently, opinion polls suggest next years winner will be the Fidesz (national conservatives), but with a simple majority rather than the super majority it won in 2010. Despite increasing since last year, the fiscal deficit is likely to remain below 3% of GDP, exerting less financing pressure going forward and avoiding problems with the EU. The country repaid its IMF debt in August this year, government deposits have declined to EUR3bn and remaining pension assets total around EUR1bn. Spending has increased but revenue raising measures have also been introduced. The resumption of EU transfers and the use of unallocated budget reserves will help the government achieve its fiscal target this year.

The central bank has kept its policy rate flat at 0.05% since lowering it by 20bps in November 2012. Headline inflation fell steadily to 1.3% in August while core inflation remains around 0.6%. Due to the risk of deflation, FX intervention is the Czech National Banks (CNB) only policy tool. However, in August and September, the CNB voted against using it, even with inflation well below target.

With the economy gaining momentum, we think it most likely the CNB will not intervene unless EUR/CZK

Since August 2012, the NBH has reduced rates at every meeting. Currently, the base rate is 3.60% after being cut

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by 20bps on September 24 in line with our and consensus expectations. The central bank statement was clearly dovish and sees no material inflationary pressure. August inflation of 1.3% y/y was below expectations, while the NBH expects average CPI of 2% y/y in 2013 and 2.4% in 2014. In addition, Hungary has a negative output gap implying substantial spare capacity and very little risk of real price increases. Weak demand will also make it difficult for firms to pass on higher prices to consumers. The NBH monetary policy statement suggested that to be able to achieve the central banks 3% y/y inflation target in the longer term, further cautious easing would be needed provided the risk backdrop remains reasonably supportive. After several years of austerity, the public debt/GDP ratio has peaked at close to 82%. Still, Hungary does not suffer from a twin deficit as many other Eastern European countries do, with a current account surplus of just over 4% of GDP. However, its total external debt is one of the largest amongst EM at 135% of GDP. Consequently, it is vital that financing remains available. The countrys external financing requirement equals 67% of reserves and 24% of GDP, making it relatively sensitive to a capital freeze.

after decreasing continuously in 2012 and at the beginning of this year. The first signs of recovery occurred in Q2 2013 with GDP up 0.8% y/y. Mainly, H2 2013 growth will be export driven (especially by exports to Germany, Polands largest trading partner). We estimate GDP will increase by 1.5% in 2013. In 2014 domestic demand will also pick up, contributing to GDP growth of 3.1%. Domestic demand will be driven by improved real wages, which are projected to rise by 2% y/y in H2 2013 and to accelerate even further in 2014. Moreover, unemployment increased to 10.8% (reported) in Q2 2013, although there are increasing signs that industry has started hiring again, with the PMI labour market indicator currently at 50.4 after languishing below 50 for almost a year. Poland reported major current account improvements in H1 2013, due to higher exports and an improved trade balance. Exports rose by 5.3% y/y in H1 2013 while imports fell by 1.3% y/y, due to weak domestic demand. The CA deficit will narrow to 2% of GDP in 2013 from 3.5% in 2012, offsetting a decline in FDI this year, as a result of large negative reinvested profits and lower portfolio investments in H1 2013. The deficit is expected to remain modest at around 3% of GDP in 2014/15 (still regarded as sustainable), mainly financed by FDI and primarily by EU funds (especially next year after the 2014/15 budget year commences starts).

The HUF appears cheap compared to its 10y historic trend (currently it is 5% below). Still, the NBH will probably try to keep the HUF stable against the EUR at just below 300, a level the private sector (with its high FX debt) can sustain while also supporting exporters.

