02 - BRAZIL - Q2 2018 ENG · South Korea Poland Not the right time for a trade war Caution Smooth sailing Argentina Egypt UAE Policy fine-tuning is needed Gradual monetary easing

ECONOMIC RESEARCH DEPARTMENT

ECO EMERGING

The bank for a changing

world

2nd

quarter 2018

Editorial

Weak links The IMF reports published in mid-April insist once again on the external financial vulnerability andindebtedness of the emerging and developing countries (EMDCs). The potential risks are highly focused on the low-income countries (LICs), especially the commodity exporters. These countriesbenefited from a financial windfall, but did not improve their macroeconomic fundamentals. Of thelarge emerging economies, Argentina, Egypt and South Africa also show many weaknesses.

Brazil Russia India

Kicking the can down the road to fiscal consolidation

Moderate growth but controlled risks

Dynamic momentum but fragilities remain

China South Korea Poland

Not the right time for a trade war

Caution Smooth sailing

Argentina Egypt UAE

Policy fine-tuning is needed Gradual monetary easing Positive economic prospects

Tunisia South Africa Ethiopia

Alarming deficits A new start A paper tiger

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EcoEmerging// 2nd quarter 2018 economic-research.bnpparibas.com

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The bankfor a changing

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Editorial Weak links The IMF reports published in mid-April insist once again on the external financial vulnerability and indebtedness of the emerging and developing countries (EMDCs). The potential risks are highly focused on the low-income countries (LICs), especially the commodity exporters. These countries benefited from a financial windfall, but did not improve their macroeconomic fundamentals. Of the large emerging economies, Argentina, Egypt and South Africa show similar weaknesses to those of the LICs. The reforms launched in the first two countries are encouraging, but further efforts are still needed. In certain respects, South Africa has made the most progress, but the hardest part is yet to come. IMF economists have just released an impressive series of documents (World Economic Outlook, Fiscal Monitor, Global Financial Stability Report) in preparation for spring meetings in Washington. Once again, the predominant themes are the external financial vulnerability and indebtedness of the emerging and developing countries (EMDCs). Yet the potential risks are highly focused on low-income countries (LICs), especially those that are commodity exporters.

■ Financial windfall

According to the IMF, rising interest rates in the advanced countries since year-end 2016 have not triggered a widespread deterioration in the solvency of emerging country governments and companies, despite heavier debt burdens. Indeed, liquidity and external solvency indicators have improved for EMDCs as a whole. Thanks to the consolidation or rebound of growth, the upturn in commodity prices and the narrowing of risk premiums - made possible by huge portfolio investment inflows - these countries managed 1) to maintain a positive spread between growth and real interest rates (or to narrow the spread when it was negative), and 2) to strengthen or rebuild foreign reserves.

The main sources of risk lie in the increased exposure of investors to the most vulnerable counterparties (governments or corporates), which took advantage of persistently abundant global liquidity to tap the international bond market. On a scale of 1 to 100, the investor base risk index rose from 32 in late 2012 (which is also the average value for the period 2004-2012) to 42 at year-end 2017. Even LICs and other small “high yield” emerging countries (i.e. rated “speculative grade” by the main rating agencies) have benefited from market financing. But these countries often managed to improve liquidity at the price of eroding external solvency. IMF economists calculate that about 45% of them have highly deteriorated solvency ratios (debt servicing as a share of exports of more than 25%, the threshold above which a country is considered to be “high risk”). Only 25% were above this threshold in 2012.

Maintaining portfolio investment inflows is a key factor for holding down the cost of financing and to ensure debt refinancing, even though these countries have managed to issue bonds with medium to long-term maturities. According to IMF experts, if the emerging financial markets were to be hit by tensions comparable to those that followed the renminbi’s mini-devaluation in summer 2015, in a matter of weeks net outflows of portfolio investment could amount to

25% of net inflows in 2017 (USD 240 bn), driving up the risk premium by an average of 100 basis points.

■ Weak links diversity

For LICs, interest rate and/or refinancing risks would create additional headwinds for turning around public finances, which are still very fragile despite the rebound in commodity prices and, for some of them, efforts to cutback spending. In two thirds of these countries, public debt to GDP ratios continued to rise through 2017. After falling as low as 25% before the 2008 financial crisis, thanks notably to debt relief for the smallest heavily indebted countries, the average debt-to-GDP ratio climbed back to 44% in 2017. The number of “debt distressed” countries doubled to 8 in 2017, compared to the previous year, hit by a 100bp increase in the apparent interest rate and the ensuing increase in the interest charge to fiscal revenues ratio, which has gained 12 points since 2014. Moreover, since 2012, fiscal consolidation efforts have been achieved by reducing investment, which tends to pull down potential growth.

Within the big emerging countries, Argentina, Egypt and South Africa are also marked by the above-mentioned weaknesses, albeit to differing degrees. Since 2015, Argentina and Egypt have tried to lift or significantly relax forex controls and unite multiple exchange rates systems while striving to achieve total exchange rate flexibility, which goes hand in hand with pure inflation targeting. For South Africa, this has already been the case for a long time. For Argentina and Egypt, however, the road ahead is still long and narrow, because they must find the right mix between fiscal consolidation (underway) and structural policies that would give more manoeuvring room to monetary policy, in order to strike the right balance between macroeconomic stability (control over fiscal and current account deficits and inflation), financial stability (to limit or to reduce exposure to portfolio investment), and raising the potential growth rate to be as inclusive as possible (to contain social unrest). For South Africa, the big challenge is to raise potential growth without fiscal margin of manoeuvre. The solution lies in deeper structural reforms. The recent political change is promising, but it still needs to be confirmed by upcoming elections.

François Faure [email protected]


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Brazil Kicking the can down the road to fiscal consolidation Despite the current economic recovery and a persistently favourable international environment, it is still premature to hope for sustainable fiscal consolidation. The errors of fiscal policy in past years have left their mark in the form of deteriorated public finances. The new administration that will take power in January 2019 will face the formidable task of meeting high social expectations while laying down fiscal targets that reassure investors. Structural reforms will have to be reintroduced, such as the pension reform that was swept under the carpet by the Termer administration. Without structural reforms, Brazil’s public finance trajectory could become unsustainable in the medium to long term. Real GDP growth averaged 1% in 2017, in line with expectations. Activity stalled in Q4 2017, with annualised growth of only 0.2% q/q, seasonally adjusted (saar), limiting the carry-over effect to only 0.4% in 2018. With the exception of retail sales, economic indicators were rather disappointing in the first two months of the year (industrial production, services, job market and bank lending).

Our forecast calls for GDP growth of 3% in 2018. Mild inflation, historically low key rates and a rebound in formal employment should bolster household purchasing power and consumption, which has been the main growth engine so far. Exports should benefit from buoyant world demand and improvements in the terms of trade. Prospects are relatively favourable in most business sectors, which should trigger an upturn in investment. Even so, there are still strong fiscal headwinds.

This scenario is subject to political risks with the approach of October’s elections. Former president Lula, who was leading in the polls, is no longer in the running after the Supreme Court’s 4 April ruling. Fortunately, Brazil has a solid external position (FDI and foreign exchange reserves) that should enable it to absorb not only a domestic shock but also an external trade and/or financial shock.

■ Reforms as hard as pulling teeth

At the dawn of a crucial election year, the indefinite postponement of pension reform has led the three main rating agencies to downgrade Brazil’s foreign currency denominated long-term sovereign debt rating. Primary public spending has risen three times faster than GDP over the past decade. After adopting a reform in late 2016 that froze current spending in real terms, pension reform was supposed to be the other commitment that would restore the credibility of fiscal policy in the medium to long term.

It is now up to the next administration to push through this unpopular reform, and in general, to overhaul the country’s social policies, which are a corner stone of more inclusive economic growth. Social spending by the federal government accounts for more than 40% of primary spending, or 8.5% of GDP (vs 6.6% between 2010 and 2014). For the consolidated public sector, the figure is even 15% of GDP. In the February 2018 Economic Survey of the OECD, potential savings from a comprehensive reform of social policies are estimated at 2.7% of GDP from a 10-year horizon. Other measures to streamline spending could generate additional savings of about 5% of GDP.

In 2017, the federal public accounts (i.e. the central government, central bank and social security administration) managed to improve despite another swelling of the social accounts deficit (to 2.8% of GDP). The federal government’s primary deficit (excluding interest charges on the debt) was reduced to 1.9% of GDP from 2.6% in 2016. Fiscal revenues increased by 5.2% in real terms in 2017, bolstered by the recovery in economic growth (which lifted fiscal revenues by 1.2%) and exceptional revenues (notably due to concessions and licenses). At the same time, spending increased by only 2.4% in real terms thanks to new cutbacks in discretionary spending. Appropriations to the Growth Acceleration Programme (PAC) – a programme initiated by President Lula in 2007 to fund

1- Forecasts

e : BNP Paribas Group Economic Research estimates and forecasts 2- Economic recovery to be confirmed

▬ Real GDP, y/y % change █ Real GDP, q/q % change (sa)

Source : IBGE

2016 2017 2018e 2019e

Real GDP grow th (%) -3.5 1.0 3.0 3.5

Inflation (CPI, y ear av erage, %) 8.7 3.4 3.3 3.8

Fiscal balance / GDP (%) -9.0 -7.8 -7.5 -7.8

Gross public debt / GDP (%) 70.0 74.0 76.4 78.9

Current account balance / GDP (%) -1.3 -0.5 -1.5 -2.2

Ex ternal debt / GDP (%) 30.5 27.1 26.2 25.3

Forex reserv es (USD bn) 354 369 370 368

Forex reserv es, in months of imports 26.0 25.1 22.4 20.9

Ex change rate USDBRL (y ear end) 3.3 3.3 3.0 2.9

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public investment, especially for infrastructure – have been slashed in half since 2014 to 0.5% of GDP. Meanwhile, federal social welfare benefits accelerated again, by nearly 10% in real terms last year.

Spending on pensions accounts for 11.6% of GDP, compared to an OECD average of 8.1%, even though the population is still relatively young (7.8% in the over-65 age group, compared to an OECD average of 16.2%). Brazil has the lowest average age of retirement leave (55, compared to an OECD average of 64), and one of the highest replacement rates (98% of wages, vs an OECD average of 73%).

Social programmes need to better target their beneficiaries. The emblematic family allowance (Bolsa Familia, 0.5% of GDP) is geared towards to poorest fringes of the population and is an undisputed success in fighting poverty and unequal access to education and health care. Yet major savings could be generated from certain social benefits provided to the middle classes. The minimum wage, which serves as the threshold for social welfare allocations, has increased 80% in real terms over the past 15 years, compared to per capita GDP growth of only 23%. It is now seven times higher than the poverty line, and even higher than the median income. Consequently, it is recommended that social benefits, including pensions, be indexed to inflation rather than to the minimum wage. The merging of the two unemployment benefit systems (Seguro Desemprego and FGTS) would also generate synergies, and the savings could be used to finance extended coverage (currently a maximum of five months).

■ Avoiding a risk of snow(ball effect on debt) in Brasilia

In three years, federal debt outstanding has increased by 56% and the gross debt ratio by nearly 20 points of GDP, to 74% at year-end 2017, which is high according to emerging country standards. Brazil’s interest charge on debt is unusually heavy at 6.1% of GDP in 2017, compared to about 4% for Italy and 1.5% for Japan, two countries whose public debt load is much higher than for Brazil. This is the corollary of structurally high domestic rates. They reflect the hysteresis effect derived from past macroeconomic instability, and more recently (2014-2016) from budget overruns, the depreciation of Brazilian real (BRL) and high inflation. As a result, the apparent interest rate on the federal debt (interest charge as a share of debt) was 8.2% in 2017.

