Primal Oct 09

Emerging Markets
PRIMALKnowledge
Still on fire?
Macro Strategy October 2009
By Philip Poole and the Emerging Markets Macro Team
Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it
Strategy and Economics Macro October 2009
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Summary
Emerging markets were on fire for much of the decade that followed the Russian economic crisis at the end of the 1990s, expanding in importance and influence on almost every front. The global crisis was a rude awakening, exposing an underlying dependence on net external demand. Armageddon has been avoided, but the crisis has mutated rather than been resolved. Massive government and central bank intervention has shifted liabilities from the private to the public sector in the G7. The consequences of expansionary fiscal policies in the developed world could end up depressing global growth and crowding out financial access for emerging economies that dont have Chinese-style savings ratios. Even if there is a smooth and successful transition of net demand from deficit to surplus blocs, the post-crisis world is likely to be characterised by slower growth. Ultimately, the world will need to find a new equilibrium where global imbalances driven by extremes in saving-consumption relationships shrink and funding them becomes sustainable. That is a global challenge, including for an EM development model that depended on net external demand. For now, though, we are back in a dollarrecycling loop similar to the pre-crisis period. EM central banks are resisting upward pressure on their currencies from buoyant liquidity, constraining the pace of global adjustment. While it can run for a while yet, ultimately this is not sustainable. Unless currencies are allowed to adjust, the medium-term risk for EM will be asset-price bubbles and eventually inflation pressure from rising commodity and financial asset prices. Should inflation result, the need to tighten will mean financial assets would again pay the price. We expect EMs as a group to grow faster than the developed world in the coming years, continuing to shift the centre of economic gravity eastwards. There are many structural advantages that argue for a significant positive growth differential. But failure to embrace greater currency flexibility and fear of a future less tied to external demand represent substantial risks, suggesting the path towards income convergence with the developed world may not be smooth.
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Contents
EM ascent: size does matter
Hard commodities Equity markets Financial architecture
3
3 6 7
Country and territory overviews

Argentina Brazil Chile China Colombia Egypt Hong Kong SAR Hungary India Indonesia Israel Kazakhstan Korea Malaysia Mexico Nigeria Pakistan Philippines Poland Romania Russia Saudi Arabia Singapore South Africa Sri Lanka Taiwan Thailand Turkey Ukraine United Arab Emirates Venezuela Vietnam
42
48 52 56 60 64 68 72 76 80 84 88 92 96 100 104 108 112 116 120 124 128 132 136 140 144 148 152 156 160 164 166 170
EM currencies: reserving their place

A system under pressure The Day of the Triffins Inertia and the current position Reforming the system Options for a multi-currency world
11
11 11 12 13 13
What could stop the juggernaut?

What caused the crisis? Time to look for the exit? Is the model broken? Protectionism how much of a drag? Full circle
19
19 20 26 31 33
Appendix The rise and rise of EM
37 38
Disclosure appendix Disclaimer
174 176
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EM ascent: size does matter

The rise of EMs has huge implications for the global order Emerging markets now drive marginal demand for commodities EM governments are increasingly shaping changes in the global financial architecture EM is firmly established as an investible asset class in its own right which will continue to grow in importance
Hard commodities
The rapid rise of emerging markets (see Appendix on page 37 for a brief history) has had a huge impact on the demand for commodities, particularly oil and hard commodities. This is something we have highlighted before (see Primal Knowledge: Shifting Fortunes, June 2008) but worth revisiting in the current context. Coming off a low base of per capita usage and given the rapid growth both in population and economic activity (and in many cases the investment intensity of this growth), emerging
Per capita oil consumption (barrels/year) 18.0 17.5 17.0 16.5 16.0 15.5 15.0 14.5
markets have become the drivers of marginal demand for commodities. We have tried to project this forward. Projected oil consumption is calculated using projected per capita oil consumption and UN population forecasts. We calculated historical per capita oil consumption for different countries by dividing their historical oil consumption by population. We then projected this forward using five-year (2004-2008) average year-on-year percentage change in per capita oil consumption, scaled by UN population forecasts for different emerging countries.
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Oil consumption - 1000 barrels / day 100000
Ex trapolation
80000 60000 40000 20000 0 1965 1975 1985 1995 BRICs 2005 2015 2025
1985 1988 1991 1994 1997 2000 2003 2006 Dev eloped Economies BRICs (RHS) Top 20 EM (inc. BRICs, RHS)
Source: BP, UN population statistics, HSBC
Dev eloped Economies

Source: BP, HSBC
EM (ex l. BRICs)
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BRICs oil consumption (1000 barrels/ day)
BRICs oil consumption - relative shares
25000 20000
Ex trapolation
Ex trapolation 100% 80%
15000 10000 5000 0 1985 1990 1995 2000 2005 2010 2015 2020 2025 China
Source: BP, HSBC
60% 40% 20% 0% 1985 1990 1995 2000 2005 2010 2015 2020 2025 China
Source: BP, HSBC
India
Russia
Brazil
India
Russia
Brazil
We created two proxy groups for developed (US, Eurozone, Japan and UK) and emerging markets (the top 20 markets by current GDP.) Oil consumption of these two groups combined grew at an average rate of 1.1% in 2003-2008. This increase in consumption was purely driven by the emerging world. Oil consumption in the developed markets we tracked has fallen since 2005, reflecting a fall in per capita consumption to 16.37 barrels a year in 2008 from 17.74 barrels a year in 2005. Per capita oil consumption in emerging countries is significantly lower, although it has risen to 2.86 barrels a year in 2008 from 2.24 barrels in 1995. Given the more than 80% share of EMs in the developed and emerging aggregate population of the proxy groups we tracked, even a small increase in per capita oil consumption results in a significant rise in absolute global oil demand. Indexed oil consumption for developed and emerging markets gives a picture of relative future oil demand using extrapolated growth rates from the percentage change in average oil consumption over the past five years (2004-2008). On this basis, demand for oil from developed markets would fall by about 15% from 2008 to 2025. On the same basis, all other things being equal, consumption by emerging markets would rise about 75% if recent growth rates were maintained. As expected, BRIC markets form the major share of consumption by emerging markets, accounting
for more than 50% of the demand of the 20 emerging markets we tracked. That would increase to more than 60% by 2025 if the extrapolation is realised. China not only has the greatest relative share of oil consumption among the BRIC countries, but also has the highest projected growth rate. Chinas share in BRIC oil consumption was already more than 50% in 2008 and would rise to more than 60% by 2025 based on the extrapolation. At the current rate of growth in oil consumption (the average during 20032008), China would exceed the US to become the largest consumer of oil globally by 2020-2025.
Indexed oil consumption 1985=100 350
300 250 200 150 100 50 0 1985 1990 1995 2000 2005 2010 2015 2020 2025 Top 20 EM
Source: BP, HSBC
Extrapolation
Dev eloped Economies
Outside of BRIC countries, Saudi Arabia, Mexico and South Korea are major emerging markets with significant oil demand. If the average growth rate of oil consumption evident in the past five years were to be maintained, Saudi Arabia would become the second-largest oil-consuming emerging economy after China by 2020.
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Oil consumption patterns

Oil consumption and population growth (5 year average, 2003-2008)
8% 5 year averag e p er cap ita o il co n su m p t io n g ro wth rate (% ) 6% 4% 2% 0%

Japan Ukraine Russia Poland China Venezuela Argentina Saudi Arabia
-2% -4% -1% -1%
Egypt India Thailand South Africa Mexico Korea Indonesia Colombia United Kingdom US Turkey Malaysia Euro Zone Brazil
Pakistan
0% 1% 1% 2% 5 year average population growth rate (%)
2%
3%
Oil and total energy consumption (2008)
0.10 0.09 Per cap ita o il co n su m p tio n (b p d ) 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0.00 0% 10% Ukraine Finland Greece Japan Spain Austria Italy Portugal Czech Republic Germany Venezuela Chile Slovakia Argentina Malaysia Mexico South Africa Poland Thailand Brazil Turkey Egypt China Indonesia Philippines India Colombia Pakistan France 20% 30% 40% 50% 60% 70% US Netherlands
2008
Saudi Arabia
Oil as % of total energy consumption

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Copper demand China is also dominant

Developed and emerging copper consumption (tonnes, 000)
20000 15000 10000 5000 0
Ex trapolation
would remain at 2008 levels, about 6,400mt. But during the same period, the extrapolated data suggests a rise of some 70% for the emerging markets group, to 17,000mt from the current 10,200mt. The average year-on-year increase in copper consumption of BRIC markets during the past five years is more than 10%, compared with a 1.4% fall in consumption for the developed economies we tracked. As with oil, China has been the major demand driver for copper globally. In 2002, it surpassed the US to become the top consumer of copper. In 2008, Chinas copper consumption was almost equal to total copper consumption of the remaining top 19 emerging economies put together. Based on this simple extrapolation, by 2020, China and India together would account for around 50% of the global copper demand (our combined developed and emerging market aggregates).
1980 1985 1990 1995 2000 2005 2010 2015 2020 Dev eloped Economies
Sourec: Brookhunt, HSBC
Top 20 EM (inc. BRICs)
The story is similar for other commodities. Copper is a case in point. Based on the available data, the top 20 emerging markets we analysed have consumed more copper than our developedworld proxy (US, UK, Japan and the Eurozone) since 2003, based on data for both historical and forecast copper consumption from Brookhunt. In 2008, the emerging world group consumed 60% more copper than the developed world. While demand in the developed world is expected to remain stagnant in the years to come, it is expected to rise significantly in emerging markets. Based on extrapolating historical growth rates (average of the past five years), by 2020, the demand for copper from the developed world
Equity markets
Although the magnitude of the growth differential is significantly lower than for commodities usage, GDP and trade (see Appendix on page 37for analysis of GDP and trade growth differentials) the relative size of equity markets in the emerging world has increased significantly in recent years (calculations are based on MSCI data).
Global copper consumption relative shares
BRICs copper consumption (tonnes, 000)
Ex trapolation 100% 80% 60% 40% 20% 0% 1980 1985 1990 1995 2000 2005 2010 2015 2020 Dev eloped Economies
12000 10000 8000 6000 4000 2000 0 2000 2003 2006
Ex trapolation
2009
2012 Russia
2015 Brazil
2018
BRICs
EM (ex l. BRICs)
China
India
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In line with the analysis above for commodities usage, we used the concept of per capita market cap of equity indices to compare the size of emerging equity markets with the developed world. The per capita market cap for BRIC markets has increased exponentially over the past five years but remains low in relation to the developed world. For instance, the per capita market cap for China has increased from USD34 in 2003 to USD320 in 2008. But even allowing for this 10-fold increase, on this most basic measure, emerging equity markets appear to have substantial room to grow further as the EM economies develop (see the chart below.) We found the growth rate of equity markets can be very high during the convergence phase of economic development. We profiled the growth rate of Spains equity market during the 1980s and 1990s and compared that with current equity-market growth in the BRIC markets to see if there have been similarities. Clearly, economies will be subject to varied determinants, but such an assessment should provide an interesting comparative picture.
Per capita market cap (USD)
15 years. Similarly, the average market cap of the MSCI indices for BRIC markets as a percentage of the market cap of the MSCI All Country index has increased from 1% in 1993 to 5.1% in 2008. In other words, in the 15 years to 2008, the share of BRIC in the All Country index has increased just over fivefold. It is evident the historical growth rate of the equity market in Spain is roughly comparable with the current growth rate of the equity market for BRIC economies. The growth story in Spain continued in the following years. The share of its MSCI equity index in the MSCI World index grew by about the same rate in 2000-2005 as it did in 1995-2000. We overlaid the same pattern on BRIC markets and extrapolated the historical growth rate of its share in the MSCI All Country index in 20032008 to 2008-2013. That extrapolation suggests the combined share of MSCI equity indices of BRIC markets as a percentage of the All Country equity index would grow to about 25% by 2013 (see chart on next page). Consequently, the current low per capita market cap of emerging markets and the similarity of their growth rates to the historical convergence of earlier less-developed markets suggest to us that EM equity markets have huge potential to grow in relative importance in the coming years as these markets continue to develop.
40000 39000 38000 37000 36000 35000 34000 US UK China India Russia Brazil Mexico RHS
2500 2000 1500 1000 500 0
Financial architecture
Votes for cash
The global financial architecture and the notion of centre versus periphery are antiquated. They do not reflect the phenomenal rise in the importance and global weight of emerging markets. That is particularly evident in the composition of what has long been the worlds most important policycoordination committee, the Group of Seven; the voting rights in the Bretton Woods institutions, most importantly the IMF and IBRD; and the
Source: Thompson Financial Datastream, UN, HSBC. Data for 2008.
The average market capitalisation of the MSCI equity index for Spain as a percentage of the market cap of the MSCI World increased from 0.42% in 1985 to 1.34% in 2000; in other words, the share of Spain in the global equity market index increased more than threefold in a period of
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Development in market cap of Spain as (% of MSCI World) and market cap for BRICs (% of MSCI All Country)
10% 8% 6% 4% 2% 0% 1993 1998 China India 2003 Russia 2008 Brazil 1990 1985 1995 2000
Extrapolated for BRIC
2005 2008
2013 Spain
2016
* Years (1985,1990,1995,2000,2005,2008) are labelled separately for Spain over the line Source: Thompson Financial Datastream, HSBC
continued dominance of the dollar as global reserve currency (see above). It is something emerging nations are now determined to address. The G20 is beginning to play a bigger role in formulating global policy. Questions have been raised about whether that only represents the illusion of participation, but this shift in emphasis is set to continue. IMF voting rights are shaping up as a touchstone for the issue. Emerging markets, especially the BRIC countries, are demanding a bigger role in the Bretton Woods institutions to reflect both their growing economic gravitas and their ability to fund recapitalisation. Despite pleas from IMF Managing Director Dominique Strauss-Kahn in the run-up to the October meeting, key emerging economies have blocked a proposal for a new IMF decision-making council until a realignment of voting rights has taken place. There is no one-to-one relationship between current GDP and quota allocations (see chart on the following page, which shows many of the countries are either below or above the 45 degree line which would represent equality of votes to economic size.) China is certainly under-represented in votes. A few EM countries have quota allocations that are
relatively high compared with GDP, but they are small in relation to the group, minimising the impact of the deviation. The big EM countries, on the other hand, mostly place below the equality line, explaining the ongoing discontent over the allocation of voting rights. And this does not take into account PPP-based GDP calculations. (Saudi Arabia is an outlier, with a large quota compared with the size of its economy.) The US and Japan have relatively fewer voting rights based on their size. Developed European countries enjoy a relatively large quota compared with their GDP, and the gap is getting larger as their economies contract. Conversely, the BRIC share of global economy activity continues to grow while their representation stays the same. Changing voting rights in the IMF and IBRD will make for a difficult discussion. If China and other large emerging markets get a bigger say, others will get less, particularly in developed Europe. But without such an accommodation, progress on a broader realignment of the global financial system is likely to be slow. Adjustment will also be constrained by vested interests and accumulated wealth that is held mostly in dollar assets by non-US residents.
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IMF quotas and economic size: BRIC vs developed Europe

34 2009f 31 28 % Share of Q uota in Total 25
Developed Europe BRICs
2008
22 19 16 13 10 2008 7 7 10 13 16 19 22 25 28 31 34 2009f
% Share in World Nom inal GDP

Source: IMF
While the architecture has not changed much yet, the furniture is already being moved around. A case in point is a new, more user-friendly face of the IMF and, in particular, the introduction of the IMFs Flexible Credit Line (FCL). The advent of the FCL is part of an overhaul of the international monetary system that has already happened. The use of ex ante rather than ex post conditionality is the hallmark of this change and when it comes to pre-qualification criteria the FCL is the extreme example. This crisis will have important long-term implications for EMs and key lessons drawn will help to shape the redesign of the global financial architecture. Two in particular come to mind from the perspective of emerging markets. Countries that had large reserves relative to short-term liabilities were able to weather the storm more comfortably. The benefits of self-reliance and specifically self insurance are something policymakers will take away from the crisis. Another lesson is that, China apart, EM economies suffered from a general perception they could not sustain counter-cyclical policies given, in particular, still-high debt-to-GDP ratios. The implication for the operation of the IMF is a need to use facilities and swap arrangements to provide a safety net that keeps the private sector engaged in lending.
The availability of the FCL and other swap lines in theory means international reserve holdings by central banks can be lower than otherwise would be the case for the same degree of comfort. But in practice the behaviour of emerging-market central banks and governments in continuing to accumulate FX holdings does not so far bear this out. Another element of future global financial arrangements is likely to be more supportive regional liquidity facilities, particularly in Asia, where the Chiang Mai initiative a network of bilateral USD swap agreements is likely to be turned into a multilateral liquidity pool. Other aspects of change include enhanced flexibility on traditional stand-by lending and a streamlining of conditionality requirements associated with IMF lending programmes to allow more robust counter-cyclical policy to be pursued. Transformation of the worlds financial architecture has already started. It will not be smooth or necessarily sequential in nature, given entrenched interests. But the emerging-market economies are intent on increasing their say in global policy formulation and the current crisis has only intensified pressure for change.
% Share of Quota in Total
10 Strategy and Economics Macro October 2009
IMF quotas vs shares in global GDP
6 France
Germany
Japan
UK
4 Saudi Arabia Canada 3 Netherlands Belgium 2 Sw itzerland Korea India Australia Mex ico Spain Brazil Russia Italy China
Venezuela Austria Sw eden South Africa 1 Argentina Norw ay Iran Malay sia Poland Nigeria Turkey Ireland Greece Czech Republic Thailand UAE 0 0 1
Developed countries
2 3 4 5 6 7
Emerging markets
8 9
% Share in World Nom inal GDP

Source: IMF
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EM currencies: reserving their place

The shift from the dollar as dominant global currency will necessarily take time, constrained by inertia and the dollar trap But it is a process that is in train and appears inevitable, given the continuing shift of the centre of economic gravity to EM and particularly to China
A system under pressure

According to French President Nicolas Sarkozy at the G8 summit, we need a multi-monetary system for a multi-polar political world. But it is hard to escape the conclusion that the current calls for new reserve currencies also have a political angle. The end of the dollars dominance would also undermine US geopolitical pre-eminence. In economic terms, the rapid growth of emerging markets and the resulting shift in economic power and influence discussed above mean the dollar will inevitably lose its status as the worlds dominant reserve currency. A key question is whether it will be possible to move away from dollar dominance without market turmoil, particularly given the size of dollar holdings by EM central banks, China in particular. In reality, dollar dominance is already being questioned. Stability relies on US policy credibility, which has been eroded by the effects of weak financial regulation and what is likely to be a difficult exit from monetary, fiscal and financial-sector intervention. This process is likely to be accelerated by what will eventually become a
reduced appetite of net external creditors to buy US debt obligations. Concentrated holdings of foreign exchange reserves have ended up being a source of instability for the global monetary system and a trap for holders that fear the implications of excessive dollar issuance.
Matrix of international currency usage Private use Medium of exchange Unit of account Store of value Vehicle currency Quotation currency Investment, debt Official use Intervention currency Anchor currency FX reserve currency
Source: OECD Development Centre, after Kenen (The Role of the Dollar as an International Reserve Currency, Occasional Papers No.13, Group of Thirty.)
The Day of the Triffins

According to Helmut Reisen, head of research at the OECD Development Centre (Shifting wealth: Is the US dollar empire falling? 20 June 2009) this fear can be explained by the so-called Triffin dilemma that postulates the need for the US to run external deficits so long as the US dollar is the dominant global reserve currency; as the marginal supplier of the worlds reserve currency, the US has no choice but to run persistent current account deficits to supply the demand for dollars from the rest of the world, issuing dollar-denominated
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Foreign exchange reserves by currency (%) 2001 USD EUR GBP JPY CHF Other 71.5 19.2 2.7 5.0 0.3 1.3 2002 67.1 23.8 2.8 4.4 0.4 1.6 2003 65.9 25.2 2.8 3.9 0.2 2.0 2004 65.9 24.8 3.4 3.8 0.2 1.9 2005 66.9 24.0 3.6 3.6 0.2 1.7 2006 65.5 25.1 4.4 3.1 0.2 1.8 2007 64.1 26.3 4.7 2.9 0.2 1.8 2008 64.1 26.5 4.1 3.2 0.1 2.0 Q1 2009 65.0 25.9 4.0 2.9 0.1 2.1
Note: annual numbers refer to end year estimates except for 2009 when Q1 data is shown
Source: Bloomberg, HSBC
obligations to fund them. To quote Reisen, if the US stopped running balance of payments deficits and supplying reserves, the resulting shortage of liquidity would pull the global economy into a contractionary spiral. In a strange twist to this logic, their demand to hold reserve-currency dollars forces developing countries to transfer resources to the US as the issuer of those dollars.
rather than return considerations, albeit that the latter have probably increased in recent years. So what could change those preferences and who are the most important actors? Emerging market central banks are the biggest holders of FX reserves and the attitude of the monetary authorities and governments in EM will be key to how things play out in future. Central bank reserve allocation between alternative currencies has a big impact directly on currency demand and indirectly via sentiment. It is not surprising that the market pays such close attention to potential changes in the allocation of reserves. Decisions by EM monetary authorities on what to hold will be an important element that shapes the post-dollar reserve-currency world.
Inertia and the current position

The dollar still dominates FX reserve holdings. Its share in official reserves holdings has been relatively stable (see table), but this masks substantial differences in the currencies that make up reserve holdings at individual central banks. Different preferences mostly reflect transactions motives the FX denomination of external indebtedness, the geographic dispersion of trade flows and exchange-rate policy (float, peg, etc)
The dollars are mostly in EM
40 2000 35 30 1500 Bil USD 25 months 20 1000 15 500 10 5 0 China Japan Russia India Korea Brazil Hong Kong Singapore Thailand Libya Malaysia Mexico Turkey US Poland Indonesia Switzerland Nigeria Norway 0
International Reserv es( lhs)

Source: Joint external debt hub (JEDH) and Thompson Financial Datastream
Import cov er (months)
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Reforming the system

China wants reserve currency stability
Changing Chinas model from export- to domestic consumption-led growth is most likely a generational challenge (see section below). In fact, while global imbalances are shrinking as saving rates rise in the US, Chinas share in global saving, as measured by its share in the global current account surplus, has remained high. On this basis, it should come as no surprise that Beijing wants somewhere safe and stable to keep it all. China has already had to realise losses on its sovereign wealth holdings as a result of falls in financial-asset prices, and it fears dollar weakness against the renminbi which would lead to a substantial loss in the renminbi value of the massive accumulated holdings of US treasuries. With such high stakes, China has been vocal in the reserve currency debate, looking for possibilities to diversify away from dollar assets but also wanting any new model to provide stability. At the March G8 summit meeting, Chinese State Councillor Dai Bingguo gave what is probably the clearest explanation of what China wants to see from the reserve currency system. In a word, stability. We should have a better system for reserve currency issuance and regulation so that we can maintain relative stability of major reserve currency exchange rates and promote a diversified and rational international reserve currency system. This desire reflects two things: the huge accumulated net position in other nations currencies, mostly the dollar, which is the result of past excess saving, and an expectation that this will only get bigger. China has no aversion to the dollar per se, but to the actual and potential volatility of the dollar (especially to the downside) and its implications for Chinas accumulated savings that are parked there. This also explains the aversion to
quantitative easing, given a belief that the resulting excess supply of dollars will eventually drag its value lower. At the first BRIC summit in Ekaterinburg, Russia, in June, according to Russian President Dmitri Medvedev, there was agreement on a need for greater stability and diversity of reserve currencies. The current range of reserve currencies, and the main one the US dollar are not exercising their functions. The emergence of a new currency is a slow process. At the same time my colleagues and I have voiced the need for an additional reserve currency. So what are the options?
Options for a multi-currency world

As Barry Eichengreen and Marc Flandeau point out (The rise and fall of the dollar, 2008), the dollar replaced sterling as the dominant reserve currency in the 1920s, 40 years after the US became the worlds biggest industrial economy. But dollar dominance was shared with sterling, just as sterling had earlier shared dominance with the franc and mark. In fact, the current extreme dominance of the dollar is an anomaly. But that is not the only problem with the current system. Jose Antonio Ocampo summarises the failings well (see Reforming the global reserve system, in Time for a Visible Hand: Lessons from the 2008 World Financial Crisis.) He argues the current system has three fundamental flaws. First, it has a deflationary bias: adjustments that deficit countries have to adopt to balance external accounts when sufficient financing is not available will not necessarily be matched by expansionary policies in surplus countries which do not face pressure to adjust. Such a bias is an important element in the current economic crisis (see section below on the need for global adjustment.)
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The second flaw has already been raised above, the so-called Triffin dilemma a reserve system based on national currencies, whether one or many, has built-in instability: the only way for the rest of the world to accumulate net dollar assets is for the issuers of reserve currencies to run a current account deficit. But running such a deficit will eventually tend to erode confidence in reserve currencies. The third flaw identified by Ocampo is that the current reserve system is inequitable. The demand to accumulate reserves forces emerging countries to transfer real resources to countries issuing reserve currencies; in the current system, the US. Faced with this starting point, an option mentioned by China, Russia and Brazil is to boost the role of their own currencies in trade and settlement, possibly by including their currencies in an expanded SDR basket. There are undoubtedly advantages in having a reserve currency. By enlarging the scope of issuers and investors, the additional demand for money creates seigniorage revenues for the currency-issuing country, effectively an interestfree loan from other countries prepared to hold the reserve currency to the monetary authority issuing that currency. In addition, currency use in key markets for commodities or trade invoicing shifts exchange-rate risk to third countries, insulating the country issuing the reserve currency.
The rising share of EM in global trade

55% 50% 45% 40% 35% 30% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
EM Ex port v olume % of global export trade v olume
Source: Netherland Bureau of Economic Policy Analysis
Is the renminbi the next global reserve currency?

What about EM currencies playing an increasing role as reserve currencies? Their role is currently restricted by capital controls and the limited depth and liquidity of debt and asset markets relative to the US and Eurozone.
Exploding bilateral trade between BRIC markets

China- Brazil China's Exp to Brazil Brazil's exp to China 2000 334 281 Q4 2008 3896 2691 Q1 2009 2325 3395 Total trade 615 6586 5720 China- India India's Exp to China China Exp to India Q4 2000 216 477 Q4 2008 4699 7956 Q1 2009 5092 6097 Total trade 693 12655 11190
971%
1727%
India-Russia India's Exp to Russia Russia's Exp to India Q4 2000 234 356 Q4 2008 394 1569 Q1 2009 295 2154
Total trade 590 1963 2448
233%
China-Russia China's Exp to Russia Russia exports to china Q4 2000 745 984 Q4 2008 9178 5442 Q1 2009 5839 4916
Total Trade 1730 14620 10755
745%
Source: Data stream, HSBC. Calculations shaded in grey show the percentage change Q4 2008 on end Q4 2000
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Ratio of Indias exports to Russia, China and Brazil to its total exports
1% 8 1% 6 1% 4 1% 2 1% 0 8 % 6 % 4 % Q4 2000
2% 8 2% 6 2% 4 2% 2 2% 0 1% 8 1% 6 1% 4 1% 2 1% 0 Q4 2000 Q2 2001 Q4 2001 Q2 2002 Q4 2002 Q2 2003 Q4 2003 Q2 2004 Q4 2004 Q2 2005 Q4 2005 Q2 2006 Q4 2006 Q2 2007 Q4 2007 Q2 2008 Q4 2008
Ratio of Brazils exports to Russia, China and India to its total exports
1% 8 1% 6 1% 4 1% 2 1% 0 8 % 6 % 4 % Q4 2000 Q2 2001 Q4 2001 Q2 2002 Q4 2002 Q2 2003 Q4 2003 Q2 2004 Q4 2004 Q2 2005 Q4 2005 Q2 2006 Q4 2006 Q2 2007 Q4 2007 Q2 2008 Q4 2008
Source: Datastream, HSBC
But, as Helmut Reisen points out, if the switch in reserve currency from sterling to the US dollar is any guide, the renminbi is likely to replace the US dollar as a reserve currency around 2050. According to Menzie Chinn and Jeffrey Frankel (Why the Euro Will Rival the Dollar, 2008), the US replaced the UK as the worlds largest economy in 1872 and the largest exporter in 1915. The switch in net debtor/creditor positions started in 1914, and as the US dollar emerged as a convertible net creditor currency, its use in finance and trade widened. Today, the US is in a net debtor position similar to Britain after 1918, with China being the worlds largest creditor. As highlighted in the analysis above, China is on track to become the largest economy and exporter globally. Such historical parallels underline the eventual switch to the renminbi as the dominant reserve currency.
Ratio of Chinas exports to Brazil, Russia and India to its total exports
Q2 2001
Q4 2001
Q2 2002
Q4 2002
Q2 2003
Q4 2003
Q2 2004
Q4 2004
Q2 2005
Q4 2005
Q2 2006
Q4 2006
Q2 2007
Q4 2007
Q2 2008
Q4 2008
For now, though, the renminbi is not ready for reserve currency status. It would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms, and make its bond markets more liquid, according to Reisen. Applying the logic of the Triffin dilemma, it would also presumably have to move from surplus to deficit on its external accounts to satisfy the huge demand for reserve money holdings in the rest of the world. That implies any move towards reserve currency status will need to be accompanied by renminbi appreciation. As our chief economist for China, Qu Hongbin, has pointed out, China is moving in the direction of internationalising the renminbi (see From greenbacks to redbacks, 6 July 2009). China has already set up currency swaps with several countries in Latin America and Asia. And by
Ratio of Russias exports to Brazil, China and India to its total exports
13 % 11 % 9 % 7 % 5 % 3 % Q4 2000 Q2 2001 Q4 2001 Q2 2002 Q4 2002 Q2 2003 Q4 2003 Q2 2004 Q4 2004 Q2 2005 Q4 2005 Q2 2006 Q4 2006 Q2 2007 Q4 2007 Q2 2008 Q4 2008
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letting institutions in Hong Kong issue bonds denominated in renminbi, it has taken a first step towards creating a deep domestic and international market for its currency. Chinese authorities have already begun a pilot project for settlement in renminbi. The first contracts have been signed for trade transactions with Hong Kong and Indonesia. The move needs to be seen both as part of a process of increasing the convertibility of the renminbi and as a necessary step in reducing, over time, dependence on the dollar. It will have the immediate advantage of reducing FX risk for Chinese companies that switch to renminbi settlement. Such moves will be gradual, given Chinas huge holdings of dollar-denominated assets (c70% of FX reserves) and its understandable desire to protect their value in renminbi terms (see section on the dollar trap below for more on this).
achieved so far. Russia has pledged loans to Belarus in roubles along with US dollars under the plans for a Russia-Belarus united state, but Belarus has not been keen to receive rouble loans. There have also been talks between Russia and China to expand a list of currencies in which reserve assets are invested to include roubles, but so far they have not gone further than that. Raising the roubles international status by using it instead of the dollar as a contract and settlement currency for exports of Russian crude oil and natural gas has also made little ground. And switching to rouble-denominated bilateral trade with CIS countries appears not to be supported by Russias trade partners. The key to the roubles broader acceptance in such a role (and in the same vein for other commodity currencies) is whether Russias partners will be prepared to start making payments for their oil and gas in roubles.
Other EM currencies
In addition to using renminbi instead of the dollar, China has been discussing use of the Brazilian real in settlement for trade transactions with Brazil and other third currencies for settling bilateral transactions with other countries. But the immediate prospects do not appear that bright. Argentina and Brazil have been negotiating the settlement of trade in local currencies for some time. It is voluntary and so far exporters from Argentina have continued to prefer US dollars. Argentina and Brazil closed a currency swap of up to cUSD1.9bn in August. The magnitude is not an issue for Brazil, but for Argentina it is eventually a chance to enhance reserves if needed. Actually, local reports suggested Argentina wanted to conclude a swap for cUSD10bn, the same amount as the swap with China. But again there is the question of acceptance. In Brazils case in the past, there has been a payment system scheme with other Latin American markets similar to the new arrangement with
Russia
There has been active discussion of using emerging-market currencies in bilateral trade, particularly between the BRIC markets. And as the chart and tables above show, bilateral trade volumes are now substantial. The volume of Russias trade with China alone reached USD17bn in the first half of 2009. President Medvedev and Finance Minister Alexei Kudrin have talked of developing a group of regional reserve currencies such as the rouble in the CIS, the renminbi in developing Asia to replace the dollar in regional trade. Medvedev has also been quoted as saying that Russia might set up rouble-renminbi swap lines similar to the lines set up by China with selected Latin American and Asian countries. Making the rouble a regional reserve currency has enjoyed strong political support from Vladimir Putin and now Dmitri Medvedev for more than three years. In practical terms, little has been
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Argentina, the so-called CCR. It was seen as a way to reduce transaction costs especially for small exporting companies. But with most Brazilian exports conducted by larger companies, and given a preference for US dollars instead of local currencies that also applies to Brazil, the scheme never took off. Local soundings from our operations in Brazil suggest the preference of Brazilian exporters and importers for dollars has not changed much. In the case of India, there has been no discernable progress, but the authorities have not been pushing the issue as much as China, Russia and, to a lesser extent, Brazil.
to global FX reserves. Less than 5% of Chinas reserves are equivalent to a full year of global gold production, so size constraints will limit the extent to which reserves can be parked in gold, except at the margin.
How realistic is a change in dollar dominance?

As our FX strategists have pointed out the dollar is still the reserve currency of the world by a big margin. It holds pole position in global transactions and until recently, anyway economic size and stability over time have been factors in its favour. It is also the most important global perceived store of value and associated with the most developed money and financial system there is. And then there are inertia and transactions costs; potential sand in the global economic machine that creates inertia and helps to preserve dollar dominance. Moreover, the latest crisis has demonstrated that only the most liquid assets are desirable as core reserves. Illiquidity will limit diversification as US assets continue to monopolise the liquidity premium.
Is the SDR a viable alternative?

Conceptually, the SDR as an alternative reserve currency merits attention, but is probably a lowprobability event. China did not mention the SDR idea at the latest global summit. One reason the euro has not made more progress as a reserve currency is the issue of governance. Both the US and the Eurozone have a single monetary agency, but in the Eurozone governance is the preserve of individual national governments. The same problem applies to the SDRs broader usage. In addition, if the SDR is to become a reserve currency, the IMF would need to assume a bigger role, akin to a global central bank, and a deep capital market in SDRs would need to develop. Could BRIC currencies play a bigger role in the SDR? In the short term, that also appears unlikely. The restrictions on the convertibility of currencies like the renmimbi would limit their inclusion.
Caught in a dollar trap

The fundamental paradox of large holders of dollars looking to move to a system where the dollar becomes less dominant, potentially driving down its value, will also prevent rapid change. The issues of resolving existing global imbalances, springing the dollar trap and achieving international monetary reform are now inseparable. Paul Krugman recently highlighted this blockage (Chinas Dollar Trap, New York Times, 2 April 2009): China has driven itself into a dollar trap and it can neither get itself out nor change the policies that put it there in the first place. This is a central element of why the existing model is dysfunctional, but also why adjustment is slow. The concern is not so much that continued accumulation of reserves from FX intervention produces a low return on dollar assets but about the potential capital loss from dollar weakness.
What about gold?

Gold is the only major financial asset that is not someone elses liability. Surely this is a major attraction when the dominant reserve currencies are being debased by huge issuance? Chinas behaviour suggests that it is. China has increased its gold holding sharply in recent years. But the gold market and flows into it are small in relation
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China owns so many dollars it cant sell them without driving the price down against itself. No acceptable short-term solution exists, and for now China will be forced to continue to invest the largest part of its FX reserves in US Treasuries. This remains the only market big and liquid enough to absorb such massive flows. Olivier Accominotti (Chinas Syndrome: The dollar trap in historical perspective) argues that Chinas dollar trap resembles the 1920s, when France held more than half the worlds foreign exchange reserves. According to Accominotti, Frances sterling trap ended disastrously. Sterling suffered a major currency crisis, French authorities lost a lot of money, and subsequent policy reactions deepened the Great Depression. How can problems be avoided this time around? China is trying to curb the growth of its US dollar exposure by encouraging state-owned enterprises to use foreign exchange to acquire real assets abroad, particularly in the energy sector. It has eased restrictions on international corporate investment to facilitate that. It is not just China that is looking to escape the dollar trap by investing in commodity and particularly oilrelated assets. In comments reported by Bloomberg, the Korean minister responsible for the oil sector indicated the Korean Investment Corp (Koreas sovereign wealth fund) could help to finance overseas acquisitions in the oil sector. China has already spent billions of dollars this year to fund such purchases, competing with national oil companies from Korea and India among others, to spend their dollars on energy assets which are benefiting from this bid, as are underlying oil prices. Clearly, though, the scale of such purchases is not enough to absorb the rapid intervention-related growth in EM reserves, most notably in China, where the ability to buy real assets has also been constrained by political considerations in the countries where the assets are located.
Consequently, it is hard not to reach the same conclusion as Krugman: China remains firmly locked in a dollar trap, with only limited ability to diversify meaningfully. In such a situation, springing this dollar trap is potentially dangerous for both China and the US, given the mutual dependence. The only safe way out is through a reduction in imbalances as both countries adjust the relationship between saving and investment. As a minimum, this will take time and the path will be strewn with potential pitfalls. However, while Chinas dollar holding might be too big to sell, at the margin other central banks are likely to continue to diversify beyond the highly liquid component of reserves, where liquidity preference still necessitates holding dollars. Given the nature of the starting point and the constraints, the overriding conclusion at this point is that the shift away from the dollar will take time, constrained by inertia and the bind of the dollar trap. But it is a process that is in train and, ultimately, appears inevitable given the continuing shift of the centre of economic gravity to EM, and particularly to China.
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What could stop the juggernaut?

We are back in a dollar-recycling loop similar to pre-crisis The risk for EMs is building asset bubbles and eventually inflation We fully expect EMs as a group to grow faster than G7 But failure to embrace greater currency flexibility and fear of a future less tied to external demand represent substantial risks
What caused the crisis?

The financial crisis arose because governments tolerated a build-up in leverage that funded excess consumption, compounded by regulatory failure. US demand exceeded output and net exporters in emerging countries were prepared to supply goods in exchange for acquiring FX reserves, mostly in dollars. That was the crux of the problem, although the adjustment mechanism was compromised by relative price distortions from exchange-rate targeting by EM central banks. From a regulatory perspective, there were also
failings grounded in the belief in light-touch regulation. For a long time, excess liquidity did not show up in measured inflation, only in asset prices and later in commodity prices. Targeting narrow measures of inflation was a mistake that allowed the asset- price bubble to build largely unchecked. There is an important lesson in this for the conduct of monetary policy in emerging markets, particularly those that have adopted inflation-targeting regimes. The inflation measure should not be too narrow.
The global current account surplus (% GDP)

3.50%
Current account balance: developed vs emerging economies (USDbn)

800 600 CA balance (bn USD) 400 200 0 -200 -400
3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
-600 1980 1984 1988 1992 1996 2000 2004 2008
Adv anced economies Emerging and dev eloping economies

Source: IMF Source: IMF
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When the financial crisis broke, contagion to EM was evident via three principal channels: a sharp downturn in international trade flows, a dramatic fall in commodity prices that hit net commodity exports and short-term liquidity pressure from an inability to roll over maturing debt and attract incremental financing. The capital-flow drought was largely a private-sector corporate and bank problem but, as in the developed world, in some instances governments stepped in to assume the burden, either directly or on a contingent basis.
EM net private flows

900,000 700,000 mil USD 500,000 300,000 100,000 -100,000 2003 2003 2004 2004 2000 2000
Source: IIF database
Private flows, net
2001 2001
2002
Equity investment, net
2005
2006 2006
2007 2007
Commercial banks, net
2008
2010f 2010f
2009f 2009f
Time to look for the exit?

For emerging markets, the immediate concern is to navigate a way out of the crisis, put the cyclical problems aside and attempt to return to the secular growth story. There is no doubt the global policy response has limited the damage. Among the key steps were agreements at the April G20 meeting in London to treble resources available to the IMF to USD750 billion. Together with other measures at the national level, that initiative formed what the G20 called a global plan for recovery on an unprecedented scale. And it has worked; the global economy hasnt dropped into a deflationary black hole. For once, the hyperbole is not misplaced. Measures that involved central banks taking on individual credit risk, for example by buying corporate debt, are
Loan to deposit ratios where the leverage was
200% 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% DISAVERS
particularly extraordinary steps because they come close to the area of fiscal policy blurring the boundaries of traditional policy. More generally, the extent and concerted nature of the global monetary and fiscal response is without precedent. The G20s statement after its London meeting summarises it well. The group pledged to do whatever is necessary to: Restore confidence, growth, and jobs Repair the financial system to restore lending Strengthen financial regulation to rebuild trust
SAVERS
Source: Datastream, HSBC, Bloomberg
Egypt Venezuela China Philippines Mexico Hong Kong Argentina Norway Turkey Colombia South Africa Kuwait Czech Republic Austria Indonesia Malaysia Japan Saudi Arabia Belgium France Chile Canada Nigeria Denmark Thailand Finland Portugal Italy Poland Ukraine Australia Germany US Korea Russia Romania Spain Switzerland Ireland Netherlands Hungary Brazil Ukraine
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Current account balances and growth (yoy)

Global
6 5 4 3 2 1 0 Country -1 -2 World GDP World Surplus 2006 2007 2008 2009 -50 -60 20 10 0 -10 -20 -30 -40
China
14 12 10 8 6 4 2 0 2006 2007 China- GDP 2008 2009 2010 China- CA 20 10 0 -10 50 40 30
Germany
4 2 0 2006 -2 -20 -4 -6 -8 Germany- GDP -40 -60 -80 Germany- CA 2007 2008 2009 2010 60 40 20 0
Japan
3 2 1 0 -1 -2 -3 -4 -5 -6 -7 Japan- GDP Japan- CA -20 -30 -40 -50 -60 2006 2007 2008 2009 2010 30 20 10 0 -10
Saudi Arabia
3 2 1 0 -1 -2 -3 -4 -5 -6 -7 Japan- GDP Japan- CA -20 -30 -40 -50 -60 2006 2007 2008 2009 2010 30 20 10 0 -10
Russia
10 8 6 4 2 50 0 -2 -4 -6 -8 Russia- GDP 2006 2007 2008 2009 2010 0 -50 -100 -150 Russia- CA 250 200 150 100
Source: IMF
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Fund and reform international financial institutions to overcome this crisis and prevent future ones Promote global trade and investment and reject protectionism and Build an inclusive, green, sustainable recovery. How well has it worked? For emerging markets, an overriding concern in Q1 was the potential inability of banks and corporate issuers to roll over their maturing FX exposure, particularly where short-term debt represented a relatively high proportion of liquid FX reserves. The combination of swap lines, the new FCL facility from the IMF, a rise in reserves in many countries and a higher-than-expected rollover ratio (partly because sentiment has improved on the back of the other factors) has alleviated these concerns. Korea is a case in point. Its Q2 external-debt data show debt levels are rising again, by USD11bn from the end of March, but reserves are rising faster, by USD27.5bn in the same period. As a result, not only has financing flowed but the ratio of short-term liabilities to assets has fallen. From a high of 97% in September 2008, the ratio shrank to c80% in June, addressing the liquidity concerns the market fretted about earlier in the year.
synchronised. For now, though, the key question is still when? Listening to central bankers the Fed in the August minutes, the ECB in recent statements or for that matter the Central Bank of Brazil after the last Copom meeting there are some common themes. One is that as far as activity is concerned, the worst is over. Another is that excess capacity and weak pricing power mean inflation is not an immediate threat. But on prospects for global recovery, the fear is that it will be weak and anaemic. That combination suggests most central banks will be in no hurry to withdraw the liquidity stimulus that has fed through so powerfully into risk assets since the Q1 trough. Green shoots need a lot more watering before this particular tap is turned off, and all the evidence suggests policy makers are prepared to err on the side of excessive ease rather than risking early withdrawal. There is a wrinkle in this argument for emerging markets. A pick-up in commodity prices has helped to ease the risk of deflation in the developed world but could start to threaten inflation for emerging markets, given the structure of their CPI baskets. According to Mexican Central Bank Governor Guillermo Ortiz, What is worrying is that rising commodity prices may put some emerging markets again in a situation where the degree of freedom in terms of monetary policy is constrained. This is largely borne out in our forecasts for policy rates: emerging markets are expected to tighten policy more quickly than developed markets for the most part.
Not done nurturing

The classic errors of economic policy during crises are that governments tend to act too late, with insufficient force, and then put the brakes on too early. We are not going to repeat those mistakes. Tim Geithner, US Treasury Secretary, September 2009. Finding an exit from this crisis is still very much a work in progress. Safety nets for the financial sector cannot be permanent, and as various officials have pointed out, rolling back these safety nets and the extraordinary measures to support the financial system will need to be
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World policy dynamics
US
2009e 1 0 Real Rates 2011e 2007 -3 2008 -15 -10 -5 Fiscal balance (% GDP) -4 0 -1 -2
Eurozone
2.5 2007 Real Rates 2 1.5 2009e 2010e 2011e 1 0.5 0 -0.5 2008 -8 -6 -4 -2 Fiscal balance (% GDP) -1 0
2010e
Japan
2010e 2009e 2011e Real Rates 2 1.5 1 0.5 2007 0 -0.5 -1 -1.5 -2 -1 0
UK
2007 4 3 Real Rates 2 2011e 1 0 2010e 2009e -15 -10 -5 Fiscal balance (% GDP) 2008 -1 -2 0
2008 -6 -5 -4 -3 -2 Fiscal balance (% GDP)
Brazil
10.0 8.0 (real rates) 6.0 4.0 2.0 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 2009e 2007 2011e 2010e 2008
China
6.0 5.0 (real rates) 4.0 3.0 2.0 1.0 0.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0
(consolidated govt balance % GDP)
2009e 2008 2011e
2010e
2007
Russia
2011e 2.0 1.0 (real rates) 2009e 2010e -1.0 -2.0 -10.0 -8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 2007 6.0 8.0 0.0 2008
India
4.0 2.0 (real rates) 0.0 2010e 2008 2009e -2.0 -4.0 -6.0 -8.0 -10.0 0.0 -5.0 -10.0 (consolidated govt balance % GDP) -15.0 2011e 2007
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Forecast policy rates 2008 US ECB BOE Argentina Brazil China Chile Colombia Egypt HK Hungary India Indonesia Israel Kazakhstan Korea Malaysia Mexico Nigeria Pakistan Philippines Poland Russia Saudi Arabia Singapore South Africa Taiwan Thailand Turkey Ukraine Venezuela Vietnam 0.0-0.25 2.5 2.0 10.5 12.2 5.3 8.3 9.5 20.2 0.5 10.0 6.5 12.0 2.5 10.5 4.1 3.3 8.3 9.75 15.0 5.5 5.0 13.0 1.5 2.4 11.5 2 2.7 15.0 22.0 22.2 8.5 2009 0.0-0.25 1.0 0.5 9.0 11.0 5.3 0.5 4.0 10 0.5 6.0 4.7 6.9 1.0 7.0 2.6 2.0 4.5 6.0 11.0 4.0 3.3 9.7 0.2 1.0 7.0 1.3 1.3 6.5 14.0 19.0 7.0 2010 0.0-0.25 1.5 2.0 8.5 11.0 5.8 3.0 5.0 10.1 0.5 4.5 5.5 8.1 3.3 7.5 3.2 2.5 5.5 8.0 10.0 4.7 3.5 12.0 0.2 0.6 7.5 1.8 2.0 9.5 9.5 20.0 11.0 2011 0.00-0.25 2.5 3.5 8.0 10.1 5.8 4.5 6.0 8.2 2.2 4.0 6.8 8.1 4.5 5.5 3.4 2.7 6.5 8.5 9.0 5.5 4.0 19.0 0.2 0.9 8 2.2 2.0 8.5 13.0 22.0 11.0
Moreover, given the export-oriented structure of many emerging economies, recovery will inevitably be constrained if there is prolonged weakness in the G3 economies. Short term, it will not be possible to sidestep this dependency. Policies to reduce savings and stimulate private consumption even if applied aggressively will for the most part have a long gestation period. This dependence will ultimately constrain any decoupling from the developed world. To quote Guillermo Ortiz again, the recovery in the world economy will only be sustainable if final demand consumption, investment and so on can be sustained in the major economies. It would be difficult to think in the absence of such a recovery in final demand, that emerging markets by themselves could sustain a recovery. Data out of Japan seem, finally, to be stabilising and elsewhere the developed world has seen a notable improvement. The US remains the most important piece in this puzzle. In September, our US economist, Ian Morris, significantly upgraded HSBCs view of both short- and medium-term US growth prospects. We are now looking for a much sharper bounce in activity in 2009 (+2.9% y-o-y) and 2010 (+3.6% y-o-y) and a very strong Q3 (as strong as 5% growth) on the back of the cash for clunkers programme and inventory effects. Despite the upgrade, our US economists still think US rates will remain on hold through 2011.
BRIC consumer spending % of US consumer spending
45% 40% 35% 30% 25% 20% 15% 2003 2004 2005 2006 2007 2008 2009 2010
Source: HSBC, national sources
Against the backdrop of weakness in external demand, the focus for EM in recent months has been on the relative strength of domestic demand and the sustainability of fiscal stimuli in order to offset weakness in external demand. Of course, there will be a limit to stimulus and private sector demand has to take up the running. In the words of Raghuram Rajan, economic adviser to Indias Prime Minister Manmohan Singh, initially, some stimulus is not a bad thing. But I think we also need to recognise that there is a limit to government spending if you dont create a substantial amount of growth from the multiplier effects from the stimulus, then in the long run, spending will just bring up more debt. So you would be sacrificing tomorrows wealth for todays pleasure.
Source: Data stream, HSBC estimates
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This upgrade has major implications for our EM view across asset classes. For sure, part of the improvement is net export-led, suggesting a corresponding drag on growth elsewhere in the world particularly in economies running bilateral surpluses with the US because of a deterioration in the balance on goods and services trade. But a healthier US outlook has to be good for overall global growth prospects, particularly if it is accompanied by continued low rates.
Asia and the US: changes in IP
1.0 0.5 0.0 -0.5 Asian EMs & Dev eloped -1.0
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09
6M rolling correlation of Av . %mom IP grow th rate

Coupling or decoupling?
Looking at the extent to which emerging markets have moved in line with the developed world, we analysed the five-year rolling correlation of yearon-year percentage change in GDP between developed and emerging markets, to see the evidence of coupling or decoupling of their economies over different periods. Before 2000, developed- and emerging-market GDP growth rates showed very low correlation. Correlation increased sharply in 2004-2006, when the economies of the two blocs moved in sync. A marginal fall in rolling correlation can be seen after 2006, although in statistical terms, it is still significant (a correlation coefficient of more than 0.5.) The other chart on the facing column represents the six-month rolling correlation of average month-on-month percentage change in industrial production (IP) for the Asian emerging markets of China, India, Korea, Indonesia, Taiwan, Thailand, Pakistan, Malaysia and Philippines and the developed economies of the US, UK, Japan and the Eurozone. The correlation rose from 2006 until June 2009, fell briefly during the first half of 2008 and since June 2009 has fallen significantly.
5 yr rolling correlation of yoy% GDP growth rate
100% 50% 0% -50% -100% 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
BRICs:Dev eloped
Source: IMF, HSBC
Top 20 EM:Dev eloped
The average year-on-year percentage changes in IP for Asian emerging markets and developed markets have historically moved together. The correlation fell significantly during the crisis (since the beginning of 2008) for both groups. However, Asian emerging markets bottomed earlier than the developed group. Moreover, as evident from the V-shape in the chart overleaf, the pace of recovery is steeper for Asian EMs. This mismatch in timing and speed of recovery has led to a significant fall in correlation since the beginning of 2009 and shows that there has been an element of decoupling in the relative speed of recovery between these two groups.
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Average yoy % change in IP for developed and Asian EMs
Most Asian economies adopted the Japanese development model. But the so-called wild geese flying model (a model based on the principle of dynamic comparative advantage) adopted from Japan depended explicitly on a goose that was not in the flock the developed world that provided the demand that the industrialisation process in these markets supplied. How difficult will it be for economies with such an economic structure to move to a more domestically focused model of development? On that question, the future prosperity of emerging markets, and not just in Asia, is likely to turn. We have written about this in the past, most recently regarding the extent to which this model, coupled with exchange rate rigidities, finally broke down (see Primal Lite: How green was my rally, July 2009 and Primal Knowledge: Wild geese flying December 2006). However, because this subject is so central to the development prospects for EM it is worth revisiting.
20% 10% 0% -10% -20% -30% Jan-00 Jan-01 Jan-02
Av . %y oy change in IP
Asian EM
Is the model broken?

So far, this report has charted the rise of emerging markets and the interruption from the current economic and financial crisis. The severity and nature of this crisis have raised some key longerterm questions. Has it caused the shift of economic power and influence to emerging countries to accelerate, by destroying wealth and eroding welfare in the developed world? Or has it exposed the Achilles heel of many emerging markets a mercantilist model that depends too much on external demand, be it for manufactured products or commodities? Will the world including emerging markets need to adjust to structurally lower growth? And will the positive growth differential with the developed world only be sustained if markets like China move rapidly to a more consumption-led model?
Jan-03
Jan-04
Jan-05
Jan-06
Dev eloped
Jan-07
Jan-08
Jan-09
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Searching for a new savingconsumption equilibrium

Ultimately, the world will need to find a new equilibrium where global imbalances driven by extremes in saving-consumption relationships shrink and their funding becomes more sustainable. This is the challenge for an EM model that has depended on someone somewhere else in the world supplying the net final demand for your products. Its clear that when governments and central banks eventually step back from policy easing (and at some point hard financing constraints have to bind), the old model will not work in a new era where easy credit no longer fuels demand.
As previously discussed, with hindsight, the idea that blue-collar workers in the US dis-saved to buy goods made by blue-collar workers in China, financed by credits extended on the back of Chinese net savings, sounds bizarre. US consumers were increasingly consuming goods and services made elsewhere, in the longer term jeopardising their jobs, income and ability to service debt. Yet the growing prosperity of many emerging economies has been built on this dependence.
2000: Global current account deficits Other,
2000: Global current account surpluses
Mex ico, 18.5% 2.7% Spain, 3.4% Brazil, 3.6% Germany , 4.8% United United Kingdom, 5.7%
Source: IMF Source: IMF
Japan, 23.6% Other, 47.6% Russia, 9.3% Sw itzerland , 6.1% China, France, Norw ay , 4.1% 4.3% 5.0%
States, 61.3%
2008: Global current account deficits

Others 26% India 2% United States 42%
2008: Global current account surpluses

China Others 28% 23%
Turkey 3% Australia 3% France 3% United Kingdom 3%

Source: IMF
United Arab Emirates 2% Sw itzerland Germany 13%
Greece Italy 5% 3%
Spain 10%
2% Kuw ait 4%
Japan Norw ay Russia 6% 5% Saudi Arabia 8% 9%
Source: IMF
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From the perspective of maximising global growth, the optimal adjustment would be for net-saving economies to start to spend, offsetting a rise in saving in markets that had been spending too much. The most straightforward way of addressing this question is to break up the world into sources of net demand and sources of net financing. This is what current account deficits and surpluses tell us. While theoretically globally current account deficits and surpluses must net to zero, in practice, because of misspecification problems, they dont. For example, the sum of global current account surpluses in 2008 exceeded the sum of current account deficits by USD262bn. However, if we assume that these measurement problems are evenly distributed, it is possible to break down the two totals geographically and use this breakdown to analyse relative geographic shares in excess spending and saving. According to IMF data, in 2008 the cumulative global current account deficit was USD1.6trn. The US accounted for 42% of this total, followed by Spain (10%) and Italy (5%). These were the sources of net external demand revving up global activity and contributing to such strong growth in emerging economies. On the other side of this trade were the net suppliers of savings that were effectively supplying goods and services on credit to economic agents in deficit countries. The largest single contributor to global savings was China (23%), followed by Germany (13%) and Japan (9%), but collectively the contribution of oil- and commodityexporting countries was bigger than Chinas. As a result, these countries were accumulating net wealth
Falling deficits and surpluses
in the form of IOUs future claims on entities, public and private in the deficit countries, mostly denominated in dollars. How is this changing as a result of the crisis? To date, the adjustment process has been far from optimal from a global growth perspective. For example, Japans current account surplus is shrinking, not because Japans imports from the rest of the world have increased but because the demand for its exports from the rest of the world has collapsed. The same is true for Germany and the Middle East, also big saving blocs in recent years. If surpluses shrink there will be a glut of supply over demand. Short term, this seems to point to deflationary pressures: deflation stems from slack in labour and goods markets which reduces the pricing power of labour and corporates.
Chinas CA surplus is shrinking ( % GDP )
11 9 7 5 3 1 -1 -3 -5 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source: IMF and HSBC estimates
Current account balance (USD bn) Country US Spain Italy Greece UK

Source: IMF and HSBC
2006 -788 -110 -48 -30 -83
Deficit 2007 2008 -731 -673 -145 -154 -51 -73 -44 -51 -81 -45
2009 -386 -106 -52 -44 -35
2010 -299 -99 -53 -42 -30
Country China Germany Japan Saudi Russia
2006 253 179 170 100 94
Surplus 2007 372 250 211 96 76
2008 440 235 157 139 102
2009 240 138 155 16 40
2010 230 153 209 48 6
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As the global economy has contracted, an event unprecedented in the post-war period, the imbalances financed by expanding credit that were a key support of high global growth and the positive growth differential in favour of EM are also shrinking. Chinas first-half current account surplus was down by 32% from a year earlier, constituting a significant drag on economic growth. This is the mirror image of the fall in the US current account deficit and shows that global imbalances are contracting. This is an extremely important part of the required global adjustment in saving and consumption patterns. It is a necessary condition for eventually finding a more stable equilibrium that supports global growth. But, to reiterate, this is happening because, in value terms, the exports of surplus countries are shrinking faster than their imports, not because surplus countries are importing and consuming more. Within the BRIC economies, Brazil and India depend much less on net external demand than China, but falling commodity prices have significantly reduced current account surpluses in commodity-exporting countries such as Russia and the Gulf states. The difficulty of moving from an economic model that relies on exports to one led by domestic consumption is well documented. And this will apply to China just as it has applied elsewhere. In fact, private consumption is lower as a proportion of GDP in many Asian countries, particularly China, than it is in the G7, because of their lower incomes and higher propensity to save.
Export growth (av. %)
25% 20% 15%
Precautionary savings rates are high because of inadequate social security and pension systems, but there also seems to be an Asian predisposition to save more. Private consumption in Japan, the most developed country in Asia, is still a relatively low 55% of GDP. Incomes have been rising rapidly in China, but Chinese end private consumption has been falling as a proportion of GDP, partly because the savings rate has risen. It is now below 40% of GDP compared with some 70% for the US. And domestic demand also depends to an extent on net external demand, given the high proportion of employment outside the agricultural sector that is export-related.
Private consumption
Private consumption in BRIC markets has increased significantly in recent years. In the past five years (2004-2008), the average year-on-year percentage change in private consumption for BRIC markets was 10.9%, compared with 5.2% for developed economies. While significant, the growth of private consumption in BRIC markets has been lower than the growth rate of exports. The growth rate differential between exports and consumption for BRICs markets has been high; during 2001-2008, BRIC countries exports grew by an average of more than 22%.
Consumption as % of GDP
70% 60% 50%
10% 5% 0% 1971-1980 1981-1990 Dev eloped

Source: Thompson Financial Dtatstream, HSBC
40% 30% 2002 2003 2004 2005 2006 2007 2008 1991-2000 BRIC 2001-2008 Dev eloped
Source: Thompson Financial Dtatstream, IMF, HSBC
EM
BRIC
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Private consumption (YOY %)

20% 15% 10% 5% 0% -5% 2000 2001 2002 2003 2004 2005 2006 2007 2008
urban areas, reflecting the fact that the governments stimulus measures to support rural areas and farmers are having a positive effect. Longer term, if China is to make the switch to more domestically focused growth, both household and corporate savings need to fall. That will require a radical revamp of the pension and social security system, something which will become even more critical as the population begins to age after 2015, when the working population is forecast to begin to fall as a proportion of total population. Better funding of health and education also needs to be an important part of the longer-term shift to a new model, freeing income to support consumer spending. But as Willem Buiter points out (see Crisis Talk: Emerging markets and the financial crisis, IFC, May 2009) a boost to consumption demand will require a matching change in the structure of production towards consumer goods and services and away from heavy industry, something which is only in its infancy. Indeed, structural change on the supply side will be essential to developing a model that is more consumption-led. In particular, the services sector needs to expand and dependence on manufacturing needs to decline. The ability to innovate in new fields also needs to be part of the response. Development of domestic banking systems and improved availability of consumer credit will be a particular challenge in this regard. As we argued at the start of this crisis, emerging-market banking systems, with some exceptions such as the Baltic states, did not suffer from the problems seen in the developed world. But for the most part the banking sector infrastructure in emerging markets is not welldeveloped and will require substantial investment before it can support a more consumption-led development model. An alternative approach for China and other emerging markets that depend on exporting manufactured goods, which could end up being an
Dev eloped
Source: Thompson Financial Datastream, IMF, HSBC
BRIC
Conversely, exports in developed markets grew about 9% during the same period; a low growthrate differential between exports and consumption. Those data point up the conclusion that overall growth in BRIC markets has been more export and trade driven than private consumption led. This can further be illustrated by the fact that private consumption still forms a much smaller part of GDP for BRIC markets than it does for developed economies. The positive here is that in the future, BRICs markets have huge potential to drive overall growth from consumption. But based on past performance, the question remains as to whether this can be realised. So is this adjustment happening? August data were encouraging, showing that Chinas domestic-demand recovery remains strong. Despite some slowdown in new bank lending, infrastructure-led investment was still the most robust component, rising 33% y-o-y in the eight months to August. Consumer spending also remained strong with 15.4% y-o-y growth in August retail sales. Retail sales growth surprised on the upside in nominal terms and, in volume terms, retail sales growth of 16.6% is close to a record high. As our China economics team points out, this was probably helped by seasonal promotions and strong sales of property and cars. Meanwhile, retail sales in rural areas are solid with 15.5% y-o-y growth, slightly higher than in
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interim solution, would be to stick with the investment-led growth model but to reposition exports higher up the value chain. To an extent, this has already been part of Chinese policy, as the increase in research and development spending as a proportion of GDP shows. However, it is unlikely such a strategy could absorb all the relatively lowskilled labour released by urbanisation. So to be successful it would likely have to be combined with development of the more labour-intensive service sector. Moreover, such an approach would pressure other economies, both developed and emerging, currently positioned higher up the value chain and might trigger a protectionist response. In the section below, we consider the protectionist threat and the extent to which the G20 pledges and WTO infrastructure help to alleviate concerns.
including fiscal policy and action in support of the financial sector; Not retreat into financial protectionism, particularly measures that constrain capital flows to developing countries; Notify the WTO promptly of any such measures, with the WTO to monitor and report publicly on adherence to such undertakings on a quarterly basis; Take steps to promote and facilitate trade and investment, including ensuring availability of at least USD250bn over two years to support trade finance through export credit and investment agencies and through multi-lateral development banks. In addition, the group reiterated the desire to reach a conclusion to the often-promised but muchdelayed WTO Doha Development Round.
EM exports powering through
70% % of global trade volumes 60% 50% 40% 30% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Protectionism how much of a drag?

