SG_EM Outlook 2014

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Please see important disclaimer and disclosures at the end of the document

EMERGING MARKETS28 November 2013

Important Notice: The circumstances in which this publication has been produced are such that it is not appropriate to characterise it as independentinvestment research as referred to in MiFID and that it should be treated as a marketing communication even if it contains a research recommendation.This publication is also not subject to any prohibition on dealing ahead of the dissemination of investment research. However, SG is required to havepolicies to manage the conflicts which may arise in the production of its research, including preventing dealing ahead of investment research.

OutlookGEM in 2014: Doom and Bloom

Many investors talk about EM in terms of doom and gloom for next year. We oppose this view

and instead propose our Doom and Bloom. We believe that after a short-livedalbeit potentially

severecorrection around the beginning of Fed tapering projected for March, GEM will burgeon

forth in a strong spring rally that will extend until later in the year. Part of that will reflect the impact

of the considerably more dovish forward guidance that we anticipate from the Fed. But it will also

be driven by attractive GEM valuations and improving growth fundamentals. However, GEM

investors will have to be more discerning next year, as differentiation between both asset classes

and regions will be a major consideration. To help investors differentiate between markets, we

produce an analysis of macro vulnerability across EM , as well as an assessment of EM authorities

policy room. We also guide EM investors in navigating the heavy political calendar next year.

Downgrading our short-term call: We turn neutral on GEM for the coming weeks. EM growth picking up: EM growth should gather pace early next year, helped by the USeconomy driving the global recovery.

EM vulnerability ranking: Ukraine, Venezuela and South Africa appear to be the mostvulnerable while China, the Philippines, and Peru are the least.

Policy room in EM: There is significant differentiation across EM in terms of policy room. Peru,Korea and Chile have the most, while India, the Czech Republic and Venezuela have the least.

EM FX: LatAm will outperform its peers, and EMEA will underperform. Our top picks are theliquidity currencies from late April onwards, including the IDR, the INR, the ZAR and the MXN.

EM local debt: We favour EMEA debt in the risk-on phase, especially Hungary and Poland. InLatAm, our top pick is Mexico.

EM credit: The Philippines, Chile, Poland, Colombia and Peru should be fairly resilient againstthe downside in Q1; high beta names from EMEA should outperform in the rally.

EM politics: We see a negative balance of risks for policies in Brazil, but a positive one inHungary, India and in Indonesia.

EM still growing faster than DM in coming years (GDP, ) Expected spot returns by region, by quarter

Source: SG Cross Asset Research/EM

3.8

2.3

-6

-4

-2

0

2

4

6

8

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

EM

DM-5

-4

-3

-2

-1

0

1

2

3

Q4-2013 Q1-2014 Q2-2014 Q3-2014 Q4-2014

EMEA LatAm Asia

Global EM FX performance, %

Head of Emerging Markets StrategyBenot Anne(44) 20 7676 7622

[email protected]

Rgis Chatellier(44) 20 7676 7354

[email protected]

Phoenix Kalen(44) 20 7676 7305

[email protected]

Eamon Aghdasi(1) 212 278 7939

[email protected]

Amit Agrawal(91) 80 6758 4096

[email protected]

CONTENTSDoom and Bloom................................... 2

EM Growth Showing Signs of

Recovery............................................... 13

Differentiated Vulnerability Risks..........15

The Haves and The Have Nots: An

Assessment of Policy Room in EM......18

EM Sovereign Credit: The Pain Before the

Gain.......................................................24

How to Trade EM Politics in 2014........28

This document is being provided for the exclusive use of QIAO CAI (SGCIB)

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GEM in 2014: Doom and Bloom

The global risk backdrop for GEM: a tough start to the year,followed by some major relief

We expect the global risk environment to be challenging for GEM over the next few

months, with EM investors remaining concerned about the threat of Fed tapering.SGs

official call is for the Feds QE tapering to be initiated in March. Against this backdrop, we

choose to turn neutral on GEM from now on up to February. Overall, we have been

frustrated by the lack of appetite on the part of EM investors to put cash to work over the past

few weeks, and we now think that the chance of a strong rally in December is relatively slim,

especially given the seasonality that is turning negative reflecting the year-end portfolio

squaring. Moving on to February, the market nervousness will likely intensify as the decision

over QE tapering will be looming, ahead of the much-awaited March Fed meeting (19 March).

The renewed fear of QE tapering will likely trigger another round of correction in GEM.

As highlighted recently, the fear of QE tapering remains the primary risk factor for global

emerging market investors. Our informal survey conducted in late October showed that the

Fed fear was mentioned as the key reason for the GEMs disappointing performance by 33%

of the participants, followed by concerns over EM fundamentals. This overall means that we

stand ready to turn outright bearish on GEM by February, expecting local rates to sell off, EM

currencies to weaken, local curves to steepen, and credit spreads to widen.

The key reason behind the GEMs disappointing performance what EM investors are saying

Notes: based on a survey of 78 accounts.

Source: SG Cross Asset Research

At that time, it will make sense to favour defensive EM currencies relative to riskier ones, while

favouring rates payers and curve steepeners in EM fixed income. Our carry-to-vol indicator for

EM FX gives an excellent overview of which particular currencies produce the strongest

defensive characteristics. The TWD, CZK, SGD or ILS are the lowest beta in EM, and are

therefore likely to outperform their peers during the sell-off. In contrast, the yield-yielders,

especially those that are supported by poor fundamentals, are likely to come under significant

pressure. These include the INR, the TRY, the BRL, the ZAR and the HUF. During the phase ofcorrection starting in February, we anticipate that the so-called growth currenciesthose

that are leveraged to global growth expectationswill outperform the liquidity currencies,

0

5

10

15

20

25

30

35

Fed fear fundamentals outflows valuation positioning China seasonality


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which tend to be more sensitive to risk aversion shocks, but this will be predicated on EM

growth continuing to show signs of recovery (see full classification below).

Fair value of EM rates based on the volatility Carry-to-vol. rankings for EM currencies

Source: SG Cross Asset Research/Cross-Asset Quant team Note: PLN, CZK, HUF, RON and RUB are computed vs EUR, the others vs USD. Rates refers to the

rates differential as implied from 3M forward, annualized; Vol to the 3M implied volatility; Fair value

to the model-value of the regression of aforementioned rates vs vols for different currency pairs.

EM currencies: a simple classification

Growth currencies Liquidity currencies Safe-haven currencies

RUB

CLP

KRW

PHP

MYR

THB

COP

ZAR*

TRY

HUF

PLN

BRL

MXN

INR

IDR

RON

ZAR*

TWD

CZK

SGD

ILS

CNY

Notes: *The ZAR is a hybrid currency, sitting in both categories. Source: SG Cross Asset Research

Calling for a major GEM rally in the spring

The QE-related correction may be severe, but we also believe that it will be short-lived.

By late April, we expect to stand ready to turn bullish on GEM, as global investors will have

fully priced in the completion of QE tapering. This process will pave the way for a major rally in

GEM, in our view, supported by the Feds strengthening of forward guidance and a much

more dovish bias expressed through the lowering of the unemployment threshold. We believe

that GEM will return to goldilocks market conditions given that the prospect of a future Fed

rate hike will be quite far away. Meanwhile, we would argue that EM valuations will beattractive, reflecting the impact of the February-April correction. This will involve a radical

change of strategy approach, of course, focusing on going long high beta EM FX, buying EM

bonds, positioning for flatter EM curves, and going long high beta credit.

