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Current edition contains:


South African Rand on the pivot point.
We examine impacts and likelihood of immediate RMB revaluation.
Long term overcapacity for nickel may push prices back to normal.
Japanese small caps seem to be about 20% undervalued on P/B metrics.
Wage growth is anemic and rise in consumption is sponsored by government transfers.
Mother of all real estate bubbles correction in Spain is not yet over.


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© ATWEL International, s.r.o. Page 1


Checking the latest odds for outright winner of the upcoming World Cup in South Africa, Spain is favored as the most
probable winner. Being big fans of Spanish soccer, events like World Cup make one forget about the dismal state of
the Iberian economy for a while. South Africa, on the other hand, has been a darling of the markets since the end of
February. South African Rand gained hefty 8% in just over 30 days. And such moves always catch our attention.
Especially when we stand at a crucial crossroads for the currency. Will we break the five year trend or not?

exchange rate



04 05 06 07 08 09 10

The reason why South African Rand has been depreciating since the 2005 is due to high inflation that was faster than
productivity gains. The inflation is deeply rooted in South Africa and the central bank does not seem to be very
successful in its efforts to wipe the inflation out of the system. We believe the ultimate reason is that it has been
keeping rates simply too low in real terms and there we do not see any shift in policy going forward.

South Africa, CPI y/y, real interest rates

percentage points




98 99 00 01 02 03 04 05 06 07 08 09 10

SA, CPI y/y South Africa, Real Interest Rates

© ATWEL International, s.r.o. Page 2

During the crisis, African companies were unable to slash costs and fire workers. With final demand going down, unit
labor costs consequently soared well above trend. High unit labor costs make African companies uncompetitive.
Unfortunately, OECD does not provide very up-to-date for South Africa so the last official data originate from mid
2009. With a bit of effort (brown line), we could artificially recreate unit labor costs time series. We employed wage
index and capacity utilization to our model, arriving at conclusion that unit labor costs at the end of 2009 dropped
probably by 2%, remaining well 8-10% above trend. If we follow the logic that South African Rand had to keep
depreciating throughout 2004-2008 to keep up with rising unit labor costs, today, USD/ZAR should oscillate around
7.80-8.00, well north of today's price.

SA, Unit Labor Costs

left axis = ULC, right axis = exchange rate
140 13

130 12




80 6

70 5
00 01 02 03 04 05 06 07 08 09 10

South Africa, Unit Labor Costs Manufacturing USDZAR

Underneath, we provide for an excerpt from the Global Competitiveness Report by World Economic Forum, which
we regard as a highly recommended reading (link):

 South Africa stands at 45th place out of 133 covered countries, the highest ranked country in sub-Saharan
Africa, with a stable performance compared with last year.
 South Africa does well on measures of the quality of institutions and factor allocation, such as intellectual
property protection (24th), the accountability of private institutions (5th), and goods market efficiency
(35th). There has been a notable improvement in the country’s financial markets, which have increased in
rank from 24th last year to a very high 5th this year, indicating strong confidence in South Africa’s financial
markets at a time when trust has been eroded in many other parts of the world.
 South Africa also does reasonably well in more complex areas such as business sophistication (36th) and
innovation (41st), benefiting from good scientific research institutions (ranked 29th) and strong
collaboration between universities and the business sector in innovation (ranked 25th).
 On the other hand, South Africa’s competitiveness would be enhanced by tackling some enduring
weaknesses. The country ranks 90th in labor market efficiency, with inflexible hiring and firing practices
(125th), a lack of flexibility in wage determination by companies (123rd), and poor labor-employer relations
 The poor security situation remains another important obstacle to doing business in South Africa. The
business costs of crime and violence (133rd) and the sense that the police are unable to provide protection
from crime (106th) do not contribute to an environment that fosters competitiveness.
© ATWEL International, s.r.o. Page 3

On April 15th, US was supposed to reveal whether it marks China as a currency manipulator or not. By decision of
Tim Geither, this date was postponed as it should relief some pressure from China. Clearly, if Beijing is to move, it
will do so only under a condition that it is perceived as not bowing to US. Therefore Geithner's move was a right one
and markets started immediately to sniff around. Oil went up, ASEAN currencies started to appreciate, risk returned
to the system and shares of exporters in developed countries moved up. This was exactly the theme since 2005 to
2008 when China let its currency appreciate by aggregate 18%.

