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MORGAN STANLEY RESEARCH Morgan Stanley & Co. International plc

CEEMEA Economics Team

For team listings, please see the last page of this report.

January 15, 2014

CEEMEA

CEEMEA 2014 Outlook Is it Going to Get Worse? After some years of relative calm, political risk has come alive again: The most visible and surprising events took place in Turkey recently, and we think that the risks are not going to dissipate throughout the year, with two key elections and significant uncertainties with numerous scenarios at hand. In CEE, we see the potential for political risk with elections in Hungary (parliamentary) and in Romania (presidential). Elsewhere, we think that South Africa’s political risks are moderate – although one cannot rule out the prospect of renewed labour and social unrest. The stepping in by Russia to provide external support to Ukraine has significantly reduced near-term risks, but the underlying problems have not been resolved and could resurface – although probably not until after the 2015 presidential elections. We have made the most significant growth revision in Turkey by downgrading our 2014 GDP forecast by a full percentage point to 2.9%Y. This is significantly below the trend growth rate and, while it will help to improve the external deficit somewhat, we doubt that a narrower current account deficit will be sufficient to allay investor concerns at this juncture. In Russia, we expect a moderate investment-led recovery, with growth rising to 2.6%Y from last year’s weak 1.5%Y. In CEE, we have upgraded our forecasts slightly across the region and we see healthier, more balanced growth across domestic demand and net exports. South Africa looks set to tread the path towards better rebalancing, but it is too early to assume that this will be a smooth transition. On the policy front, we have made the largest policy rate call change in Turkey recently and we now expect a 200bp hike in the overnight rate to address the worsening inflation outlook, currency weakness and the credibility gap at hand. In Russia, we continue to expect a 50bp cut in 2H14, while we believe that in South Africa the SARB will keep a steady hand until next year. In CEE, we are nearly at the end of the easing cycle in Hungary and in Romania, and we continue to pencil in rate hikes in Poland in 2H14.

Country Sections Belarus: Stabilisation Before Stimulus

3

Czech Republic: Another Go at the FX?

5

Georgia: Rising Risks from Protracted Political Transition

7

Ghana: Fiscally Fractured

9

Hungary: It All Hangs in the Balance Now

11

Israel: Suffering from the Strength of the Economy?

16

Kazakhstan: Waiting for Kashagan

19

Kenya: Reasonably Resilient

22

Nigeria: A Year of Heightened Uncertainty

24

Poland: The Year of Normalisation

26

Romania: Economy Improving, Political Risks Potentially Rising

31

Russia: Moderate Recovery

33

South Africa: Corrective Consolidation

39

Turkey: Hazy Outlook on Politics

45

Ukraine: Risks Postponed, for Now

51

Contents Key Events

2

Recent Research

55

CEEMEA Inflation Monitor

56

CEEMEA Real Exchange Rate Monitor

57

Global Monetary Policy Rate Forecasts

58

Structural Indicators

59

CEEMEA Vulnerability Watch

60

Annual Economic Forecasts

61

Belarus is subject to comprehensive sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”) and by other countries and multi-national bodies.

For important disclosures, refer to the Disclosures Section, located at the end of this report.


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Key Events for 2014 CZ January February

HU

PL

FX mortgage assistance plan?

Transfers of government bonds from OFE to ZUS

RO IMF visit

CEE

SA

NGN

IS

RU

GDP rebasing

March

Sochi Winter Olympics

Local elections

April May

TU

Parliamentary elections CNB reevaluates FX peg?

Choice between OFE and ZUS

UKR Risk of protest movement turning into more widespread political unrest

Presidential elections EP elections

CIS summit

June

CBN Governor Sanusi’s term expires

Presidential elections

July

August

Decision on the 6th tranche of Eurasian Anticrisis loan CNB reevaluates FX peg?

Presidential elections

September October November

BEL

Local elections CNB reevaluates FX peg?

Presidential elections

December

Risk of higher FX pressure ahead of Mar-15 presidential elections

Source: Morgan Stanley Research

2


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Belarus: Stabilisation Before Stimulus  A widening external deficit – running at 9.4% of GDP – is putting stabilisation at risk, with BYR weakening by 1.3% a month and inflation recently rising to 16.6%Y at year-end.  We expect Belarus to secure financing from Russian sources through asset sales and additional lending, and to make further progress on stabilisation in 2014, but at the cost of tight policy keeping growth flat through the year.  We see 2014 as a year of consolidation, in advance of a return to stimulus in advance of the presidential elections at end-2015.

2013 showed limits of stimulus: 2013 saw some progress towards stabilisation, with inflation (eop) falling from 21.7%Y to 16.6%Y. However, sustained stabilisation proved elusive, with inflation picking up in 2H13 and the pace of BYR weakening rising to an average 1.3% per month since the surge in FX purchases in June. In our view, achievement of price and financial stability was largely undermined by sharp increases in wages, which in turn led the current account deficit (4Q sum), a modest 2.7% of GDP in 2012, to rise sharply to a wide 9.4% by 3Q13, leading to an 18% loss in reserves over the year to US$6.6 billion (1.7 months of import cover) at year-end.

Jacob Nell/Alina Slyusarchuk Exhibit 2

Reserves Down 18% to 1.7 Months of Import Cover Nov-11: Selling 50% of Beltransgaz for US$2.5 bn

10

3.00 2.50

8

2.00 6 1.50 4 1.00 2

0.50

0 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

0.00

International reserves, USD bn Reserve cover, months of imports, (rhs) Source: Belstat, Morgan Stanley Research

Exhibit 3

Wage Growth Has Been the Key Driver of Non-Oil Imports 65% 45%

Exhibit 1

Stabilisation – Unfinished Business; Monetary Growth High, Inflation Picked Up Since Summer

25% 5%

140% -15%

100%

-35% Jul-11

Jan-12

Jul-12

Non-oil imports, 3mma Y

60%

Jan-13

Jul-13

USD wages, 3mma Y

Source: Belarus Customs, Belstat, Morgan Stanley Research

20% -20% Jan-08

Exhibit 4

Goods and Income Deficits Underpin Widening CAD Jan-09 CPI, %Y M3, %Y

Jan-10

Jan-11

Jan-12 Jan-13 M1, %Y Refinancing rate, %

Source: Belstat, Morgan Stanley Research

2014 – déjà vu all over again? In 2013, the authorities set ambitious targets for restraining monetary growth and increasing reserves, and failed to meet them. In the June revised letter of intent for the sixth tranche of the Eurasian Anti-Crisis Fund, a wide range of quantitative and structural targets were set, many of which were not met, including for instance an increase in domestic bank claims of no more than 15%, reserve cover of at least 2.1 months of imports by yearend, and US$2.5 billion in privatisations by end-2013.

2000

mil US$

1000 0 -1000 -2000 -3000 -4000 1Q-10

1Q-11

1Q-12

1Q-13

Goods Balance

Services

Primary Income

Secondary Income

Current Account

Source: NBB, Morgan Stanley Research

3


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Given this track record, many may feel sceptical that the authorities will deliver the key targets set in the 2014 monetary programme, which include a reserve increase of US$0.2-0.5 billion, an average refinancing rate at 14-16% and an increase in domestic bank claims of 16-19%. Exhibit 5

Belarus Missed the Targets in the 2013 Monetary Programme Target in 2013 monetary programme

End-2014 outcome

Reserves increase by US$0.3-0.7bn

Reserves fell by 18% or US$1.4bn

Refinancing rate 13-15% (and positive in real terms, i.e., inflation below the refinancing rate)

Refinancing rate 23.5%, inflation 16.5%

Increase in domestic bank claims of 17-20%

Increase in domestic bank claims was 25% after 11 months (and 34% including the government)

Source: NBB, Morgan Stanley Research

Russian backstop: However, as discussed in Belarus Economics: Asset Sales to the Rescue, October 23, 2013, we see the most plausible source of external financing as being Russia, given the politically unattractive conditionality demanded by the IMF, and the challenge in accessing the market in the required volumes. Our base case is that Russia continues to provide the financing required to maintain reserves around the current level and prevent a further sharp weakening in BYR, both through direct financial support and via the Eurasian development bank, through privatisation, with Russian companies buying Belarus assets, and through continuing to provide gas and oil at subsidised prices. Our confidence in this call was reinforced by the late December announcement that Russia would provide Belarus with a US$2 billion loan in 2014. Conditionality means more responsible financial policies, we think: However, in return we think that Russia will expect Belarus to run a responsible macroeconomic policy and avoid a crisis, sell some assets to Russian companies, and align some elements of economic policy with Russia, notably by raising cost recovery for utility payments from households and raising excise taxes to match Russia. In particular, we note the end-December announcement that the disbursement of the final US$400 million tranche of the current US$3 billion Eurasian anti-crisis loan would be delayed by six months. This suggests, we think, that Belarus needs to make progress on the conditionality in the June 2013 letter of intent in order to secure the final disbursement, with Russian Finance Minister Shatalov focusing in particular on the need for real wage growth to increase in line with productivity growth, and for a slowdown in the growth of bank credit to a level consistent with low inflation.

2014 consolidation for 2015 stimulus: In our view, President Lukashenko’s top priority will be to secure a convincing victory in the end-2015 presidential elections. Given the current fragility, with the wide external deficit, low reserves and still high inflation, we think that he will seek to achieve stabilisation in 2014 through tighter conventional monetary and fiscal policy, to give him policy room to pursue expansionary policies in 2015 in the run-up to the elections. As a result, we see growth being slower than the 1%Y expected in 2013, running at around 0%Y, with a fall in domestic demand offset by a pick-up in net exports. In 2015, we see a return to stimulus in the run-up to the end-2015 presidential elections, leading to a strong pick-up in domestic demand and growth rising towards 3%Y, restrained by a drag from trade. Exhibit 6

Belarus Forecast Indicators %Y

Real GDP Private consumption Government consumption Gross fixed investment Current account (% of GDP) CPI (%Y) General government balance General government debt BYRUSD (eop)

2012

2013E

2014E

2015E

1.70 10.80 -1.00 -11.00 2.7 21.7 0.7 31.3 8570

0.90 8.50 -3.00 10.00 9.4 16.6 0.5 32 9510

0.00 -1.00 -3.00 1.00 7 11 0 35 10556

2.50 5.00 3.00 5.00 9.5 15 -1.5 38 12140

Source: Belstat, NBB, Morgan Stanley Research estimates

Risks Substantial to the downside: We think that risks are skewed to the downside, given the fragile financial situation. In particular, we see a significant risk of a devaluation-inflation spiral if the authorities pursue expansionary policies again, for instance by mandating another large wage increase. We also see a risk of a sharp fall in the currency if the Belarussian authorities fail to satisfy Russian demands, who then respond by delaying provision of additional financing. Modest to the upside: We see the scope for upside in growth as relatively limited, although a good harvest after the poor 2013 harvest could add 0.5pp to GDP, and there may be some further upside if the privatisation of some Belarus assets triggers an inflow of investment from the new owners. We are also sceptical that the authorities will be able to bring inflation down much below the target 11%Y, given entrenched inflation expectations and the ongoing increases in excise taxes and utility bills.

4


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Czech Republic: Another Go at the FX?  The economy looks set to have picked up speed in 4Q, though it remains to be seen how much of this is borrowed growth from 1Q14.  We think that the CNB will stick to the FX peg this year, but would also view risks tilted towards a higher EURCZK rate.  Political uncertainty should lift following the formation of the Sobotkaled government.

The Czech economy has emerged from recession: Revised 3Q GDP data show that the economy grew by 0.2%Q, leaving the year-on-year rate at -1.2%. In terms of its structure, we see that private consumption continued to contract (-0.7%Q), whereas government consumption provided an offset (+1%Q). Fixed investment contracted for the seventh consecutive quarter (-0.4%Q). On the external side, both exports and imports rose in quarter-on-quarter terms, by 1% and 2.8%, respectively. The contributions show that compared to the previous year domestic demand neither added nor subtracted from growth; net exports turned into a drag (-1.1pp), a rare occurrence in the open Czech economy. Taking a longer-term view, it is clear that the domestic economy (household consumption and fixed investment) has been sluggish for some time. Exhibit 1

Growth Contribution Shows Broad-Based Weakness in 3Q 6

%Y HH Consumption weakness

4

Pasquale Diana (more on this below). Consumers may have chosen to bring forward purchases before prices rise in response to the FX move. If this is the case, consumption could have a decent 4Q, but only to suffer a payback in 1Q14. All in all, after the recent revisions we see growth of 1.7%Y in 2014, after -1.4%Y in 2013. These numbers are only marginally higher than in our previous forecasts.

Monetary Policy: How Stable Is the Peg? The Czech National Bank announced in November that it has started a policy of FX purchases, and will intervene to weaken the koruna against the euro to a level “close to 27”. The currency reacted instantly by depreciating strongly to around 27 versus EUR. CNB Governor Singer added that the bank has “unlimited room” to intervene, and that changes in the target FX rate (around 27 versus EUR) will be very rare or not happen at all. In other words, this looks more and more like a peg at around 27 versus EUR. Our understanding is that de facto the peg is asymmetric, in that the CNB would probably tolerate a somewhat weaker CZK than 27 versus EUR, but not a stronger CZK at this stage. If this is true, the peg is best thought of as a EURCZK ‘floor’ at 27. Fears of prolonged low inflation explain the move: The CNB revised down the inflation forecast significantly in November, especially in the near term. Monetary policy inflation (ex taxes) is even forecast to dip briefly into negative territory in early 2014. Both headline and monetary policy CPI get close to the 2%Y target towards the end of the forecast horizon.

2 0 -2 -4 -6 Q1-2010

Q1-2011 HH Consumption Net Exports

Q1-2012 Gov't Consumption Inventories

Q1-2013 Fixed Investment Headline GDP, %

Source: Haver Analytics, Morgan Stanley Research

The 4Q data out so far show that the economy is performing better: IP is tracking 2.5%Q higher than in 3Q; retail sales could rise by 1.4% versus 3Q; and trade flows are up strongly, in both exports (+2.6%Q) and imports (3%Q). It is possible that these data, especially retail sales, are distorted by the November decision by the CNB to weaken the koruna

Consistent with this baseline forecast (which assumes EURCZK at around 25.7) is a sharp fall in interest rates to negative levels, which is obviously not possible. Hence, the CNB also introduced an alternative scenario, in which the koruna weakens to 27 and remains roughly there through 2014: in this scenario, inflation rises faster and GDP is also boosted in the near term. A couple of points worth noting: While the forecast implicitly suggests that this peg will hold only through to 2014, Singer said clearly that he can see this policy in place for longer than that. Second, by assuming that a 4.5% weaker assumption for CZK (from 25.7 to just under 27) translates into a 1% rise in inflation (see 4Q14 CPI assumption in Exhibit 4), the CNB is assuming a pass-through coefficient of around 20-25% – not far from earlier estimates but quite possibly on the high side, given currently low pricing power.

5


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 2

Change in the Baseline CPI Forecast… 4

6.0

3

4.5

2

3.0

1

1.5

0

0.0

-1

-1.5

I/09

I/10

I/11

I/12

Differences

I/13

I/14

I/15

Previous forecast

New forecast

Source: CNB November Inflation Report, Morgan Stanley Research

Exhibit 3

…and the Implications for 3M Pribor (Negative) 3

2.4

2

1.6

1

0.8

0

0.0

-1

-0.8

I/09

I/10

I/11

I/12

Differences

I/13

I/14

I/15

Previous forecast

The CNB’s Projections and the Alternative Scenario of FX Purchases 5 26.8

4 3.3 3.0

25.7

2.5 2.2

2

1.8

2.1

2.0 1.8

25.8

25.9

25.9

25.7 25.6

25.4 25.2

2.1

1.5 1.2

1.2 1.0 0.8

1 0.3

0.5 0.3 0.2

0.4 0.0

0 -1

-0.9

-0.9

-1.5

-2 IV/2014 I/2015 Consumer prices

2013

2014 GDP

previous forecast

2015

2013

2014

2015

3M EURIBOR

new forecast

Also, the November decision and rationale show that Inflation Reports are critical for the CNB to reassess its strategy. This is why relaxing, revising or abandoning the peg is far more likely to happen after the CNB has seen a new inflation forecast (February, May, August, November). We think that the peg will be in place through the year, and would view risks tilted towards a revision of the CZK parity weaker (to create more inflation), rather than an early return to a free float. This is because, as we stressed before, we think that the CNB’s FX pass-through is quite ambitious. In addition, it makes sense to assume official rates at the technical zero (0.05%) for the foreseeable future (well into 2015): The CNB’s exit strategy will involve probably announcing first that FX interventions are no longer part of its toolbox, and only afterwards resorting to some rate normalisation.

Politics: Coalition Formed, at Last

Exhibit 4

3

How long will this policy be in place? And what are the risks? The December CPI began to show some impact on prices, particularly imported food prices. That said, it will take at least another couple of CPI prints to get a better sense of how effective the CZK move was at creating some inflation.

New forecast

Source: CNB November Inflation Report, Morgan Stanley Research

3.0

We argued early last year that the CNB would start FX purchases, in an effort to boost the economy and avert the spectre of deflation. After several months of discussion but no action, we (and many others) had given up on the idea. It is possible that the CNB board only decided on this policy after several months of discussions, and by a narrow vote (not disclosed).

2013

2014 EURCZK

alternative scenario

2015

The negotiations post October 25-26 elections were long and difficult, but at last uncertainty is about to be lifted. The centreleft CSSD, pro-business ANO and the centrist KDU-CSL formed a coalition in January, which should command 111 out of 200 seats in parliament. President Zeman is expected to nominate CSSD leader Sobotka as PM, although he has voiced some reservations about some of the chosen ministers. The coalition is borne out of compromise, and publicly announced that it will not increase taxes in 2014 to fund government and social welfare objectives. This came as a relief, as a corporate tax hike or a special telecom tax were mentioned as a real possibility. That said, the coalition kept the door open to tax hikes in 2015 in case not enough savings can be found elsewhere. The coalition remains committed to keeping the deficit sub-3% of GDP.

Source: CNB November Inflation Report, Morgan Stanley Research

6


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Georgia: Rising Risks from Protracted Political Transition  Growth slowed and the lari weakened in 2013. We see rising economic risks going forward, given Georgia’s heavy dependence on external financing.  We expect growth to recover from 2.8%Y in 2013 to 4.0%Y in 2014, supported by net exports, and inflation to pick up to average 7%Y in 2014, driven by import inflation as the lari weakens to about 1.76 versus USD by year-end. This would trigger a 50bp hike by the NBG, we think.  More clarity on economic policy and more pro-growth reforms are needed from the new political leadership to restore investor confidence, which would support growth and the exchange rate.

Growth slowdown in 2013: Georgia enters 2014 following a significant slowdown, as growth decelerated to 1.8%Y in 1-3Q13 compared to 6.5%Y average growth in 2010-12. According to Geostat monthly estimates, there was a pick-up in growth in October-November, but it’s hard to judge whether it’s a reversal of the trend yet. Exhibit 1

Sharp Growth Slowdown to 2.6% in Jan-Nov 2013 Parliamentary elections Oct-2012

15%

Alina Slyusarchuk

Weakness driven by domestic demand, we think: Although the transition of power from the United National Movement to Georgian Dream was peaceful, and there was some economic benefit from the normalisation of relations with Russia, so far the new government has not enjoyed the economic success of the previous one. Nonetheless, we believe that this was largely due to domestic rather than external factors, since the nominal GDP breakdown by consumption showed that the domestic components of demand (fixed investment, consumption and inventories) all made a negative contribution to growth (-3.1pp, -1.4pp and -1.8pp, respectively) – and the only support for growth which kept it positive was a strong net exports contribution at 9.1pp. We see two possible reasons for this weak performance. First, the uncertainty associated with the political transition and the new government. Second, the implementation of more populist policies, including cutting tariffs and increasing spending on wages and pensions (for more details, see Georgia Economics: Economic Success at Risk in Political Transition, November 26, 2012). Our concern is that such policies might lead to a slowdown in investment, needed to support growth, and inflows, needed to finance Georgia’s wide current account deficit.

10%

Exhibit 3 5%

Can Economic Success Be Revived?

0% -5% -10% 1Q-04

1Q-06

1Q-08

1Q-10

1Q-12

Nov-13

Medium-term scenario

2011

2012

2013F

2014F

GDP, %Y

7.2

6.2

2.8

4.0

3-4

5-7

8-10

FDI inflows, % of GDP

7.8

5.5

6.5

6.3

4-6

7-9

10-15

CA, % of GDP

PPPPP

Steady Golden

-12.7

-11.5

-5.5

-4.5

15-20

12-14

8-11

Source: Geostat, Morgan Stanley Research

Budget Balance,% GDP

-0.9

-0.7

-1.0

-1.5

-3 / -5

1 / -1

2-3

…and a weaker lari: In addition, the lari weakened markedly since mid-November, by 4.1% from 1.67 to 1.75 versus USD.

Gov-t Debt, % of GDP

29.7

32.5

32.0

31.0

34-36

31-32

29-30

CPI, %Y, avg

8.7

-0.9

-0.5

7.0

7-10

4-6

3-5

Lari/USD, eop

1.67

1.66

1.74

1.76

1.8-2.0

1.5-1.7

1.2-1.4

EODB

12.0

9.0

8.0

-

40

9

7

Real GDP, %Y

Oct-Nov 13 GDP growth by months, %Y

Exhibit 2

Lari Weakening 1.76

6.0 5.6

1.72

5.2 1.68 4.8 1.64 1.60 Jan-12

Source: Geostat, Morgan Stanley Research. Note, for more details on medium-term scenarios, see Georgia Economics: Economic Success at Risk in Political Transition, November 26, 2012

4.4

Jul-12

Jan-13

Lari/USD Source: Geostat, Morgan Stanley Research

Jul-13

Lari/100RUB (rhs)

4.0 Jan-14

More political uncertainty after presidential elections in October 2013: The October 2013 presidential elections outcome was in line with our and market expectations (see Georgia Economics: Margvelashvili Leads in Poll, October 25, 2013). Giorgi Margvelashvili, the ex-Minister of Education and a candidate from Georgian Dream, won the elections. The new president’s inauguration was then followed by the resignation of PM Ivanishvili, the key figure in the recent

7


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Georgian political transition, and his replacement as PM by the 31-year old Minister of Internal Affairs, Irakli Gharibashvili. As a result, Georgia has a new and inexperienced leadership team, while the role of Ivanishvili in government remains unclear. The lari weakness is explained by two factors: 1. Loose domestic policies run by the government: The NBG cut rates in 2013, as inflation stayed below target and monetary growth picked up. Still we note that this can be justified, given inflation below target and a commitment to tighten monetary policy if required to keep inflation close to the 5% target (for more details, see Georgia Economics: PreElection Easing on All Fronts, March 1, 2013). As inflation accelerates further, triggered by lari weakness, we expect 50bp of tightening in 2014. In addition, the government ran a looser fiscal policy, with social benefits up by 22% and wages by 16%Y in January-November 2014. Exhibit 4

Rising Inflation to Trigger Monetary Tightening, We Think

Exhibit 5

Trade Deficit Still Wide at 31% of GDP Jan-01 0.0

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

Jan-13 100 80

-1.0

60 -2.0

40

-3.0

20 0

-4.0

-20 -5.0

-40 Trade balance, bn USD, 12m sum

-6.0

-60

Exports, %Y, 3m avg (rhs) Imports, %Y, 3m avg (rhs) Source: Geostat, Morgan Stanley Research

Exhibit 6

The Switch from Portfolio Inflows to Outflows Points to a Lack of Investor Confidence 1200

US$ million

1000 16

%Y

800

12

600

8

400 200

4

0 -200

0 -4 Jan 07

-400 1Q-04 1Q-05 1Q-06 1Q-07 1Q-08 1Q-09 1Q-10 1Q-11 1Q-12 1Q-13

Jan 08

Jan 09

Jan 10

Jan 11

Monetary Policy Rate (EOP, %)

Jan 12

Jan 13

CPI, %Y

Direct

Other

Portfolio

Fin derivatives

Source: NBG, Morgan Stanley Research Source: Geostat, Morgan Stanley Research

2. Financial outflows triggered by political uncertainty: On the external account, the current account deficit narrowed, supported by exports to Russia. But consumer imports rose at the end of the year, leaving the trade deficit still wide at 31% of GDP. However, the financial account deteriorated as investors were on hold in 2013 waiting for more clarity on government policy (for more details, see Georgia Economics: At Risk of a Sudden Stop, June 21, 2013). Finally, as mentioned above, we think that this political uncertainty was exacerbated by the exit of Ivanishvili, the central figure in the Georgian Dream movement, from government.

Risks: We think that the primary risk for Georgia is a fall in external financing, leading to pressure on reserves, and triggering a significant weakening in the currency, which in turn could lead to rising inflation. On some metrics measuring the vulnerability of the external and fiscal accounts and the banking sector, we found that Georgia is more exposed than large CEEMEA peers. Its external debt/GDP ratio is at 83.8%, only lower than Hungary. Also, Georgia’s external debt to exports ratio is the highest among its peers in the CEEMEA space at 196%. Another source of vulnerability is the high level of dollarisation in the banking system, with 46% of household loans and 75% of corporate loans in FX. As a result, a sharp move in the lari could lead to a spike in NPLs at banks.

8


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Ghana: Fiscally Fractured  High debt costs and an intractable wage bill will likely keep the fiscal deficit at an elevated level in 2014. We forecast -9.5% of GDP versus the official estimate of -8.5%.  A relatively tepid recovery in exports is likely to be more than offset by a steady rise in imports of capital associated with the development of the second phase of the Jubilee oil fields as well as the Tweneboa, Enyera and Ntomme fields, at a time when the oil import bill also remains sticky. This should keep the current account in deficit territory.  Despite a 25% depreciation from USDGHS 1.9 at the beginning of 2013 to USDGHS 2.37 at the end of that year, we expect the cedi to lose a further 10% to USDGHS 2.60 at the end of this year (previously USDGHS 2.40).

Fiscal metrics to come in worse than official estimates: Despite numerous promises that it would reduce its fiscal deficit to single-digit territory, Ghana posted yet another year of double-digit deficits in 2013, thanks to an intractable wage bill and high debt costs. The 2014 budget deficit has been set at 8.5% of GDP, thanks in large measure to an anticipated deceleration in the wage bill from an average of 30% in the past five years to 5% in 2014, as well as a containment of goods & services expenditure. With regards to the wage bill, the fundamentally flawed single spine salary structure (SSSS), which neither has well-defined performance nor anchor benchmarks against which wage demands are harnessed, will make it difficult to break the vicious cycle of simply harmonising marginal wage demands to the highest point on the pay scale. To be clear, we expect the wage bill to rise by 10-15% at the least. With inflation consistently surprising both the Treasury and the Bank of Ghana to the upside, forcing bond yields to remain in double-digit territory, we expect interest costs to also come in higher than budgeted. On the whole, therefore, our forecasts point to a higher deficit of some 9.5% of GDP – uncomfortably close to double-digit territory yet again. Rather than consider cutting its cloth accordingly, we believe that the higher deficit is likely to push the government to raise even more debt, lifting the country’s debt ratio from some 26% of GDP in 2006 through an estimated 55% in 2013 to 62% in 2015/16. We note that parliament has already granted approval for the issuance of a third Eurobond. We believe that this bond is likely to be conveniently issued ahead of the publication of the Amendment Budget in June/July 2014, where we look for the fiscal authorities to display yet another set of disappointing metrics. The country’s persistently rising debt ratio not only raises the risk of further sovereign ratings downgrades, it is also likely to be a drag on GDP growth.

