Emerging Markets

Highlights The Chinese economy is recovering at a slower rate than the equity market has priced in. There is a high likelihood of negative revisions to Q2 EPS estimates and an elevated risk of a near-term price correction in Chinese stocks.  We expect a meaningful pickup in credit growth in H1 to improve domestic demand gain tractions in H2. This supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. There is still a strong probability that the yield curve will flatten, and the 10-year government bond yield may even dip below 2% in the wake of disappointing economic data in Q2. But our baseline scenario suggests the 10-year government bond yield should bottom no later than Q3 of this year. Feature This week’s report addresses pressing concerns from clients in China’s post-Covid-19 environment. China’s economy contracted by 6.8% in Q1, the largest GDP growth slump since 1976. Furthermore, the IMF’s baseline scenario projects a 3% contraction in global economic growth in 2020, with the Chinese economy growing at a mere 1.2%.1 This dim annual growth outlook means that the contraction in China’s economy will likely extend to Q2, dragging down corporate profit growth. In our April 1st report2 we recommended that investors maintain a neutral stance on Chinese stocks in the next three months due to uncertainties surrounding the pandemic, the oversized passive outperformance in Chinese stocks, and heightened risks for further risk-asset selloffs. On a 6- to 12-month horizon, however, we have a higher conviction that Chinese stocks will outperform global benchmarks. Our view is based on a decisive shift by policymakers to a “whatever it takes” approach to boost the economy. We believe that the speed of China’s economic recovery in the second half of 2020 will outpace other major economies.  Q: China’s economy is recovering ahead of other major economies. Why did you recently downgrade your tactical call on Chinese equities from overweight to neutral relative to global stocks? A: China’s economy is recovering, but it is recovering at a slower rate than the equity market has fully priced in (Chart 1A and 1B). We believe the likelihood of negative revisions to Q2 EPS estimates is high, and the risk of a near-term price correction in Chinese stocks remains elevated.  Chart 1AElevated Chinese Equity Outperformance Relative To Global Stocks Elevated Chinese Equity Outperformance Relative To Global Stocks Elevated Chinese Equity Outperformance Relative To Global Stocks Chart 1BChinese Stocks Largely Ignored Weakness In Domestic Economy Chinese Stocks Largely Ignored Weakness In Domestic Economy Chinese Stocks Largely Ignored Weakness In Domestic Economy The lackluster March data suggests that the pace of China’s economic recovery in April and even May will likely disappoint, weighing on the growth prospects for Q2’s corporate earnings (Chart 2). Chart 2EPS Growth Estimates Likely To Capitulate In Q2 EPS Growth Estimates Likely To Capitulate In Q2 EPS Growth Estimates Likely To Capitulate In Q2 The work resumption rate in China’s 36 provinces jumped sharply between mid-February and mid-March. However, since that time, the resumption rate among large enterprises has hovered around 80% of normal capacity (Chart 3). Chart 3Work Resumption Hardly Improved Since Mid-March Three Questions Following The Coronacrisis Three Questions Following The Coronacrisis The flattening of the work resumption rate curve is due to a lack of strong recovery in demand. Chart 4So Far No Strong Recovery In Domestic Demand So Far No Strong Recovery In Domestic Demand So Far No Strong Recovery In Domestic Demand The flattening of the resumption rate curve is due to a lack of strong recovery in demand. Although there was a surge in Chinese imports in crude oil and raw materials, the increase was the result of China taking advantage of low commodity prices. This surge cannot be sustained without a pickup in domestic demand. The March bounce back in domestic demand from the manufacturing, construction, and household sectors has all been lackluster (Chart 4). External demand, which growth remained in contraction through March, will likely worsen in Q2 (Chart 5). Exports shrunk by 6.6% in March, up from a deep contraction of 17.2% in January-February. Export orders can take more than a month to be processed, therefore, March’s data reflects pent-up orders from the first two months of the year. The US and European economies started their lockdowns in March, so Chinese exports will only feel the full impact of the collapse in demand from its trading partners in April and May. The work resumption rate will advance only if the momentum in domestic demand recovery increases to fully offset the collapse in external demand. The current 83% rate of work resumption implies that industrial output growth in April will remain in contraction on a year-over-year basis (Chart 6). Chart 5External Demand Will Worsen In Q2 External Demand Will Worsen In Q2 External Demand Will Worsen In Q2 Chart 6Will Q2 Industrial Output Growth Remain In Contraction? Will Q2 Industrial Output Growth Remain In Contraction? Will Q2 Industrial Output Growth Remain In Contraction? Although we maintain a constructive outlook on Chinese risk assets in the next 6 to 12 months, the short-term picture remains volatile in view of the emerging economic data. As such, we recommend investors to maintain short-term hedges for risk asset positions. Q: China’s policy response to mitigate the economic blow from COVID-19 has been noticeably smaller than programs rolled out in key developed economies, especially the US. Why do you think such measured stimulus from China warrants an overweight stance on Chinese stocks in the next 6-12 months relative to global benchmarks? A: It is true that the size of existing Chinese stimulus, as a percentage of the Chinese economy, is smaller than that has been announced in the US. But this is due to a different approach China is taking in stimulating its economy. In addition, both the recent policy rhetoric and PBoC actions suggest a large credit expansion is in the works. This will likely overcompensate the damage on China’s aggregate economy, and generate an outperformance in both Chinese economic growth and returns on Chinese risk assets in the next 6 to 12 months. China’s policy