Figure 58: Fiscal risks explain the high term premia in Brazilian local bond curve

Figure 59: Basic balance is stronger in Brazil and weak in Colombia

Nominal and real rates in Mexico are very high in a cross-EM comparison (Figure 60). We recommend shifting from the 5y TIIE receiver, 5y US payer position recommended in 2018 to the 2y point in the Mexican yield curve. Increased uncertainty related to the path of economic policymaking, US rates that continued rising and headline inflation above target, explain Banxico's defensive stance in 2018. We see the latter two of these risks subsiding in 2019, and expect the new configuration of the central bank's board to start assigning more weight to disappointing economic activity than to inflationary risks. True, the political uncertainty could intensify, keeping Banxico on the watch to fight depreciation pressures, but UBS economists' forecasts place headline inflation rate close to the 3% target by mid-year as the energy price shock from higher oil subsides. Economic activity is likely to remain subject to negative sentiment in domestic demand, with private investment still subdued, and a fading impulse in external demand as global growth decelerates and the US business cycle peaks.

The TIIE curve is currently pricing around 50bp of hikes in 2019 and one 25bp cut in 2020. We expect the macro backdrop to open the door for cuts in the intervention rate from the second half of the year, when we expect 50bp of cuts, and in 2020, when we expect a further 100bp reduction in the policy rate. Although taking longer duration risk seems attractive, longer tenors reflect longterm concerns over deterioration of fiscal policy and local bond outflow risk more than short-term debt (Figure 61). Negative risks include a more rapid deterioration in economic policymaking; a new bout of higher oil prices; and a Fed tightening significantly more than it is priced in. Near-term positive risks would come from the presentation of a reasonable fiscal budget for 2019 and continued positive messages from the administration regarding the path of economic policymaking.

Increased policy uncertainty, higher energy prices and US rates kept Banxico on the defensive side in 2018, hiking rates more than what would be implied by the macro backdrop

We expect 50bp of cuts in the second half of 2018 while the curve is pricing 50bp of hikes in the same period

Positioning in the 2Y sector decreases the exposure to currency and credit risk

vk.com/id446425943

Figure 60: Higher real yields reflecting increased policy uncertainty

Source: spread Haver, UBS estimates. Note: Real yields calculated as 10Y local debt yields minus 10Y CDS and minus 6m sequential core inflation

Figure 61: Correlation of TIIE returns to currency and credit risk returns

0.30

Source: Bloomberg, UBS estimates. Based on 7 years of weekly changes in nominal TIIE rates, USDMXN returns and changes in credit spread.

Slower Chinese growth, RMB pressure and a tight onshore credit environment will push Asia credit spreads wider. We estimate that Asian IG and HY will widen 25bp and 100bp in 2019, respectively. Valuations have corrected considerably in Asian HY relative to IG, with the HY/IG spread ratio at 3.9x, against an average of 3.5x during the 2014–15 selloff (Figure 62). From a total return perspective, we favour HY (3.1%) over IG (1.3%) given the much better carry and shorter duration. Within HY, we prefer short-dated Chinese BB/high B property names and put Chinese industrials as the least preferred on high idiosyncratic risks and lower credit quality. China's easing liquidity and credit should indirectly support sentiment more for Asian HY over IG.

We estimate that Asian IG and HY will widen by 25bp and 100bp in 2019, respectively

The major challenge for Asian HY, specifically for Chinese developers, is the rising tide of onshore bonds that are maturing and higher funding costs. A rough sensitivity on Chinese developers in our universe finds that EBITDA interest coverage will fall to 1x if interest cost increases beyond 14% from 7–8% now (Figure 63). However, developers have diversified funding channels, onshore credit availability is likely to ease, and healthy profit margins can absorb rising costs. Even if property sales and prices soften, the developers under our coverage are likely to continue to outpace the nationwide level given the benefit of expanded scale and market share.

Chinese developers are likely to weather a rise in amounts of maturing bonds and higher funding costs given ample margins, the easing of onshore credit and expanded market share

Figure 62: Asian HY decompressed against IG

Source: Bloomberg, UBS

Figure 63: Sensitivity of funding cost for China developers

Average funding cost (lhs)

EBITDA interest coverage (rhs, 100% debt)

EBITDA interest coverage (rhs, 50% debt)

Source: Company, UBS

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•

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The loss of current account cushion, softening domestic activity and upcoming tariffs mean that for the first time in 25 years, China will have to make a choice between external stability and growth.

With many policy levers still available, China is very likely to avoid uncontrolled depreciation, but with little carry protection it makes sense to remain defensive on the CNY.

A domestically oriented China will mean lesser incremental benefit for the rest of EM in the next round of China stimulus.

China is easing. But, now, it also has to balance conflicting demands between external stability and growth. This will lead to welcomed but more limited stimulus in this cycle and more emphasis on domestic than foreign spending. In turn, this easing cycle will likely benefit more domestic assets rather than traditional China satellites.

China has been different from other economies in many respects. Notably, its growth rate and its current account position have been positively, not negatively correlated (Figure 64). This is because strong export growth, which saw China’s share of global exports rise from 3.9% in 2000 to 16.5% by 2015, has underpinned both (Figure 65).

But lower global growth and rising costs at home have made China more ordinary. It has recorded only a 6.7% average annual export growth rate post-crisis compared with 29.4% annual growth in the five years before that; and in the past three years, China has stopped gaining market share globally.