The disinflation process and the relative stability of BRL since early 2016 have helped ease monetary policy (the Selic declined 750 basis points to 6.5%), which seems to be winding down. This in turn helped ease domestic financing conditions (the average debt refinancing rate in BRL declined from 16.3% in early 2016 to 9.9% in February 2018, only a third of which is in fixed rate instruments). Nearly 97% of federal debt is denominated in BRL (including 0.3% in international bonds) and handled in a deep and liquid local bond market. Non-resident holdings of Treasury notes have been reduced by 14% in two years to BRL 428 bn in February 2018 (roughly USD 128 bn), or 12.4% of local bonds outstanding. Gross external debt amounted to USD 37 bn. The “direct” currency and interest rate risks associated with the US Fed’s monetary policy are relatively

small. All else equal, a 100 basis point increase in US key rates and a 20% depreciation of the USDBRL exchange rate would increase Brazil’s public debt ratio by only 10bp and 60bp, respectively. The average maturity of the debt is rather long (4 years for domestic debt and 8 years for external debt), the average life to maturity is nearly 6 years, and the amortisation profile is relatively smooth (15-18% maturing within the next 12 months).

The 2018 target of a primary deficit of BRL 159 bn (about 2.2% of GDP) seems to be achievable. Total government financing needs1 for the current year are substantial, estimated at BRL 637 bn, or more than 9% of GDP. Moreover, they are expected to swell in the years ahead, accentuating fears that Brazil will not be able to respect the “golden fiscal rule”, which says that debt issues should not be used to finance current spending excluding investment. Whether the government will successfully reduce the primary deficit to 0.8% of GDP by 2020 will depend on the nature of future fiscal policies and the adoption of reforms. But there is also the risk of a downturn in the global economy.

Even if structural reforms were to lift the potential growth rate from 2.3% to 3.5%-4%, a primary surplus of about 1% of GDP would still be necessary to stabilise the public debt ratio. Under a best-case scenario, public debt would peak at about 84% of GDP in 2022 before falling back gradually. Inversely, in the absence of any major new reforms, a snowball effect could make the public debt unsustainable, and it could hit 110% of GDP by 2025.

Sylvain Bellefontaine [email protected]

1 Amortisation of the debt + interest + share of primary deficit in compliance with the golden rule + guaranties as part of state government bailout plans – BNDES state development bank’s payments to the Treasury.

3- Unsustainable debt dynamics cannot be ruled out Gross federal government debt (% of GDP) ▬ Best-case scenario (reforms, increase in potential GDP, primary surplus) ▬ Worst-case scenario

Source : BNP Paribas

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Russia Moderate growth but controlled risks Russia consolidated its macroeconomic fundamentals in 2017. The economy swung into growth of 1.5% after contracting 0.2% in 2016. The fiscal deficit narrowed sharply to 1.4% of GDP thanks not only to higher oil and gas revenues but also to spending cutbacks. The central bank has demonstrated its capacity to face up to rising credit risks and troubled banks. The creation of a “bad bank” should help clean up the banking sector even further. Despite persistently strong headwinds that are preventing growth from accelerating, the rating agency Standard & Poor’s has upgraded Russia’s sovereign rating to BBB-. However, new US sanctions against oligarchs should weigh on economic growth. ■ Moderate economic growth

Economic growth rebounded to 1.5% in 2017 after contracting in the two previous years. Activity was mainly driven by the increase in household consumption (+3.4%), buoyed by higher real wages and an upturn in domestic lending. Investment excluding inventory surged by 3.6%, lifted by brighter growth prospects, a stronger rouble and high production capacity utilisation rates. The contribution of net exports to growth remained negative, reflecting a moderate upturn in exports and a sharp increase in imports. Looking at the breakdown of growth by sector, the Russian economy was mainly fuelled by the dynamic momentum of the wholesale and retail sectors and, to a lesser extent, by the transport sector. The mining sector’s contribution to growth was still low due to the implementation of oil production quotas as part of OPEC agreements.

Growth in Q4 2017 and the first statistics available for Q1 2018 show that the recovery is fragile. Growth slowed to 0.9% year-on-year (y/y) in Q4 2017 due to a sharp slowdown in investment. In February, business confidence indices slid, capacity utilisation rates declined and monthly GDP estimates revealed a slowdown in activity between January and February (+1.5% year-on-year in February). In March, the central bank estimated that economic growth should range between 1.5% and 2% between 2018 and 2020, assuming that Urals oil prices average USD 65 a barrel, which falls far short of the prevailing prices prior to the 2008 crisis. However, new US sanctions against oligarchs should weigh on economic growth in the short and medium terms.

Over the period 2010-2017, economic growth averaged only 1.7%, compared to 7% in 2000-2007. According to an analysis of the Conference Board, the sharp growth slowdown since 2010 can be attributed to the decline in Total Factor Productivity (TFP), which is generally associated with technical progress and the business climate, but which also often covers other external structural factors in the short and medium terms. For the period 2010-16, TFP gains averaged about 1.1% a year, compared to 5.6% a year in 2000-07. The decline in both the contribution of the quantity of labour (Russian population has declined since 2016) and in that of information and communications technology investment (which partially explains the decline in TFP) have explained the deterioration in labour productivity.

In 2017, Russia’s GDP per capita in USD was still 33% lower than in 2013. Moreover, over five years, GDP per capita should remain below USD 13,000 according to the IMF outlook.

■ Public finances consolidate strongly

In 2017, the government managed to reduce the federal deficit by two percentage points to 1.4% of GDP, down from 3.4% of GDP in the previous year. This performance cannot be attributed solely to higher oil and gas prices. Public spending was also cut by

1- Forecasts

e : BNP Paribas Group Economic Research estimates and forecasts 2 - GDP growth slowed sharply in Q4 2017 GDP growth, year-on-year (%) and contribution to growth (percentage points)

▬ Real GDP, y/y █ Household consumption █ Public spending

█ Investment █ Net exports █ Statistical errors

Source: Rosstat

2016 2017 2018e 2019e

Real GDP grow th (%) -0.2 1.5 1.8 1.7


General Gov . balance / GDP (%) -3.6 -1.5 -0.9 0.3

Public debt / GDP (%) 13.3 12.6 12.7 12.8

Current account balance / GDP (%) 1.9 2.2 2.7 2.5


Foreign ex change reserv es (USD bn) 318 356 405 430

Foreign ex change reserv es, in months of imp 11.2 10.9 11.2 11.3

Ex change rate USDRUB (y ear end) 60.3 57.7 60.0 61.0

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1.3 percentage points, while revenues increased by only 0.7 points. Although the federal fiscal deficit excluding oil and gas revenues is still very high (7.9% of GDP), it contracted by 1.1 percentage points this year. At the same time, the fiscal deficit of the government and all public administrations decreased to 1.5% of GDP, and public debt narrowed to only 12.6% of GDP in 2017.

■ External vulnerability declined in 2017

In February 2018, foreign reserves amounted to USD 373 bn, an increase of nearly USD 43 bn from the previous year, despite larger net private capital outflows. Sixty percent of the increase in foreign reserves can be attributed to the central bank’s currency purchases on behalf of the Ministry of Finance, and to a lesser extent, to the increase in the current account surplus (+0.3 percentage points of GDP to 2.2% of GDP on average in 2017) and net portfolio investment (+0.3 percentage points of GDP to 0.5%). The increase in net private capital outflows (USD 11 bn more than in 2016) reflects the rise in external debt payments by Russian banks, estimated at USD 28 bn in 2017.

Over the past five years, total external debt has fallen sharply to 32.9% of GDP at year-end 2017 and 138% of exports at Q3 2017, compared to 157% one year earlier. However, there has been a slight upturn in the nominal value of the debt over the past year due to the increase in sovereign issues (mainly RUB-denominated bonds). Inversely, the banks’ external debt has declined constantly (-52% in five years) to only 6.6% of GDP in 2017. Companies have also cut back sharply their external debt between mid-2014 and mid-2015, and nominal debt has stabilised over the past two years (21.9% of GDP in 2017).

However, the country remains exposed to external shocks, as illustrated by the strong volatility of the rouble resulting from the recent new sanctions against Russian oligarchs.

■ The banking sector is still fragile

The central bank has just announced the creation of a “bad bank” to manage the non-performing loans held by the three banks rescued in 2017: Otkritie, Binbank and Promsvyazbank, which accounted for 7% of banking sector assets as a whole. The defeasance structure will be financed by a central bank loan of RUB 1.1 trillion (USD 19 bn) at a preferential rate of 0.5%. The goal is to clean up the three banks’ balance sheets in preparation for selling off Otkritie and Binbank by 2021. The creation of a defeasance structure goes hand in hand with efforts to clear up of the banking sector over the past five years (the central bank has already spent RUB 2 trillion to rescue private banks from default in 2017), even though the monetary authorities have not needed to create one so far given the size of the ailing banks. Although the banking sector’s overall situation is still fragile, it is now well managed by the monetary authorities.

In January 2018, risky assets accounted for 19.6% of loans outstanding, an increase of 1.8 percentage points from the low of July 2017. This deterioration only partially reflects the defaults of the three private banks. The number of companies in bankruptcy proceedings increased sharply in the second half of 2017. To face

up to the increase in credit risk, Russian banks strongly increased their provisions as of Q4 2017, after having reduced them significantly in the first 8 months of the year. Yet these provisions still seem insufficient because they cover less than 80% of the potential capital losses at the end of the year (compared to nearly 100% in 2013).

In the span of a year, bank solvency ratios have deteriorated due notably to the increase in risk-weighted assets (+10.3% year-on-year in Q3 2017). The solvency ratio was only 12.4% in January, a percentage point lower than the previous year. Moreover, the IMF estimates Tier1-CAR at only 8.6% in Q3 2017.

On the whole, there is abundant liquidity in roubles. Yet as the central bank’s bailout plan for the three private banks mentioned above shows, the most fragile banks are not sheltered from a major run on deposits by mistrustful savings investors, which could trigger a liquidity crisis.

The profitability of Russian banks is already low and could decline further with the increase in provisions and the decline in interest rates on loans. Although interest margins remained relatively stable on the whole at 420 basis points in 2017, they were below 300 bp for more than a hundred banks. On the whole, the return on equity and on assets (ROE and ROA) amounted to only 9.6% and 1.2%, respectively, in Q3 2017, according to the IMF.

Johanna Melka [email protected]

3- Foreign reserves and exchange rate

▬ Foreign reserves, USD bn (l.s.) ▬ USDRUB exchange rate (r.s.)

Source: CBR

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India Dynamic momentum but fragilities remain On the positive side, growth is accelerating rapidly and should return to levels close to the potential growth rate as of fiscal year 2018/19. Private investment finally seems to be entering a sustainable recovery. As part of a bank recapitalisation plan, public banks, whose asset quality has deteriorated further, received an injection of nearly USD 14 bn in March, which should help ease the pressures on the most fragile banks and bolster the rebound in investment. On the negative side, the government has taken a pause from the consolidation of public finances. The current account deficit has widened slightly, reflecting a deterioration in the terms of trade and a decline in export market shares.

■ Economic growth acceleration and credit rebound

The economic recovery was confirmed in the third quarter of fiscal year 2017/18 (October-December 2017). Growth reached 7.2% year-on-year (y/y), bolstered by a strong increase in investment (+12% y/y). Household consumption slowed for the third consecutive quarter as consumer prices rose and consumer confidence sagged in the year to November 2017. At the same time, public spending accelerated (+6.1% y/y). This increase does not reflect an increase in investment, but the compensation paid to the states as part of the goods and services tax. For the first time since fiscal year 2011/12, the government announced that it would miss its target and would not reduce the fiscal deficit for the year 2017/18. The deficit is expected to hold at 3.5% of GDP.

The acceleration of growth is good news, but the recovery of private investment is even more encouraging. For the third consecutive month, the production of capital goods (notably machinery and equipment) increased strongly in January (+14.6% y/y). Bank lending to companies also accelerated (+6.7% y/y) after bottoming out in May 2017, spurred by the recovery in corporate investment.

■ Banks’ asset quality continues to deteriorate

The quality of bank assets continued to deteriorate in Q3 2017, albeit at a slower pace. According to the IMF, non-performing loans increased 15.5% y/y in Q3 2017, after increasing by more than 56% the previous year. In its latest report on financial stability, the central bank estimates that for the banking sector as a whole, risky assets (the sum of non-performing loans and restructured loans) amounted to 12.2% of loans outstanding. The share was 16.2% for public banks and 4.7% for private banks. Credit risk is still concentrated in industry, where risky assets amounted to 23.9% of loans outstanding, compared to only 6.9% in agriculture and 6.4% in services. The metal, construction and mining industries reported the highest ratios of risky assets. According to the central bank, more than 44% of loans granted to iron and steel companies are at risk. Risky loans continue to be concentrated in the hands of big companies, which account for 56% of loans granted, but 83% of doubtful debt.

