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Box 8: What reforms can we expect from Brazil?

Brazil has taken a series of measures since 2015 to deal with the unsustainability in its fiscal accounts. Perhaps the most important was the passage of a constitutional reform putting in place a 20-year spending cap that restrains the nominal growth of overall expenditure to the inflation rate. However, the cap will not survive long without the passage of other measures to constrain the growth of spending in specific budget items (Figure 116). The first is pensions: Brazil already spends about four times more on its pension system than other countries with a similar demographic profile. Overall pension spending, at around 10% of GDP, will grow without bounds if no reforms are undertaken.

This makes the passage of robust pension reforms essential to the Brazilian economy. The election of the new Bolsonaro government provides an opportunity for this to happen. Reform plans are likely to evolve across two dimensions. First, a parametric reform that deals with changes in minimum retirement age, special regimes for the public sector, and indexation of benefits to the minimum wage, which should achieve savings of around BRL400bn over 10 years. Second, the transition to an individual-accounts private capitalisation system similar to the one in place in Chile. For the latter, it is still not clear how the Bolsonaro administration would handle the transition period between the systems within binding budgetary constraints.

In the short term, investors will pay close attention to two main issues. First, the make-up of the economic team. So far, only the name of the new economics minister, Paulo Guedes, has been confirmed. As approval of politically-sensitive reforms involves constant negotiations with Congress, investors will be monitoring the make-up of the team and whether some current members of government with vast public-sector experience, such as Secretary of the Treasury, Mansueto Almeida, will stay on in the new administration. Second, the government’s relationship with Congress. Jair Bolsonaro’s election created an unexpected ‘coat tails’ effect, with his PSL party (which in 2014 elected only one congressman), electing 52 deputies, becoming the second-largest party in Congress. Although this is good news for reform prospects, the new administration will still have to gain support from other parties to pass legislation. Amassing a large enough parliamentary base, while maintaining the campaign promise of avoiding the type of power-sharing arrangements of previous administrations, will be the Bolsonaro administration’s biggest challenge.

Although pension reform is necessary to stabilise the fiscal accounts, it is not sufficient by itself. Other spending-restraint measures will be needed, such as adjusting the formula that sets the minimum wage and public sector wage growth. Mr Bolsonaro and Mr Guedes also mentioned during the election campaign the possibility of selling a share of the government’s stake in public assets, such as Petrobras and Banco do Brasil, but it remains to be seen if these will be politically feasible. Dividend taxation in lieu of lowering corporate tax rates and reducing health-benefit indexation to minimum wage growth could also be pursued. Other reforms that accelerate productivity and increase potential growth rates, such as tax reform and privatisations, are also high on the reform agenda.

Figure 116: Federal government expenditures breakdown and cap (% of GDP)

Figure 117: Interest payments (% of government revenue)

Source: National Treasury, Special Committee of the Lower House, UBS. Note: The expenditure cap bill (EC 95) was approved in December 2016. We build a synthetic series for 2013–16 taking yearly average CPI as the deflator.

35

30

	(%)	25
	revenueof
		20
	Percentage	15
		10
		5
		0

Brazil

Spain

US

Japan

Indonesia

Portugal

Italy

Hungary

Canada

Poland

Thailand

Australia

China

Germany

Switzerland

Singapore

Source: Haver, UBS estimates

Tony Volpon and Armando Armenta

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Box 9: What is the collateral damage from China's inclusion in global indices?

Over the past few years, China has been gradually liberalising its capital markets, with the pace accelerating in the past couple of years. Over the past 18 months, China has lifted the ownership caps for securities firms, launched Bond Connect, further developed Stock Connect and eased onshore FX hedging regulations in its interbank bond market. Global index providers have welcomed these easing measures by including onshore Chinese assets in global indices. MSCI included China A-Shares in its indices in 2018, Bloomberg is scheduled to add onshore Chinese debt in its flagship Global Aggregate Bonds index from April 2019. Moreover, acknowledging the liberalisation efforts, MSCI is in consultation to potentially quadruple the weight of Chinese A-share Large Caps in 2019 (from 0.7% to 2.8% weight in MSCI EM), while also including A-share Mid-Caps in its indices from May 2020 (further 40bp to 3.2% weight).