Michael Kafe/Andrea Masia Contrary to official estimates of 8-10%Y in the next three years, we expect GDP to consolidate within the 7.5-8%Y range, thanks to a modest recovery in agriculture and some momentum loss in construction activity after posting heady growth rates that were led by positive sentiment associated with the discovery and eventual production of oil. While industrial activity is likely to post a significant recovery in 2014 as a result of base effects associated with the power outages last year, we expect this to fall out of the wash in 2015. The services sector – dominated by trade, financial services, public administration and hotels – should come in at around 8.5%Y in 2014 (down from 10.4%Y in 2011 and 10.2%Y in 2012) as higher interest rates and a tepid recovery in global trade continue to constrain an otherwise buoyant sector. However, there may be some modest upside from the oil and gas sector in the year(s) ahead. While official assumptions for the 2014 Budget were based on a thankfully conservative oil price level of US$93/bbl and an average daily volume of 93,029 bpd, we have no reason to doubt that production volumes of 100,000-120,000 bpd are achievable – i.e., broadly similar to current production levels of 110,000 bpd. Add to this prospects that the 150 million sfpd (standard cubic feet per day) - capacity Ghana Gas Infrastructure Project (GGIP) in the western region of Atuabo is completed by mid2014 after initial delays, and there could conceivably be some modest upside in the petroleum sector output, which currently accounts for some 6.5% of GDP. Exhibit 1

Macro Snapshot %Y

2010

2011

2012

2013E

2014E

2015E

GDP Services Industry Agriculture Current acc. bal. (%GDP) Fiscal balance (%GDP) Public debt (%GDP) Domestic External CPI USDGHC Policy rates Population (millions)

8.0 8.8 6.9 5.3 -8.6 -7.4 38.2 18.0 20.2 10.8 1.5 13.5 24.2

15.0 10.4 41.6 0.8 -9.0 -5.5 40.9 20.0 20.9 8.7 1.7 12.5 25.0

7.9 10.2 7.0 1.3 -12.3 -12.0 49.2 25.8 23.4 9.2 1.9 15.0 25.5

7.5 8.3 8.0 3.0 -10.5 -10.5 55.0 30.0 25.0 11.4 2.37 16.0 26.0

7.8 8.5 8.0 4.0 -8.5 -9.5 58.5 32.0 26.5 10.0 2.60 16.0 27.0

7.8 8.8 7.0 5.0 -7.5 -7.5 62.0 35.0 27.0 9.2 2.80 16.0 27.5

Source: Ministry of Finance, Ghana Statistical Services, Bank of Ghana, Morgan Stanley Research estimates

9


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

External sector metrics to remain in negative territory despite a modest improvement in trade flows: With regards to the external sector, we expect sustained oil production of at least 110,000 bpd to boost export receipts by some US$4 billion in 2014, supported by gold receipts of some US$5 billion and cocoa export proceeds of just under US$2.5 billion. However, our European colleagues’ view of dim growth prospects in that continent leads us to temper our view of a potential pick-up in Ghana’s exports, given that Europe accounts for roughly a third of its export trade with the world. With regards to imports, outlays on crude oil and refined products (roughly a fifth of total imports of some US$18-20 billion) are likely to remain sticky at around US$3.5-4 billion for now. This is because, while the availability of gas from the Jubilee field will no doubt place a lid on gas imports at some point after GGIP attains full functionality, we believe that this is more likely to occur in 2015 and beyond. The non-oil import bill is also likely to be buoyed by a rise in capital imports associated with the development of the second phase of the Jubilee oil field as well as Project T.E.N (Tweneboa, Enyera and Ntomme oil fields). Key infrastructure imports for the latter include oil production, water injection and gas reinjection equipment, as well as an FPSO vessel and associated subsea equipment for the processing and storage of crude oil. Freight and insurance costs associated with these imports are likely to combine with higher interest and dividend payments to foreign holders of Ghanaian portfolio investments to keep the net invisibles in negative territory, although this will be offset in part by transfers and remittances from Ghanaians living overseas. On the whole, therefore, the current account deficit is unlikely to decline sharply over the next few years, in our view. Thanks to the anticipated prevalence of twin fiscal and current account deficits in 2014/15, we expect the Ghanaian cedi to remain under pressure for most of the year. To be clear, despite a 25% depreciation from USDGHS 1.9 at the beginning of 2013 to USDGHS 2.37 at the end of that year, we look for a further depreciation of roughly 10% to USDGHS 2.60 at the end of this year (previously USDGHS 2.40), and to weaken further to USDGHS 2.80 (previously USDGHS 2.55) by the end of 2015.

The weaker currency should keep inflation elevated throughout 1H14, although technical base effects associated with the high reading of 3.7%M that was captured in the new index for January 2013 (thanks largely to sharp increases in food, transport and health prices) versus an average of 2%M for the last five years of the old index suggests that headline CPI is unlikely to accelerate any further this year – unless of course the currency blows out or food/oil prices come in much higher than we think. Policy rate to remain on hold at 16% through 2014/15: After rising from 8.8%Y at the end of December 2012 to a high 13.2%Y in November 2013, we believe that inflation will come off the boil but remain elevated in double-digit territory through 1H14. Thereafter, other technicalities from the huge increases in electricity and utility tariffs in 2H13 should aid a return to upper single-digit territory towards the end of the year. For the year as a whole, we look for an average reading of some 10%Y in 2014 before declining to 9.2%Y in 2015. Such a downward trend in CPI means that, in the absence if a currency event, the Monetary Policy Committee of the Bank of Ghana is unlikely to tighten policy this year. Exhibit 2

External Sector Metrics US$ millions

2012

2013E

2014E

2015E

Balance of payments on current account Trade balance -4,221 Exports 13,541 Cocoa 2,829 Gold 5,643 Timber 121 Oil 2,976 Others 1,972 Imports -17,763 Non-oil -14,433 Oil -3,330 Net invisibles -700 Services -975 Incomes -2,130 Transfers 2,406 Current account -4,922 % GDP -12.2

-4,300 13,500 2,000 5,000 200 3,800 2,500 -17,800 -14,400 -3,400 -1,100 -1,000 -2,100 2,000 -5,400 -12.6

-3,600 14,400 2,500 5,000 200 4,200 2,500 -18,000 -14,300 -3,700 -800 -1,200 -2,000 2,400 -4,400 -10.5

-3,450 15,550 3,000 5,300 250 4,300 2,700 -19,000 -15,000 -4,000 -600 -1,400 -2,000 2,800 -4,050 -8.5

Balance of payments on capital account Net fin transactions 3,091 Direct investment 3,293 Portfolio investment 1,122 Other -1,325 Errors and omissions 620 Overall balance -1,211 Change in reserves 1,211 GDP 40,436

4,700 3,000 1,500 200 -700 700 42,754

4,200 3,000 1,000 200 -200 200 42,000

4,550 3,000 1,200 350 500 -500 47,407

Source: Bank of Ghana, Morgan Stanley Research estimates


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Hungary: It All Hangs in the Balance Now  Growth is going through an internal rebalancing process and we should finally see better domestic demand, courtesy of fading austerity and faster credit growth (via FGS). We see growth of 2.2%Y this year, after 1%Y in 2013.  Inflation will rise due to base effects, to end 2014 at around 2.7%Y. That said, more near-term regulated price cuts skew the risks towards the downside. The NBH should cut rates further, to 2.60% in 1Q – and raise them by year-end (3.25%).  Regardless of the base rate, we think that the Funding for Growth Scheme (FGS) will be the key determinant of monetary conditions. We think that the NBH will widen the scheme in scope to ensure maximum take-up  Fidesz looks set to win another landslide in the spring elections. Investors’ focus will be primarily on whether and how they intend to change taxation for the banking system. PM Orban’s stated intention to have more of the banking system in Hungarian hands suggests that the authorities still expect some high-profile exits of foreign banks from the market

There is no doubt that 2013 was overall a better year for Hungary than most would have expected: There were many key successes. First, the fall in inflation and interest rates, which were lowered to a record-low of 3%, courtesy also of a broadly supportive risk backdrop. Second, the exit from the Excessive Deficit Procedure (EDP) for the first time in nine years. Third, Hungarian assets proved remarkably resilient in the face of the post-May ‘taper-scare’, likely due to a solid external position (current account surplus). Fourth, for all the talks about unorthodoxy, both fiscal and monetary authorities refrained from controversial policies: there was no unilateral conversion of FX mortgages into HUF; and the central bank’s ‘unorthodoxy’ consisted of the Funding for Growth Scheme (FGS), hardly an extreme case of unconventional policy. Fifth, the economy is finally back on a growth path. However, Hungary sceptics can point out flaws in each of these successes. First, a large part of the fall in inflation owes to government-sponsored cuts in energy prices, which hurts investment in the sector and has budget costs; second, the exit from the EDP was achieved via yet more tax increases on banks (hike in the Financial Transaction Tax, plus a one-off charge), which speeds up deleveraging and hurts long-term growth; third, the government still plans to rescue FX mortgage borrowers ahead of the spring elections, so the jury is still out on this issue; fourth, the FGS weakens the monetary transmission channel, and can result in asset quality issues in the years to come; fifth, the ongoing cyclical improvement does nothing to address Hungary’s structural

Pasquale Diana growth problem, which is related mostly to ongoing bank deleveraging and weakness in investment. A make-or-break year: 2014 could be the year where Hungary confirms the recent trend of stability and the growth upswing gets entrenched and the election turns out as a nonevent. Conversely, 2014 may see the return of Hungaryspecific risk, which all but disappeared in 2013. In this outlook, we look at the key themes and risks in the year ahead.

Growth Improvement Under Way, Economy More Balanced The outlook for the Hungarian economy has clearly improved, we think. The 3Q GDP details in Hungary showed growth of 1.8%Y, on the back of a 0.9%Q rise, the third consecutive sequential increase in GDP. On the supply side, agriculture was very strong (+27.6%Y) on account of a good harvest and a base effect. Note that, ex agriculture, 3Q GDP would have expanded by a much more modest 0.5%Y. On the expenditure side, there was softness in public consumption (-0.1%Q) and household consumption (0%Q), but another decent gain in fixed investment (+1.1%Q). Exports grew strongly again (+1.9%Q), outpacing imports (+0.1%Q). Looking at contributions, net exports were still the main driver of growth in 3Q (+0.9pp), but investment (+0.6pp) and government consumption (0.4pp) also boosted GDP. Therefore, the economy started to show signs of internal rebalancing in 3Q, with domestic demand also growing. Exhibit 1

Economy Goes Through Internal Rebalancing 5.0

%pts contribution to YoY growth

4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 Q1-2010

Q1-2011

Q1-2012

HH Consumption

Gov't Consumption

Net Exports

GDP

Q1-2013 Gross Investment

Source: Haver Analytics, Morgan Stanley Research

11


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

While 3Q GDP benefitted from some one-offs (harvest), the 4Q13 data show a good momentum into 2014. IP is tracking 0.5% higher than in 3Q, retail sales are up 0.2%, and the trade balance has continued to grow year over year, pointing to yet another positive contribution from net trade. We believe that Hungary can grow by 2.2%Y this year, after 1%Y in 2013. These forecasts are broadly unchanged from our previous forecasting round.

Inflation: Just How Low Is it, Really? Inflation has slowed to just 0.9%Y in November, and is likely to have ended 2013 around 0.5%Y. However, we note that headline inflation benefitted significantly from government policy and administered price changes. For example, regulated energy prices were cut by a cumulative 20% in 2013, and water and sewage charges were also cut: as a result, administered price inflation was running at -10% in November. Also, fresh food inflation trends have been benign, courtesy of the good harvest. All in all, the inflation backdrop seems benign, but nowhere near as much as suggested by headline CPI: For instance, inflation excluding fresh food and all energy was running at 2.8%Y in November; CPI ex fresh food, seasonal products and all regulated prices was 3.5%Y, above target. While the ‘true’ underlying inflation trend is hard to discern, the near-term profile still seems benign; inflation should stay under 1%Y until April, before rising more steeply due to base effects; we expect CPI at 2.7%Y by year-end. Note that another energy price cut ahead of the elections (to be discussed on January 24), coupled with a cut on VAT for meat (both rumoured by officials), could cause some deflation in the next few months. Exhibit 2

The National Bank of Hungary cut rates by 20bp to a new all-time low of 3% in December 2013: The December statement was dovish, with the NBH noting that there are no material inflationary pressures in the economy. The new Inflation Report shows that the CPI forecast for 2014 was revised down by over 1pp. The NBH now sees average CPI of 1.7%Y in 2013, 1.3%Y in 2014 and 2.8%Y in 2015. In September, the NBH forecast average CPI at 2%Y in 2013 and 2.4%Y in 2014 (no 2015 forecast). The new inflation projections look close to ours, especially for 2014 (1.4%Y in 2014 and 3.2%Y in 2015). The overall message is that the bank does not see inflation returning to target until late 2015. Note also that the forecast does not account for another possible cut in energy tariffs in early 2014, which was mentioned by PM Orban as a possibility. Therefore, near-term inflation risks are probably still to the downside. Exhibit 3

NBH Policy Rates and the Risk Backdrop 1200

320

1100

315

1000

310

900

305

800

300

700

295

600

290

500

285

400

280

300

275

200 1/1/2012

270 7/1/2012

1/1/2013

5yr CDS (LHS) NBH base rate (RHS)

7/1/2013 10-yr bond yield (bps, LHS) EURHUF (RHS)

Source: Bloomberg, Morgan Stanley Research

Gauging Price Pressures: Core versus Headline 8.0

Monetary Policy: Rates to Keep Hitting New Lows

Exhibit 4

NBH Revised Down its CPI Outlook Through 2013

%Y

7.0

7.0

6.0

%Y

6.0

5.0

5.0

4.0

Target

3.0

4.0

2.0

Target

3.0

1.0 2.0

0.0 Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12

Jan-13

CPI ex fresh food, seasonal products, reg prices

CPI ex energy and fresh food

CPI ex reg prices

Headline CPI

Jul-13

1.0 0.0 Jan-09

Jan-10

Jan-11

Jan-12

Dec-13

Source: Haver Analytics, Morgan Stanley Research

Jan-13 Sep-13

Jan-14

Jan-15 Jun-13

Source: NBH, Morgan Stanley Research

12


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Hints of caution: Smaller cuts ahead? In light of the benign inflation backdrop, it is no surprise that the NBH should still keep a clear easing bias: the bank says that “further policy easing is likely to be required in order to deliver price stability in the medium term”. That said, the December statement added that considering the risk backdrop as well as the improvement in the growth outlook, smaller rate cuts are likely to be warranted in the future. Why the change? It looks to us as though the NBH is trying to perform a difficult balancing act. It wants to use as much of the room to ease that comes from low inflation; and at the same time, it is trying to position for a more challenging risk backdrop by indicating that it will be more cautious. In practice, this suggests cuts of 15bp (or even 10bp) ahead, slower than the current pace of 20bp. At present, we stick to our 2.60% terminal rate forecast in 1Q14. Whether the NBH gets there by March or April is probably less important. What matters now is that the bank shows pragmatism and indicates that it is willing to change its stance if the circumstances require. For instance, we very much doubt that the NBH would continue cutting if the risk backdrop worsened significantly.

The credit data show that in October/November the take-up on the second tranche of the FGS was modest, with only HUF 33 billion of new forint loans to corporates. NBH will likely widen the goalposts: We think that the NBH will continue to amend FGS to ensure that the funds are disbursed. And we think that the amounts themselves are fluid. The scheme is likely to be expanded in scope in early 2014, to potentially also include lending for real estate construction, as recently indicated by the NBH. Also, note that the NBH already expanded the scheme (initially only aimed at SMEs) to also cover farmers starting next year. Exhibit 5

FGS Boosted Corporate HUF Loans in August/September, Usage Dropped Recently 15

Credit to non-financial corporates, %Y

10 5 0 -5 -10

Does the Base Rate Even Matter? Enter FGS -15

One of the reasons why the bank is not going to continue cutting at all costs that the Funding for Growth Scheme (FGS) is fully operational and will be the channel via which most credit creation will take place. Background: The FGS was launched in April 2013, with the aim of creating credit in the SME sector. The NBH would lend to commercial banks at 0%, and banks would pass on these loans at a maximum interest rate of 2.5% (for a maximum of 10 years), either for HUF credit (Pillar I) or for refinancing of FX loans into HUF (Pillar II). First tranche went well: The total usage of the FGS scheme amounted to HUF 701 billion, or 93.5% of the total available funds (HUF 750 billion): of this, HUF 472 billion was allocated under Pillar I (HUF loans – 112% utilisation relative to initial target, of which 61% were new loans), and HUF 229 billion was allocated under Pillar II (redemption of FX loans – 70% utilisation). Second tranche so far more mixed: The NBH decided in September to increase the total loans in the scheme to an extra HUF 2 trillion (6.5% of GDP), the first tranche of which (HUF 500 billion) was made available in 4Q13. 90% of the total HUF 2 trillion is supposed to be used for new loans.

2011

2012

HUF

FX, adjusted

2013

Total, FX-adjusted

Source: NBH, Morgan Stanley Research

If we are correct in anticipating an expansion of the FGS scheme, the upshot is that, almost regardless of how many more cuts in the base rate we see from here, monetary conditions are likely to ease materially in 2014, as more cheap money finds its way into the system. This is because FGS funds are 300bp (or more) cheaper than overall bank funding. This is a huge rate cut almost regardless of what the base rate does next year. We need to stress that while the efforts to restart the credit cycle are no doubt positive, FGS could also create some distortions in the market. De-linking the lending rate and the base rate weakens the transmission mechanism, as we already observed. Also, injecting such a huge amount of liquidity into the economy in a short period of time could lead to asset quality issues (cost of funds is too low for some borrowers).

13


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Why we think that the NBH could hike in (late) 2014: A natural extension of the above argument is that the link between the base rate and the monetary stance (the transmission mechanism) is fundamentally weaker, because of the FGS. And therefore, it is entirely reasonable to expect the NBH to hike rates in the latter part of 2014 as inflation rises and other regional central banks (Poland) normalise their stance. As we argued above, the rate increases would enhance credibility for the NBH, yet have little cost in terms of overall monetary tightening, as the FGS would be a powerful offset. Because of the above, we pencil in rates at 3.25% by end2014, admittedly with some uncertainty: We do not have a precedent of how quickly the new Matolcsy-led NBH would react to better growth and rising inflation.

FX Loans: Solution Delayed, as Curia Rules in Favour of the Banks The government has thus far refrained from implementing another rescue scheme for FX borrowers due to legal uncertainty. The recent Supreme Court ruling favoured the banks, and further reduces the risk of the government acting unilaterally and approving a scheme which would be punitive from the banks’ standpoint.

Overall, the Curia ruling clearly favoured the banks, and it probably pushes out into the future any further schemes to support FX debtors. In addition, it greatly reduces the risk that one day the government would want to proceed with fullscale conversion of these loans into HUF, which would likely imply a huge NBH reserve drain. We still think that the government can and most likely will still provide another package of assistance to FX borrowers prior to the elections. But this will likely be an extension of current schemes rather than something far more radical. In terms of timing, this scheme should be announced at some point in 1Q14, we think.

Why FX Is Not a Policy Tool Among the several ‘conspiracy theories’, a popular one is that the government wants to deal with the FX debt holders in order to be able to subsequently stimulate the economy via a weaker exchange rate (and with the help of a complicit NBH). We find this theory fundamentally flawed, on many grounds:

Exhibit 6

Household Loans by Currency and Product

Total HUF bn # contracts of which local currency HUF bn # contracts FX HUF bn # contracts

Some uncertainty remains, in the sense that there was no verdict on the issue of unilateral contract changes – the Curia will wait for a European Court of Justice verdict on this. This may come in March/April, though a preliminary report could be ready in February.

Mortgage loans (i) + (ii)

Housing loans (i)

Home equity loans (ii)

Other Loans (iii)

Total (i+ii+iii)

5,377 1,030

3,298 673

2,079 357

1,256 4,605

6,633 5,635

1,878 584

1,485 450

393 134

911 4,237

2,789 4,821

3,499 446

1,813 223

1,686 223

345 368

3,844 814

Source: NBH Financial Stability Report, Morgan Stanley Research

In essence, the Court said that all FX risks should be borne by the borrowers. Also, these FX risks do not invalidate the contract; the Curia added that in case a contract is found to be void, then the court must find a way to make it legal. Moreover, contract modifications by local courts cannot be applied universally to all contracts.

First, there is no sense at all in which HUF is an obstacle to growth at present. After all, Hungary’s export sector is already a huge success story. A weak HUF policy would be hard to control, and may scare non-resident bondholders (46% of the market), creating far more damage in terms of higher bond yields than benefits. Second, there is other FX debt in the system including corporate debt (HUF 3.8 trillion, or 13% of GDP), roughly 50% of which is held by SMEs, in some cases small family firms which may not necessarily be naturally hedged through exports and not all of whom may have access to FGS to refinance in HUF. These borrowers would also still be vulnerable to FX swings. Third, and as important, the government is still heavily indebted in FX, with 41% of total debt denominated in foreign currency. Achieving a lower debt/GDP ratio would be problematic if not impossible at much weaker HUF levels, barring a very significant (and unlikely) growth upswing. Hence, we doubt that the government would be overly sympathetic to that policy either.

14


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Elections on the Way: Another Fidesz Landslide Is Likely While there is no firm date yet, it seems likely that Hungary will hold general elections in early April. There is more uncertainty than usual around the opinion polls, as these are the first elections held under the new electoral system, and they will also see the participation of ethnic Hungarians who live in neighbouring countries. Ruling centre-right Fidesz should score another landslide win, judging from the recent opinion polls, and possibly gain another two-thirds majority. The anti-bank rhetoric, the cuts in utility prices and recently the improvement in the macro numbers all explain why Fidesz is so well positioned to emerge as a winner, again. The polls also explain why Fidesz may not need another scheme to aid FX borrowers in order to secure re-election, we think. It is hard to see what Fidesz might do once elected. After all, predictions in 2010 turned out to be spectacularly wrong. Economy Minister Varga spoke of introducing a single-digit PIT rate (but not before 2015), which would cost 1.6% of GDP in lost revenues. Exhibit 7

Fidesz Extended its Polling Lead in 2013 80%

The key question will of course be whether Fidesz’s policy towards the banking sector will change if it is re-elected. Governor Matolcsy (former Economy Minister) said that four big foreign-owned banks (out of eight) may choose to leave Hungary in the next 6-18 months. Thus far, only MKB has indicated that it will sell its Hungarian stake, but other banks have expressed their desire to stay, despite the dismal performance of the last few years. The fact remains that PM Orban has repeatedly said that he wants 50% of the banking system in Hungarian hands, which implies some further exits from foreign banks or more aggressive growth in market share by local players, such as Takarekbank. Investors’ main concern is that tax policy will continue to keep banks under pressure, until several foreign players no longer view Hungary as strategic and decide to sell to local players, potentially even state-controlled ones. A more domestically owned banking system could insulate Hungary to a greater extent from international deleveraging pressures, true. At the same time, domestically owned banks, especially if under state influence, also run the risk of operating in a suboptimal way and allocating credit poorly. Slovenia is a clear case in point of a domestically owned banking system which now needs to be cleaned up and sold to foreign investors. See also Slovenia: Better Risk/Reward, but Key Tests Still Ahead, November 11, 2013 Exhibit 8

70%

Banks Have Been Busy Repaying External Funding Since 2009

60% 50%

45

40%

1.5 1.45

30%

40

1.4

20%

1.35

10% 0% Jan-07

35

1.3 1.25

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

30

1.2 1.15

Fidesz

MSZP

Jobbik

LMP

Together 14

25

1.1

Source: Median, Ceemarketwatch, Morgan Stanley Research; we show decided voters only

1.05 20 2009

1 2010

2011

2012

Banks' external liabilities (EURbn)

2013 LTD ratio (RHS)

Source: Haver Analytics, Morgan Stanley Research

15


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Israel: Suffering from the Strength of the Economy?  We predict that GDP growth will be 3.3%Y in 2013 and it will be nearly the same both in 2014 and 2015 at 3.4%Y. These are all near the potential growth rate of roughly 3.5%Y. We do not believe that inflation will be an issue in 2014, and think the BoI’s main concern will regard currency appreciation. Given this backdrop, we pencil in a 25bp hike in 3Q14 and another one in 4Q14.  The natural gas production, rising FX reserves, satisfactory growth and a current account surplus all point to a strong currency. We believe that the eventual solution to this will be the setting up of a sovereign wealth fund. Until then, FX interventions and waiting for the narrowing of the interest rate differential might be the only choices.

Tevfik Aksoy

various high-frequency data into account, we raise our 2014 growth forecast to 3.4%Y from 3%Y previously. Exhibit 2

Some Improvement in Exports 25

%Y sa

20 15 10 5 0 -5 -10

Exhibit 1

Composition of Growth: A Mixed Picture 37

%Q saar

27

-15 -20 D ec -0 M 9 ar -1 Ju 0 n1 Se 0 p10 D ec -1 M 0 ar -1 Ju 1 n1 Se 1 p1 D 1 ec -1 M 1 ar -1 Ju 2 n1 Se 2 p1 D 2 ec -1 M 2 ar -1 Ju 3 n1 Se 3 p13 D ec -1 3

Revising our growth forecast higher: Israel’s real GDP growth has been slightly below potential over the last couple of years, and we now cut the year-end growth rate to 3.3%Y in 2013 from 3.8%Y previously. Essentially, the overall growth has been on the back of private consumption and public spending, while both exports and fixed capital formation have been disappointing. Yet, in comparison to most of the EM or DM peers, the growth rate was relatively satisfactory.

Exports (%Y) Source: Haver Analytics, Morgan Stanley Research

Risks to our forecasts: There are not plenty, but clearly one significant issue would be a disappointment on the anticipated improvement in global demand. Since exports comprise a significant 40% of the economy, any slight weakness might have sizeable implications. Also, there have been quite a few mixed signals regarding the state of growth.

-13

For instance, looking at the PMI data, we see a visible weakness, with the index remaining in sub-growth territory almost consistently throughout the year. Should one be concerned by this? Perhaps not: The ‘state-of-the-economy’ or the S-index published by the BoI has been suggesting mild but visibly positive growth.

