SEB's Emerging Markets Explorer October 2013

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Emerging Markets Explorer

CONTENTS

Executive summary: Determined by the flip sides of two coins.......................................................................................................... 3SEB EM forecasts & track record ............................................................................................................................................................. 4EM macro: Recoupling but sub-trend growth ....................................................................................................................................... 5

EM assets fell out of bed this summer ........................................................................................................................................ 5but recovered in September ......................................................................................................................................................... 5The trigger....................................................................................................................................................................................... 6and the undercurrents ................................................................................................................................................................... 6The macro impact from the summer sell-off ................................................................................................................................ 7What next? The main scenario ........................................................................................................................................................ 7Structural deficiencies exposed ................................................................................................................................................... 8but partial progress on reforms and reduced vulnerabilities too ............................................................................................ 9 Catch-up potential partly realised slower growth ahead ......................................................................................................... 9 Fed also in the EM driver seat ....................................................................................................................................................... 10 EM GDP growth forecasts .............................................................................................................................................................. 10Key risks ............................................................................................................................................................................................ 11Inflation is not the big headache ................................................................................................................................................... 11Heterogeneous monetary policy outlook .................................................................................................................................... 12

Theme: Deeper look into flows .............................................................................................................................................................. 13Strategy: Wary of Q4, brighter 2014 ..................................................................................................................................................... 15

EM FX drivers ................................................................................................................................................................................... 16SEB EM FX forecasts ....................................................................................................................................................................... 16Trading recommendations ............................................................................................................................................................. 17Fixed Income: Driven by the tapering ebb and flow................................................................................................................... 19SEB EM bond basket update.......................................................................................................................................................... 20Quantitative and technical analysis ............................................................................................................................................. 22

Asia ............................................................................................................................................................................................................ 25China: What is Liconomics? ........................................................................................................................................................... 25India .................................................................................................................................................................................................. 26Indonesia .......................................................................................................................................................................................... 26Korea................................................................................................................................................................................................. 27Malaysia ............................................................................................................................................................................................ 27Philippines ....................................................................................................................................................................................... 27Singapore ......................................................................................................................................................................................... 28Taiwan .............................................................................................................................................................................................. 28Thailand............................................................................................................................................................................................ 28

Emerging Europe ..................................................................................................................................................................................... 29Czech Republic ................................................................................................................................................................................ 29Hungary ............................................................................................................................................................................................ 29Poland............................................................................................................................................................................................... 30Romania ............................................................................................................................................................................................31Russia ................................................................................................................................................................................................31Turkey ............................................................................................................................................................................................... 32Ukraine ............................................................................................................................................................................................. 33

Africa ......................................................................................................................................................................................................... 34South Africa ..................................................................................................................................................................................... 34

Latin America ........................................................................................................................................................................................... 35Brazil ................................................................................................................................................................................................. 35Chile .................................................................................................................................................................................................. 36Mexico .............................................................................................................................................................................................. 37

EDITORSMats Olausson, Chief EM Strategist, +46 8 506 23 262Sean Yokota, Head of Asia Strategist, +65 65 05 05 05

CONTRIBUTORSPer HammarlundSandra HeidmannMagnus Lilja

Fredrik SkoglundDag MullerKarl SteinerAnders Sderberg

Disclaimer: See page 38Contacts: See page 39

Cut-off date: 1 October 2013

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


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Executive summary: Determined by the flip sides of two coins

TRADING RECOMMENDATITRADING RECOMMENDATITRADING RECOMMENDATITRADING RECOMMENDATIONONONONSSSS We recommend buying a 5M, 1*2 put spread in EUR/MXN and we reiterate our callto buy CNY NDF vs. USD 1M. We look to buy USD/ZAR on dips and see good relative value in buying INR/IDR as wellas going long PLN/CZK.Finally, we look to sell USD/SGD. For the rationale behind each trading recommendations and

details, see page 17.

MACROMACROMACROMACROEmerging markets (EM) have been on a rollercoaster ride since early this summer. Significantly however,these developments have been confined primarily to financial markets. The real economy has been more stable. Still,macro developments form part of the background to this summers events and the impact of greater volatility will beseen in real data later on. The sell-off was clearly triggered by an increasing likelihood that the US Fed would begintapering its asset purchases sooner rather than later. However, four undercurrents also help explain EMunderperformance this summer: 1) disappointing growth; 2) lack of structural reforms; 3) positioning; and 4) eye-catching political unrest. The macro impact of the summer sell-off will be negative for EM growth (scarcer, moreexpensive liquidity) and positive for external balances. While also negative for inflation, this is only a big issue forIndonesia and Turkey.

Looking forward, we have an optimistic view on the global economy. EM have lagged this years recovery bydeveloped markets (DM). Importantly, this largely reflects structural deficiencies (demographics and growth modelshave run their course), especially in the BRICs. In fact, this structural slowdown has been taking place since 2010/11.Despite some reforms (for example, in Mexico, Colombia and Singapore), we do not think the summer crisis hascreated sufficient crisis awareness to kick-start major changes. So, despite several signs of early recovery in many EM,which in turn support incipient recoupling with DM, the upturn in EM will only generate GDP growth of around 5%,well below their 10 year trend of 6.6%.

THEMETHEMETHEMETHEMEIn our theme article we take a Deeper look into capital flows. The US Feds message in May represented aparadigm shift in the sense that it reversed five years of on hold or additional easing of monetary policy into a firstlook towards the exit. Markets reacted strongly. Countries with current account deficits were first to be hit as capitalflows reversed. However, we also examine deeper capital flow vulnerabilities. While the how and when of taperingremain uncertain, clearly the hunt for quality and yield will be a less potent driver for EM bonds than in recent years.Instead, we expect recoupling of growth, albeit to lower levels than before, to attract capital back to this yearsunderperforming EM equity markets, at far more attractive valuation compared to many DM counterparts.

STRATEGYSTRATEGYSTRATEGYSTRATEGYIn coming quarters, the outlook for EM assets will largely depend on how investors emphasise the flipsides of two coins. Firstly, will investors focus on tighter liquidity due to Fed tapering or on the strength of the USeconomy, which is a prerequisite for tapering to happen and which will help global growth returning to trend?Secondly, will they cheer the recoupling of EM growth or rather focus on the lower growth rate and diminished growthadvantage over DM? To conclude, we are generally cautious on EM assets in Q4 but expect a better outlook in 2014.We assume the Fed will start tapering in December and, crucially, that it clarifies its intentions and ease the confusioncurrently restricting risk appetite. Market movements will largely stay within ranges established since early summer.

Investors should increasingly diversify between EMs. For now, we recommend a 25% hedging ratio in EM FX.

U.S.

Growth

Tapering

RecouplingSub-trend growth

Summer 2013

EM

The flip sides of two coins


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SEB EM forecasts & track record

