economic research department · 2017-07-10 · economic-research.bnpparibas.com editorial 3rd...

economic-research.bnpparibas.com Eco Emerging 3rd quarter 2017

Editorial

Favourable winds, but residual risks

In emerging countries, the economic recovery is firming thanks to China’s growth stabilisation, the upturn in foreign trade and the normalisation of financial conditions after the turmoil that followed Donald Trump’s election. The main two global risks – the threat of protectionism and the risk of an accelerated tightening of the Fed’s monetary policy – do not seem to be as menacing as in late 2016. But the international financial institutions keep drawing our attention to other specific risks, which call for caution.

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BRAZIL

An endless saga

RUSSIA

Macroeconomic consolidation

INDIA

Feeble investment strains growth

CHINA

Less credit should mean slower economic growth

PHILIPPINES

Getting nervous about politics?

TURKEY

Anaphora of threes

POLAND

Cyclical upswing

UKRAINE

Economic growth picks up, but not employment

ALGERIA

Striking the right balance

NIGERIA

A sluggish recovery ahead

EGYPT

Inflation: EGP depreciation does not explain everything

QATAR

Political crisis highlights economics vulnerability

ECONOMIC RESEARCH DEPARTMENT

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economic-research.bnpparibas.com Editorial 3rd quarter 2017 2

Editorial

Favourable winds, but residual risks In emerging countries, the economic recovery is firming thanks to China’s growth stabilisation, the upturn in foreign trade and the normalisation of financial conditions after the turmoil that followed Donald Trump’s election. The main two global risks – the threat of protectionism and the risk of an accelerated tightening of the Fed’s monetary policy – do not seem to be as menacing as in late 2016. But the international financial institutions keep drawing our attention to other specific risks, which call for caution.

For emerging countries, the economic environment is more buoyant. Since the beginning of the year, external trade in goods has accelerated, portfolio investments are flowing in again, and USD-denominated financing conditions are still very favourable: for the moment, the easing of risk premiums has offset the mild increase in US bond yields. In our selection of 26 of the main emerging market countries, year-on-year growth could surpass 5% in Q2 2017, up from 4.7% in Q1 and 4.5% in H2 2016. The EM Growth Tracker of the Institute of International Finance (IIF) was already up 5.2% year-on-year in May. At the same time, the rebound in oil and metal prices came to a halt and agricultural commodity prices remained flat. Of course, this is bad news for oil-exporting countries; the most fragile oil producers still have to rebuild their foreign reserves again (see Editorial of April 2017). For oil-importing countries, in contrast, the slight upturn in inflation between mid-2016 and early 2017 will probably disappear, especially since most of their currencies have regained ground against the US dollar. Central European countries are the main exceptions: inflation was negative until mid-2016 but has now swung back into positive territory, as job market pressures are building and wage growth is accelerating. If there is any region where monetary policy should be tightened, this is probably it, although only mildly. Lastly, the main two global risks for emerging countries – the threat of protectionist measures announced by Donald Trump after taking power, and the risk of an accelerated tightening of the Fed’s monetary policy – do not seem to be as menacing as in late 2016.

But the international financial institutions have warned of other specific risks in their recently published first-half reports:

Financial risk: The Bank of International Settlements (BIS), in its annual report released in June, notes that, historically, peaks in the financial cycle are generally followed by periods of financial or banking stress. BIS assesses the position of an economy in the financial cycle based on two early-warning indicators: the credit-to-GDP gap (i.e. the deviation of the private non-financial sector credit-to-GDP ratio from its long-term trend) and the debt service ratios for private agents (household and corporate debt combined) relative to the historical average. The second indicator provides a better measure of near-term risks. The use of gaps signifies that the dynamics are more important than the level.

Looking at a selection of the 15 largest emerging countries, only China and Hong Kong have high or very high credit-to-GDP or debt service gaps. Next comes Turkey, with moderately high gaps. According to BIS, the credit-to-GDP gaps are moderately high for several other countries (Thailand, Indonesia, Malaysia, and Mexico). Moreover, the Asian countries face an aggravating factor: housing prices are significantly higher than their long-term trend. Over the course of 2016, however, private sector credit-to-GDP ratios have

levelled off and the gaps have narrowed. Moreover, under a simulation of higher interest rates, debt servicing ratios do not deteriorate to the point of exceeding critical thresholds.

Bank risk: in its Global Financial Stability report released in April, the IMF warns that in some countries, the ratios of non-performing loans and problem loans (restructured loans, loans with late payments but not classified as non-performing, and loans under surveillance) increased between year-end 2013 and mid-2016, due either to general recessions (Brazil, Russia, Nigeria, Ukraine) or to heavily indebted companies operating in ailing sectors (China, India, and to a lesser extent Indonesia). Of a selection of 300 banks from 14 countries, the ratio of non-performing and problem loans in 2016 did not exceed 10% with the exception of India (11%) and Russia (15.6%). However, they accounted for nearly half of equity capital and provisions (both specific and general) in Columbia, South Africa and Brazil, and for almost 80% in India and Russia.

Sovereign risk: In the June issue of Global Economic Prospects, the World Bank points out that a high proportion of commodity exporting developing countries has a primary balance (i.e. total fiscal balance excluding interest charges) that is not large enough to stabilise the country’s public-debt ratio. This proportion is currently 80%, up from only 30% before the 2008-2009 financial crisis. The difference between the primary balance and the debt-stabilising primary balance (so called sustainability gap) was on average -5% of GDP in 2016, whereas it was clearly positive before the crisis (+5% of GDP). Moreover, despite fiscal consolidation efforts, the sustainability gap still has not started to narrow whereas, in past episodes of sharp oil price corrections, this indicator had returned to pre-shock levels in two years’ time. Yet with higher debt ratios and a narrowing gap between the GDP growth and the average interest rate on the debt, interest charges have increased sharply for low income developing countries, meaning that they will need to make even bigger fiscal consolidation efforts.

François Faure [email protected]

mailto:[email protected]

economic-research.bnpparibas.com Brazil 3rd quarter 2017 3

Brazil

An endless saga The political and legal saga that has shaken the country over the past three years is perpetually postponing the normalisation of the institutional environment. Accusations against the President are unlikely to prevent him from finishing his mandate, and the financial markets have reacted less virulently than during previous episodes. But the smooth implementation of structural reforms and the confidence of economic agents and investors are critical for fostering a solid, sustainable economic recovery. Faced with another bout of uncertainty, the central bank continues to support monetary easing in a persistently disinflationary environment.

■ Carnival marks summer’s end and the revival of the political and legal saga, which is detrimental to investor morale and the Brazilian real, …

In Brazil, the month of March signals the end of summer vacation. After the traditional Carnival festivities, the usual “back-to-business” period has been transformed in recent years into “back to court” as the political and legal saga resumes. Fall 2013 was marked by fierce protest movements against the rising cost of living, the exorbitant price tag of the 2014 Football World Cup, and corruption. March 2014 will be remembered as the start-up of Operation Car Wash (Lava Jato), the corruption probe into Petrobras, followed a year later by the first accusations against elected officials, which ensnared the presidents of both houses of Parliament. Fall 2016 marked a major turning point in the political crisis as President Dilma Rousseff was suspended from her functions (and impeached in August) and replaced by Vice-President Michel Temer. Convinced by fiscal austerity and the structural reform programme, investors regained confidence in the midst of a more buoyant international environment (fewer worries about China, rebound in commodity prices, and abundant liquidity in the international markets). The Brazilian currency (BRL) appreciated 28% against the dollar (USD) between early 2016 and mid-May 2017.

Unfortunately, fall 2017 was not spared this new tradition, and the political saga continues. In April, the Supreme Court opened a new case against a hundred politicians, including several government members. Although the Electoral Court acquitted Dilma Roussef and Michel Temer of charges of soliciting illegal campaign donations during the 2014 presidential election, since mid-May, the President has been caught up in the Lava Jato investigation for “passive corruption”, “obstruction of justice” and “participating in a criminal organisation”. The opposition party is calling for his resignation, but it seems unlikely that impeachment procedures will win the support of two thirds of Parliament, as stipulated in the constitution. The coalition may have been weakened, but it still enjoys an overwhelming majority, with 75% of the Assembly’s seats. The most probable scenario is that President Temer will complete his mandate in December 2018, after general elections in October.

This new episode in a never ending political maelstrom shook the Brazilian markets, which have since recovered somewhat. The USD/BRL exchange rate depreciated 5% between mid-May and the end of June, the Sao Paulo Ibovespa equity index lost 10% in the local currency, while the yield on 5-year Treasuries rose 50 basis points (bp) to 10.25%, and the premium on 5-year CDS on sovereign bonds in hard currencies rose to 240 bp.

According to the Finance Ministry, non-resident investors divested USD 1.8 bn from the local bond market in May. Their share of Treasury bonds declined from 19% at year-end 2015 to a little over 13%, and their portfolio valuation declined from BRL 498 bn to BRL 420 bn.

■ …may hamper the smooth implementation of fiscal and social security reforms, …

The major risk associated with this weakened government is that it could slow down the reform agenda launched a year ago. The 20-year freeze on public spending in real terms was approved in December. The Senate might still vote on the labour law reform in July, and other microeconomic and sector reforms still seem to be

1- Forecasts

e: BNP Paribas Group Economic Research estimates and forecasts

2- FX rate and confidence indices

— Business confidence — Consumer confidence — Nominal foreign exchange rate USD/BRL (rhs, inverted)

Sources : BCB, Fundação Getulio Vargas

2015 2016 2017e 2018e

Real GDP grow th (%) -3.8 -3.6 0.5 3.0

Inflation (CPI, y ear av erage, %) 9.0 8.8 3.6 4.0

Fiscal balance / GDP (%) -10.3 -8.9 -8.8 -7.7

Gross public debt / GDP (%) 66.2 69.5 79.3 80.1

Current account balance / GDP (%) -3.4 -1.3 -1.3 -2.5

Ex ternal debt / GDP (%) 30.5 34.2 29.2 28.2

Forex reserv es (USD bn) 349 354 358 365

Forex reserv es, in months of imports 20.7 23.9 22.0 19.5

Ex change rate USD/BRL (y ear end) 3.9 3.3 3.0 3.3

1.5

2.0

2.5

3.0

3.5

4.0

4.560

70

80

90

100

110

120

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

economic-research.bnpparibas.com Brazil 3rd quarter 2017 4

on track, since their voting procedures are not very restrictive, and there is a relatively broad consensus. Yet pension reform, which is currently being debated in Parliament, requires a three-fifths majority in both houses, and could be postponed and/or watered down. The same applies to fiscal reform, which is still under review.

■ …the keystone of fiscal consolidation, …

Though very unpopular, pension reform is nonetheless a key pillar for the credibility of the fiscal consolidation plan. Under this plan, the minimum retirement age would be raised to 65, about 10 years more than the current average age of retirement. The public and private pension systems would be aligned, and pensions for high-wage earners would be capped.

The country’s demographic transition, marked by a declining birth rate and longer life expectancy, makes the current pension system unsustainable. The private social security regime (INSS) reported a deficit of BRL 150 bn in 2016 (2.4% of GDP), accounting for 96% of the overall public sector primary deficit according to the Finance Ministry. According to the National Statistics Institute (IBGE), the over-65 age group as a share of the total population will rise from 11.5% in 2010 to 21.5% in 2030, and 29% in 2040. The number of active workers per retiree will be halved (from 8 to 4). Without reforms, pension-related spending would increase from 11% to 13% of GDP in ten years, including nearly three-quarters for the private sector. According to the government, its reform project would stabilise this ratio and generate savings of BRL 604 bn, or an average of about 0.7% of GDP a year.

■ …and be fatal to the economic recovery in Q2, …

Awaited for the past eight quarters, real GDP finally rebounded vigorously in Q1 2017, to a seasonally-adjusted 1% q/q. Unsurprisingly, the main growth engine was the agricultural sector, which made a positive contribution of 0.9 percentage points, thanks to double-digit growth compared to the previous quarter (+13.4%). The contraction in industrial activity and services came to a halt. In terms of demand, private consumption stagnated (-0.1%), while investment continued to decline (-1.6%). This means that exports were the only driving force for GDP (+4.8%), in an environment marked by a slight improvement in the terms of trade and an upturn in world trade, which contributed to the trade surplus.

Unfortunately, the new bout of political turmoil could jeopardise the economic recovery in Q2. Monthly and leading indicators are mixed. On the positive side, since April, manufacturing PMI has been higher than 50, the threshold separating expansion from contraction, for the first time since January 2015. Industrial output and retail sales increased slightly between March and April (the most recently available statistics), prior to the new political-legal revelations. The labour market created 193,300 net jobs between February and May, after destroying nearly 3.6 million jobs since year-end 2014. The unemployment rate slipped from a seasonally adjusted 13.1% in April to 13% in May. Real wages increased 1.8% year-on-year, bolstered by disinflation, which boosts household purchasing power. On the negative side, business and household confidence indicators (available through June) have begun to decline again. Bank lending still has not picked up, despite lower interest rates. Total loans outstanding declined again in May (-2.6% year-on-year), pulled

down by corporate loans (-8.4% year-on-year), while household loans increased 3.6% year-on-year.