-23

Exhibit 3

-33

PMI: Still in the Contraction Zone

17 7

80

Q

Q

308 40 Q 8 10 Q 9 20 Q 9 30 Q 9 40 Q 9 11 Q 0 21 Q 0 31 Q 0 41 Q 0 11 Q 1 21 Q 1 31 Q 1 41 Q 1 112 Q 21 Q 2 31 Q 2 412 Q 11 Q 3 21 Q 3 313

-3

GDP

Private Consumption

Exports

Fixed investment

70

Source: Haver Analytics, Morgan Stanley Research

60 50 40 30

-1 3 ov N

3 -1

l-1 3 Ju

-1 2

ar M

ov N

2

l-1 2

-1 ar

Ju

-1 1 M

ov N

1 -1

l-1 1 Ju

-1 0

ar

ov

M

N

0 -1 ar M

Ju

-0 9 ov

l-1 0

20

N

In recent months, there has been a visible improvement in the exports performance despite the appreciation in the currency and the concerns regarding loss of competitiveness. While still far from being strong, this improvement is likely to be helping in 2014. Especially if private consumption remains resilient and backed up by low rates throughout the year (which is our base case assumption), with the improvement in investment spending and the help of the natural gas production (Tamar gas field), we believe that a similar GDP growth rate might be maintained in 2014 and 2015. Taking these assumptions and

Israel PMI: Manufacturing (SA, 50+=Expansion) Source: Haver Analytics, Morgan Stanley Research

16


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 4

Exhibit 5

State-of-the-Economy Index: Mild Growth Lingers

Inflation: Not a Concern 4.0 %Y

20

10

15

8

3.0

10

6

2.5

5

4

3.5

Upper Border for Target Band

2.0 1.5

-5

2

1.0

0

0.5

-10

-2

-15

-4

-20

-6 Q2-01

Q2-03

Q2-05

Q2-07

State-of-the-Economy Index (%Q saar)

Q2-09

Q2-11

Q2-13

GDP (%Q saar, right axis)

Source: Haver Analytics, Morgan Stanley Research forecast (dotted line)

Inflation rate to stay in middle of target band: Since summer 2011, inflation has been comfortably inside the Bank of Israel’s target range. With significant dissipation of the indexation of local prices (housing rent) to the dollar, the public’s reaction to excessive food price hikes that were later on removed and careful management of tax hikes helped. But most of all, we attribute the success in achieving price stability to the high credibility of the BoI. In our view, inflation will not be an issue in 2014 either, and we see CPI staying in the middle of the target range (1-3%Y) at an average rate of 2%Y throughout the year. We expect year-end CPI inflation at 1.8%Y this year, followed by a similar 1.98%Y in 2015. This is more or less the consensus view, mostly based on the premise that global energy prices will remain range-bound, growth will stay relatively flat and there will not be any need to adjust taxes. Indeed, the consensus inflation forecast for the next 12 months eased noticeably to an average 1.7%Y, according to data published by the BoI. The inflation expectations calculated from the capital market (derived from debt instruments) also eased to 1.6%Y, suggesting to us that the BoI is unlikely to be considering inflation as an issue for some time. House prices remain an issue: With interest rates being quite low and supply-side problems such as scarce land, red tape, construction delays and security issues creating significant headwinds to adding to the stock of dwellings, prices have been rising. While the non-interest rate measures as well as regulatory changes have been helping in slowing down the price rises, we do not think that the matter can be handled without dramatic changes on the structural front. This is likely to take time, and we have only seen very minor improvements taking place over the past five years even when annual price rises reached above 20%Y.

Lower Border for Target Band

0.0 Fe bM 09 ay Au 09 gN 09 ov Fe 09 bM 10 ay Au 10 gN 10 ov Fe 10 bM 11 ay Au 11 gN 11 ov Fe 11 bM 12 ay Au 12 gN 12 ov Fe 12 bM 13 ay Au 13 gN 13 ov -1 3

-

Inflation Expectations (Forecasters) Inflation Expectations (Derived from debt instruments) Source: Haver Analytics, Morgan Stanley Research

Rates are appropriate and further cuts might be futile in addressing the weakness in the currency: This has been our view for some time. And in recent months various comments from BoI officials gave the impression that there is no obvious disagreement on this: The decision by the Bank of Israel to keep rates unchanged at 1% has been unanimous for some time. Essentially, the five members including Governor Flug considered the current rate as “appropriate” and, while the door for some further easing has not been closed entirely, our read was that policy-makers will be looking for a meaningful deterioration in global or domestic conditions to take action. Since this is not a base case any more and there is growing anticipation of further improvement in growth in DM, we doubt that rates will be cut. Easing rates is no panacea for currency appreciation: In our view, easing the policy rate by 25bp or even 50bp to address currency appreciation would be a risky and very likely ineffective move. The reason behind the appreciation in the shekel is not the interest rate differential or the local currency assets being overly attractive but rather due to the fact that there is a current account surplus, generally good fundamentals and the anticipation of the positive impact of natural gas finds on the balance of payments. Essentially, there is a structural reason behind the strength of the shekel and monetary policy cannot address this, in our view. Since the sterilisation costs are minimal and likely to remain low for some time, direct interventions in the currency are likely to continue. As we have indicated in the past, the setting up of a sovereign wealth fund seems to be the most viable solution. Possible hikes in the second half of the year: Looking forward, we pencil in a 25bp hike for 3Q14 and an additional 25bp hike in 4Q14 to take the policy rate to 1.50%. But for this to materialise, we believe that the BoI should be convinced

17


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

that growth will be staying robust, the external demand for Israeli exports is improving sufficiently and there is no obvious widening in the interest rate differential. Budgetary steps for 2014: The Israeli Finance Minister Yair Lapid declared late in 2014 that the previously planned tax increases for 2014 will be revoked. The main reason behind this move was that the fiscal position has been strengthening and the budget deficit for 2013 was expected to be significantly below the targeted 4.65% of GDP. Indeed, the preliminary numbers suggest that the deficit might be limited to 3.5% of GDP, nearly half of the targeted figure. The planned tax hikes included the raising of the income tax brackets by 1.5pp for all income levels except the lowest. While there is a case that the budgetary performance has been better than expected so far, there is no guarantee that 2014 will see a similar picture since part of the strength in revenues in 2013 stemmed from those that were one-off in nature. That said, expenditures have also been under control and the overall picture has been satisfactory so far.

Meeting this target will require extensive policy measures, since the cost of the programs which the government decided on is already greater than the expenditure limit which will allow meeting the target”. FX reserves continue to grow: At US$82 billion, Israel’s FX reserves reached an all-time high. Clearly, the size of the reserves is very high on any metric one could look at. With the current account surplus at hand, which is likely to be growing steadily in the coming years as export revenues pick up on natural gas sales while imports decline, appreciation pressure on the shekel should remain, as we have pointed out consistently. Exhibit 7

FX Reserves Are Noticeably High and Rising 80

US$bn

70 60 50

Exhibit 6

40

Fiscal Performance: Better than Expected

30

10000

NIS (mn), cumulative 20

D e Fec-0 b 8 Ap -09 Ju r-0 9 Aun-0 g 9 O -0 ct 9 D -0 e 9 Fec-0 b 9 Ap -10 Ju r-1 0 Aun-1 g 0 O -10 ct D -1 e 0 Fec-1 b 0 Ap -11 Ju r-1 1 Aun-1 g 1 O -11 c D t-1 e 1 Fec-1 b 1 Ap -12 Ju r-1 2 Aun-1 g 2 O -12 ct D -1 e 2 Fec-1 b 2 Ap -13 Ju r-1 3 Aun-1 g 3 O -13 ct D -1 ec 3 -1 3

5000 0 -5000

FX Reserves

-10000

Source: Haver Analytics, Morgan Stanley Research

-15000 -20000 -25000 -30000 -35000 -40000 -45000 Jan

Feb

Mar

Apr 2009

May

Jun

2010

Jul 2011

Aug

Sep

2012

Oct

Nov

Dec

2013

Source: Haver Analytics, Morgan Stanley Research

In 2014, the targeted deficit stands at 3% of GDP. To achieve this, the Ministry of Finance will have to make sure that some of the planned expenditures are lowered so that the abolishment of the tax hike becomes a budget-neutral move. Indeed, the BoI issued a statement following the decision indicating that “there is great importance in attaining the deficit target set for the 2014 budget, 3 percent of GDP. Thus, the decision to adjust the expenditure ceiling for 2014 in accordance with the cancellation of the increase in income tax on individuals, so that the overall effect of the moves on the deficit is neutral, is appropriate. The budgetary steps which were decided upon toughen the challenge of meeting the deficit target of 2.5 percent of GDP which was set for 2015.

Rating outlook upgraded to positive: Fitch upgraded Israel’s sovereign rating outlook to positive from stable in late 2013. The rating agency affirmed the long-term foreign currency rating at single A. According to Fitch, the improvement in the outlook was based on the country’s better fiscal position and the commencement of gas production. In our view, the rating action did not come as a surprise at all, considering the overall soundness of macro fundamentals, the rising current account surplus, anticipation of further improvement in the FX reserve position, sound monetary policy implementation and arguably an improved picture regarding geopolitical risks. We do not expect any significant change in the country’s rating in the near future, but the full utilisation of the natural gas resources and an eventual setting up of a sovereign wealth fund are likely to improve the creditworthiness of the sovereign further.

18


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Kazakhstan: Waiting for Kashagan  2014 growth depends crucially on Kashagan, which could produce up to 35 million barrels in 2014, or about 1.5% of GDP. Given a more cautious base case on Kashagan consumption, we mark 2014 growth down from 6.8% to 6.0%Y.  Assuming continued sterilisation of the Oil Fund in foreign securities and a generally tight fiscal policy, we see inflation at the bottom end of the 6-8%Y target range.

2013 was a good year: Helped by a 4% rise in oil production, after two years of falling output, growth, which the government now claims rose by 6%Y, was above expectations and rose from 5%Y in 2012. Inflation at 4.8%Y fell from 6%Y in 2012 and was below the NBK’s 6-8%Y target range. At the same time, Kazakhstan’s underlying robust position was shown in a large external surplus, with reserves rising by over US$9 billion (4% of GDP), and a fiscal surplus, including the Oil Fund, of 3% of GDP.

Jacob Nell/Alina Slyusarchuk However, in 2013, real wage growth fell sharply from an average 12%Y in 2012 to an average 4%Y after 11M13, reflecting in particular tighter fiscal policy. We believe that this wage slowdown had little impact on consumption as a result of dissaving – against a backdrop of full employment and good economic prospects – and a further pick-up in consumer borrowing, which rose to close to 30%Y in 2H13, after just over 20%Y growth in 2012. However, with another reasonably tight budget in 2014, keeping real wage growth moderate, we expect consumption growth to slow significantly in 2013. More generally, household consumption jumped by 5pp of GDP to 50% after 9M13, and we do not see this rate of expansion as sustainable. Exhibit 2

Strong Fixed Investment but Weaker Consumption Keep Growth Flat pp 15

Exhibit 1

Leading Indicators Point to Strong 2H13, with Recovering Investment and IP, Robust Retail Sales 20

%Y, real terms, 3m moving average

15 10 5 0 -5 -10 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 IP

Fixed capital investment

Retail sales

Source: Kazstat, Morgan Stanley Research; F = Morgan Stanley Research forecasts

Consumption slowdown: The main pillar of growth in Kazakhstan since the crisis has been consumption, reflected in strong retail sales, running at 13.2%Y in November 2013.

10 5

Consumption

Fixed investment

Net exports

Real GDP, %Y

2013F

2012F

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

-5

2001

0

2000

2014 also set for a strong performance: Growth appears to have accelerated in 2H13, with strengthening investment and IP alongside strong consumption, setting the stage for a strong 2014, backed by the sanction of the next phase of investment in the Chevron-led Tengiz oil project. However, the forecast is complicated by the discovery of gas leaks and the subsequent uncertainty about the timing and volume of Kashagan oil, which otherwise could be expected to contribute about 1.5% of GDP in 2014.

Inventories

Source: Kazstat, Morgan Stanley Research; F = Morgan Stanley Research forecasts

Investment stays strong: Investment accelerated in 2H13, and in November 2013 was reported to be running at a healthy 15.3%Y. We see this strong investment growth as supported by the sanction of the next phase of development of Tengiz, which implies an investment flow of US$4-5 billion per annum over the next 4-5 years. However, we think that it is unlikely to grow strongly, unless there is progress on the plans to invest Oil Fund resources in industrial projects in Kazakhstan. Net exports – the swing factor: Import growth has slowed from 25% in 2012 to just 6% after 9M13, and we expect slowing consumption and flat investment to lead to continued weak import growth, albeit imports will also be supported by reduced tariffs as Kazakhstan enters the WTO, expected in 2014. However, the main source of uncertainty on trade is on exports, and in particular exports from Kashagan. Production briefly touched 70,000 bpd in September before it was halted on discovery of sour gas leaks. It was scheduled to rise to 350,000 bopd by end-2015, which would have implied

19


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

production of about 175,000 bopd on average or 65 million barrels of oil in 2014, worth about 2.5% of GDP. Now, we think that likely production is anywhere in the range from zero to half the previous target, or 1.5% of GDP, around 35 million barrels of oil. Taking the base case as the middle point of this range, we now mark down our GDP forecast for 2013 by 0.8pp from 6.8%Y to 6.0%Y. Exhibit 3

2014 Oil Export Scenarios Oil exports, mmbopd

Oil export earnings, US$bn @ US$100/bbl

Oil export earnings, % of GDP

1.45

52.93

24.1%

1.48

53.98

22.5%

1.53

55.81

23.3%

1.58

57.63

24.0%

Estimated 2013 oil export baseline Bear case: 2014, assuming no Kashagan and trend growth at 2% Base case: 2014, assuming Kashagan at average 50,000 bopd and trend growth at 2% Bull case: 2014, assuming Kashagan at average 100,000 bopd and trend growth at 2%

Source: Morgan Stanley Research estimates

External account strength: In 9M13, oil exports grew at a robust 4% in volume terms, to a large extent offsetting the lower oil price and the sharp contraction in metal exports (including iron ore down 30%, ferro-alloys down 50% and precious metals down 41% after 9M13), while import growth slowed sharply from 22%Y in 2012 to 6%Y in 9M13. While there was a net drag from trade, with an estimated 4% of GDP reduction in the trade surplus in 2013 (to a still large 15% of GDP) and a 1% of GDP reduction in the current account balance (to -0.7% of GDP), we continue to see a strong external position, with reserve assets, including the Oil Fund, growing by US$9 billion or 4% of GDP in 2013, and likely to grow by a similar amount in 2014.

Trend to real KZT appreciation: Kazakhstan has been able to deflect the strong pressure on the tenge to appreciate from the high and rising oil revenues by paying high dividends to oil companies – currently running at US$25 billion per annum – and by saving surplus oil revenues in the Oil Fund and investing them in foreign assets. Overall, we believe that this tight fiscal policy – running a surplus of about 3% of GDP in 2013 – is largely responsible for restraining strong tenge appreciation despite the large external surplus. Over time, we do expect the tenge to appreciate in real terms, with the nominal KZTUSD rate weakening by less than the inflation differential. However, given the sensitivity of the exchange rate, we believe that the Kazakh authorities will continue to have a bias for stability. Timing of transition to a flexible KZT is unclear: We look to the NBK under Governor Kelimbetov’s leadership to provide more clarity in 2014 on the proposed transition to an inflation-targeting monetary policy regime. Following in Russia’s footsteps, Kazakhstan intends to move to a flexible exchange rate regime, and to use interest rates in future to target inflation. However, the pace and sequencing of measures are not yet clear. For instance, although the exchange rate regime was de jure liberalised in spring 2011, the tenge has still not weakened de facto beyond the previous 145-155 corridor. At the same time, domestic interest rates were suppressed for three years post-crisis, largely we think to provide cheap funding for Kazakhstan’s banks, burdened with 35% NPLs, and then allowed to rise this summer, even though the NBK has not yet developed a repo facility to provide funding to banks on an auction basis. Exhibit 5

The Summer Jump: KazPrime Now Positive in Real Terms

Exhibit 4

Kazakhstan Strong External Position: Reserve Assets Up 11pp to 44% of GDP in 2013 100

20

15

US$ billion

80

10

60 5

40 20 0 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 NBK FX reserves

Oil Fund assets

0 Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

KAZPRIME 3 month rate, %

Mar-13 CPI

Source: NBK, Morgan Stanley Research estimates

Source: NBK, Morgan Stanley Research estimates

20


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 6

Exhibit 7

Kazakh Forecast Indicators

Loan Growth Now Running at a Steady and Sustainable 15%

%Y

2012A 2013E 2014E 2015E

Real GDP Private consumption

5.0

5.8

6.0

6.3

11.0

15.0

10.0

8.0

Gross fixed investment

9.1

7.1

6.0

6.0

Exports

4.2

-1.0

3.0

7.0

Imports

22.5

6.0

5.0

5.0

Unemployment rate (%)

5.3

5.3

5.3

5.3

CPI inflation (annual average)

5.1

5.8

6.1

6.4

Current account balance (% of GDP)

0.3

-0.5

1.0

2.9

General govt. budget balance (% of GDP) General government debt (% of GDP) Exchange rate against USD (eop) Trade balance (US$bn)

4.0

3.5

3.3

3.1

13.2

13.8

14.5

14.5

150.4

153.8

37.9

33.1

157.6 161.5 34.8

38.3

Source: Kazstat, NBK, Morgan Stanley Research estimates

Risks Generally we see risks in Kazakhstan as lower than in previous years: Inflation risk: Previously, we were concerned about the risk of rising inflation, given plans for greater domestic absorption of oil revenues, against a backdrop of full employment. However, in practice, the authorities have continued to run a tight fiscal policy, which has helped to bring wage growth down, and have, despite apparent commitments to the contrary, refrained from any large increase in domestic investment financed from oil revenues. Inflation has declined to 4.8%Y by year-end, and we think that it will remain subdued in 2014. Banking system: The banking system is recovering, with loan growth now a support rather than a drag on growth, and the biggest banks with the highest burden of NPLs making more progress on restructuring.

60

%Y

40

20

0

-20 Jan 08

Jan 09

Corporate credit, %Y

Jan 10

Jan 11

Jan 12

Household credit, %Y

Jan 13 Total credit Y

Source: NBK, Morgan Stanley Research estimates

Investment sanction risk: We see investment as dominated by the decision on sanction of the successive phases of the mega-projects (Tengiz, Kashagan, Karachaganak). The sanction of the next phase of Tengiz should keep oil & gas FDI at current high levels to 2018, so we see this as an upside risk, if the partners reach agreement on the next phase of Karachaganak, which requires a decision on whether to process on field and export to China or process in Russia and export to Europe, and if the partners get Kashagan Phase 1 pumping and resolve their differences on who will be the operator of the project going forward, paving the way for sanction of the next Phase of Kashagan. WTO entry: We expect Kazakhstan to join the WTO in 2014, following Russia’s 2012 entry, which will likely be supportive for investment. However, we see the impact as less material than for Russia, given Kazakhstan’s superior investment climate, already ranked a respectable 50 on the World Bank’s Ease of Doing Business metric, and the high level of FDI the country has already attracted (inward FDI stock of US$128 billion, or 64% of GDP).

21


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Kenya: Reasonably Resilient  Despite last year’s terrorist attack aimed at crippling the country’s consumer and tourism sectors, we expect GDP growth in Kenya to accelerate from 4.5%Y in 2012 through 4.8%Y in 2013 to 5.3%Y in 2014 and 6%Y in 2015. A slight recovery in exports should combine with a modest pick-up in capital imports to keep the trade balance and the current account deficit broadly unchanged over the next three years, allowing for a more stable FX than previously expected.  Despite commendable efforts at improving revenue generation, the Treasury’s optimistic GDP growth forecasts suggest that fiscal revenue could continue to surprise to the downside this year, while wage and interest outlays place a floor under expenditure growth, ensuring that the deficit does not dip below 4% of GDP.  The recent surprise undershoot in food inflation, together with major electricity tariff cuts announced at the end of 2013 and a stronger FX outlook, suggest that CPI should remain within the target band this year. As a result, we no longer expect a rate hike in 2014.

Steady growth outlook: Despite last year’s terrorist attack aimed at crippling the country’s consumer and tourism sectors, we expect GDP growth to reach 5.3%Y in 2014 and 6%Y in 2015. Latest data published by the Kenya National Bureau of Statistics show that 3Q13 GDP printed broadly in line with our expectation at 4.4%Y. A deceleration in agriculture from 5.8%Y in 3Q12 to 3.4%Y in 3Q13 was offset by a turnaround in manufacturing production (up from 2.6%Y to 4.6%Y over the same period), a robust expansion in communications (up from 3.1%Y to 5.3%Y) as well as an acceleration in financial services from 6.5%Y to 7.2%Y. Looking into 2014, a technical bounce in agricultural production as weather conditions improve should help to lift full-year production from an estimated 4.7%Y in 2013 to 5.2%Y in 2014, while an anticipated recovery in global growth should help to boost domestic confidence and encourage manufacturing activity in food processing, motor vehicle assembly, cement production and general construction. Strong innovation in the communications sector should also continue to provide tailwinds to growth, while maintenance of the policy rate at 8.5% (down from 18% in mid-2012) allows financial services activity to flourish. And while there is some concern that the terrorist attacks of September 2013 could place a lid on retail activity at major shopping outlets, latest data show that the impact on inward tourism flows has been relatively muted thus far. We therefore maintain our cautiously constructive outlook on the country’s external payment metrics.

Michael Kafe/Andrea Masia Exhibit 1

Macro Snapshot %Y

2011

2012

2013E

2014E

2015E

GDP Agriculture Transport & Communications Wholesale & Retail C/A balance (% GDP) Fiscal balance (% GDP) Public debt (% GDP) Domestic External CPI USDKES Policy rates (%)

4.4 1.6 4.7 7.4 -13.0 -6.9 45.0 21.5 23.5 14.0 80.7 18.0

4.5 3.7 3.9 6.3 -11.1 -9.0 47.5 23.9 23.6 9.6 86.0 11.0

4.8 4.7 7.2 4.2 -9.0 -5.2 47.0 23.5 23.5 5.7 86.5 8.5

5.3 5.2 7.6 5.5 -8.5 -4.5 45.8 22.9 22.9 7.0 88.5 8.5

6.0 5.0 7.0 5.5 -7.0 -4.0 44.8 21.2 23.6 7.8 91.0 8.5

Source: Kenya National Bureau of Statistics, Central Bank of Kenya, Morgan Stanley Research estimates

We expect the visible trade balance to track broadly sideways over the next three years: For the upcoming year in particular, we look for a modest recovery in global demand conditions to help lift export volumes (especially tea, horticulture and basic manufactures), boosting exports from an estimated US$6.0 billion in 2013 to some US$7 billion in 2014. However, this will be offset by imports of heavy equipment for oil exploration, and other miscellaneous manufactured consumption goods such as motor vehicle parts and accessories, telecommunication equipment and white goods for households and local businesses as domestic growth improves. The devolution of powers to county governments is also likely to stoke demand for imports of start-up technological and logistical equipment, placing a floor under the import bill, which we expect to rise marginally from US$16.5 billion in 2013 to some US$17.4 billion in 2014. Exhibit 2

Balance of Payments on Current Account US$ million

Exports Imports Oil Trade balance Net invisibles Net services (tourism & travel) Net income Net transfers Current account % of GDP GDP

2012

2013E

2014E

2015E

6,126 16,289 4,081 -10,163

6,050 16,450 4,000 -10,400

6,900 17,400 4,100 -10,500

7,850 18,300 4,200 -10,450

5,625 3,266 -137 2,496

6,450 4,000 -150 2,600

6,350 4,000 -150 2,500

6,600 4,200 -200 2,600

-4,538 -11.1 40,734

-3,950 -9.0 44,000

-4,150 -8.5 49,000

-3,850 -7.0 55,000

Source: Central bank of Kenya, Kenya National Bureau of Statistics, Morgan Stanley Research estimates

22


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Looking beyond 2014, we believe that Kenya’s oil find could completely change the country’s visible trade metrics once commercial production begins in 2017: It currently imports some 80,000 bpd, estimated at US$4 billion, and is scheduled to produce up to 100,000 bpd of oil, suggesting that not only would it become self-sufficient in oil, but it could in fact become a net exporter. More importantly, its current CAD of around US$4 billion could be completely eliminated if it is able to fully exploit the opportunities in its oil and gas sector. With regards to the net invisibles, we look for some stabilisation around the US$6.5 billion level as a moderate recovery in net inward transfers is offset by some moderation in the growth of tourism receipts, slightly higher interest and dividend payments to foreigners, and sticky services payments for freight and insurance as the import bill rises. On the whole, therefore, we expect a current account deficit of some US$4 billion over the coming years to print at 8.5% of GDP in 2014 and 7.0% in 2015. The current account gap should continue to be funded by the usually hefty and historically steady inflows of official and short-term capital: Following several years of delay since it initially expressed the interest to issue a Eurobond in 2009, the Government of Kenya has finally decided to enter the international markets with a US$1.5-2.0 billion issue. Advisors were appointed towards the end of last year, and the Treasury intends to hold a roadshow for potential international investors later this month, suggesting that the bond will be issued before the end of the current fiscal year in June 2014 – perhaps as early as March/April 2014. In its official correspondence with the IMF, the government confirmed that part of the proceeds of this maiden Eurobond will be used to retire the existing US$600 million syndicated loan facility that it contracted in May 2012. Also, if recent rhetoric from the International Criminal Court is anything to go by, the case against President Kenyatta could well be dropped. Such a decision would bring a much anticipated closure that would also encourage the resumption of inward donor capital and lend further support to shilling stability. We expect USDKES to close this year at 88.50 (previously 90.0) before reaching 91.0 at end-2015. On the fiscal side, key to watch this year is the successful implementation of a Treasury Single Account (TSA) that consolidates all sub accounts of government, effectively paving the way for best practice cash management opportunities. This not only brings the country another step closer to the adoption of inflation targeting as it allows for smoother money market liquidity management, but also helps to eliminate current inefficiencies and avoidable interest costs associated with a heavy reliance on short-term central bank financing.

Efficiencies in tax administration to support revenue mobilisation effort: The recent introduction of a new VAT law that effectively cut back on the list of exempted products, the broadening of excise taxes to include financial transactions and mobile phone transfers, and the roll-out of a new user-friendly taxpayer interface (the integrated tax management system), to be complemented with an electronic tax register, should all help to improve efficiencies in tax administration and support the Treasury’s revenue mobilisation efforts in fiscal 2014/15. Even so, we believe that the Treasury’s revenue estimates, based on expected 2014 GDP growth of 6.3%Y (versus our own estimate of 5.3%Y) are somewhat optimistic. With regards to expenditure, we see upside risks to recurrent outlays from wages and interest that are likely to be less than offset by an undershoot in the capital budget. Although the government is reducing the number of ministries from 44 to 18 as part of a rationalisation exercise aimed at minimising the duplication of services under the new government structure, and appears to be taking pains to avoid a Ghana-style explosion in the public wage bill as it pursues its own harmonised salary scale framework, history suggests that a single-digit wage bill increase – as scheduled for 2014 – will be difficult to implement in Kenya. Finally, the newly established county structures are likely to overspend on logistics, travel, communications and external consultants during the first few years of their existence. As a result, we expect the budget deficit to print at -5.2% of GDP in 2013/14 and -4.5% in 2014/15. This compares with official estimates of -4.7% for 2013/14 and -4% for 2014/15. Rate call change – no more hikes in 2014: After breaching the upper end of the target band in 3Q13 in line with our call, CPI fell back within target by the end of 2013 – a lot earlier than we had anticipated. The decline was largely due to a surprise undershoot in food prices at a time when food production was relatively weak. In addition, the country’s energy regulator announced a massive 23% tariff reduction over 18 months starting December 2013. Looking forward, the combination of decelerating food prices, falling electricity tariffs and a stronger FX than previously anticipated lead us to believe that inflation should now remain within the target band for most of the coming year, thereby obviating the need for the Central Bank of Kenya to raise rates by 150bp as we had earlier anticipated.