The monetary authorities expect banks’ asset quality to level off during fiscal year 2018/19. The central bank set up new measures at the beginning of the year to accelerate the process of cleaning up risky assets. The bankruptcy law adopted in May 2016 is now the only regulatory framework applicable for default resolution. All the

other procedures have been eliminated. The banks will have 180 days from the date of default to restructure failing loans of more than INR 20 bn (USD 306 million).

To date, the monetary authorities do not esteem that sufficient provisions have been made to cover the assets at risk. Moreover, profitability has been negative since 2016 (ROA and ROE of -0.2% and -2% in Q3 2017), which means the situation is unlikely to improve in the short term.

1- Forecasts

(1): Fiscal year from April 1st of year n to March 31st of year n+1 e : BNP Paribas Group Economic Research estimates and forecasts 2- GDP growth accelerated strongly in Q3 2017/18 GDP growth, year-on-year (%) and contribution to growth (percentage points)

▬ Real GDP, y/y █ Household consumption █ Public spending

█ Investment █ Change in inventory █ Net exports █ Statistical errors

Source: CEIC

2016 2017e 2018e 2019e

Real GDP grow th(1) (%) 7.1 6.6 7.4 7.6

Inflation (1) (CPI, y ear av erage, %) 4.5 3.6 4.5 4.2

Central Gov . Balance(1) / GDP (%) -3.5 -3.5 -3.4 -3.3

Central Gov . Debt(1)/ GDP (%) 47.2 47.0 46.5 45.5

Current account balance(1) / GDP (%) -0.7 -1.6 -1.4 -1.3

Ex ternal debt(1)/ GDP (%) 21.2 20.3 20.1 19.8



Ex change rate USDINR (y ear end) 67.9 63.9 66.0 67.0

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To counter the deteriorating financial situation of public banks and to stimulate bank lending, the government announced a vast recapitalisation plan in October 2017, the first tranche of which was paid in March.

■ First tranche of the bank recapitalisation plan was injected in March 2018

In late March 2018, the government injected INR 881.4 billion (nearly USD 14 bn) into India’s public banks. As part of this move, the government issued INR 800 billion in bonds and drew the remainder from the 2017/18 budget. The banks will receive another INR 1218.6 bn by March 2019 1 . In January, the government announced that the amounts allocated to each bank would depend on their respective needs, so that they would meet all of the Basel 3 solvency criteria by 31 March 2019. The highest amounts will go to the most fragile banks, such as IDBI, State Bank of India and the Indian Overseas Bank. All in all, INR 2.1 trillion (USD 32 bn) will be injected into the Indian banking sector by March 2019, the equivalent of nearly 1.3% of GDP. This should be enough to cover future losses and to comply with the Basel 3 solvency ratios. Yet as the recent fraud at Punjab National Bank illustrates, the public banks are still shackled by shortcomings in terms of governance and internal controls. To offset these shortcomings, the authorities announced tighter supervisory regulations. Management will have to audit their financial results every quarter. Moreover, to reduce the risks of asset concentration, a limit of 25% was set per counterparty. This still seems to be very insufficient.

■ Current account deficits widened slightly in 2017

In 2017, the structure of the balance of payments deteriorated slightly. Down by 0.7 points of GDP, net foreign investment no longer covers the current account deficit, which swelled slightly. Portfolio investment, in contrast, increased strongly to 1.2% of GDP, which was enough to cover the deficit of the basic balance. Foreign exchange reserves increased by USD 50 bn during the year.

The current account deficit increased by 0.8 points to 1.5% of GDP, which is still far better than the 5.1% of GDP reported five years earlier. The slight deterioration resulted from a wider trade deficit, which rose to 5.9% of GDP, mainly due to a higher oil bill. Although exports swung back into positive growth in 2017, import growth was even stronger. So far, the increase in the current account deficit is not worrisome. India reported foreign reserves of USD 421 bn in March, which is equivalent to 1.8 times the country’s short-term financing needs.

Over the past five years, goods exports have declined by 4.4 percentage points to only 12% of GDP. In comparison, exports by Thailand, Malaysia and Vietnam accounted for 54%, 70% and 98% of GDP in 2017. The decline in Indian exports as a share of GDP reflects the decline in the prices of metal, steel, iron and oil. The majority of Indian exports are either simple or transformed

1 INR 550 bn in government bond issues, INR 570 bn in funds raised on financial markets, and INR 98.6 bn that will be drawn from the 2018/19 budget.

commodities 2 . As a result, its share of the world market has stagnated at 1.7% since 2011, after rising strongly in the period 1980-2011. To stimulate exports, the government announced last December that it was setting up an INR 54.5 bn programme to develop high labour intensive manufacturing exports (in order to boost employment). India has a comparative advantage when it comes to selling low tech but highly labour intensive products, such as textiles. Its export market share has tended to increase over the past ten years. To encourage the development of domestic production of products with high technology content, such as electronics, the government has raised import tariffs by 5 to 10 percentage points.

Johanna Melka [email protected]

2 In 2016, exports of commodities and transformed manufactured goods represented 37.6% and 26.1%, respectively, of total exports.

3- Risky credits have increased in public banks % of total loans outstanding

█ Banking sector as a whole █ Public banks

Source: RBI

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China Not the right time for a trade war Trade tensions between China and the US are growing. China continues to enjoy a very strong external financial position, and exports to the US account for only 4% of its GDP. Therefore, any implementation of tariff hikes by the US should have a moderate direct impact on China’s macroeconomic performance. However, protectionist measures could dampen its export growth and constrain the industry’s efforts to climb the value chain, whereas China is starting to see a slight loss of its world market share. Moreover, weaker-than-expected growth in exports and GDP could shake the determination of the authorities to slow the rise in domestic debt. China’s external accounts have been reshaped deeply in recent years as a consequence of the process of capital account opening and rebalancing of the economic growth model. China keeps a very solid external financial position, but small current account surpluses, declining export price competitiveness and slower export growth, net capital outflows and a less predictable exchange rate have become the new paradigm. The current rise in protectionism could represent an additional problem for the export sector.

■ Erosion of competitiveness

The current account surplus has narrowed steadily over the past decade and has remained below 3% of GDP since 2011. It declined further to 1.3% in 2017. The change in the current account balance has reflected a decline in the national savings-to-GDP ratio, which has been slow but still slightly faster than the decline in the investment ratio. Meanwhile, China has registered a structural reduction in its trade surplus and widening deficits in the balances of services and income (chart 2). These trends are expected to continue and the current account surplus is projected to slide towards 1% in 2018-2019.

The decreasing trade surplus as a percentage of GDP has highlighted the structural growth slowdown in Chinese exports and processing trade. The trade surplus increased again temporarily from 2012 to 2015 (both export and import volume growth slowed sharply while China’s terms of trade improved thanks to the fall in commodity import prices). But it has resumed its downward trend since mid-2016: total export growth has recovered but import growth has accelerated faster due to stronger domestic demand and rebounding commodity prices. The trade surplus reached 3.9% of GDP in 2017 (vs. 8.7% in 2007). It is projected to decline further in the coming years, in line with the rebalancing of China’s economic growth model.

Export growth turned positive again in 2017 after two years of contraction. However, the long-term trend in export growth is downward. Exports represented 18% of GDP in 2017, down from over 30% in the mid-2000s, and their average increase in value slowed to 6% per year in 2011-2017 from 30% in 2003-2008. The loss of momentum has stemmed from external factors (slower global demand growth, weakening pace of the international vertical specialization/expansion of global supply chains) and internal factors (rising production costs).

The export industry has lost price competitiveness over the past decade as the result of rising unit labor costs and the yuan’s

appreciation in effective terms. The deterioration was interrupted in 2015-2016: unit labor costs stopped increasing, the yuan depreciated, the decline in energy and industrial prices was carried over to production costs, and exporters squeezed their margins to maintain market shares. However, these dynamics reversed again in 2017, and export price competitiveness is expected to continue to deteriorate in the future.

China’s world market share declined slightly in 2016 and 2017, which can be seen as a blatant sign of the structural change (chart 3). The decline has been manifested by the share of total world exports for all goods (to 13.0% in 2017 from 14.0% in 2015) and for a series of manufactured products. For instance, China’s

1- Forecasts

e : BNP Paribas Group Economic Research estimates and forecasts 2- Current account surplus settled below 3% of GDP Balance, % of GDP

▬ Current account balance █ Trade balance █ Services █ Income

Source : SAFE

2016 2017 2018e 2019e

Real GDP grow th (%) 6.7 6.9 6.4 6.4


Official budget balance / GDP (%) -3.8 -3.7 -3.9 -3.6

Central gov ernment debt / GDP (%) 16.1 16.3 18.5 20.2


Total ex ternal debt / GDP (%) 12.6 14.0 13.6 13.7

Forex reserv es (USD bn) 3 011 3 140 3 275 3 325


Ex change rate USDCNY (y ear end) 6.9 6.5 6.2 6.1

-4

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0

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017


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share of world exports of electrical machinery and apparatus decreased from 20.1% in 2015 to 18.2% in 2016.

■ Rising protectionism

China should still be able to keep its position as a world leader for a number of industrial goods in the years ahead, especially thanks to continued efforts to maintain strong non-price competitiveness and, most importantly, climb the value ladder. Moreover, in the short term, export growth is projected to remain supported by stronger demand from developed countries.

However, external trade prospects are currently being increasingly darkened by the escalation of trade frictions between China and the US. The US administration’s recent announcements have included tariff hikes on a rapidly lengthening list of products (from steel and aluminum to chemicals, transport equipment, IT goods, etc.) and restrictions on Chinese FDI in high-tech sectors in the US. Rising protectionism and the mounting threat of a trade war have started to dampen global business sentiment.

If implemented, actions announced by the US should have a moderate direct impact on China’s macroeconomic performance: exports to the US account for 19% of its total exports and 4% of its GDP (about half is made up of machinery and transport equipment), and tariff hikes announced so far are on goods representing no more than 3% of Chinese exports. However, some sectors could be hurt, especially those that are particularly dependent on revenues from exports to the US (such as electronics and electrical machinery and lower valued-added sectors such as furniture and toys) and sectors that have strong export growth potential (such as aeronautics and railway equipment). Moreover, to what extent trade tensions will increase is currently highly uncertain: firstly, China has started to retaliate, even though it continues to show willingness to contain the risk of a trade war; secondly, tariff hikes will have second-round effects as they will spill over into other Asian countries through the region’s supply chains. All in all, this is really not a good time for China to face a rise in protectionist measures as they may increase the prices of its exports to the US, restrain its export growth in the short term and hamper its efforts to climb the value ladder. Last but not least, slower export growth and thus weaker-than-expected GDP growth could undermine the authorities’ determination to slow domestic debt growth and pursue corporate deleveraging efforts.

■ Capital controls have stabilized the financial account

In 2014-2016, the deterioration in economic growth prospects, changing expectations for the RMB/USD exchange rate and the global expansion of Chinese corporates have led to the rapid weakening in net inflows of foreign capital (lower FDI, net foreign debt repayments) and rising net outflows of resident capital (acquisition of overseas assets, capital flight). In turn, large net capital outflows triggered a rapid fall in forex reserves and currency depreciation while the authorities have resorted to an increasingly stringent enforcement of capital controls.

In 2017, tightening of capital controls, PBOC interventions in the forex market and renewed confidence amid stronger economic growth helped to stabilize exchange rate expectations. Net debt and portfolio investment outflows declined gradually thanks to the fall in resident capital outflows and a new rise in both foreign portfolio inflows and external borrowings by Chinese corporates. Moreover, net direct investment flows turned positive again, principally because Chinese overseas direct investment contracted in response to increasing restrictions. All in all, total net capital flows remained negative but narrowed significantly in 2017. Forex reserves picked up again during 2017, and the RMB rebounded, gaining almost 6% against the USD. The authorities succeeded in keeping the RMB relatively stable in nominal effective terms between the beginning and the end of the year. In the short term, the RMB should remain supported by favorable capital-account dynamics, but fx policy goals will also continue to be largely influenced by political factors. In particular, the authorities currently seem to be using currency appreciation as a tool to calm trade tensions with the US, but they could also opt for a more aggressive strategy in case the conflict worsens.