responses have an overarching focus on stimulating new demand and investment, which is a different approach from the programs offered by its Western counterparts. In the US, the combination of fiscal and monetary stimulus amounts to 11% of GDP as of April 16, with almost all policy support targeted at keeping companies and individuals afloat. In comparison, China’s policy response accounts for a mere 1.2% of its GDP.3  However, this direct comparison understates the enormous firepower in the Chinese stimulus toolkit, specifically a credit boom. As noted in our February 26 report,4 China has largely resorted to its “old economic playbook” by generating a huge credit wave to ride out the economic turmoil. Our prediction of the policy shift towards a significant escalation in stimulus was confirmed at the March 27 Politburo meeting. Moreover, the April 17 Politburo meeting reinforced a “whatever it takes” policy shift with direct calls on more forceful central bank policy actions, a first since the global financial crisis in 2008.5 Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles. The PBoC’s recent aggressive easing measures have pushed down the interbank repo rate below the central bank’s interest rate on required reserves (IORR). The price for interbank borrowing is now near the lower range of the rate corridor, between the IORR and the interest rate on excess reserves (IOER).  Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles (Chart 7).  Such credit super cycles, in turn, have led to both economic booms and an outperformance in Chinese stocks. Chart 7Another Credit Super Cycle Is In The Works Another Credit Super Cycle Is In The Works Another Credit Super Cycle Is In The Works Chart 8Financial Conditions Were Extremely Tight In 2011-2014 Financial Conditions Were Extremely Tight In 2011-2014 Financial Conditions Were Extremely Tight In 2011-2014 The 2012-2015 cycle was an exception to the relationship between the overnight interbank repo rate, credit growth and Chinese stock performance. A steep pickup in credit growth in 2012 coincided with a leap in the overnight interbank repo rate, and the credit boom did not help boost demand in the real economy or improve Chinese stock performance. This is because corporate borrowing was severely curtailed by high lending rates during a four-year monetary tightening cycle from 2011 to 2014 (Chart 8). The credit boom during that cycle was largely driven by explosive growth in short-term shadow-bank lending and wealth management products (WMP), and did not channel into the real economy.6 We do not think such an extreme phenomena will replay under the current circumstances. Monetary stance will likely remain tremendously accommodative through the end of the year to facilitate a continuous rollout of medium- to long-term bank loans and local government bonds. Chinese financial institutions’ “animal spirits” may have been unleashed. But under the scrutiny of the Macro-Prudential Assessment Framework and the New Asset Management Rules,7 the "animal spirits" are unlikely to run up enough risks to prompt the PBoC to prematurely tighten liquidity conditions in the interbank market. Marginal propensity in China is pro-cyclical, which tends to lag credit cycles by 6 months. Chart 9Marginal Propensity In China Is Pro-Cyclical Marginal Propensity In China Is Pro-Cyclical Marginal Propensity In China Is Pro-Cyclical Both corporate and household marginal propensity, a measure of the willingness to spend, will pick up as well. Marginal propensity is pro-cyclical, which tends to lag credit cycles by 6 months (Chart 9). In other words, when interest rates are low and credit growth improves, corporates and households tend to spend more.  The meaningful expansion in credit growth, which started in Q1 and will sustain in the coming two to three quarters, will help corporate and household spending gain tractions in H2. This constructive view on Chinese stimulus and economic recovery supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms.  Q: The yield curve in Chinese government bonds has steepened following PBoC’s aggressive monetary easing announcements. Has the Chinese 10-year bond yield bottomed?   A: No, we do not think the 10-year bond yield has bottomed. There is probability the 10-year government bond yield may briefly dip below 2% in Q2. However, barring a multi-year global economic recession, we think the 10-year government bond yield will bottom no later than Q3 this year. Chart 10A Wide Gap Between The Long and Short A Wide Gap Between The Long and Short A Wide Gap Between The Long and Short The short end of the yield curve dropped disproportionally compared with the long end, following the PBoC’s announcement to place its first IOER cut since 2008 (Chart 10). This led to a rapid steepening in the yield curve. While our view supports a flattening of the yield curve in Q2 and even a 50bps drop in the 10-year government bond yield, we think that the capitulation will be brief. In order for the 10-year government bond yield to remain below 2% for an extended period of time, the market needs to believe one or more of the following will happen: The pandemic will cause a multi-year global economic recession, preventing the PBoC from normalizing its policy stance in the foreseeable future. The duration and depth of the economic impact from the pandemic are still moving targets. Our baseline scenario suggests that the Chinese economic recovery will pick up momentum in H2 this year. The PBoC will not normalize its policy stance even when the economy has stabilized. The PBoC has a track record as a reactive central bank rather than a proactive one. Still, during each of the past three economic and credit cycles, the PBoC has started to normalize its interest rate on average nine months following a bottom in the business cycle (Chart 11). The tightening of interest rate even applied to the prolonged economic downturn and deep deflationary cycle in 2015/16 (Chart 12).    Chart 11The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern Chart 12Policy Normalized Even After A Long Economic Downturn Policy Normalized Even After A Long Economic Downturn Policy Normalized Even After A Long Economic Downturn Chart 132008 Or 2015? 2008 Or 2015? 