MSCI's proposed change in weight of China A-Shares (delta shift of 2.1pp in MSCI EM index in 2019), if implemented, would coincide with the already confirmed inclusion of Saudi Arabia and Argentina (cumulative 3.0%) in the MSCI EM index during that period, i.e. between June and September 2019. This 5% rotation within one of the most widely followed EM equity indices (Figure 118) would not come without significant volatility in EMFX.

As we noted in Q2 2018, China's financial market liberalisation has already created a drought of portfolio flows in rest of EM Asia (Figure 119), especially as this loss of wallet share coincided with increasing competition for liquidity. The abovementioned 2019 rebalancing (Argentina, Saudi Arabia and China A-shares), if it occurs in one go, would trigger over USD100bn of outflows from other EMs. About 75% of EM outflows (excluding H-Shares) would come from Korea, Taiwan, India, Brazil, South Africa and Russia (Figure 120). Alongside this equities index rebalancing, if China onshore debt is also included in the GBI-EM index of EM LC debt, these outflows could rise to about USD125bn. The FX impact could be most severe where they are needed the most, i.e. in basic-balance deficit currencies, such as ZAR, INR, IDR and COP (Figure 121).

Figure 118: China A shares weight in MSCI indices

Figure 119: EM-Asia ex China to China rotation underway

3.5%	MSCI EM weight		40	EM Asia (3m rolling equity flows)
		74%
3.0%		72%	30		China MSCI inclusion
					announced
2.5%		70%	20
2.0%		68%	10
1.5%		66%	0
1.0%		64%
0.5%		62%	-10
0.0%		60%	-20
Mar-18	Current	Proposed 2019 Proposed 2020		Rest of EM Asia	China		Total
China A (RHS)		Argentina + Saudi Arabia	-30
Rest of EM			Apr-15	Oct-15 Apr-16 Oct-16 Apr-17	Oct-17	Apr-18	Oct-18
Source: MSCI, UBS. *Note: Argentina, Saudi Arabia inclusion is confirmed, while			Source: Haver, IIF, Bloomberg, UBS
only China is in a consultation stage, with the final outcome expected by Feb 19.

Figure 120: What if China's (A Shares) weight quadruples		Figure 121: Largest collateral damage in basic-balance
and CNY debt is included in GBI-EM index?		deficit FX

USD bn

0

-5

-10

Flows GBI-EM (Theoretical)

-15

Flows MSCI

About 75% of EM -20 equity outflows

come from six countries

-25

Source: MSCI, Bloomberg, UBS

	0%		PHP	RUB
GDP)	-1%	INR		BRL
		IDR		PLN	HUF
of	-2%		COP CLP		THB
(%
		Stronger			MYR
annualized	-3%
		withdrawal		KRW
	-4%	effects on FX
		markets
Outflows	-5%		0%	5%	10%	15%
	-5%
	-6%	ZAR				TWD
			Basic Balance (% of GDP)
Source: MSCI, Haver, UBS

Rohit Arora and Alexey Ostapchuk

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A narrowing growth gap against DM still, but for different reasons

UBS Global Economics forecasts anticipate that the EM-DM growth differential will narrow slightly in 2019, but unlike 2018, both EM and DM growth rates are likely to soften. In terms of the relationship between FX returns (GBI EM and MSCI EM weighted) against the EM vs DM growth gap and global equity returns, we find that a one percentage point increase in the differential between EM and DM growth implies a 4.3% (2.14%) return for EMFX GBI EM (MSCI EM). However, does the relationship change depending on the source of the divergence in growth? To investigate this, we divide the sample into different groups depending on whether the EM-DM growth gap is decreasing or increasing, and subsequently on whether the source of that decrease or increase is a function of EM decelerating or accelerating more than DM.

