Colombia

Highlights Please note that today we are publishing an abbreviated Weekly Bulletin as tomorrow we will publish Great Debate: Does China Have Too Much Debt Or Too Much Savings? The latter report will elaborate on long-standing view differences on China within BCA. I will be debating my colleagues Peter Berezin and Yan Wang on the issues surrounding China's savings and debt as well as the growth outlook. Arthur Budaghyan Feature Singapore: MAS Will Cap Interest Rates Higher U.S. interest rates will temporarily place upward pressure on Singaporean local interest rates (Chart I-1). However, Singapore is not in position to tolerate higher borrowing costs due to lingering credit excesses and deflationary pressures that currently prevail in its economy. The Monetary Authority of Singapore (MAS) will therefore respond by injecting liquidity to keep interbank rates low. The MAS operates monetary policy by guiding the exchange rate - and by default - often allowing interest rates to fluctuate freely. Yet higher interest rates are not an optimal policy option at the moment. If and as U.S. interest rates and the U.S. dollar rise, the MAS will intervene to cap local rates even if it entails a weaker Singapore dollar. While there is a recovery going on in non-oil export volumes and narrow money (M1) (Chart I-2), many other cyclical indicators are still negative. Chart I-1Rising Libor Rates Will Exert ##br##Upward Pressure On Singaporean Rates Rising Libor Rates Will Exert Upward Pressure On Singaporean Rates Rising Libor Rates Will Exert Upward Pressure On Singaporean Rates Chart I-2Singapore: Non-Oil ##br##Exports Are Picking Up Singapore: Non-Oil Exports Are Picking Up Singapore: Non-Oil Exports Are Picking Up The exchange rate-targeting system was introduced in the early 1980s when exports stood at 150% of GDP. Today, exports relative to GDP have fallen substantially to 115% of GDP (Chart I-3). On the other hand, total private non-financial sector debt levels have risen to 180% of GDP (Chart I-3). Therefore, the Singaporean economy has become much more leveraged to interest rates and somewhat less exposed to global trade. Improving exports will not be sufficient to offset the negative impact of rising borrowing costs. Moreover, our proxy for interest payments on domestic debt has also surged and now stands at close to 10% of GDP (Chart I-4). What is precarious is that the rise in interest payments relative to income has occurred in a period when rates are close to record-low levels. Chart I-3Singapore: Debt Is ##br##Overshadowing Exports Singapore: Debt Is Overshadowing Exports Singapore: Debt Is Overshadowing Exports Chart I-4Singapore: Interest Payments Are ##br##Large Despite Record Low Rates Singapore: Interest Payments Are Large Despite Record Low Rates Singapore: Interest Payments Are Large Despite Record Low Rates If borrowing costs rise, it will likely cause major debt deflation concerns. The MAS will not allow this to happen. Employment is stagnating, while employment in the construction and manufacturing sectors is contracting (Chart I-5). Weak employment has weighed on the consumer sector. Retail and department store sales are still shrinking (Chart I-6). Chart I-5Singapore: Employment Is Weak Singapore: Employment Is Weak Singapore: Employment Is Weak Chart I-6Retail Spending Is Contracting Retail Spending Is Contracting Retail Spending Is Contracting Importantly, the real estate sector, one of the major pillars of the Singapore economy, is depressed. Property prices across the board are deflating, while vacancy rates are rising (Chart I-7). Bank loan growth to property developers has also stalled (Chart I-7, bottom panel). Weak economic growth should be reflected on banks' balance sheets. Surprisingly, non-performing loans (NPLs) among Singapore's three largest banks still stands at a low 1.4%. If and as loan losses begin to rise, commercial banks will rush to increase provisioning for these losses, which will hurt their profits and keep credit growth subdued. Furthermore, Singaporean banks are also very exposed to Malaysia. Singapore's largest banks have extended loans to Malaysia of approximately 67 billion Singapore dollars - or 16% of GDP. Aggregate external loans stand at 137% of GDP (Chart I-8). Economic fundamentals are currently very weak and will continue to deteriorate in Malaysia. This warrants more assets write-offs among Singapore banks and less appetite to expand their balance sheet. Chart I-7Property Sector In Singapore Property Sector In Singapore Property Sector In Singapore Chart I-8Singaporean External Loans Are Enormous Singaporean External Loans Are Enormous Singaporean