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Morgan Stanley - A Summer Squeeze

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					MORGAN STANLEY RESEARCH
                                                                                                                              GLOBAL EM M ACRO STRATEGY TEAM
July 22, 2013
                                                                                                                              For research analysts, please see contact list at the


Global EM Investor
                                                                                                                              back of this material.

                                                                                                                              Credit: Sell Colombia CDS-Bond
                                                                                                                              Basis
A Summer Squeeze                                                                                                                90
                                                                                                                                80
Our tactical market directional stance remains at Hold. Long USD                                                                70
positions continue to get squeezed, and fixed income assets are                                                                 60
                                                                                                                                50
likely to trade better on the back of disappointing US data and more                                                            40
dovish comments from Chairman Bernanke. However, the medium-                                                                    30
                                                                                                                                20
term outlook for EM risk remains challenging.                                                                                   10
                                                                                                                                 0
New Trades                                                                                                                     -10
Credit: Sell Colombia ’21 and sell Colombia 5Y CDS: The positive basis in                                                            J-13 F-13 M-13 A-13 M-13 J-13 J-13 A-13

LatAm appears too high in countries with strong fundamentals and where CDS                                                             Sell Colombia CDS-bond basis          Target          Stop
hedges may be unwound. Colombia is one such country and, by looking at the
basis versus all bonds, we find Col ’21 is furthest away from its historical average.                                         Source: Morgan Stanley Research, Bloomberg

Credit: Buy BNDES '20 versus BRAZIL'19: We look for opportunities in quasi-                                                   Credit: Buy BNDES ’20 vs Brazil ’19
sovereign corporates that offer an attractive pick-up to the underlying sovereign,                                             180
such as BNDES in Brazil. The current spread differential between BNDES ’20                                                     160
and BRAZIL ’19 is at 142bp, versus the historical average pick-up of 80bp.                                                     140
Rates: Receive MXN 5y TIIE: Reduced volatility in both the DM/EM rates space                                                   120
                                                                                                                               100
has improved risk/reward on initiating receivers. The 5y tenor offers the most
                                                                                                                                 80
attractive vol-adjusted carry on the curve, and we target 5.0%, given Banxico’s
                                                                                                                                 60
dovish outlook on the economy and the expected reduction in risk premium.                                                        40
Comments of the Week                                                                                                             20
                                                                                                                                  0
EM Credit – Where Has My Basis Gone? The CDS-bond basis remains as                                                                   M-13           J-13              J-13            A-13
dispersed as ever in EM credit. By calculating the current and historical basis
                                                                                                                                      Buy BNDES'20 vs. BRAZIL'19             Target          Stop
year to date, we identify the outliers. Not only does this highlight relative value
                                                                                                                              Source: Morgan Stanley Research, Bloomberg
trade ideas, but it also guides us how best to implement directional views.
Credit Companion – Selectively Adding Risk in EM IG Yankees: Together                                                         Rates: Receive MXN 5y TIIE
with our colleagues in US credit, we review how EM IG has contributed to US IG                                                 7.0
investor portfolios. US IG corporates’ total return YTD has been -3.2%.
                                                                                                                               6.5
Meanwhile, the EM IG YTD total returns were lower, at -7.9%, but given their
small market weight in the index (3%), the impact was minimal.                                                                 6.0

EMFX – Russia: Crossing the RUBicon: We are short-term constructive on                                                         5.5
RUB, as the broader market stabilises, oil prices remain strong and the CBR                                                    5.0
continues to sell USD. However, we see a weaker RUB by year-end, thanks to
                                                                                                                               4.5
USD strength, CBR easing and declining support from the balance of payments.
                                                                                                                               4.0
EMFX – INR and EM: Policy Responses to Currency Weakness: Measures
                                                                                                                                  J-12      S-12 N-12 J-13 M-13 M-13 J-13                S-13
from the RBI and government have helped INR, but the medium-term outlook is
                                                                                                                                       Receive MXN 5y TIIE               Target          Stop
challenging. India and other EMs need to engage in structural reform to correct
                                                                                                                              Source: Morgan Stanley Research, Bloomberg
external imbalances and improve productivity before we become bullish.
Assessment Changes                                                                                                            Note: Due to the nature of the fixed income
                                                                                                                              market, the issuers or bonds of the issuers
Currencies: We upgrade RUB to neutral/overweight from neutral/underweight.                                                    recommended or discussed in this report may
                                                                                                                              not be continuously followed. Accordingly,
Asset Class Stance                                                                                                            investors must regard this report as providing
       Currencies                   Local Rates              Sovereign Credit             Corporate Credit                    stand-alone analysis and should not expect
                                                                                                                              continuing analysis or additional reports relating
           Hold                         Hold                         Hold                        Hold
                                                                                                                              to such issuers or bonds of the issuers.

Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be
aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider
Morgan Stanley Research as only a single factor in making their investment decision.
For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with
a subject company, public appearances and trading securities held by a research analyst account.
                                                                       MORGAN STANLEY RESEARCH

                                                                       July 22, 2013
                                                                       Global EM Investor




Global EM Cross-Asset Compass
Rashique Rahman, James Lord                                            Exhibit 1
                                                                       AXJ FX Has Lagged the Recovery
EMFX          Sell     Reduce        Hold       Accumulate       Buy
Rates         Sell     Reduce        Hold       Accumulate       Buy      5

Sov Credit    Sell     Reduce        Hold       Accumulate       Buy                                                % deviation of currencies from
                                                                                                                            May 8th levels
Corp Credit Sell       Reduce        Hold       Accumulate       Buy      0


                                                                         -5
   We expect EM assets to trade relatively well in the short
    term, buoyed by renewed dovishness from the Fed. We stick
    to our Hold stance in light of poor EM fundamentals.                -10

   AXJ currencies have lagged the rebound but some could
    catch up, given their generally still strong external positions.    -15




                                                                                 MYR

                                                                                 MXN




                                                                                  AXJ
                                                                                  PLN



                                                                                  ZAR
                                                                                 HUF




                                                                                  INR
                                                                                  IDR




                                                                                 SGD




                                                                                   EM
                                                                                 PEN
                                                                                  TRY
                                                                                   ILS
                                                                                 RUB



                                                                                  CZK




                                                                                 PHP




                                                                                  CLP
                                                                                 COP



                                                                                Latam
                                                                                  BRL




                                                                              CEEMEA
                                                                                  THB
                                                                                 KRW



                                                                                 TWD
   There may be a stronger case for taking a more bullish
    stance in local currency bonds, given attractive valuations.
   Mexico and Colombia remain our preferred picks in credit.
                                                                                       Range                                       Current
                                                                       Source: Bloomberg, Morgan Stanley Research


What We Think                                                          Given the medium-term headwinds for the asset class, the FX
                                                                       recovery is primarily driven by positioning. Once the long USD
We expect sentiment towards EM assets to remain relatively             positions are reduced, there will likely be good opportunities to
positive, helping the bear market rally to remain in place for a       re-establish some bearish positions. Given large external
little longer.                                                         deficits and high inflation, we think that BRL, INR, ZAR, IDR
However, we stick to our more cautious Hold stance across all          and TRY remain among the more vulnerable currencies that
the asset classes, given that we do not expect the rally to be         we would look to sell once the technical backdrop of the
sustained much beyond the summer. Indeed, with EM growth               market improves.
still looking weak, and China’s growth slowdown ongoing, we            While we think that the recovery in EM currencies might be
do not see a compelling reason to be adding substantial risk           short-lived, there may be a stronger case for taking a more
to portfolios for the long term.
                                                                       bullish position on EM local rates. We have maintained our
This is certainly the case for EMFX, which we think will               Hold stance, though we are growing increasingly constructive
continue to trade poorly over the medium term on the back of           on the market, given the recent pullback in DM rates, stable
weaker current account positions and greater uncertainty over          currencies and attractive valuations.
capital flows. Indeed, the global monetary environment is
                                                                       EM rates have continued their gradual recovery, broadly
likely to be less accommodative in light of the expected
                                                                       speaking, spurred by a rally in DM rates, with USTs
tapering of asset purchases by the Fed.
                                                                       recovering to pre-June payroll levels, and in EM currencies,
However, as Exhibit 1 highlights, there has been a wide                which have made up almost a third of their recent losses.
divergence in performance since the EM currency recovery
began on July 5. CEEMEA and LatAm currencies have, on                  As for EM credit, the sovereign credit index is now up nearly
average, retraced around a third of their losses, whereas AXJ          6% since the low on June 24 as credit spreads have gradually
currencies are languishing near the lows. For some currencies          tightened across nearly all credits. Low-beta LatAm countries
in the AXJ region, this may make some sense. We would                  in particular have seen their spreads tighten significantly,
highlight IDR in this respect, which continues to suffer in light      bringing them near spread levels prior to the recent sell-off. If
of its high external imbalances and limited currency                   the index is to see further positive returns, it will therefore
adjustment compared to others. On the other hand, MYR and              need to come from the mid-tier and high-beta countries.
PHP are lagging despite their more robust external positions.          However, as risks remain for now, namely the near-term
With their fundamentals more supportive, there is some scope           outlook for China and the still-challenging fundamentals of
for some AXJ currencies to begin trading better.                       EM, we think it’s too early to move down the credit ladder.


                                                                                                                                                     2
                                                                         MORGAN STANLEY RESEARCH

                                                                         July 22, 2013
                                                                         Global EM Investor




While therefore acknowledging that valuations are no longer              What We’re Watching
as attractive, we maintain Mexico and Colombia as our
                                                                         There are four EM central bank policy meetings this week,
preferred credits as we believe that they offer better resilience
                                                                         with the Central Bank of Turkey (CBT) and the National Bank
against further EM weakness.
                                                                         of Hungary (NBH) both meeting tomorrow. The market is
                                                                         looking for a hike in the overnight lending rate in Turkey,
What Has Changed
                                                                         which would give the CBT a greater degree of flexibility and
Renewed dovish comments from the Fed have placed USD                     scope to protect the currency should external pressures
on the back foot and stabilised the US Treasury market. Given            mount again. A failure to hike at all would likely result in some
the extent of long USD positioning that existed, this was                modest weakness in the currency, in our view. The NBH is
always a risk. The data have hardly been stellar either, with            likely to ease rates by another 25bp, and this is largely
Morgan Stanley’s tracking estimate of real GDP growth down               anticipated by the market.
at 0.4% compared to 1.8% at the end of June.
                                                                         Both the Philippines (Thursday) and Colombia (Friday) are
Exhibit 2                                                                expected to leave rates on hold this week.
MS 2Q GDP Tracking Estimate
                                                                         We continue to believe that the pace of China’s slowdown will
 2.0                                                                     be an important driver for EM asset performance in the
 1.8                                                                     coming weeks and months. Last week’s decision to liberalise
 1.6                                                                     the interest rate market is reform that should have positive
 1.4                                                                     long-term implications. Further measures aimed at cushioning
 1.2                                                                     the slowdown could have a positive effect on the market too.
 1.0

 0.8

 0.6

 0.4                                                        +0.4%
 0.2

 0.0
   Apr-13                   May-13                 Jun-13       Jul-13

Source: Haver Analytics, Morgan Stanley Research




                                                                                                                                        3
                                                                                                       MORGAN STANLEY RESEARCH

                                                                                                       July 22, 2013
                                                                                                       Global EM Investor




Risk Events of the Week
  Date (ET)         Time (ET)            Ccy          Event                                                              Ref period             MS Fcast   Market    Previous
  22-Jul                                 ARS          Consumer Confidence Index                                          Jul                                          44.49
  22-26 Jul         19:00                HUF          Economic Sentiment                                                 Jul                                           -14.8
  22-26 Jul         19:00                HUF          Business Confidence                                                Jul                                            -6.9
  22-26 Jul         19:00                HUF          Consumer Confidence Index                                          Jul                                           -37.3

  23-Jul            1:00                 SGD          CPI YoY                                                            Jun                               1.60%      1.60%
  23-Jul            3:00                 ZAR          Leading Indicator                                                  May                      101                   102
  23-Jul            4:00                 TRY          Foreign Tourist Arrivals YoY                                       Jun                                          17.80%
  23-Jul            4:00                 TWD          Industrial Production (YoY)                                        Jun                     4.20%     2.50%      -0.07%
  23-Jul            4:00                 PLN          Retail Sales (YoY)                                                 Jun                               1.10%      0.50%
  23-Jul            4:00                 PLN          Unemployment Rate                                                  Jun                               13.20%     13.50%
  23-Jul            7:00                 TRY          Benchmark Repo Rate                                                Jul-23                  4.50%      4.50%      4.50%
  23-Jul            7:00                 TRY          Overnight Lending Rate                                             Jul-23                  7.50%      7.50%      6.50%
  23-Jul            7:00                 TRY          Overnight Borrowing Rate                                           Jul-23                  3.50%      3.50%      3.50%
  23-Jul            7:00                 BRL          FGV Consumer Confidence                                            Jul                                           112.9
  23-Jul            8:00                 HUF          Hungary Base Rate Announcement                                     Jul-23                  4.00%      4.00%      4.25%
  23-Jul            9:00                 CLP          PPI (MoM)                                                          Jun                                           0.30%
  23-Jul            9:30                 BRL          Current Account - Monthly                                          Jun                    -$5500M    -$5050M   -$6420M
  23-Jul            9:30                 BRL          Foreign Investment                                                 Jun                                         $3880M
  23-Jul            15:00                ARS          Trade Balance                                                      Jun                     $885M     $997M     $1338M
  23-Jul            19:00                PHP          Budget Deficit/Surplus                                             Jun                                          -13.2B
  23-Jul            21:45                CNY          HSBC Flash Manufacturing PMI                                       Jul                                48.5        48.2

  24-Jul            3:00                 CZK          Consumer & Business Confidence                                     Jul                                            -3.1
  24-Jul            4:00                 ZAR          CPI (all items) (YoY)                                              Jun                     5.70%     5.80%       5.60%
  24-Jul            9:00                 MXN          Bi-Weekly CPI                                                      Jul-15                  0.02%     0.12%      -0.05%
  24-Jul            19:00                KRW          GDP YoY                                                            2Q P                    2.00%     1.90%       1.50%
  24-Jul            21:00                PHP          Total Imports (YoY)                                                May                                           7.40%
  24-Jul            21:00                PHP          Trade Balance                                                      May                                         -$1020M

  25-Jul            4:00                 PHP          Overnight Borrowing Rate                                           Jul-25                            3.50%      3.50%
  25-Jul            4:30                 HKD          Exports YoY%                                                       Jun                               2.50%     -1.00%
  25-Jul            4:30                 HKD          Imports YoY%                                                       Jun                               4.00%     1.70%
  25-Jul            5:30                 ZAR          PPI (YoY)                                                          Jun                     5.10%     5.20%     4.90%
  25-Jul            7:30                 TRY          Industrial Confidence                                              Jul                                          111.8
  25-Jul            7:30                 TRY          Capacity Utilization                                               Jul                                         75.30%
  25-Jul            8:00                 BRL          Unemployment Rate                                                  Jun                     5.90%     5.90%     5.80%
  25-Jul            9:00                 MXN          Global Economic Indicator IGAE                                     May                     2.20%     2.10%      4.55%
  25-Jul            17:00                KRW          SK Consumer Confidence                                             Jul                                           105
  25-Jul            21:45                CNY          MNI July Business Sentiment Indicator
  25-Jul            22:30                THB          Customs Exports (YoY)                                              Jun                                1.35%     -5.25%
  25-Jul            22:30                THB          Customs Imports (YoY)                                              Jun                                8.35%     -2.14%
  25-Jul            22:30                THB          Customs Trade Balance                                              Jun                               -$1825M   -$2304M

  26-Jul            1:00                 SGD          Industrial Production YoY                                          Jun                               -4.10%     2.10%
  26-Jul            3:30                 ZAR          South Africa Unemployment                                          2Q                     25.10%     25.30%    25.20%
  26-Jul            3:30                 THB          Foreign Reserves                                                   Jul-19                                      $170.6B
  26-Jul            4:00                 TWD          Coincident Index (MoM)                                             Jun                                          0.20%
  26-Jul            4:00                 TWD          Leading Index (MoM)                                                Jun                                          0.70%
  26-Jul            9:00                 MXN          Trade Balance                                                      Jun P                             -533.0M   -469.9M
  26-Jul            9:30                 BRL          Outstanding Loans MoM%                                             Jun                                          1.50%
  26-Jul            10:00                MXN          Central Bank Monetary Policy Minutes
  26-Jul            15:00                ARS          Industrial Production (YoY)                                        Jun                     3.70%     4.10%     5.20%
  26-Jul                                 THB          Mfg. Production Index ISIC SA                                      Jun                                         172.59
  26-Jul                                 COP          Overnight Lending Rate                                             Jul-26                  3.25%     3.25%      3.25%
  26-Jul            21:30                CNY          Industrial Profits YTD YoY                                         Jun                                         12.30%
Source: Morgan Stanley Research, Bloomberg; Note: Italics indicates earliest possible release date. Bold indicates a monetary policy meeting.