23


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Nigeria: A Year of Heightened Uncertainty  Nigeria is on track to achieve GDP growth of 7.8%Y in 2014 and 7.5%Y in 2015, while CPI stabilises at around 9%Y. We do not envisage any major political unrest in the run-up to the 2015 elections.  Three key risks do concern us, however: First, severely depressed levels of oil production pose a threat to the BoP and FX. Second, the subsequent downward pressure on fiscal revenues is likely to combine with upside pressure on current spending to widen the fiscal deficit beyond official estimates. Third, monetary policy under a new CBN governor is somewhat less predictable, thus raising the risk that the CBN tightens policy rates even further.  A weaker BoP suggests that FX reserves are unlikely to recover meaningfully this year. This leads us to raise our USDNGN forecast from 157 to 160 at December 2014, reaching 163 by mid2015.

Our macro view in a nutshell: Despite production challenges in its oil sector, we believe that Nigeria is on track to achieve growth of 7.8%Y in 2014 and 7.5%Y in 2015, thanks in part to a deregulation of electricity production and distribution, which we expect to continue to yield important benefits initially to industry and services, but in time to agriculture too. A rebasing of the country’s GDP in February should give much-needed clarity on and insights into the current structure of the economy. Inflation is likely to stabilise at the upper end of the CBN’s 6-9%Y target band, with the risk of a temporary breach in 3Q14. Monetary policy is likely to remain biased towards tightening, in response to our anticipated deterioration in the fiscal metrics as election spending gathers pace. However, we maintain our view that policy rates will be kept on hold at 12% in 2014, with some easing likely post the 2015 elections. Finally, a less favourable balance of payments position and a possible slowdown in FX reserves accumulation lead us to revise our end-2014 USDNGN forecast from 157 to 160. Going into 2014, we identify three important macro risks: First, is a continuation of the severely depressed levels of oil production, which for 2013 appears to have averaged just 1.9 mbpd (down a further 7.5% from an already low 2.1 mbpd in 2012). As we highlighted in our last detailed note on Nigeria (see Sub-Saharan Africa Economics: Cautiously Constructive Despite Deteriorating Deficits, September 12, 2013), we believe that Nigeria’s oil sector faces both cyclical and structural challenges. The cyclical constraints include high levels of oil theft and illegal bunkering. Estimates of just how many barrels are being lost are wide-ranging. In February 2013, the NNPC estimated theft to be in the region of 50-80

Andrea Masia/Michael Kafe kbpd, while some independent studies put the number as high as 100 kbpd. 1 We believe that the true number is certainly higher than what appears to have been a long-run average of some 50,000 barrels per day since the government negotiated the Peace Accord in 2004. Unfortunately, efforts by the authorities to address the issue are yet to show up meaningfully in production volumes, which at 1.82 mbpd in November 2013 according to the latest OPEC bulletin have now reached their lowest levels since August 2009. From a structural perspective, the uncertainty surrounding the Petroleum Industry Bill (PIB) has also placed a cap on muchneeded investment into the industry. Indeed, the share of fixed investment in the economy – although not particularly high in Nigeria anyway – has been on the decline since 2010 and is currently just 11% of GDP. Looking forward, we do not expect the PIB to be passed ahead of the 2015 national elections and, as a result, our macro forecasts make no provision for its implementation throughout the forecast period. Exhibit 1

Macro Snapshot %Y

2010

2011

2012

2013E

2014E

2015E

Expenditure on GDP Oil sector Non-oil sector Current account (% GDP) Trade balance Net invisibles Oil production (mbpd) Oil prices (US$/bbl) FX reserves (US$ bln) USDNGN (eop) CPI Policy rates (% eop) Fiscal balance (% GDP)

8.0 5.3 8.5 2.4 10.9 -8.4 2.1 80 32.3 152 13.8 6.25 -3.2

9.2 0.1 8.8 3.7 13.2 -9.4 2.1 114 32.6 162 10.9 12.0 -2.6

6.5 -0.8 7.9 8.1 17.0 -8.8 2.1 113 43.8 157 12.2 12.0 -2.4

6.7 -0.3 7.9 6.8 13.2 -6.3 1.9 110 36.5 159 8.5 12.0 -3.0

7.8 1.5 8.7 7.0 12.3 -5.3 2.0 107 36.7 160 8.9 12.0 -3.0

7.5 0.8 8.4 6.2 11.0 -4.8 2.2 100 41.5 160 9.1 10.5 -2.7

Source: National Bureau of Statistics, Central Bank of Nigeria, OPEC, Morgan Stanley Research estimates

We believe that the macro implications of declining oil production extend beyond the immediate growth impact, and have far-reaching consequences for the balance of payments, FX reserves and the currency. Even after incorporating the recently published and better-than-expected 2Q13 current account out-turn of 7% of GDP – well ahead of our 2.5% of GDP estimate due to lower-than-expected income and transfer payments – the disappointing production performance suggests that the 2013 full-year current account surplus could undershoot our 7.0% of GDP estimate by at 1

See Nigeria’s Criminal Crude: International Options to Combat the Export of Stolen Oil, Chatham House, 2013.

24


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

least 0.2pp. We are inclined to shave our oil production estimate to 2.0 mbpd (2.25 mbpd previously) for 2014 and to 2.2 mbpd for 2015 (2.4 mbpd previously). Assuming Brent crude prices decline to US$107/bbl in 2014 and US$100 in 2015 as we expect, the knock to exports could be in the region of US$6.5 billion per annum. On the whole, therefore, we now look for a current account surplus of no more than 7.0% of GDP in 2014 and 6.2% in 2015 (previously 7.5% in both years). From a BoP perspective, the key implication of low oil production is the negative impact on the pace of FX reserve build and, as a corollary, possible downside pressure on the FX. In 2013, Nigeria lost as much as US$7 billion of FX reserves, and we see little scope for a major recovery in 2014, given our tepid view on both the price and production volumes at a time when external funding conditions are turning less favourable as the US starts to unwind its asset purchase programme. We are therefore inclined to revise our currency forecasts higher from USDNGN 157 to 160 by year-end, and to 163 by 2Q15. Indeed, the political risks surrounding the 2015 elections suggest to us that the naira could exhibit higher volatility and occasionally trade outside of the managed currency band. Ultimately, however, we are confident that the CBN has both the willingness and resources to anchor USDNGN within the 155 +/- 3% soft peg. Our second key risk for 2014 is fiscal policy: The combination of lower-than-budgeted oil production volumes and a deceleration in the growth backdrop meant that both oil and non-oil revenue were running N70 billion behind target in 1H13, and were it not for a N326 billion drawdown in the excess crude account, the Treasury may have been forced into an aggressive borrowing programme in 2013. On the whole, we believe that the fiscal deficit likely widened to 3.0% of GDP in 2013 – a full 0.8pp ahead of official estimates. Looking forward, assuming our downwardly revised oil production estimates and a benchmark Brent crude price of US$77.5/bbl as proposed by Finance Minister Ngozi OkonjoIweala to law-makers late last year, we estimate a 2014 fiscal deficit of 3.0% of GDP – some 0.3pp wider than previously expected. We also assume that some election-related spending is likely to show up in statutory transfers and recurrent spending. And while we think that the Ministry of

Finance’s capital budget estimates for 2014 are reasonable, we still believe that the risks are skewed towards a wider deficit, as we continue to see downside risks to revenues. Post the elections in early 2015, we believe that some scope for fiscal consolidation will be feasible as revenues improve and spending controls are tightened. Downward adjustments to our oil volume assumption in that year suggest that the pace of consolidation could be slower than we had previously envisaged, however. Thus, we now expect the deficit to come in at 2.7% of GDP, compared to 2.5% previously. The third risk is the potential monetary policy response to all the uncertainty: This is made all the more complicated by the appointment of a new CBN governor in June. Even so, it appears that the CBN set the tone for monetary policy in 2014 at its November 2013 MPC meeting, where it emphasised that “the MPC is of the view that we are not yet at the end of the tightening cycle and may need to tighten in response to these eventualities next year”. The eventualities the MPC was referring to included the normalisation of interest rates in the US and Europe, a process that was kickstarted last month and which underpins our US strategists’ view that the US yield curve is likely to steepen further as 10year yields in that economy reach 3.45% by end-2014. We also note that the CBN has formally adopted a rather optimistic inflation target of 6-9%Y for 2014. On our estimates, base effects alone will keep CPI close to the upper ceiling of that range for most of 2014 – in fact, we expect CPI to settle above 9%Y through 2H14. This, together with a currency that is unlikely to appreciate in any meaningful way, suggests to us that the risks of policy tightening have certainly risen. Inflation rates of some 9%Y would still be a relatively good outcome for Nigeria, in our opinion, and we take comfort in the fact that the MPC in its November statement recognised the cost of doggedly achieving a lower inflation outcome. Therefore, as long as the currency remains anchored, the CBN is unlikely to hike policy rates on account of inflation. In our baseline, we expect a normalisation in oil production volumes to help ease the pressure on the BoP and FX, providing the CBN with the opportunity to accumulate FX reserves while holding rates steady at 12%. Fiscal excesses and a surprise change in the reaction function of the CBN as a new governor takes the helm are key risks to this view.

25


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Poland: The Year of Normalisation  The Polish economy appears to be on a path of normalisation. Domestic demand is showing a gradual revival, and EU structural funds should also be a support in 2H14. We see growth at 3.2%Y in 2014 and 3.8%Y in 2015.  Inflation will likely rise significantly in 2014, mostly due to base effects. The MPC’s neutral stance should continue until at least June 2014, but we see scope for some rate normalisation in 2H. We continue to forecast 75bp of rate hikes by year-end.  The changes to the pension system will distort the fiscal metrics significantly; looking through the one-offs, the budget deficit should narrow mostly thanks to stronger growth, but remain above 3% of GDP in 2014. Debt/GDP will likely fall sharply by as much as 9% as a result of the changes.  The pension changes should reduce bond market liquidity and increase the FX share of the debt; however, lower issuance should provide an offset; the equity market may be supported initially, but structurally these changes should imply smaller OFE investment into local equities.

Growth The expected growth rotation is panning out: After several quarters of weakness, domestic demand is finally showing signs of a revival. The 3Q GDP data already showed that household consumption accelerated (+0.3%Q), and that fixed investment also expanded (+0.6%Q). And the high-frequency indicators in 4Q (retail sales, capital goods production) continued to show that domestic demand is expanding, and that the labour market is also improving: corporates have now been adding to payroll for seven months, and business surveys and data also suggest that labour demand is picking up.

Pasquale Diana Exhibit 2

Job Market Is Gradually Improving 14

%Y

12 10 8 6 4 2 0 -2 -4 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Wages

On the investment front, it looks likely to us that the start of the EU funding cycle (2014-20) will be an important support. Getting the timing right is difficult, and it is probably a story for 2015 more than 2014. But even so, the latter part of this year could see some boost to growth from this source, probably starting in the summer. And on the private investment side, firms’ replacement capex is at the lowest since 2004: this should change once corporates get more confident about the cyclical uplift. The surveys are certainly indicative of a more optimistic corporate sector, the PMI December fall being probably nothing more than a temporary blip. Exhibit 3

Business Confidence Is Recovering 10.0

Exhibit 1

Growth Is Broadening Out domestic-led growth

Employment

Source: Haver Analytics, Morgan Stanley Research

SA, %

5.0

net exports-led growth

0.0

-5.0

8 7 6 5 4 3 2 1 0 -1 -2 -3

GDP and Contributions %pts -10.0

-15.0 Jan-2010

Jul-2010

Jan-2011

Jul-2011

Jan-2012

Manufacturing Confidence

Jul-2012

Jan-2013

Jul-2013

Retail Sector Confidence

Source: Haver Analytics, Morgan Stanley Research

Q1 10

Q2 10

Q3 10

Q4 10

Q1 11

HH consumption Govt consumption

Q2 11

Q3 11

Q4 11

Q1 12

Q2 12

Fixed Investment Inventories

Source: Haver Analytics, Morgan Stanley Research

Q3 12

Q4 12

Q1 13

Q2 13

Q3 13

Net exports Headline GDP, %

Overall, we think growth could exceed 3%Y in 2014: We think that the Polish economy is recovering gradually and the backdrop points to a steady recovery. The economy could transition back to a 3%Y+ pace in the next few years, thanks to better domestic demand dynamics. We see GDP rising by 3.2%Y in 2014 (previously 3%Y), after 1.4%Y in 2013.

26


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Inflation

Monetary Policy

Soft for now, higher in 2014; beware of extrapolating the current trend: There is no question that the inflation backdrop is extremely soft at present. Headline inflation was just 0.6%Y in November, close to its all-time lows. While core inflation (ex-food and energy) is higher, at 1.1%Y, core pressures look tame also.

The big debate is on the MPC’s reaction function: We sense that a greater and greater section of the market is convinced that the MPC has no room to hike rates in 2014. After all, growth at over 3%Y will not be enough to reduce the output gap in a meaningful way: for example, the central bank estimates slack worth still around 2% of GDP, and the output gap not closing throughout all of 2015.

To some extent, the fall in headline inflation that we saw in 2013 (around 1pp) is not related to the demand side and, as such, has little to do with any notion of output gap. Over the same time period, core inflation barely moved. Moreover, core inflation was recently pushed lower by some one-offs (such as discounts on internet deals) whose effect fades over time, and which are in no way structural. The key point here is that while it is abundantly clear that inflation was lower than we expected in 2013, it must be stressed that 2013 was almost a ‘perfect’ year for disinflation in Poland. Food (24% of the basket) and energy (18%) were both softening through the year. Regulated price changes also helped, with gas (10% in January) and electricity tariff cuts (5% in the summer); there were no significant one-offs pushing inflation higher. The only way inflation will stay as low as it is, is if 2014 brings an equally fortunate combination of dovish outcomes. Under any other scenario, inflation will rise even if purely based on base effects. This is exactly what we expect to see in 2014: we think that inflation will gradually move higher, and end the year not too far away from the 2.5%Y target.

Our assumptions on growth or inflation are also not too far from the NBP’s, so we are not overly bullish. Where we most differ is probably on the central bank’s reaction function. We do not think that the NBP needs to see inflation stably back at target and the output gap closed in order to normalise rates. From a theoretical standpoint, with output at potential and inflation near target, policy rates should already be at the neutral level. Exhibit 5

Output Gap Will Likely Narrow and Close in 2015 3.0

% of GDP

2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5

Exhibit 4

-2.0

Headline and Core CPI Dynamics

-2.5 2004:1

6.0

2006:1

2008:1

2010:1

2012:1

2014:1

Output Gap, % of GDP (in a given quarter) MS forecasts

5.0

Output Gap, % of GDP (4Q sum) Source: Morgan Stanley Research; we use an HP filter and plug in our GDP growth forecasts out to 2015-2016

4.0

The ‘neutral’ level of policy rates probably deserves another discussion, which is beyond the scope of this piece. But there is little doubt that neutral rate in Poland is much higher than 2.50%.

3.0 2.0 1.0 0.0 -1.0 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Core CPI (CPI ex food and energy) %Y

Headline CPI %Y

Source: Haver Analytics, Morgan Stanley Research forecasts

We also think that gradually better domestic demand and a recovering labour market should feed into core inflation, but this is not the main driving force behind inflation in 2014.

The above therefore suggests that the rationale for rate increases in 2014 rests on one key argument – normalisation: The improvement in growth, the erosion of slack and the move of inflation closer to target remove the need for the NBP to keep rates at emergency levels. The rate increases we pencil in for 2014 (75bp starting in 3Q) should be conceptually viewed as the equivalent of ‘tapering’ for a central bank like the NBP that never did QE.

27


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

No fireworks ahead of March: The press conference at the February meeting made it clear that we should not expect anything meaningful ahead of the March meeting. Governor Belka says he cannot see any risk factors that could change the policy stance in the near term, and added that the earliest that the MPC would re-evaluate its forward guidance is at the March meeting, where a new CPI and GDP projection is unveiled. Until then, the MPC will probably stick to the mantra that rates are on hold until June at the earliest. Main risks to our monetary policy view: The MPC’s composition has probably become more dovish after the appointment of Osiatynski to replace Gilowska (hawk). It is always difficult to say too much based on a few interviews, and assumptions have often proved wrong. So far, Osiatynski is on record having said recently that it was most desirable for rates to be on hold as long as possible. Also, if deflationary pressures from outside Poland are more severe than anticipated, inflation may get stuck at around 1.5%Y, which would make it too hard for the MPC to even justify some normalisation. Finally, if analysts’ (not consumers’) inflation expectations 1-2 years ahead fell sustainably below 2%Y (currently 2.1-2.5%Y), the MPC could find reasons to justify one more rate cut. To be clear, this is a remote tail risk, in our view.

External Picture Improved, Mostly in a Sustainable Way Perhaps the most surprising development in the macro picture over the recent quarters has been the impressive adjustment in Poland’s external position. The overall current account gap now stands at just under 2% of GDP on a four-quarter basis, down from 6.5% in 2008. The correction took place mostly thanks to a significant improvement in the trade balance, which has now swung into surplus. The combination of softer domestic demand, weaker funding and a resilient export performance all contributed towards this outcome. In a sense, it is not that surprising that Poland’s current account position should have adjusted, given the softening in domestic demand. But the performance of exports is also quite impressive (see Exhibit 7). A cyclical improvement in demand will likely boost import growth in the coming quarters, which implies that the improvement in the current account balance will halt, or reverse. We see the current account gap widening back to around 2.3% of GDP by end-2014. However, the easy funding and consumption boom that caused the gap to widen significantly pre-2012 are definitely in the past.

The reason is that the external funding environment has fundamentally changed, and easy financing (such as FX loans from foreign banks for example) will no longer be available. In that sense, most of Poland’s current account improvement is structural, not merely cyclical. Exhibit 6

Current Account Gap Shrank to Record Lows… 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 -6.0 -7.0 -8.0 -9.0 -10.0

% of GDP, 4q-basis

Q1- Q1- Q1- Q1- Q1- Q1- Q1- Q1- Q1- Q1- Q1- Q102 03 04 05 06 07 08 09 10 11 12 13 C/A + Errors and Omission

C/A

Source: GUS, Haver Analytics, Morgan Stanley Research

Exhibit 7

…as Trade Balance Swung into Surplus 40

mil. EUR

%Y

2,000

30

1,500

20

1,000

10

500

0

0

-10

-500

-20

-1,000

-30

-1,500

-40 2010

-2,000 2011

2012

Trade balance (RHS)

2013 Exports

Imports

Source: Haver Analytics, Morgan Stanley Research

The improvement in Poland’s external balance has provided the zloty with an important buffer against outflows: The big picture is that capital inflows and FDI have been more than enough to fund the (narrowing) current account gap in Poland. This is the reason why the recent reversal in bond inflows (-€4.8 billion between June and October in the BoP data) has had no discernible impact on the currency: the improving current account position was enough to offset the deteriorating inflow story without the need for a large FX correction. The key takeaway is that the shrinking current account gap has lowered the zloty’s reliance on bond inflows as a source of funding for the BoP.

28


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 8

Current Account and Funding: Bond Inflows Dry Up 12.0

-12.0

% of GDP, 12m sum

10.0

-10.0

8.0

-8.0

6.0

-6.0

4.0

-4.0

2.0

-2.0

0.0

0.0

-2.0

2.0

-4.0

4.0

-6.0

6.0

-8.0

8.0

-10.0 Jan-10 Apr-10

Jul-10

Oct-10 Jan-11 Apr-11

Jul-11

Oct-11 Jan-12 Apr-12

Jul-12

Oct-12 Jan-13 Apr-13

Capital Account

FDI

Bond Portf Inf

Other Inv+Financial Der.

Ch. Reserves

Equity Portf Inf

Jul-13

10.0 Oct-13

Current Account+errors, inverted (RHS)

 The OFE will no longer be allowed to purchase any government bonds, local or foreign. Essentially, they will be able to buy equities and corporate bonds, where available. Potentially, they will be able to buy BGK bonds as long as they do not have an explicit government guarantee. Over time, the limit for the share of foreign assets would be raised (from 5% last year to 10% in 2014, 20% in 2015 and 30% in 2016).  The OFEs will have to gradually transfer assets of the insured to ZUS during the last ten years before the worker’s retirement age. This will happen regardless of whether the worker has opted for ZUS or OFE for his contributions. Exhibit 10

The OFE’s Portfolio at End-November 2013 Bank deposits 4.8%

Other 0.4%

Source: Haver Analytics, Morgan Stanley Research Treasury bonds and bills 41.6%

Exhibit 9

Zloty: EM Safe Haven 110.0

Equities 43.6%

Nominal Effective Exchange Rates, Jan 2012=100

Other debt instruments 9.6%

105.0

Source: KNF, Morgan Stanley Research

100.0 95.0

Pension Reform Implications

90.0

The debt ratio will fall, the government will have increased fiscal room: As a result of the transfer of government bonds back to ZUS, the debt/GDP ratio will be lower by up to 9% of GDP.

85.0 80.0 75.0 Jan-12

Apr-12 Poland

Jul-12 Turkey

Oct-12

Jan-13

India

Apr-13

Indonesia

Jul-13 Brazil

Oct-13 S.Africa

Source: Haver Analytics, Morgan Stanley Research

Key Risk in 2014: Pension Reform In late 2013, President Komorowski signed into law the OFE (pension funds) reform, which will go into effect on February 1. The president also referred the law to the Constitutional Tribunal, which means there is still a theoretical (and remote) chance that the measures are deemed unconstitutional. These are the main pillars of the pension reform:  The OFEs will have to transfer 51.5% of their assets to the ZUS (Social Insurance Institute). This is expected to be made up of government bonds, BGK bonds and other government-guaranteed paper.  In addition, any future contributions to the OFEs will be voluntary, and no longer compulsory. People will make that choice between April 1 and July 31 (four months). If they express no choice, the default option is that they opt into ZUS. If they choose to stay in the OFE system, the contribution will rise marginally (from 2.8% to 2.92% of the wage).

This implies that the government will not have to implement austerity measures that would have otherwise been needed with the debt/GDP threshold breaching 55%. The deficit will also fall on a sustained basis, due to two factors: i) The lower interest service costs on the debt which is cancelled (0.5% of GDP); and ii) Due to the fact that many people (a majority, we think) will choose to opt back into ZUS, so their contributions will lower the government’s borrowing needs. The 2014 budget deficit (excluding the one-off revenue from the OFE bond transfers) should therefore narrow to around 3.7% of GDP from last year’s 4.8%. The government is unlikely to implement additional fiscal tightening, given that it wants to avoid austerity at all costs ahead of the 2015 election: indeed, this was the rationale behind the pension changes. And even if the pace of deficit reduction is not as ambitious as the EC expects (deficit sub-3% by 2015), there will be no repercussions, such as structural fund withdrawals. The structure of the bond market will change: Following the transfer of the OFE debt to ZUS, the ratio of outstanding FX debt as a percentage of total will rise to 35-37% (from 30%); also, the share of debt held by non-residents will rise to around 42-44% (from 34%).

29


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

The removal of the OFEs as a market player is obviously a concern at a time when non-residents have been selling bonds and the pension funds have provided most of the offsetting demand. At future times of stress, local banks would be left as the main domestic provider of liquidity, which may not be enough. While the above sounds concerning, our strategists note that supply will also fall this year, so they do not expect a disorderly rise in yields. For more details on our strategy views, see Lower Demand, Lower Supply, December 10, 2013. Exhibit 11

Non-Resident Holdings of POLGBs Should Rise Post-Reform 50

Post-reform

45 40 35

% of POLGB held by non-residents

25 20 15 10 5 2003

2005

2007

This seems unlikely: First, we suspect that the number of those who choose to switch to ZUS may be higher than 50%. Second, over time the OFEs may want to invest more into corporate debt and foreign assets. Third, the OFEs also need to raise cash to transfer to ZUS for pension payments, which likely involves selling of equities. All in all, it seems hard to us not to see the reform as a drag on the equity market. For more analysis, see also Ronan Carr’s work (EEMEA Equity Strategy Chartbook December 2013, December 9, 2013).

Politics: Tusk Struggles to Regain Popularity

30

0 2001

weight in equities (44%), they would invest around PLN 5 billion in the stock market each year. Even assuming that 50% of workers choose to stay with OFEs, as some polls suggest, the contributions will still roughly halve to PLN 5.5 billion. It follows that almost all of this needs to go into the stock market to guarantee the same level of equity support as pre-reform.

2009

2011

2013

Source: Haver Analytics, Morgan Stanley Research estimates

Inflows into the equity market will likely slow: Clearly, the OFEs’ equity allocation will rise sharply in February, once they transfer their government bonds to ZUS. On our estimates, their equity allocation will mechanically rise from 44% in November to nearly 90%. Their new investment options will be limited, and the market for corporate debt is not deep. Therefore, the OFEs will likely continue to invest any fresh money mostly in equities. This could be supportive for the equity market, especially between February and July, before the switch to the new system is fully phased in (the ‘choice period’ is April to July). During this period, the OFEs will continue to receive the same inflows as today, and their options will be limited (no bonds, mostly equities). However, in the longer term, the picture is less favourable for equity flows: Opinion polls are suggesting that as much as 50% (and likely higher) of workers will choose to migrate to ZUS. Also, with the OFEs having to liquidate an estimated PLN 4.4 billion in 2014 (rising to PLN 6.6 billion in 2015) for pension payments, it seems likely to us that the overall OFE investment into equities will fall from what it would have been pre-changes. A simple example serves to illustrate this: pre-reform, OFEs would be getting around PLN 11 billion per year in contributions. Assuming that they would maintain their current

Policies such as the increase in the retirement age, the economic slowdown and general dissatisfaction with the job market have taken a toll on PO’s (Civic Platform) support among the electorate. The recent changes to the pension system may have also alienated some of PO’s young reformist electorate. The opinion polls now suggest that PO is trailing opposition PiS (Law and Justice) by 5-10pp, and has lost around 15% since the October 11 elections. This obviously begs the question of whether there will be a change in government at the 2015 elections. While everything is possible and voter fatigue with PO may well mean that in 2015 there is a change in government, the elections are too far away. The pension reform allows the government the extra fiscal leeway to at the very least be able to avoid extra fiscal tightening and at the margin even to spend to support growth. The ongoing recovery should help popular support for the PO-led government Exhibit 12

PO Has Steadily Lost Support 50 % 45 40 35 30 25 20 15 10 5 0 Oct-11

Apr-12 PO

Oct-12 PiS

Apr-13 Palikot

Oct-13 PSL

SLD

Source: TNS Polska, Morgan Stanley Research

30


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Romania: Economy Improving, Political Risks Potentially Rising  There are signs of economic improvement, even outside the booming agricultural sector. We think that better domestic demand should allow the economy to again grow above 2%Y in 2014, even without the help of a bumper crop.  Low inflation will probably cause the NBR to ease more in the near term (to 3.50%), but the bank will refrain from cutting too far, we think. Inflation will rise sharply in 2H on base effects and likely end the year above target.  PNL leader Antonescu is likely to win the presidential elections in late 2014; watch for increased political volatility around the event.