PLN

CZK

HUF

TRY

ZAR

ILS

TWD

KRW

INR

IDR

SGD

MXN

BRL

CLP

RON

RUB

y = 0.5273x

-4

-2

0

2

4

6

8

10

12

3 8 13

Yearlyrate(%)

Volatility (%)

Vols (%) Rates (%) Fair value CTV Rank

INR 11.7 10.5 6.2 0.9 1

RUB 7.7 6.3 4.0 0.8 2

TRY 9.6 7.5 5.1 0.8 3

BRL 12.9 8.9 6.8 0.7 4

IDR 14.3 9.2 7.5 0.6 5

CLP 9.8 4.5 5.1 0.5 6

ZAR 13.2 5.7 6.9 0.4 7

PLN 6.2 2.4 3.3 0.4 8

HUF 7.3 2.3 3.8 0.3 9

KRW 6.8 2.1 3.6 0.3 10

RON 6.5 1.9 3.4 0.3 11

MXN 10.6 3.0 5.6 0.3 12

ILS 6.5 0.6 3.4 0.1 13

SGD 4.6 0.0 2.4 0.0 14

CZK 4.4 -0.4 2.3 -0.1 15

TWD 3.4 -1.9 1.8 -0.6 16


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The past episodes of sharp UST curve steepening (2s10s)


The impact of UST 2s10s steepening on selected EM assets: a look at the recent history

UST

2s10s

(bp)

MXN

(%)

ZAR

(%)

TRY

(%)

10y

MXN

(bp)

10yr

SAF

(bp)

10yr

Turkey

(bp)

Sept. 2007/Jan.2008 110 1.87 -2.36 10.41 -13 8 -13

Sept./Oct. 2008 102 -20.13 -13.15 -16.39 54 -31 13

March/May 2009 104 5.06 17.91 7.73 10 20 -20

Aug. 2010/Feb. 2011 93 9.04 0.86 -3.92 123 115 -2

Average 102 -1.06 0.82 -0.54 44 28 -5

Source: SG Cross Asset Research/EM; Bloomberg

The key lesson that we are drawing from this look back at history is that what matters to

EM investors is not the UST curve move itself, but rather the key driver behind it.To be

precise, what we are facing next year is a UST correction not triggered by the fear of Fed

tightening, but rather by a much stronger growth performance in the US in the absence of

imminent tightening threat. Under this scenario, the risk appetite backdrop will not be dented,

and we would even argue that this could turn out to produce a risk-positive signal. We

recognise that higher US rates render EM rates less attractive on a relative value basis, but

this does not negate the risk-positive environment. It is also important to note that the front-

end rates in the US will be well anchoredhelped by a strongly dovish forward guidance,

which means that the USD will not necessarily gain strong support relative to its G10 peers.

Ultimately, higher US rates are supposed to signify that growth and macro conditions are

improving globally, which should be supportive of EM FX appreciation and narrowing EM risk

premia. The summer sell-off was completely different in nature than all the other ones we have

-50

0

50

100

150

200

250

300

350

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

bp


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seen in recent years. USD-EM was negatively correlated with UST yields, but recently this

correlation has reversed.

Historical correlation between EM FX and UST: this summer was different


Our outlook for capital flows to EM is fairly constructive

There is no denying that 2013 has been a pretty poor year for capital flows into EM. In fact,the short-term dynamics still show that outflows are ongoing, especially in EM fixed income,

where EM funds continue to register large exits week after week. Against this backdrop, we

believe that 2014 will show signs of stabilization, albeit from a lower base. The risk of further

outflows will remain present in the first few months of the new year but we expect some

upturn later on. It is interesting to note that the Institute of International Finance (IIF) does not

foresee a major decline in capital flows to EM for 2014 in its latest forecast. While the IIF

forecasts capital flows to drop significantly during the 3r quarter of 2013for which final

aggregated data are not yet availablethe path of inflows improves afterwards, with a marked

pick-up in the latter part of 2014. On an annual basis, the IIF actually forecasts a moderate

increase in total flows to EMboth private and officialin 2014 as a whole over 2013.

EM bond fund flows - cumulative EM equity fund flows - cumulative

Source: SG Cross Asset Research/EM; EPFR

-1.

-0.

0.

0.

1.

1.

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

'09 '10 '11 '12 '13

EM FX index vs USD (GDP-weighted, Jan'01 = 1)

Correlation, EM FX with UST 10y yield (180d)

60,000

65,000

70,000

75,000

80,000

85,000

90,000

95,000

100,000

105,000

Dec-12

Jan-13

Feb-13

Mar-13

Apr-13

May-13

Jun-13

Jul-13

Aug-13

Sep-13

Oct-13

140,000

150,000

160,000

170,000

180,000

190,000

200,000

210,000

Dec-12

Jan-13

Feb-13

Mar-13

Apr-13

May-13

Jun-13

Jul-13

Aug-13

Sep-13

Oct-13


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Total capital flows to EM gradually recover next year according to the IIF

Source: SG Cross Asset Research/EM; The Institute of International Finance

An uninspiring year ahead for GEM FX as a whole

Our market-size weighted index for global EM FX shows very modest appreciationless

than 1%from now to end-2014. Using a quarterly profile for FX forecasts, we expect the

trough to be registered in Q1, reflecting our top-down call on risk, followed by a risk-on phase.

This however masks some significant differentiation between the various types of currencies,

as discussed earlier, and between regions.

Global EM FX trajectory

Notes: based on our FX-market size-weighted global EM FX index. The market size weights are derived from the BIS (average daily turnover data).

Our Global EM FX index is expressed against the USD.


LatAm FX will outperform its peers next year

We project LatAm FX to appreciate as a whole by 2.8% from now until end-2014, thereby

beating the other two regions by a large margin. This outperformance is driven by our

bullish view on the MXN, our top pick in the region. The strengthening fundamentals in

Mexico, together with the completion of key reforms should help the MXN appreciate all the

way to 12.25 by December 2014, in our view. Meanwhile, the BRL will remain a drag on the

regions performance, with macro risks still weighing on Brazil in the period ahead.

-200

-100

0

100

200

300

400

20

07Q1

20

07Q2

20

07Q3

20

07Q4

20

08Q1

20

08Q2

20

08Q3

20

08Q4

20

09Q1

20

09Q2

20

09Q3

20

09Q4

20

10Q1

20

10Q2

20

10Q3

20

10Q4

20

11Q1

20

11Q2

20

11Q3

20

11Q4

20

12Q1

20

12Q2

20

12Q3

20

12Q4

20

13Q1

201

3Q2e

2013Q3f

2013Q4f

2014Q1f

2014Q2f

2014Q3f

2014Q4f

USDbn

91

93

95

97

99

101

103

Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14

actual fcsts

Jan 2007 = 100


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In contrast to LatAm, EMEA will be the underperformer in the year ahead. There are two

main factors that will undermine EMEA FX performance. First, our in-house bearish view on

the EUR means that CEE FX is set to fare poorly against the USD, even though we would be

positive on CEE FX against the EUR. On top of that, we retain a bearish view on the RUB,

mainly reflecting adverse domestic factors.

Expected spot returns by region for the period up-to Dec. 2014 Our CEE FX forecasted spot moves up to December 2014

Notes: based on our FX-market size-weighted global EM FX index. The weights are derived from

the BIS (average daily turnover data). Our Global EM FX index is expressed vs. USD.



Within Central Europe, we are the most bullish on the PLN, as the macro fundamentals

improve throughout the period and the National Bank of Poland ultimately engages in some

policy normalisation in the latter part of next year. At the same time, we are only modestly

bullish on the HUF, as we think that excessive monetary policy easing may undermine the

attractiveness of HUF assets.

Our EM FX forecasts by region Expected spot returns by region, by quarter

Notes: based on our FX-market size-weighted global EM FX index, with the base 100 set for 25

Nov. 2013. The market size weights are derived from the BIS (average daily turnover data). Our

Global EM FX index is expressed against the USD.



The seasonality of EM FX performance will be a key factor

We expect the strongest quarter to be Q2 in terms of EM FX performance, as the risk-on

signals start flashing by late April, once EM investors come to the realisation that QE tapering

is now fully in the price. This will follow a first quarter that will likely produce negative returns

for EM FX across all regions.

-3%

-2%

-1%

0%

1%

2%

3%

4%

EMEA Asia LatAm 0.00

0.50

1.00

1.50

2.00

2.50

3.00

HUF RON CZK PLN

%

95

96

97

98

99

100

101

102

103

104

105

Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14

EMEALatAm

Asia

Inde x (25 Nov 2013 = 100) forecasts

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-1

0

1

2

3

Q4-2013 Q1-2014 Q2-2014 Q3-2014 Q4-2014

EMEA LatAm Asia

Global EM FX performance, %


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Risk off, risk on in GEM local debt

We stand ready to turn bullish on EM local debt from April onwards, but only after a phase of

correction associated with the initiation of QE tapering by the Fed. Once the risk backdropimproves, we believe that EM investors will be drawn back into EM fixed income, owing to its

attractive valuation. Valuations in a number of EM local debt market are indeed quite

attractive, in our view.