AXJ Weekly Publication, July 19; CEEMEA Weekly Publication, July 19; LatAm Weekly Publication, July 19



                                                                                                                                                                                4
                                                                                                                                    MORGAN STANLEY RESEARCH

                                                                                                                                    July 22, 2013
                                                                                                                                    Global EM Investor




New Trade: Sell Colombia ’21 and Sell Colombia 5Y CDS                                                                                                                                        Sovereign
                                                                                                                                                                                                Credit
Simon Waever

Rationale                                                                                                                    Risks

The recent EM underperformance saw the sovereign CDS                                                                         Our trade rationale rests on Colombia being more resilient
generally widen out more than the bonds as bond exposures,                                                                   than the rest of EM, meaning that CDS entered into over the
both sovereign and corporate, were hedged using CDS.                                                                         past two months are unwound. An increase of sovereign or
However, while EM fundamentals remain challenging, we                                                                        corporate risk in Colombia could be negative.
believe that the basis should reduce in countries with stronger
                                                                                                                             Levels
fundamentals as hedges are gradually unwound. Mexico and
Colombia are two such countries, in our view.                                                                                We sell $10m of Colombia ’21 and sell $15.5m of CDS
                                                                                                                             protection. This makes the trade PV01-neutral. Note that the
To identify the bond, we compare the current basis to the
                                                                                                                             cash from the short sale would be used to buy US Treasuries.
basis since the start of the year. We find that Colombia ’21
                                                                                                                             The basis in price terms is currently 3.5 points, which
presents the best opportunity to sell as part of a positive basis
                                                                                                                             translates into 47bp. We set a target for this spread to reduce
trade. As described on page 14, the current bond price is
                                                                                                                             down to 10bp while setting a stop-loss at 70bp.
around 107.50 versus a CDS curve-implied price of 104. Not
only does this show that the bond is currently expensive but,                                                                Alternative Trades
looking back since the start of the year, we are also more than
                                                                                                                             A trade with similar rationale works with $10m Mexico ’20
1.5 standard deviations from the average basis.
                                                                                                                             versus $13.5m of Mexico 5Y CDS.
Ideally, the term risk of the bond would be matched with
                                                                                                                             Colombian bonds have recovered the spread widening since
appropriate CDS contracts, but for liquidity reasons we restrict
                                                                                                                             the end of May. However, as we still like Colombia, selling
the trade to the 5Y CDS. Hence, for every $1m of bond
                                                                                                                             outright CDS protection still looks attractive due to the positive
nominal we sell CDS protection on $1.55m in order to match
                                                                                                                             basis.
the PV01 risk of the two legs.

Average Z-Scores of CDS Bond Basis Across Each                                                                               Colombian CDS Bond-Basis Looks Too Wide
Country
                                                                                                                               90
  2.0                                                                                                                          80             Mexico Basis
  1.5                                                                                                                          70             Colombia Basis
                     Z-score
  1.0
                                                                                                                               60
  0.5
                                                                                                                               50
  0.0
                                                                                                                               40
 -0.5
 -1.0                                                                                                                          30
 -1.5                                                                                                                          20
 -2.0                                                                                                                          10
 -2.5
                                                                                                            REPHUN




                                                                                                                                0
                 PHILIP
         INDON




                                                                                  LITHUN



                                                                                                    CHILE



                                                                                                                     COLOM
                                          PERU

                                                 CROATI




                                                                                           TURKEY
                                 POLAND




                                                          RUSSIA

                                                                   MEX

                                                                         BRAZIL
                          SOAF




                                                                                                                              -10
                                                                                                                                Dec-12     Jan-13    Feb-13      Mar-13     Apr-13     May-13      Jun-13

Source: Morgan Stanley Research, Bloomberg                                                                                   Source: Morgan Stanley Research, Bloomberg; Interpolated CDS spread to match the bond
                                                                                                                             maturity




                                                                                                                                                                                                                     5
                                                                                                                                                                                                                                                             MORGAN STANLEY RESEARCH

                                                                                                                                                                                                                                                             July 22, 2013
                                                                                                                                                                                                                                                             Global EM Investor




New Trade: Pick-Up Over the Sovereign in Brazil – Buy                                                                                                                                                                                                                                                                                  Corporate
BNDES ’20 vs. BRAZIL ’19                                                                                                                                                                                                                                                                                                                  Credit
Vanessa Barrett, Kristina Obrtacova

Rationale

After the sharp repricing and increase in volatility in EM                                                                                                                                                                                          We believe that the respective spread over sovereign for
corporate credit over the past couple of weeks, we are now                                                                                                                                                                                          BNDES, which currently stands at 148bp across the curve,
focused on credits with stronger underlying fundamentals                                                                                                                                                                                            offers an attractive entry point, versus the historical average
where the recent moves have created more attractive                                                                                                                                                                                                 pick-up of 80bp.
risk/reward in EM credit. We look for opportunities in quasi-
                                                                                                                                                                                                                                                    Risks
sovereign corporates that offer attractive pick-up to the
underlying sovereign, such as BNDES in Brazil.                                                                                                                                                                                                      Overhang of EBX loans and lack of further disclosure
                                                                                                                                                                                                                                                    regarding the level of this exposure creates further volatility in
Since May 22, which saw the start of the broader sell-off in
                                                                                                                                                                                                                                                    BNDES bonds.
credit markets, BNDES bonds are currently 85bp wider in
spread terms, while similar-duration PETBRA and sovereign                                                                                                                                                                                           Levels
bonds saw 58bp and 12bp spread widening, respectively. The
                                                                                                                                                                                                                                                    The current spread differential between BNDES ’20 and
issue that has weighed the most on BNDES spread
                                                                                                                                                                                                                                                    BRAZIL ’19 is at 142bp and we set the target spread
underperformance has been the ongoing story in OGX/EBX,
                                                                                                                                                                                                                                                    differential at 100bp and the stop-loss at 160bp, which gives
which BNDES has a loan exposure to, reported at close to
                                                                                                                                                                                                                                                    the trade a risk/reward of around 2.3.
BRL 5 billion. While this adds to the overall volatility in the
short term, the EBX loan represents less than 1% of total
assets at BNDES and 10% of the bank’s Tier 1 capital base,
according to a recent Moody’s report. In addition, the 100%
sovereign-owned bank is highly strategic to the government,
and we expect sovereign support to remain strong.

BNDES’20 Trade Close to Their Widest Levels Since                                                                                                                                                                                                   Switch Out of Brazil ’19 into BNDES ’20 as Spread
the Start of the Broader Sell-off at the End of May                                                                                                                                                                                                 Pick-Up Is at Historical Highs

                              200                                                                                                                                                                                                                    350                          BRAZIL 5 7/8 01/15/19                                                   180
                              180                                                                                                                                                                             183                                                                 BNDES 5 1/2 07/12/20
                                                                                                                                                                                       177
                                                                                                                                                                                                                                                                                                                                                          160
                              160                                                                         157             160                                                                                                                        300                          Spread Difference (RHS)
 Spread over Sovereign (bp)




                              140                                                                                                               144                   142
                                                                                         138
                                                                                                                                                                                                                                              126
                                                                                                                                                                                                                                                                                                                                                          140
                              120                                                                                                                                                                                                                    250
                                                                                                                                                                                                                              107
                              100                                                                                                                                                                                                                                                                                                                         120
                                                     91              93
                              80                                                                                                                                                                                                                     200
                              60                                                                                                                                                                                                                                                                                                                          100
                              40                                                                                                                                                                                                                     150
                                                                                                                                                                                                                                                                                                                                                          80
                              20

                               0                                                                                                                                                                                                                     100
                                                                                                                                                                                                                                                                                                                                                          60
                                    BANBRA 4.5 '15



                                                          BANBRA 3.875




                                                                          BANBRA 6 '20



                                                                                               BANBRA 3.875



                                                                                                                BNDES 6.369




                                                                                                                                BNDES 6.5 '19



                                                                                                                                                      BNDES 5.5 '20



                                                                                                                                                                            CAIXBR 2.375




                                                                                                                                                                                             CAIXBR 3.5 '22


                                                                                                                                                                                                                    BANCO 4.125



                                                                                                                                                                                                                                    BANCO 3.875
                                                                                                                    '18




                                                                                                                                                                                                                        '20



                                                                                                                                                                                                                                        '22
                                                                                                                                                                                '17
                                                              '17




                                                                                                   '22




                                                                                                                                                                                                                                                      50                                                                                                  40
                                                                                                                                                                                                                                                                                                            Nov-12
                                                                                                                                                                                                                                                           Jan-12




                                                                                                                                                                                                                                                                                        Jul-12




                                                                                                                                                                                                                                                                                                                     Jan-13




                                                                                                                                                                                                                                                                                                                                                 Jul-13
                                                                                                                                                                                                                                                                    Mar-12



                                                                                                                                                                                                                                                                             May-12




                                                                                                                                                                                                                                                                                                 Sep-12




                                                                                                                                                                                                                                                                                                                              Mar-13



                                                                                                                                                                                                                                                                                                                                        May-13




Source: Morgan Stanley Research, Bloomberg; Spread range from May 22, 2013.                                                                                                                                                                         Source: Morgan Stanley Research, Bloomberg




                                                                                                                                                                                                                                                                                                                                                                6
                                                                                  MORGAN STANLEY RESEARCH

                                                                                  July 22, 2013
                                                                                  Global EM Investor




New Trade: Receive MXN 5y TIIE                                                                                                      LatAm Rates
Robert Habib

Rationale

Although 5y TIIE has already rallied around 70bp from the                  Importantly, our US interest rate strategy team also sees
highs, we believe that the risk/reward profile of initiating               limited upside risks for US Treasury yields in the short term
receivers has now materially improved in Mexico, given the                 (see US Interest Rate Strategy: Time to Hibernate, July 12,
more modest volatility in both the DM and EM rates space,                  2013), particularly on the back of the large amount of shorts
making the 5y tenor also the most attractive point on the curve            added.
on a vol-adjusted carry basis. We target 5.0% – pre-BoJ levels
– given Banxico’s dovish outlook on the economy and the
expected reduction of risk premium.                                        Risks
Indeed, reduced rate volatility and stabilisation in the DM                The main risk to the trade is another material sell-off in US
market should help to lower the risk premium associated with               Treasuries, with a strong 200k non-farm payroll number in two
the TIIE curve (see right-hand Exhibit) – now close to 2011                weeks’ time, for example.
highs, despite inflation expected to decrease close to 4% on
the fall of food prices, according to both Banxico and our
Mexico economics team.                                                     Levels
Furthermore, Banxico’s tone was surprisingly dovish on the                 We target 5.0% for the coming months, and set a tight stop at
balance of risks, especially with respect to the external                  5.75%. The 3m carry/roll-down is 15bp.
environment. It noted a further deceleration in trade as well as
the lower commodity prices as risks to the domestic economy.




5y TIIE Remains Elevated                                                   Risk Premium Close to 2011 Highs

7.5                                                                         1.2                                                                        5

7.0                                                                         1.0
                                                                                                                                                       4.6
6.5                                                                         0.8

6.0                                                                         0.6                                                                        4.2

5.5                                                                         0.4                                                                        3.8
5.0                                                                         0.2
                                                                                                                                                       3.4
4.5                                                                         0.0

4.0                                                                        -0.2                                                                        3
   Jan-11     Jun-11     Nov-11     Apr-12      Sep-12   Feb-13   Jul-13      Jan-11    May-11     Sep-11     Jan-12    May-12   Sep-12   Jan-13   May-13
                              5y TIIE        target
                                                                                                            5yRP        CPI (RHS)
Source: Morgan Stanley Research, Bloomberg                                 Source: Morgan Stanley Research, Bloomberg




                                                                                                                                                             7
                                                                                                        MORGAN STANLEY RESEARCH

                                                                                                        July 22, 2013
                                                                                                        Global EM Investor




Trade Radar (All Open Trades)                                                                                                                         Cross-Asset
Robert Habib, Simon Waever


Local Markets
                                                                              More Compelling
                                                                                                         Recent Opened Trades

                                                                                                         Receive MXN 5y TIIE

                                                                                                         Reduced volatility in both the DM/EM rates space has
                         CZK 2y1y              Buy USD/PLN       Buy USD/UAH 6m
                      Receiver vs. EUR                                NDF                                improved risk/reward on initiating receivers. The 5y tenor
 Trade Score




                                                                                                         offers the most attractive vol-adjusted carry on the curve, and
                                                                              Receive MXN 5y
                 Buy USD/IDR 1m                                                    TIIE                  we target 5.0%, given Banxico’s dovish outlook on the
                      NDF
                                                                                                         economy and the expected reduction of risk premium.
                   Buy 2015 BRL BE                                                                       Buy CZK 2y1y Receiver versus EUR
                       Inflation


                   Less Compelling
                                                                                                         CZK rates have underperformed EUR rates sharply despite the
                                                                                                         CNB forecasting low rates over the next two years and very
                                                 Reward / Risk                                           low inflation. We see their spread tightening back in the
                                             Rates                       FX
                                                                                                         coming weeks.