Pasquale Diana

Exhibit 2

IP Accelerated in Late 2013, Retail Sales Lag 140

Jan 2007 = 100

135 130 125 120 115 110 105 100 95

There are signs of improvement in growth, even excluding agriculture: The surge in 3Q GDP (+1.6%Q and +4.1%) owes much to a bumper harvest in 2013, which is likely to result in some payback in 2014, assuming a normal harvest. Even outside of agriculture, we did see some signs of improvement on the domestic demand side: household consumption grew by 0.5%Q, and firms started to rebuild their inventories. The high-frequency data for 4Q show a very decent gain in IP so far in 4Q (+3.9%Q). All in all, we forecast GDP growth of 2.2%Y in 2014, following 2.7%Y in 2013. Note that GDP ex agriculture should continue to accelerate. Most of the extra stimulus to growth should come from recovering domestic consumption and investment, which are slowly coming out of a very soft patch. Exhibit 1

Growth Drivers: Mostly Next Exports So Far 8 6

% pts contribution to YoY growth

4 2 0 -2

90 Jan-07

Jan-08

Jan-09

Jan-10

Retail sales, sa

Jan-11

Jan-12

Jan-13

Industrial Output, sa

Source: Haver Analytics, Morgan Stanley Research

Inflation and monetary policy: Some more easing on the way: The downtrend in inflation during 2013 due to both a good harvest and a wide output gap was very noticeable. CPI ended last year at 1.55%Y, below the 1.8%Y expected by the NBR. We think that inflation is likely to fall even further in the first half of 2014, to the 0.5-1.0%Y range. However, as sizeable base effects build in 2H (mostly relating to food prices), we think that inflation will pick up again and end the year at 3.7%Y, above the inflation target (2.5%Y). The NBR responded to the low CPI environment by cutting rates to 3.75% in January, in line with our view: Governor Isarescu’s press conference was fairly dovish, and we now think there is scope for yet another rate cut at the February meeting (to 3.50%). It cannot be ruled out that the NBR cuts rates even further, as with inflation at 0.5-1.0%Y Romanian real rates will still look fairly elevated. That said, the bank also knows that inflation will be heading significantly higher in the second half, and will likely be careful not to cut too far. This is because reversing the rate cuts could prove quite painful further down the line.

-4 -6 -8 Q1-2010

Q1-2011

Q1-2012

Q1-2013

HH Consumption

Gov't Consumption

Fixed Investment

Inventories

Net Exports

Headline GDP, %

Source: Haver Analytics, Morgan Stanley Research

Note that the NBR also cut the minimum reserve requirement (MRR) ratio on RON-denominated liabilities from 15% to 12%; and it reduced the MRR ratio on FX liabilities from 20% to 18%. These moves increase local liquidity, though we note that the system was already liquid and credit growth has disappointed for reasons that have nothing to do with liquidity, namely strategic deleveraging on the part of banks and caution on the part of borrowers.

31


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Note that the tensions between PM Ponta and President Basescu came to the fore again in late 2013: The background is that President Basescu refused to sign the IMF First Review, on the grounds that he disagreed with a rise in fuel excise tax that the review contains. As a result, the excise hike was delayed in the budget to April, which probably means that some extra sources of revenues need to be found.

Exhibit 3

Credit in the Doldrums 15

%Y

10

5

0

-5

-10 Jan-10

Jul-10

Jan-11

Total Private Sector Credit

Jul-11

Jan-12

Jul-12

Total Corporate Credit

Jan-13

Jul-13

Total Household Credit

Source: Haver Analytics, Morgan Stanley Research

Politics: Presidential Elections Likely in November The key political event this year will be the presidential elections, likely to take place in November. PNL leader and USL co-leader Crin Antonescu is widely believed to be the USL coalition candidate and has a very good chance of winning the contest. Antonescu’s win should put an end to the uneasy cohabitation between President Isarescu and PM Ponta (leader of the Social Democrats, which joined the PNL in the USL coalition). As much as the outcome of the elections seems like a foregone conclusion right now, we would not rule out some noise around the time of the vote. It is interesting that Governor Isarescu recently referred to domestic political decisions as “the greatest danger to the Romanian economy in this election year”.

The problem is that it is a little unclear whether an IMF agreement which does not have Basescu’s signature is valid: At the end of the day, if Romania complies with the IMF demands and meets its targets, we are not sure why this agreement should be suspended by the IMF, though it is possible that from a legal standpoint there may be challenges. Note that although PM Ponta decided to delay the fuel excise hike to April, the President still maintains that the hike is altogether unnecessary and he wants to persuade the IFIs of his case. The IMF will visit Romania again in January, and we will no doubt hear more about this. The Fund said that it plans to wait for a “decision by the authorities on whether they wish to modify their policies”, before it submits the letter of intent. We read this to mean that there need not necessarily be an agreement between the parliament and the president, provided the targets are credible. Admittedly, however, there is uncertainty. The worstcase scenario is that because of some legal issues Romania may lose the IMF policy anchor that investors have come to value so much. And we think that ultimately Romania still needs that policy anchor, as a sort of ‘insurance policy’. The current IMF/EU funding line (just as the previous one) was not about funding needs (no money is expected to be drawn), but ensuring good policies. We do not think that President Basescu will want to push this issue too far, given that much worse fiscal tightening was backed by him in the past (including a 5pp VAT hike) Even so, this stand-off has the potential to create some jitters in the near term.

32


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Russia: Moderate Recovery  We see growth picking up to 2.6%Y, as the public and energy sectors lead an investment recovery, consumption remains resilient and inventories stabilise.  After missing the last two years, we think that the CBR will deliver its 5%Y inflation target in 2014. Subdued monetary growth, the good harvest and the below-inflation cap on utility prices bring inflation to target by mid-year, paving the way for 50bp of easing in the key policy rate in 2H14 to 5% by year-end.  Russia’s current account surplus continues shrinking to 0.6% of GDP, as the trade surplus falls and the services, income and transfer deficits widen. With persistent capital outflows and reduced CBR intervention, we see RUB at 35 RUBUSD by yearend.

Widespread pessimism: Russia ended 2013 in a mood of widespread pessimism about economic prospects. We believe that this reflects the impact of a year of multiple disappointments. Growth came in at 1.4-1.6%Y, compared to an initial government forecast of 3.7%Y. Inflation ended the year at 6.5%Y, above the 5-6%Y target range. The current account surplus shrank rapidly from 3.6% of GDP in 2012 to 1.8% in 2013 (on our estimates), despite a stable and high oil price, and high private sector capital outflows continued. In addition, there was a further increase in the role of the state in the economy, as Rosneft bought assets worth around 2.5% of GDP in 2013, and an increased exposure to an oil price fall, as the public sector reduced savings by 1.5% of GDP in 201314 at a broadly flat oil price.

Jacob Nell/Alina Slyusarchuk

Recovery Not Stagnation But the doom and gloom is overdone, we think: Our relative optimism about Russian growth prospects is based on an expectation of stronger and more balanced domestic demand, including resilient consumption and investment recovery. Resilient consumption: We see real wage growth as moderating, as public sector wage increases moderate, and companies respond to falling profitability, down 16% after 9M13. However, we see real wage growth supported by a tight labour market, which in turn is underpinned by demography as the low birth cohorts of the 1990s start to enter the workforce and the large post-war birth cohorts leave the workforce, leading to the population of working age falling by 0.8-1 million or 0.8-1.2% per annum to 2020, before migration. The best outcome would be for real wage growth to fall to sustainable levels, in line with productivity growth (3.1%Y in 2012). Exhibit 2

A Tight Labour Market 2.4

10

2.2

9

2

7 1.6

Exhibit 1

1.4

Double Miss on Growth and Inflation

1.2

15%

8

1.8

6 5

1 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

4

10% Vacancy rate, 3mma

Unemployment rate, sa % (rhs)

5% Source: Rosstat, Morgan Stanley Research

0% -5% -10% -15% Q1-07

Q1-08 Q1-09 Q1-10 Q1-11 Q1-12 Q1-13 Real GDP, %Y Inflation, %Y Upper bound for growth and inflation target , %Y Lower bound for growth and inflation target , %Y

Source: Rosstat, Morgan Stanley Research

Investment recovery: There are three parts to our argument. First, we expect consumer-facing investment to stay robust. We note that investment in Russia by sector not been weak across the board, and in particular has been strong in the private sector-dominated, consumer-facing part of the economy, such as hotels, entertainment, vehicle production, retail trade and residential property construction. We expect this consumer-focused investment to be robust against the background of continued real wage growth and consumption, as shown for instance in retail sales running at 4.5%Y in November.

33


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 3

Investment Strong in Consumer-Facing Sectors Chemical industry Hotels and restaurants Vehicle production Entertainment and culture Extraction of other minerals Oil processing Retail trade Agriculture Manufacturing Real estate and services Construction Average Extraction of oil, gas, coal Utility (electricity, gas, water) Transport and communications Metal industry Pipelines

This year, assuming range-bound oil prices, we expect Russian oil and gas investment to turn positive, as these effects fade, and large-scale investment starts on a new generation of mega-projects, including Yamal LNG, Rosneft’s Sakhalin LNG project, South Stream and potentially the Power of Siberia pipeline to China/Vladivostock.

Second, we expect investment in the extraction of energy resources to rebound: Investment in the extraction of energy resources, overwhelmingly oil and gas, which accounts for about 20% of total investment, was down 9.2% in the first nine months of 2013, despite oil and gas prices being high and stable. We attribute this to: i) The impact of the Rosneft acquisition of TNK-BP, which saw the combined capex of the two companies fall 15% in cash RUB – over 20% in constant rubles – from RUB 329 billion in 1H12 to RUB 281 billion in 1H13; and ii) The decline in Gazprom’s investment programme from a peak around the time of the elections in late 2011/early 2012, as major projects such as Nord Stream, Yamal and the Sakhalin-Vladivostok pipeline came on line, moving from a total investment of RUB 1,337 billion in 2011 via RUB 1,189 billion in 2012 to a forecast RUB 1,030 billion in 2013, a decline of 23% in cash terms and around a third in real terms.

Third, we expect a recovery in public sector investment this year for two reasons. First, we believe that public sector investment – which in 2012 financed 18% of investment – has been particularly squeezed by the combination of the postelection slowdown in spending and the priority given to implementation of the May decrees which set Putin’s election promises as tasks for the government, and which mainly mandated increases in current spending, such as wages for health and education personnel. In 2014, budget spending is set to rise by 4.2%Y in nominal terms, marginally up from the 3.8%Y increase in 2013, and, given lower expected inflation in 2014, a more significant shift in real terms from a 3% real terms cut to spending rising only slightly slower than inflation, as the budgetary squeeze eases. In addition, the pace of increases in current spending is set to moderate, as many of the security force wage increases have now been implemented, which means less of a squeeze on public sector investment. Moreover, the pace of public sector wage increases covered by the May decrees slows in 2014. In addition, in 2014, the government is planning to use one of the oil funds, i.e., the National Welfare Fund (NWF), more intensively to support investment, including through a RUB 200 billion capital injection into VEB, the state development bank, and buying infrastructure bonds to support three new transport mega-projects: the Moscow region ring road, the Moscow-Kazan high speed railway and the expansion of the Transsiberian and BAM railway systems.

Exhibit 4

Exhibit 5

The Sharp 2013 Fall in O&G Investment Despite a High, Stable Oil Price Will Be Temporary, We Think

Fiscal Squeeze Set to Ease

-40

-30

-20

-10

0

10

20

30

40

Growth in investment, 1-3Q13/1-3Q12 , %, constant rubles Source: Rosstat, Morgan Stanley Research

30

120

25 100 20 15

40

Anticrisis spending

30

Election year

Budget 2014-16

16.0 12.0

20

8.0

10

4.0

80

10 60 5

0

0

40

0.0 2006

2008

2010

2012

2014F

2016F

-10

-5

-4.0

20 -10

-20

-15

0 2005

2006

2007

2008

2009 2010

2011

2012

Fixed investment in oil and gas extraction, %Y Urals oil, US$/brl (rhs)

3Q2013

-8.0

Oil boom years

Real public expenditure, %Y

Real GDP, %Y

Source: Rosstat, MinFin, Morgan Stanley Research

Source: Rosstat, Morgan Stanley Research

34


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Inventory cycle set to turn, we think: A key driver of weak 2013 growth has been the weak growth in inventories, which helps to explain the puzzling combination of strong consumption growth, weak production and weak imports. We think that the inventory build that peaked in 3Q12 will likely be worked off by the end of 2013. We expect the combination of continued consumption growth and investment recovery – more balanced and growing domestic demand – to lead to inventories stabilising at around the current level, somewhat below the long-run average of 2% of GDP.

surprise autumn increase in food prices as a lagged effect of the poor 2012 harvest, which raised feed prices and led to falls in flock and herd size, which in turn supported sharp rises in the price of eggs and milk products. Exhibit 7

Declining Monetary Growth Sets the Stage for Lower Inflation 60

20

%Y

%Y

45

15

30

10

15

5

0

0

Exhibit 6

We Think the Ongoing Fall in Inventories Will End, in the Face of Resilient Domestic Demand 15

pp

10

-15 Jan 02

5 0

-5 Jan 04

Jan 06

M2 -5

Jan 08

M0

Jan 10

Jan 12

CPI lagged 16m, RH axis

Source: CBR, Morgan Stanley Research

-10

Exhibit 8

-15

A 29% Increase in the Grain Harvest, and Falling Global Wheat Prices, Should Cap Food Prices

-20 1Q-08

1Q-09

1Q-10

1Q-11

1Q-12

1Q-13

Consumption

Fixed investment

Inventories

Net exports

Govt consumption

Real GDP % YoY

Source: Rosstat, Morgan Stanley Research

20

120

16

100 80

12

A Sustained Move to Lower Inflation

60 8

Second, we see a cap on the main sources of price shocks in recent years: The main sources of inflationary shocks have been food (32% of the CPI basket) as a result of poor harvests, and above-inflation hikes in regulated utility prices (9.2% of the basket). With the grain harvest up 29% on the previous year, and global grain prices falling around 20%Y in 2013 on the back of bumper production, we expect food price inflation to fall in 1H14. Incidentally, we explain the

40

2013

2012

2011

2010

2009

0 2008

0 2007

20

2006

4

2005

We expect inflation this year to fall to the CBR’s target level of 5%Y, for two main reasons. First, the monetary outlook is supportive of a sustained move to lower inflation. Monetary growth is running at a historically low level (M2 was 15.4%Y in October 2013), and we think that monetary growth will edge down over the coming year, as the components of monetary growth all look capped: growth in foreign assets by the shrinking current account surplus and muted inflows, growth in credit to government by the balanced 2014 budget, and loan growth by the CBR’s macroprudential measures to curb consumer lending, and Nabiullina’s guidance for lower loan growth (15%Y).

Grain harvest, mil tons (rhs) Food inflation during the harvest year (Aug-Jul), %Y avg Source: Rosstat, Morgan Stanley Research

Similarly, regulated utility prices have consistently risen above headline inflation since 2006, when the programme of raising utility prices to market levels was launched. This year, the policy is to increase them by less than inflation, i.e., there is an indicative cap of 70% of last year’s inflation, or 4.6%, on increases in regulated utility tariffs for consumers. The details are confusing, and past practice shows the policy may not be strictly implemented in all cases – but we believe that the residential price of gas, which is the key fuel in heating and power, will rise by less than 5% this year rather than the 15% increases of previous years, and consider the CBR’s estimate that the cap on residential utility price increases will reduce headline inflation by 0.5pp to be credible.

35


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Inflation path: We expect inflation to fall to close to the current core inflation – 5.6%Y – by mid-2014, driven by food prices falling. With the below-inflation increase in regulated tariffs in July, we then expect inflation to move close to the 5%Y target, and stay there to year-end. Our end-2014 inflation forecast is 4.8%Y. We see the CBR as having an easing bias, given growth running below potential, but do not expect any change in policy rates until both inflation is on target and the quarterly surveys of inflation expectations show that they have started to fall, so no earlier than July. Meanwhile, we expect the CBR to continue to expand liquidity provision while market rates are at the top of the interest rate corridor, given its objective that market rates should be close to the policy rate. Given limited traditional collateral, we expect the CBR to announce some extra auctions to provide additional and longer-term CBR finance against loans. In effect, this should provide some policy easing, i.e., lower rates, before the actual rate cut.

has a rapidly growing income deficit, up US$9.2 billion after 9M13. This partly reflects the higher profitability of investment in Russia, and arguably the different investment objective, since Russians investing abroad are often aiming at capital protection and portfolio diversification rather than generating an income repayable to Russia. It also reflects the low return paid on Russia’s US$175 billion oil fund investments in G10 securities during this period of low global interest rates. We see the future path of the income deficit as harder to call. Rising global interest rates may allow Russia to make a better return on its oil fund investments, and improving prospects and the business climate could encourage more investment and lower dividend payouts by foreign investors, narrowing the deficit. On the other hand, higher dividend payments by SOEs may increase it. Exhibit 9

Shrinking Current Account Surplus… 6.0%

A Weakening RUB We have argued in previous pieces (see Russian Economics: The Shrinking Surplus, November 15, 2013) that the erosion of Russia’s current account surplus from 5% of GDP in 2011 to an expected 1.8% in 2013, at a flat and high oil price, has been driven by all the elements of the current account:  Trade: We see the trade deficit as shrinking year on year, as import growth outpaces export growth, in line with the 8.7%Y fall in the trade surplus after 10M13. Nonetheless, we think that the situation on the trade account is more robust than commonly thought, since we see oil prices as range-bound and exports as supported at current levels, and import growth as muted, reflecting the ongoing substitution of imports with domestic alternatives in some categories such as cars, food and medicine.  Services: The rising services deficit is dominated by the travel deficit, which is up US$10.6 billion or 28%Y after 9M13, which in turn reflects the surge in Russians travelling abroad, and we think will continue to rise, given recent rapid growth and limited prospects for an increase in foreign visitors to Russia.  Income: According to the IIP, the Russian outward FDI stock was US$406.3 billion as of end-2012, which was only 18% smaller than the foreign FDI stock of US$496.4 billion 2 in Russia. Nonetheless, despite the near parity, Russia

5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0%

2010

2011

2012

2013

2014

2015

Current account, % of GDP Source: CBR, Morgan Stanley Research estimates

Exhibit 10

Income Payable from Inward FDI Looks Twice as High as Income Receivable from Outward FDI 25%

Return, %

20% 15% 10% 5% 0%

2

We have two reasons for believing that Russian outward FDI is significantly higher than inward FDI. First, much FDI into Russia is from Cyprus and the Caribbean, and is often believed to be Russian money reinvested into Russia from the legal security of an offshore jurisdiction. Second, Governor Ignatiev estimated capital flight – partially captured in the fictitious transactions line on the BoP – from Russia at US$50 billion in 2012, which implies that it amounts to hundreds of billions of dollars since the Soviet Union broke up 22 years ago, and suggests that Russian outward FDI might be 2-3 times higher than captured in the IIP.

2005

2006

2007

2008

2009

2010

2011

Return of Russia FDI to the RoW, % Return on FDI into Russia, % Source: CBR, Morgan Stanley Research

36


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

 Transfers: Russia, with its high wages and shrinking population of working age, attracts about 250,000 labour migrants per annum, who in turn pay growing labour remittances abroad. Given the underlying demographics, we think that this situation is likely to persist. Overall, we see a continued rapid erosion of the current account surplus, falling from an expected 1.8% of GDP in 2013 to 0.6% in 2014, with contributions from trade, services and transfers, in particular. This in turn means that we see RUB weakening by at least a sufficient amount to keep RUB flat in real terms, or by around 4% per annum, with risks to the downside.

More Consistent Reform Mixed progress on reform agenda so far: The period since Putin’s inauguration and the formation of the new government in May 2012 has seen mixed progress on the ambitious reform agenda that Putin set out in his election campaign. This was based on a macro policy mix of a balanced budget and a flexible currency, which would allow smoother adjustment to a changing oil price, and a greater role for the private sector in the economy on the micro side, to increase efficiency and competition, and support growth.

privatisations were heavily outweighed by acquisitions by state-owned companies, notably Rosneft, which acquired about US$50 billion or 2.5% of GDP – roughly equivalent to actual and planned privatisation receipts from 2005-15, or about 25 times as much as 2013 privatisation receipts. Moreover, these takeovers led to significant changes in management behaviour, with Rosneft, for instance, abolishing the commercial processes which had been established at TNK-BP. Second, the abolition, even if temporary, of funded pensions increases the role of the state in long-term savings and investment, and reduces the rate at which Russia develops institutional funds, which could reduce its high dependence on external sources of long-term financing. Exhibit 11

Revenues Running Below Spending and Inflation Requires Action to Maintain a Balanced Budget 40% 35% 30% 25% 20% 15% 10% 5% 0%

On the macro side, there has been some progress, with the CBR making further progress towards a more flexible RUB and using rates to target inflation, and a balanced budget in 2013 and 2014. On the other hand, the CBR has failed to hit its inflation target for the last two years, and the Ministry of Finance has only balanced the budget by reducing the level of savings at high oil prices by 1.5% of GDP. On the micro side, progress has been more disputable: There have been some useful developments, including a further substantial increase in Russia’s ranking on the Ease of Doing Business index, another round of tariff cuts in connection with Russia’s WTO entry, and a welcome move to international norms in clearing and settlement at the Moscow Exchange, which has significantly enhanced investor access to the local financial market. However, overall in 2013 we believe that the role of the state in the economy has increased. Although Rosstat does not publish clear data on the topic, we believe that the proportion of the economy under state control rose in 2013, for two reasons. First, although there were several significant privatisations in 2013, including Alrosa and VTB, they involved selling a minority stake in a company which remained majority state-owned, so there was in practice little impact on incentives and behaviour, and no fall in the proportion of the economy under state control. Second, these

-5% -10% Jan-10

Jan-11

Jan-12

Jan-13

General Government Revenue 6mma Y% General Government Expenditure, 6mma Y% Inflation, 6mma, Y Source: MinFin, Rosstat, Morgan Stanley Research

Reform push in 2014: However, despite this disappointing outcome, we believe that 2014 will see a more consistent reform push, focused on tackling the grey economy, or ‘deoffshorisation’, and improving efficiency at SOEs for two reasons:  Fiscal: The authorities are committed to the fiscal rule, which caps the deficit at 1% of GDP on a reasonably conservative oil price assumption (US$93/bbl), to financing Putin’s election promises as set out in the May decrees, and to not raising the general level of taxation. In order to square these commitments with the weak revenues from lower-than-expected growth, they have had to target new sources of revenue. They have raised about RUB 1 trillion or 1.5% of GDP in 2013-14 by reducing savings in the Reserve Fund and support for funded pensions, but now this source has been essentially exhausted. We think that the focus has shifted to tackling the grey economy, which in theory will allow the authorities to increase tax revenues without increasing tax rates.

37


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

 Economic: Since the election, investment has fallen steadily, despite the new centrepiece of economic policy and the new driver of growth being a rise in investment. We think that the authorities aim to increase investment, partly through measures to improve the investment climate and partly through measures to reduce capital outflows. Exhibit 12

Key Forecast Indicators Real GDP (%Y) Private consumption Government consumption Gross fixed investment

2012 3.4 6.8 -0.2 6

2013E 1.5 5.4 0.4 -0.6

2014E 2.6 3.7 1.1 4.5

2015E 2.6 3.5 1.6 4.1

4.9 -1.8 0.2 5.1

2.4 -0.8 -0.4 5.7

3.4 -0.8 0.2 5.7

3.2 -0.5 0.0 5.7

3.6 6.6 5.50 0.4 10.3 30.5

1.8 6.5 5.50 -0.4 10.6 33

0.6 4.8 5.00 -0.4 11.2 35

-0.3 4.6 4.75 -0.8 11.6 36

Contribution to GDP (pp) Final domestic demand Net exports Inventories Unemp. rate (% labour force) Current account (% GDP) CPI (eop, %Y) Policy rate (eop, %) Genl. govt. balance (% GDP) Genl. govt. debt (% GDP) RUBUSD (eop)

Source: Rosstat, Morgan Stanley Research forecasts

There is an extended discussion of risks to our views in the related stand-alone publication on the Russian 2014 outlook.

38


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

South Africa: Corrective Consolidation  The key focus will be on developments in the current account position. Contrary to consensus expectations that the deficit will remain sticky in 2014/15, we look for a narrower gap of 5.2% this year and 4.5% in 2015. Prospects of fiscal consolidation, some stability in household savings and a dearth of foreign capital that helps to place a lid on gross capital formation and the associated import demand should allow the economy to adjust towards a more sustainable external payments position.  We also look for a modest rebound in growth, some stabilisation in CPI and an unchanged policy stance until mid-2015. On the fiscus, we expect the deficit to remain around 4% of GDP in 2014 before narrowing further to 3% by 2016.  Despite a 30% cumulative depreciation over the past two years, our strategists expect USDZAR to depreciate by a further 5% to 11.00 at end-2014 and 10.30 at end-2015.

 Key risks to our macro views include disruptive labour relations that could crimp export volumes and delay the correction in the visible trade deficit; a deterioration in weather conditions that could combine with a weaker FX to push food prices higher and stoke second-round price pressures that force the central bank to tighten policy earlier than we think; and, finally, the risk of fiscal slippage ahead of national elections in April/May cannot be completely ignored.

A current account adjustment is on the cards: A less explored framework among the economist fraternity for analysing a country’s current account position is the sectoral balance approach – the basic national accounting framework that links net savings (S-I) and the budget balance (T-G) to the current account position (X–M + TR) in the form of the identity (S-I) + (T-G) ≡ (X-M +TR). Using this framework for South Africa (see South Africa Economics: How to Plug the Hole in the Current Account, December 9, 2013), we find that it is the combination of a structural decline in domestic savings, paired with a meaningful deterioration in the government budget balance in recent years, that has underpinned the widening of the current account deficit (see Exhibit 2). Importantly, our analysis also showed that the economic rebalancing that is required to steer the economy back on to the path towards a more sustainable external payments position may in fact already be under way, and should become more visible over the next year or two. In Exhibit 3, we plot South Africa’s current account, budget balance and net savings positions, and identify a theoretical ‘sweet spot’ (the orange box to the right of line AB) where net savings are positive, the government deficit is sustainable and the current account shortfall is relatively small. The country was last in this ‘sweet spot’ between 1998 and 2003.

