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The Changing Outlook for Emerging Economies

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1 The Changing Outlook for Emerging Economies
Piero Ghezzi Head of Economic and Emerging Market Research March 2010 PLEASE SEE ANALYST CERTIFICATION AND IMPORTANT DISCLOSURES AT THE END OF THIS PRESENTATION.

2 2009 was a milestone year The recession was the largest post-war downturn but EM economies held reasonably well Note: GDP gap for past crises estimated using by gap between actual GDP and GDP assuming growth at the potential rate since the beginning of the recession. EM Crisis include Argentina, Brazil, Mexico, Thailand, Korea and Singapore. Source: Haver, Barclays Capital. 2 2

3 What was different in EM this time?
Reduced dependence on external finance and large liquidity war chests have strengthened the ability to engage in countercyclical policies Embrace of macroeconomic stability by local governments after hard lessons from the 70s and 80s have resulted in more fiscal discipline and credible monetary policy Building the liquidity war chest Low inflation and better fiscal ratios RHS Source: BIS, Barclays Capital Source: World Bank, IMF, Barclays Capital

4 EM was able to administer counter-cyclical policies
Improved fundamentals allowed EM to undertake counter-cyclical monetary (almost everywhere) and fiscal (in many cases) policies Change in the cyclically adjusted fiscal deficit during the Asian and global financial crisis Aggressive countercyclical monetary policies when they were needed the most Source: National Treasury Offices, IMF, Haver Analytics, Barclays Capital Note: For AEM Economies Source: National Central Banks, Haver Analytics, Barclays Capital Note: For AEM Economies

5 Increased dependence on China also mattered..
EM Growth (ex-China) is less sensitive to G7 growth, more to Chinese growth Less Sensitivity to G7 Growth, More to China China’s share of global commodity consumption growth In addition to lower policy-induced volatility, it is useful to emphasize the increased relevance of China (relative to G7) to determine EM (ex-China) growth. Notice that overall beta of EM (ex-China) growth to global growth has not declined but has “shifted”. ___________________________ Source: IMF, Barclays Capital. Note: EM growth was regressed on G7 and China GDP growth ___________________________ Source: Bloomberg, Barclays Capital 5

6 …and China recovered extremely rapidly
A “V” shaped recovery in China End of recession timeline Source: Bloomberg, Barclays Capital Source: Barclays Capital

7 Self-reinforcing negative EM dynamics of the past were avoided
Value of $100 Invested in January 2004 There were clear indications that EM fundamentals were improving but a crisis was needed to stress test improvement was for real. No skeletons EM was capable of weathering the financial storm pretty well. Unlike previous episodes where crisis in core markets resulted in full blown EM financial crises, this time asset sell-off did not result in a negative spiral off increased risk premium and deterioration of balance sheets. But beyond the high beta nature of the asset class and the high frequency correlation there has been some alpha related to longer term/low frequency outperformance (even when corrected by volatility). ___________________________ Source: Bloomberg, Barclays Capital. 7

8 It’s not only EM’s advance…
… but also the decline of developed markets. EM countries economic “Sharpe ratios” have more than doubled Better Relative “Growth Sharpe” in EM … Growth Rate (EM Median) (G7 Median) Period : Early Late Early Late Mean 4.20% 3.68% 2.10% 1.20% EM growth volatility is declining, while G7 vol has increased. Combined with a relative deterioration of growth in G7, the economic “Sharpe” ratios in EM have improved relative to G7. Vol. 3.77% 3.17% 1.30% 2.24% Sharpe Ratio 1.16 1.22 1.54 0.68 ___________________________ Source: IMF, Barclays Capital. 8

9 Many EM Countries show high growth and low volatility
Growth Sharpe Ratios (1997–2009) EM stigma is slowly disappearing in our view. It increasingly makes sense to think of a group of EM countries that are neither exotic nor fully developed. We label them “Advanced Emerging Markets” that we would like to distinguish from traditional EM. One characteristic, when thinking in terms of growth rates is that growth is high but volatility is relatively contained. Our list has 10 countries and 4 close calls. ___________________________ Source: Barclays Capital. 9

10 EM is getting a bigger slice of the GDP pie (I)
EM share of world GDP continues to increase ___________________________ Source: IMF, Barclays Capital. 10

11 EM is getting a bigger slice of the GDP pie (II)
EM Contribution to Global Growth Chart is self explanatory. EM will contribute 70% of global growth in China’s contribution alone will be similar to the developed world. ___________________________ Source: Barclays Capital.

