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Sustainability of selected EM Overall debt positions and currency risk 1 04-05-2012 | Petercam Macro Presentation | 1/25 EM public debt is significantly lower… Gross government debt 120 (in % of GDP) 100 Advanced world 80 60 40 Developing and emerging world 20 0 2000 2003 2006 2009 2012 2 04-05-2012 | Petercam Macro Presentation | 2/25 …and EM deficits are substantially smaller Gross government net lending 4 (in % of GDP) 2 0 Developing and emerging world -2 -4 -6 Advanced world -8 -10 2000 2003 2006 2009 2012 3 04-05-2012 | Petercam Macro Presentation | 3/25 EM overall debt levels are significantly lower… Gross debt position 500 (in % of GDP) Private debt (domestic) Public debt 400 300 200 100 Indonesia Russia Mexico Turkey Bulgaria Poland India Brazil S.Korea Hungary China S.Africa Eurozone US Japan 0 4 04-05-2012 | Petercam Macro Presentation | 4/25 …but therefore not necessarily better Net international investment position (NIIP) NIIP 100 (in % of GDP) Most vulnerable 50 0 -50 -100 NIIP = difference between external assets and liabilities Hungary Bulgaria Turkey Poland Brazil Indonesia Mexico S.Africa S.Korea India Russia China US Eurozone Japan -150 5 04-05-2012 | Petercam Macro Presentation | 5/25 EM have a CA surplus as a whole…. Current account balance 800 (in bn USD) 600 400 Developing and emerging world 200 0 -200 Advanced world -400 -600 1992 1995 1998 2001 2004 2007 2010 6 04-05-2012 | Petercam Macro Presentation | 6/25 ….but some countries have large funding needs Current account 6 (in % of GDP) 4 2 0 -2 -4 -6 Most vulnerable -8 Turkey South Africa Poland India Brazil Mexico Indonesia South Korea Bulgaria China Hungary Russia US Eurozone Japan -10 7 04-05-2012 | Petercam Macro Presentation | 7/25 Some countries look vulnerable in this respective S. Africa, Poland and Turkey in particular Current account balance (in % of GDP) 4 2 0 -2 -4 -6 -8 Turkey -10 1992 Poland 1995 S.Africa 1998 2001 2004 2007 2010 8 04-05-2012 | Petercam Macro Presentation | 8/25 Turkey and Poland look particularly vulnerable Combining a large NIIP deficit with large funding needs (CA deficit) Turkey 40 (composition of NIIP, in % of GDP) Turkey Current account deficit of almost 9% of GDP in 2012 IMF projects CA deficits of around 8% of GDP until 2017 NIIP stands at 50% of GDP in 2010 But ongoing large CA deficits will lead to higher NIIP deficit Other and portfolio investment liabilities (~ hot money) account 20 0 -20 -40 -60 -80 2000 2002 2004 2006 FDI Other investments NIIP 2008 2010 Portfolio investments Reserves for almost 40% of GDP in 2010 More volatile by nature Poland 40 (composition of NIIP, in % of GDP) Poland Current account deficit of almost 5% of GDP in 2012 IMF projects CA deficits of around 4% of GDP until 2017 NIIP stands at 55% of GDP in 2011 But ongoing CA deficits will lead to higher NIIP deficit Other and portfolio investment liabilities account for 45% of GDP 20 0 -20 -40 -60 -80 in 2011 -100 2000 2002 2004 2006 2008 2010 9 04-05-2012 | Petercam Macro Presentation | 9/25 (1) What happens when investors’ risk appetite dries up? The example of Turkey Turkey (composition of capital account, in % of GDP) 15 16000 A1: Investors’ appetite dries up! A2: Primarily via other investment account! Q1: What happens here? Q2: How does it happen? 10 12000 5 8000 0 4000 -5 0 -10 -4000 Reserves Other investments FDI -15 2000 2002 2004 Portfolio investments errors and omissions Capital account 2006 2008 2010 Other investments: liabilities (4Q moving avg) -8000 Q1 1998 Q4 2000 Q3 2003 Q2 2006 Q1 2009 Q4 2011 10 04-05-2012 | Petercam Macro Presentation | 10/25 (2) What happens when investors’ risk appetite dries up? The example of Turkey …This is reflected in the exchange rate 1.9 USD/TKL 1.7 1.5 1.3 1.1 0.9 0.7 ↑ Currency depreciation 0.5 Jan-00 Oct-01 Jul-03 Apr-05 Jan-07 Oct-08 Jul-10 Apr-12 11 04-05-2012 | Petercam Macro Presentation | 11/25 (3) What happens when investors’ risk appetite dries up? The example of Poland and Hungary Poland 12000 3 3.2 Other investment liabilities (lhs) EUR/PLZ (rhs, inv) 3.4 Hungary 8000 6000 220 230 Other investment liabilities (lhs) EUR/HNF (rhs, inv) 240 8000 3.6 4000 250 3.8 260 4000 4 2000 270 4.2 4.4 0 280 0 ↓ Currency depreciation 4.6 290 -2000 4.8 -4000 Q1 2001 5 Q2 2003 Q3 2005 Q4 2007 Q1 2010 ↓ Currency depreciation -4000 Q1 2001 300 310 Q2 2003 Q3 2005 Q4 2007 Q1 2010 12 04-05-2012 | Petercam Macro Presentation | 12/25 How do EM currencies react when risk aversion sets in? Correlation with market volatility Correlation with Vix 80 (against EUR, since begin 2008) 60 Currencies (very) sensitive to market volatity 40 20 0 -20 USD benefits from high market volatity -40 BRL ZAR KRW IDR MXP PLZ HUF INR