External Loans Are Enormous On the whole, if Singaporean interest rates begin to rise due to either depreciation of the Singapore dollar or higher U.S. interest rates, the central bank will intervene to bring local rates down. It would not be the first time the MAS has intervened to bring down interest rates. In 2015 when EM risks escalated, local interbank rates spiked. The MAS promptly injected liquidity in the banking system by buying back its outstanding MAS bills, and by also purchasing government securities, supplying liquidity to the banking system. This essentially placed a cap on interbank rates. Chart I-9Go Long Singapore Real ##br##Estate Stocks Vs. Hong Kong Go Long Singapore Real Estate Stocks Vs. Hong Kong Go Long Singapore Real Estate Stocks Vs. Hong Kong What is noteworthy is that the Singapore dollar weakened as a result of the intervention, although the MAS's official monetary policy stance was not stimulative - i.e. the monetary authorities did not target to weaken the trade-weighted SGD. In that instance, the MAS decided to focus on interest rates/funding market stability and ignore the exchange rate's response. This highlights that despite the MAS's official monetary policy framework of guiding the exchange rate, it will not allow interest rates to rise. Unlike Singapore, Hong Kong does not operate an independent monetary policy and as such will be forced to import higher U.S. rates. As a bet on higher interest rates in Hong Kong and the U.S. relative to Singapore, investors should consider going long Singaporean real estate stocks and shorting Hong Kong real estate stocks. Chart I-9 shows that Singaporean real estate stocks outperform Hong Kong's when the latter's interest rates/bond yields rise relative to Singapore and when Singapore's M1 growth accelerate relative to Hong Kong. As discussed above, the MAS has the capacity and will to inject liquidity to lower interest rates. Hong Kong, however, does not have this privilege due to the currency's peg to the greenback. Besides, Singapore's property correction is now much more advanced than Hong Kong's. In fact, Hong Kong property prices are still rising, i.e., the real estate market adjustment in Hong Kong has not yet started. While both city states are vulnerable to a potential slowdown in Chinese inflows, Hong Kong real estate prices will ultimately fall from a higher starting point. Bottom Line: A rising U.S. dollar and U.S. interest rates may exert upward pressure on Singaporean local interest rates. However, the Singaporean central bank will respond by injecting liquidity, which will cap rates relative to the U.S. and Hong Kong. This opens a tactical trade opportunity (for the next 3 months): Long Singapore real estate stocks / short Hong Kong real estate shares. Asian equity portfolio investors should have a neutral allocation to Singapore stocks within the EM/emerging Asian benchmarks. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com Colombia: Not Out Of The Woods Yet Even though global economic growth has been improving and commodities prices have rallied, Colombia's growth is still bound to disappoint. We remain structurally bullish on the nation's longer-term prospects. That said, there will still be more downside this year. Credit growth will continue to decelerate, despite the beginning of a rate cut cycle (Chart II-1). Interest rates are still high, both in nominal and real terms (Chart II-2). This along with poor consumer and business confidence (Chart II-3) will depress credit demand and spending. Chart II-1Colombia: Negative Credit Impulse Colombia: Negative Credit Impulse Colombia: Negative Credit Impulse Chart II-2Borrowing Costs Are Still High Borrowing Costs Are Still High Borrowing Costs Are Still High Chart II-3Consumer & Business Confidence Are Weak Consumer & Business Confidence Are Weak Consumer & Business Confidence Are Weak Furthermore, the central bank's liquidity injections into the banking system have dropped considerably (Chart II-4). In the past few years, abundant liquidity provisioning by the central bank had allowed commercial banks to sustain robust credit growth. Hence, a withdrawal of banking system liquidity will cap loan origination. The current account deficit remains wide at $12.5 billion, or 5.2% of GDP. Financing such a wide deficit will prove challenging. Besides, BCA's Emerging Markets Strategy team believes oil prices are at risk of additional declines. Hence, we are bearish on the Colombian peso. Fiscal policy is set to tighten as the budget deficit has ballooned due to strong spending and shrinking revenues (Chart II-5). Recently introduced tax reforms represent a step forward