Poland
During the past two months, the Polish economy has turned around, with momentum currently accelerating. Recent PMI (52.6) which points towards industrial production growth of just under 10%, retail sales (3.4% y/y) and industrial production (2.3% y/y) data indicate that higher economic growth will last,

Portfolio flows turned sharply negative in June (the last month for which data is available) and probably also in August. A key risk for the zloty is the large quantities of foreign-owned POLGB, currently at 37% but set to rise to 46% once pension reforms are implemented. The Polish government has decided to transfer PLN 140bn (7.5% of GDP) of market bonds/assets from second pillar pension funds to the state-owned pay-as-you-go system, probably during H1 2014. This will cause debt to fall to well below 50% of GDP eliminating the risk of automatic spending cuts which would be triggered when debt exceeds 55% of GDP. In our main scenario, flows will be supportive as shown by improved basic balance data.

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The MPC finished its 225bps easing cycle in July and declared that the policy rate (currently 2.5%) would remain unchanged for an extended period. We expect two hikes of 25bps each in late 2014, six months later than the market currently discounts. This view is bolstered by low expected CPI inflation, which we forecast will stay below the central banks target of 2.5% (+/-1%) until 2015 (1.4% in Aug). The ECBs expected rate cut in December also supports this view, as the zloty would become too strong and hurt exports if the MPC were to hike rates prematurely.

in 2014. However, economic expansion may be offset by weak internal demand and falling bank lending. The recovery of the agricultural sector, which generates 68% of the countrys GDP, following last years weak harvest, has decreased food prices and helped reduce inflation sharply. However, this growth driver is temporary. In the longer term, expansion depends on the recovery in key export markets and internal demand. Romania exports relatively more to recession hit countries such as Italy and less to healthy markets such as Germany. Meanwhile, internal demand has suffered from high inflation which has eroded household income, although this situation may now improve as inflation falls.

Poland had managed to remain strong throughout the latest EM crisis, due to its robust fundamentals and long-term sustainable current account deficit. The zloty is well positioned after depreciating over the turbulent summer, as EM begin following the positive trend established by their developed counterparts. Currently, the REER is almost 5% below its 10-year trend, also suggesting possible near-term appreciation.

Romania
Romanian economic growth has been supported largely by the countrys recovering agricultural sector and strong net exports.

With inflation slowing, due to lower food prices, the National Bank of Romania (NBR) has continued to cut interest rates, by 75bps since Q1. Following another rate cut of 25bps in late September, the reference rate is set at 4.25%. Furthermore, Romania is progressing towards signing its third IMF programme, which is considered a precautionary arrangement as the country does not need immediate financial assistance. It will, however, serve as a seal of approval and improve investor sentiment. We expect the EUR/RON to trade a bit above 4.40 at the end of this year, and at 4.30 in 12 months.

Russia
During 2013, growth has weakened in Russia. GDP y/y has fallen from over 4% in the beginning of 2012 to only 1.2% in the second quarter of this year. Growth has been weak due to structural slowdown caused by under-investment. Real investments fell by 3.9% y/y in August, from prior readings of +2.5% in July and -3.7% in June. Industrial production remains weak, 0.1% y/y in August, despite the low unemployment rate of 5.2% (last reading in August). However, retail sales remain decent at 4.0% y/y and real wages are set to rise as CPI eases. CPI has fallen from 7.1% y/y in January to 6.5% in August. This opens up future possible rate cuts by the Central Bank of Russia (CBR). The current 1W repo is set at 5.50%. We expect a future rate of 5.25% at years end and 5.00% in a year.

We expect GDP growth of 2.2% this year, one of the highest rates in Central Eastern Europe, and by 3.0%

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Overall, we believe that the slowdown has bottomed out and expect GDP growth of 1.7% this year, rising to 2.4% next year and coming in at 3.0% in 2015.