We find that when the growth gap is narrowing, average EMFX returns for GBI EM (MSCI EM) weighted are 7.7% (4.4%) lower (Figure 122). However, this lower return is only significant when DM growth decelerates and EM growth decelerates even more (as is likely in early 2019). Similarly, as Figure 123 shows during periods in which the gap is increasing we find 10% (5%) higher returns for GBI EM (MSCI EM) currencies when a narrower gap occurs owing to an acceleration in EM growth, but this is not significant when the gap increase is attributable to a deceleration in DM growth (as is likely from late 2019 to 2020).

In sum, EMFX is set to remain under pressure as the EM-DM growth gap falls in early 2019 amid lower EM growth, and the widening we expect in the second half of next year attributable to lower DM growth does not imply higher EMFX returns. Moreover, the continued deceleration we expect in China is likely to skew the distribution over the EM growth estimates to the downside from our base-case scenario, posing an extra risk to the expected widening in the EM-DM growth gap.

EMFX is positively related to the EM-DM growth gap and to global equities returns

When the gap falls amid decelerations in EM growth, we find negative EMFX performance…

…while an increase in the gap attributable to lower DM growth does not imply higher EMFX returns

Figure 122: EM nominal trade-weighted FX (NEER) when gap narrows amid EM decelerations…

0%
-1%
-2%
-3%
-4%
-5%
-6%	EMNEER (GBIEM)
	EMNEER (MSCI)
-7%
-8%
-9%
Gap falls	Gap falls (Change in	Gap falls (Change in
	EM>0)	EM<0)

Source: Haver, UBS estimates. Note: Annualised quarterly returns.

Figure 123: …and outperforms when gap widens amid DM accelerations

12%
10%
	EMNEER (GBIEM)
8%	EMNEER (MSCI)
6%
4%
2%
0%

Gap increases	Gap increases (Change	Gap increases (Change
	in DM>0)	in DM<0)

Source: Haver , UBS estimates. Note: Annualised quarterly returns.

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Can external balances, carry and valuation help EMFX withstand the relative growth challenges?

EM external balances have improved, but not by enough. As Figure 124 shows, roughly half of the EM currencies we cover have recorded an improvement in their current account positions since 2015. On the face of it, this is encouraging, but less so when one studies the details behind the improvements. Half of the improvers are commodity producers that benefitted from higher commodity prices on the back of China’s housing boom. Although housing fixed-asset investment (FAI) remains resilient, a pickup akin to 2016 is very unlikely, therefore a boost to exports from this source is similarly unlikely.

External balances have improved in some countries, but not from growth in exports

Leaving China aside, we expect global growth and global export volumes to slow. Importantly, we expect export values to slow by more than volumes as commodity prices soften. Figure 125 uses commodity prices and EUR/USD to estimate growth in export values. When we project the model forward, we estimate export values will fall by more than volumes. This may spill over into EM facilities investment, given that export margins are an important driver of such investment.

Global exports growth to decelerate in 2019 on lower prices and volumes

Figure 124: Change in CA/GDP balance and contributions (Q2 2015 to Q2 2018)

Figure 125: EM export values are likely to decline more than volumes

	Exports		Imports	15
	Primary balance		Secondary balance
8%
	Change in CA (since Q2 2015)
				10
6%
4%				5
2%				0
0%
-2%				-5
-4%				-10
-6%				-15
-8%
-10%				-20
PH	IL AR KR CN TR MY CL	IN RO ID	PL RU ZA HU TH MX CO PE	BR SG

(%y/y)		Constant		Unexplained
		CRB food		Metals
		EUR/USD		Brent
		Model
							Forecast
12	13	14	15	16	17	18	19

Source: Haver, UBS estimates	Source: Haver, UBS estimates
	We use commodity prices, and EUR/USD to explain EM export values.