2008 Or 2015? How the yield curve has historically behaved also depended on the market’s expectations on the speed of the economic recovery, and the timing of the subsequent monetary policy normalization. The yield curved spiked in the wake of substantial monetary easing and pickup in credit growth, in both 2008 and 2015 (Chart 13). While in 2008 the yield curve moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation, in the 2015/16 cycle the yield curve spiked initially but quickly flattened. The long end of the yield curve capitulated as soon as the market realized the economic slowdown was a prolonged one. The 10-year government bond yield, after trending sideways in early 2016, only truly bottomed after the nominal output growth troughed in Q1 2016 (Chart 13, bottom panel). Will the yield curve behave like in 2008, or more like in 2015 in this cycle? We think it will be somewhere in between. The current economic cycle bottomed in Q1, but the economy is only recovering slowly and we expect a U-shaped economic recovery rather than a 2008-style V-shaped one.  At the same time, our baseline scenario does not suggest the current environment will evolve into a 4-year deflationary cycle as in the 2012-2016 period. Therefore, we expect the low interest rate environment to endure for another two to three quarters before the PBoC starts to reverse its policy stance back to the pre-COVID-19 range. As such, the yield on 10-year government bonds will fall, possibly by as much as 50bps, when the economic data disappoint in Q2 and more rate cuts are forthcoming.  But it will bottom when the economic recovery starts to gain traction in H22020 and the market starts to price in a subsequent monetary policy normalization.  When growth slows and debt rises sharply, the PBoC will need to join its western counterparts to permanently maintain an ultra-low interest rate policy to accommodate its high debt level. We acknowledge the fact that China’s potential output growth is trending down (Chart 14).  But it has been trending downwards since 2011. A structurally slowing rate of economic growth has not prevented the PBoC from cyclically raising its policy rate. Hence, unless we see evidence that the pandemic is meaningfully lowering China’s potential growth on par with growth rates in the DMs, our baseline scenario does not support a structural ultra-low interest rate environment in China. China’s debt-to-GDP ratio will most likely rise substantially this year, given that the credit impulse will gain momentum and GDP will grow very modestly. However, this rapid rise in the debt-to-GDP ratio will most likely not be sustained beyond this year. Even if we assume that credit impulse will account for 40% of GDP in 2020 (the same magnitude as in 2008/09), a sharp reversal in the output gap in 2021, as predicted by IMF,8 will flatten the debt-to-GDP ratio curve (Chart 15).  Moreover, following every credit super cycle in the past, Chinese authorities have put a brake on the debt-to-GDP ratio. Chart 14China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... Chart 15...But Has Not Stopped PBoC From Flattening The Debt Curve ...But Has Not Stopped PBoC From Flattening The Debt Curve ...But Has Not Stopped PBoC From Flattening The Debt Curve   All in all, while we see a high possibility for the 10-year government bond yield to fall in Q2, the decline will be limited in terms of duration. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1IMF World Economic Outlook, April 2020 2Please see China Investment Strategy Weekly Report "Investing During A Global Pandemic," dated April 1, 2020, available at cis.bcaresearch.com 3IMF, Policy Responses To COVID-19 https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#U 4Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?" dated February 26, 2020, available at cis.bcaresearch.com 5“Stable monetary policy must become more flexible” and “use RRR reductions, lower interest rates, re-lending and other measures to preserve adequate liquidity and guide the loan prime rate downwards.” Statements from Xi Jinping, April 17, 2020 Politburo Meeting. http://www.gov.cn/xinwen/2020-04/17/content_5503621.htm  6 Bankers’ acceptances - short-term debt instruments guaranteed by commercial banks - swelled by 887% between end-2008 and 2012. The outstanding amount of WMPs jumped from 1.7 trillion RMB in 2009 to more than 9 trillion RMB by H12013. In contrast, the amount of RMB-denominated bank loans increased by only 67% during the same period. 7The Macro-Prudential Assessment Framework and the New Asset Management Rules were implemented in 2016 and 2018, respectively. They are designed to create additional restrictions to curb shadow-bank lending and broaden the PBoC’s oversight on banks’ WMP holdings. 8The April IMF World Economic Outlook predicts a 1.2% Chinese GDP growth in 2020 and a 9.2% GDP growth in 2021. Cyclical Investment Stance Equity Sector Recommendations

Highlights In mainstream EM, foreign currency debt restructuring is more likely to occur among corporates than governments. Thus, dedicated EM credit investors should overweight mainstream EM sovereign credit and underweight EM corporate debt. Urgency among EM companies and banks to hedge their large foreign currency liabilities will continue exerting downward pressure on EM exchange rates. Ongoing currency depreciation and the lack of buyers of last resort for EM credit underpin the following strategy: short EM sovereign and corporate credit / long US investment-grade corporate credit. Feature Scope And Focus Of Analysis This report re-visits the issue of EM foreign currency debt, assessing EM debt vulnerability. This report focuses on mainstream EM (countries included in Table 1), excluding Gulf countries and frontier markets. Frontier markets like Argentina, Ecuador, Egypt, Ukraine, Lebanon and sub-Saharan African countries occupy somewhat idiosyncratic positions and are therefore not part of this report. Gulf countries on the other hand, are extremely leveraged to oil prices and, unlike mainstream EMs they have currency pegs warranting a separate analysis.1 Chart 1Favor EM Sovereign Against EM Corporate Credit Favor EM Sovereign Against EM Corporate Credit Favor EM Sovereign Against EM Corporate Credit Among mainstream EM countries, public debt restructuring is not imminent and in the majority of cases is unlikely. However, there is