Real 10yr local bond yields in Poland Real 10yr local bond yields in Hungary

Notes: estimated as nominal 10yr yields minus inflation (using daily

interpolation)


However you look at it, there is significant value in EM rates

We adopt a multi-pronged approach to EM rates valuation but the conclusion is that some

markets are quite attractive at current levels. This means that EM debt valuation should

actually improve further after the early-2014 correction if our scenario materialises. A number

of local debt markets are still quite attractive when measured in terms of 10yr bond yields

adjusted for inflation. In that category, Colombia, Hungary, Brazil, and Poland come out as the

most attractive markets, while Taiwan, Turkey and the Czech Republic do not feature well. It is

interesting to note that Turkey, while being a nominal high-yielding market, does not produce

a high real rate, suggesting that investors are currently not appropriately compensated for the

macro risks. Looking at the nominal spreads over UST, the most attractive local markets at

this point include Brazil, Turkey and South Africa, but we attach less significance to this

valuation approach, given the problem with domestic fundamentals.

Real 15yr local bond yields in South Africa Real 10yr swap rates in Mexico

Notes: estimated as nominal 10yr yields minus inflation (using daily

interpolation)


In EMEA, our top picks are Hungary, Poland and, to a lesser extent, Russia for the year

ahead.In Hungary, it will be important to wait until after the elections scheduled in the spring.

One important consideration in favour of Hungary is the high real rate, together with the policy

0

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5

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

10yr yield - CPI yoy inflation

-4

-2

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2

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6

8

10


10yr yield - CPI yoy inflation

-4

-2

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2

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6


0

1

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7


10yr swap - CPI yoy inflation


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supportive environment. In Russia, we believe that the domestic fundamentals remain

supportive of exposure to fixed income, and positioning is rather light, especially after the

recent outflows. From an historical perspective, it is interesting to note that the real yields

are trading at attractive levels both in Hungary and Poland.

In LatAm, our top pick in EM rates is Mexico, by default.We still want to stay away from

Brazil, given the uncertainty surrounding the policy framework and the macro environment,

though there could be value in the front-end of the curve if the Copom decides not to meet the

market's hawkish expectations. Meanwhile, we are bullish on Mexico from a top-down

perspective, and believe that the country is well positioned to take advantage of next years

spring rally.

There is value in EM bonds: 10y bond yields minus current inflation

Notes: Based on Bloomberg generic 10y quotes.


Value in EM bonds: 10y local bond yields minus current USTyields EM ratescarry in the front end: 1y1y fwd over 1y rates

Notes: Based on Bloomberg generic 10y quotes.


EM curves to steepen first, and flatten from the spring onward, in a correlation break

with UST dynamics. From April onwards, we anticipate that EM curves will flatten, reflectingthe favourable risk environment, despite the pressure coming from the UST steepening. This

means that compression trades, namely EM receivers against US payers, will be particularly

0

1

2

3

4

5

6

Taiwan

T

urkey

Czech

Rep.

China

R

ussia

Israel

S.Africa

M

exico

K

orea

Rom

ania

Chile

Poland

Brazil

Hungary

Colo

mbia

%

-2

0

2

4

6

8

10

Taiwan

CzechRep.

Israel

Korea

Poland

China

Chile

Romania

Hungary

Mexico

Colombia

Russia

S.Africa

Turkey

Brazil

%

0

20

40

60

80

100

120

140

Chile

Russia

Hungary

CzechRep.

Korea

Israel

Turkey

Mexico

Poland

Brazil

S.Africa

bp


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attractive, in our view. One obvious candidate for this type of strategy is Mexico, where we

think investors will come back in force to gain exposure to the local bond market.

EM Sovereign Credit: The Pain before the Gain

The debate on the timing and the extent of the Tapering is likely to drive the EM credit market,

once again. In line with our global view, we think that EM hard currency-denominated bonds

will be affected by a risk-off environment which should materialise in February 2014. However,

we believe that the sell-off will be more contained than that of last summer (at least in relative

terms), essentially due to the ongoing improvement in fundamentals and the fact that spreads

are factoring in a much higher probability that tapering measures will be implemented. At the

peak of the sell-off (April), we see the EM spread index widening to 370bp.

EM Sovereign spread index forecast (bp)


Favouring the low-beta names, for now. As the EM credit market is likely to be under

pressure during the four to five months of next year, the high beta names may underperform

over the period. This should be particularly the case for Venezuela, Serbia, Croatia, Indonesia,

South Africa and, to a minor degree, Turkey. In the low beta space, we believe that Brazil is

also likely to underperform the index due to deteriorating fundamentals. The strong low beta

credits should be fairly resilient to the downside, especially the Philippines, Chile, Poland,

Colombia and Peru.

During the phase of rally (May/December 2014), high beta names should logically

outperform the index, including Ukraine, Serbia, Hungary and Croatia. We also see

Indonesian and Turkish dollar bonds performing well in such scenario. Although Venezuelan

assets should remain under pressure due to the sharp deterioration of the economic situation,

the very high carry should partially protect the absolute return.

In terms of positioning, we favour short duration exposures during the first part of the

year, the steepness of the curves remaining very directional. More specifically in the high beta

space, we favour the short end of Ukraine as the curve is likely to des-invert, we believe. In

Venezuela, we favour low-dollar priced bonds, overall, and would move away from the belly to

favour the wings for the curve. In Hungary, short-dated assets should also perform relativelywell. Lastly regarding Brazil, we tend to favour short- to mid-dated bonds over the long end,

as we expect the credit curve to bear-steepen.

200

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Jan-13 M ar-13 May-13 Jul-13 Sep-13 Nov-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14

Historical Spread

Forecast

Upper and Lower Range


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EM remaining strongly anchored in the IG category. Over the course of next year, we

expect several important rating actions, including the downgrade of India, Brazil, Venezuela

and South Africa, while the Philippines, Colombia, Mexico (S&P) and Peru should be

upgraded. Overall, the EM asset class should benefit from a slight upgrade from, and remain

strongly anchored in the BBB- category.

An asset allocation view of Global Emerging Markets: Some

differentiation between asset classes and regions

Given the high market significance of US rates, hard-currency debt appears to be the

safest EM asset class. Both the local currency debt and EM FX tend to be more vulnerable

to swings in investor sentiment. Meanwhile, EM equities are usually high-risk but they may

continue to be well supported if we continue to see signs of strengthening EM growth. In our

latest EM investor survey, EM investors signalled that EM Equities were the preferred asset

class for both RM and HF investors, followed by external debt (EXD) and local debt (LCD).Meanwhile, EMFX was the least preferred asset class in November, reflecting the poor score

registered for real-money investors.

EM Asset preference: Equities the preferred asset class amongst EM investors

Notes: from our November EM investor survey Bullish sentiment signal, but EM investors dont want to invest, 21 November 2013.


We will favour defensive strategies in the first few months of the year. This means that

investors that have some EM asset allocation flexibility should prefer EM hard-currency

creditwith a strong focus on the low-beta creditsover FX and rates. In local fixed income,

we will focus on shorter duration and more defensive rates markets, such as Israel, the Czech

Republic or Chile. In principle, payer positions in some of the higher-beta markets would make

sense, although timing and valuation will be two key considerations. In EM FX, we will favour

the safe-haven currencies, followed by the growth currencies, while the liquidity currencies will

outperform. Relative value strategies with a defensive bias will also be appropriate.

Adding the regional exposure, we would initially favour exposure to Asia FX, given the

high proportion of low-beta growth safe-haven currencies in the region. Once the spring

rally kicks off, our favourite asset class will be EMEA fixed income, reflecting the attractive

valuation of both FX and rates in the region. In hard-currency debt, we stand ready to build up

exposure to high beta names.

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5

EXD EMFX LCD EM Equities

Investors asset preference (HF+RM)


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EM Growth Showing Signs of Recovery

EM growth prospects remain attractive

EM growth is picking up.Between Q2 and Q3 2013, the majority of EM countries have seen

a jump in their economic activity with the notable exception of Israel, Lithuania and Peru.

The rebound is particularly tangible in Eastern Europe, more specifically in Serbia, Romania,

Hungary and Poland (see table of growth momentum below). This comes as a confirmation of

Q2 data, which were already flagging some improvement relative to Q1 (seeEM Weekly: EM

Growth is Back,4 October 2013). Note that GDP growth numbers are not available yet for

Turkey and Brazil, but judging by the change in industrial production (+2.2% in Q3 vs. Q2 for

Turkey, and +1% for Brazil), the momentum seems to be also positive in these two countries.

On aggregate, we estimate that EM growth went from 4.5% to 4.7% y/y between Q1 and Q2

2013, and reached 4.9% in Q3.Excluding China, EM growth was 3.1% in Q3, up from 3.0% in

Q2.