TKL RUB USD 13 04-05-2012 | Petercam Macro Presentation | 13/25 Recent performance of EM currencies EM currencies have already lost significant ground Currency performance 10 (since begin March) 5 0 -5 -10 -15 Against EUR Against USD -20 JPY CNY IDR GBP CAD KRW SWF SKK BGN TKL NOK RUB CZK SEK MXP HNF AUD NZD PLZ ZAR INR BRL -25 14 04-05-2012 | Petercam Macro Presentation | 14/25 How much is already priced in? TKL, PLZ, HUF and INR look cheap against their own postlehman history: from current valuations the downward potential in a lehman style scenario is relatively limited. Also, their upward potential in the most optimistic senario is high (around 30%). Currency performance since lehman 40 30 Current vs peak Current vs trough ↑Downward potential in lehman style scenario 20 From the previous, however, it is clear that there seems to be a reason for this: Turkey, Poland, Hungary and India were indeed identified as the countries with the highest funding needs (current account deficits) and therefore more vulnerable. 10 0 -10 Against EUR -20 -30 ↓Upward potential in most optimistic scenario CNY KRW IDR RUB MXP BRL ZAR INR HNF PLZ TKL -40 To a large extent, a negative scenario is already priced in for the ZAR, BRL, MXP and RUB. However, the downward potential is also (very) significant when economic conditions take a turn for the worse. The IDR and KRW exchange rates have fallen back significantly less and actually strengthened against the eur in recent months. Not surprisingly, these countries have relative stronger fundamentals. The downward potential is obviously high when economic conditions would deteriorate. 15 04-05-2012 | Petercam Macro Presentation | 15/25 The valuation of (selected) EM currencies EM currencies remain (significantly) undervalued in a LT-perspective Currency undervaluation (based on PPP against EUR) BRL IDR ZAR RUB CNY INR KRW MXP TKL HNF PLZ Theory of PPP states that exchange rates between countries are balanced when their purchasing power (of a fixed basket of goods and services) is equal in both countries. Theory of PPP states that all EM currencies (apart from the BRL) are heavily undervalued. The undervaluation ranges from 64% for the INR to 23% for the RUB. -70 -60 -50 -40 -30 -20 -10 0 Currency undervaluation (based on PPP corrected for productivity differences, against EUR) BRL IDR ZAR RUB CNY INR KRW MXP TKL HNF PLZ However, the undervaluation of EM currencies is unlikely to be that large. One important reason is that not all goods and services are tradable and therefore not subject to arbitrage. Wages make up a substantial part of the final cost of any product (tradable or not). Wage differences, in turn, reflect differences in productivity so that the overvaluation of DM currencies tends to be overstated. Corrected for productivity differences, the undervaluation of EM currencies is much smaller, ranging from only 6% for the IDR to 23% for the PLZ -25 -20 -15 04-05-2012 | Petercam Macro Presentation | -10 -5 0 16 16/25 Conclusion (1) EM currencies remain a (very) risky asset class in times of high uncertainty EM overall debt is significantly lower compared to DM. However, that does not mean that debt levels are more sustainable. Some countries have large funding needs including India, S. Africa, Poland and Turkey. Poland and Turkey combine this with a large NIIP deficit (= net debtors to the rest of the world) When risk aversion sets in and investors’ confidence dries up, this is reflected via weakness in the exchange rate. The BRL, ZAR, KRW, IDR show the highest correlation with market uncertainty and volatility (VIX) while the USD benefits from financial distress and economic turmoil. 17 04-05-2012 | Petercam Macro Presentation | 17/25 Conclusion (2) EM currencies remain a (very) risky asset class in times of high uncertainty It seems that already a great deal of this is reflected in most EM currencies as exchange rates have already lost significant ground in recent months. Some currencies have hardly recovered from their pre-Lehman troughs and therefore look cheap. However, there seems to be a reason for this. Indeed, these countries also have (large) funding needs and weak net international investment positions. In a LT-perspective, corrected for productivity differences, the undervaluation of EM ranges from 6% for the IDR to 23% for the PLZ (according to the theory of PPP). The BRL is the most expensive EM currency from this perspective. Despite the undervalution of most EM currencies in a LT-perspective, playing EM currencies remains obviously very risky in times when risk aversion is high and likely to rise even further against the back of mounting uncertainty related to the eurozone crisis. 18 04-05-2012 | Petercam Macro Presentation | 18/25