a growing risk of foreign currency debt restructuring among EM companies and banks. Hence, we make a new investment recommendation: overweight mainstream EM sovereign credit / underweight EM corporate debt (Chart 1). We also reiterate the short EM sovereign and corporate credit / long US investment-grade corporate credit strategy. In this report, foreign currency debt is defined as the sum of foreign debt securities (i.e., foreign currency bonds) and foreign currency loans. In short, foreign currency debt measures foreign currency borrowing of companies, banks and governments. These statistics do not include foreign holdings of local currency bonds and equities or any other local currency liability of residents to foreigners. Overall, the level of foreign currency debt is pertinent in assessing EM debt vulnerability originating from exchange rate depreciation. Table 12 offers comprehensive foreign currency debt statistics for each individual country and EM as a whole. It details foreign currency debt by type of borrower - the government, corporates and banks – and also reveals the breakdown between foreign debt securities and foreign currency loans for each segment. Table 1EM FX Debt: Who Owes How Much EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Chart 2EM FX Debt Has Doubled Since 2008 EM FX Debt Has Doubled Since 2008 EM FX Debt Has Doubled Since 2008 The foreign currency debt of Chinese companies and banks is quite substantial relative to other EM countries. Hence, including China in the EM aggregates would materially affect these EM aggregates. We thus focus our analysis on EM ex-China and present China’s numbers separately. Since early 2009, EM ex-China aggregate foreign currency debt has doubled to about $3 trillion (Chart 2). Furthermore, this $3 trillion EM ex-China foreign currency debt is split as follows in terms of borrower type: non-financial corporates ($1.25 billion), banks ($846 billion) and governments ($878 billion). Government Foreign Currency Debt Among mainstream EM countries, foreign currency government debt is not vulnerable to restructuring or default. The reason is that the foreign currency debt burden of governments is low, having declined dramatically in the last decade. Table 2 illustrates that the share of local currency government debt is by far greater than the foreign currency debt in each EM country. Table 2EM Public Debt: Local Currency Exceeds FX Debt EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains In the past 10 years, EM governments have deliberately replaced their foreign currency debt with local currency debt. Search for yield by international fixed-income investors has facilitated this debt swap: enormous foreign demand for EM domestic bonds has allowed EM governments to issue a considerable amount of local currency bonds. Chart 3EM Foreign Exchange Reserves Are Large EM Foreign Exchange Reserves Are Large EM Foreign Exchange Reserves Are Large In addition, mainstream EM countries, with exception of Turkey and South Africa, hold large foreign currency reserves (Chart 3). Lately, several mainstream EM countries have gained a new defense tool from the Federal Reserves – US dollar swap lines. EM central banks’ swap lines with the Fed are primarily intended to instill confidence among investors in financial markets. They could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot alleviate insolvency problems. We will elaborate more about these swap lines with the Fed in another report this week. As to local currency public debt, the odds of debt restructuring are also low. First, the majority of EM countries have low aggregate public debt burdens as a share of the GDP (Table 2). Second, the majority of these nations have flexible currency regimes. This means that their central banks control the printing press. In the worst-case scenario - when investors become reluctant to own EM local currency government bonds, EM central banks can buy those bonds in both the secondary or primary markets if needed. In short, EM central banks can resort to a form of quantitative easing, i.e., purchasing local currency government bonds that would amount to public debt monetization. The wild card in this case will be the exchange rate – the currencies could depreciate substantially amid public debt monetization by central banks. Given that government liabilities in foreign currencies have declined substantially, exchange rate depreciation will not be a constraint for policymakers’ ability to monetize local currency debt. Remarkably, in the past two months amid the global indiscriminate selloff, central banks in several EM countries have begun purchasing government bonds or have stated that they will do so if required. This has created a precedent that will be used in future. One country that has large local currency government debt is Brazil. We have previously argued that Brazil requires robust nominal GDP growth to climb out of a public debt trap. With the COVID-19 crisis, the outbreak for its public debt has worsened considerably. Without the central bank monetizing public debt, it will be difficult for Brazil to escape rising government debt strains and, ultimately, local currency debt restructuring. In short, the cost of avoiding local currency public debt restructuring in Brazil could be large currency depreciation. Bottom Line: In mainstream EM, neither foreign currency nor local currency government debt face an imminent risk of restructuring. Public debt restructuring and defaults are occurring in Argentina and among frontier markets like Ecuador, Lebanon and a few sub-Saharan nations that are beyond the scope of this report. If local currency government bond markets become anxious about public debt sustainability, EM central banks could purchase government paper. If done on large scale, this will cause further currency depreciation. Corporate Foreign Currency Debt From a macro perspective, there are presently some pre-conditions that herald rising odds of foreign currency debt restructuring among EM corporates and banks: (1) rapid and massive foreign currency debt built up in the past 10-15 years; (2) substantial plunge in corporate revenues; and (3) massive currency depreciation. Taken together, these create fertile ground for debt restructuring by some corporate debtors. Foreign currency