Turkey
Manufacturing PMI rose to a 30-month high of 54 in September, up from 50.9 in August. While this obviously is good news, it is a concern that the rise was driven by domestic rather than external demand, which will not be sustainable in the long run. Nominal credit growth, which is crucial for the domestic demand driven economy, is still up 30% y/y, but started to fall in w/w term starting in August. We dont expect any full stop but credit growth is set to ease further. We have cut our GDP forecast to 3.7% this year and to 3.3% and 4.0% in 2014/15. Export growth remained positive (except to the Middle East) but imports grew much faster. The latest trade data showed a deficit above expectations. This will ease as credit growth softens and due to the weaker lira. Growth will, hence, be less imbalanced than previously. Medium term growth prospects remain good but recent turbulence is a reminder of the speed limit for countries with insufficient savings. The Central Bank of Turkeys (CBT) focus has shifted towards keeping inflation (headline 8.2% and core 6.4% in August) from exceeding the target (5% +/-2%) by too much. Hence, it is worried that the lira will weaken further. Having raised the O/N lending rate by 125bps since July to 7.75%, Governor Basci has said further hikes are off the cards for now. Banks funding costs will remain at the top of the corridor until CPI approaches the CBTs year end forecast (6.2%). Instead, the CBT may reduce banks use of the Reserve Option Mechanism to free up FX liquidity and increase lira demand and intervene directly (but net reserves are low). If needed, policy rates will be lifted. Given our cautious view on risk appetite during Q4, we think it is more likely than hot that temporary pressure on the lire forces the CBT to hike the O/N lending rate by another 50bps to 8.25%. The 1W repo rate, however, is likely to remain on hold until late next year when growth again is likely to be on the rise. The latest basic balance data (until June) showed net portfolio flows turning negative. That most likely continued in July and especially in August. Outside the basic balance, other investments (largely from foreign banks) may also have reversed. Historically however, Turkish banks and corporations have maintained a very high roll-over ratio during liquidity crises despite the countrys very high external financing need (currently 220% of FX reserves). Looking forward, we assume improved risk appetite, despite Feds tapering, and expect portfolio as well as bank flows to stabilize/recover albeit at a lower level than before. Turkeys financing vulnerability will though remain on investors minds for quite some time. With softer domestic demand, the C/A deficit might not rise beyond the current 6.5% of GDP, still a burden to finance.

During 2013, we expect the current account surplus to shrink as increased domestic demand drives imports, and due to slightly falling oil prices (we expect Brent to fall from USD 108/barrel to 102.5 in 2014) which will hurt export income. With improving risk appetite and a synchronized global recovery in 2014, we expect less capital outflows and think the overall flow picture will be modestly rouble supportive.

The main risk for the future development of the rouble is the development of oil prices. Historically, events causing flight to liquidity has been rouble negative. Hence, tensions in Middle East, Euro zone crisis and budget deficit in US are rouble negative. We expect the RUB against the basket to be vulnerable on the upside near term with our year-end forecast at 37.5. The improved outlook for EM and recovering Russian economy bodes well for the RUB in the first half of 2014 but in the absence of rising productivity, the still high inflation rate will continue carving out competitiveness from the non-oil industry and eventually put pressure on the rouble to adjust weaker in nominal terms.

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The lira lost about 5% in REER terms from April to July and an additional 2.8% in August. It is now weaker than its 10-year trend in both nominal and real terms. Valuation has improved markedly and the lira is now better aligned with whats needed to reduce the structural C/A deficit. But given Turkeys higher inflation (than its trading partners), the slope of the REER trend is fairly high.

