Didim Today

The recent uptick in PMI numbers in the US and the EM world has many wondering whether the growth slowdown is over and done with. While this is likely true for some EM economies, particularly LatAm economies, one would caution against taking such a benign view of these data points at this stage for the rest of the EM world. Risks to external demand from Europe as well as the US (where we can expect growth to slow down to about 2% in early 2012) are still to the downside. EM domestic demand is still slowing down thanks to weaker external demand and domestic tightening in 2011. Many policy-makers were less willing to unshackle growth in 2011 due to concerns about inflation but have much more legroom now that EM inflation is on its way down. Growth moderation will likely begin sometime in 2Q for the EM world.

In a nutshell, one believes that EM growth will be weak, with downside risks in the first couple of quarters but better prospects in 2H12. The differentiation among EM economies will be an important driver of market performance, particularly in 1H12, where the EM world is split roughly down the middle into economies that have downside risks and ones where growth is holding up quite well. For a change, we can expect LatAm economies to hold up better than the AXJ region, with CEEMEA remaining the underperformer.

Market performance should reflect the end of the slowdown as it becomes more apparent. The aggressive rate cuts being priced into markets are already providing implicit monetary easing. Even if all the expectations priced into the market are not fully realised, the ongoing disinflation and the resulting willingness of policy-makers to support growth should mean that such ‘implicit’ rate cuts via market expectations will continue to help. Consistent with a mid-year turnaround, forward-looking FX markets are likely to push EM currencies higher in 2Q12 according to strategists.

What if things are worse than expected? Naturally, if a disruptive dynamic emerges from the ongoing problems in Europe or the infection reaches the US economy more strongly than expected, there is likely to be no place to hide. A slow burn would give EM policy-makers time to respond and could support EM currencies, but a rapid decline might put EM currencies at risk until policy-makers ease aggressively.

Economic performance in 2012: The list of factors that skew risks to EM growth to the downside is long and well known. Easily the most prominent external risk is the fallout from Europe’s economic downturn as well as the related risk of a rapid deleveraging by Europe’s banks. But there are home-grown EM risks too, thanks to issues ranging from balance sheet problems in CEEMEA to the domestic demand response to policy tightening in AXJ.

Unlike the DM world, most EM economies still have a healthy intrinsic growth dynamic. The withdrawal of policy accommodation (to varying degrees) in 2011 was partly responsible for slowing EM growth down. However, a symmetric willingness to prop up EM growth has been sporadic and measured. Rather than being pre-emptive, the majority of EM policy-makers have been prepared to react only to the weakness apparent in the data rather than on the horizon.

In 2012, one expects EM growth to remain weak, with downside risks in 1H before a turnaround in 2H, thanks in part to monetary and fiscal easing in EM and mostly monetary easing by the Fed, the ECB and the BoE. The handful of policy-makers who have taken pre-emptive steps to ease in 2011 and a much larger segment that is likely to join in that easing should help to raise growth back up to trend. Given the lags in policy, easing some time now will kick in only towards the middle of the year, much as the tightening in early 2011 had an effect only in 2H11. Fiscal stimulus remains an option for many AXJ (though not India) and LatAm economies. Since one does not expect 2009-style aggression from the EM world (particularly from China), the probability of a strong bounce in 2H12 remains very low.

EM performance and policy easing in 1H12: The EM world, true to its idiosyncratic nature, is set for a year of differentiation in terms of economic performance as well as differentiation in terms of policy easing. This is particularly true in 1H12. Going into this period, economies will fall on one side or the other of the performance divide according to their exposure to DM economies (particularly the euro area), the strength of the domestic economy and the domestic policy stance (particularly the ability and willingness of policy-makers to ease).

Rebalancing interrupted: An immediate consequence of the cyclical developments in the EM region is that global and internal rebalancing has been put on hold. The most important manifestation of global rebalancing was the appreciation of EM currencies in real terms against developed market currencies either by EM currency appreciation or by EM inflation staying wide of DM inflation. The EM currency depreciation in the latter half of 2011 and the more recent EM disinflation have moved the EM real exchange rate in the ‘wrong’ direction. Some believe that a switch back to real exchange rate appreciation will have to wait until EM currency strength reasserts itself. Likely triggers for this are signs of the bottoming out of EM growth or then the next round(s) of QE from the Fed and the ECB.

Internal rebalancing: EM economies have been quick learners and this time appears to be no different. Given the hangover that the aggressive easing of 2009 created, it is no surprise that policy-makers are reluctant to ease aggressively when confronted with slowing growth at home and abroad. Internal rebalancing by way of stronger consumption in China and stronger investment in India were both pushed down the priority ladder as China pushed up investment and India consumption to avoid a sharp downturn. Similarly, CEEMEA and LatAm economies pushed their policy rates to historical lows and expanded deficits aggressively, disregarding the change in internal balance that was required to sustain long-term growth.