debt of companies and banks in mainstream EM ex-China countries has swelled in the past 10 years reaching $2.1. Bonds account for about $1.4 trillion while foreign currency loans account for the remaining $0.7 trillion. The global recession brought about by the COVID-19 pandemic is producing a collapse in EM companies’ local currency revenues and exports. Notably, EM ex-China exports were contracting even before the COVID-19 outbreak and they are currently crashing (Chart 4). Chart 4EM Exports & Corporate Credit Spreads EM Exports & Corporate Credit Spreads EM Exports & Corporate Credit Spreads Chart 5Commodities Prices And Currencies Drive EM Credit Spreads Commodities Prices And Currencies Drive EM Credit Spreads Commodities Prices And Currencies Drive EM Credit Spreads The top panel of Chart 5 illustrates EM corporate credit spreads (inverted) correlate with commodities prices. Hence, plunging commodities prices entail growing foreign currency debt stress for EM companies and banks. Finally, EM ex-China currencies have depreciated substantially making foreign currency debt more expensive to service (Chart 5, bottom panel). Please refer to Box 1 attesting that for EM debtors with US dollar liabilities, EM exchange rate depreciation is worse than that of higher US bond yields.     Box 1 What Is More Imperative For EM FX Debt: Exchange Rates Or Interest Rates? EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising US interest rates. Table 3 illustrates this point using the following hypothetical simulation: We consider a conjectural Brazilian debtor with $1,000 in debt with five years remaining to maturity, and a starting point exchange rate of 4 BRL per USD. In our example, a 5% depreciation in local currency against the dollar boosts the overall debt burden by 200 BRL (please refer to row 2 of Table 3). This does not include the rise in local currency costs of interest payments. It reflects only the increased burden of principal. Table 3A Hypothetical Simulation: FX Debt Burden Is More Sensitive To Exchange Rate Than Borrowing Costs EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains An equivalent rise in debt servicing costs in local currency will require a 100-basis-point increase in US dollar borrowing costs. In brief, US dollar rates should rise by 100 basis points for interest payments to increase by BRL 200 over a five-year period, the time remaining to maturity. This simulation reveals that a 5% dollar appreciation versus local currency is as painful as a 100 basis points rise in US dollar rates and is more burdensome if the cost of coupon payments is accounted for. Provided there are higher odds of 5% currency depreciation in many EMs than a 100-basis-point rise in US dollar borrowing costs, we infer that EM FX debtors’ creditworthiness is more sensitive to exchange rates than to US Treasury yields. As the bottom panel of Chart 5 above clearly demonstrates, EM corporate and sovereign credit spreads correlate strongly with EM exchange rates. Consequently, the trend in EM exchange rates versus the US dollar is much more important for EM credit spreads than fluctuations in US bond yields. As to the currency composition of EM FX debt, about 82% of EM external debt is in US-dollar terms. Bottom Line: So long as EM currencies depreciate against the greenback, EM FX debt stress will mount, and EM corporate and sovereign credit spreads will widen. This will occur irrespective of whether US Treasury yields rise or drop.   If the bear market in commodities persists and/or EM currencies depreciate further – which is our baseline scenario, defaults on and restructuring of foreign currency debt among EM companies and banks are probable. One avenue to avoid corporate defaults is for the government to guarantee or assume the banks’ and companies’ foreign currency liabilities. It is probable because many of these borrowers are large entities with close links to their governments. However, governments will step in only after a debtor is on the brink default and its credit spreads are very wide. Briefly put, investors should be careful not to bet too early on government backstops of EM corporates’ and banks’ foreign currency debt. Identifying which corporate issuers could default or restructure debt involves bottom-up analysis that is beyond the scope of the macro research that BCA specializes in. An important question is what portion of corporate foreign currency liabilities have these debtors already hedged? Unfortunately, there are no macro data to answer this question either. Judging by the magnitude and speed of EM currency depreciation we have seen in the past two months, odds are that they have already partially hedged their exchange rate risk. Yet, given the sheer size of foreign currency liabilities, it is hard to imagine that corporates and banks have hedged all of them. Below we analyze each countries’ ability to service its foreign currency debt from a macro perspective. Vulnerability Assessment From a macro standpoint, foreign debt servicing vulnerability can be measured by foreign debt obligations (FDOs) and foreign funding requirements (FFRs). Chart 6EM FDOs And FFRs (Annualized) EM FDOs And FFRs (Annualized) EM FDOs And FFRs (Annualized) FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDO data are available until Q3 of 2019 (Chart 6, top panel). Hence, using this latest datapoint is pertinent to gauging the ability of individual countries to service their foreign debt over the coming six months. FFRs are the sum of FDOs in the next 12 months and current account balance (Chart 6, bottom panel). It measures the amount of foreign capital inflows required in the next 12 months for a country to cover any shortfalls in its balance of payment dynamics. Exports Coverage Of FDO: This measure compares annualized US dollar export revenues available to each country to its foreign debt service obligations in the next 12 months (Chart 7). The most vulnerable countries according to this measure are Brazil, Colombia, Turkey and Peru. On the other hand, Russia, Mexico, India & Korea have higher exports-to-FDO ratios. Chart 7Exports-To-Foreign Debt Obligations Ratio EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Foreign Exchange Reserves-to-FFRs Ratio: These metrics compare the size of foreign exchange reserves held by each nation’s