Frontier Markets

HighlightsRussian negotiators in Vienna say talks with the West over Ukraine have reached a “dead end.” If talks are verifiably discontinued, global investors should reduce risk in their portfolios.Social unrest in Kazakhstan does not reduce the probability that Russia will partially re-invade Ukraine. We still give 50/50 odds of new Russian military action.Our Geopolitical Strategy recommends staying short EM Europe versus DM Europe stocks; short RUB/CAD; short CZK/GBP; and long defense stocks.Risks to Russian financial markets remain very elevated due to the Ukraine situation.For Kazakhstan, our Emerging Markets Strategy recommends that dedicated EM credit investors overweight sovereign Kazakh credit relative to the EM benchmark. Equity investors should underweight Kazakhstani equities versus the emerging market equity benchmark.FeatureOn January 2, Kazakhstan witnessed an explosion of civil disorder, the worst since 1986, when it was still part of the Soviet Union. The government, with Russia’s help, has restored order for the time being. But Kazakhstan’s problems have broader lessons for investors that we explore in this report. Chart 1Global Social Unrest Adds To Supply Risks Global Social Unrest Adds To Supply Risks Global Social Unrest Adds To Supply Risks  First, Kazakh unrest will not prevent Russia from staging a partial re-invasion of Ukraine, the odds of which are 50/50. These odds have not changed after this week’s high-level negotiations between Russia and the West.Theoretically instability in the former Soviet Union will constrain Russia’s foreign policy options. But Ukraine is of unique strategic value to Russia.If Russia believes its domestic politics and broader sphere of influence will become less stable in future, then it has more incentive to act now on long-term strategic objectives, like neutralizing Ukraine.Second, Kazakh unrest corroborates the emerging trend of global social unrest that we have been monitoring since the outbreak of the Covid-19 pandemic. This trend reinforces our strategic theme of populism and nationalism.The Kazakh government has been struggling to maintain popular support amid eight years of economic malaise and is now backtracking on fiscal discipline.Previously we identified the “Shia Crescent” – e.g. Iran and Iraq – as ripe for instability but now we can add Central Asia to the list. Kazakhstan is better off than most of Central Asia, which means that other countries are even more vulnerable to this kind of unrest. Even Russia is vulnerable, which supports the first point above.For investors the chief takeaway is to guard against commodity price overshoots, since Central Asia, like the Middle East and other regions, is vulnerable to production disruptions at a time of tight global supply (Chart 1).Yet investors should stay short Russian ruble and equities, as the showdown over Ukraine is not yet resolved.What Just Happened In Kazakhstan?The unrest began in the western city of Zhanaozen, a restive oil town, but escalated in Almaty, the country’s business center, located far away in the far southeast. The nationwide crisis resulted from two factors: (1) pandemic-induced recession and inflation and (2) an ongoing political leadership transition.To stabilize the situation, the government of President Kassym-Jomart Tokayev gave “shoot to kill” orders to police and invited an extraordinary deployment of nearly 4,000 troops, mostly Russian peacekeepers, under the auspices of the Collective Security Treaty Organization (CSTO). Civil order has been at least temporarily restored and some Russian troops may already be leaving.1Reports indicate 164 civilian deaths and about 12,000 arrests. Authorities shut down the Internet so information about the events remains sketchy. The embers are still burning and further flareups can occur. To understand what happened we need to look at Kazakhstan’s geopolitics and recent political history.Kazakh GeopoliticsKazakhstan is a vast country that covers most of the steppe ranging from Russian Siberia to the mountains of Iran, Afghanistan, Krygyzstan, and China. The flatlands are interrupted only by large inland seas, the Caspian and Aral Seas in the west and Lake Balkash in the east, and Tian Shan mountains in the south.The geopolitical problem for Kazakhstan is how to control this vast area, given that its population, wealth, and technology are insufficient for the task. The strategic solution is to integrate or cooperate with the powerful Russian security apparatus while exploiting natural resources to generate revenues.Strongman former leader Nursultan Nazarbayev – who has immense influence and is apparently still in the country, though rumors say he fled into exile this month – founded Kazakhstan as a fledgling republic when the USSR fell. He sought to solidify the country’s independence by attracting foreign investment from capital-rich, resource-hungry foreign regions, while continuing to cooperate closely with the Russians on strategic security.Nazarbayev balanced Russia by means of new trade and investment partners: the EU and especially a rising China. China views Kazakhstan as the centerpiece of its Belt and Road Initiative, which aims to give China the leading role in developing the economies that lie between China and Russia and Europe.Kazakhstan’s population changes since the USSR fell suggest emerging Kazakh nationalism. Ethnic Kazakhs make up 69% of the population and have gained ever greater control of the state. Ethnic Russians have declined from 38% of the population in 1989 to 19%, and still falling, today. Kazakh nationalism is one of the drivers of today’s unrest, with the common folk feeling deprived of the country’s newfound wealth and blaming Russians, and especially Chinese and other foreigners, for exploiting the country’s resources.2Of course, the Kazakh elite are not unified, there are rival clans, and there is now a power struggle between Nazarbayev and Tokayev intertwined with the social unrest. But the point is that Kazakh nationalism poses a long-term challenge to Russian dominance. Russia will continue to have a major interest in Kazakhstan due to the presence of Russians as well as Russia’s own geopolitical needs, which forbid a truly independent Kazakhstan (Chart 2).3 Chart 2 Russia Has An Interest In Former Soviet States Like Kazakhstan Due To Geography, Strategy, And Russian Ethnic Population Russia Has An Interest In Former Soviet States Like Kazakhstan Due To Geography, Strategy, And Russian Ethnic Population Chart 3 Kazakh Governance Is Not The Worst Kazakh Governance Is Not The Worst Kazakhstan is wealthier and better governed than its central Asia neighbors. Adjusted net national income per capita stands at $6717 versus the central Asian average of $2963. While the country’s governance is poor, it ranks higher than several major emerging markets when it comes to governance. It scores better than Russia, China, and Ukraine on the Economic Freedom Index. Income inequality is lower than in Turkey, China, and Russia. Corruption perceptions are not as bad as in China or Turkey (Chart 3).Having said that, governance is still weak and Kazakhstan’s government is very corrupt even if it scores better than some peers.The takeaway is that while social unrest will pose a persistent challenge, Kazakhstan is not a failed state. Real income growth has been strong enough and can be underpinned by government largesse for now (Chart 4). The recent riots were put down quickly.The country is blessed and cursed with abundant natural resources. Its economic structure is overly dependent on oil and natural gas production and distribution (Chart 5). The Great Recession and the oil price and commodity bust of 2014 caused a downshift in growth rates and initiated the current cycle of unrest. Chart 4Kazakh Real Income Grew Rapidly Pre-Pandemic Kazakh Real Income Grew Rapidly Pre-Pandemic Kazakh Real Income Grew Rapidly Pre-Pandemic ​​​​​​  Chart 5 Kazakh Elite Thrive On Resource Rents Kazakh Elite Thrive On Resource Rents ​​​​​​Succession CrisisUnrest flared in 2011 and sporadically throughout the decade, including around Tokayev’s January 2021 election, and culminated in today’s riots. In 2019 Nazarbayev unexpectedly resigned as president and symbolically “handed power” to President Tokayev. The goal was not only to lay the groundwork for his eventual succession but also to share the blame for sluggish growth in the wake of the commodity boom.Nazarbayev kept the title of national leader, and the chairmanship of the powerful National Security Council, and intended to stay in control of most state functions. But Covid-19 foiled his plans. The global pandemic pushed the country into outright recession and sparked a new wave of social unrest that has evolved into a full-blown succession crisis.The Tokayev administration adopted Nazarbayev’s reform initiatives, and launched some of its own, but structural reforms provoked the seething populace. The proximate cause of today’s crisis was a government hike of liquefied petroleum gas prices. Global price pressures have caused the second major bout of food and fuel inflation since 2014, when the currency came under enormous devaluation pressure and the government was forced to float it (Chart 6). Inflation coinciding with recession and an illiberal succession process made for a noxious combination.Tokayev rose to power as Nazarbayev’s loyalist and is now attempting to purge the state of the former leader’s influence, making Nazarbayev into a scapegoat to appease popular wrath. He reversed the LPG price hike, reshuffled the cabinet, and is promising reforms. Simultaneously he is using a heavy hand against protesters and rioters. It is not known if security forces will remain loyal to him but so far they have cracked down aggressively.4 The Russian troops who came to Tokayev’s assistance reclaimed the Almaty airport.Russian backing will give Tokayev the extra physical and moral force he needs to stay in power for the time being. Beyond that, Tokayev may or may not survive. The power struggle with Nazarbayev’s faction will continue in the coming months and years. Nazarbayev controlled the security forces as well as most of the bureaucracy.Either way, the Kazakh state will persist more or less in its current form, for the following reasons:The country’s leaders, whoever they may be, are willing to use force and the security apparatus is large – Kazakhstan spends 5% of total government expenditure on internal security, more than Russia (Chart 7). Chart 6Inflation Tipped Kazakhstan Into Major Unrest Inflation Tipped Kazakhstan Into Major Unrest Inflation Tipped Kazakhstan Into Major Unrest ​​​​​​  Chart 7 Kazakh Security State Large – Similar To Russia’s Kazakh Security State Large – Similar To Russia’s ​​​​​​The new global business cycle will sustain reasonable commodity prices that give the government fiscal resources to deal with unrest. Benchmark crude prices at $84 today are right in line with Kazakhstan’s fiscal breakeven oil price over the 2018-20 period (Chart 8A). As long as prices do not collapse the regime will be able to use revenues to fund security operations and placate disaffected groups (Chart 8B). Chart 8A Kazakh Fiscal Stimulus Below Global Average, Will Rise To Allay Unrest Kazakh Fiscal Stimulus Below Global Average, Will Rise To Allay Unrest ​​​​​​ Chart 8B Kazakh Regime Has Means As Long As Oil Price Holds Up Kazakh Regime Has Means As Long As Oil Price Holds Up ​​​​​​Russia has a vital interest in preventing a revolution or regime failure in Kazakhstan. The rapid response of the CSTO in its first-ever peacekeeping mission abroad shows Russia’s seriousness. The Kazakh elite will continue to receive Russian backing (even beyond what they asked for!). Chart 9China No Longer Writing Blank Checks To Kazakhstan China No Longer Writing Blank Checks To Kazakhstan China No Longer Writing Blank Checks To Kazakhstan  True, Kazakh nationalism and the exodus of Russian speakers will continue to pose problems for Russia over the long run. But the Kazakh government cannot meet its geopolitical needs without Russia, and there is no alternative – China is far from supplanting Russia’s influence.There is no chance of liberal democracy taking shape or of Kazakhstan revolutionizing its foreign relations: Russia and China would not allow it. The regime would be isolated. If Ukraine and Georgia cannot ally with the West and join NATO, then Kazakhstan cannot even think about it. It is stuck in its geopolitical situation.There is a chance that Russia will gain a little political influence vis-à-vis China once the dust settles, but any change is unlikely to be drastic. Nazarbayev oversaw a period of rising Chinese influence but never had the will or ability to turn away from Russia (Chart 9). Russia only needs to retain control of security in Kazakhstan – it does not oppose Chinese trade and investment as long as it does not threaten that control. Modern Russia is not the USSR and cannot afford to subsidize Kazakhstan on its own.American and European trade and investment with Kazakhstan could come under risk – especially if Russia’s broader showdown with the West results in western sanctions on Russia. But Europe is a dominant trading partner of Kazakhstan and Russia will face even greater trouble in this region if it interferes with EU trade. By contrast Kazakhstan will be an essential way for Russia to bypass western sanctions.Bottom Line: Kazakhstan is seeing a rise in populism and nationalism that will persist. But Kazakhstan’s structural problems are not so bad as to lead to regime failure. Elite infighting will be limited by Russia’s and China’s shared interest in supporting the current regime, as well as the country’s lack of geopolitical options.Will There Be A Global Impact?Kazakhstan’s importance to global economy and financial markets centers on its commodity production and distribution. Commodity output did not suffer much during recent unrest but it is possible that government resource taxes, labor strikes, or further unrest could impede exports.  Chart 10Kazakh Currency Compared To Ukrainian During 2014 War Kazakh Currency Compared To Ukrainian During 2014 War Kazakh Currency Compared To Ukrainian During 2014 War  Kazakhstan makes up 1.7% of global oil production and 3.8% of global exports. A total cutoff of Kazakh oil exports, combined with the recent loss of 400,000 barrels per day of Libyan output, could reduce global oil inventories by 2.1%. There is no indication that a total cutoff is occurring but the country is not yet stable.Kazakhstan provides 0.8% of global natural gas supply, 2.1% of Chinese natgas consumption, and serves as a transit country for Turkmenistan natural gas exports. A total shutdown of this supply would amount to 1.3% of global imports and 3.3% of Chinese imports. Both China and Europe are already struggling with very low natural gas inventories and demand is high in the winter season. Thus while Kazakhstan’s exports so far continue mostly unimpeded, any future disruption would have a global impact.Otherwise Kazakhstan is mostly notable for providing 41% of the world’s uranium exports.Kazakhstan’s situation is very different from that of Ukraine. But if social unrest re-escalates, then the currency, the tenge, will collapse and follow the Ukrainian hryvnia’s trajectory since the 2014 Crimea crisis (Chart 10).The Russian ruble has fallen by 4.4% since the border showdown with Ukraine intensified in September, and 2.5% since the Kazakh unrest began. Russian equities have dropped off by 20% in absolute terms and 16% relative to EM equities since October 2021 (Chart 11). We expect the risk premium to remain high at least until the US and Russia reach some kind of mode of living with each other over the Ukraine standoff. Chart 11Market Pricing Higher Russian Geopolitical Risk, Weighing On Relative Equity Performance Market Pricing Higher Russian Geopolitical Risk, Weighing On Relative Equity Performance Market Pricing Higher Russian Geopolitical Risk, Weighing On Relative Equity Performance  Bottom Line: The Kazakh situation is not yet interrupting commodity supply but disruptions cannot be ruled out. The broader point is that Kazakhstan’s sociopolitical problems are shared across many resource producers – and thus investors should bet on policy-induced supply challenges persisting.How Will Kazakhstan Affect Russia’s Standoff With The West?Kazakh unrest affects our strategic theme of great power struggle. The timing of the unrest is suspicious – it broke out just as Russia attempted to blackmail the US into strategic concessions by threatening to re-invade Ukraine (at least part of it).Tokayev explicitly blames foreign interference for the unrest and Russia may also blame the US at some point. It is possible. But foreign actors do not have to do much to spark unrest other than hold a match to the powder kegs of former Soviet states, which are poor, corrupt, ethnically divided, badly governed, and lacking in prospects for the young.The collapse of the Soviet Union and rise of independent republics structurally encourages nationalism and works against Russian centralism. The Eurasian Economic Union is a pathetic alternative to the European Union. The Internet spreads ideas about how life could be better.If Kazakhstan or other Central Asian states destabilize further, it could reduce the odds of Russian taking military action in Ukraine in the near term. Especially if Russia does not want to incur the costs of re-invading Ukraine anyway. But that does not appear to be the case so far.Renewed military conflict in Ukraine cannot be ruled out, for reasons we discussed in a recent special report, “Russia/Ukraine: Don’t Be Complacent.”Unlike Kazakhstan, Ukraine could integrate with the West both economically and militarily over the long run. If Russia believes that it will face greater troubles in its sphere of influence in the coming years – not only in Kazakhstan, but also in Belarus and Turkmenistan, and even at home – then it has all the more reason to settle the Ukrainian strategic question now, while it still has the advantage. Given that Tokayev and his Russian backers appear to have restored order quickly, Russia will turn back to Ukraine promptly.Russia’s goal in the newly opened negotiations with the US is to rule out NATO’s eastward expansion and force a halt to western arms sales and defense cooperation. If the US refuses to rule out NATO expansion and continues to provide arms and defense support for Ukraine (and Georgia), then Russia will take aggressive action. This is probably true even if the coals in Kazakhstan are still burning. Ukraine is long-term strategic threat to Russia, whereas Kazakhstan is ultimately isolated.Looking beyond Ukraine and the short term, Russia will probably have to start paying more attention to maintaining order within Russia and the former Soviet space, rather than clawing back control of parts of the Soviet space that it lost. If Kazakhstan is relatively well off compared to other central Asian states, then its current crisis suggests other crises await.Belarus has already seen the first rumblings of its own succession crisis and instability – and it is more susceptible to western influence than Kazakhstan. Turkmenistan is another candidate for political change. Kyrgyzstan is already in tumult. There are several former Soviet countries whose autocratic leaders, like Nazarbayev, have been in power too long – including Russia’s own President Putin. Post-pandemic economic troubles and inflation will accelerate the decay of these administrations (Chart 12). Chart 12 Aging Autocratic Leaders In Former Soviet Union A Major Source Of Future Political Upheaval Aging Autocratic Leaders In Former Soviet Union A Major Source Of Future Political Upheaval Kazakhstan also shows that even a carefully arranged succession, in which the autocrat tries to keep power behind the scenes but phase out his rule gradually, can instantly give way to factional struggle and national chaos as soon as something goes wrong for the new administration. Chart 13Putin Has Record Of Boosting Domestic Support Via Foreign Adventures Putin Has Record Of Boosting Domestic Support Via Foreign Adventures Putin Has Record Of Boosting Domestic Support Via Foreign Adventures  Nazarbayev is the founding father of Kazakhstan – the capital was just renamed Nur-Sultan, in his honor, in 2019 – and yet his best laid plans were overturned in a week. Now he is on the verge of exile, and his faction may or may not avoid being purged. This is a serious problem for Putin to consider – and if Russia’s succession is not smooth then the world will experience a huge increase in uncertainty.A risk to the view would be that Russia drastically cuts back on its foreign ambitions – and settles with the US over Ukraine – because it recognizes sociopolitical instability as the massive challenge that it is in Russia and its sphere of influence. But we have clear evidence from the past 30 years that Russia responds to domestic weakness with foreign adventurism (Chart 13). Maybe Kazakhstan will mark a change to that pattern. But the thing to watch will be US-Russia strategic negotiations, not Kazakhstan.Regarding US-Russia negotiations, this week’s important diplomatic talks have not lowered the risk of conflict. The US did not offer the required concessions: it did not rule out Ukraine joining NATO someday and did not forswear future defense cooperation with Ukraine. Russia carried out tank drills near Ukraine in a signal that it will not negotiate forever. As we go to press, there is no basis for lowering the risk level of renewed military conflict.Bottom Line: Russia and the former Soviet Union face rising political instability in the coming years. Moscow has a record of pursuing foreign adventures when troubled at home. We still would not rule out a limited re-invasion of Ukraine if the US does not concede limits to NATO expansion and defense cooperation.An Unbalanced EconomyKazakhstan’s economic outlook still hinges by and large on commodity prices, especially oil and natural gas prices. Importantly, the unrest appears to have left the country’s natural resource production unaffected, for now.As long as global resource prices stay elevated, they will provide the Kazakhstani government with the financial means to bolster income and keep the economy going despite lingering political uncertainty.Historically, economic activity and financial markets have tracked the 6-month average of commodity prices (Chart 14). So, major trends in commodity prices, not their short-term fluctuation, have mattered for the Kazakh economy and its equity and sovereign credit relative performance versus EM and frontier market peers.    