EM Growth momentum: Changes in real GDP from Q2 to Q3 2013*

Source: SG Cross Asset Research * Q2 vs. Q1 2013 for Brazil, Colombia, India, Philippines and Turkey

The positive move can also be perceived through PMI numbers, the latter showing a

continuous improvement in the EM economic environment since July (see graph next page).

Based on IMF forecasts, EM growth should gather pace early next year, the US economy

driving the global recovery. China should continue to play an important role in that respect;

our economic team see the Chinese economy to decelerate a bit next year, but the country

should still grow at a sustained pace (7.4% y/y expected in 2014, vs. 7.6% for 2013).

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

SERB

ROM

TURK*

COL*

BRZ*

HUN

POL

KOR

CHILE

MAL

CHINA

RUS

THAI

UKR

PHI*

INDO

CZH

MEX

INDIA*

SOAF

PER

LITH

ISR

Changein

GDPgrowth(%)

https://publication.sgresearch.com/en/3/0/0/130854.html?sid=e3c2d87cc7f04bff656c01fb5c78050chttps://publication.sgresearch.com/en/3/0/0/130854.html?sid=e3c2d87cc7f04bff656c01fb5c78050chttps://publication.sgresearch.com/en/3/0/0/130854.html?sid=e3c2d87cc7f04bff656c01fb5c78050chttps://publication.sgresearch.com/en/3/0/0/130854.html?sid=e3c2d87cc7f04bff656c01fb5c78050chttps://publication.sgresearch.com/en/3/0/0/130854.html?sid=e3c2d87cc7f04bff656c01fb5c78050chttps://publication.sgresearch.com/en/3/0/0/130854.html?sid=e3c2d87cc7f04bff656c01fb5c78050c

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PMI on the rise since JulyGDP-weighted average EM PMI

EM growing faster than DM in coming yearsEM and DM growth, GDP weighted (excl. China)

Source: SG Cross Asset Research/EM Source: SG Cross Asset Research, based on IMF data

EM should continue to grow faster than developed economies. Growth in Asia should

outpace that of other regions in the coming years. In Latin America, the Andean countries

(Peru, Chile and Colombia) should continue to show strong economic performance (in part

due to the high volumes of exports to Asia), while growth in Mexico and Brazil is likely to

remain more modest. Turkey stands out as the leading country in terms of growth

performance in the EMEA region.

2014 real GDP growth forecast ( , y/y)

Source: IMF WEO

Overall, EM countries are expected to grow well above developed markets: based on IMF

forecasts, EM aggregate growth should be around 4.6% in 2013, rising to 4.9% in 2014 and

reach 5.1% in 2015 (excluding China, EM growth should be 2.7% in 2013, 3.3% in 2014 and

3.8%, which is still substantially above DM).

Expected GDP growth for Emerging and Developed MarketsPercentage, based on IMF data

2012 2013 (F) 2014 (F) 2015 (F)Emerging Markets 4.8 4.6 4.9 5.1

EM ex China 3.0 2.7 3.3 3.8

Developed Markets 1.5 1.1 1.9 2.3

Source: IMF WEO, SG Cross Asset Research

49.0

49.5

50.0

50.5

51.0

51.5

52.0

52.5

53.0

Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13

3.8

2.3

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

EM DM

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

PHI

PER

INDO

THAI

INDIA

MAL

CHILE

COL

KOR

TURK

LTU

ISR

RUS

MEX

SOAF

BRZ

POL

ROM

VEN

UKR

CRO

CZE

HUN

ExpectedGDPgrowth(%)

Asia

Latam

EMEA


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Differentiated Vulnerability Risks

Indebtedness in EM is considerably lower than in developed markets.Following the sell-

off of last summer, crossover investors have become worried about EM fundamentals, the

latter being considered as vulnerable to global liquidity conditions. At the initial stage of the

sell-off, investors made very little differentiation among EM, all countries being adversely

affected in relatively similar proportions. As far as we are concerned, we argue that the

fundamental backdrop in EM is relatively sound (especially compared to DM) and that a great

deal of differentiation must be operated, EM countries showing very different level of

vulnerability to external shocks.

Higher growth...As a starting point, we would say that EM fundamentals remain attractive,

especially versus developed markets. As mentioned earlier, the economic growth in EM is

likely to stay much higher than in DM: based on IMF forecasts, EM GDP growth should be

around 5% on average in the next two years (+3% ex China), well above the 2.1% average

expected for DM countries.

... and less debt.Moreover, the level of indebtedness in EM is still considerably less than in

DM: in fact, we calculate that the average public debt to GDP is 44% in EM, which is nearly

twice as less than in DM. As far as the level of external debt is concerned, it has remained

quite stable in the last ten years at around 50% of GDP for EM, when it has jumped from

120% to 170% over the same period see graphs below.

Half the Public Debt of DMPublic Debt/GDP for EM and DM countries (%)

One third the external debt* of DMExternal Debt/GDP for EM and DM countries (%)

Source: World Bank, SG Cross Asset Research/EM Source: World Bank, SG Cross Asset Research *Defined as the public

and private debt held by non-domestic investors

Foreign direct investments covering current account deficits.Many have argued that the

majority of EM countries are showing current accounts deficits, and this has become the main

weakness for the asset class. Indeed, EM countries show an average C/A deficit of 1.2% of

GDP, in sharp contrast with the average surplus of 1.9% for DM. But we would highlight two

points in that respect: 1.) A current account deficit of 1.2% is still a manageable level in our

view, especially considering that most of the external deficits are funded via FDI (which by

nature are less volatile than portfolio investments), and 2.) EM countries have built a

considerable cushion of FX reserves, in such a way than they cover an average of 7 months of

imports for EM, versus only 4 months for DM countries.

A great deal of differentiation among EM countries is necessary. Considering other

fundamentals, it is also necessary to look at individual situations as they considerably vary

from one country to another. For our purpose, we have computed scorecards based on

44.3

83.9

0

10

20

30

40

50

60

70

80

90

'99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14

EM DM

51.4

169.3

0

20

40

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100

120

140

160

180

200

'99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14

EM DM


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eleven macroeconomic critieria, including GDP growth, inflation, vulnerability to external

shocks and sustainability of fiscal dynamics. We present below the results of each

scorecards:

Vulnerability Indicators*See grey box next page to see criteria included in the vulnerability indicator


The results of this scorecard are quite compelling and highlight the high disparity among EM

countries, in our view. Notably, EMEA countries are the most vulnerable, with an average

score of 14.4, due to a combination of slower growth, high external and public debt burdens,

low levels of foreign reserves. LatAm countries, with an average score of 12.7, are moderately

vulnerable, while Asian countries, with an average score of 9.6, are the least vulnerable amongemerging markets.

Ukraine, Venezuela and South Africa the most vulnerable.At the top of the vulnerability

ranking, we logically find Ukraine and Venezuela. For these two countries, pretty much all

indicators are showing distressed situations apart from the current account surplus for

Venezuela (although sharply declining in the last few years), and the low level of inflation for

Ukraine (which also reflects an economy on the verge of deflation). Surprisingly (or not), South

Africa shows one of the worst fundamentals in EM, due to particularly slow growth and its twin

deficit. Then follows India, Hungary, Turkey and Poland (the external and public debt levels are

indeed relatively high for the latter).

Asian economies the strongest. At the other hand of the spectrum, we find the Asian

countries which clearly appear as the strongest economies overall, starting with China.

Second to China comes the Philippines: despite its BBB- rating, the country shows very

0 5 10 15 20

China

Philippines

Peru

Korea

Thailand

Russia

Israel

Malaysia

Colombia

Romania

Mexico

Brazil

Lithuania

Indonesia

ChileCroatia

Czech Rep.

Poland

Turkey

Hungary

India

South Africa

Venezuela

Ukraine

Vulnerability indicator

Latam

EMEA

Asia


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strong fundamentals and is very likely to be upgraded during the course of next year, we

believe. In Latin America, we highlight the strength of the Peruvian economy, which has been

able to sustain high growth performance while keeping inflation at relatively low level. We note

also that Russia also compares relatively well in this ranking (due to its very high level of FX

reserves, as well as its very low level of public debt relative to GDP).

In view of this analysis, it is therefore necessary to differentiate among EM countries

when the market experiences higher volatility than usual, the fundamental risk being

considerably different depending on the credit profile.

Note that the market risk associated to each country (as measured in the present case by the

FX volatility) is strongly correlated to our indicator (correlation is around 86%), which

reinforces the relevance of the Vulnerability indicator.

FX volatility vs. Vulnerability Indicator


VULNERABILITY INDICATOR: METHODOLOGY

We compute the Vulnerability Indicator using 11 macroeconomic criteria, including:

* Growth performance:We assess growth performance and changes in GDP.