A colossal export boom lay at the heart of China's growth and current account surplus; it has not had to choose between external stability and growth

Figure 66: Previous episodes of current account deterioration and currency performance highlight China’s exceptional position to date

Source: Haver, UBS. Note: negative values along the y-axis indicate depreciation

To compensate for weaker external growth, Chinese policymakers swung towards credit, most of it collateralised on and directed towards one resource – land. Despite three import-thirsty housing booms (2009/10, 2012/14 and 2015/16), however, Chinese growth slipped from 12.5% in 2010 to the current 6.5%. Over the same time, its current account balance shifted from a 6.5% surplus to a small deficit. As credit-fuelled domestic demand boomed amid slowing exports, the current account began coming down more sharply than would otherwise been the case. In the five years from 1999 to 2003, before China's export boom really took off, the current account surplus still averaged 1.9% of GDP despite growth ticking along at an average of 8.7%; there was no credit to propel an import explosion then.

No other country, irrespective of its net international investment position, has managed to avoid serious depreciation in the exchange rate with such a sizable change in the current account (Figure 66), and we do not think China can remain an exception. The degree of losses against the USD will be strongly tempered by support from an undervalued EUR finding its feet as the ECB normalises, but the CNY should depreciate in trade-weighted terms in the quarters and, likely, years ahead.

But, how much will the CNY depreciate, and in what manner? China has to make a choice, like other countries have long had to, between external stability and growth for the first time in a quarter of a century (Figure 67). It is a stark choice; during the 2015/16 round of stimulus, as y/y TSF growth picked up by 4.5pp, the current account slipped by 3% of GDP. From today's starting points, that would risk a sharp depreciation in the currency.

Low export growth and high credit growth changed the current account quickly

USDCNY upside may be limited by a strong EUR, but the case for trade-weighted weakness in the CNY is strong

As it makes choices for the first time in the era of globalisation, China is likely to prioritise external stability over growth rebound

Figure 67: Basic balance: China and EM ex China

Basic Balance (% of GDP)

16%

China

14% EM ex China (GDP-weighted)

12%

10%

8%

6%

4%

2%

0%

Source: Haver, UBS

Figure 68: Breakdown of PBoC's balance sheet by foreign and domestic assets

(USD tn)

6

Other Domestic Assets

5Claims on Domestic Depository Institutions Foreign Assets

3

2

1

0

Source: Haver, UBS

We think China will err on the side of external stability, and choose not to stimulate its economy aggressively. China’s willingness to let leverage rise sharply is limited, but its lack of ability imposed by CNY pressure adds a new dimension.

Despite accepting lower growth, the trend towards a weaker balance of payments is likely to remain in play, especially now that exports will suffer further under pressure from tariffs. The shift in the structure of PBoC's balance sheet in favour of domestic assets away from net foreign assets is symptomatic of this rising pressure (Figure 68). We see USDCNY rising to 7.3 by end-2019 and remaining there by end-2020. With little carry available amid higher Fed rates (Figure 69), our forecasts are above the respective forward rates of 6.97 and 7.01. We think it makes sense to stay defensive. Chinese policymakers are not likely to intervene hard to prevent depreciation of this magnitude, but we expect them to remain in control, and to prevent a sharper depreciation in the currency.

They have several policy levers they can use to ensure this. Over the past three years, services have played a key role in the CA deterioration (Figure 70); the deficit on travel alone is nearly 2% of GDP. The authorities have demonstrated an ability to influence this heavily: tourism to Korea fell by nearly half during a diplomatic spat. The recent underperformance of luxury stocks in Europe suggests that greater scrutiny of Chinese spending abroad may have already begun (Figure 71).

We see USDCNY rising to 7.3 by end-2019

Figure 69: Interest rate spread between China and US Libor, and USDCNY

Figure 70: China current account breakdown (4q, % of GDP)

Figure 71: Europe luxury and trade weighted CNY

Source: Bloomberg, UBS

Figure 72: Breakdown of the capital account and CNY

Source: Haver, UBS

The cushion on the capital account may also pick up with inclusion in global fixed income and equity benchmarks (Figure 72). First, the share of China's domestic equity markets in MSCI EM index is likely to quadruple. This could trigger over USD100bn of inflows between May and August 2019. Second, CNY debt will be included in Bloomberg Global Aggregate Bonds index from April 2019 – a staggered inclusion over 20 months until end-2020. We estimate that this will divert USD110-130bn of passive inflows into Chinese debt. In aggregate, these flows just from the inclusion in benchmarks could bring in over USD200bn in the next two years.

The good news is that the combination of these flows would give China's financial account a c.1% of GDP (USD130bn/annum) boost in 2019 and 2020 (over and above the existing full-year 2017 average). The bad news (Figure 77) is that this would offset only half of the losses the balance of payments has accrued from the CA shrinkage so far (between 2017: 1.3% average and 2018: -0.5% average YTD), let alone the upcoming risks from trade tariffs and potential resident outflows if domestic returns on investment start to fall (which we expect). But why will China not be able to run decent sized current account deficits? It is going to be the next reserve currency, is it not? See Box 4.

China should achieve flows of up to USD200bn over 2019 and 2020 from inclusion in global benchmarks

Figure 73: 'Other Investment' on the capital account and house price growth

Figure 74: China short-term external debt as % of reserves