Motherhood and apple pie
Between 1929 and 1934, world trade shrank by around two-thirds. Much of the decline was caused by protectionist policies. By contrast, rapid growth in world trade has underpinned rising prosperity in the post-war period. But trade is now falling for the first time in 25 years. Declining demand has been exacerbated by growing protectionist pressures and a withdrawal of trade credit. Reinvigorating world trade and investment is essential for restoring global growth. In its postsummit statement in April, the G20 vowed not to repeat the protectionist mistakes of the past. Specifically, it committed to: Refrain from raising new barriers to investment or to trade in goods and services, not to impose new export restrictions, or implement WTO-inconsistent measures to stimulate exports; Minimise any negative impact on trade and investment of domestic policy actions,
Adv ance economies ex port trade v olume EM economies trade v olumes

Source: Netherland Bureau of Economic Policy Analysis
On paper, this is a strong and comprehensive commitment. In reality, the protectionist threat has not gone away. WTO rules by themselves cannot prevent the adoption of low-intensity restrictions on trade, including the use of subsidies that favour local suppliers. Moreover, while the WTO dispute-resolution mechanism can reverse high-intensity restrictions, resolution normally takes three years and provides no
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Impact of Cap and Trade on US manufacturing sectors (at USD15/tCO2) Industry Industrial Chemicals Paper Iron & Steel Aluminium Cement Bulk Glass Manufacturing average Production 2.7% 3.3% 2.7% 2.0% 1.6% 3.4% 1.3% Consumption 1.8% 2.4% 1.9% 1.4% 0.9% 2.7% 0.6% Competitiveness 0.9% 0.9% 0.8% 0.7% 0.7% 0.6% 0.7% Employment 1.5% 2.1% 1.6% 1.0% 0.4% 2.3% 0.2%
Source: http://www.pewclimate.org/international/CompetitivenessImpacts
retrospective compensation mechanism. In other words, countries could see it to be in their interest to adopt protectionist measures they will eventually be forced to remove, because they will benefit in the interim, to the detriment of foreign suppliers. Moreover, the problem is not straightforward. Comprehensive fiscal and monetary stimulus and rescue packages introduced during the crisis have blurred the familiar lines between monetary, fiscal and trade policies, particularly in the area of unconventional polices introduced by central banks to protect domestic financial systems. Financial protectionism has already crept in and we have probably not yet seen the full consequences. The IMF recently argued that trade and financial protectionism is a rising concern. Notwithstanding commitments by G-20 countries not to resort to protectionist actions, there have been worrying slippages. Referring to interventions in advanced economies, the IMF said lines were being blurred between public intervention to contain the impact of the financial crisis on troubled sectors and inappropriate production subsidies to industries whose longterm viability is questionable. In some instances, financial support was inevitably focusing domestic bank lending locally. The IMF has also noted separately that there remains a risk that some emerging-market economies subject to pressures on external accounts may introduce capital controls. There are also risks from the developed-world side. Chinese and Russian
attempts to buy real rather than financial assets in the pre-crisis period produced a spate of economic nationalism. The risk of additional dollar weakness could reinforce their desire to move into real assets; the developed world may respond by imposing more restrictions on inward investment.
Green protectionism?
As developed economies adopt domestic emission-trading systems, they are concerned the domestic emission limits will put their companies at a competitive disadvantage to companies operating in countries with less stringent emission controls, such as China and India. To address this threat, developed economies, including the EU and US, are proposing restrictions on imports unless an international agreement subjecting all industrialised countries to similar climate-change mitigation measures is reached. A typical form of such a proposal would obligate foreign companies or importers of dirty goods to obtain emission permits equivalent to the companies subjected to domestic legislation. There is a fine line between controlling emissions and recklessly protecting domestic industries from fair trade, since heavy industries then have little incentive to clean up their carbon act. The WTO has looked at the issue and suggests carbon tariffs may be viewed the same way as border adjustments associated with value-added taxes. A climate and energy bill in the US contains a provision to address carbon leakage because of fears of job losses in heavy industry. The bill uses
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two primary approaches. The first is the allocation of carbon allowances at no cost to energyintensive, trade-exposed industries like iron, steel, cement, and paper. The second is an international reserve allowance scheme that imposes a shadow allowance requirement on importers of energyintensive, trade-exposed products, creating a green tariff. Under a revised ETS directive in the EU, carbon leakage has been addressed by free allocation of emission allowances to energyintensive industries deemed to be most at risk to competition outside the EU. China has outspokenly opposed such green tariff measures, saying We are firmly against such attempts to advance trade protectionism under the pretext of climate change1 India registered the same concern, calling green tariffs protectionism under a green label2 Canada has also warned green tariffs could be a prescription for disaster3 for the global economy.
China is the best example and this will be a further lesson for other economies that reinforces the desire for net external creditor status and the craving to accumulate FX reserves. But the hangover from expansionary fiscal policy for the developed world could end up depressing growth and crowding out financial access for private-sector entities and emerging-market economies that dont have Chinese-style savings ratios. A legacy of this is likely to be an enduring concern about sovereign risk in developed markets, something that in the past was restricted to emerging economies. That said, our recent upgrade of what was previously a very dismal view of US GDP growth prospects is a positive for the global growth outlook and our emerging-market view across asset classes. Part of the forecast improvement is net-export-led, suggesting a corresponding drag on growth elsewhere in the rest of the world, particularly emerging markets, through deterioration in the trade balance in goods and services. But a healthier US outlook has to be good for overall global growth prospects, particularly if interest rates also remain low. Short-term, the improved external outlook helps to validate the rally in emerging-market asset prices since February and to support additional upward pressure on assets and currencies. In many ways, though, we have come back full circle to the dollar-recycling model that applied precrisis, with EM central banks resisting upward pressure on their currencies from buoyant liquidity that is bidding up risk assets globally. We may end up going round this loop for a while yet but, ultimately, this is not sustainable. Unless there is greater currency flexibility, the longer-term risk for emerging markets under these circumstances will be asset-price bubbles and eventually inflation pressures through elevated commodity and financialasset prices. Should inflation result, the need to tighten will mean financial assets would again pay the price.
Full circle
The post-crisis world will probably be characterised by lower trend growth than the pre-crisis world, even if there is a successful transition of net demand from deficit to surplus blocs. Global growth before the crisis was running above potential, as the tightening capacity constraints and labour markets in many countries showed. Armageddon may have been avoided, but the crisis has mutated rather than been resolved. Massive government and central bank intervention has shifted liabilities, actual and contingent, from the private to the public sector. Emerging market policy used to be essentially procyclical because of financing constraints. One comforting conclusion from this crisis is that now, for some markets at least, it can be counter-cyclical.
1 chinapost.com.tw/business/asia/b-china/2009/07/02/214676/China-opposed.htm 2http://www.boston.com/news/world/europe/articles/2009/08/14/india_against_us_trade_barr ier_for_climate_policy 3http://www.nationalpost.com/news/canada/story.html?id=1593753
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Official reserves: scenarios for potential local currency wealth loss from USD depreciation and rising treasury yields (USDbn)
5000 4500 220.7 4000 3500 3000 2500 2000 1500 1000 500 0 Total current USD denominated reserves (US$, bn)
Source: Joint External Debt Hub (JEDH), IMF, HSBC
Assuming 65% of total reserves are US$ denominated 441.4 882.9 430.4 640.1 1059.4
1385
1315
1246 1108
1250
1184 1052
5%
10%
20%
% fall in USD by
5%
10%
20%
I. No change in Treasury price
II. 5% fall in Treasury price
All other
China
Japan
Russia
India
Korea
A key part of the residual problem is that the aggregate wealth loss from asset-price deflation has not been enough to bring the level of outstanding nominal financial assets back into line with future income streams that have to service them. The injection of central bank liquidity and aggressive government intervention programmes stopped and then reversed the cleansing process of wealth destruction. If there are too many obligations to be sustainably serviced from future income, eventually their real value will have to fall. This applies to US treasuries just as it did to securitised mortgages. Bringing the outstanding level of liabilities into line with income streams could be achieved through a long period of austerity, with the private and government sectors saving rather than spending at the margin in order to de-lever. An alternative route could be via inflation and devaluation of the dollar against the renminbi and the currencies of other emerging economies that are big holders of dollardenominated assets, destroying real wealth in renminbi terms or the other local currencies of holders of these assets.
In an attempt to quantify this effect we have considered the impact of a fall in value of US dollar denominated international reserves as a result of depreciation of the US dollar against the local currencies of the holders, coupled with the impact of a fall in treasury prices. Historically, a 10% change in US 10-year treasury yield leads to a maximum approximate change of 4% in its price. Erring on the conservative side, we have therefore examined the effect of a 5% fall in the treasury price. We looked at two scenarios:
1
5%, 10% and 20% generalised falls in US dollar with no change in treasury prices. 5%, 10% and 20% generalised falls in US dollar combined with a 5% fall in treasury prices.
As of Q1 2009, the average percentage holding of foreign exchange reserves allocated to US dollars is 65%. Therefore, of the total reserves of cUSD6.8 trillions held globally by central banks, USD4.4 trillion is held in USD. China, Japan, Russia, India and Korea, in that order, are the five
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Private sector holdings: potential local currency wealth loss from USD depreciation and lower asset prices of US securities (non-US residents, USDbn)
8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Current Non official holdings (US$, bn)
Source: Treasury International Capital System, IMF, HSBC
6829 342 683 1366 666 990 1639
5%
10%
20%
% fall in USD by
5%
10%
20%
I. No change in Securities' price Equity LT debt
II. 5% fall in Securities' price ST debt
leading holders of foreign exchange reserves, which together account for more than 58% of global international reserves. In the chart on the preceding page, numbers in red above the columns represent the cumulative destruction of wealth that would result from a fall in USDbn against local currencies and (for scenario II) a fall in treasury prices. In the worst case considered, a 20% fall in the US dollar against all local currencies coupled with a 5% fall in the treasury price would lead to a USD1,059 billion fall in the local currency value of foreign exchange reserves. For China alone, it would be USD332 billion. As a point of reference, such a fall in the value of total foreign exchange reserves would be equivalent to almost 11.3% of the market cap of the S&P 500 (as at 30 September, 2009). But the total wealth effect for non US residents would be much larger. As of June 2008 (the latest consolidated data we could find) foreign private (non-official) holdings of US securities were in the region of USD6.8trn. As with the calculation for international reserves above, we examined the
impact of a fall in the US dollar against the local currencies of the holders of these assets, coupled with a fall in price of US securities, on the value of non-official holdings of US securities using the same assumptions. In the worst case we considered, a 20% fall in the US dollar against all the local currencies of the holders coupled with a 5% fall in the price of such securities would lead to a USD1,639bn fall in the local currency value of US securities held by foreign non-official institutions. Combining this with the pessimistic scenario fall in the value of foreign exchange reserves valued in local currencies mentioned above, USD2.7trn of wealth could disappear in local currency terms. Again for reference, this value is equivalent to getting on for 29% of the market cap of the S&P 500 (as at 30 September, 2009).
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At present, this potential adjustment mechanism to bring total assets into line with future income streams is not working. This is because of currency intervention (and the resulting dollar recycling) and because treasury yields have still not reacted to the massive increase in net issuance (partly itself a product of dollar recycling back into treasuries.) Currencies and their alignment are also at the centre of growth rebalancing. So long as China remains ensnared in its dollar trap, it will resist allowing sufficient currency realignment to speed the shrinkage of external global imbalances; that will also inhibit currency adjustments elsewhere. So we come full circle to the point where currency inflexibility restricts the move to a more permanent and stable equilibrium running the risk that adjustment is via a renewed build-up and subsequent collapse in asset prices.
There is an increasing need to differentiate between emerging markets. Over time, the idea of characterising the world as core (developed) or periphery (emerging) will become less and less relevant. The global financial architecture will inevitably change to reflect that. For now though, we still see merit in this classification and fully expect EM as a group to grow faster than the developed world in the coming years, shifting the centre of economic gravity further eastwards. But continuing failure to embrace greater currency flexibility and a fear of grasping a future that will of necessity need to be less tied to G7 external demand (something that applies to both commodity- and manufacturing-based emerging economies) represent substantial risks, suggesting the path toward income convergence with the developed world may be less than smooth. Philip Poole, Paras Patel, Amit Shrivastava Other contributors: Kubilay Ozturk, Nick Robins
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Appendix
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The rise and rise of EM

The centre of economic gravity continues to shift eastward as EM activity, trade and population outpace the developed world The BRIC markets have led the charge, rapidly increasing their share in almost every area Extrapolations point to EM becoming ever more important
Sharply rising shares

In this appendix, we look at the rising global share of EM from economic activity, population and trade perspectives.
in favour of emerging markets that prevailed before the onset of the latest crisis. Specifically, we projected real GDP to 2025 using the average real GDP growth rates of the last five years (2004-2008.) The analysis is not adjusted for differences in the purchasing power of currencies. It provides a good picture of the change in relative shares, but for completeness, later on we also take this into account by using PPP estimates. The results show the gap in GDP between the developed and emerging worlds has narrowed dramatically. If the growth differential of the past five years were to be maintained, by 2025-30 the combined size of the top 20 emerging markets would be broadly equal to the developed economy aggregate, even without taking account of differences in purchasing power. The growth differential between the developed and emerging markets has widened since 2000, in favour of EM. Both groups have taken a dent during the current crisis, but the differential remains high, although differentiation within the EMs between China and Russia, for example has increased. Since 1980, the average year-on-year GDP growth rate of the top 20 EMs has been 4.5%, compared with 2.5% for developed economies.
Economic activity
What matters most when it comes to economic performance is growth. Below we analyse the relative growth performance of the developed and emerging worlds back to 1980, when emerging markets were still badged as underdeveloped countries. Just like we did to analyse commodity demand, as a proxy for the developed world, we aggregated the US, Japan, the UK and the Eurozone. And for EM, we took a composite of the largest 20 emerging economies by GDP. To alleviate data problems and facilitate the comparison, we constructed real GDP series using nominal GDP and GDP deflators, rebasing all the data to 2000. That may introduce some distortions to the data, but they should not be significant; rebasing to the same year will affect data for all countries proportionately. This provides a picture of relative performance from the past. We also projected the data out to 2025 on the basis of prior trends to see what the world would look like in the future if it returned to the growth differential
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Current and extrapolated real GDP at 2000 prices
50000 GDP (US$ bn) 40000 30000 20000 10000 0 1980

Source: IMF, HSBC
Ex trapolation
Dev eloped
Top 20 EM
During the same period, the GDP of the BRIC markets grew by an average 5.5%. As a result, the combined GDP of the BRICs markets as of 2008 is more than the total of the other 16 emerging markets in the top 20 group we tracked. A positive growth rate differential of about 3% over developed markets has enabled the BRIC economies to increase their relative share since 1980. During the past five years (2004-2008), this differential increased further and the BRIC markets grew at an average year-on-year rate of 8.6% compared with 2.2% for our developed market aggregate. GDP extrapolation based on the average of the past five years growth rate would see the combined BRIC GDP growing to become a USD23trn to USD28trn economy by 2025, in 2000 (base year) prices. During the same period and based on the same extrapolation, using average 2003-2008 growth rates, the developed economies we tracked would grow to about USD45trn, from their current USD30trn (see indexed growth chart).
Extrapolating, the relative share of the emerging world (as represented by our aggregate) in the global economy (the sum of developed and emerging aggregates we tracked) would increase to 43% by 2025 from around 23% in 2008; its share was just 12% in 1980, 13% in 1990 and 18% in 2000. The share of the BRIC economies would increase from 13% currently to 32% over the same period, dominating the contribution to both EM and global growth. Using these extrapolations, China is the dominant force for growth within EM and would become the worlds largest economy by 2030 (at base price year = 2000). In PPP terms, the ascent of emerging markets relative to the developed world is even more profound. During 2003-2008, the average growth rate of GDP based on PPP for developed markets was 5.1% compared with 10.3% for the top 20 emerging markets (data from IMF.) Extrapolation based on the past five years would put GDP based on PPP for the top 20 emerging markets broadly at the size of developed economies by 2014. In PPP terms, the relative share of BRICs GDP in the global economy has grown from 10.1% in 1980 to 12.2% in 1990, 19.4% in 2000 and 26.7% in 2008. Extrapolating based on the average 11.9% growth of the past five years, the share of BRIC markets in PPP terms in the developed and developing aggregates we tracked would increase to 48.6% by 2025. Again, China remains the most prominent performer within emerging markets.
Current and extrapolated indexed GDP (2000 =100)
Historical GDP growth rates 12% YOY % change in GDP 10%
1985
1990
1995
2000
2005
2010
2015
2020
2025
1000 800 600 400 200 0 Index ed GDP (2000=100) Ex trapolation
8% 6% 4% 2% 0% -2% 1981
Source: IMF, HSBC
Dev eloped
1986
1991
EM (ex cl. BRIC)
1996
2001
BRICs
Source: IMF, HSBC
2006
2000
Dev eloped
2005
2010
Top 20 EM
2015
2020
BRICs
2025
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Extrapolating, China would become the largest economy globally in PPP terms by 2018.
Trade
The growth rate differential for exports and total trade has also widened sharply between the emerging and developed markets we analysed. The average year-on-year growth rate of total trade for emerging markets increased from 11.4% during 1991-2000 to 15.6% for the period 2001-2008. During the same periods, the growth rate of total trade for developed economies grew from 5.1% to 9.7%. If those growth rates were to be maintained, at the given rate of growth in exports and total trade, the top 20 emerging markets we tracked would surpass the total for the developed markets group by 2015-2020
Current and extrapolated relative share of GDP based on PPP
The combined value of exports for the two groups was about USD12trn in 2008, having grown at an average rate of more than 14% in the five years to 2008. This growth was again primarily driven by emerging markets, whose share reached 35% in 2008 and which grew at an average rate of more than 19% during 2004-2008 compared with 12% for the developed economies tracked during the same period. That shows how much so-called south-south trade flows between emerging economies have picked up. The value of exports for the combined developed and emerging group analysed would reach USD75trn to USD80trn by 2020, extrapolating using 2003-08 growth rates, more than 60% of which would be contributed by the emerging markets we analysed. BRIC markets account for a significant share of export and total trade for emerging markets and that share has increased dramatically. The BRIC markets share of total trade of the top 20 EMs we analysed increased from 32% in 2000 to more than 52% in 2008. At the average rate of growth for the past five years (2004-2008), the BRIC share would rise to about 85% of total trade of emerging markets by 2025. If the current growth differential were maintained, BRIC exports would exceed exports from the developed markets before 2020 and total trade before 2025. Within the BRIC countries, Chinas share is again dominant, accounting for more than 60% of exports and total trade in 2008. The average year-on-year
2020 2010 2000 1990
BRICs
Source: IMF, HSBC
EM (ex cl. BRIC)
Dev eloped
Current and extrapolated relative shares in exports
Current and extrapolated relative share of total trade
Exports-Shares
100% 80% 60% 40% 20% 0%
Ex trapolation 100% 80% 60% 40% 20% 0%
Total Trade-Shares
Ex trapolation
1970 1980 1990 2000 2008 2015 2020 2025 Dev eloped Economies BRIC EM (ex cl. BRIC)
Source: Thompson Financial Datastream , HSBC
1970 1980 1990 2000 2008 2015 2020 2025 Dev eloped Economies BRIC EM (ex cl. BRIC)
Source: Thompson Financial Datastream , HSBC
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growth rate of total trade for China rose from 15.4% during the period 1991-2000 to 24% during 20002008. China is followed by Russia, whose relative share of BRIC total trade would rise from 19% in 2008 to about 25% by the year 2025 on the basis of the extrapolation. Indias share would remain roughly constant at 10% to 14% during this period on the basis of the extrapolation.
5 year population growth rate (%) 14% 12% 10% 8% 6% 4% 2% 0% -2%
Forecast
1950-1955
1965-1970
1980-1985
1995-2000
2010-2015
2025-2030
2040-2045
Population
Since 1950, the top 20 EMs have been more populous than the developed markets aggregate we examined. As of 2005 (using UN data), the top 20 EM group we tracked represented more than 80% of the combined population of the two groups.
Population projections (millions): UN forecasts 1980 Developed BRICs EM (excl BRICs) 696 1934 730 1990 737 2302 899 2000 785 2630 1053 2010 833 2904 1202 2020 868 3143 1304
Dev eloped
Source: UN population statistics, HSBC
BRIC
TOP 20
Source: UN population statistics, HSBC. EM (excl BRICs) based on the residual from the top 20 EM group analysed
Moreover, population growth remains higher in emerging markets than in developed countries. Average annual growth in emerging markets during 1950-2005 was 1.83%, compared with 0.77% in developed countries (again using our aggregates.) However, the five- year population growth rate across both developed and emerging markets is expected to fall below 2% by 2040-2050. A proportionate decline in population growth rates is expected across all geographic groups. Emerging markets are forecast to rise to c85% of global population by 2050.
The BRIC markets share of population in the top 20 emerging markets we tracked was more than 70% in 2005 and is expected to remain in that range in the coming years. In 2005, the combined population of China and India (2.44 billion) represented about 90% of the BRIC total and more than 50% of the total population of the combined developed and emerging markets we tracked. Population growth is expected to slow proportionately across all countries, so the BRIC share of global population should remain close to 60% during the period 2010-2050. Philip Poole, Paras Patel, Amit Shrivastava
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Country and territory overviews
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Argentina
The recovery is starting but will be modest, in our view, restrained by low consumer and business confidence. Easing of FX pressures on better external conditions (especially the Brazilian reals strength) led to the recent relative strength of the Argentine peso. The fiscal front is more worrisome now, with the government relying on public-sector liquidity pockets to cover this years financing. Although we see a manageable gap for 2010, helped by the prospect of better agricultural export taxes, the government will have to regain access to markets to get the needed funds next year.
terms, thanks to the recovery in the property market and the stronger-than-expected car sales in Q2. Plenty of new investment projects are still in the pipeline, so we believe the infrastructure-centric, investment-driven recovery can be sustained into 2010 and GDP growth can reach 9.5% next year.
Chile
Already growing in recent months, the economy is benefiting from the size of the fiscal and monetary impulse still in place. We expect several quarters of above potential growth to come. Inflation is now in negative territory and should remain there into 2010. There are contributing forces from lower import prices and Chilean peso strength, which are pushing prices downward to the benefit of consumers. Base effects will reverse next year and we see inflation converging to the centre of the target range, 3%, in 2011.
Brazil
Recent data support the view of a V-shaped recovery in Brazil. GDP grew 1.9% q-o-q in Q2 2009 and high-frequency activity data for Q3 suggest the recovery is gaining momentum. Stronger demand should drive 2010 inflation higher HSBC forecasts by 5.0%. That doesnt seem strong enough to precipitate a pre-emptive rate increase, and we do not expect any tightening until Q4 2010. However BCB may then effect a larger tightening once it does move we expect a 10.25% policy rate by end 2010. Fiscal expansion continues to support demand, and we see no significant risk of deterioration in the debt-to-GDP ratio. The real should remain under appreciation pressure until mid 2010.
Colombia
The contraction has yet to show clear signs of bottoming out. On a year- over-year basis, we expect consumption to stabilise around Q3 2009 and begin growing early in 2010. The fiscal accounts continue to deteriorate, partly because of the contraction. The authorities have acknowledged a central government deficit of 4% of GDP. The uncertainty is compounded by the possibility President Alvaro Uribe will run for a third term.
China
Chinas infrastructure investment-led recovery is accelerating, as the filtering-through of stimulus measures substantially lifts domestic demand. Despite the normalisation in new lending, fixedasset-investment growth remained strong at 33% y-o-y in January-August, thanks to local government-backed investment catching up and property investment picking up. Meanwhile, the second-round effect of the stimulus package is materialising in the form of robust consumer spending. Retail sales growth remains steady in real
Egypt
Egypt is enjoying reasonable growth amid the global crisis thanks to momentum from an earlier investment boom, robust domestic demand, a relatively insulated financial system, low external financing requirements and public-sector fiscal stimulus. We expect economic growth to maintain its current pace or perhaps slow slightly as external shocks are transmitted slowly through the real economy. Inflation has moderated from its disconcerting levels last year but remains high because of a rigid and uncompetitive food market.
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Monetary easing is coming to an end, though fiscal loosening is likely to run further.
Indonesia
The economy has proved surprisingly resilient through the global recession and as a result is likely to show a less pronounced pick-up than most Asian countries through the rest of this year and next. Inflation is set to surprise on the upside and we expect Bank Indonesia to start raising rates from Q2 next year, albeit modestly. Indonesia has made significant structural progress over recent years and a key test of President Yudhoyonos second and final term will be the extent to which he extends the change for good. Will labour-market reform prove a step too far?
Hong Kong
Hong Kong regained its growth momentum in Q2 after four quarters of sequential contractions. The gains were largely driven by a recovery in consumer confidence on the back of asset-market rallies and slower-than-expected job cuts. But some overhangs remain on private investment, so the process of broad-based recovery is not complete yet. Given the improved outlook for the G3 economies, we expect HK's exports to pick up, along with private investment. Accordingly, we expect a fully-fledged rebound in 2010 and have raised our GDP forecast to 3.8% y-o-y from 2.4%.
Israel
The economy has been resilient during the global slowdown because of its vibrant high-tech sector and steady household demand. GDP growth is expected to reach 0.3% in 2009 and 3.3% in 2010. A two-year budget framework will support fiscal credibility as the fiscal deficit should shrink on the back of rebounding growth. The external position should remain positive for the shekel, but intermittent FX purchases by the BoI will slow appreciation.
Hungary
The economy slid in the first half of 2009 as consumption and investment plummeted. But more recent data signal the worst is over and recovery is on the way. The trade and current account deficits have narrowed sharply as a fall in exports has been far outpaced by declining imports. A recovery of the forint in Q2 has allowed the NBH to resume easing, and it is set to cut further, assuming risk appetite remains relatively firm. Budget spending has remained tight and fiscal reforms should ensure tighter budgets are here to stay.
Kazakhstan
After a period of stagnation, the economy could not escape a mild recession in H1 2009 as the external environment deteriorated and two systemic banks defaulted. A modest increase in real wages and incomes and output growth in the oil sector encouraged expectations that growth would resume in H2. The high concentration of FDI in the resource sector kept FDI inflows resilient during the economic crisis, which helped offset the newlyemerged current account deficit and ensured stability of international reserves.
India
Recent months have seen a marked improvement in a number of Indian economic indicators, such as motor vehicle sales, industrial production and the service-sector purchasing managers index. Overall, it is clear recovery has begun. Despite drought and stubborn inflation, we are happy with our forecast of 6.2% GDP growth in 2009/10 and 8% in 2010/11. The full impact of the various fiscal and monetary stimulus measures, many of which target the rural and urban poor, have yet to be felt.
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Korea
The economy bounced back sharply in Q2 after GDP fell 4.2% in Q1 in annual terms. Unprecedented fiscal and monetary stimulus in the short run has cushioned the downturn and fuelled private consumption. The high-frequency data suggest continued acceleration into the third quarter, although the pace is beginning to slow. With exports rebounding, Korea may even eke out positive growth for 2009. The asset-market rally puts pressure on the Bank of Korea to raise rates before the end of this year. Given official concern over growth, we stick by our view that rate hikes will only begin in the first quarter of 2010, with the first hike being a full 50bp.
Nigeria
Nigeria faces repercussions from a major banking sector overhaul as well as the earlier slump in oil prices. Although the real economy has been doing surprisingly well, thanks to the non-oil segment, this is also now set to slow because of the sharp deceleration in growth of monetary aggregates. Meanwhile, the government hopes a recent amnesty programme aimed at the Niger Delta can lift oil production from its current levels of 2535% below potential. While the cost of bank bailouts, coupled with low oil prices and production, is likely to strain public finances, Nigeria does have room to borrow. The public balance sheet is still in a good shape and external financing requirements are fairly low.
Malaysia
The economy sprung back to life in Q2 and we expect the recovery to be sustained over the coming quarters. The bulk of the various fiscal and monetary stimulus measures have yet to feed through and the country will be one of the main beneficiaries of the turn in the regional and world trade cycle. Relatively high palm oil and rubber prices will help and government liberalisation measures may pay dividends in time. We doubt Bank Negara will start raising rates until the second half of next year.
Pakistan
Pakistan has had its fair share of troubles in the past few years, but the economy is now showing signs of stabilising. Inflation continues to ease, exports are looking up, the trade and budget balances are shrinking, and the central bank has room to cut rates further. But these are tentative signs of recovery at best. A lot more needs to be done to bring growth back up to the levels seen earlier this decade. Foremost, political uncertainty continues to weigh heavily on investment sentiment.
Mexico
We expect GDP to shrink 7% in 2009, but the positive global environment and, in particular, the expected economic recovery in the US should support the domestic economy, which appears to have bottomed in Q2 2009. We expect this positive trend to continue and GDP growth to reach 3.6% in 2010. Since we estimate inflation will slow to 4.1% by year end, we expect the central bank to keep rates on hold for the rest of the year. Inflationary pressure from administered price increases in Q1 2010 support our forecast of a 100bp tightening cycle starting in Q2 10.
Philippines
Modest recovery should remain on track in the Philippines. Remittances, which have held up exceptionally well during the current crisis, should continue to mark steady growth in 2009 and 2010. Given the robust remittances and healthy foreign reserves, the countrys BOP position should be solid, despite a potential drag from weak trade. The fiscal outlook remains a concern, however, as revenue continues to falter and government spending remains high. Political uncertainty ahead of the 2010 election may heighten fiscal risks. Monetary policy is likely to
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remain neutral until Q1 2010. We expect the central bank to begin raising rates from Q2 10.
Saudi Arabia
Although we suspect Saudi Arabia has yet to return to growth, the ground for economic recovery in the kingdom appears increasingly well prepared. After an initial delay, it looks as if a government commitment to higher spending is translating into growth in outlays and we expect the fiscal stimulus, encouraged by resilient oil earnings, will build momentum next year and into 2011. The impact of that spending will be boosted by a continuing loose monetary stance and resumption in private-sector lending. Last years pronounced inflationary pressures have subsided and look unlikely to reemerge near term.
Poland
While many economies in the region have seen a steep decline, Poland has avoided recession, since it relies less on exports than its neighbours. But consumption, government spending and investment have slowed, suggesting a quick return to faster growth is unlikely. After a cumulative 250bp cut in rates, inflation risks leave little room for further easing. The government will face a more stringent fiscal environment in 2010 as it seeks to avoid exceeding the 55% debt-to-GDP threshold that would trigger more drastic spending cuts. 2014 is now a more likely date for adopting the euro, assuming inflation and the budget deficit fall.
Singapore
After Singapores deepest-ever recession came one of its strongest-ever quarters of economic growth in Q2. Activity was boosted by a huge bounce in the pharmaceutical sector, and now there are clear signs the recovery is broadening out. We continue to expect a strong, sustained V-shaped pick-up in GDP. The government has already taken modest steps to cool activity in the housing market, which may signal a more pre-emptive approach to policy making. But we doubt there will be tightening of the exchange rate stance at the October MAS meeting.
Romania
An IMF-led stabilisation package alleviated financing concerns and lowered the risk premium but is no remedy for recession. The economy shrunk in the first half of 2009 as private consumption and investment tumbled. A revival in bank lending appears to be the main prerequisite for a sustained recovery, which is likely to arrive only in 2011. The NBR has lowered rates by 225bp and we expect further measured cuts.
Russia
After bottoming out in Q2 09, the economy is showing signs of an export-led recovery in Q3. But consumer and investment demand remain weak, indicating that the recovery is still fragile. The financial sector is still reporting rising bad loans and loss provisions, which drag on credit growth. At the same time, a positive current account, high rollover ratio of foreign debt and decelerating inflation led to a welcome decline in interest rates and to currency stability. A credible exit strategy from high public spending and budget deficits is the key medium-term policy challenge.
South Africa
The impact of the global economic downturn was somewhat delayed, so the recovery may lag as well. Manufacturing and private investment suffered the most, but government spending has moderated the recession. Large-scale public investment will continue to support growth, even though the fiscal deficit is widening fast and looks likely to stay high, given the governments growing role in the economy. Politics have settled since the elections and radical policy shifts do not look to be on the cards. Interest rates were cut by 500bp, but it is unclear whether easing has stopped; a change of leadership at SARB complicates the calculation.
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Taiwan
The economy is finally showing signs of life, with a strong rebound in domestic demand. High liquidity and normalising cross-strait relations will continue to support the revival of domestic demand, outpacing export recovery in the coming quarters. High unemployment remains the main obstacle to a recovery in domestic demand. Policy makers are likely to keep monetary policy accommodative until the end of Q1 10 to maintain the recovery momentum. Nevertheless, we believe Taiwan will lag the regional recovery.
UAE
Both of the UAE city states have been forced to face up to an abrupt downturn, but the reversal has been much more severe for Dubai than for Abu Dhabi and its recovery is likely to take far longer. For Abu Dhabi, rising oil prices and a pick-up in global asset prices have been coupled with renewed access to global capital markets, laying the groundwork for an uptick in confidence and gains in investment spending. Although concerns over a Dubai default have eased substantially, the public sectors heavy debt burden is likely to weigh on recovery.
Thailand
The economy bounced back in Q2, with GDP rising by 2.3% q-o-q sa after a 2% fall in Q1 and a 5.6% contraction in Q4 2008. Manufacturing production rose for the sixth straight month in July with indicators of domestic demand looking up as well as strong sequential gains in exports. Overall, we expect the economy to contract by 2.8% in 2009 and to accelerate sharply next year, with growth hitting 4.5%. Politics remain a key risk. Given lingering political uncertainties, the Bank of Thailand may keep rates on hold a little longer than its neighbours, possibly tightening only by the late second quarter of 2010.
Venezuela
Real GDP dropped 1% y-o-y during H1 2009 with inflation hovering around 29% y-o-y. With prospects for oil prices improving, Venezuela might have averted a BoP crisis. But in our view, external accounts need further adjustment. Although we expect the Venezuelan mix to trade 18% higher in 2010-11, its price would still be 30% below the 2008 average. Imports fell just 5% y-o-y during H1 2009, so pressure should keep building in the parallel market, which is now financing about 20% of overseas purchases. Further US dollar debt issuance is likely, both to reduce the swap rate and to increase expenditure in the run-up to the 2010 legislative election.
Turkey
Turkey has seen a phenomenal convergence in interest rates to single-digit territory during its worst economic contraction since 2001, with real GDP shedding more than 10% in the four quarters to Q1 2009. A massive output gap and slumping commodity prices have enabled the CBRT to slash rates by more than half, a cumulative 950bps, since November 2008. We reckon deterioration in public finances and the Treasurys high rollover ratios are risk areas. Hence, any sustainable compression in yields needs to be supported by structural reforms, focusing on Turkeys chronically low domestic savings rate.
Vietnam
Huge monetary and fiscal stimulus is beginning to pay dividends and we expect GDP to expand 4.9% in 2009 and 6.8% in 2010. Inflation is likely to return to double digits next year, driven by higher commodity prices, but the governments biggest challenge will be to keep the trade deficit within manageable limits. It is encouraging that the central bank looks to be taking a more preemptive approach. We expect this to continue, with the base rate rising 200bps in the first half of next year and the same again in the second half.
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Javier Finkman: +54 11 4344 8144 javier.finkman@hsbc.com.ar Jorge Morgenstern: jorge.morgenstern@hsbc.com.ar
Argentina: the essentials
Argentina had a moderate recession by its standards, but we expect a similarly modest recovery to come. Although the fiscal position is worrisome, we assign a very low probability to a credit event in the medium term
Recession ending, slow recovery on the horizon The economy may have emerged from the recession in Q2, growing marginally after two consecutive quarters of contraction. In fact, its deceleration started before the global crisis hit, when, in Q2 2008, country-specific factors put the brake on an economy that had been growing at 8% y-o-y rates. The fall in consumer confidence, together with episodes of financial instability and demonetisation led to a decline in investment and activity that was aggravated by the effect on expectations and foreign demand of external factors. After the inventory adjustment and some improvement in expectations, industrial production and export volumes started to recover in Q2. Private consumption and investment rapidly followed suit. The external sector presented better results than could have been expected earlier in the year, because of the fall in import volumes. Q3 2008 Q4 2008 Q1 2009 GDP (% y-o-y)* Industrial production (% y-o-y)* CPI, end quarter (% y-o-y)* PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) ARS/USD, end quarter ARS/EUR, end quarter
* Previous methodology estimates
This helped offset the effects of falling exports, but was also a sign of sliding domestic demand. A possible jump in the exchange rate is now less of a concern, as the real exchange rate is recovering to levels seen a year ago. That said, the inflation carry puts a floor on the depreciation required to keep the currency competitive. We assign a very low probability to the possibility of a credit event in the medium term. This is based on signs of willingness to meet public debt payments, the ability to do so in the form of liquidity pockets inside the public sector and resources of last resort also available, plus the high reputational cost of such an event. If it happened, it would be because of a significant worsening of the global economic and financial environment.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -4.2 -8.8 15.5 5.3 8.3 5.3 46.0 10.5 25.0 3.8 5.3 -4.3 -5.6 13.5 4.8 5.0 3.8 45.3 9.3 14.0 3.8 5.6 -1.8 -2.7 14.6 4.3 2.9 2.2 45.2 9.0 12.0 4.0 5.9 3.6 3.7 14.6 4.7 4.0 1.5 44.3 9.0 11.0 4.0 6.1 3.0 3.1 15.7 5.2 6.1 3.5 45.7 9.0 11.0 4.1 6.2 2.0 1.8 15.7 5.7 3.7 2.6 46.2 9.0 11.0 4.3 6.4 1.1 0.8 15.7 6.3 2.3 1.5 45.9 8.5 10.5 4.5 6.8
4.8 3.8 26.2 11.0 5.8 4.0 47.1 9.8 23.6 3.1 4.4
0.3 -11.9 22.9 5.9 3.7 1.6 46.4 10.5 69.0 3.5 4.8
-3.8 -12.2 19.6 5.6 5.3 2.2 46.5 10.5 33.0 3.7 5.3
Modest recovery, with high inflation Inflation has slowed from the level of over 20% at the turn of the year to just under 14% at present. Nevertheless, we expect certain factors to offset the downward pressure created by labour market and capital slack, keeping inflation above 14% for the medium term, on our estimates. These include public expenditure growth of above 30%, ongoing wage pressures, running close to 20% y-o-y, high inflation expectations (over 20% for the next 12 months) and a weakening ARS (we expect depreciation of over 13% in the next 12 months), with some pass-through. Signs of stabilisation emerged in Q2, and signs of expansion in Q3 despite the negative effect of the H1N1 outbreak in Q3. We expect these modest readings to continue during 2010; downward risks should be related to external conditions and local political noise. Activity & inflation
12 9 6 3 0 -3 -6 -9 -12 -15 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) Industr ial grow th (LHS) CPI (RHS) 30
Expansionary policies take moderate effect The relaxation in FX demand allowed the central bank to lower its shortterm rates in Q3, but the effect is limited in an economy such as Argentina where financial intermediation is low. The economy has operated with a negative or near zero real interest rate for several years now, yet credit is stalled and falling in real terms, and business and consumer confidence remain low. That leads to our modest recovery forecast, which factors in an expected improvement in exports especially from the agricultural and livestock sector, which suffered a 27% decline in production owing to a severe drought this year. The 2.4% fiscal impulse in 2009 lifted activity to some extent, but the majority of the expansion came from a fall in activityrelated revenues. We expect a recovery in such revenues next year and, in consequence, a better fiscal balance, close to neutral in 2010. Policy stance
3.0 (% GD P, 4 qma) 2.0 1.0 0.0 -1.0 -2.0 4Q04 4Q05 4Q06 30 25 20 15 10 5 0 4Q07 4Q08e 4Q09e 4Q10e Policy rate (R HS)
25 (% y-o-y) 20 15 10
(% y-o-y)
Fiscal balance (LHS) CPI, % y-o-y (RHS)
Data sources: Central Bank, Thomson Financial Datastream, Bloomberg, HSBC estimates and forecasts
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Argentina: at a glance
Interest rate spread (vs USD Libor)

30 25 (%)
Yield curve dynamics

50 40 (%) 30 20 10 0
20 15 10 5 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 3M spread over US-Libor 12M spread over U S-Libor
1yr
2y N ow +4 months
3y
5y -4 months Current CPI
6y
Exchange rate dynamics

110 4.0 3.0 2.0 1.0 0.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e ARS vs USD (LHS) Annualised volatility (RHS) 90 70 50 30 10 -10 (%)
Inflation adjusted exchange rates

400 300 (%) 200 100 0 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate v s USD Cumulativ e CPI Cumulativ e PPI 09
International reserves & liquidity ratio

60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short- term debt % reserves (RHS) 200
Policy dynamics
0.0 -2.0 -4.0 2011e -6.0 2010e -8.0 -10.0 2008 2.0 1.5 1.0 0.5 0.0 -12.0 -14.0 -0.5 -1.0 -1.5 -2.0 (real rates) 2009e
(% of r eser ves)
160 120 80 40 0
(USD bn)
Equity vs fixed income

5000 4000 (ind ex) 3000 2000 1000 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Argenti na sub-index (LHS) EMBI Argentina sub-index (RHS) 2500 (spread bp s)
Local vs convertible currencies yields

3000 2500 2000 1500 1000 500 0
1500 1000 500 0
(spread b ps)
2000
1/05
5/05
9/05
Buenos Air es 365 day in terbank offer rate EMBI Argentina sub-index
1/06
5/06
9/06
1/07
9/07 5/07
1/08
5/08
1/09 9/08
5/09
9/09
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Argentina: local knowledge/global drivers

Change expected after the mid-term elections did not materialise. The FPV government still occupies centre stage. Better external conditions give it leeway to push its agenda without significant negative market reaction
Government still in control, despite election defeat The defeat of the government (FPV party) in the 28 June mid-term elections has not prevented it from continuing to push its policies, despite the expectation that it will lose its majority in both chambers of congress after 10 December, when the elected legislators will take office. Lack of cohesion among the opposition has contributed to the administrations ability to act almost at will. The government managed to extend delegated economic power for 12 months and is expected to pass a controversial media regulation law that will require the main media conglomerate to sell many of its assets. Several new tax regulations are due at the end of the year. The debate is expected to centre on possible changes to the system of revenue sharing between the central and provincial governments. Congress composition after 10 Trade surplus rising on import compression Exports have been hit by a combination of falling external demand (industrial manufacturers are down 9% y-o-y in volumes for the first eight months of the year), a severe drought that affected crops (agricultural export volumes fell 35% y-o-y) and lower prices (17% drop, in the first eight months, y-o-y). This led to a 24% y-o-y value reduction in exports in the year to date. That said, imports have fallen much more sharply owing to lower domestic and foreign demand and the implementation of trade restrictions. Import volumes were down 30% for the first eight months of the year, leading to a 39% y-o-y fall in value. All in, as at August the trade surplus in the year to date was at the same level as the surplus for fullyear 2008, USD12bn. We project it to close 2009 at USD15bn. Effect of prices and volumes on trade (first eight months of the year)
50 40 30 20 10 0 2008 Imports Year 2008 Exports
House Opposition 42% Opposition 53%
Senate
FPV 46%
FPV 36%
Others 12%
Others 11%
USDb n
2009 Value
Volumes Effect
Price Effect
Expansionary fiscal policy without funding Argentina has extended its expansionary fiscal policy, beyond the expected period owing to the political cycle, as it had elections mid-year. Expenditure grew 30% y-o-y in the January to August period, but revenue by only 11%. The policy stance would not be such a concern if Argentina didnt lack access to market funding. As a result of this, however, the government is relying on sources that have hidden future associated liabilities, such as social security, which accounts for the full increase in revenues for the year. On the spending side, less flexible items such as wages and social security explain half the increase, but their growth has been slowing in the past few months. The primary balance fell to 1.2% in August. We expect the declining trend to continue until the end of the year, falling towards 0.7%. Expenditure and revenue growth (3month average, y-o-y)
50 45 40 35 30 25 20 15 10 5 0 03/08 05/08 07/08 09/08 11/08 01/09 03/09 05/09 07/09 % y-o -y 8.0 7.0 6.0 % GDP 5.0 4.0 3.0 2.0 1.0 0.0
Dollarisation pressures eased, but political risks persist Capital outflows are absorbing the economys entire current account surplus (USD11.8bn and USD10.4bn, respectively, in the 12 months to June). Private sector demand for foreign assets (cash basis, BCRA figures) averaged USD6.4bn quarterly from Q2 2008 to Q2 2009. However, since July and especially in August and September a notable easing in demand for FX assets has occurred. We estimate that it will amount to cUSD3.7bn this quarter. The decline can be attributed to less political noise than expected before the elections and a much better external environment (namely, the strength of other currencies, especially the Brazilian real), which reduced expectations of FX weakness. NDF 1-year implied yields fell from 39% at end-March to 15% at present. Private sector foreign asset demand and central bank intervention
5 4 3 USDbn 2 1 0 -1 -2 01/08 03/08 05/08 07/08 09/08 11/08 01/09 03/09 05/09 07/09 09/09
Primary Balance -RHSSource: MECON
T otal Revenues
Primary Spending
Foreign assets priv ate sector demand (CB)
Central Bank FX sales
Source: BCRA. Since July, private sector foreign assets demand are HSBC estimates.
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Argentina: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) * Nominal GDP (USDbn) * GDP per capita (USD) * Private consumption (% y-o-y) * Government consumption (% y-o-y) * Investment (% y-o-y) * Industrial production (% y-o-y) * Gross domestic saving (% GDP) * Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y)* CPI, end-year (% y-o-y)* PPI, end-year (% y-o-y)* Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) ARS/USD, end-year ARS/USD, average ARS/EUR, end-year ARS/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (UAHbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 9.0 152.1 3,954 9.5 2.7 34.4 10.7 20.6 14.5 4.4 6.1 6.7 9.3 22.3 20.5 2.50 15.0 3.0 2.9 4.0 3.7 34.5 22.4 12.1 3.4 2.3 4.6 3.0 5.3 16.9 62.5 19.1 10.2 25.7 166.9 78.5 55.3 2.6 2.6 3.9 236.2 52.8 111.6 73.4 126.2
2005 9.2 181.8 4,670 8.9 6.1 22.7 8.0 23.7 11.4 9.6 12.3 11.6 20.3 21.5 19.5 4.58 16.3 3.0 2.9 3.6 3.6 40.0 28.7 11.3 5.6 3.1 5.0 2.8 5.9 16.0 27.8 28.0 11.7 18.1 109.3 65.0 48.4 1.8 1.8 3.7 203.8 38.3 60.9 33.5 71.8
2006 8.5 212.7 5,399 7.8 5.2 18.2 8.4 26.4 9.3 10.9 9.8 8.0 18.9 23.5 24.6 6.16 15.2 3.1 3.1 4.0 3.9 46.5 34.2 12.3 8.0 3.8 4.8 2.3 6.0 16.1 19.0 32.0 11.3 17.7 108.9 58.9 47.8 1.8 1.8 3.5 246.3 37.6 56.2 26.4 64.1
2007 8.7 260.5 6,534 9.0 7.6 13.6 7.5 26.1 7.8 12.7 20.1 17.5 21.0 20.1 16.8 8.00 12.9 3.2 3.1 4.6 4.3 55.9 44.8 11.2 7.4 2.8 4.5 1.7 4.6 20.4 31.1 46.2 12.4 17.1 124.6 46.3 53.8 1.1 1.1 4.2 260.2 32.2 62.1 23.9 56.1
2008 4.7 317.4 7,869 6.5 7.0 8.7 1.0 27.3 7.4 24.7 22.9 5.9 25.0 9.6 -0.4 10.50 69.0 3.5 3.2 4.8 4.8 70.0 57.4 12.5 7.0 2.2 4.3 1.4 3.6 25.1 28.2 46.4 9.7 18.1 124.7 45.1 59.9 1.4 1.4 3.2 311.7 30.8 55.7 17.6 48.3
2009e -3.5 288.2 7,058 -0.2 3.0 -13.8 -7.3 27.7 9.5 14.0 14.6 4.3 19.0 7.0 -4.0 9.00 12.0 4.0 3.8 5.8 5.5 57.9 42.2 15.7 9.9 3.4 4.1 1.4 4.8 -17.2 -26.5 45.2 12.8 20.2 121.6 45.2 57.8 -1.4 -1.4 0.7 344.5 31.4 55.0 19.1 50.5
2010e 2.4 309.2 7,484 0.9 2.3 3.3 2.4 27.7 8.8 15.4 15.7 6.3 17.0 11.2 -3.2 8.50 10.0 4.5 4.2 6.8 6.3 60.8 48.2 12.5 7.2 2.3 4.2 1.4 3.7 4.9 14.2 45.9 11.4 21.8 121.6 44.5 56.6 -0.2 -0.2 1.4 406.2 31.3 54.3 17.6 48.9
2011e 2.6 329.2 7,873 2.0 2.9 4.5 2.5 27.7 8.0 14.6 13.9 9.2 14.0 12.0 0.1 8.00 10.5 4.8 4.6 7.0 6.8 63.0 53.8 9.2 4.3 1.3 4.3 1.3 2.6 3.7 11.6 42.2 9.4 23.2 129.6 43.4 57.7 0.0 0.0 1.7 450.7 29.6 55.8 17.0 46.5
Source: HSBC based on MECON, INDEC and BCRA. * Previous methodology estimates.
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Andre Loes: +55 11 3371 8184 andre.a.loes@hsbc.com.br Tatiana Gomes: +55 11 3371 81843 tatiana.g.gomes@hsbc.com.br
Brazil: the essentials
V-shaped recovery already under way in Brazil, owing to a strong labour market. We still expect monetary tightening to start in Q4 2010, as the slight rise we project in inflation may be insufficient to justify a pre-emptive move by the BCB
Crisis definitely past Recent readings of different economic activity data support the view that Brazil has already embarked on a V-shaped recovery. GDP grew 1.9% q-o-q in Q2 2009 (-1% in Q1 2009 and -3.4% in Q4 2008), in a recovery driven by domestic consumption. The breakdown of this higher-than-consensus reading confirmed the importance of household consumption within the recovery: it posted a q-o-q seasonally adjusted variation of 2.1% in Q2 2009, after an already positive 0.6% in Q1 2009. Fixed asset investment, although still lagging and showing negative y-o-y variation, was flat q-o-q in Q2 2009 a big improvement from the 12.1% decline q-o-q posted in Q1 2009. The sharp recovery in the business confidence index suggests Brazilian companies could resume their investment plans more decisively in Q4 2009. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) WPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 2-yr yield, end quarter (%) BRL/USD, end quarter BRL/EUR, end quarter 6.8 6.7 6.3 14.3 1.9 -1.6 206.5 13.75 14.4 1.91 2.68 Q4 2008 1.3 -6.3 5.9 9.8 1.6 -1.8 206.8 13.75 12.2 2.34 3.23 Q1 2009 -1.8 -14.6 5.6 5.0 1.7 -1.6 202.4 11.25 10.4 2.32 3.07 High-frequency economic activity data for Q3 suggest that the recovery that started in Q2 is gaining momentum. Both industrial production figures and the HSBC Brazil PMI (manufacturing as well as services) point to an acceleration in production. In light of the points above, and the additional stimulus introduced by a primary fiscal surplus that continues to fall at the margin, we have raised our 2009 GDP growth forecast to 0.4% (from 0%) and our 2010 projection to 5.3% (from 4.6%). The main driver of this quick turnaround is the performance of the labour market. Unemployment peaked in April, while formal job creation reversed its declining trend, showing the strength of the labour market (see the last page of this section on Brazil.) -1.2 -12.2 4.8 -1.7 2.0 -1.4 208.4 9.25 10.6 1.95 2.83 0.1 -9.7 4.4 -3.3 1.9 -1.1 214.2 8.75 11.0 1.85 2.68 4.4 2.0 4.7 -2.5 1.8 -0.8 219.9 8.75 11.0 1.80 2.66 5.9 12.8 4.8 0.8 1.5 -1.1 224.5 8.75 10.5 1.75 2.63 5.8 12.4 4.5 3.0 1.2 -1.4 229.1 8.75 10.5 1.70 2.55 5.2 10.4 4.9 5.0 0.9 -1.7 233.8 8.75 11.5 1.70 2.55 4.3 7.2 5.0 5.1 0.6 -2.0 238.4 10.25 11.0 1.70 2.55
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
Inflation may show a moderate rise... Brazils y-o-y inflation converged to the target and should remain around the central value of 4.5% for some months. The main forces behind this convergence the prices of food and core tradable goods are tending to be replaced by the other groups monitored goods and the core nontradable items as future benign contributors to inflation. Monitored prices are partially indexed to past inflation, and should benefit from the decline of headline inflation since the outbreak of the global crisis. The core non-tradable group consists largely of services. In this case the natural lagged convergence of these prices to headline inflation a lag that could be as long as 12 months may be attenuated by the vigorous performance of the labour market. The balance between the favourable influence of the lagged convergence of indexed (or informally indexed) prices and the effects of stronger demand should drive 2010 inflation just a little higher. Our 2010 inflation estimate is +5.0%. Activity & inflation
15 10 5 0 -5 -10 -15 -20 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e Industrial grow th (LHS) CPI (RHS) 8 7 6 5 4 3 2
...and monetary tightening should come only in Q4 2010 However, the deterioration we forecast for inflation from now to H1 2010 doesnt seem strong enough to precipitate a pre-emptive rate increase, especially during an election year. As inflation pressures shouldnt translate into a more marked deterioration in current inflation, higher inflation expectations should also take longer to show up despite the pricing of higher interest rates by the yield curve. Although we dont expect early monetary tightening, the fact that the economic recovery is proving very robust means the BCB will have to take decisive action once it does move. Accordingly, we recently raised our 2010 year-end Selic rate forecast to 10.25% (from 9.50% previously). We also expect that the tightening cycle will be on a larger scale than we previously forecast. We estimate the Selic rate will reach 12.25% by end2011, making for a 350bp cumulative cycle. Policy stance
0 (% GDP, 4 qma) -2 -4 -6 -8 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e Policy rate (RHS) 30 25 20 15 10 5 0
(% y-o-y)
(% y-o-y)
GDP (LHS)
Source: IBGE and HSBC forecasts
Fiscal balance (LHS) CPI, % y -o-y (RHS)

Source: IBGE, BCB and HSBC forecasts
52
(%)
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Brazil: at a glance

20 16 (%) 12

12.0 11.0 (%) 10.0 9.0 8.0
8 4 0 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M spread over US-Libor 2yr spread over US-Libor
3M Now
6M -4 months
1y r +4 months
2y r

5 4 3 2 1 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e BRL v s USD (LHS) Annualised v olatility (RHS) 60 50 30 20 10 0 (%) 40
Exchange rate and inflation

300 250 200 150 100 50 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate v s USD Cumulativ e CPI Cumulativ e PPI 09

250 200 (USD bn) 150 100 50 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short-term debt % reserves (RHS) 150 120 90 60 30 0
Policy dynamics
10.0 8.0 (real rates) 6.0 4.0 2.0 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 2009e 2011e 2010e 2008 2007
(%)
(% of reser ves)

5000 4000 (ind ex) 3000 2000 1000 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Brazil s ub-index (LHS) EMBI Brazil sub-index (R HS) 400 200 0 800 (spread bp s) 600
Local vs convertible currency yields

1500 (spread bps) 1200 900 600 300 0
1/05
5/05
9/05
1/06
5/06
Brazil 5yr Sw ap EMBI Brazil sub-index
9/06
1/07
9/07 5/07
1/08
5/08
1/09 9/08
5/09
9/09
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Brazil: local knowledge/global drivers

Fiscal deterioration is largely due to lower tax collection, and thus cyclical. However, the government will need to start generating a larger surplus from 2011, to preserve healthy debt/GDP trends. BRL may keep appreciating for a while
Fiscal: no solvency concerns Fiscal expansion continues to support demand. There has been a sizeable reduction of the primary fiscal surplus since Q4 2008. We expect this to continue until the beginning of 2010, when the recovery in the economy, coupled with the end of the tax rebates introduced during 2009, should drive tax collection up substantially. Although the recent growth of current spending may raise concerns, expected fiscal account trends suggest no significant risk of deterioration in the debt/GDP ratio. Simulations we run regularly on debt dynamics suggest that, as long as the government resumes the generation of slightly higher fiscal surpluses and the Selic rate stays at c10%, net debt/GDP should remain stable (neutral path, below). Possible trajectories for net debt/GDP ratio (%)
55 50 45 40 35 30 25 20 2009 2010 Pessimistic 2011 2012 Neutral 2013 2014 Optimistic 2015
BRL still appreciating The higher growth we estimate for 2009 and 2010 will certainly generate a higher current account deficit. Import growth should accelerate to around 20% per year, as growth in both industrial production and fixed asset investment rebounds in 2010 inputs for the industry and capital goods are the main components of Brazilian imports. Profit remittances may also regain mid-2008 levels, as higher profits and a stronger currency would favour outward remittance by multinational companies. However, we expect capital flows to more than compensate for this. Brazil currently offers growth, resilience and high yield a combination that is attractive for both equity and fixed-income investment. The table detailing uses and sources of external funds, below, illustrates this point Uses and sources of external funds
Source: HSBC forecasts
Source: BCB and HSBC forecasts
The crisis revealed a structural change in the labour market The strong performance of the labour market during the crisis has been one of the most important reasons for the resilience of the economy. In fact, we believe it reveals a structural change. This is, in part, because the agreements between companies and unions temporary job stability in exchange for a reduction in hours worked/wages per hour mitigated the adjustment through massive lay-offs that has traditionally been a characteristic of this very rigid labour market. Recourse to those agreements made possible by the approval of legislation earlier this decade aimed at reducing this rigidity occurred only because the gradual reduction in the unemployment rate and the formalisation of jobs has turned labour into a much more scarce Monthly unemployment rates for selected years (%)
14 13 12 11 10 9
-400,000 0
resource, we believe. The chart below, illustrating monthly unemployment rates for selected years, illustrates a clear change in the average level of unemployment compared with recent years including our estimate for the rest of 2009 and 2010 and the beginning of the decade. Looking forward, the Ministry of Labours data on net formal job creation (CAGED) reinforce the rosy picture in the labour market. The August reading showed it to be strong across the board, with eight out of nine sectors posting positive figures. For the first time since October 2008,12month accumulated net job creation interrupted its decline. Unemployment rate data point to a 2010 labour market with figures close to 2008 levels; HSBC forecasts 7.7% for next year. Net formal job creation (1000s of jobs)
400,000 2,400 2,000 200,000 1,600 1,200 800 400 -200,000 0 -400 -800 -1,200 -600,000 -1,600 -2,000 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jul-09
8 7 6 Jan Feb Mar Apr

2004
May
2006
Jun
Jul
2008
Aug
Sep
Oct
2010
Nov
Dec
-800,000
-2,400
2009
MoM (LHA)
Last 12 months (RHA)
Source: IBGE and HSBC forecasts
Source: Ministry of Labour
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Brazil: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) WPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 2-yr yield, end-year (%) BRL/USD, end-year BRL/USD, average BRL/EUR, end-year BRL/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (BRLbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 5.7 663.6 3664 3.8 4.1 9.1 8.3 18.5 9.6 6.6 7.6 14.7 4.6 17.9 11.9 17.8 17.0 2.65 2.93 3.60 3.64 96.5 -62.8 33.6 11.7 1.8 8.3 1.3 3.0 32.0 30.1 52.9 10.1 17.4 201.4 35.4 69.1 -2.8 -1.4 3.8 1111.2 54.6 83.1 10.8 65.4
2005 3.2 881.8 4808 4.5 2.3 3.6 3.1 17.3 8.4 6.9 5.7 -1.0 7.6 18.0 15.0 18.0 15.7 2.34 2.44 2.77 3.04 118.3 -73.6 44.7 14.0 1.6 12.5 1.4 3.0 22.6 17.1 53.8 8.8 20.5 169.5 34.9 69.2 -3.4 -3.4 3.9 1262.9 58.5 81.5 8.8 67.4
2006 4.0 1088.5 5866 5.3 2.6 9.8 2.8 17.6 8.4 4.2 3.1 3.3 7.2 18.1 17.0 13.3 12.3 2.14 2.18 2.82 2.73 137.8 -91.4 46.5 13.6 1.3 -9.4 -0.9 0.4 16.5 24.1 85.8 11.3 24.6 172.6 23.7 83.3 -3.5 -3.1 3.2 1186.1 48.9 70.4 6.2 55.1
2007 5.7 1333.3 7107 6.3 4.7 13.5 6.0 17.5 7.4 3.6 4.5 9.4 7.3 17.4 22.3 11.3 12.8 1.77 1.95 2.60 2.66 160.6 -120.6 40.0 1.6 0.1 27.5 2.1 2.2 16.6 32.0 180.3 17.9 38.7 193.2 21.6 107.3 -2.8 -2.3 0.0 1426.1 52.1 65.9 4.3 56.4
2008 5.1 1575.3 8309 5.4 5.6 13.8 3.1 16.9 6.8 5.7 5.9 9.8 9.9 17.8 23.8 13.8 12.2 2.34 1.83 3.23 2.68 197.9 -173.2 24.7 -28.3 -1.8 24.6 1.6 -0.2 23.2 43.6 206.8 14.3 38.9 198.3 19.3 114.2 -2.0 -0.9 3.7 1595.9 53.7 62.0 4.9 58.6
2009e 0.4 1506.7 7868 2.5 3.5 -10.0 -8.7 17.0 7.5 5.0 4.7 -2.5 6.2 14.0 2.0 8.8 11.0 1.80 2.02 2.66 2.79 156.6 -129.0 27.6 -12.8 -0.8 26.0 1.7 0.9 -20.9 -25.5 219.9 20.5 37.5 192.1 16.6 123.5 -3.2 -3.0 2.0 1846.2 60.6 63.3 3.7 64.4
2010e 5.3 1957.6 10127 4.5 3.2 15.0 10.6 17.2 7.7 4.8 5.0 5.1 7.4 18.0 14.9 10.3 11.0 1.70 1.72 2.55 2.57 172.1 -161.0 11.1 -39.0 -2.0 21.0 1.1 -0.9 9.9 24.8 238.4 17.8 40.0 191.6 14.9 123.1 -1.6 -1.4 2.5 1942.7 57.8 63.2 3.2 61.0
2011e 4.2 2054.4 10541 4.2 3.8 9.0 5.5 17.0 6.2 5.2 5.3 6.2 7.6 18.0 13.3 12.3 10.1 1.85 1.79 2.68 2.61 194.0 -193.0 1.0 -54.6 -2.7 21.0 1.0 -1.6 12.7 19.9 238.4 14.8 40.0 195.0 14.9 127.0 -1.9 -1.0 3.3 2204.9 59.8 62.8 3.2 63.0
55
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Jorge Morgenstern: jorge.morgentern@hsbc.com.ar
Chile: the essentials
Recent data suggest that the economy resumed growth in Q2. There is momentum for a strong recovery in the coming quarters
The economy is turning the corner Activity readings, while still negative in y-o-y terms, suggest that the Chilean The policy effort is beginning to pay off. Industrial production and economy is bottoming-out from recession and may be ready to begin economic activity have both climbed in seasonally-adjusted terms for growing quickly. 2Q GDP reported what we estimate was the peak three consecutive months through July. GDP is on its way to increasing y-o-y contraction, falling 4.5%. On a quarterly basis, activity fell 0.4% and by over 6% in annual terms in this and the next quarter. we expect this to be the last negative reading. Private consumption fell by Apart from the local drivers, we believe external forces will help the 2.6% y-o-y while fixed investment contracted 19% y-o-y, contributing 5 Chilean economy in the coming months. A recovery in the price of percentage points to the GDP decrease, the same as the reduction in copper and the fast growth sustained by its main consumers could boost inventories. Import contraction, also 19%, is allowing a positive contribution exports and bring the current account back into equilibrium in 2010. of net exports to the GDP figures in 2009. The other source of growth came from the fiscal stimulus: a 9% of GDP reversal in the primary balance was engineered by the government to offset the economic slowdown. Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) WPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) CLP/USD, end quarter CLP/EUR, end quarter 4.6 -1.3 9.2 19.4 -0.3 -6.6 24.2 8.3 7.5 552.5 779.0 0.2 1.7 7.1 22.7 -1.2 -5.1 23.2 2.3 5.9 629.1 880.8 -2.3 1.0 5.0 15.5 7.0 0.7 23.4 2.3 4.6 582.1 844.0 -4.5 -3.4 1.9 2.5 9.1 3.0 23.4 1.0 4.7 529.1 742.1 -1.7 -2.0 -2.2 -6.0 -0.4 -2.0 25.3 0.5 4.9 546.1 791.8 2.0 -1.0 -1.5 -5.0 2.4 -4.4 28.2 0.5 4.9 540.0 810.0 4.1 0.5 -0.8 -3.0 3.5 -2.6 27.8 0.8 5.0 545.0 817.5 4.9 1.7 0.0 -1.0 3.5 0.3 29.0 1.5 5.2 550.0 825.0 3.8 2.4 1.6 2.0 3.5 0.1 31.0 2.3 5.7 555.0 832.5 3.3 3.8 2.5 4.0 8.5 3.0 32.4 3.0 5.7 560.0 840.0
Inflation in negative territory and to remain there for a while The fall in commodity prices, the anchoring of import prices due to currency strength, and the large output gap opened up by the fall in activity have pushed y-o-y inflation into negative territory for the first time in five years, reaching -1% in August. We believe these forces will take a while to fully reverse. Meanwhile, deflation is helping consumption and sustaining real wages. Negative figures should continue until Q1 2010 but soon afterwards, we believe, inflation should re-emerge, moving up to 3% by end-2010. Activity is still negative in y-o-y terms, but the seasonally-adjusted monthly indicator marked gains in the three months up to July. Thus, the reading for Q3 q-o-q GDP should be positive and, with fiscal and monetary stimuli still coming through, we expect annualised growth of over 6% for the remainder of 2009. Activity & inflation
8 6 4 2 0 -2 -4 -6 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e Industrial Production (LHS) CPI (RHS) 15
Rates close to zero for the near-future. Reversion in 2010. The Central Bank pushed its policy rate to 0.5% and launched additional liquidity measures in July. Inflation went into y-o-y negative territory in August, and is expected to stay there until 2010. Nevertheless, as the main force behind the transitory deflation is the fall in commodity prices (due to a stronger CLP, lower oil- and gas-related administered prices and food imports), we believe that by end 2010 inflation should be back to 3%, at the center of the target range. While the output gap will persist, its influence on core inflation for a small, very open economy, such as Chile, will be limited. We expect the Central Bank to reverse course in H1 2010 and begin to raise rates by mid-year.
Policy stance
10.5 8.5 6.5 4.5 2.5 0.5 -1.5 4Q04 4Q05 4Q06 4Q07 Fiscal balance (LHS) CPI, % y-o-y (RHS) 4Q08e 4Q09e 4Q10e Policy rate (RHS) 12 10 8 6 4 2 0 -2
(% y-o-y
(% GDP
10 % y-o-y) 5 0 -5
GDP (LHS)
56
(%)
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Chile: at a glance
Interest rate spread (vs. USD Libor)