In this piece we will examine two issues: a) What is the likelihood of China restarting appreciation of RMB?, and b)
What the implications of such move are.

What is the likelihood of China restarting appreciation of RMB?

If you asked us this question few days ago, the odds of such move were pretty high. The most likely date the market
is focused on now is the US-Chinese strategic talks in May as it is widely perceived Chinese will restart appreciation
some time before this date.

The reasons for such move are quite clear. Inflation in China is on the rise again and all leading indicators point out
that inflation will accelerate. Inflation in the industrial sphere (PPI) has already reached 5% and it is just matter of
time before companies will pass on these costs on customers. Wages of migrant workers in five Chinese provinces
rose by as much as 10-20% due to labor shortages. And real estate prices in March overshot 10% as well. The
experience from the past tells us that the Chinese allowed for faster appreciation in times of increased inflation.

So as everything was pointing to a smooth ride, a one big caveat appeared over the weekend. Namely the Chinese
government stepped up new measures to cool property prices with some of the most draconian orders yet. As a
matter of fact, these measures are considered by some as even harsher than the policies in 2007-2008 that caused a
slowdown in GDP and sizeable stock market sell-off. Beijing significantly increased minimum down payments of first
and second homes mortgages and allowed banks to stop offering mortgages for third-home purchases. Interest rate
on mortgages for investment properties was simultaneously raised significantly by 2.38% (from 4.16% to 6.53%).

Given the historical pattern of slowdown when harsh administrative measures are introduced, we would not be
surprised if Chinese take some time to assess the impacts of their tightening measures before moving the currency.
Compared to largely ineffective tightening measures introduced in early February, this time the impact seems to be
immediately felt. Anecdotally, real estate purchase contracts in Beijing, Shenzhen and Shanghai were reported to be

© ATWEL International, s.r.o. Page 4

China, Stock market index, amount of loans y/y Oct 2008: Stimulus
Shanghai ndex(left axis), percentage points (right axis) programs, loans
7000 20

Apr 2004: Oct 2007: Loan 18

6000 Recstrictions on loans quotas introduced,
5000 14


2000 6


0 0

Shaghai A-Share Stock Price Index China, Financial Insititutions, Loans Y/Y (RHS)

What are the implications if China revalues?

 Rebalancing of global economy will be given a further tailwind. Chinese and US current accounts imbalances
should narrow.
 OECD exporters and Chinese consumers should harvest the benefits. Chinese exporters are set to lose. Chinese
companies with USD debt will be positively affected.
 Basic metals and energy will become more affordable to the Chinese. As China is now the biggest marginal
player in the commodities sector and the infrastructure boom is set to continue, the raw materials should
benefit. In case markets evaluate RMB strengthening as monetary tightening that cools off Chinese economy,
then raw materials could come under pressure though in the short term.
 Low cost retailers in OECD countries will face price stresses in their respective supply chains where most of
goods is sourced from China. Price and margin adjustments will be shared by both Chinese exporters and OECD
importers. Over time, production of cheap products will probably move to countries like Vietnam.
 Luxury goods will become more affordable for Chinese. Companies like LVMH and strong brands should do well
over time.
 Resumption of RMB appreciation is a strong case for appreciation of other Asian currencies against an otherwise
strong USD. Asian countries are generally intervening in the FX markets to stem appreciation of their currencies
and to some degree they see RMB as an anchor. They simply do not want to put domestic exporters at risk until
China moves its exchange rate first. SGD has already appreciated in anticipation of RMB revaluation. Korean won
still remains the most undervalued currency in the region.

What are the implications if China does not revalue?

 China will face an increasing protectionist pressure from US, which would be ultimately detrimental for equity
markets. Trade wars have never created any value, nor increased the overall wealth.
 It will be left with the inflation channel as the only adjustment channel left. Inflation will further add to real
estate speculation frenzy. However, we believe China will have to learn live with higher structural inflation
anyways (maybe as high as 4-5%) as a result of necessity of higher wages which would promote the internal
rebalancing toward consumption.

© ATWEL International, s.r.o. Page 5


Since early 2009, being short base metals has been a very poor exercise. Copper showed some enormous strength
and is now just 12% short of its peak high in 2008. Record high inventories do not seem to matter. Zinc, aluminum,
and nickel had some great time lately too. Of the four base metal musketeers, nickel has been a clear winner for the
period since early February, gaining +40% in just two months. And yet we think nickel may turn out to be quite a
weak performer in the months ahead.