In 2018, net capital flows should remain negative but moderate: Outflows should still be limited by capital controls, and confidence may be supported by improved macro-financial conditions (assuming efforts to reduce corporate debt and financial risks continue). Meanwhile, inflows of foreign portfolio investment may be encouraged by new measures aimed at opening up domestic markets to foreign investors and by the inclusion of Chinese bonds and equities in some global benchmark indexes. However, there are downside risks: China remains vulnerable to sudden bouts of large capital outflows in case of internal shocks (brutal policy adjustments, sudden problem in the financial sector) or external trade/financial shocks. The escalation of trade tensions with its negative effects on export performance could be one of them.

Christine Peltier [email protected]

3- Export performance: cyclical rebound, long-term slowdown %

▬ Export growth, 3-month moving average, l.s. ▬ Import growth, 3mma ▬ Global market share, % of world exports, 12-month moving sum, r.s.

Source : SAFE

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6

8

10

12

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018


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South Korea Caution The situation improved in 2017: the election of President Moon Jae-In marked the end of the political crisis, diplomatic relations have calmed down and GDP growth has bounced back. The outlook is good in the short term but there are still a number of weaknesses. First, the lack of parliamentary majority could make it hard for the government to implement its proposed reforms. Secondly, maintaining a normal relationship with the United States and China while fending off the North Korean threat will be a major challenge. Lastly, although South Korea’s external financial position is robust, the economy still relies substantially on its export sector, which is exposed to the ups and downs of world trade and the rising tide of protectionism.

■ A new political thrust

The political situation stabilised during 2017. The impeachment of former President Park Geun-hye, overwhelmingly approved by Parliament in December 2016, was unanimously upheld by the country’s constitutional court in early March 2017. Fresh elections were held in May 2017, leading to the election of President Moon Jae-In, former leader of the Democratic Party. After his predecessor’s stormy mandate1, Moon Jae-In’s election was seen as a new departure. The “national reconciliation” programme proposed during the campaign met with strong popular approval.

At the same time, diplomatic relations with North Korea, the United States and China have gradually, if only slightly, improved. Some progress has been made under the “appeasement strategy” introduced by the new government since it came to power. Several meetings are scheduled to take place in 2018.

But diplomatic relations are expected to remain strained and we cannot rule out further tension.

■ An ambitious programme

As soon as it came to power, the government proposed a constitutional revision2 and a set of reforms aimed at creating fairer “income-driven growth”, while maintaining the previous government’s objective of promoting growth through innovation. The minimum wage increase (more than 15% to USD 7 an hour) was the first of these measures. Several further increases are envisaged during the new government’s mandate with the aim of gradually raising the minimum wage to USD 9.20 an hour in 2020.

The government’s other proposed measures aim to boost potential growth (estimated at about 3% by the IMF). The government’s main priority is to reduce youth unemployment (15-29 year-olds). Although the overall unemployment rate is relatively low, standing at 3.7% in March 2018 and below 5% since the beginning of the 2000s, youth unemployment is much higher at close to 10%. The government’s target is to reduce it to 8% in 2021. Several measures 1 During her mandate, which began in 2012, the former President was accused of incompetence and abuse of power, and was implicated in several bribery affairs. She was sentenced to 24 years’ imprisonment and KRW 18 billion for bribery, abuse of power and coercion on 6 April 2018. 2 The proposed reform comprises a series of varied measures, including reducing the presidential term from five to four years (renewable once), lowering the age of electoral majority from 19 to 18 years, and a decentralization process to increase local authority power.

have already been announced: by the end of the mandate, young people must make up at least 5% of the total workforce of all public institutions and various tax incentives have been introduced to encourage private companies (especially SMEs) to take on young workers. An additional budget of 0.2% of GDP, almost entirely earmarked for improving the working conditions of young people, was announced in early April.

In addition, measures to promote innovation (by supporting the development of SMEs and encouraging growth in the artificial intelligence technology sector) could accelerate growth in productivity. Lastly, a raft of social reforms aims to increase social

1-Forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- Youth unemployment remains high Unemployment rate, %

Total 15-29 years

Source: Bank of Korea

2016 2017 2018e 2019e

Real GDP grow th (%) 2.8 3.1 3.0 3.0

Inflation, CPI, y ear av erage (%) 1.0 1.9 2.0 1.9

Gen. gov . balance / GDP (%) 1.8 1.4 1.4 1.0

Gen. gov . debt / GDP (%) 38.6 39.6 39.5 39.5





Ex change rate USDKWR (y ear end) 1 160 1 130 1 150 1 150

0

2

4

6

8

10

12

2001 2003 2005 2007 2009 2011 2013 2015 2017

EcoEmerging// // 2nd quarter 2018 economic-research.bnpparibas.com

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protection and reduce inequalities (particularly wage differences between employees of conglomerates and large groups on the one hand and SMEs on the other, as well as an increase in the female labour participation rate).

Political uncertainty has therefore receded significantly, even though implementing the economic policy could prove difficult. The presidential party (Democratic Party, Minjoo) does not have a majority and coalitions could be hard to form. Constitutional reform launched last June and the additional budget proposed at the end of March by the government are currently held up in parliament due to lack of agreement. In addition, the small parties are reluctant to do anything before the planned mid-June elections (local and partial legislatives). However, the President’s strong popularity should help him to get most of his proposed reforms through without any major changes. For example, the 2018 budget vote (in December 2017) has been postponed but the proposals have all been accepted.

■ Economic growth to settle at around 3%

On the economic front, the domestic political crisis and geopolitical tensions appear to have had only a limited impact on growth and the financial environment, once again illustrating the robustness and credibility of the country’s institutions.

The growth outlook is relatively good for the next two years. After accelerating to 3.1% in 2017 from 2.8% in 2016, real GDP growth is expected to settle at about 3% in 2018 and 2019. Domestic demand will benefit from the recovery in investment started in 2017, while household consumption should be supported by the minimum wage increase and the set of social measures envisaged by the government.

Although constrained by high household debt levels, monetary policy should remain largely accommodative. The Central Bank raised its key policy rate in November 2017 for the first time in 16 months, to 1.5%. New macro-prudential measures were introduced in 2017 to slow down growth in household debt (95% of GDP in Q3 2017) and others are expected to follow in 2018. In the short-term, household debt does not present a systemic risk.

Fiscal policy is likely to remain less accommodative. The scope of growth stimulus plans introduced over the past ten years has been moderate, despite the comfortable fiscal policy leeway. The new proposed measures proposed are unlikely to buck this trend: according to government estimates, the budget deficit should remain contained until the end of the current mandate (in 2022) at about 2% (it was 1.7% of GDP in 2017 and 1.4% in 2016): this is excluding the social security fund (whose surpluses represent about 2.5% of GDP). Public debt will remain below 40% of GDP (it stood at 39.6% in 2017).

Lastly, driven by the recovery in global demand, exports continued to grow in 2017 (by almost 15%) and in Q1 2018 (by almost 11%). The current account surplus has fallen compared with the past two years (7.7% and 7.1% respectively in 2015 and 2016), but remains comfortable at over 5% of GDP.

The recovery should continue even though South Korea’s integration in regional and global value chains and the heavy exposure of its exports to the Chinese economy leave the export sector vulnerable to changes in global demand and the rising tide of protectionism.

However, the diplomatic lull has enabled South Korea to resume negotiations of its various trade agreements. At end-March, an in-principle agreement was reached on a revision of the bilateral trade agreement between South Korea and the United States (which represented 12% of total exports in 2017). The new agreement, which ultimately is not very different from the old one, will focus on opening up the automotive market in the United States (this sector accounts for more than one third of exports to the US). At the same time, in November 2017, the Chinese authorities partially lifted the ban on group travel to South Korea imposed in March 2017, and the two countries have embarked on discussions with a view to extending their bilateral free trade agreement to the services and investment sector.

Hélène Drouot [email protected]

3- Rebound in exports in 2017 %, y/y

█ ASEAN █ China █ United States █ Europe █ Rest of the World

▬ Total

Source : Bank of Korea

-20-15-10-505

101520253035

2011 2012 2013 2014 2015 2016 2017


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Poland Smooth sailing Poland’s economic indicators are excellent. Economic growth is the strongest since 2011. Consumption is bolstered by real wage increases and new social transfer programmes. Investment is accelerating thanks to the inflow of EU structural funds and an upturn in credit. The fiscal deficit is the lowest since 1995. Although the economy is operating at full employment, inflation is still mild and below the central bank’s target. Lastly, a compromise could be taking shape on the thorny issue of judicial reform, which has escalated tensions between Poland’s leaders and Brussels since 2016.

■ Record economic growth

Polish growth has surprised to the upside. Real GDP accelerated from 2.9% in 2016 to 4.6% in 2017, in line with the general acceleration trend in the region. In Q4 2017, real GDP growth reached 5.1% year-on-year (y/y), the fastest growth rate since year-end 2011.

Several factors have buoyed consumption, including wage increases, which rose 6% in real terms in 2017. A family allowance programme was also set up to help families with children. Launched in April 2016, it provides families with a monthly allowance of PLN 500 per child as of the second child. With a total outlay of EUR 10 bn since the programme was launched, Poland now ranks among the countries spending more than 3% of GDP on family policies. It has helped lower the child poverty rate from 9% in 2015 to 6% in 2016. The number of births also increased by 5% in 2017, which is another goal of the programme.

Investment rebounded after contracting in 2016, fuelled by the growing importance of projects co-financed with European funds. Investment grew by 6% in 2017. The number of projects submitted as part of European co-financing surged by 80% compared to 2016, and most of the funds are still to come. The projects are concentrated in the transport, energy transition and environmental sectors, with a special focus on small and mid-sized enterprises (SME).

Business in the construction sector is still going strong. The number of new units put on the market rose 9% in 2017, and continues to rise in 2018 (+10% year-on-year in the first 2 months of the year). There was also a double-digit increase in the number of new building permits (+17% in 2017). Investment growth should remain strong over the next 3 to 4 years.

■ Lowest fiscal deficit since 1995

The fiscal deficit narrowed to 1.3% of GDP in 2017, down from 2016, the lowest level since 1995. A buoyant and stronger than expected economic cycle and more active efforts to combat tax fraud led to higher tax inflows. Central government revenue increased 11% in 2017, much more than spending, which rose only 4% over the same period.

Public debt declined to 50.6% of GDP from 54.1% of GDP in 2016. It is likely to contract further in the years ahead thanks to vigorous economic growth and a moderate appetite for spending.

■ Full employment

Unemployment has continued to decline from its 2012 peak. In February 2018, the unemployment rate fell to a historical low of 4.4%, a level that has not been seen since 1990. Job creations hit a record high, up 3.5% in 2017. With 9 million jobs registered in Q3 2017, Poland is nearing the all-time high of 10 million jobs reported in 1990.

1-Forecasts

p: BNP Paribas Group Economic Research estimates and forecasts 2- Inflation and wages Year-on-year change, %

▬ Public sector wages ▬ Private sector wages ▬ HICP inflation

Sources: Poland’s Central Statistical Office, Eurostat, BNP Paribas

2016 2017 2018p 2019p

Real GDP grow th (%) 2.9 4.6 4.0 3.0

Inflation (HICP, y ear av erage, %) -0.2 1.6 2.2 2.6

Gen. Gov . balance / GDP (%) -2.5 -1.3 -1.9 -2.1

Gen. Gov . debt / GDP (%) 54.1 50.6 49.0 48.2

Current account balance / GDP (%) -0.3 0.3 -1.6 -1.6


Forex reserv es (EUR bn) 108.1 94.5 97.6 99.6


Ex change rate EURPLN (y ear end) 4.2 4.2 4.2 4.3

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The economy is operating at full employment, even as the active population contracted in 2017 for the second consecutive year. According to demographic forecasts, this decline is bound to continue. In the period 2018-2020, Poland’s active population will decline by an estimated 270,000 persons, and by 2030, the decline could reach 3.7 million. To offset this decline, the government wants to open the job market to more foreigners, notably from Ukraine. This tendency has already begun: the number of foreign workers, mostly Ukrainians, is currently estimated at one million.