8.0 6.0 (%)

8.0 6.0 (%) 4.0 2.0 0.0
4.0 2.0 0.0 -2.0 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M spread ov er US-Libor 5yr spread ov er US-Libor
2y r Now
5yr -4 months +4 months
10y r

800 750 700 650 600 550 500 450 400 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e CLP vs USD (LHS) Annualised v olatility (RHS) 30 25 20 15 10 5 0 (%)
Exchange rates and inflation

250 200 (%) 150 100 50 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate vs U SD Cumula tive C PI Cumula tive PPI 09

28 24 20 16 12 8 4 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserv es, IFI definition (LHS) Short-term debt % reserv es (RHS) 120 110 100 90 80 70 60 50
Policy dynamics
4.0 3.0 2008 2.0 2011e 1.0 (real rates) 2009e
(% of reser ves)
(USD bn)
0.0 2010e -1.0 2007 12.0 9.0 6.0 3.0 0.0 -2.0 -3.0 -6.0
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Chile: local knowledge/global drivers

While unemployment keeps rising, consumer confidence is improving, in our view, thanks to lower inflation readings. The presidential race is close with the opposition candidate still out in front
First signs of recovery On the back of better retail sales, external sales, and a recovery in industrial production, the monthly proxy for GDP, IMACEC, bottomed in April and has now accumulated three (seasonally adjusted) consecutive months of improvement. The worst number in y-o-y terms was the -4.6% recorded in June, and the contraction of the economy eased to -2.8% y-oy in July. The reading for July and the prospect of an even better performance in the remainder of Q3 puts the economy on a path to exceed 6% annualized, q-o-q , seasonally adjusted growth this quarter, a feature we see extending through the end of the year. In terms of industrial production, the worst reading was a -10.3% fall from its recent peak as at March. Since May, the index has risen by 3%. Industrial production and activity rising
115 110 105 100 95 90 01/06
Source: INE
Unemployment picture still worsening Despite the promising signs we see in the economy, unemployment is still rising and, while its trend has moderated, a better picture will not emerge until next year, in our view. A drop in the participation rate (from 56.3% to 55.8% in the last four months) is helping the bottom-line figure, but is almost certainly due to discouraged workers exiting the labor force. A better economic backdrop should elevate the participation rate again in the near future. An incipient job creation started in the last few months (only in seasonally-adjusted terms) but it will need to outweigh the force of job-seekers re -entering the labor force for unemployment figures to decline again. Our forecast is for that turn to be delayed until next year. Employment is starting to recover
115 110 105 100 95 90 150 100 50 0 0 -0 1 6 0 -0 7 6 0 -0 1 7 0 -0 7 7 0 -0 1 8 0 -0 7 8 0 -0 1 9 0 -0 7 9 -50 -100 -150 12 10 8 6 4 2 0 Employment (3m change s.a., thousands, ) Unemployment (% s.a.; RH S)
Source: INE
Opposition candidate ahead for presidential elections CEP polls for the December presidential election continue to show opposition candidate Sebastin Pieira (Renovacin Party, center-right) leading in the first round, and winning on a second round vote. Former president Eduardo Frei (Concertacin, ruling party, center-left) lost some ground in the last months in favor of Marco Enrquez-Ominami (independent, left). Second round projections for Pieira are now slightly better for the most likely scenario of a showdown against Frei. His margin is decreasing in a potential second round against Enrquez-Ominami, but still remains ample. First and second round polls
50 40 30 20 10 0 First Round Pieira Second Round 1st escenario Frei Second Round 2nd escenario
07/06
Activity index (s.a., jan 2006=100) Industrial Production (s.a., jan 2006=100)
01/07
07/07
01/08
07/08
01/09
07/09
Deflation boosting sentiment The fall in consumer prices linked to lower commodity prices and a stronger exchange rate, is boosting consumer confidence, for the time being. At first sight, this seems at odds with the shaky evolution of the economy and the worsening employment picture. Consumer confidence appears more related to the evolution of prices and started to recover in line with the advent of deflation. A similar pattern is seen in the approval rating of the Government, which suffered from a rise in administered prices but has subsequently improved despite the recessionary economy. Consumer confidence index and CPI
42 40 38 36 34 32 30 03-08 03-08 05-08 05-08 07-08 07-08 09-08 09-08 11-08 11-08 01-09 03-09 05-09 07-09 -1.5 -1 -0.5 0 0.5 1 1.5 2
Enrquez-Ominami
Consumers' confidence index Inflation (m-o-m %, inverted, -RHS- )
Source: CEP Poll
Source: Adimark and INE
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Chile: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) WPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) CLP/USD, end-year CLP/USD, average CLP/EUR, end-year CLP/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (CLPbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP)
Source: National sources and HSBC estimates
2005 5.6 118.3 6,895.7 7.4 5.9 23.9 6.0 23.4 7.9 3.2 3.7 3.2 5.0 11.9 3.5 4.5 6.2 512.0 559.8 604.2 696.6 41.3 30.5 10.8 1.0 0.8 4.8 4.1 4.9 28.9 32.5 16.8 6.6 2.5 46.2 42.3 36.4 4.6 4.6 5.4 2876.4 4.3 9.8 8.3 12.7
2006 4.3 146.4 8,372.4 6.5 5.8 2.9 3.3 21.6 6.0 3.4 2.1 7.9 5.4 11.4 3.0 5.3 5.6 533.0 530.2 703.6 666.3 58.0 35.8 22.2 6.8 4.7 4.5 3.1 7.7 40.4 17.3 17.1 5.7 2.5 49.2 54.5 37.8 7.7 3.9 8.4 1853.3 2.4 11.4 7.8 10.2
2007 5.1 163.8 9,204.2 7.7 5.8 11.9 6.0 19.8 7.2 4.4 7.8 14.0 7.3 14.7 10.0 6.0 6.2 499.0 522.9 728.0 716.8 67.6 43.9 23.8 7.2 4.4 10.6 6.5 10.9 16.6 22.7 15.5 4.2 2.5 55.7 72.1 43.2 8.8 3.5 9.4 1797.6 2.1 12.5 7.6 9.7
2008 3.2 170.3 9,413.6 4.3 4.0 19.5 -0.2 19.0 7.7 7.8 7.1 22.7 8.5 19.1 8.0 8.3 5.9 637.0 519.8 880.8 782.9 66.5 57.6 8.8 -3.4 -2.0 9.9 5.8 3.8 -1.8 31.3 23.2 4.8 2.2 62.2 75.1 50.1 5.3 3.4 5.8 1991.4 2.2 12.1 7.1 9.4
2009e -1.6 145.5 7,908.9 -2.9 7.3 -12.4 -5.8 18.7 11.1 1.2 -1.5 -5.0 5.0 6.0 3.0 0.5 4.9 540.0 573.7 810.0 831.8 49.6 43.1 6.5 -1.0 -0.7 1.2 0.8 0.1 -25.4 -25.2 28.2 7.8 2.1 63.6 61.0 49.2 -4.1 3.6 -3.6 2156.3 2.6 14.4 9.9 12.4
2010e 4.0 146.0 7,802.6 3.8 6.0 2.0 5.2 18.6 10.3 0.9 2.5 4.0 3.0 9.0 5.0 3.0 5.7 560.0 550.0 840.0 825.0 55.4 48.5 6.9 0.2 0.1 3.6 2.5 2.6 11.8 12.6 32.4 8.0 2.3 64.6 54.7 49.7 -1.7 3.5 -1.2 2365.0 2.7 14.9 9.2 11.9
2011e 4.6 134.0 7,045.7 3.6 4.0 5.5 2.8 17.4 9.3 2.8 3.2 3.8 4.0 10.0 6.2 4.5 5.5 570.0 565.0 826.5 833.4 62.1 53.8 8.3 -0.9 -0.7 6.0 4.5 3.8 12.1 11.0 36.0 8.0 2.3 65.2 50.3 50.3 -1.5 3.7 -1.0 2393.9 2.8 14.9 10.0 12.9
6.1 95.7 5,694.4 7.2 6.1 10.0 10.2 21.3 8.9 1.1 2.4 7.8 2.9 5.8 3.5 2.3 5.1 556.0 609.0 756.0 757.8 32.0 23.0 9.0 2.1 2.2 5.6 5.9 8.0 48.8 27.8 16.0 8.3 2.9 43.5 49.1 33.7 2.1 2.2 3.1 3758.7 6.4 9.8 10.3 16.7
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Hongbin Qu: +852 2822 2025 hongbinqu@hsbc.com.hk
China: the essentials
We expect the recovery to sustain its momentum into 2010, because infrastructure-focussed investment is likely to remain a key growth driver and the second-round effect of stimulus is likely to support steady consumer spending
Recovery to sustain into 2010 Chinas economy is well on track for a V-shaped recovery, thanks to the faster than expected delivery of the RMB4trn stimulus package introduced last November. The infrastructure-focussed investment has been a key growth driver of domestic demand. Helped by significant growth in new bank lending, fixed asset investment saw strong growth at 33% y-o-y in the first eight months in nominal terms. This growth is boosting industrial output and consumption, partially offsetting the decline in exports. Industrial production growth reached a 12-month high at 12.3% in August. Meanwhile, consumer spending has been holding up well, as indicated by nearly 17% y-o-y growth in retail sales, thanks to the recovery in the property market and strong car sales. We believe the recovery will sustain its momentum into 2010 and drive Q3 2008 GDP (% y-o-y) Industrial production* (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr lending rate, end quarter (%) CNY/USD, end quarter CNY/EUR, end quarter 9.0 13.0 4.6 9.1 7.9 1,905.6 7.2 7.6 6.85 9.73 Q4 2008 6.8 6.4 1.2 -1.1 8.5 1,946.0 5.3 5.8 6.82 9.48 Q1 2009 6.1 6.0 -1.2 -6.0 6.5 1,953.7 5.3 5.8 6.83 9.02 GDP growth to 9.5% y-o-y next year, simply because the infrastructurefocussed investment is likely to remain a key growth driver and the second-round effect of stimulus likely to support steady consumer spending. Those infrastructure projects, once started, should have a multiyear impact on the economy and there are still plenty of new projects in the pipeline. Meanwhile, the government is making efforts to facilitate the growth driver shift from public investment to private investment and consumption in the coming quarters. That said, the government is likely to keep the current proactive fiscal policy and appropriately loose monetary policy unchanged to support the ongoing recovery, which is deemed to be fragile by the government. We do not expect rate hikes through to Q2 next year. 8.6 10.6 -0.2 -5.5 6.7 2,180.0 5.3 5.8 6.83 9.90 9.2 12.6 0.3 3.5 5.0 2,250.0 5.3 5.8 6.80 10.20 9.7 14.2 3.1 2.5 4.7 2,285.7 5.3 5.8 6.80 10.20 9.5 14.0 2.8 3.0 1.9 2,302.5 5.6 6.0 6.80 10.20 9.3 13.8 2.6 3.5 5.6 2,354.1 5.8 6.3 6.73 10.10 9.4 14.0 3.3 4.0 3.8 2,398.7 5.8 6.3 6.66 9.99
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e 7.9 9.6 -1.0 -7.8 3.1 2,130.0 5.3 5.8 6.83 9.56
Note: * Industrial production is measured as the output of companies with annual sales over CNY5m
Strong infrastructure-focussed investment Urban fixed asset investment rose 33% y-o-y in the first eight months in nominal terms. In real terms, August urban FAI growth accelerated to 41% y-o-y from 38% in July, due to the catching up of local government investment and the pick-up in property investment. Infrastructure investment remains strong. For instance, railway investment rose 107% y-o-y in the first eight months of this year, compared with around 30% growth in the same period last year. Yet, besides the rebound in property investment growth, private investment is still growing more slowly than public investment. That said, the outlook for investment growth is positive given that new projects investment still rose more than 80% y-o-y in January-August and there is still plenty of possibilities for infrastructure investment that the government could spend more on if needed. Activity & inflation
20 16 (% y-o-y) 12 8 4 0 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) 10 6 4 2 0 -2
Limited inflation pressures in the near term Deflation pressures started to ease in August, as the headline CPI and PPI both bottomed out, albeit still a decline in year-on-year terms. As the base effect gradually fades out, we expect the headline CPI to return to positive territory in Q4 2009. That said, there is no imminent inflation pressures or rate hikes, in our view. We think inflationary risks are manageable through 2010, given that (1) the likely below-trend growth should check inflation; (2) consumer goods prices inflation should be limited, given the persistent over-capacity owing to the slow recovery in global demand; (3) food prices, weighted a third in CPI, should be stabilised given that the good harvests of the last five consecutive years ensure sufficient supply. All these factors, combined with the initiative to strengthen the recovery, imply no rate hikes until Q2 2010, in our view. Policy stance
2 (% GDP, 4 qma) 1 0 -1 -2 -3 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e 10 8 6 4 2 0 -2
8 (% y-o-y)
GDP (LHS)
Industrial grow th (LHS)
Policy rate (RHS)
60
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China: at a glance

3 2 1 0 -1 -2 -3 -4 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M s pread over US-Libor 10y r spread over US Tbond

6.0 4.0 (%) 2.0 0.0 -2.0 6M 1y r Now + 4 months 3y r 5y r - 4 months Current CPI 10y r

8.5 8.0 7.5 7.0 6.5 6.0 2004 2005 2006 2007 2008 2009e 5.0 4.0 2.0 1.0 0.0 -1.0 (%) 3.0
(%)

130 120 (%) 110 100 90 80 00 01 02 03 04 05 06 07 08 Growth of nominal exchange rate vs USD Cumulative PPI Cumulative CPI 09
CNY v s USD (LHS)
Annualised v olatility (RHS)

1800 1500 1200 900 600 300 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 International res erv es , IFI definitio n (LHS) Short-term debt % res erves (RHS) 15 12 9 6 3 0
Policy dynamics
6.0 5.0 (real rates) 4.0 3.0 2.0 1.0 0.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 2007 2011e 2010e 2009e 2008
(% of reserves)
(USD bn)

120 100 (ind ex) 80 60 40 20 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI China sub-index (LHS) EMBI China sub-index (RHS) 350 300 250 200 150 100 50 0

600 (spread bps)
(spread bp s)
450 300 150 0 1/05 5/05 5/05 9/05 1/06 1/06 5/06 1/07 1/07 9/06 9/06 5/07 1/08 9/07 9/07 5/08 9/08 5/09 5/09 1/09 1/09 9/09
China 12M base lending rate EMBI China sub-index
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China: local knowledge/global drivers

Exports should continue to be a big swing factor for Chinas economic growth in the coming quarters. But it wont affect the ongoing recovery driven by domestic demand
Industrial production growth accelerating IP growth accelerated to a 12-month high of 12.3% y-o-y in August from 10.8% in July, thanks to new investment projects substantially increasing demand for industrial products. Electricity production growth also reached a high at 9.3% y-o-y, the highest level since May 2008, reconfirming the strong stimulus-led rebound in industrial activities. Heavy industries grew faster than light industries, as they benefit more from the investmentfocussed stimulus measures and the strong car sales. IP growth will gain further momentum in the months ahead as the construction works are being implemented at full speed. Meanwhile, the leading indicator, manufacturing PMI, has risen for three consecutive months above the expansion line, portending improvement in IP growth. IP growth gaining momentum
25 20 15 10 5 0 05 06 IP 07 08 M anu facturing PM I 09 %yr , 3m m a 60 55 50 45 40 35
Consumer spending holding up well Consumer spending has been holding up steadily. August retail sales rose 16.6% y-o-y in volume terms, close to the highest pace since this series begun in 1993. Besides the steady income growth, this robust consumer spending is helped by rising housing and car sales, both gaining a boost from the stimulus package. We believe consumer spending will remain steady, given that the governments proconsumption measures should have a positive impact in the coming quarters. The ongoing subsidies for farmers purchases of home appliances, the pilot rural pension scheme programme, the medical care reforms, and increased spending on hospitals and education encourage consumer spending. Consumer spending boost helped by strong car sales
80 60 40 10 20 0 -2 0 0 1 02 03 04 05 06 07 08 09 5 0 (% yr ,3 m m a) (% y r, 3m m a) 20 15
C a r sa le s (u nit) R e ta il sa le s (R h s, a djuste d by C PI)
Bank lending normalising New bank lending slowed to around RMB400bn in July-August, compared with a monthly average of RMB1.2trn in H1 2009. August new lending was RMB686bn as matured discount bills were replaced by medium- and long-term loans. Government-backed infrastructure projects have remained the key driver of loan growth in August, as medium to long term corporate loans represented more than 50% of new lending. Yet, such a normalisation in new lending won't affect the recovery in the real economy because banks have lent heavily in the first part of the year. New lending totalled more than RMB8trn in the first eight months, maintaining outstanding loan growth at 34.1% y-o-y - more than sufficient to support 8% GDP growth in 2009. Government-backed infrastructure projects remained the key driver of loan growth
R MB b n 2500 2000 1500 1000 500 0 -500 02/07 06/07 10/07 02/08 06/08 10/08 02/09 06/09 ST MLT Bill Others
Exports to bottom out The decline of exports stabilised at 23% y-o-y in July-August, while the value of imports dropped 16% y-o-y in July-August, reflecting the fall in commodities prices. In volume terms, commodities imports are rising. Thus, the commodities exporting countries, along with the advanced machinery exporters are best positioned to benefit from Chinas investment-driven recovery. As a result, the trade surplus was USD122.8bn, down 19% y-o-y. Though contracting exports are still the weakest link, it wont affect the ongoing recovery driven by domestic demand. We think the stabilisation in Chinas exports, combined with the gradual recovery in the global economy, indicates that Chinas exports are going to bottom out in the coming months, but probably at a slow pace. Decline of exports stabilised
50000 40000 30000 20000 10000 0 -10000 03/93 03/96 03/99 Trade balance (LHS) 03/02 03/05 Export (RHS) US$m,3m ma %yr,3mma 80 60 40 20 0 -20 -40 03/08 Import (RHS)
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China: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production* (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr lending rate, end-year (%) CNY/USD, end-year CNY/USD, average CNY/EUR, end-year CNY/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Consolidated government balance (% GDP) Central government balance (% GDP)
Note: * Industrial production is the output of all industrial companies
2005 10.2 2,239.1 1,723 8.5 12.9 22.3 15.9 48.2 4.2 1.8 1.6 3.2 12.3 16.0 16.0 5.6 5.8 8.07 8.18 9.52 10.19 762.0 660.0 102.0 160.8 7.2 72.4 3.2 10.4 28.4 17.6 818.9 14.9 169.3 281.0 19.1 -1.2 -1.2
2006 11.6 2,661.2 2,035 8.7 11.7 21.5 16.2 50.1 4.1 1.5 2.8 3.0 14.0 18.1 16.0 6.1 6.5 7.81 7.96 10.29 10.01 969.0 791.5 177.5 253.3 9.5 72.7 2.7 12.2 27.2 19.9 1,066.3 16.2 200.3 323.0 17.2 -1.0 -1.0
2007 13.0 3,385.9 2,576 9.0 14.3 22.7 16.0 51.0 4.0 4.8 6.5 5.4 16.2 17.5 17.0 7.5 7.7 7.30 7.60 10.66 10.56 1,218.6 956.0 262.7 371.8 11.0 83.5 2.5 13.4 25.8 20.8 1,528.2 19.2 188.4 373.6 14.4 0.6 0.6
2008 9.0 4,330.9 3,278 8.9 12.0 19.2 12.9 51.4 4.2 5.9 1.2 -1.1 17.0 16.7 15.0 5.3 5.8 6.82 6.94 9.48 10.11 1,429.2 1,131.8 297.3 426.1 9.8 108.3 2.5 12.3 17.2 18.5 1,946.0 20.6 180.9 374.7 10.8 -0.4 -0.4
2009e 8.1 4,735.5 3,566 8.0 18.0 31.4 9.5 50.0 6.0 -0.6 0.3 3.5 9.0 21.9 13.0 5.3 5.8 6.80 6.83 10.20 9.87 1,258.4 1,007.9 250.5 240.0 5.1 85.0 1.8 6.9 -12.0 -11.0 2,250.0 26.8 211.6 350.0 6.7 -2.9 -2.9
2010e 9.5 5,366.0 4,021 8.5 16.0 22.8 14.0 50.5 5.5 2.6 3.3 4.0 13.0 21.5 15.5 5.9 6.3 6.66 6.77 9.99 10.15 1,371.6 1,159.1 212.5 230.0 4.3 86.0 1.6 5.9 9.0 15.0 2,400.0 24.8 245.5 330.0 5.0 -4.3 -4.3
2011e 8.9 6,202.9 4,625 8.6 14.0 16.5 13.0 50.0 5.0 2.5 2.3 3.3 11.5 16.0 13.0 5.9 6.3 6.40 6.53 9.60 9.80 1,508.6 1,263.4 245.2 260.0 4.2 98.9 1.6 5.8 10.0 9.0 2,550.0 24.2 292.4 360.0 5.1 -3.2 -3.3
10.1 1,931.7 1,495 7.2 8.6 21.5 16.3 45.7 4.2 3.9 2.4 7.1 12.3 16.2 16.2 5.6 5.8 8.28 8.28 11.25 9.69 593.3 561.2 32.1 68.7 3.6 60.6 3.1 6.7 35.4 36.0 609.9 13.0 129.7 247.5 20.2 -1.3 -1.3
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Javier Finkman: +54 11 4344 8144 javier.finkman@hsbc.com.ar
Colombia: the essentials
The economy does not show clear signs of bottoming out. Actually, real data still point to a contracting economy and only financial data show significant improvements
Still targeting the rebound in 2010 The rhythm of contraction of the Colombian economy has yet to show clear Adding to lagging activity partly brought about by the contraction the signs of bottoming out yet. On a year-over-year basis, we expect fiscal accounts continue to deteriorate. The authorities have acknowledged consumption to stabilize around Q3 2009 and begin growing early in 2010. a central government deficit of 4% of GDP. Pushed by consumption, GDP should follow the same path of recovery. The uncertainty is compounded by the possibility that President Alvaro The timing we propose is probably shared by the monetary authorities who Uribe will run for a third term. Congress recently opened the way for the in spite of an optimistic forecast of 0.5% growth for 2009 that will require referendum, though Uribe has not yet confirmed his decision to be a a sharp upswing in the H2 of the year have recently surprised the market candidate. The trade-off between a well-known candidate responsible for by reducing the reference rate another 50bps to 4%. Unsurprisingly, words maximizing the peace dividend and the institutional deterioration caused and deeds often differ in Colombia, as they do almost everywhere else by forcing constitutional amendments so that he can run makes it unclear where authorities are trying to maximize not only policy impact but also what the market reaction would be to any decision finally taken by expectations. President Uribe. Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) COP/USD, end quarter COP/EUR, end quarter 2.84 -3.85 7.57 9.79 -0.78 -3.01 24.08 10.00 11.90 2108 3089 -1.07 -5.30 7.67 9.00 -3.05 -4.66 24.03 9.50 12.40 2223 2873 -0.45 -5.34 6.14 6.79 -1.06 -2.36 23.84 7.00 12.10 2250 3147 -0.51 -8.50 3.81 2.74 -1.13 -2.51 23.72 4.50 11.80 2350 3033 -0.20 -4.30 3.60 1.80 -0.94 -2.08 25.40 4.00 11.70 2000 2900 0.20 -2.30 3.40 2.60 -0.88 -1.95 26.20 4.00 11.80 1918 2877 2.40 2.20 3.60 4.70 -0.33 -1.74 25.80 4.00 11.40 1875 2813 2.70 4.80 3.80 4.90 -0.33 -1.74 26.70 4.00 10.90 1850 2775 2.40 8.30 3.90 3.48 -0.32 -1.70 26.10 4.00 10.70 1850 2775 3.00 5.10 4.10 3.00 -0.32 -1.67 26.50 4.00 10.60 1850 2775
Activity data offer no clues as to the timing of recovery GDP data are still unclear as to the timing of recovery. GDP contracted 0.5% y-o-y in Q2 2009 but increased 0.7% q-o-q on a seasonally adjusted basis. The fall in manufacturing activity in the period was a dismal 10.2% y-o-y. Nevertheless, other sectors gave stellar performances: construction pushed by public investment increased 16.8%; mining pushed by sustained FDI as prices recovered grew 10.2%; and the financial sector increased 4.3%, in Q2 2009 relative to Q2 2008. These three were the main positive contributors to GDP. On the demand side, total consumption fell 0.3%, gross fixed investment fell 7.3% and exports fell 5.7%. The most negative contributors to the fall in GDP were imports and gross fixed investment. Activity & inflation
16 12 8 4 0 -4 -8 -12 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) Industria l grow th (LHS) CPI (RHS) 10 8 6 4 2 0
Only financial data give some hope Sales data do not provide a better picture. Car sales fell over 30% in Q2 2009 y-o-y. Retail sales fell 5.2% in the same period. Energy demand virtually stagnated, rising 0.3% in the quarter, a further deceleration. Expectations are likewise gloomy. Consumer confidence and business expectations are still falling. The only clear improvements are on the financial side. First, country risk using the Colombia EMBI+ spread as a proxy has halved since January, from 500bp levels to 250bp levels in mid September. Rates have also fallen substantially with the 3-month deposit rate almost halving between early January (9.7%) and early September (5%). The main problem is that borrowing rates fell by less in relative terms, from 15% levels to 11% levels in the same period. The latter limits the pass-through of lower rates to higher activity. Policy stance
0 (% GDP, 4 qma) -2 -4 -6 -8 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e Policy rate (RHS) 5 0 15 10 (%)
(% y-o-y)
(% y-o-y)
Fisc al balance (LHS) CPI, % y-o-y (RHS)
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Colombia: at a glance

10 8 (%)

12 11 10 9 8 7 6 5 3m 6m 1yr Now +4 months 3y r 7yr 8yr 13yr -4 month s Current CPI
4 2 0 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09
12M spread ov er US-Libor
2Y spread over US Libor

3,200 2,800 2,400 2,000 1,600 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e COP v s USD (LHS) Annualised vola ti lity (RHS) 32 24 16 8 0 (%)

200 175 (%) 150 125 100 75 00 01 02 03 04 05 06 07 08 Growth of nominal exchange rate vs USD Cumulative PPI Cumulative CPI 09

30 25 20 (USD bn) 15 10 5 0 20 00 2 001 200 2 20 03 2 00 4 20 05 2 006 200 7 20 08 2 00 9 60 50
Policy dynamics
4.0 3.0 (real rates) 2.0 1.0 0.0 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 -4.0 2008 2010e 2011e 2009e
(% of reserves)
(%)
2007
40 30 20 10 0
Inte rn atio na l res e rv es, IF I de fin ition ( LHS ) S hort-ter m deb t % re s e rv e s (R HS)
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Colombia: local knowledge/global drivers

Renewed intervention by Banrep is the first official sign of concern at the pace of currency appreciation.
Banrep surprised reducing rates further On 25 September, Banrep reduced the reference rate by another 50bps, to 4%, surprising most analysts, who were expecting the pause in rate reductions to continue. We believe there were three drivers behind the Boards decision. First, real data are not showing signs of improvement. Secondly, foreign policy uncertainty and Venezuelan trade restrictions could also have affected the decision to resume an expansionary monetary policy. Thirdly, an attempt to prevent a stronger exchange rate: the COP has strengthened 26.7% an impressive annualized rate of 42% since its low of 2608/USD on 3 March. The BRL is the only other currency in the region to have shown such strong appreciation, but the economic shoots are greener in Brazil. Retail sales continue falling (% y-o-y)
4.0 2.0 0.0 -2.0
Super-COP The renewed intervention is the first official sign we have seen of concern at the pace of currency appreciation. At current exchange rates, we expect increased government intervention in COP, and in the region in general. While the 2,000/USD level was broken without much fuss, anecdotally we have heard that the 1,900/USD level is one the authorities have been eying more closely. What next? If 1,900 continues to be tested, we think the resumption of dollar purchases (USD20m to USD50m a day) could be announced. Of all the measures tried by the central bank, such daily purchases have proven the most successful in slowing the pace of appreciation in the past, even if they did not reverse the overall trend. Manufacturing also heading down (% y-o-y)
6.0 4.0 2.0 0.0 -2.0
-4.0 -6.0 -8.0 06-08 07-08 08-08 09-08 10-08 11-08 12-08 01-09 02-09 03-09 04-09 05-09 06-09
-4.0 -6.0 -8.0 06-08 07-08 08-08 09-08 10-08 11-08 12-08 01-09 02-09 03-09 04-09 05-09 06-09
DANE
DANE
CPI continues decelerating In August, consumer prices increased 0.04%, for a 3.13% increase in the previous 12 months. The typical inflation measures CPI ex-food, core inflation and PPI decelerated further. The breakdown by income level shows that the middle class reported a higher level of inflation at 3.29% for the 12 months. The lower-income bracket recorded a CPI increase of 2.74%. This is because inflation was higher for education, healthcare and housing and lower for transport, food and clothing. Services have a larger impact on the middle classes than on lower-income sectors that allocate a much larger share of their budget to food.
Uribe rerun? The Constitutional Court is studying the bill that, if approved, would allow a referendum on whether President Uribe should be allowed to run for president for a third term. For the measure to be passed Uribe would need a majority with around 7.3m votes, or 25% of the electoral census, being cast. Though Uribe has remained silent in general about running in 2010 probably waiting for the seal of approval he has been pushing the process forward at all costs. It is hard to believe Uribe would want to have no option other than to step down. Therefore, we reiterate our view that he will try to run for a third term and that most likely he will be allowed to. The consequence is a trade-off between a well-known candidate who has maximized the peace dividend and some institutional deterioration. Country price halved (Colombia EMBI+)
600 500 basis points 400 300 200 100 0 01-09 05-09 02- 09 03- 09 04- 09 06- 09 07- 09 08-09 09- 09
Inflation by type of expenditure (August, last 12 months)

7.0 6.0 5.0 % change 4.0 3.0 2.0 1.0 0.0 -1.0 Education Healthcare Housing Others Com m CP I Leisure Transport Food Clothing
DANE
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Colombia: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) COP/USD, end-year COP/USD, average COP/EUR, end-year COP/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (ILSbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 4.66 114.45 2554.76 3.70 4.64 12.97 6.45 18.93 12.10 5.90 5.50 4.60 7.80 17.60 4.80 6.50 11.50 2360 2613 3248 3265 16.52 16.75 -0.23 -0.91 -0.79 3.00 2.62 1.83 26.45 20.59 13.50 10.60 11.1 39.4 32.6 13.7 -1.3 -4.3 3.2 68.6 22.9 23.6 23.2 52.0
2005 5.72 144.76 3153.75 4.68 6.40 19.92 3.85 19.92 10.30 5.00 4.90 2.06 7.90 16.50 8.30 6.00 7.70 2284 2318 3139 2999 21.19 21.20 -0.01 -1.88 -1.30 10.20 7.05 5.75 28.30 26.62 14.90 9.20 13.2 38.5 32.2 14.0 0.0 -4.1 3.4 97.1 28.9 20.8 17.2 51.2
2006 6.94 162.49 3472.09 6.79 4.19 19.14 10.94 21.82 11.80 4.30 4.48 5.54 8.60 16.90 26.52 7.50 8.90 2240 2359 2912 3067 24.39 26.16 -1.77 -2.98 -1.84 6.50 4.00 2.16 15.10 23.38 15.40 7.06 13.8 40.1 33.1 14.3 -0.7 -3.4 2.9 103.7 27.1 26.5 16.3 42.1
2007 7.50 206.30 4324.95 7.61 4.52 13.71 10.86 21.21 9.90 5.50 5.70 1.27 4.00 17.70 20.30 9.50 10.30 2014 2093 2946 2809 30.01 32.90 -2.89 -5.82 -2.82 9.00 4.36 1.54 23.04 25.74 20.90 7.62 16.5 44.7 26.3 15.9 -0.7 -2.7 3.2 110.1 25.5 28.8 14.0 44.0
2008 2.40 243.58 5022.37 2.53 1.31 7.50 -3.47 20.20 10.60 6.40 7.67 8.99 5.30 16.40 10.33 9.50 12.40 2223 1969 3112 2954 37.61 39.57 -1.97 -6.71 -2.76 10.60 4.35 1.60 25.31 20.30 24.03 7.29 17.4 45.8 23.3 16.9 -0.1 -2.4 3.6 118.3 24.7 29.4 12.1 36.8
2009e -0.24 232.86 4752.22 -0.10 1.10 -6.40 -5.10 20.90 12.50 4.24 3.40 2.60 5.00 12.10 1.60 4.00 11.80 1918 2130 2839 3088 30.80 33.10 -2.30 -5.10 -2.19 9.80 4.21 2.02 -18.10 -16.36 26.20 9.50 17.9 48.1 23.7 15.5 -3.6 -4.4 0.4 120.2 24.3 32.3 13.9 38.2
2010e 2.60 282.73 5700.28 3.20 2.30 5.00 5.00 20.40 11.90 3.75 4.10 3.00 6.30 14.50 10.90 5.00 10.60 1850 1869 2775 2803 32.60 33.50 -0.90 -4.80 -1.70 8.90 3.15 1.45 5.84 1.21 26.50 9.49 16.6 47.6 21.5 14.9 -3.5 -4.3 0.4 121.3 23.1 32.8 11.6 34.7
2011e 4.10 301.00 6007.96 4.00 1.30 7.00 6.10 20.20 11.30 4.30 4.90 5.20 6.00 15.60 10.10 6.00 10.50 1900 1875 2755 2755 31.30 34.10 -2.80 -5.90 -1.96 9.00 2.99 1.03 -3.99 1.79 26.80 9.43 16.1 46.5 20.9 15.3 -3.4 -4.0 0.4 120.5 21.4 31.8 10.6 31.9
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Dr Murat Ulgen: +90 212 376 4619 muratulgen@hsbc.com.tr
Egypt: the essentials
The economy has enjoyed reasonable growth despite the global crisis. While overall activity will likely remain soft for the next few years, robust domestic demand should offset some slack in export activity
Political stability remains intact Egyptian politics remains reasonably stable under the administration of President Mubarak and the National Democratic Party. We expect this stability to persist until the next parliamentary and presidential elections, scheduled in 2010 and 2011, respectively. While rampant (food) inflation in fiscal 2007-08 as well as a sharp slowdown and a subsequent rise in unemployment in 2008/09 led to sporadic protests, the administration remains strong and popular. The NDP will hold its annual convention at the end of this month, which could see Gamal Mubarak showcase his leadership skills if, as many observers of Egypt expect, he is to be groomed as his fathers successor. The NDP says the election timetable remains intact, refuting speculation that elections could be held early after a recent law increased the number of seats in the lower house of parliament. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) EGP/USD, end quarter EGP/EUR, end quarter
Note: Egypt's fiscal year runs from July to June
Obamas visit confirms Egypts important role in the region US president Barack Obama chose to address the Arab and Muslim world from Cairo during his trip to Egypt on 4 June. This confirms Egypts strong role and importance as the most populous Arab state, a predominantly Muslim country and a close partner of the US. Egypt also maintains diplomatic relations with Israel despite some public protests over the Gaza situation. While the US is pressing the Egyptian administration to improve its democratic credentials and reform efforts, it also relies on the country to advance US Middle East policies and peace efforts. The current administration will likely maintain the goodwill of the international community, which is positive for Egypts profile and hence the economy. The country enjoys a preferential free-trade agreement with the US and Israel, which it wants to expand into industrial zones located in the south of the country. 4.5 -5.8 10.0 -11.9 -12.0 -1.7 31.3 9.00 10.30 5.64 7.95 3.5 -0.5 10.2 -7.3 -12.1 -1.7 31.9 8.25 9.80 5.55 8.05 4.1 3.3 12.5 13.2 -12.4 -1.6 32.4 8.25 10.00 5.60 8.40 4.0 4.9 12.0 13.7 -12.6 -1.5 33.1 8.50 10.50 5.60 8.40 4.9 6.5 10.1 8.3 -12.8 -1.4 33.5 9.00 11.20 5.55 8.33 4.5 5.9 8.5 8.1 -13.3 -1.3 34.0 9.00 11.50 5.65 8.48 4.1 4.6 8.2 8.6 -13.9 -1.2 34.8 9.00 11.60 5.55 8.33
Q4 2008 4.1 0.4 18.3 -0.3 -13.0 0.5 34.2 11.50 11.20 5.51 7.66
Q1 2009 4.4 -9.7 12.1 -10.4 -12.7 -1.4 32.2 10.00 10.00 5.60 7.45
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
5.8 7.2 21.5 22.6 -13.8 0.1 35.0 11.50 10.40 5.45 7.65
Economic activity has held up relatively well so far The Egyptian economy has posted enviable growth in the midst of the global crisis, if much slower than the 7.0% average for the last three fiscal years. Real GDP grew a respectable 4.1% y-o-y in Q4 08, picking up slightly to 4.3% in Q1 09. This was thanks to carry-over momentum from the earlier investment boom, supportive private domestic demand, a relatively insulated financial system, low external financing requirements and public sector fiscal stimulus. In terms of sectors, export-orientated areas like manufacturing, tourism and revenue from the Suez Canal all slowed sharply, passing the torch to the likes of transport, communication and construction. We expect real economic growth to remain around current levels for some years, or slightly lower, as external shocks are transmitted slowly through the real economic channel. Activity & inflation
8 6 (% y-o-y) 4 2 0 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) CPI (RHS) 25
Inflation moderates but food inflation remains high Egypt is reeling from the massive inflation shock of the last fiscal year largely driven by commodities (specifically food). This pushed urban consumer inflation up to a high 23.7% y-o-y peak in August 2008. The level retreated to 9% in August this year, although it remains fairly high in monthly terms. This is mainly due to relentless food price pressure, which averaged 2.2% m-o-m in the first eight months. High food inflation results from Egypts susceptibility to global price shocks as it is one of the worlds top wheat importers and has an uncompetitive, rigid domestic food market. Sharp rises in July-August are also attributable to the pre-Ramadan effect. We note, however, that non-food consumer inflation our preferred core inflation gauge in the absence of official data fell substantially, to 5.6% y-o-y in August, its lowest level in almost two years. Policy stance
0.0 (% GDP, 4 qma) -2.0 -4.0 -6.0 -8.0 -10.0 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e Fiscal balance (LHS) CPI, % y -o-y (RHS) Policy rate (RHS) 24 18 12 6 0 (%)
20 (% y-o-y) 15 10 5 0
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Egypt: at a glance
Equity and fixed income

2000 1500 (ind ex) 1000 500 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Egypt sub-index (LHS) EMBI Egy pt s ub-index (RHS) 500 400 (spread bp s) 300 200 100 0

13 11 (%) 9 7 1yr 2y r 3yr Now +4 months 5yr 7y r -4 months Current CPI 10yr

7 6 5 4 3 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e EGP vs USD (LHS) Annualised v olatility (RHS) 40 30 20 10 0 (%)

260 220 (%) 180 140 100 60 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09

35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Internatio nal reserves, IFI definition (LHS) Short-term debt % reserves (RHS) 50
Policy dynamics
12.0 9.0 (real rates) 6.0 3.0 0.0 2007 -3.0 -7.5 -8.5 2010e 2009e 20011e -9.5 -10.5 -11.5 -12.5 2008
(% of reserves)
(USD bn)
40 30 20 10
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Egypt: local knowledge/global drivers

Monetary easing is coming to an end, although fiscal loosening will probably run further and could complicate the inflation and public debt outlook
CBE is coming to the end of its easing campaign The Central Bank of Egypt uses a slightly different core inflation indicator, urban consumer inflation excluding fruit and vegetables, which has reportedly also retreated significantly (a cumulative 4.2% y-t-d in 2009 versus 14.4% in the same period of last year). Hence, despite sticky headline monthly inflation, the CBE has delivered rather aggressive rate cuts, totalling 325bp y-t-d (375bp for the lending rate). After easing 50bp at each of the four MPC meetings since March, it cut the policy rate by a smaller 25bp in September and switched its wording to neutral bias. Although the CBE has not yet specified any inflation target to be reached before it moves to an official inflation-targeting regime, it is known to be aiming for a positive real interest rate. This may necessitate rate hikes in early 2010. Headline urban CPI, food and non-food (%, YoY)
30%
Government mulls another fiscal stimulus package Egypts relatively robust economic activity and local pricing dynamics, coupled with an unsupportive base effect in future, will likely keep inflation high. This is probably why the CBE has moved from an easing to a neutral bias. Nonetheless, unemployment picked up to 9.4% in Q2 2009 from 8.4% in the same period a year earlier, although the administration hopes to see above 7.0% real GDP growth owing to Egypts very favourable demographics. Hence, government officials have recently been mulling another fiscal stimulus package worth EGP15bn (USD2.7bn or 1.4% of GDP) that would probably look similar to the same-sized package from fiscal year 2008/09, which was spent on investments in infrastructure, health, export promotion and support for industrial zones. Ex-post policy rate based on realised urban consumer inflation
10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10%
25%
20%
15%
10%
5%
01/06
01/05
07/05
07/06
01/03
07/03
01/04
07/04
07/08
01/09
Old CPI
New CPI
Food
Non-f ood inflation
Source: CAPMAS, HSBC
07/09
01/07
07/07
01/08
Source: CAPMAS, CBE
Fiscal consolidation deferred, public debt to rise Egypts ambitious fiscal consolidation plan to lower the budget deficit to 3.0% of GDP in 2010/11 is deferred owing to global shocks. While the 6.9% budget deficit target for 2008/09 fiscal year was achieved, the 2009/10 target is set at an 8.4% deficit owing to a cyclical deterioration in revenues (40% of tax income came from corporate earnings in 2008/09). Moreover, a new fiscal stimulus package under consideration by the cabinet is unlikely to have been included in this years fiscal framework. The long-awaited 10% property tax is set to be introduced in 2010, which is clearly positive, although there is still no concrete plan to overhaul the sales tax system and replace it with a VAT scheme. Egypt also needs measures on the expenditure side and pension/healthcare reforms to facilitate disinflation and prevent crowding out. Excerpts from Egypt's fiscal results and 2009-10 targets
Budget Sector (in EGP mn) Total Revenues & Grants Tax Revenues Income Tax On individual income On corporates Property Tax Taxes on Goods & Services Taxes on International Trade Other Taxes Grants Other Revenues Total Expenditures Wages & Salaries Purchases of Goods & Services Interest Payments Subsidies, Grants & Social Benefits Other Expenditures Purchases of Non-financial Assets Cash Balance Net Acquisition of Financial Assets Overall Fiscal Balance 2007/08 221,402 137,194 67,058 11,495 55,563 2,052 49,747 14,020 4,317 1,462 82,746 282,292 62,839 18,471 50,528 92,371 23,892 34,191 -60,890 236 -61,126 2008/09 2009/10T 274,807 100.0% 224,987 100.0% 163,573 59.5% 145,545 64.7% 80,614 29.3% 58,749 26.1% 15,442 5.6% 14,512 6.5% 65,172 23.7% 44,237 19.7% 3,690 1.3% 8,106 3.6% 61,918 22.5% 61,377 27.3% 13,887 5.1% 14,018 6.2% 3,464 1.3% 3,295 1.5% 8,819 3.2% 7,700 3.4% 102,415 37.3% 71,742 31.9% 343,660 125.1% 323,917 100.0% 73,178 26.6% 87,485 27.0% 22,877 8.3% 27,349 8.4% 52,693 19.2% 71,066 21.9% 128,776 46.9% 73,480 22.7% 25,789 9.4% 28,058 8.7% 40,347 14.7% 36,479 11.3% -68,853 -98,930 2,753 730 -71,606 -99,660
Egyptian pound (EGP) to remain stable The Egyptian pound is a tightly managed currency with a comfortable reserve position. However, faced with different global shocks over the past two years, first inflation then growth, Egyptian policymakers have been more flexible on the currency. Massive supply-side shocks to inflation in late 2007 and early 2008 created some leeway for appreciation until the deepening of the financial crisis, which then substantially reduced inflation risks via a slump in global commodity prices. However, Egypts interaction with the rest of the world on merchandise trade, tourism, Suez canal and remittances then came to a grinding halt, allowing for some depreciation of the EGP. In future, given a more balanced growth-inflation outlook, we expect the currency to remain fairly stable against an equally weighted basket of USD and EUR. Egypt's official FX reserves
22 20 18 16 14 12 10 8 6 4 2 4Q04 1Q08 2Q05 1Q06 3Q06 2Q07 3Q08 2Q04 3Q04 1Q05 3Q05 4Q05 2Q06 4Q06 1Q07 3Q07 4Q07 2Q08 4Q08 1Q09 0 Months of Imports Times ST External Debt
Source: CBE
70
01/99 07/99 01/00 07/00 01/01 07/01 01/02 07/02 01/03 07/03 01/04 07/04 01/05 07/05 01/06 07/06 01/07 07/07 01/08 07/08 01/09 07/09
0%
ex post policy rate (%)
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Egypt: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) EGP/USD, end-year EGP/USD, average EGP/EUR, end-year EGP/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (EGPbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 4.1 78.7 1,149 2.1 2.0 6.2 n.a 16.2 10.0 14.3 10.6 15.9
2005 4.5 89.5 1,280 4.7 2.8 14.2 n.a 16.1 10.5 8.9 4.7 5.1
2006 6.8 107.4 1,507 6.4 3.1 13.3 n.a 16.2 10.9 4.2 6.4 2.1
2007 7.1 130.4 1,794 4.2 3.2 31.8 8.9 17.5 8.9 11.1 8.5 12.4
2008 7.2 163.0 2,198 7.6 2.1 15.5 14.0 17.8 8.9 11.7 20.2 33.7
2009e 4.7 196.4 2,594 4.8 5.5 3.7 -2.0 19.9 9.4 15.5 10.0 -11.9
2010e 4.1 220.7 2,858 3.9 5.2 4.4 3.6 19.2 9.7 11.2 10.1 8.3
2011e 4.2 244.7 3,107 4.3 3.9 4.9 4.8 19.3 9.8 8.3 8.2 8.5
13.2 3.2 10.00 10.60 6.19 6.16 7.53 7.35 10.5 18.3 -7.8 3.4 4.3 0.4 0.5 4.9 27.4 23.4 14.8 9.7 9.2 29.9 13.5 2.4 -6.1 -9.1 -3.1 388.4 80.0 29.9 38.0 118.0
13.6 2.2 9.50 8.60 5.79 6.02 7.01 7.66 13.8 24.2 -10.4 2.9 3.3 3.9 4.4 7.6 32.2 32.3 19.2 9.5 11.3 28.9 9.9 2.0 -8.4 -9.6 -3.5 469.0 87.1 27.8 31.1 118.2
13.5 5.9 8.00 8.40 5.74 5.75 7.34 7.24 18.5 30.4 -11.9 1.8 1.6 6.1 5.7 7.3 33.9 25.7 22.9 9.0 15.6 29.6 7.0 2.1 -9.2 -8.2 -2.2 470.3 76.1 29.6 27.6 103.7
12.8 7.9 8.75 8.90 5.69 5.71 7.68 7.71 22.0 37.8 -15.8 2.3 1.7 11.1 8.5 10.2 18.9 24.3 31.0 9.8 25.4 29.8 4.8 2.0 -7.7 -7.3 -0.9 493.9 66.3 29.7 22.8 89.1
15.7 13.2 10.50 9.60 5.33 5.50 8.40 8.11 29.4 52.8 -23.4 0.9 0.5 13.2 8.1 8.7 33.4 39.6 34.6 7.9 28.0 33.9 6.4 3.0 -7.5 -6.8 -1.2 537.6 60.0 29.5 18.1 78.1
8.4 7.8 9.00 10.30 5.64 5.49 7.95 8.18 23.8 47.3 -23.5 -3.4 -1.7 6.4 3.3 1.6 -18.9 -10.4 31.3 7.9 28.5 32.5 8.9 2.5 -8.4 -6.9 -1.8 655.0 60.1 32.1 16.3 77.4
9.5 8.2 9.00 11.20 5.55 5.60 8.33 8.14 26.2 54.4 -28.2 -3.0 -1.4 7.5 3.4 2.0 10.0 15.0 33.5 7.4 29.5 33.5 7.5 2.6 -11.6 -9.5 -3.2 825.0 66.3 31.5 14.3 81.4
9.8 8.5 9.00 11.50 5.50 5.53 8.25 8.29 30.1 66.6 -36.5 -4.5 -1.8 7.8 3.2 1.4 15.0 22.5 38.0 6.8 31.4 34.2 5.5 2.8 -9.5 -8.3 -2.0 955.0 67.9 31.1 12.7 82.0
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Janus Chan: +852 2996 6975 januschan@hsbc.com.hk
Hong Kong SAR: the essentials
We expect a fully fledged rebound in growth in 2010, and raise our 2010 GDP forecast to 3.8% y-o-y from 2.4%
Riding on regional recovery Hong Kongs economy has rebounded faster than we thought. In Q2 real GDP gained 3.3% (sa) from Q1. On a yearly basis, it contracted 3.8% in Q2 after recording -7.8% in the previous quarter. There are still some overhangs but we expect a fully fledged recovery in 2010. As well as raising our G3 forecast, we are also increasing our 2010 GDP estimate for Hong Kong to 3.8% from 2.4%. In Q2 consumer confidence rose a significant 12% q-o-q, due, in part, to global asset market strength and slower-than-expected job cuts in the local market. Private consumption thus rose 4% (sa) from Q1. Although we have not yet seen any net increase in jobs, we now expect the jobless rate to peak at 6.2%, versus 6.7% previously, in Q1 2010. We therefore only expect private consumption to improve at a faster pace next year. Q3 2008 GDP (% y-o-y) 1.5 Industrial production (% y-o-y) -7.0 CPI, end quarter (% y-o-y) 3.1 PPI, end quarter (% y-o-y) 5.4 Trade balance (% GDP) -9.6 Goods and services balance (% GDP) 13.2 International reserves (USDbn) 160.6 Policy rate, end quarter (%) 3.5 5-yr yield, end quarter (%) 2.6 HKD/USD, end quarter 7.80 HKD/EUR, end quarter 11.08 Q4 2008 -2.6 -10.6 2.0 3.8 -7.0 15.8 182.5 0.5 1.2 7.80 10.84 Q1 2009 -7.8 -10.2 2.0 -1.4 -9.1 10.6 186.3 0.5 1.6 7.75 10.23 Merchandise trade also surprised us in Q2 by recording export growth of 11% (sa) q-o-q. This was better than Chinas export performance, which still posted negative growth. Hong Kongs export strength was achieved thanks to strong public investment in China, which imported 16% more goods than in the previous quarter. We now expect growth prospects for Hong Kongs exports to improve as the G3 countries are expected to recover at a quicker pace. Private investment is still the biggest hindrance, having posted a largerthan-expected contraction in Q2. While banks have eased their lending criteria, corporate lending remains subdued. We believe companies are still reluctant to expand until they see a meaningful improvement in the global economy. -3.8 -9.5 -0.5 -2.9 -10.0 7.7 207.0 0.5 2.1 7.75 10.85 -3.1 -8.0 0.5 -2.0 -7.1 13.3 230.0 0.5 1.9 7.80 11.31 -1.1 -6.5 1.8 -1.3 -7.5 14.1 245.0 0.5 1.5 7.80 11.70 4.0 2.3 2.1 0.3 -8.9 11.1 246.0 0.5 1.5 7.80 11.70 3.5 0.8 3.3 1.1 -9.5 9.0 245.0 0.5 1.5 7.80 11.70 3.7 1.3 2.5 1.6 -6.4 14.5 245.0 0.5 1.5 7.80 11.70 3.9 1.5 1.2 1.8 -6.9 15.2 247.0 0.5 1.5 7.80 11.70
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
Deflation will not be long lasting Hong Kongs headline inflation continues to be affected by fiscal measures. Average headline CPI rose 0.5% y-o-y and underlying CPI rose 1.8% y-o-y in the first seven months of the year. Hong Kong entered a deflationary phase from July 2009 based on underlying CPI, which is in line with the economic contraction in Q1-Q2 2009. While general prices are still under downward pressure from the contracting economy, the quicker-than-expected rebound in economic growth could give some support. In addition, the property market rally since February 2009 reversed the fall in the property rental index in April. As there is a time lag before this passes through into the housing CPI, housing prices are likely to stop falling in Q4 this year. Therefore, unlike in 1998-04, this time around we expect deflation to be short-lived. Activity & inflation
8 4 (% y-o-y) 0 2 -4 -8 -12 2Q07 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e GDP (LHS) Industrial grow th (LHS) CPI (RHS) 0 -2 6 4 (% y-o-y)
HIBOR stays low As the credit situation has eased globally, capital has continued to flow into Hong Kong this year. The HKMA injected another HKD256bn between March and 16 September of this year, pushing the aggregate balance (i.e. banks clearing account balance with the HKMA) to a new high of HKD234bn in early August 2009. It has since slid back slightly to the current level of HKD190bn amid the issuance of additional exchange fund bills. The ample liquidity has pushed all tenors of HIBOR to below 1%. However, capital inflows have slowed in September and this has led to a narrowing of the interest rate spread between HIBOR and USD LIBOR. Nevertheless, we expect liquidity to remain ample as we believe monetary easing is likely to continue at least through year end. Policy stance
10 (% GDP, 4qma) 7 4 1 -2 -5 4Q07 4Q08 Fiscal balance (LHS) CPI, % y -o-y (RHS) 4Q09e 4Q10e 8 6 4 2 0 -2 -4 -6
Policy rate (RHS)
72
(%)
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Hong Kong SAR: at a glance

1 0 (%) -1 -2 -3 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M s pread ov er US-Libor 2y r spread ov er US-Lib or

3.0 2.0 (%) 1.0 0.0 -1.0 3M -2.0 Now + 4 months - 4 months Current CPI 6M 1yr 2yr 3yr 4yr 5yr 7y r 10yr

7.90 7.85 7.80 7.75 7.70 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e HKD v s USD (LHS) Annualised volatility (RHS) 1.9 1.4 0.9 0.4 -0.1 (%)

800 (spr ead bps) 600 400 200 0
-200
1/05
5/05
9/05
1/06
5/06
Hong Kong 5yr Govt. Hong Kong HSBC av. spread
1/07 9/06
5/07
9/07
1/08
5/08
9/08
1/09
5/09
9/09

210 180 150 120 90 60 30 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definiti on (LHS) Short-te rm debt % reserv es (RHS) 80
Policy dynamics
2007 2.0 1.0 (real rates) 0.0 2011e 2008 10.0 5.0 0.0 2010e -1.0 2009e -2.0 -5.0
(% of reserves)
(USD bn)
70 60 50 40

1200 0 1000 0
(ind ex)
10 00 80 0 60 0 40 0 20 0 0 1/ 05 7 /05 1/ 06 7/ 06 1 /07 7/ 07 1/0 8 7/ 08 1/ 09 7/ 09 M SCI Hong Kong sub-index (LHS) Ho ng Kong HS BC av . s pread
(spread bps)
8 00 0 6 00 0 4 00 0 2 00 0 0
73
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Hong Kong SAR: local knowledge/global drivers

Hong Kong has emerged from the recession but has yet to fully recover
Retail sales contraction to ease HKs retail sales fell 4.6% y-o-y in JanuaryJuly 2009. While this was partly due to the drop in tourist arrivals (-4.9% y-o-y for that period), it was also driven by a y-o-y fall in private consumption. Nevertheless, consumer confidence returned quickly in response to asset market rallies as well as slower-than-expected job cuts. As a result, private consumption posted sequential growth in Q2 09. While we believe the worst is over, we expect the unemployment rate to remain the major overhang given the absence of a broadly-based increase in jobs. The contraction in tourist arrivals could ease in the coming months as: 1) the global economy has already bottomed out; 2) business travel is resuming (though still below normal levels); and 3) concern about swine flu has abated. Retail sales growth improving
% y-o-y, 3mma 20 15 10 5 0 -5 -10 -15 Sep-05 May-05 May-07 Sep-08 Jan-06 Sep-07 Sep-06 May-09 May-06 Jan-09 Jan-05 Jan-07 Jan-08 May-08
Exports to record positive growth in 2010 HKs export growth has rebounded quickly from the historical low (since the 1960s) of -23% y-o-y in February 2009. For JanuaryJuly, exports contracted 17.7% y-o-y. The rebound has been better than that of the overall region owing to Chinas strong external demand for capital goods, given that HK is still the major entreport for China. We expect HKs export growth to continue improving on a sequential basis. The outlook for the global economy has improved following the better-than-expected GDP growth recorded in Q2 of this year. Having raised our G3 GDP growth forecast, we now also expect HKs exports to respond and record positive growth in 2010. Exports are clawing back
% y-o-y, 3mma 24 18 12 6 0 -6 -12 -18 -24 Jan-06 Jul-07 Jul-05 Jan-05 Jan-07 Jan-08 Jan-09
Jan-09 May-09
Retail sales val
Reta il sales vol
Imports
Exports
Fixed investment not ready to fly Fixed investment has contracted for three quarters in a row since Q4 2008, mainly owing to sluggish private investment. While banks lending criteria have eased, corporate debt only marginally reversed its decline in Q209, inching up 0.4% q-o-q (sa). This was mainly due to the lack of investment incentives as the outlook for the global economy remains uncertain. By contrast, the governments spending on public projects has increased on the back of the fiscal stimulus plan announced late last year. Pre-construction work for the 10 major public infrastructure projects has also boosted public spending on building and construction. Nevertheless, this is still too small to fully offset the decline in private investment. Strong public investment
4% 2% 0% -2% -4% -6% 98 99 00 01 02 03 04 05 06 07 08 09 20% 10% 0% -10% -20% -30%
Higher upside risk on mortgage rate with slower capital inflow HKD M1 rose significantly, by 35.5% y-o-y in July 2009, on strong capital inflows. Nevertheless, slow lending activity (HKD loans fell 2.4% in July 2009) has caused HKD M3 growth to lag, at 13.8% for the same time period. As a result, the HKD loan-to-deposit ratio fell 13pp from the August 2008 high to 71% in July 2009. While loan growth to both corporates and individuals was still negative, new mortgage approvals have increased m-o-m since January 2009 in the context of a rebounding property market and low interest rates. We believe the downside potential for the mortgage rate is limited, but that there are some upside risks on capital inflows. This is mainly attributable to the smaller quantitative easing measures, despite our belief that monetary easing will continue this year. Property price vs HKD M3 growth
%y-o-y 45 35 25 15 5 -5 -15 -25 Jan-05 Jan-06 May-06 Jan-07 May-07 Sep-07 Jan-08 May-08 May-05 Sep-08 Sep-05 Sep-06 % y -o-y 35 25 15 5 -5 -15
Publi c B&C contribution (LHS)
Real GF CF grow th (RHS)
HKD M3 (LHS)
Property price (RHS)
74
Jul-09
Jul-06
Jul-08
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Hong Kong SAR: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) HKD/USD, end-year HKD/USD, average HKD/EUR, end-year HKD/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Goods and services balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Consolidated government balance (% GDP) Gross public* domestic debt (HKDbn) Gross public* domestic debt (% GDP) Gross public* external debt (USDbn) Gross public* external debt (% GDP)
Note: * Public debt refers to government debt only
2005 7.1 177.8 25,629 3.0 -3.2 4.1 2.5 33.3 5.2 0.9 1.4 1.0 2.6 7.4 6.9 5.7 4.1 7.75 7.77 9.15 9.68 288.7 296.3 -7.6 22.1 12.4 6.4 3.6 16.0 11.1 10.1 124.3 5.0 531.4 43.0 1.0 1.6 0.9 1.6 0.9
2006 7.0 189.9 25,630 5.9 0.2 7.1 2.2 33.3 4.4 2.0 2.3 2.1 1.3 12.7 6.9 6.8 3.7 7.77 7.77 9.69 9.67 316.3 330.3 -14.0 21.7 11.4 0.1 0.0 11.4 9.6 11.5 133.2 4.8 603.9 52.0 4.0 1.6 0.9 1.6 0.9
2007 6.4 207.0 25,630 8.5 3.0 3.4 -1.5 31.0 3.4 2.0 3.8 4.2 0.2 18.4 13.2 5.7 3.1 7.80 7.80 10.30 9.80 346.0 365.7 -19.7 22.4 10.8 -6.7 -3.3 7.6 9.4 10.7 152.7 5.0 789.1 83.0 7.7 N/A N/A N/A N/A
2008 2.4 215.7 25,631 1.7 1.8 0.0 -6.6 30.4 4.1 4.3 2.1 3.8 3.7 7.0 12.5 0.5 1.2 7.75 7.78 10.84 10.82 364.6 387.7 -23.1 23.5 10.9 3.1 1.4 12.3 5.4 6.0 182.5 5.6 864.0 47.6 0.1 N/A N/A N/A N/A
2009e -4.0 209.2 28,812 -1.0 1.8 -8.3 -8.5 30.3 6.0 0.6 1.8 -1.3 1.0 7.7 -1.6 0.5 1.5 7.80 7.78 11.70 11.32 319.3 336.8 -17.5 24.1 11.5 6.0 2.9 14.4 -12.7 -13.3 245.0 8.7 870.0 40.0 -3.9 N/A N/A N/A N/A
2010e 3.8 219.5 29,647 2.1 1.5 5.0 1.5 30.6 6.0 2.3 1.2 1.8 3.3 27.0 8.4 0.5 1.5 7.80 7.80 11.70 11.28 346.6 363.9 -17.3 27.5 12.5 8.0 3.6 16.2 8.8 8.3 247.0 8.1 900.0 45.0 -1.2 N/A N/A N/A N/A
2011e 4.3 233.6 30,627 3.0 1.3 6.0 2.3 32.6 5.4 3.0 3.2 1.9 3.5 15.8 16.0 0.5 2.0 7.80 7.80 11.70 11.70 379.5 397.7 -18.2 30.9 13.2 10.0 4.3 17.5 9.5 9.3 250.0 7.5 950.0 50.0 2.5 N/A N/A N/A N/A
8.5 165.9 24,093 7.0 0.7 2.7 2.9 30.2 6.6 -0.4 0.3 1.4 -2.5 7.8 2.4 3.8 2.7 7.78 7.79 10.57 9.69 259.9 269.2 -9.3 14.7 8.9 -11.7 -7.0 1.8 15.9 17.0 123.6 5.5 529.4 29.0 1.7 1.7 1.0 1.6 1.0
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Juliet Sampson +44 20 7991 15657 juliet.sampson@hsbcib.com Kubilay Ozturk: +44 20 7991 360 kubilay.ozturk@hsbcib.com
Hungary: the essentials

