• Emerging markets tanked yesterday as investor fear that a US slowdown could

spread globally was only fueled by cautious remarks form the ECB president on

growth and inflation risks

• US initial jobless claims report retreated to 356,000, tempering the negative

message somewhat from last week’s claims and the sharp drop in the ISM non

manufacturing index added more volatility to core markets; US equities

bounced back from an afternoon slump while crude oil gained over 1.1% after

trading to US$86bbl lows intraday

• Amid negative sentiment and an overall choppy session, the EMBIG index

posted a 0.36% loss tightening 9bp to 285bp with the worst performers

Argentina (-1.09%; -6bp) and Bulgaria (-1.02%; 5bp) weighing heavy

• In Latin local markets, Venezuela 5-year CDS widened 55bp as reports that UK

and Dutch courts had frozen substantial PDVSA assets. Look for more noise as the

market digests the developments (and consults with lawyers), but we do not see

any worse-case scenario (ie PDVSA technical default) materializing from the news

• Meanwhile, in CEEMEA, the CNB hiked rates 25bp to 3.75% but remarks from

the governor were relatively dovish. JPMorgan sees rates peeking at 4% as the

inflation outlook should improve later in the year which is favorable to pay the

front-end FRA curve and receive the back-end (page 3)

• Elsewhere, Hungarian GDP growth has been moderate, but HUF weakness

(-4.2%ytd) threatens to push inflation above the central bank’s target. Thus, we

revised our NBH rate call and expect just 50bp in cuts to 7% (see page 5)

83.01%m/m, sa from 83.14% in November, but this result reflects the fact that the

November reading was revised up appreciably. In fact, taking into account the CNI reading

we see upside risks to our -1.8%m/m, sa forecast fall for the December IP (due today), but

a fall close to 1% is still very likely.

consensus (Banamex survey) and the 0.54% by JPMorgan; core was more in line and

reached 0.40% (JPMorgan: 0.41%). The lower then expected inflation print may prompt

Banxico to cut rates earlier than anticipated. We still are calling for the first 25bp cut in

August, but see risk of the first cut sometime between June and August.

increasingly concerned about the deteriorating global scenario, mentioning the more

negative US outlook specifically. JPMorgan continues to envision rates on hold until midyear,

as supply-side inflation shocks have likely peaked, and pencils in two 25bp rate cuts

in 2H08 amid a context of below-potential growth.

News and views

The December CNI industrial survey showed that capacity

utilization fell a bit to 83.01%m/m, sa (from 83.14% in

November), but this result reflects the fact that the

November reading was revised up appreciably. Indeed, the

former November reading of seasonally adjusted data was

82.9%, meaning that even after the December fall unveiled

yesterday, the capacity utilization is at higher levels than

previous data suggested. Additionally, the CNI survey

pointed that hours worked in production increased

1.1%m/m, sa, the highest uptick since February 2007 and is

a very strong figure compared to other IP coincident

hawkish but we have to recognize the fact that operating

rates are finally reaching a plateau, along with early signals

that inflation is receding and market inflation expectations

are stabilizing at levels consistent with the targets, would

help to prevent the preemptive monetary policy action that

the market is pricing into the local yield curve.

January inflation printed 0.46%m/m, lower than the 0.53%

forecasted by consensus (Banamex survey) and the 0.54%

by JPMorgan; core was more in line and reached 0.40%

(JPMorgan: 0.41%). The year-on-year headline figure was

also positive and fell a bit to 3.70%oya from 3.76% in

December and the core to 4.06%oya from 4.14%. The

surprisingly lower January inflation puts the fears of a

“January inflation hump to rest” and that inflation will end

up higher in 2008 than in 2009. Most of the surprise

resulted from the minimal 0.26% increase in tortilla prices,

much lower than anticipated and the 6% increase last year.

Its effect on overall inflation is sizeable as it accounts for

1.23% of the overall CPI index. The lower than anticipated

inflation means that headline inflation would now converge

to Banxico’s official 3%(+/-1%) in July and core in

Tejal Ray (1-212) 834-8580

tejal.t.ray@jpmorgan.com

Emerging markets tanked yesterday as investor fear that a

inflation risks. The US initial jobless claims report which

retreated to 356,000, tempering the negative message

somewhat from last week’s claims and the sharp drop in

the ISM non manufacturing index added more volatility to

core markets, which were on a roller coaster ride for the

session. US equities bounced back from an afternoon slump

while crude oil gained over 1.1% after trading to US$86bbl

lows intraday on demand concerns. Amid negative

sentiment and an overall choppy session, the EMBIG

index posted a 0.36% loss tightening 9bp to 285bp with the

worst performers Argentina (-1.09%; -6bp) and Bulgaria

(-1.02%; 5bp) weighing heavy. In Latin local markets,

Look for more noise as the market digests the developments

(and consults with lawyers), but we do not see any worsecase

scenario (i.e., PDVSA technical default) materializing

from the news. Meanwhile, in CEEMEA, the Czech

central bank hiked rates 25bp to 3.75% but remarks from

the governor were relatively dovish. JPMorgan sees rates

peeking at 4% as the inflation outlook should improve later

in the year which is favorable to pay the front-end FRA

curve and receive the back-end (page 3). Elsewhere,

weakness (-4.2%ytd) threatens to push inflation above the

expect just 50bp in cuts in the policy rate by year-end to

7% (see page 5).