with respect to the country's structural reforms agenda, as it will simplify the tax code and reduce corporate tax rates. Chart II-4Withdrawal Of Liquidity Will Cap Credit Growth Withdrawal Of Liquidity Will Cap Credit Growth Withdrawal Of Liquidity Will Cap Credit Growth Chart II-5Government Fiscal Balance Is Deteriorating Government Fiscal Balance Is Deteriorating Government Fiscal Balance Is Deteriorating However, redistributing the tax burden onto individuals, mainly by increasing the VAT from 16% to 19%, will reinforce the slump in household spending. In terms of high frequency data, there are little signs of economic revival (Chart II-6). Retail sales volume remain tame. The latest bounce in this series most likely reflects consumers front running the impending VAT hike. Furthermore, oil production is likely to decline further, and non-oil exports are still contracting. In terms of financial markets, we recommend the following: We are closing our bet on yield curve flattening - receive 10-year/pay 1-year swap rates. Initiated on September 16, 2015, this trade has produced a 190 basis-point gain (Chart II-7). At the moment, the risk-reward for this position is no longer attractive. Chart II-6Cyclical Economic Activity Remains Subdued Cyclical Economic Activity Remains Subdued Cyclical Economic Activity Remains Subdued Chart II-7Take Profits On The Yield Curve Trade Take Profits On The Yield Curve Trade Take Profits On The Yield Curve Trade We remain neutral on Colombian equities and sovereign credit relative to their respective EM universes. Even though our long Colombian bank stocks/short Peruvian banks bet has been deep in the negative, we are reluctant to cut it. The basis is that Colombia's central bank may opt to cut rates further, even if the peso depreciates anew. In contrast, the Peruvian central bank is more likely to hike rates if its currency comes under downward pressure. Bank share prices will likely react to marginal shifts in relative interest rates between the two countries. Andrija Vesic, Research Assistant andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights A central bank cannot control/target the quantity and price of money simultaneously. For the past few years, China's central bank has silently moved away from controlling money growth toward targeting interest rates. As such, the reserve requirements imposed on banks have not and will not be a constraint on Chinese commercial banks' ability to lend and create money if the PBoC continues to supply banks with reserves "on demand." China's banks have created too many RMBs (broad money/deposits) and the PBoC has accommodated them. Such enormous supply of RMBs and mainland households' and companies' desire to get rid of their RMBs will lead to further yuan depreciation. Continue shorting the RMB and Asian currencies versus the U.S. dollar. Re-instate a short Colombian peso trade; this time against an equal-weighted basket of the U.S. dollar and the Russian ruble. Feature Following our October 26 Special Report titled, "Misconceptions About China's Credit Excesses",1 some clients have asked us how our analysis squares with fact that the People's Bank of China (PBoC) conducts its monetary policy using a reserve requirement ratio. The relevant question being, why would the PBoC's reserve requirements not limit commercial banks' ability to create money/credit? In that Special Report, we wrote: "A commercial bank is not constrained in loan origination by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks "on demand." Given PBoC lending to banks has surged 5.5-fold over last three years (Chart I-1), we concluded that the reserve requirement ratio had, for all intents and purposes, lost its meaning in China. In this week's report we elaborate on this issue in detail. The main implication of our analysis today reinforces our conclusion from the previous report: namely, China's commercial banks have expanded credit enormously, and the PBoC has accommodated it. With respect to financial market implications, there are simply too many RMBs (broad money/deposits) in the system (Chart I-2). Chinese households and companies can instinctively sense this, and are opting to move their wealth into real assets, such as real estate, or foreign currencies. Hence, the oversupply of RMBs will continue to weigh on China's exchange rate, which will depreciate much further. We expect the US$/CNY to reach 7.8-8 over the next 12 months. Chart I-1The PBoC Has Provided Banks With Liquidity 'On Demand' bca.ems_sr_2016_11_23_s1_c1 bca.ems_sr_2016_11_23_s1_c1 Chart I-2There Are Too Many RMBs Floating Around bca.ems_sr_2016_11_23_s1_c2 bca.ems_sr_2016_11_23_s1_c2 