This time round, most EM economies appear to be willing to settle for lower growth rather than for a quick boost to growth that puts the health of fundamentals at risk.

In summary, EM performance is likely to see differentiation by the health of the economy, the exposure to DM economies and the ability and willingness of policy-makers to ease. While the first half of the year will see weaker growth from many AXJ and CEEMEA countries but outperformance by LatAm economies, growth will be better for EM as a whole in 2H12, in our view. By then, EM easing could well be accompanied by QE from the central banks of the advanced economies.

EM easing is coming, and the differentiation among the EM giants tells the story of differentiation in terms of easing.  With only a handful of EM economies having eased preemptively (including Brazil), many EM economies will likely have to wait until policy constraints are lifted and growth is unshackled (China, and to a lesser extent India), while for yet another bunch their domestic credentials are likely to see them through this difficult first half of the year (e.g., Russia). As in mid-2010, QE from the Fed or the ECB could serve as implicit easing by EM central banks and push capital into these economies. If all goes to plan, the debate is likely to shift around the middle of the year to currency appreciation and internal rebalancing as part of the longer-term process of global rebalancing.

1. Russia: What Does the New Politics Mean?

The protests after the Duma elections were a sign of a sea-change in Russian politics, one thinks. The protesters were not demanding higher spending but a change in the political system, i.e. fair elections, honesty in public life, rule of law. One does not expect additional pre-election spending, beyond the fairly modest amount already in the Budget 2012. The issue is the pace and extent of reform in the government and policy. This in turn depends on Mr. Putin, still the overwhelming favourite to be the next president.

Following the Putin-Medvedev policy response to the protests in the second half of December, we can now expect accelerated reforms as a response to the opposition protests after the Duma elections, including an anti-corruption campaign and political liberalisation. We considered five cases in Russia Economics: Russia’s New Politics, January 4, 2012. The economic implications are the following, in one’s view: accelerated political and economic reform, which is positive for the medium-term growth outlook, but heightened short-term political risk would imply higher capital outflows, a weaker RUB and worse investor sentiment in 1H12.

2. Hungary: Will Orban’s U-Turn Pay Off?

As expected, intense market pressure has resulted in a far more conciliatory tone by the Hungarian authorities, who are now willing to negotiate with the IMF without preconditions. One sees a good probability that a SBA with the IMF (with EU participation) will be signed in 1Q. One thinks that a two-year programme of €15-20 billion would be sufficient to reassure markets about Hungary’s funding needs. Importantly, the presence of an IMF/EU programme is likely to reassure foreign banks of the sustainability of the macro outlook, and therefore to ease the pace of foreign bank deleveraging.

The next few months should see Hungary’s refinancing risks fall significantly thanks to assistance provided by the IMF/EU. That said, even though there are good chances of a deal in the near term, the relationship with the IMF is likely to be rocky to say the least, as long as the current administration is in place. Therefore, the risk of some rift between Hungary and the EU/IMF a few months down the line remains intact.

3. CEE Deleveraging: How Serious?

European banks have invested heavily in the CEE region, where they control about 80% of the banking system. Equity analysts have estimated that the total amount of parent funding/cross-border loans from Western European banks to CEE5 is €139 billion. Their ‘bear case’ would imply a 100% loan/deposit ratio by 2013. In such an adverse scenario, most countries except the Czech Republic would need to either tap existing support packages or negotiate additional ones with the IMF/EU, in our view. Given that a Vienna 2 agreement does not look likely at present, negotiating external assistance seems like an optimal strategy, especially in those countries where banks have already started to delever.

4. Turkey: A Soft Landing or No Landing?

Fast growth rates of 2010 and 2011 on the back of domestic demand resulted in a significant external imbalance, leading to a record current account deficit. This, coupled with the unorthodox (or non-standard) monetary policy implementation, led to significant TRY deprecation, which pushed inflation higher and expectations to deteriorate. Now the CBT is in a hawkish mode and raised the effective interest rate significantly while actively intervening in the currency market. The good news is that the current account has peaked and the worst is likely to be over there. Also, we expect inflation to stay high in 1H12 but decline gradually later in the year. The fiscal performance has been commendable and clearly the authorities have ample space to act in case the economy stalls noticeably. The question is whether the current monetary and fiscal policy mix manages to achieve a soft landing in the economy, given the state of the global backdrop.

5. Ukraine: Can it Hold onto the Hryvnia Peg?

Ukraine faces a challenging external situation. It has a 12-month current account deficit widening to about 5.6% of GDP, which makes it reliant on inflows on the capital account.  In addition, there have been high devaluation expectations, as shown by the sharp increase in dollar purchases by Ukrainian residents since September. In addition, US$53.5 billion in external debt falls due in the next 12 months (1.6 times reserves) according to the NBU latest data as of end-July. One expects the government to do its best to keep the UAH exchange rate stable until parliamentary elections in October 2012 as it is the most sensitive indicator for population. To hold the current exchange rate, the NBU has tightened rates dramatically, while the MinFin has taken to issuing USD-indexed and USD-nominated T-bills.