■ Surprisingly low inflation

Inflation has picked up but remains low. After three years of deflation, the harmonised inflation rate rose to 1.6% in 2017. In the first 3 months of 2018, inflation was surprisingly low, at an average of 1% year-on-year, despite the acceleration in private sector wage growth, which rose 7% y/y in value in the first two months of 2018. Public sector wages were less dynamic which undoubtedly helped moderate inflationary pressures (chart 2).

Price inflation is holding below the National Bank’s target of 2.5% ± 1%, which justifies maintaining key policy rates at historically low levels. Consequently, monetary policy will continue to be accommodating and should stimulate activity in the quarters ahead.

■ A mild upturn in lending

With buoyant economic activity, rising income and low interest rates, the conditions are ideal for a rebound in credit. So far, however, lending growth has remained moderate: total loans to the private sector increased 4% y/y in February 2018. Unlike the 2006-2010 credit cycle, when the country experienced a large boom in lending to individuals, Polish banks are giving priority to corporate loans. The total volume of corporate loans increased by 7% y/y in February 2018 while household lending rose by a more moderate 2.7% y/y. In particular, housing loans have continued to lag, growing by no more than 2% in 2017 and in early 2018. This has helped slow the increase in housing prices (chart 3).

■ Tensions over judicial reform: towards a compromise?

Major judicial reforms introduced by the Law and Justice (PiS) party, which cover everything from the ordinary courts to the Constitutional Tribunal, the Supreme Court and the National Council of the Judiciary, have escalated tensions with the EU. Brussels sees these reforms as undermining judiciary independence, by placing it under tighter executive control and distorting the balance of powers of democratic institutions. After exhausting all recourse to dialogue without reaching an agreement, the European Union opted to use Article 7 of the EU Treaty, opening the possibility of sanctioning Poland for the violation of democracy and the fundamental principles of the European Union. Several proposals have been made, notably one freezing access to European Cohesion Funds for countries that do not respect judiciary independence. It will not be easy to effectively apply Article 7, a procedure that has never been used before, or to introduce other sanction mechanisms, because they must be approved by all member states, including countries that support Poland’s point of view, notably Hungary.

On March 22nd, the Polish authorities suggested that they could make amendments to some of the more controversial reforms, which might signal the beginning of a compromise with Brussels. Ordinary court and Supreme Court reforms could be amended to make them more compatible with EU principles. Court presidents and deputy presidents would be appointed and dismissed from their functions not by the Minister of Justice but via a two-phase consultation process, with a “judiciary college” and the National Council of the Judiciary. These proposals have been welcomed by Brussels.

Anna Dorbec [email protected]

3- Home loans and real estate prices Year-on-year change, %

▬ Housing loans ▬ Residential property prices

Sources: National Bank of Poland, BIS, BNP Paribas

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Argentina Policy fine-tuning is needed Argentina continued to report robust economic growth in H2 2017, and it clearly maintained this pace in Q1 2018. From the demand standpoint, economic growth should be somewhat better balanced than it was last year thanks to an upturn in exports. However, we can already see signs of overheating and tensions: domestic lending has increased sharply in real terms, the trade deficit has widened, and above all, inflationary pressures have picked up. For the time being, there is nothing alarming about the underlying savings-investment imbalance, notably because fiscal consolidation targets have been met. Yet the authorities are faced with a monetary policy dilemma that is typical of an emerging economy. More than two years have passed since Mauricio Macri took power in Argentina in November 2015. The economy swung back into growth in Q3 2016, and has been advancing at a rather robust pace ever since. Moreover, growth should be slightly better balanced this year than in 2017. Main macroeconomic trends, in contrast, are more mixed. The fiscal deficit is under tighter control, but inflation has accelerated again, after slowing sharply through mid-2017. Worse, even though exports of agricultural commodities are more dynamic, the trade deficit has widened sharply with the recovery of domestic demand and a persistently overvalued real exchange rate.

■ Signs of overheating have already emerged

In H2 2017, Argentina’s economy grew at an annualised rate of 3.5%, a mild slowdown compared to the first half (4.5%). Real GDP growth was 3.2% higher than the 2011-2015 average, a period that followed the 2009 global recession and 2010 rebound, but preceded Macri’s election. Between the Q2 2016 low and Q4 2017, real GDP grew by 5%, with private consumption and investment each contributing about 4 percentage points (pp) while net foreign trade made a negative contribution of 5.5 pp. Growth has tended to be unbalanced so far, although the rebound in investment is a very positive factor.

Indicators available since the beginning of the year (industrial output, construction sector activity, monthly GDP indicator, and the Torcuato di Tella University leading indicator of turning points in the business cycle) confirm the consolidation of growth (chart 2). One positive factor is the rebound in merchandise exports in the first two months of the year (+10.7% year-on-year, compared to 0.9% in H2 2017), not only for crude agricultural commodities (in line with the recovery in wheat, soya and maize prices) but also for manufactured goods excluding processed food products.

Credit to the economy also accelerated strongly (+55% year-on-year in January-February, up from 40% in mid-2017, and 30% in late 2016/early 2017), far outpacing both inflation (see below) and the peso conversion effect of USD-denominated loans (18% of total lending). At the macroeconomic level, the rebound in lending is not a problem in itself, since the penetration rate for domestic lending is low (15% of GDP). However, it becomes problematic when accompanied by a wider current account deficit, which is now the case. Merchandise imports in USD value rose to +33% in January-February, and +27% excluding oil. The trade deficit soared to USD 10.4 bn (CIF-FOB data) from USD 1.2 bn in June 2017. As a share of GDP, the trade deficit is still moderate (1%), but we must

also add the balance of trade on services, the so-called invisible balance (4%). The current account deficit has thus hit a level that requires supervision. We are not yet at an alert threshold, however, because the nature of the underlying imbalance between domestic savings and investment is not alarming, since investment contributes as much as consumption.

Argentina now offers better visibility. As a result, direct investment inflows (nearly USD 11 bn in 2017) should be able to offset the normalisation of net inflows of portfolio investment, which narrowed

1-Prévisions

e: BNP Paribas Group Economic Research estimates and forecasts 2- Activity indicators Year-on-year % change

▬ Real GDP ▬ Industrial production

▬ Construction sector activity - - - Di Tella advanced indicator

Sources : INDEC, GlobalSource

2016 2017 2018e 2019e

Real GDP grow th (%) -2.3 2.7 3.0 3.5

Inflation (official, annual av erage, %) 41.0 25.2 23.4 15.7

Fiscal balance/ GDP (%) -5.9 -6.1 -5.7 -5.1

Public debt/ GDP (%) 53.7 53.0 55.0 55.0





Ex change rate USDARS (y ear end) 15.8 18.8 22.5 23.0

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10

15

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018


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to about USD 8 bn per quarter from an average of USD 11 bn between Q2 2016 and Q1 2017. Foreign reserves continued to strengthen to nearly USD 62 bn at the end of March, with no further increase in external debt. However, Argentina’s external debt, which stood at USD 233 bn at year-end 2017, remains one of the highest in emerging countries; it accounts for more than 3 years of exports of goods and services.

■ Persistent inflation

Consumer price inflation accelerated again, rising from an average of 1.5% a month between May and November 2017 to 2.4% between December 2017 and March 2018. After bottoming out at 21.4% in July, year-on-year inflation rose to 25.4%. Core inflation also accelerated from 1.4% in November to 2.6% in March (22.4% year-on-year). The acceleration in headline and core inflation can be largely attributed to the increase in regulated prices – which contributed 8 percentage points to the 2017 inflation rate, compared to 12 pp in 2016 – as well as currency depreciation (the peso was down 2.5% per month on average against the US dollar between July 2017 and March 2018, compared to 0.3% in H1 2017). Consequently, the central bank has had to raise its inflation forecasts: from 8-12% year-on-year to 15% for December 2018, from 3-7% to 10% for December 2019 and from 3-7% to 10% for December 2020.

The central bank’s governor expects inflation will slow down by the end of the year, thanks to: 1) the end of regulated price increases (the last one occurred in April), 2) more moderate wage increases, which were negotiated based on official inflation targets as well as past inflation, and 3) a persistently cautious monetary policy (after easing in H2 2016, policy rates were raised during 2017 and the main key policy rate is now at 27.25%). The central bank will also continue to intervene in the forex market to support the peso, since the governor does not believe that the current downside pressure is justified by real shocks (decline in productivity, deterioration of competitiveness) nor by the shift in the policy rate trajectory following the revision of inflation forecasts.

This situation is not easy to analyse. On the one hand, changes in economic policy (i.e. lifting forex controls, unification of exchange rates, lowering some tariffs and fiscal consolidation) and the programmed elimination of monetary financing of the fiscal deficit are powerful structural factors of disinflation. On the other, the inertia of regulated price increases and supply-side constraints are persistent factors of inflationary pressure, even if they are cyclical and thus temporary.

■ Dilemma

At a time of rapidly accelerating credit growth, persistent inflationary pressure and deteriorating external accounts, macroeconomic stability largely depends on fiscal policy.

For the time being, the federal budget is being executed in keeping with the goal of reducing the primary deficit (i.e. excluding interest payments) from 3.8% of GDP reported in 2017 (vs a target of 4.2%) to this year’s target of 3.2%. At the end of March, the 12-month cumulative primary deficit was 3.6%. Most importantly, deficit

reduction was achieved through both higher revenues (excluding exceptional revenue generated from fiscal amnesty), up 2.2% year-on-year in real terms in Q1 2018, and a 5.5% cut in primary spending. We would like to make two reserves: 1) higher pension spending forced the government to reduce investment, and 2) interest charges rose again, to 2.2% of GDP, vs 1.6% in mid-2015. Estimated at 65% of GDP at year-end 2017, the unconsolidated public debt ratio has increased by 18 points of GDP since year-end 2015. Yet such a big increase should have triggered an even bigger increase in interest charges. In fact, long-term debt issues on international markets in US dollars have enabled the State to benefit from a negative apparent real interest rate on this part of the debt.

Argentina’s authorities face a dilemma that is particularly complex since the various components are intertwined: break the inflationary dynamics fuelled by the loss of credibility of inflation targets and currency depreciation, at the price of maintaining a restrictive monetary policy, yet without deteriorating external accounts through an appreciation of the real exchange rate that is higher than productivity gains. One possible response is fiscal orthodoxy (in any case, it would be better than a restrictive monetary policy that is sub-optimal in terms of growth and financial stability). Another is to pursue structural reforms (deregulation of the goods and labour markets; incentives for investment in physical and human capital), which is not only preferable socially, but indispensable in terms of economic effectiveness.

François Faure [email protected]

3- Inflation and exchange rate Year-on-year % change

▬ Consumer price index, private source ▬ Officiel Consumer price index ▬ Nominal effective exchange rate, r.s. (inversed)

Sources : INDEC, GlobalSource

-45-40-35-30-25-20-15-10-5051015200

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2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018


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Egypt Gradual monetary easing After the Egyptian pound’s floatation in November 2016, the Central Bank of Egypt (CBE) drastically tightened its monetary policy. Inflation has fallen regularly since Q3 2017, and should meet the central bank’s target. Money supply is growing at a relatively fast pace, bolstered by capital inflows. Maintaining interest rates at a high level is placing a major strain on lending growth, and the monetary easing that began in 2018 will continue gradually. The ongoing decline in inflation is still vulnerable to higher energy prices, and external financing constraints are still high.

■ Monetary consequences of the pound floatation

Egyptian pound floatation had two consequences at the monetary level: inflation increased sharply and money supply growth accelerated. The average annual inflation rate more than doubled in fiscal year 2016/17 to 23%, from 10% the previous year. This increase is largely due to import prices (notably food products), although the energy subsidy reform also contributed.

Inflation was also driven up by monetary factors. The increase in foreign currency inflows in the economy (portfolio investment inflows rose from virtually non-existent levels to USD 16 bn in 2016/17 and USD 8 bn in H1 2017/18) and the return of foreign currency liquidity into the banking system (following exchange rate market unification) contributed to the acceleration in the M2 money supply aggregate. Taking into account the exclusion of the exchange effect on the foreign currency components of M2 money supply, the later accelerated to an annual growth rate of about 24%, compared to an average of 18% in the year prior to the pound’s float. Note, however, that although the acceleration in foreign currency inflows contributed to swell M2, claims on the government were the main contributor through October 2017.