01-okt-13 1M Q4 13 Q1 14 Q2 14 Q3 14 Q4 14

PLN 4,22 4,25 4,20 4,15 4,15 4,10 4,05

HUF 297 300 298 295 295 295 295

CZK 25,7 25,8 25,9 25,8 25,5 25,5 25,2

RON 4,45 4,45 4,43 4,38 4,33 4,30 4,27

RUB 43,8 44,1 43,4 42,1 41,6 41,7 41,4

RUB/BASKET 37,4 37,8 37,5 36,8 36,5 36,8 37,0

RUB 32,3 32,7 32,7 32,4 32,4 32,8 33,4

PLN 3,11 3,15 3,17 3,19 3,23 3,23 3,27

HUF 219 222 225 227 230 232 238

CZK 19,0 19,1 19,5 19,8 19,8 20,1 20,3

UAH 8,18 8,20 8,20 9,00 9,10 9,20 9,30

TRY 2,01 2,05 2,05 1,98 1,98 2,05 2,10

ZAR 10,00 10,20 10,20 9,80 9,80 10,20 10,50

BRL 2,22 2,25 2,25 2,20 2,20 2,25 2,30

MXN 13,09 13,20 13,00 12,70 12,50 12,40 12,30

CLP 505 508 505 500 495 490 490CNY 6,12 6,10 6,08 6,02 5,98 5,94 5,90

CNH 6,11 6,10 6,08 6,02 5,98 5,94 5,90

HKD 7,75 7,80 7,80 7,80 7,80 7,80 7,80

IDR 11315 12000 12000 11500 11200 11000 11000

INR 62,3 63,5 65,0 64,5 63,5 63,0 60,0

KRW 1074 1150 1100 1080 1070 1060 1050

MYR 3,23 3,20 3,30 3,25 3,20 3,20 3,20

PHP 43,3 43,0 44,0 43,8 43,5 43,0 42,5

SGD 1,25 1,28 1,30 1,28 1,26 1,24 1,22

THB 31,1 32,5 32,7 32,5 32,0 31,5 31,0

TWD 29,5 30,2 30,2 30,0 29,7 29,4 29,2

EUR/USD 1,36 1,35 1,33 1,30 1,29 1,27 1,24

USD/JPY 98,0 100 103 105 107 109 110

SEB EM FX forecasts for eop

Vs. EUR

Vs. USD

EM FX recommendations track record

# of recommendations Hit ratio P&L

2008 11 72,7% 22,8%

2009 14 50,0% 10,4%

2010 11 54,5% 19,5%

2011 8 50,0% 17,8%

2012 12 58,3% 4,0%

2013 6 50,0% 2,1%

Total 62 56,5% 76,6%

Average P&L per year 2008-2012 12,8%

Average P&L per recommendation 2008-2012 1,24%

01-okt-13 4Q13 1Q14 2Q14 3Q14 4Q14

EMEA

Poland 2,50 2,50 2,50 2,50 2,75 3,00

Czech 0,05 0,05 0,05 0,05 0,25 0,50

Hungary 3,60 3,20 3,00 3,00 3,00 3,00

Turkey 1W repo 4,50 4,50 4,50 4,50 5,00 5,50

Turkey O/N borrowing 3,50 3,50 3,50 3,50 3,50 3,50

Turkey O/N lending 7,75 8,25 8,25 8,25 8,25 8,25

S. Africa 5,00 5,00 5,00 5,00 5,00 5,00

Romania 4,25 3,75 3,75 3,75 4,00 4,50

Russia 1W repo 5,50 5,25 5,00 5,00 5,00 5,00

LatAm

Brazil 9,00 9,50 9,50 9,50 9,50 9,50

Chile 5,00 4,50 4,50 4,50 4,50 4,75

Mexico 3,75 3,75 3,75 3,75 4,00 4,25

Asia

China lending 6,00 6,00 6,00 6,25 6,25 6,75

China deposit 3,00 3,00 3,00 3,25 3,25 3,75Korea 2,50 2,50 2,50 2,50 2,50 2,50

India 7,50 7,75 7,75 7,50 7,50 7,25

Indonesia 7,25 8,00 8,00 8,00 7,50 7,25

Malaysia 3,00 3,00 3,00 3,25 3,25 3,75

Philippines 3,50 3,50 3,75 3,75 3,75 4,50

Thailand 2,50 2,75 2,75 3,00 3,00 3,50

Taiwan 1,88 1,88 1,88 1,88 2,00 2,25

Source: Bloomberg, SEB

SEB EM policy rates forecasts for eop

2010 2011 2012 2013 2014 2015

China 10,4 9,3 7,8 7,5 7,4 7,0

India 10,6 7,5 5,4 5,0 5,6 6,0

Indonesia 6,2 6,5 6,2 5,8 5,3 5,5

EM 7,4 6,4 4,9 4,8 5,2 5,4

Latvia -0,9 5,5 5,6 3,5 4,8 5,0

Mexico 5,5 3,9 3,9 1,8 4,5 4,5

Singapore 14,8 5,3 1,3 2,6 4,1 4,0

World (P 5,1 3,8 3,4 3,2 4,0 4,2

South Kor 6,3 3,6 2,0 2,8 3,6 3,5

Lithuania 1,5 5,9 3,6 3,2 3,5 4,5

Turkey 9,2 8,5 2,2 3,7 3,3 4,0

Estonia 3,3 8,3 3,2 1,5 3,3 3,5

World (n 4,4 3,1 2,7 2,5 3,2 3,5

Poland 3,9 4,5 2,0 1,5 3,1 3,5

Romania -1,2 1,9 0,7 2,2 3,0 3,5

South Afri 3,1 3,5 2,5 2,0 2,6 3,0

Russia 4,5 4,3 3,4 1,7 2,4 3,0

OECD 3,1 1,8 1,5 1,2 2,4 2,8

Brazil 7,5 2,7 0,9 2,5 2,2 2,7

Ukraine 4,1 5,2 0,2 -0,8 2,0 3,4

Czech Re 2,5 1,8 -1,2 -0,8 2,0 2,5

Hungary 1,3 1,6 -1,7 0,7 1,5 1,8

Source: IMF, SEB

SEB GDP forecasts


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September 19 but later gave back about 1.5%-points).Local government bond yields fell by around 50bps (aquarter of their previous rise) while the spread vs. USTdropped by 40bps to 500bps (compared to 440bps inearly May) but widened modestly again by the end ofSeptember. To draw conclusions regarding the nextlikely turn on this rollercoaster ride, we need to betterunderstand what caused this turbulence in the firstplace.

The triggerThe sell-off was clearly triggered by the increasinglikelihood that the US Fed would begin tapering itsasset purchases sooner rather than later. Although aneventual move in that direction was expected,strengthening US data and comments from the Fedapparently came as a surprise to the market. Although

it was clear the Fed would carry on expanding itsbalance sheet until mid-2014 and wait longer stillbefore starting to hike interest rates, the marketreaction was tantamount to an immediate reduction inglobal liquidity. This response makes sense in the waythat the expected tapering decision could be seen as aparadigm shift. After spending five years discussingwhether monetary policy was sufficiently loose orwhether additional stimulus was needed, this was thefirst time in the cycle that the Fed began to look theother way: towards the exit (even if it will take a longtime to get there).

However, the impact of the expected reduction inasset purchases on asset markets that presumably hadbenefited from the Feds balance sheet expansion wasuneven. For example, many stock exchanges indeveloped markets (DM) performed well over thesummer, while US corporate bonds reacted mildly. EMassets were beaten more severely. This was nocoincidence, in our view.

and the undercurrentsFour undercurrents help explain theunderperformance by EM this summer:

Disappointing growth

Lack of structural reforms

Positioning

Prominent political unrest

Disappointing growth. After the global bounce ineconomic activity in 2009/10, the world economyentered a long period of deceleration. During the firsthalf of 2013, however, the US and Japanese

economies shifted into higher gear while the Eurozone climbed out of recession in the second quarter.

Conversely, most emerging markets continued todecelerate.

Source: IIF

Lack of structural reforms. In several economies, notleast the BRIC, structural impediments to growth werebecoming increasingly apparent. Still, generally decisivepolicy actions to overcome these challenges did not takeplace. (We discuss in more detail what is needed and howlikely progress is in coming years below). Consequently,growth forecasts were revised downwards instead of up,benefitting DM at the expense of EM whose growthadvantage in recent years began to shrink.

Positioning. The more tilted market positioning becomes,

the greater the risk of a reversal. The less liquid a market is,the greater the likely effect on asset prices. By the earlysummer of this year, several years of G4 balance sheetexpansion had created an environment characterized by 1)historically low yields on DM bonds, 2) supportive riskappetite and 3) investors hunting for yields. The tiltedpositioning was most evident in several EM where bondmarkets had received massive inflows since the beginningof 2012. EM stocks had also experienced large inflows buthad underperformed since the start of this year. Currencies,meanwhile, were nominally cheap even before the summerbut still suffered substantial losses. Overall, positioning in

bonds was most vulnerable. It appears likely that manyinvestors began hedging FX risk rather than sell bonds, atleast initially. This may explain the damage done to EMcurrencies. Other flows obviously played an important part.One source of capital inflows that probably fell sharply, oreven reversed, when tapering fears were highest is bankloans.

Prominent political unrest. The fourth factor that madeEM assets vulnerable during the summer was probably thefact that general sentiment surrounding EM had been hurtby political unrest in several countries. Even if street

protests in Turkey and Brazil did not overthrow theirpolitical leaders and perhaps wont change economicpolicymaking much, the global media presented eye-


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catching images of violent unrest and instability. Norwere the wave of strikes in South Africa and chaos inEgypt exempt from such coverage.

The macro impact from the summer

sell-offSeptember brought some relief to EM markets (butprobably in rather thin volume, especially theimmediate response to the FOMC meeting) but thesummer sell-off obviously remains fresh in investorsminds. Its potential impact continues to be evaluated.As a starting point we think the impact come in threeareas:

Growth

External balances

Inflation

Growth will be hurt as the uncertainty created by highvolatility undermines investment and consumerconfidence. More importantly, credit growth will bereduced, due to:

the tighter global liquidity,

higher nominal interest rates and

the withdrawal of domestic liquidity inconnection with FX interventions.

This will be particularly important in countries wherecredit growth has been crucial for growth, such asBrazil, Indonesia and Turkey.

External balances. Those countries whose currencieswere hardest hit during the summer (INR, BRL, IDR,ZAR, TRY and MXN) all run current account deficits. Insome, such as Mexico and Brazil, these have largelybeen offset by FDI inflows. In others, such as Turkeyand South Africa, FDI inflows have only partly covereddeficits, leaving such countries to rely on shorter term(and more vulnerable) capital inflows. At any rate, the

weakening of their currencies can certainly be seen asa welcome boost to competitiveness and a helpinghand in reducing these external imbalances. The flipside of the coin is that a weaker currency will pushinflation higher.