rife at least since the conclusion of the latest agreement with the IMF in July 2010. After the IMF halted payments in March 2011 (over the governments refusal to hike gas prices), speculation increased, but the expected date has been pushed gradually into the future as a result of ample global liquidity. However, with the US Fed now signalling an end to its quantitative easing programme, weaker growth in China, and falling commodity and, especially, steel prices, the day of reckoning is near. The most likely scenario, we think, is that Ukraine reaches a Stand-byagreement with the IMF and devalues the hryvnia in the first quarter of 2014. Ukraine has been bleeding foreign exchange reserves almost without interruption since August 2011, when they covered almost 5 months of imports. Now they cover around 2.5 months. Three interrelated factors are driving down reserves and undermining the confidence in the exchange rate. First is the economic backdrop. The current account deficit has widened from 6.6% of GDP in 2011 to 8.3% of GDP in 2012, driven by rising gas import costs from Russia and falling steel exports. At the same time, net FDI has fallen from 4.6% in 2011 to 3.9% in 2012, and 1.5% of GDP in the first half of 2013, putting the onus on loans and more volatile portfolio investment to cover the current account deficit. However, investors and lenders have been reluctant to put money in Ukraine. The economy is in recession, with real GDP falling by 1.3% y/y in 2Q13. And, government finances have weakened, with the general government deficit (excluding Naftogaz) widening to 3.6% of GDP in 2012, from 1.8% in 2011. The deficit is on track to be even higher in 2013, as it was more than double in 2Q13 compared to 2Q12. A shortfall in Naftogaz will likely add another 2% of GDP to the fiscal deficit in 2013. Second is the authorities response. The government has increasingly turned to the central bank to fund the fiscal deficit. As a result, broad money supply (M2) growth jumped in early 2013 and reached 18% y/y in July 2013. The combination of falling reserves and rising money supply has caused reserves as a share of money to fall precipitously to a very weak 18% from an adequate 48% in 2011. While CPI inflation is currently flat, due to lower global food prices, the excessive growth in money supply will, ultimately, lead to higher inflation, a rising real effective exchange rate, and a (forcible, if not voluntary) sharp and potentially disorderly weakening of the hryvnia. And third is the bleak and uncertain outlook. This years bumper harvest will support export growth and hold down food inflation. Another positive factor is the governments intention to sign an EU Association agreement, which together with slowly recovering global demand will also support Ukrainian exports, if it is signed in November. However, any benefit of a free-trade agreement with the

Unless productivity growth is much faster in Turkey, the nominal exchange rate will eventually have to weaken to compensate for the higher inflation in order to maintain the competitive gains from the currencys recent weakening. Against the USD and EUR basket, the lira is 8% weaker than the 2011 bottom and 17% weaker than the after Lehman. Short term valuation, thus, looks attractive. The key event risk for Turkey is if the Syrian civil war were to 1) escalate in a way that drags Turkey actively into it, 2) damages exports to the Middle East or 3) drive oil prices significantly higher. Turkey is vulnerable due to its high oil import dependence and given the already high C/A deficit and inflation. We assume that these risks will not materialise. The street protests in June have ended but PM Erdogans harsh response to them has cost him political capital. Protests may well return as we approach local elections in March 2014, presidential elections in August 2014 and general elections in 2015. Despite this, Turkey received its second investment grade rating (from Moodys) as late as in May. The liras correlation to risk appetite has (temporarily?) been weak since last spring. We expect USD/TRY to trade at 2.05 at the end of 2013 but that the lira can recover to about 1.98 during the former part of next year. Gradually, however, excessive inflation will take its toll resulting in depreciation back to 2.10 by the end of 2014.

Ukraine
Conjectures about when Ukraine will devalue, or allow more flexibility in the hryvnia exchange rate have been

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EU may be offset by a potential trade war with Russia the destination of 25% of Ukrainian exports. In addition, in July 2013, short term debt at remaining maturity (short- and long-term debt coming due over the next 12 months, but excluding intercompany lending), was high at US$59.5 billion, or more than a third of GDP, according to the central bank. Payments to the IMF alone amount to $1.6 billion during the remainder of 2013 (OctoberDecember) and $3.7 billion in 2014. As a result, the external financing requirement for 2013 equals about 250% of FX reserves and over 35% of estimated GDP.

peg arrangement similar to Russias FX basket and fluctuation band. While this will come at a political price and drive inflation to 5-6%, it will also support the economy through better competitiveness, reduced uncertainty and greater stability (with the IMF as a watchdog). Overall, we expect the economy to recover to about 2% y/y growth next year after a contraction of close to 1% this year.

