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Emerging markets at a glance: Voice or money.

EMs increasingly face two interconnected challenges. Firstly, inflation is climbing further,and central banks will continue to tighten.

Secondly, the situations in Tunisia, Egypt and Libya suggest that people need voice or money. Some countries seem more vulnerable than others to MENA contagion: those where the increase in GDP per capita has been slow, and where perceived freedom of speech and political freedom are limited. They happen to be located in the Middle East. And some of them are huge oil producers.

Two challenges mounting

Back in our last EM Monthly Roadmap (Food for hawks, published 26 January), we mentioned mounting challenges for EMs. Quite clearly, things have not got better since then, in terms of inflation as well as in terms of MENA political tension.

Inflation climbing further

On the inflation front, challenges have intensified further. The EM headline inflation has accelerated further, reaching multi-month record- high levels in many countries, including China, Russia and Brazil. In India, disinflation has been sticky, and too slow to avoid street protests. Our sequential inflation index for 27 large emerging markets has climbed further. The gauge reached 7.6% in January. This level is similar to that reached in November 2007, just five months before the index reached its record level of 11.1%, in April 2008.

The sharp increase in global food prices between early December and early February (+20%), and the recent spike in oil prices, suggest inflation pressure may not moderate in the coming months.

The rather strong data momentum in both the US and Europe suggests that demand is strengthening there - also supportive for food and energy prices. We still believe that most EM central banks will continue to tighten monetary policy ... and those that have been reluctant to hike policy interest rates so far (Turkey) may have to reconsider sooner rather than later.

Libya opens Pandora's Box to contagion

On top of that, the spread of the MENA political unrest to Libya makes a big difference to the possible regional and even global impact. Tunisia and Egypt are not oil exporters. By contrast, each Libyan person is sitting on about 7,000 barrels of proven oil reserves. This is more than Iran and Iraq (respectively about 2,000 and 4,000) and only marginally less than Saudi Arabia (about 10,000). Almost the same could be said when looking at levels of development. GDP per capita in Libya is about USD12,200 - much higher than Tunisia (about USD4,100) and Egypt (USD2,700). This has two implications in our view:

*It shows that oil is not an efficient shield against political instability, after all. Therefore, the door is now open to the market contemplating the idea that other oil producers may get into trouble. Hence a risk on the upside for oil prices if this idea spreads.

*It means that being relatively rich does not mean a country's institutional framework cannot be seriously challenged by its population. This could at the end of the day ring bells in other parts of the world. For instance, some social networking websites claimed to have been temporarily frozen last week by Chinese censorship, and the issue of possible contagion to China has been raised here and there.

Who is vulnerable to contagion?

It is actually striking that criticism expressed in Tunisia, Egypt and Libya is targeting both the inability of these regimes to generate sufficient improvement in wealth per capita as well as some frustration vis-Ea-vis the lack of political freedom and freedom of speech.

In an attempt to illustrate how emerging markets rank according to these two criteria, we chart 42 markets, according to...

*...the 'Voice and accountability' index of the World Bank's KKZ index

*...the average real growth of GDP per capita over the past decade.

Three large Middle East countries are in the bottom-left corner (not the most comfortable position - where Tunisia, Libya and Egypt also stand): Saudi Arabia, Syria and Iran (this could also be said about Iraq and Algeria to some extent). This suggests that the situation in these three countries should be monitored closely. Still, we argue in Hot topic 1: Is Saudi Arabia next? (later in this report) that the kingdom faces serious challenges, but also benefits from a series of buffers which have to do with the use of the financial leeway provided by the oil rent.

It is also interesting to note that China does not rank well as far as the KKZ index is concerned, but - not surprisingly - has displayed impressively strong growth in GDP per capita over the past ten years. This, in our view, provides an important buffer against possible social or political anger.

Interest rate outlook: EM inflation hawks

Inflation pressures are intensifying in Asia and EMEA, pushing up rates, while they are less threatening for Latam markets. It is becoming trickier to time the ultimate flattening of curves, depending on how quickly policymakers are reacting to inflation. A way to position for bad news, be it inflation or MENA risks, could be paying EMEA rates and buying linkers. Meanwhile, safe-haven flows into bonds amid geopolitical risk could result in bond outperformance.

