Trade of the week: hard currency vs. local currency bond switch opportunities As positioning is stronger in local currency than hard currency EM bond funds (also evidenced in last week bond fund flow data) while USD appreciation seems to be the main driver of recent EM underperformance, we believe it makes sense to investigate switch opportunities from local to hard currency bonds. In our chart we mapped the spread between 10y local currency government bond yield and 10y cross currency swaps versus 10y sovereign CDS in the CEEMEA universe. We see two main outliers in CEEMEA. The Hungarian and Romanian external credit (proxied with 10y CDS) seems to be disproportionally higher than the local credit risk. In case of Romania this might be related to the fact that the MinFin similar to 2009 introduced a yield cap on long end local currency bonds. Similar to that period we would expect local market participants to increasingly participate in the Eurobond market and to create synthetic local currency bonds. We see the Romania EUR 06/16 paper as relatively attractive at current levels. In the case of Hungary we issued a recommendation to short 22/A HGB vs. 10y HUF IRS last week to exploit the relative richness of the local currency bond. For investors who need to keep some Hungarian exposure we believe the switch from local to hard currency makes sense.
Event & data watch: Another busy data week We are monitoring three sets of data to gauge the impact of the EMU crisis on the CEE region, namely real economy data, bank funding and portfolio flows. That said we are aware that the EMU crisis is moving rapidly while real economy and bank funding data are released with a lag, reducing their relevance somewhat in terms of capturing the current environment. Examining the most timely data that we have to hand at this stage, there has been clear deterioration in terms of portfolio flows to the region but the data on bank funding and economic activity is more mixed. The last couple of weeks have seen evidence of some central banks (e.g. Poland, Turkey, Russia, Croatia) taking a more active role in FX markets to smooth outflows while Hungary is scheduled to act next week. To the extent that at least in the near term, a comprehensive EMU solution is not yet within reach, these central banks will likely be forced to remain present. Other central banks in the region, e.g. Romania, appear increasingly content to facilitate some FX adjustment to reflect a weaker growth environment.
The most timely data available is on fund flows. The newsflow on this front last week was negative, with EM funds posting their largest outflow on record. Data available for Turkey up to 23rd September shows an outflow from domestic government debt of USD3.1bn month to date, with outflows over Aug-Sep sufficient to reverse over 30% of total inflows YTD.
August banking sector data in the region was more mixed than the portfolio flows picutre. In Hungary the banking sytem managed to increase its stock of external liabilities in August (+EUR0.7bn) for the first time since March, though this inflow is minimal to the extent that it doesn’t even reverse July’s outflow. New credit transactions remain negative. Following the government’s most recent bank announcement, some deterioration in September data seems likely. August was a weak month for the Polish banking system, with new credit transactions (fx-adjusted) turning negative while banking sector external liabilities declined by EUR2.7bn, reversing 3 months of inflow. That said the stock of external liabilities for the banking sector is up EUR3.3bn YTD. More so than any other country in the region, Poland has seen the largest widening in the net foreign asset position of its banking sector since the 2008 crisis. Turkey is performing better. At least in August the banking system continued to borrow abroad, though at a much slower pace than at the end last year and early this year. The banking system increased its external liabilities by EUR0.7bn in August. Credit growth has slowed to 0.3% week on week (4 week moving average, fx adjusted), approximately half of its YTD average, but new credit extension remains positive. August data for Russia is not yet available.
On the economic activity front, Monday sees the release of September manufacturing PMI data for the region. This is the most timely indicator of economic activity available in the region and should provide us with an indication of the impact of last month’s market turmoil on output. Last Friday saw the release of the European Commission’s economic sentiment indicator for all EU countries for September. Most of the countries in the EU under our watch edged downwards due to a combination of a weakening in industry and consumer sentiment. As of end August, the PMIs had posted a number of months of declines but were largely in line with their long term average. With the flash EMU estimates moving lower in September, another decline in CEE seems on the cards. That said we remain some way away from the lows seen during the 2008 crisis. For example in Poland and Turkey in August this year the manufacturing PMI stood 0.5 standard deviations above and 0.3 standard deviations below its long term average respectively. In Dec-08 the PMI for Poland and Turkey stood 3.1 and 3.3 standard deviations below their long term average. Meanwhile August industrial producton data for Poland showed a robust 2.2% MoM gain while in Turkey industrial production posted a gain of 2.7% MoM. At least up until now the message from the real economy data seems to be one of a slowdown but not a collpase.
This week will also see September inflation data begin to filter through, with Turkey and Kazakhstan to release on Monday and Russia on Tuesday-Wednesday. In contrast with many other contries in the region, inflation in Kazakhstan remains elevated, having ticked up to 9.0% YoY in August, in part due to the impact of the customs union. With RUB having depreciated and oil prices ticking downwards, the case for KZT gains has weakened significantly over recent weeks.
Turkey saw inflation surprise to the upside last month. This combined with a stronger than expected industrial production reading for July and a stronger than expected Q2 GDP reading has seen the CBT turn a little less dovish, though as per the minutes of its recent rate meeting, the CBT is unconvinced that these sort of IP readings will continue. CBT policy action in the near term is much more likely in the case of a lower rather than higher than expected inflation reading, most likely in the form of a reduction in reserve requirements. The size of CBT intervention last week declined but TRY still managed to recover some of its mid-week losses.