Credit

                                                                                                         Recent Opened Trades
                                                       Buy SOAF 2022
                                                       vs. SOAF 2041**
                                                                                                         Sell Colombia 5y CDS vs. Sell Colombia ’21
                Switch into KZOKZ                      Buy BNDES'20 vs.
                 '43 from KZOKZ                          BRAZIL'19**                                     The positive basis in LatAm appears too high in countries with
                                                                                      More Compelling
                        '18**               Sell Colombia 5y                                             strong fundamentals and where CDS hedges may therefore be
                                              CDS vs. Sell
                                                                                                         unwound. Colombia is one such country and, by looking at the
  Trade Score




                          Buy Peru 2019 vs. Colombia'21**
                          Brazil Jan-2019**                                                              basis versus all bonds, we find that that Colombia ’21 is
                                                                                                         furthest away from its historical average.

                                                                                                         Buy BNDES ’20 vs. BRAZIL ’19

                                                                                                         We look for opportunities in quasi-sovereign corporates that
                                                                                                         offer attractive pick-up to the underlying sovereign, such as
                    Less Compelling                                                                      BNDES in Brazil. The current spread differential between
                                                                                                         BNDES ’20 and BRAZIL ’19 is at 142bp, versus the historical
                                                     Reward / Risk
                                                                                                         average pick-up of 80bp.

                                            Sovereign Credit             Corporate Credit

*Trade score is a simple sum of four components, with the maximum score for each component given in parentheses. Conviction (4): This is
subjectively assigned based on the trade rationale, with four being the highest conviction level and zero the lowest. Directionality (2): Between
zero and two, with two indicating a non-directional trade and zero indicating a directional trade. Carry (2): A score is given depending on the
trade’s three-month carry. Negative carry gets a value of zero. Positive carry, which is less than the stop-loss of the trade, gets one. Carry in
excess of the stop-loss gets two. Z-Score (2): The difference of the current level of the trade and its mean, divided by the one-year standard
deviation of weekly changes. In any case where mean > current > target, or where mean < current < target, a score of zero is awarded.
Otherwise, a z-score above 4 is given a score of 2, one between 2 and 4 is given a score of 1 and one below 2 is given a zero. Trade Score is
represented below each recommended trade (except for Hedges).




                                                                                                                                                                         8
                                                                                                           MORGAN STANLEY RESEARCH

                                                                                                           July 22, 2013
                                                                                                           Global EM Investor




Trades We Recommend
                                                                                       Entry                                                                Notional        Gross P&L
                                                                                                             Current        Target         Stop
Trade                                                        Status             Date           Level                                                       ($m or DV01*)   bp      US$k
CREDIT
Sovereign Credit
Buy SOAF 2022 vs. SOAF 2041**                                                18-Feb-13          -26             -20            -51          -11                10x5         -8     5
Buy Peru 2019 vs. Brazil Jan-2019**                                          15-Apr-13           -4             -13            -44          16                10x10.5      +10     48
Sell Colombia 5y CDS vs. Sell Colombia'21**                   NEW            25-Jul-13           47             47              10           70               15.5x10        -      -
Corporate Credit
Switch into KZOKZ '43 from KZOKZ '18**                                        1-Jul-13          313             302            270          370                 10         +20    275
Buy BNDES'20 vs. BRAZIL'19**                                  NEW            25-Jul-13          142             141            100          160                10x10        -       -

RATES
Buy 2015 BRL BE Inflation                                                    18-Apr-13         5.53             5.66           6.20        5.00                  10        +13    (123)
CZK 2y1y Receiver vs. EUR                                                     9-Jul-13          49               49             15          60                   40        +0      18
Receive MXN 5y TIIE                                           NEW            17-Jul-13         5.38             5.51           5.00        5.75                  10        -13      1
CURRENCIES
Buy 1y USD/ CNY Put Spread (K = 6, 6.18)                                     26-Apr-13         6.22            6.17                                               10
Buy USD/IDR 1m NDF                                                           10-Jun-13        10,327          10,386          10,500      10,000                 -10              (123)
Buy USD/UAH 6m NDF                                                           14-Jun-13         8.81            8.77            9.50        8.65                  -10              (172)
Buy USD/PLN                                                                  20-Jun-13         3.29            3.20            3.40        3.14                  -10              (293)




Trades Closed This Week
                                                                                       Entry                           Exit                                 Notional        Gross P&L
Trade                                                        Status             Date           Level           Date           Level                        ($m or DV01*)   bp      US$k

CREDIT
Sovereign Credit
Buy Mex 2044 vs. Indo 2043                                   Target           8-Jul-13          -38         17-Jul-13          -77                              9x10       +39    512

Corporate Credit


RATES


CURRENCIES



**Trade spreads (entry, current, target and stop) are displayed in z-spreads, all other credit trades are displayed in yield (bp). Gross P&L in always in yield terms
Gross P&L includes carry but excludes transaction costs. These are hypothetical, not actual, trades. Past performance is no guarantee of future results.
Source: Morgan Stanley Research


For a longer history of our recommended trades, see Recommended Trade Summary, July 12, 2013.




                                                                                                                                                                                          9
                                                                         MORGAN STANLEY RESEARCH

                                                                         July 22, 2013
                                                                         Global EM Investor




Credit
 Sovereign       Sell    Reduce        Hold      Accumulate        Buy   Last week saw over US$5 billion issuance, coming mostly
 Corporate       Sell    Reduce        Hold      Accumulate        Buy   from IG financials in LatAm and CEEMEA. Total issuance
                                                                         year-to-date amounts to US$193 billion, which represents
   We maintain our Hold stance in EM sovereign and corporate
                                                                         nearly 70% of total issuance from last year. July saw over
    credit. This stance signals our acknowledgement of an
    improved risk/reward profile for EM risky assets despite the         US$10 billion of issuance so far, and we expect the issuance
    challenging medium-term fundamentals.                                pipeline to remain relatively busy, reflecting the current
                                                                         positive backdrop for risk markets more broadly.
   We remain overweight low-beta LatAm despite the recent
    rally towards tighter ends of recent spread ranges. While            Exhibit 1
    mid-tier and high-beta credits still have space to rally further,    Relative Assessment and 3m Performance
    we believe it’s too early to move down the credit ladder.
                                                                                              −          o          +        CDS 3m perf. bp
   Instead, we prefer to switch into corporates, where we stay
    positioned in quasi-sovereign issuers offering relative pick-up             COL                                                       +33
    over sovereign names.                                                       MEX                                                       +26
                                                                                KAZ                                                       +33
Sovereign Credit                                                                TURK                                                      +61
The sovereign credit index is now up nearly 6% since the low                    PER                                                       +37
on June 24 as credit spreads have gradually tightened across                    PHI                                                       +19
nearly all credits. Low-beta LatAm countries in particular have
seen their spreads tighten significantly, bringing them near                    EGY                                                       +158
spread levels prior to the recent sell-off. If the index is to see              HUN                                                       -6
further positive returns, it will therefore need to come from the
mid-tier and high-beta countries. However, as risks do remain
                                                                                LIT                                                       +16
for now, namely the near-term outlook for China and the still-                  RUS                                                       +25
challenging fundamentals of EM, we think it’s too early to
move down the credit ladder.
                                                                                SOAF                                                      +35
While therefore acknowledging that valuations are no longer
                                                                                UKR                                                       +172
as attractive, we maintain Mexico and Colombia as our                           CRO                                                       +9
preferred credits as we believe that they offer better resilience               ARG*                                                      -115
against further EM weakness.
                                                                                BRA                                                       +52
Corporate Credit                                                                VEN                                                       +114
We maintain our Hold stance in corporate credit. We saw                         CHL                                                       +17
another week of spread tightening in both corporate and EM                      INDO                                                      +77
sovereign credit spreads; however, sovereigns did outperform
corporates. On a regional basis, LatAm corporates
                                                                                MAL                                                       +42
outperformed, while Asia was the weakest. On a sector basis,
M&M outperformed, while banks was the weakest.                                               Current               Prior
                                                                         Source: Morgan Stanley Research; *We allocate all exposure to the Par bond.
Weaker technicals into the summer: The relative stability
we have seen in EM credit markets has eased the outflows
compared to June. However, retail outflows remain highly
sensitive to performance, and we expect this to be a source of
volatility. The primary market is regaining its momentum, in
line with our expectations.



                                                                                                                                                                                       10
                                                                                                                                MORGAN STANLEY RESEARCH

                                                                                                                                July 22, 2013
                                                                                                                                Global EM Investor




Local Rates
   Sell                  Reduce                        Hold                Accumulate                                Buy        Other markets have lagged, either due to central bank
                                                                                                                                tightening and currency weakness, as in the case of Indonesia
    We maintain our Hold stance in local rates, though we are
                                                                                                                                and Turkey, or simply due to illiquidity, as in the case of the
     growing increasingly constructive on the market, given the
                                                                                                                                Philippines and Peru. Given the reduction in external market
     recent rally in DM rates and EM currencies, and attractive
     valuations.
                                                                                                                                pressures, these markets could pull back sharply in the near
                                                                                                                                term.
    Local markets that have lagged in the recent recovery, such
     as Turkey, could pull back sharply if broader markets                                                                      This is particularly the case for Turkey, where the market has
     continue to stabilise.                                                                                                     priced in significant tightening (around 200bp in six months),
                                                                                                                                yet the CBT continues to provide liquidity at low rates (around
                                                                                                                                5% at the moment). The central bank meets this week; our
We maintain our Hold stance in local rates, though we are                                                                       economist expects it to raise the upper end of the interest rate
growing increasingly constructive on the market, given the                                                                      corridor by 100bp to 7.50%.
recent pullback in DM rates, stable currencies and attractive
                                                                                                                                Exhibit 2
valuations.
                                                                                                                                Relative Assessment and Recent Performance
EM rates have continued their gradual recovery, broadly
speaking, spurred by a rally in DM rates, with USTs
                                                                                                                                                 −      o         +   3m Perf of 5y Bonds, bp
                                                                                                                                RUB                                                    +31
recovering to pre-June payroll levels, and in EM currencies,
which have made up almost a third of their recent losses.                                                                       MXN                                                    +77
                                                                                                                                HUF                                                     +4
Exhibit 1
Local Bond Market Returns, %                                                                                                    PLN                                                    +44
                                                                                                                                ILS                                                    -22
  5
                                                                                                                                RON                                                     -2
  0                                                                                                                             CZK                                                    +31
                                                                                                                                COP                                                   +128
  -5
                                                                                                                                KRW                                                    +51
 -10
                                                                                                                                INR                                                    +63
                                                                                                                                ZAR                                                   +130
 -15                                                                                                                            NGN                                                     +233
                                                                                                                                BRL                                                   +144
 -20
                                                                                                                                TRY                                                   +262
                                                                                MXN
                                                                    INR




                                                                                                  ZAR




                                                                                                                          IDR
       ILS




                                     THB




                                                              CZK




                                                                                                        TRY
             RON




                                           MYR
                                                 PLN




                                                                                            NGN




                                                                                                              PEN
                               BRL
                   HUF
                         RUB




                                                        CLP




                                                                                      COP




                                                                                                                    PHP
                                                                          KRW




                                                                                                                                PHP                                                      +89
                                           May-Jun                   Jun-Jul                Total
                                                                                                                                CLP                                                     -8
Source: Morgan Stanley Research, Bloomberg
In some markets, mainly in CEEMA, the recovery is nearly                                                                        PEN                                                   +138
complete. Israel, Hungary and Russia are either up, or down                                                                     MYR                                                    +37
less than 1%, since the beginning of May when the EM sell-off                                                                   THB                                                    +25
began; we are overweight all three.                                                                                             IDR                                                    +242
                                                                                                                                Source: Morgan Stanley Research
Hungary is likely to continue to perform well, recent
speculation regarding impact of FX loan conversion measures
notwithstanding, as the end of the NBH’s easing cycle does
not seem to be in sight yet. We expect the central bank to cut
rates for the 12th time in a row by 0.25% to 4.00% this week.



                                                                                                                                                                                                                                   11
                                                                       MORGAN STANLEY RESEARCH

                                                                       July 22, 2013
                                                                       Global EM Investor




Currencies
  Sell       Reduce          Hold        Accumulate             Buy    the more pronounced role of policy-makers within EM. A key
                                                                       beneficiary of high oil prices has been RUB, which has traded
   EM currencies can make further near-term gains on the back
                                                                       well compared to its beta in past corrections. As such, we
    of the dovish Fed, more scope for expansionary policy in
                                                                       upgrade our stance on RUB (see below and page 18).
    Japan and a recent normailisation of the CNY IRS curve –
    amid still heavily short EM positioning.                           On the policy front, developments in India and Turkey are of
   However, the recovery is likely to remain choppy and uneven        note. In India, several measures have been announced from
    as currencies are driven by positioning adjustments on the         the RBI and government, but we do not think that announced
    one hand and a negative medium-term outlook on the other.          policy steps will be enough to alter the medium-term uptrend
                                                                       in USD/INR (see page 24). Meanwhile in Turkey, our
   Still high oil prices keep us constructive RUB in the near term,
    while we are mindful of policy responses in INR and TRY, but       economist sees a strong possibility that the CBT raises the
    look for attractive levels to establish USD longs.                 upper end of the interest rate corridor on Tuesday. Following
                                                                       Governor Basci’s statement last week, the market has priced
Three developments may help EM currencies continue to                  in a rise in the upper end of the corridor of 50-100bp. In the
make gains versus USD over the near term amid still heavily            near term, a positive external backdrop may help to support
short positioning in the asset class. First, Bernanke’s more           TRY, but if the CBT does not increase its flexibility to raise
dovish testimony last week sets the stage for a more firmly            rates via the corridor mechanism, then we would expect TRY
grounded USD correction in our G10 colleagues’ view. He                to weaken a little in the short term, with downside medium-
emphasised that the decision-making path for the Fed will              term risks.
remain data-dependent, thereby increasing the risk of tapering
                                                                       Exhibit 2
being pushed back. Given this focus, data releases this week
such as durable goods orders will be watched closely.                  Relative Assessments
Second, with the LDP gaining more seats in the Upper House                          −    o     +     3m Perf vs USD*
                                                                       CNY                                         0.4%
elections in Japan, we believe that PM Abe is better placed to
                                                                       MXN                                       -3.2%
pass further expansionary economic policies. This should help                                                      0.9%
                                                                       ILS
to support broader risk markets as optimism about Japan’s              PEN                                       -5.0%
growth prospects builds. Third, in China over the last week or         RUB                                       -3.5%
so we have seen a continued normalisation of the CNY IRS               RON                                       -1.0%
curve, helping to improve sentiment towards EM.                        COP                                       -2.6%
                                                                       PHP                                       -5.0%
All these factors in combination with what we believe to be a          SGD                                       -2.4%
healthy technical backdrop for EM currencies should                    TWD                                       -1.1%
                                                                       INR                                       -9.1%
encourage further bouts of strength in EMFX. However, we
                                                                       CLP                                       -6.4%
also believe that price action will remain choppy, as markets          KRW                                       -0.9%
will be driven by all these near-term drivers on the one hand,         BRL                                       -12.4%
and what we believe remains a negative medium-term outlook             CZK                                        0.1%
for the asset class on the other. In addition to being a choppy        PLN                                       -0.9%
                                                                       MYR                                       -5.2%
recovery for EM currencies, we believe it will be an uneven
                                                                       HUF                                        3.0%
one, whereby currencies with comparatively worse                       THB                                       -6.2%
fundamentals and larger external imbalances will lag behind.           TRY                                       -6.7%
For example, currencies such as BRL, INR and TRY have all              IDR                                       -4.2%
underperformed our EM currency index (made of 23 EM                    ZAR                                       -8.5%
                                                                       Source: Morgan Stanley Research; *CEE performance is versus EUR
currencies) over the last month or so. Meanwhile, currencies           Assessment Changes
with better contained current account deficits or surpluses
                                                                       We upgrade RUB to neutral/overweight from neutral/underweight:
have performed better, such as ILS, HUF and CZK.
                                                                       Strong oil combined with continued USD selling by the CBR should
We are also mindful of the distorting impact on currency               continue to support RUB in the near term, with the RUB basket
performance caused by persistently high oil prices, as well as         recovering back towards the middle of the corridor.