central bank to its FFRs in the next 12 months (Chart 8). By this measure, Chile, Colombia, Turkey, Indonesia and Mexico have large FFRs relative to their central bank foreign exchange reserves. Meanwhile, Russia, Korea and Thailand fare well on this metric. Chart 8FX Reserves-To-Foreign Funding Requirements EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains On the whole, Chart 9 is a scatter plot combining both FDO and FFR measures to determine the most and least vulnerable EMs. The most vulnerable EMs are Brazil, Turkey, Colombia and Chile. Meanwhile, Russia, Korea, India and the Philippines are the least vulnerable. Chart 9EM FX Debt And Currency Vulnerability EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Investment Recommendations So long as EM currencies depreciate against the greenback, EM foreign currency debt stress will mount, and EM corporate and sovereign credit spreads will widen. We remain bearish on EM currencies. They usually trade with the global business cycle and the latter remains in free fall. We continue recommending shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. There will likely be no imminent restructuring or default on public debt in mainstream EM countries, outside frontier markets like Argentina, Ecuador, Lebanon and sub-Saharan African countries. However, there could be meaningful credit stress among EM corporate issuers. Consequently, dedicated EM credit investors should overweight mainstream EM sovereign credit and underweight EM corporate debt. We continue to recommend underweighting EM sovereign and corporate credit versus US investment-grade corporate credit (Chart 10). Not only is the Fed buying US investment-grade and some high-yield bonds but US companies will also benefit from the substantial fiscal stimulus. In EM, corporates and banks lack such support. Crucially, in contrast to US corporates, EM issuers also suffer from currency depreciation. Within the EM sovereign credit universe, our overweights are Russia, Mexico, Peru, Thailand and Malaysia. Underweights include South Africa, Brazil, Indonesia, the Philippines and Turkey. The rest warrant a neutral allocation within an EM sovereign credit portfolio. Finally, within corporate credit, we reiterate our long-standing recommendation of long Asian investment-grade corporates / Asian short high-yield corporate (Chart 11). We continue recommending shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Chart 10Remain Underweight EM Credit Versus US IG Credit Remain Underweight EM Credit Versus US IG Credit Remain Underweight EM Credit Versus US IG Credit Chart 11Long Asian IG Corporate / Short Asian HY Corporate Long Asian IG Corporate / Short Asian HY Corporate Long Asian IG Corporate / Short Asian HY Corporate     Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1We will publish a report on Saudi Arabia in the coming weeks. 2We have compiled data on foreign currency securities issued by non-financial companies and banks from Bloomberg. Bloomberg data accounts for the nationality of debt issuers. For instance, a US dollar bond issued by a Brazilian corporate subsidiary or a shell company located in the Cayman Islands is counted as Brazilian foreign corporate debt, rather than a Cayman Island debt security. For foreign loans, we use the Bank of International Settlements (BIS) datasets on Banking Statistics.

Feature In this report, we determine which South and Southeast Asian countries are better equipped to endure the COVID-19 pandemic. Answers to this question combined with our macro fundamental analysis lead us to recommend which countries to favor or avoid. We assess several factors in regard to the COVID-19 shock: (1) the healthcare capacity in each country, (2) the COVID-19 containment measures that have been implemented, and (3) the magnitude of fiscal and monetary stimulus packages that have been announced. We conclude that EM equity investors should keep an overweight position in Thai equities and a neutral one in the Malaysian stock market. Indian, Indonesian and Philippine stock markets, on the other hand, warrant an underweight stance. Healthcare System Capacity The COVID-19 virus can cause individuals with underlying medical conditions and already in poor health, as well as those above a certain age, to become seriously ill when infected. These patients will require the kind of special medical attention  – such as ventilation – that is only provided in a hospital’s intensive care unit (ICU). A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks overburdening the health care system. This would be a social catastrophe. A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks over¬burdening the health care system. Therefore, a key measure of the current coronavirus crisis is the relation between a population’s risk of developing critical illness from COVID-19 infections and a country’s intensive care unit (ICU) availability. We assess the risk of COVID-19 infections developing into critical illnesses in ASEAN countries and in India by gauging (1) the prevalence of diabetes in the population and (2) the share in population of people above the age of 60. Chart I-1 and Chart I-2 illustrate these factors separately. Chart I-1ASEAN & India: Population With Diabetes COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-2Population Above 60 Years Old COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities In addition, we combine these two risk variables to calculate the risk of critical illness. This measure is shown in Chart I-3. The measure shows that the population of both Malaysia and Thailand carry the highest risk of developing critical illnesses from COVID-19, owing to Malaysia’s high prevalence of diabetes and to Thailand’s rapidly aging population. Meanwhile, that risk is somewhat lower in India and dramatically lower in both the Philippines and Indonesia.  