With a return in risk appetite and a bottoming of the economic downturn, Hungary is pulling back from the brink. IMF funding has been essential, but it may not be long before it is no longer necessary
Back from the brink The Hungarian economy declined steeply in the first half of 2009 as consumption and investment collapsed, and industrial activity and exports plummeted. However, from recent data it is appears likely that the worst is over and recovery is on the way. While recovery is set to be gradual, growth may turn positive by H2 2010. In the meantime, the economy has adjusted considerably over the past year. The trade and current account deficits have narrowed sharply as a fall in exports has been far outpaced by declining imports, and the income deficit has narrowed. While a decline in the forint has helped in this adjustment, the HUF proved a primary concern with regard to financial stability, losing one-third of its value in the six months to early March, forcing the NBH to maintain sub-optimally high interest rates through July. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) HUF/USD, end quarter HUF/EUR, end quarter 1.3 -2.8 5.7 4.7 -1.7 -8.9 24.7 8.5 9.3 171.84 242.15 Q4 2008 -2.5 -13.1 3.5 5.7 -0.5 -9.3 33.6 10.0 9.4 189.73 265.62 Q1 2009 -6.7 -21.3 2.9 9.1 3.3 -2.9 36.8 9.5 13.0 232.51 337.14 A recovery of the HUF in Q2 has allowed the NBH to resume the easing cycle, which started with an aggressive 100bp cut in July and is set to continue apace in the months ahead, assuming risk appetite remains relatively firm. Inflation has risen following a July VAT hike, but far less than expected. As a stipulation of its IMF programme, budget spending has remained exceedingly tight. Fiscal reforms brought in under the Bajnai government, which will serve until parliamentary elections next year, have addressed pensions, local government financing and social transfers, and should ensure tighter budgets are set to stay. As a result, the IMF has been complimentary of Hungarys efforts, and is due to complete its third disbursement in late September. Hungary was able to return to capital markets in July. -7.5 -20.9 3.7 6.6 6.3 -5.8 32.0 9.5 9.8 194.05 272.18 -5.8 -18.1 5.3 4.2 2.2 -4.0 33.5 7.5 7.6 182.76 265.00 -3.5 -6.7 5.7 1.9 1.6 -5.0 33.0 6.0 7.5 175.68 260.00 -2.5 0.4 4.8 -3.6 4.0 -4.9 32.0 5.5 7.4 170.00 255.00 -1.0 3.4 2.9 1.6 8.2 -4.9 30.0 4.5 7.0 170.00 255.00 0.1 3.5 1.5 2.5 2.2 -6.4 32.0 4.5 6.8 166.67 250.00 1.1 5.0 1.3 2.7 0.8 -6.4 34.0 4.5 6.2 163.33 245.00
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
The worst is probably over, but recovery is set to be slow and weak Economic activity in Hungary is, to a large extent, dependent on exports to the rest of Europe and recovery cannot pick up momentum until exports are on firmer footing. The same can be said for household consumption, which is of primary importance in the composition of GDP. Both appear to have bottomed in Q1 2009 and contraction slowed in Q2 2009. We expect further improvement but a stronger recovery into positive growth still appears to be three to four quarters off. High interest rates and fiscal austerity measures have contributed to this delay and the export performance in the next few months will also be critical. However, the worst-case scenarios of complete economic collapse now appear unlikely. Activity & inflation
10 5 0 -5 -10 -15 -20 -25 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e CPI (RHS) 8 6 (% y-o-y) 4 2 0
Monetary policy is set to loosen gradually markets permitting Weak domestic and foreign demand, in conjunction with falling food and utility prices has put considerable downward pressure on inflation in recent months. However, a VAT hike (from 20% to 25%) from July increased the CPI to 5.1% in July from 3.7% in June. In the event, the impact of the tax hike was weaker than expected. As a result, the headline rate is likely to peak below 6% at year-end, and to fall sharply, probably below 2%, by mid-2010. Underlying inflation now appears very weak. Meanwhile, financial stability risks have fallen sharply since June, permitting the NBH to resume easing, starting with an aggressive 100bp cut in July. We expect continued gradual easing in the months ahead barring a deep or extended return of risk aversion. Policy stance
0 10 8 4 2 0 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e 6
(% GDP, 4 qma)
-2 -4 -6 -8 -10
(% y-o-y)
GDP (LHS)
Industrial growth (LHS)
Policy rate (RHS)
76
(%)
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Hungary: at a glance

14 12 10 (%)

11 10 9 8 7 6 5 3m 6m 1y r 3y r 5y r 10y r
- 4 months Current CPI
6 4 2 0 8/06 12/06 4/07 8/07 12/07 4/08 8/08 12/08 4/09 8/09
(%)
15y r
3M spread ov er Euribor
3yr spread ov er Euribor
Now +4 months

320 300 280 260 240 220 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e HUF vs EUR (LHS) Annualised volatility (RHS) 30 24 (%) 18 12 6 0

180 160 (%) 140 120 100 80 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate vs EUR Cumula tive CPI Cumula tive PPI 09

40 35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Internatio nal reserves, IFI defi nition (LHS) Short-term debt % reserves (RHS) 140 120 100 80 60 40 20
Policy Dynamics
8.0 2008 6.0 (real rates) 4.0 2.0 0.0 -2.5 -3.5
(% of r eser ves)
(USD bn)
2010e 2011e 2009e -4.5 2007 -5.5

1400 1200 1000 8 00 6 00 4 00 2 00 0 1/0 5 7/ 05 1/ 06 7 /0 6 1/ 07 7/ 07 1/ 08 7 /08 1/ 09 7/ 09 M SC I Hu nga ry s ub-inde x (L HS) EM B I Hungary s ub-index (R HS) 7 00 6 00 5 00 4 00 3 00 2 00 1 00 0

1200 1000 800 600 400 200 0
(spread bps)
(spread bps)
(ind ex)
1/05
5/05
9/05
1/06
9/06 5/06
Hungary 5y r Gov t. EMBI Hungary sub-index
1/07
5/07
1/08 9/07
5/08
1/09 9/08
5/09
9/09
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Hungary: local knowledge/global drivers

Hungary was Central Europes weak link heading into the global financial crisis; but it should emerge from it more fiscally fit and chastened by its brush with catastrophe
Fiscal reform has the IMF seal of approval The Bajnai government has implemented a series of reforms to permanently reduce government expenditure by cutting 13th month wage and pension bonuses, and local government expenditure. It raised the retirement age to 65 from 62 starting from 2012. It also introduced a pension link to GDP growth, and reductions in disability benefits. Housing subsidies are suspended for all but the most needy and utilities subsidies will be gradually eliminated. Excise and VAT taxes are raised, while income tax brackets have been adjusted so that more than 90% of tax payers fall into the lower tax bracket (which was raised). Employers contributions were cut by 5ppt. Restructuring is aimed at raising the rate of employment and improving competitiveness over the long term. Hungary may emerge from the crisis more fiscally fit
0
Recovery in exports appears weak so far With exports equating to over two-thirds of GDP, and most of those exports headed elsewhere in Europe, Hungarys recovery is greatly dependent on a return to heath of in western Europe. The collapse in exports bottomed in Q1 with a 30% y-o-y decline, while imports continued to decline further into Q2 as demand plummeted. However, while the fall in exports slowed in Q2 to around 25%, it has showed no sign of gaining momentum into Q3. While signs of a stronger recovery in Germany and France are heartening, there is as yet some downside risk associated with the phasing out of car-scrapping schemes in Western Europe. The upside to this is a sharp narrowing in the trade and current account deficits helped, not least, by a weaker HUF. Weak domestic demand suggests a growing trade surplus
3 2 1 0 -1 -2 -3 -4 -5 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 T rade balance (LHS) Exports Imports 24 16 8 0 -8 -16 -24 -32 -40
12m cum., EUR bn
-2 -4 -6 -8 Forecast -10 04 05 06 07 08 2009e 2010e 2011e
General government defic it (% of GDP)
Financial stability improves Hungarys IMF programme did much to stabilise the forint and prevent economic crisis from turning into disaster. But it is the improvement in investor risk appetite that has made the improvement in financial stability more lasting. It is now clear that foreign parent banks have continued to lend to their subsidiaries, keeping open a key source of external financing. Meanwhile, with Hungarys issuance of a EUR1bn Eurobond and increased international demand for domestic debt, Hungarys access to alternative sources of capital has also improved. At the same time, an austerity budget and a sharp narrowing in the current account deficit have cut capital requirements. As further stabilisation of the twin deficits is likely in the future, vulnerability to shocks is set to improve further. Improved risk appetite has permitted rate cuts
700 600 500 400 300 200 100 0 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 13
Economic weakness leaves the next government little flexibility With the Socialists lagging well behind Fidesz in the polls, and widespread disillusionment with the party after the events of recent years, there is little chance the Socialists can pull off another last minute win and nearly certain that Fidesz will win a ruling majority in parliament. While the smaller MDF and SzDSz parties may lose parliamentary representation, the new far right Jobbik party made a strong showing in the EP elections and is likely to gain a handful of seats. Fidesz currently supports tax cuts and a reversal of some of the Socialists fiscal reforms (like property tax). However, these may be empty promises: any policies it implements that threaten relations with the IMF or cause deterioration in the fiscal outlook are likely to backfire and risk a swift reaction from markets. Socialists (MSZP) lag well behind Fidesz in the polls
50 (average of pools, % of total) 40 30 20 10 0 May -06 Oct-06 Mar-07 Aug-07 Jan-08 Jun-08
FIDESZ SzDSz
12 11 10 9 8 7 6
Nov -08
Apr-09
MSZP (Soc ialists)
5yr CDS spread (EUR)
NBH polic y rate (RHS)
Jobbik MDF
78
y-o-y %, 3mma
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Hungary: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) HUF/USD, end-year HUF/USD, average HUF/EUR, end-year HUF/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (HUFbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 4.7 102.3 10,127 3.2 -0.0 7.7 8.3 13.8 6.3 6.8 5.4 1.6 6.2 11.6 21.6 9.5 7.9 180.92 202.37 245.22 251.51 54.8 58.6 -3.8 -8.9 -8.7 1.4 1.4 -7.2 29.0 25.1 15.3 3.1 19.2 75.1 65.3 24.0 -6.5 -4.3 -2.1 8,608.8 41.6 31.9 31.2 72.8
2005 3.9 110.1 10,940 3.8 0.2 5.6 7.0 16.1 7.3 3.6 3.2 4.7 8.7 14.6 21.1 6.0 7.0 213.22 199.71 252.65 248.52 62.2 65.8 -3.6 -8.1 -7.3 7.0 6.4 -1.0 13.5 12.2 18.3 3.3 22.4 78.6 65.1 24.4 -7.8 -2.5 -3.7 9,153.5 41.6 33.5 30.4 72.0
2006 4.0 112.1 11,164 1.3 4.4 -3.2 10.6 13.8 7.5 3.9 6.4 4.5 8.2 16.2 15.0 8.0 7.2 190.30 212.00 251.18 266.40 73.5 76.5 -3.0 -8.7 -7.8 4.1 3.7 -4.1 18.2 16.3 21.3 3.3 32.6 107.2 65.2 36.0 -9.1 -8.1 -5.3 10,552.3 44.4 34.8 31.0 75.4
2007 1.2 139.7 13,922 -1.8 -2.2 1.5 8.5 14.4 7.7 8.0 7.4 0.1 8.0 9.8 14.5 7.5 7.4 173.31 182.42 253.04 250.07 95.1 95.2 -0.2 -9.2 -6.6 1.5 1.1 -5.5 29.3 24.5 23.8 3.0 45.6 144.6 89.9 43.0 -4.9 -5.5 -1.4 11,103.8 43.6 41.9 30.0 73.6
2008 0.6 146.2 14,585 -0.1 -2.1 -2.6 4.9 11.0 7.8 6.1 3.5 5.7 7.9 11.1 11.5 10.0 9.4 189.73 182.14 265.62 245.00 102.7 103.2 -0.4 -13.1 -9.0 5.0 3.4 -5.6 8.0 8.3 33.6 3.9 59.4 168.2 76.2 48.0 -3.3 -3.2 0.9 11,250.6 42.3 44.6 30.5 72.8
2009e -5.9 139.0 13,887 -6.5 -1.2 -6.1 -16.8 16.5 10.5 4.3 5.7 1.9 1.0 7.8 3.5 6.0 7.5 175.68 188.03 260.00 278.28 80.7 76.7 3.9 -5.5 -4.0 3.0 2.1 -1.8 -21.5 -25.6 33.0 5.2 58.2 172.8 71.1 50.0 -4.0 -4.0 1.1 10,969.3 42.0 50.1 36.0 78.0
2010e -0.6 158.8 15,885 -1.8 -0.5 0.0 3.1 16.0 11.2 2.9 1.3 2.7 2.5 8.7 5.2 4.5 6.2 163.33 168.33 245.00 252.50 96.4 89.1 7.3 -7.7 -4.8 3.8 2.4 -2.5 19.5 16.2 34.0 4.6 59.1 183.0 74.4 53.0 -4.0 -3.9 1.9 11,210.7 41.9 60.4 38.1 80.0
2011e 3.5 170.5 17,065 3.0 0.0 1.5 4.6 17.3 10.3 2.0 2.0 4.1 3.5 9.5 7.5 4.0 6.0 162.07 165.52 235.00 240.00 106.9 98.8 8.1 -6.0 -3.5 3.5 2.1 -1.5 10.9 10.9 25.0 3.0 67.9 190.0 98.0 57.0 -3.5 -3.5 2.1 11,771.2 41.7 58.4 34.3 76.0
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Robert Prior-Wandesforde: +65 62 390 840 robert.prior-wandesforde@hsbc.com.sg Prithviraj Srinivas (Economics Associate)
India: the essentials
Recovery is well under way and we continue to expect 6.2% growth in FY2009-10 and 8% in FY2010-11.
Our core assumptions about the economy remain solid We have held on to our 6.2% FY10 growth forecast since the beginning of this year and over this time been very bearish against consensus, well above consensus and now roughly in line with consensus. We have also kept our 8% 2010/11 projection, where we remain amongst the most optimistic, although the gap is narrowing. Our core assumptions regarding the drivers for growth still hold good: 1) the benchmark PLR has fallen 240bps so far in response to a 425bps repo rate cut by the RBI since Sept 2008; we still believe that the full impact from the monetary easing is yet to come through to the economy; 2) the Government announced an expansionary budget in July, which will put more spending power in the hands of the rural and urban poor ; 3) external trade is showing signs of improvement with 3m/3m seasonally adjusted export growth registering double digits in June and July; Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) WPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) INR/USD, end quarter INR/EUR, end quarter 7.7 4.7 9.8 12.3 -13.6 -4.4 277.3 9.0 8.6 47.00 66.74 Q4 2008 5.8 0.8 9.7 6.2 -11.8 -4.4 246.6 6.5 5.3 48.70 67.69 Q1 2009 5.8 0.5 8.0 1.2 -5.2 1.7 241.4 5.0 6.7 50.70 66.92 Locally driven demand 4) Although a bit delayed, higher oil and gas output will play a vital role in boosting power generation in an energy starved nation; spill over effects from this sector has economy-wide significance. Cairns oil well in the north-west has already started production with a capacity equal to 25% of the countrys crude oil demand. FY10 Q1 GDP readings showed strong growth in industrial output, despite a smaller role played by the state. Services held up well but provided a mixed bag, transport and communications strengthened to register 8.1% yo-y growth but growth in financial services and social services softened. More recently, indicators such as auto sales, industrial production and freight traffic have continued to improve pointing to an on-going robust recovery, which we doubt the drought will de-rail (see later section).
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e 6.1 3.9 9.3 -1.0 -5.8 1.1 254.1 4.7 7.0 47.90 67.06 6.0 6.5 11.8 2.0 -11.1 -3.8 251.4 4.7 6.0 48.60 70.47 6.7 9.6 12.3 6.0 -10.7 -4.3 246.0 4.7 6.3 48.0 72.00 6.1 9.4 12.0 8.0 -5.0 0.8 258.4 4.7 6.5 48.0 72.00 6.8 9.6 9.7 7.2 -5.7 0.8 270.1 5.0 6.8 47.5 71.25 7.5 8.4 7.5 6.8 -11.3 -4.0 266.1 5.2 7.0 47.0 70.50 8.5 8.6 6.5 6.3 -11.0 -4.4 257.5 5.5 7.3 46.5 69.75
RBI Governor has turned more hawkish The Reserve Bank of India (RBI) left policy rates unchanged at its last policy meeting in July. We are now seeing the RBI governor take a more hawkish tone in his speeches, but we dont really see the benefit of raising rates at this stage (more on this later). The main reason for the change in tone is likely to be the persistence of CPI inflation which has proved surprisingly stubborn. Inflation in food items, a key element of the CPI basket, has seen particularly strong increases. From our earlier study we find that despite a decline in international food commodity prices, food prices in the domestic market did not witness such a drastic decline mainly on account of supply side issues. Drought effects from a poor monsoon will also add to inflation concerns. Activity & inflation
12 10 8 6 4 2 0 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) (% y-o -y) 15
Populist budget The Finance Minister announced a record budget, stepping up expenditure by 36% over the previous fiscal year. The plan was expansionary and populist, designed mainly to appeal to the rural voters on whose support the election was won. As a result, and in view of the economic slowdown, the budget requires unprecedented levels of funding which the governments latest estimates put at USD 93 billion in total for FY10. The government is already half way through its borrowing program and the strong supply has pushed up treasury yields. The government will expect the RBI to wait until growth is firmly on track before making any policy move. Our own assessment is inclined towards a rate hike in April 2010. Policy stance
0 (% GD P, 4qma) -2 -4 -6 -8 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e Policy rate (R HS) 15 12 6 3 0 (%) 9
12
(% y-o-y)
9 6 3 0
GDP (LHS)
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India: at a glance

10 8 (%)

9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 3M 6M 1yr N ow +4 months 2yr 3yr 5yr 7yr 10yr -4 months Current CPI
4 2 0 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M spread over US-Libor 2y r spread ov er US-Lib or

55 50 45 40 35 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e INR vs USD (LHS) Annualised vola tility (RHS) 5 0 15 10 (%)

180 (%) 160 140 120 100 80 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD C umulative CPI C umulative PPI 09

350 300 250 200 150 100 50 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definitio n (LHS) Short-term debt % reserves (RHS) 50
Policy dynamics
4.0 2.0 (real rates) 0.0 2010e 2008 2009e -2.0 -4.0 -6.0 -8.0 -10.0 0.0 -5.0 -10.0 (consolidated govt balance % GDP) -15.0 2007 2011e
40 30 20 10 0

800 600 (ind ex) 400 200 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI India sub-index (LHS) India HSBC av. spread 2500 (spread bp s)
(USD bn)

2100 1800 1500 1200 900 600 300 0
1500 1000 500 0
(spread bps)
2000
(%)
(% of r eserves)
1/05
5/05
9/05
1/06
9/06 5/06
India 5yr Govt. India HSBC av . spread
1/07
5/07
1/08 9/07
5/08
1/09 9/08
5/09
9/09
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India: local knowledge/global drivers

Yes, recovery is on track but can it move ahead without fiscal / monetary support? There are some risks to the positive outlook still, but we think that the current level of stimulus support is sufficient to avoid any downside.
Drought This year the monsoon rains, on which more than 50% of agricultural land rely on for irrigation, was the poorest in seven years. Indias agricultural output accounts for less than 20% of GDP but, nearly 60% of its population depend on the land for their livelihood. Lower farm incomes would mean that the government will have to compensate with larger subsidies or employment programmes, stretching its finances further. Although the country has a larger area under cultivation now and better irrigation facilities than it did some decades ago, we are still likely to see price rises on account of the drought. We expect WPI inflation, which is currently just above zero, to reach 8% by fiscal year end. negative for agriculture growth
% Yr 20
15 60 40 20 0 00 01 02 03 04 05 06 07 08 09 -20 -40 Food CPI* (LHS) Food commod. Price** (RHS)
Squeezing real purchasing power The more widely followed measure of inflation in India, the Wholesale Price Index (WPI), is likely to see a broad based pick up over coming months. The up coming turn in energy and metal price inflation will have powerful effects as will sharp rises in food and food based manufactured products , recent WPI readings (5 Sept) showed inflation for fruits & vegetables (+24.1% y-o-y) and meat (+14.4% y-o-y), for example, picking up sharply. The strength in food price inflation largely reflects supply, rather than demand side pressures making an interest rate response harder to justify. An early rate move would risk spooking the markets and putting an end to any further reductions in commercial bank interest rates. as CPI inflation remains stubborn
20 % Yr % Yr 80
Ag ricultur e rea l GD P gro w th
10
10
0
5
-10
0
-20 F Y 73 F Y 08 FY 52 FY 87 FY 01 FY 59 FY 66 FY 80 FY 94
-5 -10
Grey : Drou ght period s
Hoping for a pick up in private credit growth Non-food credit growth was 14.1% in the year to end of August - the weakest rate since 2002.The banking system though, is awash with liquidity with the overnight interbank continually at the bottom of the RBIs interest rate band. Commercial banks have been using the excess fund either to lend back to the RBI or buy government bonds; in fact so much so that most banks have reached the limit set by the regulator (RBI). More lending to the government from here on will mean mark-to-market rules apply on these purchases which banks might be unwilling to take. Some hope of improvement has been provided by several banks who have pointed to a pick-up in loan enquiries, particularly on the retail side, but it is yet to be seen if these will translate into actual loans. ample liquidity in the system
20 18 16 14 12 10 8 6 4 2
%
Fiscal situation Faced with a massive fiscal deficit, currently budgeted at 6.8% of GDP, the government is attempting an austerity drive to control costs. However, the drought will probably put upward pressure on spending by way of an increase in fuel/fertiliser subsidies as well as the purchase of food products at higher prices to support farm incomes. We still expect the central government fiscal deficit to reach 6.9% of GDP in 2009/10, with the general government shortfall hitting 11.5% of GDP. The structural deficit also continues to expand, as the Congress Party attempts to build the basics of a welfare state, and will need to be tackled in due course. As in the past, our fear is that infrastructure spending will be compressed to keep a lid on the deficit. It still seems unlikely that the government is prepared to expand the tax net significantly although it has at least promised to clamp down hard on tax evasion. requires prudence
0% -2% -4% -6% -8% 98 98 99 00 01 01 02 03 04 04 05 06 07 07 08 09
Jan-08 Apr-08 Jul-08 Oc t- 08 J an-09 Apr-09 Jul-09 Ov ernight IB* rate Reverse repo Repo
Central Govt Fiscal deficit as a % of Markt GDP
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India: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) WPI, end-year (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) INR/USD, end-year INR/USD, average INR/EUR, end-year INR/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP)
Note: Data pertains to fiscal year starting April
2005 9.5 784.7 727 7.1 6.2 17.6 8.2 35.1 4.0 5.3 4.4 16.1 19.9 6.3 6.7 45.1 44.1 53.14 54.9 102.2 149.4 -47.3 -14.7 -1.9 4.6 0.6 -1.3 31.1 41.0 131.0 10.5 162.8 138.1 6.6 -9.2 -4.2 -0.7
2006 9.7 877.3 800 6.3 5.5 14.5 11.5 37.0 6.3 6.7 5.7 19.6 18.4 7.3 7.5 44.3 45.2 58.42 56.8 123.8 184.9 -61.2 -9.3 -1.1 6.0 0.7 -0.4 21.1 23.8 170.2 11.0 209.5 171.3 7.0 -7.0 -3.6 -0.1
2007 9.0 1,114.8 1,001 8.5 7.4 12.9 8.5 38.1 6.4 5.5 3.8 21.8 15.6 7.8 7.7 39.4 40.9 57.52 56.8 149.3 231.0 -81.7 -11.3 -1.0 7.8 0.7 -0.3 20.6 24.9 266.6 13.8 324.3 224.6 16.4 -6.5 -2.8 -0.1
2008 6.7 1,175.1 1,039 2.9 20.2 8.2 2.6 36.3 8.3 9.7 6.2 20.3 14.1 6.5 5.3 48.7 44.7 67.69 65.1 187.9 315.1 -127.2 -36.1 -3.1 22.8 1.9 -1.1 25.9 36.4 246.6 9.4 265.4 229.9 19.5 -9.8 -6.3 -3.0
2009e 6.2 1,160.1 1,010 5.0 12.0 6.0 5.0 38.5 10.5 12.3 6.0 19.0 8.0 4.8 6.3 48.0 48.8 72.00 70.6 157.0 253.2 -96.2 -17.0 -1.5 10.7 0.9 -0.5 -16.4 -19.6 246.0 11.7 270.0 235.0 16.3 -11.5 -6.9 -4.5
2010e 8.0 1,364.3 1,170 8.0 5.0 11.0 9.0 39.0 9.6 6.5 6.3 19.0 12.0 5.5 7.3 46.5 47.4 69.75 71.2 175.9 290.4 -114.5 -25.1 -1.8 17.5 1.3 -0.6 12.0 14.7 257.5 10.6 300.0 250.0 17.1 -10.0 -5.8 -3.5
2011e 8.5 1,624.7 1,371 8.3 2.0 12.5 7.7 39.5 6.0 6.4 5.0 19.0 15.0 6.8 8.0 44.5 45.5 66.75 68.3 196.4 326.2 -129.8 -26.6 -1.6 30.5 1.9 0.2 11.6 12.3 271.5 10.0 320.0 270.0 18.4 -8.5 -4.9 -2.5
7.5 677.4 638 5.2 3.6 18.9 8.4 33.8 3.9 4.6 6.7 14.1 25.0 6.0 6.4 43.5 44.8 57.70 55.5 77.9 106.0 -28.0 0.8 0.1 3.6 0.5 0.6 28.0 40.3 125.2 14.2 148.4 133.0 6.0 -9.0 -4.1 -0.5
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Robert Prior Wandesforde : +65 62 390 840 robert.prior-wandesforde@hsbc.com.sg
Indonesia: the essentials
Indonesia has not only been an outperformer on growth but has stood out in the region for its sound handling of the current financial crisis. We remain positive on the countrys outlook.
Consistent growth Indonesias growth has held up very well in the current global downturn, given that the country is largely domestically driven, and the electionrelated boost is helping as well. GDP expanded by 4% y-o-y in the second quarter, which is the slowest pace since March 2004, but much better than its neighbours. One thing worth mentioning is that, as Indonesia did not like most of the region suffer a major collapse in output in Q4/Q1, the bounce-back in Q2 has also been more muted; however, it has seen more consistent growth. We think momentum should hold up, with consumer confidence running strong and loan demand showing signs of turning. The decisive election results were a positive and suggest continuity in economic policy management. For the year as a whole we look for growth to average 4.3%, accelerating to 5.8% next year. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) 3M SBI rate, end quarter (%) 5-yr yield, end quarter (%) IDR/USD, end quarter IDR/EUR, end quarter 6.4 4.3 12.1 27.5 4.1 -0.6 57.1 9.9 13.0 9,506 13,499 Q4 2008 5.2 1.8 11.1 9.7 3.4 -0.6 51.6 12.0 11.8 11,325 15,742 Q1 2009 4.4 1.5 7.9 4.9 6.2 2.6 54.8 8.6 11.7 11,700 15,444 Indonesia outperformed not only on the growth front but also in the way in which it handled the crisis, with the finance minister, Sri Mulyani, being the main architect of that success. The country was quick to obtain stand-by facilities from the World Bank, among others, and to boost its swap lines in order to ensure that it had the necessary buffer. Being ahead of the curve has paid off, as the country has had no difficulty financing its deficit. For 2009 the governments planned budget deficit stands at 2.5% of GDP (IDR133trn); however, given that the shortfall in the first half of the year was only IDR26trn we think it will undershoot. For next year the government has announced a planned deficit of 1.6% of GDP, including a stimulus of 1% of GDP. The countrys external balances are strong as well, with a current account surplus of USD 6bn in H1 09 and FX reserves of nearly USD55bn as at July. 4.0 1.5 3.7 -5.9 7.0 2.5 57.6 7.0 10.0 10,208 14,291 3.7 1.0 3.0 0.0 5.4 0.9 59.4 7.0 9.2 10,018 14,526 4.9 2.5 5.5 10.0 4.2 0.4 60.5 6.9 9.2 9,500 14,250 5.5 5.0 7.2 12.0 4.5 0.1 60.1 6.8 9.2 9,200 13,800 5.8 6.0 8.7 13.0 5.2 1.2 61.7 7.2 9.7 9,000 13,500 6.2 7.0 9.2 12.0 4.2 0.5 62.0 7.5 10.3 8,900 13,350 5.8 7.0 8.0 10.0 3.2 -0.8 60.1 8.1 10.8 8,800 13,200
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
Inflation to turn Indonesias inflation rate is running at a nine-year low of 2.7%, versus a peak of 12% last year. Year-on-year inflation may dip a bit in September given favourable base effects arising from the difference in the timing of Ramadan: in 2009 it was spread over August-September whereas in 2008 it fell only in September. However, inflation will head up after this on account of commodity price movements and strong domestic demand. Consumer inflation expectations have also risen for three consecutive months, currently running at a seven-month high. The strength in the currency should, however, limit the pass-through of imported inflation. With fuel prices misaligned and the president talking about subsidy reform in his budget speech, we think some fuel price hikes are likely. Overall we expect inflation to average 7.9% in 2009, possibly hitting a high of around 9% during the year. Activity & inflation
8 6 (% y-o -y) 4 2 0 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) GDP (LHS) Industria l growth (LHS) 14 12 10 8 6 4 2 0
Bank Indonesia (BI): game over, next move up Having started its easing cycle in December last year, BI has cut the policy rate by a cumulative 300bp to 6.5%. The pass-through to the economy has been lower but further rate cuts will do little to address this and therefore BI is taking alternative measures (see later box). As growth is holding up well (BI is expecting to hit the upper end of its 3.5-4% 2009 GDP forecast (HSBC: 4%)) and inflation pressures are expected to rise its hard to justify another cut. Furthermore, in tandem with the tick up in inflation expectations BI has said that monetary policy is going to be more anticipative of inflation going forward. Overall, we stick with our view that 6.5% marks the bottom of this rate cycle. Thereafter, we are pencilling in 50bp hikes in both the second and third quarters of next year. Policy stance
0 (% GDP, 4 qma) -1 -2 -3 Fiscal balanc e (LHS) CPI, % y -o-y (RHS) Policy rate (RHS) 20 15 10 5 0 4Q04 4Q05 4Q 06 4Q 07 4Q08 4Q09e 4Q10e (%)
(% y-o-y)
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Indonesia: at a glance

12 10 8 (%) 6 4 2 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09

12 10 8 6 4 2 0 1yr 2yr 4yr Now + 4 months 5yr 7yr 10yr 20yr - 4 months Current CPI

13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e IDR vs USD (LHS) Annualised volatility (RHS) 50 40 (%) 30 20 10 0

300 260 220 180 140 100 60 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate v s USD Cumulativ e CPI Cumulativ e PPI 09

70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserv es, IFI definition (LHS) Short-term debt % reserv es (RHS) 80
Policy dynamics
2.0 2011e 1.5 (real rates) 1.0 2008 0.5 0.0 0.0 -0.5 -1.0 -1.5 2010e -2.0 2007 2009e
(USD bn)
60 40 20 0
(%)
(%)
(% of reserves)
(central govt balance % GDP)

800 600 1200 800 600 400 200 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Indonesia sub-index (LHS) EMBI Indonesia sub-index (RHS)

1800 1500 1200 900 600 300 0
400 200 0
(spread bp s)
(spread bps)
1000
(ind ex)
1/05
5/05
9/05
1/06
5/06
Indonesia 5y r Gov t. EMBI Indonesia sub-index
9/06
1/07
5/07
9/07
1/08
5/08
9/08
1/09
5/09
9/09
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Indonesia: local knowledge/global drivers

Upbeat consumers and rising loan demand mean that the domestic economy should remain underpinned. Large current account surplus provides a positive backdrop for the currency.
Consumer confidence is soaring Consumer confidence in Indonesia has been rising since July last year and is currently running at a four-and-a-half-year high of 115.4. This is 30% above its long-term average and compares with an all-time peak of 120.4 in November 2004. Confidence has been aided by the countrys outperformance of its neighbours in terms of growth, as well as by fuel price cuts, easing price pressures and, importantly, the decisive election results which brought Yudhoyono back to power with a strong mandate. The latter means continuity in economic policy management and the anticorruption drive which the president started in his last tenure. We expect soaring confidence to underpin consumer spending, which should remain one of the mainstays of economic growth. which should support consumption going forward
1 30 1 10 90 70 50 01 02 03 04 05 06 C on sum e r co nfiden ce ind ex 07 08 09 Av e ra ge
Limited policy easing pass-through Although the central bank has cut the policy rate by 300bp the passthrough to the real economy has been lower, with lending rates declining by only 120bp or so because bank funding costs remain high. In an effort to bring down lending rates further, BI recently announced guidelines for deposit interest rates to be capped at a 150bp premium over the policy rate from 1 September onwards (8%), falling to a 50bp premium from 1 December onwards (7%). Although second-tier banks are exempt from this, the cap will probably lead to a flight to quality, exacerbating liquidity issues at some banks. It could also lead to slower deposit growth as savers switch to alternative assets like stocks, and could be an issue when loan demand picks up decisively. is seeing BI flex its muscles
17 15 13 11 9 7 5 05 06 Poli cy rate 07 Lending rate 08 09 Deposit rate
Current account surplus wider but As Indonesias imports contracted by more than exports in the first half of the year, the countrys external balances strengthened. The trade surplus was nearly USD16bn, 20% higher than in H1 2008. Over the same period the current account surplus tripled to USD6bn. This provided a favourable backdrop for the currency, and, together with an improved global risk appetite, enabled the Indonesia rupiah to make strong gains. Looking ahead, imports are expected to turn around faster than exports given strong domestic demand and especially for intermediate goods; we therefore think the largest trade surpluses are behind us. On the capital account side, foreign direct invest flows have slowed, as is to be expected, and we think a strong turnaround is still some time away. Foreign direct investment flows have softened
10 8 6 USD bn 4 2 0 -2 04 -4 C u rr en t a/ c T rad e a/ c F DI 05 06 07 08 09
Demand for loans has jumped. Credit growth has slowed over the last six months in Indonesia, from a peak of 36% y-o-y in December last year to roughly 22% in June 2009. In the regional context, however, it is still pretty robust and the outlook appears promising. For one, the latest bank loan survey shows that demand for new loans jumped in the second quarter after being in the doldrums in the Dec-Mar period. Typically the survey leads actual credit growth by roughly two to three quarters, with a correlation between the two of 0.60. Second, with the regional trade recovery under way, credit demand from exporters should pick up while, at the same time, increased government disbursements should support business activity and so loan demand. and we expect credit growth to pick up, with some lag
1 00 80 60 40 20 0 01 02 03 04 05 06 07 08 09 40 30 20 10 0
N e w loa n de m and s urv ey
C red it y -o-y (R HS )
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Indonesia: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) 3M SBI rate, end-year (%) 5-yr yield, end-year (%) IDR/USD, end-year IDR/USD, average IDR/EUR, end-year IDR/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Central government balance (% GDP) Primary balance (% GDP) 5.0 256.9 1,188 5.0 4.0 14.7 6.4 24.9 9.9 6.1 6.4 8.9 16.4 7.4 17.2 7.3 10.1 9,270 8,933 12,607 11,336 70.8 50.6 20.2 1.6 0.6 -1.5 -0.6 0.0 10.4 28.0 36.3 8.6 2.0 137.0 47.1 54.3 -1.0 1.7
2005 5.7 285.6 1,300 4.0 6.6 10.9 4.6 27.5 11.2 10.5 17.1 24.4 8.5 12.4 18.9 12.8 13.3 9,830 9,705 11,595 12,083 87.0 69.5 17.5 0.3 0.1 5.3 1.8 1.9 22.9 37.2 34.7 6.0 6.4 130.7 53.9 50.6 -0.5 1.8
2006 5.5 364.4 1,635 3.2 9.6 2.6 4.6 28.7 10.3 13.1 6.6 6.6 6.3 15.5 1.1 9.5 9.4 8,994 9,166 11,860 11,519 103.5 73.9 29.7 10.9 3.0 2.2 0.6 3.6 19.0 6.3 42.6 6.9 3.9 128.7 47.0 52.9 -0.9 1.5
2007 6.3 432.0 1,914 5.0 3.9 9.4 4.7 28.1 9.1 6.4 6.6 21.9 5.1 15.9 15.0 7.8 9.2 9,400 9,143 13,724 12,708 118.0 85.3 32.8 10.5 2.4 2.3 0.5 3.0 14.0 15.4 56.9 8.0 -0.7 136.6 50.2 56.0 -1.3 0.8
2008 6.1 517.4 2,264 5.3 10.4 11.7 3.7 30.6 8.4 10.2 11.1 9.7 10.0 16.1 19.6 12.0 11.8 11,325 9,575 15,742 13,944 139.6 116.7 22.9 0.3 0.1 2.8 0.5 0.6 18.3 36.9 51.6 5.3 4.0 149.1 53.8 62.6 -0.1 1.7
2009e 4.3 518 2,226 4.9 12.8 3.3 1.6 29.8 9.6 5.3 5.5 10.0 6.0 15.3 9.5 6.9 9.2 9,500 10,585 14,250 15,313 110.6 81.4 29.3 7.8 1.5 1.5 0.3 1.8 -20.7 -30.3 60.5 8.9 2.0 145.8 43.0 59.8 -1.9 -0.9
2010e 5.8 688 2,931 5.4 2.5 8.7 6.3 30.4 9.1 7.9 8.0 10.0 8.0
2011e 5.5 796 3,358 5.0 2.3 7.4 4.7 30.8 8.5 7.0 6.4 0.0 8.0
16.0 15.5 8.0 12.0 8.1 8.1 10.8 11.9 8,800 8,800 9,063 8,800 13,200 13,200 13,594 13,200 120.0 90.6 29.3 1.6 0.2 2.5 0.4 0.7 8.4 11.4 60.1 8.0 2.0 147.8 44.9 60.8 -1.6 -0.2 130.7 99.9 30.9 5.3 0.7 2.5 0.3 1.2 9.0 10.2 64.6 7.8 3.0 152.0 44.9 62.0 -1.0 1.1
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Juliet Sampson: +44 20 799 1 5651 Juliet Sampson@hsbcib.com
Israel: the essentials
Despite the vulnerability to global deceleration of the large export sector, the contraction has been moderate and growth was already apparent in Q2, on the back of a well-diversified export sector and resilient private consumption
Economy surprisingly resilient to global slowdown Growth turned positive in Q2 09 (1% q-o-q annual) following contractions of 3.3% in Q1 09 and 1.6% in Q4 08. GDP for Q2 09 was only 0.7% lower than for Q2 08 (in real terms). GDP growth in the second quarter of the year was fuelled by rebounding exports (26.4% q-o-q annual) and private consumption (5.6%). We expect modest positive growth in 2009e of 0.3% as activity accelerates in H2 09. The resilience of the economy is somewhat surprising in light of the relative importance of total exports to GDP (44%). Nevertheless, the country boasts a well-diversified high-tech sector (accounting for 51% of total merchandise exports) which is expanding on the back of a new Intel factory, contributing approximately 0.8% to GDP in 2009. In addition, military and pharmaceutical exports have not suffered from the global slowdown. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) ILS/USD, end quarter ILS/EUR, end quarter 4.1 6.5 5.8 8.5 -2.9 1.9 35.3 4.25 5.5 3.55 5.10 Q4 2008 2.1 2.2 3.8 3.0 -3.4 1.5 42.3 2.5 5.1 3.87 5.21 Q1 2009 -0.1 -5.9 3.6 0.8 1.3 5.4 44.0 0.75 3.6 4.159 5.44 Consumption has remained positive on high savings rate Private consumption (excluding imported durables) has remained fairly stable throughout the recession on the back of a high net household savings rate of 12%. In addition, Israel avoided a housing bubble in recent years and, therefore, total household wealth has remained intact following the upward correction of financial assets this year. Israels population growth of 1.8% annual is supportive of domestic demand. On the other hand, unemployment has drifted higher to 8.0% in Q2 09 from 5.9% one year ago and real wages are expected to decline by 1.5% this year. Consumption growth accelerated in Q3, leading to an increase in tax revenues. We expect the fiscal deficit to undershoot the 6% GDP target and approach 5% this year. A two-year fiscal budget framework through 2010 should prevent political pressure, thereby supporting fiscal credibility.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -0.7 -8.9 3.6 -2.8 -0.1 4.3 50.0 0.5 4.3 3.944 5.53 0.1 -4.6 3.0 -1.7 -1.4 3.3 60.0 0.75 3.4 3.76 5.38 1.6 1.4 4.2 -0.2 -1.8 2.8 65.0 1.00 3.9 3.68 5.45 2.5 2.5 4.1 0.0 -1.9 2.5 67.0 1.75 4.0 3.67 5.51 3.0 4.0 3.1 0.3 -2.0 2.3 67.0 2.5 4.2 3.65 5.48 3.5 6.0 2.0 0.7 -2.1 2.2 66.0 3 4.3 3.63 5.46 4.0 7.0 2.4 1.0 -2-2 2.1 65.0 3.25 4.4 3.6 5.40
Inflation remains above target Probably the strongest indication of Israel's modest slowdown in 2009 has been sticky inflation on the back of surging housing prices (see below). Rebounding demand for housing, although in part influenced by loose monetary policy, is a strong indicator of consumer optimism. Headline inflation reached 3.1% y-o-y in August with surging housing prices contributing 2.4% y-o-y. Core inflation (excluding energy and food items) is up 4.6% y-o-y, in part due to higher purchase taxes. Nevertheless, the ease with which the 1% VAT increase was passed on to consumers is indicative of buoyant domestic demand, as well as a far-from-competitive food market. With inflation in 2009e expected to surpass 4%, it is apparent that monetary policy has succeeded in preventing deflation the initial concern when the global recession hit. Activity & inflation
12 9 6 3 0 -3 -6 -9 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e
Industrial growth (LHS) CPI (RHS)
Aggressive monetary policy buffers the recession The monetary style of Bank of Israel governor Stanley Fischer has differed from that of his predecessors (Frankel and Klein) in its emphasis on growth and employment in conjunction with inflation-targeting. Fischer expected global deceleration to have a major impact on Israel, as exports make up 44% of GDP. Pro-growth policy included both pushing rates to 0.50% in Q1 09 and a QE policy of daily purchases of FX and FI, geared towards maintaining a competitive shekel and facilitating corporate financing by pushing down long yields. Fischers radical use of tools was in part due to the lack of fiscal stimulus (in fact, taxes were raised by 1% of GDP). Indications of both improving growth and high inflation led the governor to cease QE (although intermittent FX purchases continue) and become the first central bank governor to actually raise rates in September. Policy stance
0 -1 -2 -3 -4 -5 -6 10 7 (%) 4 1 -2 -5 4Q07 4Q08e 4Q09e 4Q10e
8 6 (% GDP, 4 qma)
(% y-o-y)
(% y-o-y)
4 2 0
GDP (LHS)
Policy rate (RHS)
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Israel: at a glance

2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 1/05 5/05 9/05 1/06 5/06 9/06 1/07 5/07 9/07

6.0 5.0 (%) 4.0 3.0 2.0 1.0 1
Now
(%)
3
- 4 months
5
+4 months

5.50 5.00 4.50 4.00 3.50 3.00 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e ILS v s USD (LHS) Annualised v olatility (RHS) 20 16 (%) 12 8 4 0


50 45 40 35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserv es, IFI definition (LHS) Short-term debt % reserv es (RHS) 30
Policy dynamics
3.0 2.0 1.0 (real rates) 0.0 -1.0 -2.0 -3.0 -4.0 0.0 -2.0 -4.0 -6.0 2008 2009e 2007 2011e 2010e
(% of reserves)
(USD bn)
25 20 15 10

300 250 (index) 200 150 100 50 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Israel sub-index (LHS) Israel 4.625% 2013 110

400 (spread bps)
(spread bps)
105 100 95 90 85 80
200 0 -200 -400
1/05
5/05
9/05
1/06
Israel Makam Bond 12 month Israel 4.625% 2013
5/06
9/06
1/07
5/07
9/07
1/08
5/08
9/08
1/09
5/09
9/09
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Israel: local knowledge/global drivers

Israels economy has weathered global deceleration and turmoil fairly well owing to a current account surplus, a conservative banking sector, credible fiscal policy and avoidance of a housing sector bubble
Housing prices surge despite economic slowdown Housing prices have boomed in the past year (11.9% y-o-y in August) despite negative growth, higher unemployment and wage erosion. The backdrop is clear: from 2004 to date housing starts (averaging 31,000 units annually) have not kept up with household growth (averaging 37,000). Nevertheless, housing prices remained flat during the boom years of 2004 to mid-2008, in part due to an appreciating shekel and strong ILS/USD linkage in the housing market. Near-zero rates have certainly contributed to the present froth in the housing market, as 70% of all mortgages in 2009 are linked to the overnight rate, providing deceptively low financing, for now. In addition, households view housing assets as a safe haven during financial turmoil and low yields. Housing prices rebound in 2009
120 house price indez 0 fiscal account (%gdp) 115 110 105 100 95 2005
Source : CBS
Fiscal policy concentrates on capping deficit, not on stimulus Fiscal policy in Israel contributed little to economy recovery, and was delayed until mid-year due to parliamentary elections and the formation of a coalition. Although some guaranteed loans were provided to small businesses and industry, the overall picture is one of a fairly restrictive fiscal policy. With tax revenues contracting by 14% y-o-y in H1 09 owing to the recession, higher taxes were imposed in order to cap the fiscal deficit at 6% of GDP. This included a VAT increase, a water shortage tax, higher petrol and cigarette taxation, and an additional tax on luxury vehicles, which, in total, added slightly more than 1% of GDP to the government coffers. This restrictive stance is a result of Israels high government debt, expected to reach 84% of GDP in 2009 from 78% in 2008. The fiscal deficit set to improve in 2010
2009F 2010F 2003 -1 -2 -3 -4 -5 -6
Source: MoF and HSBC
2004
2005
2006
2007
2008
2006
2007
2008
2009
Current account surplus improves in H1 09, supporting the shekel The current account surplus in H1 09 increased to USD4.4bn from USD1.7bn in H2 08 and USD0.7bn in H1 08 (seasonally adjusted). This improvement is a result of falling energy and commodity prices, shaving USD5.0bn from the trade deficit in 2009e. Imported goods have plummeted more sharply in dollar terms (40% y-o-y in H1 09) than exports (30%). This resulted in a small trade surplus in H1 09, following years of deficit. The service surplus actually improved in H1 09 on the back of an increase in exports of business services. Looking forward, it is fair to assume that the c/a surplus will decline as imports rebound on the back of a recovery and inventory replenishment. Nevertheless, we expect a small surplus of 2.3% of GDP in 2010e following 3.8% in 2009e. Current account surplus
2500 2000 1500 $ mil 1000 500 0 1Q05 3Q05 1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 -500 -1000
Offset of financial outflows by Israelis Although Israel enjoys both a current account surplus and net positive FDI (USD2.5bn in JanuaryJuly 2009) net financial outflows (equity and bonds) reached USD4.7bn. Israeli institutions have increased their exposure to foreign assets as the global financial markets have rebounded. Israeli long-term savings institutions (provident, insurance and pension funds) have a strong home bias in their investment strategy, although foreign investments have increased in recent years as tax disincentives have disappeared. At present, about 9% of total institutional assets are invested abroad, and this share is expected to expand gradually in the coming years. Foreigners, on the other hand, have not changed their position in Israel, buying USD0.5bn in equity but selling a similar amount of bonds. Israelis are expected to increase investments abroad
Israeli financial flows abroad (USD mn) 1400 1200 1000 800 600 400 200 0 10/08 11/08 12/08 01/09 02/09 03/09 04/09 05/09 06/09 07/09
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Israel: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) WPI, end-year (%, yoy) Real Wage Growth (%, yoy) Money, FX & interest rates Narrow money supply M1 (%, yoy) Policy rate, end-year (%) 5-yr yield, end-year (%) ILS/USD, end-year ILS/USD, average ILS/EUR, end-year ILS/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (ILSbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 5.2 122.5 17,172 5.0 -2.4 4.0 6.9 23.5 10.4 -0.4 1.2 7.6 2.5 17.9 3.7 6.3 4.31 4.48 6.09 5.58 36.7 39.5 -2.8 2.9 2.4 -2.5 -2.0 -0.2 20.9 17.5 26.6 8.1 76.6 97.6 23.4 -5.0 -3.9 0.5 405 73.8 29.9 24.4 98.2
2005 5.3 129.7 17,229 3.4 2.3 2.9 3.6 23.9 9.0 1.3 2.4 4.3 1.0 23.8 4.5 5.9 4.60 4.49 5.43 5.58 39.8 43.9 -4.1 4.3 3.3 1.9 1.5 6.9 9.5 10.1 27.5 7.5 76.3 101.6 23.5 -3.0 -1.9 1.3 407 69.8 31.6 24.4 94.2
2006 5.2 145.7 20,637 4.8 3.3 6.4 8.5 25.7 8.4 2.1 -0.1 2.7 1.6 8.3 5.0 5.4 4.20 4.46 5.54 5.55 43.3 47.2 -3.9 8.1 5.6 -0.1 -0.1 5.5 8.7 7.1 29.0 7.4 85.0 110.7 28.8 -1.9 -0.9 2.4 411 63.2 32.5 22.3 85.5
2007 5.3 166.9 23,247 7.2 2.6 13.6 4.3 22.8 7.4 0.5 3.4 6.7 1.8 17.4 4.0 5.8 3.90 4.11 5.68 5.63 50.3 56.0 -5.7 4.6 2.8 2.6 1.6 4.3 16.2 18.7 28.4 6.1 87.7 126.0 31.8 -1.5 0.0 2.6 419 61.0 30.6 18.4 79.4
2008 4.0 202.9 27,790 3.9 2.8 3.8 7.1 22.7 6.1 4.6 3.8 3.0 -0.8 17.5 2.5 5.1 3.87 3.57 5.21 5.24 57.2 64.4 -7.2 1.6 0.8 2.4 1.2 2.0 13.7 15.1 42.3 7.9 90.0 78.0 29.0 -2.5 -2.1 0.9 456 62.9 30.7 15.1 78.0
2009e 0.3 193.5 26,068 0.2 3.2 -5.2 -4.5 18 8.1 3.4 4.2 -0.2 -1.5 65.0 1.0 3.9 3.68 3.89 5.45 5.45 47.0 48.3 -1.3 7.3 3.8 3.5 1.8 5.6 -17.8 -25.0 65 16.1 93.0 50.8 28.0 -5.6 -5.2 -4.0 502 66.8 33.4 17.2 84.0
2010e 3.3 220.2 29,205 3.5 3.0 3.0 4.9 20 7.9 3.1 2.4 1.0 0.5 35.0 3.3 4.4 3.60 3.64 5.85 5.40 50.8 54.8 -4.0 5.0 2.3 2.5 1.1 3.4 8.1 13.5 65 14.0 93.0 51.6 27.0 -4.9 -4.5 -3.1 519 64.8 34.4 15.6 82.0
2011e 4.2 238.9 31,694 3.8 2.6 5.5 9.0 22 7.0 2.5 2.6 2.0 1.5 12.0 4.5 5.0 3.55 3.58 5.40 5.35 55.4 60.3 -4.9 4.0 1.7 2.3 1.0 2.6 9.0 10.0 64 12.7 93.0 51.6 27.0 -3.9 -3.5 -2.0 530 62.0 34.9 14.6 77.0
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Alexander Morozov: +7495 783 8855 alexander.morozov@hsbc.com Dmitry Chernyadev (Economics Associate)
Kazakhstan: the essentials

While Kazakhstans long-term growth prospects remain good, economic recovery will take time
Recession confirmed, but not the recovery Officials reported that GDP fell 2.3% y-o-y in H1 2009, thereby confirming a recession. The heavily affected property market has yet to bottom out, and residential prices are drifting further down. An accelerating rise in oil output has taken the energy industry out of the woods since June, but manufacturing output has yet to recover. Despite recent improvements, the economic activity indicator remains ambiguous in its diagnosis of the economy-wide output recovery. Resumption in the growth of real wages led by the resource-rich regions raises hopes for improvement in hitherto sluggish demand, yet declining commercial bank lending could be offsetting that. The long and painful process of foreign debt restructuring at BTA and Alliance Bank is keeping investors appetite for KZ assets low, adversely affecting portfolio capital inflows. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) UAH/USD, end quarter UAH/EUR, end quarter 1.4 1.3 18.2 46.7 26.3 7.4 47.5 10.5 20.6 119.90 172.70 0.0 -0.3 9.5 -18.6 15.0 0.9 45.4 10.5 11.8 120.64 170.16 -2.2 -4.6 8.9 -28.6 9.0 -4.6 38.8 9.5 8.7 150.94 199.39 On the positive side, inflation fell to its lowest level since 2004, enabling the NBK to ease its interest rate policy more aggressively and finish the easing cycle either in September or in October. Current account deterioration in H1 2009 appears to have been temporary as the recovery in oil exports and post-devaluation constraints on imports should substantially reduce the current account deficit in H2. Robust FDI inflows underpin balance-of-payment strength. Against this backdrop, the stability of the tenge appears to be consistent with fundamentals. High international reserves and low public debt are additional factors of the overall macroeconomic strength that should eventually drive economic growth in the longer term, albeit at a lower rate than in the pre-crisis period.
Q4 2008 Q1 2009e Q2 2009e Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -2.4 -0.8 8.2 -31.1 8.7 -7.2 40.0 8.5 7.0 150.39 210.96 -3.5 3.0 5.8 -26.0 25.4 -1.6 41.2 7.0 4.9 151.00 217.50 -2.1 4.0 7.1 6.0 17.7 0.1 42.7 7.0 6.0 154.00 231.00 1.1 2.0 7.6 5.5 19.5 -9.9 42.6 7.0 6.0 153.00 229.50 4.1 3.0 7.1 5.0 12.7 -1.6 45.1 7.5 6.0 152.00 228.00 4.6 4.0 6.6 4.5 22.1 -2.9 47.3 7.5 6.0 151.00 226.50 4.1 4.0 6.1 4.0 13.9 -2.2 48.9 7.5 6.0 150.00 225.00
Better than regional peers The idea that Kazakhstan could become a First In, First Out (FIFO) country was rather popular in some circles last year. However, the emergence of additional external shocks and past strong overheating in Kazakhstans economic development gave little macroeconomic support for that idea. Indeed, the country started experiencing economic problems long before most other emerging markets, but its economic downturn was prolonged by the onset of the global economic crisis, and the economy gradually adjusted downwards to a new equilibrium level. In our opinion, this explains why the fall in industrial output in Kazakhstan has been much less pronounced than in Russia and Ukraine, two other ex-Soviet countries. However, it does not guarantee rapid recovery. Activity & inflation
6 4 2 0 -2 -4 -6 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e Industrial grow th (LHS) CPI (RHS) (% y-o-y) 20
Finishing the easing cycle Inflation slowed to single-digits in December 2008 and the trend has since persisted despite post- KZT-devaluation effects on imported consumer goods. Benign inflation dynamics allowed the NBK to intensify monetary easing, cutting a cumulative 350bp in the year to September. Further easing, however, is not assured. While another 50bp policy rate cut would likely be consistent with the inflation level in September-October, past monetary expansion has already raised the risk that inflation could start to rise again this year. The NBK, being well aware of this risk, may opt to finish the easing cycle earlier. This would safeguard against too rapid a Uturn from monetary easing to monetary tightening and start restraining inflation pressures early. Policy stance
2 1 (% GDP, 4 qma) 0 -1 -2 -3 -4 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e Policy rate (RHS) Fiscal balance (LHS) CPI, % y -o-y (RHS) 20 16 12 8 4 (%)
16
(% y-o-y)
12 8 4
GDP (LHS)
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Kazakhstan: at a glance


7.5 7.0 6.5 (%) 6.0 5.5 5.0 4.5 1yr Now 2yr 3yr +3 months 5yr 10yr -3 months

160 150 140 130 120 110 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e KZT v s USD (LHS) Annualised v olatility (RHS) 50 40 (%) 30 20 10 0
Policy dynamics
2011e 2.0 2010e 0.0 -2.0 -4.0 -6.0 -8.0 2007 -10.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 2008 (real rates) 2009e

25 20 (USD bn) 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Internati onal reserves, IFI definition (LHS) Short-term debt % reserves (RHS) 80 70 60 50 40 30 20 10
(% of reserves)
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Kazakhstan: local knowledge/global drivers

Stable currency outlook and low sovereign credit risks should help restore market confidence
False hopes of a V-shaped recovery While the economy has good potential for fast economic growth in the medium term, this will materialise only when large deposits or crude oil and other mineral resources are developed, and pipeline infrastructure for their exports is put in place. Meanwhile, the surprisingly upbeat output data for June proved to be a one-off spike. The economic activity indicator returned to negative territory in July. Fortunately, however, y-o-y industrial growth slowed but remained positive in July-August. Real wages and incomes have been showing modest yet positive growth, also led by resource-rich regions. Overall, this suggests that the economy has started growing but that any hopes of a V-shaped recovery are ill-founded. Industry resumed growth
8 6 4 2 0 -2 -4 -6 -8 Jan-08 Apr-08 Jul-08 Oct-08 Economic activ ity indic ator Jan-09 Apr-09 Jul- 09 Industr ial production
Ailing banks temper economic growth The crisis had already hit the overleveraged Kazakh banking system in mid-2007. Since then the loan portfolio has remained virtually unchanged in nominal terms. The only episode when loans grew markedly, in February 2009, merely reflected a valuation effect related to FXdenominated loans after the tenge devaluation. Still, the high loan-todeposit ratio in Kazakhstan implies that robust loan growth should not be expected until the deposit base expands and access to foreign funding is restored. This may take some time following the default by BTA and Alliance Bank on their foreign debts, which involved creditors in painful restructuring talks. In the past, credit growth was one of the key drivers of economic growth in Kazakhstan, so future growth is likely to be tempered. Bank loans stagnate
11000 10000 9000 KZTbn 8000 7000 6000 5000 Jan-07 Jul-07 Jan-08 Loans (lhs) Jul-08 Jan-09 Jul-09 Loan growth (rhs) 140 120 100 80 60 40 20 0 -20
CA deficit is not a concern The current account switched to a deficit in Q1 2009, and this expanded in Q2 owing to a previous worsening in the terms of trade. FDI, being concentrated in the energy sector, was largely resilient to the economic crisis and more than offset the negative current account. Despite the ongoing deleveraging of the banking sector, the combined reserves of the National Oil Fund and NBK have resumed modest growth since April, reflecting the overall positive balance-of-payment position. Since oil exports from Kazakhstan respond to changes in world oil prices with a lag of a few months, oil price growth in H1 2009 should translate into higher oil exports in H2 2009. The current account deficit should shrink, as a result, providing further support to the balance of payments and reserves. Reserves start to grow again
4 2
USD bn
%, y-o -y
Sovereign credit risks overpriced Kazakhstan CDS was trading at a significant premium to EM early this year when the KZT devalued and some major banks started experiencing problems with foreign debt repayments. Since then KZ CDS have become one of the top EM performers and recently started trading at a discount to the EMBI+ index. Currency stability, high and stable international reserves, the absence of tradable sovereign debt, and very modest levels of GDP decline are all factors that have favoured KZ s sovereign credit. While markets have already digested most of the negative news related to banks defaults and foreign debt restructuring in Kazakhstan, other EM countries may still have similar experiences ahead. KZ sovereign CDS is still attractive, long KZ/short EMBI+ would be a natural hedge solution. CDS levels still attractive
1500
50 40
USDbn
(bp)
0 -2 -4 Jan -0 7 Ju l-0 7 Ja n-08 J ul-08 J an-09 Jul-09 N ation al O il Fun d N BK res erv es C urrent ac oun t ba lanc e (q uarterly , lhs )
30 20 10 0
1000 500 0 Oct-08 Dec-08 Jul-09 Aug-09 Mar-09 May-09 Sep-08 Nov-08 Feb-09 Sep-09 Apr-09 Jan-09 Jun-09
RU 5Y CDS
KAZ 5 Y CDS
EMBI+ sov
94
%, y-o-y
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Kazakhstan: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) UAH/USD, end-year UAH/USD, average UAH/EUR, end-year UAH/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (UAHbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 9.6 43.2 2,875 9.5 18.4 22.5 10.4 27.4 8.6 6.9 6.7 27.6 22.5 69.8 30.6 7.0 5.8 130.00 136.00 177.10 168.98 20.5 13.8 6.8 0.5 1.1 5.4 12.5 13.5 55.6 46.0 13.6 11.8 3.9 32.7 29.0 30.2 2.6 -1.5 -0.9 231.1 3.9 2.5 5.8 9.7
2005 9.7 57.1 3,771 11.1 10.8 28.1 4.8 30.7 8.2 7.6 7.5 20.3 20.2 25.2 48.2 7.0 5.8 133.98 132.88 158.10 163.44 28.2 17.9 10.3 -0.5 -0.9 1.7 3.0 2.2 37.2 30.1 14.2 9.5 8.9 43.4 57.6 41.8 6.0 0.6 1.0 458.9 6.0 1.6 2.8 8.8
2006 10.7 81.3 5,310 10.8 6.2 29.7 7.2 33.1 7.8 8.7 8.4 14.6 19.8 78.1 48.9 9.0 6.3 125.65 125.65 165.86 158.32 38.8 24.1 14.6 -2.0 -2.5 6.6 8.1 5.7 37.5 34.5 31.8 15.8 17.1 74.0 39.8 71.4 0.7 0.5 1.1 911.9 8.9 2.6 3.2 12.1
2007 8.9 106.6 6,887 10.9 14.0 17.3 5.0 43.8 7.3 10.8 18.8 31.9 28.7 25.9 33.9 11.0 8.4 120.68 120.51 176.62 165.20 41.5 26.6 14.9 -8.2 -7.7 8.0 7.5 -0.2 7.0 10.1 32.8 14.8 23.1 96.9 36.5 95.3 -1.6 -1.7 -1.3 740.6 5.8 1.6 1.5 7.3
2008 3.3 130.7 8,336 3.7 5.5 1.7 2.1 46.6 6.6 17.1 9.5 -18.6 15.9 35.3 -15.0 10.5 11.8 120.90 122.86 170.53 175.12 72.0 38.5 33.5 7.0 5.3 10.7 8.2 13.6 73.5 44.7 45.4 14.2 25.4 107.8 23.5 106.2 -2.1 -2.0 -1.7 1,132.5 7.1 1.7 1.3 8.3
2009e -2.5 108.2 6,797 -5.0 -6.0 -12.0 -0.1 31.0 8.5 7.4 7.1 6.0 7.4 15.0 -3.3 7.0 6.0 154.00 137.45 231.00 194.76 46.8 27.8 18.9 -2.9 -2.7 9.0 8.3 5.6 -29.7 -26.6 42.7 18.4 32.0 103.0 40.7 101.6 -6.6 -3.6 -3.3 1,432.5 9.6 1.4 1.3 10.9
2010e 3.5 105.9 6,557 4.0 3.0 3.0 3.3 33.0 8.0 7.0 6.1 4.0 10.2 20.0 10.0 7.5 6.0 150.00 152.00 225.00 228.00 47.0 29.1 17.9 -4.0 -3.8 10.0 9.4 5.7 0.5 4.7 48.9 17.6 29.0 103.0 40.7 101.7 -1.9 -3.9 -3.7 1,732.5 10.8 1.3 1.2 12.0
2011e 5.4 117.6 7,169 5.0 4.0 6.0 4.0 33.0 7.0 5.1 4.1 4.0 9.8 20.0 17.2 5.5 6.0 150.00 150.10 225.00 225.15 48.6 32.3 16.2 -5.6 -4.8 10.8 9.2 4.4 3.3 11.0 49.5 15.8 31.0 108.0 42.6 106.8 3.4 -1.9 -1.7 2,032.5 11.5 1.2 1.0 12.5
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Song-yi Kim + 852 2822 4870 songyikim@hsbc.com.hk
Korea: the essentials
GDP bounced impressively in Q2 and the leading indicator is pointing towards a further rise in industrial production, leaving room for the Bank of Korea to raise the key rate; exports are growing sequentially
Koreas economy bounced back sharply There are signs that Koreas economic downturn is over, as Q2 GDP was up 2.6% q-o-q while industrial production and service activity continued to grow in July. In annual terms, GDP was down 2.2% in Q2, an improvement from 4.2 in Q1, but we expect a positive result in Q3. The economys stronger-than-expected performance underscores the recovery in domestic demand, as private consumption rose 3.6% in Q2 on q-o-q terms, while corporate investment climbed 10.1% q-o-q in the same period. The latest leading index, which has proven fairly reliable in the past, points to further strength in the coming months. There is also plenty of anecdotal evidence that the property market is picking up. Private construction is showing tentative signs of a rebound, following the government-led construction boom in the first half. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) KRW/USD, end quarter KRW/EUR, end quarter 3.1 5.6 5.1 11.3 -1.5 -3.7 239.7 5.2 5.8 1,187 1,686 Q4 2008 -3.4 -11.3 4.1 5.6 2.3 3.5 201.2 3.0 4.3 1,260 1,751 Q1 2009 -4.2 -15.5 3.9 3.5 4.6 4.8 206.3 2.0 3.8 1,367 1,804 We increased our annual growth forecasts for Korea to -0.4% (from 2.3%) for 2009 and +4.6% (from 3.6%) for 2010. Most surprisingly, the Korean economy is adding jobs again if only a few and this has brought down the unemployment rate in recent months. Fortunately, the recovery in consumption has prevented unemployment from rising. Also the sequential rebound in exports, together with government support, helped manufacturers retain employees. Although exports remain weak, recording a 20% y-o-y contraction even in the traditionally strong JulySeptember period, the corporate sector has been profitable as low raw material costs and a weak exchange rate have lifted sales and profits. We expect a strong V-shaped recovery to follow in the rest of the year, although sequential growth may slow. -2.2 -6.2 2.0 -3.1 8.9 6.6 231.7 2.0 3.9 1,274 1,783 0.1 3.0 2.4 -3.2 7.7 4.9 251.1 2.0 4.9 1,243 1,802 4.5 6.0 2.6 1.0 -1.0 -3.3 248.4 2.0 5.0 1,200 1,800 4.9 12.0 2.8 2.0 3.3 1.5 252.8 2.5 5.3 1,150 1,725 5.2 7.0 3.0 3.5 5.6 4.1 263.8 2.7 5.3 1,125 1,688 4.5 6.0 3.4 3.8 4.9 3.3 274.6 3.0 5.5 1,100 1,650 4.0 7.0 3.2 3.4 -0.9 -2.8 267.8 3.0 5.5 1,075 1,613
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
CPI cooling dependent on Korean won August CPI jumped to 2.2%, up from 1.6% a month earlier. The recent recovery in commodity prices may push up headline CPI readings by the fourth quarter. The increase reflected higher global oil prices as well as a seasonal rise in some agricultural prices. However, inflation is not a concern as the rise in international commodity prices is being mitigated by appreciation of the won. Year-on-year consumer price inflation will probably remain in the Bank of Koreas (BoK) 2.5-3.5% target band. Core pressures are likely to remain muted, especially for tradable goods, giving the BoK leeway to stay in accommodative mode. Furthermore, risks to growth are still far too high for immediate interest rate hikes until exports have bounced back to the pre-Lehman Brothers level seen in September last year. Activity & inflation
16 12 8 4 0 -4 -8 -12 -16 -20 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e C PI (RHS) 6 5 4 3 2 1 0
Government has promised to keep expansionary policy until next year There has been a rapid loosening in fiscal and monetary policy to minimise Koreas economic downturn. The large fiscal deficit that was announced in the budget for this year was accompanied by 325bp in interest rate cuts by the BoK. With stimulus measures mainly the government subsidy to prevent lay-offs and back new infrastructure projects the economic outlook for 2009-10 is much improved. In addition, a more robust economic performance will boost tax revenue in 2010-11. We expect interest rate hikes in the coming six months once the fiscal stimulus has fed through fully into domestic demand. With government spending continuing and a gradual economic recovery, a balanced budget is unlikely in 2010, and will probably not result until 2013, in line with the governments medium-term budget planning. Policy stance
4 (% GDP, 4qma) 3 2 1 0 -1 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e 6 5 4 3 2 1 0
(% y-o-y)
(% y-o-y)
GDP (LHS)
In dustrial grow th (LHS)
Policy rate (RHS)
96
(%)
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Korea: at a glance