A prime example of this scenario is the tech sector. We expect DRAM blended ASP prices to fall through Q4 2018 and to record six to seven quarters of persistent decline. NAND prices are likely to continue to decline as well (See Box 7). This will have an important impact on the export prices of key semiconductor exporters, such as Korea and Taiwan, and will weigh on overall export values even if the quantity of semiconductor exports doesn’t change (which we doubt). This fall in export margins could keep a lid on investment, as witnessed in Korea. (Figure 126).

EM countries have not improved their market share in G3 imports since the financial crisis. Commodity economies lost market share as commodity prices declined in 2014–15, and non-commodity producers have not gained market share through the pickup in growth over the past 18 months. The reason behind this important to understand, and is central to main thesis (See Box 10). Despite persistent FX depreciation, some emerging markets have still recorded deterioration in their external balances. The Philippines is a stark case in point. Its current account has shrunk from a surplus to material deficit over the past three years, despite a 13% TWI depreciation, all attributable to solid imports.

Falls in DRAM prices will weigh on KRW and TWD exports with effects on investment

EM has not benefitted from higher DM growth as the nature of spending in DM is changing

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Figure 126: A close relationship between facilities investment and exports in Korea

40%	yoy	Facilities investment	Exports
30%

20%

10%

0%

-10%

-20%

-30%

06

07

08

09

10

11

12

13

14

15

16

17

18

Source: Haver, UBS estimates

Figure 127: Have basic balances improved?

1Y change in basic balance (% of GDP)

5%	Weak and improving				Strong and improving
					ILS
			CLP		PLN
			COP
3%					MYS
1%		ZAR	MXN	BRL		THB
-1%		ROM	CNY		KRW
		INR			RUB
		TRY	IDR PHP
					HUF
-3%
				CZK
	Weak and worsening				Strong and worsening
-5%
-10%		-5%	0%		5%	10%
			Basic balance Q2-2018 (% of GDP)

Source: Haver, UBS estimates. Note: Basic balance is defined as the current account balance plus direct investment as a percent of GDP.

This backdrop means that it is unlikely that there will be much support from external demand for EMs with vulnerable external balances hoping to foster a recovery in growth driven by higher exports. Therefore, if financing costs rise while export growth slows, these currencies will be in a more vulnerable position.

The capital inflow side is in a similar position: for countries where basic balances have improved this has been small, while the majority do not show a significant change (Figure 127). In Box 12 we investigate EM asset price vulnerabilities to the expected removal of monetary stimulus by the ECB and BOJ.

The carry cushion is still inadequate for severe stress. As Figure 128 and Figure 129 show, carry remains low despite some central banks hiking rates during the mid-2018 stress episode. Turkey and Argentina introduced large tightening measures, while Indonesia, Russia, South Africa, Mexico and Brazil turned more hawkish despite still-manageable inflation. However, the aggregates still show low levels of carry for the asset class, and in most countries the increases in USD rates have decreased carry compared with the start of 2018 (Figure 129).

Basic balances have not improved across emerging markets despite currency depreciation

Central banks are turning more sensitive to higher DM real rates and depreciation pressures, increasing carry for selected currencies…

Figure 128: Evolution of 12m EM aggregate carry

7%
	EM (Ex Turkey, MSCI-weighted)			EM (Ex Turkey, GBI-weighted)
6%
5%
4%
					Latest: 9%ile
3%
2%
1%					Latest: 5%ile
0%
Jan-13	Jan-14	Jan-15	Jan-16	Jan-17	Jan-18

Source: Bloomberg, UBS estimates

Figure 129: 12m FX carry: Latest vs YTD change

22%		10%
Latest	YTD change (rhs)
19%		8%
16%
13%		6%
10%		4%
7%
4%		2%
1%		0%
-2%
-5%		-2%
TRY IDR MXN INR ZAR RUB BRL PHP COP CNY MYR RON CLP SGD PLN THB		KRW CZK HUF ILS TWD

Source: Bloomberg, UBS estimates

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