The next thing to look at is each country’s ICU capacity. Chart I-4 shows the number of ICU beds available per 100,000 people. Thailand has the highest number and Malaysia the second highest. On the other hand, India, Indonesia and the Philippines all have lower rates of ICU capacity. Chart i-3The Risk Of Critical Illness From COVID-19 COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-4Intensive Care Unit (ICU) Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Finally, we compare the risk of critical illness in each country to its available ICU capacity. Chart I-5 shows a scatter plot between these two variables. The risk of critical illness is shown on the Y-axis and the availability of ICU beds per 100,000 people is plotted on the X-axis. Thailand and Malaysia both have the highest risk of critical illness but also a large number of available ICU beds. India, Indonesia and the Philippines have lower average risk of critical illness but also far fewer ICU bed availabilities. Chart I-5The Risk Of Critical Illness Versus ICU Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities It is also important to note that Malaysia has the highest relative number of medical doctors per 10,000 people in the region (15 versus an average of 8). Furthermore, both Malaysia and Thailand appear to be performing many more COVID-19 tests. That in turn should help slow the spread of the virus and avoid overwhelming health care systems of Malaysia and Thailand. Bottom Line: Thailand and Malaysia have decent healthcare care capabilities relative to the threat of critical illness among their populations. India, Indonesia and the Philippines, on the other hand, seem relatively unprepared to weather this outbreak. Containment Response The magnitude and effectiveness of social distancing measures implemented is a critical means of protecting a country’s health care system. Indeed, the sooner such measures are put into place, the earlier the threat of the pandemic is likely to subside. This will then allow a country to normalize its economic activities sooner.  It appears that the Philippines and India have enacted the most stringent social distancing measures. Both announced complete lockdowns and called in their respective national armies to intervene. Malaysia has also announced extremely inhibitive measures and their enforcement has been quite successful. In Thailand, while the authorities have not imposed a complete lockdown, they have placed curfews and checkpoints that are subject to extension. Thai authorities have also warned that more restrictive measures could be imposed if residents do not comply. Indonesia, on the other hand, has been much softer on enforcement and is reluctant to introduce additional measures due to its economic concerns. Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Remarkably, the effectiveness of the measures can be quantitatively assessed via Google’s COVID-19 mobility tool and TomTom’s traffic congestion data. The average of all Google’s mobility variables, as of April 5, has declined most significantly in the Philippines, Malaysia, and India, relative to baseline values (Chart I-6).1 Likewise, TomTom’s traffic congestion data for the major cities in these same countries’ shows a similar decline during average peak hours over the first two weeks of April 2020, relative to the same period in 2019 (Chart I-7). Chart I-6How Effective Are Social Distancing Measures? COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-7Decline In Traffic From ##br##A Year Ago COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Bottom Line: The Philippines, India, and Malaysia have imposed the most effective and successful social distancing measures. This is then followed by Thailand. Indonesia on the other hand has not been as effective in this aspect. Fiscal And Monetary Stimulus Table I-1Stimulus Packages So Far Announced COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities The magnitude of the stimulus plans announced by each country is also important. Once the pandemic subsides and social distancing measures are relaxed, countries with a larger stimulus package in place should experience a faster economic recovery. Table I-1 shows the size of the overall stimulus packages announced so far. Malaysia and Thailand have the largest overall stimulus packages to the tune of 16% and 14% of GDP, respectively. India, Indonesia and the Philippines fall well short of these levels. Regarding monetary policy, central banks in all these countries have been cutting policy rates and injecting local currency liquidity. However, some of the programs announced by some of the central banks stand out: The Bank Of Thailand will inject 400 billion baht ($13 billion or 2% of GDP) into the corporate bond market. The central bank is also allocating 500 billion baht ($15 billion or 3% of GDP) of soft loans to small-and mid-sized companies.2 The central bank of the Philippines will be purchasing 300 billion pesos worth of government bonds ($6 billion or 1.6% of GDP) under a 3- to 6-month repurchase agreement to aid government efforts in countering the pandemic. Bank Indonesia may also begin buying government bonds (recovery/pandemic bonds) directly from the primary market. Details are not yet clear but the Indonesian government plans to issue $27 billion worth of these bonds and the central bank might emerge as the largest buyer. Similarly, the Reserve Bank of India has been injecting liquidity and purchasing government bonds for some time now. For instance, it announced a 1 trillion rupees injection in February – or $13 billion – via the long-term repo operation channel. It is now infusing an additional 1 trillion rupees through the same channel. It will also continue purchasing government bonds and securities to keep liquidity aflush and suppress market interest rates. Crucially, Governor Shaktikanta Das indicated that the RBI might even be forced to purchase government bonds directly from the primary market and that all options – including non-conventional ones – are on the table. Bottom Line: Both Thailand and Malaysia have so far announced larger overall stimulus packages than Indonesia, the Philippines and India have. This combined with their better health care capacities, suggests that the Thai and Malaysian economies will recover more quickly than they will in India, Indonesia and the Philippines. Conclusions Having considered risk of critical illness, the ICU availability and general medical capacities, the effectiveness of social distancing measures, and the stimulus packages each country has announced, Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Despite their elevated risk of critical illness, both countries have decent healthcare system capacities. Additionally, Malaysia has put in place very effective social distancing measures. Meanwhile, Thailand is placing curfews and monitoring developments very closely. Finally, both countries have enacted massive stimulus packages that will aid in the recovery of their economies later this year.  