Michael Kafe/Andrea Masia Exhibit 1

Macro Snapshot %Y

2010

2011

2012

2013E

2014E

2015E

Expenditure on GDP HH consumption Gov consumption Gross fixed investment Inventories Exports Imports Current account (% GDP) Trade balance Net invisibles USDZAR (eop) CPI Policy rates (% eop) Fiscal balance (% GDP) General govt debt (% GDP)

3.1 4.4 4.4 -2.0 -2.0 9.1 11.3 1.6 1.9 -3.8 6.2 4.3

3.6 4.9 4.3 4.2 7.7 6.8 10 -1.3 1.6 -3.9 8.2 5.0

-4.2

-3.6

2.5 3.6 4.0 4.5 9.9 0.4 6.1 -2.5 -1.3 -4.0 8.5 5.7 5.0 -4.2

1.8 2.7 2.5 3.2 8.7 4.4 7.2 -6.0 -2.5 -3.5 10.4 5.8 5.0 -4.0 55.2

2.8 2.8 3.0 4.3 3.3 5.2 5.6 -5.2 -1.8 -3.4 11.0 5.8 5.0 -4.0 55.8

3.5 3.8 3.0 5.5 2.6 5.8 6.2 -4.5 -1.1 -3.4 10.3 5.6 7.0 -3.8 56.1

Source: National Bureau of Statistics, Central Bank of Nigeria, OPEC, Morgan Stanley Research estimates

Exhibit 2

Burgeoning CAD Synchronous with Recent Deterioration in Government Budget Balance 15

% GDP Morgan Stanley forecast

10

5

0

-5

-10

-15 1970

1975

1980

Current Account

1985

1990

1995

Net Savings (S-I)

2000

2005

2010

2015

Budget Balance (T-G)

Source: South African Reserve Bank, RMB Morgan Stanley Research forecasts

What stands out in this chart is the observation that the country is currently running its worst-ever combination of triple deficits (i.e., current account, budget and net savings deficits). Historically, it has run triple deficits in only five out of the past 52 years – the most recent being 2012 and the 2009 economic downturn (1982, 2004 and 2005 are the other three). Looking forward into 2014/15, while we do not expect the economy to gravitate back to the sweet spot any time soon, we certainly foresee a move in the right direction via three main pillars of adjustment:

39


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 3

In Uncomfortable Territory with the Worst Possible Combination of Triple Deficits 0.08

Budget surplus

Net savings deficit (S-I) < 0

B

0.06

-

-

+

0.04 0.02 0 Current Acct deficit 2015E -0.02 2014E 2013E -0.04 2012 -0.06

Current Acct surplus

Net savings surplus (S-I) > 0

-

A -0.08 -0.08

income ratios in recent quarters. Presumably households have already begun to anticipate the almost inevitable normalisation of policy rates in the upcoming cycle. This should be reflected in meaningfully higher discretionary savings over time.

+

Budget deficit -0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

Source: South African Reserve Bank, RMB Morgan Stanley Research estimates

First, is budget consolidation: The October 2013 MediumTerm Budget Policy Statement (MTBPS) promises to rein in recurrent outlays on public sector remuneration from some 12% of GDP in 2013/14 to 11.5% in 2014/15 and 11% by 2016/17; cut general goods and services expenses from 5% of GDP in 2013/14 to 4.8% by 2015, and cap its subsidy and transfer allocations at some 9% of GDP over the foreseeable future. The Treasury also expects current receipts (mostly tax and non-tax revenues) to rise from 25.7% of GDP in 2013/14 to 26% this year, on the back of anticipated improvements in both domestic economic activity and external demand for South African exports. We believe that the combination of these measures should aid the rebalancing process, allowing the country to gravitate towards a smaller current account deficit of 5.2% of GDP in 2014 and 4.5% in 2015.

Higher interest rates also tend to increase investment income for households. Thus, while the share of interest earnings in gross disposable income has fallen from a peak of 7.2% in 2008 to 3.9% in 2012, we believe that our call for 200bp of policy normalisation in 2015 should ultimately contribute positively towards raising interest earnings and, as a corollary, household savings, ceteris paribus. Our baseline assumes further gains in household savings from an estimated 1.6% of GDP in 2013 to 1.7% in 2014 and 1.9% in 2015. Albeit still low by any standard, this alone should shave roughly half a percentage point off the current account deficit. Third, the increasing dearth of foreign capital should help to slow the pace of gross capital formation and associated import demand: Given the paltry levels of domestic savings, it is not surprising that South Africa has had to rely increasingly on foreign capital to give a fillip to its ambitious capex programme in recent years (see Exhibit 4). Thankfully, with developed markets’ growth prospects and investment returns generally underperforming the promise of emerging market asset classes in the past few years, foreigners have been happy to pile into South African equity and fixed income investments. But will this continue? Exhibit 4

Foreign Savings a Key Source of Funding Gross Capital Formation 40

Second, is an increase in household savings over the upcoming tightening cycle: As a general observation, household savings in South Africa appear rather low, presumably as a result of high household dependency ratios, low real after-tax returns on savings, and a deregulation of financial institutions which reduces the need for precautionary savings. Even so, net household savings, which shrunk consistently from 6.7% of GDP in the 1960s to a low of -0.75% in 2008, appears to have stabilised at a flat reading in 2012/13. Looking forward into 2014/15, we expect continued improvements in employment as the business cycle matures and as global demand conditions improve to help boost disposable incomes at a time when household deleveraging already appears to be under way, as reflected in a modest – albeit important – decline in household debt/disposable

% of GDP

35

Morgan Stanley forecast

30 25 20 15 10 5 (5) (10) 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Gross domestic savings

Foreign inflows

Gross capital formation

Source: South African Reserve Bank, RMB Morgan Stanley Research estimates

40


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Our strategy colleagues expect capital flows into structurally challenged economies such as South Africa to face serious hurdles in the year ahead. On their estimates, South Africa looks expensive relative to its global emerging market peer group, and this could restrain a more meaningful recovery in non-resident equity inflows in the year ahead (see South African Equities: Charts of the Week – Foreign Outflows Impact the ZAR, November 29, 2013). Elsewhere, they have also highlighted the fragility of inward capital flows and their expectations for a further sell-off in bond yields (see EM Strategy Update: Measuring EM’s Vulnerability to QE Tapering, November 19, 2013, and Global EM Strategy Outlook: Meet the New EM, December 3, 2013). It is also important to note that, although we expect the current account deficit to narrow from an average of some 6% of GDP in 2013 to 5.2% this year, the implied funding requirement of just under R200 billion is still onerous – especially if one considers that some of the easy money from DM that has helped to fund the deficit in recent years has already begun to dry up (monthly data from the SARB show that portfolio inflows into the domestic bond market slumped from R86.8 billion in 2012 to just R3.5 billion in 2013, while inflows to the equity market swung from -R3.4 billion in 2012 to a meagre R2.2 billion). It is therefore not surprising that, despite a narrower current account deficit, and the fact that the currency has already depreciated by 13% in 2012 and 18% in 2013, our strategists expect USDZAR to weaken by a further 5% in 2014 to close the year at 11.00 before appreciating marginally to 10.30 at the end of 2015. More importantly, we believe that, in the absence of a clear economic reform programme, a weaker currency alone may not be enough to attract the required foreign capital to finance South Africa’s investment ambitions. This, together with an eventual normalisation in policy rates, should help to constrain gross capital formation around current levels of some 20% of GDP over the medium term, suggesting that the National Development Plan’s target of a 30% of GDP investment ratio by 2030 may be difficult to achieve. The obvious implication of such an inadequate investment intensity of course is the structural constraint that it places on the GDP growth path. With regards to economic growth, we remain cautiously constructive on the household sector (which accounts for some two-thirds of GDP) and expect consumption growth, which decelerated from some 6% in early 2011 to a low of 2.3% in 3Q13, to recover somewhat in the coming quarters to average 2.8% in 2014 and 3.8% in 2015. It is important to note that the low reading in 3Q13 in particular must have had to do with the timing of public sector wage emoluments that were paid out a quarter earlier than usual.

Weak credit growth to dampen – not derail – consumption expenditures: Although consumer credit growth – especially unsecured credit – is likely to remain weak this year, it is important to note that the total stock of gross household credit (including mortgages) is just about a fifth of consumption expenditures, and that the share of net credit advances in nominal household spending has now fallen from double-digits in the pre-crisis period to just over 8%. The relatively low base here suggests to us that while an outright contraction in credit will no doubt be disruptive, a mere deceleration on an already low base is less likely to hurt. Exhibit 5

Share of Gross Credit Advances in Nominal Consumption Expenditure 30%

25%

20%

15%

10%

5%

0% Dec-07 Mortgage

Mar-09 Secured

Jun-10 Unsecured

Sep-11 Credit facilities

Dec-12 short term

Source: National Credit Regulator, South African Reserve Bank, Morgan Stanley Research estimates

Decent wage increase to prop up disposable incomes and help to place a floor under consumption spend: We would be more concerned if there was reason to believe that household disposable income – the largest single driver of consumer spend in South Africa – was to slow down sharply from here. It is important to note that a number of the major wage agreements that were reached towards the end of 2013 – and should thus underpin consumption spend for the next year or so – were 2-3-year agreements that were locked in at relatively decent levels. For example, the clothing industry settled at 7-10%, gold mining companies came in between 7.5% and 8%, parts of the communications sector reached 8.5%, construction sector unions locked in 8-10%, and the vehicle manufacturing sector agreed to a 10% wage offer. These are fairly significant increases that should help to place a floor under consumer spending growth in the coming year, we believe.

41


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 6

Households to Benefit from Decent Wage Growth and Positive Job Creation 800

thousand

%Y

600

14.0 12.0

400

10.0

200 8.0 0 6.0 -200 4.0

-400 -600

2.0

-800

0.0 2002

2004

2006

Employment (change)

2008

2010

2012

2014

Disposable Income

Source: Statistics South Africa, Morgan Stanley Research estimates

Our baseline assumption postulates an average 7.5% increase in household wage settlements over the next three years – compared to 7.9% in the past three years. This, together with modest job expansion, should allow real disposable income to recover from an estimated 2.5% in 2013 to some 3% in 2014 and 3.5% in 2015 – in line with our view of a gradual recovery in household expenditure growth that allows for a much-needed narrowing of the deficit. Upper-income households may face headwinds in 2014/15, however: While upper-income households – the largest single driver of household consumption – remain the most defensive segment of the household sector for now (at least as far as job security, cash flow stability and discretionary spend sustainability is concerned), it is important to note that these households stand to be impacted by two important headwinds in 2014/15. First, while we expect policy rates to remain on hold until mid2015, the fact that the market is already pricing in more than 100bp of hikes in 2014 could well introduce an element of frugality into the near-term behavioural consumption functions of high-income households with whom most of the country’s debt resides. Second, is the upcoming switch from employer to employee taxation of pension and retirement annuity contributions that was first mooted in the February 2011 Budget and subsequently rescheduled pending discussions with the public. Under the most recent proposals, individual taxpayer deductions for pension, provident and retirement fund contributions are to be set at a maximum of 27.5% of gross

income, capped at R350,000 per annum. This suggests that households earning more than R1.3 million per annum (some 2% of total taxpayers) could – at least in theory – see a slight increase in their effective tax rates if they were to opt to contribute more than R350,000 per annum towards retirement when the new pension reforms are introduced in or after 2015. Food prices to push CPI back to target ceiling in 1H14: After decelerating sharply from 11%Y at the end of 2011 to a low of 3.8%Y in November 2013, food price leading indicators such as near-term grain futures suggest that domestic food prices may be headed higher in 2014 – particularly the first half of the year – thanks largely to the combination of inadequate rainfall patterns and a weaker currency. As shown in Exhibit 7, local near-term white and yellow maize futures prices have now risen by 20-25% since 3Q13. The fact that this happened at a time when food inflation outcomes in fact surprised to the downside suggests to us that poor weather conditions in the drought-stricken areas must have forced farmers to cull livestock in order to ease the pressure on grazing requirements. Higher costs of animal feed (yellow maize in particular is a key input in animal feed production) may also have forced farmers to embark on unscheduled slaughtering, leading to supply excesses and forcing prices southwards. Exhibit 7

Recent Rise in Grain Futures Portends Higher Food CPI 140

Index, Jan 2013 = 100

130 120 110 100 90 80 Jan-13

Apr-13

Yellow maize

Jul-13 White maize

Oct-13 Wheat

Jan-14 Brent(spot)

Source: South African Futures Exchange, Bloomberg, Morgan Stanley Research estimates

Looking forward into 2014, it is reasonable to expect meat prices to ratchet higher once the initial glut falls out of the wash. Typically, this process should take anything between 3-6 months to show up in food inflation, and could be sustained for a further 3-6 months, depending on the strength

42


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

of domestic demand conditions and the level of price competition among local retailers. In our opinion, despite the currently weak FX pass-through, already-compressed retailer margins point towards limited capacity to absorb further price increases. We therefore expect both farm-gate and shop-shelf prices to rise in the coming months. Specifically, we look for food CPI to accelerate from 3.8%Y in November 2013 to 6%Y by mid-2014, with technical base effects associated with recent low prints suggesting that annual food inflation outcomes could accelerate even further into 4Q14. Thanks to the higher food inflation profile, we now believe that headline inflation is likely to accelerate from 5.3%Y in November to 5.8%Y in January, dip slightly thereafter, before printing at the upper end of the country’s 36%Y inflation target band by mid-year. The mid-year spike also has to do with unfavourable base effects from the low readings of 2Q13, when weak demand from China led to a sharp decline in commodity prices that helped to drag oil prices from US$119/bbl to US$97/bbl. Exhibit 8

CPI to Bump Against Upper End of Target Band in 1H14 8.0

%Y

%Y

Morgan Stanley forecast

14.0 12.0

7.0

10.0 6.0 8.0 5.0 6.0 4.0 4.0 3.0

2.0 Jan-10

2.0 0.0 Jan-11

Headline

Jan-12

Jan-13

Jan-14

Core

Jan-15

Food (rhs)

trajectory. The timing here could be propitious if it were to coincide with a mid-year inflation upswing that subsequently tapers off into year-end as we expect. This is because the opportunity to extend the forecast horizon at a time when the market is likely to get even more aggressive with the pricing of rate hikes as inflation outcomes push against the upper end of the target band affords the SARB the leeway to de-emphasise the most recent inflation outcomes and focus instead on the forward-looking profile. Unless the MPC has a reasonable basis at that time to believe that one or more of its key input variables (e.g., oil prices, unit labour costs, FX or electricity tariffs) are likely to rise sharply in 2016 (i.e., more than 12 months out), we believe that it is only reasonable to expect its 2016 CPI forecast to come in at or below the 2015 trajectory – especially if one also considers that base effects from the potential acceleration in 2014 food prices are likely to place a lid on the 2015 profile. With such a profile, any normalisation in rates would have to be based on a stronger growth profile than the MPC currently expects – we think that this is unlikely. However, we see credible risk of a rate hike if the currency were to breach USDZAR 11.50-12.00 on a sustained basis: In this scenario, unless domestic demand takes a meaningful turn to the south, we would expect both headline and core CPI to come in at or above the upper end of the target band for most of the forecast horizon, leaving the MPC with no choice but to tighten policy or risk some credibility loss. Fiscal metrics are in acceptable shape: South Africa’s move to fully adopt the IMF’s Government Financial Statistics reporting standards late last year had a slightly positive impact on its fiscal metrics – especially for 2013, where its consolidated budget deficit improved from 4.5% of GDP to 4.2%. This was largely due to the treatment of extraordinary transactions (worth more than R10 billion in 2013), which are now defined above the line as a revenue item.

Source: Statistics South Africa, Morgan Stanley Research estimates

Rates on hold; SARB rhetoric to remain on the hawkish side of neutral: With such an inflation profile, we believe that SARB MPC rhetoric is likely to remain on the hawkish side of neutral for most of the year. However, a policy rate hike is unlikely, as we expect the MPC to look through the hump in food prices, and focus instead on the 12-18-month trajectory, where we expect CPI to fall back to 5.5%Y. We would also point out that the MPC is likely to extend its forecast horizon into 2016 – either at its May or July meeting – in order to maintain the usual 18-24-month forecast

Looking out into the 2014/15 fiscal year, we expect the headline deficit to consolidate around the 4% of GDP level (the Treasury forecasts 4.2%) before declining to 3% in 2016/17. We look for slightly higher tax revenues than budgeted by the Treasury (especially in personal taxes, corporate income taxes and VAT, where official estimates appear most conservative). For example, despite expectations of slightly stronger household consumption expenditures, official Treasury forecasts for VAT receipts for example are only up R24 billion in 2014 – lower than the R27 billion increase that was reported in 2013.

43


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 9

General Government Deficit, Debt and Cash Position R billions

FY 2013/14E Oct-13 MTBPS

Budget balance % of GDP Central govt debt (gross) % of GDP Central govt debt (net) % of GDP Domestic Foreign Contingent liabilities Guarantees General govt debt (gross) % of GDP Debt issuance (net) Short term Long term (gross) Long term (net) Foreign (gross) Foreign (net)

-145 -4.2

FY 2014/15E

Oct-13 MS MTBPS

-140 -4.0

-157 -4.1

FY 2015/16E

Oct-13 MS MTBPS

-152 -4.0

-156 -3.8

MS

-159 -3.8

1,562 1,565 1,749 1,754 1,967 1,971 44.8 45.1 46.0 46.4 47.3 47.6 1,370 1,380 1,574 1,590 1,788 1,794 39.3 39.8 41.4 42.0 43.1 43.4 37.6 37.7 39.9 40.0 41.4 41.5 1.7 2.1 1.5 2.0 1.7 1.9 350 355 350 215 225 220 - 1,915 - 2,109 - 2,321 55.2 55.8 56.1 173 23 171 150 20 0.5

176 23 173 152 20 0.9

163 24 171 138 15 1.1

169 25 175 142 15 1.5

184 25 176 148 14 11

188 25 180 152 15 12

Cash holding (Natl. Rev Fund) 177 184 161 172 165 167 Domestic 118 125 102 113 107 109 Foreign 58 59 58 59 58 59 Nominal GDP 3,484 3,466 3,800 3,783 4,153 4,136 Source: National Treasury, Morgan Stanley Research estimates

However, part of the revenue overshoot will likely be eroded by a potential overshoot in interest and wage outlays. After rising by some 14% in both 2012 and 2013, the Treasury forecasts a 9% increase in the 2014 interest bill despite a higher funding requirement and the likelihood that US ‘tapering’ results in higher funding costs for most emerging markets including South Africa. Its wage bill, which has risen by an average 10.5%Y in the past four years, is also forecast to rise by less than 7% this year. Although election-related fiscal slippages have never really been an issue in postapartheid South Africa, we struggle to see how the growth in the wage bill would decelerate significantly in an election year. It is also important to bear in mind that the public wage increase for this year has already been set at CPI+1 – similar to 2013. If one assumes similar inflation rates for both 2014 and 2015 as we expect, and that the 2013 wage bill rose by 9% after adjustments for headcount, pay progression, etc., it is not too difficult to see why we believe that the official 2014 wage bill appears low.

Cash position remains healthy: With regards to funding, we expect bond issuance to remain within the R170-175 billion range – slightly higher than the headline deficit of R155-160 billion, and thus providing some insulation against unforeseen contingencies. South Africa continues to maintain a healthy cash position of some R160-180 billion – enough to fund a full year’s deficit! These enviable cash reserves will likely be called to redeem maturing debt over the busy 2016-20 period. The country’s gross debt/GDP ratio (i.e., including guarantees and other contingent liabilities) remains below the 60% mark. International credit rating downgrade unlikely: South Africa’s sovereign risk rating has been placed on negative watch by two of the three rating agencies. Key to watch, in our view, are fiscal developments in the February and October budgets, political elections in April/May, progress on infrastructure implementation and developments in external sector metrics. While we do not expect a downgrade to the country’s international credit rating, a one-notch downgrade on local debt that helps to narrow the current two-notch gap between local and international ratings cannot be ruled out. Risks abound: First, disruptive labour relations in the country’s mining sector could crimp export volumes and delay the correction in the visible trade deficit. Second, an unwind of the fledgling recovery in global growth conditions could depress local consumer/business confidence, forcing households and businesses to further delay consumption and investment outlays. Third, further significant deterioration in already poor weather conditions could combine with a weaker currency to push food prices above our baseline scenario, and stoke second round price pressures that force the central bank to tighten policy earlier than we think. Finally, although this has never really been the case in democratic South Africa, the risk of fiscal slippage ahead of the national elections in April/May cannot be completely ignored. While we expect the elections to go smoothly, with a clear majority win by the ruling ANC as suggested by recent polls, a significant slippage in its share of total votes relative to history could still push the ruling party towards some form of populism, thereby unsettling the fiscus and financial markets.

44


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Turkey: Hazy Outlook on Politics  Growth is likely to slow down on political concerns, deteriorating consumer and business sentiment and weak investment spending. We expect the CBT to tighten policy further to address the credibility gap, volatility in the currency and risks against financial stability. The political agenda will be busy throughout the year, with local elections in late March carrying high significance as a first true test of popularity for the government since the Gezi Park demonstrations and the graft probe.  Inflation is likely to stay in the 7-8%Y range for most of the year, with significant upside risks from currency weakness and the delayed utility price adjustments. We expect the 5%Y target to be missed by a wide margin in 2014 as well. Budgetary targets might be missed slightly, but the fiscal performance should remain robust and the debt/GDP ratio should decline further to around 34% of GDP.  The current account deficit will likely decline gradually from 6.7% of GDP and stay around 6%. Given the high external financing requirement, the currency will remain under pressure and the CBT’s reaction will be key in setting the course, in our view. At any rate, we expect a challenging year for funding the external gap. We do not expect any rating downgrade, but recent political events have raised the credit risk noticeably.

Political events are likely to set the general course: One of the key pillars of the Turkish story over the past decade has been political stability and the associated implementation of structural and financial reforms that improved the overall resilience of the economy against external and internal shocks. Starting with the Istanbul Gezi Park demonstrations in late May, which transformed into a nationwide protest wave against the government during summer 2013, foreign investor sentiment and overall perception towards Turkey have started to deteriorate. On the other hand, government officials and especially Prime Minister Erdogan managed to persuade at least half of the public that the protests were part of an international conspiracy to topple the AKP government, supported by the “interest rate lobby”. Hence, the damage was mostly limited to a partial tarnishing of Turkey’s image internationally, while local sentiment and investment appetite were hardly hurt. One explanation of this phenomenon could be that while there was a wide coverage of the events by the international media, it was fairly limited domestically. This time it’s different? Then came the major surprise on December 17, when a corruption probe was launched, leading to the resignation of three cabinet members and eight MPs from the ruling party. The wide and detailed media coverage of the graft investigations, this time equally by the local media,

Tevfik Aksoy resulted in a much bigger cognisance among the public. In particular, the government’s response to the probe by reshuffling the police force by reassigning some 800 police officers to different cities and positions, the reshuffling of the prosecutors involved in the graft probe and various statements by top officials claiming that there is a “parallel state within the state”, and the Speaker of the Parliament’s claim that the judicial system is politicised have kept the issue current in the eyes of the public. Lots of questions: Various questions are still very difficult to answer and, until some clarity is achieved in at least some of them, we doubt that investors will be able to position themselves with peace of mind: Will there be more surprises and/or probes that involve key politicians or bureaucrats? How will this crisis end? Will AKP manage to keep its popularity in the upcoming local elections (March 30)? Is there any chance the opposition might win in larger cities? Will PM Erdogan decide to change the self-imposed three-term limit for members of parliament? Will Erdogan run for the presidency in August? Can AKP maintain its strength as a single party government or will there be a coalition government in 2015? Recent polls point to varying degrees of erosion in the popularity of the ruling AKP and equal gains for the opposition parties. One recent poll (by SONAR) even suggested that should the country hold parliamentary elections today, there could be a need for a coalition government. Clearly, this would raise further questions, if not complicate the matters in terms of macro policy-making, in our view. Macro implications: Before the commencement of the recent volatility in the market associated with the corruption probe and its aftershocks, we have been approaching Turkey with caution due to its sizeable external funding need and its dependence on ‘low-quality funding’ simply because of the anticipation of Fed tapering. Therefore, the recent political crises made the already-challenging outlook look even more challenging (if not negative). While we believe that it is still too early to turn highly cautious or negative on the outlook, we think that the authorities will need to act swiftly and in a timely fashion to contain the impact of the recent adverse developments. This involves continuation of the needed structural reforms, a tighter monetary policy and the maintenance of good fiscal performance (if not better).

45


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Changing our assumptions: Heading into 2014, our 2014 GDP growth forecast of 3.9%Y was based on four key assumptions: First, we expected a revival in investment spending this year, given the weak performance over the past few years. Second, we assumed that credit growth would stay sufficiently high (in the 15-20%Y range) and that private consumption would remain resilient. Third, the government would only resort to a switch to fiscal stimulus in case the headline growth rate was to decline below a certain comfort rate. And fourth, the contribution of net exports to growth would remain negative. Today, we believe that the first assumption may not hold at all, given the significant blow to business sentiment and the corruption probe spreading into key growth sectors. In an environment where the political outlook becomes increasingly blurred, currency volatility rises to multi-year highs and the added concerns surrounding Fed tapering, it seems unlikely that investors, either local or external, will be in a hurry to increase investment spending. Hence, we are cutting our fixed capital formation growth assumption noticeably by 3pp to 3.6%Y. The second assumption is still in place but the downside risks are growing and higher interest rates and the overall rise in the cost of funding (or narrowing margins) are likely to result in a deceleration in credit growth. Another significant factor will be consumer demand. With the rising cost of imported goods and an overall rise in the cost of living, the souring sentiment on the political outlook and possibly worsening employment conditions, we expect domestic demand to subside. Hence credit growth might ease to 15%Y if not slightly lower. Overall, we think that this might limit real private consumption growth to 2.1%Y.