Russia at this stage is much more about gauging the potential for capital outflows in the face of an increase in political instability than it is about economic activity or inflation. Last week CBR Governor Ignatiyev indicated that the CBR has sold USD6bn in September to smooth RUB losses. Relative to 2008 Russia is in a better position to the extent that it is one of the few large emerging markets globally not to see a return of foreign capital post the 2008 crisis. The net foreign asset position of the banking sector has moved from negative to positive. A repeat of 2008 whereby rollover ratios on foreign borrowing fall significantly below 1 for a protracted period is much less likely this time around. Moveover there are a number of factors which should protect the economy against a collapse in economic activity. For example inflation, scheduled for release on Tueday/Wednesday should decline to close to 7.0% YoY from 8.2% in August and a peak of 9.6% in May. This should boost consumer purchasing power. A better harvest should see agriculture contribute to GDP gains while fiscal policy is also likely to support economic activity over the remaining months of this year ahead of elections given that the budget has posted a surplus YTD. At least for now however uncertainty on the scope for domestic capital outflows is likely to remain the key driver of RUB.
In Poland the NBP decides on its policy rate on Wednesday but focus is likely to be much more on any statements on PLN following the meeting than the decision itself. We expect the Bank to leave its policy rate on hold at 4.5%. Last Friday saw the NBP step into the market for a second time. Much as in the case of Turkey, the NBP appears to be of the view that at this stage PLN has depreciated sufficiently to take account of deteriorating growth prospects. In the absence of a significant deterioration from here in the external environment the NBP sees value in smoothing any outflows from the domestic banking sector and government fixed income market to prevent a sharper adjustment. We watch for any statements from Governor Belka on the extent of his willingness to draw down reserves follwing the rate decision, e.g. is the use of Poland’s FCL a likely option. Meanwhile uncertainty surrounding the outcome of next Sunday’s general election is likely to weigh on PLN over the coming days.
In Hungary focus this week will be on Monday’s first FX auction by the NBH to cover bank demand for FX related to mortgage conversion. On Friday the NBH indicated that it will run auctions once a week, if not more, until the end of February while closely monitoring mortgage transactions at a bank level. A 30% participation rate implies FX demand of almost EUR6bn. FX reserves currently stand at EUR34.7bn, 2.2 times their level in Oct-08, making this sort of run down of reserves in itself manageable. However with the sovereign facing EUR2bn and EUR3.7bn in repayments to the EU in Q4 and IMF in 2012 respectively, there are further risks to FX reserves ahead. Sovereign access to eurobond markets by Q1 next year, in itself a function of developments in EMU to a large extent, will be crucial in determining the sustainability of this situation.
Lastly within the Balkans, a few words on Romania versus Croatia. Last week saw the NBR abandon its key 4.30/EUR level. Romania enjoys some cushions to growth given that the impact of last year’s 5pp VAT hike has fallen from the base while agriculture should also help GDP this year. Nonetheless the NBR seems to have taken the view that the combination of easing inflation and weakening external demand was sufficient to faciliate weaker monetary conditions. In Croatia the central bank has taken the opposite view. Having opted against an IMF programme in late 2008, Croatia has lagged some of its peers in terms of reform on fiscal and structural issues. It is also a clear laggard in terms of economic activity in the region. Of late this has translated into FX depreciation pressure but in contrast with Romania, Croatia’s more inflexible FX regime means that the central bank has taken measures to stem such pressure. Indeed to the extent that FX reserves stand at 1.4 times base money, Croatia’s FX regime in a way resembles a currency board. Central bank measures include hikes to reserve requirements, FX sales by the central bank and FX t-bill issuance by the government. It is notable that HRK did not enjoy its seasonal rally this year over the course of the tourism season. There is a general election scheduled for early December and as such the government will be unwilling to take measures ahead of the new year. This leaves the central bank primarily responsible for countering any increase in market pressure from here.
Country focus: Poland – election preview Parliamentary elections to both the Lower House (Sejm) and the Upper House (Senat) will be held in Poland on October 9, 2011. The outcome of the upcoming elections is much more uncertain than it seemed a month or two ago, but the two key parties are unlikely to bring serious threat to public finance. In our election preview we provide an update about the latest polls and likely post election scenarios.
EM bond fund flows: biggest outflow on record Data published last Friday shows that EM bond funds saw their biggest weekly outflow on record (in absolute terms) at USD3.2bn. As we have highlighted in our fund flow report last week the serious underperformance of JPM-GBI vs. the UST will likely lead to outflows from EM bond funds. Data published last Friday confirmed our view. Looking ahead we believe the key will be how broad based in the USD appreciation and how much it hurts the relative performance of EM fond funds. As our chart shows only 2 weeks of relative outperformance might be enough to stabilize the EM bond fund flow backdrop.
Gillian Edgeworth
Chief EEMEA Economist
UniCredit Research