■ Significant tightening of monetary policy

The CBE’s main two objectives are price stability and the management of inter-bank liquidity (the two objectives are obviously linked). The tools for managing interbank liquidity include an interest rate corridor (the overnight lending rate is its key rate) and open market operations. With the pound floatation, monetary policy was drastically tightened. Between November 2016 and July 2017, the CBE increased its key rate by 700 basis points (bp) to 19.25%. Initially, this attracted international investors to the local government debt market. At year-end 2016, there was a strong transmission between CBE rates and T-bill rates given the lack of diversified sources of government financing. Thereafter, key rates were raised to cap inflation, notably second round effects arising from wage growth. For major private sector companies, wages rose 15-20% on average in 2017.

The CBE also proceeded with open market operations to absorb excess liquidity in the banking system. This took the form of short-term deposit facilities for commercial banks.

■ Inflationary pressures have eased, but challenging control of money supply

Consumer price inflation began to decline in late 2017. After peaking at 33% in July 2017, the year-on-year CPI rate dropped to 13% in March (although the average annual rate was 26%).

Money supply continues to expand at a rapid pace. Open market operations have currently increased to the equivalent of 20% of M2 money supply, from an average of 7.8% in the year 2015/16. The

1-Forecasts*

* Fiscal year: T-1/T (from July to June) e: BNP Paribas Group Economic Research estimates and forecasts 2- Inflation Year-on-year % change

▬ Headline ▬ Core

Source: Central Bank of Egypt

2016 2017e 2018e 2019e

Real GDP grow th (%) 4.3 4.2 5.0 5.5



Gen. Gov . debt / GDP (%) 96 103 89 88


Ex ternal debt / GDP (%) 17 36 39 37



Ex change rate USDEGP (y ear end) 7.4 8.8 17.5 17.0

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2015 2016 2017 2018


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contribution of government debt has fallen significantly since mid-2017, thanks to the reduction in the fiscal deficit and the issue of Eurobonds in international markets. At the same time, the strong improvement in foreign currency liquidity in the banking system continues to contribute to M2 money supply growth. Over the past three months, it was still averaging 1.7%, compared to a 2017 average of 1.8%.

■ Recent trends in domestic lending

By conducting a restrictive monetary policy, the CBE was trying to curb the increase in lending and to address its financial stability objective, in addition to its price stability mandate. In real terms, domestic lending fell slightly at first before swinging back into growth in late 2017. The real growth of lending to the private sector in the local currency (two thirds of total private-sector lending) was negative starting in November 2016, and only became slightly positive again in December 2017 (0.5% for the year). Lending to the industrial and services sectors remained positive in 2017 (at about 5% for the year to December) and was mainly used to fund working capital expenditures. In contrast, household lending dropped sharply, down 11%. With the reduction in the fiscal deficit and the growing use of external financing, claims on the government stopped progressing and actually declined 13.7% in real terms in late 2017.

It is hard to evaluate the impact of higher interest rates on loan demand. The Egyptian economy has a low banking penetration rate (15%). Yet we can affirm that it had a negative impact on corporate investment. First, despite exchange rate unification, the lack of corporate visibility encourages cautious behaviour. Second, the high return on bank deposits discourages productive investment.

■ Monetary easing will remain gradual

Monetary policy began to ease in Q1 2018 (-200 bp) and is expected to continue throughout the year, albeit at a moderate pace. Upward pressure on M2 money supply should level off in the short term with the slowdown in foreign capital inflows. Moreover, monetary financing of the fiscal deficit by the CBE (equivalent to 25% of M2 in June 2016) is no longer expected to be a source of money supply growth since the finance minister has pledged to no longer resort to this type of financing. The ongoing improvement in the public accounts is also expected to reduce the government’s financing needs.

Yet inflationary risks cannot be completely ruled out. The CBE’s target of average inflation equivalent to 13% (+/-3%) in December 2018 seems reasonable, despite further cuts in energy subsidies in H2 2018. A higher than expected increase in oil prices is the main factor that could jeopardise this target. The exchange rate’s upside potential also seems to be limited, even though capital flows should continue to provide support in the short term. In the medium term, the current account balance will remain negative, and portfolio investment should stabilise at best, given the expected decline in returns in the local currency. Direct investment, in contrast, should continue going strong, buoyed by bright prospects in the energy sector. Lastly, Egypt will continue to benefit from abundant multi and bi-lateral financial support.

In any case, in the short term it is in Egypt’s interest to limit the currency’s appreciation in order to maintain the country’s attractiveness with international investors.

All in all, CBE key rates could be lowered by as much as 400 basis points over the course of 2018. This would help preserve the attractiveness of local currency domestic debt while leaving real interest rates in positive territory (3.6% according to our estimates). The spread between real interest rates and the expected growth rate in 2018/19 (5.5%) should gradually contribute to a reduction in the public debt as a percentage of GDP. Given the limited risk of overheating due to domestic factors (loan penetration is limited structurally, and household purchasing power has eroded) and the expected appreciation of the Egyptian pound, monetary policy could be eased even further if external constraints were to be reduced (i.e. an improvement in the sovereign rating in foreign currency).

Pascal Devaux [email protected]

3- Contributions to M2 growth %, excluding fx effect

█ CBE net foreign assets █ Commercial banks net foreign assets

█ Net government debt █ Net public business sector debt

█ Net private sector debt █ Other factors ▬ M2 money supply (y/y)

Sources: Central Bank of Egypt, BNP Paribas

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0,2

0,3

0,4

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2011 2012 2013 2014 2015 2016 2017 2018


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United Arab Emirates Positive economic prospects In a less buoyant regional environment and at a time of fiscal consolidation, economic growth has remained positive even though it slowed in 2017. Thanks to a mild upturn in oil prices and fiscal stimulus in 2018, the economy should gradually return to more robust growth, despite some persistent geopolitical and economic uncertainties. The country’s fiscal position is still precarious, but the government’s solvency is solid. In the medium term, the public sector’s external debt should continue to swell. The Emirates benefit from favourable financing conditions, which will facilitate ongoing efforts to diversify the economy.

■ Dubai is still the main economic growth engine

In 2017, the United Arab Emirates (UAE) reported the lowest economic growth rate since the 2009 crisis. Real GDP rose by only 1.1%, undermined by the decline in oil GDP (-1%), reflecting OPEC restrictions on oil production, and sluggish non-oil activity (70% of total GDP). Non-oil GDP rose by only 2% in 2017, compared to an average of 4.6% in 2012-2016. This was the lowest growth rate among the countries of the Gulf Cooperation Council (GCC), excluding Saudi Arabia. The UAE’s underperformance can be attributed to the negative impact of Abu Dhabi’s fiscal consolidation (57% of total GDP) while Dubai’s economic growth was sapped by a depressed oil environment and regional political tensions. Dominated by services and very open internationally, Dubai’s economy is particularly sensitive to fluctuations in the regional political situation.

In Abu Dhabi, the introduction of new taxes on expatriates and on several consumer goods had a negative impact on private consumption. In Dubai, the tourism industry experienced another bad year, even though the situation has improved compared to 2016. Hotel turnover declined 3.5%, after plunging 10% in 2016, and hotel occupancy rates increased slightly, by 0.5%. In 2017, the airport activity reported the weakest growth ever (+5.5%). Tourists from the GCC countries (20% of the total) dropped off sharply, with a 6% decline in the number of Saudi tourists (the second biggest source of tourists after India). In general, the economic impact of the Qatar embargo was limited (trade with Qatar accounts for less than 1% of UAE foreign trade), although it had a non-negligible impact on business in Dubai’s services sector. Consumer spending by Qatari tourists (the 4th biggest contributor in 2016) dropped by 42%. In the construction sector, business was still going strong, even though house prices continued to decline in 2017.

■ Growth is expected to accelerate moderately in 2018

The economic rebound forecast for 2018 should remain moderate. Considering that OPEC’s 2017 production agreement was renewed by member countries, oil GDP is expected to remain flat. Non-oil activity should get a boost as Abu Dhabi relaxes its fiscal consolidation efforts and Dubai’s economy enjoys a more growth-supportive environment. VAT was introduced in January 2018, but at a reduced rate of 5% and with numerous exemptions.

The oil cycle is expected to improve (with a 19% increase in the average crude oil price this year) and the region’s fiscal policy is

expected to be more accommodating, which should have a favourable impact on tourism and real estate. Dubai also has another growth engine: ongoing investment in preparation for the 2020 World Expo. About USD 7 bn (5.7% of Dubai’s GDP) has been allocated to this event.

Yet short-term economic indicators are still mixed. PMI has declined since November 2017, although it is still comfortably in positive territory (54.8 in March 2018). Bank lending to the private sector continued to increase at a sluggish pace. Lending to quasi-public entities declined, at an annualised rate of -9.7% in February 2018,

1-Forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- Real GDP growth (%)

▬ Hydrocarbons ▬ Non-hydrocarbons ▬ Total

Sources: Department of Economic Statistics, BNP Paribas

2016 2017 2018f 2019f

Real GDP grow th (%) 3.0 1.1 3.0 3.7


Gen. Gov . balance / GDP (%) -4.3 -1.7 1.0 0.0

Gen. Gov . debt / GDP (%) 21 21 19 18


Ex ternal debt / GDP (%) 65 69 66 65



Ex change rate USDAED (y ear end) 3.67 3.67 3.67 3.67

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while growth in private sector lending was barely positive at 1.4%. The current upturn in US interest rates risks limiting any attempts at a rebound in lending. The dirham’s peg to the dollar means that the UAE central bank must follow US monetary policy. The 3-month interbank rate has increased by more than 90 basis points (bp) since October, to 2.46%.

The economic recovery in 2018 is still vulnerable to several factors: oil price trends, Saudi Arabia’s economic recovery, the risk of depreciation of the rouble (Russia was the 4th biggest foreign contributor to consumption in Dubai in 2017), and the evolution of sanctions on Iran (the UAE’s 5th largest trading partner).

■ Fiscal expenditure remains under control

In 2017, the UAE reported a fiscal deficit for the third consecutive year (1.7% of GDP). With the expected upturn in oil-related fiscal revenues in 2018, the government should be able to generate a small surplus (estimated at 1% of GDP). The government’s financial position is still very comfortable. Government debt is estimated at 21% of GDP in 2017, while external assets are estimated at nearly two times GDP.

Fiscal consolidation efforts are expected to continue, notably in Abu Dhabi (about 70% of the UAE’s consolidated budget), albeit at a slower pace than in previous years. The government intends to increase spending on education and healthcare. Tax increases should be more moderate this year, but efforts to streamline the public sector will continue. In 2017, the government launched major mergers in the banking sector and between sovereign funds. Dubai has clearly adopted a more expansive budget. It intends to increase total expenditure by 20%, with a 47% increase in infrastructure spending, notably in preparation for Expo 2020.

Despite fiscal consolidation efforts engaged since 2015, public finances will continue to be highly vulnerable to oil price fluctuations in the medium term. A large part of current expenditure is hard to curb, and the impulse of economic activity is still largely dependent on the state. So far, the introduction of new taxes has only generated a small increase in non-oil tax revenues compared to fiscal revenues as a whole. The introduction of VAT in January 2018 is likely to yield the equivalent of 1.5% of GDP. In the medium term, given the mixed outlook for oil prices and the upward pressure on public spending, the fiscal balance should be slightly positive at best.

■ Public debt is high but sustainable

General government debt is moderate but total public-sector debt is large. This is mainly due to the period of excessive debt run up by Dubai conglomerates over the previous decade. According to IMF estimates, Dubai’s public debt (including entities in which the government’s stake exceeds 50%) was equivalent to 111% of GDP (25% of GDP in Abu Dhabi). In 2018, debt repayment obligations will be high in Dubai (equivalent to 26% of Dubai GDP), but it will be rolled over.

Faced with higher domestic interest rates and favourable financing conditions in international markets, public-sector external debt should continue to rise in the medium term. The Abu Dhabi government made two Eurobond issues in 2016 and 2017 (USD 10 bn), while some state-owned companies (ADCOP and Investment Corporation of Dubai) issued sizeable foreign debt amounts. Financing needs will remain high given the fragile fiscal position and ambitious investment projects. The Abu Dhabi National Oil Company (ADNOC) plans to spend USD 109 bn on refining, petrochemicals and natural gas exploration over the next five years.