Targeting Either The Quantity Or The Price Of Money Any central bank can target and control either the quantity of money or the price of money, but not both simultaneously. This holds true for any monopolist supplier of any good/service that does not have control over the demand curve. A demand curve for money is the function that ties the quantity demanded at various price points (the price being interest rates). Central banks - being monopolist suppliers of money, but unable to control money demand - must choose between controlling either the quantity of money or the price of money. The system of required reserves (RR) is a tool to control money supply (the quantity of money). When central banks reinforce the RR ratio, interbank interest rates typically swing enormously and often deviate considerably from the target policy rate (Chart 1). For example, when commercial banks expand loans too much and lack sufficient reserves at the central bank, they must borrow from the interbank market and thereby bid up interbank rates- i.e., short-term interest rates rise. This in turn restrains credit demand or the willingness to lend, and eventually reduces money growth. The opposite also holds true. When a central bank wants to target interest rates (the price of money), it cannot control money supply. To ensure that interbank/money market rates stay close to the policy rate - i.e., to reinforce its interest rate target - a central bank should provide the banking system with reserves "on demand." In other words, when interbank rates rise above the target policy rate, a central bank should inject sufficient liquidity into the system to bring interest rates down. Similarly, when interbank rates fall below the target policy rate, a central bank should withdraw enough liquidity from the banking system to assure interbank rates rise converging to its target policy rate. By supplying commercial banks with reserves (high powered money) "on demand" - i.e., providing as much reserves as they need - a central bank is de facto failing to enforce reserve requirements. As such, the central bank is giving up control over money creation. By and large, RRs lose their effectiveness if a central bank provides commercial banks with as much reserves as they request. In short, when a central bank opts for targeting interest rates, it cannot steer monetary aggregates - i.e., RRs and RR ratios lose their meaning. In the 1970s and 1980s, most central banks in advanced countries targeted money supply to achieve their policy goals such as inflation and sustainable economic growth. However, starting in the early 1990s, developed nations' central banks (the Federal Reserve, the Bank of England, the Bank of Canada, the Swiss National Bank and others) began to move away from controlling money supply (monetary aggregates) and toward targeting interest rates. Individual banks' limitations to borrow from the central bank often rests with the availability of collateral. So long as a commercial bank has eligible collateral (often government bonds), it can access central bank funding. This is true for Chinese commercial banks too. Bottom Line: Monetary authorities cannot control/target the quantity and price of money simultaneously. The Money Multiplier In An Interest Rate Targeting System When a central bank opts for targeting interest rates, commercial banks can originate an unlimited amount of loans and demand the central bank provide additional reserves, as long as they have eligible collateral. This corroborates our point from our previous report that a commercial bank's loan origination is not constrained by its reserves at the central bank if the latter supplies liquidity (reserves) "on demand." In a fractional reserve system, the ability of commercial banks to create loans/money is defined by a money multiplier. A potential ceiling for a money multiplier (MM) is calculated as: MM = (1 / RR ratio) For example, when the RR ratio is 10%: The money multiplier MM = (1 / 0.1) = 10 In effect, the banking system can create up to 10 times more money/loans/deposits per one dollar of reserves. Under the current system of interest rate targeting – which has prevailed among most developed countries since the early 1990s and more recently in China (more on China below) – we can think of the RR ratio as heading towards zero because central banks provide banks with almost unlimited liquidity (reserves). The RR ratio is not zero because there are still limitations on banks' ability to borrow from central banks due the availability (or lack thereof) of eligible collateral or compliance with Basel III requirements. Yet as the RR ratio gets smaller