Asia: competing with time

Asian rates had been paid up in the past month, quite aggressively in some markets, despite some easing in late February amid heightened geopolitical risk. The curves were little changed in the CNY, INR, SGD, KRW and TWD markets, while the HKD and THB curves flattened over the month. We still expect Asian curves to largely steepen/remain steep in the weeks ahead, but it is becoming trickier to time the ultimate flattening.

Inflation pressure is intensifying, with signs that it has been spreading from the usual housing and food items to broader consumer products. This will push up long-end rates further and steepen curves. At the same time, precisely because of the higher risk of inflation, central banks are becoming more hawkish, potentially stepping up their tightening process and flattening curves earlier. So it is a matter of whether central banks will be able to catch up with or even run ahead of the development on the inflation front.

Geopolitics on bond/swap spreads

Complicating monetary decisions is geopolitics. It represents an external uncertainty which could impact global growth, affecting prospects for Asia, but oil prices have already risen adding to the inflation threat. Overall we believe more weight will be given to the geopolitical impact through inflation rather than the growth channel, given strong fundamentals in Asia. Central banks are likely to remain hawkish at a time when the bond markets are benefiting from safe-haven flows.

As such, recent developments in geopolitics add to our view that central banks' hawkishness is likely to be reflected more in the IRS market, resulting in bond outperformance. Our long 5Y KTB/IRS position has been resilient and performed. We are looking for similar opportunities in the HKD rate market, with bond/swap spreads seen wider. In the past month, government bond performances relative to IRS have been mixed, with yields falling relative to IRS in the CNY, TWD, INR and front-end THB curves, while bonds have underperformed in the HKD, SGD and KRW markets. We expect bond outperformance to become more obvious in the weeks ahead.

Asian local factors rule near term

In the HKD rate market, we expect some steepening in the month ahead, for a number of reasons. Firstly, former issuance-related receiving flows at the long-end appear to have dissipated. Secondly, liability hedging flows are coming in amid rising inflation - CPI inflation unexpectedly rose markedly to 3.6% YoY in January from 3.5% previously. Price pressures have spread across consumer items, pointing to an extended period of high inflation. Thirdly, the 10Y USD-HKD IRS spread (with 10Y HKD IRS below USD IRS) has widened of late where a technical correction is likely. Meanwhile, increases in front-end rates are constrained by the loose Fed policy, leading to a steeper curve when long-end rates are paid up more aggressively.

The SGD curve is likely to remain steep as well, with the front-end anchored by expectations for SGD appreciation and still-low USD Libor. Headline CPI surged to a two-year high of 5.5% YoY in January, driven by the costs of housing and transport. While the MAS (Monetary Authority of Singapore) underlying inflation, which excludes accommodation and private transport, remained benign, we expect it to pick up gradually. Nevertheless, policymakers have to pay attention to surging headline CPI. The MAS is likely to tightening policy at its April meeting by re-centring

the SGD NEER band. Expectations for SGD to strengthen will pressure down forward points, suppressing the floating leg of SGD IRS - 6M SOR - which is a synthetic rate implied by FX swaps.

The flattening of the THB IRS curve over the past month was due primarily to the surges in front-end rates, which in turn was triggered by FX swap trades. We see consolidation in front-end THB rates at current levels, before another round of upward movement around Q2/Q3. With the WHT (withholding tax) in place on Korean bonds, and the narrowing of the KRW basis, the yield pick-up for Thai investing in Korean assets (the so-called Kimchi funds) is diminishing. Given that there are not too many investment alternatives, a portion of the USD is likely to flow back into Thailand and be exchanged into THB when these Kimchi funds mature, clustering around Q2/Q3. Improved USD liquidity then will push up the floating leg of THB IRS - 6M THBFIX - which is a synthetic rate implied by FX swaps.

EMEA: temporary pause in the flattening

The rate market direction across EMEA countries has become less clear, with markets looking for a direction. The conjunction of postmodern monetary policy - Russia is joining the party as well - growing inflation fears and emerging capital outflows is not helping to forge a strong view.

The inflation theme, as we suspected, has become the major source of concern for EMEA rate markets, though to an extent that we were not expecting. The flattening of rate curves has come earlier than we thought. Indeed, since the end of January markets have been pricing many rates hikes even in countries where inflationary pressures are not yet mounting sharply - Czech Republic, South Africa for instance. The relaxation of the official authorities' position regarding FX appreciation has proved to support the rate hike view as well.