5 4 3 2 1 0 -1 -2 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M spread over U S-Libor 2yr spread over US-Libor

6.0 5.0 (%) 4.0 3.0 2.0 3M 6M 1y r Now + 4 months 2yr 3y r 5yr - 4 months Current CPI 10yr

1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 1999 2000 2001 2002 2003 2004 2005 2006 200720082009e KRW v s USD (LHS) Annualised v olatility (RHS) 55 45 25 15 5 -5 (%) 35
(%)

140 (%) 120 100 80 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate v s USD Cumulativ e CPI Cumulativ e PPI 09

300 250 200 150 100 50 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short-term debt % reserves (RHS) 80 60 40 20 0
Policy dynamics
1.5 2009e (real rates) 2010e 2011e 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0 2007 2008
(% of reserves)
(USD bn)
97
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Korea: local knowledge/global drivers

Housing prices have started to rise again sequentially, triggering immediate interest hikes and supporting household consumption, although it still remains below its peak
Loosening financial condition further help consumption Loose financial conditions have pushed up property prices sharply, and the Korean stock market has risen 50% year to date. The wealth effect is supporting private consumption; in particular, the ongoing run-up in apartment prices in the premium residential districts of Seoul is causing the BoK concern about overheating asset prices. Equity and property prices are also affecting financial conditions: a rise in asset values amounts to an effective easing for the economy, not least because it raises the net asset position of households and firms, and boosts the value of collateral for bank loans. As both property and stock prices in Korea have returned relatively swiftly to their recent peaks, private consumption will likely stay strong. Asset prices: recovery to recent peak looks under way
5 50 5 00 4 50 4 00 3 50 3 00 2 50 2 00 1 50 1 00 50 98 99 00 01 02 03 04 05 06 07 08 09 Seo ul a pa rtm en t price s (1 998 =10 0) KOSP I (199 8=1 00 ) 91-da y C D ra te (rhs) 18 16 14 12 10 8 6 4 2 0
Labour market has stopped sliding Labour figures show that the domestic job market is improving. The number of people employed stood at 23.62 million in August, up 3,000 from a year ago. Worries about cuts in non-regular workers, in particular, proved to be overdone: these are more likely to become regular posts following a change in the relevant law in July. It is interesting that signs of labour market recovery are occurring at a time of persistently weak export growth. A stabilised job market will further support household spending, although a closer examination of the labour market shows that conditions are not as good as they look at first. Sight. Most of the jobs created have been in public services or have been supported by government subsidy. Labour market started to add jobs
8 7 6 5 4 3 2 20 00 15 00 10 00 50 0 0 -500 -100 0 -150 0 -200 0 97 98 99 00 01 02 03 04 05 06 07 08 09 C h ang e in e m ploy m ent from the p re v ious y ear (1 000 ) U n em ploy m ent ra te sa
Trade surplus is declining Exports still fell 21% y-o-y in August because of a slowing in vessel shipment, which has accounted for more than 10% of total exports in recent years. We do not expect to see positive annual growth in exports until October but in sequential terms exports have now continued to grow for five consecutive months. Shipments to China, especially of consumer goods, contributed to this growth. In August, imports increased 13% on a three-month sequential basis, while exports rose 9%, suggesting that the trade surplus will slow somewhat in the coming months since the import bill is picking up because of a recovery in domestic demand and a steady gain in raw material costs. However, we expect a stronger won to help on input costs for Korean manufacturers. Exports and imports sequentially rebounding
20 10 0 -10 -20 -30 -40 Au g-97 Aug -9 9 Au g-01 Aug -0 3 Au g-05 Aug -0 7 Au g-09 im po rts 3m / 3m sa % ex p orts 3m / 3m % s a
Bank of Korea cautiously monitors home-backed loans Outstanding household credit amounted to KRW697.75trn at the end of June, up a historically high 5.7% from a year before. On the other hand, disposable income grew a mere 0.2% to KRW502.8trn during the first half of this year the lowest rate of growth since 1970. Home-backed loans account for half of all household debt. They stood at KRW341.4trn won at the end of August, and as much as KRW4.2trn was added in that one month. The government has imposed restrictions on home-backed loans to prevent property bubbles from forming. Household debt remains elevated: while not a source of potential banking sector instability, high leverage will nevertheless restrict the pace of consumption growth. Rising house loans accompanying property prices hike.
15 15 10 10 5 0 5 -5 0 01 HH lo ans 03 3m/3m 04a s 02 gan gnam 3m /3 m s a 05 -10 0 6 mortgage loans 3m/3m s a 07 08 09
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Korea: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) KRW/USD, end-year KRW/USD, average KRW/EUR, end-year KRW/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (KRWbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 4.6 693.1 14,428 0.3 3.8 2.1 10.4 35.0 3.8 3.6 3.0 5.3 9.9 6.1 1.5 3.3 3.3 1,035 1,124 1,411 1,302 257.7 220.1 37.6 28.2 4.1 4.6 0.7 4.7 30.6 25.6 199.1 10.9 172.3 28.3 155.9 0.7 1.8 159,991.0 20.5 16.4 2.4 22.9
2005 4.0 790.8 16,428 4.6 4.3 1.9 6.3 33.2 3.5 2.8 2.6 1.5 7.8 7.0 5.8 3.8 5.0 1,008 1,025 1,189 1,276 289.0 256.3 32.7 15.0 1.9 2.0 0.3 2.1 12.1 16.4 210.4 9.9 187.9 31.3 172.3 0.4 1.7 227,055.0 28.0 15.5 2.0 30.0
2006 5.2 890.1 18,430 4.7 6.6 3.4 8.4 31.5 3.3 2.2 2.1 0.3 5.6 8.2 11.7 4.5 4.8 930 953 1,226 1,197 331.8 303.9 27.9 5.4 0.6 -4.5 -0.5 0.1 14.8 18.6 239.0 9.4 260.1 47.6 240.2 0.4 1.9 262,369.0 30.9 19.9 2.2 33.2
2007 5.1 970.7 20,033 5.1 5.4 4.2 6.9 30.8 3.1 2.5 3.6 3.6 6.9 10.3 12.4 5.0 5.6 936 928 1,367 1,290 379.0 350.9 28.2 5.9 0.6 -13.8 -1.4 -0.8 14.2 15.4 262.2 9.0 383.2 61.1 329.5 3.8 5.2 278,790.0 30.9 53.6 5.5 36.5
2008 2.2 947.4 19,494 0.9 4.2 -1.7 3.1 37.6 3.3 4.7 4.1 5.6 3.7 11.6 9.4 3.0 4.3 1,260 1,081 1,751 1,574 433.4 427.4 6.0 -6.4 -0.7 -10.6 -1.1 -1.8 14.3 21.8 201.2 5.6 381.1 75.1 329.9 1.2 2.6 288,720.0 28.2 51.2 5.4 33.6
2009e -0.4 824.6 16,924 -0.5 4.4 -2.0 -3.4 38.5 3.8 2.8 2.6 1.0 2.3 8.0 4.2 2.0 5.0 1,200 1,268 1,800 1,834 360.3 320.1 40.2 25.8 3.0 -1.0 -0.1 2.9 -17.7 -24.8 245.3 9.2 350.0 63.9 252.4 -2.6 -1.0 334,084.8 32.0 97.6 11.8 43.79
2010e 4.6 997.3 20,428 3.2 1.8 4.3 7.8 41.2 3.4 3.1 3.2 3.4 4.3 9.0 4.9 3.0 5.5 1,075 1,128 1,688 1,692 398.0 365.2 32.7 15.7 1.4 -4.0 -0.4 1.0 10.5 14.1 263.3 8.6 335.0 50.4 224.4 -1.8 -0.2 378,918.1 33.7 110.6 11.1 44.77
2011e 4.9 1,107.0 22,629 3.5 3.3 5.5 8.5 43.8 3.2 3.2 3.4 3.6 5.5 11.0 4.8 3.3 6.0 1,050 1,100 1,575 1,650 447.9 414.8 33.1 14.5 1.2 -4.0 -0.4 0.8 12.5 13.6 279.8 8.1 330.0 46.5 207.0 -1.4 0.2 421,258.4 34.6 123.0 11.1 45.71
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Robert Prior-Wandesforde: +65 62 390 840 robert.prior-wandesforde@hsbc.com.sg
Malaysia: the essentials
The recovery is underway and looks likely to be sustained at a strong pace as the full effects of the monetary and fiscal easing come through and the trade cycle turns. Central Bank unlikely to be in a hurry to raise rates either
Strong, sustained success? Tthe Malaysian economy sprang back to life in the second quarter, registering 17% quarter-on-quarter annualised growth. Moreover, given the strong rise in the countrys lead indicator as well as an impressive improvement in consumer confidence, Q2 is unlikely to represent a flash in the pan. More fundamentally, the vast bulk of the fiscal and monetary stimulus measures have still to feed through to the real economy, while Malaysia will be one of the main beneficiaries of the turn in the regional and world trade cycles; exports represent roughly 120% of GDP. Relatively high palm-oil and rubber prices will help the agricultural sector and there is some hope that the governments liberalisation measures will pay dividends in time, boosting the investment share of GDP. Overall the country looks set to enjoy a sustained, V-shaped Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) MYR/USD, end quarter MYR/EUR, end quarter 4.8 1.8 8.2 8.7 25.1 19.5 110.3 3.5 4.1 3.44 4.88 Q4 2008 0.1 -8.8 4.4 -3.4 21.9 16.7 92.0 3.3 3.0 3.45 4.80 Q1 2009 -6.2 -17.9 3.5 -8.9 23.8 20.2 87.9 2.0 3.5 3.65 4.82 recovery and we have raised our already above-consensus growth forecasts. Given the terrible start to the year, GDP is still on course to contract in 2009 as a whole, although by just 2%, while we expect the economy to expand by nearly 7% in 2010. If we are right, then unemployment will start to fall next year and the property market should receive a lift as well. This is not to say it will all be plain-sailing. Inflation is set to pick up fairly sharply over the coming months and Bank Negara will face a tricky decision about when to start hiking the policy rate, which currently stands at just 2%. It will also be important to see if the government tackles the high fiscal deficit in the October budget and whether the reform process continues.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -3.9 -14.5 -1.4 -12.2 22.6 17.4 91.7 2.1 3.9 3.52 4.93 -1.3 -7.0 -1.8 -3.5 19.1 13.1 91.1 2.0 3.9 3.50 5.08 3.3 0.0 1.8 3.5 18.5 12.0 84.9 2.0 4.0 3.50 5.25 9.8 4.0 3.1 6.5 18.4 13.9 85.5 2.0 4.0 3.50 5.25 7.3 7.0 3.5 7.5 21.2 16.2 87.5 2.0 4.0 3.50 5.25 5.6 9.0 3.4 6.5 17.8 11.7 87.0 2.2 4.3 3.48 5.22 5.0 10.0 2.7 11.5 17.1 10.3 82.5 2.5 4.5 3.46 5.19
From deflation back to inflation As last years fuel price hike and other commodity related price rises have dropped out of the comparison, while the level of commodity prices has declined, the headline CPI inflation rate has fallen to -2.4%. This should really be seen as good deflation as it has helped support real personal incomes in the context of a deteriorating labour market. We suspect it has now bottomed, however, and will move higher as commodity price inflation is now turning positive again. So how high will headline CPI inflation get in the months ahead? On the basis of current commodity prices, we expect it to reach 3.5% by mid-2010. This compares with a long-term average (from 1986) of 2.8%. Core (ex. food and energy) inflation should remain around 1-2% given the lagged effects of the recession. There is no doubt plenty of spare capacity in both labour and product markets. Activity & inflation
12 8 4 0 -4 -8 -12 -16 -20 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) 9
When to hike? Last year, Bank Negara Malaysia was the only major Central Bank in the region not to hike rates and see through the commodity-driven spike in inflation. This was a brave move at the time with the headline CPI rate hitting 8.5% - comfortably the highest level since at least the mid-1980s. Consumer spending was also very strong in the first half of last year, raising the risk of second round effects coming through to core inflation. In the end, the synchronised global recession put paid to that possibility. The final months of this year and the first half of 2010 will also see the headline inflation rate increasing, albeit not to the same extent, while the economic recovery should prove sustainable. Although BNM is unlikely to be rushed into raising rates, we expect it to hike modestly (by 50bps) next year bearing in mind just low the policy rate is. Policy stance
0 (% GDP, 4qma) -3 -6 -9 -3 3Q06 2Q07 1Q08 4Q08 3Q09e 2Q10e 9 6 3 0 -3 (%)
(% y-o-y)
(% y-o-y)
3 0
GDP (LHS)
Policy rate (RHS)
100
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Malaysia: at a glance

2.5 1.5 0.5 (%) -0.5 -1.5 -2.5 6/05 10/05 3/06 7/06 11/064/07 8/0712/074/08 9/08 1/09 5/09 3M spread over US-Libor 2yr spread over US-Libor
3.5 1.5 -0.5 1y r -2.5 Now + 4 months - 4 months Current CPI 2y r 3y r 5y r 7y r 10y r 15y r

4.00 3.80 3.60 3.40 3.20 3.00 2.80 2.60 2005 2006 2007 MYR vs USD (LHS) 11 9 7 5 3 1 -1 2009e 2009e Annualised volatility (RHS) (%)

175 150 (%) 125 100 75 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09

140 120 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short- term debt % reserves (RHS) 30
(% of reserves)
Policy dynamics
1.5 2007 0.5 (real rates) 2011e -0.5 2008 -1.5 -2.0 -3.0 -4.0 -5.0 -6.0 -7.0 -8.0 -9.0 (central govt balance % GDP) 2010e 2009e
(USD bn)
25 20 15 10

500 400
(ind ex)

600 400 300 200 100 0
(spread bp s)
(%)
300 200 100 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Malays ia sub-index (LHS) EMBI Malaysia sub-index (RHS)
(spread bps)
500
500 400 300 200 100 0 -100 -200

1/05 5/05 9/05 1/06
Malay sia 5yr Govt. EMBI Malaysia sub-index
9/06 5/06
5/07 1/07
9/07
1/08
5/08
1/09 9/08
5/09
9/09
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Malaysia: local knowledge/global drivers

Consumer spending looks set to rebound sharply, partly helped by the recovery in palm-oil prices. The governments budget deficit is a problem and requires structural remedies
A V-shaped consumption recovery? It was not just exports that took a big hit in the second half of last year and the beginning of 2009 but consumer spending as well. From a high of 11.3% in the year to Q1 2008, Malaysian consumption slumped to 0.7% in Q1 2009. Confidence dropped even more dramatically, as shown by the chart, hitting its weakest level since the series began in the late 1980s. Interestingly, the low point was hit in Q2 last year, before the global crisis really took hold, suggesting there was a strong domestic element to it. The most likely explanation was the fuel price hike of June 2008. More recently, confidence has surged, offering considerable hope of a strong recovery in private consumption in the months ahead. We could be seeing 8% consumer spending growth again in the not too distant future. Confidence points to strong consumption bounce
I nde x 1 30 1 20 1 10 1 00 90 80 70 M a lay s ia % Yr 20 16 12 8 4 0 -4 -8
Budgetary issues The combination of the economic downturn and stimulative fiscal measures is leading to a sizeable deterioration in public finances which were, in any case, not in the best of shape going into the recession. By mid-2009, the budget deficit was running at 6.5% of GDP and we expect it to get worse before it gets better. In our view the deficit will hit 8.5% of GDP by the end of this year, slightly higher than that witnessed in mid2003. If our growth projections are correct, a sharp improvement is then likely, although even by 2011 the deficit could be running at about 4% of GDP. The country has one of the most troublesome fiscal positions in the region and structural measures are required to place the deficit on a more sustainable footing. A need to squeeze?
0 -2 -4 -6 -8 -10 % G DP Bud get ba la nce F'cst 00 01 0 2 03 0 4 05 0 6 07 08 0 9 10 11
0 0 0 0 0 1 0 2 03 03 04 05 06 06 0 7 0 8 0 9 C o ns um er C onf. (LH S) C o nsu m ption (R HS)
Foreign direct investment Malaysia only attracted USD863m of inward FDI in Q2 this year. Apart from Q3 2008, when it received just USD344m, this was the lowest quarterly number for more than six years. Figures for the first half of 2009 also show a more than 80% year-on-year drop in inward FDI. Although the global recession meant a large fall was inevitable, the government will be hoping the situation improves quickly and significantly. In our view, it has a reasonable chance of success. The Prime Ministers recent service sector liberalisation measures, which he has promised will be extended to other areas of the economy, signal an important and positive change in policy direction. Meanwhile, Thailands political woes could also lead foreign investors to look more closely at Malaysia. Inward FDI has slowed to a trickle; how strong will the recovery be?
RMB bn 20 0
10 0
Commodity prices and the economy Palm oil and rubber still play an important role in Malaysias economy, together accounting for about 10% of total merchandise exports (with palm oil the far more important of the two) as well as a sizeable chunk of employment and hence incomes. As the chart shows, the prices of these commodities have been on something of a roller-coaster ride over the last couple of years, first surging in 2007 and the first half of 2008, before falling sharply late last year and in early 2009. They have subsequently seen a renewed recovery and, although still well below their recent highs, are nearly double their respective long-term averages. At current prices, farmers are making fairly sizeable profits which in turn should provide some support to consumption. Palm-oil and rubber prices high and rising again
4 000 3 000 2 000 12 10 8 6 4 2 0 8 3 8 5 8 7 8 9 91 93 95 9 7 9 9 01 03 05 07 09
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- 20 0 F DI o utflo w F D I inflow
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Malaysia: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) MYR/USD, end-year MYR/USD, average MYR/EUR, end-year MYR/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (MYRbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 7.3 124.7 4,877 10.5 6.0 3.1 11.3 44.0 3.3 1.4 2.2 3.4 3.4 10.5 4.6 2.7 3.6 3.80 3.80 5.16 4.79 126.8 99.2 27.6 15.1 12.1 2.6 2.1 14.1 21.1 25.6 66.2 8.0 52.8 17.5 27.1 -4.1 -1.9 182.0 38.4 25.7 20.6 59.0
2005 5.3 137.9 5,276 9.1 6.5 5.0 5.2 43.5 3.8 3.0 3.3 9.9 3.9 11.7 5.8 3.0 3.7 3.78 3.79 4.46 4.72 142.3 108.3 34.0 20.7 15.0 1.0 0.7 15.7 11.9 8.9 70.2 7.8 53.1 16.5 29.1 -3.6 -1.4 198.7 38.0 24.0 17.4 55.4
2006 5.8 156.3 5,581 6.8 5.0 7.5 6.7 43.4 3.0 3.6 3.1 4.9 10.1 8.6 4.2 3.5 3.7 3.53 3.67 4.65 4.62 160.6 123.2 37.4 25.4 16.3 0.0 0.0 16.3 9.4 10.3 82.3 8.0 56.0 16.2 31.0 -3.3 -1.2 217.2 37.8 25.0 16.0 53.8
2007 6.2 186.3 6,857 10.4 6.5 9.6 3.1 46.1 3.0 2.0 2.4 10.8 7.3 12.7 6.1 3.5 3.8 3.31 3.43 4.83 4.77 176.5 139.3 37.2 29.2 15.7 -2.7 -1.4 14.2 2.7 5.6 101.5 8.7 55.8 12.7 29.8 -3.2 -2.2 247.1 38.6 26.0 14.0 52.6
2008 4.6 222.5 8,025 8.5 10.9 0.8 1.4 49.1 3.1 5.4 4.4 -3.4 0.5 12.5 4.9 3.3 3.0 3.45 3.32 4.80 4.83 200.1 148.7 51.4 38.8 17.4 -7.8 -3.5 13.9 9.6 3.2 120.2 9.7 54.3 13.1 27.3 -4.8 -3.5 286.1 38.7 27.0 12.1 50.9
2009e -2.0 195.1 6,893 2.5 2.1 -7.5 -9.9 44.3 4.0 0.8 1.8 3.5 2.0 7.0 7.0 2.0 4.0 3.50 3.54 5.25 5.12 165.3 124.6 40.7 30.1 15.4 0.1 0.0 15.4 -12.0 -10.8 84.9 8.2 50.0 14.3 25.0 -8.5 -7.5 330.0 47.7 25.0 12.8 60.5
2010e 6.8 218 7,330 5.6 1.0 4.1 7.5 47.1 3.5 3.3 2.7 11.5 4.0 9.7 5.0 2.5 4.5 3.46 3.49 5.19 5.24 181.6 141.2 40.5 28.1 12.9 0.6 0.3 13.2 8.5 11.8 82.5 7.0 52.0 16.4 23.0 -5.8 -4.0 360.0 47.3 29.0 13.3 60.6
2011e 5.5 222 7,174 5.0 1.0 7.0 6.5 44.9 3.2 2.5 2.5 2.0 3.5 11.5 4.0 2.7 4.8 3.42 3.43 5.13 5.15 202.1 159.4 42.8 29.3 13.2 2.3 1.1 15.4 9.4 10.9 84.0 6.3 55.0 17.5 28.0 -4.0 -2.0 370.0 48.6 27.0 12.2 60.8
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Sergio Martin: +52 55 5721 2164 sergio.martinm@hsbc.com.mx
Mexico: the essentials
We estimate that GDP will fall 7.0% in 2009; however, a more positive global economic environment should support an incipient domestic recovery in H2 09, and a GDP growth rate of 3.6% in 2010
GDP to fall 7% in 2009, rebounding in 2010 on US recovery The Mexican economy appears to have bottomed out in Q2 09, when GDP fell 10.3% (y-o-y). We forecast that year-on-year growth rates in the second half of the year will remain in negative territory: Q3 09: -7.5% and Q4 09: -2.3%. In total, we project a GDP decline of 7.0% for 2009. Despite this bleak scenario, we observe that the positive global environment and, in particular, the expected return of growth in the US support Mexicos economic recovery. In this context, we envisage positive quarter-on-quarter growth rates for Q3 09 and Q4 09 of 2.2% and 1.8%, respectively. This positive trend may continue into 2010, when we project a GDP growth rate of 3.6%. One important aspect to emphasise is the rebound in US industrial production and, in particular, in the automotive industry, which has a Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) MXP/USD, end quarter MXP/EUR, end quarter 1.7 -1.1 5.5 6.9 -2.1 -1.5 98.9 8.25 8.3 10.95 15.38 Q4 2008 -1.6 -4.3 6.5 10.5 -3.6 -2.8 95.2 8.25 7.8 13.81 19.34 Q1 2009 -8.0 -9.8 6.0 9.3 -1.0 -1.7 85.7 6.75 7.1 14.21 20.60 positive impact on the sector in Mexico. For instance, the Mexican automotive industry has benefited from the implementation of the US cash for clunkers programme, which allowed auto exports to increase 7% (mo-m) in July and 22% in August. In the context of this improvement in the auto industry, Mexican industrial production grew by 2.8% (m-o-m) in July 2009 the highest increase since August 2005. Other signs of recovery have also emerged, such as the IMEF manufacturing and non-manufacturing indicators (the Mexican counterpart of the US ISM), which have been above the threshold of 50 points for two consecutive months, indicating economic expansion. We expect this pattern to be repeated in the months ahead.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -10.3 -11.4 5.7 5.8 0.3 0.2 81.5 4.75 7.1 13.17 18.47 -7.5 -5.9 5.0 5.0 -3.5 -2.3 83.2 4.50 7.6 13.00 18.85 -2.3 -5.5 4.1 4.9 -4.2 -3.0 92.7 4.50 7.0 12.90 19.35 3.9 6.0 4.1 4.5 -2.5 -2.5 90.0 4.50 6.9 12.90 19.35 5.5 4.6 3.7 4.1 -3.0 -2.0 87.5 5.50 6.8 12.90 19.35 3.5 3.5 4.0 4.4 -2.0 -1.5 89.0 5.50 6.6 12.90 19.35 1.5 1.5 4.0 4.4 -0.9 -2.0 90.9 5.50 6.6 12.90 19.35
Inflation is declining but pressures may appear in Q1 10 We reiterate our forecast that inflation will decline towards 4.1% by end-2009. There have been some inflationary pressures such as higher electricity tariffs for high-end consumers and higher highway tolls, as well as a significant increase in international sugar prices. However, these pressures have not translated into higher CPI inflation, as demand is still too weak to support any such increases. We recently revised our 2010 forecast inflation rate to 4% from 3.6% because we expect a gradual increase in administered prices (gasoline, diesel and electricity, for example) from January 2010; we estimate that second-round effects will materialise in Q2 10. The fiscal package sent to Congress on 8 September confirms this policy but it is still too early to gauge the extent of the administered price increases. Activity & inflation
8 6 4 2 0 -2 -4 -6 -8 -10 -12 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) Industrial grow th (LHS) CPI (RHS) 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0
Wexpect 100bp tightening starting in Q2 10 Inflation expectations this year remain well anchored at 4.3% for end2009 according to the latest central bank survey. This figure is within the central banks targeted range of 4.0%-4.5% in Q4 10; we therefore expect the central bank to leave the monetary policy rate unchanged at 4.5% for the rest of the year. Neither do we expect any change throughout Q1 10 because we sense that the central bank will be very cautious about increasing the policy rate in the middle of the worst economic recession in 70 years. However, we expect inflationary pressure in Q1 10 and believe that the central bank could be inclined to tighten by 100bp in Q2 10. Moreover, the extent of the tightening may be greater if inflationary pressures are stronger than expected. Policy stance
0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e 10 8 6 4 2 (%)
(% GD P, 4 qma)
(% y-o -y)
(% y-o-y)
F is cal Bala nce (LHS) C PI, % y -o-y (RHS)
Policy Rate (RHS)
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Mexico: at a glance

7 6 5 4 3 2 1 0 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M s pread ov er US-Libor 12M spread over US-Libor

8.8 7.6 (%) 6.4 5.2 4.0 1M 3M Now 6M 1yr 3y r +4 months 5yr 10yr 20yr -4 months

16 14 12 10 8 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e MXN v s USD (LHS) Annualised v olatility (RHS) 40 31
(%)

175 150 (%)
(%)
22 13 4
125 100 75 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09

100 80 (USD bn) 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short- term debt % reserves (RHS) 80
(% of reserves)
Policy dynamics
4.0 3.0 (real rates) 2.0 1.0 2009e 0.0 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 (consolidated govt balance % GDP) -3.0 2008 2010e 2007
60 40 20 0
2011e

8000 6000 700 600 500 400 300 200 100 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Mexico sub-index (LHS) EMBI Mex ic o sub-index (RHS)

700 600 500 400 300 200 100 0
1/05 5/05 9/05 1/06
4000 2000 0
(spread bp s)
(spread bps)
(ind ex)
Mexico 1yr T-Bill EMBI Mexico sub-index
5/06
9/06
1/07
5/07
9/07
1/08
5/08
9/08
1/09
5/09
9/09
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Mexico: local knowledge/global drivers

Fiscal discussions in Congress are the focal point; we are optimistic that Congress will approve the proposed budget with only minor adjustments
The budget proposal is not the much-needed fiscal reform The 2010 budget proposal is definitely not the much-needed fiscal reform. Although it involves the revision and introduction of some taxes, as well as a change in the make-up of expenditure, it is still a complicated tax structure with substantial loopholes, exemptions, and subsidies that potentially add up to 4% of GDP. In addition, Mexicos dependence on oil revenue will persist, although it will be somewhat reduced, and the temporary increase in income taxes may adversely affect investment and encourage tax evasion. The authorities designed the economic package with an eye to approval by the PRI the dominant force in Congress. Therefore, it contains a large portion of expenditure directed towards social issues, which is congruent with the PRIs political priorities in the context of an economic recession. Public sector budget proposal (as % of GDP)
Revenues Oil Non-oil Tax Non-tax Public enterprises Expenditure Balance Off-budget (new methodology) PSBR
Source:SHCP
Fiscal and macroeconomic stability is preserved The 2010 budget proposal maintains expenditure at 24.6% of GDP in real terms, similar to the approved 2009 budget. Given the fall in revenue owing to the economic recession and lower oil revenues, there is a fiscal gap. To cover this gap the government has proposed several tax measures and an increase in the deficit of 0.5% of GDP. This fiscal deficit comes on top of the 2.0% of GDP deficit previously approved to allow investment in state-owned oil company, PEMEX, as well as other off-budget expenditure of 0.6% of GDP; this implies a total deficit of 3.1% of GDP. The government is preserving fiscal stability: the total debt to GDP ratio, which includes off-budget debt of about 4% of GDP, would increase only marginally to 37.8% in 2010 from 37.2% in 2009. Fiscal balance vs. PSBR
0.5 0.0 -0.5 (% of GDP) -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e 2010e PSBR Fiscal balance
2009e 22.4 6.6 15.8 9.3 3.2 3.3 24.6 -2.1 -0.6 -2.7
2010e 22.1 6.9 15.2 10.8 0.9 3.5 24.6 -2.5 -0.6 -3.1
Source: HSBC, SHCP
Fiscal leakage will amount to 4% of GDP in 2010 One of the main problems with fiscal revenues is the number of exemptions, negative taxes, subsidies, transfers and economic stimuli. The government estimates that these will decrease revenues by around 4% of GDP in 2010. For income taxes, the fiscal loss is 2.4% of GDP, the main beneficiaries being the transport sector, agricultural activities, inbond industries and individuals. For VAT the fiscal leakage is about 1.3% of GDP and results from products that are taxed at zero rates food and medicines, for example and those that are exempt, such as education and transport. For special taxes, the fiscal loss is 0.3% of GDP given the negative tax on gasoline and diesel. Finally, the diverse economic stimuli for different activities reduce fiscal revenues by 0.05% of GDP. Fiscal leakages (as % of GDP)
Fiscal stimulus
Unemployment surpassing the 1995 peak The current economic recession is the worst in 70 years, and unemployment has been increasing rapidly. The urban unemployment rate was around 7% in mid-2009, but we estimate that it will peak at close to 8% in Q1 10 about 0.5% above the level the authorities reported in 1995, when GDP fell 6.2%. We note that the reported unemployment rate somewhat understates the actual situation: the absence of unemployment benefits causes workers to look for any employment, at any wage, and for any number of hours in order to obtain some income. However, underemployed workers do not declare themselves unemployed, and this distorts the unemployment rate. Urban unemployment rate (trend)
8.0 7.0
Special tax es (%) VAT Income tax
6.0 5.0 4.0 3.0 2.0 1.0 0.0 0.5 1.0 % of GDP 1.5 2.0 2.5 87 89 91 93 95 97 99 01 03 05 07 09
Old definition
Source: INEGI
Current definition
Source: SHCP
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Mexico: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) MXP/USD, end-year MXP/USD, average MXP/EUR, end-year MXP/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (MXPbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 4.0 759.2 7,437.5 5.6 -2.8 8.0 3.7 19.0 4.2 4.7 5.2 8.0 4.7 11.9 1.3 8.8 9.3 11.2 11.3 15.2 14.0 188.0 196.8 -8.8 -5.2 -0.7 23.7 3.1 2.4 14.1 15.4 64.2 3.9 57.7 128.0 66.5 48.8 -0.2 -1.2 2.2 1,194.7 13.9 79.2 10.4 24.4
2005 3.2 849.3 8,224.5 4.8 2.4 7.5 2.6 19.7 3.7 4.0 3.3 2.5 3.8 16.0 1.5 8.3 7.9 10.6 10.9 12.5 13.4 214.2 221.8 -7.6 -4.4 -0.5 21.9 2.6 2.1 14.0 12.7 74.1 4.0 69.2 122.7 41.6 51.0 -0.1 -1.1 2.2 1,373.1 14.8 71.7 8.4 23.3
2006 5.1 951.8 9,126.1 5.7 1.7 9.8 5.3 20.4 4.3 3.6 4.1 7.1 4.4 14.1 21.9 7.0 7.3 10.8 10.9 13.5 13.1 249.9 256.1 -6.1 -4.4 -0.5 19.3 2.0 1.6 16.7 15.4 76.3 3.6 79.7 107.6 42.3 52.9 0.1 -1.8 2.5 1,756.9 16.9 54.8 5.8 22.7
2007 3.3 1,025.3 9,736.8 3.9 2.1 7.2 3.1 20.6 4.4 4.0 3.8 3.7 4.2 10.0 20.8 7.5 7.8 10.9 10.9 14.7 14.2 271.9 281.9 -10.1 -8.3 -0.8 27.3 2.7 1.8 8.8 10.1 87.2 3.7 95.0 123.1 45.5 67.7 0.0 -1.9 2.2 1,959.8 17.5 55.4 5.4 22.9
2008 1.3 1,085.7 10,204.0 1.5 0.6 4.9 -0.7 20.7 5.5 5.1 6.5 10.5 5.1 17.3 7.1 8.3 7.8 13.8 11.2 19.3 16.7 291.3 308.6 -17.3 -15.7 -1.4 21.9 2.0 0.6 7.2 9.5 95.2 3.7 141.5 129.9 47.9 72.9 -0.1 -1.6 1.8 2,017.5 16.7 56.9 5.2 21.9
2009e -7.0 862.4 8,025.3 -8.1 10.2 -12.7 -8.2 18.8 7.4 5.4 4.1 4.9 4.6 15.1 -4.0 4.5 7.0 12.9 13.9 19.4 20.8 206.6 224.6 -18.0 -14.7 -1.7 12.9 1.5 -0.2 -29.1 -27.2 92.7 5.0 155.6 148.4 57.3 57.3 -2.1 -1.5 0.3 2,752.3 23.0 91.0 10.6 33.6
2010e 3.6 1,009.3 9,299.1 2.1 5.3 4.9 3.9 18.8 6.6 4.0 4.0 4.4 3.8 14.5 11.7 5.5 6.6 12.9 12.9 19.4 19.4 226.7 247.6 -21.0 -20.2 -2.0 20.2 2.0 0.0 9.7 10.3 90.9 4.4 100.0 166.6 66.0 67.1 -2.5 -1.7 -0.1 2,880.5 22.1 99.5 9.9 32.0
2011e 3.4 1,075.6 9,812.0 4.1 3.4 7.2 3.7 20.0 5.3 3.7 3.4 3.7 4.0 15.8 17.7 6.5 7.5 13.0 13.1 18.8 19.0 252.1 270.1 -17.9 -18.1 -1.7 21.5 2.0 0.3 11.2 9.1 100.1 4.4 115.0 175.9 63.5 71.5 -2.3 -1.7 0.4 3,281.4 23.3 104.4 9.7 33.0
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Nigeria: the essentials
The economy faces repercussions from a major banking sector overhaul as well as the earlier slump in oil prices However, the real economy has been doing surprisingly well so far, thanks to the non-oil segment
Administration has great expectations of new amnesty programme President YarAduas administration introduced a comprehensive amnesty programme in early August, offering an unconditional pardon to Niger Delta militia in return for renouncing violence and laying down their arms. It expires in 60 days on 4 October. The main militant group of the oil-producing Delta region, the MEND, extended its ceasefire for another 30 days on 16 September but has also expressed discontent during negotiations. While evidence is fairly mixed, administration officials claim the amnesty programme is steadily achieving its objectives. Meanwhile, surrendering militants are shedding light on the deeply complex structure of the oil theft mechanism, implicating senior figures from the business world and political elites in logistical and financial support. Thus, the amnesty will either progress slowly or prove to be a historic opportunity for Nigeria to resolve this acute problem. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) WPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 1-yr rate, end quarter (%) NGN/USD, end quarter NGN/EUR, end quarter 6.1 -2.4 13.0 n.a 19.2 3.1 62.1 9.8 9.7 117.6 165.4 Q4 2008 7.1 -1.4 15.1 n.a 25.7 4.6 52.7 9.8 5.5 139.7 194.9 Q1 2009 4.5 -2.1 14.3 n.a 19.2 1.2 46.8 9.8 3.5 148.1 196.0 Oil production is reportedly improving with the amnesty Nigerias oil production suffers greatly from ongoing unrest in the Niger Delta region. According to International Energy Agency, production fell to 1.68m bbl/day in July, the lowest levels since 1988 and well below the average of 2.6m bbl/day in 2006. The Nigerian Foreign Minister has recently stated that current oil production is actually about 1.6m bbl/day. According to the central bank, the Niger Delta situation has cost cUSD1bn per month in lost oil revenues (or 25-35% of potential) for the past three years. Webelieve any long-lasting peace, and resultant improvement in the prospects of the oil industry, should hinge on a more equitable sharing of oil revenues among the oil-producing states. In fact, a panel of academics and former ministers has already recommended that the administration should allocate 25% of the nations oil revenues to the region, up from the current 13%. 6.7 -3.3 11.2 n.a 16.8 -2.3 45.3 8.0 6.4 148.1 208.1 5.0 -3.6 10.4 n.a 13..4 -4.7 42.0 6.0 6.5 152.6 225.3 4.4 -0.5 9.8 n.a 11.4 -6.5 40.0 6.0 6.6 150.0 225.0 4.5 1.8 9.2 n.a 11.4 -5.0 40.5 6.0 6.8 149.5 224.3 5.4 3.6 7.4 n.a 11.3 -4.6 40.9 6.0 7.1 147.5 221.3 5.5 4.8 5.8 n.a. 11.5 -3.9 41.3 7.0 8.2 145.0 217.5 5.6 3.7 7.2 n.a. 11.6 -3.7 41.5 8.0 8.9 143.5 215.3
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
Real economy has remained surprisingly vibrant so far While slumping oil production is a drag on activity, the non-oil segment, in particular agriculture and trade, has been doing fairly well so far. CBN governor Sanusi recently stated that real GDP growth accelerated to 6.7% in Q2 09 from 4.5% in Q1 09. Growth has reportedly also been supported by a relatively high contribution from the resource sector. Details are not available and we find this hard to square with anecdotal evidence on the oil and gas industry, let alone poor electricity output, hence we expect activity to slow in the remainder of 2009 and early 2010 before picking up again with potentially higher oil production. While there are usually drastic revisions, we would still stress that the Nigerian economy has been faring better than expected so far amidst the global crisis, thanks to its low financing requirements and external/fiscal balance sheets. Activity & inflation
8 6 4 2 0 -2 -4 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e CPI (RHS) 20 15
(% y-o-y)
Sharp deceleration in money growth likely to drag inflation down Composite consumer inflation moderated to 11.0% y-o-y as at July, from over 15.0% at end-2008, as the food price shock has been transmitted with a lag. Spending pressure from state governments remains intact and weakness in the naira will likely add to inflation through the import price channel. This, combined with a sharp deceleration in money and credit growth rates in the run-up to a massive banking sector overhaul, will likely drag headline inflation lower, aided by a supportive base effect, before it picks up again later next year. Although the CBN supplies ample liquidity, this is not feeding into broader monetary aggregates another reason why we think economic activity including retail and wholesale trade is likely to slow. Nonetheless, it is worth noting that headline inflation is susceptible to severe volatility given the hefty 63.8% weight of food. Policy stance
16 12 (%) 8 4 0 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e 30 25 20 15 10 5 0
(% y-o-y)
10 5 0
GDP (LHS)
Policy rate (RHS)
CPI, % y -o-y (RHS)
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Nigeria: at a glance

8 7 6 5 4 3 2 1 0
(%)
(%)
10
5
2/06 8/06 2/07 8/07 2/08 8/08 2/09 8/09
1y r
2yr 3yr Now +4 months
5yr
10yr -4 month s Current CPI
15yr

160 140 120 100 80 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e NGN vs USD (LHS) Annualised volatility (RHS) 60 50 40 30 20 10 0 -10
Policy dynamics
4.0 2.0 (real rates) 2007 2010e 2011e 2009e 2008 -6.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0
(%)
0.0 -2.0 -4.0

70 60 50 40 (USD bn) 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserv es, IFI definition (LHS) Short-term debt % reserv es (RHS) 5 0 15 (% of reserves) 10 25 20
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Nigeria: local knowledge/global drivers

The central bank has undertaken a major overhaul of the banking sector, which is positive for the long-term health of the economy. Furthermore, the y-t-d rally in oil prices provides some relief
CBNs overhaul of the banking system continues to have repercussions On 14 August the CBN announced that it was bailing out five undercapitalised banks, which used to account for c90% of exposure to the discount window, via a capital injection of NGN400bn (or USD2.6bn, c1.5% of GDP) because of the risks they were posing for the financial system. They apparently need additional provisioning of NGN539bn (or USD3.4bn, c2.0% of GDP). These banks accounted for 40% of total loans and 30% of deposits in the system, while their aggregate NPLs exceeded 40% of their total loan portfolio. CBN also widened its audit to all 24 banks after bailout, while guaranteeing all foreign loans and correspondent banking lines of these five banks. Reflections so far indicate that the remaining problems are much smaller in scale. Snapshot picture of five bailed-out banks
NGN bn Total loans Exposure to margin loans Exposure to oil & gas sector Total deposits Total assets CBN discount window Net guarateed interbank takings Non-performing loans Non-performing loans (%) Liquidity ratio Capital Adequacy Ratio 2,801.9 456.3 487.0 127.9 253.3 1,143.0 40.8% Share in Regulatory banking system limit 39.9% 30.0% 31.5% 89.8% 17.7-24.0% 25.0% 1.0%-<10% 10.0%
Administration also clamps down on bad debtors Shortly after this operation, on 19 August, CBN also published a list of more than 200 of the largest debtors of failed banks, while the Economic and Financial Crimes Commission (EFCC) said it would clamp down on these firms/individuals and seize their assets to recoup bank losses. Shortly after this development S&P lowered Nigerias LT sovereign credit rating to B+ from BB- with a stable outlook (Fitch at BB-, Moodys does not rate the country), citing the cost of bank bailouts and slipping oil revenues as the main reasons for its rating actions. HSBC believes this operation will improve the long-term health of the banking system, helping value to emerge gradually. Please see report on Nigerian banks: A brave new world by Marcel Mballa-Ekobena dated 27 August. Excerpts from Nigeria's Budget
in bn NGN Total Revenues Total Expenditures Development/transfers Debt Service Wages Central Admin. Balance Central Admin. Balance (% of GDP) Federal Balance (% of GDP)
Source: Ministry of Finance, HSBC
2007 2,191.9 1,861.0 475.6 206.8 1,178.6 330.8 1.6 -0.7
2008 3,042.0 2,918.4 1,137.7 371.0 1,409.7 123.7 0.5 -2.7
2009 F 2010 Draft Change 2,093.2 2,200.0 5.1% 3,087.5 3,230.0 4.6% 1,177.4 n.a. n.a. 287.8 297.8 3.5% 1,622.2 n.a. n.a. -994.3 -1,030.0 3.6% -3.8 -3.1 -4.9 -3.2
Bailout to strain public finances, but there is room for borrowing Budget revenues will be strained by falling oil production, which is highly likely to be much lower than the 2.3m bbl/day assumption in original 2009 budget. Oil proceeds make up around 80% of Nigerias fiscal revenues. This, coupled with cost of the banking bailout, leads us to expect a considerable deterioration in the federal deficit, to 4.9% of GDP this year from -2.7% in 2008. We also foresee an ensuing rise in domestic debt, for almost the first time since 2005, as Nigeria remains conservative in contracting external debt. That said, we do not expect this to endanger macro stability as the public balance sheet is still in relatively good shape, while gross external financing requirements to current account receipts plus FX reserves ratio will likely stay at a modest 60%. Oil price, production and federal balance
3 1 -1 -3 -5 2004 2005 2006 2007 2009 2010F 2011F 2003 2008 100 80 60 40 20
2010 budget looks optimistic; CBN focused on financial stability While oil production is forecast to improve along with oil prices in 2010, the fiscal framework approved by the cabinet for next year envisages production of 4m bbl/day, which seems unrealistic at the moment. The oil price assumption at USD50/bbl, on the other hand, is still conservative and prudent. The actual proposal will be submitted to assembly in October and will probably be subject to fierce debate on the spending side. Meanwhile, the CBN remains focused on financial stability and will probably keep the monetary policy rate (MPR) at currently low levels for a time, while maintaining its liquidity support. Loose monetary and fiscal policy would, in turn, probably complicate the future inflation outlook gradually, but not before the credit cycle starts turning again, which we expect to happen towards 2011. Broad money supply (M2) and private credit (y-o-y
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 01/01 07/01 01/02 07/02 01/03 07/03 01/04 07/04 01/05 07/05 01/06 07/06 01/07 07/07 01/08 07/08 01/09 07/09
Federal Bala nce (% of GDP, right) Oil production (mn bbl/ day) Oil price (USD/bbl, Bony Lig ht)
Broad Money Supply (M2)
Credit to Private Sec tor
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Nigeria: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Oil production (mn barrels/day) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) Money, FX & interest rates Broad money supply M2 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 1-yr interest rate, end-year (%) NGN/USD, end-year NGN/USD, average NGN/EUR, end-year NGN/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Gross external debt (USDbn) Federal government balance (% GDP) Central government balance (% GDP) Non-oil primary balance (% GDP) Gross public domestic debt (NGNbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 15.0 14.0 9.3 29.7 15.00 n.a. 133.2 134.4 179.7 167.2 28.3 11.8 16.5 4.3 5.1 0.7 0.8 5.9 20.9 -18.6 17.0 10.5 37.9 -1.8 -0.3 -26.4 1,369.3 12.0 35.7 42.0 54.0 6.1 84.9 615.4 3.1 -8.7 43.6 2.5 7.9 13.4
2005 7.2 109.7 776.0 7.4 5.0 14.0 2.5 8.0 11.9 17.9 11.6 22.4 29.2 13.00 13.6 130.4 132.8 154.3 165.2 50.0 13.4 36.6 8.0 7.3 1.7 1.5 8.8 76.7 13.6 28.3 13.4 22.2 -1.2 -0.4 -27.8 1,530.1 10.5 20.4 18.6 29.1
2006 6.0 144.5 998.7 7.5 8.0 19.0 2.6 8.3 13.7 8.2 8.6 34.9 25.9 10.00 10.2 128.8 128.5 168.9 155.7 58.8 22.8 36.0 13.8 9.6 4.1 2.8 12.4 17.6 70.1 42.3 16.4 7.8 -0.6 1.8 -26.9 1,745.1 9.4 4.9 3.4 12.8
2007 6.3 164.5 1,110.9 8.3 15.0 15.0 2.2 9.3 14.6 5.4 6.6 33.7 59.2 9.50 9.0 117.9 125.7 171.9 172.2 55.0 32.8 22.2 2.7 1.6 2.3 1.4 3.0 -6.5 43.9 51.5 15.9 8.9 -0.7 1.6 -24.3 1,964.4 9.5 3.6 2.2 11.7
2008 6.0 205.5 1,356.7 6.0 12.5 10.0 2.0 10.7 14.4 11.6 15.1 73.1 88.6 9.75 5.5 139.7 118.9 194.9 174.8 80.6 27.7 52.9 9.5 4.6 2.0 1.0 5.6 46.5 -15.5 52.7 22.8 10.0 -2.7 0.5 -32.5 2,248.4 9.2 4.1 2.0 11.2
2009e 5.1 193.5 1,248.4 4.0 7.5 3.5 1.8 12.3 15.4 12.3 9.8 18.5 34.5 6.00 6.6 150.0 149.9 225.0 204.9 48.4 26.3 22.0 -12.5 -6.5 1.0 0.5 -5.9 -40.0 -5.0 40.0 18.2 9.7 -4.9 -3.8 -38.6 3,102.9 10.7 6.4 3.3 14.0
2010e 5.2 229.6 1,453.8 5.4 8.5 5.0 1.9 11.5 15.2 7.1 7.2 22.5 37.5 8.00 8.9 143.5 146.8 215.3 220.2 55.6 28.9 26.7 -8.5 -3.7 2.5 1.1 -2.6 15.0 10.0 41.5 17.2 10.8 -3.2 -3.1 -33.9 3,337.3 9.9 6.4 2.8 12.7
2011e 5.6 272.4 1,692.5 5.7 9.0 5.5 2.1 11.2 14.9 7.9 8.6 25.0 42.5 8.50 8.3 141.0 142.3 211.5 213.5 66.7 33.3 33.4 1.5 0.6 3.0 1.1 1.7 20.0 15.0 48.0 17.3 11.5 -1.9 -1.7 -27.9 3,721.6 9.6 3.2 2.5 12.1
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Frederic Neumann: +85 22 822 4556 fredericneumann@hsbc.com.hk
Pakistan: the essentials
The economy has stabilised and the central bank has room to cut rates further, yet soaring population growth requires more profound reforms to engender lasting growth
Still work to do Pakistan has had its fair share of troubles in the past few years. Yet there are signs that the economy is starting to stabilise. Inflation continues to ease, exports are looking up, the trade and budget balances are shrinking, and the central bank has room to cut rates further. But, these are tentative signs of recovery at best. A lot more needs to be done to bring growth back up to levels seen earlier this decade. Foremost, political uncertainty continues to weigh heavily on investment sentiment. In the fight against Northern insurgents, some progress has been made. But the army remains heavily involved in the conflict and political uncertainties prevail across the country at large. Other challenges loom as well, including the pervasive shortage of electricity, which continues to cripple industrial production and hampers a swift recovery in exports in particular. Q3 2008 Industrial production (% y-o-y) CPI, end quarter (% y-o-y) WPI, end quarter (% y-o-y) Trade balance (USDbn) Remittances (USDbn) International reserves (USDbn) Policy rate, end quarter (%) 2-yr yield, end quarter (%) PKR/USD, end quarter PKR/EUR, end quarter -5.7 23.9 30.6 -5.6 1.9 8.2 13.00 13.3 78.15 110.97 Q4 2008 -3.3 23.3 29.0 -4.0 1.8 10.0 15.00 14.875 79.11 109.97 Q1 2009 -12.1 19.1 17.6 -3.1 2.0 10.5 15.00 12.25 80.52 106.28 With foreign assistance pouring into Pakistan, any risk of an external payments crisis appears comparatively minor for the time being. Of greater concern is the process of reform aimed at placing the economy on a sustainable footing in preparation for the time when foreign assistance will be scaled back. In particular, tax revenue collections need to be improved and expenditure curtailed. Inflation is also still too high for comfort, and structural reforms, including further privatisation, may well be needed to revive growth. For now, Pakistan has earned a reprieve from external payments constraints, but the risk is that this window of opportunity for reform may be squandered. Growth this year and next should be positive, although barely enough to guarantee rising living standards for Pakistans burgeoning population. The country still has work to do. -10.1 13.1 11.1 -4.3 2.2 11.4 14.00 12.125 81.42 113.98 4.0 10.0 8.0 -3.5 2.2 8.3 12.00 10.75 88.00 127.60 4.0 8.0 7.0 -3.1 2.0 10.1 11.00 10.5 90.00 135.00 5.0 8.0 6.0 -3.1 2.2 10.6 10.00 9.8 92.00 138.00 5.0 8.0 8.0 -4.6 2.4 11.5 9.00 8.8 92.00 138.00 5.0 8.0 9.0 -3.6 2.4 8.4 9.00 8.8 92.00 138.00 6.0 8.0 9.0 -3.0 2.2 10.2 9.00 8.8 92.00 138.00
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
State Bank has room to cut Falling inflation has allowed the SBP to cut its policy rate in recent months. Over the coming months, we expect rates to drop further, although the pace of cuts may disappoint: potential exchange rate volatility and a still glaring trade deficit make it necessary to run relatively tight monetary policy. Also, inflation may prove more stubborn than widely expected, not least because global commodity prices are rising again, and the pass-through to Pakistan inflation is more potent this time as many subsidies have been curtailed. Encouragingly, however, there are signs that the central bank has ceased its earlier practice of monetising the fiscal deficit. This should make monetary policy much more effective in the future and at the margin allow the SBP to take rates lower still. Activity & inflation
8 6 4 2 0 -2 -4 -6 -8 -10 -12 -14 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e GDP (LHS) Industrial grow th (LHS) CPI (RHS) 30 25 20 15 10 5 0 (% y-o-y)
Population growth a challenge One of the prime challenges for Pakistan, and one that is often neglected in economic commentary on the country, is rapid population growth. For the current year, estimates suggest that the population is rising at over 1.5%, one of the fastest rates in Asia. Whats more, Pakistan has an extremely young population, with the median age below 25 years, among the lowest in Asia. While a young, and growing, population can be positive for economic growth, this is only the case if political stability persists. In Pakistans case, however, there are worries that demographics are raising political pressures, as unemployment among young males is especially high and public services are struggling to keep up with the expanding population. Policy stance
24 20 16 12 8 4 0 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e
(% y-o-y)
Policy rate
CPI, % y -o-y
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Pakistan: at a glance

16 14 12 10 8 6 4 2 0 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M spread ov er US-Libor 2Y spread ov er US-Lib or

14 12 10 8 3m 6m 1y r Now +4 months 2yr 3y r 10yr -4 month s Current CPI 15yr

100 90 80 70 60 50 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e PKR v s USD (LHS) Annualised v olatility (RHS) 25 20 (%) 15 10 5 0
(%)

250 225 200 175 150 125 100 75 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09

16 14 12 10 (USD bn) 8 6 4 2 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 0 100 50 200 150 (% of r eserves) 250
Policy dynamics
4.0 2.0 0.0 (real rates) -2.0 -4.0 -6.0 -8.0 -10.0 -4.0 2008 -5.0 -6.0 -7.0 -8.0 2011e 2010e 2009e 2007
International reserves, IFI definition (LHS) Short-term debt % reserves (RHS)
(%)
(%)

250 200 3000 2000 1500 1000 500 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 Pakistan stock-ex change (LHS) Pakistan av . spread

2500
(spread bp s)
(spread b ps)
2500
2000 1500 1000 500 0

1/05 5/05 9/05 1/06 5/06 9/06 1/07 9/07 5/07 1/08 5/08 1/09 9/08 5/09 9/09
(ind ex)
150 100 50 0
Pakistan 12M Gov t. Pakistan av. spread
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Pakistan: local knowledge/global drivers

Credit growth remains subdued but soaring remittances help stabilise demand amid falling inflation
Money in circulation has risen As in many other countries where hard economic data is difficult to come by, Pakistan watchers have long kept an eye on currency in circulation as a gauge of the strength of domestic demand. This has, indeed, turned up in recent months, suggesting that consumption is reviving as inflation slows. But, the recovery may prove difficult to sustain: broad money growth, while stabilising, hasnt shown a similar pick-up. This suggests that credit growth remains subdued as banks keep a close eye on risk. Ultimately, however, an expansion requires growth in credit, especially to private enterprises, to spur investment. This, in turn, depends on political stability, and it is here that Pakistan faces its greatest challenge of convincing companies to invest again and support future growth. But credit growth remains low
30 25 20 15 10 5 0
Inflation on the wane Pakistan is finally beginning to shake off the inflation shock that hit its economy, along with most other Asian markets, in the first half of 2009. The removal of subsidies for various food items, as well as the precipitous depreciation of the exchange rate, have kept up price pressures even as domestic demand has faltered and international commodity prices have slumped. As prices begin to stabilise, officials have started to relax monetary policy to abet a nascent recovery. However, risks remain that the fall in inflation will prove more gradual than hoped for. First, structural bottlenecks in the economy, such as electricity shortages, risk raising price pressures again as soon as growth returns. Second, international commodity prices have started to rise again, exposing Pakistan to growing price pressures once more. Although it still remains high by historical standards
30 25 20 15 10 5 0
Exports have stabilised After suffering the double blow of domestic electricity shortages and collapsing overseas demand, exports have started to stabilise of late, even though they are still down in annual terms. Even textiles, the countrys most important export item, has shown signs of life after the sector was especially hard hit by domestic turmoil and global shortage of trade financing facilities during the financial crisis. Imports, meanwhile, have remained subdued despite the rise in oil prices. Here, most likely, depressed domestic demand is keeping a lid on imports. As a result, the trade balance has improved markedly in recent months. Although Pakistan still grapples with a structural trade deficit, the tide has turned and external financing needs are being met with IMF assistance. While imports remain subdued
80 60 40 20 0 -20 -40 -60
08/04 09-04
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C ur re nc y in cir c ula tion ( % y y )
Im p o rts ( % y y )
08/05 09-05
08/06 09-06
08/07 09-07
E x p o r ts ( % y y )
08/08
M 2 (% y y ) 1 000 800 600 400 200 0
Remittances keep coming Along with other countries, such as the Philippines, Pakistan has seen remittances hold up throughout the global recession. In part, this strength can be attributed to ongoing demand for workers in the Middle East where the majority of Pakistani overseas workers reside. The recovery of the oil price, therefore, bodes well for remittances, pointing to continued strength over the coming quarters. In addition, the recent strength of remittances may reflect domestic political turmoil, enticing overseas Pakistanis to remit savings to relatives onshore in order to help them in times of trouble. This latter source of remittances, however, is bound to prove temporary as savings will ultimately dry up. As a result, we expect a cooling of remittance flows from the current pace. But growth seems bound to cool in the coming quarters
60 40 20 0 -2 0 -4 0
09/04
03/05
09/05
Core CPI (% y y )
03/06
09/06
03/07
09/07
CPI (% y y )
03/08
09/08
03/09
09/04
09/05
09/06
09/07
09/08
09-08
R em itta nc es ( U S D m n)
% y y ( R HS )
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Pakistan: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) WPI, average (% y-o-y) WPI, end-year (% y-o-y)) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 2-yr yield, end-year (%) PKR/USD, end-year PKR/USD, average PKR /EUR, end-year PKR /EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (ILSbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 7.7 111.0 721 12.9 1.7 13.5 17.8 14.6 7.7 7.4 7.4 8.5 8.0 20.5 9.6 7.5 4.5 59.5 58.5 81.1 73.1 12.9 13.0 -0.1 -1.5 -1.4 1.5 1.3 -0.1 9.2 36.7 12.0 11.0 2.8 34.0 2.3 1.3 -4.3 -4.3 -0.1 217.8 3.4 34.0 30.7 34.0
2005 6.2 128.0 816 1.0 48.3 19.9 14.9 13.9 6.2 9.1 8.5 8.7 11.9 17.2 18.8 9.0 8.8 59.8 59.6 70.5 74.2 15.9 17.8 -1.9 -5.0 -3.9 3.5 2.7 -1.2 23.1 42.2 11.7 7.9 2.4 35.9 1.4 1.6 -4.3 -4.3 -1.2 233.7 3.1 35.9 28.0 31.1
2006 5.7 143.8 901 4.7 -9.6 13.6 10.7 14.3 5.3 7.9 8.9 8.5 8.0 14.7 9.7 9.5 9.5 60.9 60.3 80.3 75.8 16.8 25.3 -8.5 -6.9 -4.8 5.0 3.5 -1.3 5.6 17.7 12.9 6.1 2.3 39.0 0.2 2.3 -3.7 -3.7 -0.1 261.0 3.0 39.0 27.1 30.1
2007 2.0 169.3 1,043 -1.3 39.0 3.8 5.5 11.2 5.2 7.6 8.8 8.5 12.8 20.0 7.6 10.0 9.6 61.4 60.8 89.7 84.5 17.3 29.8 -12.5 -13.9 -8.2 5.3 3.2 -5.0 2.9 9.3 15.6 6.3 2.2 44.5 4.6 2.9 -7.6 -7.6 -2.8 322.7 3.1 44.5 26.3 29.4
2008 3.7 184.5 1,127 5.2 -13.5 -6.5 -0.4 12.7 8.0 20.3 23.3 25.0 29.0 8.7 -7.3 15.0 14.9 79.1 71.0 110.0 103.4 20.0 32.6 -12.6 -8.9 -4.8 3.7 2.0 -2.8 15.6 29.3 10.0 3.7 3.3 51.1 7.7 2.3 -5.2 -5.2 -0.3 392.9 3.0 46.6 25.2 28.2
2009e 0.8 170.5 1,038 1.0 4.0 3.0 -4.2 17.8 8.0 13.1 8.0 6.5 7.0 10.0 2.2 11.0 12.3 90.0 83.6 135.0 122.2 17.3 42.2 -24.8 0.5 0.3 3.0 1.8 2.0 -13.3 -25.7 10.1 2.9 3.4 56.3 8.4 2.5 -6.3 -6.3 -1.4 442.1 3.1 51.4 30.1 33.2
2010e 2.6 169.0 1,026 2.0 3.0 4.0 5.2 18.8 7.0 7.9 8.0 7.8 9.0 7.0 0.0 10.0 12.1 92.0 91.8 138.0 137.6 18.2 31.3 -13.1 1.8 1.1 3.0 1.8 2.9 5.1 3.6 10.6 4.1 3.5 60.2 8.5 2.6 -5.6 -5.6 -0.6 489.6 3.2 55.6 32.9 36.1
2011e 3.7 185.2 1,121 3.5 3.0 4.0 5.5 19.5 7.0 7.6 7.0 8.6 0.0 7.0 1.0 9.0 10.8 92.0 92.0 138.0 138.0 19.6 32.4 -12.9 3.2 1.7 3.0 1.6 3.4 7.5 6.0 11.5 4.3 3.6 64.4 8.4 2.8 -4.6 -4.6 0.4 532.4 3.1 59.4 32.1 35.2
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Frederic Neumann: +85 22 822 4556 fredericneumann@hsbc.com.hk
Philippines: the essentials
Gradual recovery is on track but at the cost of higher spending, which, together with faltering revenue is set to worsen the fiscal outlook
In recovery mode, but fiscal risks remain Growth in the Philippines ground to a halt at the beginning of this year as private consumption, exports, and investment took a hit. However, the economy has bounced back in recent months, more broadly reflecting the recovery across the region. What is, perhaps, most surprising is the strength of remittances, which underpin more general growth in the Philippines. Whereas we had expected remittances to decline earlier this year, they have in fact continued to rise, driven by stronger flows from the Middle East in particular. This, along with easing inflationary pressures, is also helping revive consumer spending, although we expect a more convincing upturn in household spending to materialise only towards the year-end. As consumption stabilises, construction should also rebound, and ongoing growth in mortgage lending points to a possible property Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) PHP/USD, end quarter PHP/EUR, end quarter 4.6 5.4 11.8 6.5 -10.4 -1.1 36.6 6.0 7.6 47.10 66.88 Q4 2008 2.9 3.4 8.0 7.3 -5.0 4.9 37.4 5.5 6.6 47.40 65.89 Q1 2009 0.6 -7.6 6.4 0.9 -5.8 5.3 38.9 4.7 6.3 48.40 63.89 boom in the coming quarters. More generally, credit growth is still positive, albeit slowing, highlighting the ample liquidity in the banking system. Muted inflationary pressures have so far allowed the central bank to keep rates low, and they will probably stay on hold for the time being at 4%. Nevertheless, we suspect that inflationary pressures will be more prevalent going forward, and project that the headline reading will breach the official target towards the end of next year. We therefore pencil in a full 75bp in hikes over the course of next year, with the initial step coming in the second quarter. Growth should also surprise on the upside, especially if remittances continue their current run. One risk is that the fiscal deficit continues to widen, especially as we approach elections in the second quarter of next year. Even so, the recovery looks solid.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e 1.5 -7.2 1.5 -1.6 -6.4 5.3 39.4 4.3 6.2 48.40 67.76 1.9 -1.0 0.3 2.0 -10.4 1.4 38.5 4.0 7.3 48.40 70.18 3.0 2.0 3.5 3.0 -7.6 3.0 38.5 4.0 7.3 46.00 69.00 4.7 1.0 3.6 3.0 -6.2 6.6 40.3 4.0 7.5 45.50 68.25 4.9 1.0 5.3 3.5 -7.0 5.1 42.9 4.3 7.5 45.00 67.50 4.4 2.0 5.5 3.7 -10.8 0.2 43.4 4.5 7.5 44.50 66.75 2.8 2.0 5.7 4.8 -7.9 2.1 45.0 4.7 7.5 43.50 65.25
Inflation at a cycle low, breaching target by end-2010 Inflation over the past few months has provided a much-needed reprieve for the monetary board. It has also aided the countrys domestic consumption, which is feeling the pinch of rising unemployment. In August, headline CPI growth slowed to a record low of 0.1% in annual terms. Nevertheless, inflation has probably hit bottom in the Philippines and we expect headline CPI to start trending up as commodity price pressures become more prevalent over time, and as the base effect turns less favourable. However, we expect a moderate upturn until H1 2010, because core prices will continue to decelerate owing to the presence of excess capacity. We expect CPI growth of 3.2% y-o-y in 2009 and 4.8% in 2010, both within the central banks target zone for the year on average, although we project that it will start to breach the target towards the end of the year. Activity & inflation
8 (% y-o -y) 6 4 2 0 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e Industrial grow th (LHS) CPI (RHS) 5 0 15
No tightening before second quarter next year Since November 2008, the Philippine central bank has used key monetary instruments to resuscitate the economy. It has already reduced policy rates by 200bp, lowered reserve ratios by 2ppt to 19%, opened the dollar repurchase window, and increased the peso rediscounting budget. However, we have now reached the end of the easing cycle. A potential build-up in inflationary pressure owing to rising commodity prices led the central bank to place rates on hold, leaving them unchanged at 4% at the last policy meeting. With the economy still performing poorly on key measures, such as high unemployment, monetary tightening is unlikely over the remainder of this year. That said, with elections out of the way in the second quarter, we expect rate hikes to ensue quickly as officials gently put on the brakes and return to a more neutral monetary stance. Policy stance
0 (% GD P, 4q ma) -1 -2 -3 -4 -5 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e 10 8 4 2 0 (%) 6
10
(% y-o-y)
GDP (LHS)
Fiscal balance (LHS) CPI, % y-o-y (R HS)
Policy rate (RHS)
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Philippines: at a glance