* Inflation:We gauge inflation pressure as well as the change in inflation dynamics.

* FX vulnerability:Valuation of the real effective exchange rates.

* External vulnerability:Current account, foreign direct investment, gross international reserves (relative

to imports and relative to short-term liabilities) and level of external debt.

* Fiscal Position: Overall fiscal position, the primary balance and the level of public debt relative to GDP.

PLN HUF

CZK

RON

RUB

TRY

ZAR

ILS

BRL

MXN

CLP

COP

PEN

INR

IDR

MYR

PHP

KRW

THB

CNY

R = 0.7452

0

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4

6

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12

14

16

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20

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FXv

olatility

Vulnerability Indicator


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The Haves and the Have Nots: An Assessment ofPolicy Room in EM

Extent of policy space likely to determine economic resilience

Across global emerging markets, policy makers are facing the daunting reality of declining

policy space, amidst a global financial environment sensitive to the readjustment and

normalization of monetary policy led foremost by the US Federal Reserve and still sluggish

growth prospects. Against this backdrop, a gradually declining inflation trajectory in emerging

markets has helped to create much-needed policy space. Nonetheless, investors remain

skittish. Indeed, the lack of conviction may linger over the coming months until there is clarity

on Fed policy and on the liquidity available to emerging markets once tapering commences. In

this tentative environment, investors will likely differentiate between countries that have the

policy room to respond to external shocks, versus those that face difficult trade-offs betweenpromoting growth and protecting financial stability.

Declining inflation in GEM creates much-needed policy space (headline CPI, )

Notes: Based on GDP-weighted indices

Source: SG Cross Asset Research/EM.

We think that a key determinant of a countrys economic resilience to the potentially violent

period of financial markets readjustment ahead is the extent of its policy space. Some

countries notably Turkey, India, and Indonesia have had to resort to rate hikes, in many

instances to support their currencies. We would argue that in the case of Turkey, Indonesia,

and India, lack of monetary policy room forced the hands of the central banks to hike,

accepting the concomitant adverse impact on growth.

0%

5%

10%

15%

20%

25%

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

EM

Asia

CEEMEA

Latam


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Real policy rates reflect the extent of remaining monetary policy space


POLICY ROOM INDICATOR: METHODOLOGY

To gauge differences between countries remaining monetary and fiscal policy space, we have created a

rough measure called the Policy Room Indicator. It assesses the remaining policy space among our major

emerging market countries, and considers the following factors:

* The level of real interest rate: high real policy rates enable more scope for monetary policy

accommodation to support domestic growth

* Primary balance, as a percentage of GDP: high primary surpluses enable more fiscal flexibility to spend

on priorities

* Public debt, as a percentage of GDP: high general government debt may constrain the countrys

borrowing capacity, raise borrowing costs, and destabilize the financial markets in times of stress

* Official FX reserves, as a percentage of GDP: high levels of reserves can be deployed to support the

currency

We note that this rough gauge does not capture all relevant considerations, such as the varying amounts

of policy credibility across our markets, or the momentum of inflation pressures.

The results of our Policy Room Indicator suggest that Peru, Korea, Chile, and Hungary may

have among the most flexibility to steer their economies in the coming year. These countries

benefit from a combination of high real interest rates, strong primary balances, and with the

exception of Hungary low public debt. Regionally, LatAm countries, with an average score of

14.3, have the most policy room, thanks to high real interest rates, strong primary balances,

and low public debt. Asian countries, with an average score of 12.2, have moderate policy

space, while EMEA countries, scoring 11.7 on average, have the least policy flexibility. We

discuss below our key thoughts on the available policy space by region.

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Croatia

Ukraine

Brazil

Chile

China

Hungary

Romania

Korea

Poland

Colombia

Thailand

Peru

Philippines

Lithuania

Malaysia

Mexico

Turkey

SouthAfrica

Russia

Israel

Indonesia

Cze

chRepublic

India

Policy rate (%) Latest CPI (YoY %) Real policy rate (%)


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EM Policy Room Indicator a gauge of countries remaining fiscal and monetary flexibility


EMEA

Czech Republic: Lack of policy room prompts the authorities to be creativeThe country is recovering slowly out of a recession, with growth remaining fragile. Monetary

policy space remains low, with nominal policy rates essentially at zero. Disinflationary

pressures have prompted the central bank to intervene directly in the FX markets and avoid

the deflationary trap. We expect the CNB to defend the desired 27.00 level of EURCZK with

unlimited sales of CZK, and to postpone interest rate hikes until 2016. Early elections held in

October have removed some tail risks, and the coalition government is likely to embark on a

pro-growth fiscal policy, while still maintaining the budget deficit within the 3% of GDP

threshold.

Hungary: Largest policy room in the region

Fiscal space is constrained by the governments commitment to meet its fiscal deficit target of3% of GDP, having so recently escaped the shackles of the EUs excessive deficit procedure.

However, real interest rates are still among the highest in the region, while inflation is on the

decline. Against a backdrop of weak growth, this combination creates the space for Hungary

to provide more monetary policy accommodation, which is what we foresee the central bank

continuing to do ahead of general elections in the spring.

Israel: Some difficult choices in the context of constrained policy roomNegative real interest rates, a weak primary balance, and high levels of public debt restrict

policy space in Israel. Fiscal space is hampered by a large budget deficit and an ambitious

target to keep the deficit within 3% of GDP next year, which will require extensive policy

measures. ILSs appreciation continues to adversely impact exports. The countrys growth is

slowing, while inflation expectations remain benign. Notably, concerns regarding the rapid

growth of the housing market and the risk to the banking system weigh on central bank policy

0 2 4 6 8 10 12 14 16 18 20

India

Czech Republic

Venezuela

South Africa

Indonesia

Israel

Malaysia

Lithuania

Mexico

Turkey

Poland

Russia

Ukraine

Colombia

Croatia

Philippines

Romania

China

Thailand

Hungary

Brazil

Chile

Korea

Peru

EMEA

Latam

Asia


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making. One consideration in favour of Israel is the strong credibility that the Bank of Israel

has enjoyed over recent years.

Poland: Committed to preserving monetary ammunition at a cost

The countrys fiscal spaceis constrained by a large fiscal deficit and ongoing efforts to exit the

EUs excessive deficit procedure. Space remains on monetary policy side, in light of relatively

high real yields. However, the central bank has completed its easing cycle earlier this year,

and is committed to maintaining the current level of policy rates at 2.5% until mid-2014 at the

earliest. In the absence of fiscal space, Poland has embarked on pension reforms, which are

likely to significantly improve the near-term fiscal balance, but entail long-term costs for the

government.

Romania: A strengthening policy frameworkThe country has higher than average policy room, benefiting from its positive real interest rate,

lower than average public debt, and adequate FX reserves. The central bank remains in easing

mode, helped by declining inflation. Romania is continuing to make progress in fiscal

consolidation, in restructuring its economy toward external demand, and in strengthening its

financial sector stability. As a result, fiscal policy space remains low. Improved absorption of

EU structural and cohesion funds from the current low capacity may help to boost investment

activity, as well as increase budgetary flexibility.

Russia: Assessment helped by its low debtDespite negative real interest rates, Russias primary surplus and low public debt profile

contribute to Russias moderate level of policy room. As a result of the countrys continued

reliance on commodity exports, declining oil prices are exerting budgetary pressures and

eroding the current account surplus. Reforms by the central bank and the ministry of finance

are slow-moving, and as yet ineffective at reviving the stagnant economy. The business

climate remains poor, while industry faces declining competitiveness.

South Africa: Serious policy challengesA worsening primary balance, negative real interest rates, and an elevated stock of

government debt conspire to restrict policy makers ability to revive the slowing economy.

Internal resistance from powerful labour unions and entrenched politics impede the pace of

reforms. We expect that the SARB will maintain an accommodative policy stance, with policy

rates on hold at 5%, and that fiscal loosening will be limited. But with relatively little in the way

of FX reserves to defend the currency, the SARB lacks adequate policy tools to respond in a

stress scenario.

Turkey: Fiscal outperformance, monetary underperformanceThe central bank has limited policy room, and is becoming more vigilant in protecting financialstability. It has recently tightened local liquidity conditions and raised the interest rate corridor,

although more tightening in monetary policy may still be needed to restore market confidence

and tame inflation. Positively, the country is showing signs of fiscal outperformance, with the

budget deficit likely to be substantially smaller this year than the government previously

projected.