Chart 14Medium-Term Oil Prices Drive Economy & Markets Medium-Term Oil Prices Drive Economy & Markets Medium-Term Oil Prices Drive Economy & Markets  In the past 12 months, oil and natural gas have represented 50% of overall export revenues, and government revenues from this industry accounted for almost a third of the total. Kazakhstani oil production will be constrained by the OPEC+ agreement at least until December 2022. Afterwards, oil output will most likely surpass the 2020 peak (Chart 15, top panel). Chart 15Commodity Production Commodity Production Commodity Production ​​​​​​ Other non-energy commodities represent the other half of export revenues. Since 2016, the country’s production of non-oil commodities has been rising (Chart 15, bottom 3 panels). Rising output volumes along with elevated prices, for now at least, will provide the government with sufficient revenues to support income and economic growth.In the long run, however, government stimulus and spending can sustain high nominal growth but not real growth. In any economy, real GDP growth is solely determined by the nation’s productivity and labor force growth (Chart 16) Chart 16Real Vs. Nominal GDP Real Vs. Nominal GDP Real Vs. Nominal GDP  The structural growth outlook is dismal:Productivity growth has slowed to a mere 1% (Chart 17, top panel). Stagnant productivity translates to mediocre real per capita income.    Chart 17Meager Productivity Growth Meager Productivity Growth Meager Productivity Growth ​​​​​​ Working age population is projected to grow by 1% annually over the next decade according to UN projections (Chart 17, bottom panel). The country has had negative net immigration balance, i.e., more people are leaving the country than entering it. This will only get worse following the protests and increased political uncertainty. Chart 18Large Profit Repatriation By Multinationals Large Profit Repatriation By Multinationals Large Profit Repatriation By Multinationals  Kazakhstan has failed to develop a domestic manufacturing capacity. Even though authorities have been promoting import substitution in key sectors, these policies have failed to produce tangible results. It is unlikely to be different going forward despite the intentions of President Tokayev to launch structural reforms.Finally, the country has not reaped the full benefits from commodity export revenues. Even though the trade balance was boosted by the country’s commodity export revenues, most of these revenues are being repatriated out of the country through multinational companies’ profits.The country has been running trade surpluses but current account deficits. Chart 18 demonstrates that over 13% of GDP (or $24 billion) in the form of income leaves the country, which is much larger than the trade surplus (Chart 18). This is unlikely to change because multinationals have invested heavily in Kazakhstan’s resource industries, and they will continue reaping a large share of the profits from these industries.     Bottom Line: High commodity prices will enable more government spending, which will sustain the nation’s nominal growth over the medium term. However, beyond the medium term, real economic growth will underwhelm due to the lack of productivity gains.Easy Fiscal + Tight Monetary Policy = Stable Exchange RateInflation in Kazakhstan will prove to be sticky. Headline and core inflation are well above the central bank’s target of 4-6% (see Chart 6 above). Inflation is a politically and socially sensitive issue and persistent high inflation could once again fuel public discontent. Hence, Kazakhstani authorities have a strong political incentive to moderate inflation. Chart 19Wages Outpacing Productivity Wages Outpacing Productivity Wages Outpacing Productivity  Overall, policymakers will adopt a tight monetary and loose fiscal policy mix. This will ensure currency stability for now.On the one hand, the National Bank of Kazakhstan (NBK) will continue hiking interest rates. Interestingly, before the recent unrest, President Kassym-Jomart Tokayev was calling on the central bank to raise interest rates to curb accelerating inflation.On the other hand, fiscal spending will be strong, exerting upward pressure on inflation. Government spending plans for FY 2022 prior to the unrest were geared towards public wage increases alongside direct transfers to households from the National Fund. Now, chances are that these measures will be even larger, and front loaded to appease the population.Soaring nominal wages and lack of productivity gains entail surging unit labor costs (Chart 19). The latter will prolong inflationary pressures.Currency depreciation will fuel higher inflation. Hence, achieving currency stability will for now be the key macro objective for policymakers.To avoid residents converting local currency deposits into US dollars, the central bank needs to offer positive real rates in the tenge deposits by pushing interest rates above the inflation rate. Real (deflated by core CPI) interest rates on domestic local currency deposits have turned to almost a full 1% negative. As a result, aggressive rate hikes by the central bank should be expected in the coming months.Finally, the central bank has adequate foreign exchange reserves to counter capital flight by the country’s elites and to service foreign debt obligations due in the next 12 months.Bottom Line: Faced with strong inflationary pressures, the central bank will be forced to hike interest rates considerably. By doing so, it will maintain elevated enough real interest rates to avert the currency from dropping meaningfully and driving inflation higher.Investment ConclusionsGreat Power Struggle: Russia’s critical negotiations with the West (the US, NATO, and the OSCE) have not produced a diplomatic breakthrough this week. Media reports suggest the talks have gone badly but talks are ongoing as we go to press. If talks are verifiably discontinued, it will be a risk-off sign for global investors.We expect Russian and Eastern European financial assets to suffer a high risk premium until a diplomatic solution presents itself. This is true despite high energy/commodity prices that would otherwise benefit Russia. In the event of a partial reinvasion of Ukraine and western sanctions on Russia, energy prices could spike and harm global demand.Populism and Nationalism: Kazakhstan’s situation has stabilized temporarily but it could easily flare up again given the negative cyclical & structural macroeconomic and political backdrops. Kazakh unrest highlights the high risk of social unrest in the former Soviet Union and in other EMs in the wake of the global pandemic.Risks to Russian markets remain very elevated due to the Ukraine situation. We continue to recommend underweighting Russian stocks, a neutral stance on local bonds and overweighting sovereign credit relative to the their respective EM benchmarks.Kazakhstan's exchange rate will be stable for now. Authorities will avoid any major downside moves in the currency in the medium term and they have the means – in the form of large foreign exchange reserves – to do so.As such, we recommend that dedicated EM credit investors overweight sovereign Kazakh credit relative to the EM respective benchmark. Low public debt and adequate foreign exchange reserves (including the National Fund) will support the ability of government to service its foreign debt.Lastly, equity investors should underweight Kazakhstani equities versus the emerging market equity benchmark. Matt Gertken Vice PresidentGeopolitical Strategymattg@bcaresearch.com Andrija VesicAssociate Editorandrijav@bcaresearch.com Footnotes1      For a breakdown of the troop deployments by country, see Catherine Putz, "CSTO Deploys to Kazakhstan at Tokayev’s Request," The Diplomat, thediplomat.com, January 6, 2022.2     For Kazakh nationalism, see Paul Goble, "New Wave of Kazakh Nationalism Changing Astana’s Domestic and Foreign Policies," Eurasia Daily Monitor 16:32, March 7, 2019, and Serik Rymbetov, "Anti-China Sentiments Grows [sic] in Kazakhstan as Economic Cooperation Stalls," Eurasia Daily Monitor 18:118, July 26, 2021, Jamestown Foundation, Jamestown.org.3     Dosym Satpayev, "Identity Politics," in "Kazakhstan: Tested By Transition," Chatham House Report, November 27, 2019, chathamhouse.org.4     Paul Stronski, "Kazakhstan’s Unprecedented Crisis," Carnegi Endowment for International Peace, January 6, 2022, carnegiendowment.org.

Highlights The bull run in Vietnamese stocks is due for a pause as the weakness in overall EM markets spreads to this bourse.  Household consumption will stay constrained as new COVID-19 cases remain high and fiscal and monetary stimulus remain absent. Social distancing measures and related supply disruptions have hobbled labor-intensive manufacturing and exports thereof. Vietnam is facing saturation or stagnation in two of its major exports: electronics and phones. The country needs to find a new high value-added export sector to which to transition to maintain large trade surpluses. Vietnam’s longer-term structural outlook remains bright. The country is set to gain further global export market share due to strong productivity gains and competitive unit labor costs.  Absolute-return investors should book profits on their Vietnamese holdings for now and wait for a better entry point. Asset allocators, however, should continue to overweight this bourse in overall EM, emerging Asia or frontier market equity portfolios. Feature Vietnamese stocks have surged to new highs in absolute terms and have outperformed their frontier and emerging market peers since spring 2020 (Chart 1). Can the bull run continue into the new year? We advise caution. Vietnamese stocks may be in for a period of weakness in absolute terms. The reason is a negative outlook on EM markets: a drop in EM stock prices is typically followed by one in Vietnamese stock prices (Chart 2).   Chart 2Weakness In EM Markets Typically Spreads To Vietnamese Stocks Too Weakness In EM Markets Typically Spreads To Vietnamese Stocks Too Weakness In EM Markets Typically Spreads To Vietnamese Stocks Too Chart 1The Bull Run In Vietnamese Stocks May Be Due For A Pause The Bull Run In Vietnamese Stocks May Be Due For A Pause The Bull Run In Vietnamese Stocks May Be Due For A Pause   In addition, Vietnam’s exports, the mainstay of this market, are likely to face some headwinds in the months ahead. Absolute-return investors therefore would do well to book profits now and wait for a better entry point to this bourse later in the year. That said, the longer-term outlook of this economy remains bright, and that will help boost this market beyond any near-term jitters. Robust fundamentals should also ensure continued outperformance relative to overall EM stocks. We recommend that investors stay overweight Vietnam in EM and emerging Asian equity portfolios. Battered Consumption The surge in daily new cases since August last year forced Vietnam to implement stringent lockdowns and social distancing measures. A consequence of these measures was a free fall in Vietnam’s household consumption. Both retail sales and car sales plummeted to levels not seen since 2016 before recovering recently (Chart 3). This caused the economy to shrink by over 6% in real terms in the third quarter last year – the first-ever contraction in decades. Now, with the new, highly infectious Omicron variant spreading fast, the number of daily new cases and deaths remains stubbornly high – despite many of the lockdown measures still in place (Chart 4). It is therefore far from clear when normal economic activity will resume. Incidentally, 57% of Vietnamese people have been fully vaccinated so far. Chart 4Rising Omicron Cases May Hobble Economic Activity Again Rising Omicron Cases May Hobble Economic Activity Again Rising Omicron Cases May Hobble Economic Activity Again Chart 3The Surge In The Delta Variant Last Year Severely Hurt Vietnamese Household Consumption The Surge In The Delta Variant Last Year Severely Hurt Vietnamese Household Consumption The Surge In The Delta Variant Last Year Severely Hurt Vietnamese Household Consumption   Notably, despite the weak economy, there has not been any meaningful policy stimulus in recent months. Fiscal policy has remained very tight. Government spending, excluding interest and principal payments, has contracted by 4.5%. The 2022 budget proposals envisage only a 2% rise in total nominal fiscal expenditure. The central bank, for its part, has also not announced any new easing measures in the recent past. Lacking fiscal and monetary support, domestic consumption and therefore overall growth will remain somewhat constrained going forward. Supply Disruptions While domestic consumption is a concern, a more investor-relevant issue in Vietnam is the pandemic’s negative impact on the country’s manufacturing/export sector. This is because, unlike household consumption, manufacturing activity and manufacturing exports have a strong bearing on the country’s stock prices. The reason is that developing market stocks in general are driven by global trade cycles. And since Vietnam’s total trade amounts to almost twice as much as the country’s GDP, the ebbs and flows in the former have an outsized impact on the domestic economy, and by extension, on the stock market (Chart 5). The surge in new cases since August created severe hindrances in the manufacturing/export sector supply chains and labor availability. In the clothing and textile industry, almost a third of the sector’s three million employees quit jobs, or stayed away from work with or without pay, as per Vietnam Textile & Apparel Association, an industry body.1The lack of labor coupled with bottlenecks in logistics have led to a sharp drop in Vietnam’s textile and garment exports (Chart 6, top panel).  Chart 6Garment Exports Are Badly Hit, While Phone Exports Are Facing Stagnation Garment Exports Are Badly Hit, While Phone Exports Are Facing Stagnation Garment Exports Are Badly Hit, While Phone Exports Are Facing Stagnation Chart 5Vietnamese Stocks Are Highly Leveraged To Export Growth Vietnamese Stocks Are Highly Leveraged To Export Growth Vietnamese Stocks Are Highly Leveraged To Export Growth   Due to hobbled production, manufacturing inventories have piled up (Chart 7). It is estimated that most of this large inventory is comprised of raw materials and intermediate goods. If so, that will discourage local raw material/intermediate goods production in the months to come. Chart 7The Pandemic Is Hampering Shipments While Inventories Are Piling Up The Pandemic Is Hampering Shipments While Inventories Are Piling Up The Pandemic Is Hampering Shipments While Inventories Are Piling Up In sum, it’s far from clear that a rapid revival in manufacturing production and exports is in the cards amid the ongoing Omicron surge. This will remain a headwind for Vietnamese stock prices. Exports Outlook Despite the setback in the textile sector, the country’s overall exports held up quite well last year. That’s because the slack was more than made up by the booming computer and electronics exports. This is thanks to the massive demand surge in those goods in past two years due to the global work-from-home phenomenon (Chart 6, top panel). However, going forward, odds are that global demand for these items will abate as saturation sets in. This will slow the growth rate in Vietnam’s computer and electronic exports. Incidentally, Vietnam’s single largest export items, phones and spare parts, are also showing signs of stagnation. In absolute dollar terms, they have been flattish since early 2018. Phone production volumes have remained at the same level as in 2015 (Chart 6, bottom panel). With mobile phone penetration in all major economies is already quite high, phone exports certainly cannot propel Vietnam’s exports as strongly as in the past decade. If this is the case, it can have a meaningful negative impact not only on Vietnam’s exports, but also on its trade balance, and by extension, its current account balance. The reason for this is that phones and spare parts have probably been the most value-added item among Vietnamese exports. The difference between the export revenues they earned and the import cost of the components has been much higher and has risen more sharply than in any other major export items (Chart 8, top and middle panels). This helped the country rack up rising trade surpluses. In the absence of net export revenues from phones and spare parts, Vietnam’s trade and current account balance would be deeply negative (Chart 8, bottom panel). Given that phones are no longer the sunrise sector worldwide, the country needs to find and move to some other high value-added sector to maintain its wide trade surplus. As of now, it’s not clear that this is happening. In the past two years, the number of newly approved manufacturing FDI projects have fallen to decade-low levels. The dollar value of approved manufacturing FDI projects has also fallen in tandem (Chart 9, top panel). In fact, overall FDI approvals have also fallen – suggesting actual FDI inflows might weaken in the months ahead (Chart 9, bottom panel). Chart 8Net Phone Exports Had Been Crucial To Vietnam's Large Trade Surpluses Net Phone Exports Had Been Crucial To Vietnam's Large Trade Surpluses Net Phone Exports Had Been Crucial To Vietnam's Large Trade Surpluses Chart 9FDI Inflows Into Vietnam Might Recede In The Coming Months FDI Inflows Into Vietnam Might Recede In The Coming Months FDI Inflows Into Vietnam Might Recede In The Coming Months   Until Vietnam finds a new high value-added export sector to which to transition, its stagnating phone and electronics exports mean that overall export growth is set to take a breather. Finally, one external tailwind for Vietnam since 2018 has been the trade war between the US and China. Because the two largest economies put various tariff and non-tariff barriers on each other, it allowed Vietnam to double its share of imports to the US in just three years (Chart 10). Vietnamese exports also clearly benefit when the dong weakens vis-à-vis the Chinese yuan. The fact that the Chinese authorities have allowed the yuan to be one of the strongest currencies over the past year has helped Vietnamese exports. In the future, however, decelerating growth in China may prompt the PBOC to seek a weaker yuan. If so, that could be another headwind to Vietnamese exports (Chart 11).       