Tejal Ray (1-212) 834-8580

tejal.t.ray@jpmorgan.com

The central bank left the policy rate unchanged at 6.25% in

line with JPMorgan and consensus expectation. BCCh

sounded increasingly concerned about the deteriorating

global scenario, and mentioned the more negative US

outlook specifically. Regarding domestic activity, the central

bank acknowledged the recently diminished dynamism and

while blaming it on specific sectors, also mentioned that

consumption performance has been decelerating. On

inflation, BCCh highlighted that headline oya inflation

remains visibly above the target, and that while core inflation

stays elevated, it has not accelerated further. Authorities

also took comfort from the fact that long term inflation

expectations remain anchored near the 3% target. On a last

note, the central bank stated that future decisions remain

data-dependent but expressed a hawkish bias by explicitly

stating that “further (upward) adjustments to the TPM

cannot be ruled in order to ensure the convergence of

inflation to the target.” We see the latter comment as a

reflection of the central bank’s focus on preserving its

January CPI rose by 2.9%m/m brining inflation to 19.4%oya

after 16.6% in December. Food, which constitutes 60% of

the CPI basket, was the main driver with food prices up

4.4%m/m (29.7%oya), and vegetable prices in particular

were up 17.7%m/m (51.8%oya). Prices for utility services

were only up 1.4%m/m, but this was due to the government

moratorium on increasing public utility tariffs. We see

inflation remaining high this year especially following the

government’s recent announcement on compensating

households for their lost Soviet-era savings. Pressure on

wages should remain high in view of expected populist

fiscal measures and the fact that nominal wages remain

Bank to become more active in trying to control inflation,

but we think that they would favor administrative measures

over tighter monetary policy.

The CNB cut rates yesterday by 25bp to 3.75%, in line with

our expectations. Five out of the seven Board members

voted for a hike (Holman and Rezabek were against), but

the message was fairly dovish. The central bank cut its

growth forecast to 4.1%oya and 4.9%oya for 2008 and

2009 respectively. CNB now forecasts inflation at 5.4% in

the fourth quarter this year and 2.4%oya in the second

quarter next year. For the first time, the CNB published

an interest rate trajectory compatible with an inflation

forecast. The staff forecasts 3-month Pribor at 3.2% in the

fourth quarter and 2.8% in the second quarter of 2009,

which would mean a sizable reduction in rates, but note

that the staff forecast is not binding for the MPC.

We think that a final rate hike to 4% is still in the cards

with record-high inflation, elevated inflation expectations

and labor market shortages. In today’s reports, inflation is

set to reach 6.1%oya in January. We believe 4% will be the

peak in the policy rate as the inflation outlook is set to

improve significantly in the second half of the year. CPI

should drop to 3-4%oya from the fourth quarter of 2008

to the first quarter of 2009 thanks to the fading effects of

deregulation, tax hikes and currency appreciation. As we

pointed out earlier, the changing inflation outlook during

the year is likely to be favorable for paying the front-end

of the FRA curve and receiving the back-end. The FRA

market is starting to price-in rate cuts, but we do not think

that the CNB will start cutting this year unless the ECB

starts an easing cycle. Currently, JPMorgan sees the ECB

holding its base rate at 4% during 2008. That said, if it

makes sense to play a rate cut story, the place to be is at

the back-end of the yield curve (Czech 10-year bond yield

is 60bp above the Bund yield).

As expected, the Turkish Parliament passed in its first hearing

a package of constitutional amendments that would allow

women to wear the traditional Islamic headscarf while

attending university. The second and final round of

discussions will take place on Saturday. Given the fact that

the two parties supporting the package, the ruling AKP and

the junior opposition MHP, have 409 seats between them,

and should easily get the necessary 367 votes again on

Saturday. During and after the parliamentary discussions,

we expect some widely attended public demonstrations

against the change as this package is seen by a part of the

secular elite as part of a campaign to undermine the secular

principles of the republic. Furthermore, the main opposition

CHP has already vowed to submit amendments to the

Constitutional Court if they are passed. The judiciary has

been highly critical of these changes but a court ruling is

still not easy to foresee. In short, the issue is likely to be in

According to Reuters, the European Commission (EC) will

warn Latvia next week that its fast-growing economy might

face a hard landing and urge the country to tighten fiscal

policies and keep wages under control. With CPI inflation

running at 14.1%oya and with a current account deficit of

24% of GDP, Latvia looks particularly vulnerable among

its emerging market peers. Although the currency peg looks

safe in the short term, and although the economy has already

started cooling off, we agree with the EC report that more

needs to be done on the fiscal front. In the currency peg

arrangement, fiscal policy is the most effective policy tool

to curb inflation. It was somewhat encouraging to see the

budget surplus amounting to 0.7% of GDP, higher than the

0.4% target in 2007. The target for this year is 1.0% of GDP,

but this looks too low to be considered truly anti-inflationary.