LatAm

Brazil: A false positive of our Policy Room IndicatorThe country faces high amounts of policy constraints, despite its appearance near the top of

our Policy Room rankings (consequence of its high real interest rate and primary surplus).

Headline inflation is running well above the Copom's 4.5% target even after 275bp in Selic

hikes in 2013, and core inflation is now above 7%. Fiscal stimulus does not seem to be an


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option, either, with markets showing increasing concern over Brazil's long-term debt

trajectory. Policy makers could aim to ease conditions ahead of the October elections, but not

without risking more damage to the inflation outlook.

Chile: Plenty of policy ammunitionAlthough the Chilean Central Bank cut rates by 50bp in Q4, we still see ample room for further

monetary easing. Chile's economy and the central bank are highly sensitive to external

conditions, rendering policy responsive to global pressures. Inflation levels and expectations

remain extremely mild. Meanwhile, both nominal and real rates are much higher than in most

EM economies a fact which has bolstered the rationale for the recent easing cycle.

Colombia: Policy status quoWe view further policy stimulus in the country as unlikely, as with Mexico. Policy makers have

provided both monetary and fiscal stimulus earlier this year, and expects a gradual recovery

through next year.

Mexico: Focus shifting to reformsAfter 100bp of rate cuts in 2013 and plans for a slightly looser fiscal balance next year, further

stimulus appears unlikely. Growth is expected to accelerate next year, amid signs of recovery

in manufacturing and an expected increase in public spending. Meanwhile, inflation

expectations for 2014 have risen well above target, perhaps reflecting the uncertainty

regarding the impact of reforms on prices.

Peru: A solid policy frameworkThe country may be a candidate for looser policies next year, thanks to relatively high real

rates and solid fiscal accounts. However, the central banks tight inflation target (2%),

combined with the upward trajectory of core inflation, may constrain policy makers from

further easing.

Asia

India: Facing enormous policy challengesThe country is running tight on the fiscal policy front. Meanwhile, higher inflation is posing

constraints on monetary policy, as evident from Indias lowest rank in our EM Policy Room

Indicator. The fiscal deficit for FY2012-13 stood at 5.2% of GDP. The government aims to

improve it to 4.8% of GDP for FY2013-14, while the medium term goal for fiscal deficit

reduction remains at 3% for FY2016-17. The Reserve Bank of India (RBI) is facing a growth-

inflation dilemma. GDP growth slumped below 5%, well below the RBI sestimated potential

GDP growth of 7%, while WPI inflation has remained persistently higher. Near term inflation

risks are present from second round effects and diesel price pass-through effects. We expect

the RBI to reduce repo rates to 7.25% by the end of 2014, as inflation is expected to soften

starting the next fiscal year on demand slowdown.

Indonesia: Policy pressures are mountingOil subsidies are putting pressure on the budget balance, with 3-4.5% of GDP in oil subsidies.

The Bank of Indonesia (BI) has hiked the benchmark rate by 25bp to 7.5% as the CPI has

remained above 8%, much higher than the target level of 4.51%. We believe that the BI will

remain hawkish during 1H 2014 on higher inflation and a weak IDR, while some base effects

can ease inflation in 2H 2014.

Korea: A lot of breathing room

We believe that South Korea has the most policy room of the countries in the region. We

anticipate a gradual recovery, despite a considerable period of a negative output gap. Inflation

is likely to remain below the Bank of Korea's target range of 2.5%-3.5% throughout 2014.


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Hence, a pick-up in inflation is unlikely to be a major trigger for rate hikes. Upside surprises in

economic growth and downside surprises in inflation continued over recent months. In our

view, this development justifies a neutral, wait-and-see stance towards monetary policy until

the end of 2014.

Malaysia: Below averageThe Bank Negara Malaysia (BNM) has maintained an overnight policy rate at 3% since May

2011, while inflation has remained stable in a range of 1.3%-3.5% YoY, with the latest

October print at 2.8%. Amid a slower pace of government spending, improving export

dynamics are supporting GDP growth. According to the BNM, inflation is expected to pick up

on domestic cost factors. Risks to the inflation outlook are present from the external price

environment and domestic demand pressures. The BNM continues to see uncertainties in the

balance of risks surrounding the outlook for domestic growth and inflation. We anticipate that

the BNM will remain on hold, with a hawkish bias.

Philippines: Well positioned on the policy frontThe Bangko Sentral ng Pilipinas (BSP) targets inflation in the range of 41% for 2012-2014

and 31% for 2015. Although inflation expectations have been in line with the forecast, with

the latest print at 2.9% YoY for October, damage due to typhoon Haiyan from earlier this

month is likely to push inflation higher as commodity prices rise. We believe that

developments will stay within the BSPs tolerance band.

Thailand: Some room to manoeuvreThe Bank of Thailand (BoT) targets core inflation between 0.5-3%. This past year, core

inflation has ranged between 0.7%-1.7% YoY this year, with last month's inflation at 0.71%

YoY. Ongoing political uncertainty in the country puts further pressure on the growth outlook,

consumer confidence, and demand. With core inflation hovering near the lower end of the

range, the BoT has reduced policy rate to 2.25% on weaker Q3 growth and downside risks.

We expect growth to improve next year and for inflation to trend higher, placing the BoT in

neutral mode for 2014.


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Sovereign Credit: The Pain before the Gain

US Treasuries to drive the market

In the short term, we think EM dollar-denominated bonds will tend to outperform US

Treasuries, although to a limited extent. For now, downward pressure should ease a bit: SG

expects the 10Y UST yield to be around 2.70% by year end, which is in line with the current

level. In this context, EM sovereign bonds may be supported by relatively attractive valuations

(especially vs. US high yield and high grade bonds) and benign technicals (EM funds remain

underweight risk vs. their benchmark). We believe the EMBI spread index could tighten by

around 25bp to trade in the 310bp area by the end of January 2014.

The pain before the gain.Considering the outlook for 2014, the debate on the timing and the

extent of the Tapering is likely to drive the market, once again. We believe the gradual rise in

UST yields may prompt another correction in EM, possibly by February as the Fed scales

down its USD85 billion monthly bond-buying program as expected by our US Economics

team. In this scenario, concerns that EM assets will be affected by another wave of outflows

should resurface, resulting in higher sovereign spreads across the board. At the peak of the

sell-off (April), we see the EM spread index widening to 370bp.

Later in the spring of next year, as most of the risk may be priced in, EM spreads should tend

to compress until year end, following the improvement in fundamentals (see graph below).

EM Sovereign spread index forecast (bp)


EM dollar bonds more resilient to the downside. We believe the next sell-off could last two

to three months (from February until April/May), but the correction in the EM credit space is

likely to be more contained than that of last summer. We see four reasons why the EM credit

market should be more resilient against the downside:

Interest rate risk better reflected in EM valuations.As opposed to six months ago, EMspreads are now incorporating a much higher probability that tapering measures will be

implemented, which is reflected into cheaper valuations. In fact, even assuming that the EMBIspread index would trade at 310bp by early next year (our base case scenario), it would still

200

250

300

350

400

Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14

Historical Spread

Forecast

Upper and Lower Range


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be 35bp wider than prior to the sell-off of last summer. In yield terms, EM bonds are currently

trading 140bp wider than a year ago.

EM fundamentals still strong. The last episode of EM sell-off may have been

disproportionate in light of fundamentals. In many aspects, the EM backdrop remains more

attractive than in developed markets, especially in terms of growth prospects and debt levels

(see EM vulnerability section).

Growth picking up, stronger exports.By the time the Fed implements the Tapering, EMgrowth may have strengthened further; at current pace, we would expect GDP growth in EM

to be around 5%yoy by Q1 2014. Also, the pressure on current accounts may be less after the

drastic depreciation of EM currencies that we saw last summer. In fact, we expect this

depreciation to boost EM exports, in particular towards the US.

Less opportunistic investment, better technicals. The majority of crossover investorshave considerably reduced their exposure to EM. The withdraw of opportunistic/fast money

investments is therefore less of a threat for our market, most of EM hard currency bonds nowbeing held by dedicated investors typically driven by long-term macroeconomic criteria, the

latter still comparing positively for EM, in our view.

EM rating strongly anchored to the IG category

EM fundamentals holding better than DM.Although credit ratings are imperfect measures

of the overall sovereign risk (they indeed tend to underestimate the potential impact of global

factors, such as quantitative easing or tapering measures from the major central banks), the

changes in credit ratings still reflect relatively well the evolution of EM fundamentals over long

periods. Considering the EM and DM average ratings since 1996, it clearly appears that EM

fundamentals have considerably improved in the last ten years; they have therefore become

more resilient to global turbulence, including during the subprime and the EU Periphery debt

crises (see graph below).