The aggressive pricing of rate hikes has come too quickly in our view and we would expect a pause in the flattening move over the month. Nevertheless, the scope for steepening seems limited given the MENA tensions and the associated short-term risk and inflation premium. We still expect a flattening over the medium term.

EMEA: positioning for inflation and tail risks

The outperformance of emerging markets has been a consensus, or in other words an overcrowded trade. Alongside the rising fears, be it inflation or the MENA turmoil, trade positioning for bad news is increasingly relevant but one should remain very selective.

Firstly, with higher risk and inflation premiums and the expected rate hikes, paying 5Y rates would make sense but carry could make it costly. Thus, a very selective approach should be made - for instance, Poland or Hungary exhibit affordable negative carry. Still, positioning should not be as overcrowded as in Turkey where the monetary policy's mistake trade is highly fashionable.

Secondly, investors may take long positions in local debt but on a selective basis and at reduced duration. Downside risks are present but they may benefit FX appreciation and safe-haven flows. Still, we continue to favour bonds over swaps as (1) Eurozone debt worries are fading, (2) the EMEA budget issue is improving and (3) liquidity will help local Treasuries to fund their deficit.

Thirdly, buying breakevens may offer value given they have not moved too fast and still remain far from their 2008 levels when commodity prices were reaching highs. The ongoing rise in commodity prices has not yet pushed breakevens to extreme levels. Nevertheless, in terms of real rates, levels are well below their pre-crisis level and room for further downside seems limited. A position in the breakeven space appears so much more appealing (Turkey, South Africa).

Latam: the safe haven?

Comparatively, the Latam rate market exhibits a clearer situation as it is less sensitive to the MENA turmoil, and central banks have already tackled the inflation issue. In Brazil, we still view a further decline as the BCB is building up its credibility after having paused in Q410, and uncertainties concerning rate hikes and the new authorities' policy are dissipating. Nevertheless, one should not overestimate the importance of current inflation figures as the stance on fiscal policy has more and more impact on the behaviour of future inflation and on the yield curve. The new authorities will keep fighting inflation as it hurts the poorest people through spending cuts recently announced. So, we expect only 150bp in hikes for the remainder of the year (including the March hike) versus 217bp priced in by the markets. Assuming that the BCB remains on hold from H211 to 2013, we see value in receiving 2013 DI contracts.

In Mexico, the inflationary pressures appear moderate and the Banxico is comfortable with its current stance. Even if it has decreased, pricing of a first rate hike at the beginning of Q3 is too early in our view, but now we see less value in receiving Mexican front-end rates. Alongside the curve, rates should continue to creep higher on the back of positive Mexican macro data as well as US.

Interest rates: What's priced in vs our forecasts

FX outlook: What doesn't kill you makes you stronger

Despite rising uncertainty, no EM currency is sending an obvious sell signal. Some could even benefit (RUB and, to a lesser extent, ZAR). BRL and INR may find it difficult to appreciate further/rally. Asian FX should be resilient, supported by gradual CNY appreciation. KRW and PHP may still outperform.

What would be a reasonable way to position on the EM FX market against the current backdrop of rising uncertainties (MENA-related risk aversion, inflation building up, current account balance deteriorating)?

Overall, we believe that, among the main EM currencies, there is no obvious candidate to a clear sell signal. True, higher risk aversion and more expensive oil should induce volatility on EM currency markets. However, in our view the underlying medium-term bullish scenario for EM currencies remains robust. Also, higher oil prices suggests that central banks may hike interest rates further, and this fuels the carry attractiveness.

For some currencies, good news is bad news

For some markets, bad news even means good news, to some extent (and provided the global rise in risk aversion remains limited). This is the case for those markets that are benefiting as some commodity prices are pushed up because of the MENA-related uncertainty.

RUB may benefit

The RUB is a typical example. True, the RUB was one of the main victims of the 2008 EM crisis. However, the trigger for the RUB depreciation was the sudden fall in oil prices. For the time being, the current crisis seems to be having the opposite impact - rising oil prices. The trade surplus will remain supported in the short term. On top of that, the CBR has clearly kicked off its tightening cycle, and this should add to the RUB's attractiveness. We keep our short USD/RUB position as we believe that the behaviour of oil prices should add to the RUB's bullish short-term story.