Inflation. Although global inflation remains at ahistorically low level, several EM central banks arestruggling to get inflation down to their target range.The sell-off in their currencies this summer will maketheir task even more challenging given the worseningoutlook for imported inflation. Still, we think many of

them will manage to meet their targets by next year ascommodity prices and global inflation remainsubdued, and domestic growth sluggish. This applies

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

What next? The main scenarioSumming up so far weve seen a dramatic sell-off over thesummer and a partial recovery in September. On the macroside, we expect further pressure on credit driven growthbut more competitive exchange rates and few inflationarychallenges. What next for EM macro economically? In ourview, there are two conflicting, or opposing, stories playing

out.

Firstly, we have an optimistic view on the globaleconomy moving into 2014 and 2015. Indeed, five yearsafter the Lehman crash, it is finally moving back towardstrend growth. We expect worldwide growth in PPP terms toease from 3.4% to 3.2% in 2013 but to accelerate to 4.0%this and 4.2% next year. Since 2008, EM have lent crucialsupport during this healing process. They have accountedfor around 75% of global growth. With domestic demandrising faster than in DM, the aggregate current accountsurplus in EM (including Middle Eastern oil exporters) has

decreased. Mirroring this, the current account balances ofthe US and Euro zone have improved to the benefit of theirrespective economies. Looking forward, we expect the USeconomy to resume its historical role as a global economiclocomotive. Meanwhile, Japan is being given the benefit ofthe doubt under the Abenomics doctrine, while currentlywe are seeing the Euro zone taking further faltering stepstowards recovery, albeit slowly.

The second story to be told is that so far this year, the vastmajority of emerging economies have fallen behinddeveloped markets in reversing the deceleration seen since

early 2010. Indeed, EM overall have been laggards ratherthan leaders. While G3 economies substantially improvedduring the first half of this year, EM generally extended themalaise suffered since the economic bounce in 2009 tofour years of almost constant deterioration. After a falsestart (mostly in Asia) late last year, the aggregate EMmanufacturing PMI once again turned downward, hitting afour year low in July.

So, EM have decoupled from DM during 2013. Why is this,and will it last?


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Structural deficiencies exposedTo a large extent, the reason for recentunderperformance is to be found in structuraldeficiencies. Indeed, the structural slowdown in EMhas been going on since 2010/11. Firstly, the

demographic trend has for long been supporting EMeconomies. In conjunction with intensified structuralreforms as well as globalisation 10-15 years ago, vastamounts of labour could enter the market,contributing to rapidly rising economic growth. Amongthe BRIC, however, the demographic trend is turningin China and Russia with dependency ratios beginningto increase going forward. In Brazil, this will happen inonly a few years while India will continue to benefitfrom supportive demographics for a couple moredecades.

Secondly, EM have excelled over the past decade orso, but the growth models of several key economies,especially the BRIC, have now run their course. Theirstrategies have been quite different and it is, perhaps,a coincidence that they have all lose steam at thesame time.

The Brazilian success story since President Lula tookoffice in 2003 was actually based on the marketoriented reforms of his predecessor Cardoso(including fiscal responsibility and a disinflationoriented central bank). Lula harvested the benefits of

these reforms supported by a global environment thatincluded rising demand and higher commodity prices.Apart from some well-designed social initiatives,however, the pace of reform slowed. Instead,additional growth impetus resulted largely fromexpansionary policies and more credit, especially frompublic sector banks. However, this route is becomingexhausted, with debt service costs as a share ofdisposable income having risen from 16% to 22%over the last eight years. External debt to GDP remainsmodest at about , but increasing global interest rateswill still make the problem worse. Strong credit growth

has spurred domestic demand and imports, whileexports and industrial production have so far been lessdynamic. The infamous costo Brazil reflects many ofthe challenges facing that part of Brazilian industrythat is exposed to international competition.

The Russian economy is a basket case of the Dutchdisease. While spectacular, improvements during the1990s and 2000s were largely based on improvingterms of trade. Admittedly, the switch from Yeltsin toPutin brought greater administrative order, while the2003 tax reform was a success. However, many strongfundamentals (external balances, debt ratios, FXreserves) would look dramatically worse if natural

resource extraction industries were excluded. Much of therest of the economy is weak and without ever-rising oil/gasprices or productivity enhancing structural reforms, theeconomy would be destined to settle for much slowergrowth than for several years.

India benefited like everybody else from the big exportboom in the 2000s but has structurally fallen short in threeareas, which prevents India from growing at 10% like restof Asia in the early stage of economic development. First,Indias labor laws are still too restrictive to dominate lowend, labor intensive manufacturing. Chinas rising wagesare opening up this sector for India to enter but India hasnot capitalized because they continue to support smallmanufacturers. Second, India has not efficiently used therise in savings accumulated from strong export market.Most Asian economies build infrastructure using their

savings but in India, the government uses those savingsand distributes them as cash handouts to win votes. Theyincrease consumption short term but reduce long termgrowth potential. Third, India still has not learned tocontrol inflation. Part of the problem is that food supplychain is undeveloped and cause erratic swings in WPI,which makes monetary policy more difficult to control. Inturn, this led India to cut interest rates too aggressively in2009 and too late to hike in 2010 and 2011, which has leftinflation expectations more entrenched. Fortunately, thenew RBI governor Rajan understands these challenges andis addressing them from his first meeting and tackling the

inflation issues.

China needs to shift its growth dependence frominvestments and exports towards domestic, private,consumption, not least in services. This strategy lies at thecore of its current 5-year plan, which began in 2011. It hasalso been fully confirmed by the new political leadershipwhich seems prepared to pursue the course even at theprice of substantially slower (but higher-quality) growth.The demographic situation is also catching up with realityas the one-child policy is taking its toll and urbanization ismore than half way complete. More importantly, increase

in labor can only lead to higher growth if there are jobs andthe slower global growth and export environment makesdemographics less powerful. Overall, the shift in strategy isclearly necessary, even at the cost of lower growth, as it willhelp deflate bubbles that might burst later. The sharpincrease in leverage in the Chinese economy (especially inthe less regulated shadow banking system) in recent yearshas received plenty of attention lately since consequencesfor the rest of the world could be large. An importantdifference compared to many other crises, however, is thatChinas credit boom has been inflated by domestic loans.The ripple effect through financial linkages should

therefore be smaller. On the other hand, the country hasbecome the second largest global economy, and a crisiswould certainly not go unnoticed either by capital goods


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exporters or EM commodities providers. An additionalworry would be the extent to which China would seeitself as forced to bring home money heavily investedabroad during the past 10 years (during which periodFX reserves have increased tenfold to USD 3.5tn).

but partial progress on reforms andreduced vulnerabilities tooThere are also encouraging signs of progress indesigning and implementing structural reforms.Mexico is the most shining example but Colombia andSingapore are also seen as strong reformers. Further,several countries, not least in Eastern Europe and theCIS have progressed well up the World Banks list ofcountries ranked based on Ease of Doing Businessand are now rated more highly than many developedeconomies. Similarly, many CEE economies that

suffered most from their close trade and financialconnections with Western Europe have seen theirdomestic economies tighten their belts. As a result,their former current account deficits have either fallensharply or even become surpluses.

Overall, however, we are not particularly optimistic onstructural reform initiatives and implementation goingforward. Firstly, the EM crisis of this summer couldhave created the sort of crisis awareness that is oftenneeded for politicians to overcome hurdles andchallenge vested interests to push through reforms

that may bring long term gains but short term pain.However, the crisis was largely financial while the realeconomy were the wider electorate operates has seenrather fewer changes in recent months. Secondly,several large EMs have elections scheduled for thenext year including:

South Africa General MayIndia General MayIndonesia Presidential JulyBrazil Presidential October 5Turkey Local March 30

Presidential August 28General June 13, 2015

Hungary General April

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

Catch-up potential partly realised slower growth aheadAll this implies that even though developed marketsare picking up speed, EM will not return to their 10-

year trend growth rate of 6.6% but instead remain ataround 5%. The slowdown in the large Chineseeconomy from a peak of 14% in 2007 to

approximately 7% going forward is obviously a bigcontributor to this trend. This deceleration is, however,probably welcome as it reduces the risks of a sharpersetback in the future. However, China alone does notexplain the poorer aggregate EM growth outlook. Thereasons are more broadly based. This reflects emergingmarkets growing up in the sense that the lowest hangingfruit of trade integration and productivity improvementshave already been harvested. Consequently, the marginalreturn on new investments in EM is lower today than 10years ago.

EM have substantially caught up DMs. Going forward, thenext step will be more challenging. The potential, however,remains vast. A key question is whether investors regardslowing EM growth compared to the last decade as adisappointment and turn their backs, or whether they

adopt more realistic expectations, acknowledging that EMgrowth still remains double that in DMs and moresustainable. The jury may still be out on this call but itseems fair to say that the underperformance of EM assetsthis summer probably reflects the former interpretation.Our guess, however, is that the realisation of slower EMgrowth than before is largely discounted in prices now.However, while forecasts will probably continue to adjustlower for a while, we are already fairly close to endingdownward revisions of EM growth. This assumptionobviously depends on several assumptions, mainly asfollows:

OECD growth will double from 1.2% this year to2.4% next, and further increase to 2.8% in 2015.For further details, see Nordic Outlookpublishedat the end of August.