The driving force behind the rise in price of nickel has been a continuation of significant supply distortion in Canada
while demand for stainless steel. As a matter of fact, 60% of all nickel is used for production of stainless steel, so this
is the key product to follow. If we look at following chart depicting 3 week moving average of inventory buildup or
drawdown at LME, February and March had quite a strong activity in drawdown of inventories. The immediate ratio
between production capacity and demand became unusually tight and the price reacted.

Nickel, LME inventory buildup / drawdown (3 week moving average)

metric tons
6 000

5 000

4 000

3 000

2 000

1 000

-1 000

-2 000

-3 000

-4 000

2010 2009 Avg Min Max

It is quite important to understand that we are nowhere close to peak supply. In fact, producers are so sure that
business is terrible that they are in no hurry to reopen their mines. One third of world nickel capacity is sitting idle.
The biggest nickel mine in Canada Inco is currently on strike, which is about 10-12% of the world capacity. All the
mines that closed when world economy collapsed remain shut down and 3 or 4 new mines are purposely being
developed at very snail pace.

We believe the recent surge in prices is unjustified and it will be corrected as swing capacity comes online. First, Vale
plans to use external mine contractors to return output at its Ontario nickel mines Sudbury and Voisey's Bay to half
of their annualized capacity by the end of June. That would add approximately 4.000 metric tons of new supply and
move market balance into a surplus.

© ATWEL International, s.r.o. Page 6

Canada nickel production, y/y
percentage points





Canada, nickel production y/y, MA2

The second force that should put some weight on nickel prices is the resurgence of "nickel pig iron" (NPI) production
in China. In 2006, when world started running out of nickel inventories and price of nickel shot up to $50.000/MT,
Chinese stainless steel producers realized they needed a new alternative supply to nickel. The NPI is produced from
lower grade nickel ore, not generally used for nickel production, yet constituting about 2/3 of world's nickel
resources. Chinese NPI production is very sensitive to cost pressure and could easily switch off if prices dip below
operating cost, estimated at around 16-17.000 /MT.

Where does this all leave us? Despite strikes and voluntary shut-ins of mines, exchange inventory reached 20 year
highs. With prices sharply recovering, Vale's intention to bring production back on line and NPI producers in China
capable of coping with shortages, we should see additional supply move slowly back into market and price to ease
substantially from today's price of $26.000/MT, probably to around $20.000/MT. This strategy can be exercised
either through outright shorting of futures or via an option strategy.

Nickel spot price, metric tons in LME warehouses

left axis = USD/MT, right axis = exchange inventories in metric tons
60 000 2000

50 000

40 000

30 000

20 000

10 000 128000

0 256000

Nickel spot price Nickel, LME inventories

© ATWEL International, s.r.o. Page 7


Small cap companies in Japan offer a compelling investment case. Price to book ratio stands at 0.9 and it is
impossible to find such a cheap index anywhere else in Asia. One can find similar metrics in Greece and Italy, yet we
would argue that these countries are not competitive by any means. Japan on the other hand is still running healthy
trade and current account balance.

When we look at long-term trends in P/B ratio of Japanese small caps, they tend to revert to the mean. The multiple
average is 1.17 P/B. Now we are around one standard deviation under the long term average which would imply
about 20% undervaluation of current prices.

Topix Small Cap Index, Price to Book









94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Topix Small Cap Index, Price to Book Ratio Average

Everyone who has ever invested in Japan knows, the market can be stuck in this value trap for a very long time. For
the valuation to normalize, investors need a spark, a theme they could associate with and allocate capital to. In 1999
it was the technology bubble and in 2005 it was the belief that Japan can start unlocking shareholder value. Today,
we think the potential themes could be a) corporate restructuring and higher profits, b) indirect exposure to the
Chinese growth story, and c) central bank getting more accommodative and injecting money into the system.

If we were to bet on a single theme, the most probable one seems to be the corporate restructuring and increase in
corporate profits. Japan is clearly stuck between rock and hard place. South Korea became a tough high tech
competitor due to its undervalued exchange rate and China is slowly moving up the value chain. The only way
around for Japanese companies is to fire people and focus on higher margins, something the Japanese companies
have not been lately. The good sign is that while overall production in Japan is growing strongly, companies did not
truly start hiring yet. The adjustment variable today is number of hours worked instead of re-hiring and that is very
positive for labor productivity and corporate profits.