This evolution is in sharp contrast with that of DM countries, which in average have been

downgraded by 2.5 notches since 2007. We expect EM to benefit from a slight upgrade in

2014, the asset class remaining well anchored in the investment grade (BBB-) category.

EM average rating* vs. Developed Markets

Source: SG Cross Asset Research *Based on simple average S&P, Moodys and Fitch ratings.

BBB

BBB-

BB+

BB

BB-

AAA

AA+

AA

AA-

A+'96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14

DM (RHS)

EM (LHS)


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Although the overall rating of EM sovereign bonds should marginally improve in 2014, we

expect some important rating actions to be undertaken over the next twelve months,

including:

Potential upgrades: Philippines, Colombia, Mexico, Peru, Uruguay, Latvia, LithuaniaKazakhstan, Romania and Ukraine;

Potential downgrades: India, Brazil, Venezuela, South Africa, Croatia, Slovenia and CzechRepublic.

Many of these rating actions are already priced in by the market (such as the likely upgrade of

the Philippines or Colombia, or the downgrade of South Africa), but some of them may not be

fully anticipated by investors, which could imply a significant repricing, in our view. These

changes include:

Brazil to be downgraded.We see a continuous deterioration in inflation and fiscal balance,while GDP growth may disappoint on the upside. We therefore believe a downgrade of Brazil

to BBB- by one or two rating agencies is very likely, in spite of the very high level of FX

reserves. The downgrade should send a negative signal on the credit, and Brazilian bonds

could significantly underperform the EM sovereign credit index.

Mexico likely to be upgraded by S&P. The implementation of economic reforms(especially regarding the status of Pemex) has long been considered a precondition to any

upgrade. However, the relatively poor GDP performance has had a significant impact on the

credit rating; according to the IMF forecasts for 2014, Mexico should see a jump in GDP

growth from 1.2% in 2013 to 3.0% in 2014, representing the best improvement among Latin

American countries. We believe this improvement could trigger an upgrade from S&P to

BBB+, to be in line with Moodys and Fitch (S&P downgraded Mexico to BBB in Dec. 2009).

South Africa: At least two agencies triggering a downgrade. The deterioration in SouthAfricans fundamentals hasbeen continuous since 2009. In fact, the fiscal balance and the

C/A deficit stand at preoccupying levels, and an average rating of BBB will be very difficult to

sustain for the country. We therefore expect South Africa to be downgraded by at least two

rating agencies next year, although the country should remain in the investment grade

category. Nevertheless, we cannot rule out that these rating actions will be associated with

negative outlooks.

Ukraine should retrieve its single B status. As we write these lines, we assume that thegovernment will not sign the trade agreement with the EU this Friday. For the majority of

Ukraines watchers, the decision of M. Yanukovych is sending a negative signal, as in the long

term the country would have greatly benefitted from such trade agreement. However, we

believe that the reestablishment of the economic and political ties with Russia substantially

reduces the credit risk in the short term. Independently from political considerations, it is likely

that the rating agencies will revert their recent downgrades to reflect the lower risk of default

of the country (we assign a high probability that Russia will eventually provide financing

facilities and/or a gas deal to Ukraine).

SG expected 1Y change insovereign rating (notches)

-1.5 -1 -0.5 0 0.5 1 1.5

Korea

Chile

EstoniaCzech Rep.

Israel

Slovakia

Poland

Malaysia

Thailand

Lithuania

Latvia

Kazakhstan

Peru

Mexico

South Africa

Slovenia

Russia

PanamaBrazil

Bulgaria

Colombia

Philippines

India

Uruguay

Indonesia

Turkey

Romania

Croatia

Hungary

Sri Lanka

Vietnam

Venezuela

Ukraine

Argentina


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Underweight risk for the coming months

Favouring the low-beta names, for now. As the EM credit market is likely to be under

pressure during the four to five months of next year, the high beta names may underperformover the period. This should be particularly the case for Venezuela, Serbia, Croatia, Indonesia,

South Africa and to a minor degree Turkey. In the low beta space, we believe that Brazil is

also likely to underperform the index due to deteriorating fundamentals. The strong low beta

credits should be fairly resilient to the downside, especially the Philippines, Chile, Poland,

Colombia and Peru (see table below).

Starting in the spring, we think that EM dollar bonds will significantly outperform US

Treasuries, reflecting the continuous improvement in fundamentals. The adverse impact of

UST may not be fully compensated by spread compressions before this summer, but EM

bondsreturn should be back to positive territory during the second half of the year.

10Y dollar bonds spread to UST forecastsCurrent Current 10Y benchmark spread forecast Spread

10Y Yield Spread Q4 '13 Q1 '14 Q2 '14 Q3 '14 Q4 '14 Change10Y UST (Yield) 2.7 - 2.7 3 3.35 3.5 3.75 -

Chile 3.53 83 93 113 88 83 73 -10

Philippines 3.22 52 62 97 72 67 52 0

Mexico 4.08 138 123 152 113 96 83 -55

Poland 4.09 139 125 148 110 91 77 -62

Lithuania 4.11 141 127 151 113 94 80 -61

Colombia 4.12 142 127 155 116 97 84 -58

Peru 4.34 164 150 160 121 103 89 -75

Brazil 4.49 179 163 196 157 138 128 -51

Russia 4.51 181 166 195 156 136 124 -57Romania 4.81 211 193 233 193 173 163 -48

Turkey 5.04 234 212 269 228 207 200 -34

South Africa 5.05 235 215 262 222 201 193 -42

Indonesia 5.14 244 222 247 206 181 166 -78

Morocco 5.32 262 240 294 253 232 225 -37

Hungary 5.57 287 268 312 271 251 242 -45

Croatia 6.01 331 312 356 315 295 286 -45

Serbia 6.42 372 351 401 361 340 332 -40

Ukraine 9.66 696 674 679 637 616 610 -86

Venezuela 13.58 1088 1059 1141 1098 1075 1074 -14

EM Index 5.86 328 310 350 310 290 280 -48


During the phase of rally, high beta names should logically outperform the index,

including Ukraine, Serbia, Hungary and Croatia. We also see Indonesia and Turkey performing

well in such scenario. Although Venezuelan assets should remain under pressure due to the

sharp deterioration of the economic situation, the very high carry should partially protect the

absolute return.

In terms of positioning, we favour short duration exposures during the first part of the

year, the steepness of the curves remaining very directional. More specifically in the high beta

space, we favour the short end of Ukraine as the curve is likely to des-invert, we believe. In

Venezuela, we favour low-dollar priced bonds, overall, and would move away from the belly to

favour the wings for the curve. In Hungary, short-dated assets should also perform relatively

well. Lastly regarding Brazil, we tend to favour short- to mid-dated bonds over the long end,

as we expect the credit curve to bear-steepen.


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How to Trade EM Politics in 2014

Beyond election outcomes, changes in the political landscapecan drive long term value

This past year, politics once again played a significant role for emerging markets. European

sovereign issues took somewhat of a backseat, thanks largely to the actions taken by the ECB

in 2012 and some modest but sorely-needed steps towards a banking union early this year.

US politics, on the other hand, threatened EM and other risky assets in the form of fiscal

headwinds and yet another debt ceiling standoff. Within EM itself, for that matter, there was

no shortage of storylines. Most importantly, the Chinese Communist Partys Plenum meeting

yielded a set of reform goals that, however vague for the time being, raised hopes for gradual

economic reforms and a more sustainable growth path in the coming years. Mexicos push

towards landmark reforms, meanwhile, gained the attention of many investors looking for anew EM darling. Hungary and Poland, conversely, raised eyebrows over monetary policy

independence questions and pension reform, respectively.

Next year, we expect political headlines to continue to help determine value within EM. In a

number of markets, the focus will be on scheduled elections, while in others, political issues

outside the voting booth will demand attention. Below, we discuss by region the key political

events and trends we think will prove most important in 2014.

EMEA

Hungary: Chance of a positive policy surpriseThe key question in the upcoming Hungarian elections next April / May is whether Viktor

Orban and his Fidesz administration will retain a supermajority in Parliament. We expect that

Fidesz will hang firmly onto power, but that the party may not achieve the supermajority that

will enable them to so easily push laws through Parliament. Opposition parties E14, led by

former technocratic Prime Minister Gordon Bajnai, have teamed up with the Socialist Party

(MSZP) after intense feuding and are attempting to appeal to disparate segments of voters,

but face what may be an insurmountable uphill climb. Post elections, we expect that Fidesz

may ease up slightly on some of the punishing policies toward the banking sector and utilities,

providing the chance of a positive policy surprise (relative to the dire current state of affairs).