Chart 11The Tailwind From A Weak Dong Versus The Chinese Yuan May Diminish This Year, Hurting Exports The Tailwind From A Weak Dong Versus The Chinese Yuan May Diminish This Year, Hurting Exports The Tailwind From A Weak Dong Versus The Chinese Yuan May Diminish This Year, Hurting Exports Chart 10Vietnamese Exports Benefitted Immensely From The US-China Trade War Vietnamese Exports Benefitted Immensely From The US-China Trade War Vietnamese Exports Benefitted Immensely From The US-China Trade War   In sum, Vietnamese exports could well see a period of weakness in the coming months. That is usually a harbinger of weaker Vietnamese stock prices in absolute terms (Chart 5, above). Structurally Sound Despite our near-term cautious outlook on Vietnamese stocks, we have a positive view on the country’s structural prospects. The country’s fundamentals remain robust and that will help propel this market beyond any near-term weakness: Vietnam has boosted capital spending in the past few years to reach an impressive 32% of GDP, among the highest in the developing world (Chart 12, top panel). This has helped raise the economy’s productive capacity. Consistently, Vietnam’s labor productivity gains have been superior to most developing countries (Chart 12, bottom panel). The country’s wage growth has been relatively lower than those of China and Bangladesh, its two main export competitors (Chart 13, top panel). Chart 12Vietnam's Capital Spending And Labor Productivity Remains Among The Highest In EM Vietnam's Capital Spending And Labor Productivity Remains Among The Highest In EM Vietnam's Capital Spending And Labor Productivity Remains Among The Highest In EM Chart 13Competitive Unit Labor Costs Are Helping Vietnam Rapidly Grab Global Market Share Competitive Unit Labor Costs Are Helping Vietnam Rapidly Grab Global Market Share Competitive Unit Labor Costs Are Helping Vietnam Rapidly Grab Global Market Share Stronger productivity gains coupled with relatively muted wage growth is helping keep Vietnamese unit labor costs lower than its competitors. This is boosting its competitiveness; and not only helping grab an ever higher global market share, but also doing so at a faster clip than even China and Bangladesh (Chart 13, bottom panel). The country is also well placed to take advantage of its competitive unit labor costs. It has entered into a number of free trade agreements (FTA) with many countries and regions, the latest of which is the RCEP agreement – comprising ASEAN, China, Japan, South Korea, Australia, and New Zealand – which kicked in this January. These FTAs have eliminated export import tariffs for hundreds of items. Vietnam is likely to be a major beneficiary of these treaties in the medium to long term, given its rising competitiveness.  Given the already available infrastructure and labor and its competitive edge in manufacturing, Vietnam is also set to be the major recipient of the firms relocating away from China. This will further boost its longer-term prospects as exports will continue to generate solid income growth. Overall, real income per capita in Vietnam will continue rising at a rapid rate, outpacing that of most emerging economies. Investment Conclusions Chart 14Vietnamese Stock Valuations Are Not Attractive Now Vietnamese Stock Valuations Are Not attractive Now Vietnamese Stock Valuations Are Not attractive Now Since the country’s exports will likely decelerate in the coming months, its share prices will also likely correct. In addition, the ongoing sell-off in EM risk assets has further to run, as explained in our last report, EM: A Perfect Storm. This is a harbinger of weaker Vietnamese stock prices. What’s more, a sell-off in EM risk assets is often associated with a considerable decline in capital inflows into Vietnam – as was the case in 2015 and 2018. Those periods were negative for Vietnamese stocks as well.  Finally, valuations are not attractive either. Trailing P/E and P/Book ratios of Vietnamese stocks are much higher (21 and 3.6, respectively) compared to those of EM (14 and 1.9) and frontier market (15.5 and 2.3) stocks (Chart 14). Putting it all together, absolute-return investors should book profits on their Vietnam holdings and wait for a better entry point. Asset allocators, however, should continue to maintain their overweight positions on Vietnamese stocks, in EM, emerging Asia or frontier market equity portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1     Please refer to “Vietnam garment exports hit hard by labor shortage, disrupted supply chains, and swelled freight fares” on Textile Today Bangladesh.

Highlights Liquidity conditions in Bangladesh are easy and growth has revived. Exports are set to recover as well. Foreign reserve accumulation will continue, which will have positive implications for the economy and stock prices. Steadily rising capital expenditure has improved the economy’s productivity and competitiveness. Progress towards gender and income equality has also been impressive. Growth will stay strong and steady, which warrants higher equity multiples. Bangladeshi stocks also have low correlation with their EM and Emerging Asian counterparts, providing diversification benefits. Absolute return investors should buy this market on dips. Dedicated EM/Frontier market equity portfolios should consider overweighting Bangladeshi stocks. Feature A new business cycle appears to be unfolding in Bangladesh. Domestic demand has picked up. Exports are slated to rise as well. The country’s structural progress also continues to be impressive. Not surprisingly, stocks have gone up in tandem. Yet, high and rising oil prices may lead to a pause in the rally. Absolute-return investors with a time horizon of more than one year should therefore consider accumulating equities on dips. Dedicated equity investors should consider adding the very ‘low-correlation’ Bangladeshi equity market to an EM Asia/EM equity portfolio (Chart 1).   External Tailwinds Bangladesh’s foreign reserves have surged to a new high. This has been a very positive development for both the economy and stock prices (Chart 2). Chart 1Bangladeshi Stocks Will Benefit From Liquidity Tailwinds Bangladeshi Stocks Will Benefit From Liquidity Tailwinds Bangladeshi Stocks Will Benefit From Liquidity Tailwinds Chart 2Foreign Reserves, M1 And Stock Prices Foreign Reserves, M1 And Stock Prices Foreign Reserves, M1 And Stock Prices Chart 3Both Current And Capital Account Balances Have Improved Both Current And Capital Account Balances Have Improved Both Current And Capital Account Balances Have Improved The country’s balance of payments (BoP) has improved substantially in the last couple of years. The improvement can be attributed to both current and capital accounts: The current account deficit has narrowed significantly since 2018. The improvement will likely persist as the outlook of its two main components are both promising: Remittances have surged to an all-time high of $25 billion over the past 12-months. In the coming year too, it will likely stay buoyant thanks to a 2% incentive scheme that the government introduced on inward remittances (Chart 3, top panel). The second major component, the trade deficit, will likely stabilize. This is because exports are set to pick up, in part due to rising orders from the EU, Bangladesh’s prime export destination (Chart 4). The recent surge in trade credit inflows also implies a significant rise in export revenues in the coming months (Chart 5). That said, high oil prices, if they remain as such, will lead to higher import bills. Crude and petroproducts make up about 10% of Bangladesh’s import costs and can be a headwind to the trade balance, and by extension, stock prices. Chart 6 shows that stock prices accelerate when oil prices are low, but struggle when oil prices rise. Chart 4Strong EU Orders Means Exports Are Set To Accelerate Further Strong EU Orders Means Exports Are Set To Accelerate Further Strong EU Orders Means Exports Are Set To Accelerate Further Chart 5A Surge In Trade Credit Also Implies Strong Export Numbers Ahead A Surge In Trade Credit Also Implies Strong Export Numbers Ahead A Surge In Trade Credit Also Implies Strong Export Numbers Ahead   Capital account inflows have risen sharply too. The rise is due mainly to surging trade financing inflows (as mentioned above), and elevated government foreign borrowing (Chart 3, bottom panel). Going forward, trade financing inflows can remain at a high level if the country continues to obtain the same volume of export orders. The government’s foreign borrowing may also persist. Notably, this long-term financing is mostly used to import capital goods – something that the country needs for its investment and infrastructure projects (Chart 7). With Bangladesh’s ever-rising capital expenditure, such long-term capital inflows – either in the form of government borrowing, or FDI, or a combination of two – will likely continue. If so, this will not only help boost the country’s BoP in the short-term, but it will also be a long-term positive for Bangladesh since capital spending will help improve productivity. Chart 6Stocks Struggle Whenever Oil Prices Rise Too Much Stocks Struggle Whenever Oil Prices Rise Too Much Stocks Struggle Whenever Oil Prices Rise Too Much Chart 7Government's Foreign Borrowings Help Finance Infrastructure Projects Government's Foreign Borrowings Help Finance Infrastructure Projects Government's Foreign Borrowings Help Finance Infrastructure Projects   Overall, odds are that the BoP will stay in healthy surplus, thus allowing the central bank continue to accumulate foreign exchange reserves. This has major ramifications for the domestic economy. Rising foreign reserves augment domestic money supply. Stronger money supply is bullish for the economy, and in turn, stock prices (Chart 2, above).   Growth Has Revived Domestic demand has revived. Manufacturing has risen to well-above pre-pandemic levels. Robust economic activity is also vouched for by strong electricity generation (Chart 8). What’s more, the recovery will likely have legs as a new credit cycle could well be unfolding. For one, banks are flush with excess reserves – usually a precursor to rising credit going forward. This is because the Bangladeshi central bank uses excess reserves to achieve its monetary policy objectives1 (Chart 9). Chart 8Bangladesh's Domestic Growth Has Revived Well Beyond Pre-Pandemic Levels Bangladesh's Domestic Growth Has Revived Well Beyond Pre-Pandemic Levels Bangladesh's Domestic Growth Has Revived Well Beyond Pre-Pandemic Levels Chart 9A Deluge Of Excess Reserves Will Help Kickstart A New Credit Cycle A Deluge Of Excess Reserves Will Help Kickstart A New Credit Cycle A Deluge Of Excess Reserves Will Help Kickstart A New Credit Cycle Chart 10Banks' NPL Problems Have Abated Marginally Banks' NPL Problems Have Abated Marginally Banks' NPL Problems Have Abated Marginally Incidentally, the central bank is planning to engineer an acceleration in its domestic credit growth rate to 17.8% by June 2022, up from 10.3% in June 2021. It is also planning to augment the broad money growth to 15% from 13.6% in June 2021 as part of its 2021-22 policy objectives. That means the monetary policy setting will remain very accommodating in the foreseeable future, paving the way for a new credit cycle. Notably, the country’s inflation is under control, with both headline and core CPI hovering around 5 - 6% over the past few years. Wage growth has also been broadly in line with consumer inflation and shows no sign of accelerating. Contained wages and consumer price inflation will make the central bank’s plan to run easy policy more feasible.  Meanwhile, the banks’ bad loan problems have abated somewhat. As per the latest data from the IMF, the banking system’s gross NPL ratio has fallen to 8.1%, and its net NPL ratio to 4.6% as of Q1 this year (Chart 10, top panel). The lingering NPLs are concentrated in a handful of state-owned banks whose role in the economy has steadily diminished and which now hold about 20% of the banking sector loans. Banks' capital adequacy ratios are also decent at 11.6% and 7.8% (for Tier I capital) respectively (Chart 10, bottom panel). Hence, banks will likely be more willing to expand their loan books going forward which should help propel economy. Chart 11Bangladesh Has Notched Up Impressive Growth Without Any Credit Gush Bangladesh Has Notched Up Impressive Growth Without Any Credit Gush Bangladesh Has Notched Up Impressive Growth Without Any Credit Gush Remarkably, over the past decade, Bangladesh has been able to notch up a robust growth rate of 7%+ without any credit gush in the economy. Domestic credit, at 48% of GDP, is at the same level as it was ten years ago (Chart 11). Hence, should a new credit cycle unfold, Bangladeshi’s growth rate will likely move up a notch higher than it has been in the recent past. The country’s fiscal stance is not going to be tight either. The parliament has passed a budget for the 2021-22 fiscal year (July – June) that envisages a nominal spending growth of 6.3%. Incidentally, government debt is rather low at 23% of GDP. Including the debt held by all the public corporations (concentrated in public financial corporations), gross public debt goes up to 56% of GDP - still a manageable figure.  Real government borrowing costs are low as well. The 10-year nominal bond yield is at 6%; in real terms (deflated by non-food CPI), it is 0%. Thus, fiscal authorities have the wherewithal to ramp up borrowing and spending to stimulate the economy should there be a need. Robust Structural Backdrop Structurally, the Bangladeshi economy is remarkably resilient. The growth rate has not only been very steady but has also seen acceleration over the past quarter century. This is in sharp contrast to the boom-and-bust cycles experienced in most other developing nations (Chart 12). Even during the recent pandemic, Bangladesh has been one of the rare countries where growth has remained positive. Importantly, factors behind this stable growth are likely to persist: Bangladesh has done very well to ramp up its capital expenditure to a substantial 32% of GDP, one of the highest rates globally (Chart 13, top panel). This has helped the economy gain competitiveness over time – which is evident in the continued improvement in its net exports volume (Chart 13, bottom panel). Chart 12Bangladeshi Economy Has Been Devoid Of Boom-Bust Cycles Bangladeshi Economy Has Been Devoid Of Boom-Bust Cycles Bangladeshi Economy Has Been Devoid Of Boom-Bust Cycles Chart 13Strong And Rising Capex Has Led To Higher Competitiveness Strong And Rising Capex Has Led To Higher Competitiveness Strong And Rising Capex Has Led To Higher Competitiveness   Strong capex has also been instrumental for the economy to grow at a very robust 6-7% rate for decades at a stretch and yet keep inflation under control. This indicates that productive capacity and labor productivity have been rising. Inflation is often a binding constraint to fast growth over a prolonged period of time. Bangladesh’s productivity growth rates have indeed risen to among the highest rates globally, the pandemic-hit last year being a deviation from the long-term trend (Chart 14). What’s more, given the sustained investment in productive capacity and the still low absolute level of labor productivity – compared to other East and South-east Asian economies – Bangladesh should continue to see robust productivity gains in the foreseeable future. Bangladesh specializes in a staple consumer product: textiles. Rising productivity has helped export volumes quintuple over the past two decades; handily beating both emerging markets and global exports volume growth. Incidentally, in common currency terms, the relative wage ratio between Bangladesh and China has been flat at a low level. This has helped Bangladesh remain competitive and continue to expand its global export market share (Chart 15). Chart 14Bangladesh's Productivity Growth Rate Is Among The Best Globally Bangladesh's Productivity Growth Rate Is Among The Best Globally Bangladesh's Productivity Growth Rate Is Among The Best Globally Chart 15Bangladesh Has Been Consistently Gaining Market Share In Global Trade Bangladesh Has Been Consistently Gaining Market Share In Global Trade Bangladesh Has Been Consistently Gaining Market Share In Global Trade   The country’s demographic outlook is also positive. The working age population as a share of the total is projected to rise for another decade.2 Together, strong productivity growth and a rising labor force will ensure an enviable potential growth rate of around 7 - 8% over the next decade. Inclusive, Sustainable Growth Economic factors aside, strong and steady growth in Bangladesh also owes much of its achievements to social progress. Over the past few decades, the country has attained significant improvements in various human development areas: Bangladesh boasts of one of the highest female participation rates in its labor force in the Muslim world. At 36%, this is almost twice as high as the Middle East & North Africa (20%), Pakistan (22%), and neighboring India (21%) – as per the World Bank. In the fledgling textile industry in Bangladesh, over 75% of workers are women. The country pioneered microcredit, which by design mostly goes to women. The social fabric of the country is changing as women are now much more likely to make family / economic decisions. Spending on children’s food, health and education has gone up. Women’s fertility rates have gone down significantly. At the same time, infant / maternal mortality rates have witnessed one of the fastest declines seen anywhere globally.   Chart 16Bangladesh’s Income Inequality Has Remained Low As Growth Has Been Inclusive Bangladeshi Equities: Buy On Dips Bangladeshi Equities: Buy On Dips Bangladesh’s income inequality – as measured by the Gini index – is one of the lowest in the world (Chart 16). What’s more, despite strong growth, inequality has not risen over the past 25 years. This is in stark contrast to many other advanced and developing countries. Such inclusive growth has rendered the society more equitable, making growth itself more sustainable. Bangladeshis have largely embraced their more liberal linguistic identity over their religious identity. For context, Bengali-speaking Bangladesh was born out of an extremely violent secession from the Urdu-speaking people of Pakistan in 1971 as the former realized that culturally their linguistic identity supersedes their religious identity.3  As such, the vast majority of Bangladeshis practice a moderate form of Islam. This factor has helped to encourage such social changes as the empowerment of women and the expansion of microcredit as religious / cultural opposition has been low. These major traits of this society, including those of gender and income equality, are likely to persist in the foreseeable future. Therefore, odds are that the strong growth will continue to remain inclusive and therefore sustainable. Investment Conclusions The Bangladeshi equity market exhibits a very low and often a negative correlation with both the EM and Emerging Asian markets. In particular, periods of global risk aversions, such as in 2014-15 and early 2020 saw the correlations turn negative. This increases market attractiveness to asset allocators as it will allow them to reap diversification benefits (Chart 17). That said, this bourse has risen significantly over the past year or so and has outperformed its EM counterparts (Chart 1 in page 1). Its valuations have also risen and are now on par with their EM peers (Chart 18). As such, there could well be a period of indigestion / consolidation – especially if our view of a stronger dollar and rising US bond yields transpires, and oil prices remain elevated over the next several months. Chart 17Bangladeshi Stocks' Correlation With EM Turns Negative During Bear Markets Bangladeshi Stocks' Correlation With EM Turns Negative During Bear Markets Bangladeshi Stocks' Correlation With EM Turns Negative During Bear Markets Chart 18Bangladeshi Stock Valuations Have Risen, But Are Not Excessive Bangladeshi Stock Valuations Have Risen, But Are Not Excessive Bangladeshi Stock Valuations Have Risen, But Are Not Excessive   Putting it all together, we recommend that absolute return investors with a time horizon of over one year should adopt a strategy of ‘buying on dips’ for Bangladeshi stocks. Dedicated EM/frontier market equity portfolios should consider overweighting Bangladeshi stocks. Finally, regarding the currency, the Bangladeshi taka will likely remain more or less stable over the next year or so. The taka rarely depreciates unless the country’s BoP begins to deteriorate materially. As explained above, that is not in the cards. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Bangladeshi central bank tries to control the ‘quantity’ of money/credit, rather than the ‘price (i.e., interest rate)’ to conduct its monetary policy. To explain, it controls the ‘reserve money’ growth and thereby impact the ‘broad money (M2)’ growth - to achieve its objectives on economic growth, inflation, and the exchange rate. 2 As per the United Nations’ World Population Prospects 2019. The same metric for Vietnam, Bangladesh’s main exports competitor, has peaked in 2015. 3 For a detailed account of the geopolitical outlook of Bangladesh and the larger South Asia, please see South Asia: A New Geopolitical Theatre from BCA’s Geopolitical Strategy team.