8 6 4 (%)

10 8 6 (%) 4 2 0
2 0 -2 1/05 5/059/051/065/069/06 1/075/079/07 1/085/089/08 1/095/099/09 3M spread over US-Libor 2yr spread over US-Libor
3M
6M
1YR 2YR 3YR Now +4 months
4YR
5YR 7YR 10YR -4 month s Current CPI

60 55 50 45 40 35 35 30 25 20 15 10 5 0

250 200
(%)
(%)
150 100 50 0 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD C umulative CPI C umulative PPI 09
1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e PHP v s USD (LHS) Annualised v olatility (RHS)

40 35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserv es, IF I defin ition (LHS) Short-term debt % reserv es (RHS) 65
(% of reser ves)
Policy Dynamics
2.0 2007 2009e 2011e 2010e 2008 -3.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 (consolidated govt balance % GDP) -5.0
(USD bn)
(real rates)
55 45 35 25 15
1.0 0.0 -1.0 -2.0

40 0 30 0 10 00

1000
(spread bps)
(spread bps)
80 0 60 0
800 600 400 200 0

1/05 5/05 9/05 1/06 5/06 9/06 1/07 9/07 5/07 1/08 5/08 1/09 9/08 5/09 9/09
(ind ex)
20 0 10 0 0 1/ 05 7 /0 5 1/ 06 7/ 06 1 /0 7 7 /0 7 1/ 08 7/ 08 1 /0 9 7/09 M S CI Ph il ipp in es s ub-inde x (L HS) E MBI Ph ilipp ines s ub-ind ex (R HS)
40 0 20 0 0
Philippines 5yr Govt. EMBI Philippin es sub-index
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Philippines: local knowledge/global drivers

Remittances are proving surprisingly resilient, and will probably continue to grow this year and beyond, helping to offset a structural trade deficit
Cyclical recovery under way but structural risks prevail Exports have taken a hit since Q2 2008 after electronics shipments collapsed in response to the global crisis. Both exports and imports contracted at an unprecedented pace, the former causing large-scale job cuts. Nevertheless, as the global economy is set to recover, the prospects for electronics, which are highly cyclical, are improving. Nonetheless, we do not foresee a rapid recovery as the closure of several electronics producers may have led to structural weakness in the export sector. Overall, we expect exports to embark on a mildly positive growth trajectory in early 2010. Consequently, despite a moderate recovery in exports, the trade deficit will remain high given that rising oil prices are pushing up imports even faster Export recovery on track but will prove gradual
2 1 .5 1 0 .5 0 U S bo ok- to- bill ratio (lag ged b y 3 m onth s) Ex p or ts % Yr, 3 m m a 40 30 20 10 0 -1 0 -2 0 -3 0 -4 0 -5 0 Ju l- 98 M ay -0 0 M a r-02 Ja n-04 Nov -0 5 S ep-07 Jul-09
Middle East powers remittances Philippine remittances remain seemingly impervious to the global financial crisis and ensuing recession, beating expectations of a contraction. We attribute this remarkable resilience primarily to steady demand for migrant workers in the Middle East, where an overwhelming 51% of overseas Filipinos are employed. Despite a slump in oil prices, remittance flows from Saudi Arabia and the UAE continue to grow because of steady demand from the healthcare and retail sectors. Anecdotally, bilateral agreements signed between the Philippine government and some host countries, such as Japan, have helped sustain the current level of migrant workers and also facilitated the hiring of new or displaced workers. We now expect remittances for full-year 2009 to exceed last years level. No sign of stress on remittances
2 ,0 00
USD bn
1 ,5 00 1 ,0 00 5 00 0 Ja n- 96 S ep- 98 M ay - 01 Ja n- 04 R em itta nc es, sa Se p- 06 M ay - 09
Fiscally challenged The governments fiscal consolidation efforts have been dented by the current global crisis. The fiscal deficit reached PHP210bn in the first eight months after the administration embarked on pump-priming of the economy at a time when revenue collection was faltering. Indeed, the countrys fiscal outlook remains challenging for this year and next. Given the scarcity of growth stimuli, revenue collection will remain weak for some time. Weak imports and structural bottlenecks will add to the roster of revenue-related concerns. With the election approaching, the government may struggle to tighten policy, which could push the deficit to PHP297bn (3.8% of GDP) this year. Fiscal policy turns counter-cyclical in 2009
2 % of GDP 0 -2 -4 -6 2010f 1994 1996 1998 1992 2000 2002 2004 2006 2008
Government borrowing blocking private sector lending? Unscathed by global financial dislocation, Philippine banks have ramped up lending at a robust pace since 2008. This rapid growth in bank lending is partly attributable to re-intermediation, ie capital market financing being switched to banks as the equity and bond markets came under pressure. However, the speedy expansion of lending to the private sector over time has been reversed by the increase in government borrowing requirements. Recent data show that credit extended to the public sector posted record 28% y-o-y growth in July 2009. As the government may run a large deficit this year, higher public borrowing needs could continue to crowd out private sector lending. Lending to the public sector accelerated
25 20
% y-o-y
40 20 0 -20 -40 Dec-02 Mar-04 Jun-05 Sep-06 Dec-07 Mar-09 Credit to private sector Credit to public sector
% y-o-y
15 10 5 0 -5
Cyclically neutral budget balance
Actual budget balance
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Philippines: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal* (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) PHP/USD, end-year PHP/USD, average PHP/EUR, end-year PHP/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (PHPbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP)
Note: * refers to minimum wage index
2005 5.0 99.0 1,171 4.8 2.3 -6.6 5.3 21.0 8.1 7.7 6.7 12.1 8.5 7.0 -4.0 7.5 9.6 53.09 54.99 62.65 68.46 40.3 48.0 -7.8 2.0 2.0 1.7 1.7 3.7 3.8 8.0 18.4 4.6 11.8 54.2 34.8 22.8 -1.8 -2.7 2.8 2,164 39.76 31.35 31.67 71.42
2006 5.3 117.6 1,375 5.5 10.4 3.9 4.2 20.1 7.8 6.3 4.3 3.7 7.9 13.8 -2.3 7.5 6.0 49.01 51.29 64.63 64.45 46.5 53.3 -6.7 5.3 4.5 2.8 2.4 6.9 15.6 10.9 22.8 5.1 14.8 53.4 21.9 20.3 0.2 -1.1 4.1 2,154 35.72 33.10 28.14 63.86
2007 7.1 147.1 1,700 5.8 6.6 10.9 3.3 20.8 7.4 2.8 3.9 -3.0 4.5 17.1 2.7 5.2 5.7 41.20 45.18 60.15 62.80 49.5 57.9 -8.4 7.1 4.8 -0.6 -0.4 4.4 6.4 8.7 33.6 7.0 15.9 54.9 21.1 21.5 0.4 -0.2 3.8 2,201 33.11 33.45 22.74 55.85
2008 3.8 167.1 1,909 4.7 3.2 2.9 4.3 19.2 7.7 9.3 8.0 7.3 5.3 14.2 10.0 5.5 6.6 47.40 44.43 65.89 64.69 48.2 60.8 -12.6 4.2 2.5 1.3 0.8 3.3 -2.6 5.0 36.5 7.2 17.7 53.9 19.2 13.2 -0.9 -0.9 2.7 2,414 32.53 40.66 24.34 56.86
2009e 1.8 161.0 1,807 2.4 8.8 0.2 -3.2 13.8 7.5 3.2 3.5 3.0 3.8 12.6 9.1 4.0 7.3 46.00 47.98 69.00 69.40 38.1 50.3 -12.2 5.9 3.6 0.9 0.5 4.2 -21.1 -17.7 38.5 9.2 18.1 52.0 16.2 14.3 -3.8 -3.8 -0.1 2,600 33.66 37.68 23.41 57.07
2010e 4.2 186.6 2,057 3.7 8.3 4.3 1.5 13.0 9.0 4.7 5.7 4.8 4.5 9.0 3.0 4.7 7.5 43.50 44.94 65.25 67.41 40.4 55.4 -15.0 6.2 3.3 1.4 0.8 4.1 6.0 10.0 45.0 9.7 20.3 50.0 13.3 6.9 -4.3 -4.3 -0.3 2,788 33.25 43.15 23.12 56.37
2011e 4.7 216.4 2,321 5.2 6.4 5.9 1.6 11.7 9.0 5.8 5.9 2.5 5.5 8.0 2.2 5.5 7.5 42.50 42.88 63.75 64.31 44.5 62.7 -18.2 6.5 3.0 1.9 0.9 3.9 10.1 13.2 48.0 9.2 22.5 50.0 12.5 2.2 -3.3 -3.3 0.5 2,947 31.76 47.80 22.09 53.85
6.4 86.9 1,052 5.9 1.4 1.3 5.0 21.2 11.3 6.0 8.6 14.3 3.6 16.5 -3.7 6.8 12.9 56.23 56.04 76.34 70.06 38.7 45.1 -6.4 0.9 1.1 0.1 0.1 1.2 9.6 10.6 16.1 4.3 9.4 54.8 31.4 22.5 -4.8 -3.8 1.5 2,001 41.08 32.31 39.20 80.28
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Juliet Sampson: +44 20 7991 5651 juliet.sampson@hsbcib.com Kubilay Ozturk: +44 20 7991 360 kubilay.ozturk@hsbcib.com
Poland: the essentials

Polish zloty one of the currencies hardest hit by the global economic crisis but the real economy has fared much better, avoiding recession altogether and, most likely, outperforming the rest of the EU in 2009
Recession? What recession? While many economies in the region faced a steep decline in GDP, the Polish economy managed to achieve positive growth in every quarter of the last year. Growth was fuelled by consumption (in turn, supported by a strong labour market), powerful momentum in investment, and a considerable increase in net exports. The current account deficit, which was over EUR19bn in 2008, will be very close to flat or in surplus in 2009. Steady interest rate cuts delivered by a dutifully dovish MPC even as the zloty plummeted also helped. Going forward, recovery will be gradual as consumption growth is likely to ease. The government will have a more stringent fiscal environment as it seeks to avoid exceeding the 55% debt/GDP threshold that would trigger more drastic expenditure cuts. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) PLN/USD, end quarter PLN/EUR, end quarter 4.8 2.0 4.5 2.4 -4.0 -4.4 71.0 6.0 6.1 2.41 3.40 Q4 2008 2.9 -6.1 3.3 2.6 -5.2 -5.9 58.9 5.0 5.3 2.96 4.15 Q1 2009 0.8 -10.6 3.6 5.6 -0.7 0.5 57.8 3.8 6.0 3.50 5.07 The 2010 budgets growth and inflation assumptions (both 1%) appear very conservative to us, leaving a fiscal cushion in the budget, though the government has set an ambitious privatisation timetable that will have to have some success if the deficit target is to be met. Inflation is unlikely to come anywhere close to the target and is more likely to be in the region of 3% for the year. Stronger inflation would have been an issue for Polands euro adoption plans, but since missing the Q2 target to join ERMII, the government has conceded that 2012 is no longer a realistic euro adoption target. 2014 is now a more likely date, assuming inflation and the budget deficit fall and political issues are resolved. Presidential elections in 2010 will soon come into focus, and may favour the ruling Citizens Platform candidate given the partys robust popular support. 1.1 -7.3 3.5 4.0 0.0 1.1 63.6 3.5 5.8 3.17 4.45 0.8 -3.3 3.8 2.5 -1.5 0.0 64.6 3.5 5.7 2.76 4.00 1.4 -1.2 3.6 4.1 -3.4 -0.5 66.0 3.3 5.5 2.53 3.80 2.0 1.1 2.7 0.9 0.1 -1.7 67.0 3.3 5.0 2.47 3.70 1.6 5.0 2.3 2.4 0.6 -1.9 68.0 3.3 5.0 2.40 3.60 1.8 6.5 2.5 4.2 -0.7 -2.3 69.5 3.3 5.2 2.33 3.50 2.4 7.1 2.5 2.9 -2.7 -2.9 71.0 3.5 5.5 2.27 3.40
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
The economy has outperformed most of Europe Economic activity has slowed considerably in the last year, but conditions in Poland have been far less dire than in the rest of the EU and beyond. Consumption, supported by a red hot labour market heading into the crisis, has held up well even as exports plummeted. Industrial activity fell, but with less reliance on exports than its neighbours, Poland avoided recession altogether. It now appears that January was the bottom of the downturn with Q2 showing clear signs of a turn. Unemployment has stabilised around the level last seen in early 2008, and industrial production growth is close to flat. Nonetheless, consumption, government spending and investment growth have slowed, suggesting that a quick return to higher growth rates is unlikely and economic activity will remain positive but subdued for a number of quarters. Activity & inflation
9 6 3 0 -3 -6 -9 -12 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e
GDP (LHS) Industrial growth (LHS) CPI (RHS)
Signs of inflation stickiness leave little room for further easing Inflation has remained relatively high in spite of softening demand and falling food and fuel prices. There are some signs of stickiness in recent data as service prices remain relatively firm. This owes something to the relative resilience of Polish consumer demand and, equally, to an aggressive NBP loosening policy. While policy easing was appropriate under the circumstances, the voting majority on the MPC still seems to favour a loose policy. If, as we expect, Q3 GDP is softer than Q2, further (limited) easing is possible in the months ahead. However, inflation risks leave little room to cut, and if they persist in 2010, a tightening of policy may be necessary before too long. With Polands Maastricht-relative inflation well above the reference rate, tighter policy will be required to ensure it does not cause a delay in euro adoption. Policy stance
0 -1 -2 -3 -4 -5 -6 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e Policy rate (RHS) 8 6
(%)
(% GDP, 4 qma)
(% y-o-y)
5 4 3 2 1 0
4 2 0
(% y-o-y)
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Poland: at a glance

6 5 4 3 2 1 0 1/055/05 9/051/065/06 9/061/075/07 9/071/085/089/081/095/099/09 3M spread over Euribor 2y r spread ov er Euribor

12 10 8 6 4 2 0 1y r 2yr 3yr Now +4 months 5yr 10yr -4 month s Current CPI 15yr

5.0 4.5 4.0 3.5 3.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e PLN vs EUR (LHS) Annualised vola tility (RHS) 30 25 15 10 5 0 (%) 20
(%)

150 (%) 125 100 75 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate vs EUR Cumula tive CPI Cumula tive PPI 09

90 80 70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short- term debt % reserves (RHS) 60 50 40 30 20 10
Policy dynamics
2.0 1.5 2007 (real rates) 1.0 0.5 0.0 -0.5 -2.0 -3.0 -4.0 2009e -5.0 -6.0 -7.0 2011e 2008 2010e
(USD bn)
(%)
(% of reser ves)

2000 1500 500

500 400 300 200 100 0 -100
300 1000 500 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Poland sub-index (LHS) EMBI Poland sub-index (RHS) 200 100 0
(spread bp s)
(spread bps)
400
(ind ex)
5/05 1/05
9/05
1/06
5/06
Poland 5yr Govt. EMBI Pola nd sub-index
9/06
1/07
5/07
1/08 9/07
5/08
9/08
1/09
5/09
9/09
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Poland: local knowledge/global drivers

A weak zloty and plummeting imports helped turn a large current account deficit into a surplus in H1, but the budget deficit has widened and euro adoption plans have been put on hold
A large current account deficit has turned to surplus Polands current account deficit, which grew to over EUR19bn or 5.4% of GDP in 2008, vanished in the first half of 2009. This owes much to a sharp narrowing of the trade deficit: exports dropped 25% y-o-y in the three months to April (which appears to be the bottom) while imports dropped even further, falling by a third in the three months to April. The fall slowed in the following three-month period, but imports remain considerably weaker than exports and trade deficit narrowing looks set to continue through most of H2. A weak zloty has clearly helped, though a recent zloty recovery suggests that the deficit may return/widen in 2010. The income balance has also narrowed sharply, while the transfers surplus has increased as EU funds peak this year. External deficit shrinks acutely with economic downturn
1 0 USD bn - 1 9 8 9 9 0 0 01 02 03 04 0 5 0 6 0 7 08 09 -2 -3 -4 T r ade b alan ce (LHS ) Im ports y / y E x p or ts y /y 10 0 75 50 25 0 - 25 - 50 % y-o-y
The budget deficit will widen further in 2010, then narrow in 2011 Weaker growth has inevitably put a strain on budget financing in 2009. However, the government has tried to limit expenditure and reduce the deficit as much as possible rather than loosening policy, avoiding stimulus packages that have become standard in Western Europe. It has also attempted to accelerate privatisations of state-owned holdings to limit debt-financing. Nonetheless, the deficit for 2009 has widened and the state deficit target for 2010 was increased significantly to PLN52bn or 3.8% of GDP. Conservative growth and inflation targets mean the deficit may be narrower than plan; but fiscal stability laws will trigger stringent expenditure cuts if the government debt stock rises to over 55% of GDP a distinct possibility if privatisation plans fall through. Debt-to-GDP ratio to remain below 55%
20 15 10 5 0 -5 0 0 -1 0 In dus try C on s tr uc tion S e rv ic es 01 02 03 04 05 06 07 08 09
EMU will have to wait most likely until 2014 Polands aim to adopt the euro in 2012 fell through earlier in 2009 when it was unable to join ERMII in Q2, in time to keep to the tight adoption schedule. Until there is a two-thirds parliamentary majority in favour of changing the constitution not likely until parliamentary elections are held in 2011 it will be awkward if not impossible for Poland to join the exchange rate mechanism. Unless the President is voted out of office next year (which appears likely) and his departure shifts the balance of power in parliament (questionable) this means the earliest likely date for euro adoption is now 2014. Even without this political hurdle, Poland no longer meets the Maastricht inflation or budget criteria, and it may be two years at least before these are again within reach. Polish inflation is far above Maastricht benchmark
20 15 10 5 0 -5 99 00 01 02 03 04 05 06 07 08 09 3 3 2 2 1 1 0 -1 -1
Weak no longer; the zloty recovery has begun The zloty underperformed most of the region and the EM world in Q4 2008 and Q1 2009, but it has recovered convincingly since June 2009. The abrupt narrowing of the current account deficit and continued capital inflows (including funding of subsidiaries by foreign parent entities, net EU transfers and successful Eurobond issuance) have been supportive. Evidence of Polands economic outperformance (particularly the Q2 GDP outcome) has also helped. An interruption of the easing cycle for a number of months has also supported the currency. But the zloty remains cheap on a REER basis, and its macroeconomic vulnerability (real or potential) has diminished. Over time the zloty is likely to make further gains, and it should be less vulnerable in the event of risk aversion. The zloty still appears undervalued on a REER basis
20 15 USD bn 10 5 0 01 02 03 04 05 06 07 08 09
Core inflatio n (L HS)
En ergy co ntrib p pts
F DI c om m itm en ts
F DI d isbu rs em en t (R HS)
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Poland: macro framework

2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) PLN/USD, end-year PLN/USD, average PLN/EUR, end-year PLN/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (PLNbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 5.3 253.7 6,646 4.0 2.3 6.4 12.7 13.4 19.1 3.5 4.3 5.4 -8.1 9.4 6.3 6.5 6.2 3.01 3.64 4.08 4.53 81.6 87.2 -5.6 -10.4 -4.1 0.0 0.0 -4.1 33.7 30.6 34.6 4.8 25.0 129.8 71.9 57.1 -3.8 -4.5 -1.2 319.5 34.6 30.7 12.1 46.7 2005 3.6 303.9 7,964 2.7 6.6 6.5 4.0 17.4 17.6 2.1 0.7 0.2 3.2 13.1 12.7 4.5 5.0 3.25 3.24 3.85 4.03 94.4 97.4 -3.0 -4.8 -1.6 0.5 0.2 -1.4 15.7 11.7 40.5 5.0 25.5 132.8 66.7 56.9 -2.9 -2.5 -0.3 315.5 32.1 46.7 15.4 47.5 2006 6.2 341.5 8,957 5.0 4.3 14.9 12.0 17.1 14.9 1.0 1.4 2.5 5.0 16.0 20.0 4.0 5.0 2.90 3.10 3.83 3.90 117.2 122.2 -5.0 -7.9 -2.3 1.7 0.5 -1.8 24.2 25.5 46.1 4.5 29.5 159.1 74.9 74.4 -3.8 -2.4 -1.1 352.3 33.2 49.2 14.4 47.7 2007 6.7 425.1 11,156 5.0 1.9 17.6 9.4 16.8 11.4 2.5 3.8 2.3 9.1 13.4 19.5 5.0 6.1 2.47 2.77 3.60 3.79 147.9 159.4 -11.4 -20.4 -4.8 16.2 3.8 -1.0 26.2 30.4 62.7 4.7 30.2 205.3 28.8 102.3 -2.0 -1.4 0.2 380.4 32.4 53.2 12.5 44.9 2008 4.8 524.5 13,778 5.4 0.0 7.9 3.0 16.7 9.5 4.2 3.3 2.6 10.3 18.6 28.2 5.0 5.3 2.96 2.41 4.15 3.52 175.6 198.4 -22.8 -28.6 -5.4 13.5 2.6 -2.9 18.7 24.5 58.9 3.6 20.4 250.0 35.6 125.0 -3.9 -1.9 -0.3 420.2 33.2 73.8 14.1 47.3 2009e 1.0 499.9 13,137 1.8 1.1 0.8 -5.6 18.7 11.3 3.6 3.6 4.1 3.8 3.6 -3.5 3.3 5.5 2.53 2.65 3.80 4.23 136.9 144.3 -7.4 0.8 0.2 6.2 1.2 1.4 -22.0 -27.3 66.0 5.5 15.0 275.0 40.2 135.0 -4.7 -2.8 -2.1 479.0 36.2 77.7 15.6 51.7 2010e 2.0 577.3 15,181 2.5 2.0 3.5 4.9 17.0 11.0 2.6 2.5 2.9 4.5 8.7 5.0 3.5 5.5 2.27 2.40 3.40 3.60 143.8 151.5 -7.7 -12.9 -2.2 8.0 1.4 -0.8 5.0 5.0 71.0 5.6 20.0 300.0 39.4 150.0 -6.3 -3.8 -3.4 526.9 38.0 92.9 16.1 54.1 2011e 3.4 645.2 16,980 3.1 1.6 5.5 5.5 17.2 10.5 2.5 2.3 4.0 4.0 10.0 8.5 4.0 5.0 2.21 2.28 3.20 3.30 156.0 165.9 -9.9 -18.0 -2.8 11.5 1.8 -1.0 8.5 9.5 76.0 5.5 28.0 325.0 39.5 168.0 -4.0 -2.4 -1.2 553.3 37.7 97.4 15.1 52.8
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Kubilay Ozturk +44 20 7991 11360 kubilay.ozturk@hsbcib.com
Romania: the essentials
IMF-led stabilisation package alleviated financing concerns but it is no remedy for recession. Our forecasts suggest there will not be a sustainable economic recovery until 2011 given rising political risks
IMF is no remedy for recession The IMF-led EUR20bn external loan package secured by the centre-left coalition government in March boosted confidence in Romanian assets. Notwithstanding bouts of global/regional risk aversion, the leu has stayed relatively stable while CDS spreads have come down from their peaks. However, the IMF deal is no remedy for recession and the Romanian economy is set to shrink materially this year after high rates of growth, averaging 6.6% over the last six years. Private consumption and investment, the main drivers of that growth, have been hit severely since the last quarter of 2008 as real wage and loan growth slowed rapidly while foreign capital inflows remained subdued. Although external demand provided some support (as the contribution of net exports to GDP remained positive), this will likely fade away as fiscal incentives in Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 3M Interbank rate, end quarter (%) USD/RON, end quarter EUR/RON, end quarter 9.2 2.4 7.3 18.6 -12.1 -12.2 37.3 10.3 13.4 2.67 3.75 Q4 2008 2.9 -6.1 6.3 7.9 -12.4 -10.0 36.7 10.3 14.7 2.89 4.03 Q1 2009 -6.2 -11.4 6.7 3.9 -9.9 -3.1 33.3 10.0 14.0 3.20 4.24 Western Europe will expire in the last part of the year. Given worse-thanexpected economic performance, the IMF and EU watered down the key macro assumptions in the programme in August and increased this years budget gap target nearly two-fold to 7.3% of GDP (in cash terms) while the government has agreed to cut spending by 0.8% during the second half, along with a further commitment to structural measures, including an overhaul of the public wage system. Public dissatisfaction with IMF-induced fiscal reforms appears high and led to a recent break-up of centre-left government ahead of the November presidential election, in which the two strongest contenders are from each of the coalition parties. The worsening political backdrop may lead to delays in IMF/EU disbursements, which may disrupt the ongoing normalisation in Romanian financial markets. Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -8.7 -8.8 5.9 0.0 -5.9 -6.4 37.3 9.5 10.0 3.00 4.21 -8.6 -9.0 5.0 -3.4 -6.2 -4.6 39.3 8.0 9.0 2.93 4.25 -6.2 -8.5 4.5 -5.3 -5.5 -5.5 42.0 7.5 8.2 2.80 4.20 -2.4 -5.0 3.1 -1.2 -3.2 -2.6 43.4 7.0 7.5 2.73 4.10 1.0 3.0 3.5 2.9 -5.7 -5.2 47.8 6.5 6.9 2.67 4.00 1.5 3.5 4.3 4.9 -5.8 -5.5 47.1 6.5 6.8 2.60 3.90 2.4 4.0 3.8 6.1 -6.7 -4.2 50.3 6.0 6.3 2.53 3.80
No quick fix The recession in Romania deepened in the second quarter as the economy shrank by 8.7% y-o-y after a fall of 6.2% in Q1. Household consumption and fixed investment remain the main contributors to the material downturn while net exports maintained their positive contribution to headline growth. Although firms seem to have embarked upon the long-awaited inventory-building cycle, it is unlikely to be material enough to boost growth. Looking ahead, the economy is likely to start recording positive growth from the second quarter of 2010. A revival in bank lending and a subsequent increase in private consumption appear to be main prerequisites of a sustained recovery, which we believe to be unlikely before 2011. Activity & inflation
12 9 6 3 0 -3 -6 -9 -12 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) 10
Further rate cuts in the pipeline Emboldened by IMF-led external financial support, the National Bank of Romania (NBR) has lowered its key rates by 200bp since March to 8.0% and shifted to a dovish bias. The NBR appears determined to revive lending as minimum reserve requirement ratios on local and foreign currency denominated loans were also reduced by 3 and 10 percentage points, respectively. Assuming the markets continue to normalise, the widening negative output gap and benign inflation outlook justify further measured cuts ahead. However, aggressive moves (ie larger than 50bp cuts) should not be expected as the banking system remains vulnerable to the high weight of foreign currency lending in total loans (c60%) and a high FX loan-to-deposit ratio (1.78). Policy stance
0 -2 -4 -6 -8 -10 -12 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e 15 12 9 6 3 0 (%)
6 4 2 0
(% GDP, 4 qma)
8 (% y-o-y)
(% y-o-y)
GDP (LHS)
Policy rate (RHS)
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Romania: at a glance

500 400 (%) 300 200 100 0 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate v s USD Cumulativ e CPI Cumulativ e PPI 09

12 11 10 9 8 7 6 5 4 1yr 2yr 3yr Now +3 months 4y r 5yr 8yr 10yr -3 month s Current CPI

4.0 3.5 3.0 2.5 2.0 1.5 1.0 60 50 40 30 20 10 0 -10
Policy dynamics
6.0 2008 2009e
(real rates)
(%)
(%)
4.0
2.0 2007 0.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 2011e
2010e

45 40 35 30 25
(USD bn)
2000
20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2 007 2008 2009 International reserv es, IF I de fi n ition (LHS ) S hort-term debt % re serv e s (R HS)
2001
RON vs USD (LHS)
2002
2003
2004
2005
2006
Annualised volatility (RHS)
2007
2008
2009
2010e
160 140 120 100
(% of reserves)
-6.0
-7.0
-8.0
80 60 40 20 0
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Romania: local knowledge/global drivers

Political risks resurfaced with the break-up of coalition government but the financial and economic backdrop is buttressed by IMF scrutiny on the banking system, a narrowing external deficit and a stable currency
A break-up in coalition ahead of presidential election The structural benchmarks of the IMF programme include an overhaul of the public compensation and pension systems. Public dissatisfaction, particularly with the former, appears high as it necessitates lay-offs, and caps on wages and bonuses. The centre-left coalition government survived a no-confidence vote in late September and managed to pass the controversial public wage bill but tensions within the coalition mounted ahead of the November presidential elections, which led to a recent breakup of the government. The parties are likely to form a minority government to overcome the political crisis while the possibility of early elections can not be ruled out. The political backdrop may delay the IMF/EU disbursements but the adherence to IMF programme is likely to continue. Distribution of seats in Romanian Parliament (Chamber of Deputies)
5% 7%
Banking sector under IMF scrutiny The Romanian banking sector entered global financial turmoil with a strong solvency position. The capital adequacy ratio (CAR) reached 13.8% at the end of 2008, but asset quality has deteriorated since then mainly owing to a weaker currency, high share of FX loans in the total and surging unemployment. Non-performing loans have risen and credit extension has slowed materially. The threshold for CAR was increased from 8% to 10% under the IMF programme. Following the stress tests conducted by the NBR and IMF, the largest foreign parent banks (with a market share of 70%) agreed to increase the capital of their subsidiaries by EUR1bn by March 2010. The debt roll-over ratio improved after the conclusion of the IMF deal, lowering risks pertaining to the sector. Non-performing loans on the rise
20 15 10 5 0 -5 -10 60 50 40 30 20 10 0 01 02 03 04 05 06 07 08 2009e
35% 19%
34% Liberal Democrat Party (PD-L) National Liberal Party (PNL) Others Social Democrat Party (PSD) UDMR
Real GDP growth (y-o-y %) Real private credit growth (RHS, y-o-y %) NPLs (% of total loans)
Note: NPLs reflect unadjusted exposure of loans classified as "loss", "doubtful", and "substandard". Source: IMF, World Bank, HSBC
Note: Shaded regions refer to share of current ruling parties Source: Romanian Electoral Committee
Recession brings welcome balance-of-payments adjustments While the macroeconomic deterioration is clearly unwelcome, one desirable by-product of the economic crisis is the rapid shrinkage of the current account deficit. Much of the improvement has come from merchandise trade as the shrinkage in imports has outpaced the drop in exports. The recession in the Eurozone explains withered demand for exports while a high level of imported inputs in manufacturing and subdued household consumption led to the larger collapse in imports. The income deficit and current transfers improved year-to-date as well, underlining the fall in external financing requirements. However, correction in external balances may prove temporary as the import bill is likely to surge with rising commodity prices and global recovery. Current account deficit shrinks with waning demand
20 15 10 5 0 -5 -10 -15 -20 Jan-05 40 30 20 10 0 -10 -20 -30 -40 Jul-09
A stable currency remains key for recovery The leu has underperformed regional EMEA currencies year-to-date. Contributing factors include a worse-than-expected economic performance, a relatively illiquid market and the NBRs covert interventions on both sides. The latter appears to have kept leu volatility low, which is of critical importance given the high share of FX loans and high levels of exchange rate pass-through. A weak and stable leu is likely to support exports and help recovery while a high level of carry, correction in external balances, fast growing local currency debt market and eurozone convergence process point to a firming currency. While the official 2014 target for euro adoption is still possible, 2015 or 2016 seems more realistic given the high public deficit ahead. The leu volatility is low compared to CE3 currencies
30 30-day volatility (annualised, %) 25 20 15 10 5 0 Jan-09 Mar-09 May-09 EUR/RON EUR/HUF Jul-09 EUR/PLN EUR/CZK Sep-09
EUR bn, cum12m
y-o-y %, 3mma
Oct-05
Jul-06
Apr-07
Jan-08
Oct-08
Current account Exports (RHS)

Source: INSEE, NBR
Trade balance Imports (RHS)
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Romania: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Gross wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) USD/RON, end-year USD/RON, average EUR/RON, end-year EUR/RON, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Gross external debt1 (USDbn) Short term external debt1 (% of int'l reserves) Private sector external debt1 (USDbn) Consolidated government balance2 (% GDP) Gross public domestic debt (RONbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 8.5 75.8 3,478 15.9 -8.5 11.0 1.6 14.7 6.2 11.9 9.3 15.9 22.6 37.6 28.7 17.0 2.91 3.26 3.96 4.05 23.5 30.1 -6.6 -6.3 -8.3 6.4 8.4 0.1 33.8 36.4 14.6 5.8 27.0 24.0 15.2 -1.2 14.8 6.0 11.8 16.5 22.5
2005 4.1 99.2 4,567 10.0 3.8 15.3 -2.5 13.1 5.9 9.0 8.6 9.5 17.1 36.5 34.5 7.5 3.11 2.91 3.68 3.62 27.7 37.4 -9.7 -8.8 -8.9 6.5 6.6 -2.3 17.7 24.1 19.9 6.4 38.7 35.6 25.7 -1.2 16.8 5.8 13.0 14.6 20.4
2006 7.9 122.7 5,670 12.8 -3.8 19.9 9.4 14.4 5.2 6.6 4.9 11.6 18.9 28.1 49.5 8.8 2.56 2.81 3.38 3.52 32.4 47.2 -14.8 -12.8 -10.4 11.4 9.3 -1.1 17.2 26.2 28.1 7.1 52.6 49.4 40.0 -2.2 27.4 7.9 12.6 10.4 18.4
2007 6.2 169.3 7,850 11.6 1.2 28.9 10.1 17.1 4.1 4.8 6.6 10.5 22.6 33.7 53.9 7.5 2.45 2.46 3.57 3.34 40.3 64.4 -24.1 -23.5 -13.9 9.7 5.7 -8.2 24.4 36.4 37.2 6.9 79.7 63.9 66.4 -2.5 45.1 10.9 13.3 9.0 19.9
2008 7.1 199.7 9,292 9.1 3.1 19.3 2.6 18.8 4.4 7.9 6.3 7.9 23.6 17.5 27.4 10.3 2.89 2.52 4.03 3.68 49.5 76.5 -27.0 -25.2 -12.6 13.6 6.8 -5.8 22.8 18.8 36.7 5.8 106.8 74.8 91.5 -5.4 67.2 13.3 15.3 8.4 21.8
2009e -7.5 165.9 7,747 -10.1 1.5 -20.6 -9.4 19.9 9.2 5.6 4.5 -5.3 6.0 6.3 4.2 7.5 2.80 2.98 4.20 4.22 40.6 51.7 -11.1 -8.4 -5.0 5.0 3.0 -2.0 -17.8 -32.4 42.0 9.7 108.9 38.9 80.6 -7.2 93.3 18.9 28.3 16.0 34.9
2010e 0.9 196.8 9,222 0.8 1.0 2.0 1.4 18.7 10.1 3.8 3.8 6.1 4.5 9.8 7.0 6.0 2.53 2.63 3.80 3.95 42.0 52.9 -10.9 -8.9 -4.5 6.5 3.3 -1.2 3.3 2.4 50.3 11.4 122.2 43.7 90.4 -5.7 103.7 20.0 31.8 15.6 35.6
2011e 3.2 223.7 10,521 4.8 2.1 9.4 4.9 16.9 8.5 4.0 5.1 7.3 5.0 12.1 14.5 6.5 2.48 2.54 3.60 3.68 46.0 62.8 -16.8 -14.5 -6.5 8.5 3.8 -2.7 9.6 18.7 47.7 9.1 123.9 57.2 92.9 -3.8 111.7 20.1 31.0 13.9 34.0
Note: 1 External debt figures include direct investment intercompany lending; 2 General government deficit according to EU definition (ESA95)
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Alexander Morozov: +7495 783 8855 alexander.morozov@hsbc.com Dmitry chernyadyev: Economics Associate
Russia: the essentials

The economy is bouncing, benefiting from the improved global environment, yet risks to medium-term growth and inflation appear high
Uneasy recovery The significant decline in economic output in Russia from its pre-crisis peak suggests potential for a strong rebound once the global and domestic economies stabilise: it is easier to grow from a low base. That seems to be happening now. After GDP reached a bottom with a drop of 10.9% y-o-y in Q2, Russias economy began bouncing in June. The recovery looks rather shaky, though. So far, the economy has mainly been boosted by export demand, restocking and a rally in global commodity and financial markets. Other growth ingredients are missing. Private consumption keeps weakening, real wages are still declining and jobs continue to disappear. Banks struggle with problem assets and, apart from state-owned banks, are reducing loan portfolios. Government efforts to stabilise the situation helped to avoid a bigger fall Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) RUB/USD, end quarter RUB/EUR, end quarter 6.0 4.7 15.1 25.7 11.3 6.2 542.1 11.0 8.2 25.25 36.37 Q4 2008 1.2 -6.1 13.3 -7.0 6.2 2.1 412.5 13.0 11.9 29.38 41.44 Q1 2009 -9.8 -14.3 14.0 -2.8 7.1 3.4 368.1 13.0 12.9 34.01 44.94 in output, but public procurement and many public investment programmes had to be cut to keep the fiscal situation under control. Internal growth stimuli promise to be weak. Credit will remain curtailed by the gradual approach to solving the banking sectors problems. At the same time, the potential for boosting the economy by further fiscal easing has disappeared, with the budget deficit jumping to c8% of GDP in 2009. Therefore, economic recovery in Russia depends to a large degree on how fast the global economy and financial markets recover. Moreover, a credible fiscal exit strategy has yet to be worked out. The choice taken to boost current public spending while curbing investment is politically challenging to reverse. Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -10.9 -15.4 11.9 -9.4 8.6 2.6 396.0 11.5 11.7 31.16 43.71 -8.4 -14.0 10.8 -8.0 10.0 4.8 401.9 10.0 11.6 30.88 44.78 -4.3 -4.5 9.5 11.0 7.5 2.7 408.5 9.0 12.1 31.17 46.76 4.6 5.0 7.0 11.0 7.3 3.8 410.9 8.5 11.1 29.80 44.70 4.2 4.6 7.0 10.0 6.5 -0.1 400.6 8.5 10.1 31.17 46.76 2.1 2.0 8.0 12.0 6.5 0.7 403.0 8.5 12.2 31.86 47.79 1.5 2.0 12.0 15.0 3.7 -1.8 395.9 12.0 15.2 33.23 49.84
Inflation heads to single digits At least an economic crisis and credit crunch help to curb inflation. Domestic demand slackens and money-supply growth loses momentum. That is what has been happening in Russia since August 2008, after time lags and the one-off post-devaluation effect dissipated in May. Inflation decelerated to 11.6% y-o-y in August and should continue to slow for the next few quarters. It may have already reached single digits this year, although officials and markets still expect it to be a few percentage points higher. Once the economy gets out of the woods, high budget deficits that the government plans to monetise to a large extent may cause prices to climb faster in the medium term. Activity & inflation
12 8 4 0 -4 -8 -12 -16 16
Further policy easing ahead The managed rouble depreciation of November 2008-January 2009, together with the rise in credit risks, kept real interest rates high. With devaluation expectations fading and inflation starting to stabilise, the CBR cut its policy rate by a total of 250bps. Acting ahead of the curve, the CBR is guided by its inflation expectations rather than actual inflation. But lending rates have adjusted slowly, making it likely 25bp monthly cuts will continue until Q2 2010. At the same time, the CBR has begun an exit strategy by curbing the amount of its outstanding lending to banks and shifting from uncollaterised term loans to short-term repo refinancing. For now, the CBRs rouble liquidity has been enough to offset the monetisation of the budget deficit. Policy stance
12 8 4 0 -4 -8 -12 -16 4Q04 4Q05 4Q06 4Q07 Fiscal balance (LHS) CPI, % y -o-y (RHS) 4Q08e 4Q09e 4Q10e Policy rate (RHS) 16 14 (%) 12 10 8 6
(% y-o-y)
12
10 8 6
4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) Industrial grow th (LHS) CPI (RHS)
128
(% GDP, 4 qma)
14
(% y-o-y)
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Russia: at a glance

20 00 15 00 (index) 10 00 40 0 5 00 0 1/0 5 7/ 05 1/06 7 /06 1/07 7/07 1/08 7/08 1 /0 9 7/ 09 MSCI Russia sub-index (LHS) EMB I Russia su b-inde x (RHS ) 20 0 0 10 00 80 0 60 0 (s pr ead bp s)

13.0 12.0 11.0 (%) 10.0 9.0 8.0 1y r 2yr Now 3yr +3 months 5y r 7yr -3 months 10yr

38 34 30 26 22 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e RUB vs USD (LHS) Annualised volatility (RHS) 30 25 (%)

20 15 10 5 0

600 500 400 300 200 100 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserv es, IF I definition (LHS) Short-term debt % reserv es (RHS) 100 80 60 40 20 0
Policy dynamics
2011e 2.0 1.0 2009e 0.0 2010e -1.0 -2.0 -10.0 -8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 2007 8.0 2008 (real rates)
(% of reserves)
(USD bn)

1000 (spread bps) 800 600 400 200 0
1/05
5/05
9/05
1/06
Russia 10yr Govt. EMBI Russia sub-index
5/06
9/06
1/07
5/07
1/08 9/07
5/08
9/08
1/09
5/09
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Russia: local knowledge/global drivers

Problems in the banking sector will restrain economic recovery, fiscal sustainability could be jeopardised
W- or U-shaped recovery? Operational indicators of economic activity pretty consistently show the resumption of economic growth. The MOED estimates industrial growth resumed in May and overall GDP growth in June. The PMI series point to output growth in manufacturing and services, although they put it at a later date. Headline manufacturing PMI, which incorporates expectations and unemployment sub-components, was still marginally below 50 in August. At the same time, operational indicators for domestic demand, such as real wages and unemployment, remain weak and could weaken further. Such a combination suggests economic recovery is likely to be W- or U-shaped that is, exposed to the risks of retracement and sluggishness. Output out of the red
2 1 0 -1 -2 -3 -4 Sep-08 Jan-09 Jul-08 Mar-08 May-08 Nov-08 Mar-09 May-09 Jul-09 60 55 50 45 40 35 30
Banks still need to clean up loan books Banks are still struggling. Their NPLs are rising and they need to increase provisions and boost capital. But a systemic crisis and deposit run have been prevented and deposits are rising. That is putting the loan-to-deposit ratio at a more sustainable level, since lending has been stagnating. Still, looser requirements for provisioning and accounting are producing only a gradual approach to cleaning up loan books. New lending by private banks, which cannot easily get access to public funds and raise their capital, should not be expected before the cleanup is complete. That implies credit probably wont boost domestic demand and growth in Russia the way it did before the crisis. Bank imbalances diminishbut NPLs still rising
1 .5 5 1 .5 0 1 .4 5 1 .4 0 1 .3 5 1 .3 0 1 .2 5 J un-08 Sep -0 8 De c-08 M a r-09 Ju n-09 1% 4% 3% 2% 5%
GDP grow th, % m-o-m SA Manufacturing PMI, SA (RHS)

Source: Markit, MOED
loa n-to -d ep osit ratio, lh s

Source: CBR
Ov erdu e Loa ns (% o f loa ns, rh s)
Looking for a fiscal exit Fiscal policy has been loosening since the early 2000s, with crude oil prices that balance the budget rising from about USD15/bbl to over USD100/bbl. That puts long-term fiscal sustainability at risk despite the current low public debt level. The 2010-2012 fiscal plan assumes a drastic cut of 7.5% of GDP and 4.8% of GDP in federal budget spending and the budget deficit, respectively, by 2012, with lower nominal expenditures in 2012 than in 2009. Even accounting for the scheduled rise of the payroll tax to the Pension Fund, the plan is ambitious. Most public investment has been put on hold and will require financing sooner or later. A failure to raise payroll tax or keep expenditures as planned could result in deficit funding problems and, eventually, high inflation. Ambitious fiscal consolidation plan
The show must go on rates to keep falling Devaluation expectations and high inflation had kept interest rates, including implied NDF yields, high. Currency stability, albeit with increased volatility, and decelerating inflation lead to lower rates over time. But rouble rates still appear high and could decline further after the downward moves that have already occurred this year. The rouble NDF represents one of the most liquid market instruments to use in order to benefit from that, either through long RUB/USD or RUB/basket positions. The entry point, however, also matters, given that the rouble is traded within a band allowing a good deal of RUB/basket volatility. RUB/basket 37.5-38.0 or higher look like good entry points in that respect, in our view. RUB NDF yields are still high
35 30 25 20 15 10 5 0 1/12/2009 2/6/2009 3/5/2009 4/1/2009 4/28/2009 5/25/2009 6/19/2009 7/16/2009 8/12/2009 9/8/2009
2009 RUBbn Revenues Expenditures Deficit % of GDP Revenues Expenditures Deficit 6725 9692 2967 17.7 25.5 7.8
2010 6950 9887 2937 16.1 22.9 6.8
2011 7456 9390 1934 15.4 19.4 4.0
2012 8070 9681 1611 15.0 18.0 3.0
RUB 12M NDF impied y ield

Source MOF
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Russia: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) RUB/USD, end-year RUB/USD, average RUB/EUR, end-year RUB/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (RUBbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 7.2 591.7 4,114 12.1 2.1 12.6 8.3 24.9 8.2 10.9 11.7 28.8 21.9 35.8 21.0 13.0 6.8 27.70 28.81 37.70 34.46 183.2 97.4 85.8 59.9 10.1 2.1 0.4 10.5 34.8 28.0 120.7 14.9 26.0 214.5 29.9 108.9 4.9 4.3 5.5 778.5 4.6 105.6 17.8 22.4
2005 6.4 760.2 5,323 11.8 1.3 10.6 4.0 25.1 7.6 12.7 10.9 13.4 26.9 38.6 17.9 12.0 6.4 28.78 28.45 33.96 34.99 243.8 125.4 118.4 84.3 11.1 2.5 0.3 11.4 33.1 28.8 175.9 16.8 39.2 257.2 24.7 176.2 8.1 7.5 8.5 875.1 4.0 82.4 10.8 14.9
2006 7.7 989.5 6,948 11.3 2.4 18.0 3.9 26.7 6.9 9.7 9.0 10.4 24.3 48.8 27.7 11.0 6.3 26.33 27.19 34.72 34.17 303.9 164.7 139.2 94.3 9.5 9.2 0.9 10.5 24.7 31.3 295.6 21.5 65.2 310.6 19.2 262.0 8.4 7.4 8.1 1,052.1 3.9 48.6 4.9 8.8
2007 8.1 1,295.0 9,120 13.6 3.4 21.1 6.3 28.4 6.1 9.0 11.9 25.1 27.8 47.5 34.3 10.0 6.3 24.55 25.57 35.93 35.05 354.4 223.5 130.9 77.2 6.0 9.2 0.7 6.7 16.6 35.7 465.9 25.0 93.3 459.6 23.2 413.9 6.1 5.4 5.9 1,729.7 5.2 45.7 3.5 8.8
2008 5.6 1,679.5 11,836 11.5 2.5 10.3 2.1 28.7 7.7 14.1 13.3 -7.0 25.9 1.7 -8.8 13.0 11.9 29.38 24.81 41.44 34.86 471.6 291.9 179.7 102.3 6.1 17.9 1.1 7.2 33.1 30.6 412.5 17.0 159.3 483.5 19.3 453.8 4.8 4.1 4.5 2,004.2 4.8 29.7 1.8 6.6
2009e -8.3 1,214.8 8,567 -8.0 -4.0 -16.0 -12.1 24.9 11.0 11.9 9.5 11.0 5.2 10.0 0.7 9.0 12.1 31.17 32.14 46.76 45.54 285.9 182.9 103.1 41.6 3.4 -1.4 -0.1 3.3 -39.4 -37.4 408.5 26.8 160.3 479.5 19.4 443.8 -8.8 -8.0 -7.4 2,335.7 6.0 35.7 2.9 8.9
2010e 3.1 1,418.8 10,019 2.0 -3.0 1.0 3.4 24.7 10.0 8.7 12.0 15.0 10.9 30.0 13.0 12.0 15.2 33.23 31.26 49.84 46.89 306.2 222.8 83.4 7.7 0.5 10.0 0.7 1.2 7.1 21.8 395.9 21.3 181.2 533.5 22.2 483.8 -8.3 -7.4 -6.9 3,094.6 7.0 49.7 3.5 10.5
2011e 2.4 1,522.3 10,766 2.0 -3.0 5.0 2.7 25.4 8.5 15.4 17.0 21.0 17.7 25.0 5.9 19.0 17.1 36.99 35.22 53.63 51.06 317.8 243.9 73.9 -10.9 -0.7 12.0 0.8 0.1 3.8 9.5 408.5 20.1 191.8 589.5 23.8 523.8 -8.6 -6.6 -6.1 4,094.6 7.6 65.7 4.3 12.0
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Simon Williams: +97 14 423 6925 simon.williams@hsbc.com
Saudi Arabia: the essentials
Recovery is coming, but it hasnt arrived yet and lending to the private sector continues to fall
The long road back to growth Our confidence that the Saudi economy is set to return to growth is draw on their large stock of foreign assets to fund spending. Our undimmed. So is our conviction that the recovery hasnt started yet. expectation is that the double-digit growth in public spending which put a Timely data are scant but consolidated banking sector figures are available floor under the downturn in 2009 will be the trigger for an acceleration in and show that lending to the private sector has continued to fall. The trend activity during 2010 and a continued driver well into 2011. Furthermore, marks the unwinding of the 2004-08 credit boom and points to a downward although bank lending is currently very weak, the system appears liquid, shift in private consumption and investment spending. Weak early-year trade which should open the way for a recovery in credit growth once the fiscal data and a sustained fall in inflation also point to slow domestic demand. stimulus begins to get traction. We look for economic growth averaging With oil output down y-o-y, we still expect the Saudi economy to contract this over 5% in 2010-11e on a rising trend. year for the first time since 1999. Recovery from the 2009 recession and low US rates are likely to lead to The conditions for recovery, however, seem to be increasingly well SAMA maintaining its very loose monetary policy stance over at least the established. In part this reflects improvements in the external environment. coming year. We do not expect the 1 January 2010 deadline for Easing recession in the west and accelerating, energy-intensive growth in introducing a Gulf single currency will lead to any change in monetary Asia should see oil prices rise in 2010 and 2011, giving the government more arrangements and believe it likely that the Saudi riyal will remain pegged room to boost recurrent and capital spending without facing a budget to the dollar at its current value. shortfall. Oil production is also set to rise. Moreover, even if oil revenues remain subdued, the authorities have shown this year they are ready to Q3 2008 Q4 2008 Q1 2009e Q2 2009e Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e CPI, end quarter (% y-o-y) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) SAR/USD, end quarter SAR/EUR, end quarter 10.4 35.9 2.0 3.9 3.75 5.28 9.0 30.3 1.5 1.9 3.75 5.24 6.0 29.8 0.5 1.9 3.75 5.43 5.2 31.1 0.2 2.2 3.75 5.25 4.5 33.6 0.2 2.6 3.75 5.43 3.4 35.6 0.2 2.5 3.75 5.62 3.3 37.6 0.2 2.7 3.75 5.62 3.3 39.8 0.2 2.9 3.75 5.62 3.6 42.3 0.2 3.0 3.75 5.62 4.2 44.6 0.2 3.0 3.75 5.62
Inflationary pressures evaporate, for now After rising to generational highs in 2008, inflationary pressures have rapidly subsided during 2009. The most recent reading put annual inflation at just over 4% in August, the lowest rate in over two years and a fall of seven percentage points on the same point last year. Even this figure overstates underlying inflationary pressures, which have seen prices rise by just 2% since the start of 2009. No near-term acceleration in price growth is likely, but our concern is that the kingdoms vulnerability to consumer and asset price inflation may begin to show itself in the longer term. The dollar peg may leave SAMA tied to low policy rates even after Saudi growth begins to pick up pace. Moderating the fiscal stimulus will also prove challenging, given the lengthy lag in the kingdom between capital spending projects being agreed and actually executed. Activity & inflation
5 4 3 2 1 0 -1 -2 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) CPI (RHS) 12.0 10.0
Loose policy stance to persist until credit growth accelerates SAMA began to loosen policy rapidly in Q4 2008, reducing reserve requirements, injecting deposits and tracking fed fund cuts all the way down to 25bps the lowest rate on record. Interbank rates have responded well to the policy action; one-month SIBOR has stood below 0.5% since June, and offers the narrowest differential on dollar LIBOR in the region. However, while rates have come down rapidly, data show commercial banks continuing to boost their non-statutory deposits at SAMA rather than resuming lending. The brake on credit growth appears to be driven by weak sentiment, not poor liquidity, and until lending begins to pick up, we do not expect any steps to be taken to tighten policy. Policy stance
6 5 (% GDP, 4qma) 4 3 2 1 0 4Q04 4Q05 4Q06 4Q07 Policy rate (LHS) 4Q08e 4Q09e 4Q10e CPI, % y -o-y (RHS) 12 10 8 6 4 2 0
(%)
8.0 6.0 4.0 2.0 0.0 (% y-o-y)
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(% y-o-y)
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Saudi Arabia: at a glance

2.5 2.0 1.5 1.0 (%) 0.5 0.0 -0.5 -1.0 -1.5 4/05 1/06 10/06 7/07 4/08 1/09 3M SAIBOR over US-Libor 12M SAIBOR over US-Libor

5 4 3 (%) 2 1 0 1yr 2yr 3yr Now -4 months 5yr 7yr +4 months Current CPI 10yr

40 35 30 25 20 (USD bn) 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 110 100 90 80 70 (% o f reserves) 60 50 40 30 20 10
Policy dynamics
0.0 2007 2010e 2009e (real rates) -4.0
2008 35.0 30.0 25.0 20.0 15.0
2011e 10.0 5.0 0.0
-8.0 -5.0
Internatio nal reserves, IFI defi nition (LHS) Short-term debt % reserves (RHS)
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Banking sector recovery is required before the full impact of fiscal stimulus will make itself felt
Credit growth is very weak, but banks look liquid The abrupt downswing in credit creation that marked the end of the 200308 boom has yet to be reversed. In July, credit to the private sector stood below its start-year level, cutting annual credit growth from 33% to less than 4% in just eight months. Although the high-profile problems experienced by some family firms have tightened the credit squeeze, the trend predates those episodes and appears to reflect a more deepseated downturn in sentiment. No swift return to credit-boom conditions is likely, but the 10ppt drop in the loan-to-deposit ratio this year is a signal to us that the banking sector is liquid enough to resume lending once confidence turns. The absence of government paper issuance is also creating conditions for private sector lending growth. The credit cycle turned abruptly in Q4 2008 and has yet to reverse
4 3 2 1 0 -1 -2 39356
140 120 100 80 60 40 20 39630 39692 39753 39814 39873 39934 39995 40057 Brent (USD/b) Oil Production (mb/d)
Foreign asset fall suggests fiscal stimulus larger than thought SAMA foreign assets began to fall in November 2008 as oil prices weakened. We viewed the trend as evidence of the government drawing down on foreign holdings to maintain spending growth without issuing debt, and expected the sell-off to reverse once oil prices rose over USD60/b. However, new data show assets continuing to fall by around USD7bn per month in June and July 2009, even though oil prices averaged close to USD70/b, suggesting growth in spending may be even greater than we had expected. This expansionary stance remains readily sustainable; although SAMA assets have dropped USD60bn from their peak, at just under USD400bn they remain equivalent to roughly 100% of GDP, or close to three years of total public spending. Spending last years surplus to fund this years stimulus
30 20 10 0 -10 -20 50 0 40 0 30 0 20 0
39569
39630
39692
39753
39814
39873
39934
Saudi starts to ease oil market squeeze As the depth of the global recession became clear at the end of 2008 OPEC members agreed to cut output in a bid to shore up slumping prices. As they did, Saudi Arabia not only shouldered the largest share of the reduction, but cut its own output below quota level. Although many factors were at play, the kingdoms success in persuading the market that it was determined to play its swing-producer role seems to have been key to the subsequent recovery in prices. OPEC quotas have been left unchanged in 2009, but as prices have firmed, Saudi Arabia has boosted its own output. That has allowed it to regain market share but also appears to signal the kingdom will try to adjust production to hold prices within a USD60-80/b range. The kingdom has shown its swing producer role
10 9.5 9 8.5 8 7.5
39448
39539
Monthly grow th lendin g
39630
39722
39814
39904
39995
400 300 200 100 0
C hng m -o-m (US D b n, L HS) S AMA Foreig n Ass sets (USD bn , RHS )
Saudi takes ownership of Gulf currency union project Following a decision in May to base the new Gulf central bank in Saudi Arabia rather than Abu Dhabi, the UAE withdrew from plans for regional monetary union. The departure of the regions second-largest state highlighted just how little progress the single currency project had made since it was proposed in 2001 and how far short of the original goals the region will have fallen when the 2010 deadline passes. However, it would be premature to declare the project dead. We see Saudi Arabias determination to host the central bank as evidence of renewed commitment to the plan and expect it may give the project the leadership it has always seemed to lack. There is much work to do, but a single regional currency by 2015 remains a real possibility. Saudi Arabia is the regions natural economic leader
Saudi Arabia
UAE
Kuwait
Qatar
Oman Bahrain
2009 USD GDP
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Saudi Arabia: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) SAR/USD, end-year SAR/USD, average SAR/EUR, end-year SAR/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (SAR,bn) Gross public domestic debt (% GDP) 5.3 250.3 10,453 5.8 11.9 5.6 45.9 11.0 0.3 0.4 18.8 37.1 2.2 4.1 3.75 3.75 5.08 4.67 125.7 41.1 84.6 49.3 19.7 -0.3 -0.1 19.6 34.8 21.2 27.5 8.1 24.7 27.8 61.7 11.4 14.4 614.0 65.4
2005 5.6 315.6 12,843 9.5 18.4 25.1 51.3 11.5 0.4 1.4 11.6 38.5 4.3 4.9 3.75 3.75 4.42 4.65 180.1 54.6 125.5 90.0 28.5 0.4 0.1 28.6 43.3 32.9 26.8 5.9 24.4 33.7 69.1 18.4 20.2 475.0 40.2
2006 3.1 356.6 14,132 13.4 18.4 19.1 50.1 12.0 2.3 3.2 20.7 6.9 4.7 5.1 3.75 3.75 4.94 4.71 210.5 63.8 146.6 98.9 27.7 0.6 0.2 27.9 16.9 17.0 27.5 5.2 34.6 46.9 69.0 21.7 22.9 366.0 27.4
2007 3.4 382.0 14,739 14.0 3.5 22.8 49.2 12.4 4.1 6.5 19.9 17.3 4.0 4.2 3.75 3.75 5.06 4.87 233.4 82.5 150.8 95.0 24.9 1.1 0.3 25.2 10.9 29.3 33.8 4.9 39.4 53.5 63.9 12.5 13.4 309.0 21.6
2008 4.3 487.8 18,343 20.0 14.0 23.0 53.3 11.2 9.9 9.0 17.7 17.2 1.5 1.9 3.75 3.75 5.24 5.62 326.4 107.3 219.1 150.4 30.8 2.8 0.6 31.4 39.9 30.0 30.3 3.4 40.8 58.7 75.9 31.7 32.6 340.0 18.6
2009e -1.1 393.2 14,412 4.0 9.0 9.0 38.5 11.9 5.0 3.4 11.6 -2.5 0.2 2.5 3.75 3.75 5.62 5.43 184.1 97.6 86.5 16.4 4.2 0.8 0.2 4.4 -43.6 -9.0 35.6 4.4 46.3 57.2 57.5 -1.8 -0.9 275.0 18.7
2010e 4.1 470.3 16,819 8.5 10.0 17.0 43.9 12.0 3.8 4.2 16.9 7.3 0.2 3.0 3.75 3.75 5.62 5.62 231.9 106.4 125.5 47.7 10.1 2.3 0.5 10.6 26.0 9.0 44.6 5.0 49.5 61.5 48.9 1.9 3.0 300.0 17.0
2011e 5.9 545.4 19,027 11.0 12.0 18.0 46.1 11.8 6.0 7.0 18.3 12.0 0.2 3.4 3.75 3.75 5.62 5.52 286.6 127.7 158.8 87.3 16.0 4.1 0.7 16.8 23.6 20.0 50.1 4.7 51.4 68.3 51.2 4.9 5.9 320.0 15.7
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Robert Prior-Wandesforde: +65 62 390 840 robert.prior-wandesforde@hsbc.com.sg
Singapore: the essentials
Singapores economic recovery is broadening and looks set to continue at a rapid pace. Inflation has bottomed but we dont expect the central bank to shift to a policy of currency appreciation until its April 2010 meeting
The roller-coaster ride continues After Singapores deepest ever recession has come one of its strongest ever quarters of economic growth. The more than 20% quarter-on-quarter annualised GDP rise in Q2 2009 was heavily influenced by a huge bounce in the pharmaceutical sector, although financial services also showed a dramatic improvement and construction continued to boom. Higher-frequency industrial production, exports and retail sales data suggest that the recovery continued at a relatively rapid clip in the third quarter, while domestic policy support, positive wealth effects and the prospect of a strong regional/world trade recovery bodes very well for the future. Whereas we previously expected a catastrophic, possibly double-digit, GDP contraction this year, it is now shaping up to be a more modest 2.5% fall. For 2010, we have upped our growth forecast from 5.3% to a healthy 6.5%. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) 3M interbank rate, end quarter (%) 5-yr yield, end quarter (%) SGD/USD, end quarter SGD/EUR, end quarter 0.0 -10.9 6.7 9.1 19.8 17.1 169.4 1.9 2.4 1.43 2.03 Q4 2008 -4.2 -10.7 4.3 -11.2 10.9 10.4 173.9 1.0 1.4 1.44 2.00 Q1 2009 -9.5 -24.2 1.6 -16.3 13.2 10.7 166.5 0.7 1.4 1.52 2.01 As a trade-dependent economy, Singapore really needs to see a strong improvement in external demand if our growth forecasts are to prove accurate. There are two reasons for optimism. First, the fundamental drivers of an export recovery are now largely in place: Asian domestic demand is picking up smartly on the back of improved consumer spending and investment, and should continue to do so as the full effects of the hugely powerful and synchronised policy easing in the region filter through. We shouldnt write off the Western world as a positive source of demand either; after all, US and German domestic orders have improved dramatically in recent months. Second our own lead indicator, which proved accurate in gauging the scale of the export recession, is now pointing towards a strong export recovery in the second half of 2009. Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -3.5 -2.3 -0.5 -18.6 17.0 11.6 173.0 0.7 1.5 1.45 2.03 -1.2 2.0 -0.1 -5.0 18.6 14.9 175.9 0.6 1.2 1.44 2.09 4.5 5.0 0.8 1.0 8.7 4.3 180.1 0.6 1.3 1.40 2.10 9.6 12.0 2.1 5.0 9.0 5.5 179.2 0.7 1.5 1.40 2.10 5.9 10.0 3.2 8.0 16.4 13.8 184.1 0.7 1.6 1.38 2.07 5.4 8.0 2.6 6.0 16.7 14.1 189.5 0.8 1.7 1.36 2.04 5.3 7.5 2.3 4.0 8.9 3.4 189.7 0.9 1.8 1.34 2.01
Inflation is turning In year-on-year terms, consumer price inflation has edged up from a low of -0.7% in April to -0.3% in the latest number for August. The turn is, however, more evident if we look at sequential changes. Consumer prices have now shown five consecutive month-on-month seasonally adjusted rises, with CPI up 2.2% on a three-month-on-three-month annualised basis; that compares with a low of -5.5% in April. We expect the headline CPI rate to reach a year-on-year high of 3.3% around the middle of next year as the impact of stronger international food and energy commodity price inflation feeds through in a country which imports all such products. A 3.3% rate would be double the countrys long-term average CPI rate (calculated from the mid-1980s) but a long way below the 7.5% multidecade high of mid-2008. Activity & inflation
16 12 8 4 0 -4 -8 -12 -16 -20 -24 -28 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) 8 6
but will the MAS respond in the October meeting? So does the turn in CPI inflation mean that the Monetary Authority of Singapore (MAS) will tighten its exchange rate stance at the six-monthly meeting in October? We doubt it. Inflation is hardly roaring, and the central bank probably needs to be more confident about the sustainability of the Singapore/global economic recovery before shifting. It is not as optimistic about the countrys growth prospects as we are. If our projections are right, however, the MAS may well opt to return to a policy of modest and gradual appreciation in the trade-weighted exchange rate at the following meeting in April next year. Meanwhile, there seems no need for a second fiscal stimulus package and we expect the fiscal deficit to peak in 2009. It may be a couple of years, however, before the budget returns to the more accustomed surplus. Policy stance
8 (% GDP, 4qma) 3 1 -1 -3 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e 6 2 0 -2 (%) 4
(% y-o-y)
(% y-o-y)
4 2 0 -2
GDP (LHS)
3M interbank rate (RHS)
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Singapore: at a glance