Against this backdrop, we have lowered our average growth outlook for the year 2017 from 1% to 0.5%. Activity should regain some vigour in H2, bolstered by the gradual acceleration of investment and consumption as well as decent export performance, whereas the increase in imports is likely to strain growth.

■ …without jeopardising the easing of the central bank’s monetary policy

Disinflation continues, and the IPCA-15 slipped to 3.5% year-on-year in June. The persistently negative output gap favours the convergence of core inflation (+4.7%) towards the mid-point of the target range (4.5% +/- 2 percentage points). The very strong farm harvest held down food prices (+0.7% year-on-year). The Selic rate was trimmed from 14.25% in September 2016 to 10.25% in June 2017, and the pace of key rate cuts was amplified to 100bp in recent months.

Despite renewed financial volatility, the real’s depreciation and greater uncertainty over the implementation of reforms, the fragility of the economic recovery in the short term should encourage the central bank (BCB) to continue easing its monetary policy. In the latest inflation report released in June, Brazil’s monetary policy committee (Copom) announced that the size of the next rate cuts would be determined by cyclical trends, the balance of risks and inflation expectations. The later seem to be well anchored at 3.8% at year-end 2017, 4.5% at year-end 2018 and 4.3% at mid-2019. In early July, the National Monetary Council (CMN) is expected to approve the downward revision of the 2019 inflation target, bringing it more in line with emerging market standards.

Sylvain Bellefontaine [email protected]

3- Real GDP growth (%)

█ q/q, sa — y/y

Source : IBGE

-6

-4

-2

0

2

4

6

8

10

2010 2011 2012 2013 2014 2015 2016 2017


economic-research.bnpparibas.com Russia 3rd quarter 2017 5

Russia

Macroeconomic consolidation Russia’s macroeconomic situation has consolidated significantly in recent months. Real GDP growth accelerated to 0.5% year-on-year in Q1 2017, and the latest indicators point to an upturn in household consumption in early Q2 2017. The banking sector situation has stabilised since the end of last year, which should help support the recovery in H2 2017. Moreover, in the first five months of fiscal year 2017, the deficit narrowed sharply, thanks to higher oil and natural gas revenues and cutbacks in spending. The Russian authorities have also begun to rebuild the reserve fund, using surplus fiscal revenues, without placing a strain on the rouble.

■ Private consumption picks up

In first-quarter 2017, Russian economic activity rebounded to 0.5% year-on-year. The main support factor was the upturn in investment, while household consumption continued to contract. Yet retail sales stopped declining in March, and even increased 0.9% year-on-year in April, while automobile sales rebounded by 5.1% year-on-year.

The upturn in private consumption was fuelled by the increase in real wages resulting from the net slowdown in inflation and the decline in the unemployment rate. In May, consumer prices rose only 4.1% year-on-year, compared with 7.3% in the year-earlier period. Yet the central bank esteems that inflation is close to a low point, and that it could reach around 4% at the end of the year.

At the same time, industrial output accelerated to 5.6% year-on-year in May, and business confidence indexes are looking upbeat in both manufacturing and services.

Non-financial corporates also consolidated their position over the course of 2016. On the whole, earnings increased nearly 38%. The strongest earnings growth was in manufacturing industry, notably in textiles and the production of machines and equipment. The number of corporate bankruptcies also levelled off at 9.9 per 1000 in February and March 2017, down from 19.1 per 1000 in December 2016. The easing of monetary policy enabled interest rates on rouble-denominated corporate loans to decline by 200 basis points over the past year, which should further consolidate the position of companies and support renewed investment.

■ The situation levels off in the banking sector

In a much more favourable economic environment, the banking sector situation stabilised in late 2016. The quality of bank assets stopped deteriorating. In the first four months, the non-performing loan ratio declined by 0.6 points to 8% in April 2017, and the share of total risky assets1 stabilised at 18.8%.

Capital adequacy ratios (CAR and Tier 1 CAR) stopped deteriorating as of late H1 2016 and increased to 13.3% and 9.2%, respectively, in April 2017.

The liquidity deficit has totally disappeared and Russian banks have reported a liquidity surplus since the beginning of the year. Under these conditions, the central bank managed to introduce new monetary policy instruments to maintain money market rates close to key rates.

1 Defined as the sum of non-performing loans, overdue and loss loans.

In the span of a year, Russian banks have increased their earnings five-fold to RUB 930 bn, returning to the pre-crisis level. This improvement was confirmed by the statistics available for Q1 2017.

Yet despite the stabilisation of the banking sector situation, credit growth is still weak. Adjusted for currency fluctuations, the stock of private-sector loans contracted by 2.1% in full-year 2016, and this trend does not seem to have reversed itself in the first three months of 2017.

1- Forecasts


2- Industrial output and PMI in manufacturing industry

▬ Industrial output (yoy, %, LHS) ▬ PMI (RHS)

Source: Rosstat

2015 2016 2017e 2018e

Real GDP grow th (%) -2.8 -0.2 1.4 1.6


General Gov . balance / GDP (%) -3.4 -3.7 -2.7 -2.1

Public debt / GDP (%) 17.7 18.4 19.0 19.3

Current account balance / GDP (%) 5.0 1.9 3.4 3.2


Foreign ex change reserv es (USD bn) 320 318 349 395

Foreign ex change reserv es, in months of imports10.8 11.2 10.9 11.2

Ex change rate RUB/USD (y ear end) 72.5 60.3 60.0 62.0

47

48

49

50

51

52

53

54

55

56

-2

-1

0

1

2

3

4

2014 2015 2016 2017

economic-research.bnpparibas.com Russia 3rd quarter 2017 6

■ Fiscal consolidation early in the year

In the first 5 months of 2017, the federal government’s fiscal deficit is estimated at 1.7% of GDP, a 2.9 point decline from the previous year. Over the same period, the primary deficit narrowed to only 0.8% of GDP.

This consolidation can be attributed in part to higher oil and natural gas revenues (+0.9 points of GDP), which offset the decline in non-oil and gas revenues, and in part to cutbacks in government expenditure2, which declined by nearly 3 points of GDP. As a result, in the first five months of the year, the non-oil and gas fiscal deficit declined by 4.6% y-o-y to a total of 7.9% of GDP.

In the first three months of the year, 70% of the deficit was financed by dipping into the reserve fund, and the remainder was financed by issuing debt instruments in the domestic market. A new fiscal rule was introduced in February to allow surplus oil and natural gas revenues 3 to be used to acquire hard currencies in the foreign exchange market, in order to rebuild the reserve fund, which has held steady since the beginning of the year at USD 16 bn. Despite the risk of tighter US sanctions, the Russian finance ministry managed to issue USD 3 bn in bonds last June.

■ Towards tighter US sanctions?

On 15 June, the US Senate approved a bill to tighten the sanctions against Russia and to prevent President Trump from easing its sanctions policy without prior congressional approval.

Adopted by a vote of 98 to 2, the bill calls for existing sanctions to be expanded to cover state-owned companies in mining, iron & steel, rail & maritime transport and pipelines. It also calls for reducing the duration of financing for Russian banks and oil companies to 14 days and 30 days, respectively, down from 90 days currently. It also prohibits taking any equity stakes of more than USD 10 m in Russian companies “close to the government”, and all purchases of treasury notes might ultimately be forbidden4.

Easing these sanctions would require prior approval by two thirds of the members of the House of Representatives and the Senate, whereas currently, the president alone has the authority to ease sanctions.

The bill must still be adopted by the House of Representatives before it is sent to the US president for ratification. The House is unlikely to vote in favour of tighter sanctions against Russia, unless the scope of the initial bill is modified somewhat, under pressure from Germany and Austria. Both countries have companies that are involved in numerous energy projects in Russia, and have expressed their disapproval of the US Senate’s vote on this proposal, which imposes financial sanctions on companies that contribute in one manner or another to the construction of Russian pipelines.

2 In Q1 2017, nearly 60% of spending was allocated to pensions and defence. 3 Whenever international oil prices exceed those set in the 2017 budget, i.e. USD 40 per barrel. 4 The US Treasury reserves the right to prohibit the purchase of Russian sovereign securities in the six months that follow the law’s adoption.

At the same time, the European Union extended its sanctions against Russia for another six months.

■ Consolidation of external accounts

In the first five months of 2017, Russia’s external accounts strengthened significantly, thanks notably to the improvement in the terms of trade. The rouble has stabilised at RUB 57 to the USD (+6% year-on-year) despite central bank interventions to purchase dollars as part of its programme to rebuild the reserve fund. Foreign reserves have increased by nearly USD 19 bn to USD 326 bn, which is equivalent to nearly 16 months of imports of goods and services.

In Q1 2017, the balance of payments surplus (excluding fluctuations in foreign reserves) amounted to more than 4.1% of GDP, nearly 2 points of GDP higher than in Q1 2016. The current account balance increased by 1.6 points of GDP compared to Q1 2016 to reach 6.7% of GDP, bolstered by the increase in the trade surplus, thanks to the rise in oil and natural gas prices.

At the same time, despite major debt repayments by the banks, the financial account deficit narrowed slightly by 0.4 points of GDP to 2.6% of GDP.

Johanna Melka [email protected]

3- Exchange rate and foreign exchange reserves

▬ Exchange rate RUB/USD (LHS, inverted scale)

▬ Foreign exchange reserves (USD bn, RHS)

Source: Central Bank of Russia (CBR)

250

300

350

400

450

50030

40

50

60

70

80

902014 2015 2016 2017


economic-research.bnpparibas.com India 3rd quarter 2017 7

India

Feeble investment strains growth Economic growth slowed in the fourth quarter of fiscal year 2016/2017. This slowdown is only partly due to the demonetisation process. As of September, investment began to slow and the production of capital goods to decline. Looking beyond the difficulties of some corporates, the deterioration in the quality of bank assets has placed a heavy strain on loan distribution. Faced with this situation, the government adopted a new measure to increase the central bank’s role in managing non-performing loans. Although this measure should accelerate the debt resolution process, it will not offset the major capital needs of the state-owned banks.

■ Activity slows

Real GDP growth slowed to 6.1% year-on-year in the fourth quarter of fiscal year 2016/2017, which ended on 31 March 2017. This slowdown is partly due to the demonetisation process introduced in November 2016. By late May 2017, money supply in circulation was still 16% below the October 2016 level. The withdrawal of INR 500 and INR 1000 notes triggered a slowdown in household consumption. At the same time, investment contracted (down 2.1% y/y excluding inventory in Q1 2017) and net exports made a negative contribution to growth, despite a buoyant increase in exports.

The slowdown in household consumption is likely to be temporary. In contrast, the contraction in investment (down 1.7% y/y in Q1 2017) is more troublesome because it dampens the country’s medium-term growth prospects. It cannot be blamed solely on demonetisation. The decline in investment confirms the contraction in industrial production of capital goods reported as of September 2016. Until now, higher public investment has offset the decline in private investment. Yet in the fourth quarter of fiscal year 2016/2017, the government cutback spending in order to limit the fiscal deficit to 3.5% of GDP.

The decline in private investment is due to the deleveraging of Indian companies, a strategy justified by persistently high surplus production capacity, notably in the steel sector. The financial situation of state-owned banks is also straining their lending policy. In the first four months of 2017, the growth of bank lending remained weak (+4.3% y/y), even though it accelerated slightly, buoyed by increased lending in the services sector. Yet lending to industry continued to contract (-1% y/y). Moreover, interest rates on 1-year loans granted by state-owned banks have declined only 86 basis points over the past two years, even though key rates have been lowered by 125 basis points (bp). The increase in non-performing loans and the provisions they require have sharply curtailed the credit supply of state-owned banks. As a result, over the past two years, the market share of state-owned banks has declined by 5 percentage points in favour of private banks. Even though private banks are more active and have reduced their lending rates more sharply than the state-owned banks, the overall credit supply continues to hamper the recovery of investment.

■ The burden of non-performing loans

Last May, the government adopted a new rule to increase the central bank’s role in the resolution of non-performing loans. For nearly the past three years, NPL remain a burden for the state-owned banks despite numerous measures taken by the Indian

authorities to clean up their balance sheets. Risky assets 1 accounted for 16.1% of total loans outstanding for the state-owned banks at the end of December 2016, two points more than the previous year, and the equivalent of 5.6% of GDP. Risky debts continue to be concentrated in the iron and steel sector, energy and infrastructure. In these sectors, corporate situations continued to deteriorate in fourth-quarter 2016, which means that non-performing loans are likely to continue rising in the months ahead.