Africa
South Africa
Real GDP expanded by a pedestrian 1.8% y/y in 2Q13, down from 1.9% in 1Q and 2.5% in 2012. The slowdown was driven both by sluggish external demand and weakening private consumption growth. South Africas manufacturing PMI fell to 49.1 in September from 56.5 in August, suggesting that weakness will continue well into next year. Household spending has been hit by weak growth in real wages, with inflation running at 6.4% in August 2013, a four-year high, while private sector credit growth slowed to 8.1% in August. We foresee real GDP growth reaching only 2.0% in 2013, before recovering slowly to 2.6% in 2014 and 3.0% in 2015.

Source: IIF

Credit markets have reacted predictably. The 10-year government yield has increased from 7.5% in May 2013 to over 10% in late September, after jumping sharply after Moodys downgrade to Caa1 on September 20. This latter shock is also seen as Ukraines CDS spread diverted from the spread on the benchmark EM hard currency debt index (EMBI+).

The current account deficit widened to 6.5% of GDP in 2Q13 and the latest trade data, for August, showed a much larger trade deficit than expected. While a cyclical global slowdown is the immediate cause of weak GDP growth in South Africa, the root cause is domestic structural weaknesses, primarily the countrys low investment level at only 19% of GDP. Lack of investment has led to declining competitiveness (infrastructure bottlenecks and insufficient electricity generation), high unemployment, and rising social tensions. In response, the government has enacted counter cyclical fiscal policies. However, this has fuelled inflation and led to deterioration in government finances. Gross central government debt is still moderate at 43% of GDP, but that is sharply up from 26% in 2009. Expectations for government spending are high and will likely keep the budget deficit around its

Thus, international credit markets are now too expensive for the government to fund the budget deficit and finance its $10.8 billion foreign debt servicing cost through 2014. The most likely scenario, in our view, is that Ukraine reaches a Stand-by agreement with the IMF during the 1Q14 involving reduced gas price subsidies and a devaluation of about 10%. This is largely priced into the NDF market already. We also expect more currency flexibility with a

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current level of 4.8% of GDP through the elections in April 2014.

Nevertheless, ZAR looks likely to remain weak. Exports of mining products in volume terms will likely be slightly higher than last year, but falling commodity prices will hit earnings. The ZAR has been battered by speculation about the US Feds tapering, depreciating by 13% since early May, 2013. And, with the ANC looking to protect its narrowing majority, few economic reforms should be expected before general elections in April 2014. Rebounds in the value of the ZAR will present opportunities to hedge ZAR exposure or to buy USD/ZAR.

Lack of investment and tense labour market relations are particularly pronounced in the important mining industry. While this years strike season looks likely to be less severe than last year, uncertainty over when it will end weighs on investor sentiment and export earnings. Thankfully, the coal sector looks stable. On September 30, the dominant union in the coal sector, the National Union of Mineworkers (NUM), signed a wage deal with producers through South Africas Chamber of Mines that raises workers compensation by between 7% and 11%. However, work stoppages in the platinum sector will continue, potentially through the middle of October. Strikes at Amplats Rustenberg operations broke out in late September and look likely to spread to Implats and Lonmins operations too. The turf war between long-dominant NUM and the Association of Mineworkers and Construction Union (AMCU), where both are trying to outdo each other by promising better deals for its members, risks hardening the unions demands and create unrealistic expectations among members. In the gold sector, strikes may still be looming as AMCU rejected the 8% pay increase that was accepted by NUM in early September. NUM represents more than 60% of South Africas gold miners, but despite some early confusion, any AMCU strikes would be legal, as AMCU (which represents almost 20%) is now the largest union in mines operated by key producers such as Sibanye, AngloGold Ashanti, and Harmony. Despite these concerns about strikes in the mining sector, conflicts are likely to be less violent this year compared to 2012. The AMCU has now partly solidified its position and is keen to become a reliable and established workers representative in negotiations with employers. And the AMCU is now also coordinating its strikes with the police, thus reducing the risk of violent confrontations.