Many countries in the region are keenly watching developments in Hungary, andcontemplating using Viktor Orbans policies as a template.

Poland: StabilityThe latest government reshuffle included the replacement of Finance Minister Rostowski by

Mateusz Szczurek, formerly INGs chief economist for CEE countries. We believe that existing

fiscal policy is likely to remain intact. The country will hold local elections next year, followed

by parliamentary and presidential elections in 2015. Despite gains by the opposition Law and

Justice (PiS) party in recent polls, we expect the ruling PO party to remain in power, and will

focus on reviving growth next year ahead of the 2015 elections.

Romania: Expect some noise, as usualThe country will see a change in the office of the president following presidential elections in

2014, with current president Traian Basescu likely replaced by Crin Antonescu, current leader

of the National Liberal Party (PNL) and head of the senate. Ahead of the presidential elections,


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there is a risk that the government may stray slightly from current structural reforms and

budget objectives.

South Africa: Low political risk

With the African National Congress firmly entrenched in power, South African elections next

June are less about a change in power, and more a forum to witness the erosion of the ANC's

appeal. Pro-business Democratic Alliance - traditionally perceived as a white-led party - is

likely to hang on to strongholds in the Western Cape and gain incremental ground from the

ANC. Meanwhile, newly launched party Agang SA and its ideological star Mamphela

Ramphele will not have sufficient time to attract a broad following. One positive note for

markets will be the return of Cyril Ramaphosa to the ANC's leadership as deputy president, as

he brings with him clout from private industry and the potential to mend some of the strained

relationships between government and business.

Turkey: Expect some politics-driven volatilityLocal elections next March will test the appeal of ruling AKP, following the protests that

erupted earlier this year. Opposition parties remain weak, and do not constitute a credible

threat. However, they are likely to encourage protestors to return to voice concerns against

Prime Minister Erdogan's increasingly autocratic rule. And unless Erdogan manages to change

AKP's rules to enable him to stand as prime minister for a fourth term in the 2015 general and

parliamentary elections, he may have to opt instead to run for the presidential post opening up

in August 2014.

LatAm

Brazil: A negative balance of risksThe countrys presidential election in October will easily be the most significant political event

in the region in 2014. Incumbent President Dilma Rousseff has seen her popularity partially

recover from a downturn earlier this year, and is the early frontrunner. But Rousseff will need

to manage a difficult mix of economic conditions ahead of the vote, namely stubbornly high

inflation coupled with sluggish economic activity. How the Presidents administration

approaches fiscal policy in 2014 will be crucial. Markets have grown increasingly concerned

about Brazilian fiscal dynamics and the future trajectory of debt-to-GDP, and we see the

possibility for at least one rating agency to downgrade Brazils long-term sovereign rating this

year. Nonetheless, satisfying calls for tighter fiscal policies may ultimately be perceived to be

too politically unpalatable ahead of elections, putting the administration in a difficult place.

Barring an upset at the polls, we think the balance of political risks ahead of the elections isnegative from a policy standpoint.

Chile: Low risksThe focus will shift towards new policies under a presidency of Michelle Bachelet (who is

strongly likely to win the second-round vote next month). Bachelet has pledged to pursue an

ambitious social agenda and commit to new spending, but thanks to Chile's fiscal rules and

limits on the President's fiscal discretion, we think risks to Chilean assets are relatively

insignificant.

Colombia: Supportive politicsThe announcement earlier this month that sitting President Juan Manuel Santos will stand in

May's elections should be considered a positive development for markets. The notion of a

Santos re-election should mean less policy uncertainty and the continuation of a generally

investor-friendly administration (embodied in last year's cut on foreign investors' bond

earnings). Perhaps more importantly, it would mean continued negotiations with FARC rebels,


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with a successful resolution having the potential to raise business confidence and spur

investment.

Mexico: Some upside signals

Although the electoral calendar is empty in 2014, the political focus will continue to be on

supply side reforms. With fiscal reform already passed, energy reform is now likely to be

wrapped up next month. Nonetheless, negotiations over implementation of reforms will

continue into next year. That presents some additional risk, though in total we believe markets

have been slow to price in the positive impacts of energy reform, particularly in the case of the

MXN.

Asia

China: Reforms on trackHow effectively policymakers put the reform promises of the Plenum meeting into substantive

policy in the coming years may be crucial to the trajectory of broader emerging markets. In the

near term, we see risks to growth from the prospective financial liberalisation. The central

government may continue to maintain tighter liquidity conditions and dampen credit growth.

India: Politics expected to be market positiveA great deal of attention will be on India, with parliamentary elections set for early 2014.

Recent governments having leaned more towards populism than embarking on needed

reforms, and bills related to insurance, a national VAT, the tax code, and fuel are still pending

in parliament and are unlikely to be agreed upon prior to elections. Markets are justifiably

worried about a policy logjam in the case of a hung parliament; some state election results in

December may provide clues here. But in the more likely event of any of the two major partiesforming a coalition government, we believe the reform momentum would likely continue after

the elections and political risks are positively skewed.

Indonesia: Fiscal impact in the balanceThe country will hold presidential elections in July, with markets watching for any post-

election adjustment of oil subsidies, currently running at 3.0-4.5% of GDP and a major

component of the budget deficit. Given low expectations, we think that the chance of a

positive surprise is actually fairly high.

Thailand: Fiscal pressures from sticky domestic policiesAlthough Thailand isnt scheduled to hold general elections until 2015, the issue of rice

subsidies is likely to be a closely watched political topic next year. The government is facing

pressure from markets and ratings agencies to reduce such subsidies, but the path forward

may be politically difficult. Prior attempts failed, after angering farmers who constitute an

important support base for the current government.


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Key events on the political calendar in 2014

EMEACzech Republic Jan-Mar 2014 Formation of the new government

Hungary Apr-May 2014 Parliamentary elections

European Union May 2014 Parliamentary elections

Lithuania May 2014 Presidential elections

South Africa Jun 2014 General elections

Turkey Aug 2014 Presidential elections

Romania Nov 2014 Presidential elections

Croatia Late 2014 / Early 2015 Parliamentary elections

LATAMChile Mar 2014 President starts term

Colombia May 2014 Presidential elections

Brazil Oct 2014 Presidential elections

ASIAIndia May 2014 General elections

Indonesia Jul 2014 Presidential elections



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EM FX ForecastsDec-13 Mar-14 Jun-14 Sep-14 Dec-14EUR/PLN 4.16 4.28 4.15 4.10 4.10

EUR/HUF 294 303 297 295 295EUR/CZK 27.00 27.00 27.00 27.00 26.80EUR/RON 4.40 4.48 4.42 4.37 4.37EUR/RSD 114 115 114 113 113EUR/RUB 43.30 44.01 43.24 42.75 42.13EUR/TRY 2.69 2.74 2.60 2.48 2.44RUB/BASK 37.00 38.00 37.75 37.75 37.50USD/RUB 31.84 33.09 33.26 33.66 33.71USD/TRY 1.98 2.06 2.00 1.95 1.95USD/ZAR 10.00 10.60 10.20 9.95 9.95USD/ILS 3.55 3.65 3.60 3.55 3.55USD/EGP 6.90 7.00 6.90 6.80 6.80USD/NGN 158.00 160.00 158.00 157.00 157.00USD/GHS 2.38 2.43 2.38 2.34 2.30USD/BRL 2.30 2.45 2.40 2.40 2.40USD/MXN 12.70 13.00 12.75 12.50 12.25USD/CLP 515 525 515 510 510USD/COP 1885 1900 1870 1860 1850USD/PEN 2.75 2.80 2.68 2.64 2.60

USD/CNY 6.10 6.10 6.12 6.09 6.08USD/HKD 7.75 7.75 7.75 7.75 7.75USD/INR 63.00 66.00 63.00 62.00 61.00USD/IDR 11000 11500 10750 10250 10250USD/MYR 3.16 3.25 3.20 3.13 3.13USD/PHP 43 44 43 42 42USD/SGD 1.24 1.27 1.24 1.23 1.23USD/KRW 1060 1060 1075 1090 1105USD/TWD 29.40 29.8

SG_EM Outlook 2014

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