                                                                                                                                                               12
           MORGAN STANLEY RESEARCH

           July 22, 2013
           Global EM Investor




Comments




                                     13
                                                                           MORGAN STANLEY RESEARCH

                                                                           July 22, 2013
                                                                           Global EM Investor




EM Credit: Where Has My Basis Gone?
Simon Waever                                                               Special care is also needed due to high dollar prices…
                                                                           EM yields have dramatically reduced in the past ten years.
     The CDS-bond basis remains as dispersed as ever in EM                This has led to large price discrepancies of bonds from the
      credit. The recent sell-off has generally pushed the basis           same credit trading at similar yields but issued with very
      wider, with the CDS spread widening more versus cash as it
                                                                           different coupons – e.g., Col ’20 trades at a price of 150
      is used to hedge both sovereign and corporate exposure.
                                                                           whereas Col ’21 trades around 105.
     By calculating the current and historical basis since the start
      of the year, we identify the outliers. Not only does this            Exhibit 2
      highlight relative value trade ideas but it also guides us how       Basis Important to Both RV and Directional Calls
      best to implement directional views.
                                                                             80
     We see the positive basis in Mexico and Colombia reducing
                                                                             60
      and hence sell the basis, namely selling Mexico ’20 + selling                              Average Basis, bp
      Mexico CDS or selling Colombia ’21 + selling Columbia CDS.             40
                                                                             20

The basis should in theory be zero… The CDS-bond basis                        0
is a measure of the difference in spreads between the credit                -20
default swap (CDS) spread and the implied spread of a similar               -40
maturity-bond on the same credit. Since these two                           -60
instruments both measure the credit risk, the spread should in
                                                                            -80




                                                                                                                             REPHUN
                                                                                                PHILIP
                                                                                       INDON



theory be zero.                                                                                           LITHUN




                                                                                                                                                                 CHILE




                                                                                                                                                                                            COLOM
                                                                                                                                                CROATI

                                                                                                                                                          PERU
                                                                                                                                      TURKEY
                                                                                                                   POLAND




                                                                                                                                                                                   MEX



                                                                                                                                                                                                    RUSSIA

                                                                                                                                                                                                             BRAZIL
                                                                                                                                                                          SOAF
…yet this is rarely the case in EM: The first problem EM
runs into is the much-reduced liquidity versus the EU and US
credit markets. Additionally, in Europe, a ban of naked short                2.0
selling CDS on sovereigns within the EU area keeps CDS                       1.5
                                                                                                     Z-score
spreads artificially low, resulting in a negative basis (see EM              1.0
CDX and SovX CEEMEA: Impact of CDS Ban, November 1,                          0.5
2012, for more details).                                                     0.0

Exhibit 1                                                                   -0.5
CDS-Bond Basis Differentiation Across Regions                               -1.0
                                                                            -1.5
   60
            CDS-bond basis (Average across regions, bp)                     -2.0

   40
                                                                            -2.5
                                                                                                                                                                                                    REPHUN
                                                                                                 PHILIP
                                                                                        INDON




                                                                                                                                                                          LITHUN



                                                                                                                                                                                            CHILE



                                                                                                                                                                                                             COLOM
                                                                                                                                       CROATI
                                                                                                                              PERU




                                                                                                                                                                                   TURKEY
                                                                                                                    POLAND




                                                                                                                                                 RUSSIA

                                                                                                                                                          MEX

                                                                                                                                                                 BRAZIL
                                                                                                           SOAF




   20


    0                                                                      Source: Bloomberg, Morgan Stanley Research. Scores are a simple average across each
                                                                           country since the start of 2013.

  -20                                                                      …meaning that bond z-spreads are not sufficient:
                                                                           Whereas the z-spread of the bond has traditionally been used
  -40
                                                                           to compare to the CDS, this is not appropriate given that
               LATAM       ASIA      CEEMEA (EEA)       CEEMEA (Non EEA)
  -60
                                                                           many bonds now trade far away from par. Instead, we use the
    Jan-13      Feb-13    Mar-13      Apr-13   May-13    Jun-13   Jul-13   CDS curve and the Libor curve to discount the bond cash
Source: Bloomberg, Morgan Stanley Research                                 flows in order to get a CDS-implied bond price. The difference
                                                                           in prices is then taken as the basis. Note that for illustrative
Another factor relates to the lack of CDS on EM corporate
                                                                           purposes we show this price difference in basis points in the
bonds. For countries with large corporate exposures, e.g.,
                                                                           charts.
Brazil and Russia, this leaves the sovereign CDS as one of
the few available proxy hedges. This pushes the CDS spread
wider and leads to a positive basis.


                                                                                                                                                                                                              14
                                                                        MORGAN STANLEY RESEARCH

                                                                        July 22, 2013
                                                                        Global EM Investor




We identify outliers… We calculate the basis in price terms             We highlight Mexico and Colombia as two countries whose
across all bonds. Furthermore, we also calculate the weekly             fundamentals are strong enough to outperform in case of
basis over the past six months. This allows us to calculate the         further EM weakness. The z-scores help us identify the two
z-score of the basis and identify where the basis truly looks to        specific bonds that we recommend using to implement the
be an outlier. This is of particular importance given the               view of a reducing positive basis.
technicalities described previously which mean that the
                                                                           Sell Mexico ’20 and sell Mexico CDS;
average basis cannot always be expected to be zero. For
example, while Brazil has the widest basis, it has a z-score of            Sell Colombia ’21 and sell Columbia CDS.
only 0.6 (see Exhibit 2). In Exhibit 3 we highlight the top and         Specifically, the trades would be implemented by using the
bottom ten z-scores of the CDS-bond basis. Note that we only            cash proceeds from the EM bond to purchase US Treasuries
include bonds with a maturity between 4y and 12y. Bonds with            in addition to selling CDS protection. A mix of 5Y, 7Y and 10Y
a maturity below 4y struggle with liquidity. For bonds with a           CDS contracts would be used to match the risk. Admittedly,
maturity above 12y the maturity mismatch against available              liquidity may suffer as we move away from the 5Y CDS,
CDS is too large, in our view.                                          meaning that we could also use just the 5Y CDS contract but
…to reveal where relative value opportunities are... The                increase the nominal amount. While this will lead to a slight
recent EM underperformance, both sovereign and corporate,               maturity mismatch, it will also increase the expected roll-down.
saw the sovereign CDS widen out more than the bonds as                  …and also to help guide directional calls: While EM
bond exposures were hedged using CDS. However, while EM                 liquidity struggles at times, meaning that it may be difficult to
fundamentals remain challenging, we believe that the basis              enter into relative value basis trades, the basis also plays a
should reduce in countries with stronger fundamentals as                role in directional calls. A positive basis, e.g., for Colombia,
hedges are gradually unwound.                                           means that the CDS is cheaper than the bonds. Therefore, a
                                                                        bullish view on Colombia is better expressed through the CDS
                                                                        as it may provide more upside. Conversely, a bearish view
                                                                        would be better implemented through the bonds.
Exhibit 3
Top and Bottom Ten CDS-Bond Basis Z-Scores
                            Bond                  Bond   Price CDS Imp. Price Basis (PV) Basis (bp) Z-score
                            MEX 5 1/8 01/15/20           113.5           111.2         2.3        36     1.9
                            COLOM 4 3/8 07/12/21         107.4           103.9         3.5        48     1.6
                            CROATI 6 5/8 07/14/20        109.4           108.0         1.4        23     1.5
                            BRAZIL 5 7/8 01/15/19        115.6           112.8         2.8        52     1.3
                            CHILE 2 1/4 10/30/22          92.2             89.3        2.9        38     1.3
                            TURKEY 2.803 03/26/18         96.9             99.2       -2.3       -54     1.2
                            PHILIP 9 7/8 01/15/19        135.7           136.7        -1.1       -18     1.2
                            PHILIP 4 01/15/21            106.2           104.9         1.3        18     1.1
                            TURKEY 7 06/05/20            118.1           118.1         0.0         0     0.9
                            COLOM 8 1/8 05/21/24         136.2           133.7         2.5        24     0.9

                            Bond                  Bond Price CDS Imp. Price Basis (PV) Basis (bp) Z-score
                            INDON 3 3/4 04/25/22        93.1             96.3       -3.2       -47    -1.9
                            INDON 11 5/8 03/04/19      136.8           144.7        -7.9      -131    -1.8
                            PHILIP 6 1/2 01/20/20      120.4           123.9        -3.5       -53    -1.8
                            INDON 5 7/8 03/13/20       108.6           113.4        -4.7       -79    -1.7
                            RUSSIA 11 07/24/18         139.2           141.8        -2.6       -46    -1.5
                            MEX 8 09/24/22             133.7           133.7         0.0         0    -1.5
                            BRAZIL 8 3/4 02/04/25      142.8           137.5         5.4        47    -1.2
                            CHILE 3 7/8 08/05/20       105.9           106.8        -0.9       -13    -1.0
                            SOAF 5 1/2 03/09/20        109.7           109.5         0.2         4    -1.0
                            BRAZIL 4 7/8 01/22/21      109.6           107.1         2.4        35    -0.9
Source: Bloomberg, Morgan Stanley Research



                                                                                                                                     15
                                                                      MORGAN STANLEY RESEARCH

                                                                      July 22, 2013
                                                                      Global EM Investor




Credit Companion: Selectively Adding Risk in EM IG Yankees
Peter Mallik (1 212) 761 0896                                         has caused investors to scrutinise their holdings more closely.
Vanessa Barrett                                                       Second, a further downturn in China growth is likely to have
Simon Waever                                                          knock-on effects in the rest of EM.

This is an excerpt from Credit Companion: Selectively Adding          See EM Strategy Update: Tilting to Neutral Stance, June 28,
Risk in EM IG Yankees, July 15, 2013.                                 2013.

    Total returns a rates story: US IG corporates’ negative          EM Yankees Market Has Weighed Down Index
     YTD total returns (-3.2%) are mainly due to the rates curve      Excess Returns
     bear-steepening. Meanwhile, EM IG Yankees’ YTD total
     returns were lower, at -7.9%, but given Yankees’ low market      US IG total returns YTD are approximately -3.2%: For the
     weight in the index (3%), the impact was minimal.                US IG index, almost all of the negative return has occurred
    Excess returns weighed down by EM IG Yankees: US IG              due to the bear-steepening in the rates curve. In other words,
     corporates’ YTD returns above duration-matched USTs have         credit risk has not materially repriced higher overall.
     been weakly positive (+0.6%) as spreads remain positively
                                                                      EM IG corporates’ total returns YTD are around -7.9%, but
     range-bound. Meanwhile, EM credit risk has re-priced
     higher, leading to a -3.8% YTD return and cutting the index
                                                                      their market weight is only ~3% of the index: As such, the
     return by 20% (~0.1%) despite its small weight.                  impact of EM on the index is marginal (with the bulk coming
                                                                      from LatAm), contributing only -0.3% to the index YTD total
    Within EM IG Yankees, long-maturity, lower-quality and
                                                                      return.
     LatAm lagged: So far, EM IG Yankees 10+y sector and
     BBBs have underperformed similar US IG corp sectors, by          Exhibit 1
     6.9% and 5.9% total returns and 7.7% and 5.1% excess
                                                                      EM IG Yankees’ Contribution to Total Returns Small
     returns, respectively. Meanwhile, LatAm IG Yankees
     performed the worst within EM regions with a -8.3% total             0.0%
     return and -4.4% excess return.
                                                                         -0.5%

                                                                         -1.0%
Maintain OW on IG as our models ‘rally’: We maintain an
                                                                         -1.5%                                                      Total Return
Overweight recommendation on IG credit as index spreads
have rallied almost to our model’s year-end base case spread             -2.0%

level of 143bp (with a bull-bear range of +/- ~50bp). Our                -2.5%
excess return forecast remains at 1.3% for the year.                     -3.0%

Beware rates volatility: We have noted previously that a                 -3.5%
sharp move higher in yields was the biggest risk to the IG                         US IG Corps      Non EM Corps        EM Corps   Latam Corps
credit market in 2013, given the performance asymmetry and            Source: Morgan Stanley Research, Bloomberg, Yield Book
liquidity dynamics. As such, Treasury yield stability is a
                                                                      US IG excess returns YTD are around +0.6% YTD:
necessary component for credit outperformance (see Credit
                                                                      Spreads continue to be positively range-bound despite the
Strategy Playbook: Rates Revaluation, July 16, 2013).
                                                                      rates movements in the IG market. This makes sense in the
We maintain our tactical Equal-weight call on EM credit:              context of potentially higher growth and earnings, low inflation,
Since mid-May, investors have re-priced the EM asset class            strong balance sheets and natural buyers of long-dated risk.
to factor in risks from i) Increased volatility; ii) Poor secondary
                                                                      The EM credit risk component in US IG indices has
market liquidity; iii) Less favourable fundamentals; and iv) A
                                                                      deteriorated as YTD excess returns are -3.8%, bringing
possible negative feedback loop between a stronger USD and
                                                                      down the US IG index return: Since the YTD US IG excess
upward pressure in local rates with a possible negative impact
                                                                      return was relatively small, the negative EM sector excess
on EM growth.
                                                                      return contributed a sizeable -0.1% to the index. In other
Medium-term risks limit scope for a sustained recovery in             words, the EM IG Yankees sector cut excess returns for the
asset prices: The prospect of less abundant global liquidity          index by ~20%.