Latin America
Brazil
After a weak finish of last year and a poor start of 2013, Brazilian GDP growth surprised positively in 2Q13, but for the wrong reasons. In recent years, the Brazils growth model has mainly been driven by expansionary policies and private credit expansion which has spurred domestic demand. Retail sales have been strong, wage growth good and unemployment is at historical lows. But, industrial production and exports have been lacklustre as seen in the graph below. This discrepancy is not a sustainable path. In order to achieve a higher and more balanced growth, structural reforms are needed.

Any ground-breaking structural reforms are though not expected to come any time soon as the general election is coming up in October next year. In our view, GDP growth is likely to come in at 2.5% in 2013 and decline to 2.2% in 2014.

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The tax burden compared to the quality of government spending is a main problem in Brazil, resulting in poor, but costly public services and still massive inequality. In an attempt to improve infrastructure in the country, the Public Private Partnership (PPP) program will be utilized. It is a program that enables the private sector to invest in public sector projects. There was though a failure of one of the two toll road concession auctions on September 13 which highlights the flaws in the governments investment strategy. The Brazilian Central Bank had to fight an increase in the real for most part of H1, but has after tapering talks been forced to intervene against depreciation instead. In the absence of tighter fiscal policy the BCB has increasingly had to devote its attention to inflation rather than competitiveness. The lira weakened by around 16% against the USD between May and August but has recovered in September and is now down by 10% from early May. Inflation is gradually rebounding from its seasonal mid-year low, and so far there hasnt been any impact from the weakening real on the IPCA. But the impact has been picked up in other inflation measures, as well as in the PPI and will most likely be present in the September CPI reading. An increase in PMI input prices has also been observed, adding to the inflation-pressure scenario. Given the modest growth outlook, however, we expect that COPOM will be able to keep inflation within their target (4.5%+/-2%).

into next year, we expect a better environment for the real to take USD/BRL down to 2.20 (temporarily probably lower) during Q1 2014. The longer term outlook for USD/BRL, however, points upwards since high inflation will put pressure on nominal depreciation necessary to maintain competitive gains made recently.

Chile
Chile is adjusting to slower growth. During Q2, real GDP increased by 4.1 % y/y, compared to an average of 5.7% y/y in 2010-2012. We do not expect a commodity boom and see little scope for credit driven domestic demand and recovery is unlikely to reach all the way to 5% next year. GDP drivers are unevenly distributed. Retail sales continue to rise at double digit rates and came in at 12% y/y for August, though industrial expansion remains modest and manufacturing slowed by 2% y/y in August.

The combination of higher inflation, weaker growth and political pressure implies that conflicting driving forces will influence monetary policy going forward. On balance, we expect the policy rate to be hiked to 9.5% and stay there at least until the end of 2014. We expect the BRL to trade around 2.25 against the USD by end 2013. The cross could certainly go much higher during periods of sharp risk aversion but the precommitted intervention program of USD 60bn reduces the risk of the BRL falling out of bed. The central bank has shown it is prepared to back its words with action and still sits on very substantial FX reserves. Moving

Inflation in August was 2.2% y/y, near the lower end of the Central Bank of Chiles (CBCH) inflation target of 2-4%. This increases the possibility of future rate cuts. The reference rate has been maintained at 5.0% since the beginning of 2012. Even if the approximately 5% depreciation of the peso this year increases short-term inflation pressure, we expect the central bank to cut rates by 50bps in Q4. We forecast USD/CLP will trade around 505 by the end of the year but think a recovery of the peso to 490 in 12 months is likely as the global environment improves. Previous USD/CLP data suggest copper prices are the main determinant of long-term exchange rate movements. Lower future copper prices have already exerted downward pressure on the current account deficit, which accounted for 4.0% of GDP in Q2 2013. However, given Chiles high credit rating and low external debt, the deficit is not a great cause of concern. Finally, Chile faces the uncertainty of an imminent government election in November. According to polling data, the former regime is likely to win. However, the CBCH may delay rate cuts to safeguard its independence.