Emerging markets will benefit from such growthwith a lag. Decoupling of growth during the firsthalf of this year will gradually give way torecoupling going forward.

The wild card is the Feds journey towards exitingits supportive monetary policy, and how it willaffect global liquidity and risk appetite. Here we

take a more balanced view looking forward.

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


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Septembers PMI readings looked promising in theemerging world. Hungary was the outperformeradvancing to 54.5 (prior 51.8) but the reading is rather

volatile. Turkey rose to 54, which was a 40 monthhigh, up from 50.9 in August. The increase was due toan increase in domestic demand, hence, suggestingthat the current account deficit may widen further.Poland improved to 53.1 and Czech Republic droppedslightly to 53.4, both still in expansionary territory.Moreover, there were some countries with lesspositive news for September; S Africaplummeted to49.1 after 56.5 in August due to labor unrest andconstrained productivity, and Brazil edged higher and

printed 49.9 from Augusts 49.4 marking the third

consecutive month below 50, but the first upward move

for 2013. Generally, a rather promising picture for theEM countries that are more dependent on the recoveryof the German economy.

Fed also in the EM driver seatAs we have discussed, expected Fed tapering was thetrigger for this summers EM sell-off. Tighter globalliquidity will dampen growth prospects in EM,especially those with credit driven growth models andhighly dependent on external capital. We now expecttapering to start in December and to be finished by

mid-2014. This is also the consensus view. Thedecision not to start tapering in September surprisedthe market in a big way. Importantly, the positivemarket reaction proved very short-lived. We thinkthere were two reasons for this;

the Fed left the market feeling very confused,and

renewed uncertainties about US fiscalpolicies (the approach of a new budget yearwith no budget agreement and the debtceiling expected to be reached by October

17).

These factors may well continue to dampen risk appetitefor a while. Nevertheless, we assume that Congress willagree on a budget and lift the debt ceiling in a way thatdoes not obstruct the continuing recovery of the USeconomy. If so, the Fed will probably start tapering inDecember. We assume it will communicate its intentions ina way that reduces uncertainties going into 2014. There is,of course, a risk that market concerns once again revive asquestions emerge regarding the length of time the Fed willroll over maturing Treasury and mortgage securities, whenit will abandon its zero interest rate policy and how fast itwill normalise conditions. In our main scenario, we do notexpect these bouts of uncertainty to escalate to levels seenearlier this summer. Consequently, the main impact of USmonetary policies on EM macroeconomic conditions will benegative for growth, positive for external balances andmodestly negative for inflation. Despite, considerable

uncertainty regarding the Feds behaviour right now,arguably the messages it sent in May and September definethe issues. In May, we learnt that many Fed members haveincreasing doubts as to whether the benefits of continuedquantitative easing outweigh the costs. The market reactedto this and by early September 10 year US Treasury yieldshad risen to 3% from 1.6% in May. In the two week leadingup to the September FOMC meeting, the market took a fewsmall steps back from its hawkish expectation.Furthermore, as Larry Summers withdrew his candidacy, itnow looks increasingly likely the next Fed Chairman will bea woman; Janet Yellen. At the margin, this will ensure the

Fed remains slightly more dovish than not. Obviously, theFed will respond to incoming data.

Consequently, we believe the central bank will adopttighter (or less loose) policies only if longer term marketrates have not run ahead of themselves and if the recoverystays on course. Conversely, if the US economy were to failto meet expectations, the Fed would maintain its stimulusmeasures for longer. Therefore, the flip sides of this coinwill affect EM in opposing ways. This summer, which beganwith very depressed US yields, the market focused entirelyon the negative effect of the paradigm shift to a

decreasingly stimulative monetary policy. In future, weexpect its reactions to the Fed to be more balanced with anegative tilt until tapering begins in December and a moresanguine response next year. However, it deserves to berepeated that the Feds journey towards the exit is likely toremain an important source of volatility for EM assets forquite some time.

EM GDP growth forecastsA modest pick-up in growth in most EM appears to betaking place. For reasons already considered, previoushighs will not be revisited. In the 10 years to 2012, EMgrowth averaged 6.6% (including both the super-cycle andthe Great Recession). Going forward, we expect EM


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

As we forecast OECD GDP to double to 2.4% next

year, EM will expand at approximately 2x rather than3-4x that of DM seen in recent years.

Our country by country forecasts are as follows:

2010 2011 2012 2013 2014 2015

China 10,4 9,3 7,8 7,5 7,4 7,0

India 10,6 7,5 5,4 5,0 5,6 6,0

Indonesia 6,2 6,5 6,2 5,8 5,3 5,5

EM 7,4 6,4 4,9 4,8 5,2 5,4

Latvia -0,9 5,5 5,6 3,5 4,8 5,0

Mexico 5,5 3,9 3,9 1,8 4,5 4,5

Singapore 14,8 5,3 1,3 2,6 4,1 4,0

World (P 5,1 3,8 3,4 3,2 4,0 4,2South Kor 6,3 3,6 2,0 2,8 3,6 3,5

Lithuania 1,5 5,9 3,6 3,2 3,5 4,5

Turkey 9,2 8,5 2,2 3,7 3,3 4,0

Estonia 3,3 8,3 3,2 1,5 3,3 3,5

World (n 4,4 3,1 2,7 2,5 3,2 3,5

Poland 3,9 4,5 2,0 1,5 3,1 3,5

Romania -1,2 1,9 0,7 2,2 3,0 3,5

South Afri 3,1 3,5 2,5 2,0 2,6 3,0

Russia 4,5 4,3 3,4 1,7 2,4 3,0

OECD 3,1 1,8 1,5 1,2 2,4 2,8

Brazil 7,5 2,7 0,9 2,5 2,2 2,7

Ukraine 4,1 5,2 0,2 -0,8 2,0 3,4

Czech Rep 2,5 1,8 -1,2 -0,8 2,0 2,5

Hungary 1,3 1,6 -1,7 0,7 1,5 1,8Source: IMF, SEB

SEB GDP forecasts

In line with our analysis above, we have made thelargest downward revisions to our estimates incountries that are most vulnerable to tightening inglobal liquidity, due either to high external financingrequirements or an exhausted growth model, which isdependent on credit growth, or both. We have, forinstance, lowered our Brazilian GDP forecast for nextyear from 4.0% to 2.5%, and for Turkey from 5.0% to3.3% compared to our EM Explorer report in February.

Despite reducing our Chinese projection, the countryremains the fastest growing major country.Meanwhile, positive momentum attributable to the

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

Key risksWe see four key risks to our scenario:

Rapid exit by the Fed

US economy dips on failure to resolve fiscal issues

Renewed Euro zone debacles

Spike in oil prices

Clearly, the first risk has the greatest effect on EM (firstlyfinancially, then later in the real economy) which is why wehave devoted a large part of this report to the subject. IfCongress fails to agree a budget or to lift the debt ceiling,the locomotive of the global economy would falter. WhileEM would be hurt, the Fed would probably adjust itsmonetary policy stance in such a way as to at least partlyoffset the impact.

In Europe, Greece is expected to restructure yet more of itsdebt, although as this is already discounted by the marketwe expect little accompanying market turbulence. It isnevertheless, a clear risk. The Italian political situation andchallenges in Portugal also threaten improved Euro zonesentiment with potential ripple effects far beyond it. TheRussian initiative on Syrias chemical weapons appears tomake further progress, defusing the immediate risk of

directly involving other countries in the civil war. Still, thesituation is, of course, far from resolved and the politicalsituation in large parts of the Middle East remains fragile.A sharp (and lasting) rise in oil prices could wreck theincipient recovery in oil importing EM and also harm oilexporters, due to the negative impact on risk appetite andthe global outlook in general.

Inflation is not the big headacheThis summers sell-off in May EM currencies has refocusedattention on inflation risks. Overall, however, thedampened outlook for commodities and for global inflation


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Theme: Deeper look into flowsBackground

Here is how we see capital flows impact emergingmarkets. Emerging markets are less developed andthe uncertainty brings higher risk. The last five years

have shown that parts of developed markets are riskytoo and indeed this has been reflected in marketprices. To compensate for the higher risk, emergingmarkets provide higher growth or higher yield relativeto developed markets. Higher growth translates intohigher earnings for equity investors and higher incomefor debt and credit investors that allow them tocontinue paying interest on their borrowings. Thehigher yields compensate debt investors with higherinterest payments.

Recently, emerging markets stopped delivering on

both. Since 2011, growth in emerging markets havebeen declining and providing less relative growth todeveloped markets. More recently, with US yields atless depressed levels and potential for a continuedrise, EM yields have to compete harder to attractinvestors. Investors dont like this dynamic and aretaking capital out of emerging markets.