Highlights Kenyan financial markets will sell off considerably ahead of the presidential elections next August given the backdrop of very weak growth, a rising public debt-to-GDP ratio and growing odds of a shift away from orthodox macroeconomic policies. We do not think that the IMF-imposed fiscal austerity program will stabilize public debt dynamics. Kenya is currently experiencing an unprecedented political change from ethnic politics to class-based confrontation. Such a shift will raise the probability of populist policies following the elections. Besides, both main presidential candidates are advocating for the abandonment of fiscal and monetary austerity. This bodes ill for sovereign credit and the exchange rate. Feature Deflationary forces stemming from substantial fiscal austerity and potential political volatility ahead of the presidential elections next August will produce a major growth disappointment in Kenya in the coming 12 months. Dismal growth will depress share prices. Underwhelming nominal GDP growth and a rising public debt-to-GDP ratio warrants wider Kenyan sovereign credit spreads. The impact on the exchange rate is more complicated. In the short run, the currency could be supported by high real rates and tight fiscal policy. Yet, potential political volatility and associated capital flight amid large twin deficits will weigh on the exchange rate. In the long run, the only way for the nation to stabilize the public debt-to-GDP ratio is to boost nominal growth and bring down interest rates. This will herald currency depreciation. Unsustainable Public Debt Dynamics Chart 1Kenya: Negative Fiscal Thrust Ahead Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now With guidance from the IMF, the government has adopted fiscal austerity that commenced in fiscal year (FY) 2020/21 and is expected to last into FY 2023/24. The primary fiscal thrust will be -1.8% of GDP and -1.6% of GDP for FY 2021/22 and FY 2022/23, respectively, according to IMF estimates (Chart 1). This constitutes an enormous fiscal drag on the Kenyan economy. This fiscal straitjacket has been imposed in response to dire state finances and worsening public debt dynamics. Specifically: Public debt has risen considerably over the past decade from 35% to close to 70% of GDP (Chart 2, top panel). Kenyan authorities have borrowed heavily, in both local and foreign currencies, to finance various development projects (Chart 2, bottom panel). Yet, the government has failed to generate adequate revenues to service its debt. Notably, tax and overall government revenues have been falling relative to GDP (Chart 3). Chart 2Kenya: Public Debt Has Doubled Over The Past Decade Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Chart 3Kenya: Lackluster Government Revenues Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now More worryingly, interest expenditures on public debt consume 28% of revenues and 18% of government expenditures (Chart 4). Meanwhile, interest on foreign currency debt makes up 15% of total exports. All these ratios are high. Chart 4Kenya: Interest Payments On Public Debt Are High Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Lastly, debt restructuring among state-owned enterprises1 (SOEs) will further raise public debt. In short, Kenya’s public debt has increased significantly, forcing authorities to enact fiscal austerity measures to appease the country’s creditors. Fiscal Austerity Will Dampen Growth… We do not believe that the fiscal austerity program imposed by the IMF will help achieve fiscal sustainability. Both IMF and government projections for nominal growth, fiscal revenues and public debt are too optimistic given the weak state of the economy and tightening fiscal and monetary policies. Primary fiscal spending is expected to grow by only 1.6% in nominal terms in FY 2021/22. Meanwhile, nominal GDP and government revenue are projected to grow by 10% and 11%, respectively, in FY 2021/22. Consequently, the government expects to improve the primary budget balance from a deficit of 4.6% of GDP in 2021/22 to a primary surplus by FY 2023/24 (Chart 5). Specifically, nominal GDP and government revenues will underwhelm because: First, fiscal austerity amid a feeble economic recovery will materially depress nominal growth and government revenues/taxes. As a result, the nation will not meet its budget balance targets and the public debt-to-GDP ratio will continue to rise. Core inflation measures are at the lower end of the central bank target range of 2.5% to 7.5% (Chart 6). Lower inflation implies that nominal GDP growth will fall short of government projections for next year. Besides, government expectations of improved tax collection in such a short time span are unrealistic. Chart 5Kenya: Dire State Finances Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Chart 6Kenya: High Headline CPI Will Prevent The Central Bank From Cutting Rates Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Chart 7Kenya: The Banking System Is In A Dire State Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Second, interest rates are very high in real terms (adjusted for core CPI) for the current state of the economy. Notably, diverging headline (high due to sharply increased food and energy prices) and core CPI (very low due to very subdued domestic demand) makes it unlikely that the central bank will chose to cut interest rates anytime soon (Chart 6). High government bond yields, large non-performing loans and a weak economy will incentivize commercial banks to buy government bonds rather than lend to the private sector (Chart 7). This will hinder household and business spending. Third, the government has reinstated higher personal, corporate and VAT tax rates to pre-pandemic levels. These de-facto tax increases will hurt both consumer and business incomes and confidence. With tight fiscal policy and high lending rates in real terms, domestic demand will fail to recover. The uncertainty over next year’s election outcomes will entice domestic firms to delay their capital expenditure plans. This also bodes ill for an economic recovery. Fourth, delays in vaccine procurement will allow COVID-19 variants to continue spreading across the country. In addition, vaccination rates in Kenya will remain depressed due to vaccine hesitancy and the significant mistrust of the government. Bottom Line: A substantial growth recovery will fail to materialize under fiscal austerity, high real lending rates and election uncertainty. Nominal GDP growth will underwhelm in the next 12 months. …And Fail To Stabilize Public Debt Dynamics The two pre-requisites to cap the rise in the public debt to GDP ratio – (1) running continuous primary fiscal surpluses and/or (2) having nominal growth above government borrowing costs – will not be met in Kenya for now. First, projected small primary surpluses will not materialize as nominal GDP and government revenue growth underwhelm. Second, as the central bank will be forced to keep high interest rates, nominal GDP growth will remain below government borrowing costs. Chart 8Kenya: Large Current Account Deficit Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now The central bank will be reluctant to reduce interest rates meaningfully despite very low core inflation and weak real GDP growth. The basis is that monetary authorities will fear that the Fed’s tapering and potential political volatility in Kenya could lead to considerable currency depreciation. Notably, dwindling FDI amid political uncertainty will force the central bank to maintain high interest rates to attract foreign portfolio capital. The latter are needed to finance a still sizable current account deficit (Chart 8). Overall, local interest rates will remain higher than is warranted by fundamentals. As a result, the public debt-to-GDP ratio will continue to rise due to elevated interest rates and disappointing growth. Bottom Line: Very low nominal GDP growth amid high government borrowing costs as well as the need to take over SOE debt will result in a wide fiscal deficit and a rising debt-to-GDP ratio. Political Volatility And A (Post-Election) Shift To Populism Chart 9Elections = Currency Depreciation Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now In the next 12 months, the current government is unlikely to abandon fiscal austerity. The fragmentation within the Jubilee coalition government will not produce a shift away from fiscal austerity. Besides, President Kenyatta has been a vocal supporter of orthodox economic policy in recent years. Yet, a key contender for next year’s presidential elections, deputy President William Ruto, is a fierce critic of fiscal austerity (and of the IMF). He has already been running a populist campaign calling for a more equitable society and a redistribution of income and capital in favor of the poor. His campaign slogan “Hustlers nation vs. Dynasties”2 is already gathering support amongst lower income young voters whilst creating socio-political tensions within the country. Similarly, opposition leader Raila Odinga has been a long-time critic of the IMF’s fiscal austerity. His recent comments also call for more fiscal spending. In brief, neither presidential candidate is likely to follow through with fiscal austerity upon being elected. Historically, past Kenyan election outcomes have been determined by “tribal power brokers” who garnered inter-ethnic alliances. This election cycle, however, will be dominated not by ethnic and tribal politics but rather by social and class-based hostilities possibly leading to some violence. This unprecedented shift in Kenyan politics from ethnic to class-based confrontation will raise the probability of populist policies following the elections next August. This will likely cause capital flight from the country’s elites who stand to lose from the more redistributive “neo-Marxist” ideas proposed by William Ruto. Remarkably, Kenya has been mired in violence, political instability, and large gyrations in domestic financial markets both before and after past elections (Chart 9). Investment Conclusions Chart 10Kenyan Sovereign Spreads Will Widen Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Sovereign credit: Avoid/underweight (Chart 10). We recommend investors go long Egyptian / short Kenyan sovereign credit. The report on Egypt can be found here. Stocks: Avoid/Underweight within an EM equity portfolio. Currency: The currency will depreciate versus the US dollar in the next 12 months.   Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes 1 These include, Kenyan Airlines, Kenyan Airport Authority, Kenyan Railways Corporation, Kenyan Power and Lighting Company, Kenyan Electricity Generating Company, Kenyan Port Authority and three of the largest universities. 2 “Hustlers” relates to young, less economically fortunate citizens, while “Dynasties” designates the wealthy families that have ruled the country since independence in the 1960s. Both President Kenyatta and opposition leader Raila Odinga are said to come from the “Dynasties”, whereas William Ruto comes from the “Hustlers” group. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Authorities will be reluctant to devalue the currency this year to avoid a pass-through of higher global food prices into domestic food prices. Yet, chronically underwhelming economic growth will ultimately force the government to abandon tight fiscal and monetary policies and adopt a pro-growth agenda. A part of such a policy shift will be currency devaluation. Egypt’s productivity gains will be limited, which will keep potential GDP growth tame. A major buying opportunity in Egyptian local currency bonds, sovereign credit and equities will follow on the heels of currency devaluation. Feature The Egyptian government is facing a dilemma between tolerating very weak economic growth and a rising public debt burden on the one hand and currency devaluation on the other hand. In the near-term, they will continue pursuing tight fiscal and monetary policies to avoid currency devaluation. However, over a long-run time horizon, the dismal productivity outlook leaves them with no option except to ease fiscal policy and reduce interest rates substantially to boost (nominal) growth. The upshot will be significant depreciation pressure on the exchange rate. No Appetite To Devalue … Yet Chart 1Rising Food Prices Is A Major Constraint To Currency Devaluation Egypt: A Policy Dilemma Egypt: A Policy Dilemma Over the near-term, Egyptian authorities will not devalue the currency because of the following: Rising food prices carry both economic and socio-political risks. Egypt imports 62% of its wheat and 60% of its corn consumption. Global food prices have risen sharply in the past 12 months. Devaluing the pound would exert pain on household budgets by raising the price of key imported grains in local currency terms (Chart 1). Higher food prices can reduce popular support for the government and heighten socio-political instability. Provided that food accounts for 35% of the consumer basket, rising food prices will curtail disposable income left after food expenditures. In turn, that will depress non-food household spending with negative implications for the entire economy.  In brief, macro economic policy choices are presently constrained by high global food prices and the country’s large dependence of food imports. Currency devaluation is currently not a palatable political option. Structurally, Egypt’s domestic agricultural production is unable to meet its domestic consumption needs. Food insecurity has socio-political ramifications and also affects macro policy choices available to and made by authorities (for a more detailed discussion on food insecurity, please refer to Box 1).  Box 1 Food Insecurity In the coming years, Egypt will continue to encounter severe challenges in food production and, hence, securing sufficient supplies of food for its rising population. Over the past decade, only 5% of overall investments went into agriculture while private investments into agriculture fell. This has resulted in stagnant agriculture productivity. Chart 2 illustrates that output per area harvested of wheat, corn and rice has been flat over the past decade. Of greater concern is the fact that wheat and corn production per capita have been falling while their consumption per capita has been rising (Chart 3). Faced with a projected population increase of 30 million by 2030 (from 100 million to 130 million), Egypt will be forced to spend more on food imports. Thus, these dynamics will expose Egypt even further to global food price fluctuations. In addition, Egypt faces a severe risk of fresh water shortages due to the Grand Ethiopian Renaissance Dam (GERD) construction on the Nile by Ethiopia. Critically, Egypt relies almost entirely on this source of water from the Nile for agriculture. Any major resolution appears unlikely to be reached between Egypt and Ethiopia. In particular, Ethiopia views the dam as part of its own national economic interests in the region. Above all, Ethiopia will not be materially pressured by the US or Europe to back down from its own national economic interest surronding the dam, as has been argued by BCA Research’s Geopolitical Strategy Service. Abroad, President Biden is focused on restoring relations with Iran and countering Chinese and Russian regional ambitions, while not showing major interest in the Horn of Africa. The Europeans, for their part, will not react too punitively towards Ethiopia, not wishing to destabilize Ehtiopia’s stability for now.  