in size, its reciprocal (1 / RR ratio) becomes very large (not infinite, but a plausibly very large number). Overall, when a central bank targets interest rates, the ceiling of the money multiplier is not set by the central bank. Rather, the money multiplier is de facto determined by commercial banks' willingness to originate loans. Thus, the money multiplier can potentially be very high when animal spirits among bankers and borrowers run wild. Consequently, the points discussed in our Special Report titled, "Misconceptions About China's Credit Excesses"2 - namely that commercial banks create loans/money/deposits out of thin air - holds, and is relevant in a system where central banks target/control interest rates. Bottom Line: When central banks opt to control short-term interest rates, they must provide commercial banks with as much liquidity as the latter demands. In such a case, RRs and the RR ratio become almost irrelevant. Therefore, in an interest rate targeting system, banks' ability to originate loans/create money and deposits is not contingent on their reserves at the central bank. This point is greatly relevant to China. The PBoC: Shifting From Money To Interest Rate Targeting For the past few years, China’s central bank has silently moved away from controlling money growth to targeting interest rates. As a result, nowadays the PBoC has very little quantitative control over money/credit creation by commercial banks or the money multiplier. It is Chinese commercial banks that effectively drive money/credit/deposit creation. Chart I-3SHIBOR Crises In 2013 Forced PBoC ##br##To Start Targeting Interest Rates bca.ems_sr_2016_11_23_s1_c3 bca.ems_sr_2016_11_23_s1_c3 We suspect this shift in China's monetary policy management has been occurring since early 2014 on the heels of the so-called SHIBOR crisis, which erupted in June 2013 when interbank rates surged and was followed by another spike in interbank rates in December 2013 (Chart I-3). During these episodes, the PBoC enforced reserve requirements and thus did not provide liquidity to banks that were running short on it. In essence, it did whatever a central bank targeting money growth via control over RR would do. However, as interbank rates surged and banks complained, policymakers backed off, and provided banks with as much liquidity as they demanded. This stabilized interbank rates and, importantly, appears to have marked the PBoC's shift toward interest rate targeting. Thus, by de facto moving to a monetary system of targeting interest rates, the PBoC cannot effectively reinforce reserve requirements because it must supply any amount of reserves that commercial banks require to preclude a major spike in interbank rates. A few points illustrate that in fact the PBoC has been targeting short-term money market rates, and banks have expanded loans enormously despite their excess reserves being flat: Volatility in interbank rates has dropped substantially (Chart I-4), as the PBoC's claims on commercial banks has exploded 5.5-fold since the early 2014. Even though commercial banks' excess reserves have been flat, their lending has been booming - i.e., the money/credit multiplier has been rising (Chart I-5). This is only possible when the PBoC has been supplying reserves "on demand" or when it cuts the RR ratio. Since the RR ratio has not been cut over the past two years, it means that the former is true. Chart I-4Interbank Rate Volatility Has Fallen As ##br##PBoC Injected A Lot Of Liquidity bca.ems_sr_2016_11_23_s1_c4 bca.ems_sr_2016_11_23_s1_c4 Chart I-5China's Money/Credit Multiplier##br## Has Been Rising bca.ems_sr_2016_11_23_s1_c5 bca.ems_sr_2016_11_23_s1_c5 Just like central banks in advanced economies, the only way the PBoC can alter money/credit growth is if it lifts or cuts its interest rate target. Barring any changes to its policy rate, commercial banks, not the PBoC, determine money/loan/deposit creation in China. As to other factors that determine the amount of credit/money creation by commercial banks in China, we elaborated on these in the above-mentioned report. Bottom Line: It appears the PBoC has shifted toward targeting interest rates. Consequently, the PBoC cannot pretend to control money/credit origination unless it changes its interest rate target. Moreover, we reiterate that China's abnormal credit growth has been the result of speculative behavior among Chinese banks and borrowers, and not the natural result of the country's high savings rate. Oversupply Of RMBs = A Lower Currency As China's central bank has been printing RMBs and commercial banks have been "multiplying" them at a high rate (by originating loans), the supply