                                                                                                                                                 16
                                                                             MORGAN STANLEY RESEARCH

                                                                             July 22, 2013
                                                                             Global EM Investor




Exhibit 2                                                                    Exhibit 4
But for Excess Returns, EM Sector Is Significant                             EM Yankees vs. US IG Index Returns by Rating
        0.9%                                                                      0%
        0.8%
                                                                                 -1%
        0.7%
        0.6%                                                                     -2%
        0.5%
        0.4%                                                 Excess Return       -3%
        0.3%
        0.2%
                                                                                 -4%
        0.1%                                                                     -5%
        0.0%
       -0.1%                                                                     -6%        Total Returns
       -0.2%                                                                                Excess Returns
                                                                                 -7%
                US IG Corps     Non EM Corps      EM Corps   Latam Corps
                                                                                                  AA                      A                  BBB
Source: Morgan Stanley Research, Bloomberg, Yield Book
                                                                             Source: Morgan Stanley Research, Bloomberg, Yield Book
Non-financials and financials have underperformed
                                                                             Overall corporates slightly outperformed sovereigns:
equally: Both fins and non-fins have underperformed their US
                                                                             Within EM Yankees, sovereigns produced -9.1% and -4.9%
IG counterparts by ~4% YTD for total and excess returns.
                                                                             total and excess returns and EM corporates produced -7.9%
However, non-financials is a much larger sector (~US$98
                                                                             and -3.8% total and excess returns, respectively.
billion versus ~US$6 billion).
                                                                             LatAm performed the worst: LatAm sovereigns and
Mainly long-dated Brazilian and Mexican quasi-sovereign
                                                                             corporates returned -5.7% and -4.4% excess return YTD
and benchmark bonds have spearheaded the move lower:
                                                                             (-10.8% and -8.3% total return YTD).
Nearly half (6 of 14) of the bonds issued with large notionals
(>US$1 billion) have logged double-digit excess return losses.               Within LatAm, the largest issuer countries spearheaded
These issuers include Vale, Petrobras and America Movil.                     the move lower: Both Brazil and Mexico sovereigns and
                                                                             corporates (the two largest Yankee issuer countries)
Exhibit 3
                                                                             contributed greatly with -11% and -9% total returns YTD.
EM Yankees vs. US IG Index Returns by Maturity
                                                                             Exhibit 5
     0%
                                                                             EM IG Yankee Returns by Region
    -1%
    -2%                                                                           0%

    -3%                                                                          -2%
    -4%
                                                                                 -4%
    -5%
    -6%                                                                          -6%

    -7%                                                                          -8%
               Total Returns                                                                   Total Return
    -8%
               Excess Returns                                                   -10%           Excess Return
    -9%
                1-3y              3-7y              7-10y          10+y         -12%
Source: Morgan Stanley Research, Bloomberg, Yield Book                                   CEEMEA         Asia     CEEMEA Asia Sovs        Latam     Latam
                                                                                          Corps        Corps      Sovs                   Corps      Sovs
For maturity and rating the long end has underperformed
                                                                             Source: Morgan Stanley Research, Bloomberg, Yield Book, TRACE
the most… The average OAS change for the 10y+ maturity
sector is ~+60bp YTD, while for the index, it was only +14bp.                EM IG Yankees’ realised return volatility was significantly
In fact, the EM IG Yankee >10y maturity sector has returned                  higher than the index: The EM sector generated 4.8%
6.9% and 7.7% less relative to its index counterpart in terms                annualised monthly return vol versus 2.8% for the US IG
of total and excess returns, respectively.                                   index. Due to the small size of the sector, the incremental vol
                                                                             from the sector was only ~0.1%.
…as have lower-quality EM IG Yankees: BBB EM Yankees
had a spread sell-off of +~60bp versus an US IG index sell-off               Portfolios with higher EM allocations risk greater return
of only 10bp. In fact, the EM IG Yankee BBB sector has                       volatility: Although we still like certain pockets in EM, we are
returned 5.9% and 5.1% less relative to its index counterpart                cautious with an Equal-weight recommendation overall, in part
in terms of total and excess returns, respectively.                          because of greater volatility of returns.


                                                                                                                                                           17
                                                                        MORGAN STANLEY RESEARCH

                                                                        July 22, 2013
                                                                        Global EM Investor




Russia: Crossing the RUBicon
James Lord, Jacob Nell, Alina Slyusarchuk                               Not so high-beta: RUB traded well compared to its historical
                                                                        beta during the recent EM correction. Many of the factors that
                                                                        caused this better performance are likely to remain in place,
    We are short-term constructive on RUB, as the broader
                                                                        which should prompt some continued strength in the currency
     market stabilises, oil prices remain strong and the CBR
     continues to sell USD. However, we see a weaker RUB by             in the near term.
     year-end, thanks particularly to USD strength and CBR              We see some reasons for being constructive on RUB in
     easing. Fundamentally, with declining support from the
                                                                        the short term… Oil prices remain strong and the Central
     balance of payments, we no longer expect real RUB
                                                                        Bank of Russia (CBR) continues to sell USD. The broader
     appreciation.
                                                                        market should continue to trade well in the short term too on
    RUB has performed in line with the broader market                  the back of recent dovish commentary from the Fed and a
     during the recent EM currency correction, which is atypical of     normalisation of liquidity conditions in China, particularly amid
     its status as a high-beta currency.                                the backdrop of still-heavy long USD/EM positioning (see
    Short-term constructive. We think that strong oil prices,          Global EM Investor: Some Kind of Normal, July 15, 2013).
     less risk from fixed income outflows related to Fed tapering,      Further near-term relief for broader EM assets should help
     the CBR’s sizeable USD selling and prior underperformance          RUB trade well in the short term too and we see potential for
     explain why RUB performed in line with peers, rather than          the RUB basket to move to around the middle of the corridor
     underperforming during the May-June correction.                    (35.25) over the coming weeks, at which point risk/reward of
      Thus, RUB may stay strong in the short term, particularly         being long RUB would no longer look attractive.
      against a backdrop of greater stability for the broader market.
                                                                        …but expect a weaker RUB before year-end: However, we
      Continued dovish Fed comments plus a normalisation of
                                                                        see a number of risks on the horizon. EM currencies in
      financial conditions in China should contribute to EMFX
                                                                        general could come under pressure again, given the ongoing
      strength and the RUB basket trading to the middle of the
      corridor (around 35.25, or a USD/RUB rate of 31 assuming          growth slowdown in the China (though Russia could be
      stable EUR/USD) over the summer.                                  somewhat insulated from this). Furthermore, renewed USD
                                                                        strength, CBR easing and MinFin USD purchases all mean
    However, a number of risks could undermine RUB in 4Q:
                                                                        that any gains will probably be limited to around the middle of
     For instance, the significant easing of policy we expect from
                                                                        the intervention corridor, and RUB could weaken again into
     the CBR. The start of Ministry of Finance USD purchases in
                                                                        year-end. We target USD/RUB 33 by year-end.
     August may also contribute, although this could be mitigated
     by additional CBR selling of USD, as well as the relatively        Crossing the RUBicon: More fundamentally, declining
     small size of the purchases.                                       support for RUB from the Russian balance of payments – as
    Crossing the RUBicon: More fundamentally, declining                the declining current account surplus is now balanced by
     support for RUB from the Russian balance of payments               private sector capital outflows – means we have switched
     means we have switched from expecting real RUB                     from expecting real RUB appreciation to a more neutral
     appreciation to a more neutral position on the currency. This      position on the currency. This implies that RUB is likely to
     implies that RUB is likely to weaken and the corridor to keep      weaken in nominal terms and the corridor is likely to keep
     shifting higher to balance higher Russian inflation.               shifting higher to offset the impact of Russian inflation being
    Finally, broader market strength could lose steam:                 higher than US and eurozone inflation, and keep RUB broadly
     Fundamentals in EM are weak, with China’s growth                   flat in real terms.
     slowdown weighing on the asset class. Eventual Fed
     tapering could lead to more concerns about fixed income            Why Has RUB Traded So Well?
     flows to EM. It is unlikely that RUB will be fully immune from
     this process. We target USD/RUB 33 by year-end.                    RUB has performed in line with the broader market during the
                                                                        recent EM currency correction. Our index of 23 EM currencies
                                                                        depreciated by 6.0% versus USD during the EM currency
                                                                        correction that started on May 8, compared with 6.4% for
                                                                        RUB.



                                                                                                                                      18
                                                                                                                                                 MORGAN STANLEY RESEARCH

                                                                                                                                                 July 22, 2013
                                                                                                                                                 Global EM Investor




During the last four EM currency corrections (which we define                                                                                    happens at a time of global growth concerns and commodity
here as a larger than 5% depreciation in our index versus                                                                                        price weakness. The strength of oil causes a headache for the
USD), RUB has depreciated by over 10%, compared to a                                                                                             rest of EM, which on the whole comprises net energy
market average of 7.3%. In other words, RUB typically has a                                                                                      importers, but it is a boon for Russia and explains some of the
high beta to the market during corrections, but on this                                                                                          resilience of the currency.
occasion the beta has been roughly 1.                                                                                                            In fact, as Exhibit 2 shows, a significant divergence has
The performance of other EM currencies has been                                                                                                  opened up between RUB and our proxy indicator for Russia’s
inconsistent with history too, such as the EUR-linked CEE                                                                                        terms of trade, which of course is dominated by oil. On the
currencies which have deviated from script the most. The                                                                                         basis of this alone, RUB should’ve actually strengthened. But
price action of the latter though is easily explained by the                                                                                     of course, it hasn’t, and naturally this is because there have
atypical strength of the EUR during the EM sell-off.                                                                                             been other flows offsetting the benefit of a higher oil price.
Exhibit 1                                                                                                                                        Second, Russia is less vulnerable to a reversal of fixed
RUB Typically Underperforms, but Not This Time                                                                                                   income flows than most EM economies: Much of the recent
                                                                                                                                                 strength in USD has been driven by rising US Treasury yields
    2
                                                                                                                                                 and the associated market assessment on the size of future
    0
                                                                                                                                                 asset purchases from the Fed.
    -2
                                                                                                                                                 This caused disruption in EM fixed income markets because
    -4
                                                                                                                                                 of the extent to which QE from the Fed has contributed to
    -6
                                                                                                                                                 significant fixed income flows in high-yielding EM economies.
    -8
                                                                                                                                                 An end to QE naturally raises concerns about the durability of
   -10
                                                                                                                                                 these flows.
   -12
                                                                                                                                                 As Exhibit 3 highlights, Russia has received a lower level of
   -14
                                                                                                                                                 fixed income inflows since the global recovery began in 2Q09
   -16
                                                                                                                                                 compared to the average EM economy. Recently exposure
                                                                                         MXN




                                                                                                                                         EM Av
                                                                                                           MYR



                                                                                                                             BRL
                                 HUF
               IDR




                                        SGD


                                                    RON


                                                                PEN


                                                                             PLN




                                                                                                                       INR


                                                                                                                                   ZAR
         CNY



                           CZK



                                              COP




                                                                      RUB


                                                                                   THB


                                                                                               PHP
                                                                                                     CLP


                                                                                                                 TRY
                     TWD




                                                          KRW




                                                                                                                                                 has been rising, which is consistent with our own metrics (see
                       Chg vs USD Since May 9                               Average Chg During Prior Corrections                                 Market Technical Watch: Underweight Risks and Increasing
Source: Bloomberg, Morgan Stanley Research                                                                                                       Cash, July 2, 2013), but overall the difficulty of gaining access
                                                                                                                                                 to Russian fixed income securities in recent years has meant
The resilience of the RUB requires a little more explanation,
                                                                                                                                                 that overall exposure is low. As such, it stands to reason that
but we can see four principal reasons:
                                                                                                                                                 the currency has less to lose from a potential reversal or
Exhibit 2                                                                                                                                        slowdown in fixed income flows compared to other markets.
Oil Up, RUB Down
                                                                                                                                                 Exhibit 3
   125                                                                                                                             27            Fixed Income Inflows Have Risen, but Still Relatively
   120
                                                                                                                                   28
                                                                                                                                                 Low
   115
                                                                                                                                                   3.0
                                                                                                                                   29
   110                                                                                                                                                          Debt security portfolio inflows, 4Q rolling sum, %GDP
                                                                                                                                                   2.5
   105                                                                                                                             30
                                                                                                                                                   2.0
   100                                                                                                                             31              1.5
    95
                                                                                                                                   32              1.0
    90
                                                                                                                                                   0.5
                                                                                                                                   33
    85
                                                                                                                                                   0.0
    80                                                                                                                             34
     Jan-11                            Oct-11                         Jul-12                           Apr-13                                     -0.5

            Index of Russia's Commodity Exposure                                                     USD/RUB (RHS, inv)                           -1.0

Source: Bloomberg, Morgan Stanley Research                                                                                                        -1.5
                                                                                                                                                         4Q05     4Q06      4Q07    4Q08      4Q09    4Q10      4Q11    4Q12
First, oil prices have actually headed higher over the past                                                                                                           RUB                                 EM Avg
few months: Typically, when EM currencies weaken it                                                                                              Source: Morgan Stanley Research, Haver Analytics




                                                                                                                                                                                                                               19
                                                                                    MORGAN STANLEY RESEARCH

                                                                                    July 22, 2013
                                                                                    Global EM Investor




Third, RUB had already spent February-April                                         Exhibit 5
underperforming the broader EM currency asset class: This                           RUB Interventions Picked Up in June
meant that the May correction was starting from an already
                                                                                      25,000                                                                                 35
weak base. The main reason for RUB underperformance at this
                                                                                                                                                                             34
point was the weakness in oil prices, with Urals crude dropping                       20,000

18% from peak to trough during February-April.                                        15,000
                                                                                                                                                                             33

Exhibit 4 highlights that the decline of RUB was in proportion                        10,000
                                                                                                                                                                             32

to the oil price decline we saw, based on recent correlations.                                                                                                               31
                                                                                       5,000
Exhibit 4                                                                                                                                                                    30

Significant RUB Underperformance in Feb-Apr                                                  0
                                                                                                                                                                             29

  108                                                                                 -5,000                                                                                 28
                                  Significant underperformance during
                                  Q1 set the stage for a relatively more             -10,000                                                                                 27
  106
                                  resilient performance in Q2                              Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13

  104                                                                                                             CBR Purchases of FX (USDmn)             USD/RUB