Bottom Line: There are risks that Egypt’s food production per capita could decline due to shortages of fresh water in the years ahead. In such a scenario, the nation’s food insecurity will rise and will have ravaging effects on Egypt’s balance of payments and the economy as well as might also lead to socio-political distress. Chart 2Egypt: Stagnant Crop Productivity Egypt: A Policy Dilemma Egypt: A Policy Dilemma Chart 3A Large Gap Between Food Production And Consumption Egypt: A Policy Dilemma Egypt: A Policy Dilemma Chart 4Egypt: A Large Portion Of Foreign Debt Obligations Is Owed To Bilateral Creditors Egypt: A Policy Dilemma Egypt: A Policy Dilemma At $14.5 billion for the next six months, foreign debt obligations are manageable (Chart 4). FDOs measure the sum of maturing short-term claims, interest payments and amortization over the next 6 months. Two thirds of FDOs are composed of short-term banking claims that can be extended/rolled over. Meanwhile, amortization and interest payments make up about $5 billion of the FDOs due over the next six months. Critically, three-quarters of these payments are owed to bi-and multi-lateral creditors. Egypt’s bi-lateral partners include Gulf states as well as the IMF and the World Bank. All of them have an interest in the country’s stability and are likely to roll over Egypt’s debt. Even though the central bank’s net foreign currency reserves are only $14 billion, its gross reserves are $39 billion (Chart 5). Additionally, if needed authorities may request additional financing from their bi-and multi-lateral creditors to preclude a major currency depreciation in the coming months. The current account deficit will not widen in the coming months (Chart 6, top panel). Exports will benefit from high natural gas and oil prices (Chart 6, bottom panel). Energy represents 32% of the nation’s exports. Chart 5Egypt: FX Reserves Are Above 2016 Devaluation Levels Egypt: A Policy Dilemma Egypt: A Policy Dilemma Chart 6Egypt: Current Account Will Improve With Rising Nat Gas Prices... Egypt: A Policy Dilemma Egypt: A Policy Dilemma   Besides, tourism revenues will improve later this year as European travellers, who represent two-thirds of tourist entries, resume vacationing amid a broadening rollout of vaccines. Further, remittances have remained resilient in the face of the pandemic (Chart 7, top panel). In the meantime, export revenues from transportation – primarily, from the Suez Canal – will be bolstered by booming global trade (Chart 7, bottom panel). In turn, tame fiscal spending and high real lending rates will keep a lid on domestic demand and, thereby, imports (Chart 8). Chart 7...And Rising Remittances And Transport Revenues Egypt: A Policy Dilemma Egypt: A Policy Dilemma Chart 8Egypt: High Real Interest Rates Are Weighing On Growth Egypt: A Policy Dilemma Egypt: A Policy Dilemma Chart 9Egypt: Real Bond Yields Are High Egypt: A Policy Dilemma Egypt: A Policy Dilemma Lastly, multi-decade low inflation, fiscal and monetary prudence, and high real bond yields will preclude large foreign outflows from local currency government bonds (Chart 9). This will help the government to avoid currency devaluation. Remarkably, the overwhelming majority of foreign portfolio inflows have been into domestic bonds, not equities. Therefore, as long as investors in local currency bonds do not flee, the authorities will manage to avoid devaluation. Besides, Egypt offers one of the highest real bond yields in EM, and as such offers value to investors in an environment of low global yields (Chart 9). Bottom Line: Authorities will be reluctant to devalue the currency this year to avoid a pass-through of higher global food prices into domestic food prices. They will do everything they can to defend the exchange rate in the coming months, including requesting more US dollar financing from bi-and multi-lateral creditors and possibly hiking domestic interest rates. An Unsustainable Macro Policy Mix Chart 10Egypt: Nominal GDP Growth Needs To Be Above Borrowing Costs Egypt: A Policy Dilemma Egypt: A Policy Dilemma Beyond the next six months or so, authorities will be compelled to choose between tolerating very weak economic growth and the rising public debt burden on the one hand and currency devaluation on the other hand. The rationale is as follows: Egypt has pursued very high interest rate policy to attract portfolio capital and preclude exchange rate depreciation. Interest rates in real terms have been extremely high (Chart 9 above). This has depressed economic activity and inflation. In fact, nominal GDP growth has fallen well below nominal government bond yields, lethal dynamics for public debt sustainability (Chart 10). We elaborated on Egypt’s public debt sustainability in our report from June 10th, 2020 and concluded that its public debt dynamics are on a dangerous trajectory due to elevated interest rates. Egypt needs to bring down local interest rates substantially and rapidly. In so doing, the central bank will lose control of the exchange rate. This analysis remains valid today. With interest payments on public debt consuming 50% of government revenues, 35% of government expenditures and 10.5% of GDP (Chart 11), high domestic interest rates are unsustainable in the long run. Given that local currency government debt makes up 80% of total public debt, lower domestic interest rates are critical to reduce interest payments on government debt and stabilize the public debt-to-GDP ratio which at the end of 2019 stood at 100% of GDP – the latest for which data is available. Tight fiscal policy has been, and will continue to be, used to cap the rise in public debt. The government is expected to run a primary fiscal surplus equivalent to 1.5% of GDP for the 2021/22 fiscal year (Chart 12). Chart 11Egypt: Interest Payments On Public Debt Are Enormous... Egypt: A Policy Dilemma Egypt: A Policy Dilemma Chart 12...Leaving Little For Fiscal Spending Egypt: A Policy Dilemma Egypt: A Policy Dilemma   Yet, depressed government non-interest spending is capping nominal income growth and contributes to lower GDP growth. Overall, tight monetary and fiscal policies are not sustainable in the long run as they will continue to depress income growth, ultimately resulting in socio-political discontent. Given that the productivity outlook remains dismal (please refer to the section below), the only option to boost (nominal) growth is to ease fiscal policy and reduce interest rates substantially. The upshot will be significant depreciation pressure on the exchange rate. Fiscal and monetary easing along with currency devaluation will boost nominal GDP growth, pushing it above borrowing costs. In time, the public debt-to-GDP ratio will stabilize due to a faster rising denominator. This will remove the constraint on fiscal policy, allowing the government to abandon fiscal austerity and meaningfully boost public sector wages, various subsidies and social benefits (Chart 13). This will also allow, authorities to counter rising food prices with greater outlays to support lower-income households. Importantly, the split between local and foreign currency denominated public debt is 80% and 20%. The majority of local currency public debt is held by domestic institutions and local banks (Table 1). Foreigners own only 15% of government local currency bonds. Thus, local institutions will blunt the impact of foreign selling amid fears of currency devaluation. Chart 13Egypt: Fiscal Spending Has Been Downshifting For Several Years Egypt: A Policy Dilemma Egypt: A Policy Dilemma Table 1Egypt: Composition Of Domestic Bond Holdings Egypt: A Policy Dilemma Egypt: A Policy Dilemma   Meanwhile, loans from international and bilateral organizations account for three-quarters of foreign currency public debt. These can be restructured, and debt servicing can be delayed, providing fiscal authorities with some breathing room. Bottom Line: Chronically underwhelming economic growth will ultimately force the government to abandon tight fiscal and monetary policies and adopt a pro-growth agenda. A part of such a policy shift will be currency devaluation. No Structural Growth Improvement Chart 14Egypt: Structural Deficiencies Egypt: A Policy Dilemma Egypt: A Policy Dilemma The only way an economy can grow faster in an environemnt characterized by tight fiscal and monetary policies and no currency devaluation is via higher productivity growth. Odds of higher productivity growth in Egypt are low. The nation has not implemented the structural reforms necessary to improve productivity growth.  Egypt’s structural vulnerabilities, namely depressed investment, an uncompetitive manufacturing sector and a lack of skilled labor, will all hinder productivity gains (Chart 14). Privatization plans for most SoEs have been canceled or delayed. Only one major state asset has been sold to private entities since 2015. Nevertheless, some recently enacted reforms will incentivize foreign companies to increase investment in some key strategic sectors, particularly in the oil & gas sector. For instance, all foreign firms which are now able to own 100% of their investments in Egypt, have the ability to repatriate all of their capital and profits and have been offerred guarantees against nationalisation and price controls on goods. Bottom Line: Egypt’s productivity gains will be limited, which will keep potential GDP growth tame. As a result, the economy can only rely on the reflationary push from fiscal and monetary policies and currency devaluation to achive higher (nominal) growth. Investment Conclusions The Egyptian pound’s valuations are presently neutral (Chart 15). Authorities are unlikely to devalue the exchange rate in the coming months. This creates a window of opportunity to collect the carry by being long currency bonds without hedging currency risk. That said, Egypt’s domestic bond yields could rise along with US bond yields (Chart 16, top panel). Chart 15Egypt: Currency Is Fairly Valued Egypt: A Policy Dilemma Egypt: A Policy Dilemma Chart 16Egypt: High Carry But Yields Could Rise Alongside US Yields Egypt: A Policy Dilemma Egypt: A Policy Dilemma   Nevertheless, in the long run, a major currency devaluation is likely as continued fiscal and monetary austerity, a depressed economy and rising public debt are not viable options for the government. Substantial fiscal and monetary easing will be required to reflate the economy. The upshot of this will be a considerable currency devaluation. Chart 17Egypt: Wait For Reflationary Policies To Upgrade Equities Egypt: A Policy Dilemma Egypt: A Policy Dilemma Concerning US dollar bonds, dedicated EM credit portfolios should remain neutral on Egypt. In the near term, spreads could widen as public debt stress builds up amid very weak nominal GDP growth. In the long term, currency devaluation will be a trigger to go long/overweight this sovereign credit. Finally, equity investors should continue avoiding this stock market until authorities adopt reflationary policies and devalue the exchange rate (Chart 17). Fiscal easing and lower interest rates will herald higher nominal growth and will be conducive to higher share prices.   Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com

Highlights Massive fiscal deficits and high borrowing costs have led the government into a debt trap: interest payments alone cost the exchequer nearly half its revenues. Pursuing a tight fiscal and monetary policy now reduces the country’s chances of extricating itself out of a debt trap. Foreign capital inflows have dried up, while the current account is set to deteriorate. Another balance of payment crisis looks increasingly likely. Foreign investors should stay away from Pakistani assets. Feature Pakistani stocks have massively underperformed their Emerging Markets counterparts over the past several years (Chart 1). They have become very cheap too. Is it the right time for investors to get in there? Or, is it a value trap? Our analysis suggests that it’s the latter. The government has fallen into a debt trap. It will likely take a long time and significant currency devaluation before the country gets its macro affairs back in order. Investors, therefore, should stay away from Pakistani assets. The Debt Trap Pakistan’s fiscal deficit, at 9% of GDP, is one of the highest among emerging economies. Notably, it’s not the pandemic-time expenditure that caused it to swell. Deficits had already ballooned to 10% of GDP by mid-2019 (Chart 2). Chart 1Pakistani Stocks' Massive Underperformance Reflects A Dire Fiscal Situation Pakistan, Trapped Pakistan, Trapped Chart 2Years Of Massive Fiscal Deficits Have Led The Government To A Debt Trap... Pakistan, Trapped Pakistan, Trapped Chart 3...As Interest Payments Alone Cost The Exchequer Half The Fiscal Revenue... Pakistan, Trapped Pakistan, Trapped Rampant fiscal deficits over the years have caused the country’s government debt to soar. At 87% of GDP (Chart 2, bottom panel), the federal debt has already become untenable because borrowing costs are very high. Worse, it is set to rise further in the coming years: The interest payments on public debt alone cost the country 45% of its total fiscal revenues every year. If defense spending is added, that figure reaches to two-thirds of fiscal revenues (Chart 3). This is clearly unsustainable as the government is left with little resources for developmental expenditure. The latter’s share in total expenditure has shrunk to a measly 12% (Chart 4). The meager developmental spending in productive capacity and infrastructure - both hard and soft - stymies an economy’s sustainable growth potential. Pakistan’s private sector capital spending, at just 10% of GDP, is also abnormally low. The underinvestment results in lower growth – which in turn, jeopardizes future tax revenues. That compels the government to borrow even more, and thereby incur even higher interest expenses – completing a vicious cycle. This is indeed what has happened: tax revenue growth has been cascading down over the past decade. Incremental revenues in the recent past have been clearly inadequate to cover the government’s debt servicing because borrowing costs have been high (Chart 5, top panel). The result is additional borrowing to pay interest on the existing debt. Chart 4...Leaving Little For Capital Spending, Which Fuels Inflationary Pressures Pakistan, Trapped Pakistan, Trapped Chart 5When Revenue Growth Can't Pay For Borrowing Cost, The Currency Sells-Off Pakistan, Trapped Pakistan, Trapped   Rising current fiscal expenditure relative to developmental expenditure creates another problem: inflation. The reason is, higher current expenditure fuels demand for goods and services, while lower developmental/capital expenditure stifles their supply in the long run. Pakistan’s depleted capital stock has made the situation worse. Every time current expenditure surges relative to developmental expenditure, core inflation rises. The middle panel of Chart 4 shows that after a short break due to the pandemic, core inflation is set to rise again.  Incidentally, it is the producer price inflation that leads the country’s overall inflation dynamics. This is because, being an underinvested economy, the supply side/producers have pricing power. Any rise in costs therefore can be easily passed on to the consumers. The bottom panel of Chart 4 shows that PPI inflation leads core consumer price inflation at every turn. This also means that core CPI will follow PPI higher in the months to come. To sum it up, Pakistan is heading towards a stagflation quagmire: not only is the country stuck in low growth, but also its core inflation will rise.    The government’s borrowing costs (bond yields) are highly sensitive to inflation, especially to producer price inflation. The latter has accelerated and is approaching 10%; bond yields have begun to rise in tandem (Chart 6). This will cause the gap between the government’s revenue growth rate and the borrowing costs to become more adverse. Chart 6Government's Borrowing Cost Will Rise More As Inflation Is Rising Pakistan, Trapped Pakistan, Trapped This widening gap has investment implications. During stressful times when fiscal revenue growth rate falls significantly below borrowing costs, the currency typically takes the hit (Chart 5, bottom panel) The reason for that is, when this happens, investors become skittish about the sustainability of the country’s fiscal health and head for the exit. As capital leaves, the nation’s balance of payments dwindles – weighing on the exchange rate. Pakistan’s perennial primary fiscal balance deficits also tell a similar story, but from a different angle. Chart 7shows that even if one excludes interest payments, the country’s fiscal revenues always falls short of non-interest expenditures. The upshot is more borrowing to be able to pay for the non-interest spending. In brief, Pakistan is being compelled to borrow more not only to repay old obligations, but also to pay a rising amount on the interest on old loans. As such, the country’s fiscal position is on an unsustainable path. What’s important from an investor’s point of view is that fiscal dynamics have a major impact on the currency, and the present level of high deficits warrants a much weaker currency (Chart 8). Chart 7Fiscal Revenues Always Fell Short Of Even Non-Interest Expenditure Pakistan, Trapped Pakistan, Trapped Chart 8High Fiscal Deficits Usually Lead To A Weaker Currency Pakistan, Trapped Pakistan, Trapped   The Policy Headwind The question then is, can the country grow its way out of this debt trap? The answer is, it’s doubtful. One reason it’s doubtful has to do with the restrictive policies Pakistan is pursuing as part of the IMF bailout terms.1 The authorities are raising taxes; they are also curtailing government spending. The immediate incentive for doing so is to raise fiscal revenues enough to plug the primary deficits. The IMF also favors raising interest rates. The rationale for that is both consumer and producer price inflation rates are approaching 10% and rising, while policy rate is only at 7%. Yet, it’s far from clear how pursuing tighter fiscal and monetary policies will be able to revive an economy skirting with recession. The IMF itself expects the country to grow at only 1.5% for the year ending June 2021. Chart 9Higher Interest Rates Are Bad News For Both Credit Growth And GDP Pakistan, Trapped Pakistan, Trapped Interest rates are a major driver of growth in Pakistan. This is because the loan demand in the country is highly sensitive to borrowing costs. As the top panel of Chart 9 shows, periods of rate cuts (shown inverted in the chart) materially boosted bank credit. Similarly, the periods of rising rates lead to decelerating credit. Bank credit, in turn, has a strong impact on economic growth. Periods of accelerating credit coincided with accelerating GDP, and vice-versa (Chart 9, middle panel). In effect therefore, it’s the interest rates that cause the ebbs and flows in this economy (Chart 9, bottom panel). Hence, if policy rates are raised materially going forward, that will be a formidable headwind for the economy. Fiscal spending, on its part, is the prime driver of the country’s money supply. This is because at around 24% of GDP every year, fiscal expenditures far outweigh the annual incremental bank credit in Pakistan. When fiscal deficits are financed by commercial banks and the central bank, money expands. As such a reduction in fiscal deficit will decelerate money supply. Indeed, once the effect of pandemic-time de facto QE that led to a surge in money supply wears off, there will be a meaningful slowdown in money growth – as fiscal expenditure has already decelerated significantly (Chart 10). A slowing money supply is indicative of a slowing economy. The only way Pakistan could escape the debt trap is via a strong and sustained economic (and fiscal revenue) recovery. But the authorities are adopting policies that will do the exact opposite: curtailed government spending and slower money/credit will hinder growth – at least in the near term. Meanwhile, the state of the economy remains fragile. Production levels of steel and automobiles are far below the pre-pandemic peak (Chart 11). The same is true for the overall manufacturing sector. Chart 10Curtailing Of Fiscal Spending Will Lead To Slower Money Growth Pakistan, Trapped Pakistan, Trapped Chart 11The Economy Remains Fragile, With Manufacturing Far Below Pre-Pandemic Levels Pakistan, Trapped Pakistan, Trapped   Tighter fiscal and monetary policies to gratify the IMF program requirements at this juncture are going to short-circuit the recovery. Subdued growth, in turn, entails lower tax revenues. That means, primary balance will remain in substantial deficit – leading to even higher debt-to-GDP ratio. In sum, it will be very difficult for the government to grow its way out of the debt trap by pursuing tight macro policies. The External Mirage The next question then is, can external financial aids and loans help Pakistan to wiggle out of the debt trap? Again, the answer is, unlikely. Pakistan’s balance of payment (BoP) appears to have improved over the past year. But a closer scrutiny reveals that this improvement is fleeting: Part of the progress in BoP stems from the current account. Overseas workers’ remittances surged by 30% from a year ago in dollar terms. Trade deficit also improved as imports sank due to COVID-19 lockdowns. Neither of the above will persist. Remittance growth will come back to more realistic levels since most of the reasons for the surge were one-off in nature (See Box 1). As the economy reopens, imports will rise closer to pre-pandemic levels, further widening the trade deficit in the process. BOX 1 The Surge In Remittance Will Not Persist  Pakistan government data shows that 47% more Pakistanis went overseas for employment in 2019 than in 2018. This must have a major, but one-off effect on remittances’ annual growth in 2020. The World Bank attributes the 2020 increase to the ‘Hajj effect’: a sharp reduction in Hajj visas by Saudi Arabia allowed Pakistani migrants remitting home the money saved for the pilgrimage. The sharp rupee depreciation in 2018-19 also encouraged migrant workers to send more money home in 2020. Finally, the Pakistani government gave tax incentives to boost remittances by cutting withholding tax on bank transfers in July 2020. This might have encouraged both genuine remittances as well as to disguise some exports revenues as remittances to take tax benefits.  