BRICS real GDP % yoy

0%

2%

4%

6%

8%

10%

12%

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Source: CEIC, Macrobonds, Bloomberg, SEB

Differentiation by current account positionEmerging market performance has been hit overall butthere are divergences. And market commentatorshave focused on the current account in the balance ofpayments. Current account deficit economies needconstant capital inflow to fund the economy and keepthe currency stable. In times of capital outflow andrisk aversions, they are hit more than the currentaccount surplus economies. The chart below showsthat the ones that were hit most are concentrated onthe right in places like Turkey, South Africa and India.

-10

-5

0

5

10

15

20

Sing.

Norway

Taiwan

Sweden

Malaysia

Russia

Korea

Phils

China

HungaryEU

Israel

Mexico

Thailand

Czech

Indonesi

Brazil

Chile

PeruCol.

Romania

Poland

India

SAfrica

Turkey

Current Account as % of GDP


Adjustment neededHowever, we think flows need to be adjusted to get thecomplete picture and be able to project the consequencesgoing forward. First, we should focus on the basic balance

instead of the current account. In the initial sell-off,markets are focused on the short term flows. However, asweve already had a taste of emerging market sell off,markets will focus on longer term issues. We would startfocusing on the basic balance, which includes the currentaccount and foreign direct investment (FDI). FDI are longerterm, sticky investment and will not depart like short termequity, bond and lending flows and buffer economies fromoutflows. The chart below shows the basic balances. Muchof the ranking remains the same but the main differencesare that, many of the economies have a surplus when FDIsare included. The most notable economies with

improvements are Israel, Czech Republic, Brazil, andColombia.

-10

-5

0

5

10

15

20

Sin

g.

Norwa

y

Taiwa

n

Isra

el

Malays

ia

China

Russ

ia

Ph

ils

Hunga

ry

Czech

Col.

Pe

ru

Swede

n

Korea

E

U

Brazil

Mexico

Thailand

Indones

ia

Ch

ile

Romania

Ind

ia

Poland

SAfric

a

Turkey

Basic Balance (Current Acccount + FDI) % of GDP


Second, on capital flows, we should focus less on debtflows and more on equity flows. The hunt for yield basedon the quality balance sheets was the big emerging markettheme since the beginning of Feds Quantitative Easing.Now with US providing higher yields with a bettereconomic outlook, the hunt for yield should slow and withit debt flows. We should return to the pre-QE era whereemerging market attracted equity inflow from a growthperspective. Much of emerging markets are still exportdependent and a healthier US economy and a bottoming in


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Europe will lead to a bounce in growth and againattract equity flows.

The shift in focus to equity from debt flows will haveregional consequences. Asia had benefited greatly inthe QE era since it has the best balance sheet with lowpublic debt and attracted large debt inflows. Thechart below shows the average portfolio investmentflows as a percentage of GDP since 2010 and Asianeconomies in red are concentrated mostly to the leftwith the large inflows. On the other hand, EasternEurope suffered from the poor balance sheets andLatin America sat in between. This will likely reverseand Eastern Europe should outperform Asia.

-10

-5

0

5

Malaysia

Poland

Phils

Col.

Korea

Turkey

Israel

Hungary

Brazil

Czech

Thailand

India

Indonesia

Romania

SAfrica

Mexico

China

Russia

Peru

Chile

Taiwan

Sing.

Portfolio Investment % of GDP avg since Jan 2010


Furthermore, the debt to equity shift will make it

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


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Strategy: Wary of Q4, brighter2014In coming quarters, the outlook for EM assets willlargely depend on how investors emphasise the flipsides of two different coins, as follows:

1. US growth:a. Strong US economic data are good for global and

EM growth and generally positive for EM assets.b. However, robust US figures may also encourage

the Fed to begin tapering earlier/faster, whichwould be bad for EM assets.

2. EM growth:a. Green shoots of recovery in many EM suggest

growth is recoupling.

b. However, this upturn may only reach sub-trendgrowth rates due to structural impediments,primarily in BRICs.

U.S.

Growth

Tapering

RecouplingSub-trend growth

Summer 2013

EM

The flip sides of two coins

The matrix: This summer, investors certainlyemphasised the potential impact from Fed taperingwhile the EM story that was told was focused entirelyon the continued deterioration in growth and thestructural reasons behind it. Hence, we foundourselves solidly in the lower/left corner of our matrixabove. The nirvana for EM assets would be ifinvestors anxiety about Fed tapering eases and focus

instead turns to the strong US recovery whilesimultaneously the recoupling of EM economies takesprecedence over sub-trend growth expectations. Thatis represented by the top/right corner of the matrix.

US growth and what the market will emphasise:As discussed in this report, we see several risks to bothglobal and US growth going forward. However, in ourmain scenario, we believe most of these problems tobe overcome and US GDP growth to acceleratehandsomely from 1.6% y/y this year to 3.3% and 3.7%respectively in the next two years. However, we expect

the market to remain anxious over tapering until itstarts and crucially the Fed clarifies its intentions, bothof which we believe will occur in December. In our

scenario, this means that actual tapering can take place ina more orderly manner (After all, the market will then havespent around six months focused on and worrying aboutit). As it occurs, US yields will increase only slightly furtherand reach 3.15 in the 10-years segment by the end of 2014.In this environment, the market will have a better chance torefocus on the global, more synchronised recovery, whichwill reach trend levels for the first time in several years.

EM growth and what the market will emphasise:Whether investors will cheer the recoupling of EM growthto the recovery taking place in DM since 1H13 or focusdisappointedly on the failure of EM growth to return totrend, may crucially depend on psychological factors. Bothstories will probably be true simultaneously; the question iswhich story will be told, and listened to? If generalsentiment is supportive, the recoupling story may well win

out. However, if bears seize control, the focus will morelikely be on sub-trend growth and structural challenges.

So, having spent the summer in the lower/left corner of thematrix, where-to from here? As outlined, fear of tapering(and worries about US fiscal policies) will remain dominantduring Q4. Moving into next year, however, we think a shiftwill take place towards the lower/right corner of the matrix;more focus on EM recoupling as the Fed clarifies itsintentions and US fiscal issues are resolved. Potentially, aperiod of focus on strong US growth and EM recouplingcould follow. But the surprise effect of recoupling will not

last too long and with more, potentially destabilising, stepsto follow on the Feds (long) route towards the exit, wedont expect the top/right corner to characterise 2014.

We draw the following strategic conclusions from theanalysis above:

1. Generally cautious on EM in Q4 better outlook2014.Generally speaking, EM assets will remain vulnerableduring Q4. On balance, heading into 2014, flip sideinfluences should support a more conducive

environment for them. We expect a debt to equity shiftin capital flows.

2. Range-bound trading creates opportunities.In coming months, most markets are likely to bebounded by market pricing before tapering worriesbegan in May and when market stress peaked in lateAugust. Rather than extrapolate market movements,they should seek opportunities as such boundaries areapproached, albeit with discrimination.

3. Diversification.

Old and familiar correlations and trading patterns havechanged rather dramatically in recent months. Forexample, the correlation between EM FX vs. USD and


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risk appetite broke down in late 2012, whilebetween EM FX vs. USD and EUR/USD thisbreakdown occurred in May this year. Meanwhile,since last spring the correlation to US yieldschanged sign and became very strong, only toweaken again following the September FOMCmeeting. Also, while several Asian currencies haveperformed worse than during previous periods ofmarket stress, many CEE currencies have beenremarkably stable. This reflects recent diversetrends in industrial production, exports and currentaccounts. By implication, there are plenty ofpotential gains to be had from diversification. Thestrength of recovery will be crucial. Also, can astronger cyclical recovery take hold or willstructural deficiencies restrict growth? How strongis the economys dependence on credit expansion

and external financing? Where have valuationsimproved and where not? Differences in theseareas create often attractive intra-EM relativetrading opportunities.

EM FX driversThe balance between EM FX currency drivers in ourscenario will change in time. Consistent with theconclusion we drew based on our reasoning regardingthe flip sides of both coins, more defensive driverswill dominate during Q4, while factors that appealmore to risk seeking investors may be preferred

heading into 2014. As a result, we expect focus in thenear-term to be on:

weak/deteriorating current account balances

high external financing requirements, and

reliance on credit driven growth.

Towards the year end, after the Fed has begun modesttapering and also resolved much of the currentconfusion, the market should gradually refocus on:

recovering growth improved valuations

light positioning

capital flows (mainly equities) and

carry (to some extent).

SEB EM FX forecastsAccordingly, currencies most at risk during the rest of thisyear are KRW, IDR, THB and INR, with expected nominaldepreciation of about 5% vs. the USD. By the end of 2014,we forecast currency gains, excluding carry, of about 6%

for MXN and 3-4% for CNY, INR, IDR and CLP vs. the USD.Among the EUR-traded crosses, we see a nominal upside ofabout 4% for PLN and RON by the end of next year.