                                                                                    Source: Haver Analytics, Bloomberg
  102


  100                                                                               Exhibit 6
                                                                                    Our Understanding of CBR Intervention Policy
   98
                                                                                      Width      Range                         Rule
   96                                                                                                               31.75      CBR moves corridor 0.05 up for $450m
                                                                                                                               ‘non-target’ purchases
   94                                                                                 1.00         31.75      –     32.75      CBR buys $350m daily
    Sep-11       Jan-12       May-12         Sep-12               Jan-13   May-13
                                         RUB vs EM                                    1.00         32.75      –     33.75      CBR buys $250m daily
                                                                                      1.00         33.75      –     34.75      CBR buys $170m daily (observed)
Source: Bloomberg, Morgan Stanley Research
                                                                                      1.00         34.75      –     35.75      no interventions (observed)
Fourth, central bank support for RUB has been                                         1.00         35.75      –     36.75      CBR sells $70m daily (observed)

meaningful: Plenty of EM central banks have emerged to                                1.00         36.75      –     37.75      CBR sells $200m daily (observed)

support their currencies in recent weeks, deploying a                                 1.00         37.75      –     38.75      CBR sells $300m daily
                                                                                                   38.75                       CBR moves corridor 0.05 down for $450m
combination of interest rates and selling currency reserves.
                                                                                                                               ‘non-target’ sales
This is familiar territory for the CBR, which regularly                             Source: CBR, Morgan Stanley Research; Intervention is against the basket which is 55%
intervenes on both sides of the market in a mechanistic                             USD and 45% EUR. Note that the CBR announces the edges of the 7 RUB wide corridor and
                                                                                    the level of cumulative ‘non-target’ intervention required to move the corridor by 5 kopecks,
fashion to smooth out volatility.                                                   but the intra-corridor intervention bands are not published. We have estimated them by
                                                                                    looking at the level of CBR intervention, which is published daily, for those bands marked
                                                                                    ‘observed’ and by extrapolation for the other bands.
Recently, RUB has been trading well inside the CBR’s USD
selling zone, which means that the central bank has sold a
                                                                                    New CBR Governor Nabiullina has affirmed her commitment
reasonable amount of USD in support of RUB. Data for June
                                                                                    to the floating RUB, with the CBR intervening to smooth
show that the CBR sold just over US$2.7 billion and €245
                                                                                    volatility, not to target a particular exchange rate. We expect
million into the market as the RUB basket traded in the upper
                                                                                    the CBR to continue with its current regime, which implies
half of the corridor. This is the largest monthly intervention
                                                                                    rising intervention as RUB approaches the edge of the
since the worst days of the eurozone crisis in 4Q11.
                                                                                    corridor.
Admittedly, the size of intervention is small compared to the
2008/09 period when the RUB basket corridor was narrower,                           Short-Term Support for RUB
and the quantities of intervention were larger. However, it is
                                                                                    Many of the above factors that caused RUB to trade well
still true that RUB would almost certainly be weaker if it
                                                                                    during the May-June correction remain in place, and they
weren’t for the fact that the CBR was selling a large quantity
                                                                                    should continue to provide support for the currency in the near
of USD. Indeed, it is the prospect of central bank support
                                                                                    term.
which prompted us to remove our bearish RUB trade on June
24 (see Global EM Investor: Are We There Yet).


                                                                                                                                                                            20
                                                                                            MORGAN STANLEY RESEARCH

                                                                                            July 22, 2013
                                                                                            Global EM Investor




Indeed, we believe that strong oil prices will continue to be                               from Reduce (i.e., sell into strength) on July 1 (see Global EM
supportive of RUB since our commodity analysts continue to                                  Investor: Taking Stock of the Sell-off). Chairman Bernanke
see near-term strength in crude prices (see US Oil Data Show                                has softened his tone on US monetary policy, prompting some
Improving Global Oil Fundamentals, July 8, 2013).                                           USD weakness and more stability in US bond yields.
                                                                                            Furthermore, although the slowdown in China continues,
Russia is heavily dependent on oil, which accounts for two-
                                                                                            monetary conditions have eased significantly compared to the
thirds of exports and half of federal budget revenues (see
                                                                                            volatility we saw in June, prompting a normalisation of the
Russia Economics: Responding to Oil’s Challenge, November
                                                                                            China rates market – and this should help to foster some
12, 2012, for more discussion of the impact of oil on Russia).
                                                                                            near-term stability in EM risk assets.
Some observers have argued that oil is likely to weaken, as the
prices for some metals, such as aluminium, nickel and iron ore,                             This, in the context of strong oil and CBR support, should help
have weakened. But we see two reasons for significant                                       RUB perform relatively well in the near term.
resistance to a lower oil price. First, the oil market is                                   While we can see reasons for some near-term strength in
reasonably tight, with for instance the IEA recently reducing its                           RUB, there are substantial medium-term risks that mean good
estimate of spare capacity, and DM demand may pick up if                                    entry points for long USD positions will likely emerge over the
growth picks up in the US and Europe, in line with the Morgan                               course of 3Q.
Stanley forecast for an average US$108/bbl price in 3Q13.
Second, unlike other commodities, oil has a cartel in OPEC and                              RUB Risks on the Horizon
a cartel leader in Saudi Arabia, which has a track record of
being willing to adjust production in support of its price objective,                       Although current levels mean that short-term risk/reward
which is currently US$100/bbl. Moreover, the core Gulf 3                                    favours being long RUB versus the basket, any rebound will
producers are currently producing 2 mmpobd above their 2009-                                probably be limited to around the middle of the CBR’s
10 average level, giving them scope to reduce production.                                   intervention corridor, which currently starts around 35.75, and
                                                                                            is around 3.4% stronger than current levels. Indeed, we see a
Exhibit 7                                                                                   number of risks that could undermine RUB into year-end.
2 mmbopd Gulf 3 Production Excess over 09-10
                                                                                            First, we expect USD to remain strong on the back of
Average Level a Headwind to Oil Below $100/bbl
                                                                                            robust US economic growth and the implications this has on
 16000      mbopd                                                                           US monetary policy and US Treasury yields. The slowdown in
                                                                                            capital flows to EM that should accompany this process
 15000                                                                                      should keep pressure on EM currencies. While RUB has less
                                                                                            to lose than others from this process, as we described earlier,
 14000                                                                                      it is unlikely that the currency would be entirely insulated.
                                                                                            Exhibit 8
 13000
                                                                                            Crossing the RUBicon: Declining RUB Support from
 12000                                                                                      the Balance of Payments

 11000                                                                                          70
                                                                                                         US$ billion

                                                                                                50
 10000
     Jan-02         Jan-04        Jan-06        Jan-08        Jan-10       Jan-12
                                                                                                30
                             Gulf 3 actual             Gulf 3 average 09/10
Source: JODI, Morgan Stanley Research. Gulf 3 = Saudi Arabia, Kuwait and United Arab            10
Emirates. Note assumed that Kuwait production in April 2013 flat at the March 2013 level,
and UAE production flat to April 2013 at the November 2012 level.
                                                                                               -10
Furthermore, the absence of heavy positioning in the bond
market and the CBR’s USD selling mechanisms will continue                                      -30
                                                                                                                                                 US$ -130.2 bn
to provide some support for the currency.
                                                                                               -50
Finally, our tactical stance on the market remains Neutral,                                       1Q-04 1Q-05 1Q-06 1Q-07 1Q-08 1Q-09 1Q-10 1Q-11 1Q-12 1Q-13

as many of the broader global risks for EM currencies                                                   private sector flows             current account                balance
have become more benign: In EM FX, we moved to Neutral                                      Source: CBR, Morgan Stanley Research. Balance refers to the sum of the current account
                                                                                            and private sector flows.



                                                                                                                                                                                21
                                                                    MORGAN STANLEY RESEARCH

                                                                    July 22, 2013
                                                                    Global EM Investor




Second, Russia’s balance of payments is no longer                   Third, the CBR has begun to cut rates: In September 2012,
supportive of a stronger RUB: This is partly because the            when inflation moved above the 5-6%Y target, the CBR hiked
current account surplus has fallen, and we forecast it this year    rates. With inflation holding above target, the CBR has kept
at a more modest 2.3% of GDP. Moreover, the current                 rates on hold since, despite rate cuts and monetary easing in
account surplus is now fully offset by net private sector capital   many countries and a growth slowdown in Russia. Now, after
outflows, which are broadly equivalent in size. In fact in 1H13,    three months of largely symbolic cuts in longer rates in April-
on preliminary data, the current account surplus was US$32          June, following a sharp deceleration in inflation in June-July
billion, while private sector capital outflows were US$38           and continued signs of weak growth, the CBR announced a
billion. Looking ahead, we also see prospects of continuing         new auction facility at the July rates meeting, which we
structural decline in the current account surplus, with export      believe amounts to a significant easing. The first auction on
growth capped by limited potential for expanding key oil and        July 29 will offer the equivalent of over 20% of the liquidity
gas exports, and import growth running at 5-6%Y, supported          currently provided by the CBR to banks, at much longer
by strong income growth.                                            durations (1 year) and at lower rates (up to 175bp lower), and
                                                                    tied to short-term rates, so positioned to benefit from any
BoP seasonality: However, the Russian balance of                    subsequent cuts in policy rates. Further, we expect a further
payments has a pronounced seasonal pattern, though history          50bp of cuts in short-term policy rates this year as inflation
suggests that this results in similarly seasonal performance in     falls back to target levels in 2H13 (see Russia Economics:
RUB only in the first half of the year. The strongest months for    Russian LTRO, July 12, 2013, for details).
the current account are January to May as a result of lower
                                                                    Exhibit 10
imports; then from June to August net dividend payments and
                                                                    2013 MinFin Reserve Fund Transfer Under $5 bn
the travel services deficit keep the current account weak,
                                                                       40
before the current account returns to a stable surplus in                    US$ billion
September-December (though at lower levels than in January-            30
May). The financial account follows a different pattern: a wide        20
deficit at the start of the year driven by private sector capital
                                                                       10
outflows, before strengthening to a spring surplus, and then
returning to deficit in 2H. On balance, these patterns imply            0
that RUB gets the most support from the balance of payments
                                                                      -10
in 1H (particularly March-May) and less support in 2H, with 3Q
particularly weak. Over the last five years, however, 3Q has          -20
                                                                                    2011                  2012                  2013F
generally seen a fairly stable RUB, with the exceptions of the                        CBR interventions: Total CBR purchase of FX
eurozone crisis in 2011 and Global Financial Crisis in 2008.                          CBR interventions: Total CBR sale of FX
                                                                                      Reserve Fund transfer
                                                                    Source: CBR, MinFin, Morgan Stanley Research; 2013 Reserve Fund transfer estimate from
Exhibit 9                                                           Finance Minister Siluanov.
BoP Seasonality: Strong in Spring, Weak in 3Q
                                                                    Fourth, the MinFin will start buying USD: The MinFin plans
            US$ billion, Average 2009-2012
                                                                    to start buying dollars for transfer to the Reserve Fund
  10                                                                through the market, starting in August, which adds to pressure
                                                                    on RUB. Still, this additional USD buying may not have a
    5                                                               major impact for two reasons:
                                                                     Any MinFin USD buying that pushed RUB weaker within
    0
                                                                      the corridor could be offset by even more CBR intervention.
                                                                      Generally CBR intervention (currently US$200 million per
   -5
                                                                      day) is significantly larger than potential MinFin USD
 -10                                                                  purchases (up to US$40-50 million per day, according to
                                                                      Deputy Finance Minister Moiseev);
 -15                                                                 The scale of the planned Reserve Fund transfer is smaller
        Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec               than in previous years, at RUB 149 billion or under US$5
            Current account                  Financial account        billion by year-end, and even this is at risk, given the
            ow PS Capital outflows           Balance                  decision to use oil revenues to cover any shortfall in non-oil
Source: CBR, Morgan Stanley Research                                  revenues.


                                                                                                                                                      22
                                                                   MORGAN STANLEY RESEARCH

                                                                   July 22, 2013
                                                                   Global EM Investor




Exchange rate policy: A key driver of RUB is the CBR’s             exporters, who have costs in RUB and revenues in FX;
exchange rate policy. On current settings, or even with a          manufacturers, who face foreign competition; the MinFin,
further modest downward step in intervention levels, a RUB         which favours a weaker RUB since it increases the budget’s
staying in the second intervention band would maintain the         RUB income from oil and gas; and some policy-makers, such
RUB corridor broadly flat in real terms. More radical moves in     as Belousov, the president’s economic adviser, who see a
exchange rate policy, dramatically reducing CBR intervention       weaker RUB as supportive of growth. We therefore see a risk
or targeting a weaker RUB, are often discussed in Moscow.          of a shift in exchange rate policy to one which supports a
However, we see any near-term change as unlikely, given            weaker RUB.
Governor Nabiullina’s endorsement of current exchange rate         Exhibit 11
policy.                                                            In Real Terms, RUB Is Still Close to Historical Highs
Current settings and RUB would keep the corridor
                                                                                2005 = 100
broadly flat in real terms: The CBR gradually moves the              135

corridor in response to pressure. For instance, since the start      125
of June the CBR has moved the corridor down 10 kopecks to
                                                                     115
reflect cumulative ‘non-target’ sales of US$900 million.
                                                                     105
Broadly, the idea is that target sales are related to smoothing
the RUB impact of movements in oil prices, and non-target              95
sales are related to smoothing the RUB impact of speculation.          85
In practice, 22% of total CBR dollar interventions since 2010
                                                                       75
have been non-target. On current settings, if this proportion
holds going forward, and RUB continues to sit in the second            65
                                                                        Jan 03       Jan 05       Jan 07         Jan 09     Jan 11       Jan 13
intervention zone, selling US$200 million per day, then the
                                                                                      REER                NEER            Bi-Currency Basket
CBR would move the corridor roughly every 10 trading days,
                                                                   Source: CBR, Morgan Stanley Research
or by a further 60 kopecks, or a further 1.6% in total to 32.35-
39.35 RUBBSKT by year-end. This in turn would keep the             But continuity more likely, we think: Despite this, we see
RUB corridor approximately flat in real terms against USD to       three reasons for expecting the CBR to keep the current
end-2013.                                                          market-driven exchange rate policy broadly unchanged:
Small impact from a further downward step in                        Nabiullina support: Governor Nabiullina has strongly
intervention levels: We expect another step to widen the             endorsed the current exchange rate regime, and the
corridor and reduce the levels of intervention, as part of the       objective of allowing the rate to be determined by market
ongoing planned transition to a freely floating RUB in 2015.         forces (which would be difficult to reconcile with a REER
However, we think that the step is not imminent, since we            target, for instance) while smoothing volatility (which would
believe that the CBR would prefer, as in the past, to widen          argue against any radical change in the intervention
when RUB is in the non-intervention zone, to avoid triggering        mechanism that might lead to a significant further move in
speculative pressure. Moreover, in line with past moves, we          RUB).
expect the change to be modest, perhaps taking another
US$20-50 million off the level of intervention at each level,       Continuity at the CBR: Governor Nabiullina has stressed
widening the non-intervention central zone and further               that she will act in line with the policy of Igantiev’s CBR.
widening the corridor by another RUB.                                The significant easing which she is introducing is, we think,
                                                                     in line with Ignatiev and Ulyukayev’s policy. However, a
Multiple lobbies for engineering a weaker RUB: RUB is still          change in the exchange rate policy would be a major
close to historical highs in real or inflation-adjusted terms.       departure.
Since 2009, RUB has continued to strengthen against USD in
real terms, despite regular periods of weakness in nominal          Crossing the RUBicon: With a declining current account
terms. Even after the significant weakening in June,                 surplus and capital outflows which broadly match the
RUBUSD was in real terms just back to the level of December          current account surplus, there is now little fundamental
2012. In response to this strong appreciation, we see several        pressure from the balance of payments for further real
powerful lobbies for engineering a weaker RUB. They include          appreciation of RUB.