Notably, the rupee is once again becoming a headwind for trade. The reason is accelerating inflation – which is making real exchange rates more expensive. An expensive rupee makes the country’s businesses less competitive and hurts trade balance. In fact, trade balance has already begun to deteriorate following the appreciating real effective exchange rate. All this means the days of current account surplus are over (Chart 12). In terms of the financial account, the recent deterioration is more emblematic of the country’s core problems. A look at the components of the financial account would reveal that net FDI inflows have long been meagre at about 1% of GDP, despite Chinese investments in several Belt and Road Initiatives in Pakistan. Portfolio inflows have been negative (Charts 13). The only reason the financial account had surged in the recent past was due to sovereign borrowings by the federal government and the central bank (Chart 13, bottom panel). Those inflows from some benefactor countries (i.e., Saudi Arabia, the UAE, China) have since dried up. In fact, in a turn of events, Saudi Arabia has called back the $3 billion soft loan it had extended to Pakistan in 2018. The kingdom has also withdrawn a $3.2 billion oil financing facility.2   Chart 12Trade Deficit Is Widening Again, And Current Account Will Be Back In Deficits Pakistan, Trapped Pakistan, Trapped Chart 13Capital Inflows Have Receded Materially As Loans From Benefactor Countries Dried Up Pakistan, Trapped Pakistan, Trapped   On its part, the IMF was unhappy with the progress on bailout conditions and had temporarily suspended the program last year – before releasing the latest tranche of $0.5 billion last week. In short, none of the financial account components seem promising enough to finance the impending current account deficits. That will push down Pakistan’s BoP to negative territory. A negative BoP means further depletion in Pakistan’s foreign reserves or currency depreciation or a combination of both. The country’s reserves (excluding gold) are already low at $9.2 billion – a mere two and a half months’ worth of imports. More crucially, the government’s annual foreign debt service obligations (amortization plus interest) alone can wipe out the entire reserve. In 2019 (latest data available), those obligations totaled $8 billion (Chart 14). Hence, odds are that Pakistan will face another balance of payment stress in the not too distant future. A relapse in BoP will be very bearish for the rupee (Chart 15). This warrants that foreign investors stay away from Pakistani assets for the moment. Chart 14Foreign Reserves Are Barely Enough For A Year's Foreign Debt Service Obligations Pakistan, Trapped Pakistan, Trapped Chart 15A Relapse In BoP Will Be Very Bearish For The Rupee Pakistan, Trapped Pakistan, Trapped   The End Game And Investment Conclusions The least painful and the most plausible solution for Pakistan’s macroeconomic problems is a sizable currency devaluation to boost nominal GDP and grow out of its public debt trap. This will help the country gain external competitiveness. That time might then be useful to initiate meaningful structural reforms and begin building up the country’s infrastructure and productive capacity. Moreover, once a credible devaluation is done, FDI and other types of foreign investments are more likely to come in – capital that Pakistan desperately needs. Notably, of the $228 billion total government debt of Pakistan, about a third ($75 billion) is external debt. Most of the external debt is either from multi-lateral, bi-lateral or Paris Club lenders (about $60 billion) – which are typically soft loans (i.e., very extended repayment period, and lower rates). Hence, while a currency devaluation will surely raise the overall debt burden, the immediate amortization and interest payment pressures will not be that severe. They can also be renegotiated at the sovereign levels. If Pakistan opts instead to continue to pursue tight monetary and fiscal policies, the rebalancing of the economy will happen via real economic variables i.e., weaker growth, retrenchment of employment and lower income and spending. That will be a much more painful process. The irony is that even in that case, facing lower growth, capital will tend to leave the country and therefore currency will sell off anyway. What all this means for foreign investors is that they should wait for Pakistan’s macro adjustments to run their course before venturing in. Equity The country’s equity markets are dominated by bank stocks (67% of market cap in MSCI Pakistan index). As explained before, tighter policies will choke bank lending. And subdued growth will push up NPLs of Pakistani banks. Both are bearish for bank stocks. As such we are closing our pair trade of long Pakistan/short EM initiated on December 5, 2019, which has incurred a 12% loss as per Datastream indexes, and 44% as per MSCI indexes. For long-term asset allocators, however, we recommend a neutral weighting to Pakistan in an EM equity portfolio. The reason is, after the huge underperformance, much of the gloomy outlook is now priced in. The relative valuations are already at a hefty discount of 75% (trailing P/E) and 65% (price/book value) respectively, against their EM counterparts. Fixed Income And Currency Fixed income investors should stay away. Local government bond yields are set to rise further. All kinds of inflation measures – CPI, PPI and WPI – are accelerating; and government’s borrowing costs will rise with them. Rising US treasury yields will not help either. The rupee is highly vulnerable too. Notably, last year, in a de facto QE, the central bank had purchased a massive amount of government bonds. Its holdings of government securities are now five times as high as its foreign reserve holdings. Yet, that could not prevent bond yields from rising since April 2020 - when PPI bottomed. While the central bank will surely engage in more rounds of bond buying this year, that is unlikely to keep bond yields down. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1  In July 2019, IMF approved a US$ 6 billion, 39-month, Extended Fund Facility for Pakistan. This was the country’s 23rd IMF bail-out since the country’s membership in 1950. 2  After Pakistan tried to form an alternative coalition of Muslim countries along with Malaysia and Turkey, the Saudi-Pakistan bilateral relations soured. The kingdom initially withdrew the deferred payment arrangements of $3.2 billion for oil purchases, and then last year asked Pakistan to repay the $3 billion soft loan. Pakistan had to take commercial loans from China to repay Saudi Arabia. Geopolitical tensions with the UAE also rose, following Pakistan’s alignment with Turkey. It has prompted the Emiratis to stop issuing new work visas to Pakistani migrants since last November.

In the May 7, 2020 report, we argued that structurally low oil prices could, eventually necessitate a devaluation of the Saudi riyal. Our assumption for average oil prices was and remains $40 in 2020, $40 in 2021 and $35 in 2022. As a long-term bet, we continue to recommend selling Saudi Arabian riyals in the forward market. This trade has very little carry cost, extremely low volatility and, if our analysis proves correct, it will have a substantial payoff. This is not just a bet on devaluation but on a rising probability of devaluation over the long run. Even if the kingdom does not devalue its currency, three-year currency forwards will, at some point, start pricing some devaluation risk. That will be sufficient to make this trade profitable. Oil Prices: Low For Longer The spot crude oil price has rallied close to 30% since October 29, 2020 despite the decline in the global mobility index on the back of renewed lockdown measures in Europe and the US (Chart 1). The mobility index’s weak reading is a clear sign of reduced current oil demand in major DM and in some EM economies.1 How do we square the relapse in global mobility with the latest rebound in spot oil prices? Odds are that investor buying has been largely responsible for the latest rebound in crude prices from early November lows. Investors flocking to oil is also consistent with purchases of assets that benefit from the reflation trade. Importantly, the spot crude price has recently risen more than medium-term (two-year) forwards (Chart 2) and, critically, long-term (three- and five-year) forwards have failed to advance. Given subdued current demand for crude, this also suggests that the spot price has been supported by investors. Chart 1Spot Oil Prices Have Diverged From Short-Term Demand Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Chart 2Spot Oil Prices Are Above Forward Prices Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment   Moreover, the strong rise in Chinese oil imports since May was partially due to inventory restocking. Recently, Chinese imports of crude oil and petroleum products have weakened as the restocking phase comes to an end (Chart 3). Going forward, we assume Chinese final demand for oil and oil products will be running at 3-4% in the coming years, in the best case scenario. Global oil demand will rise next year, as the deployment of coronavirus vaccines revive mobility and travel. However, greater demand will be offset by higher production as OPEC+ producers continuously increase oil output in 2021 (Chart 4). Chart 3Chinese Oil Imports Have Slowed Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Chart 4Oil Production Will Rise For Major Producers Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment   Beyond next year’s normalization period, the rotation towards renewables and green technology will emerge as headwinds to the oil market. On the supply side, the group of OPEC+ producers has been suppressing oil production. Given the weak state of a number of petro-economies and their troubling socio-political situations, these producers, particularly Russia, Nigeria and Iraq, are incentivized to raise their crude production.  In the long run, the OPEC+ arrangement of suppressing crude output will likely prove unsustainable. Ultimately, every producer’s overreaching objective is to maximize the net present value of its potential cash flow from oil. Due to inflation, $45 today is worth more than $45 in five or ten years. OPEC+ production constraints work as long as oil producers believe this setup is maximizing the net present value of their very long-term cash flow from oil. When producers realize that, in the long run, oil prices will remain under $50, they will rush to produce and sell as much as they can at current prices. Early signs of such behavior are already occurring as the UAE’s state-run oil company plans to invest in oil production at a time when the country is producing well below its capacity. Remarkably, the five-year forward oil price is now at $48 per barrel, which is close to its lows in April 2020 and January 2016 (Chart 5). A break below its previous lows will send a signal to oil producers, incentivizing them to produce and sell more oil at current prices. In short, tensions among OPEC+ members will rise over capping crude output. This was demonstrated in last week’s OPEC+ meeting during which members faced difficulty in reaching an agreement. These tensions will grow and will eventually lead to either sharply increased production quotas or reneging on the agreement. In addition, US President-elect Joe Biden and his new administration will likely start talks with Iran and provide some sanction relief. The motive is to undo some of Trump’s policies and re-establish some of Obama’s signature foreign policy accomplishments. The outcome of a U-turn in the US approach to Iran will be an increase in Iranian crude output (Chart 6). Chart 5Long-Term Oil Prices Remain Depressed Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Chart 6Iranian Oil Production Will Increase With Biden's Presidency Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment   Bottom Line: Oil prices will remain depressed going forward, averaging $40 in 2021 and $35 in 2022. These estimates form the basis of our analysis regarding Saudi Arabia’s required macro adjustments. Fiscal Tightening: How Much And For How Long? The Saudi government has already undertaken substantial fiscal tightening this year. Going forward, the government projects that fiscal spending in nominal terms will contract by 7.3%, 3.5% and 1.5% in 2021, 2022 and 2023, respectively (Chart 7). Under these assumptions, and if oil prices average $40 in 2021 and $35 in 2022, the fiscal deficit will be wide at –14% and –16% of GDP (Table 1). Chart 7Saudi Arabia: Fiscal Austerity Will Persist Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Table 1Projections For Oil Prices, Fiscal Balance, BoP And SAMA’s FX Reserves Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment   Nevertheless, fiscal austerity cannot be sustained for many years. Fiscal fatigue could set in as tight policy becomes socially and politically unacceptable. Hence, risk to the government’s spending projections is to the upside. The budget deficit, however, is not an ultimate constraint. Authorities can allow the budget deficit to balloon and finance it via bond issuance. In our simulation, we assume the government will finance about 25% of the fiscal deficit in 2021 and 2022 by issuing US dollar-denominated government bonds. The rest will be financed by local currency bond issuance. This raises the question whether the kingdom has sufficient savings to domestically finance its large fiscal deficits. As we wrote in the previous report, this is not a pertinent question. The basis is that when domestic commercial banks buy government bonds, they create new money/deposits “out of thin air.” This is true for any country in the world that has its own currency. If large fiscal deficits are only financed by domestic banks purchasing local currency bonds, it will lead neither to higher interest rates nor to the crowding out of the private sector. This is the least painful adjustment and the Saudi authorities could be tempted to resort to this solution, i.e., urge commercial banks to buy a substantial portion of local currency government bond issuance. So far this year, 20% of Saudi Arabia’s fiscal deficit has been financed via the issuance of US dollar bonds, 55% by local currency bonds, and 25% by drawing on the government's US dollar reserves at the central bank. Commercial banks’ purchases of local currency government bonds can continue for many years, allowing the kingdom to finance its budget deficits. The central bank may or may not need to provide commercial banks with liquidity (excess reserves) for banks to continue doing it. Chart 8Saudi Arabia: Broad Money And Excess Reserves Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Excess reserves are created by central banks “out of thin air” so they do not represent a major constraint. The ratio between broad money supply and excess reserves represents the money multiplier. Chart 8 illustrates there is no strong or constant relationship between Saudi commercial banks’ excess reserves and broad money (M3) creation. The latter could fluctuate, i.e., commercial banks could create more or less new money/deposits for the same level of excess reserves provided by the central bank. Critically, on aggregate, the commercial banking system does not lend out or part with excess reserves when it originates loans or purchases securities, except in cases where the counterpart is the central bank, as we demonstrated in our October 22 and January 16 2020 Special Reports.  Bottom Line: The purchase of debt securities, including government bonds, by commercial banks is nothing more than debt monetization. Hence, any country can finance its fiscal deficit by encouraging domestic commercial banks to purchase local currency government bonds. Ultimate Macro Constraints The ultimate macro constraint for any country when budget deficits are financed by local commercial banks is inflation and/or downward pressure on the currency. Monetization of government debt could eventually be problematic in Saudi Arabia because the country pegs its currency to the US dollar. The risks to the exchange rate peg due to mushrooming money supply will ultimately limit the government’s ability to rely on commercial banks to finance its budget deficits (Chart 9). Chart 9Saudi Arabia: Divergence Between Broad Money And FX Reserves Will Continue For Now Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Another Achilles’ heel of this economy is its dependence on imports. Structurally, the economy is plagued by low productivity and a lack of domestic productive capacity. Consequently, any boost to domestic demand from fiscal spending will translate into higher imports as well as increased remittance outflows from foreign workers who dominate Saudi Arabia’s workforce. Ultimately, pressure on the current account balance will build as the expansion in domestic demand leads to US dollar outflows. Both FDI and portfolio inflows have been meager and will stay depressed if oil prices remain low, since foreign investors will be hesitant to invest in this petro-dependent economy. Amid a deteriorating balance of payments, the only way to defend the currency peg will be for the central bank to sell its foreign exchange reserves. Chart 10 (top panel) shows that the central bank’s foreign reserves have been shrinking while broad money supply has been expanding rapidly. Chart 10The FX Reserves-To-Broad Money Supply Ratio Will Fall Close To 0.5 In 2022 Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Such dynamics will persist in the coming years. As a result, the foreign exchange reserves-to-broad money ratio will drop from 0.85 today to 0.68 by the end of 2021 and 0.53 by the end of 2022 (Chart 10, bottom panel). There is no threshold for this ratio or any other financial and economic variable to gauge when the peg will have to be adjusted. In the case of Saudi Arabia, de-pegging or devaluing the currency carries major political implications. Authorities will be reluctant to do it before Crown Prince Mohammed bin Salman becomes king. Nevertheless, long-term currency forwards could start pricing a probability of such currency adjustments earlier than it eventually occurs. The Risk Premium In Currency Forwards The risk premium in the long-term currency forwards will widen as (1) oil prices stay low for longer (Chart 11), (2) Saudi Arabia engages in some form of covert debt monetization, and (3) the traditional pillars of US-Saudi relations gradually erode. Chart 11Bet On A Rising Probability Of Devaluation Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment Chart 12Underweight Saudi Versus EM Equities Saudi Arabia: Oil And Macro Adjustment Saudi Arabia: Oil And Macro Adjustment US-Saudi relations will likely sour in the coming years stemming from the Biden administration’s engagement with Iran. Having reached self-sufficiency in energy production, the US will, in the long run, have less incentive to be involved in the region and defend its allies. Together, these factors could raise the geopolitical risk premium in the Saudi riyal forwards. Poor domestic growth, as well as a rising risk premium due to devaluation, bodes ill for equities. Investors should consider underweighting Saudi stocks within an EM equity portfolio (Chart 12). For credit investors, we recommend underweighting both Saudi sovereign and corporate spreads in an EM credit portfolio. Lower oil prices will force more borrowing and start eroding the balance sheet of the government and corporates. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The global index is constructed based on data from 25 developed and developing countries, including India but excluding China.

