Emerging Markets Outlook

June 3, 2011

EM OUTLOOK UPDATE: CHINA Tighter policy gaining traction

Key Points & Strategy
Recent activity data suggest that Chinese growth is moderating in response to recent policy moves but should remain solid over the rest of the year. Inflation measures have also ticked lower. Price pressures should ease later this year but near-term risks are skewed to the upside, pointing to more rate hikes in coming months. We also expect more CNY gains - we forecast USD/CNY to fall to 6.20 by end-2011 and have initiated a short NDF trade.

June 3, 2011

Forecast Table (all % except FX cross)

Real GDP growth Inflation (Dec) Govt balance/GDP Current Acct/GDP (end of period) 1-year lending rate USD/CNY
Source: RBCCM

2008 9.6 1.2 -0.4 9.4 11Q1 6.06 6.50

2009 9.1 1.9 -2.2 6.0 11Q2 6.56 6.40

2010 10.3 5.0 -1.6 4.9 11Q3 6.81 6.30

2011F 9.5 3.0 -1.5 4.5 11Q4 6.81 6.20

2012F 9.5 3.5 -1.0 4.5 12Q4 6.81 5.80

Growth solid but moderating as policy gains traction

April data suggests that solid growth has extended into Q2, but at a pace somewhat below that recorded in Q1, indicating that recent policy tightening is gaining traction. Industrial production growth, in particular, slowed from 14.8% y/y in March to 13.4% in April, the lowest reading since last November. April and May PMI data also point to a deceleration in the manufacturing sector. Retail sales growth also eased, although investment remains strong, supported by ongoing infrastructure spending and public sector housing construction. New bank lending also remained strong at CNY740 billion in April, while trade data showed that external demand is continuing to provide strong support to headline growth. Overall, then, recent data does little to suggest China is facing a hard landing over the next few months but does point to some moderation in activity over the rest of the year, consistent with our forecast for annual GDP growth to fall from 10.3% in 2010 to 9.5% in 2011. CPI inflation eased slightly in April from 5.3% to 5.2%, primarily due to a smaller increase in housing costs, while PPI inflation also pulled back from 7.3% to 6.8%, consistent with recent PMI input price data. We continue to expect price pressures to moderate later in the year. Much of the recent pick-up in headline inflation reflects base effects from earlier weakness in prices, with officials estimating this to have contributed 3.1 percentage points of the 5.3% increase in consumer prices in April. These base effects should turn more favourable in the second half of the year as y/y comparisons are made with a period of higher prices. Previous policy tightening should also have a greater impact as the year progresses. Nevertheless, risks are skewed to the upside in the near-term. In particular, higher oil and commodity prices at the start of the year are still to have their full impact on headline measures of inflation, while poor weather conditions could also send food prices sharply higher again in the next few months.

Graph 1: IP and PMI data point to moderating but solid growth

60 58 56 54 52 50 48 46 44 42 40 38 2008 2009

index

percent

40 35 30 25 20 15

headline PMI (LHS) investment (y/y growth YTD) (RHS) industrial production (y/y growth) (RHS)
2010 2011

10 5 0

Source: Bloomberg

Graph 2: Headline inflation stabilizing but risks skewed to the upside

percent 16 14 12 10 8 6 4 2 0 -2 -4 -6 -8 -10 -12

Inflation should ease in H2 but upside risks still serious

purchasing price index consumer price index producer price index 2004 2005 2006 Source: Bloomberg 2007 2008 2009 2010 2011

INVESTMENT STRATEGY

Asset Allocation

FX O/W

Local FI M/W

External Debt N/A

Top Trade Recommendations:

Sell 12-month USD/CNY NDFs

For Required Conflicts Disclosures, please see page 3

Emerging Markets Outlook

June 3, 2011
Graph 3: Policy rates up sharply over last six months, but more coming
7.56 7.31 7.06 6.81 6.56 6.31 6.06 5.81 5.56 5.31 5.06 2006 2007 Source: Bloomberg 2008 2009 2010 2011 percent percent 9