                                                                                                                                                  23
                                                                         MORGAN STANLEY RESEARCH

                                                                         July 22, 2013
                                                                         Global EM Investor




INR and EM – Policy Responses to Currency Weakness
Kritika Kashyap, James Lord                                              According to our India economist, Chetan Ahya, the liquidity
                                                                         tightening move by the RBI marks a reversal in its monetary
    EM FX should rebound in the short term thanks to renewed            policy stance, giving increased importance to currency stability
     dovish comments from the Fed, and INR should benefit.               in the current environment of higher USD currency and rates
     Measures from the RBI and the Indian government have also           (see India Economics: RBI Announces Quantitative Tightening,
     helped INR, but the policy steps will not be enough to alter        Increasing Downside Risks to Growth, June 16, ,2013). By
     the medium-term uptrend for USD/INR, in our view.                   doing so, the RBI has tied the direction of future policy to
                                                                         developments in US rates. Should USD continue to appreciate
    The medium-term outlook for INR is challenged by high
                                                                         over the medium term as our G10 colleagues expect, we may
     external deficits and high inflation. India is also vulnerable to
                                                                         see further liquidity tightening to keep USD/INR capped.
     rising global commodity prices.
                                                                         At the same time, the Indian government has engaged in
    India and other EMs need to engage in structural reform to
                                                                         structural reforms, increasing FDI caps and relaxing FDI
     correct external imbalances and improve productivity before
                                                                         norms for investment in 13 different sectors of the economy. It
     we become bullish on the medium-term currency outlook.
                                                                         is encouraging to see these more fundamental reform
                                                                         measures being taken, which we think improve the stability of
A Near-Term Recovery
                                                                         the external position and therefore the currency in a more
EM currencies have rallied in fairly indiscriminate fashion in
                                                                         sustainable manner.
the past week, buoyed by more dovish comments from
Chairman Bernanke. Several EM central banks have also                    Indeed, these measures did succeed in pushing USD/INR
stepped up the defence of their exchange rates, using                    below the policy-makers’ preferred level of 60, albeit
primarily FX reserves but also higher interest rates in some             temporarily. We also do not rule out more such measures
cases. India is one of the few places where the government               being implemented in the near term, should INR see another
has responded to the currency weakness with, in addition to              round of weakness. Potential measures could include further
the use of reserves and interest rates, a series of reforms              policy tightening, continued RBI intervention, issuing offshore
aimed at attracting capital on a more sustainable basis.                 bonds or Non-Resident Indian (NRI) bonds and/or increased
Indeed, along with a marginally more dovish Fed, these                   incentives on NRI deposits.
measures should help to foster a near-term recovery in INR.              Exhibit 1

India, like many EM economies, still faces many challenges               FII Flows in Indian Equities (Monthly)
that threaten to undermine the currency over the medium                   USD mn
                                                                          6000
term. We believe that BRL, ZAR, IDR, INR and TRY all face a
                                                                          5000
challenging medium-term outlook when we consider the                      4000
rebalancing under way in China, likely future tapering by the             3000
Fed and each country’s inflation rates. But before highlighting           2000
the vulnerabilities of these currencies relative to the rest of the       1000
                                                                             0
market, and where India in particular fits in, we will explore the
                                                                          -1000
measures recently taken by officials in India to stabilise INR.           -2000
What Do the Recent Policy Measures Mean for INR?                          -3000
                                                                                                                                  Nov-12
                                                                                     Jan-12




                                                                                                                Jul-12




                                                                                                                                           Jan-13




                                                                                                                                                                      Jul-13
                                                                                              Mar-12




                                                                                                                         Sep-12




                                                                                                                                                    Mar-13
                                                                                                       May-12




                                                                                                                                                             May-13




Through the policy measures announced on July 15, the RBI
has effectively increased short-end interest rates to support
                                                                         Source: Bloomberg, Morgan Stanley Research
the currency. These measures included:
1) Limit on the inter-bank liquidity provision to banks via the          Keep an Eye on: Foreign Investor Flows into Equities
liquidity adjustment facility (LAF) to Rs750bn (US$12.5bn);              Tightening monetary policy when growth is already weak and
                                                                         spending finite FX reserves are at best smoothing operations
2) Hike in the ‘penal borrowing rate’ for banks or the MSF rate
by 200bp to 10.25%;                                                      and at worse counterproductive, given the risk of further
                                                                         capital flight on the back of weaker growth and asset price
3) Announcement of OMO sales of Rs120bn (US$2bn).                        weakness. As Exhibit 1 shows, flows into Indian equities have
                                                                         turned around to outflows in June and the first half of July.


                                                                                                                                                                               24
                                                                                       MORGAN STANLEY RESEARCH

                                                                                       July 22, 2013
                                                                                       Global EM Investor




Policy Measures in Other EM Countries                                                  from the Fed have poured some cold water on the expected
India is not the first country in EM to embark on such policy                          timing of tapering, less easy monetary policy will likely mean
tightening measures in the face of steep currency                                      fewer capital inflows into EM. Those currencies that have been
depreciation. Similar measures were also taken by policy-                              the most reliant on these flows within the context of an already
makers of other externally vulnerable EM economies in light of                         weak external position could suffer more.
uncertainty over the availability of external funding.
                                                                                       Furthermore, China’s growth slowdown poses major risks,
For example, in Asia, Indonesia has tightened policy, hiking                           through direct trade linkages but also commodity price effects.
both its benchmark policy rate and FASBI (deposit) rates by                            Finally, high inflation and the lack of structural reform efforts
75bp while also simultaneously intervening in the FX and                               will likely undermine many EM currencies over time.
bond markets. However, bond yields and USD/IDR have
                                                                                       INR remains at risk from a number of these processes, but it
continued to rise.
                                                                                       is by no means the worst affected. As we address some of
At Exhibit 2 highlights, Indonesia has used a significant                              these fundamental issues, it will be clear why we continue to
proportion of its FX reserves in defence of its currency and so,                       take a cautious medium-term stance on TRY, BRL, IDR and
in light of a desire to preserve FX reserves, use of the interest                      ZAR. Like INR, all these currencies are held back by their
rate tool is not entirely surprising.                                                  weak external positions and high inflation, but in addition, they
We can see a similar dynamic in markets outside Asia too.                              have been much more reliant on fixed income flows stemming
The Central Bank of Turkey’s FX reserves are limited relative                          from Fed QE.
to the size of its external funding requirements and so, despite                       1. Dependence on External Funding
the aggressive use of available reserves, as shown in Exhibit                          Since the 2008-09 crisis, India’s current account deficit has
2, the CBT also tightened liquidity by raising the effective cost                      widened from 2% of GDP to 5.1% in the last quarter, making
of funding to the banking system.                                                      the country increasingly dependent on external financing to
The Brazilian Central Bank has similarly used a combination                            fund its economic growth. As a result, INR is more vulnerable
of FX reserves and interest rates.                                                     to swings in capital flows and foreign investor sentiment.

Exhibit 2                                                                              The last few months have clearly shown the risks to EM
Change in Central Banks’ FX Reserves                                                   currencies from a withdrawal or even a slowdown of portfolio
                                                                                       inflows. While expectations of Fed tapering are now being
   2%                                                                        10,000    watered down following renewed dovish talk from the Fed, it is
                                                                             5,000
   0%                                                                                  reasonable to assume a slower pace of fixed income portfolio
                                                                             0
                                                                                       inflows to EM going forward.
                                                                             -5,000
  -2%
                                                                             -10,000   Exhibit 3
  -4%                                                                        -15,000   Who Is the Most Exposed from Fixed Income Flow
                                                                             -20,000   Slowdown?
  -6%
                                                                             -25,000
                                                                                            16                                                                                                                  180
                                                                             -30,000
  -8%                                                                                                                                                                                                           160
                                                                             -35,000        14

 -10%                                                                        -40,000                                                                                                                            140
                                                                                            12
            MYR
             TRY


             ARS



            RUB


             CZK




             CLP


              ILS
             IDR

            UAH
             ZAR



             INR


             PEN




            SGD

             PLN
            BRL*




            HUF




             VEF
             THB




            MXN
            KRW



            TWD




                                                                                                                                                                                                                120
                                                                                            10
                                                                                                                                                                                                                100
        Change in FX reserves over May and June, %April stock         USDm (RHS)             8
                                                                                                                                                                                                                80
Source: IMF, Morgan Stanley Research; *Including use of derivatives                          6
                                                                                                                                                                                                                60
                                                                                             4
INR and EM Currencies with Similar Fundamentals Face a                                                                                                                                                          40
                                                                                             2
Significant Medium-Term Challenge                                                                                                                                                                               20

                                                                                             0                                                                                                                  0
Although policy rate hikes and the use of FX reserves have
                                                                                                         CNY
                                                                                                   ILS




                                                                                                                            RUB




                                                                                                                                              COP




                                                                                                                                                                CLP
                                                                                                                                                                      PHP


                                                                                                                                                                                  TRY


                                                                                                                                                                                              CZK
                                                                                                                                  BRL




                                                                                                                                                    IDR




                                                                                                                                                                                        ZAR


                                                                                                                                                                                                    PLN
                                                                                                                                        HUF
                                                                                                               INR*




                                                                                                                                                          THB




                                                                                                                                                                                                          MXN
                                                                                                                                                                            KRW
                                                                                                                      TWD




been able to tone down some of the currency depreciation in
many EM currencies in the near term, we do not believe that                                        Portfolio debt security inflows since 2Q09, %GDP                                           USDbn (RHS)

these are the foundation for a sustainable recovery.                                   Source: Haver Analytics, Morgan Stanley Research


In the medium term, fundamental risks to most EM currencies                            Fixed income portfolio inflows in India were limited by the
remain through a number of channels. While recent weak data                            foreign investor caps in debt (see Exhibit 3); however, in light


                                                                                                                                                                                                                      25
                                                                                                                                 MORGAN STANLEY RESEARCH

                                                                                                                                 July 22, 2013
                                                                                                                                 Global EM Investor




of the increasing current account deficit, declining capital                                                                     Outside India, TRY, ZAR and IDR have benefitted from
inflows have clearly had a disruptive effect on the currency.                                                                    sizeable fixed income flows since 2Q09. There are other
Moreover, the rise in real interest rates from capital outflows                                                                  currencies where inflows have been higher, but few face the
increases the downside risks to growth over the medium term.                                                                     same additional headwinds. In particular, these currencies
                                                                                                                                 suffer from large and/or widening current account deficits,
However, while India has not seen as much bond portfolio
                                                                                                                                 which makes their reliance on volatile fixed income inflows
capital inflow over the years, nonetheless India’s funding mix
                                                                                                                                 that bit more significant. BRL is vulnerable in this respect too.
has deteriorated. There has been an increased reliance on
short-term external debt as capital inflows into the economy                                                                     2. Risk from Further Current Account Deterioration
diminished on a slower growth outlook. Over the last 12                                                                          The prior section took a brief look at the vulnerability of the
months, of the total capital inflows of US$89.3 billion, about                                                                   existing external position, in the context of a more challenging
53.5% have been from debt-creating flows (see Exhibit 4),                                                                        global funding environment. However, for many EM
and the percentage of short-term debt to total debt has risen.                                                                   economies, the prospect of China rebalancing its growth
                                                                                                                                 model raises further risks for the external positions and
Exhibit 4
                                                                                                                                 therefore currencies. These are affected by:
India’s Growing Dependence on External Debt
                                                                                                                                 a) Direct trade linkages with China;
 120                                                                                        Rise in dependence
                Foreign Direct Investment (net)
                                                                                            on debt creating
 100
                Portfolio Investment
                Debt creating capital flow s                                                inflow s
                                                                                                                                 b) Commodity price exposures.
                Others
  80                                                                                                                             While India has limited direct trade linkages with China, its
  60   US$ bn
                                                                                                                                 trade balance stands at risk from shifts in commodities prices,
  40                                                                                                                             which makes up a major component of India’s import basket.
  20
                                                                                                                                 Hence, the outlook for global oil prices and the demand for
                                                                                                                                 gold will define the direction for India’s current account
   0
                                                                                                                                 balance going forward, in our view.
 -20
                                                                                                                        F2014E
        F2000

                F2001

                        F2002

                                F2003

                                        F2004

                                                F2005

                                                        F2006

                                                                F2007

                                                                        F2008

                                                                                F2009

                                                                                        F2010

                                                                                                F2011

                                                                                                        F2012

                                                                                                                F2013




                                                                                                                                 Our economists are projecting India’s current account to
                                                                                                                                 improve marginally to 4% of GDP by end-2014, due to the
Source: RBI, Morgan Stanley Research estimates (see India Economics: How the Dollar’s
Rise and China's Slowdown Affect India, July 9, 2013).                                                                           RBI’s recent restrictions on gold imports and a pick-up in
                                                                                                                                 exports. However, our economists as well as Indian policy-
In light of what is likely to be a more difficult global                                                                         makers estimate that a current account deficit wider than
environment in terms of the availability of capital inflows to                                                                   ~2.5% of GDP remains unstable for India’s balance of
EM, we believe that further policy steps to shore up the                                                                         payments situation (see India Economics: How the Dollar’s
external position cannot be ruled out in India.                                                                                  Rise and China's Slowdown Affect India, July 9, 2013).
 Keep an Eye on:                                                                                                                 Exhibit 5
 i) Further easing of FDI norms: The Finance Ministry’s                                                                          Current Account versus Net Energy Exports (% GDP)
 steps to encourage more stable FDI inflows improve the
 country’s basic balance of payments over the long term,                                                                           15

 reducing the dependence on volatile portfolio flows for                                                                           10
 funding growth. However, these FDI flows could be slow to
                                                                                                                                    5
 come against the backdrop of investor sentiment shifting
 towards the US.                                                                                                                    0

 ii) Issuance of offshore debt: While issuing foreign                                                                              -5

 currency bonds helps to shore up the RBI’s FX reserves and                                                                       -10
 will be stabilising for the currency in the short term, these
                                                                                                                                  -15
 bonds increase India’s increasing external liabilities in the
                                                                                                                                                                                                                                  CNY
                                                                                                                                        TRY




                                                                                                                                                                                                                                              MYR
                                                                                                                                                    CLP




                                                                                                                                                                                  COP


                                                                                                                                                                                              CZK



                                                                                                                                                                                                                ILS
                                                                                                                                              ZAR




                                                                                                                                                                                                                      RUB
                                                                                                                                                          PEN
                                                                                                                                                                INR