The third assumption is also in place for the time being and the recent rise in taxes (on consumption) was encouraging from a fiscal prudence perspective but questionable from a growth angle. However, we are convinced that a substantial deceleration in growth carries the risk of the fiscal authority raising spending and/or cutting certain taxes. The rapid depreciation in the currency, even if it proves to be transitory in the coming quarters, is likely to help net exports. While Turkeyâ&#x20AC;&#x2122;s exports are less sensitive to the exchange rate, in combination with a gradual improvement in external demand conditions, the more competitive exchange rate will probably help to lift revenues. Imports, on the other hand, are highly sensitive to the currency and likely to ease in the coming quarters. As a result, we now expect the net contribution of exports to headline growth to be marginally positive. Downgrading growth forecasts for 2014 and 2015: Taking into account these changes in assumptions and incorporating recent data, especially the 3Q13 GDP growth numbers, into our projections, we are raising our 2013 expectation to 3.8%Y (previously 3.6%Y) but we now expect 2014 real GDP growth to ease to 2.9%Y from our previous forecast of 3.9%Y. We are also lowering our 2015 forecast slightly to 4.4%Y (previously 4.7%Y). If these forecasts turn out to be correct, the economy will be growing at a sub-trend rate for nearly four years. Exhibit 2

Mixed Contribution to Growth 12 10 8 6 4 2

Exhibit 1

-

Credit Growth Likely to Slow Down Noticeably 65%

(2) (4)

YoY, 4wma

(6)

55%

(8) 45%

Q106

35%

31%

25%

28%

15% 5% -5% 0 0 0 0 1 1 1 1 1 1 2 2 2 2 2 2 3 3 3 3 3 3 4 -1 l-1 -1 -1 -1 -1 -1 l-1 -1 -1 -1 -1 -1 l-1 -1 -1 -1 -1 -1 l-1 -1 -1 -1 ay Ju Sep Nov Jan Mar ay Ju Sep Nov Jan Mar ay Ju Sep Nov Jan Mar ay Ju Sep Nov Jan M M M M

Total Loans (Excl. Fin. Sector) FX Loans (Excl. Fin. Sector) Source: Haver Analytics, Morgan Stanley Research

TRY Loans (Excl. Fin. Sector)

Q406

Private Cons.

Q307

Q208

Q109

Government Cons.

Q409

Q310

Q211

Fixed Capital Form.

Q112

Q412

Net Exports

Q313

Stocks

Source: Haver Analytics, Morgan Stanley Research

Credit growth will be a key variable to watch again: Turkey is no longer a country with a low credit penetration rate at all. At above 60%, the overall level of leverage has increased noticeably over the past five years. Essentially, the credit/GDP ratio has doubled in the past six years and the overall rise in leverage has been equally shared by households and commercial. As of end-2013, household debt to GDP reached 22%, while it stood at 11% in 2008.

46


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

prices are being kept unchanged deliberately by the government to avoid a negative reaction from the public. This might continue until after the local elections (March 30) and, considering that the fiscal performance is fairly robust, the budget has room to handle this delay. But eventually there might be an adjustment which poses an upside risk. Our bear case for inflation in this case would be 8.5-9%Y, also depending on the extent and duration of the currency depreciation to come.

Exhibit 3

Credit Penetration in EM: Turkey No Longer a Laggard 180% 160% 140% 120% 100% 80%

Exhibit 5 60%

Inflation Targeting: A 50% Hit Ratio

40%

40

20%

N

R KO

AL M

C H

L

F

H

SA

C

R

R IS

IN D

TU

AR G M EX ID N H U N R U S PO L BR A C ZE

0%

We have revised up our 2014 inflation forecast: In light of the recent data, the weakness in the currency and the impact of the recently introduced tax hikes, we raised our 2014 CPI inflation forecast to 7.5%Y from 6.9%Y previously. Essentially, this means that on a yearly basis we expect the inflation rate to remain nearly flat even though the average inflation rate this year (7.1%Y) is likely to be lower than last year (7.5%Y). Part of the reason why we think that inflation might be ‘contained’ at 7.5%Y is that we think the CBT will be taking action, and also due to the slowing demand conditions associated with worsening sentiment. Exhibit 4

Inflation Target Remains a Distant Ambition %Y

11 10

Forecast

9 8 7 6 5 4

30 Hit

25

Source: National Sources, Haver Analytics, Morgan Stanley Research

12

%Y

35

Targeted Inflation: 5%

3

D

ec M 09 ar -1 Ju 0 nSe 10 pD 10 ec M 10 ar Ju 11 nSe 11 pD 11 ec M 11 ar Ju 12 nSe 12 pD 12 ec M 12 ar -1 Ju 3 nSe 13 pD 13 ec M 13 ar -1 Ju 4 nSe 14 pD 14 ec -1 4

2

CPI Inflation Source: Haver Analytics, Morgan Stanley Research forecasts

Risks to our inflation forecast are on the upside: Considering that the ongoing currency weakness is likely to be lingering for some time and quite possibly get weaker in the coming months, some of the utility prices might have to be raised. In fact, we believe that the natural gas and electricity

Miss

20 15 10 5 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Target

Realization

Source: CBT, Morgan Stanley Research

Policy response likely to be a key ingredient: There is no doubt that interest rates in Turkey are low in comparison to the inflation performance, expected inflation (i.e., ex ante real rates) and the weakness in the currency, not to mention the rapid growth in credit. While we do not expect the CBT to change its policy stance and switch to an orthodox monetary policy regime any time soon, we think that the current trend in macro fundamentals, the volatility in the currency and the events surrounding domestic politics might force the CBT to hike. We expect hikes: We recently made two changes to our policy outlook (see Turkey Economics: Third in a Row and the Fourth on Its Way? January 3, 2014): First, we switched to using the overnight lending rate (currently at 7.75%) as the policy rate as opposed to the weekly repo rate (currently 4.50% and irrelevant for all intents and purposes). And second, we raised our policy rate hike call to 200bp (9.75%), from 100bp previously for the former policy rate. Predicting the timing of the hike is difficult, given the fluidity of the political situation, the global trends surrounding Fed tapering and the CBT’s preference for keeping rates unchanged but using FX reserves to stem the volatility in the markets.

47


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Two questions that we receive frequently on rates: 1) Will the CBT really act and can it raise rates that much if growth is slowing heading into elections? 2) If the policy rate is raised by 200bp, would it be enough? Regarding the first, we think that the CBT has demonstrated in the past (for instance in 2011/12) that, when necessary, it would not hesitate to act. So, in theory the answer is yes. But our concern is that it might act with a delay. For the second question, our response is simple: If it is not enough, the CBT will have to hike more. For the time being, a 200bp rise should help to calm the market down, slow down inflation and improve credibility. However, the political landscape is not inspiring these days and we are not sure if the CBT should be the sole body to address this by tightening.

The question for the near term is and has been for a while whether this deficit would be as easily financed as it has been the case for the past years, or will there be a significant rise in the cost of funding and/or any issues with accessing sufficient 'quantity' of funds. That is, will Turkish firms manage to roll a sufficient portion of their obligations. Until the recent political crisis, our view has been that this would be a 'price' rather than a 'quantity' issue. However, these days we have some serious doubts, especially if the situation gets visibly worse. Given the political and election agenda at hand, we find it difficult to envisage a year of smooth financing. Exhibit 6

Non-Oil and Non-Gold C/A in Surplus: So What? 20

Why is the CBT hesitating? In fact, we think that the CBT is probably hesitating to act on politics-driven lira weakness for two reasons: First, it might be thinking that a 50bp or 100bp hike, initially, might stabilise the currency, but there is no guarantee that further complications on the political scene would not result in further weakness in the currency and essentially cause the hike to be ‘wasted’. Second, the CBT might be thinking that the political scene might cool off soon and a hike might lead the economy to slow down excessively and possibly flirt with recession. At this juncture, it seems like the CBT will be looking at the extent of deterioration in inflation expectations, the duration of the weakness in the lira and the pace of loss in net FX reserves before taking action. Our concern is that further delays might necessitate a bigger tightening. Current account deficit to ease somewhat: It is a wellknown fact that Turkey has a sizeable current account deficit and most of it is structural, i.e., it is not going to narrow any time soon. While the currency depreciation and slower growth will help to lower the deficit, we doubt that it will be sufficient to take Turkey out of the risk radar range. Moreover, the nature of the funding, the reliance on short-term capital and the anticipation of higher global funding rates do not help even in the absence of the recent addition of political risk. Essentially, Turkey's current account deficit is here to stay. True, a sub-trend growth rate is likely to be limiting the extent of deterioration and in fact more likely to help to improve the trade deficit somewhat. However, in any case, whether it falls down to 4.5-5% of GDP or remains in the 6-7% range, it will be high enough to cause concern, especially in a period where the Fed starts to taper. We are lowering our current account deficit forecast to 6% of GDP for 2014 (previously 6.7%) on the back of the downgrade in our growth forecast, the increased level of weakness in the currency and the anticipated impact of the adverse political climate on consumer and business sentiment.

C/A in surplus excluding gold and energy…

US$ billion

10 0 -10 -20 -30 -40 -50 -60 -70 -80 Sep-07

May-08

Jan-09

Sep-09

C/A C/A excluding gold

May-10

Jan-11

Sep-11

May-12

Jan-13

C/A excluding energy C/A excluding energy & gold

Source: CBT, TURKSTAT Morgan Stanley Research

Is there any hope that the current account deficit might ease in the future: Our answer to this question, under normal circumstances, is yes there is. The government's efforts to curb the structural deficit in recent years focused mostly on lowering the dependency on energy imports by encouraging the production of renewable energy (hydropower, solar and wind) as well as nuclear power generation. These will take up to 5-7 years to bear significant results. Also, the passage of the law (in June 2012) encouraging investments in the “strategically key sectors” should help to cut the reliance on imports in manufacturing and hence improve the value-added on the part of exports, and we would expect results to be seen in the next couple of years. However, the significant currency depreciation, rising costs of financing projects and the souring sentiment might hold back some planned projects. Export market diversification helped: During the 2008/09 global crisis, especially at the time when European demand for Turkey’s exports declined visibly, the diversification in other markets, especially the Middle East and Africa, helped to minimise the deterioration in export performance. The share of the EU in Turkey’s total exports eased from 55% to 38% in recent years while that of the Middle East rose to as high as 28%. This has been a key strength of the economy.

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MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

using a generous assumption of, say, 65-70% of a hedge ratio, the sector would end up with a significant FX loss through the currency weakness.

Exhibit 7

Main Export Markets 60

% Of Total Exports, 12m ma

55

Exhibit 9

50

Low-Quality Financing

45 40

US$ billion

35

Capital account Foreign direct investment Portfolio investment o/w equity o/w debt securities o/w domestic issues Other investment Net errors and omissions Reserve assets (- for increase)

30 25 20 15 10 5

EU Mid. East Other Europe Source: Haver Analytics, Morgan Stanley Research

Africa

20 13

20 12

20 11

20 10

20 09

20 08

20 07

20 06

20 05

20 04

20 03

20 02

20 01

0

Americas

12m rolling

% of C/A

5.1 0.4 1.2 0.8 0.6 (1.2) 3.5 1.0 (2.1)

70.5 8.3 29.5 1.9 24.5 6.9 32.7 3.1 (12.9)

14% 49% 3% 40% 11% 54% 5% -21%

Source: CBT, TURKSTAT Morgan Stanley Research Asia

Gold trade complicated the picture: However, we should add that the gold exports to Iran and the UAE in 2012 and the restocking of inventories in 2013 distorted the picture somewhat by inflating exports in 2012 and imports in 2013. With the recent graft probe covering the gold trade as well as the international sanctions limiting trade with Iran, we think that the gold trade will not be an important issue any longer. Exhibit 8

Gold Trade Is Over 3.0

Nov-13

The low-quality funding picture should not change – at least not in the near term. It is not a coincidence that the share of stable funding – namely FDI – is low in the country. There are various structural reasons ranging from the lack of a level-playing field between foreign investors and locals, tax policy, rigidities in the labour market and now the recent turbulence. Especially the recent events suggesting the loss of independence in the judiciary system can do nothing but hurt confidence among foreign investors. Non-financial sector debt rollover still untarnished so far: Despite the various concerns surrounding the Fed’s tapering during the summer months, Turkish corporates seem to have had minor problems, if any, with regards to their external borrowing. In September, the debt rollover ratio reached 107% and pulled the year-to-date average to 102%. This is in line with our general view that the primary impact of Fed tapering might be seen as a rise in the cost of borrowing for Turkish companies rather than a decline in the quantity.

US$bn

2.5 2.0 1.5 1.0 0.5

Ja n M -10 a M r-10 ay Ju 10 Se l-10 p N -10 ov Ja -10 n M -11 ar M -11 ay Ju 11 Se l-11 p N -11 ov Ja -11 n M -12 ar M -12 ay Ju 12 Se l-12 p N -12 ov Ja -12 n M -13 a M r-13 ay Ju 13 Se l-13 p13

0.0

Gold Exports

Gold Imports

Source: Haver Analytics, Morgan Stanley Research

Financing likely to be the main focus: Turkish non-financial companies’ external debt and the associated net FX position are worrisome on a first-look basis. At US$166 billion, the short FX position is significantly high by any measure. But the data on the FX exposure are quite misleading in a sense that while these firms' liabilities are well-known, there is no full access to their assets. Hence, it is not clear what portion of their FX exposure is naturally (via exports and other FX receivables) or financially (via collaterals) hedged. But even

External financing requirement: The big question: Every December or January, it has become customary to predict Turkey’s external financing requirement, usually end up facing a very high figure and then making assumptions as far as what portion of amortisations can be rolled, whether portfolio flows will be helping or hurting the bottom line, if there will be any welcome support from ‘net errors and omissions’, etc. The outcome is usually a high figure, especially when using the standard definition of external funding requirement. At first sight, the figure causes alarm bells to ring, but somehow the year goes by with minor problems. This ‘somehow’ is mostly related to the assumptions behind the nature of the borrowing by corporates and the ‘hidden assets’ mentioned earlier.

49


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Exhibit 10

Non-Financial Corporations Manage to Roll Debt 300%

Average rollover rate: 120% in 2011, 117% in 2012, 102% in 2013

250% 200%

Average rollover rate was 72% in 2009

150% 100% 50%

D

ec M -0 7 ar Ju - 0 8 n Se -08 p D -08 ec M -08 ar Ju -09 n Se -09 p D -09 ec M -09 ar Ju -10 n Se -10 p D -10 ec M -10 ar Ju -11 n Se -11 p D -11 ec M -11 ar Ju -12 n Se -12 p D -12 ec M -12 ar Ju - 1 3 n Se -13 p13

0%

Domestic financing programme for 2014: According to the Turkish Treasury, domestic borrowing will be TRY 134.6 billion in 2014 – noticeably lower than last year. The domestic debt rollover ratio will be 86% and nearly unchanged compared to 2013. Compared to the rather high debt rollover ratios realised in 2010 (89.3%) and especially in 2009 (103.5%), the relatively low ratio of 2014 would help to improve debt dynamics further. The decline in domestic borrowing might help to remove some of the pressure on yields that are otherwise affected by the Fed tapering and the political outlook concerns. The downside risks to the financing outlook remain slippage in privatisation revenues, a lowerthan-planned primary surplus (if not a deficit) and lack of interest on the part of non-resident investors.

Debt Rollover Ratio (non-bank) Source: CBT, TURKSTAT Morgan Stanley Research

According to our calculations, the overall funding requirement (defined as the current account deficit + medium and longterm debt amortisations) in 2014 will be close to US$116 billion and very near the level of 2013. The standard definition adds short-term external debt to this, which stands at US$125 billion (it stood at US$100 billion at end-2012), pushing the overall figure to roughly US$240 billion. But our experience tells us to omit the short-term external debt and assume that a significant portion would be rolled or paid partially by the offshore assets that we cannot see. At any rate, based on our assumptions for FDI, portfolio, short-term funding as well as medium- to long-term borrowing, we think that FX reserves might go through a reduction of some US$10 billion in 2014. If there are problems for the Turkish banks and/or corporates to roll a significant portion of the short-term debt, then it will probably be due to further escalation in political risks, further deterioration in risk appetite globally and/or a Turkey-specific event that we cannot envisage as part of our baseline scenario. Fiscal policy is on track: Without a doubt, Turkey’s fiscal performance has been commendable in recent years. This has been partially due to the rise in revenues due to one-off factors (such as asset sales and privatisation) and partially careful spending on part of the government. As a result, the 2013 budget deficit is likely to be limited to 1.5% of GDP. However, the outlook is somewhat blurred, with slow growth affecting revenues and the election calendar placing upside risks on spending. For the time being, we are revising our 2014 deficit to GDP forecast to 2.5%, but we think that there are upside risks to this. There will be a slight surplus on the primary balance, in our view, which leads to a slight decline in the debt/GDP ratio to 34.8%.

Exhibit 11

Domestic Financing: Does Not Look That Tough TRY billion

Total debt service Domestic debt service External debt service Financing Borrowing Domestic borrowing External borrowing Other financing Domestic debt rollover rate

2013 Plan

2013 Official projection

2014 Plan

188.6 172.1 16.5 188.6 164.3 150.6 13.7 24.3 87.5%

183.2 167.1 16.1 183.2 154.4 142.3 12.1 28.8 85.1%

176.7 156.5 20.2 176.7 149.3 134.6 14.8 27.4 86.0%

Source: Turkish Treasury, Morgan Stanley Research

Sovereign rating outlook: While the political uncertainties added to the risk profile of the country, we doubt that there is sufficient reason to expect a downgrade, given the overall fundamental picture and the authorities’ options to use various policy tools. That said, as stated by Fitch recently, the “tensions have the capacity to weaken creditworthiness”. For the time being, both Fitch and Moody’s mentioned that the current sovereign rating of Turkey reflected the political risk profile. Hence, we do not expect any rating action in the absence of a serious deterioration in the political scene and/or acceleration in outflows that might jeopardise the debtservicing capacity of the corporate sector.

50


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Ukraine: Risks Postponed, for Now  The Russia deal announced in December 2013 including a 34% discount in the gas import price and US$15 billion in loans removes the FX adjustment and debt repayment risk before the March 2015 presidential elections. We expect UAH to remain stable and that reserves will be maintained at current levels.  We also expect fiscal stimulus in advance of the elections, and increase our growth forecast from 1.3%Y to 2.0%Y, driven by stronger domestic demand, especially from households, and expect inflation to pick up to 4.5%Y by year-end.  There remains a risk of further political protests, or a breakdown of the Russian deal. Post-election, we see radical uncertainty about Ukraine’s development path.

Disappointing performance in 2013: 2013 ended with a deteriorating performance on many fronts.  Growth fell to -1.2%Y in 1-3Q13 as the tight monetary and fiscal policy required to defend reserves and hold UAH exacerbated the downturn. As a result, consumption has weakened, while weak external demand pushed production and fixed investment growth into negative territory and inventories contracted as Ukraine depleted its gas reserves to reduce its gas import bill. We expect growth at -1.2%Y for 2013 as a whole, significantly lower than the 3.4%Y growth assumed in the 2013 budget and down from 0.2%Y in 2012.  The fiscal deficit widened to over 6.0% of GDP: Through most of the year due to slower growth and deflation, revenues fell faster than spending, which widened the 12month rolling fiscal deficit to UAH 66 billion or 4.3% of GDP by August. However, a further reduction in spending (down 23%Y in November) and consolidated efforts of tax administration narrowed the 12-month deficit to UAH 49 billion. At the same time, we assume that the Naftogaz deficit stayed at 2% of GDP, due to unchanged gas tariffs for households, pushing the broad fiscal deficit up to 6.2% of GDP in 2013.  The current account deficit widened to 8.4% of GDP on our estimates, despite a 9% contraction in gas import volumes, due to weak external demand, unfavourable metal prices and robust consumer demand for imports, supported by the flat exchange rate.  Reserves fell by 17%Y in 2013: The NBU policy of defending the exchange rate peg resulted in reserves contracting by 26%Y to US$18.8 billion by November 2013, to 2.2 months of import cover. Reserves recovered in December to US$20.4 billion, supported by the US$3 billion Eurobond issuance to Russia.

Alina Slyusarchuk/Jacob Nell Exhibit 1

Reserves Down 17% in 2013 45

9.0

US$bn

40

8.0

35

7.0

30

6.0

25

5.0

20

4.0

15

3.0

10 Jan 06

2.0 Jan 07

Jan 08

Jan 09

Foreign reserves

Jan 10

Jan 11

Jan 12

Jan 13

Reserves,months of imports (rhs)

UAHUSD (rhs) Source: NBU, Morgan Stanley Research

 Failure to sign the EU FTA in November sparked public protests, which continue into 2014. Overall, with low reserves and restricted access to financing Ukraine finished the year with a high risk of FX adjustment and a prospect of stagnation or crisis in 2014. Russian deal in December 2012 changes the game: In a major surprise, on December 17, Presidents Yanukovych and Putin announced a package of US$15 billion in financial support for Ukraine (see Ukraine Economics and Strategy: Stimulus Today, Adjustment Delayed, December 19, 2013). Moreover, the gas price Ukraine pays to import Russian gas fell by one-third from US$406/mcm to US$268.5/mcm from January 1, 2014. The meeting included the signing of 30 agreements covering a wide range of topics, including trade and economic cooperation measures. We see this deal as a major positive surprise for the Ukrainian economy in the short run, as it effectively eliminates the risk of an uncontrolled adjustment in UAH or a default before the March 2015 elections. For Yanukovych, the deal also allows running an expansionary policy into the election, without having to commit to either of the politically risky steps of joining the Customs Union or selling a GTS stake to Gazprom.

2014 Outlook: Pre-Election Stimulus We expect growth to pick up to 2.0%Y from -1.2%Y in 2013, revising up our previous forecast of 1.3%Y. The improvement will primarily come from stronger consumer demand, we think. We forecast private consumption growth at 5.5%Y in 2014, up from 4.5%Y in 2013, which would mean a

51


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

4.8pp contribution to GDP growth. Some improvement in investment will be driven by government spending and industry recovery, but we think that the uncertainty related to the elections and post-election economic strategy will keep investors on hold, and forecast a moderate recovery in fixed investment growth to 3%Y. Importantly, the lower gas price will support replenishment of gas reserves, which we reflect in forecasting a 1.2pp positive contribution to GDP from inventories. The Russia deal includes trade-enhancing measures, which should restore exports of some goods to Russia (railcars, chocolate, etc.) and support Ukraine exportoriented sectors, such as machinery, chemical industry, etc. However, we forecast that the improvement in exports will be offset by the pick-up in gas import volumes, including gas to replenish reserves. Together with stronger consumer and investment imports demand, this will push import growth up to 10% in real terms, we think. On balance, we expect the contribution to growth from net exports to be negative at 3.7pp. Overall, however, given the 4% of GDP output gap, we still expect stimulus to lead to a pick-up in growth, and revise our 2014 GDP growth forecast to 2.0%Y from the previous 1.3%Y. The positive fiscal impact from lower gas import price… The reduction in the Naftogaz deficit could be significant, of the order of 1-1.5% of GDP, since a lower gas price will reduce Naftogaz’s losses from supplying gas to households and utility enterprises at a regulated price below the import price. Also, the price cut for industrial users is only 10% from January 2014, compared to a 34% cut in the import price, which should improve Naftogaz’s financial position.

…is likely to be offset by extra pre-election spending: As the pressure on FX subsides, we believe that the authorities will use this chance to ease fiscal policy in the run-up to elections in March 2015. PM Azarov’s statements on the 2014 budget imply an increase in social spending, including increases in the minimum wage, public wages, pensions, etc. The Cabinet of Ministers approved a draft 2014 Budget on December 18. It assumes GDP growth of 3.0%Y, inflation of 4.3%Y and an average exchange rate of 8.5 UAHUSD. In addition to social spending increases (including public wages up by 19%), the profit tax rate (accounting for 17% of the state budget revenues) will be reduced from 19% to 18%. Given the poor track record of prudent budget execution and the incentives of the government to increase spending closer to the election, we don’t expect the fiscal deficit to improve despite the reduced gas subsidies. We still forecast the broad budget deficit to widen to 6.5% of GDP in 2014. Exhibit 3

Spending to Accelerate in Pre-Election 2014 UAH bn

%Y, 3m avg

120

60 40

70

20 20 0 -30

-20 -40 Jan 07

-80 Jan 08

Jan 09

Jan 10

Gen govt 12m balance (RH axis) Exhibit 2

0

-10

Consumption

GFCF

Inventories

Errors

Govt

GDP growth

Source: Ukrstat, Morgan Stanley Research forecasts

2015F

2014F

2013F

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

-20

2002

Jan 13

Revenue growth

Source: MinFin, Morgan Stanley Research

Easier monetary policy ahead: As the pressure on FX subsides, we believe that the authorities will use this chance to ease monetary policy. We expect access of banks to financing to improve somewhat, and easier credit conditions to benefit both corporates and households. The strengthened confidence in UAH stability should foster the dedollarisation, with more short-term deposits switching to UAH from USD. And UAH short-term credit should be more popular with the corporate sector now.

pp

10

-30

Jan 12

Expenditure growth

Stronger Domestic Demand to Revive Growth 20

Jan 11

Net exports

Reserves have increased to US$20.4 billion in December 2013 from US$18.8 billion in November as the proceeds from selling a US$3 billion Eurobond to Russia were transferred to the reserves. We expect the Russian US$15 billion in financing to cover Ukraine’s external financing needs and keep reserves stable at their current level.

52


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Inflation should pick up on stronger demand pressures: In 2013, inflation was broadly flat at an average -0.3%Y, well below the NBU’s 4.8-6.1%Y inflation target range and below the government’s 4.8%Y forecast. It was driven by tight monetary policy aimed at preserving the hryvnia exchange rate peg, but also helped by food deflation (average food prices were -2.2%Y in 2013) due to the good harvest in 2013 (grain harvest at 60 million tonnes, up 30%Y in 2013). We expect inflation to stay subdued in 1H13 as the economy recovers. However, we expect the budget spending to accelerate monetary growth further. Also, social spending should strengthen demand pressure from consumption. We forecast inflation to rise to 4.5%Y by end-2014 from 0.5%Y in December 2013. Exhibit 4

Inflation to Pick Up on Stronger Demand Pressures 15

Political Outlook

%Y MS fcast

10

5

0

-5 Jan-10

Jan-11 CPI, %Y

UAH to remain stable as external financing needs met, but highly dependent on the ongoing Russia deal: We expect the new gas prices and the loans provided to allow Ukraine to keep the exchange rate flat at around 8.3 UAHUSD in 2014. On our recent estimates, the net financing need from January 2014 to March 2015 is approximately equal to the current size of the reserves at US$18.6 billion, which implies that Ukraine would need to raise external financing of US$18 billion to keep reserves flat (for more details, see Ukraine Economics: A Turn to the East? December 2, 2013). Given the expected improvement in the 2014 current account, the promised US$15 billion in Russian financial support will cover Ukraine’s financing needs until the presidential election in March 2015, we estimate, and allow Ukraine to hold the hryvnia close to its current level without any significant loss of reserves.

Jan-12 Food

Jan-13 Non-food

Jan-14 Core

Source: Ukrstat, Morgan Stanley Research forecasts

The external deficit is likely to remain wide at 6.8% of GDP, compared to 8.4% in 2013: The 34% gas price discount implies a reduction in the 2014 current account deficit by about 2% of GDP. However, this will be partially offset by higher import volumes. According to the Minister of Energy Stavytsky, Ukraine plans to increase gas import volumes to 30-33 bcm from 25.7 bcm in January-November 2013 and will import gas only from Russia. A number of agreements appeared to be aimed at increasing mutual trade and removing barriers to trade. Given the weak growth in intra-Customs Union trade and moderate Russian growth, we see only limited scope for an increase in Ukrainian exports to Russia. This should include Russia-oriented machinery exports and some exports that have recently been blocked from the Russian market (railcars, chocolate, etc.). However, we expect a pick-up consumer imports and some improvement in investment demand to offset the impact. Hence, we forecast the current account deficit to narrow by only 1.6pp from 8.4% of GDP in 2013 to 6.8% in 2014.