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Mexico
Mexicos growth has slowed down sharply during the past year. GDP grew by only 0.6% y/y in Q1 and 1.5% in Q2. In q/q terms, however, GDP contracted by 0.7% in Q2 despite a handsome increase in exports. The countrys industrial production has contracted in annual terms three consecutive months, with Julys reading of -0.5%. Total capital investment decreased in June by -3.1% y/y, from prior month of-0.8%. However, there are better times ahead, we think. We have cut our forecast of 1.8% in 2013 but look for a bounce to 4.5% in 2014 and 2015. There are some early signs of improvement such as retail sales that increased in June to 1.3% y/y, from prior month reading of -1.9%.

Mexicos president, Enrique Pena Nietos, took office in December 2012 and managed to unlock the prior political status quo. Mexico has won substantial praise for its progress on structural reforms. Three upcoming political reforms are on the agenda, which are crucial for future economic growth. The first is a political reform, presented by the opposition. The political reform is important, as the opposition states it as a prerequisite for President Nietos fiscal and energy reforms. The fiscal reform proposes raised tax levels on high income individuals, taxing dividends and stock market gains, capping deductions, eliminating certain VAT exemptions and special treatment in agricultural, mining and transport sectors amongst others. The public sector is rather small in Mexico and with these reforms public investments will be made possible the dependence on oil related public revenues will diminish. The energy reform aims to enhance private sector participation in the oil sector in order to enhance investments and efficiency. The proposed implementation of future laws in the sector through secondary law (majority vote), which makes legislation easier.

The deep integration between the Mexican and US economies make US ISM manufacturing index the best indicator of Mexican industrial growth, with a lead of around 3 months. The ISM reading in September came in at 56.2, a twenty-nine month high. Higher U.S. growth is expected to have a positive impact on the countrys growth and current account. On the other hand tapering talks in May, set of a roughly 9% depreciation of the peso against the US dollar in roughly one month.

CPI came in at 3.5% y/y in August and has fallen steadily since Aprils readings of 4.7%. Meanwhile, core inflation has fallen to 2.4%, below the 3% inflation target. We expect that the upcoming fiscal reform will provide an upward pressure on inflation coupled with increased demand. Banco de Mexico surprisingly cut interest rates in September by 25bps to 3.75%. We expect no further cuts this year. Given the expected recovery in the economy, ongoing reforms and sound fundamentals to start as well as favourable positioning, we are bullish on the peso in the medium term. We expect the MXN/USD to trade around 13.00 by years end, and at 12.40 in 12 months.