1 The sum of non-performing loans and restructured assets, according to the central bank’s definition.

1- Forecasts

e: estimation and forecast Group Economic Research BNP Paribas

2- GDP and its components

Real GDP growth (y/y) and its components (percentage points)

▬ GDP (y/y) █ Government expenditure (pp) █ Net exports (pp) █ Private consumption (pp) █ Investment █ Change in inventory (pp) █ Statistical errors (pp)

Source: Central Bank (RBI)

2015 2016 2017e 2018e

Real GDP grow th(1)

(%) 7.9 7.1 7.5 7.9

Inflation (1)

(CPI, y ear av erage, %) 4.9 4.5 4.6 4.9

Central Gov . Balance(1)

/ GDP (%) -3.9 -3.5 -3.4 -3.4

Central Gov . Debt(1)

/ GDP (%) 46.6 47.2 47.0 46.5

Current account balance(1)

/ GDP (%) -1.1 -0.9 -1.2 -1.4

Ex ternal debt(1)

/ GDP (%) 23.2 21.2 20.4 19.8

Forex reserv es(1)

(USD bn) 336 346 369 390

Forex reserv es(1)

, in months of imports 7.8 7.7 7.9 8.1

Ex change rate INR/USD (y ear end) 66.2 67.9 66.0 68.0

(1): Fiscal y ear from April 1st of y ear n to March 31st of y ear n+1

-10

-5

0

5

10

15

2013 2014 2015 2016 2017

economic-research.bnpparibas.com India 3rd quarter 2017 8

At year-end 2016, the IMF estimated the non-performing loan ratio (net of provisions) at 38.7% as a share of bank equity, compared to only 24% the previous year.

Cleaning up bank balance sheets is still problematic because the banks are reticent to sell their non-performing loans to the Asset Reconstruction Companies, private defeasance structures created in August 2014. The banks esteem that the ARC are demanding excessively high discounts on asset value. Moreover, the banks are finding it difficult to reach an agreement on debt resolution terms. Until now, they have had to obtain an agreement with 60% of their debtors holding at least 75% of the debt. The regulation adopted in May should help ease the NPL resolution terms. The central bank notably decided to lower the threshold for obtaining an agreement between lenders2. Moreover, it can intervene directly in the loan restructuring process in order to advise ailing banks. Even so, although the measure aims to accelerate the NPL resolution process, it will not offset the banking sector’s major recapitalisation needs, estimated at INR 1.8 trillion (the equivalent of 3.4% of 2016 GDP), 83% of which is for the state-owned banks alone. Until now, the Indian authorities have planned to inject only INR 0.7 trillion in the state-owned banks. Although capital adequacy ratios improved slightly for the Indian banking sector as a whole at the end of 2016 (CAR and Tier 1 CAR of 13% and 10.7%, respectively, according to the IMF), the situation remains extremely heterogeneous depending on the bank. Moreover, most of the state-owned banks will not meet their Basel III regulatory requirements in 2019.

■ Application of GST as of 1 July 2017

A year after it was adopted by the upper house of Parliament, the goods and services tax (GST) was officially launched across the country on 1 July 2017, and will be applicable in all states. Fresh produce, alcohol, drugs and electricity will be tax exempt. As for the rest, there are four tax rates: 5% for basic goods, 12% for small appliances and frozen foods, 18% for the vast majority of goods and services, and 28% for luxury goods and services. There will be a supplementary tax on certain goods like automobiles to provide financial compensation for states due to the revenue loss arising from the elimination of certain taxes. The tax rates were revised downwards from the initial figures presented in December 2016. By setting up a highly progressive tax system, the government’s goal is to spare the poorest segments of the population.

To take into account the country’s federal structure, the tax will be levied at the government (central GST) and state levels (State GST). For operations between states, a single tax will be levied (integrated GST), the sum of the central and state GST.

In the short term, the introduction of a single VAT tax applicable to all states should have a neutral impact on fiscal revenues, and possibly even a disinflationary effect of 2 percentage points according to Finance Ministry projections. In the longer term, the reform should generate additional fiscal revenues thanks to higher investment and accelerated economic growth.

In the short term, the disinflationary effect is likely to be mild. According to a Nomura study, the decline in food prices (60 basis

2 It now suffices to reach an agreement with 50% of creditors holding 60% of the debt.

points) should reduce inflation by about 33 bp. But the increase in the average rate for services (from 15% to 18%) should generate higher inflation excluding food products. In the short term, the introduction of GST will trigger a temporary slowdown in economic growth due to the difficulties for small and mid-sized companies to set up the new tax system, and the informal sector’s heavy weighting within the Indian economy.

In the medium term, implementation of a single tax applicable to all states should generate competitiveness gains and revitalise trade within the country, because the reform will considerably reduce costs and red tape for companies. This should strengthen their profit margins and competitiveness, and in turn encourage further investment.

The IMF esteems that the introduction of a single tax could boost India’s growth potential by 8%. According to Leemput and Wiencek (2017)3, the increase in real GDP is estimated at between 3.1 and 4.2 percentage points.

Johanna Melka [email protected]

3 “Financial frictions, underinvestment and investment composition: evidence from Indian corporates”, IMF working paper 17/134.

3- Loans

Year-on-year (%)

Corporates loans Loans in industry Total loans

Source: RBI

-10

-5

0

5

10

15

20

25

2012 2013 2014 2015 2016 2017


economic-research.bnpparibas.com China 3rd quarter 2017 9

China

Less credit should mean slower economic growth Monetary tightening and a stricter prudential and regulatory framework for the financial sector should curb domestic credit growth in 2017. For the time being, the main consequences are a slowdown in interbank financing, a bond market correction and the slower expansion of certain shadow banking activities. Commercial bank loan growth has not really decelerated yet. The slower growth in the real estate sector in recent months could spread to other sectors that are credit-dependent, and economic growth is likely to slow again in the quarters ahead.

■ Tighter monetary conditions…

China’s monetary policy stance has changed since the last quarter of 2016. The authorities have adjusted their priorities at a time when economic growth was stabilising, industrial activity was improving, inflation was accelerating, asset market bubbles were forming and capital outflows were surging. After bolstering support for economic growth, they have focused more on reining in risks of financial instability since last fall1.

Firstly, the People’s Bank of China (PBOC) has adjusted its open market operations in order to guide money market rates higher. Repo rates have been gradually increased since October 2016, then the central bank increased the rates on its “liquidity facilities” (which enable it to provide liquidity to certain well-targeted institutions) in Q1 2017. These measures are mainly designed to discourage the use of interbank financing (which has increased rapidly in recent years), thereby reducing the leverage levels of financial institutions and curbing the expansion of their lending and investment activities.

Although benchmark rates for loans and deposits have remained unchanged for more than two years, the cost of borrowing for corporates has begun to rise as a result of the tightening of liquidity conditions in the interbank market. The weighted average rate on bank loans, which had mirrored the benchmark rates between late 2014 and Q4 2016, started to rise in early 2017. It increased to 5.5% in January 2017 from 5.3% in December. Bond yields have also increased rapidly since October 2016: this has been the consequence of monetary tightening measures, but also of a confidence crisis in the bond market that led to the reassessment of risk premia. See chart 2.

The authorities have accompanied the tightening of monetary conditions: 1) by tightening the prudential rules governing house purchases and property loans in most of the big cities, and 2) by taking new measures to strengthen the financial sector’s regulatory framework. PBOC set up a Macro-Prudential Assessment (MPA) last year. As part of this MPA framework, Chinese banks should be rated according to a series of financial soundness ratios. The ratings then could change the remuneration on reserve requirements paid to the banks (premiums and penalties are determined on the basis of financial soundness ratios), as well as access conditions for the PBOC’s liquidity facilities. The MPA framework also makes it easier for the regulators to supervise growth in a broad array of assets. Moreover, since Q1 2017, the PBOC has increased its control over shadow banking activities by integrating Wealth Management

1 For more information on China’s excessive debt and financial risks, see:

“Danger in China’s financial nebula”, Conjoncture, BNP Paribas, June 2017.

Products (WMPs), which are off-balance-sheet items, into the MPA framework. Their inclusion means that WMP activities must be fully accounted for in the banks’ risk management systems (with the same capital buffer requirements as its balance-sheet activities, the same reporting rules, etc.).

Moreover, the various financial-sector supervisory authorities are also trying to better coordinate their actions in order to close persistent regulatory loopholes, to make it harder for financial institutions to resort to regulatory arbitrage and engage in complex and opaque structuring of financial products, and to better control all the existing ties between banks and non-banking institutions.

1- Forecasts


2- Tensions in the money and bond markets

Interest rates, %

▬ 7-day repo rate ▬ Benchmark rate on 1-year loans

▬ 5-year AAA+ note yield

Sources: PBOC, CEIC

2015 2016e 2017e 2018e

Real GDP grow th (%) 6.9 6.7 6.6 6.4


Official budget balance / GDP (%) -3.4 -3.8 -3.2 -3.0

Central Gov . debt / GDP (%) 15.5 16.1 18.0 19.5

Current account balance / GDP (%) 3.0 1.8 1.4 1.1

Total ex ternal debt / GDP (%) 12.6 12.7 12.7 13.0

Forex reserv es (USD bn) 3 330 3 011 3 024 3 072


Ex change rate CNY/USD (y ear end) 6.5 6.9 7.0 6.9

1

2

3

4

5

6

7

2014 2015 2016 2017

%

economic-research.bnpparibas.com China 3rd quarter 2017 10

■ … will weigh on credit and economic growth

Monetary tightening, stricter prudential regulations and a more systemic and better coordinated approach to supervision should logically slow domestic credit growth. For the moment, the consequences can be seen mainly in the interbank and bond markets. Interbank financing has slowed sharply since Q4 2016, affecting shadow banking institutions in particular and thereby limiting their lending capacity. Combined with a more restrictive prudential framework, this has helped trigger a drop in WMP activity. Moreover, bond issuance stopped increasing in December 2016, bringing an end to several years of steady expansion. In the meantime, overall growth in “total social financing” (TSF)2 has not shown any real signs of deceleration over the past six months. The increase in “traditional” bank loans dipped slightly in late 2016 and in Q1 2017, but picked up again in April and May. Over the same period, creditors and borrowers also took greater advantage of trust loans. See chart 3.

We should see a slight easing in total social financing growth in the short term (to 12% year-on-year at the end of 2017, from 12.8% at the end of 2016). Shadow bank lending (particularly activities not reported in TSF data) could slow somewhat more sharply. Consequently, we should also see slower activity in the sectors that are the most heavily dependent on credit, particularly real estate and construction. Signs of a slowdown have emerged: growth in volumes of property transactions has weakened since last spring (it reached 14% year-on-year in the first 5 months of 2017); average house price inflation peaked at 10.5% in December 2016 and has eased slightly ever since (to 9.5% year-on-year in May 2017); and investment in both real estate and infrastructure has lost momentum for the past three months. Real GDP growth, which stood at 6.9% year-on-year in Q1 2017, is projected to slow gradually to 6.5% in Q4 2017.

The authorities will undoubtedly continue to strike a balance between containing financial-instability risks and at the same time maintaining generally adequate credit conditions to contain the slowdown in economic growth. In this context, the big state-owned commercial banks, which benefit from large customer deposits, may be encouraged to increase their credit supply to partially offset the decline in bond issuance and loans from institutions hit harder by the effects of tighter liquidity conditions in the interbank market.

Certain financial institutions (small banks, shadow banking institutions) could face some difficulties in the months ahead. Their earnings growth prospects will continue to deteriorate due to their higher financing costs and smaller asset expansion. Moreover, after a period of reprieve last year, the debt servicing capacity of corporates is likely to deteriorate again, due to higher interest rates

2 Total Social Financing comprises the main, but not all, domestic sources

of financing provided by banks and nonbanks to Chinese corporates, local government financing vehicles and households. In May 2017, bank loans accounted for 69% of TSF; bonds, 11%; the main shadow banking credits, 16% (entrusted loans, 8%; trust loans, 4%; and banks’ acceptance bills, 3%); and equities, 4%. Financing of the economy also includes other shadow banking activities (such as WMPs) that are excluded from official statistics on social financing flows.

and the expected economic growth slowdown in the short term3. Consequently, commercial banks could see another surge in non-performing loans (the NPL ratio has levelled off for the past year), while the deterioration in the average quality of shadow bank assets is likely to persist and default risks in the bond market should continue to rise.

Under this environment (deleveraging of financial institutions, credit boom, ongoing rise in credit risks, deterioration in bank profitability, slightly slower domestic credit growth, and downward correction in asset markets), the risks of financial-sector instability increase. Faced with a new bout of financial instability and slowing economic growth, the authorities must not back down again by easing monetary policy and scaling back the implementation of new prudential regulations. To the contrary, the solution to the debt excess and high credit risks is to maintain a very cautious monetary policy, to accept more moderate real GDP growth rates, and to continue pushing through structural reforms, notably aimed at strengthening the governance of financial and non-financial institutions, and restructuring state-owned companies.

Christine Peltier [email protected]

3 For more information on corporates’ financial health, see: "Credit risks still

rising”, EcoEmerging BNP Paribas, 4th quarter 2016.

3- Financing of the economy

Total social financing components, year-on-year % change

▬ Bank loans ▬ Bonds Entrusted loans

▬ Trust loans ▬ Banks’ acceptance bills ▬ Equity

Source : PBOC

-40

-30

-20

-10

0

10

20

30

40

50

60

2014 2015 2016 2017


economic-research.bnpparibas.com Philippines 3rd quarter 2017 11

Philippines

Getting nervous about politics? Since taking office in June 2016, President Duterte has adopted a brutal governing style and opted for drastic methods in his war against crime, drugs and corruption. Political predictability has lessened as a result. In the meantime, the country continues to enjoy strong economic growth and good macro fundamentals. On the fiscal front, the new government plans to reform the tax system and increase spending to close infrastructure gaps and reduce poverty. This will lead to wider deficits, which can be manageable given the currently moderate levels of fiscal imbalances and government debt. However, the authorities will have to be careful not to damage the credibility of the Philippines’ policymaking, which has been built gradually since the early 2000s.