The UAE’s medium-term growth prospects are positive, thanks notably to the complementary nature of the different Emirate economies. Abu Dhabi continues to develop its downstream oil sector, which will enhance the value of its hydrocarbon resources. In Dubai, tourism is still a core business, but other sectors are also showing encouraging prospects. Dubai is increasingly positioning itself as a regional hub for the high-tech sector.

Pascal Devaux [email protected]

3- Financing conditions

▬ 5-year CDS spreads, Abu Dhabi (basis points, lhs)

▬ 3-month EIBOR (%)

Sources: Thomson Reuters, CBUAE

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0,5

1

1,5

2

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20

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60

80

100

120

140

2015 2016 2017 2018


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Tunisia Alarming deficits The year 2017 ended with record high twin deficits, which brought the exchange rate and inflation under fierce pressure. Strengthening macroeconomic stability will be hard to achieve. The authorities have very little manoeuvring room. Foreign exchange reserves have fallen below the threshold of three months of imports. The central bank has tightened monetary policy at the risk of increasing the squeeze on bank liquidity, but the impact on inflation will remain small as long as the dinar continues to depreciate. Fiscal consolidation also promises to be a difficult process. Between social pressures, conditions imposed by the IMF and a high public debt, the government has no other option but to reduce the fiscal deficit.

The economy has regained slight momentum but remains very fragile. After two years of virtual stagnation, real GDP growth picked up to 1.9% in 2017 as tourists began returning to the country. Although the recovery is expected to firm in the short term, it will only be gradual and too weak to absorb an unemployment rate that has culminated at 15%. There are numerous sources of tensions. Security issues have diminished but have not disappeared. The electoral cycle is intensifying in the midst of fierce social pressure, which risks derailing the reform process. Above all, the worsening of macroeconomic stability is a source of concern. Between rising inflation, low foreign exchange reserves and rapidly swelling public debt, the accumulation of high twin deficits is placing an increasingly heavy strain on the economy.

■ Inflation accelerates as the dinar plunges

Inflation picked up sharply in 2017 fuelled mainly by the 16% drop in the dinar (TND) against the euro (chart 2). The average annual inflation rate rose to 5.3% from 3.7% in 2016. It has accelerated constantly to reach 7.1% in February 2018, the highest level in 20 years. Above 6%, inflation exceeds nominal non-farm wage growth in the private sector, which in turn erodes real disposable household income.

This situation poses numerous problems to the monetary authorities. The Central Bank of Tunisia (CBT) raised its key policy rate by 75 basis points (bp) in March 2018, after a similar move in 2017, but at 5.75%, the real interest rate is negative. Further hikes are likely in the short term. But the move should be modest to avoid placing more pressure on a banking sector that is already facing strong liquidity challenge. The money market rate climbed to 6% in March, its highest level since 2001. At the same time, banks have increased their reliance on central bank refinancing, which rose from TND 7.7 bn in Q1 2017 to TND 12.3 bn in Q1 2018, and are so more vulnerable to the risk of monetary policy tightening.

Moreover, rate hikes would do little to contain imported inflation should the currency remain under pressure. The Tunisian financial market is not very attractive due to numerous restrictions on portfolio investment flows. Moreover, the ability of the CBT to defend the currency is increasingly limited. Given the low level of foreign reserves, the monetary authorities had to scale back their interventions in the foreign exchange market in 2017. The IMF has long been arguing for a more flexible foreign exchange regime. However, the central bank is concerned by this situation and decided to impose restrictions on local banks’ lending for the

importation of 220 consumer products that were not considered to be a priority. Given the magnitude of the external imbalances, this measure has little chance of being very effective. In other words, the TND will continue to depreciate against the euro in 2018, and as a corollary, inflationary pressures will remain high.

■ High external vulnerability

Tunisia’s external position is precarious. The year 2017 ended with a record high current account deficit of 10.5% of GDP. Figures on external trade in volume for the first 2 months of 2018 (+19% for exports, +1% for imports) suggest that the effects of the TND’s

1-Forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- Monetary indicators

▬ EURTND ▬ Inflation, r.s. ▬ Policy rate, r.s.

Sources: BCT, Datastream

2016 2017e 2018e 2019e

Real GDP growth (%) 1.0 1.9 2.5 3.0

Inflation (CPI, year average, %) 3.7 5.3 6.4 5.5

Central Gov. balance / GDP (%) -6.2 -6.0 -5.5 -5.0

Central Gov. debt / GDP (%) 62.4 70.6 72.6 73.9


External debt / GDP (%) 69.2 77.4 82.1 85.0

Forex reserves (USD bn) 6,0 5,6 5,8 6,1

Forex reserves, in months of imports 3.3 3.0 2.9 2.9

Exchange rate USDTND (year end) 2.34 2.46 2.61 2.74

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depreciation are beginning to pay off. But any quick turnaround is unlikely.

There are several reasons for this. The manufacturing sector’s steady loss of market share in Europe and disturbances in mining regions have considerably weakened the country’s export performance. The drop in phosphate exports to USD 600 mn in 2017 from USD 1.5 bn in 2010 has been highly detrimental, and a full recovery of export losses will take time, without counting the risk that new protests could prevent production from resuming.

A similar observation can be made for the tourism industry. Although the number of tourists has returned to pre-terrorist attack levels, revenues generated by the sector amounted to only 2.9% of GDP in 2017, compared to 4.5% in 2014. Import pressure will also remain strong. On the one hand, a tighter fiscal policy could moderate demand. On the other, the increase in oil prices, even modest, will aggravate the already high energy deficit. It rose to 4.1% in 2017 up from 1% of GDP in 2010, because of a 50% decline in national hydrocarbon production.

The current account balance will thus continue to post a sizeable deficit, estimated at 10% of GDP in 2018 and 8.9% in 2019. Covering external financing needs will be problematic. The government plans to issue between USD 1 bn and USD 1.5 bn in Eurobonds soon. Yet with a risk premium of 300 bp, and with Moody’s once again downgrading Tunisia’s sovereign rating to B2, it is a costly strategy with an uncertain outcome. Given the lack of visibility, foreign investors are also expected to maintain a wait-and-see attitude. Net FDI flows are relatively stable at about USD 1 bn, which barely covers 25% of the expected current account deficits in 2018 and 2019. Under these circumstances, international donor funds will be crucial for halting the erosion of external liquidity. According to the latest BCT figures, foreign exchange reserves are now below the alert threshold of 3 months of imports of goods and services (chart 3), which keeps the economy highly vulnerable to cope with exogenous shocks.

The accumulation of large current account deficits also means that external debt could reach 85% of GDP in 2019, up from 50% in 2010, a situation that looks less and less sustainable even if the bulk of financing flows are still at concessional rates.

■ Little fiscal manoeuvring room

The deterioration of public finances is also a major source of concern. The 2018 finance bill is ambitious. After two fiscal years marked by large slippage, the goal is to trim the deficit to 4.8% of GDP against 6% in 2015 and 2016, thanks to tax increases and more controls on spending.

Yet there is very little manoeuvring room. On the one hand, the announcement of cuts in subsidies triggered violent protests in January 2018. The government has made minor concessions in the form of social expenditure accounting for only 0.6% of the budget. Although calm has since been restored, social pressures will remain strong especially as local elections approach in 2018 and general elections in 2019.

On the other hand, there is no real alternative. Public debt rose from 44% of GDP in 2010 to 70% in 2017. The government’s investment capacity is restricted by the public sector wage bill, which now absorbs 67% of fiscal revenues, up from 53% in 2010. Above all, the consolidation of public finances is one of the IMF’s top priorities. Without support of the international community, the government would have difficulties to cover its deficit as the local capital market is shallow. The average cost of domestic debt was 6.4% in 2017, compared to 2.8% for external debt. Maturities are also shorter.

Consequently, the government will surely make the necessary efforts to go ahead with fiscal reforms, although it should not fully comply with its targets. With a budget deficit expected to come at 5.5% of GDP in 2018 and 5% in 2019, public debt will continue to swell (to 74% of GDP by year-end 2019), albeit at a slower pace than over the past two years. Downside risks are still significant, including due to the debt’s high vulnerability to exchange rate fluctuations (2/3rd of the debt is denominated in foreign currency). Given the financial fragility of state-owned companies, high contingent liabilities (about 12% of GDP) are another factor that must be taken into consideration in the analysis of public debt sustainability.

Stéphane Alby [email protected]

3- Foreign exchange reserves

█ USD bn ▬ Months of imports of goods & services, r.s.

Sources: CBT, INS, BNP Paribas

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South Africa A new start Cyril Ramaphosa became South Africa’s new President in February 2018, which created a positive confidence shock. The formation of a new government, the presentation of the 2018-2019 budget and the announcement of structural reforms ended a long period of political uncertainty, restored investor confidence, strengthened the rand and paved the way for improvements in public finances. In the short term, renewed confidence should boost economic growth. If the recovery is to extend into the medium term, however, the country must successfully introduce major structural reforms that are essential for raising the potential growth rate. The new administration, and the ones to follow, face a daunting challenge. Cyril Ramaphosa’s designation as South Africa’s President in February 2018 brought a long period of political uncertainty to an end, restored market confidence, triggered a rebound in financial variables and paved the way for improvements in the country’s macroeconomic performance. Above all, the announcement of a series of reforms raises hopes for a turnaround in public finances, an acceleration in economic growth and a reduction in corruption. The new government must now get to work to tackle the daunting tasks that lay ahead.

■ Ramaphosa triggers a virtuous circle

The election of Cyril Ramaphosa as the ANC’s new President in December 2017 and then as South Africa’s new President in February 2018 (following the resignation of Jacob Zuma) marks a turning point in South Africa’s political history. His election seems to have reduced the political uncertainty and the risk of sliding into populist economic policies that had plagued the Zuma presidency. President Ramaphosa has rapidly formed a new government, appointed new leaders to head certain state-owned enterprises and announced major fiscal adjustments for 2018. He has also given priority to judicial investigations and cases seeking to end the “State capture” system (under which state resources were plundered by a corrupt network of political cronies in the Zuma circle working under the influence of the Gupta family).

As a result, South Africa has managed to avoid a much feared downgrade of its sovereign rating (for both the foreign currency and local currency denominated debt) by Moody’s during its March 2018 review. Standard & Poor’s and Fitch had already downgraded South Africa’s sovereign rating to speculative grade in 2017. As long as Moody’s maintains its investment grade rating, the country is spared a massive sell off of sovereign debt instruments (90% of which are denominated in local currency) resulting from regulatory constraints and index-linked portfolio management. According to the Institute of International Finance (IIF), should Moody’s had downgraded South Africa’s local currency-denominated sovereign rating to speculative grade, it would have triggered the sale of up to USD 8.5 bn in bonds (or about 5% of South African government debt issued in the local market).

With the upturn in investor confidence, the rand (ZAR) has appreciated against the US dollar. It has gained 11% since Ramaphosa’s election at the head of the ANC on 18 December. Bond yields have also fallen sharply, ending the fierce tensions of previous months (chart 2).

■ Economic policy adjustments

Thanks to the easing in financial and fx market conditions, the central bank has gained some room of manoeuvre that it has not seen for a long time. Given sluggish economic growth and currency appreciation since early 2017, inflationary pressures have decreased. Consumer price inflation dropped from 6.7% year-on-year in December 2016 to 4% in February 2018. Inflation is expected to pick up again in the months ahead (due to stronger domestic demand and an increase in VAT), but it should remain within the authorities’ target band of 3% to 6%.

1- Forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- Financial markets regain confidence Exchange rate (against USD) and bond yields (%)

▬ USDZAR, l.s. ▬ 10-year sovereign bond yields, r.s.

Source: Central bank

2016 2017 2018e 2019e

Real GDP grow th (%) 0.6 1.3 2.0 1.5



Gen. Gov . debt / GDP (%) 50.7 54.2 55.0 56.4



Forex reserv es (USD bn) 42.6 45.0 50.0 50.0


Ex change rate USDZAR (y ear end) 13.7 12.1 12.4 12.7

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The central bank did not lower its key policy rate before the end of the political crisis and until there was less risk of new pressures on the exchange rate. The repo rate was cut by 25 basis points to 6.5% in March 2018, for the first time since July 2017, and another moderate decline is possible before the end of 2018. Monetary policy easing, coupled with the rebound in business confidence, could trigger an upturn in bank credit in the short term. After weakening in 2016, bank lending growth did not rebound very much last year (+6.7% year-on-year at the end of 2017).