More rate hikes on the way

These near-term upside risks to inflation suggest there will be little complacency in Beijing about the inflation outlook despite signs that growth is moderating. Senior officials, including Premier Wen, have stressed that curbing price pressures is their key economic priority this year, clearly indicating that further policy moves are likely in coming months. We forecast another 25bps increase in policy rates by the end of Q2, and then another one in Q3 to take the benchmark lending rate to 6.81%. Further hikes in banks reserve requirements are also likely. We also expect CNY to strengthen further against USD in the months ahead as part of Beijings efforts to curb price pressures, with officials now more explicit about the role currency appreciation can help to play in reducing imported inflation. High inflation provides policy-makers with the motive to move faster on the currency, while solid export growth provides them with the opportunity to do so. CNY has also been flat on a trade-weighted basis in recent months, suggesting there is ample scope for further moves higher against USD. Longer-term goals also point in this direction. Senior officials including Premier Wen have indicated that a major goal over the next 5-year plan is to rebalance the economy away from an over-reliance on exports and unsustainable investment and in favour of households. Such a transition would allow (and be assisted by) a move to a stronger currency, which would drive changes in Chinas manufacturing sector while also boosting the purchasing power of Chinese consumers. Ongoing efforts to develop CNYs status as an international currency should also support the longer-term appreciation trend. Reflecting our forecast for solid CNY gains, we have initiated a short 12-month USD/CNY NDF trade recommendation at 6.382. Although we have a broadly defensive stance for EM FX in the near-term, CNY is a relatively low-beta currency, and we now see value in this trade 12-month NDFs backed up from around 6.30 over May as global risk appetite weakened, suggesting that richness/over-positioning has diminished, while implied yields have also moved to more favourable levels. We expect moderate gains over the rest of the year, forecasting spot USD/CNY to keep falling steadily to around 6.20 by year-end, compared with around 6.43 implied by the NDF market.

benchmark lending rate (LHS) 8 consumer price index (RHS) 7 6 5 4 3 2 1 0 -1 -2

Short-term and long-term goals point to stronger CNY

Graph 4: CNY trending higher against USD, but scope for more gains
index: 18/06/2010=100 108 106 104 102 100 98 96 94 92 90 88 86

CNY/EUR CNY/USD CNY/JPY RBC NEER 18-Jun 30-Jul 10-Sep 22-Oct 03-Dec 14-Jan 25-Feb 08-Apr 20-May

Source: Bloomberg, RBC

Graph 5: Policy rate and currency forecasts

7.74 7.47 7.20 6.93 6.66 6.39 6.12 5.85 5.58 5.31 5.04 2008 2009 Source: Bloomberg, RBC 2010 2011
RBC forecasts

percent policy rate (LHS) USD/CNY (RHS)

USD/CNY (inverted)

6.00 6.25 6.50 6.75 7.00 7.25 7.50 7.75 8.00 8.25

8.50 2012

For Required Conflicts Disclosures, please see page 3

Emerging Markets Outlook

June 3, 2011

Emerging Markets Research Team RBC Dominion Securities Inc.

Toronto Nick Chamie, CFA (Global Head Emerging Markets Research) Paul Biszko, CFA (Senior Emerging Markets Analyst) Eduardo Suarez (Senior Emerging Markets Analyst) Daniel Carabajal (Associate) (416) 842-2802 (416) 842-2802 (416) 842-2802 (416) 842-2802 [email protected] [email protected] [email protected] [email protected]

Royal Bank of Canada Europe Limited

London Nigel Rendell (Senior Emerging Markets Analyst) Robert Beange (Head EEMEA Strategy) +44-20-7029-7403 +44 20-7029-0098 [email protected] [email protected]

Royal Bank of Canada, Hong Kong Branch

Hong Kong Brian Jackson, CFA (Senior Emerging Markets Analyst) 852-2848-5173 [email protected]

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