of RMBs has continued to explode. Such an oversupply of local currency will continue to depress the value of the nation's exchange rate. The PBoC's liquidity injections have exploded in recent years (Chart I-6). The central bank has not only been offsetting the liquidity withdrawal due to its currency foreign exchange market interventions, but it has also been providing banks with as much liquidity as they require. The objective seems to have been to avoid a rise in interbank rates when corporate leverage is extremely high and banks are overextended. Since February 2015, the PBoC's international reserves have dropped by US$0.9 trillion, or 4.2 trillion RMB (Chart I-7). This means that the PBoC has withdrawn 4.2 trillion RMBs from the system. If the central bank did not re-inject these RMBs into the financial system, interbank rates would have skyrocketed. As the PBoC has injected RMBs into the system, it has effectively undone its RMB defense. The whole point of defending the exchange rate from falling or depreciating too fast is to shrink local currency liquidity. Yet, naturally, that would also lead to higher interbank rates. If the central bank chooses not to tolerate higher interest rates and continues to inject local currency into circulation, the RMB's depreciation will likely continue and accelerate. By injecting RMBs into the system, the monetary authorities have allowed banks to continue to lend, thereby creating enormous amounts of money and deposits. Banks create deposits when they lend. The Chinese banking system has a lot of deposits partially because commercial banks have lent too much. In short, the supply or quantity of money (RMBs) has continued to explode, despite massive capital outflows. Notably, if the PBoC did not lend RMBs to commercial banks, the latter's excess reserves would have plunged by 4 trillion RMB (Chart I-8) and banks would have been forced to pull-back their lending. Chart I-6PBoC's Liquidity Injections Have ##br##Exploded Since Early 2014 bca.ems_sr_2016_11_23_s1_c6 bca.ems_sr_2016_11_23_s1_c6 Chart I-7China: Foreign Exchange##br## Reserve Depletion bca.ems_sr_2016_11_23_s1_c7 bca.ems_sr_2016_11_23_s1_c7 Chart I-8China: What Would Have Banks' Excess Reserves##br## Been Without Borrowing From PBoC? bca.ems_sr_2016_11_23_s1_c8 bca.ems_sr_2016_11_23_s1_c8 Overall, in the current fiat money system, when a central bank targets interest rates, the monetary authorities can print unlimited high-powered money (bank reserves) and commercial banks can multiply it by creating enormous amounts of loans/deposits.3 However, there is no free lunch - no country can print its way to prosperity (otherwise all countries would have been very rich already). The negative ramifications of unlimited money creation are numerous, but this report focuses on the exchange rate implications. The growing supply of RMBs will lead to a much further drop in China's exchange rate. It seems Chinese retail investors and companies intuitively sense this, and are eager to get rid of their RMBs. This also explains Chinese investors' desire to overpay for any real or financial asset, domestically or abroad. We expect growing downward pressure on the RMB as capital outflows accelerate anew. Although China’s foreign exchange reserves are enormous in absolute U.S. dollar terms, they are low relative to money supply (Chart 9). The ratio of the central bank’s international reserves-to-broad money is 15% in China and it is relatively low compared with other countries (Chart 10). Chart I-9China: International Reserves Are Not##br## High Relative To Broad Money bca.ems_sr_2016_11_23_s1_c9 bca.ems_sr_2016_11_23_s1_c9 Chart I-10International Reserves-To-Broad##br## Money Ratio China's Money Creation Redux And The RMB China's Money Creation Redux And The RMB As a final note, the oversupply of local currency has not created inflation in the real economy because of massive overcapacity following years of booming capital spending. However, continued money creation will eventually lead to higher inflation. This does not seem imminent but we will be monitoring these dynamics carefully going forward. Bottom Line: China's banks have created too much RMBs and the PBoC has accommodated them. Such enormous supply of RMBs and mainland households' and companies' desire to get rid of their RMBs will lead to further yuan depreciation. Investment Implications: A Free-Fall For RMB And Asian Currencies The RMB's value versus the U.S. dollar will drop much further. Our new target range for US$/CNY is 7.8-8 over the next 12 months, or 11-14% below today's level. The forward market is discounting only 2.8% depreciation in the next 12 months (Chart I-11). We maintain our short RMB / long U.S. dollar trade (via 12-month NDF). A persistent relapse in the RMB's value will drag down other Asian currencies. In particular, the Korean won and the Taiwanese dollar have failed to break above important technical levels (their long-term moving averages), and have lately relapsed (Chart I-12). Chart I-11RMB Will Depreciate Much More##br## Than Priced In By Forwards RMB Will Depreciate Much More Than Priced In By Forwards RMB Will Depreciate Much More Than Priced In By Forwards Chart I-12Asian Currencies:##br##More Downside Ahead bca.ems_sr_2016_11_23_s1_c12 bca.ems_sr_2016_11_23_s1_c12 For the Korean won, we believe there is considerable downside from current levels. Consistently, we recommended shorting the KRW versus the THB trade on October 19.4 Chart I-13EM ex-China Currencies Total Return##br## (Including Carry): Is The Rally Over? bca.ems_sr_2016_11_23_s1_c13 bca.ems_sr_2016_11_23_s1_c13 Traders who believe in continued U.S. dollar strength, like we do, should consider shorting the KRW versus the U.S. dollar outright. For DM currencies, this means that the drop in the JPY has further to go. In emerging Asia, we are also shorting the MYR and the IDR versus the U.S. dollar and also versus Eastern European currencies such as the ruble and the HUF, respectively. As emerging Asian currencies depreciate versus the U.S. dollar, other EM currencies will likely follow. It is hard to see the RMB and other Asian currencies plunging and the rest of EM doing well. The total return (including the carry) of the aggregate EM ex-China exchange rate versus the U.S. dollar (equity market-cap weighted index) has failed to break above a critical long-term technical resistance, and has rolled over (Chart I-13). This is a bearish technical signal, implying considerable downside from these levels. As such, we maintain our core short positions in the following EM currencies outside Asia: TRY, ZAR, BRL and CLP and add COP to this list today. This is based on an assumption of diminished foreign inflows to EM and lower commodities prices. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Colombia: Headed Toward Recession In our May 4 Special Report on Colombia,5 we argued that despite a bright structural backdrop this Andean economy was headed for a growth recession (i.e. very weak but still positive growth). Domestic demand has buckled and now we believe the nation could be on the verge of its first genuine recession in two decades (Chart II-1). Colombia's Achilles heel is its low domestic savings rate, reflected by a still large current account deficit financed by FDI and portfolio capital inflows (Chart II-2). As a result, low oil prices and rising global interest rates have exposed the nation's main cyclical vulnerability. Given the trade deficit is still large (Chart II-3) and our bias is that oil prices will be flat-to-down, a further retrenchment in domestic demand is unavoidable. Chart II-1Colombia's First Recession##br## In 20 Years? bca.ems_sr_2016_11_23_s2_c1 bca.ems_sr_2016_11_23_s2_c1 Chart II-2Colombia's Lingering Balance Of ##br##Payments Vulnerability bca.ems_sr_2016_11_23_s2_c2 bca.ems_sr_2016_11_23_s2_c2 Chart II-3A Weaker COP Will Force The ##br##Necessary Adjustment bca.ems_sr_2016_11_23_s2_c3 bca.ems_sr_2016_11_23_s2_c3 Going forward, the external funding constraint will continue to bite. Moreover, policymakers are trapped and will be unable to prevent growth from contracting. The central bank is stuck between the proverbial rock and hard place. Cutting interest rates will undermine the appeal of the peso to foreign investors. Raising rates to prop up the currency, however, will exacerbate the economy's downward momentum. In the end, downward pressure on the exchange rate and still high inflation mean the central bank will not cut rates soon (Chart II-4). Tight monetary policy in turn means that private sector credit will decelerate much more (Chart II-5). Chart II-4High (Well Above Target) Inflation Limits##br## Central Bank's Ability To Ease bca.ems_sr_2016_11_23_s2_c4 bca.ems_sr_2016_11_23_s2_c4 Chart II-5Colombia: Credit Growth Is ##br##Headed Much Lower bca.ems_sr_2016_11_23_s2_c5 bca.ems_sr_2016_11_23_s2_c5 Our marginal propensity to consume proxy, an excellent leading indicator for household spending, signals consumption is set to weaken even further (Chart II-6). Facing weakening demand, investment is set to continue contracting (Chart II-7) and, ultimately, unemployment will be much higher, reinforcing the downtrend in consumer expenditures. Chart II-6Colombian Domestic Demand##br## To Retrench Further bca.ems_sr_2016_11_23_s2_c6 