■ Less predictable political environment

President Rodrigo Duterte took office in June 2016 for a six-year term, succeeding Benigno Aquino (210-2016). He was elected on his campaign promises to tackle crime and corruption, promote more inclusive economic growth and tackle poverty. So far, Duterte has focused on the war on crime, drugs and corruption, opting for drastic methods such as granting enhanced powers to the security forces and allowing extrajudicial killings of drug dealers and users. His brusque style of governing, which is visible in domestic political affairs but also foreign relations, and his threat that martial law could be declared, are a potential danger for the Philippines’ still fragile institutions and make the political outlook less predictable.

At the same time, on the economic front, growth continues to be strong, macro fundamentals are good and the Duterte administration appears to be willing to maintain fiscal and monetary discipline. Since taking office, the president’s priorities have included increased spending in infrastructure and social services. This will lead to wider fiscal deficits, but it should also fill a void given the currently poor stage of infrastructure and low-human development levels in the Philippines. Moreover, Duterte also plans to reform the tax system and attract more foreign investment in order to fund infrastructure development. All this could help improve the country’s economic growth potential in the medium term. Uncertainty yet remains high for the time being, in part because the president’s ability to introduce reforms and thus truly improve the country’s economic development prospects will also depend on his capacity to moderate his rhetoric, avoid deterioration in macro fundamentals and succeed in attracting private investors.

■ Strong economic growth

Real GDP growth averaged a solid 6.3% per year in 2010-2016, supported by a stable macroeconomic environment. In 2016, it reached a 6.9% in 2016, up from 6.1% in 2015. Investment grew by over 25% in real terms and became the main growth driver, supported by buoyant private and public investment in construction, the government’s infrastructure development program and the accommodative monetary policy. Private consumption growth remained strong last year (+7%), stimulated by high confidence levels, low CPI inflation (1.8% in average in 2016), fast-rising consumer lending amid low interest rates, declining unemployment (4.7% at end-2016 vs. 5.6% one year before) and large remittance inflows (8% of GDP in 2016). These factors have compensated for the effects of the poor performance of agriculture on household revenues (agriculture employs around one-fourth of total employment).

Net exports contributed negatively to growth in 2016 as import volumes were buoyed by robust domestic demand and grew faster (+19%) than export volumes (+11%). Volumes of exports were primarily driven by service exports, which remain supported by the information technology and business-process outsourcing (IT-BPO) sector. Merchandise export volumes were less dynamic, especially as exports of electronic components suffered from both weak global demand and a continued loss in competitiveness.

Real GDP growth is projected at 6.8% in 2017, unchanged from last year, even though the economy had a slower start to the year (real GDP was up 6.4% year-on-year in Q1 2017). Merchandise exports have rebounded in the past six months and should perform better in

1- Forecasts


2- Robust economic growth driven by domestic demand

Year-on-year % change and contributions in percentage points

▬ Real GDP, y/y █ Private consumption █ Gov’t consumption

█ Gross capital formation █ Net exports

Source : Philippine Statistics Authority

2014 2015 2016 2017e 2018e

Real GDP grow th (%) 6.2 6.1 6.9 6.8 6.8

Inflation (CPI, y ear av erage, %) 4.2 1.4 1.8 3.6 3.5

National gov ernment balance / GDP (%) -0.6 -0.9 -2.4 -3.0 -3.0

National gov ernment debt / GDP (%) 45.4 44.7 42.1 41.7 41.4

Current account balance / GDP (%) 3.8 2.5 0.2 -0.4 -0.7

Ex ternal debt / GDP (%) 27.3 26.5 25.4 25.3 24.5

Forex reserv es (USD bn) 79.5 80.7 80.7 78.7 77.5

Forex reserv es, in months of imports 10.8 10.7 9.5 8.6 8.0

Ex change rate PHP/USD (y ear end) 44.6 47.2 49.8 52.0 54.5

-6

-4

-2

0

2

4

6

8

10

12

02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

economic-research.bnpparibas.com Philippines 3rd quarter 2017 12

2017 than last year thanks to improved global demand conditions. Despite the loss of steam in Q1, domestic demand dynamics are expected to be robust in 2017 as key factors of strength will persist (such as public spending and infrastructure development, high confidence levels and robust remittances).

However, we also expect the central bank to start to tighten its monetary policy in the coming months (the Philippines has a flexible inflation-targeting regime, with a target band for headline inflation at 2-4%). The key policy rate has been unchanged (at 3%) since June 2016 but inflation has accelerated, with headline CPI up 3.1% y/y in May 2017 vs. 1.1% in Q1 2016, as a result of the recovery in global commodity prices, the rebound in local rice prices and the build-up of domestic demand-side price pressures (economic growth is estimated to be close to potential, as illustrated by high capacity utilization rates in the manufacturing sector). These dynamics should persist in the short term while fiscal stimulus is expected. Moreover, higher US Fed interest rates and lower political predictability could contribute to episodes of peso depreciation and pass-through effects on domestic inflation. Prudent monetary policy tightening is therefore expected in the year ahead.

In 2018-2022, real GDP growth is projected to average 7% by the IMF. This is assuming a positive scenario including continued macro stability, and higher productivity in the manufacturing, services and agriculture sectors thanks to reforms (especially to encourage foreign investment), infrastructure upgrading (transportation in urban areas, inter-island connections and farm-to-market roads, hospitals, schools, tourism…) and investment in human capital (education, job training, healthcare…). The Philippines’ demographic dynamics will also remain supportive to growth in the coming years.

■ Reasonable fiscal slippage is possible

The Philippines has registered steady progress in macroeconomic consolidation in the last fifteen years. During the Aquino administration in particular, management of public finances was strengthened, inflation has been reduced, the current account balance registered comfortable surpluses and forex reserves grew to solid levels.

The deficit of the national government has remained below 2.5% of GDP in the last six years, and its debt fell to 42% of GDP at the end of 2016 from 52% in 2010. In the meantime, the share of foreign-currency debt declined to 35% of total debt from 42% in 2010 on the back of government efforts to reduce its exposure to exchange rate rate volatility and foreign investor sentiment.

Some weaknesses in public finances persist, including structurally low fiscal revenues (national government revenue collections represented 15% of GDP in 2016) and a degree of budget underspending. The Duterte government projects to act on both fronts in the coming years. In the short term, its policy will lead to wider fiscal deficits.

The national government deficit already rose to 2.4% in 2016 from 0.9% in 2015 due to higher spending and revenue underperformance, and the 2017 budget targets a deficit of 3% of GDP as expenditure in public infrastructure and social services is due to grow rapidly. In its medium-term fiscal plan, the government maintains the same spending priorities and targets the fiscal deficit to remain at 3% of GDP in 2017-2022. It also projects to introduce a

comprehensive tax reform. The first stage of the tax reform package was passed by the lower house in May 2017; some of the key measures include a widening of the tax base, hikes in indirect tax rates and a simplification of the tax structure.

A moderate deterioration in fiscal performance is manageable in the short term as: i) it starts out with moderate deficits; ii) the coverage of fiscal financing needs should not be problematic given the comfortable liquidity levels of local markets (for 2017, the government plans to cover 80% of its borrowing program on local markets). iii) strong GDP growth should compensate for the effect of wider primary deficits on debt dynamics and government debt is projected to remain very moderate; iv) increased spending is due to raise the country’s growth potential.

However, at the same time, the authorities will have to show continued determination to contain fiscal slippage and maintain policy discipline in order to preserve the credibility that has been built gradually since the early 2000s, or investors could turn increasingly nervous.

Christine Peltier [email protected]

3- Good fiscal metrics give some room for higher spending

National government debt and balance, % of GDP

█ Debt (lhs) ▬ Budget balance (rhs, inversed scale)

Source : Bureau of the Treasury

-5,0

-4,0

-3,0

-2,0

-1,0

0,020

25

30

35

40

45

50

55

60

2008 2009 2010 2011 2012 2013 2014 2015 2016


economic-research.bnpparibas.com Turkey 3rd quarter 2017 13

Turkey

Anaphora of threes The number three, a symbol of unity, marks Turkey’s history and provides a cardinal reference point for the country’s modern economy. More prosaically, despite recent geopolitical and financial upheavals, the Turkish economy remains relatively dynamic. Yet the substitution of public spending for private spending raises questions about the quality of its policy mix and the sustainability of growth, at a time when potential GDP is slowing and the country faces chronic macroeconomic imbalances. The predominance of political and geopolitical issues has relegated essential economic reforms into the background, while relations with Europe have become tempestuous.

■ Focusing on the 2023 centennial

The number three occurs repeatedly throughout Turkish history. To cite but two red letter dates, the year 1453 marks the fall of Constantinople and the Byzantine Empire, and 1923, the birth of the Republic of Turkey from the ruins of the Ottoman Empire, defeated during the First World War. In 1963, Turkey signed the Ankara Agreement creating an association with the European Economic Community, a symbol of the country’s anchorage to Europe. The introduction to the agreement mentions the prospects of full EEC membership. After three coups d’etat, Turkey returned to a civil regime in 1983, and the year 2003 marked another political turning point with Recep Tayyip Erdogan’s rise to power. Despite 15 years of political continuity, the outbreak of social unrest in 2013 marked a rupture in Turkey’s trajectory, the economic consequences of which are still emerging. The predominance of political and geopolitical issues have relegated essential economic reforms (see below) into the background, and relations with Europe have become tempestuous.

Despite a narrow victory, the referendum on constitutional reform in mid-April 2017 ratified the switch to a presidential system and reinforced the powers of the executive arm, giving the President a free hand, at least until the next general elections in November 2019. Yet the major infrastructure projects launched in recent years, the most emblematic of which are the Third Bosporus Bridge and Istanbul’s third airport (the city’s third name after Byzantium and Constantinople), are part of a longer term vision: in 2023, President Erdogan wants to celebrate the Republic’s centennial at the head of a strong and modern Turkey.

■ Positive economic track record

Following the 2001 crisis, the country made a spectacular turnaround under the IMF’s supervision. For the past fifteen years, the country has reported average annual GDP growth of 5.7% (5% before the national accounts were revised in December 2016), compared to 3% over the course of the previous decade. In line with the average for the emerging countries, this performance is all the more remarkable considering that Turkey was hit by the commodities boom through 2014, and its oil bill structurally cuts into its external accounts, which explains in part the high level of inflation. During this period, GDP nearly tripled (expressed in USD and purchasing power parity), per capita GDP more than doubled (in PPP), income inequality narrowed and a large middle class emerged.

The three keys to its socio-economic success were: 1) a pragmatic and liberal economic approach accompanied by structural reforms

(fiscal, monetary, banking and financial), 2) a stable political and institutional framework, and 3) acceleration of the EU accession process launched in 2005 (following customs union agreements dating back to 1995), which reinforced investor confidence and fuelled double-digit annual export growth, especially in manufacturing, through 2012.

■ GDP under fiscal perfusion

From 6.1% in 2015 (revised upwards from a preliminary 4%), GDP growth nonetheless slowed to 2.9% in 2016. The aftershock of the aborted coup triggered an economic slump in Q3 (-1.3% y/y), which proved to be short lived as activity picked up rapidly again in Q4 (+3.5% y/y). Construction continues to be the main growth engine, followed by industry, while services and agriculture have declined

1- Forecasts


2- Per capita GDP in USD (purchasing power parity)

— Turkey — Advanced countries — Emerging & developing countries

Source : IMF-WEO

2015 2016 2017e 2018e

Real GDP grow th (%) 6.1 2.9 3.5 3.2


Budget balance / GDP (%) -1.0 -1.1 -3.0 -1.9

Public debt / GDP (%) 29.0 26.6 28.7 28.8



Forex reserv es (USD bn) 95.7 92.0 88.0 90.0


Ex change rate USD/TRY (y ear end) 2.9 3.5 4.1 4.4

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

50000

1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

economic-research.bnpparibas.com Turkey 3rd quarter 2017 14

slightly. The tourism sector (-30%) was particularly hard hit by rising political and security risks. In terms of demand, private consumption rose 2.3% in 2016, two times slower than in 2015. After a net decline in Q3, it rebounded in Q4, stimulated by renewed lending, notably via the state-owned banks, while the unemployment rate continued to rise (to a 2016 average of 11.8%). Growth of investment (GFCF) slowed from 9.2% in 2015 to 3% in 2016, despite the dynamic pace of construction and public spending.

Net exports made a negative contribution to GDP growth in 2016, but exports have picked up in recent months, buoyed by the weak Turkish lira and robust world trade. The EU-28 continue to absorb 47% of Turkish exports. At the same time, primary spending by the central government accelerated by 10% y/y in real terms in the first 5 months of the year. Buoyed by these factors, GDP growth rose to 5% y/y in Q1 2017.

The available monthly and leading indicators for Q2 – including industrial output, production capacity utilisation rates, credit growth (stimulated by the government’s guaranteed credit fund), PMI indexes and the confidence indexes of economic agents – point to persistently buoyant economic growth. The solid carry-over effect at the end of H1 and an ongoing expansionist fiscal policy in the months ahead have led us to raise our 2017 forecast substantially to growth of between 2.5% and 3.5%.