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Disclaimer
Analyst Certification We, the authors of this report, hereby certify that the views expressed in this report accurately reflect our personal views. In addition, we confirm that we have not been, nor are or will be, receiving direct or indirect compensation in exchange for expressing any of the views or the specific recommendation contained in the report. This statement affects your rights This research report has been prepared and issued by SEB Research a unit within Skandinaviska Enskilda Banken AB (publ) (SEB) to provide background information only. It is confidential to the recipient, any dissemination, distribution, copying, or other use of this communication is strictly prohibited. Good faith & limitations Opinions, projections and estimates contained in this report represent the authors present opinion and are subject to change without notice. Although information contained in this report has been compiled in good faith from sources believed to be reliable, no representation or warranty, expressed or implied, is made with respect to its correctness, completeness or accuracy of the contents, and the information is not to be relied upon as authoritative. To the extent permitted by law, SEB accepts no liability whatsoever for any direct or consequential loss arising from use of this document or its contents. Disclosures The analysis and valuations, projections and forecasts contained in this report are based on a number of assumptions and estimates and are subject to contingencies and uncertainties; different assumptions could result in materially different results. The inclusion of any such valuations, projections and forecasts in this report should not be regarded as a representation or warranty by or on behalf of the SEB Group or any person or entity within the SEB Group that such valuations, projections and forecasts or their underlying assumptions and estimates will be met or realized. Past performance is not a reliable indicator of future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. Anyone considering taking actions based upon the content of this document is urged to base investment decisions upon such investigations as they deem necessary. This document does not constitute an offer or an invitation to make an offer, or solicitation of, any offer to subscribe for any securities or other financial instruments. Conflicts of Interest SEB has in place a Conflicts of Interest Policy designed, amongst other things, to promote the independence and objectivity of reports produced by SEB Research department, which is separated from the rest of SEB business areas by information barriers; as such, research reports are independent and based solely on publicly available information. Your attention is drawn to the fact that SEB, its affiliates or employees may, to the extent permitted by law, have positions in, buy/sell in any capacity, or otherwise participate in, any financial instrument referred to herein or related securities/futures/options or may from time to time perform or seek to perform investment banking or other services to the companies mentioned herein. Recipients In the UK, this report is directed at and is for distribution only to professional clients or eligible counterparties. In the US, this report is distributed solely to persons who qualify as major institutional investors. Any U.S. persons wishing to effect transactions in any security discussed herein should do so by contacting SEB Securities Inc (SEBSI). The distribution of this document may be restricted in certain jurisdictions by law, and persons into whose possession this document comes should inform themselves about, and observe, any such restrictions. The SEB Group: members, memberships and regulators Skandinaviska Enskilda Banken AB (publ) is incorporated in Sweden, as a Limited Liability Company. It is regulated by Finansinspektionen, and by the local financial regulators in each of the jurisdictions in which it has branches or subsidiaries, including in the UK, by the Prudential Regulation Authority and Financial Conduct Authority (details about the extent of our regulation is available on request); Denmark by Finanstilsynet; Finland by Finanssivalvonta; Norway by Finanstilsynet and Germany by Bundesanstalt fr Finanzdienstleistungsaufsicht. In the US, SEBSI is a U.S. broker-dealer, registered with the Financial Industry Regulatory Authority (FINRA). SEBSI is a direct subsidiary of SEB.

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Emerging Markets Sales /Trading Stockholm Lars-Erik Kristensen FX, Fixed Income Sales Louise Valentin FX, Fixed Income Sales Mikael Lundberg FX Sales Gothenburg Peter Mars Malm Tomas Anelli Helsinki Henrik Typpnen Oslo Marius Lmo Trond Solstad Copenhagen Peter Lauridsen London Chris Dorman Tom Prior Frankfurt Taner Tuerker Peter Friedman New York Caroline Sthlberg Marcus Jansson Jonas Englund Moscow Ksenia Uralskaya Singapore Gustaf Ljungdahl Shanghai Fredrik Hhnel Vesa Toropainen Hong Kong Pablo Riddell Chloe Merdjanian Per Nordstrm EM Sales EM Sales Head of EM Helsinki Head of EM Oslo EM Sales EM Sales EM Sales EM Sales FX Sales Fixed Income Sales FX Sales Fixed Income Sales Fixed Income Sales EM sales EM Sales Head Head of Trading Capital Markets FX Sales FX Sales Fixed Income Sales

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SEB is a leading Nordic financial services group. As a relationship bank, SEB in Sweden and the Baltic countries offers financial advice and a wide range of financial services. In Denmark, Finland, Norway and Germany the banks operations have a strong focus on corporate and investment banking based on a full-service offering to corporate and institutional clients. The international nature of SEBs business is reflected in its presence in some 20 countries worldwide. At 30 June 2013, the Groups total assets amounted to SEK 2,596 billion while its assets under management totalled SEK 1,387 billion. The Group has around 16,000 employees. Read more about SEB at www.sebgroup.com. With capital, knowledge and experience, we generate value for our customers a task in which our research activities are highly beneficial. In 1999 SEB created a dedicated team to cover Emerging Markets (EM) with the research arm of the unit both complementing and extending macroeconomic assessments provided by the banks Economic Research group and market analysis generated by its Trading Strategy team. SEB EM Research provides extensive analysis and trading recommendations such as Emerging Markets Explorer, a major publication comprising macroeconomic analysis and strategy as well as market analyses and investment recommendations. Other publications include EM Trading Views, Asia Strategy Focus, various Investment Guides as well as the daily Emerging Alert.