Although political protests continue, we see the focus shifting to the presidential elections in March 2015: Recession and a slowdown in household incomes in 2012-13 were reflected in falling approval ratings for Yanukovych. Also, the political protests sparked after the failure to sign the DCFTA with the EU created uncertainty. However, the generous Russia deal will allow significant pre-election fiscal and monetary easing, and provide Yanukovych with a more favourable environment to contest the election. Post-election scenarios: Back to the old choices? The looming presidential elections and the Russia deal make 2014 much more predictable, and significantly reduce the risks of an uncontrolled weakening in the EU or stagnation as a result of tight policy to defend reserves, in our view. However, the external and fiscal deficits remain substantial and will need to be tackled in the future. At this point, it is hard to foresee the direction of Ukraine foreign and economic policy after the elections. First, the election outcome is hard to call, given a fairly evenly divided country. Second, we think that the incentives are mixed for any Ukrainian leader, since a turn back to the EU could trigger Russian resistance, while deeper dependency on Russia may constrain Ukrainian sovereignty. Given all the above, we see four plausible scenarios: 1. Economic sovereignty: Back to the IMF: This scenario is based on our view that, post-elections, the priorities of the government will change. Given the political unattractiveness of austerity, an IMF programme before the election is highly unlikely. However, post-election, the incoming president may decide to reduce economic dependence on Russia, even at some economic cost, by agreeing to an IMF programme.

53


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

From a longer-term perspective, we believe that the IMF programme would be better for tackling the underlying fiscal and external imbalances and for balanced growth. The government debt repayment schedule looks still demanding for 2015, with US$7.1 billion due compared to US$7.8 billion due in 2014. The two-year maturity of the Russia loan means that the repayment of the first US$3 billion tranche would come in December 2015 only. This scenario includes FX and policy adjustment in 2015. Exhibit 5

Redemption Schedule 9.0

Government External Debt Redemptions ($US billions)

8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Bond Principal

IMF

Bond Interest

Source: Bloomberg, MinFin, IMF, Morgan Stanley Research; Note: The schedule does not include US$12.6 billion 2016 repayment of planned Russia loan.

2. Russian Union: The current Russia deal has two key medium-term consequences. First is a reversal of attempts to diversify the structure of gas suppliers to the economy. With the favourable price from Russia, Ukraine has already stopped gas imports from Europe. Second, the US$15 billion loan increases Russia’s leverage significantly. More generally, although Putin has made it clear that there are no formal conditions attached to the agreement, we remain uncertain whether there is any informal understanding – such as an assurance that Ukraine will not sign an association agreement with the EU, or will join the Russian Customs Union later or sell a stake in the gas transit system to Gazprom. Moreover, the Russian package of support is structured so that any future Ukrainian government may be constrained. For instance, it might be difficult in future to sign an association agreement with the EU or avoid entering the Russian-led Customs Union without triggering a financial cost, such as a higher gas price. In this scenario, Ukraine continues to deepen economic ties with Russia, including through loans, joint projects and policy alignment, which may over time lead to Ukrainian membership of the Russian Customs Union.

3. Muddling through for as long as possible: Given that the repayment schedule in 2015 is not so demanding, the government might – and on past performance we think is quite likely to – choose to postpone the difficult decisions for as long as possible. 4. EU FTA deal: We see this scenario as likely in case of an opposition victory. Under any new president, if Ukraine decides to return to the FTA deal talks, the potential negative reaction from Russia would mean that the FTA deal would likely have to be accompanied by an IMF programme to secure the necessary financing.

Risks Implementation of the Russian deal: Hryvnia stability, elimination of debt repayment risk and the overall improvement in the Ukraine 2014 outlook are largely dependent on smooth implementation of the Russia deal, with funding coming on a timely basis and a continuation of the 34% gas discount. In case Ukraine resumes negotiations with the EU or there is disagreement on external or internal policy and the financing is disrupted, the FX pressures which Ukraine faced at the end of 2013 could rapidly resurface. Political risk: There continues to be a risk that the protest movement might turn into some more widespread political unrest, particularly if the government uses excessive force on protestors. However, generally we think that the political focus will shift to the March 2015 presidential elections. Election risk: Ukraine is an evenly divided country politically, and we see the election as open, if the opposition can manage to coalesce around a single credible candidate. At the same time, we see Yanukovych as being in a stronger position following the deal: he has now avoided the risk of a currency crisis before the election and he is in a position to run a more expansionary policy going into the elections, while he has avoided making any politically risky commitments. Long-term risk: Ukraine has postponed and not resolved its underlying economic challenges: While solving the short-term liquidity problem, the Russia deal does not tackle the longer-term structural imbalances, including energy inefficiency caused by expensive subsidies, its high energy dependency from Russia and the wide current account deficit. The risk for Ukraine is that it is postponing the steps needed to tackle its underlying fiscal and external imbalances and modernise its economy, while exacerbating the imbalances through expansionary pre-election policies and running up additional debt.

54


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Recent Research in CEEMEA Title

Analyst

Turkey: Risks Still Not in the Price Political developments will drive Turkey’s macro and asset markets in 2014. We see downside risks to growth and remain bearish on FX, credit and equities – but high carry should absorb price declines in local currency bonds.

Tevfik Aksoy

09/01/14

Turkey Economics: Third in a Row and the Fourth on its Way? At 7.4%Y, the CBT missed its inflation target for the third year in a row. Based on our current forecast, it seems likely that this year’s target might be missed by a margin as well. We amend our inflation and policy outlooks accordingly.

Tevfik Aksoy

03/01/14

Ukraine Economics and Strategy: Stimulus Today, Adjustment Delayed Alina Slyusarchuk/Jacob Nell The meeting between Yanukovych and Putin produced an announcement of US$15 billion in financial support for Ukraine and a one-third cut in the gas price, which will allow Ukraine to hold UAH and reserves at current levels until the March presidential elections.

Date

19/12/13

Hungary Economics: A Difficult Balancing Act The NBH cut the base rate by 20bp to another all-time low of 3% (Morgan Stanley and consensus: 20bp cut). As we expected, a significant downgrade to the official inflation forecast provided the backdrop for the rate cut and the continuation of the easing bias.

Pasquale Diana

18/12/13

Slovenia: Stress Test Done, Bail-Out Unlikely We think the stress tests remove an important source of near-term uncertainty. The underlying macroeconomic scenarios and the expected losses assumed look conservative to us, which makes the whole exercise credible, in our view.

Pasquale Diana

13/12/13

South Africa: CPI Trajectory Obviates Need for Tighter Money in 2014 South Africa’s November CPI printed at 5.3%Y, lower than our and consensus expectations of 5.5%Y and 5.4%Y, respectively. Core CPI also came in unchanged.

Michael Kafe/Andrea Masia

11/12/13

South Africa Economics: How to Plug the Hole in the Current Account South Africa’s high 3Q13 current account print of -6.8% of GDP, even after favourable data revisions, was a reminder of the challenges it faces as it seeks to rebalance its economy towards a more sustainable external payments position.

Michael Kafe/Andrea Masia

09/12/13

CEEMEA Macro Monitor (Are There Any Bright Spots?) As part of the global macro revisions published this week, we have made some revisions to our growth forecasts (albeit most were quite minor). The revisions are mostly downwards, but the broad themes remain the same.

CEEMEA Economics Team

06/12/13

Tevfik Aksoy Turkey Economics: An Inflation Breather? November CPI, at 0.01%M, came as a positive surprise against Morgan Stanley and consensus expectations of 0.5%M and 0.48%M, respectively. The monthly realisation led to a decline in the 12-month rolling inflation rate to 7.3%Y (previously 7.7%Y).

03/12/13

Russia Economics: Tackling the Grey Economy Russia has a sizeable informal economy, and we see a renewed effort to reduce its size, mainly to support budget revenues.

Jacob Nell/Alina Slyusarchuk

29/11/13

CEEMEA Macro Monitor (Deal and No Deal) We believe that the historic deal reached between P5+1 and Iran was a significant event in the region. Meanwhile, there was no deal between Ukraine and the EU.

CEEMEA Economics Team

29/11/13

55


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

CEEMEA Inflation Monitor Czech Republic

Poland

8.0

Target: 2.0% (+/-1%)

7.0

6.0

Target: 2.5% (+/-1%)

5.0

6.0 5.0

4.0

4.0

3.0

3.0 2.0

2.0 1.0

1.0

0.0 -1.0 Jan-08

-

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-08

Jan-15

Hungary Target: 3.0%

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

18.0

7.0

16.0

6.0

14.0 12.0

5.0

10.0

4.0

8.0

3.0

6.0

2.0

4.0

1.0

2.0 Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

South Africa

0.0 Jan-08

Israel Target: 3-6%

12.0

6.0

10.0

5.0

8.0

4.0

6.0

3.0

4.0

2.0

2.0

1.0

0.0 Jan-08

Jan-10

Nigeria

8.0

0.0 Jan-08

Jan-09

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Turkey

0.0 Jan-08

Target: 1-3%

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Russia

14.0

Target: 5%

Target: 5-6%

16.0

12.0

14.0

10.0

12.0

8.0

10.0 8.0

6.0

6.0

4.0

4.0 2.0 0.0 Jan-08

2.0 Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

0.0 Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Source for all charts: Haver Analytics, Morgan Stanley Research estimates

56


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

CEEMEA Real Exchange Rate Monitor Czech Republic

Poland 130

120

120

110

110

100

96.9

100

90

92.7

80

80 Jan-07

90

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-07

Jan-13

Hungary

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Romania 130

120

120

110 96.0

110

100.8

100 100

90

90 80

80 Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-07

Jan-13

South Africa

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Israel 110

110

104.9

100 100

90 90

80 78.6 80

70 Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-07

Jan-13

Turkey

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Russia 120

110

110

105.5

100

100 90

90 86.1

80

80 Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Source for all charts: BIS, Haver Analytics; Solid line stands for the average over the last five years, dashed line for the last ten years. For all indices, 100 is the average real effective exchange rate in 2010.

57


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

Global Monetary Policy Rate Forecasts Global Economics Team (as of January 13, 2014) Current

1Q14

2Q14

3Q14

4Q14

1Q15

2Q15

3Q15

4Q15

US

0.15

0.15

0.15

0.15

0.15

0.15

0.15

0.15

0.15

Euro Area

0.25

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

Japan

0.100

0.100

0.100

0.100

0.100

0.100

0.100

0.100

0.100

UK

0.50

0.50

0.50

0.50

0.50

0.50

0.75

0.75

1.00

Canada

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

1.00

Switzerland

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Sweden

0.75

0.75

0.75

0.75

0.75

1.00

1.25

1.50

1.75

Australia

2.50

2.50

2.50

2.50

2.50

2.50

2.75

3.00

3.00

New Zealand

2.50

2.50

2.75

3.00

3.25

3.50

3.75

4.00

4.25

Russia

5.50

5.50

5.50

5.25

5.00

5.00

4.75

4.75

4.75

Poland

2.50

2.50

2.50

2.75

3.25

3.75

4.00

4.00

4.00

Czech Rep.

0.05

0.05

0.05

0.05

0.05

0.05

0.05

0.25

0.50

Hungary

3.00

2.60

2.60

2.60

3.25

3.75

4.00

4.25

4.50

Romania

3.75

3.50

3.50

3.50

3.75

4.00

4.25

4.50

4.75

Turkey

7.75

7.75

9.75

9.75

9.25

8.50

8.00

8.00

8.00

Israel

1.00

1.00

1.00

1.25

1.50

1.75

2.25

2.25

2.25

S. Africa

5.00

5.00

5.00

5.00

5.00

5.00

5.00

6.00

7.00

Nigeria

12.00

12.00

12.00

12.00

12.00

11.50

10.50

10.50

10.50

Ghana

16.00

16.00

16.00

16.00

16.00

16.00

16.00

16.00

16.00

Kenya

8.50

8.50

8.50

8.50

8.50

8.50

8.50

8.50

8.50

China

6.00

6.00

6.00

6.00

6.00

6.00

6.25

6.25

6.25

India

7.75

8.00

8.00

7.75

7.50

7.50

7.50

7.50

7.50

Hong Kong

0.50

0.50

0.50

0.50

0.50

0.50

0.50

0.50

0.50

S. Korea

2.50

2.50

2.50

2.50

2.75

3.00

3.00

3.25

3.25

Taiwan

1.875

1.875

1.875

2.000

2.125

2.250

2.375

2.375

2.375

Malaysia

3.00

3.00

3.00

3.00

3.00

3.00

3.00

3.00

3.00

Thailand

2.25

2.25

2.25

2.25

2.75

3.00

3.00

3.00

3.00

Brazil

10.00

10.50

10.50

10.50

10.50

12.00

13.00

13.00

12.00

Mexico

3.50

3.50

3.50

3.50

3.50

3.50

3.50

3.50

4.00

Chile

4.50

4.25

4.25

4.25

4.25

4.25

4.25

4.25

4.25

Peru

4.00

4.00

4.00

4.00

4.00

4.25

4.25

4.25

4.25

Source: National Central Banks, Morgan Stanley Research forecasts

58


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

CEEMEA Structural Indicators External Debt and Reserves

Cz. Rep.

Hungary

Israel

Kazakhstan

Poland

Romania

Russia South Africa

Turkey

Ukraine

External Debt and Reserves International Reserves (USD bn)

56.1

46.5

106.2

52.2

515.6

49.6

64.0

166.1

81.8 101.6

24.7

External Debt % Exports

168.6

155.3

167.4

120.5

124.9

149.2 166.2

160.4

18.8

External Debt % GDP

50.4

157.5

33.6

68.3

70.6

70.9

33.6

38.1

42.5

77.5

ST External Debt % GDP

13.3

18.0

13.2

4.5

8.8

8.2

4.3

7.1

14.0

19.6

Med. and LT External Debt % GDP

31.7

74.9

19.5

30.3

45.2

47.7

22.1

22.9

28.6

53.0

5.4

64.7

na

33.5

16.6

15.0

7.2

8.1

Short-Term Debt/Reserves (%)

49.0

49.9

45.6

39.5

42.2

30.0

17.7

51.5

na 77.1

185.0

Total Reserves/Import (%) Fiscal

37.3

41.4

90.7

38.8

45.2

62.9

109.7

41.2

56.7

18.6

Intercompany Loans % GDP

5.0

Budget Balance % of GDP (2012)

-4.4

-1.9

-4.2

4.5

-3.9

-3.5

0.4

-4.9

-2.1

-5.5

Revenue, % GDP (2012)

40.1

46.5

26.6

25.3

38.4

33.5

36.9

27.7

22.8

31.6

Expenditure % GDP (2012)

44.5

48.5

30.8

20.8

43.4

37.0

36.5

32.6

24.9

37.1

Government Debt % GDP (2012) Credit and Banking Sector

45.5

79.2

73.2

13.1

55.6

35.4

10.3

47.2

37.0

36.6

Private Sector Credit % GDP

53.2

48.4

73.5

34.4

51.0

35.4

49.8

77.6

63.8

60.5

30.5

24.1

41.3

10.9

34.8

16.7

14.5

44.6

21.8

13.5

0.2

54.2

na

14.3

31.9

66.5

2.6

na

0.1

42.8

22.8

24.3

32.2

23.4

16.2

18.6

35.4

na

42.1

47.0

21.0

49.7

na

36.6

24.3

56.7

22.2

na

44.5

35.6

4.1

-1.0

8.1

15.5

3.0

2.2

18.0

7.0

32.2

7.9

0.76

1.01

1.1

1.43

1.12

1.17

1.27

1.05

1.08

1.36

Current Account % GDP

-1.7

2.4

1.2

-1.4

-1.9

-1.2

1.8

-6.2

-7.2

-8.9

Capital Account % GDP

2.6

3.2

0.2

0.0

2.3

2.0

0.0

0.0

0.0

0.0

Financial Account % GDP

1.4

-9.1

-1.6

0.7

2.0

0.4

-1.3

3.5

8.7

4.4

Direct Investment % GDP

2.3

0.1

2.8

3.3

0.7

1.3

-0.3

0.4

1.0

2.4

Portfolio Investment % GDP

0.9

2.0

-4.6

-3.4

0.6

4.8

0.2

0.9

4.3

4.0

-1.7

-11.2

0.2

0.8

0.7

-5.7

-1.2

2.2

3.3

-2.1

HH Credit % GDP FX % Total HH Credit NFC Credit % GDP FX % Total NFC Credit Private Sector Credit % yoy Loan/Deposit Ratio Balance of Payments

Other Investment % GDP Reserve Assets % GDP

-0.2

2.4

-0.9

2.9

-1.0

-1.1

-0.1

-0.2

-1.7

4.0

Net Errors and Omissions % GDP GDP and Population

-2.1

1.1

1.2

-2.2

-1.4

-0.1

-0.5

2.9

0.2

0.5

Nominal GDP (USD bn, 4q sum) Nominal GDP (bn, local currency, 4q sum)

197

129

282

216

509

182

2103

359

823

178

3847

28787

1040

32752

1620

616

66466

3324

1518

1425

Population (mil people)

10.51

9.93

7.91

16.91

38.53

21.35

143.00

52.28

74.89

45.45

GDP per capita (USD)

18741

12964

35697

12801

13201

8508

14704

6860

10989

3921

Source: Haver Analytics, National Central Banks, MoF, Morgan Stanley Research; latest available data

59


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

CEEMEA Vulnerability Watch For further analysis, see “CEEMEA: On Funding Concerns and Vulnerability”, CEEMEA Macro Monitor, July 13, 2012. Latest

TU

IL

RU

UA

KZ

CZ

HU

PL

RO

BU

SA

NG

C/A, % of GDP

-7.4

1.2

1.8

-9.1

-1.4

-1.1

2.4

-1.9

-1.1

2.0

-6.2

7.5

External debt/GDP

45.3

33.6

33.8

77.3

68.3

50.4

118.4

72.0

70.9

91.2

38.1

2.6

St external debt/FX reserves

83.9

53.7

17.4

170.3

39.5

43.5

49.4

42.2

30.0

71.3

54.0

4.6

Loan to deposit ratio for the whole banking system FX loans as a % share of total PS credits (HH + NFC)

1.0

0.9

1.2

1.4

1.5

0.7

1.0

1.1

1.2

1.1

1.0

0.6

27.0

10.3

16.8

37.0

29.1

8.1

55.8

31.3

62.7

63.9

11.7

3.5

Budget deficit, % of GDP

-1.3

-2.7

-0.6

-3.6

7.0

-4.4

-3.2

-3.9

-2.7

-1.5

-4.8

-2.3

Government debt, % of GDP

38.1

66.3

9.3

31.7

11.8

46.4

80.8

55.0

37.9

18.0

41.6

19.8

20.4

3Q08 C/A, % of GDP

-6.0

0.7

7.1

-6.7

3.2

-2.4

-7.0

-6.4

-13.6

-23.7

-7.7

External debt/GDP

37.8

42.1

32.3

55.3

81.5

42.6

112.9

51.4

51.8

105.9

26.2

1.8

St external debt/FX reserves

48.0

111.1

19.5

73.0

47.0

77.7

116.5

84.7

64.5

87.6

80.0

2.1

Loan to deposit ratio for the whole banking system FX loans as a % share of total PS credits (HH + NFC)

0.8

0.9

1.4

1.6

1.6

0.8

1.3

1.0

1.4

1.1

1.1

0.9

25.2

10.0

22.6

47.0

43.9

8.5

55.9

27.6

56.1

55.5

8.0

6.0

Budget deficit, % of GDP

-2.2

-0.1

8.0

-0.2

4.5

-1.4

-3.5

-2.4

-5.1

2.2

0.9

-0.2

Government debt, % of GDP

37.7

71.0

5.3

7.4

8.9

27.0

66.0

42.8

11.4

14.3

24.0

11.9

Source: Haver Analytics, Eurostat, national statistical offices, national central banks. Data on loans, deposits, external debt and reserves, most recent available data used. Data on external debt/GDP and government debt/GDP, latest available, based on 4Q rolling sum of GDP. Current account % of GDP and budget deficit numbers were calculated using the 4Q or 12M rolling sums, using the most recent available data. For the budget deficit in Hungary, we used the European Commision March estimate, which provides the budget deficit net of the exceptionally large revenues in 1Q11, of a one-off character, coming from the pension system reform.

Vulnerability Scoring Indicator (VSI)

Changes in the VSI Since 3Q08

1.5

0.6

1.0

0.4

0.5

0.2

0.0

0.0

-0.5

-0.2

-1.0

-0.4

less vulnerable

-0.6

-1.5 NG

RU

KZ 3Q08

CZ

IL

SA

TR

BG

PL

RO

HU

UA

Latest

Source: Morgan Stanley Research; the chart shows an aggregation of the vulnerability metrics we show above as an equally weighted average of each indicator’s deviation from the regional average (expressed in standard deviations).

more vulnerable

-0.8 UA

SA

TR

RU

PL

CZ

NG

RO

IL

KZ

BG

HU

Source: Morgan Stanley Research

60


MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

CEEMEA Annual Economic Forecasts Real GDP growth (%)

Private consumption (%)

Gross fixed investment (%)

Exports (%)

Imports (%)

CPI inflation (% year-end)

C/A balance (% GDP)

Govt. debt (% GDP)

Public sector balance (% GDP)

2012 2013E 2014E 2015E 2012 2013E 2014E 2015E 2012 2013E 2014E 2015E 2012 2013E 2014E 2015E 2012 2013E 2014E 2015E 2012 2013 2014E 2015E 2012 2013E 2014E 2015E 2012 2013E 2014E 2015E 2012 2013E 2014E 2015E

Cz. Rep.

Hungary

Israel

Kazakhstan

Nigeria

Poland

Russia

S.Africa

Turkey

Ukraine

-0.9 -1.4 1.7 2.5 -2.1 -0.3 0.4 1.7 -4.3 -4.6 1.9 4.0 4.5 0.4 5.4 5.3 2.3 0.7 5.8 5.3 2.4 1.4 2.2 2.0 -2.5 -1.1 -0.6 -0.5 46.2 46.8 48.5 49.0 -4.4 -2.4 -2.4 -2.1

-1.6 1.0 2.2 1.9 -1.5 0.0 0.8 1.0 -11.4 1.1 6.2 3.5 1.7 4.6 3.5 4.9 -0.1 4.3 2.8 4.9 5.0 0.5 2.7 3.6 1.0 2.7 2.3 2.0 79.8 79.5 79.2 79.0 -1.9 -2.8 -2.9 -3.0

3.2 3.3 3.4 3.4 2.7 4.5 3.0 3.5 4.0 -1.0 4.5 5.0 0.1 -1.0 3.8 4.0 3.4 -3.5 4.0 5.3 1.4 1.9 1.8 1.9 0.0 1.5 2.0 2.5 73.2 74.2 74.0 73.0 -4.2 -3.5 -3.5 -3.0

5.0 5.8 6.0 6.3 11.0 15.0 10.0 8.0 9.1 7.1 6.0 6.0 4.2 -1.0 3.0 7.0 22.5 6.0 5.0 5.0 6.0 5.0 6.1 6.4 0.3 -0.5 1.0 2.9 13.2 13.8 14.5 14.5 4.0 3.5 3.3 3.1

6.3 6.7 7.8 7.5 -11.3 na na na -19.9 na na na 2.7 na na na -38.5 na na na 12.0 7.8 9.1 9.2 9.5 6.8 7.0 6.2 18.3 19.7 20.5 20.8 -2.4 -3.0 -3.0 -2.7

2.0 1.4 3.2 3.6 1.2 0.6 1.9 2.0 -2.8 -3.8 6.8 8.8 3.9 5.0 5.8 5.3 -0.6 1.9 4.9 5.3 2.4 0.7 2.4 2.6 -3.7 -1.8 -2.3 -2.7 55.6 58.0 50.1 50.0 -3.9 -4.7 4.8 -3.3

3.4 1.5 2.6 2.6 6.8 5.4 3.7 3.5 6.0 -0.6 4.5 4.1 1.4 1.5 1.1 1.2 9.5 3.2 3.0 2.6 6.6 6.5 4.8 4.6 3.6 1.8 0.6 -0.3 10.3 10.6 11.2 11.6 0.4 -0.4 -0.4 -0.8

2.5 1.8 2.8 3.5 3.6 2.7 2.8 3.8 4.5 3.2 4.3 5.5 0.4 4.4 5.2 5.8 6.1 7.2 5.6 6.2 5.7 5.5 6.0 5.5 -5.8 -6.0 -5.2 -4.5 42.1 45.1 46.4 47.6 -4.2 -4.0 -4.0 -3.8

2.2 3.8 2.9 4.4 -0.6 4.1 2.1 4.2 -2.7 4.1 3.6 7.0 16.7 0.6 6.1 5.3 -0.3 7.9 5.3 6.8 6.2 7.4 7.5 6.9 -6.2 -7.0 -5.9 -6.4 36.2 35.0 34.8 34.5 -2.1 -1.5 -2.5 -2.1

0.2 -1.2 2.0 2.2 11.7 4.5 5.5 3.5 0.9 -9.5 1.6 3.0 -7.7 -9.0 3.0 4.3 1.9 -6.5 10.0 5.0 -0.2 0.5 4.5 10.0 -8.1 -8.4 -6.8 -6.5 36.6 40.0 45.0 48.0 -5.5 -6.2 -6.5 -5.0

Source: Morgan Stanley EMEA Economics. Notes: E = Morgan Stanley EMEA estimates; For Poland and Hungary, we use gross investment instead of gross fixed investment.

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MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

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MORGAN STANLEY RESEARCH January 15, 2014 CEEMEA 2014 Outlook

CEEMEA Economics Team

Tevfik Aksoy (Head of CEEMEA Economics)

tevfik.aksoy@morganstanley.com

(44 20) 7677-6917

pasquale.diana@morganstanley.com

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Turkey, Israel Pasquale Diana

Poland, Hungary, Czech Republic, Romania, Bulgaria, Slovenia Michael Kafe

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(27 11) 587-0806

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jacob.nell@morganstanley.com

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alina.slyusarchuk@morganstanley.com

(44 20) 7677-6869

South Africa, Nigeria, Ghana, Kenya Andrea Masia South Africa, Nigeria Jacob Nell Russia, Ukraine, Kazakhstan, Belarus Alina Slyusarchuk

Russia, Ukraine, Kazakhstan, Belarus, Georgia

Morgan Stanley entities: London/Johannesburg â&#x20AC;&#x201C; Morgan Stanley & Co. International plc; Russia â&#x20AC;&#x201C; OOO Morgan Stanley Bank.

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