■ Doubts about the sustainability of growth

This rebound seems to be more cyclical than structural. Fiscal policy has taken over from monetary policy, which became more restrictive in January 2017 to counter the depreciation of the Turkish lira following the aborted coup of July 2016, and a new surge in inflation. This raises questions about the sustainability of economic growth, especially since potential GDP growth has fallen by about 3% due to the lack of structural reforms and the deterioration in the business environment, which is to blame for sluggish private investment and productivity gains.

Over the past decade, the boom in domestic demand and relatively weak domestic savings have generated macroeconomic imbalances. The country’s external vulnerability remains its Achilles’ heel with an incompressible current account deficit of about 3.5% of GDP (despite fairly low oil prices), a dependency on portfolio investment flows, a tripling of corporate debt in hard currencies to USD 300 bn, and a low level of “free” FX reserves (USD 36 bn). To promote domestic savings, especially long-term savings, the fiscal and legal framework must be reformed and efforts made to strengthen the confidence of savings investors. Monetary policy has a key role to play in order to stabilise inflation and the exchange rate, and to reduce the euro-dollarization of the economy.

A growth model based on consumption and construction, and fuelled by lending, is winding down. The composition of production and employment is mainly geared towards the domestic market. The unemployment rate is high and the participation rate is low (51%), especially for women, given the country’s apparent economic momentum. Turkey must strengthen its international competitiveness, openness to trade (exports account for only 22% of GDP) and participation rate in global supply chains.

Major infrastructure projects are important for building the country’s attractiveness and competitiveness. Yet Turkey will not be able to

avoid a “middle income trap” and join the club of advanced countries without strengthening policies to promote education and innovation (rather than imitation), which are essential for boosting productivity and promoting higher value-added products and services. R&D spending accounted for 1% of GDP in 2014, compared to an OECD average of 2.4% (see OECD Economic Survey, July 2016). Only 17% of the 25-64 age group have degrees in higher education, two times lower than the OECD average, which illustrates the investment that needs to be made in terms of human capital.

It remains to be seen whether the authorities will launch reforms or continue to count on discretionary economic policies that undermine its fiscal credibility and the business climate. Although public debt is still moderate (30% of GDP), the government does not have unlimited fiscal manoeuvring room. Fiscal revenue stagnated during the first 5 months of the year, and the deficit could rapidly approach 3% of GDP. The domestic debt rollover ratio rose to 130% in the three months to May, and Eurobond issues have already surpassed the annual target of USD 6 bn. In February, a sovereign fund directly under the President was created that uses public assets to serve as collateral for external financing.

Although Turkey is trying to diversify and strengthen its partnerships, notably with the GCC, Russia, Africa and even China, its relations with the European Union remain key. The EU is a strategic market for Turkish exports, and its main source of foreign investment and financing. Inversely, Turkey is vitally important for Europe from a geostrategic perspective given regional conflicts and the refugee crisis.

Sylvain Bellefontaine [email protected]

3- Contributions to real GDP (%, excl. inventory change)

— GDP █ Private consumption █ Public consumption █ Investment █ Net exports

Sources : Turkstat, BNP Paribas

-6

-4

-2

0

2

4

6

8

10

12

14

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016


economic-research.bnpparibas.com Poland 3rd quarter 2017 15

Poland

Cyclical upswing The economy has entered a phase of cyclical acceleration. The output gap is closed and inflation is gradually picking up though from a low level. Unemployment has reached a historic low, thanks to growth-driven job creation and the still large supply of posted workers to other countries in the EU. Real wage growth exceeds productivity growth. The fiscal stance is pro-cyclical, with increases in spending stimulating the already buoyant domestic demand. EU fund inflows are expected to accelerate in 2017, boosting economic growth and investment further.

■ Growth accelerates

Despite a slight deceleration, Polish growth remained above the EU average in 2016, at 2.7% y-o-y. Growth accelerated to 4% y-o-y in Q1-2017, driven by still buoyant consumption and the recovery in investment. The slow start of the 2014-2020 EU budget cycle explains the GDP growth slowdown in 2016 after an acceleration in 2015 due to the record transfers of the remainder of the sums available under the 2007-2013 envelop. Structural funds’ inflows are expected to accelerate in 2017, further boosting growth and investment. The output gap has closed; the tightening in labor market conditions as well as the record capacity utilization rates that reached their peak of 2008 show that Poland has entered the phase of cyclical expansion.

■ Inflation : synchronization with the Eurozone

After a period of deflation in 2015-16, largely in response to the fall in global energy prices, headline inflation is back in positive territory in 2017 (Chart 2). The HICP was up 1.7% y-o-y in average in the first five months of the year. The increases in food and fuel prices were the main drivers of this acceleration. Despite robust nominal wage growth, overall demand-side pressures remain fairly modest, with core inflation still subdued (0.8% y-o-y in January-May 2017). Inflation rate is now very closely following the average inflation in the euro zone and the correlation has strengthened since 2014 (Chart 2).

■ The cycle of interest rate lowering is definitely behind

With faster inflation and firmer GDP growth, monetary policy tightening in Poland may start earlier than in the Eurozone, with the first rate hike already in the second half of 2017.

In the medium term, the convergence in inflation trends will trigger an alignment in monetary policy decisions, an important condition for the successful joining to the Monetary Union. While economic conditions support the joining of the Eurozone, the current political environment opposes to it: a greater integration with the EU is not amongst of priorities of the ruling political party. Therefore, more time will be needed to convince the population and politicians in the interests of the Euro adoption.

■ Wages grow faster than productivity

Labor market conditions have continued to improve since mid-2013. Unemployment reached its historic low of 4.8% in April 2017 and continues to decline. The problem is now the opposite: employers’

complaints about labor shortages are increasingly audible and especially focus on the lack of a qualified workforce.

As a result, wages have been rising rapidly since 2013 and since 2014, wage growth has exceeded productivity growth (Chart 3). If this trend continues in the medium term, it may become harmful for the competitiveness of industry.

Despite the rather favourable situation in the job market as a whole, pockets of unemployment, notably in depressed eastern regions, persist and require specific policy efforts to boost “inclusiveness” that help the long-term unemployed to return to the job market.

1- Forecasts


2- Inflation rate : picking up in line with the Eurozone Yoy growth, 12m-moving average, %

▬ Poland ▬ Euro Zone

Source: Eurostat

2015 2016 2017f 2018f

Real GDP grow th (%) 3.8 2.7 3.6 3.4

Inflation (CPI, y ear av erage, %) -0.7 -0.2 2.4 1.9

Gen. Gov . balance / GDP (%) -2.6 -2.4 -2.9 -2.7

Gen. Gov . debt / GDP (%) 51.1 54.4 54.6 54.8



Forex reserv es (USD bn) 94.9 114.4 118.4 120.4


Ex change rate EURPLN (y ear end) 4.3 4.2 4.2 4.2

-2

0

2

4

6

8

10

12

2000 2002 2004 2006 2008 2010 2012 2014 2016

12M - MMA

economic-research.bnpparibas.com Poland 3rd quarter 2017 16

Poland is the biggest supplier of posted workers in the EU. According to the latest official data available (2015) the country has sent about 460,000 people or 2.5% of its total workforce, to other EU countries, and this number has almost doubled since 2010. Therefore, given the strong growth momentum and the appearance of labor shortages, the posting of workers exacerbates tensions in the labor market. The emigration of labor to other EU countries and the decline of the active population due to the negative demographic trends of the past 20 years are partly compensated for by the massive immigration from neighboring Ukraine: according to unofficial estimates, the number of migrants from Ukraine working in Poland reached 1.3 million in 2016.

■ Fiscal stance: pro-cyclical bias

In 2016 Poland's general government deficit narrowed to 2.4% of GDP. This was smaller than the 2.6% of GDP in 2015 and 3.3% in 2014. The fiscal policy stance is pro-cyclical, with several increases in spending stimulating the already buoyant domestic demand. A child-benefit scheme was rolled out in mid-2016 providing families with a monthly allowance of PLN500 for every second and subsequent child. The measure aims to stimulate births (Poland has one of the lowest birth rates in Europe). Moreover, from October 2017, the retirement age for men will decline two years to 65, and seven years to 60 for women, rising costs of the pension system. The authorities also plan to increase defense spending to 5% of GDP (from 2.2% of GDP in 2015).

On the revenue side, the government was successful in improving tax collection in 2016 (tax revenues increased by 5.2%), but the future sources for funding the planned increase in expenditures are unknown. As a result, the planned deficit for 2017 should remain close to 3%, despite buoyant economic growth.

Government debt reached 54% of GDP at end-2016. This is significantly less than the EU median, but only 1 percentage point below the limit of 55% of GDP set by the national fiscal rule, above which the spending should be cut automatically. Therefore, the room to manoeuvre on fiscal policy is quite limited. The bulk of support for growth will be provided by the expected increase in EU funds. In a statement of May 2017, the IMF recommended that Polish authorities adopt a more conservative approach seeking to rebuild a safety buffer by reducing the deficit and debt in the current period of strong growth.

■ Structural policy

Long-term challenges have been the subject of the specific action plan for a responsible development of Poland (the Morawiecki plan). In order to deliver balanced economic growth and avoid both the middle-income and mid-range product traps, the authorities plan to focus on innovation and investment, boosting the investment rate from the current 18% of GDP to 25% of GDP by 2020 (notably using the EU funds), on supporting exports and foreign investment abroad and on developing more active regional and sectorial policies. The goal is to raise Poland’s GDP per capita to 79% of the EU average by 2020. This does not look unrealistic, but, as always in such projects, comes with implementation risks, notably due to fiscal constraints and the increased uncertainty over future EU funding.

■ EU funds: likely to grow in the coming two years, but greater uncertainty for the end of the budget period

The EU budget envelope of 2014-2020 planned substantial capital flows to all “new members”: about 3% of their GDP on average. Poland should remain the biggest receiver of the funds, with the total allocated in the envelope at EUR 110 bn (15% of total). This represents 3.4% of its GDP for the period (2.4% net of contributions).

The organization of the EU budget process has cyclical characteristics. At the beginning of the period, the disbursements are below the schedule due to the time needed for projects’ preparation. Then, the funds may be disbursed two years after the end of the period, and substantial amounts are in fact disbursed at the end. This explains the observed volatility in the EU funds in 2015 and 2016. The year 2015 saw a “cyclical” peak when the regular funding of the 2014-2020 envelop was added to the remainder of funds from the 2007-2013. In 2016 there was a “cyclical” low: the funding was only “regular”. In 2016 the transfers to Poland reached a cyclical low (EUR 5 bn, or 0.4% of GDP) after EUR 11 bn, or 2.5% of GDP, in 2015. Transfers are expected to catch up in the remainder of the budget period (until 2020-2021 given the possibility to overlap) and drive growth and investment in Poland as well as in all the countries of the region.

However, the forthcoming exit of the UK from the EU (Q1-2019) may hamper the execution of the current budget. The UK provides about 20% of the net contribution to the EU. The potential loss of this amount (the concrete details remain unknown at this stage of negotiations) may trigger a revision of funding for countries that are net receivers of the funds. Moreover, the continuation of such a generous policy in the next budget period should not be taken for granted. The rising political tensions as well as the need for growth-supporting policies in several countries of the west of the EU (such as Italy, Greece or Portugal) may trigger the revision of the priorities of the EU’s structural policy, obliging Poland to seek for alternative sources of financing growth.

Anna Dorbec [email protected]

3- Wages grow faster than productivity Variation annuelle en valeur, moyennes mobiles sur 3 mois, %

▬ Real wage growth Real wage growth minus productivity growth

Sources: Eurostat, BNP Paribas

-8

-6

-4

-2

0

2

4

6

8

10

2002 2004 2006 2008 2010 2012 2014 2016

% per annum


economic-research.bnpparibas.com Ukraine 3rd quarter 2017 17

Ukraine

Economic growth picks up, but not employment After a severe political and economic crisis, the economy has swung back into growth. Stabilisation of the exchange rate laid the groundwork for lower inflation. The central bank has begun to ease monetary policy, but for the moment it has not yet had an impact on lending, which continues to contract. The IMF programme has encountered new delays: it is conditioned on the implementation of pension reform, which will not be adopted before fall. The recovery is too tepid to create jobs, and numerous Ukrainians have left to seek work in neighbouring countries. Exports are picking up, and will now receive greater EU support. The difficult situation in the eastern part of Ukraine (embargo, armed conflict) hampers a veritable industrial recovery.

After a severe political and economic crisis in 2014 and 2015, Ukraine has returned to relative stability, which has enabled it to swing back into growth. Yet growth seems to be too mild to fuel a rapid catching-up movement. Ukraine reported GDP growth of 2.3% in 2016 and 2.5% year-on-year in first-quarter 2017. The national bank’s Primary Sectors Index, a leading indicator of growth, increased 2.4% year-on-year in the first five months of 2017, signalling an ongoing recovery.

Industrial activity began to recover in H2 2016, but is now being hampered by new trade barriers (see below). Industrial output contracted again, down 1% year-on-year in the first five months of 2017, after increasing 3% in 2016.