As a rule of thumb, in determining appropriate hedging ofEM currency exposures in coming months, we recommenda 25% hedging ratio for all major EM regions, based on:

recent improvements in positioning and valuation

our main scenario, and

risks to it and the potential damage to EMcurrencies that may be inflicted if this happens.

This recommended hedging ratio is largely consistent withour last report, though for Emerging Europe we havereduced our previous 50% hedge to bring it more into linewith other regions.

Our forecasts for EM currencies in coming quarters are asfollows:

01-okt-13 1M Q4 13 Q1 14 Q2 14 Q3 14 Q4 14

PLN 4,22 4,25 4,20 4,15 4,15 4,10 4,05

HUF 297 300 298 295 295 295 295CZK 25,7 25,8 25,9 25,8 25,5 25,5 25,2

RON 4,45 4,45 4,43 4,38 4,33 4,30 4,27

RUB 43,8 44,1 43,4 42,1 41,6 41,7 41,4

RUB/BASKET 37,4 37,8 37,5 36,8 36,5 36,8 37,0

RUB 32,3 32,7 32,7 32,4 32,4 32,8 33,4

PLN 3,11 3,15 3,17 3,19 3,23 3,23 3,27

HUF 219 222 225 227 230 232 238

CZK 19,0 19,1 19,5 19,8 19,8 20,1 20,3

UAH 8,18 8,20 8,20 9,00 9,10 9,20 9,30

TRY 2,01 2,05 2,05 1,98 1,98 2,05 2,10

ZAR 10,00 10,20 10,20 9,80 9,80 10,20 10,50

BRL 2,22 2,25 2,25 2,20 2,20 2,25 2,30

MXN 13,09 13,20 13,00 12,70 12,50 12,40 12,30

CLP 505 508 505 500 495 490 490

CNY 6,12 6,10 6,08 6,02 5,98 5,94 5,90

CNH 6,11 6,10 6,08 6,02 5,98 5,94 5,90HKD 7,75 7,80 7,80 7,80 7,80 7,80 7,80

IDR 11315 12000 12000 11500 11200 11000 11000

INR 62,3 63,5 65,0 64,5 63,5 63,0 60,0

KRW 1074 1150 1100 1080 1070 1060 1050

MYR 3,23 3,20 3,30 3,25 3,20 3,20 3,20

PHP 43,3 43,0 44,0 43,8 43,5 43,0 42,5

SGD 1,25 1,28 1,30 1,28 1,26 1,24 1,22

THB 31,1 32,5 32,7 32,5 32,0 31,5 31,0

TWD 29,5 30,2 30,2 30,0 29,7 29,4 29,2

EUR/USD 1,36 1,35 1,33 1,30 1,29 1,27 1,24

USD/JPY 98,0 100 103 105 107 109 110

SEB EM FX forecasts for eop

Vs. EUR

Vs. USD


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Trading recommendations

Buy CNY NDF vs USD 1MWe currently have this position in our SEB Asia FXPortfolio. We like CNY for three reasons. First, we still

find it undervalued. According to our FundamentalEquilibrium Exchange Rate valuation model, we findCNY to be undervalued by about 2% in REER terms.Over the longer time horizon, we still find CNYundervalued by almost 17%. Second, with therecovery in exports to US, China will be reluctant toaccumulate as much FX reserves as in the past andslowdown. FX appreciation is one solution. Third, hotmoney inflows will be slowly increasing as RMBdenominated assets such as property continue toperform well. We prefer NDF instead of CNH since thepolicy rate is less susceptible to Fed policy.

12.4

8.86.0

2.0 1.5

-3.3 -4.5-7.1

-9.9

-15.9-20

-15

-10

-5

0

5

10

15

20

SGD

TWD

KRW

CNY

PHP

THB

MYR

INR

IDR

JPY

REER change needed for macro adjustment (%)

Undervalued

Overvalued

Source: CEIC, SEB

Look to buy INR/IDRThese two currencies run current account deficits andtheir performance have been hit this year. We like INRbetter since it has fewer chances of inflationpressures. India hiked fuel prices faster and we thinkIndonesia has 3-6 months before inflation peakswhereas the central bank thinks it has already peaked.Our experience from 2005 tells us that Indonesia hasstrong secondary effects when fuel prices are hiked.Next, we think India is three months ahead in its

current account adjustment relative to Indonesia.Lastly, India has been more transparent and flexible inthe spot currency market, which will make it easier forbargain hunters to enter India. In Indonesias case,spot USD/IDR is still unclear and deters investors fromre-entry.

140

160

180

200

220

240

260

280

05 06 07 08 09 10 11 12 13

INR/IDR 3M NDF

Look to sell USD/SGDSGD has very strong fundamentals with a large currentaccount surplus, low foreign inflow positioning and stronginvestment. Most importantly, they are following a similarstrategy to China where they want to live with lower growthbut with higher quality. One policy has been to limit

immigration to improve wages of local residents, which willlead to steady inflation pressures. Singapore uses thecurrency to control monetary policy and will continue to doso. Currently, SGD is still expensive and we prefer to buyon dips towards fair value of the NEER on risk off events.

112

113114

115

116

117

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119

120

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123

Jan-12

Feb-12

Mar-12

Apr-12

May-12

Jun-12

Jul-12

Aug-12

Sep-12

Oct-12

Nov-12

Dec-12

Jan-13

Feb-13

Mar-13

Apr-13

May-13

Jun-13

Jul-13

Aug-13

Sep-13

Oct-13

SGD NEER

Buy 1*2 put spread in EUR/MXNThe Mexican peso tops the list of our favoured currencies.Three factors stand out in its support looking forward. First,the progress on reforms will continue which graduallyreduces bottle-necks in the economy and lifts potentialgrowth. It also distinguishes the country in an intra-EMcomparison since we expect rather modest structuralimprovements elsewhere. Also, fundamentals are good fora start. Second, Mexico is the EM country that most directlywill benefit if our optimistic scenario for the US economymaterialises. Third, positioning has become veryfavourable.


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Given our cautious views for EM FX in the near term,we prefer to express our bullish stance on the MXN inthe medium term through options, and vs. the EUR.We recommend buying a 5M, 1*2 put spread inEUR/MXN with strikes at 17.50 and 16.50. With ourforecasts on USD/MXN and EUR/USD, the 16.50 levelwill be reached by the end of 1Q14. The all in cost ofthis is about 1% of notional and the potential net gainis about 4 times the invested amount.

Buy USD/ZAR on dipsThe rand is one of the currencies that has taken a bighit this summer. This is for reasons that continuemaking it one of the most vulnerable currenciesahead. The country suffers from substantial twindeficits with a C/A deficit in Q2 of 6.5% of GDP and

poor trade data as late as August. The September PMIwas a cold shower, dropping from 56.5 to 49.1. Theoutlook for reforms is dimmed by continued unrest onthe labour market as well as among trade unions andby the upcoming elections in April next year. Withoutproductivity enhancing reforms, continued highinflation will eventually require a weaker nominalexchange rate to maintain competitiveness.

The rand is also vulnerable to episodes of liquiditystress since the SARB is unlikely to intervene to lendthe rand support. Finally, the technical outlook of

USD/ZAR is bullish.

We look to buy USD/ZAR on dips to around 9.80 and

would look for a move towards 10.40 with a stop at 9.50,below the post September-FOMC low.

Buy PLN/CZK on dipsThe Polish economy is revering up with influences fromimprovements not least in Germany. This has helpedturning the current account into surplus in recent months.The sharp slowdown has been cyclical in nature and wethink the domestic economy will gradually kick in as well tosupport a return to decent growth next year. The Czechexport industry too is gaining strength but the domesticeconomy remains weaker. Further improvement reducesthe odds that the CNB actually uses FX interventions (tobuy EUR/CZK) at least if inflation start rising from itscurrent very low level.

The CNB has voted twice on the issue but held its powder

dry but statements from Governor Singer keeps thepossibility very much alive. We think the likelihood ofinterventions has fallen below 50% but not by much. Thistrade would immediately benefit if that scenario plays outand the sheer threat of interventions will keep a floor underEUR/CZK. In our main scenario, we dont expect massivemovements in PLN/CZK but would regard risk reward asattractive to buy on dips to about 6.0 aiming for a move to6.20 (in line with our targets during 1Q14) and with a stopat 5.90. The risk to this trade would be a severe liquiditysqueeze since EUR/PLN is more vulnerable to the upsidethan EUR/CZK given Polands still substantial foreign

ownership in the bond and equity markets.


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Fixed Income: Driven by the taperingebb and flowIn our previous EM Explorer published back inFebruary, we argued for the stretched valuations ofboth local and hard currency bonds in the EM space,

with the reasoning that hard currency bonds would behit harder than local currency bonds under marketdistortions. Looking back on the performance duringthe period since our cut-off date of 20 February untiltoday, we conclude that hard currency bonds,measured as EMBI+ sovereign spread versus UStreasuries, increased by 83bps compared with 55bpsspread change for the local currency GBI EMbenchmark over US treasuries.