Additional external financing will be needed next year to prevent uncontrolled devaluation. One thinks that an IMF deal on top of a Russian gas deal would put the Ukrainian economy on a stable path, and provide access to adequate additional financing to support reserves in the face of external funding pressure. On balance, the Ukrainian authorities will close both deals, since that is preferable to an uncontrolled devaluation – but the risks of failing to agree both deals are significant and rising.

6. Russia: Could it be the New Brazil?

Russia is tantalisingly close to a set of policies which will give it a realistic chance of higher, more sustained growth and a more investor-friendly business climate. In terms of the macro framework, the authorities are moving to a combination of inflation targeting and a revised fiscal regime based on reducing the non-oil deficit to a sustainable level, which would enhance stability. In terms of structural reform, the anti-corruption campaign, an aggressive privatisation programme, and the programme to improve the business climate provide potential to enhance investment and increase growth.

There are significant risks to this optimistic scenario – the new politics may complicate and slow down reform, while vested interests may dilute reform. And one also does not think that 2012 will see effective implementation of all the suggested reforms. But Russia will be driven to make some reforms, since oil exports and prices are not expected to rise, so Russia needs a new growth driver, and there is a wide consensus that this driver should be increased private investment, which in turn points in the direction of a stable macro framework and structural reform.

7. South Africa: Proactive Easing by the SARB?

Recent comments by the Minister of Energy that she was considering changes to the electricity pricing policy (EPP) in the upcoming Multi-Year Pricing Determination (MYPD) framework that begins in 2013 to accommodate a lower rate of return that allows Eskom to move towards long-run marginal cost recovery over a longer period than the current 5-year dispensation have encouraged speculation that the SARB could engineer pre-emptive easing as early as the January 19 MPC meeting. One does not rule this out completely. However, history suggests to us that the SARB is very unlikely to front-run such an event.

8. Kazakhstan Politics: Legitimacy and Succession

Political risk in Kazakhstan has appeared subdued – the country avoided the problems of its neighbours. But the Nazarbayev health scare and the oil workers’ strike and deaths have raised the issues of pluralism, legitimacy and succession. Although President Nazarbayev appears in robust health, he is now 71.  Moreover, following the oil worker protests in Zhanaozen in which 70 workers were killed, Nazarbayev replaced the entire management of KMG for failing to settle the dispute, including dismissing Mr. Kulibayev, the head of Samruk-Kazyna, and the son-in-law whom many had seen as the obvious successor.

One expects the Zhanaozen dispute to be resolved peacefully and the wages at state-owned companies to be increased, but I see two major political challenges ahead. First, Nazarbayev needs a process for identifying his successor. Second, the Kazak authorities need to improve their capacity to respond to grievances and resolve conflicts. In both cases, the additional political pluralism promised in this year’s parliamentary elections, when at least one party in addition to the ruling party is expected to win seats, will be a sign of the extent of change.

9. Fuel Subsidies in Nigeria: Relative Price Shock but Good News for FX Reserve Position

Occupying the minds of most Nigerian investors at the moment is the government’s decision to remove the subsidy on petrol prices in Nigeria. From a fiscal standpoint, the removal of the subsidy implies immediate savings of roughly the NGN 1 trillion that was spent on the subsidy last year. We also estimate that the resulting jump in domestic fuel prices (from NGN65/l to NGN141/l represents a relative price shock that could add as much as 1pp to 2012 CPI, eroding discretionary incomes in the process. Over the medium-to-long term, however, the abolition of the subsidy permanently frees up millions of US dollars for FX reserve accumulation, supporting the naira in the process. Even so, labour unions and civil society have been quick to threaten rolling strike action aimed at forcing the government to rescind.

10. Iran/Middle East Tensions

One is 100% certain that the ongoing concerns surrounding a ‘nuclear’ Iran, the possible increase in sanctions against the country and the potential set of retaliatory responses that Iran might come up with will occupy the agenda in the region and in global markets. While one prefers to refrain from speculating on this matter, I believe that an escalation into a conflict would be likely to have noticeable impact on oil prices and a detrimental effect on sentiment. While oil price changes will have varying degrees of an impact on our countries (both in magnitude and direction), the overall result will likely be highly adverse. The two countries that seemingly will be directly impacted by a possible intervention in Iran seems to be Israel via weaker tourism, heightened security and terrorism concerns, and Turkey through the rising cost of energy imports.

Burak Altin, Aydin Real Estate. For further information please visit  www.aydinestate.com or e-mail This e-mail address is being protected from spambots. You need JavaScript enabled to view it