Chart II-1Nigeria: Poor BoP Position Nigeria: Poor BoP Position Nigeria: Poor BoP Position The Nigerian naira is facing a considerable risk of major devaluation stemming from strains on its balance of payments (BoP). That said, the risk of a sovereign default is very low over the next 12-18 months. Nigeria suffers from large external imbalances in an environment of low oil prices and dreadful FDI inflows. The nation’s current account deficit is wide at 5% of GDP and its foreign currency (FX) reserves are low (Chart II-1). Importantly, oil prices have hit a critical technical resistance – their 200-day moving average – and have relapsed (Chart II-2). Global oil demand weakness stemming from some renewed tightening of lockdown measures will result in lower crude prices. We at BCA’s Emerging Markets Strategy team expect Brent prices to be in a trading range of $35-$45 over the next 12 months.2 An Optimal Macro Adjustment A low oil price environment creates a dillemma for Nigeria’s policymakers given their limited FX reserves. They can either (i) draw down FX reserves to support the exchange rate, or (ii) preserve FX reserves and allow a major currency devaluation. So far, Nigerian authorities have avoided these options by resorting to strict capital controls and limiting imports. Yet, capital controls are derailing much needed foreign capital inflows in general and FDIs in particular. These capital account controls are also restricting the ability of domestic firms to access US dollars to service their foreign debt payments, undermining the confidence of foreign investors and multilateral creditors. Allowing currency depreciation is the least-worst macro policy solution. Propping up the currency by administrative restrictions amid low oil prices will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. Remarkably, Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and a non-competitive currency (Chart II-3). Chart II-2A Relapse In Oil Prices Is Likely A Relapse In Oil Prices Is Likely A Relapse In Oil Prices Is Likely Chart II-3Nigeria Has A Current Account Deficit Ex-Oil Nigeria Has A Current Account Deficit Ex-Oil Nigeria Has A Current Account Deficit Ex-Oil   Bottom Line: Capital controls and import restrictions are impeding FDIs and productivity growth in this most populous African country (Chart II-4). While a steep devaluation will spur inflation in the short run, a cheapened currency and the abolishment of import and capital controls will help to attract foreign capital that the nation desperately needs. Running Out Of FX Reserves Critically, the Central Bank of Nigeria (CBN) is running out of FX reserves: Nigeria’s foreign exchange (FX) reserves are very low at $35.6 billion. That compares with foreign debt obligations (FDOs) of $28 billion in the next 12 months and foreign funding requirements of $47 billion in the next 12 months (Chart II-5). Chart II-4Nigeria: Weak FDI = Low Productivity Nigeria: Weak FDI = Low Productivity Nigeria: Weak FDI = Low Productivity Chart II-5Nigeria: Large Foreign Funding Required In Next 12 Months Nigeria: Large Foreign Funding Required In Next 12 Months Nigeria: Large Foreign Funding Required In Next 12 Months   FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Meanwhile, foreign funding requirements is the sum of the current account deficit and FDOs. FDI inflows were a mere $2.5 billion in 2019 compared with a $20 billion current account deficit. Along with foreign portfolio inflows, FDI inflows will remain depressed so long as capital controls persist. The FX reserves-to-broad money ratio currently stands at 0.4. A ratio below one indicates foreign currency reserves do not entirely cover currency in circulation and local currency deposits.  How much should the exchange rate be devalued versus the US dollar for this ratio to reach 1? For the broad money supply coverage ratio to be equal to 1, the currency must depreciate by 56% against the US dollar. Bottom Line: CBN’s FX reserves are insufficient to maintain the current de-facto crawling currency peg in the long run. No Worries About Sovereign Credit For Now Chart II-6Nigeria: Low Public Debt Burden Nigeria: Low Public Debt Burden Nigeria: Low Public Debt Burden While the Nigerian government is reeling from lower oil prices, the likelihood of a sovereign default is presently low. Public debt is low, currently standing at 22.5% of GDP. Notably, foreign debt represents nearly 30% of overall public debt or 6.5% of GDP. Moreover, only 40% of external debt (3% of GDP) is owned to private foreign investors (Chart II-6). The rest is split between bilateral and multilateral creditors. Foreign bilateral and multilateral debt is easier to renegotiate. While overall (domestic and foreign) debt servicing costs have risen to 55% of government revenues, foreign currency debt servicing costs only represent 2% of overall revenues. Provided foreign public debt servicing is minimal, even a large currency depreciation will not make public debt dynamics unsustainable. Crucially, a substantial currency devaluation will ameliorate the fiscal position. A large share (about 55%) of fiscal revenues come from oil, i.e., they are in US dollars. Conversely, expenditures are in local currency terms. As a result, currency depreciation will boost revenues but not expenditures, narrowing the budget deficit. According to the newly revised budget for the 2020 fiscal year, fiscal spending will grow by 8.7% in nominal terms but most likely contract in real terms (Chart II-7). Overall, the fiscal balance will widen to 3.65% of GDP in 2020 according to government projections. In nutshell, policymakers refrained from large fiscal stimulus amid lockdown measures earlier this year. This is bad for the economy but positive for the trajectory of public debt. Finally, public debt dynamics are presently not worrisome with nominal GDP growth above local interest rates (Chart II-8). Chart II-7Nigeria Will Run Tight Fiscal Policy Nigeria Will Run Tight Fiscal Policy Nigeria Will Run Tight Fiscal Policy Chart II-8Nigeria: No Public Debt Sustainability Problem Nigeria: No Public Debt Sustainability Problem Nigeria: No Public Debt Sustainability Problem   Bottom Line: The risk of a sovereign default is low in the coming years. The low starting points in both public debt levels and debt servicing costs will allow the government to boost fiscal spending to support the economy. Investment Implications Overall, a currency devaluation will help restore balance of payment dynamics without causing a major stress for sovereign credit. A 25-30% devaluation over the next 12 months will be the least-worst policy choice. Currency forwards are currently pricing a 20% depreciation in the naira versus the US dollar in next 12 months (Chart II-9). Yet, the average black market exchange rate, currently at around 470, implies almost a 25% discount from the current official rate. Sovereign credit spreads are presently tight (Chart II-10). Investors should consider buying Nigerian sovereign credit only after a substantial devaluation takes place. Chart II-9Naira Forwards Discount Will Widen With Lower Oil Prices Naira Forwards Discount Will Widen With Lower Oil Prices Naira Forwards Discount Will Widen With Lower Oil Prices Chart II-10Nigeria: Buy Sovereign Credit After Devaluation Nigeria: Buy Sovereign Credit After Devaluation Nigeria: Buy Sovereign Credit After Devaluation   Finally, equity investors should continue avoiding the local bourse. Due to capital controls, the latter is uninvestable for now. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 2 This differs from BCA Commodity and Energy Strategy service’s expectation that Brent prices will average $65 in 2021.

The Kenyan shilling will depreciate by 15-20% in the next 12 months. The downward pressure on the currency stems from the country’s sizeable current account deficit. In addition, Kenya needs lower local interest rates and a weaker exchange rate to boost nominal growth and stabilize public debt dynamics.  Kenya has gone through an extensive macro adjustment since 2015 when the current account deficit was 10% of GDP and the primary fiscal deficit was 8% of GDP. Since then the current account deficit has narrowed to 6% of GDP as the private sector deleveraged and fiscal policy tightened substantially over the past 3-years (Chart I-1, top panel). Remarkably, the primary fiscal deficit has narrowed to a mere 0.4% of GDP as of June 2020 (Chart I-1, bottom panel). Yet, the macro adjustment is incomplete with a lingering current account deficit and public debt on an unsustainable path. Further, economic growth is extremely weak (Chart I-2). Crucially, core inflation is at 2% - an all-time low, suggesting that low inflation/deflationary pressures is the main problem in Kenya (Chart I-3). Chart I-1Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Chart I-2Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth   In this context, the optimal policy choice for Kenya is to reduce local interest rates, while allowing the currency to depreciate. This will reduce the interest burden on public debt, boost both economic activity (real growth) and inflation as well as make exports more competitive. Balance Of Payments Strains Persist Kenya’s balance of payments will weigh on the currency in the next 6-9 months. While improving, its exports will remain tame over the next 6-12 months. The volume of tea, horticulture and coffee exports, which account for about 50% of total Kenyan exports, has rebounded. Yet, their prices have failed to rebound meaningfully. Meanwhile, substantial fiscal tightening – an 11% drop in government non-interest nominal expenditures – has led to a collapse in imports (Chart I-4). If and when fiscal policy is relaxed, it will boost imports weighing on the trade balance. Chart I-3Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Chart I-4Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Chart I-5Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets The biggest headwind to the balance of payments has been the drastic fall in both tourism revenues and remittances. Combined, they represent around $4 billion (4.2% of GDP). It is unlikely that international travel will resume in the next six months. Remittances will also remain subdued in the coming months as unemployment rates remain elevated worldwide. Kenya has been losing its export market share in neighboring countries such as Uganda and Tanzania (Chart I-5). Hence, this nation needs to improve its competitiveness via tolerating a cheaper currency and undertaking structural reforms to bolster productivity growth. FDI inflows have been subdued. In the near term, FDI inflows will be discouraged by very weak domestic demand. Critically, the outlook for Chinese FDI inflows into the country remains uncertain due to the debacle with previous China-financed projects in Kenya. In particular, Kenyan courts declared the construction contract awarded to the China Road and Bridge Corporation for the Nairobi-Mombasa railway illegal.1 This impasse between Kenyan courts and Chinese companies could for now dissuade financing and investment from China. In the medium term, international organizations such as the IMF and World Bank could step in to fill in for Chinese investments. As recent financing by the World Bank and IMF of $1.74 billion (1.9% of GDP) to Kenya suggest, the US might be enticed alongside European nations to step in to fill the vacuum left by the withdrawal of China’s financial backing. However, this might take some time and there will be shortage in foreign financing in the coming months. Chart I-6Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Finally, another risk is the considerable amount of foreign debt obligations (FDOs) and the lack of foreign currency reserves at the central bank to meet these obligations (Chart I-6). Kenya’s FDOs in the next 12 months are about $6 billion, while the central bank has only $8.8 billion of foreign exchange reserves. In this case, FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Bottom Line: The exchange rate will continue facing depreciation pressures. The optimal policy for the central bank will be to allow the currency to weaken meaningfully and to reduce interest rates rather than use high interest rates or deplete its foreign exchange reserves to defend the exchange rate. Public Debt Sustainability Despite substantial fiscal tightening, Kenya’s public debt trajectory remains worrisome. Two prerequisites for capping the rise in the public debt-to-GDP ratio are (1) running continuous primary fiscal surpluses and (2) for local government borrowing costs to be below nominal GDP growth. Neither of these two are presently satisfied in Kenya. Crucially, interest payments are taking up a quarter of overall government revenues (Chart I-7). This necessitates considerably lower domestic interest rates to reduce this ratio. In brief, public debt sustainability hinges on the central bank reducing local borrowing costs, which will both boost nominal growth/government revenues and lower interest costs of public debt. The government of President Uhuru Kenyatta announced a new budget in June (for the period of July 1, 2020 to June 30, 2021) with a projected primary deficit of -3% and -1.8% of GDP, for 2020/21 and 2021/22 respectively (Chart I-1, bottom panel on page 1). Meanwhile, the new budget’s nominal annual growth projections for 2020/21 and 2021/22 are 10.6% and 11.5%, respectively. Chart I-8 presents both the government’s as well as our projections for public debt dynamics until the end of 2022 based on assumptions for nominal GDP, government expenditures and revenues for the next two fiscal years. The public debt-to-GDP ratio will reach 75% of GDP in our scenario and 66% in the government’s scenario. Chart I-7Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Chart I-8Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise   The key difference between the two projections are expectations for nominal GDP and government revenue growth. If fiscal and monetary policy remain tight, nominal output growth will disappoint. Notably, broad money supply growth is tame (Chart I-9). Sluggish nominal growth risks derailing government revenue projections. Notably, recent comments by finance minister Ukur Yatani suggests that revenues have already begun underperforming government expectations in the first two months of the new fiscal year. On the whole, public debt will rise by more than what the government expects over the next two years as borrowing costs remain above nominal GDP growth (Chart I-10). Chart I-9Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Chart I-10Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth   Faced with the prospect of rising public debt dynamics over the next two years, the economically less painful response for policymakers is for the central bank to lower interest rates and to instruct domestic commercial banks to buy government domestic debt. This will boost nominal GDP growth and push local interest rates below nominal GDP growth. There is scope for the central bank to cut interest rates and allow the currency to depreciate without feeding into runaway inflation. Notably, core consumer price inflation excluding fuel and food items is presently at an all-time low, running below the lower bound of the central bank’s inflation target (Chart I-2 on page 2). Higher inflation also feeds into higher nominal growth, which is good for public debt dynamics. A weaker currency will augment the cost of servicing foreign debt. The latter accounts for 52% of public debt and 32% of GDP. However, a large share (65%) of foreign debt is owed to bilateral and multilateral creditors. This debt can be renegotiated/restructured, which would in turn benefit private creditors. Bottom Line: To stabilize public debt dynamics, local interest rates should be lowered considerably. This will increase nominal GDP and government revenue growth as well as lower debt servicing costs. In this scenario, currency will depreciate a lot. Investment Implications Faced with very depressed economic growth, very low inflation, unsustainable public debt dynamics and a wide current account deficit, the optimal policy for Kenya is to ease monetary policy dramatically and tolerate material currency depreciation. So long as the central bank does not reduce interest rates, the economy will continue to underwhelm, public debt dynamics will be worrisome and share prices will stumble (Chart I-11). Critically, as the public debt-to-GDP ratio continues rising, sovereign credit will underperform (Chart I-12). Chart I-11Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Chart I-12Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance   If and when the central bank brings interest rates down substantially, nominal growth will improve and share prices will fare well. Lower domestic borrowing costs and higher nominal GDP growth will help stabilize public debt dynamics. In such a scenario, EM sovereign credit portfolios should overweight the nation’s US dollar bonds. The Kenyan shilling also is set to depreciate materially. If the government embarks on this macro adjustment early, currency depreciation could be gradual. If the government delays this macro adjustment and resists currency weakness by tolerating high interest rates, the exchange rate depreciation could be delayed, but will be abrupt and disorderly. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The standard gauge railways project built between the port city of Mombasa and its capital Nairobi has been heavily scrutinized by Kenyan authorities. After only three years of operation, the Kenyan Railways Company (KRC) has already defaulted on its loan from Chinese lenders. Kenyan courts have been arguing that Kenyan government and state-owned enterprises are facing sovereign risk over Chinese debt overhang. More than half of Kenya’s loans from China are attached to the construction of the Mombasa-Nairobi railway project.