■ Inflation levels off after the exchange rate stabilises

The exchange rate has remained relatively stable since early 2016. This stabilisation has helped to anchor inflation expectations, which are declining gradually. After a record high of 48% in 2015, inflation dropped to an average of 14% in 2016. This easing trend has continued, albeit at a slower pace, since the beginning of the year, to an average of 13.5% year-on-year in the first five months of the year.

With this stabilisation, the central bank has been able to gradually ease monetary policy. After peaking at 30% in 2015, the key rate was steadily reduced to 12.5% in May 2017. Yet financing conditions are still restrictive, with short-term lending rates averaging 16.3% in April. Banking sector restructuring is still incomplete, which limits the possibilities of lending rebound. Credit volume contracted for the third consecutive year. In April 2017, the total volume of bank lending to the non-financial private sector was down 6% compared to April 2016.

■ Vital need for IMF support

The country continues to benefit from IMF support, which released a new USD 1 bn instalment in April 2017. The USD 17.5 bn funding programme launched in March 2015 was supposed to end in 2019, but there have been some delays with respect to the initial calendar. In April 2017, only half of the funds had been used. The support of international donor funds is still vital for external liquidity. In May 2017, the USD 12.5 bn in debt with the IMF accounted for 71% of the central bank’s currency reserves (USD 17.6 bn).

Continuing the programme is thus crucial for the country’s external liquidity. It is also a necessary condition for the government’s plans to issue Eurobonds in 2017. The pay out of another USD 1.9 bn instalment is conditioned on the implementation of two major reforms: agrarian reform, including the lifting of a moratorium on

land sales, and comprehensive pension reform, which aims to restore the viability of a system that is currently running up deficits. Neither of these reforms will be ready before summer, which means the next instalment will be postponed until fall at the earliest.

Agrarian reform is still a very sensitive topic. Although it is needed to boost the country’s agricultural potential, it is very unpopular: local investors, notably small farmers who are under severe financial restraints due to domestic financing conditions, fear the massive arrival of non-resident investors. To allow the government more time to negotiate a compromise arrangement, the IMF now seems to be ready not to consider the full completion of this reform as a necessary precondition for the release of a new instalment.

1- Forecasts


2- Inflation levels off following the exchange rate stabilisation

▬ Currency depreciation ▬ Inflation rate

Sources: UkrStat, National Bank of Ukraine

2015 2016 2017e 2018f

Real GDP grow th (%) -9.8 2.3 1.8 2.8



Gen. Gov . debt / GDP (%) 79.3 81.2 84.2 79.5



Forex reserv es (USD bn) 13,3 15,5 17,5 18,5


Ex change rate UAH/USD (y ear end) 23.4 26.2 27.5 29.0

0

10

20

30

40

50

60

70

2014 2015 2016 2017

%, annual

economic-research.bnpparibas.com Ukraine 3rd quarter 2017 18

Pension reform is the other thorny issue. According to the memorandum of understanding between the Ukrainian government and the IMF, the reform must be fully adopted by January 2018. The project approved by the Cabinet in mid-May 2017 calls for the alignment of the retirement age at 60, with 25 years of mandatory contributions (vs. 15 years today). Given that more than a third of Ukraine’s economy is now in the informal sector, further increasing the duration of mandatory contributions risks placing people who have pursued mixed careers in both the formal and informal sectors in a situation of extreme poverty on retirement. The number of years of mandatory contributions will gradually increase to 35 years in 2028, with incentives to postpone retirement until age 63-65. The government has pledged to index pensions to average wage growth and inflation, while maintaining the system’s financial equilibrium.

Ukraine’s fiscal performance is still satisfactory, although it has deteriorated slightly since 2015. At 2.2% of GDP, the fiscal deficit complies with the performance criteria imposed by the IMF programme. Excluding debt servicing, the budget generates a surplus of 1.9% of GDP. With the increase in the debt-to-GDP ratio, which reached 81% of GDP in 2016, debt servicing costs are rising. From only 2% of GDP in 2012, it exceeded 4% of GDP in 2015 and 2016. There are also the new banking sector restructuring charges, with the injection of an extra UAH 39 bn (1.5% of GDP) in Privatbank, the country’s main bank. Privatbank was nationalised in December 2016, and has already been recapitalised for the equivalent of 6.5% of GDP.

■ Jobs are created elsewhere

Despite the return to growth, employment was still in decline in early 2017, the fourth consecutive year of contraction. From a 2013 peak, the Ukrainian economy has lost 4.6 million jobs, or 22% of the total. Consequently, the unemployment rate has held at 11% of the active population in Q1 2017 (Chart 3).

Emigration has become the solution for many unemployed Ukrainians. The rebound in growth in neighbouring Poland triggered a spectacular decline in unemployment and the emergence of labour market tensions, creating an attractive opening for non-residents. According to unofficial estimates, more than a million Ukrainians crossed the Polish border in search for work in 2016. In Russia, which is struggling with the same negative demographic tendencies as Poland, the upturn in growth is also generating demand for skilled labour (mainly from the regions of eastern Ukraine). In Russia, Ukrainian workers benefit from simplified hiring conditions, but wage conditions are often less favourable than in Poland. In May 2017, the average wage in Ukraine was only 23% of the Polish average and 36% of the Russian average.

As a result of this outflow of labour, private transfers to Ukraine rose to USD 4 bn in 2016, the equivalent of 4% of GDP. They rose 10% in nominal terms in 2016 and 7% year-on-year in the first 5 months of 2017.

■ Exports pick up

After four years of uninterrupted decline, during which exports were virtually slashed by half, the year 2017 looks much brighter. Exports of goods rebounded 27% year-on-year in value in the first 5 months of 2017. This rebound was accompanied by a 10% increase in revenues from service exports.

The European Parliament’s decision in July 2017 to expand the preferential trade regime should provide greater export support, notably in the agro-food sector. The European decision eliminates custom duties on imports of Ukrainian products and increases quotas (which were too restrictive, because Ukrainian exporters filled the quotas for most of the goods in this regime in less than a quarter). Tariff-free import quotas will increase by 2,500 tonnes for honey, 3,000 tonnes for canned tomatoes, 65,000 tonnes for wheat, 625,000 for corn and 325,000 tonnes for hops. The EU Council is expected to definitively adopt this decision toward the end of July, providing support for farm exports as of the 2017 harvest.

The main risk for the recovery of exports is the persistent hostilities in the Donbass region, the country’s main mining and industrial basin. The conflict is festering and hopes for a diplomatic solution are fading. Since mid-March 2017, following the blockade imposed by nationalist forces, the Ukraine Security Council has officially enacted an embargo on trade with the separatist regions.

Anna Dorbec [email protected]

3- Employment remains in the doldrums

__ Jobless rate (seasonally adjusted, LHS) - - - Total employment (seasonally adjusted, RHS)

Sources: UkrStat, Datastream, BNP Paribas

15

16

17

18

19

20

21

22

23

24

25

0

2

4

6

8

10

12

2005 2007 2009 2011 2013 2015 2017

% de la population

active

in % of active population million of people


economic-research.bnpparibas.com Algeria 3rd quarter 2017 19

Algeria

Striking the right balance The Algerian economy has been hard hit by the drop off in oil prices. Although the adjustment process was launched rather late, the first measures are beginning to pay off. Though still significant, the budget deficit nonetheless contracted in 2016, and the government’s goal is to bring the budget deficit close to zero by 2019. The roadmap looks very ambitious, possibly excessively so. Major cutbacks in public spending threaten the economy, which is already showing signs of weakness. Granted, there is still some manoeuvring room. The external position is still solid despite the rapid drop in foreign reserves, and public debt is moderate. However, it is still uncertain how the authorities intend to cover their future financing needs.

Legislative elections in May 2017 did not change the balance of power. As expected, the ruling coalition held on to its absolute majority in the National Assembly. Yet the participation rate continued to plunge, to only 38%. The main reasons people didn’t vote are the parliament’s secondary role relative to the executive branch, and the high level of unemployment. The new government will have to operate within a tough environment until the next presidential elections in 2019. A durably low oil prices questions the Algeria’s development model. After letting fiscal and external deficits deteriorate sharply to buffer the shock, Algiers finally seems to have changed its strategy. The 2016-2019 development plan, approved in April 2016 but only published in April of this year, marks some noteworthy changes, beginning with recognition of the excessive level of public spending. That’s a good place to start, but if the State disengages from the economy, it quickly risks running up against reality.

■ Public finances: adjustments are finally underway

With a fiscal breakeven point of more than USD 90 a barrel, the Algerian economy faces a long and delicate adjustment process to adapt to the new oil market situation. Yet the authorities have decided to act. Whereas government expenditures continued to rise sharply in 2015, to an all-time high of 46% of GDP, they were cut back last year by 4% in nominal terms. Granted this is far less than the initial 9% target approved in the fiscal bill. Yet these first spending cuts, combined with strong growth in non-hydrocarbon revenues, helped to stop the deterioration in the public finances, even as oil prices continued to drop. The budget deficit narrowed slightly to 13.7% of GDP, after peaking at 15.4% of GDP in 2015. This makes Algeria one of the region’s rare oil producing countries in the MENA region to successfully consolidate public finances last year (see chart 2). Although the budget deficit is still alarmingly high, it should nonetheless continue to narrow in the years ahead, assuming that oil prices are not hit by another sharp correction.

For the first time in its history, a multi-annual fiscal plan was presented at the same time as the 2017 budget was approved. The plan’s very ambitious targets aim to balance the budget by 2019. To achieve this, the authorities plan to cut public spending to DZD 6,880 bn in 2017 (43% of GDP) from DZD 7,384 bn in 2016 (36% of GDP), before it stabilises thereafter, thanks to reforms to the subsidy system, greater control over the public sector wage bill, and a more selective approach to public investment. The biggest clean-up efforts are expected to focus on public investment, because the planned capital expenditure of DZD 2,300 bn in 2017 is 18% lower than the real outlays in 2016. As to revenues, oil price assumptions are rather conservative at USD 50 a barrel in 2017,

USD 55 in 2018 and USD 60 in 2019. New VAT increases are planned after those introduced in 2016, and gasoline prices will also be raised.

The 2017 budget is highly restrictive, with potentially recessionary effects on the economy (public investment accounted for more than 30% of total investment in 2016). Considering the sharp deterioration in the financing situation of the State, the clean-up process is likely to proceed, albeit at a more gradual pace. We are forecasting a fiscal deficit of 6.5% of GDP in 2019.

Moreover, it is still uncertain how the authorities intend to cover their future financing needs. The oil stabilisation fund already reached its statutory floor of DZD 740 bn in 2016, and could dry up completely in 2017. The USD 1 bn loan from the African Development Bank in

1- Forecasts

e: estimates and forecasts BNP Paribas Group Economic Research

2- Budget balance

% of GDP

█ 2014, █ 2015, █ 2016

Sources: Central bank, IMF, BNP Paribas

2015 2016e 2017e 2018e

Real GDP growth (%) 3.8 3.5 1.9 2.0

Inflation (CPI, year average, %) 4.8 6.4 6.9 6.5

Gen. Gov. balance / GDP (%) -15.4 -13.7 -8.4 -7.8

Gen. Gov. debt / GDP (%) 8.4 21.0 23.2 29.4


External debt / GDP (%) 1.8 2.4 4.0 6.0

Forex reserves (USD bn) 145 114 95 79

Forex reserves, in months of imports 27.3 22.8 18.9 15.5

Exchange rate DZD/USD (year end) 107.2 110.5 114.0 119.0

-20

-15

-10

-5

0

5

Algeria GCC Iran

economic-research.bnpparibas.com Algeria 3rd quarter 2017 20

late 2016 seems to indicate that Algeria will call on international donor funds, but the authorities seem to have ruled out the international financial markets, even though they would offer the additional advantage of boosting forex reserves. The domestic debt market is embryonic, bank liquidity has tightened considerably following major deposit withdrawals, and a significant volume of domestic savings is kept outside of the financial system (according to the central bank, the share of the currency in circulation outside of the banking system amounted to 32% of money supply at year-end 2016, up from 26.7% at year-end 2014). In 2016 alone, government support for state-owned companies increased the public debt by 9 points of GDP. With a total debt ratio of 21% of GDP, the authorities still have comfortable manoeuvring room. But the fragile financial position of numerous state-owned companies is an additional source of pressure.

■ Threats to growth

At first sight, Algeria’s robust growth figures (3.8% in 2015, 3.5% in 2016) seem to reflect the economy’s resilience to the oil shock. Yet the overall dynamics in 2016 is misleading because it masks a net slowdown in non-hydrocarbon growth, to 2.9%, the lowest level since the early 2000s. The support from the hydrocarbon sector to growth is expected to reduce since part of last year’s rebound is due to the normalisation of production at major gas plant that was hit by terrorist attacks in 2013. Economic growth forecasts have been revised downwards to 2% for the next two years (see chart 3), and the downside risks are high.