The market has now corrected to the upper part of theprevious years range. So would that mean that it istime to buy the asset class again? Our answer is; notquite yet. Given the current drivers of the market, weare cautiously optimistic on the asset class over themedium term but we see risks of poor performance inthe near term. We believe that the timing to add to EMfixed income will come, but not until the Fed clarifiesits intentions and reduces the confusion currently inthe market. Presumably, this will happen in December.

With EM growth showing signs of green shoots, and

PMIs in a number of countries on the rise, it lookspromising on a stand-alone basis. However thetapering ebb and flow, where the Fed has taken themarket by surprise twice since the speech by BenBernanke on June 19 and September 18 respectively,makes the market sensitive to the timing of the actualtapering.

Flows in redThe EM fixed income fund flow statistics show aboutthe fairly steady inflows to the asset class during thelast years. However, YTD flows are in red after inflows

during the first five months of the year followed byoutflows since then.

Source: IIF

Taking the accumulation of assets during 2011 andespecially 2012 into account, there is still room forcontinued outflows from EM fixed income funds near term,

should the market become anxious about the taperingimpact on risky assets.

Liquidity and central banks dominateIn the absence of EM self-sustained growth, the asset classwill continue to be driven by liquidity and central bankactions. Since the tapering discussion started to surface inMay, there has been an increased correlation between USbonds and EM ditto as seen below. While US yields are upby about 80bps, the GBI-EM rates have risen by close to150bps during the same time.


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We believe that EM yield levels over the medium termwill be closely linked to the yield levels of the USTreasuries. Our projection for the 10-year US treasuryyield by December 2014 is 3.15%, 50 bps higher thancurrent market pricing. The level correlation betweenthe 5-year US treasury and GBI EM has moved outsideits recent correlation range, now being close to 0.9measured as the rolling 90day level correlation. Webelieve in continued strong correlation near term, witha risk of spread widening, should the markets start tofeel the tapering discussions surface again.

Taking a closer look at the short end, the market hasnot altered its projection for FED funds more thanmarginally compared to the pricing as of Februarywhen we last looked at the projections for the rate

using Fed Funds futures.

FED Funds futures

Yield 2013-02-20 Change

Sep 13 0,08 0,14 -0,06

Dec 13 0,11 0,15 -0,04

Mar 14 0,12 0,17 -0,05

Jun 14 0,14 0,2 -0,06

Sep 14 0,19 0,25 -0,06

Dec 14 0,24 0,31 -0,07

Mar 15 0,33 0,4 -0,07

Jun 15 0,45 0,47 -0,02

Sep 15 0,59 0,58 0,01

Dec 15 0,81 0,69 0,12

Maturity

Downside market risks near termAlthough hard currency spreads have come back upand the VIX is range bound, we are still in the lowerpart of recent years range for VIX, something that addsto our cautious stance.

EM bonds still offer fundamental value

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

for some reversal of this summers spread widening. Thiswill, however, not take us back to levels from before thesummer since the playing field has changed with theparadigm shift of Fed now looking towards the exit. In linewith that, and as we explore in the Theme article we expecta shift from bond to equity flows moving forward. Still,yields have risen to attractive levels and fundamental arebetter than historically. Excluding the EM dummy riskpremium EM ratings would be 3.6 notches higher onaverage, equivalent to AA-, according to an IIF study madein 2011. In addition, better fundamentals leads to a positivecredit migration of some EM countries. Given the globaloutlook still with plenty of resources available and the Fedto stay put until 2015 as we see it, EM fixed income stilloffers a massive yield pick-up. Combined withstrengthening fundamentals in a number of emergingeconomies, we think the combined yield and currency

performance bodes well for the asset class over themedium term.

SEB EM bond basket updateSince our last EM Explorer cut off 20 February our portfoliohas delivered a return of -6.6% in USD terms and a slightpositive return in local currency, up 0.6%. The localpositive development is mainly driven by the performancefrom Hungary and Mexico. The largest negativecontribution comes from Indonesia where we have beenwrongly positioned; having 15% weight in the portfoliodeducting 0.8% of the total weighted return in local

currency. The IDR is also the worst performing currencyadding to the negative performance, weakening almost15% since February. Brazil has also been one of our largestpositions in the portfolio, adding to negative performancethis time, mainly driven by the currency that lost 11.5% tothe USD. We were wrong on this pick as we believed in astronger BRL. Our position in South Korea added to anoverall positive return in local currency. The GBI EMbenchmark has rendered a negative return in local currencyof -3,8% local return and -8,2% in USD terms.

SEB EM Bond Portfolio February 20 2013 to Oct 1 2013

GBI-EMweight

SEBweight Yield Yield

20-Feb 01-Oct `= i~=K rpa=K

Poland 10% 10% A- 3.6% 3.6% MKNB OKPB OKQB

Hungary 6% 7.5% BB 5.6% 5.0% JMKPB RKSB RKOB

S. Africa 10% 7.5% BBB 5.3% 6.2% JNOKNB NK VB JNMK RB

Turkey 10% 15% BB+ 5.9% 8.4% J NNK NB J NK PB JN OK PB

S. Korea 0% 10% A+ 2.8% 2.9% MKQB NKQB NKUB

Indonesia 10% 15% BB+ 4.8% 7.6% J NQK UB J RK PB JN VK PB

Malaysia 10% 10% A- 3.1% 3.1% JQKPB NKVB JOKRB

Brazil 10% 15% BBB 9.3% 11.4% JNNKRB MK PB JNNK OB

Mexico 10% 10% BBB 4.5% 3.8% JPKTB QKMB MKNB

Average 100% BBB 5.2% 6.3% JTKPB MKSB JSKSBGBI-EM: -3.80% -8.24%

m~==c=OMRatingS&P

(LT-FC)

Underweighting South Africa and Indonesia,

overweighting Hungary and Mexico


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In the new bond basket, we change referencesecurities in South Africa, Mexico, Turkey andMalaysia. The overall duration of our new portfolio is3.4 years.

We increase weights and our overweight in Hungary,

Poland, Mexico and Malaysia, since we likefundamentals and the currency outlook, at least on arelative regional basis. In Hungary we also expectanother 60bps cut in policy rate, more thanconsensus. We remain overweight in Korea butsomewhat less since our previous allocation as thewon has already outperformed. We have reducedIndonesia from overweight to underweight. We remainunderweight in South Africa and have reduced Brazilto market weight given lingering nervousness abouttapering.

Our new portfolio is presented below:

New SEB EM Bond Basket Oct 1 2013

GBI-EM

weight

SEB

weight Yield

Duration

years

01-Oct

Poland 10% 15.0% A- 3.6% 2.8

Hungary 6% 15.0% BB 5.0% 3.6

S. Africa 10% 7.5% BBB 7.0% 4.3

Turkey 10% 10% BB+ 8.6% 3.9

S. Korea 0% 7.5% A+ 2.9% 2.8

Indonesia 10% 5% BB+ 7.6% 3.1

Malaysia 10% 15% A- 3.1% 4.1Brazil 10% 10% BBB 11.4% 2.8

Mexico 10% 15% BBB 4.6% 3.6

Average 100.0% BBB 5.5% 3.5

Rating

S&P

(LT-FC)


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Quantitative and technical analysisStarting in the quantitative corner:

Downtrends in USD/KRW and USD/TWD stand outwhen screening the EM FX universe for interesting

trend trades and deserve further fundamental andtechnical scrutinizing.

USD/IDR and USD/TRY uptrends are overstretchedand there is an intensified risk of correction in theseparticular currencies.

Screening for trend trades

In order to screen currency pairs for interesting trendtrades we apply the three standardized measures: (1)trend-o-meter, (2) stretch-o-meter and (3) vol-o-meter. What we are looking for are currencies with astrong trend (high chance of autocorrelation), low

stretch (low probability of a correction) and low vol(trademark of a smooth trend).

CCY Trend Stretch Vol 3m change 1m change

USDIDR 1.87 2.75 0.65 12.9% -0.4%

USDKRW -1.70 -1.23 -0.07 -5.7% -1.9%

USDPLN -1.32 -0.95 0.05 -6.8% -3.6%

USDTWD -1.09 -0.10 -0.11 -1.7% -0.9%

EURRUB 0.96 1.66 -0.20 3.4% -0.6%

Top 5 trending currency pairs

We screen for the five top trending currency pairs andthen evaluate these using the two other measures.USD/IDR has the strongest trend but also a severestretch making a correction (mean reversion tendency)to probable for a trend trade to be optimal.Furthermore, the vol-o-meter indicates that realizedvolatility has been higher than usual which tells us thatthe trend, even if strong, has not been nice andsmooth. On this basis we would not consider goinglong USD/IDR at the moment.

The two currencies among the top five trending

currency pairs that we find interesting are shortUSD/KRW and short USD/TWD. Both these currencypairs combine strong trends with relatively lowstretches and below average volatility. Furthermore,when comparing their respective 3 months changewith the 1 month change they both point in the samedirection further, indicating that the trend has not lostmomentum.