Fiscal policy, in contrast, has become more restrictive. Fiscal adjustment measures will constrain economic growth, but they seem to be needed for reducing fiscal deficits and improving public debt dynamics, which in turn will help consolidate investor confidence.

Public finances have eroded in recent years mainly due to very weak GDP growth and rising interest payments on debt. The total central government deficit was estimated at 4.6% of GDP in the 2017-2018 fiscal year (ended 31 March 2018), compared to 3.9% in 2016-2017. The primary deficit (before interest payments on debt) swelled to 1.2% of GDP, from 0.5% the previous year. The government actually has extremely little manoeuvring room to contain deficits. This is due to several factors, including: sluggish fiscal revenues (slower-than-expected revenue growth in 2017-2018 was partly to blame for the wider deficit), high spending (notably on public sector wages, which account for 40% of government expenditure excluding interest payments) and the debt servicing charge.

At the end of fiscal year 2017-2018, government debt was estimated at 54% of GDP (compared to less than 30% of GDP in 2009). To this we must add the contingent liabilities resulting from the debt of state-owned enterprises; some of them are in dire financial trouble, notably the Eskom electricity company.

The 2018-2019 budget presented in February raises hopes for improvements in public finances in the short and medium terms. The fiscal adjustment planned in 2018-2019 hinges mainly on higher taxation (including an increase in the VAT rate by 1 percentage point to 15% and a rise in the general fuel levy). The 2018-2019 budget also calls for the reallocation of spending in favour of certain social expenditures (such as fee-free higher education offered to low-income families). The central government deficit should narrow in 2018-2019, but will still hold close to 4% of GDP.

■ Economic growth picks up… a bit

Economic growth has slowly picked up since it bottomed out in Q1 2016 (chart 3). It rose to 1.3% in 2017 from 0.6% in 2016 (the Statistics Institute just revised its GDP series for 2014-2017). The main growth engine for the recovery has been domestic demand. Private consumption made the biggest contribution to growth in 2017, buoyed by the increase in employment and the upturn in real wages. Investment began making a positive contribution again in 2017, after contracting in 2016, but it is still very mild. The rebuilding of inventories, thanks notably to good farm harvests, also made a positive contribution to growth. Net exports, in contrast, made a negative contribution in 2017: import volumes rebounded after declining in 2016, while export volumes remained flat. In value

terms, in contrast, export performance benefited largely from the upturn in commodity prices. Total exports rose by 19% in 2017 after contracting by 8% in 2016.

Real GDP growth should continue to recover slowly and reach 2% in 2018. Renewed investor and household confidence will boost domestic demand, real wages should benefit from disinflation and the minimum wage increase, and lending conditions should become more favourable for growth. Higher taxes, in contrast, should have a restrictive impact on private consumption.

Any economic growth acceleration will mainly remain held back by major structural headwinds, such as the lack of infrastructure and skilled labour, sluggish investment and labour market rigidity. In the medium term, it is vital to introduce major structural reforms to raise South Africa’s growth potential. The reform measures announced by the new government are reassuring. However, while there is a broad consensus over the need to eradicate corruption at the government level, it is more fragile on other subjects. The Congress of South African Trade Unions (Cosatu) and the far left political party the Economic Freedom Fighters (EFF) could oppose certain public sector and labour market reforms. The ANC might also hesitate to throw in its support for unpopular measures in the run up to national elections in 2019. As of today, the ANC’s victory seems to be far from certain given the steady erosion of its voters’ support over the past decade.

Christine Peltier [email protected]

3- A timid recovery GDP growth, year-on-year (%) and contribution to growth (percentage points) *

▬ Real GDP, y/y █ Household consumption █ Government spending █ Investment █ Change in inventories █ Net exports

Source: Statistics South Africa * The residual component is not shown

-4

-2

0

2

4

6

2011 2012 2013 2014 2015 2016 2017


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Ethiopia A paper tiger In the midst of an economic transformation, Ethiopia is the fastest growing country in Sub-Saharan Africa, thanks to major public infrastructure investments. But this robust activity hides major macroeconomic imbalances and the vulnerability of the country to fluctuating weather conditions and commodity prices. Low foreign exchange reserves and high current account deficits remain a major source of concern despite the birr’s recent devaluation against the dollar. Above all, an increasingly tense political climate could slow the country’s economic development.

■ Strong will for economic development

Ethiopia, Africa’s second most populous country after Nigeria, has reported average annual GDP growth of about 10% for the past ten years. Whilst this growth seems solid actually it follows the 2002/2003 recession, a period associated with drought, famines and conflicts with neighbouring countries. Growth has been notably fuelled by debt relief provided in 2002 (about 40% of GDP) as part of the Heavily Indebted Poor Country Initiative, in exchange for reforms to reduce poverty. Above all, the recovery has been attributed to strong government intervention, with three successive economic development plans since 2002 and a controlled expansion of the private sector. To attract investors, the government has also limited fluctuations in the birr (ETB), the national currency.

Yet there is still a sizable gap between the government’s ambitions and Ethiopia’s economic reality. Although GDP per capita has tripled in 10 years, it is still very low (USD 860 in 2017). The country’s main social-economic pillar is still agriculture, which accounts for 40% of GDP, 80% of jobs and 65% of exports (mainly coffee, corn and livestock), and is highly vulnerable to periods of drought. The secondary sector is small (15% of GDP) due to a poorly trained and overly rural labour force, and the lack of infrastructure1. The tertiary sector (45% of GDP) is driven by state-owned companies in the banking, tourism and transport sectors.

Ethiopia’s second Growth and Transformation Plan (2015-2020)2 supports public investment in infrastructure and industrial zones to stimulate the manufacturing sector. According to IMF estimates, the country attracted more than USD 4 bn in foreign direct investments (FDI) in 2017 – almost double the 2016 figure – mainly in industrial parks and infrastructure.

Yet despite the government’s determination, Ethiopia is still fragile and plagued by structural problems that could strain its economic transformation.

■ Strong external imbalances and high inflation

Given the economy’s major needs for capital goods and low export diversification, Ethiopia runs up a major trade deficit. The current account deficit should continue to narrow in the short term, thanks to

1 Mainly roadways, since with the loss of Eritrea, the country no longer has any ports. Since 2013, the Grand Ethiopian Renaissance Dam has been under construction on the Blue Nile. With a 6,000-megawatt capacity, the project should enable Ethiopia to become an energy exporter to its neighbouring countries. 2 The plan targets an annual growth rate of 11%.

a rebound in exports following a better agricultural season and the inauguration of several industrial parks. Even so, the current account deficit is still high. Despite their dynamism, FDI only covers about 70% of the current account deficit, and the country must finance the rest through external debt, mostly on concessional terms. Low foreign reserves, which cover less than 2 months of imports of goods and services, exacerbate the country’s external vulnerability.

The central bank controls the exchange rate and orchestrates a nominal depreciation of the birr against the dollar of about 6% a year in order to maintain a stable real exchange rate. As a result, the birr has gradually become overvalued in real terms (by about

1-Forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- The most vigorous growth in Africa Real GDP, annual change in %

Ethiopia ▬ Sub-Saharan Africa ▬ East Africa

Sources: AfDB, IMF, BNP Paribas

2016 2017 2018e 2019e

Real GDP grow th (%) 8.0 8.5 8.0 8.1


Cent. Gov . balance / GDP (%) -2.4 -3.4 -2.9 -2.6

Cent. Gov . debt / GDP (%) 57.9 59.7 59.1 58.4



Forex reserv es (USD bn) 3.0 3.1 3.2 3.8


Ex change rate USDETB (y ear end) 21.1 22.3 28.0 30.0

0

2

4

6

8

10

12

2009 2010 2011 2012 2013 2014 2015 2016 2017e 2018p


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22% in Q3 2017 according to the IMF), which has encouraged import demand and hampered export diversification.

External account imbalances maintain the birr under strong pressure, and the central bank must draw on foreign reserves to defend the currency. In October 2017, it was obliged to devaluate the birr by 13.5% against the dollar. Even after that, the real exchange rate is still overvalued. The spread between the official and parallel exchange rates is about 15%. The persistence of external imbalances will keep external liquidity and the exchange rate under strong pressure in the medium term.

Historically, Ethiopia has a very high inflation rate (44% in 2008 and 32% in 2011), and devaluations have a significant impact on inflation3. The central bank’s restrictive policy has helped limit the impact of October’s devaluation (the minimum deposit rate was raised from 5% to 7%). Even so, inflation accelerated to 15.6% in February 2018 (compared to 12.2% in October 2017), the highest level in the past five years.

■ Intensifying political crisis

Ethiopia gives the impression of a stable political system under the direction of an authoritarian regime, which claims to have ensured peace in 1993 by granting Eritrea’s independence (although the two countries still have several disagreements). The ruling coalition, the Ethiopian People’s Revolutionary Democratic Front (EPRDF 4 ), adopted a constitution based on ethnic federalism that is a source of strong social tensions. Among the ethnic groups, the Oromo and Amhara (60% of the population) claim to be underrepresented in political life in favour of the Tigrayan minority.

At each election, the EPRDF has consolidated its grip on power, absorbing the other parties and intimidating the media and the opposition. In late 2015, protest movements broke out against this unanimous façade and repressive climate, but they were violently repressed during the state of emergency that was declared between October 2016 and August 2017. Following the resignation of Prime Minister Hailemariam Desalegn to counter far-reaching divisions within the coalition, a second state of emergency was called for a 6-month period in February 2018.

Among other things, the Oromo opposition party5 denounced the illegal nature of the vote on the state of emergency, and has organised massive disruptions across the country6.

3 According to the IMF, a 1% change in the nominal exchange rate would trigger a 0.43% change in the consumer price index, cumulated over three years, with a major impact in the first 18 months. 4 A Social-Democratic coalition, from the alliance of 4 political parties with a regional and ethnic basis (Tigrayan, Oromo, Amhara and Southern populations). 5 The Oromo ethnic group was initially represented in the coalition by the Oromo Liberation Front (OLF), which pulled out in 1992 following conflicts with the other member groups. The coalition decided then to create the Oromo People’s Democratic Organisation (OPDO) to represent the Omoro in the government. But the OLF continued to lead the opposition against the government, affirming that its fundamental objective is to help the Oromo people exercise their right to self-determination. 6 A strike broke out in the Oromo region and spread as far as Addis Ababa, resulting in the shutdown of the majority of businesses, schools and roadways.

In an attempt to resolve this political crisis, the EPRDF Congress has just elected a new leader with a large majority (63% of the vote). This is a historic decision for Ethiopia, because the new Prime Minister, Abiy Ahmed, belongs to the Oromo, the majority ethnic group that has been the victim of political, economic7 and cultural marginalisation. Moreover, he was elected with the support of the Amharas.

Ahmed’s election will certainly be a stabilising factor in the short term, especially since he has a track record of easing tensions between Muslims and Christians. In his inaugural speech, he called the opposition to cooperate and extended an olive branch towards Eritrea. But a lasting co-habitation will depend on the government’s determination to resolve fundamental problems. Given the opacity of Ethiopia’s power dynamics and the struggles within the coalition, it is hard to predict which solutions the new government will put forward to appease the frustrations created by Ethiopia’s ethnic federalism.

For the moment, the tense situation risks discouraging international investors and could hamper the country’s ambitious economic modernisation plans.

Sara Confalonieri [email protected]

7 In ten years, nearly 150,000 farmers have been expulsed from their lands, notably in order to lease arable land to foreign investors.

3- Persistent currency and inflation pressures Year-on-year inflation in %, and USDETB exchange rates

█ Official rate (LHS) ▬ Parallel rate (LHS) ▬ CPI (RHS)

Sources: IMF, Central Bank, Central Statistics Agency, BNP Paribas

0

2

4

6

8

10

12

14

16

18

0

5

10

15

20

25

30

35

2013 2014 2015 2016 2017 2018

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