Highlights Bangladesh’s balance of payments (BoP) is a key pillar for the country’s financial markets and economy. The country’s BoP will deteriorate going forward. That, coupled with ongoing public debt monetization, will pose major risks to the currency in the next 6-12 months. The central bank will have to defend the exchange rate by selling its foreign exchange reserves and/or hiking policy rates. As a result, liquidity conditions will tighten, hurting the equity market, as it will disproportionally hinder commercial banks and credit flow into the economy. We recommend investors avoid this bourse or underweight it relative to the EM equity benchmark. Feature Chart 1Bangladesh's BoP: A Pillar For Markets Bangladesh's BoP: A Pillar For Markets Bangladesh's BoP: A Pillar For Markets Bangladesh’s balance of payments (BoP) is a key pillar for the country’s financial markets and economy. Essentially, the central bank has been de facto targeting a stable exchange rate as it works to smooth out all material currency fluctuations. Specifically, when a BoP surplus exerts upward pressure on the exchange rate, the central bank accumulates foreign exchange (FX) reserves and reduces interest rates in order to cap currency appreciation. Easing monetary policy and liquidity expansion, in turn, pushes share prices higher (Chart 1). Worryingly, the improvement in Bangladesh’s BoP that has occurred over the past 18 months has now peaked. A decidedly worsening BoP position, coupled with ongoing public debt monetization by the central bank and commercial banks, will pose major risks to the currency in the next 6-12 months. To defend the exchange rate, the central bank will likely sell its FX reserves and will, thereby, shrink the commercial banks’ excess reserves at the central bank, as well as curtail growth in money supply. Such liquidity tightening is a bad omen for the stock market. All in all, we find the risk/reward profile of this stock market currently poor. We therefore recommend equity investors avoid this bourse for now, and dedicated EM equity portfolios to underweight it. The Balance Of Payments: Deterioration Ahead Chart 2Current Account Deficit Is Set To Widen Sharply Current Account Deficit Is Set To Widen Sharply Current Account Deficit Is Set To Widen Sharply Odds are that Bangladesh’s balance of payments surplus has peaked and will soon begin to deteriorate: Current Account: The current account deficit – which has already rolled over – will widen further (Chart 2, top panel). Remittances Remittances into Bangladesh, which amount to a whopping $20 billion annually (or 6% of GDP), are set to drop dramatically (Chart 2, second panel). Crucially, they have been rising markedly due to various factors that will prove to be temporary and will quickly dissipate. First, the Bangladesh government introduced a 2% incentive to encourage Bangladeshi nationals working abroad to send money back home. This has triggered a one-off boost in remittances, as these workers rushed to send back savings. The government has extended this incentive to this fiscal year (July 2020-June 2021). However, it will be less effective as it is highly likely that Bangladeshi foreign workers have already sent most of their savings back when the incentive was originally introduced. Furthermore, global employment will remain weak for some time. Thus, sooner rather than later, the one-off effect of this policy will subside. Second, the official reported value of remittances into the country has been artificially boosted during the pandemic. Particularly, Bangladeshi workers abroad have been forced to send money via official/banking means instead of transporting physical cash while travelling. The official banking channel is easily accounted for in official data, as opposed to physical cash. Third, around 58% of remittances into Bangladesh emanate from GCC countries. These oil-driven economies have been severely struck by two deflationary events: the crude oil price collapse and the pandemic. In turn, GCC businesses have laid-off a massive number of foreign workers, which has forced many Bangladeshi workers to transfer their entire savings back home (Chart 3, top and mid panels). All in all, we find the risk/reward profile of this stock market currently poor. Chart 3Unsustainable And One-Off Rise In Remittances Unsustainable And One-Off Rise In Remittances Unsustainable And One-Off Rise In Remittances There is ample evidence that foreign workers from Bangladesh have been brutally affected by layoffs in GCC states. For instance, several GCC governments have asked the Bangladeshi government to take back undocumented Bangladeshi workers. In turn, the government has set up programs to help receive thousands of workers returning home. As GCC economies struggle to recover fully, Bangladeshi citizens will no longer enjoy the same access to the GCC labor market for the foreseeable future. Indeed, the number of new foreign workers from Bangladesh (of which, most end up in GCC states) has virtually fallen to zero in June and will not rebound to pre-pandemic levels any time soon (Chart 3, bottom panel). All in all, remittances into Bangladesh will fall a great deal in the coming months and will not likely go back to their pre-pandemic levels any time soon. Exports Bangladesh is heavily reliant on textile exports. The latter account for around 70% of the country’s total export earnings. Furthermore, around 60% of the nation’s overall exports are destined to Europe, and 15% to the US. Worryingly, the outlook for Bangladesh’s textile industry is fraught with challenges, both cyclically and structurally. Cyclically, despite recent improvement (Chart 4), demand for apparel in both the US and the euro area will likely be subdued and remain below pre-pandemic levels. Chart 4Subdued DM Demand For Apparels Subdued DM Demand For Apparels Subdued DM Demand For Apparels The basis is that the global pandemic is far from over and continues to evolve idiosyncratically. In turn, renewed social distancing measures (restricting movement and encouraging people to continue working from home) will temper demand for apparels/clothing. Structurally, Bangladesh’s textile industry is falling behind its main competitors, as cheap wages alone are no longer enough to boost textile exports. According to LankaBangla Asset Management, Bangladesh suffers from a lack of technological innovation, poor infrastructure, rising utility costs and inadequate port capacity.1 Indeed, this nation has been losing market share to other Southeast Asian countries. The top panel of Chart 5 illustrates that Bangladesh’s exports of apparels have massively underperformed those of Vietnam in value terms. Finally, the EU and Vietnam signed a comprehensive Free Trade Agreement on February 12, which went into effect on August 1. The agreement drops tariffs significantly on Vietnam’s exports to the EU. That will allow Vietnam to take substantial market share from Bangladesh’s EU market (Bangladesh’s largest textile buyer). Imports Bangladesh’s imports have been contracting less severely than exports, and this will continue to be the case going forward. First, the government announced an expansionary budget for the July 2020-June 2021 fiscal year that entails 9% growth. Higher government expenditures will, in turn, feed into somewhat stronger imports (Chart 6). Chart 5Bangladesh Textile Industry Is Falling Behind Its Competitors Bangladesh Textile Industry Is Falling Behind Its Competitors Bangladesh Textile Industry Is Falling Behind Its Competitors Chart 6Bangladesh: Rising Government Expenditures Will Boost Imports Bangladesh: Rising Government Expenditures Will Boost Imports Bangladesh: Rising Government Expenditures Will Boost Imports   Second, basic goods such as food, medicine, and petroleum account for 30% of Bangladesh’s total imports. Such essential goods imports will remain necessary, regardless of the direction of Bangladesh’s business cycle. Therefore, they will keep Bangladesh’s overall import bill somewhat strong relative to exports. Financial account: To fund its current account deficit, Bangladesh relies on foreign financial inflows. Their outlook is uncertain, however: Private-sector foreign funding Net FDI inflows into Bangladesh have relapsed (Chart 7, top panel). Meanwhile, external borrowing by non-financial companies was already contracting in March 2020 and is unlikely to recover briskly (Chart 7, bottom panel). Crucially, FDI inflows into Bangladesh’s private sector will remain weak, as foreign businesses will likely invest elsewhere in Asia For instance, Bangladesh failed to attract a single company out of the 30 Japanese companies relocating from China. Instead, 15 companies relocated to Vietnam, six to Thailand, four to Malaysia and three to the Philippines. This highlights how unfriendly the Bangladesh business environment is Finally, public governance is deteriorating in Bangladesh. The Awami League (the ruling party) has been busy cracking down on all form of dissent and courting Islamist organizations for legitimacy. The league has also been targeting minorities, journalists, and bloggers. All in all, the government is more concerned with staying in power, and has failed to address the basic needs of its citizens and pressing economic issues. This will be a major reason why FDI to the private sector will remain structurally subdued. The current account deficit is set to deteriorate significantly. Public-sector funding With private-sector foreign funding subdued, Bangladesh has been increasingly relying on public-sector foreign funding to reduce the current account deficit (Chart 8). Chart 7Outlook For Private-Sector Foreign Funding Is Gloomy Outlook For Private-Sector Foreign Funding Is Gloomy Outlook For Private-Sector Foreign Funding Is Gloomy Chart 8Public-Sector Foreign Funding Will Not Keep Rising Indefinitely Public-Sector Foreign Funding Will Not Keep Rising Indefinitely Public-Sector Foreign Funding Will Not Keep Rising Indefinitely   Bangladesh has already received almost $4 billion in funding from international organizations due to the COVID-19 pandemic.2 Therefore, further significant borrowing from such organizations is not in the cards for now. As to bilateral borrowing from countries, Bangladesh has been actively signing infrastructure deals with China. However, most of these deals seem to have gone unimplemented. For instance, of the $24 billion-dollar worth of infrastructure projects, Bangladesh signed with China in 2016, only five projects worth about $1 billion were implemented by December 2019. Furthermore, many of these agreements expire this year and it is unclear whether they will be renegotiated. Most of these projects were not implemented due to Bangladesh’s regulatory hurdles. Bangladesh is now seeking a $6.4-billion infrastructure loan from China. If financing is undertaken and projects are implemented faster than before, this will constitute a major risk to our downbeat analysis on the BoP. The motive behind a faster implementation of these projects funded by China going forward lies in the ongoing and rising tensions between China and India, which could encourage the former to pour money into Bangladesh to bring it closer to its orbit and away from India’s. Doing so would provide China with greater presence in the Bay of Bengal, which directly threatens India’s national and geopolitical interests. Bottom Line: The current account deficit is set to deteriorate significantly. Meanwhile, private-sector funding is very subdued and the outlook for public-sector funding is uncertain. As and when public-sector foreign financial inflows slow, the BoP will deteriorate and that will put depreciation pressure on the currency. Will A Worsening BoP Lead To Monetary Tightening? In the context of improving BoP dynamics, the central bank has not only reduced its policy rate but has also injected large amounts of liquidity by lending to commercial banks and by purchasing government bonds (Chart 9, top panel). Banks have also been purchasing government debt securities (Chart 9, middle panel). The purchases of government debt securities by Bangladesh Bank (BB) and commercial banks have, in turn, led to a considerable acceleration in broad money supply despite weak loan growth (Chart 9, bottom panel). Yet, the deteriorating BoP position along with public debt monetization is a perfect cocktail for currency weakness (Chart 10). Importantly, the BoP does not necessarily need to dip into negative territory for the Bangladeshi taka (BDT) to depreciate. It suffices for the BoP to deteriorate marginally for the currency to weaken (middle panel of Chart 1 on page 2). Chart 9Public Debt Monetization By Central Bank & Commercial Banks Public Debt Monetization By Central Bank & Commercial Banks Public Debt Monetization By Central Bank & Commercial Banks Chart 10Bangladesh: Central Bank Liquidity Injections Is Currency Bearish Bangladesh: Central Bank Liquidity Injections Is Currency Bearish Bangladesh: Central Bank Liquidity Injections Is Currency Bearish   In turn, as the currency begins to depreciate, BB will have to defend the exchange rate given to its objective of securing a stable exchange rate. The central bank will have to sell its foreign exchange reserves and/or hike policy rates as well as reduce its purchases of government bonds. The outcome will be rising interest rates and worsening liquidity conditions. While monetary tightening would eventually stabilize the currency, this policy setting will hurt the equity market, as it will disproportionally hinder commercial banks and credit flow in the economy. Crucially, financials make up about 22% of the Dhaka Stock Exchange index. While monetary tightening would eventually stabilize the currency, this policy setting will hurt the equity market. Non-performing loans (NPLs) of commercial banks will soar amid sluggish growth and higher borrowing costs (Chart 11). Also, given that the central bank tends to cap commercial banks’ lending rates, higher short rates will cause commercial banks’ net interest rate margins to fall significantly. This is negative for banks’ share prices (Chart 12). Chart 11Bangladesh: A New Cycle Of Rising Non-Performing Loans Is In The Cards Bangladesh: A New Cycle Of Rising Non-Performing Loans Is In The Cards Bangladesh: A New Cycle Of Rising Non-Performing Loans Is In The Cards Chart 12Bangladesh: Compressing Net Interest Rate Margins Are Negative For Bank Stocks Bangladesh: Compressing Net Interest Rate Margins Are Negative For Bank Stocks Bangladesh: Compressing Net Interest Rate Margins Are Negative For Bank Stocks     Investment Recommendations Bangladesh’s BoP dynamics are set to deteriorate significantly, which is bearish for the currency. Depreciation pressure on the currency will force the central bank to intervene by selling its FX reserves and/or to hike interest rates. Such monetary and liquidity tightening is negative for share prices (Chart 10, bottom panel). Chart 13Underweight Bangladesh Equities Relative To EM Underweight Bangladesh Equities Relative To EM Underweight Bangladesh Equities Relative To EM We recommend investors underweight this bourse relative to the EM equity benchmark (Chart 13). In terms of absolute performance, the risk-reward is unattractive. Moreover, as with other markets there are signs of frenzy and aggressive retail trading in Bangladesh. Like any retail frenzy, this will likely end with a major downleg in this bourse in the coming months. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com     Footnotes 1  Please refer to COVID-19 Impact on Bangladesh Economy, June 7, 2020 – LankaBangla Asset Management. 2  Bangladesh this year alone received $1.2 billion from the ADB, $1.3 billion from the World Bank, a $730-million loan from the IMF, and $500 million from the AIIB. It has also received loans from the Japan International Cooperation Agency and the Islamic Development Bank, among other organizations and countries.