To conclude, the quantitative screen forinteresting trend trades show that one shouldinvestigate shorting USD/KRW and USD/TWD inmore detail, e.g. are there fundamental reasons why

these trends should continue and what has technicalanalysis to offer regarding timing of a trade.

Another way to assess the trend is the use of linearregression on the aggregated change. The advantage withthis approach is that it takes each observation in the 3month sample into consideration (while the trend-o-meteronly use the initial and ending levels), provides both ameasure of the strength of the trend (the regressioncoefficient) and the reliability of the trend (the explanatorypower as shown by R2), and is more visual.

As can be seen in the charts below a regression approachcomplement our conclusions regarding the USD/KRW andUSD/TWD trends: USD/KRW trend has been stronger (witha daily change of -0.06%) than the USD/TWD trend (-0.02%) and it is more reliable as it shows a more persistentpattern (R2 0.8 vs. 0.6).

The question is if the fundamental reasons behind thetrend still are in play? If so, short USD/KRW is the EMtrend trade to seek!

y = -0.0006x + 25.083

R = 0.8006

-0.07

-0.06

-0.05

-0.04

-0.03

-0.02

-0.01

0

USD/KRW Aggregated change past 3m

y = -0.0002x + 6.686

R = 0.6035

-0.025

-0.02

-0.015

-0.01

-0.005

0

USD/TWD Aggregated change past 3m

FX-o-meter descriptions

The trend-o-meter is the standardized three monthchange where a positive (negative) score indicates that theEM currency has depreciated (appreciated) and the score isexpressed in standard deviations. It assumes that astronger trend indicates a higher probability that the trendwill continue.

The stretch-o-meter provides a measure for the strengthof mean reversion tendencies which is standardizedbetween currency pairs (making direct comparisonpossible). The larger the stretch score the larger is theprobability that mean reversion tendencies will set in and


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drive a currency towards its longer term average (inthis case its one year moving average).

-3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3

USDIDR

USDTRY

USDUAH

EURRUB

USDINR

USDMYR

USDZAR

USDCLP

USDMXN

USDPHP

USDBRL

USDTHB

USDRUB

EURPLN

EURHUF

USDSGD

EURRON

EURCZK

USDTWD

USDHKD

USDHUF

USDPLN

USDKRW

USDCNY

USDCNH

Stretch-o-meter

Region with intensified risk of correction

The vol-o-meter is our third measure for currencypairs. It measures how current realized volatilitydeviates from the average/normal realized volatility. Anegative (positive) score indicates that currentvolatility is lower (higher) than normal. The measureserves as a warning signal when contemplatinginvesting in a trend. A positive vol score indicates that

the risk is high and that one has to be prepared forswings in the P/L. Also the lower the vol score thesmoother and in one a sense the stronger the trend.

-1.0 -0.5 0.0 0.5 1.0

USDIDR

USDINR

USDBRL

USDTRY

USDMYR

USDSGD

USDMXN

USDTHB

USDCLP

EURRON

USDPLN

USDZAR

EURPLN

USDPHP

USDRUB

USDKRW

USDHUF

EURCZK

USDTWD

EURRUB

EURHUF

USDHKD

USDCNH

USDUAH

USDCNY

Vol-o-meter

In the following we share some key conclusions from ourteam Technical Analysts:

USD/KRW to test 1,050 area in medium-term

Short-term, USD/KRW is impulsively trending lower having

already fallen back below the yearly moving average band.Recent violation below 1,082 adds to the already presentmedium-term downside in a technical environment thatalready supports the won. Provided it remains below 1,095-1,110, or even 1,127, we favor further downside targeting1,054-1,048. In fact, the 2011-2013 wave structuresuggests levels as low as 1,009 are possible. The KoreanKS11 stock market index (2,010) is holding above apreviously violated medium-term trendline but has yet tobreak key resistance at 2,042-2,057. When it does, itshould represent yet another bullish factor for the won.

USD/INR is set to move higher from medium-termequilibrium position

In the medium-term, USD/INR was severely overstretchedonly a few weeks ago. The market rally has paused andneutralized previous strained short- to medium-termconditions. The correction down to the rolling 21 weekhigh/low average or "Base line" (aka "Tenkan-Sen") hasreturned the pair to medium-term equilibrium, bothsupporting (because over time it is increasing) andattracting during correctional moves. A short-term moveback above 64.65-65.25 would strongly argue for a freshhigh above 68.80 then moving closer to a 2008-2011

261.8% Fibo projection point at 78.20 as a topside beacon.


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

The real trades like the rupiah, though the marketmanaged to extend USD/BRL losses slightly below therolling 21week high/low average, albeit with no

greater success in maintaining the break. Now, theprevious medium-term stretch is fully neutralized. Ifbuyers are encouraged by support at the 50%retracement ref, they should soon be able to breakback above minor resistance currently at 2.3150. Amove back below 2.18 would call for an alternativeroute closer to 2.1375 before moving upward. In theshort-term, the Brazilian BOVESPA index (53,785) isshowing signs of exhaustion near its medium-termdynamic resistance (at market). Falling back under54,110 on a weekly close would increase downsiderisks considerably, probably adversely affecting the

currency.

Russian rouble faces new headwindsThe Russian rouble basket (37.52) has reboundedsharply from its rolling 21week high/low average. Thehigh weekly close (27/9) may once again startchallenging its recent 38.31 high. A move above thispoint would refocus medium-term attention on a2012-2013 "Equality point" at 39.00. The Russian IRTSEquity index (1,433) risks having completed a Jun-Sep3-wave correction. Below 1,401 would make this morelikely, while a move under 1,285 would substantially

increase the risk of a break below a long-term key refat 1,200. Being hardly rouble positive, this would inturn have a significant and far reaching negativeeffect.


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Asia

China: What is Liconomics?From Freakonomics to Abenomics, now the termLiconomics is making the rounds in markets and

media. Similar to Abenomics in Japan coined by PrimeMinister Abes economic policy, Liconomics isnamed after Chinas Premier Li Keqiangs economicpolicy. Unlike Abenomics, Liconomics is not an officialterm endorsed by Li and was concocted by theinvestment community. Liconomics is roughlyframed around three pillars, which are 1) limitedleverage 2) limited stimulus and 3) structural reform.In our view, Liconomics isnt a paradigm shift inChinas economic policy but a small step away fromthe stop and go economy. The 7% floor in growth willbe firmly protected but this time well only get a light

tap on the pedal if the economy starts heading belowthe 7.5% target.

The magic 7Before we begin, Liconomics needs to be put intocontext of the GDP growth target and the floor. InJune interbank rates spiked where 7 day repo ratejumped from around 4% to almost 11% (for moredetails see Is China risk on the rise?, China Tracker 20June 2013). Spikes in interest rates happen often butthis time, the spike was more extreme, lasted longerand the government did this deliberately to teachbanks a lesson to better manage risk. The governmentwas getting serious about inflicting short term pain toimprove long term growth.With a 7.5% growth target for 2013, how much painare the authorities willing to take? Unofficialcomments from Li state that the floor on growth is6.9%. Former President Hu Jintao set a goal in 2010to double the size of GDP by 2020 and China needs togrow by 6.9% to meet that goal. China sets long termgoals and those dont change with a newadministration. In addition, Li believes that when the

economy grows below 7% as China saw in 2008-09the adverse impact on employment becomes toostrong. 7% or 6.9% looks to be the floor and the painthreshold.

China Real GDP

56

7

8

9

10

11

12

13

14

15

16

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

% yoy 4qtr mvavg

Li's 7% floor

The pillars of LiconomicsWith that in mind, we can better understand the threepillars of Liconomics. The first pillar on limited leverageshould not mean deleverage but to slow the pace ofleverage. For example, this years bank credit target wasset at 13.5% but as of June we are already averaging14.8%yoy. Our estimate of total social financing, whichincludes bank and non-bank loans (e.g. corporate bondissuances and trust loans) shows credit growth averagingeven higher at about 22%yoy. Liconomics will bring creditgrowth towards the target of 13.5% instead of contractingit. We are too close to the growth floor for deleveraging.

10

15

20

25

30

35

40

05 06 07 08 09 10 11 12 13

Bank Loans Total social financing estimate% yoy

The second pillar of limited stimulus does not mean shocktherapy. The 7% floor will be protected. Instead,Liconomics will move away from the old habits of overstimulating the economy when growth falls below the 7.5%target. So in todays context, Li will provide small measuresto support the economy such as the one announced todayto exempt small companies from value-added and businesstaxes.

Third, Li will focus on economic restructuring while growthis not at the floor. Li has mentioned several areas of focus.First, he wants to control Chinas volatile food inflation.Much of Chinas inflation is food related from things likepork and feed, which inflates CPI and forces the authoritiesto tighten aggressively. Li will focus on agricultural reformsto smooth out food inflation. Second, he wants to r

Documents

SEB's Emerging Markets Explorer October 2013