12 EM is getting a bigger slice of the AUM pie (III)…
There has been a structural reallocation of money into EM ___________________________ Source: EPFR Global, ICI, Barclays Capital. Note: EM and Developed flows include both bonds and equities 12

13 …consistent with improved returns of including EM in Global Portfolios
Equity Credit FX MSCI World MSCI Global Portfolio(1) US IG Corps G6 tsy(2) Portfolio(3) Short DXY G10 comm(4) Portfolio(5) Mean 0.12% 0.21% 0.34% 0.42% 0.38% 0.50% 0.05% 0.20% 0.25% Vol 5.03% 5.26% 5.59% 2.10% 2.46% 2.28% 2.54% 3.44% 2.58% ___________________________ Source: Bloomberg, Barclays Capital. Note: Median values in EM alphas and betas from country-by-country regressions against a short DXY position (FX) and MSCI World total returns. The equity sample includes the top ten EM markets based on market cap. In Adding EM to the global portfolio: MSCI World includes developed countries. MSCI Global includes developed and emerging countries. Mean is the average of the m/m TR (capital return for equities) over the sample period (Jan 05 to Feb 10). Volatilities (non annualized) are the standard deviations of the return series over the same sample period 70% of MSCI World and 30% of MSCI EM. G6 treasuries (G7 ex US) Equally weighted US corps, G6 tsy, G7 and EM Corp and Sov. Equally weighted long AUD-CAD-NZD-NOK position. 50% short DXY, 25% long G10 comm, and 25% long GEMS. (Not sure this slid is adding much yet considering that we don’t have optimal EM weights in global portfolios). It is difficult to extrapolate based on the past but just confirms the high beta nature of EM Equities and the lower beta of EMFX. It also highlights the positive alpha we mentioned in the first slide

14 Looking forward… Important to continue limiting vulnerabilities
Some thoughts on growth It has been important to highlight the achievements in EM countries and how we are unlikely to return to the historical average in the eyes of investors. At the same time, it is useful to understand how to keep reducing vulnerabilities looking forward and, second, think about the macro conditions/constrains to enhance potential growth. 14

15 Limiting Vulnerabilities: Fiscal Policy
Fiscal deterioration has been greater in advanced economies but EM countries remain very dependent on commodities Increase in Public Debt (% GDP) from 2008 to 2009 Commodity Revenue (% Total Gov. Revenue) Two points to highlight: Due to the fiscal deterioration (proactive or as a result of tax collection reduction) and the fall in GDP, Debt to GDP ratios have increase. Fiscal situation has hence worsened (even if it is still very minor compared to deterioration of advanced economies) Given the still large dependence on commodities it is crucial to advance on fiscal rules that help to smooth economic activity. Secular improvement in commodities will last for still some years but volatility is likely to remain high. Very importantly: with the possible exception of Chile no country has well designed fiscal rules (and even in Chile rule can be improved) ___________________________ Source: IMF, Haver Analytics, Barclays Capital. ___________________________ Source: Haver Analytics, Barclays Capital. 15

16 Limiting Vulnerabilities: Monetary Policy
Need to rethink inflation targeting regimes Hitting inflation targets has been difficult Food weight in the CPI (%) Most EM countries have exceeded the upper bound of their inflation targeting regimes. Food weight in CPI an important reason for that. With the great moderation obviously behind us, it is fair to assume that even after the financial crisis is over, global volatility will be higher than in pre This may call into question the level of inflation targets, the amplitude of the bands or even the idea of explicit inflation target altogether. Important not to be too religious about these issues NB: max, min and mean of 6mma deviations of inflation from mid target. Lower and upper targets show the deviations to the limits of the inflation bands ___________________________ Source: IMF, Bloomberg, Barclays Capital. ___________________________ Source: Haver Analytics, IMF, Barclays Capital. 16

17 Limiting Vulnerabilities: Credit and Asset Prices
Correlation is too high to ignore Excess money growth and the stock exchange Excess money growth and the property prices We are using the China example here but the relationship of credit with asset prices is crucial. It has also been proved that Central Banks can’t ignore asset prices and hence they will need to limit excessive expansion. We will never know for sure whether there is a bubble but if probabilities are sufficiently large Central Banks and Banks regulator will need to intervene with pro-cyclical reserve provisions. The new conventional view appears to be that quantitative tools should be utilized to asses price inflation (leaving interest rates to address goods inflation) ___________________________ Source: Haver Analytics, Barclays Capital. ___________________________ Source: Haver Analytics, Barclays Capital. 17