Tejal Ray (1-212) 834-8580

tejal.t.ray@jpmorgan.com

J.P. Morgan Securities Inc.

February 8, 2008

GDP growth is close to stalling, which on its own would call for rate cuts.

But the market refuses to recognize the improvement in the country’s

fundamentals that has occurred over the past year, and a weaker currency is

now threatening to push inflation above target.

highly open and over 55% of private sector borrowing is denominated in

foreign currencies. In a recent research note we outlined the impact of various

EUR/HUF levels on CPI inflation and how we think the NBH would react to

these levels. EUR/HUF at 260 or higher would be sufficient to push CPI

inflation above the NBH’s 3% target midpoint in 2009. A move to 280 would

be needed to push inflation to the upper end of the target range at 4%. All else

equal, we noted that the NBH would only be comfortable cutting rates at 255-50

or lower, while a rate hike would materialize either following a sudden spike

to 275-280 or a prolonged period (several months) of EUR/HUF above 260.

recession, and there has been a marked improvement in the twin deficits. The

fiscal deficit fell from 9.2% to 5.7% of GDP in 2007, and is on track for a 4%

gap this year. The CAD is estimated at 4.5-5.0% of GDP in 2008-09, the

same expected in Poland. True, the CAD is primarily covered by FX

borrowing (i.e., other investments) and the absence of solid FDI financing

leaves HUF vulnerable in an environment where cyclical fundamentals are in

the spotlight. Inflation is now higher than in 2006, but this is due almost

entirely to supply side shocks. We expect next week’s January CPI number

to confirm that the peak is behind us. We expect inflation to drop to around

6%oya by June 2008, 4% by December 2008 and 3.0-3.5% by end-2009,

assuming that EUR/HUF stabilizes at lower levels.

(44-20) 7777-3981

nora.szentivanyi@jpmorgan.com

nora.szentivanyi@jpmorgan.com

This is because oil prices have moved higher and the

EUR/HUF assumption used in the NBH’s forecast will be

256 (i.e., the January average) rather than the 251 used

previously. Following very strict inflation targeting this

forecast could prompt the NBH to raise rates at the February

meeting. However, we think the weak growth backdrop

(fourth quarter GDP growth is expected to remain around

1%oya with further downside risks in the first quarter) and

the likely temporary nature of the current EUR/HUF spike

will convince the NBH to remain on hold for now. We do

expect a rate hike to be discussed again, though.

rate hike nor rate cut territory in our view, at least not in

the first half of the year. Therefore, we are revising our rate

call to be consistent with the FX forecast changes. We now

expect the NBH to remain on hold through mid-year, with

50bp of cuts in the second half of 2008, taking the base

rate to 7.0% by year-end (i.e., 50bp higher than our

previous forecast). We continue to see 6.5% as the end-point

for rates, but now do not expect this level to be reached

before mid-2009.

J.P. Morgan Securities Inc.

February 8, 2008

past few years. However, reported deficits overstate the extent of

improvement as off-budget liabilities are estimated at 2.0-2.5% of GDP.

Indeed, issuance of special bonds to oil, food and fertilizer companies is

rising, distorting the government’s regular borrowing program. Upcoming

spending ahead of elections risks further increase in special bond issuance

narrowed against expectations, owing to relatively weaker growth in both

exports and imports. Separately, the government revised up the GDP growth

estimate for 2006-07 to 9.6%oya from an earlier estimate of 9.4%.

JPMorgan expects the economy to grow 8.6%oya in the current fiscal year

and moderate to 7.5% in 2008-09. The IP data scheduled to be released next

week will likely grow 7.7%oya in December, recovering from a one-off

weakness in November owing to the impact of Diwali holidays.

Index companies show a meaningful deceleration. While revenue growth

for the Sensex companies has been decelerating over the past three quarters,

earnings growth during 3Q dipped sharply to 16%, after sustaining a growth

of over 25% over CY07. Profit margin, on an oya basis, contracted for most

of the sectors except Consumer Discretionary and Staples. Interestingly, the

CNX mid cap universe continued to record robust growth rates.

portfolio investors and a flip in carry. Near-term, this can continue as the

overnight FX forward is still at a discount and the global backdrop fragile.

We stay positioned for further near-term upside in spot USD/INR

review as the central bank sounded hawkish. Sentiment has improved

since and rates have partially retreated from the highs. We believe the

outcome of easy liquidity is unlikely to change for at least the next several

weeks. We recommend staying received 1-year OIS. In bonds, the

demand-supply balance is improving further; stay long duration.

(65) 6882-2375

rajeev.malik@jpmorgan.com

(65) 6882-2214

siddharth.mathur@jpmorgan.com

(91-22) 6639-2961

vikas.x.agarwal@jpmorgan.com

(91-22) 6639-3005

bharat.x.iyer@jpmorgan.com

If you would like to be included on our distribution list, or if your e-mail address has changed, please contact Susan at

Please visit http://www.morganmarkets.com to view our archives and find a wide range of analytical tools.

Russia and Turkey)

Latin American Banks)

and Romania)

South Africa)

(Emerging Europe and Russia)

North Africa, Ukraine and Serbia)

Andean Region)