To a large extent, much will depend on the size of fiscal adjustment. The IMF underscores this point in its latest report on Algeria. If the government’s targets are followed to the letter, economic growth would average only 1% in 2017/18. The non-hydrocarbon growth could even fall to 0.3% in 2018, which could weigh not only on employment and the social climate, but also could affect the stability of the financial system. Payment delays to government’s supplier have already driven up non-performing loans, which accounted for an estimated 11.4% of total loans outstanding at year-end 2016, up from 9.8% at year-end 2015. Granted, banks are adequately capitalized. But the deterioration in the state’s financial health at a time of rising credit risk is a factor to watch. An aggravating factor is that 48% of the portfolio of bank loans to the economy is allocated to state-owned companies.

■ External stability: still solid

If it will be particularly hard to strike the right balance between fiscal consolidation targets and maintain a robust growth, it will also have a non-negligible impact on the pace of rebalancing the external accounts.

From a structural surplus, the current account balance swung into negative territory in 2015, and reached a record deficit of 17% of GDP in 2016. With oil prices unlikely to exceed USD 60 a barrel in the years ahead, the chances of turning around the external accounts are rather slim. Although imports have declined slightly over the past two years, they are still nearly twice as high as hydrocarbons exports in 2016. At the same time, the authorities still seem to be hesitant about letting the exchange rate adjust itself again. The dinar depreciated 27% against the US dollar between mid-2014 and year-end 2015, before stabilizing thereafter. And

since inflation has accelerated strongly, the impact on the real effective exchange rate is virtually nil, which strains external competitiveness and favours demand for imports. In the short term, this trend is unlikely to reverse. This means the only way of reducing imports would be a slowing down in economic activity. Yet, as our central scenario calls for a gradual adjustment, external deficits will remain above 10% of GDP over the next two years.

In the absence of major capital inflows, external liquidity will remain under strong pressure. Foreign reserves are expected to dwindle to USD 79 bn in late 2018, compared to USD 180 bn at year-end 2014. Yet the authorities still have comfortable manoeuvring room. There is virtually no foreign currency debt, and although foreign reserves, have declined sharply, they still cover 15 months of imports of goods and services.

Stéphane Alby [email protected]

3- Economic growth

Yearly change, %

█ Hydrocarbon █ Non-hydrocarbon ▬ Real GDP

Sources: National Statistics Office, BNP Paribas

-8

-6

-4

-2

0

2

4

6

8

2010 2011 2012 2013 2014 2015 2016 2017p 2018p


economic-research.bnpparibas.com Nigeria 3rd quarter 2017 21

Nigeria

A sluggish recovery ahead Economic activity has been severely hit by the decline in oil prices and the troubles disrupting oil production. Real GDP contracted by 1.5% in 2016, and the recession continued in first-quarter 2017. Stimulated by higher crude oil prices and an increase in oil production, the return to growth will nonetheless be sluggish. Restrictions on external liquidity continue to hamper industrial activity and weaken the exchange rate. President Buhari’s health problems, the risk of terrorist attacks, and the sabotage of oil facilities are all threats to economic activity.

■ Political troubles

President Muhammadu Buhari has severe health problems and must travel frequently to England for treatment. This situation raises doubts about President Buhari’s capacity to govern and could trigger a change of leadership before the next elections, scheduled for February 2019. According to the constitution, if the president fails to complete his term in office, he would be replaced by the vice-president, Yemi Osinbajo. This situation already occurred in 2010. The transition risks becoming a source of conflict as power would be shifted from President Buhari, a Muslim from the north, to Mr. Osinbajo, a Catholic from the south, whereas tensions are rife between the two communities.

The government has launched the Economic Recovery and Growth Plan, an ambitious reform programme through 2020. It aims to diversify an economy that is still heavily dependent on oil, which accounts for about 10% of GDP, 40% of state revenues, and 80% of exports. The plan also aims to strengthen the role of the private sector and is targeting GDP growth of 7% by 2020. These targets seem very optimistic. The government is unlikely to carry out liberal reforms or to lift capital controls, trade restrictions or energy price regulations. To date, the most important progress has been made towards oil sector reform, which aims to split up the national oil company (Nigerian National Petroleum Corporation) into three distinct entities, to provide more control over them and to combat corruption.

In the northern part of the country, jihadist movements like Boko Haram represent a permanent threat. In the south, tensions have calmed somewhat in the Niger delta, mainly after the government declared amnesty in fall 2016 and proposed to pay compensation to rebels who agree to lay down their arms. Even so, violence can break out again at any moment, as illustrated by the sabotage of an oil pipeline at the end of May. Actions by the Biafra separatist movement are another source of tension.

■ Gradual return to growth

Nigeria entered recession in 2016, and real GDP contracted another 0.5% year-on-year in first-quarter 2017. This cyclical downturn is mainly due to troubles in the oil sector. The oil price drop since year-end 2014 has also eroded external accounts and public finances, making it harder to access hard currency, which has negative consequences, notably for industry. Public expenditure has also been squeezed, straining economic activity. Oil output dropped from an average of 2.1 million barrels per day (bpd) in 2015 to 1.8 million bpd in 2016. This drop-off can be attributed to sabotage operations

by separatist movements in the Niger Delta, who demand a better distribution of oil wealth and greater political autonomy.

Yet the worst of the recession seems to be over (real GDP contracted 2.3% in Q4 2016). Under normal conditions, the country should swing back into growth with full-year GDP growth of 0.5% in 2017, followed by 1.2% in 2018. Growth will be driven by the rebound in oil production, which should reach 2.2 million bpd in 2018 (according to the IMF), now that the government has signed agreements with the rebel groups in the Niger Delta. Favourable weather conditions in recent months should yield a healthy farm harvest, with a positive impact on growth in a country where agriculture accounts for 20% of GDP. The expected upturn in oil

1- Forecasts


2- Breakdown of growth

Change in GDP, % (year-on-year)

▬ Total GDP ▬ Non-oil GDP ▬ Oil GDP

Source: Central Bank of Nigeria

2015 2016 2017e 2018e

Real GDP grow th (%) 2.7 -1.5 0.5 1.2

Inflation (official, annual av erage, %) 9.0 15.7 17.4 17.5

Fiscal balance/ GDP (%) -3.5 -4.7 -5.0 -4.2

Public debt/ GDP (%) 12.1 18.6 23.3 24.1

Current account balance / GDP (%) -3.0 0.6 1.6 1.9


Forex reserv es (USD bn) 28,3 28,2 29,2 30,3


Ex change rate NGN/USD (y ear end) 197.0 315.0 340.0 375.0

-25

-20

-15

-10

-5

0

5

10

15

2013 2014 2015 2016 2017

economic-research.bnpparibas.com Nigeria 3rd quarter 2017 22

prices will ease the restrictions on external liquidity (this trend is already visible), with positive effects on industrial activity. Lastly, higher oil tax revenues will allow a more growth-supportive fiscal policy, with an increase in public spending in 2017.

■ Slight improvement in external liquidity

Capital controls, import restrictions and difficult access to foreign currency are restrictions that recurrently hamper business activity in Nigeria. However, external liquidity has already picked up since the beginning of the year. This improvement has resulted from the increase in oil prices, which enabled the current account balance to swing into a surplus again, and the issuance of international sovereign debt (of USD 1.5 billion) in the first quarter. Consequently, foreign reserves were rebuilt from USD 23.9 billion in October 2016 to USD 30 billion in spring 2017. The improvement in external liquidity can also be seen in the narrowing spread between the official and parallel exchange rates. Whereas the official NGN/USD exchange rate1 has held steady for nearly a year at NGN/USD 310, the parallel exchange rate has fallen from NGN/USD 520 in February to NGN/USD 370 in early June.

The central bank intervenes to stabilise the exchange rate. Yet the naira has been devalued on several occasions when the central bank was no longer in a position to defend the exchange rate, as was the case in mid-2016. Further devaluations are likely to occur in late 2017 and in the years ahead. The risk of devaluation has diminished in the near term, but pressures on the parallel exchange rate could intensify again with the increase in imports. The gradual depreciation of the naira has fuelled inflation, which reached 15.7% in 2016. In 2017, the government intends to provide fewer energy subsidies, which should drive up inflation to 17.4%. March and April inflation figures support this outlook, with monthly inflation reaching 1.68%, compared to 0.89% in average in fourth-quarter 2016.

■ Mixed situation for public finances

At first sight, there is nothing alarming about Nigeria’s fiscal situation. Public debt is rising, but it should reach only 23.3% of GDP in 2017, according to the IMF. External debt is relatively low (25% of total debt), maturities are long (14 years on average) and about 85% is with bilateral or multilateral creditors at concessional rates (which averaged 1.74% in December 2015). The federal government’s main debt repayments as planned at the end of 2016 will occur in 2018, 2021 and 2023, and should account for less than USD 900 million each (barely 3% of forex reserves). Eurobond spreads have also narrowed from 600bp in March 2016 to 400bp in March 2017.

However, although the federal government deficit should hold at 2.2% of GDP in 2017, the consolidated public deficit is expected to widen from 4.7% of GDP in 2016 to 5% of GDP in 2017 according to the IMF. In 2016, fiscal revenues accounted for only 5.3% of GDP, which indicates that the government has very limited resources. Although the public debt-to-GDP ratio seems relatively low, debt servicing accounts for nearly a quarter of revenues. Domestic debt is financed at slightly negative real interest rates, but this situation is unlikely to last given the banking sector’s growing fragility (the non-

1 The official exchange rate used here is the one reported by the central

bank. Other exchange rates also exist for transfers between banks, money transfers and pilgrimages to Mecca, Rome or Jerusalem.

performing loan ratio rose from 2.9% of total loans outstanding in 2014 to 12.8% at year-end 2016). Moreover, fiscal revenues are highly dependent from oil. In 2016, 39% of state revenues were linked to oil operations, compared to 58% in 2014. The financial situation of local administrations has deteriorated sharply (precise statistics are hard to obtain at this level). Although they benefited from federal bailouts in 2015, many continue to accumulate arrears. Corruption and ineffective public administration are also problems that are straining public accounts. Lastly, the government did not build up its reserves very much during the period of high oil prices. The Nigerian sovereign fund has assets of USD 3 billion, which accounts for only 0.8 months of imports.

In the medium term, Nigeria’s public finances will be hit by sluggish economic growth and will continue to depend on hydrocarbons. Revitalising growth and diversifying the economy will require major investments, which are bound to increase public debt in the short term.

Sylvain Bersinger [email protected]

3- Comparison of official and parallel exchange rates

USD/NGN exchange rate

▬ Official exchange rate ▬ Parallel exchange rate

Sources: Datastream and Abokifx

0

100

200

300

400

500

600

06 07 08 09 10 11 12 01 02 03 04 05 06

2016 2017


economic-research.bnpparibas.com Egypt 3rd quarter 2017 23

Egypt

Inflation: EGP depreciation does not explain everything The floatation of the Egyptian pound since November 2016 and the introduction of fiscal reforms have significantly improved the macroeconomic situation, in particular forex reserves. The sharp EGP depreciation has pushed inflation to 30-year high, highlighting the sensitivity of consumer prices to currency fluctuations. However, other factors have also had a key role such as strong corporate pricing power in the consumer goods sector, particularly due to supply chain inefficiencies. Fiscal policy is also contributing to rising prices, but to a more limited extent. Getting inflation down could take some time, and in the short term, the authorities have limited resources to tackle it.

The economic situation in Egypt has improved significantly since the Egyptian pound was allowed to float in November 2016. To no great surprise, the most significant improvement has come in external accounts and foreign currency liquidity. Currency reserves at the Central Bank of Egypt (CBE) have increased by 60%, reaching USD 31.3 billion in June 2017, equivalent to nearly six month cover of goods and services imports. The credibility of the new exchange rate regime and substantial increase in yields on government securities have attracted more than USD 10 billion in foreign portfolio investment as of July 2017, compared to virtually zero up until mid-2016. It should be noted that this figure, relating to carry-trades, is not included in official currency reserves as it is based on inflows prudently considered by the CBE as volatile. The improvement in public finances has been lower, but the trend is positive for the moment. The gradual reduction in energy subsidies and the increase in certain fiscal receipts (VAT) should help reduce the primary budget deficit for the fiscal year (FY) 2016/17 by more than half (to 1.9% vs estimated 4.5% of GDP in FY 2015/16). However, the debt servicing cost remains very high, at more than 8% of GDP, or around 45% of total fiscal receipts, meaning that the overall budget deficit will remain above 10% of GDP in FY 2016/17.

Economic activity is showing signs of vigour, but that remains to be confirmed. Household consumption, one of the main drivers of economic activity, is severely constrained by rising prices. Annual consumer price inflation has been running at an average of over 30% since January. This rate of inflation is partly due to the sharp EGP depreciation since November 2016 (-50% against the USD). However, we believe that other elements are important explanatory factors in Egypt's structurally high inflation and the magnitude of price rises over the last six months.

■ Currency movement is crucial

There is significant exchange rate pass-through to inflation. Analysis of the period from 2003 to 2015 by faculty members of Cairo University and the CBE1 showed that relatively little of this happens through a direct effect on the price of imported goods; more significant transmission occurs through an indirect effect via the increase in the prices of semi-finished goods and commodities, which feeds through into production prices and then consumer prices. This mechanism is particularly due to existence of few sizeable domestic manufacturers across consumer goods segments. According to the authors, this transmission is not immediate, and persists over a two-year period. Moreover, the level of transmission

1 Omneia Helmy, Mona Fayed, Kholoud Hussein, 2017, Exchange rate Pass-through to Inflation in Egypt: A Structural VAR Approach, 37th Annual meeting of the Middle East Economic Association.

is considered as incomplete, due to the existence of numerous goods for which prices are controlled.