1 0 (%) -1

3 2 (%) 1 0
-2 -3 -4 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 3M spread over U S-Libor 2yr spread over US-Libor
-1
3M
1yr Now + 4 months
2yr
5yr
7yr - 4 months Current CPI
10yr

1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e SGD vs USD (LHS) Annualised volatility (RHS) 14 12 10 8 6 4 2 0

160 140 (%) (%) 120 100 80 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09

200 160 (USD bn) 120 80 40 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Internatio nal reserves, IFI definition (LHS) Short-term debt % reserves (RHS) 120
Policy dynamics
1.0 0.0 (real rates) -1.0 -2.0 -3.0 -4.0 2008 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 (central govt balance % GDP) 2007 2011e 2010e 2009e
(% of r eser ves)
100 80 60 40 20

5000 4000 (ind ex) 3000 2000 1000 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Singapore sub-index (LHS) Sin gapore av . spread 700 600 500 400 300 200 100 0

600
(spread bp s)
(spread bps)
400 200 0 -200 -400
1/05
5/05
9/05
1/06
5/06
Singapore 5yr Govt. Singapore av. spread
9/06
1/07
5/07
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5/08
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Singapore: local knowledge/global drivers

The economy has been extremely volatile over the last decade; consumption will need to contribute a higher share in GDP and the policy approach must be more pre-emptive to dampen future cycles
Electronics to the rescue? A further reason for optimism about the strength and sustainability of the recovery is the fact that the global tech cycle is showing more encouraging signs. While the message is not universally positive (US consumer spending on tech remains lacklustre for example), recent months have seen strong increases in US and Japanese semiconductor book to bill ratios, as well as a big bounce in German domestic orders for electrical products and a strong recovery in Singapores electronics PMI. The last of these is comfortably above 50, which, in turn, is consistent with rising output in the sector. Indeed, as the chart shows, electronics production surged more than 40% between March and July, although it is still 17% below the February 2008 peak. Electronics output rebounding
Inde x
1 20 1 10 1 00 90 80 70 60 03 04 05 06 07 08 09
Property market on the mend Property market transactions have picked up substantially in the last few months and private residential property prices have probably bottomed, having fallen 25% from their peak. With a lot of supply coming on stream, few are expecting property prices to surge from here but, interestingly, the government has already taken modest steps to cool activity. In September, the Minister for National Development said that interest-only mortgages for uncompleted housing projects would be stopped, while the governments land sales programme would be reinstated. The measures may represent a more pre-emptive attempt to prevent asset bubbles from developing. If successful this could help dampen economic volatility. Higher property transactions should lead to price rises
70 00 60 00 50 00 40 00 30 00 20 00 10 00 0 99 00 01 02 03 04 05 06 07 08 09 I n d e x ( '9 8 Q 4 = 1 0 0 ) 190 180 170 160 150 140 130 120 110 100
E lec tr onic s outpu t
N u m b e r o f T r a n s a ctio n s
P ro p e rty P r ic e s (R H S )
Singapores volatile GDP Singapore has now experienced four recessions in the past 12 years, usually followed by periods of very rapid growth. The standard deviation of the countrys GDP growth has been 5.5 since 2000, higher than for other Asian countries and also up from prior periods. Singapore looks to have become a boom/bust economy despite the governments valiant attempts to diversify the sources of growth. It is noticeable that the share of consumption in GDP is less than 40% much lower than for the likes of Hong Kong for example and its economy is highly dependent on more volatile elements of demand, particularly investment and exports. If the economy is to become less volatile, consumption needs to make a more substantial contribution and policy-making be more pre-emptive. Four recessions in 12 years
% Yr 15 10 5 0 -5 -10 Real GDP 76 79 82 85 88 91 94 97 00 03 06 09
Supply of money outpacing demand The 2008/early 2009 recession has certainly taken its toll on private sector lending which was up just 3% in the year to July the weakest figure for more than three years. Judging by the strong growth in deposits and the apparent willingness of banks to lend, the slowdown most probably reflects soft demand rather than a lack of supply. The size of the gap between lending and deposit growth, which is virtually unprecedented, is, in turn, helping keep a firm lid on short-term rates the three-month interbank rate, for example, is still sitting at just 0.6%, with the overnight rate at around 0.1%. It may take a few more months, but as the corporate and personal sectors become more confident about the sustainability of the recovery, lending growth will start to recover, probably quite strongly. Lower loan growth, strong narrow money growth
% Yr 30 25 20 15 10 5 0 -5 92 -10 -15
94
96
98
00
02
04
06
08
M1
Priv ate domestic credit
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Singapore: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) 3M interbank rate (%) 5-yr yield, end-year (%) SGD/USD, end-year SGD/USD, average SGD/EUR, end-year SGD/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Central government balance (% GDP) 8.7 109.7 26,339 5.9 -1.1 10.2 13.9 46.8 3.0 1.7 1.3 8.6 2.6 7.7 4.4 1.5 2.1 1.63 1.69 2.22 2.13 199.6 168.8 30.7 29.0 26.4 9.2 8.4 34.8 23.4 27.5 112.4 8.0 -5.8 -0.8
2005 8.7 120.8 28,324 3.1 9.6 -2.0 9.5 48.7 2.6 0.5 1.3 4.1 4.3 5.2 1.8 3.3 3.0 1.66 1.67 1.96 2.07 232.3 196.0 36.3 33.2 27.5 3.2 2.6 30.1 16.4 16.1 115.9 7.1 1.2 -0.2
2006 8.4 139.7 31,743 4.0 6.6 13.3 11.9 49.9 2.7 1.0 0.8 -2.9 3.5 11.9 2.6 3.4 3.0 1.53 1.58 2.02 1.99 276.0 233.0 43.0 35.5 25.4 14.4 10.3 35.7 18.8 18.9 136.2 7.0 11.0 0.6
2007 7.8 167.5 36,503 5.2 2.2 19.2 5.9 51.7 1.7 2.1 4.4 4.9 4.1 20.6 8.1 2.4 2.3 1.44 1.50 2.10 2.09 305.0 257.8 47.2 39.3 23.5 7.0 4.2 27.7 10.5 10.6 162.9 7.6 3.9 1.7
2008 1.1 184.0 38,014 2.4 8.1 13.7 -4.2 48.3 2.5 6.5 4.3 -11.2 5.0 10.9 12.8 1.0 1.4 1.44 1.40 2.00 2.04 347.6 316.4 31.2 27.3 14.8 13.9 7.5 22.4 14.0 22.7 173.9 6.6 9.8 2.7
2009e -2.5 171.5 35,272 -2.5 3.6 -5.2 -5.5 45.1 3.7 0.3 0.8 1.0 1.5 10.0 4.0 0.6 1.3 1.40 1.47 2.10 2.12 270.3 245.8 24.5 17.6 10.3 7.8 4.5 14.8 -22.2 -22.3 180.1 8.8 2.0 -2.6
2010e 6.5 194.6 39,838 3.6 4.2 8.0 9.2 44.3 3.6 2.5 2.3 4.0 3.0 12.0 8.0 0.9 1.8 1.34 1.41 2.01 2.11 300.8 276.0 24.8 17.8 9.1 5.7 2.9 12.1 11.3 12.3 189.7 8.2 5.0 -1.0
2011e 5.5 210.4 42,837 3.2 0.0 7.6 6.0 45.6 3.4 2.0 2.3 3.0 4.0 8.0 7.0 1.2 1.8 1.32 1.40 1.98 2.10 330.0 302.2 27.8 20.7 9.8 5.7 2.7 12.6 9.7 9.5 196.4 7.8 5.0 0.5
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Juliet Sampson: +44 20 7991 5651 juliet.sampson@hsbcib.com Kubilay Ozturk: +44 20 7991 1360 kubilay.ozturk@hsbcib.com
South Africa: the essentials
Recession does not look deep, but recovery could be weak. The private sector is suffering as the government shifts its focus to projects and political aims in the public sector
Stabilisation is at hand, but recovery appears farther off The impact of the global economic downturn was somewhat delayed in South Africa and the recovery may, likewise, come with a lag. GDP dropped 2.8% y-o-y in Q2 after a 1.3% decline in Q1 and looks set to remain in negative territory through Q3 at least. Manufacturing has suffered most (mining has been very weak), while sectors that have benefited from the governments attention and investment have fared better. Government spending has kept the recession moderate, and may keep it short. But the weakness of the private sector and its relative lack of investment could place it on a weaker footing in the future and make for a slow recovery. The political situation has settled since parliamentary elections early this year, and no radical policy shifts are on the cards. However, the increasingly influential left of the party wants to see more of its policies implemented in the future. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) ZAR/USD, end quarter ZAR/EUR, end quarter 2.9 3.2 13.0 16.0 -4.2 30.5 12.0 9.0 8.29 11.64 Q4 2008 1.0 -6.2 10.3 11.0 -3.4 30.2 11.5 7.3 9.53 13.34 Q1 2009 -1.3 -13.2 8.5 5.3 -3.2 30.0 9.5 8.2 9.50 13.78 Interest rates were cut by 500bp from December 2008 through August 2009, and it is still unclear whether easing is over. The appointment of Gill Marcus to replace SARB governor Tito Mboweni when he steps down in November adds to the uncertainty created when the SARB cut rates unexpectedly in August, just as wage agreements were coming in on the high side of expectations. Inflation remains high but has eased substantially and to within 1% of the 3% 6% target range, but persistent price stickiness in the past couple of years and generous wage agreements put further improvement in doubt. On the fiscal side, spending has increased, as one would expect during a recession in a country with ample fiscal flexibility. However, many of the governments plans permanently raise spending and are likely to increase indebtedness over time.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -2.8 -18.7 6.9 -4.0 0.7 31.5 7.5 8.6 7.71 10.82 -1.8 -14.0 6.3 -1.5 1.7 32.0 7.0 8.2 7.50 10.88 -1.2 -6.6 6.2 1.3 -0.9 32.0 7.0 8.1 7.75 11.63 0.9 1.4 5.5 3.8 -0.5 32.5 7.0 8.2 8.00 12.00 1.2 10.8 5.8 5.9 1.8 33.0 7.0 8.5 7.75 11.63 2.0 11.3 5.8 5.7 2.6 33.8 7.0 8.5 8.25 12.38 2.2 9.1 5.9 7.2 -0.1 34.5 7.5 8.5 8.50 12.75
Later recession; later recovery South Africas recession started later than those elsewhere in the world, and its recovery may also be delayed by a quarter or so. It appears that the bottom of South Africas economic downturn is likely to have been in Q2 and, like much of the world, its recovery may be slow. Household and consumption has been very weak, dropping 3.5% in Q2. A collapse in trade also significantly worsened in that quarter, despite signs of improvement in Q3. Investment, driven primarily by the public sector, held up very well in H1, rising 6.6% in Q1 and 5.1% in Q2, and this strength should continue in H2 as well. Public spending remains strong as the government tries to make good on its commitments to support job creation and improve health, education and welfare. But the private sector is in worse condition, and may cause the recovery to lag. Activity & inflation
10 5 (% y -o-y) 0 10 5 0 4Q07 2Q08 e 4Q08e 2Q0 9e 4 Q09e 2Q10e 4Q10 e CPI (RHS) (% y-o-y ) GDP (LHS) Industrial growth (LHS) -5 15
Inflation is slowing, but it is unclear whether further cuts can follow In August 2009, consumer price inflation fell to 6.4% still above the 3% 6% target band, but less than half the 13.7% inflation rate a year or so earlier. Nevertheless, the inflation picture is not free of concern: including signs of lingering price stickiness and generous wage hikes, among other factors. The SARB has noted these concerns, but unexpectedly agreed a 50bp cut in August, on top of 450bp in prior rate cuts, even as key wage agreements were being settled at levels well above the rate of inflation and, more importantly, the inflation target. The strength of the rand is one explanation for some additional policy loosening, as were some initial signs that inflation stickiness was finally starting to dissipate. If these factors remain in play, further easing cannot be ruled out. However, a change of leadership at the SARB will complicate this calculation. Policy stance
2 (% GDP, 4qma) 0 (%) -2 -4 -6 -8 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e 14 12 10 8 6 4 2 0
-10 -15 -20
Fiscal balanc e (LHS) CPI, % y- o- y (RHS)
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South Africa: at a glance

10 8 (%) 6 4 2 0 1/05 8/05 3/06 10/06 5/07 12/07 7/08 2/09 9/09 3M spread over U S-Libor 2yr spread over US-Libor

10 9 9 8 8 7 7 3M 6M
Now
(%)
1y r
5y r
10y r
- 4 months
15y r
+4 months

15 13 11 9 7 5 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e ZAR vs USD (LHS) Annualised volatility (RHS) 60 50 30 20 10 0 (%) 40

225 200 175 150 125 100 75 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD C umulative CPI C umulative PPI 09

35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definiti on (LHS) Short-te rm debt % reserv es (RHS) 200
Policy Dynamics
3.0 2007 (real rates) 2.0 2010e 2011e 1.0 2008 2009e
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150 100 50 0
(%)
(% of reserves)
0.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0

700 600 500 400 300 200 100 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI South Africa sub-index (LHS) EMBI South Afr ica sub-index (RHS) 1000

800 (spread bps)
(spread bp s)
800 600 400 200 0
600 400 200 0
(ind ex)
1/05
5/05
9/05
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South Africa 10y r Gov t. EMBI South Africa sub-index
5/06
9/06
1/07
5/07
9/07
1/08
5/08
9/08
1/09
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South Africa: local knowledge/global drivers

The departure of SARB governor Tito Mboweni in November will add more uncertainty to the mix as inflation falls, the rand strengthens and the budget deficit widens
Tito moves on SARB Governor Tito Mboweni will retire as governor in early November, to be replaced by Gill Marcus. Marcuss appointment will not only define monetary policy in the years to come, it also may say a great deal about President Zuma, who appointed her. Marcus is a trusted ANC insider with a solid pedigree, who has served as deputy finance minister (19961999) and deputy SARB governor (1999-2005) before serving as chairman of ABSA Bank and should be a safe pair of hands at the SARB. Her appointment also suggests Zuma is taking no risks on key appointments, and, in naming a white woman to a key post, has made a stand for inclusiveness. Nonetheless, Mbowenis departure will add to monetary policy uncertainty until Marcuss views become clearer. Change of leadership will complicate prospects of further easing
15 14 13 12 11 10 9 8 7 6 5 Jan-07
Falling inflation has been helped by ZAR strength; but will it last? Inflation has fallen sharply in the past year; but signs of inflation stickiness lingered well into 2009 and have not dissipated completely. Service sector prices, in particular, have remained firm. And in spite of the sharp falls in global food and energy prices over the past year, food prices were slow to fall in South Africa. Generous wage agreements for 2010 pose a risk in the future. Electricity shortages, combined with the immense cost of building new capacity, have kept strong upward pressure on electricity prices, and pressure is likely to continue for the foreseeable future. A strong rand has helped bring down inflation in Q3, and price pressures may ease as long as the currency remains strong. But the disinflationary impact of the rand is hardly something to rely on over the long term. Inflation decelerates with softer food prices and strong rand
25 20 y-o-y % 15 10 5 0 -5 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 12 11 10 9 8 7 6
Jun-07
Nov-07 Apr-08
Sep-08
Feb-09
Jul-09
Headline CPI PPI Food inflation USD/ZAR (RHS)
SARB policy rate

Source: SARB, Bloomberg and HSBC
CPI (y-o-y, % )
ANC policies look more like evolution than revolution so far Jacob Zuma ascended to the presidency against a backdrop of ANC infighting. While tension between ANC factions continues, the political situation has calmed to some extent. Zuma has made key appointments from the left and the centre, while avoiding a loss of faith in government institutions. Priorities have changed in favour of increased spending on health, education and benefits for the poor. COSATU and the SACP have not given up on controversial plans, but so far none of them like land reform, sharp limits on FDI and eliminating the inflation targeting regime have come to full fruition. Nonetheless, the governments role in the economy is growing and the private sector is facing a tough road ahead, which may curtail growth in the longer term. Government spending remains high despite the decline in revenues
75 50 25 ZAR bn 0 -25 -50 -75 -100 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Budget deficit, cum - 2008/09 Govt expenditure - 2007/08 Govt expenditure - 2009/10 75 50 25 0 -25 -50 -75 -100 ZAR bn
Deficit spending may continue well beyond the end of recession After turning some impressive budget surpluses in recent years, budget deficits have returned with a vengeance. From a surplus of ZAR7.1bn in H1 2008, the deficit has grown to -75.2bn in H1 2009 and is set to nearly double from there by year-end. It is precisely because of earlier surpluses and the countrys low debt burden that it has the fiscal flexibility to spend its way out of the downturn. But deficit spending on ambitious and expensive government programmes is set to continue well beyond the end of the recession. Between plans for massive infrastructure projects, the introduction of universal healthcare, a pension system and an extensive expansion of welfare benefits, deficits appear to be here to stay. Budget surpluses are a thing of the past
2 0 -2 -4 -6 -8 04 05 06 07 08 2009e 2010e 2011e Forecast
Budget deficit, cum - 2007/08 Budget deficit, cum - 2009/10 Govt expenditure - 2008/09
Consolidated government balanc e (% of GDP)
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South Africa: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) ZAR/USD, end-year ZAR/USD, average ZAR/EUR, end-year ZAR/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (ZARbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 4.9 216.9 4,594 6.7 6.2 8.9 3.3 13.0 26.2 1.4 4.3 1.9 7.5 12.8 13.5 7.5 7.5 5.63 6.43 7.66 8.00 43.8 48.5 -4.7 -6.9 -3.2 -0.6 -0.3 -3.5 27.4 37.9 12.8 3.2 26.1 43.6 87.5 6.3 -2.0 -2.1 1.4 443.6 31.8 31.7 14.6 46.4
2005 5.0 243.5 5,134 6.9 4.8 8.9 4.2 13.3 26.5 3.4 4.8 4.8 6.5 24.0 20.0 7.0 7.3 6.33 6.33 7.54 7.88 51.4 56.9 -5.5 -9.2 -3.8 5.2 2.1 -1.6 17.3 17.3 18.3 3.9 26.4 46.2 82.6 6.5 -0.5 -0.2 2.9 475.2 30.8 34.3 14.1 44.9
2006 5.3 257.2 5,427 8.3 5.1 13.8 4.9 12.5 25.5 4.7 4.2 9.3 9.1 23.1 25.7 9.0 8.2 7.01 6.77 9.25 8.51 58.9 70.4 -11.5 -16.4 -6.4 -6.0 -2.3 -8.7 14.6 23.8 22.7 3.9 33.1 59.4 90.5 9.8 0.2 0.9 3.2 496.0 28.5 39.3 15.3 43.8
2007 5.1 283.5 5,925 6.6 4.8 17.1 5.5 13.9 23.0 7.1 8.6 9.5 8.8 23.6 21.6 11.0 8.7 6.86 7.05 10.01 9.67 69.7 79.7 -10.0 -20.6 -7.3 3.4 1.2 -6.1 18.4 13.2 29.2 4.4 49.5 75.3 82.2 10.1 0.7 1.3 3.4 492.8 24.7 52.5 18.5 43.2
2008 3.0 276.1 5,672 2.3 5.0 10.2 1.0 15.4 21.9 11.5 10.3 11.0 12.4 14.5 14.0 11.5 7.3 9.53 8.27 13.34 12.41 79.9 88.0 -8.1 -20.5 -7.4 12.5 4.5 -2.9 14.7 10.4 30.2 4.1 57.0 71.8 84.0 11.1 -0.3 0.2 2.2 516.5 22.6 60.0 21.7 44.3
2009e -1.8 298.4 6,028 -2.5 4.8 5.5 -13.1 18.0 24.0 7.2 6.2 1.3 6.5 6.5 4.7 7.0 8.1 7.75 8.06 11.63 11.69 66.6 67.8 -1.2 -15.7 -5.3 8.7 2.9 -2.3 -16.7 -23.0 32.0 5.7 48.0 85.0 82.8 11.5 -5.8 -5.2 -3.3 625.0 26.0 67.0 22.5 48.4
2010e 1.6 318.1 6,312 1.2 5.1 7.1 8.1 17.2 24.5 5.8 5.9 7.2 8.7 7.5 3.5 7.5 8.5 8.50 8.13 12.75 12.19 69.3 71.2 -1.9 -18.5 -5.8 5.6 1.8 -4.0 4.1 5.1 34.5 5.8 51.4 90.0 79.7 12.1 -5.4 -3.5 -2.5 690.7 26.7 70.0 22.0 48.7
2011e 2.8 318.9 6,264 2.5 5.3 7.5 3.5 17.1 23.5 6.5 6.5 6.0 8.5 15.8 6.5 8.0 8.3 9.25 8.88 13.41 12.87 71.1 73.1 -2.0 -20.3 -6.4 7.0 2.2 -4.2 2.5 2.5 36.0 5.9 57.8 100.0 79.2 12.7 -5.7 -2.7 -2.7 749.4 26.5 75.0 23.5 50.0
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Robert Prior-Wandesforde: +65 62 390 840 robert.prior-wandesforde@hsbc.com.sg Prithviraj Srinivas (Economics Associate)
Sri Lanka: the essentials
The end of the war has not only boosted confidence at home but has also turned off-shore investors more positive on the country. The large budget deficit remains a key worry but here, too, steps are being taken
Growth: looking up Sri Lanka posted modest growth of 2.1% year-on-year in Q2, dragged down One of the key concerns for investors has been the governments big by a weak services sector. The outlook is definitely more positive from Q3 budget deficit and the high level of debt. For 2009 the government is onwards given the boost the end of the war has given to sentiment both at targeting a deficit of 7% of GDP, which we think will be a challenge, home and overseas, the massive rehabilitation and reconstruction work that although it must be said that it has already taken a number of measures to boost revenues, such as introducing a nation-building tax and raising needs to be undertaken and the fact that the east and the north will be excise duties on liquor, cigarettes and other consumer items. Overall we integrated into the economy. The external environment is also looking more remain optimistic that things will move in the right direction over time. upbeat than a couple of months back. Overall we expect the economy to There were some concerns about the low level of foreign exchange grow by 4% this year and accelerate to above 7% next year. The country reserves, but the country has recently seen record inflows into the bond has immense investment potential, especially in tourism, manufacturing, market, and the IMF stand-by facility is a positive as well. agriculture and business process outsourcing. Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) WPI, end quarter (% y-o-y) Trade balance (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 2-yr yield, end quarter (%) LKR/USD, end quarter LKR/EUR, end quarter 6.3 1.5 24.3 20.6 -13.8 2.6 12.0 19.2 107.9 154.9 4.3 4.3 14.4 0.7 -12.0 2.4 12.0 20.6 113.3 159.5 1.5 3.0 5.3 -15.1 -6.7 2.3 11.8 16.9 115.5 152.9 2.1 -2.3 0.9 -10.0 -6.3 2.3 11.0 12.8 115.0 162.3 5.0 3.0 2.5 6.0 -5.8 4.0 10.5 12.0 116.5 168.9 7.2 6.0 7.3 13.0 -6.1 4.2 10.5 13.0 118.0 177.0 7.0 7.0 11.2 16.0 -7.1 4.0 10.5 13.5 118.0 177.0 7.5 6.0 12.5 18.0 -7.0 4.5 10.5 13.5 118.0 177.0 6.8 6.3 11.3 15.0 -6.3 4.8 11.0 14.0 118.0 177.0 6.5 6.8 9.6 15.0 -6.2 5.0 11.0 14.0 118.0 177.0
Inflation pressures are building Inflation was running at 0.9% y-o-y in August, matching the decade low seen in June. This is a very long way south of the peak of 28.2% in June last year and compares with a long-term average of 11%. In seasonally adjusted terms, however, prices have now risen for four consecutive months, with the 3-month-on-3-month annualised change of the series running at +8.1% in July from a low of -7% in February. Clearly price pressures are building again. Looking ahead, the bulk of the impetus to inflation is going to come from commodity price movements, food and oil being key. Note that base effects are also unfavourable from September onwards. Overall we think inflation will hit 7% by the end of the year and will be in double digits by early next year. Activity & inflation
10 8 6 4 2 0 -2 -4 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) GDP (LHS) Indus trial growth (LHS) 30
Central Bank of Sri Lanka has done its bit The Central Bank of Sri Lanka (CBSL) has done its bit to support the economy, having cut the reverse repo rate by 150bp to 10.5% and the repo rate by 250bp to 8%. The most recent move was a 50bp cut at its September review meeting. The bank clearly believes that the rate cut was necessary to induce commercial bankers to further reduce lending rates. This should help improve the rather poor private domestic credit demand growth. Given the rise in sequential inflation and the increased pass-through of policy easing, we expect the CBSL to begin tightening by July next year.
Policy stance
2 (% GD P, 4 qma) 30 25 20 15 10 5 0 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09e 4Q10e C PI, % y -o-y (RHS)
(% y-o-y)
25 20 15 10 5 0
Policy rate (RHS)
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Sri Lanka: at a glance

21 18 15 12 9 6 3 0 5/08 8/08 11/08 3M spread over US-Libor 2/09 5/09 8/09 12M spread over US-Libor

15.0 10.0 (%) 5.0 0.0 1yr 2 yr 3y r N ow + 4 months 4yr 5y r 7yr 10yr - 4 months Current CPI 15yr

125 115 105 95 85 75 65 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e LKR vs USD (LHS) Annualised v olatility (R HS) 10.0 5.0 0.0 25.0 20.0 15.0 (%)
(%)

300 250 (%) 200 150 100 50 00 01 02 03 04 05 06 07 08 09 Grow th of nominal exchange rate v s USD Cumulativ e CPI Cumulativ e PPI

140 120 100 (USD bn) 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserv es, IFI definition (LHS) Short-term debt % reserv es (RHS) 5 4
Policy Dynamics
6.0 4.0 2.0 (real rates) 0.0 -2.0 -4.0 -6.0 -8.0 -4.0 -5.0 -6.0 -7.0 -8.0 -9.0 2007 2008
(% of reserves)
2011e 2009e 2010e
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Sri Lanka: local knowledge/global drivers

Nation building is at stake, but the government needs to balance fiscal prudence as well
Business confidence has risen Sri Lankan business confidence leapt higher after the end of the war, rising 72 points to 161 in July. Since then sentiment has softened somewhat but still remains well north of the long-term average of 121. As we discussed in detail in our report Sri Lanka: A new chapter begins (May 2009), the country has immense opportunities. The positive business sentiment indicators are encouraging while the monetary policy easing so far should also help to support the economy. At the same time the external environment is looking much better than a couple of months back. Overall we think activity should pick up through the course of the year. positive for the domestic economy
2 00 1 50 1 00 50 0 0 Se p-07 Jan -0 8 M a y -08 Sep -0 8 J an-09 M ay -0 9 B usin ess c onfide nce in dex Av erage R e serv e s (U S Dbn ) Im por t C o v er (R H S , m ) 00 01 02 03 04 05 06 07 08 09
FX reserves Sri Lankas foreign exchange reserves have risen sharply to nearly USD4bn in September surpassing the previous high of USD3.6bn in July 2008 from a low of USD1.3bn in the March/April period. The turnaround is a function of more positive off-shore sentiment after the end of the war, with strong inflows into the bond market and the first tranche of the USD2.6bn 20-month IMF stand-by facility coming through as well. The country has also received its one-time allocation of USD475m under the IMFs plan to boost member country reserves, approved on 13 August. The governor expects reserves to hit USD5-6bn over a 20-month period. import cover ratio
4 3 2 1 10 8 6 4 2 0
Food inflation set to move higher Food inflation was running at 0.6% y-o-y in August, somewhat higher than the nine-year low of -1.1% in April. This compares with a high of 43% in May last year. Looking ahead we think food inflation is set to trend higher. History suggests that domestic food prices are closely correlated to international price movements given the high proportion of imported food. The correlation of food inflation with The Economist food price index in local currency terms is 0.80 with a lag of three months. Even if we assume that international food prices and the rupee (LKR) stabilise at current levels, this implies a sharp upward movement in food prices at home. Note that food makes up 46% of the CPI basket and is therefore a key factor for overall inflation in the country. following international food price movements
80 60 40 20 0 -20 00 -40 CCPI (Food) Food 01 02 03 04 05 06 07 08 09 3mma %y-o-y
Large budget deficit The budget position deteriorated sharply at the start of the year as revenues collapsed owing to weak growth and expenditure picked up as the government provided support. Since then, however, things have gradually moved in the right direction: the three-period moving average of expenditure growth has declined and the fall in revenues is stabilising. In the year to May the countrys total budget deficit stood at LKR232bn (USD2bn) compared with LKR120bn (USD1.1bn) last year. On an annualised basis the deficit stands at 11.3% of GDP. The government is planning to limit the budget deficit to 7% of GDP in 2009 a target we believe may prove quite challenging. but moving in the right direction
0 -2 % of GDP -4 -6 -8 -1 0 -1 2 91 93 95 97 99 01 03 05 07
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Sri Lanka: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate (end-year, %) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) WPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 2-yr yield, end-year (%) LKR/USD, end-year LKR /USD, average LKR/EUR, end-year LKR/ EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Gross external debt (USDbn) Short term external debt (% of int'l reserves) Central government balance (% GDP) Gross public domestic debt (USDbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP)
2005 6.2 24.4 1,241 2.6 4.8 9.8 6.0 21.6 7.2 11.0 7.5 1.7 3.3 19.6 15.4 10.3 11.20 102.1 100.5 121.1 125.0 6.4 8.9 -2.5 -0.7 -2.7 0.2 1.0 -1.7 10.1 10.7 2.0 2.7 12.0 33.5 -8.4 12.6 51.6 9.5 39.0 90.6
2006 7.7 28.3 1,421 7.3 6.0 13.9 5.7 23.7 6.5 10.0 13.5 17.3 1.1 20.7 18.3 11.5 13.35 107.7 103.9 141.5 130.7 6.9 10.3 -3.4 -1.4 -5.0 0.4 1.6 -3.4 8.5 15.6 2.2 2.6 13.3 27.9 -8.0 14.2 50.3 10.6 37.5 87.9
2007 6.8 32.4 1,634 7.8 5.5 12.0 7.6 25.3 6.0 15.8 18.7 26.8 39.6 15.6 9.3 12.0 17.63 108.7 110.7 160.2 154.1 7.6 11.2 -3.5 -1.3 -4.0 0.5 1.7 -2.3 11.0 8.9 2.4 2.6 15.2 45.2 -7.7 15.5 47.9 12.0 36.9 84.9
2008 6.0 40.7 2,014 6.7 6.0 11.0 4.3 25.0 5.3 22.7 14.4 0.7 23.3 11.7 -10.8 12.0 20.63 113.3 109.2 159.5 163.7 8.1 14.0 -5.9 -3.8 -9.3 0.7 1.7 -7.6 6.4 25.3 2.4 2.0 18.7 61.9 -7.7 19.7 48.3 13.4 32.8 81.1
2009e 4.0 44.6 2,180 3.5 6.0 4.5 2.4 25.9 6.0 5.2 7.3 13.0 6.0 12.0 9.8 10.5 13.00 118.0 116.2 177.0 165.3 7.0 9.6 -2.5 0.8 1.8 0.7 1.6 3.4 -13.5 -31.5 4.2 5.3 20.1 40.3 -10.7 20.1 45.0 17.8 40.0 85.0
2010e 7.0 53.8 2,602 6.8 8.0 13.0 6.5 27.1 6.0 11.0 9.6 15.0 7.0 13.0 14.0 11.0 14.00 118.0 118.0 177.0 177.0 7.7 10.9 -3.2 0.1 0.2 0.8 1.5 1.8 9.1 13.2 5.0 5.5 20.8 41.6 -9.5 20.8 40.0 19.2 37.0 77.0
2011e 7.2 62.0 2,965 7.0 8.0 12.0 6.5 28.1 6.0 6.7 7.2 8.2 6.0 11.0 18.3 11.0 14.00 118.0 118.0 177.0 177.0 8.3 12.5 -4.2 -0.8 -1.3 0.8 1.3 0.0 8.0 15.1 6.0 5.8 21.9 39.4 -5.0 21.9 37.0 21.3 36.0 73.0
5.5 20.7 1,062 4.7 7.8 17.8 5.6 21.6 8.5 9.0 12.9 23.9 3.4 18.5 10.9 9.0 9.55 104.7 101.2 142.5 125.8 5.8 8.0 -2.2 -0.7 -3.2 0.2 0.8 -2.5 12.4 20.2 1.7 2.5 12.1 39.1 -7.9 11.3 54.7 9.8 47.6 102.3
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Christopher Wong: +852 2996 6917 christopherwong@hsbc.com.hk
Taiwan: the essentials
Export growth continues to recover gradually, but the strong pick-up in domestic demand is likely to be the main driver of the islands recovery
Looking up, at last The Taiwanese economy is finally showing signs of life. After recording a record contraction of 10.1% y-o-y in Q1, real GDP growth came in at a surprising -7.5% y-o-y in Q2. Even more positively, the economy expanded 4.8% q-o-q on a seasonally adjusted basis, indicating that the island is on the road to recovery. A revival in domestic demand is likely to outrun any recovery in exports over the coming quarters. Meanwhile domestic credit and financial markets have been fundamentally stable, and improving cross-strait relations and loose monetary conditions have stimulated the islands domestic demand. Exports have recovered from the trough, but the recovery is likely to be gradual, given still-sluggish demand in the US and Europe. We now expect Taiwans economy to contract 4.2% in 2009 and expand 4.4% and 4.9% in 2010 and 2011, respectively. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) WPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) TWD/USD, end quarter TWD/EUR, end quarter
Sources: HSBC, CEIC
The recent cabinet reshuffle served to minimise murmurings of discontent from the opposition party after the Typhoon Morakot disaster. Political pressure will prompt the Ma administration to carry out the reconstruction work immediately and possibly bring forward the previously announced major public construction programme for next year, further supporting the islands domestic demand. Meanwhile, despite the delay in signing the Financial MOU and the proposed economic cooperation framework agreement (ECFA), overall cross-strait relations should remain stable in the medium term, benefiting Taiwans economy by boosting onshore investment and confidence. Nevertheless, we believe the country will remain the laggard in the regional recovery, as it is grappling with deeper structural challenges than many of its neighbours. -7.5 -16.6 -2.0 -13.7 8.7 11.6 317.6 1.3 1.0 32.80 45.92 -3.2 -6.5 0.1 -7.5 2.1 1.8 319.7 1.3 1.0 32.90 47.71 4.7 4.7 0.8 -1.2 6.9 5.3 324.0 1.3 1.0 31.5 47.25 6.2 7.6 0.6 3.0 8.7 8.6 333.4 1.4 1.3 31.0 46.50 4.4 9.4 1.1 3.5 7.5 7.7 342.0 1.5 1.4 30.0 45.00 3.4 7.8 1.4 4.0 2.2 2.3 344.4 1.6 1.5 29.5 44.25 3.6 5.5 1.5 4.2 6.5 6.8 352.4 1.8 1.6 29.0 43.50
Q4 2008 -8.6 -24.2 1.3 -9.7 7.0 8.1 291.7 2.0 1.0 32.80 45.59
Q1 2009 -10.1 -32.4 -0.1 -9.3 9.9 13.9 300.1 1.3 1.0 33.90 44.75
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
-1.0 0.5 3.1 6.1 1.6 1.9 281.1 3.5 2.0 32.20 45.72
Inflation to return in 2010 Taiwans deflation pressures eased in August, when headline CPI declined 0.8% y-o-y versus -2.3% in July. The rebound was largely driven by an abrupt hike in food prices, which rose 6.6% m-o-m, most likely owing to temporary disruptions caused by Typhoon Morakot. Meanwhile, core CPI also picked up marginally to -0.8% y-o-y in August from -0.9% in July. Wholesale price deflation also eased to -11.2% y-o-y in August from 14.1%, again mostly on account of rising agricultural prices. Looking forward, inflationary pressure is likely to return in 2010 as global economic conditions recover. In addition, low interest rates and abundant domestic liquidity will probably inflate asset prices in Taiwan. We therefore expect Taiwans CPI to rise 1.1% and 1.6% in 2010 and 2011, respectively. Activity & inflation
20 10 (% y-o-y) 0 -10 -20 -30 -40 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e GDP (LHS) Industrial grow th (LHS) C PI (RHS) 5 4 3 2 1 0 -1 -2 -3
Steady rate until year-end, with a gradual tightening in early 2010 The Central Bank of The Republic of China (CBC) left the policy rate unchanged at a historical low of 1.25% during its scheduled MPC meeting in September. Although the economy is recovering, policymakers are still concerned about the outlook for recovery given that unemployment remains high. To maintain momentum, policymakers will have to leave accommodative monetary policies in place for the rest of the year. However, inflation is on the way up, and energy prices in particular are likely to surge in the coming quarters. As a result, we expect the CBC to raise rates by the end of the first quarter. This is not solely attributable to stabilising inflation, however, but also to emerging concerns about excess liquidity and the risk of asset price bubbles. Gradual rate hikes will not remedy these, but we should be prepared for the CBC to be one of the first central banks in Asia to increase rates. Policy stance
0 (% GDP, 4q ma) -1 -2 -3 -4 -5 4Q04 4Q05 4Q06 4Q07 0 -2 4Q08 4Q09e 4Q10e Policy rate (R HS) 4 2 (%) Fiscal balance (LHS) CPI, % y-o-y (RHS)
(% y-o-y)
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Taiwan: at a glance

1 0 (%) -1

3.0 2.0 (%) 1.0 0.0
-2 -3 -4 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M spread over US-Libor 2y r spread ov er US-Libor
-1.0
2yr
5yr N ow + 4 months
10y r
15yr - 4 months Current CPI
20yr

36 35 34 33 32 31 30 29 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e TWD v s USD (LHS) Annualised v olatility (RHS) 10 8 (%) 6 4 2 0


300 250 200 150 100 50 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 International reserv es, IF I defin ition (LHS) Short-term debt % reserv es (RHS) 21 18 15 12 9 6
Policy dynamics
1.0
(% of reserves)
2008 (real rates) 0.5 2007 0.0 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 -4.0 -4.5 2011e 2009e 2010e
(USD bn)
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Taiwan: local knowledge/global drivers

The central banks accommodative monetary policy will continue to support the islands recovery, together with the governments public infrastructure investment stimulus programmes and normalising cross-strait relations
Surprise upturn in private consumption Perhaps the most encouraging news from Q2 GDP data is the big swing in private consumption, rising 0.4% y-o-y versus a 1.6% decline in Q1. Furthermore, real retail sales rose 3.6% y-o-y in July, the highest rise since January 2008. Domestic car sales in August rocketed 113% y-o-y, the highest growth since 2002. Fiscal stimulus measures, such as the TWD186bn shopping voucher programme and a series of tax cuts carried out by the government, certainly encouraged spending. But more is happening here and we believe the main catalysts are improving crossstraits relations and the wealth effect from inflating asset prices. However, challenges remain ahead for Taiwan, as its labour market is still in a fragile condition and income growth continues to decelerate. Spending the money (% yr 3mma)
15 10 5 0 0 -5 -1 0 00 01 02 03 04 05 06 07 08 09 R e a l re ta il s a les (L H S ) D o m e s tic m o tor v e h ic le s a le s (R H S ) -5 0 -1 0 0 100 50
A gradual recovery in fixed investment Equally encouraging, fixed investment rebounded to -23.7% y-o-y in Q2 from -33.4% in Q1. The improvement is even more impressive on a seasonally adjusted basis, rising 30.7% q-o-q in Q2 versus -21.2% previously. The latest data on capital goods imports, which closely track the islands fixed investment growth, improved to -13.6% y-o-y in July from -23.9% in June, thanks to the governments public infrastructure stimulus programme and loose monetary conditions. However, Taiwans fixed investment slump is not over yet. Private fixed investment is still lacklustre and it will take time for private enterprises to digest the destruction in real demand in the West, which has left Taiwanese firms with excess capacity and little need to invest. As such, we expect the public sector to lead the islands recovery in fixed investment in the coming months. Rebounding capital good imports, reviving fixed investment
60 40 20 0 -2 0 -4 0 -6 0 99 00 01 02 03 04 05 06 07 08 09 C a p ita l g o o d s im p o rts (% y r 3 m m a )
Export recovery remains on track Taiwan recorded better-than-expected export growth in August in view of the severe damage caused by Typhoon Morakot, falling 24.6% y-o-y versus -24.4% in July. It appears that this unexpectedly strong result was largely driven by the rapid rebound from emerging Asian countries, particularly China. In fact, three Chinese trade delegations have so far spent about USD13bn on procurement, giving the islands exporters further cause for optimism. However, final demand from the US and Europe remains sluggish, denting the outlook for the islands overall export recovery. The good news is that if the current recovery trend remains on track, we think Taiwan is likely to return to positive annual export growth in December of this year. Asian demand is driving the islands export recovery (% yr 3mma)
60 40 20 0 - 20 - 40 - 60 99 00 0 1 02 03 0 4 E x po rts to C hin a 05 06 0 7 E urope 08 09 U SA
Negative income growth is the only downside The islands seasonally adjusted unemployment rate posted another record high of 6.1% in August, largely driven by the addition of fresh university graduates to the labour force. That said, the pace of the rise in unemployment seems to be stabilising. In addition, the Council of Labour Affairs reported that the number of workers on unpaid leave dropped further in August to 58,983, about one-quarter of the 238,975 posted in the peak month of March, further confirming that the employment situation has stabilised somewhat. Nevertheless, unemployment is likely to remain high in the near term given the persistent reluctance of private enterprises to expand their capex, and this will hamper the recovery in private consumption. Weakness in the labour market to weigh on private consumption
7 6 5 4 3 2 1 0 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 U nem ploy m ent rate sa (% )
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Taiwan: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) WPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) TWD/USD, end-year TWD/USD, average TWD/EUR, end-year TWD/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Central government balance (% GDP) Gross public domestic debt (TWDbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP)
Source: HSBC, CIEC
2005 4.2 356.2 15,701 3.0 1.1 1.2 3.8 25.6 4.1 2.3 2.2 1.7 2.7 6.2 6.0 2.2 1.8 32.83 32.15 38.73 39.42 198.5 179.0 19.5 17.6 4.9 -4.4 -1.2 3.7 8.8 8.5 253.3 17.0 324.5 86.7 29.1 72.8 -1.2 2,831.0 24.7 13.9 3.9 28.6
2006 4.8 364.9 16,011 1.8 -0.4 0.9 4.7 27.1 3.9 0.6 0.7 6.4 1.4 6.2 1.9 2.7 1.9 32.59 32.66 42.97 41.04 223.8 199.6 24.2 26.3 7.2 0.0 0.0 7.2 12.8 11.5 266.1 16.0 336.3 85.8 27.9 75.2 -0.5 3,046.0 25.6 10.6 2.9 28.5
2007 5.7 385.5 16,857 2.3 0.9 1.9 7.8 29.0 3.9 1.8 3.3 8.6 1.7 4.3 0.9 3.4 2.5 32.40 32.78 47.30 45.57 246.5 216.1 30.4 33.0 8.6 -3.3 -0.9 7.7 10.1 8.2 270.3 15.0 346.6 94.5 30.8 91.1 -0.3 3,394.8 26.9 3.5 0.9 27.8
2008 0.1 393.0 17,131 -0.3 1.1 -10.6 -1.8 25.8 4.1 3.5 1.3 -9.7 -0.3 2.7 -1.0 2.0 1.0 32.80 31.40 45.59 45.73 254.9 236.7 18.3 24.9 6.3 -4.9 -1.2 5.1 3.4 9.5 291.7 14.8 411.9 90.4 27.0 88.9 -1.3 3,705.0 30.0 1.5 0.4 30.4
2009e -4.2 364.1 15,827.6 0.4 2.4 -16.3 -13.6 23.1 5.9 -0.7 0.8 -1.2 -1.2 7.8 -1.3 1.3 1.0 31.50 32.94 47.25 47.65 201.9 176.8 25.0 29.4 8.1 -6.5 -1.8 6.3 -20.8 -25.3 324.0 22.0 404.5 114.9 30.3 113.0 -4.2 4,193.8 35.0 1.9 0.5 35.5
2010e 4.4 419.0 18,160.0 2.1 2.0 3.8 7.6 25.5 5.8 1.1 1.5 4.2 1.8 9.2 -0.6 1.8 1.6 29.00 30.19 43.50 45.28 221.2 195.1 26.0 26.5 6.3 1.6 0.4 7.0 9.6 10.4 352.4 21.7 454.5 118.8 28.5 116.5 -2.9 4,558.1 36.0 2.3 0.6 36.6
2011e 4.9 474.7 20,512.9 2.6 1.2 3.7 7.8 28.4 5.2 1.6 1.7 5.2 2.5 7.2 0.4 2.2 1.9 28.00 28.38 42.00 42.56 244.0 213.1 31.0 33.2 7.0 -2.2 -0.5 7.1 10.3 9.2 390.3 22.0 498.1 136.2 28.6 127.5 -1.0 4,728.5 35.1 8.7 1.8 36.8
6.2 331.2 14,645 4.5 -0.5 19.5 9.3 26.0 4.4 1.6 1.6 6.0 2.7 7.4 8.4 1.8 1.9 31.74 33.41 43.20 42.12 182.4 165.0 17.4 19.7 6.0 -5.2 -1.6 4.4 21.1 32.6 241.7 17.6 278.4 80.9 25.4 75.9 -3.2 2,543.8 23.0 5.0 1.5 24.5
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Frederic Neumann: +852 2822 4556 fredericneumann@hsbc.com.hk
Thailand: the essentials
The recovery is now well underway, supported by the turnaround in manufacturing. With deflation expected to be temporary, the policy rate has hit the bottom, with the next move being up in the first quarter of next year
Growth bounce The Thai economy bounced back in the second quarter, with GDP rising by 2.3% quarter-on-quarter on a seasonally adjusted basis. This follows a 2% contraction in Q1 and a 6% drop in Q4 last year. Clearly, the country still has a long way to go, but things are moving in the right direction. Manufacturing production and exports have seen strong sequential gains with indicators of domestic demand looking up too. The aggressive easing by the central bank has had a crucial part to play, and government support has also had a positive effect. Overall, we expect the economy to contract by 2.8% in 2009 and accelerate sharply next year, with growth hitting 4.5%, a touch below trend. The key risk here is the political landscape, with unrest clearly dampening growth prospects. Politically, the country is not quite out of the woods. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) THB/USD, end quarter THB/EUR, end quarter 3.9 6.1 6.1 19.0 -0.3 -2.0 102.4 3.8 4.3 33.90 48.14 Q4 2008 -4.2 -6.7 0.4 -1.7 -2.1 -3.1 111.0 2.7 2.5 34.70 48.23 Q1 2009 -7.1 -14.4 -0.2 -4.0 12.6 14.7 116.2 1.5 2.6 35.47 46.82 The much talked about three-year investment plan was finally approved by the Cabinet in mid-August, now worth THB1.1trn (USD 31bn) versus a plan of THB1.4trn in May. Roughly THB27bn is to be spent before the end of the current fiscal year in September, and the rest over the coming years until 2012. The big spending plan, however, means that the country is set to see larger budget deficits with debt levels expected to rise as well. On the external front, Thailand has a current account surplus of USD11.4bn compared with USD3bn in the same period last year, with a big boost coming from a widening trade account as imports collapsed more than exports. The country has been adding to its foreign exchange coffers as the central bank has been preventing appreciation of the baht, with reserves standing at USD120bn at the end of June. -4.9 -8.4 -4.0 -10.5 6.2 3.7 120.8 1.3 3.2 34.06 47.68 -3.1 2.0 -0.5 -12.5 1.3 0.3 122.1 1.3 3.3 34.00 49.30 3.8 3.0 2.0 6.0 -2.6 -3.1 121.41 1.3 3.3 33.00 49.5 5.4 4.0 3.0 9.0 10.8 11.0 131.08 1.3 3.4 32.50 48.8 4.5 4.0 3.8 12.0 4.2 2.1 134.83 1.5 3.6 32.00 48.0 4.4 4.5 3.8 12.0 -0.4 -1.6 136.60 1.8 3.8 31.50 47.3 3.6 4.5 3.8 10.0 -1.5 -2.3 137.73 2.0 3.8 31.50 47.3
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
Temporary deflation Thailands inflation rate has been negative since January, the longest run for data going back to 1977. This is largely driven by big declines in domestic energy prices with clothes discounting and falling housing related costs also chipping in. Interestingly, core inflation has a strong relationship with energy prices (correlation of 0.7 with a six-month lag). Even if we assume that oil prices and the currency remain flat at current levels the energy component of the CPI will start turning around (the extension of the utility subsidy until December may limit it somewhat) but it will eventually feed into core prices. Overall with the growth outlook now better, and less favourable base effects, deflation will turn to inflation towards the end of the year. Activity & inflation
15 10 5 0 -5 -10 -15 -20 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) GDP (LHS) Indus trial growth (LHS) 10 8 6 4 2 0 -2 -4 -6
Bank of Thailand: steady as it goes The Bank of Thailand (BoT) has been aggressive in its support of the economy, having cut the policy rate by 250bps to a five-year low of 1.25%. This compares with an average policy rate of 2.5% since 2000. The pass-through to the real economy, however, has been lower with the minimum lending rate falling by roughly 130bps. With Thai GDP rising in the second quarter and deflation expected to be temporary, we think 1.25% marks the bottom in rates. However, the BoT could keep rates at this low level until the middle of next year to provide strong support to the recovery. On rate hikes, the Bank indicated that it will raise rates only if inflation comes from real demand and there is no point reacting to inflation coming from supply side shocks such as oil prices. Still, with growth returning, we expect the Bank of Thailand to start hikes in Q2. Policy stance
2 (% GD P, 4 qma) 0 (%) 0 -5 4Q04 4Q05 4Q06 4Q07 Fiscal balance (LHS) CPI, % y-o-y (R HS) 4Q08 4Q09e 4Q10e Policy rate (RHS) -2 -4 -6 -8 5 10
(% y-o-y)
(% y-o -y)
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Thailand: at a glance

3.0 2.0 1.0 (%)

6.5 4.5 (%) 2.5 0.5
0.0 -1.0 -2.0 -3.0 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 3M spread over US-Libor 2yr spread over US-Libor
-1.5 1yr
2y r
3yr
4yr
5y r
7yr
10yr
15yr
Now + 4 months
- 4 months Current CPI

46 42 15 10 (%) 5 0

175 150 (%) 125 100 75 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09
38 34 30 26 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e THB v s USD (LHS) Annualised v olatility (RHS)

120 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short- term debt % reserves (RHS) 50
Policy dynamics
3.0 2.0 1.0 (real rates) 0.0 -1.0 -2.0 -3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 2011e 2010e 2007 2009e 2008
(% of r eser ves)
40 30 20 10 0
(USD bn)

350 300 250 200 150 100 50 0 1200 800 600 400 C 200 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Thailand sub-index (LHS) Thailand HSBC av. spread
(spread bp s)

1000 800 600 400 200 0 -200
(spread bps)
1000
(ind ex)
1/05
5/05
9/05
1/06
Thailand 5yr Govt. Thailand HSBC av. spread
5/06
9/06
1/07
9/07 5/07
1/08
5/08
1/09 9/08
5/09
9/09
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Thailand: local knowledge/global drivers

Manufacturing production and exports have risen strongly on a sequential basis. At the same time, business and consumer confidence have turned, suggesting things on the domestic front are looking better as well.
Manufacturing production Production in the Thai manufacturing sector is coming back with a vengeance. On a sequential basis, output has risen for six consecutive months with the 3-month on 3-month annualised change in the seasonally adjusted series up to 30% in July from a low of -65% in January. Admittedly, the year-on-year change is still negative but it is only -7% compared with a low of -21%. The main sectors seeing a rebound are food and electronics, with the latter benefitting from the electrical appliances to rural China programme. Looking ahead, with the global economy in better shape and confidence indicators at home turning around, we expect the manufacturing sector to continue improving. back with a vengeance
30 10 -10 -30 -50 00 01 02 03 IP % Yr 04 05 06 07 08 09 IP % 3 m /3 m s aa r
Business confidence has been rising Despite the political noise in the country, business confidence in Thailand has been on an upward trajectory since the 10-year low in November, supported by the aggressive easing from Bank of Thailand and the fiscal plans announced by the government. The stabilising external environment has also had an important part to play with business total order books making a very strong come back, up 20 points from the low last year. This is positive for production and exports going forward. Business sentiment towards investment has risen sharply as well and was around the breakeven level of 50 in June-July a first since September last year. All other components, such as profits, employment and production, have also seen solid improvements. with firms looking to expand investment
60 55 50 45 40 35 30 99 00 01 02 03 04 05 06 07 08 09
Bus ines s sen tim e nt in dex
inv e stm en t
Consumer confidence looking up The optimism in the business community and some stabilisation locally have seen consumer sentiment improve for two consecutive months. While it is still at very low levels, it is at least moving in the right direction. At the same time the 3-month on 3-month annualised change in the central banks composite private consumption indicator has improved for four consecutive months. Running at +14.5% in July compared with a low of nearly -20% in March. The turnaround has been reflected in Q2 GDP data as well, with personal consumption expenditure increasing by 0.4% q-o-q on a seasonally adjusted basis compared with a 3.6% drop in Q1. Looking ahead we think consumer spending should continue to improve. and the central banks consumption indicator has risen sharply
20 10 0 -10 -20 00 01 02 03 04 05 06 07 08 p riv a te c on s um p tio n 3m / 3m s aa r c ons u m e r c o nfid en c e inde x 09 12 0 11 0 10 0 90 80 70 60
Exports turning but imports by even more Given the collapse in external demand Thailands exports did the same at the turn of the year. However, sequential data are now improving, with the 3-month annualised change of the seasonally adjusted export series running at -2% in July from a low of -77% in January. The turnaround in imports has been even sharper, currently at +41% from a 20-year low of -134% in February, reflecting rising intermediate goods demand as the export outlook improves, a tick up in oil prices and better domestic demand indicators. Given these trends, we think the biggest monthly trade surpluses are now probably behind us. Year-to-date, the country has seen a trade surplus of nearly USD12.5bn compared with USD1.4bn in the same period last year. largest trade surpluses are now behind us
60 40 20 0 -20 -40 99 00 01 02 03 04 05 06 07 08 09 3 2 1 0 -1 -2
tra d e b a la nc e , U S Db n im p o r ts % y -o -y
e x p o rts % y -o -y
154
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Thailand: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) THB/USD, end-year THB/USD, average THB/EUR, end-year THB/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (THBbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 6.4 161.5 2,469 6.1 5.8 13.2 11.7 31.7 1.5 2.8 3.0 10.1 2.3 7.0 5.4 2.0 N/A 38.92 40.28 52.90 50.69 94.9 93.5 1.5 2.8 1.7 5.8 3.6 5.3 21.6 25.7 49.8 6.4 4.6 51.3 24.4 36.4 1.4 0.0 1.1 2,482.3 38.2 14.9 9.2 47.4
2005 4.7 176.1 2,708 4.9 11.4 10.5 9.1 30.9 1.4 4.5 5.8 8.0 6.9 4.7 2.0 4.0 5.5 41.03 40.28 48.42 50.15 109.4 117.6 -8.3 -7.6 -4.3 7.5 4.3 -0.1 15.2 25.8 52.1 5.3 8.1 52.0 31.5 38.0 1.0 0.3 1.9 2,704.9 38.1 14.0 7.9 46.1
2006 5.2 206.7 3,014 3.0 2.4 3.9 7.3 32.4 1.0 4.6 3.5 2.7 6.2 8.8 -0.9 5.0 4.9 35.45 37.93 46.75 47.67 127.9 126.9 1.0 2.3 1.1 8.5 4.1 5.2 17.0 7.9 67.0 6.3 16.9 59.6 27.7 45.6 2.4 1.2 2.2 3,186.8 40.6 14.1 6.8 47.5
2007 4.9 236.8 3,724 1.6 9.2 1.3 8.2 34.1 0.8 2.2 3.2 8.7 3.0 7.4 3.4 3.3 4.6 33.70 34.58 49.20 48.07 150.0 138.5 11.6 14.0 5.9 9.4 4.0 9.9 17.3 9.1 87.5 7.6 21.1 61.7 24.7 49.7 -0.6 -2.3 1.6 3,226.2 39.4 12.0 5.1 44.5
2008 2.6 273.6 4,116 2.5 0.5 1.1 5.3 33.2 1.4 5.5 0.4 -1.7 10.2 5.4 15.7 2.7 2.5 34.70 33.28 48.23 48.46 175.3 175.1 0.2 -0.2 -0.1 7.0 2.6 2.5 16.8 26.4 111.0 7.6 22.0 64.8 21.7 51.8 0.9 -1.1 1.5 3,434.0 37.7 13.0 4.7 42.5
2009e -2.8 258.2 3,933 -0.7 7.0 -8.1 -7.0 32.3 3.3 -0.9 2.0 6.0 -1.4 6.6 5.9 1.3 3.3 33.00 34.35 49.50 49.69 148.0 138.9 9.1 7.9 3.7 4.6 1.8 4.9 -15.6 -20.6 121.4 10.6 23.0 53.1 15.6 44.0 -4.4 -6.4 1.1 4,167.5 47.0 9.3 3.6 50.6
2010e 4.5 298.4 4,363 2.6 6.0 7.1 6.0 33.0 2.7 2.6 3.8 10.0 5.0 5.0 6.7 2.0 3.8 31.50 32.06 47.25 48.09 162.5 156.4 6.1 3.1 2.2 6.7 2.2 3.6 9.8 12.6 137.7 10.8 24.0 56.5 14.5 46.0 -4.0 -6.1 1.6 4,376.8 45.7 10.5 3.5 49.3
2011e 4.7 334.4 4,673 2.9 5.0 7.1 6.6 33.8 2.7 2.9 4.0 11.0 5.0 5.0 6.4 2.0 4.3 31.00 31.06 46.50 1.25 178.6 165.8 12.8 9.5 3.4 6.7 2.0 5.6 9.9 6.0 614.5 44.9 25.0 58.1 3.4 47.0 -3.1 -5.2 1.9 4,552.3 43.8 11.1 3.3 47.2
155
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Turkey: the essentials
Turkey has seen a phenomenal convergence in interest rates due to sharp economic contraction and CBRTs aggressive easing campaign. The conjectural compression in yields should be supported by structural efforts
Domestic politics is mostly quiet The ruling AKP party lost some popularity at the March 2009 local elections, falling to 38.8% of the poll from 46.5% in the July 2007 general elections. However, it remains by far the strongest political movement and dictates the agenda. AKPs recent efforts on democratisation, ie granting more ethnic rights to the large Kurdish minority, rapprochement with Armenia and an active foreign policy to mediate conflicts in the region, have improved its standing with the international community. At home, there is a risk of a rise in nationalism within the population, which is only slowly recovering from a sharp economic contraction and suffering from high unemployment. However, polls do not consistently point in that direction. After years of skirmishes, the conservative-secularist struggles have also subsided substantially. Hence, domestic politics look generally quiet. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 1-yr rate, end quarter (%) TRY/USD, end quarter TRY/EUR, end quarter 1.0 -1.4 11.1 12.5 -10.4 -6.5 76.6 16.75 19.3 1.24 1.80 Q4 2008 -6.5 -12.6 10.1 8.1 -9.6 -5.5 70.1 15.00 15.8 1.52 2.13 Q1 2009 -14.3 -22.0 7.9 3.5 -8.8 -4.6 66.5 10.50 13.5 1.67 2.22 EU accession front may attract attention again While Turkeys efforts on domestic and foreign policy will likely go down well in the EU, the report on the Cyprus issue and the December summit are worth following. In 2006, the EU Council asked the Commission to track until 2009 Turkeys compliance on Cyprus conditionality, namely granting access to Greek Cypriot vessels, which Ankara has refused to do until there is a permanent solution in the island. The commissions mid-October progress report and year-end summit are thus important. Despite a potentially clamorous Turkey-sceptic camp, the end result could be some qualifiers added to Turkeys accession process rather than a derailment. This is due to Turkeys increased importance, slow but sound improvement in democratic credentials and the strategically very important Nabucco gas pipeline project. Still, we advise following the Merkel-Sarkozy line on this closely. -7.0 -15.4 5.7 -1.9 -7.1 -3.1 64.9 8.75 10.9 1.52 2.15 -4.3 -6.4 5.8 0.4 -5.8 -2.1 71.1 7.25 8.7 1.52 2.20 4.5 4.2 6.8 5.4 -6.0 -2.0 69.0 6.50 8.5 1.58 2.36 2.8 4.0 8.4 5.2 -6.5 -2.4 70.0 6.50 9.5 1.63 2.44 2.4 3.5 9.4 5.8 -6.6 -2.5 71.5 9.50 10.9 1.60 2.39 3.4 3.8 9.7 7.4 -6.7 -2.7 73.0 9.50 11.3 1.62 2.42 3.0 3.2 7.7 7.2 -6.9 -2.8 73.0 9.50 11.5 1.60 2.40
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
Worst economic contraction since 2001 crisis The real economy has taken a major hit from the global crisis, contracting 10.6% y-o-y in H1 2009 after a 6.5% contraction in Q4 2008. Seasonally adjusted, the output loss in the four quarters to Q1 2009 is actually more than 10%. However, there was a sharp sequential bounce-back in Q2 2009, around 4.0% q-o-q seasonally adjusted, thanks to the governments fiscal stimulus via tax cuts on durable goods. High-frequency indicators are mixed to soft for Q3 2009 so far, following partial removal of tax incentives in mid-June. We expect better activity in Q2 2009 with a lagged impact of monetary easing, but there may be a soft patch in early 2010 due to mounting domestic debt redemptions by the Treasury, hence potential crowding out of the private sector. An earlier recovery in key export markets, particularly in the EU, could improve the growth outlook. Activity & inflation
8 4 0 -4 -8 -12 -16 -20 -24 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) 12 10 (% y-o-y) 8 6 4
Inflation has fallen precipitously so far, watch out for cost pressures Due to the massive output gap and earlier slump in global commodity prices, inflation has fallen to historically low levels and has been cruising at 5.0%6.0% since spring. The CBRT has seized the opportunity to slash policy rates from 16.75% to a record low 7.25% in September. While inflation will probably remain subdued in the immediate term, cost pressures from a pickup in commodity prices and loose fiscal policy (administered price hikes, tax adjustments) as well as a extremely unsupportive base (a mere 1.83% cumulative in H1 2009) are likely to cause considerable headline volatility. Although the CBRT will remain focused on core indicators, a potential turn in the global monetary cycle, a better outlook on the economy, a further rise in commodity prices and the deep reduction in risk premium may all argue for earlier-than-expected tightening. Policy stance
0 -1 -2 -3 -4 -5 -6 4Q04 4Q05 4Q06 4Q07 Fiscal balance (LHS) CPI, % y -o-y (RHS) 4Q08e 4Q09e 4Q10e Policy rate (RHS) 20 16 (%) 12 8 4 0
GDP (LHS)
156
(% GDP, 4 qma)
(% y-o-y)
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Turkey: at a glance