Notably, Thailand and Malaysia have been running current account surpluses for a long period of time whereas India, Indonesia and the Philippines generally run current account deficits. This, in turn, will allow the former to implement much larger overall stimulus packages than the latter, without risking major currency depreciation. Despite strong and successful social distancing efforts, India and the Philippines are hampered by a weakness in their health care infrastructures. They also are unlikely to be able to provide a large enough stimulus without subjecting themselves to significant currency depreciation. Additionally, India also has an elevated critical illness risk. Finally, Indonesia is likely to emerge from the crisis in the weakest position. Its healthcare system capacity is weak, the social distancing measures it implemented are insufficient and its enforcement has been lax. Indonesia is likely to emerge from the crisis in the weakest position. The government has also been timid about enacting significant stimulus given that it runs a large current account deficit. Moreover, it is unwilling to tolerate any further large currency depreciation due to the elevated foreign currency debt that Indonesian companies and banks carry. The latter stands at  $124 billion in the form of both bonds and loans. Investment Strategy Chart I-8Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets The following is our strategy recommendations for each country: Thailand: Our equity overweight stance on this bourse has been significantly challenged since early this year (Chart I-8). However, Thai stocks seem to be holding up at an important technical support level in relative terms.       Furthermore, as of December 2019, the ownership of the country’s local currency bonds was low at 17% (i.e. even before the global sell-off commenced). Further selling by foreigners should therefore be limited, which should reduce renewed depreciation pressures on the Thai currency. We recommend that respective EM portfolios keep an overweight position on Thai equities, sovereign US dollar and local currency bonds. Malaysia: On the one hand, Malaysian stocks have been underperforming EM benchmarks since 2014. Also, foreign ownership of Malaysian local currency bonds has declined from 34% in 2016 to 25% as of December 2019. This limits the possibility of future foreign selling. On the other hand, the economy was facing severe deflationary pressures even before the COVID-19 shock occurred. The latter will only reinforce these deflationary dynamics. Considering the positives and the negatives together, we recommend a neutral allocation to Malaysia within an EM equity portfolio. The Philippines:  Philippine stock prices relative to EM seem to have broken below a critical support level that will now act as resistance (Chart I-9). Moreover, local currency government bond yields have risen sharply (Chart I-10 and Chart I-11). This does not bode well for real estate and bank stocks that account for a very large market-cap chunk of the Philippine MSCI Index (46%). Critically, government expenditures were strong even before the COVID-19 pandemic occurred and it was only a matter of time before that contributed to higher imports. Now that exports are crashing - due to collapsing global demand - and imports are likely to remain high because of even higher government spending/fiscal stimulus, the current account deficit will widen substantially. This will cause the peso – which has been holding up so far – to depreciate significantly. Stay underweight on this bourse and local currency government bonds relative to their respective EM benchmarks. We also recommend keeping a short position on the Philippine peso versus the US dollar. Chart I-9Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Chart I-10Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Chart I-11...And Relative To Their EM Peers ...And Relative To Their EM Peers ...And Relative To Their EM Peers India: We discussed India in detail in a recent report. We recommend an underweight position amid the pandemic. In previous years, private banks lent enormous amounts to consumers via mortgages and consumer loans/credit cards. Therefore, the performance of both sectors has been contingent on the health of the Indian consumer sector. However, the outlook for the Indian consumer has worsened dramatically because of the unprecedented income hit households will suffer from the lockdown. Moreover, social safety nets and health care capacities (as mentioned above) are very weak in India. Indonesia: We also discussed Indonesia in detail in a report published on April 2. In recent years, the Indonesian bourse benefited from lower US interest rates and ignored deteriorating domestic fundamentals and lower commodities prices. Global investors’ increased sensitivity to individual EM fundamentals amid this pandemic will only make Indonesia’s weakest spots – like its exposure to commodities and its anemic domestic demand – more apparent. With global growth being very weak, commodities prices will remain low – reinforcing currency depreciation and pushing corporate bond yields higher. Combined with relapsing domestic growth, the Indonesian bourse will likely continue underperforming. Bottom Line:  Within an EM equity portfolio, we are keeping an overweight position on the Thai stock market. We also recommend keeping Malaysian equities on neutral. Our equity underweights are India, Indonesia, and the Philippines. In terms of fixed income markets, we recommend overweighting Thai, Malaysian and Indian local currency bonds and US dollar sovereign bonds. We recommend underweighting Indonesian and Philippine local and US dollar sovereign bonds.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 The baseline is the median value between January 3 and February 6. Our average calculation includes retail & recreation, grocery & pharmacy, parks, transit stations, and workplaces. It excludes the residential variable. 2 Note that this is part of the stimulus shown in Table 1.