ZAR as well, to some extent

The ZAR could benefit as well, through a different channel. Firstly, ZAR has begun to perform rather well since mid-February, as the underlying ZAR story has become more supportive. Signs of recovery have intensified recently. Retail sales have been rather strong, at 8.3% YoY; GDP was slightly above expectations in Q4; the PMI was also strong in recent months. This renewed dynamism - even if the recovery will likely be gradual - makes the local market more attractive.

Also, it is interesting to note that the ZAR appreciation has not generated a large trade deficit - contrary to what has happened in Turkey for instance (see chart). Limited external imbalances suggest that ZAR may be penalised less than those currencies where there are large current account deficits. On top of that the ZAR may benefit from higher gold prices as the MENA-related uncertainty remains strong.

Current account deficit - FX on a defensive stance

Apart from those currencies that may benefit in the current environment, the bulk of the EM FX universe may see increased volatility. This may be the case in particular for the current account deficit currencies.

For instance, in our view, the TRY may eventually rally on a multi- month basis due to a mix of: higher interest rates, rating upgrades and reasonably strong growth outlook. However, in the short term, the current account deficit may be an obstacle to such a rally.

BRL to stabilise

It may also be the case for both the BRL and the INR. The BRL has slowly crept higher vs USD over the past few weeks, but the potential for it to appreciate further may be limited. Overall, the net impact of the MENA-related jitters on the BRL may be minimal. But higher risk aversion may eventually make it more difficult to finance the widening current account deficit, and may help to cap the BRL appreciation (on top of the authorities' intervention).

INR seems vulnerable (up to a point)

The impact on the INR may be more straightforward, as it goes via two channels. Higher risk aversion may cap capital flows to India, and oil prices should widen the trade deficit. Still, even if it seems tempting to short the INR, against such a backdrop, we believe it could be a risky bet. Indeed, the RBI has traditionally used the INR appreciation to cap inflation, and this may happen again in coming months. Also, the RBI will likely continue to tighten monetary policy, and this may provide support to the INR.

Asia: resilient, partly thanks to the CNY

Asia is an oil-intensive economic region. Therefore, one could think of the recent spike in oil prices as a strongly negative factor for currencies in the region. However, it is only partly true; and for the moment we would expect the market to play the 'what doesn't kill you makes you stronger' game. Being oil-intensive also suggests that the recent increase in oil prices will fuel inflation pressure. This could sound frightening if inflation pressure were intensifying in a context of weak economies. But it is not the case, the growth outlook remains fairly strong, and apart from Vietnam (and to a lesser extent India), we do not expect the main Asian economies to run current account deficits in 2011.

Hence, what the market may read in the acceleration in inflation pressure is the promise of central bank tightening, and not the risk of imbalances derailing economic growth.

The continued appreciation after the Chinese New Year break has likely also contributed to the resilience of other Asian currencies. In our view, CNY upward pressure will remain significant, due to the current account surplus and current CNY undervaluation. Also, policymakers will allow more currency gains due to higher inflation, which may peak at a level close to 6% in June. As Governor Zhou hinted last week: '... to battle inflation, it's about using all means including ... currency'.

KRW and PHP: still some upside

Apart from the CNY, we keep open our long positions on the KRW and the PHP despite rising global uncertainty. Both currencies benefit from rather low valuations, with in particular real effective exchange rates that stand way below their pre-crisis levels (see chart). As far as Korea is concerned, it is also interesting to note that the stock market does not seem overvalued. We present in Hot topic 2: Are EM equity markets overvalued? some indicators that help us to gauge whether some of the main equity markets are sending signals of under/ overvaluation. Out of the 11 markets on which we focus, Korea stands out as the one that sends the strongest signals of cheapness.

FX: What's priced in vs our forecasts


This research report or summary has been prepared by Credit Agricole Corporate and Investment Bank or one of its affiliates (collectively "Credit Agricole CIB") from information believed to be reliable. Such information has not been independently verified and no guarantee, representation or warranty, express or implied, is made as to its accuracy, completeness or correctness.

Source : Credit Agricole, Corporate & Investment Bank, FIM Research,

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Publication:Saudi Economic Survey
Geographic Code:6TUNI
Date:Mar 16, 2011
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