18 Limiting Vulnerabilities: Reserve accumulation
Accumulation of net foreign assets has worked well for individual countries although inefficient for the world EM External debt and reserve accumulation… …but Global Imbalances a problem Current Account Countries have accumulated much more reserves that ex-ante models of optimal reserve accumulation would have suggested. And even if expensive ex-post this proved to be the right decision. Countries with very limited reserve accumulation were in trouble. However, in addition to being expensive insurance excessive reserve accumulation does not seem to be optimal for the world as a whole but, for the time being, hard to think of a workable alternative (given moral hazard and resource issues of centralized IMF) ___________________________ Source: IMF, Barclays Capital. ___________________________ Source: Barclays Capital. 18

19 Growth: Difference between two regions is remarkable
Real GDP Growth (% y/y)… Savings and Investment (% GDP) During the 60s and early 70s Latin America used to grow at levels similar to Asia but since then it has fallen. Differential in savings and investment rates explain a large percentage of the difference in growth potential…. ___________________________ Source: IMF, Haver Analytics, Barclays Capital. ___________________________ Source: IMF, Barclays Capital. 19

20 Growth: Intra Regional differences key in Asia
Asia is not as homogeneous as one would think Growth is now dominated by China and India… …And the recent increase in investment as well …. But it is important to understand that we can increasingly think of EM Asia as India and China on one hand and the rest (developed Asia) on the other (with Indonesia somewhere in the middle). Growth in EM Asia is now mostly explained by those two countries. And the pick up in investment is basically only in China and India as well. ___________________________ Source: IMF, Haver Analytics, Barclays Capital. ___________________________ Source: World Bank, Barclays Capital. 20

21 Growth: Demographics will accentuate intra Asia differences
Outside South Asia birth rate below replacement By 2020, populations in North Asia will have peaked Demographic will play an important role in the outlook as well. Again difference in India (and more , China with “developed” Asia) ___________________________ Source: CIA World Factbook, Barclays Capital ___________________________ Source: United Nations, Barclays Capital. 21

22 LatAm Growth: Brazil has gained weight relative to Mexico
Latin American growth composition Moving to Latin Americ….a there has also been a re-composition of sorts with Brazil becoming increasingly the dominant force in the region. Although clearly the process it is not as marked ___________________________ Source: IMF, Barclays Capital. 22

23 Latam Growth: larger economies save too little…
Gross domestic savings in Latam (% GDP) Fixed Investment in Latam (% GDP) One characteristic of LatAm savings pattern is that it is mostly the large economies that have the low savings rate. Smaller economies saving rates are reasonably ok. For some of the smaller economies the key challenge will be how to administer the commodities boom and make sure it is channelled into permanent improvements in institutions (strengthening the public sector) and education, where the region lags. For the larger economies, particularly Brazil. The problem is unlikely to be lack of available capital to finance investment but certainly growth may be be constrained. The problem is likely to be that given limited domestic savings, funding will need to be external. Hence important to control the macroeconomic effects of those inflows (like RER overshooting) and the risk of having excessive external imbalances. ___________________________ Source: World Bank, Barclays Capital ___________________________ Source: World Bank, Barclays Capital. 23

24 .. and the region needs to live with worsening CA balances
Latin American Current Account (% GDP) The global rebalancing (with US current account surplus having contracted in a potentially permanent basis) and the increased interest in the region implies that LatAm may move back to current account deficits. In a certain way it is not a problem as it will ___________________________ Source: IMF, Barclays Capital 24

25 Latam: Composition of foreign liabilities is improving
LatAm Foreign Liabilities (USD bn) Fortunately inflow composition is better. Some form of ktal control/strong intervention will be necessary to reduce hot money and hence make sure exchange rate does not undershot. ___________________________ Source: IMF, Haver Analytics, Barclays Capital. 25

26 Analyst Certification and Important Disclosures
Analyst Certification(s) I, Piero Ghezzi, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY or refer to https://ecommerce.barcap.com/research/cgi-bin/all/disclosuresSearch.pl or call Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information was obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise. 26 26 26

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