bca.ems_sr_2016_11_23_s2_c6 Chart II-7Contracting Investment Bodes ##br##Poorly For Employment bca.ems_sr_2016_11_23_s2_c7 bca.ems_sr_2016_11_23_s2_c7 Meanwhile, fiscal policy will remain tight as Colombia's orthodox policymakers struggle to adjust the fiscal accounts to the structurally negative terms-of-trade shock in this oil-dependent economy. The current fiscal reform effort is very positive for sustainable long-run dynamics, as influential central bank board members have highlighted.6 Yet particular parts of the reform, such as raising VAT taxes from 16% to 19%, will almost inevitably lead to a drop in consumer demand. Furthermore, nominal government revenues are already contracting and a slumping economy means that the total fiscal effort will need to be greater than currently envisioned. Overall, with monetary and fiscal policy stimulus hamstrung by the nation's low domestic savings rate (i.e. large current account deficit), a mild recession seems very likely. And while a lot of weakness has already been priced into the nation's financial markets, we think there is still more downside ahead. For instance, the Colombian peso may be cheap in real (inflation-adjusted) terms, but it is highly vulnerable due to the nation's still wide current account deficit. This week we recommend re-instating a short position in the peso; this time against an equal-weighted basket of the U.S. dollar and the Russian ruble.7 Turning to equities, Colombian stocks have fallen sharply since 2014, mostly a reflection of the collapse of the nation's energy plays. At present bank stocks account for 60% this nation's MSCI market cap, and though we believe they will fare better than many other EM banking systems,8 they will not go unscathed by a recession. Still, orthodox policymaking should limit the downside in the performance of this bourse and sovereign credit (U.S. dollar bonds) relative to their respective EM benchmarks. Meanwhile, fixed-income investors should continue to bet on yield curve flattening by paying 1-year/ receiving 10-year interest rate swaps, a trade we have recommended since September 16, 2015.9 The recent steepening in the yield curve will prove unsustainable as the economy tanks. Bottom Line: Colombia is probably headed toward recession and policymakers are straightjacketed and cannot ease monetary and fiscal policies to prevent it. As such, the currency will be the main release valve and it will depreciate further. Go short the COP versus an equal-weighted basket the U.S. dollar and the Russian ruble. Dedicated EM equity and credit investors should maintain a neutral allocation to Colombia within their respective EM benchmarks. Continue to bet on flattening in the yield curve by paying 1-year/ receiving 10-year interest rate swaps. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses", dated October 26, 2016. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016. 3 As we argued in Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses", dated October 26, 2016, it is new loans that create new deposits and vice versa. 4 Please refer to the section on Thailand in our Emerging Markets Strategy Weekly Report, titled " The EM Rally: Running Out Of Steam?" dated October 19, 2016. 5 Please refer to the Emerging Markets Special Report titled, "Colombia: A Cyclical Downturn Amid Structural Strength," dated May 4, 2016, available at ems.bcaresearch.com 6 Please see Cano, Carlos Gustavo "Monetary Policy in Colombia: Main Challenges 2016 -2017" Bank of America Merrill Lynch, Small Talks Symposium, October 7, 2016, Washington DC http://www.banrep.gov.co/sites/default/files/publicaciones/archivos/cgc_oct_2016.pdf 7 For more on the ruble please refer to the section on Russia in our Emerging Markets Weekly Report, dated November 16, 2016, titled, "Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade". 8 Please refer to the Emerging Markets Special Report titled, "Colombia: A Cyclical Downturn Amid Structural Strength" dated May 4, 2016, available at ems.bcaresearch.com 9 Please refer to the section on Colombia in our Emerging Markets Weekly Report, dated September 15, 2015, titled "Colombia: An Incomplete Adjustment", available at ems.bcareseach.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.

Colombia's structural growth outlook is superior to many other developing economies. In the near-term, however, Colombia's economy is set to weaken materially. Upgrade Colombian equities and sovereign credit to neutral versus EM benchmarks. Continue betting on further yield curve flattening/inversion and buy 10-year domestic bonds on weakness. Go long Colombian bank stocks / short Peruvian banks, and stay short the peso.