25 20 (%)
11 (%) 9 7 5
15 10 5 0 7/07 11/07 3/08 7/08 11/08 3/09 7/09
3M Now
6M -4 months
9M +4 months
12M
3M spread over US-Libor
12M spread over US-Libor

2.0 1.5 1.0 0.5 0.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e TRY vs USD (LHS) Annualised vola tility (RHS) 100 80 (%) 60 40 20 0

800 600 (%) 400 200 0 00 01 c 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09

80 (USD bn) 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definition (LHS) Short- term debt % reserves (RHS) 50 0 150
Policy dynamics
8.0 6.0 (real rates) 4.0 2.0 0.0 -2.0 0.0 2009e -2.0 -4.0 -6.0 (central govt balance % GDP) -8.0 2008 2010e 2011e 2007
(% of reser ves)
100

1000 800
(ind ex)

1000
(spread bp s)
600 400 200 0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 MSCI Turkey sub-index (LHS) EMBI Turk ey sub-in dex (RHS)
600 400 200 0
(spread bps)
800
2400 2000 1600 1200 800 400 0
7/06
11/06
3/07
Turkey 1y r Gov t. EMBI Turkey sub-index
7/07
11/07
3/08
7/08
11/08
3/09
7/09
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Turkey: local knowledge/global drivers

After nearly one full year of negotiations, the government is likely to implement its own programme, without IMF support. Turkeys new investment story needs to focus on raising the domestic savings rate to be successful
Historical convergence in rates Turkey has seen a historical convergence in real and nominal interest rates. The key reason was sharp disinflation due to very weak economic activity. In addition, CBRTs distinctly dovish stance and future monetary policy outlook (no rate hikes until end-2010 in its base-case scenario) have helped the Treasurys most liquid benchmark borrowing rate (yield of discount bond with around 1.5 years maturity) to tighten to a single-digit level for the first time in history. CBRT has also taken its cue from outperformance of Turkeys CDS spreads and has reduced real interest rates also to historical lows. In addition, improvement in global risk appetite as well as expectations of an IMF deal with a sizable funding package have also been instrumental in a massive rates rally. Real policy rates (%, c.a., ex-post based on realised CPI, ex-ante based on expectations) High rollover and rising public debt This historical opportunity in compression of rates led to a re-rating of Turkey, as evident in the recent upgrade of credit rating outlook by S&P and Moodys. However, the fly in the ointment is the Treasurys rising rollover ratio from the market, which has reached 107% y-t-d due to a soaring public sector borrowing requirement with weak privatisation prospects. The deterioration in the public primary balance is due to both expenditure pressures, as the public sector is trying to replace falling private demand, and to a poor tax intake. Turkeys total tax revenues as a ratio of GDP are low by OECD standards and rely too much on contemporaneous activity (89% of GDP direct tax gap with the OECD). There will be a steep rise in the gross public debt to GDP ratio this year, the first since the 2001 crisis. Domestic debt rollover ratio from markets
110% 105%
15%
Ex-post
Ex-ante
100% 95% 90%
10%
85% 80% 75%
5%
70% 65% 60%
0% 02/04 08/04 02/05 08/05 02/06 08/06 02/07 08/07 02/08 08/08 02/09 08/09
55% 50% 2003 2004 2005 2006 2007 2008 2009 YTD
Source: TURKSTAT, CBRT
Source:Turkish Treasury
Markets giving up on IMF hopes The Turkish government and the IMF have been negotiating on a potential three-year stand-by arrangement with a sizable funding package for nearly a year. Originally, the key sources of contention were different macro and fiscal forecasts and differing approaches to second-generation fiscal reforms. The governments recent medium-term programme appears much more realistic in terms of macro forecasts and closer to the IMFs current assumptions. There has also been a plan to put together the framework for a fiscal rule next year in order to start implementation in 2011. Nonetheless, the IMF has recently hinted that more supporting measures and structural reforms (possibly more on the revenue side) are needed to enable Turkey to meet its targets of stabilising and reducing the public debt to GDP ratio. Direct taxes (income and corporate tax) over GDP (%)
18 16 14 12 10 8 6 4 2
Government relies on cyclical recovery, structural efforts needed The medium-term programme relies too much on cyclical economic recovery next year, while commitments on the primary balance front do not appear that impressive. Government also seems likely to implement its own programme without the IMFs support. This is clearly a choice, though it may require more stringent fiscal reform efforts, such as expanding the tax base, invigorating Revenue Administration, clamping down on huge grey/untaxed activity, consolidation of other public finances, and increasing domestic savings, in order to convince investors that rates can stay sustainably low even though global rates creep up and the Treasury has to redeem more debt next year, especially if Turkey looks again like a twin-deficit country. We still believe a well funded and designed IMF programme would be very useful. Excerpts from medium-term economic programme
All in %
Growth (real, YoY) Inflation (CPI, YoY) 2009 -6.0 5.9 2010 3.5 5.3 2011 4.0 4.9 2012 5.0 4.8
Brazil
South Africa
Philippines
Indonesia
Singapore
Malaysia
Kazakhstan
Pakistan
India
Ukraine
Thailand
Hungary
Taiwan
Poland
Russia
Turkey
Korea
Egypt
Israel
China
IMF-defined, % of GDP Central Administration Revenues Central Administration Primary Spending Central Administration Primary Balance Other Public Primary Balance Consolidated Public Primary Balance % of GDP Privatisation Revenues EU-defined Gross Public Debt Stock
Source: Turkish Treasury
20.1 22.3 -2.2 0.1 -2.1
21.4 22.2 -0.8 0.5 -0.3
21.4 21.6 -0.2 0.6 0.4
21.4 21.0 0.4 0.6 1.0
0.5 47.3
1.0 49.0
0.8 48.8
0.7 47.8
Source: Ministry of Finance, HSBC
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Turkey: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 1-yr interest rate, end-year (%) TRY*/USD, end-year TRY*/USD, average TRY*/EUR, end-year TRY*/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (TRYbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 8.6 9.4 15.3 9.2 39.5 59.6 18.00 21.9 1.34 1.42 1.83 1.77 63.7 97.5 -34.4 -15.6 -4.0 2.0 0.5 -3.5 33.5 40.7 36.0 4.4 79.3 161.0 88.6 63.8 -4.7 -5.4 3.9 224.5 40.2 75.7 19.4 59.5 9.4 390.4 5,487 11.0 6.0 28.4 9.8 16.8 10.3
2005 8.4 481.5 6,681 7.9 2.5 17.4 5.4 16.5 10.2 8.2 7.7 2.7 11.6 30.8 51.4 13.50 14.1 1.34 1.34 1.60 1.67 73.5 116.8 -43.3 -22.6 -4.7 8.7 1.8 -2.9 16.4 19.8 50.5 5.2 95.6 169.7 73.5 83.7 -0.9 -1.3 3.7 244.8 37.7 70.4 14.6 52.3
2006 6.9 526.4 7,500 4.6 8.4 13.3 7.8 17.1 9.9 9.6 9.7 11.6 12.8 33.8 43.6 17.50 20.6 1.41 1.43 1.85 1.80 85.5 142.6 -57.1 -32.2 -6.1 19.2 3.7 -2.5 16.4 22.1 60.8 5.1 114.7 207.6 66.4 120.1 3.5 -0.5 4.4 251.5 33.2 71.6 13.6 46.8
2007 4.7 646.5 9,157 5.5 6.5 3.1 7.2 16.5 9.9 8.8 8.4 5.9 8.8 17.6 26.3 15.75 16.7 1.16 1.30 1.71 1.78 107.2 170.0 -32.8 -38.2 -5.9 19.8 3.1 -2.9 25.3 19.2 71.3 5.0 124.7 249.4 60.6 160.1 -0.4 -1.6 3.5 255.3 30.3 73.5 11.4 41.6
2008 0.9 731.1 10,239 -0.1 1.9 -5.0 -0.6 18.2 13.6 10.4 10.1 8.1 6.5 23.7 25.9 15.00 15.8 1.52 1.30 2.13 1.90 132.0 201.8 -69.8 -41.6 -5.7 15.1 2.1 -3.6 23.2 18.7 70.1 4.2 144.5 277.1 72.2 185.4 -0.8 -1.8 2.0 274.8 28.9 78.2 10.7 39.6
2009e -5.3 603.4 8,344 -2.2 0.9 -15.9 -9.9 21.5 17.0 6.4 6.8 5.4 4.0 19.5 0.9 6.50 8.5 1.58 1.57 2.36 2.19 98.3 133.2 -34.9 -11.9 -2.0 6.0 1.0 -1.0 -25.5 -34.0 69.0 6.2 139.0 270.0 70.3 177.4 -5.8 -6.1 -1.7 330.0 34.8 76.5 12.7 47.4
2010e 2.9 657.6 8,980 2.9 2.7 3.6 3.6 21.0 16.2 8.7 7.7 7.2 5.4 15.5 5.7 9.50 11.5 1.60 1.61 2.40 2.42 111.1 156.5 -45.4 -18.6 -2.8 7.5 1.1 -1.7 13.0 17.5 73.0 5.6 143.5 281.0 71.6 185.9 -3.4 -4.2 -0.9 365.0 34.4 78.5 11.9 46.4
2011e 4.1 753.5 10,160 4.0 4.8 3.8 4.3 19.7 15.5 6.7 6.5 5.5 7.2 20.8 12.1 8.50 10.4 1.55 1.58 2.10 2.25 129.5 187.0 -57.6 -24.6 -3.3 13.5 1.8 -1.5 16.5 19.5 76.5 4.9 149.7 296.0 75.2 198.7 -4.5 -5.5 -0.7 395.7 33.3 81.9 10.9 44.2
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Alexander Morozov: +7495 783 8855 alexander.morozov@hsbc.com Dmitry chernyadyev: Economics associate
Ukraine: the essentials

The Ukrainian economy still waiting for stronger external stimuli to bounce. Financial assistance from IFIs safeguards some stability but may fail to cope with intensifying political fighting ahead of presidential elections.
The worst is over but still waiting for the rebound A country, like Ukraine, that has suffered the most from the output loss during the economic crisis might be expected to recover more strongly, other things being equal. While signs of economic stabilisation on the back of external demand have been seen since Q2, Ukraine still has to prove it will rebound. The financial sector has not reached a turning point yet, making this task more difficult. But external growth drivers have grown stronger, which should help the recovery in Ukraine as well. Technical assistance and funding from the IMF, WB, EBRD, and others help to keep the overall situation under control, despite the lack of concerted efforts from the political elite to fix the problems. Preparation for the January 2010 presidential elections will probably halt implementation of any structural policies, a failure to raise natural gas prices for households being one example. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) UAH/USD, end quarter UAH/EUR, end quarter 6.4 3.0 24.6 42.7 -7.2 -3.7 36.6 15.0 13.7 5.07 7.30 Q4 2008 -8.0 -25.0 22.3 23.0 -9.5 -9.5 30.8 22.0 15.6 7.80 11.00 Q1 2009 -20.3 -31.9 18.1 12.8 -5.0 -3.6 24.6 18.0 15.6 8.20 10.84 After failing to fix the financial problems of Naftogaz, a state-owned energy company, by increasing natural gas tariffs, the government left the company without any alternative to foreign debt restructuring. Disbursement of IMF funds directly to the budget in May and July allowed the government to repay its own eurobonds. With sovereign default risks abated, however, the IMF might take a tighter stance on further disbursements, which could cause serious fiscal distress. The inflation outlook has improved, allowing the NBU to cut rates. At the same time, the NBU faces a tough trade-off trying to preserve its reserves in order to meet the stand-by programme target and to prevent the UAH from weakening, which would be considered politically unacceptable ahead of the elections.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e -18.0 -30.4 15.0 -0.9 -3.6 -0.6 26.5 16.0 23.5 7.50 10.52 -17.0 -23.0 14.9 -3.0 -7.2 -1.9 24.6 15.0 23.5 8.60 12.47 -8.0 -13.0 11.9 7.0 -3.0 -4.4 24.1 14.0 23.1 9.50 14.25 8.0 5.0 9.0 12.0 -5.5 -4.2 21.7 12.0 22.1 8.50 12.75 7.0 6.0 9.0 11.0 -3.9 -1.2 21.4 10.5 20.3 8.00 12.00 5.0 6.0 8.0 10.0 -6.5 -1.7 21.4 9.5 18.2 9.00 13.50 4.0 6.0 8.0 10.0 -2.1 -3.4 18.5 9.5 16.1 10.00 15.00
Export demand seeded green shoots Ukrainian GDP hit bottom in Q1 2009, falling 20.3% y-o-y, according to official data. So did industrial output, falling by 31.9% y-o-y. A move by some businesses to the shadow economy and generally better resilience of the shadow economy to the crisis helped to prevent a bigger output fall. Green shoots that have emerged since Q2 rely on some restoration of export demand for steel, chemicals and agricultural commodities. Other sectors and industries still have to find growth drivers, since domestic demand remains extremely weak retail sales fell by 15.9% y-o-y in July and August. But an improved economic outlook for the US, China, Russia and the exceptional depth of GDP decline in Ukraine give grounds to expect a fairly strong initial rebound by the economy in the near future, driven by export demand. Activity & inflation
10 5 0 -5 -10 -15 -20 -25 -30 -35 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) Industr ial grow th (LHS) CPI (RHS) 30 25
Declining inflation favours policy easing A tight monetary stance and weak domestic demand laid the basis for inflation to decelerate. In August, consumer price growth moderated to 15.3% y-o-y and it may reach single digits in Q1 2010. A programme with the IMF safeguards against any significant spikes in money supply in support of banks or the budget deficit. Positive inflation dynamics allowed the NBU to cut its overnight repo rate from 22% in December 2008 to 15.5% by mid-September. In September, the NBU also introduced a formal floor for the overnight repo rate at the level of discount rate (10.25% at present) plus 300bp. Further policy easing may be delayed amid devaluation expectations until the local currency finds a new equilibrium.
Policy stance
4 2 (% GDP, 4qma) 0 -2 -4 -6 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e Policy rate (RHS) 30 25 20 15 10 5 0
(% y-o-y)
(% y-o-y)
15 10 5
160
(%)
20
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Ukraine: at a glance

1400 1200 1000 800 600 400 200 0 40 00
(spread bp s)

28 27 26 25 24 23 22 21 1yr Now 2yr -4 months 3y r +4 month s 5yr
30 00 20 00 10 00 0 1 /0 5 7/ 05 1/ 06 7 /0 6 1/07 7 /0 7 1/ 08 7/ 08 1 /0 9 7/09 U kraine PF TS Index (LHS) E MBI Uk ra ine PFT S Index (LHS) su b-inde x (RHS)
(ind ex)

10.0 9.0 (%) 8.0 7.0 6.0 5.0 4.0 1999 2000 2001 20022003 2004 2005 2006 2007 20082009e UAH v s USD (LHS) Annualised volatility (RHS) 80 50 20 -10

225 (%) 175 125 75 00 01 02 03 04 05 06 07 08 Grow th of nominal ex change rate v s USD Cumulativ e CPI Cumulativ e PPI 09

35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 International reserves, IFI definiti on (LHS) Short-te rm debt % reserv es (RHS) 60 50 40 30 20 10 0
Policy dynamics
3.0 2.0 (real rates) 1.0 0.0 -1.0 -2.0 -3.0 0.0 2007 -2.0 -4.0 -6.0 -8.0 2008 2010e 2011e 2009e
(USD bn)
(%)
(% of reserves)
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Ukraine: local knowledge/global drivers

Fiscal stance and the banking sector became the Achilles heel for Ukraine but markets seem to be overpricing medium-term FX risks
Fiscal strain, public pain The economic crisis hit public finance hard. With GDP declining in both real and nominal terms, the shortfall in budget revenues against 2008 results is even bigger because of a decline in tax discipline and a significant reduction in corporate profits and taxes on them. On the expenditure side, pressures have increased during the crisis as financing the social safety net and bank recapitalisation programme required additional resources. Advance payments of NBU profits and some taxes and late VAT refunds to exporters had supported revenues of the general budget fund before May 2009. Since then, revenues have been recording a 23-40% shortfall compared with 2008. It makes the budget critically dependent on continuing external funding by IFIs or the NBU. Revenue shortfall rises
24 20
UAHbn
Survival challenge for banks Ukrainian banks entered the economic crisis highly leveraged and exposed to FX risks. The exceptional severity of the crisis in Ukraine had strong negative implications for the quality of bank assets, and weak regulatory and institutional protection of creditors prompted additional losses for banks. While massive depositor runs on banks have been avoided, with the help of moratoriums on deposit withdrawals imposed on banks taken into state receivership, the amount of deposits had declined by 13% in April from their peak. As a result, the loan-to-deposit ratio actually rose from 1.6 in July 2008 to 2.3 in March and has shown only a minor decline since then. Until this imbalance is corrected through loan write-offs and deposits rise, the banking system will be in survival mode. Alerting high loan-to-deposit ratio
800 600
UAHbn UAHbn
16 12 8 4 0
23 21 19 17 15 13 11 9
2.3 2.1 1.9 1.7 1.5 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Loans (lhs) Deposits (lhs) Loan-to-deposit ratio (rhs)
400 200 0
Feb
Jan
Apr
Jun
Jul
Aug
Sep
Oct
Nov
Cumula ti ve rev enue shortfall (lhs) 2008 general fu nd rev enues (rhs) 2009 general fu nd rev enue (rhs )
Source: State treasury Source: NBU
Political landscape ahead of presidential elections The official electoral campaign will start in October for elections on 17 January 2010. Yanukovich, ex-PM and the leader of the Regions of Ukraine party, appears well-positioned to lead the race, with a stable electoral base and having kept to the political sidelines in the opposition. Ratings of Timoshenko, the current PM, suffered during the crisis. Yatsenyuk had been rising as a new political star but during the past few months has seen some decline in his support. A key challenge for both Timoshenko and Yatsenyuk is to revive electoral interest among those who have grown tired of domestic political wrangling. Yanukovich might face either of them in the second round, but the next president would have to seek a political coalition in the Rada in any case. Yanukovich is frontrunner
30 25 20 15 10 5 0 1Q2008 2Q2008 Jul-08 Aug-08 Sep-08 Oct-08 N ov-08 Dec-08 F eb-09 Apr-09 May-09 J uly-09 3Q2007 4Q2007
May
Dec
Mar
Is FX risk overpriced? Devaluation pressures on the UAH have returned since July. NBUs rationing of FX intervention amounts and restrictions imposed on FX demand fuelled devaluation expectations further. The outright UAH NDF curve shifted upwards. Since then the curve has started flattening, with the short end moving up along with the UAH spot and the long end moving down. But implied yields of the 2-3Y NDF still exceed 30%. Although the medium-term inflation outlook for Ukraine is uncertain, we expect it to decelerate to single digits next year. The current FX spot level is not far away from the level that would be consistent with balance-ofpayment neutrality, while NBU reserves are still plentiful. Against such a backdrop, current high implied NDF yields appear excessive. Flattening of outright UAH NDF curve
22.5
UAHUSD
17.5 12.5 7.5 1M 2M 3M 6M 17-Sep-09 11-Aug-09 9M 1Y 18M 8-Sep-09 9-Jun-09 2Y 3Y
T imoshenko Yusc henko

Source: FOM
Yanukov ich Yatseny uk

Source: Reuters
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Ukraine: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) UAH/USD, end-year UAH/USD, average UAH/EUR, end-year UAH/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (UAHbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP) 12.1 64.8 1,366 12.2 12.1 -2.2 12.5 26.9 9.2 9.0 12.3 24.1 27.6 32.4 15.8 10.0 11.9 5.31 5.32 7.21 6.61 33.4 29.7 3.7 6.8 10.5 1.7 2.6 13.1 40.8 23.7 9.3 3.8 2.3 30.6 112.2 18.1 -3.7 -3.3 -2.7 21.0 6.1 12.9 19.9 26.0
2005 2.6 81.8 1,737 16.6 2.7 -0.3 3.1 18.2 7.8 10.3 10.3 9.6 36.7 54.3 38.4 10.5 5.05 5.12 5.96 6.30 35.0 36.2 -1.2 2.5 3.1 7.5 9.2 12.3 4.8 21.7 19.1 6.3 2.8 38.8 57.2 25.1 -1.5 -1.1 -0.7 19.2 4.6 13.7 16.7 21.3
2006 7.1 107.8 2,305 14.4 4.8 18.7 6.2 19.1 7.4 9.1 11.6 14.1 29.2 34.5 39.9 9.5 9.5 5.05 5.05 6.66 6.36 38.9 44.1 -5.2 -1.6 -1.5 5.3 5.0 3.4 11.2 22.1 21.8 5.9 4.1 52.6 69.6 38.8 -1.1 -0.7 -0.4 16.6 3.1 13.8 12.8 15.8
2007 7.9 141.2 3,037 17.1 2.8 24.8 10.2 20.7 6.9 12.8 16.6 23.3 31.9 51.7 30.0 14.5 7.8 5.05 5.05 7.39 6.87 49.8 60.4 -10.6 -5.3 -3.7 9.2 6.5 2.8 28.1 36.9 32.0 6.4 6.1 84.5 64.7 69.3 -0.8 -1.4 -0.9 18.5 2.6 15.2 10.8 13.4
2008 2.1 180.7 3,910 15.5 3.0 10.0 -3.1 20.5 9.5 25.2 22.3 23.0 33.7 30.2 -0.2 22.0 15.6 7.80 5.26 11.00 7.38 67.7 84.7 -16.9 -12.9 -7.2 10.0 5.6 -1.6 35.9 40.1 30.8 4.4 7.5 103.2 65.9 83.9 -1.9 -1.3 -1.3 46.7 4.9 19.3 10.7 15.6
2009e -15.8 107.8 2,343 -16.5 -5.0 -22.5 -23.8 18.6 14.0 15.9 11.9 7.0 7.4 3.0 -12.3 14.0 23.1 9.50 8.24 14.25 11.67 37.7 42.8 -5.1 -2.8 -2.6 4.1 3.8 1.2 -44.3 -49.4 24.1 6.7 9.5 103.7 84.7 76.4 -6.1 -5.1 -5.5 85.0 9.6 27.3 25.3 34.9
2010e 5.5 114.6 2,505 2.5 0.0 0.0 5.7 18.4 13.0 9.0 8.0 10.0 11.5 10.0 -0.1 9.5 16.1 10.00 9.00 15.00 13.50 41.5 46.8 -5.3 -3.0 -2.6 4.2 3.6 1.0 10.0 9.2 18.5 4.8 10.5 113.7 119.9 85.6 -5.4 -4.4 -4.6 130.0 12.6 28.1 24.5 37.1
2011e 4.0 120.7 2,651 2.0 -2.0 6.0 6.0 19.1 11.0 9.2 12.0 13.0 11.3 15.0 4.3 13.0 15.5 10.00 9.80 14.50 14.21 45.6 48.8 -3.2 -0.9 -0.7 5.2 4.3 3.5 10.0 4.4 20.5 5.0 12.0 120.7 114.5 92.8 -4.8 -3.8 -4.1 170.0 14.4 27.9 23.1 37.5
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Simon Williams: +97 14 423 6925 simon.williams@hsbc.com
United Arab Emirates: the essentials
The domestic economy went into reverse in late 2008 and remains weighed down. Abu Dhabi not Dubai will lead the Federations recovery
Tale of the two cities Although the structural differences between the UAEs two key city states oil-rich Abu Dhabi and leveraged, service exporter Dubai - are stark, both have faced strong headwinds. Dubai, the regions most globally integrated economy, lost access to international funding and a sharp fall in demand for the services it provides exposed the excesses and vulnerabilities of its investment strategy. Despite its far greater wealth, Abu Dhabis infrastructure development strategy was also slowed by lost confidence and reduced access to credit. In addition, policymakers were forced to develop strategies to deal with steeply falling global asset prices. We believe that both economies probably shrank this year and suspect the risks to our forecast contraction of 2% for the UAE as a whole are to the downside. Next year, however, the differences between the two economies will become increasingly clear and growth trajectories are likely to diverge. Key will be the impact of the fiscal stimulus which will we expect to be more powerful in Abu Dhabi than Dubai. Q3 2008 International reserves (USDbn) Policy rate, end quarter (%) 1-yr yield, end quarter (%) AED/USD, end quarter AED/EUR, end quarter 44.6 2.0 3.9 3.67 5.18 Q4 2008 31.6 1.8 4.25 3.67 5.14 Q1 2009 34.0 1.0 3.7 3.67 5.33 That the main drivers of Abu Dhabis economic development programme are domestically orientated will also encourage an earlier recovery than Dubai which must demonstrate that it can deal with its substantial debt burden before growth is likely to resume. We look for UAE growth of over 4% in 2010 a substantial pick up but still below trend and likely to be driven heavily by Abu Dhabi. We expect oil prices to average close to USD75/b over 2009-11 on a rising trend. Although still standing below the prices generated in 2008, the level will leave the UAE with fiscal and current account surpluses throughout this forecast period and should see Abu Dhabi sovereign wealth fund managers return to the market. Despite rising oil earnings, we expect Abu Dhabi government-linked corporate and financials to also be active borrowers on the international markets, as the state continues its long standing strategy of building up foreign assets while simultaneously taking on foreign liabilities to part fund expansion plans.
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e 33.5 1.0 3.5 3.67 5.15 36.0 1.0 2.75 3.67 5.33 37.0 1.0 2.2 3.67 5.51 38.5 1.0 2.0 3.67 5.51 38.1 1.0 2.0 3.67 5.51 39.0 1.0 2.0 3.67 5.51 40.0 1.0 2.0 3.67 5.51
Credit squeeze tightens and inflation falls Timely data remain scant, but newly commissioned monthly inflation and banking sector series point to a domestic economy that went into reverse in late 2008 and remains weighed down. At mid-year, annual inflation stood at a little over 1% y-o-y, down 12ppt on its 2008 average. Credit growth had run as high as 50% y-o-y in Q4 2008 but showed no growth at all in H1 2009 and liquidity levels appear strained. Unsurprisingly, asset prices have also weakened. There are signs of normalisation, notably in the banking sector, where extensive government support has enhanced capital adequacy levels. Real estate prices have stabilised and international capital flows have begun to resume. However, bank balancesheet pressures remain pronounced, and we suspect credit growth and price pressures will be weak well into 2010, particularly in Dubai. Activity & inflation
300 250
(USD bn)
Dubai debt concerns ease, but big tests still to come Having peaked at over 1000 points, Dubais sovereign five-year CDS fell below 300 points in September, the lowest level in a year. Cash bonds issued by Dubai sovereign-related entities have also rallied strongly. In part the tightening reflects global capital market trends and improved risk appetite. However, the market also seems to have reassessed Dubais refinancing needs and concluded the probability of default has fallen. There are grounds for this view, notably evidence of restructuring within Dubai and support for the emirate from the federal authorities. However, Dubais external debt stock stands at over 100% of GDP, and we estimate it faces maturities equivalent to at least 20% of GDP over the coming year. Cooperation from creditors and support from the federation will be crucial if those obligations are to be met. Policy stance
40 30 20
(% GDP)
15 10
200 150 100 50 0 2 003 20 04 2005 20 06 2007 200 8 200 9 2010 USD GDP (LHS) CPI ann a v g (RHS)
(% y-o-y)
5 0 -5
10 0 -1 0 20 02 2 003 2 004 2 00 5 200 6 20 07 20 08 20 09
Rea l gro w th y -o -y (RHS)
Gross fisc al b alan ce
C u rren t a cco unt ba la nce
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United Arab Emirates: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Nominal private consumption (% y-o-y) Nominal government consumption (% y-o-y) Nominal investment (% y-o-y) Gross domestic saving (% GDP) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) AED/USD, end-year AED/USD, average AED/EUR, end-year AED/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Central government balance (% GDP) 7.4 105.2 24,359 29.1 3.8 11.1 35.3 7.0 8.0 20.8 17.0 3.0 3.67 3.67 4.98 4.57 91.0 63.4 27.6 10.5 10.0 10.0 9.5 19.5 35.5 38.4 18.5 3.5 34.4 27.8 75.0 10.0
2005 10.5 139.7 29,941 17.6 16.4 15.5 42.8 9.0 9.8 33.8 32.8 4.7 3.67 3.67 4.35 4.55 117.3 74.5 42.8 24.4 17.4 11.0 7.9 25.3 28.9 17.4 21.0 3.4 47.7 41.0 109.0 20.6
2006 9.4 170.1 33,749 12.2 12.4 29.0 47.2 10.5 10.0 23.2 22.4 5.2 3.67 3.67 4.85 4.62 145.6 88.0 57.5 36.0 21.2 13.0 7.6 28.8 24.1 18.2 27.6 3.8 63.2 82.7 100.8 27.3
2007 5.2 198.7 36,854 18.0 21.0 25.0 45.7 11.1 9.0 40.2 18.9 4.3 3.67 3.67 4.96 4.77 178.6 132.1 46.5 19.6 9.9 12.5 6.3 16.2 22.7 50.0 77.2 7.0 53.6 133.2 57.1 22.8
2008 7.0 226.5 39,270 20.0 16.0 26.0 43.2 13.5 12.0 35.2 22.5 1.8 3.67 3.67 5.14 5.51 239.2 176.3 62.9 22.3 9.8 8.5 3.8 13.6 33.9 33.4 31.6 2.1 55.4 180.5 184.6 29.8
2009e -2.0 225.0 39,796 2.0 9.0 -5.0 41.0 1.8 2.0 7.0 1.3 1.0 3.67 3.67 5.51 5.33 200.7 144.5 56.1 19.9 8.8 1.0 0.4 9.3 -16.1 -18.0 37.0 3.1 59.8 177.2 129.0 7.6
2010e 4.2 248.7 42,298 6.0 9.0 8.0 43.1 3.0 4.5 15.0 7.0 1.0 3.67 3.67 5.51 5.51 222.6 154.7 68.0 27.3 11.0 4.0 1.6 12.6 10.9 7.0 40.0 3.1 64.6 194.5 123.8 11.8
2011e 6.4 277.3 44,486 11.0 10.0 14.0 43.4 6.0 6.0 18.0 11.0 1.0 3.67 3.67 5.33 5.42 247.2 171.7 75.6 34.8 12.5 8.0 2.9 15.4 11.0 11.0 42.0 2.9 70.4 208.2 127.0 10.5
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Ramiro Blazquez: +44 20 7991 6714 ramiro.blazquez@hsbc.com.ar
Venezuela: the essentials
President Chavez is likely to resort to looser fiscal policy to boost the economy. However, this could lead to an acceleration of inflation given capacity constraints and expected sub-par capital accumulation rates
Medium-term growth prospects hampered by policy As political activity gathers pace in the run-up to the 2010 legislative elections, the government seems ready to step up public spending once again. Unsurprisingly, with output declining and inflation hovering around 30%, President Chavezs approval ratings are beginning to dwindle. As on previous occasions, we expect that the strategy to rebuild his political footing will involve expansive fiscal policy. Although the improved prospects for oil prices should go some way to easing budgetary constraints, this is unlikely to prevent a sharp rise in public indebtedness. As a result, we estimate that total gross public debt (including PdVSA) could surge by 72% in USD terms towards end-2009, thus taking the debtto-GDP ratio to 25% (40% if we were to employ the average between the official and the swap rate for USD-denominated stocks). Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) PPI, end quarter (% y-o-y) Trade balance (% GDP) Current account (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) VEF/USD, end quarter VEF/EUR, end quarter 3.8 1.9 36.0 26.5 24.7 22.0 28.2 23.1 20.1 2.15 3.03 Q4 2008 3.5 4.7 31.9 32.0 -5.1 -6.3 43.1 22.2 20.3 2.15 3.01 Q1 2009 0.5 6.8 28.5 32.4 -1.4 -4.2 28.5 21.4 21.1 2.15 3.12 While debt levels still appear manageable, it is unclear how effective fiscal policy will be in jump-starting the economy. By contrast with the 2002-03 crisis (when real GDP plunged 16%), we forecast only a mild 2.1% contraction in activity for the current year. Therefore, given high capacity utilisation and relatively low unemployment, the output gap is likely to remain in negative territory. Real investment should therefore provide an underpinning for economic growth in the months to come. However, the nationalisation policy has dealt a severe blow to business confidence, which could lead to sub-par capital accumulation rates in future. Consequently, although Venezuela has averted a major BoP crisis, it will probably be difficult to look back at the Asian-style growth rates of the 2004-07 period without nostalgia. -2.4 -12.4 27.4 32.8 4.6 2.2 30.8 20.7 22.0 2.15 3.02 -2.4 -4.2 29.1 33.1 2.0 1.5 30.5 19.8 20.0 2.15 3.12 -3.4 -5.5 29.9 33.4 4.1 3.4 30.0 19.0 18.1 2.15 3.23 0.9 0.3 31.0 32.2 4.2 2.6 28.9 19.4 18.7 2.80 4.20 1.3 0.8 31.9 31.2 2.2 1.2 28.1 20.0 19.0 2.80 4.20 1.6 1.2 33.2 29.8 5.7 4.1 26.7 20.0 19.4 2.80 4.20 1.8 1.4 34.0 28.70 4.7 2.4 24.9 20.0 19.9 2.80 4.20
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
The worst is behind but the future still looks far from rosy While activity began to slow consistently from Q3 2008, the latest national accounts data show that real GDP contracted 2.4% y-o-y in Q2 2009 the first annual decline since Q3 20O3. Output therefore dropped 1% y-o-y in H1 2009. This result is hardly surprising considering the countrys dependence on oil, although Venezuela is not among the worst performers in the region in terms of economic growth. While it is true that domestic absorption posted a 4.1% y-o-y decline in Q2, the governments improved ability to run looser fiscal policy as oil prices recover should help support activity in future. However, this does not mean that Venezuela is likely to experience a sharp rebound. Instead, we envisage mediocre growth rates as the deteriorated business environment is likely to prevent investment from picking up. Activity & inflation
30 25 20 15 10 5 0 -5 -10 -15 4Q07 2Q08e 4Q08e 2Q09e 4Q09e 2Q10e 4Q10e GDP (LHS) Industria l grow th (LHS) CPI (RHS) 40 35 30
Headline inflation drops although pressures keep building After peaking at 36% y-o-y in September 2008, headline inflation has eased somewhat, to about 29% y-o-y in the August survey. However, this decline was not so much the result of sound anti-inflationary policy as of a slowing in food inflation, which fell from 53% y-o-y last September to 28% y-o-y in August 2009. Indeed, underlying inflationary pressures are building despite the economic contraction. Core inflation began to accelerate from April, and is currently hovering at around 36% y-o-y. In turn. Pass-through effects stemming from the depreciation of the swap rate (+90% y-o-y in August) are also fuelling inflation, as the government has diverted a large share of imports into the parallel market (in H1 2009 allocations at the official rate plunged almost 45% y-o-y). Policy stance
4 (% GD P, 4 qma) 2 0 -2 -4 -6 4Q04 4Q05 4Q06 4Q07 4Q08e 4Q09e 4Q10e Reference rate (RHS) Fiscal balance (LHS) CPI, % y-o-y (RHS) 40 35 30 25 20 15 10
(% y-o-y)
(% y-o-y)
25 20 15 10
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(%)
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Venezuela: at a glance

70 00 0 60 00 0 50 00 0 40 00 0 30 00 0 20 00 0 10 00 0 0 1/ 05 7 /0 5 1/ 06 7/ 06 1 /0 7 7/ 07 1 /0 8 7/ 08 1/ 09 7/09 VENGE NL EM BI V ene zu ela sub -in dex (RHS) 20 00
(spread bps)

19.5 17.5 (%) 15.5 13.5 11.5 6m N ow -4 months +4 months 1yr
15 00 10 00 50 0 0

4 3 2 1 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e VEF v s USD (LHS) Annualised v olatility (RHS) 80 60
(ind ex)

800 600 (%)
(%)
40 20 0
400 200 0 00 01 02 03 04 05 06 07 08 Grow th of nominal exchange rate vs USD Cumulative CPI Cumulative PPI 09

35 30 25 20 (USD bn) 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 70 60 50
Policy dynamics
0.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0 -14.0 -16.0 -1.0 2007
(real rates)
40 (% o f reserves) 30 20 10 0
2008
2009e 2011e 2010e -6.0
-2.0
-3.0
-4.0
-5.0
In ternational res erv es , IFI d efinitio n (LHS) Short-te rm debt % res erv es (RHS )
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Venezuela: local knowledge/global drivers

Growing indebtedness could become the cornerstone of the presidents strategy to secure a victory in the 2010 elections. Meanwhile, the latest BoP figures show that further adjustment is needed on the external front
Public spending and popularity In Venezuela, as in other Latin American countries, the use of fiscally expansive measures to populist ends has led to unsustainable increases in public indebtedness. The graph below illustrates the close correlation between Mr Chavezs approval ratings and the level of public spending. From the outset of the current administration in 1998 until mid-2003, fiscal policy was austere more out of necessity than choice, as oil prices remained depressed. However, the presidents popularity mirrored the 32% decrease in real spending between July 2001 and July 2003, plunging from 56% to 31%. From that moment onwards, real spending tripled on the back of bouncing oil prices, taking approval ratings to just below 70% and allowing the president to be re-elected in 2006. Cycle of fiscal expenditure and approval ratings
25 0 80 70 20 0 Real VEF b n 60 50
an old tale likely to be revisited Finally, the 19.7% decline in real outlays from December 2006 up to July 2009 was coupled with waning popularity, which stood at 57% by the end of this period. In the run-up to the 2010 legislative elections, and as the oil shock begins to unravel, Mr Chavez is likely to boost spending as a way to rebuild his political footing, in our view. Thus, even though the latest central bank (BCV) figures show a real cumulative 24% y-o-y decline in expenditure to May, the National Assembly has recently increased the budgetary quotas, which stand almost 13% above their March 2009 level. While rising oil prices should provide some relief, we would still be looking at a steep jump in public indebtedness, which we estimate will climb by 72% y-o-y by year-end. Debt is on the rise, but still manageable
12 0 10 0 80 USD bn 30 60 20 40 20
10 0
50 40
15 0
40 10 0 30 20
50
10 0 200 4 200 5 20 06 20 07 20 08 2 00 9f
0 08-02 08-03 08-04 08-06 08-07 08-08 08-05 08-01
R eal Ex p end itu re s
P r es id en t's ap pr ov a l r atings - R HS -
G r os s P ub lic D ebt (inc P d V S A )
A s a % of G DP - R HS -
Poor prospects for investment Following the 2002-03 crisis, investment rebounded sharply in Venezuela, showing an impressive annual average growth rate of 35% between 2004 and 2007. However, gross capital formation last year posted a 2.4% y-o-y decline. Despite the recovery of oil prices, real investment is unlikely to resume the remarkable growth rates of previous periods, we believe. Property rights have become less secure as the administration has moved ahead with its nationalisation agenda. In addition, with the parallel market financing an increasing share of imports, the purchasers of foreign capital goods will find it hard to benefit from an overvalued exchange rate. Hence, public investment is likely to play a greater role in the coming months. Public investment set to play a relatively greater role
25
Further adjustment needed on external accounts The latest BoP figures evidence the sizeable terms-of-trade shock suffered by the economy. In annual terms, exports virtually halved during H1 2009, which explains the steep current account reversal (from a USD25.1bn surplus in H1 2008 to a USD2.0bn deficit in H1 2009) as imports posted a y-o-y decline of only 5%. The resilience of imports highlights the sharp overvaluation of the pegged currency. Foreign exchange rationing meant that about 20% of overseas purchases were financed through the parallel market (where the swap rate depreciated 45% y-o-y on average) compared with just 6% in 2008. While the recent improvement in oil prices should bring some relief, these figures convey that further adjustment is needed on the external front. USD scarcity: the abrupt current account reversal
40 35 20 16 12 8 4 0 20 04 2 00 5 20 06 2 00 7 20 08 200 9f 20 10 f 201 1f C ur r ent Acc oun t ( U S D bn ) A s a % of G DP -R HSAs a % of GDP
20 As a % of GDP
30 USD bn 25 20 15 10
15
10
5 0
2007 2002 2003 2004 2005 2008 2006
Pu blic R eal Inv e stm ent
Priv ate R ea l Inv e stm en t
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Venezuela: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices & wages CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Manufacturing wages, nominal (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) VEF/USD, end-year VEF/USD, average VEF/EUR, end-year VEF/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Commercial banks FX assets (USDbn) Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Central government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (VEFbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP)
Source: HSBC, BCV and MEF
2005 10.3 144.0 5,393 15.7 10.7 38.4 11.3 35.8 12.3 16.0 14.4 14.4 13.5 54.6 51.5 16.4 13.2 2.15 2.11 2.54 2.60 55.5 23.7 31.8 25.5 17.7 1.4 1.0 18.7 39.8 39.2 30.4 15.4 1.4 44.8 33.3 13.6 4.1 1.6 4.6 34.4 11.3 31.2 21.7 33.0
2006 9.9 184.3 6,770 15.5 9.6 26.6 10.1 34.8 10.1 13.7 17.0 15.5 18.2 69.5 39.6 15.9 12.4 2.15 2.15 2.69 2.58 65.2 32.5 32.7 27.1 14.7 -2.7 -1.4 13.3 17.6 37.2 37.4 13.8 2.8 42.1 31.6 14.8 -1.5 0.0 2.1 36.2 9.1 27.3 14.8 23.9
2007 8.2 227.8 8,212 18.7 6.1 25.4 6.9 30.2 8.2 18.7 22.5 16.0 17.7 30.0 38.0 22.0 13.7 2.15 2.15 2.90 2.80 69.2 45.5 23.7 20.0 8.8 -1.6 -0.7 8.1 6.1 39.9 34.3 9.0 5.3 55.6 44.8 28.3 -2.8 3.0 4.5 36.0 7.4 27.3 12.0 19.3
2008 4.8 313.4 11,086 7.1 6.7 -2.1 1.4 30.9 7.6 31.4 31.9 32.0 24.2 26.0 -5.2 22.2 20.3 2.15 2.15 3.01 3.23 95.1 49.5 45.7 37.4 11.9 -0.9 -0.3 11.6 37.6 8.8 43.1 10.5 5.6 57.2 31.6 27.4 -2.6 -1.2 0.1 30.5 4.5 29.9 9.5 14.1
2009e -2.1 395.0 13,711 -2.6 2.4 -7.9 -3.8 29.4 9.2 28.7 29.9 33.4 23.4 29.2 -9.3 19.0 18.1 2.15 2.15 3.18 3.23 53.3 44.0 9.2 2.8 0.7 -2.0 -0.5 0.2 -44.0 -11.0 30.0 8.2 9.1 77.7 43.7 22.3 -4.7 -2.5 -1.4 55.5 6.5 55.4 14.0 20.6
2010e 1.5 407.7 13,886 0.9 4.5 2.8 0.9 27.4 8.9 32.5 34.0 28.7 25.8 26.0 -7.5 20.0 19.9 2.80 2.80 4.20 4.20 63.0 45.9 17.1 10.4 2.6 -2.5 -0.6 1.9 18.3 4.3 24.9 6.5 13.2 80.0 55.5 21.9 -5.3 -3.3 -2.1 90.5 7.9 58.1 14.3 22.2
2011e 1.1 486.7 16,267 0.8 3.1 2.1 0.8 25.5 8.7 35.0 36.0 30.1 29.1 28.1 -3.2 22.0 21.1 3.20 3.20 4.64 4.72 65.5 47.2 18.4 11.5 2.4 -2.5 -0.5 1.9 4.0 2.7 20.9 5.3 16.5 78.2 69.4 23.0 -5.2 -3.2 -1.9 127.5 8.2 55.2 11.3 19.5
18.3 110.8 4,228 15.4 14.2 49.7 28.9 30.3 15.6 21.7 19.2 23.3 15.6 48.2 85.4 17.1 14.3 1.92 1.92 2.61 2.39 39.7 17.0 22.6 15.5 14.0 0.9 0.8 14.8 45.7 62.4 24.2 17.1 1.6 42.3 32.4 14.8 2.5 -1.9 1.8 34.0 16.0 27.5 24.8 40.8
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Robert Prior-Wandesforde: +65 6239 0840...robert.prior-wandesforde@hsbc.com.sg
Vietnam: the essentials
With the V-shaped recovery now under way and credit growth rampant the central bank is becoming concerned about inflation risks. Quiet tightening has already begun
Growth looking up The size and speed of the policy stimulus thrown at the economy has rapidly borne fruit, causing activity to turn around in the second quarter. GDP was up 9.5% on a seasonally adjusted annualised basis, more than off-setting the 6.5% drop in Q1. The key, we believe, has been the governments 4pp interest rate subsidy, under which roughly USD25bn worth of loans have been given out. No doubt so much lending will create problems of non-performing loans further down the road; however, the strong numbers suggest that there was pent-up demand. The government has also increased the size of its overall stimulus by USD2bn to USD8bn (8.5% of 2009 GDP). With the regional trade recovery that we had been awaiting now under way, we expect growth to average 4.9% in 2009 and accelerate to nearly 7% next year. Q3 2008 GDP (% y-o-y) Industrial production (% y-o-y) CPI, end quarter (% y-o-y) Trade balance (% GDP) International reserves (USDbn) Policy rate, end quarter (%) 5-yr yield, end quarter (%) VND/USD, end quarter VND/EUR, end quarter 6.5 10.6 27.9 -5.5 24.1 14 15.9 16,600 23,572 Q4 2008 5.7 5.5 19.9 -5.9 24.2 8.5 10.0 17,483 24,301 Q1 2009 3.1 2.3 11.3 8.5 23.3 7.0 9.2 17,797 23,492 We remain confident of the countrys long-term growth prospects given the young and hard-working population, expanding urbanisation, Vietnams close proximity to China and strong foreign direct invest flows, among other factors. We believe the country can clock GDP growth of around 7.5% for the next 15 years. The governments big spending plan is expected to push the budget deficit to 8% of GDP the highest since 1990. However, Vietnams domestic public debt level (25% of GDP) remains fairly low by regional standards. External balances should improve this year, with the current account deficit shrinking to 7% of GDP from nearly 12% last year. Vietnams FX reserves were USD18bn at the end of Q2, more than three times the countrys short-term external debt of USD5.4bn according to World Bank data, but down from USD22bn in the first quarter. 4.5 1.8 3.9 -15.2 18.0 7.0 9.4 17,798 24,917 5.5 6.0 3.0 -16.8 17.0 7.0 10.0 17,816 25,833 6.6 9.0 9.0 -16.9 16.0 7.0 10.0 18,200 27,300 6.8 10.0 13.0 -24.5 15.0 8.0 10.5 18,400 27,600 7.0 11.0 11.0 -17.8 14.0 9.0 11.0 18,400 27,600 6.8 12.0 9.0 -16.9 14.0 10.0 11.5 18,400 27,600 6.6 13.0 8.0 -12.0 14.0 11.0 11.5 18,400 27,600
Q2 2009 Q3 2009e Q4 2009e Q1 2010e Q2 2010e Q3 2010e Q4 2010e
Inflation: ready to take off Vietnams headline inflation rate slowed to 2% y-o-y in August, as the fuel price hike of last year dropped out of the annual comparison. This is the slowest pace of price increases the country has seen since 2001-02 and compares with a high of 28.3% in August last year. In seasonally adjusted terms, however, prices have now risen for six consecutive months clearly pressures are building. Looking ahead we think inflation is going to start ticking up from September given commodity price movements, mainly in food and oil. At the same time domestic demand remains fairly robust, with retail sales growing at 20% or so, and total credit has grown by 25% from end-2008 levels, with consumer lending up 15%. Overall we expect inflation to hit 9% by year-end and 13% by end-Q1 next year. Activity & inflation
25 20 (% y-o-y) 15 10 5 0 4Q07 2Q08 4Q08 2Q09 4Q09e 2Q10e 4Q10e CPI (RHS) 27 22 (% y-o-y)
State Bank of Vietnam (SBV): tightening the screws Although the policy bias remains towards supporting growth, the central bank has not only voiced its concerns about rampant credit growth and inflation risks but has also quietly started tightening. First, it cut the interest rate on compulsory reserves to 1.2%, effective as of 1 August, from 3.6% previously. Second, it is planning to cap credit and M2 growth at 30% (bank loans have already risen 25% in the year to August and grew by roughly 40% last year). Third, SBV has cut the proportion of short-term funds that can be used to make medium- to long-term loans by 10pp to 30%, effective as of 1 January 2010. We believe such quantitative controls will continue, but that the SBV will keep the base rate at 7% until year-end before hiking by 200bp in first half of next year, to 9%. Policy stance
16 12 (%) 8 4 0 4Q06 4Q07 Policy rate (RHS) 4Q08 4Q09e 4Q10e 30 25 20 15 10 5 0
17 12 7 2
GDP (LHS)
CPI, % y -o-y (RHS)
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Vietnam: at a glance

21 18 15 12 9 6 3 0 5/07 8/07 11/07 2/08 5/08 8/08 11/08 2/09 5/09 8/09 12M spread over US-Libor 2yr spread ov er US-Libor

12 10 8 6 4 2 0 1y r 2yr 3yr Now +4 months 5yr 10yr -4 month s Current CPI 15yr

18,500 17,500 16,500 15,500 14,500 13,500 1999 2000 2001 2002 2003 2004 2005 2006 2007 20082009e VND v s USD (LHS) Annualised v olatility (RHS) 12.0 10.0 (%)
(%)

8.0 6.0 4.0 2.0 0.0

30 25 20 (USD bn) 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20 15 10 35 30 25 (% of reserves)
Policy dynamics
6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0 -14.0 -4.0 2011e 2010e 2009e 2007 2008
(real rates)
(%)
-5.0
-6.0
-7.0
-8.0
-9.0
International reserves, IFI definition (LHS) Short-term debt % reserves (RHS)

1500 1200 1000 (index) 1000 500 800 600 400 200 0 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 Vietnam stock-ex change (LHS) EMBI Vietnam sub-index (RHS) 0 (spread bps)
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Vietnam: local knowledge/global drivers

Foreign direct investments have held up better than expected and a strong GDP recovery is on the cards. Rising domestic demand should push up imports and lead to some widening of the trade deficit
Exports supported by gold shipments Vietnams exports have weakened, as was to be expected, but the average fall in the JanuaryJuly period was only 5% y-o-y, much better than the above20% drops seen regionally. Shipments were supported by massive gold reexports given the gap between on-shore and off-shore gold prices, and cooling inflation. The bulk of the excess gold stocks have now been depleted although the regional trade cycle is looking better. Imports, on the other hand, declined by an average of 31% in the JanuaryJuly period; and have been turning around in recent months as the big boost from gold/steel imports last year has dropped out of the annual comparison and domestic demand has picked up. Given these trends, the trade deficit is expected to widen from here but should remain well short of the high seen in early 2008. imports are turning around, so trade deficit is set to widen
1 0 10 0 75 50 25 0 -25 -50 T rade b alan ce (LHS ) Im ports y / y Ex p orts y /y
V-shaped recovery under way The V-shaped recovery that we had been anticipating is now under way, with the economy expanding by 2.3% q-o-q on a seasonally adjusted basis in Q2. In year-on-year terms growth ticked up to 4.4% from 3% previously. The main driver of this turnaround is the revival of the industrial sector, supported by improvements in external demand and consumption at home, with retail sales running at 20% y-o-y. The construction sector is now back to 10% y-o-y growth given lower lending rates, the collapse in construction costs and progress on government infrastructure projects. The services sector has held up reasonably well, with financial services growth nearly doubling to 8% y-o-y, although hotel & restaurants are still seeing some contraction. supported by the turn in industry and the boom in the construction sector
20 15
USD bn
% y-o-y
-1 9 8 9 9 0 0 01 02 03 04 0 5 0 6 0 7 08 09 -2 -3 -4
10 5 0 -5 0 0 -1 0 In dus try C on str uction S e rv ic es 01 02 03 04 05 06 07 08 09
Core inflation to head higher Although Vietnam does not publish core inflation we make our own inhouse calculation. What is interesting is that core inflation tends to closely follow the trajectory of headline inflation, which is not the case in developed markets. That reflects the quicker pass-through of energy prices into the economy: the contemporaneous correlation of core inflation and the energy contribution to inflation is 0.75 for monthly data going back to 1999. Applying a two-month lag the correlation improves to 0.80. We think this close relationship is explained by the countrys unusually high energy intensity. What this means is that, as the energy contribution to inflation starts ticking up then, assuming oil prices and the dong remain flat at current levels, core inflation will head higher as well. as energy contribution has ticked up
20 15 10 5 0 -5 99 00 01 02 03 04 05 06 07 08 09 3 3 2 2 1 1 0 -1 -1
Foreign direct investment commitments have collapsed Foreign direct investment commitments in Vietnam in the JanuaryJuly period were USD10bn, down 80% from the same period last year. This was pretty much in line with expectations, given the uncertain global economic environment. However, what has been surprising is the strength of actual disbursed FDI, which totalled USD6.5bn in the first eight months of 2009, down only 8.5% from the same period last year. This is 72% of the governments full-year target of USD9bn. Given the strong performance we are upgrading our FDI forecast to USD8.5bn from USD5bn previously. It is interesting to note that the gap between commitments and actual FDI, which widened so much over the past few years, will shrink in 2009. NB: The chart is truncated at USD20bn, but 2008 pledges totalled USD60bn. but actual FDI has surprised on the upside
20 15
USD bn
10 5 0 01 02 03 04 05 06 07 08 09
C or e in fla tio n (L HS )
En er gy c o ntrib p pts
F DI com m itm en ts
F DI d is bu rs em en t (R HS )
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Vietnam: macro framework
2004 Production, demand and employment GDP growth (% y-o-y) Nominal GDP (USDbn) GDP per capita (USD) Private consumption (% y-o-y) Government consumption (% y-o-y) Investment (% y-o-y) Industrial production (% y-o-y) Gross domestic saving (% GDP) Unemployment rate end-year (%) Prices CPI, average (% y-o-y) CPI, end-year (% y-o-y) PPI, end-year (% y-o-y) Money, FX & interest rates Broad money supply M3 (% y-o-y) Real private sector credit growth (% y-o-y) Policy rate, end-year (%) 5-yr yield, end-year (%) VND/USD, end-year VND/USD, average VND/EUR, end-year VND/EUR, average External sector Merchandise exports (USDbn) Merchandise imports (USDbn) Trade balance (USDbn) Current account balance (USDbn) Current account balance (% GDP) Net FDI (USDbn) Net FDI (% GDP) Current account balance plus FDI (% GDP) Exports (% y-o-y) Imports (% y-o-y) International FX reserves (ex gold) (USDbn) Import cover (months) Public and external solvency indicators Gross external debt (USDbn) Short term external debt (% of int'l reserves) Private sector external debt (USDbn) Consolidated government balance (% GDP) Primary balance (% GDP) Gross public domestic debt (VNDbn) Gross public domestic debt (% GDP) Gross public external debt (USDbn) Gross public external debt (% GDP) Gross public sector debt (% GDP)
2005 8.4 52.9 636 7.3 8.1 9.7 25.5 34.6 5.3 8.3 8.8 4.4 29.8 28.7 7.8 8.8 15,896 15,866 18,835 19,743 32.4 33.3 -0.8 -0.6 -1.1 2.0 3.8 2.7 22.5 15.7 9.0 3.2 14.2 17.8 1.6 -4.9 -3.0 9,239 1.1 12.6 23.8 24.9
2006 8.2 60.8 723 8.3 8.6 9.9 16.0 36.5 4.8 7.5 6.6 4.2 33.6 23.5 7.8 8.3 16,050 16,006 21,184 20,114 39.6 44.4 -4.8 -0.2 -0.3 2.4 3.9 3.7 22.1 33.4 13.4 3.6 15.6 13.4 1.7 -5.0 -3.5 11,346 1.2 13.9 22.9 24.0
2007 8.5 70.7 829 9.6 9.0 23.0 11.6 31.8 4.6 8.3 12.6 6.8 43.2 41.7 8.3 8.7 16,017 16,096 23,369 22,066 48.6 62.7 -14.1 -7.0 -9.9 6.6 9.3 -0.6 22.7 41.2 23.5 4.5 19.3 20.9 2.7 -5.0 -3.4 12,400 1.1 16.6 23.5 24.6
2008 6.2 87.7 1,016 7.6 5.8 13.2 11.8 29.9 4.7 23.0 19.9 20.0 25.0 4.7 8.5 10.0 17,483 16,759 23,602 24,803 63.1 80.6 -16.3 -9.2 -10.5 11.5 13.1 2.6 29.9 28.5 24.2 3.6 21.8 19.8 3.0 -5.0 -2.5 14,500 1.0 18.8 21.4 22.4
2009e 4.9 92.4 1,056 3.4 6.5 3.2 4.8 34.2 5.4 7.6 9.0 2.0 15.0 17.5 7.0 10.0 18,200 17,903 27,300 25,900 59.7 68.4 -11.1 -6.5 -7.0 8.5 9.2 2.2 -5.4 -15.1 16.0 2.8 23.0 28.1 3.0 -8.0 -5.0 21,528 1.3 20.0 21.7 23.0
2010e 6.8 107.3 1,214 5.8 5.0 8.0 11.5 33.0 5.3 10.4 8.0 10.0 20.0 14.6 11.0 11.5 18,400 18,400 27,600 27,600 67.0 80.0 -18.3 -9.0 -8.4 6.0 5.5 -2.8 12.2 17.0 15.0 2.3 25.0 36.7 3.0 -7.0 -4.0 25,000 1.3 22.0 20.5 21.8
2011e 5.9 121.0 1,354 5.0 3.0 6.0 7.3 35.5 4.9 7.1 7.0 6.0 18.0 17.9 11.0 11.5 18,400 18,400 27,600 27,600 74.0 88.0 -12.8 -7.0 -5.8 8.0 6.5 0.8 10.4 10.0 14.0 1.9 26.0 35.7 3.0 -5.5 -3.0 27,000 1.2 23.0 19.0 20.2
7.8 45.4 554 7.1 7.8 10.4 17.6 32.0 5.6 7.8 9.7 7.8 29.5 26.0 7.5 8.5 15,754 15,738 21,353 19,583 26.5 28.8 -2.3 -1.0 -2.1 1.9 4.1 2.0 31.4 26.6 7.0 2.9 13.5 21.4 0.9 -4.9 -3.0 7,007 1.0 12.6 27.8 28.7
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Notes
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Disclosure appendix
Analyst certification
The following analyst(s), who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Philip Poole and Paras Patel This report is designed for, and should only be utilised by, institutional investors. Furthermore, HSBC believes an investor's decision to make an investment should depend on individual circumstances such as the investor's existing holdings and other considerations. Analysts are paid in part by reference to the profitability of HSBC which includes investment banking revenues. For disclosures in respect of any company, please see the most recently published report on that company available at www.hsbcnet.com/research.
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Additional disclosures
1 2 3 This report is dated as at 02 October 2009. All market data included in this report are dated as at close 01 October 2009, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Chinese Wall procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.
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Disclaimer
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Contributors
Philip Poole* +44 20 7991 5641 philip.poole@hsbcib.com Andre Loes* +55 11 3371 8184 andre.loes@hsbc.com.br Juliet Sampson* +44 20 7991 5651 juliet.sampson@hsbcin.com
Paras Patel* +44 20 7991 5624 paras.patel@hsbcib.com
Sergio Martin Moreno* +52 55 57212 164 sergio.martinm@hsbc.com.mx
Amit Shrivastava* Associate Bangalore
Ramiro D Blazquez* +54 11 4348 5759 ramiro.blazquez@hsbc.com.ar
Jorge Morgenstern* +54 11 4 130 9229 jorge.morgenstern@hsbc.com.ar
Murat Ulgen* +90 212 376 4619 muratulgen@hsbc.com.tr
Janus Chan* +852 2996 6975 januschan@hsbc.co.hk
Alexander Morozov* +7 495 721 1577 alexander.morozov@hsbc.com
Simon Williams* +971 4507 7614 simon.williams@hsbc.com
Dmitry Chernyadyev* Associate Moscow
Frederic Neumann* +852 2822 4556 fredericneumann@hsbc.com.hk
Christopher Wong* +852 2996 6917 christopherwong@hsbc.com.hk
Lorena Dominguez-Torres* +52 55 5721 2172 lorena.dominguez@hsbc.com.mx
Kubilay Ozturk* +44 20 7991 6045 kubilay.ozturk@hsbcib.com
Richard Yetsenga* +852 6270 2281 richard.yetsenga@hsbc.com.hk
Javier Finkman* +54 11 4344 8144 javier.finkman@hsbc.com.ar
Jonathan Katz* Robert Prior-Wandesforde* +65 6239 0840 Consultant robert.prior-wandesforde@hsbc.com.sg
Tatiana G Gomes* +55 11 3371 8183 tatiana.g.gomes@hsbc.com.br
Hongbin Qu* +852 2822 2025 hongbinqu@hsbc.com.hk
* Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to NYSE and/or NASD regulations.

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Emerging Markets

Macro Strategy October 2009

By Philip Poole and the Emerging Markets Macro Team

Strategy and Economics Macro October 2009

Strategy and Economics Macro October 2009

Country and territory overviews

EM currencies: reserving their place

What could stop the juggernaut?

Appendix The rise and rise of EM

Disclosure appendix Disclaimer

Strategy and Economics Macro October 2009

EM ascent: size does matter

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

Oil consumption - 1000 barrels / day 100000

Dev eloped Economies

Strategy and Economics Macro October 2009

BRICs oil consumption (1000 barrels/ day)

BRICs oil consumption - relative shares

Ex trapolation 100% 80%

Dev eloped Economies

Strategy and Economics Macro October 2009

Oil consumption patterns

8% 5 year averag e p er cap ita o il co n su m p t io n g ro wth rate (% ) 6% 4% 2% 0%

-2% -4% -1% -1%

0% 1% 1% 2% 5 year average population growth rate (%)

Source: BP, UN population statistics, HSBC

Oil and total energy consumption (2008)

Oil as % of total energy consumption

Strategy and Economics Macro October 2009

Copper demand China is also dominant

20000 15000 10000 5000 0

Top 20 EM (inc. BRICs)

Global copper consumption relative shares

BRICs copper consumption (tonnes, 000)

12000 10000 8000 6000 4000 2000 0 2000 2003 2006

Strategy and Economics Macro October 2009

2500 2000 1500 1000 500 0

Source: Thompson Financial Datastream, UN, HSBC. Data for 2008.

Strategy and Economics Macro October 2009

Extrapolated for BRIC

Strategy and Economics Macro October 2009

IMF quotas and economic size: BRIC vs developed Europe

% Share in World Nom inal GDP

% Share of Quota in Total

10 Strategy and Economics Macro October 2009

IMF quotas vs shares in global GDP

% Share in World Nom inal GDP

Strategy and Economics Macro October 2009

EM currencies: reserving their place

A system under pressure

The Day of the Triffins

Strategy and Economics Macro October 2009

Source: Bloomberg, HSBC

Inertia and the current position

International Reserv es( lhs)

Import cov er (months)

Strategy and Economics Macro October 2009

Reforming the system

Options for a multi-currency world

Strategy and Economics Macro October 2009

The rising share of EM in global trade

EM Ex port v olume % of global export trade v olume

Source: Netherland Bureau of Economic Policy Analysis