From November 2016, the increase in consumer prices has been incremental rather than immediate, but it has been substantial. The scale of the EGP depreciation is clearly a decisive factor. After the pound was allowed to float in 2003, its depreciation relative to the USD was fairly modest (13% after one year, and 25% after twenty months), whereas it immediately fell 50% following the decision to let it float in November 2016.

In addition, the level of transmission has varied since 2003 due to more structural factors. The share of imports in GDP is currently

1- Forecasts


2- CBE forex reserves

█ USD bn ▬ months of G&S imports, rhs

Sources: CBE, BNP Paribas

2015 2016e 2017e 2018e

Real GDP grow th (%) 4.1 4.3 3.8 4.5



Gen. Gov . debt / GDP (%) 88.0 97.0 94.0 82.0





Ex change rate EGP/USD (y ear end) 7.4 8.8 18.1 16.5

(*) Fiscal y ears T-1/T (July -June)

0

1

2

3

4

5

6

7

0

5

10

15

20

25

30

35

40

10 11 12 13 14 15 16 17

economic-research.bnpparibas.com Egypt 3rd quarter 2017 24

much higher at 21% compared to 14% in 2003 in real terms. We can also assume that over the medium term this figure will be higher, given the tight restrictions on the availability of foreign currencies that hampered importers over the quarters preceding the EGP liberalisation in November 2016.

Another factor affecting the degree of transmission is the reaction of companies to the currency depreciation. Schematically, faced with higher import costs they need to choose between maintaining their margins or their market share. One determiner of this choice can be the scale of any depreciation. A modest change would be easier to absorb in terms of costs, and the depreciation in March 2016, of around 13%, did not result in a significant rise in inflation. After the depreciation in November 2016, on top of the increase in prices for imported factors of production, most private corporates in the formal sector raised wages (by 10-20%), making an increase in selling prices necessary. Another more structural factor influencing inflation relates to market organisation, and specifically the level of competition in the consumer goods sector.

■ Limited competition in the consumer retail market

We believe that limited competition in the consumer goods market, and specifically food retail, is a major driver of inflation. Food is a crucial item as it represents circa 34% of average household expenditure as well as 31% of the inflation basket (excluding seasonally-fluctuating fruits and vegetables). It appears that control over distribution channels (up to and including a certain level of integration) is a key determining factor for producers in setting their pricing strategies. Companies may have direct control over part of their distribution channels and/or be mainly distributing through traditional circuits (local shops) in which they have higher control over selling prices. The modern retail sector (e.g. hypermarkets) sector is expanding rapidly as demonstrated by recent entry of major regional supermarkets to Egypt2. However producers tend to favour traditional distribution channels. Their products are present in supermarkets, but there is a real desire to limit the share that this represents, in order to protect pricing power. This strategy is made possible due to relatively low competition in the domestic market. According to the latest World Economic Forum report on global competitiveness, Egypt ranks 112th (out of 138) in terms of the efficiency of the market for goods and 127th on the “intensity of domestic competition” sub-component. In a certain number of markets for consumer goods, particularly food, local producers hold the bulk of market share and the role of multinationals remains fairly marginal. Following the EGP depreciation there is anecdotal evidence that some price hikes in certain consumer good categories may have gone beyond covering the rising cost of intermediate imported goods allowing producers to make up lost ground after several years of relative price stability. Limited competition in the consumer retail market may also explain the persistence of high inflation over a long period, even when production capacity is not fully utilised. The expansion of modern supermarkets in Egypt may therefore promote competition and relieve inflation, but also threaten producer margins.

2 In 2013-2016, leading MENA supermarket groups entered Egypt such as Lulu, Panda, Al Othaim and BIM in addition to expansion of existing foreign players such as Carrefour and Spinney’s.

■ Fiscal policy

In H2 2016, the reduction in energy subsidies was another important factor of consumer inflation. Petrol prices were more than 100% higher than in 2014, whilst increases in electricity prices ranged from 29% to 124% depending on the consumption tier. The monetisation of the budget deficit, by expanding the money supply, may be inflationary, but this factor does not appear decisive. This monetisation was fairly substantial in 2015 but was reduced in 2016. In more general terms, we are not seeing an uncontrolled expansion of money supply. The M2 aggregate as a percentage of GDP rose only slightly – from 76% to 80% – between late 2014 and March 2017.

In the short term, consumer price inflation is likely to remain elevated. CPI inflation reached 23.7% in FY2016/17 and almost 25% is expected in FY2017/18. Further subsidy cuts, the persistence of imported inflation and a possible upturn in domestic demand are all likely to continue driving inflation. Higher energy and farm product prices on international markets should also be considered, although oil price recovery is likely to be subdued in the medium term. The resources available to the government and the CBE to tackle inflation are currently limited. The effectiveness of the interest rate lever is limited by the low adult bankability ratio (less than 15%), whilst, up to now, the CBE’s exchange rate policy focuses building up currency reserves in order to protect against possible tensions. The recent EGP appreciation could signal a change in this policy.

Pascal Devaux [email protected]

Thanks to Youssef Beshay (BNP Paribas Senior Banker for Egypt) for his insightful comments.

3- EGP floatation and CPI inflation: 2003 and 2016

index

▬ EGP:USD m=dec 2002 ▬ CPI m=dec 2002

▬ EGP:USD m=oct 2016 ▬ CPI m=oct 2016

Sources: CBE, BNP Paribas

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220

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11

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18


economic-research.bnpparibas.com Qatar 3rd quarter 2017 25

Qatar

Political crisis highlights economic vulnerability The impact of the Saudi and Emirati embargo against Qatar will depend on the length of the crisis and on the intensity of the sanctions. Economic growth should slow but remain positive and CPI inflation should accelerate. Fiscal accounts are expected to be moderately affected. The main threat would be an extension of sanctions to the financial sector. Qatar is highly dependent on external financing, and the liquidity of a part of the sovereign fund could be questionable. Nevertheless, the government should confirm its support to the banking sector in case of deterioration in the situation of banks.

The consequences of the Gulf crisis on the Qatari economy are contained for the time being. Alternative trade routes are used and exports of Liquefied Natural Gas (LNG) are preserved. However, if sanctions were extended to other sectors, financial for example, the economic situation could rapidly deteriorate. More generally, this political crisis is taking place in a context of slowing economic growth and tightening banking liquidity.

■ Declining economic activity

Economic growth has been losing steam for several years because of the moratorium on gas development and fiscal consolidation measures. Real GDP growth reached 3.9% on average during the period 2012-16 against 16% on average from 2007 to 2010.

In the short term, activity should be significantly affected by the regional embargo against the country. The restrictions on transportation will slow the inflow of goods and reduce domestic consumption and investment. The numerous infrastructure projects linked to the Vision 2030 plan and to the World Cup (WC) 2022 will suffer from delays. Trade of goods and the circulation of workers are likely to be affected. To run its economy and execute its projects, Qatar relies heavily on expatriate workers.

Beyond the consequences of the embargo, which are difficult to estimate at this stage, the investments linked to the WC 2022 project (a total of USD 65 bn, or 40% of 2015 GDP, has been earmarked for WC-related public works) will continue to be one of the main drivers of activity, but domestic consumption should be sluggish given the downsizing process in numerous sectors that entailed the layoff of expatriate workers. We expect real GDP growth to reach around 1.5% in 2017 and 2.1% in 2018. In the medium term, developments in the hydrocarbon sector should support growth given the end of the moratorium on gas investment.

■ Growing inflation

CPI inflation has accelerated since 2015 as cuts in subsidies have driven up prices. It reached 2.7% in 2016 (against 1.8% in 2015). CPI inflation is likely to rise in 2017, especially for consumer goods and building materials. However, we estimate that housing prices will decline as the vacancy rate will increase given the decline in incoming expatriates and the repatriation of part of the resident expatriate workers.

Another source of inflation could be linked to inflating monetary aggregates consecutive to the QCB’s need to compensate for the decline in local banks’ external resources. We assume that this monetary-led inflation will be negligible. At this stage, according to

our central scenario, CPI inflation is expected to reach 6.1% on average in 2017 and 8.6% in 2018.

■ High external debt

External debt is usually at a fairly high level compared with that of the other GCC countries. The financing of the LNG facilities at the end of the 1990s pushed external debt up to 129% of GDP in 1998. After a period of decline, the external debt markedly accelerated for five years as a consequence of the coming on stream of numerous projects linked to infrastructure and economic development and the need to finance the fiscal deficit. We estimate that this debt reached a record high of 155% of GDP at end-2016. The net external position

1- Forecasts


2- Banks deposits

% of total

Private sector ▬ Public sector ▬ Non residents

Sources : QCB, BNP Paribas

2015 2016 2017e 2018e

Real GDP grow th (%) 3.6 2.7 1.5 2.1



Gen. Gov . debt / GDP (%) 34.0 43.0 55.0 54.0

Current account balance / GDP (%) 8.0 -5.0 -1.3 2.3




Ex change rate /USD (y ear end) 3.6 3.6 3.6 3.6

0

10

20

30

40

50

60

70

12 13 14 15 16 17

economic-research.bnpparibas.com Qatar 3rd quarter 2017 26

is largely positive (114% of GDP) despite the high level of debt. At end-2016, the QIA was estimated to be the equivalent of 204% of GDP, QCB FX assets 20% of GDP, and banks’ NFA negative at 26% of GDP. The country’s external position is still comfortable, but the liquidity of a part of the sovereign fund could be questionable. We estimate that around 1/3rd of those assets are invested locally and a non-negligible part of the remaining is not very liquid as it is invested in real estate or private equity for example.

■ Sustainable fiscal deficits

Fiscal performance should be only marginally affected by the current crisis according to our central scenario. As long as LNG exports are possible, fiscal revenues are ensured. On the expenditure side, we can assume a slight increase (+5%) in current expenditures in order to ease the consequences of shortages of goods within the population. Non-hydrocarbon fiscal revenues (excluding sovereign fund revenues) should decline, but they account for a small part of total revenues. As a consequence, we have revised our fiscal deficit forecast for 2017 to 8.3% of GDP. The deficit could be far more significant in case of as an extension of the sanctions’ duration and escalation of their intensity. This would require sovereign support for the banking sector in the form of deposits and/or capital injections given banks’ declining resources and the deterioration in their asset quality.

■ Banking sector under pressure

Prior to the embargo, the main source of concern was the consequence of the drop in oil prices for banks’ liquidity. Since end-2014, the deterioration in the fiscal balance has entailed an increase in banks’ sovereign exposure and a significant decline in public sector deposits. The banks’ net exposure to the sovereign as a percentage of banks’ domestic assets rose from less than 2% in 1Q2014 to 16% in March 2017. Claims on the public sector are rising (+25% y-o-y in March 2017, +76% for the government alone), and they currently account for more than 40% of total domestic credit. In parallel, public sector deposits have been steadily declining since end-2014. They currently account for 26% of total deposits against 43% in Sept. 2014. Given the heavy dependence of banks’ resources on deposits and the positive (albeit slowing) growth of claims on the private sector (+7% y-o-y in March 2017), domestic liquidity has tightened since end-2014.

Some bonds and sukuk have been issued by banks to increase their resources. Interbank rates have risen but above all the tensions on banking liquidity have entailed a sharp increase in foreign liabilities. Non-resident deposits are currently equal to public sector deposits (against respectively 6% and 43% of total deposits in Sept. 2014). As a consequence, the banks’ negative NFA position has significantly deteriorated since end-2014, shifting from 2.4% of GDP in Sept. 2014 to 26% in March 2017.

If the current regional crisis is temporary, the banking sector should not be significantly affected. For the time being, there is no official guideline from the Saudi, Emirati and Bahraini banking sectors for relationships with Qatari banks. Recent news suggests that some credit lines have been cut and short-term credit lines have not been rollovered, but financial sanctions have not been implemented. If they were, the situation would remain manageable as some liquidity could be temporarily provided by the QCB.

Deterioration in asset quality is likely given the expected economic slowdown and increasing difficulties for some corporates to find short-term financing. In the system of investment projects currently underway in Qatar, the relationship between contractors and tenders is based on regular payments in tandem with the progress on the projects. The drying-up of short-term financing would be harmful for contractors and entail further delays in investments. Some contractors may be in a difficult financial situation after several months without payments.

In case of a lengthening of the crisis and worsening of sanctions (moving toward financial sanctions), we can expect some deposit outflows. Estimates of Qatari banks external liabilities on GCC vary from USD 20 bn (10% of GDP) to USD 35 bn (18% of GDP). In any case, sovereign support for the banking sector is expected to be strong as seen after the 2009 financial crisis.

Pascal Devaux [email protected]

3- Spread QIBOR 3M LIBOR 3M

Basis points

Sources : Macrobond, BNP Paribas

20

40

60

80

100

120

140

2016 2017


© BNP Paribas (2015). All rights reserved. Prepared by Economic Research – BNP PARIBAS

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economic research department · 2017-07-10 · economic-research.bnpparibas.com editorial 3rd...

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