                                                                                                                                                                            PLN


                                                                                                                                                                                        IDR




                                                                                                                                                                                                                                                          SGD
                                                                                                                                                                      BRL




                                                                                                                                                                                                                            HUF
                                                                                                                                                                                                          THB
                                                                                                                                                                                                    MXN




                                                                                                                                                                                                                                        KRW


                                                                                                                                                                                                                                                    TWD




 medium term.
                                                                                                                                                2013 C/A Forecast (% GDP)                             Net Energy Exports (% GDP)
                                                                                                                                 Source: Morgan Stanley, UNCTAD




                                                                                                                                                                                                                                                          26
                                                                      MORGAN STANLEY RESEARCH

                                                                      July 22, 2013
                                                                      Global EM Investor




 Keep an Eye On: Global Commodity Prices                              Exhibit 7
 According to our economists, for every 10% change in crude           USD/INR Is Now Close to its PPP Equilibrium
 oil prices, India’s current account deficit changes by 0.6% of                                       (USD/INR)
                                                                                             70
 GDP. Thus, a change in oil prices is an important parameter
 for the currency. Our commodities research team is bullish                                  60
 on oil prices in the short term, expecting a possible move                                                                    USD/INR
                                                                                             50
 above US$110/bbl before heading down again to US$105
 by year-end. This implies that India’s current account is still                             40

 at risk in the near term.                                                                   30                                                     "USD/INR Has Unwound Most of
                                                                                                                                    PPP                   Its Undervaluation"
                                                                                             20
India is not the only EM economy vulnerable to high oil prices.
                                                                                             10
Turkey and South Africa have significant current account                                             90    92     94     96    98   00      02    04     06    08    10    12
deficits, with the oil balance making up a substantial portion of     Source: Haver Analytics, Bloomberg, Morgan Stanley Research
the shortfall.
                                                                      Although our economists expect India’s CPI inflation to
Exhibit 6                                                             gradually decline by another 2% by 2014, it is still expected to
EM Trade Exposure to China                                            have one of the highest rates of inflation within EM. Exhibit 8
                                                                      shows Morgan Stanley’s CPI forecasts for 2014 across a
                                                                      number of EM economies versus their current REERs as a
                                                                      percentage deviation from their 10-year averages (a proxy for
                                                                      valuations). Clearly, currencies that are elevated in REER
                                                                      terms and suffer from high inflation will not have a particularly
                                                                      rosy outlook. As the chart shows, INR’s REER is not the most
                                                                      elevated in EM, but with such a high rate of inflation, we
                                                                      believe that it will not take long before the REER is high again,
                                                                      absent nominal adjustment.
                                                                      Exhibit 8
                                                                      High CPI + High REER = Negative FX Outlook
                                                                                                                                          Av. EM REER Deviation
                                                                                                 8

                                                                                                 7                                       INR
                                                                         2014 CPI Forecast (%)




                                                                                                 6                                       TRY
Source: Haver Analytics, Bloomberg, Morgan Stanley Research                                                 ZAR                                    BRL
                                                                                                                                                              RUB
                                                                                                 5                                               IDR
                                                                                                                                                                     Av. EM 2014 CPI
3. Steep Inflation Differential with Trading Partners                                            4                                                                   Forecast
Another macroeconomic vulnerability for India is its high level                                                                                                SGD
                                                                                                 3
of inflation. India has a steep CPI inflation differential with the                                                           KRW                        COP
                                                                                                 2                                TWD                                     CNY
US and other DM trading partners, due to which INR’s
                                                                                                 1
equilibrium or fair value against USD has declined over time.
                                                                                                 0
As seen in Exhibit 7, INR is now close to its fair value on a
                                                                                                     -20           -10          0             10                    20           30
PPP basis, after the sharp depreciation in June.                                                                          REER Deviation 10y av (%)
                                                                      Source: Haver Analytics, Morgan Stanley Research
In addition, India’s real effective exchange rate (REER) has
depreciated meaningfully too. In order to help an economy             The chart also demonstrates why we remain concerned about
                                                                      the outlook for BRL, IDR and TRY. We are bearish ZAR too,
maintain decent export performance, in an environment of still
                                                                      though the significant adjustment the currency has already
subdued global growth, it is important to prevent too fast a rise
                                                                      had suggests that valuations may not be such a constraint
in the REER. This can be achieved through structural reforms
                                                                      going forward. RUB scores badly on the CPI versus REER
aimed at improving productivity, which help to keep a lid on
                                                                      front and, as we explain on page 18, we doubt that RUB will
inflation, or alternatively adjustment to higher inflation can
                                                                      continue appreciating in real terms over the coming quarters,
occur through gradual nominal depreciation of the exchange            which suggests that further nominal depreciation will be
rate.                                                                 required over time.

                                                                                                                                                                                   27
                                                                                                                   MORGAN STANLEY RESEARCH

                                                                                                                   July 22, 2013
                                                                                                                   Global EM Investor




Exhibit 9 helps us to judge which currencies could see their                                                       Conclusions
nominal trade-weighted exchange rates come under pressure.                                                         We see scope for EM currencies to rebound over the course
In order to convert these data into valuation versus USD, we                                                       of the summer thanks to a more dovish Fed, amid significant
incorporate our USD forecasts against the major trading                                                            long USD positioning versus many EM currencies.
partners of each EM economy. USD, EUR, JPY and CNY
                                                                                                                   Beyond this, many EM currencies will likely face significant
were taken as the major trading blocks for EM. Assuming a
                                                                                                                   depreciation pressures over the medium term thanks to
stable REER, the chart shows us the implied depreciation
                                                                                                                   greater uncertainty over the pace of capital flows to emerging
versus USD required in order to adjust for the inflation
                                                                                                                   markets; the ongoing slowdown in China’s growth rate and the
divergences by end-2014. Unsurprisingly, the high inflation
                                                                                                                   associated impact on EM current account positions; and high
currencies would see the most adjustment.
                                                                                                                   inflation differentials versus DM. We see a number of EM
Exhibit 9                                                                                                          currencies that are particularly at risk from these factors and
Stable REERs Imply High Inflation Currencies                                                                       consider INR to be among the vulnerable group.
Underperform
                                                                                                                   EM central banks and other policy-makers will likely pursue
   0
                                                                                                                   measures to stabilise their currencies, using a range of tools.
  -2                                                                                                               The RBI and the Indian government have deployed FX
  -4                                                                                                               reserves, tightened monetary policy and announced a series
  -6                                                                                                               of reforms aimed at attracting capital. All these factors should
                                                                                                                   help to stabilise the currency, but we doubt that these
  -8
                                                                                                                   measures will have a sustainable impact, given the broad
 -10
                                                                                                                   upward trend for USD.
 -12
                                                                                                                   INR remains under downside pressure from three factors:
 -14
                                                                   MYR
       TRY




                         RUB




                                                             CZK


                                                                         ILS


                                                                                     CLP


                                                                                                 COP
                                                 BRL
             INR
                   ZAR


                               IDR




                                                       PLN




                                                                                                             PEN
                                     HUF
                                           THB




                                                                                           MXN
                                                                               KRW




                                                                                                       TWD




                                                                                                                   1. Increasing reliance on debt for C/A financing;
                          Implied Chg vs USD (assuming stable REER)                                                2. High current account deficit;
Source: Morgan Stanley Research, Haver Analytics
                                                                                                                   3. Steep inflation differentials with the US.
Given our expectation of USD strength, those currencies with
smaller weights for USD within their TWIs also fare worse,                                                         In addition, INR is vulnerable to a rise in commodity prices,
such as the CEEMEA currencies.                                                                                     which could affect India’s macro conditions by pushing
                                                                                                                   inflation higher and pressuring the current account deficit.
Keep an Eye on: Structural Reforms to Improve
Productivity                                                                                                       However, in the near term, we do not rule out more measures
As mentioned, gradual nominal depreciation may not be the                                                          from policy-makers in case INR sees another round of
ideal way for India to improve competiveness. Indeed, to the                                                       weakening. The RBI has already signalled that it may tighten
extent that currency weakness simply causes more inflation, it                                                     liquidity further in case currency depreciation pressures
is counterproductive. Efforts to improve competitiveness                                                           intensify. Other than this, the RBI may also shore up its FX
through reform will likely result in capital inflows and less                                                      reserves for contingency use through issuing offshore bonds
pressure on the exchange rate, in our view.                                                                        or ‘Diaspora’ bonds for Non-Resident Indians (NRIs) or even
                                                                                                                   through more incentives on NRI deposits.
In India specifically, government reforms that encourage a
shift towards private investment and more transparent                                                              Such measures, we think, only help to slow the pace of
regulations – like increasing FDI, public-private partnerships,                                                    weakening in the currency, and do not make any changes to
divestment of state-owned companies – should help to unwind                                                        the fundamental trends. Instead, we would watch out for any
the productivity decline that the economy has experienced                                                          sustainable reforms by policy-makers that focus on correcting
since the 2008 global financial crisis. Furthermore, reforms for                                                   the imbalances in the economy and increasing productivity to
improvement in infrastructure should help to constrain the                                                         reconsider our current medium-term bearish view on INR.
supply-side inflation factors.




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EM Strategy and Economics Teams
EM Fixed Income and Foreign Exchange Strategy
New York
Rashique Rahman                  Team Head, EM Macro Strategy                     Rashique.Rahman@morganstanley.com                                    +1 212 761 6533
Juha Seppala                     Global FXEM Quantitative Strategist              Juha.Seppala@morganstanley.com                                       +1 212 761 1949
Robert Habib                     EM Strategy                                      Robert.Habib@morganstanley.com                                       +1 212 761 1875
London
Paolo Batori, CFA                European Head of EM Strategy                     Paolo.Batori@morganstanley.com                                       +44 (0)20 7677 7971
                                 & Global Head of Sovereign
                                 Credit Strategy
Vanessa Barrett                  Chief EM Credit Strategist                       Vanessa.Barrett@morganstanley.com                                    +44 (0)20 7677 9569
Mihail Bozinov                   CEEMEA Rates Strategy                            Mihail.Bozinov@morganstanley.com                                     +44 (0)20 7677 1150
James Lord                       CEEMEA Macro Strategy                            James.Lord@morganstanley.com                                         +44 (0)20 7677 3254             +44 (
Kristina Obrtacova               EM Corporate Credit Strategy                     Kristina.Obrtacova@morganstanley.com                                 +44 (0)20 7677 7597
Robert Tancsa                    Sovereign Credit Strategy                        Robert.Tancsa@morganstanley.com                                      +44 (0)20 7677 6671
Simon Waever                     Credit Relative Value, EM Analytics              Simon.Waever@morganstanley.com                                       +44 (0)20 7425 1640
Meena Bassily                    CEEMEA Macro Strategy                            Meena.Bassily@morganstanley.com                                      +44 (0)20 7677 0031
Hong Kong
Viktor Hjort                     Head of AXJ Credit Strategy/                     Viktor.Hjort@morganstanley.com                                       +852 2848 7479
                                 Fixed Income Research
Nishant Sood                     AXJ Credit Strategy                              Nishant.Sood@morganstanley.com                                       +852 2239 1597
Kritika Kashyap                  AXJ Rates Strategy                               Kritika.Kashyap@morganstanley.com                                    +852 2239 7179
EM Economics
Manoj Pradhan                    Global                                           Manoj.Pradhan@morganstanley.com                                      +44 (0)20 7425 3805
Tevfik Aksoy                     Head of CEEMEA Economics                         Tevfik.Aksoy@morganstanley.com                                       +44 (0)20 7677 6917
                                 / Turkey, Israel
Michael Kafe                     South Africa, Nigeria, Ghana, Kenya              Michael.Kafe@morganstanley.com                                       +27 11 587 0806
Andrea Masia                     South Africa, Nigeria, Kenya                     Andrea.Masia@rmbmorganstanley.com                                    +27 11 282 1593
Pasquale Diana                   Poland, Hungary, Czech, Romania                  Pasquale.Diana@morganstanley.com                                     +44 (0)20 7677 4183
Jacob Nell                       Russia, Kazakhstan, Ukraine                      Jacob.Nell@morganstanley.com                                         +7 495 287 2134
Alina Slyusarchuk                Russia, Kazakhstan, Ukraine, Baltics             Alina.Slyusarchuk@morganstanley.com                                  +44 (0)20 7677 6869
Gray Newman                      LatAm                                            Gray.Newman@morganstanley.com                                        +1 212 761-6510
Luis Arcentales                  Chile, Mexico                                    Luis.Arcentales@morganstanley.com                                    +1 212 761-4913
Arthur Carvalho                  Brazil                                           Arthur.Carvalho@morganstanley.com                                    +55 11 3048 6272
Daniel Volberg                   Argentina, Colombia, Peru, Venezuela             Daniel.Volberg@morganstanley.com                                     +1 212 761-0124
Helen Qiao                       China                                            Helen.Qiao@morganstanley.com                                         +852 2848 6511
Sharon Lam                       Korea, Taiwan                                    Sharon.Lam@morganstanley.com                                         +852 2848 8927
Yuande Zhu                       China, Hong Kong                                 Yuande.Zhu@morganstanley.com                                         +852 2239 7820
Jason Liu                        Korea, Taiwan                                    Jason.JL.Liu@morganstanley.com                                       +852 2848 6882
Chetan Ahya                      Asia ex-Japan, India                             Chetan.Ahya@morganstanley.com                                        +852 2239 7812
Deyi Tan                         ASEAN                                            Deyi.Tan@morganstanley.com                                           +65 6834 6703
Derrick Kam                      Asia ex-Japan                                    Derrick.Kam@morganstanley.com                                        +852 2239 7826
Jenny Zheng                      Asia ex-Japan                                    Jenny.L.Zheng@morganstanley.com                                      +852 3963 4015
Upasana Chachra                  India                                            Upasana.Chachra@morganstanley.com                                    +91 22 6118 2246

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                                                                                MORGAN STANLEY RESEARCH

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                                                                                Global EM Investor




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(as of June 30, 2013)
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stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended


                                                                                                                                                    30
                                                                                              MORGAN STANLEY RESEARCH

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                                                                                              Global EM Investor




relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy
recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.

                              Coverage Universe    Investment Banking Clients (IBC)
                                             % of                   % of % of Rating
Stock Rating Category            Count       Total     Count Total IBC Category
Overweight/Buy                   1020           36%           410          39%           40%
Equal-weight/Hold                1263           44%           485          47%           38%
Not-Rated/Hold                    109            4%            24           2%           22%
Underweight/Sell                  469           16%           123          12%           26%
Total                           2,861                        1042
Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual
circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan
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                                                                                            MORGAN STANLEY RESEARCH

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                                                                                            Global EM Investor




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                                                         MORGAN STANLEY RESEARCH




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Description: Our tactical market directional stance remains at Hold. Long USDpositions continue to get squeezed, and fixed income assets are likely to trade better on the back of disappointing US data and more dovish comments from Chairman Bernanke. However, the mediumterm outlook for EM risk remains challenging.