Emerging Markets: What has Changed

(from my colleagues Dr Win Thin and Ilan Solot)

(1)        Liquidity conditions in China tighten again – though we doubt it will last 

(2)        Once again the Brazilian central bank’s intervention policy is leaving markets guessing 

(3)        The much discussed auction of the Brazilian oil field Libra brought some surprises 

(4)        Expectations for a 50 bp cut by Banxico on Friday have increased – incorrectly, in our view 

(5)        The Indian government may increase its capital in state-run banks 

(6)        The RBI confirmed it will keep the FX swap window for refiners open 

(7)        The Russian central bank scaled down the volumes of its regular interventions 

(8)        Singapore and China agreed to introduce direct trading for their currencies 

Notable price action (October 17-24): Over the last week, Chile (+3%), Peru (+3%), and Turkey (+4%) have outperformed in the EM equity space in local currency terms, while Brazil (flat), China (-1%), and Israel (-1%) have underperformed.  In the EM local currency bond space, Turkey (10-year yield up 12 bp), China (up 4 bp), and Mexico (up 2 bp) have underperformed over the last week, while Poland (10-year yield down 8 bp), Hungary (down 10 bp), and Malaysia (down 12.5 bp) have outperformed. Also note that Chinese repo rate (7-day) rose 130bp on the week. In the FX space, HUF (+0.5% vs. EUR), RUB (+1% vs. USD) and ZAR (+1% vs. USD) have outperformed over the last week, while BRL (-2.5%), CLP (-2.5%), and MXN (-1%) have underperformed.

(1) Liquidity conditions in China tighten again – though we doubt it will last.  Here are the drivers:  (1) Earlier in the week, news that Chinese banks significantly increased bad loan write-offs shook markets.  The article estimated that the amount of bad loans written off in the first half of the year tripled as banks brace for potential rises in NPLs; (2) Nervousness about the forthcoming report by the National Audit Office on local government debt – estimates range from RMB15 trln to RMB30 trln (about 30-60% GDP), compared with RMB10.7 trln in 2010; (3) Corporate tax payments, which are draining liquidity; (4) Concerns about PBOC removing liquidity or not injecting it into the system.  Taken together, these factors led to more than a 1.0 percentage point jump in the 7-day repo rate to 4.67%, thought it remains within its range since July.  Our view is simple: There is very little chance, in our view, that the PBOC will let local rates markets go into another mini-crisis ahead of the 3rd Plenary next month. The market is overreacting.

(2) Once again the Brazilian central bank’s intervention policy is leaving markets guessing. So much for transparency of the new intervention program.  USD/BRL traded back above 2.20 today for the first time since October 10, but has since dipped back below.  Admittedly, this is all guesswork, but it appears that BCB is dealing with the firmer real by adjusting the rollovers of expiring swaps while still holding the daily 10,000 contract auctions.  The big expiry worth $8.9 bln is coming up November 1 and, so far, BCB has held auctions to roll over about $2 bln.  Another $1 bln will be rolled over today, leaving $5.9 bln to potentially roll off at the beginning of the month.  Not rolling basically removes dollar supply from the market, which has the desired (we think) effect of weakening the real.  BCB could still decide to roll more ahead of November 1, but so far, markets are reacting in an orderly fashion and so BCB may not need to roll any more.  To be continued.

 (3) The much discussed auction of the Brazilian oil field Libra brought some surprises.  The bid (at the minimum price) was accepted by the consortium composed of:  Total (20%), CNOOC (10%), CNPC (10%), and the surprise participation of Shell (20%).  Also contrary to expectations, the Chinese participation (total of 20%) was much smaller than originally expected.  Petrobras took 40% (10% more than required).  The consortium offered the minimum share of profit required of 41.65%.  Mantega estimated that inflows from the deal would be around $4 bln.  

(4) Expectations for a 50 bp cut by Banxico on Friday have increased – incorrectly, in our view. We stay in the 25 bp cut camp.  We think Banxico will prefer to extend the easing cycle rather than frontloading it, in line with its traditionally more cautious approach.  The bank already surprised the markets in the last meeting with a 25 bp cut to 3.75%, so we think it is unlikely to want to deliver another surprise.  We would place the odds at 4-1 in favor of 25 bp.  The market is currently pricing in about 40 bp for this meeting, so there is an opportunity there.  We could see a knee-jerk MXN bid after the meeting should they cut by only 25 bp.  

(5) The Indian government may increase its capital in state-run banks.  Reports suggest this injection would amount to INR140 bln ($2.3 bln), including INR20 bln for State Bank of India and INR18 bln for the Central Bank of India.  The idea is to help prepare against rising bad loans amidst a worsening economic slowdown.  NPLs rose to a six-year high in June, with state-run banks suffering the most.

(6) The RBI confirmed it will keep the FX swap window for refiners open.  This comes after a report citing unnamed sources suggested that the window would be closed.  Shortly after the report, the central bank said there were no plans to do so.  The bank also added in a statement that “any tapering of the window, as and when it occurs, will be done in a calibrated manner. “

(7) The Russian central bank scaled down the volumes of its regular interventions to $60 mln from $120 mln previously.  After widening the non-intervention band to 3.1 rubles earlier this month, this is simply the latest (albeit small) step towards further liberalization of the managed float towards a free float.  We expect further cautious steps towards FX liberalization in the coming months.  Governor Nabiullina said the bank aims to stop its intervention bands in 2015.  However, we note that the bank’s timetable for FX liberalization has always turned out to be too optimistic.

(8) Singapore and China agreed to introduce direct trading for their currencies.  This is similar to the recent agreement between China and the UK.  Moreover, China granted an $8.2 bln QFII quota allowing for Singapore financial institutions to invest in mainland companies, and Singapore will become one of the destinations for QDII (outbound money from Chinese institutional investors).