We are aware that the structural theme in Japan is not the brightest one, but after many years, Japan is not the
boogey-man of markets any more. It is Greece and Portugal and Spain these days so in terms of relative value and
diversification logic, we think Japanese small caps may be still a good bet after all.

© ATWEL International, s.r.o. Page 8


Retail sales in US have been exceptionally strong and there is no doubt they helped drive the stock market higher.
But this kind of consumer spending happened on the back of 2 main influencing factors. Virtually no improvement in
saving rate since the last year (we are still stuck at 3.8% saving rate as a percentage of disposable income) and a fat
increment of government transfers to its citizens.

Saving rate

The latest available reading of saving rate from February showed a dip to 3.1%, down from 4.0% at the end of last
year. Customers seem to be less scared and some pent-up demand is showing up. Less saving can be a good thing to
boost the economy in the short term, however it was the irresponsible spending mania of 2007 and 2008 that
brought the economy to its knees. We think it would be reasonable for US to keep about 4-5% saving rate,
somewhat in line what we have seen before the bubble burst. That said, the major adjustment in spending
behavior since 2008 has been completed from about 2/3 and should not be too much of a drag into future. However,
the recent dip to 3.1% in February should be discounted in our opinion and not perceived as new normal. We still
need some adjustment in savings and pace of retail sales increases should be lower over the rest of the year.

Compared with less developed nations, the saving rate of 5% may seem a bit low. But it is important to realize that
US can already boast with extensive capital stock and it does not need to save to build much new infrastructure.
Most of it is already in place. With all the outsourcing of capital-intensive processes into Asia, US is focusing mainly
on services that are labor intensive and revolve around education and organization efficiency.

US Saving rate as a % of disposable personal income (MA3)

percentage points


90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

y/y as difference Saving rate % of disposable income (MA3)

Government transfers

This is an area which we are not too cheerful about. As much as 10% of all personal income is now derived from
government transfers. Growing government transfers are a function of an ageing society and extended pool of the
unemployed. As you can see from the chart below, the reading of 10% is well north of trend and what is worse, it
does not seem to be improving. US government will have one of the naughtiest fiscal budgets as far as the eye can
see and we fear that in case the bond market decides it does not want to finance such deficits, the readjustment will
have a severe impact on the disposable incomes of households. And less income will mean less spending and
consequently less revenues for companies.
© ATWEL International, s.r.o. Page 9
Net government transfers as % of personal income
percentage points






1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

Personal current transfer receipts as % of Personal Income

So we need an improvement in the job market really badly, so that households can earn their income through higher
wages. Unfortunately, small businesses still do not show any signs of improved willingness to hire more and chances
of getting a job are just 25%, opposed to normal readings of 40-50% during recoveries. Hopefully we are just at the
brink of job creation as shown by the household survey, but these numbers do not show any convincing momentum.
On the other hand, the average duration of unemployment still keeps increasing.

US Average duration of unemployment







94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Recession Average Unemployment Duration

© ATWEL International, s.r.o. Page 10


Shorting Spanish banks is certainly not one of the out-of-the-box macro calls. It may have been so last summer, when
we profitably executed this trade while many people still rode on the reflationary wave. If I recall it right we found
inspiration for this trade in one of the Variant Perception studies. Those guys were truly well ahead of everyone else.
Now, six months later, the research universe is full of reports on European banks in the PIGS states. Citi, SocGen,
Nomura, Morgan Stanley, pretty much all of them are bearish on Spanish banks. And so are we. After a recent bear
market correction in South European markets, we believe it is time to challenge the stakes once again.

1) Spanish banks are a leveraged play on real estate

According to Bank of Spain, loans to developers stood at over €300bn at the end of 2009, which represents about
1.7x total banking system's equity. As real estate developers in Spain have no meaningful chance to repay their debts
due to pricing pressures and vanished demand, the banks have to take properties on their balance sheets or
restructure the provided debt. As of 2009, banks have already acquired about €30bn of real estate on their books.
We believe this real estate is taken back on the banks' books at often inflated prices as they do not have to reflect
actual bid prices. But this may defer problems for just so long.

A lot of developers' debt is also being restructured (maturities are being extended). This creates a fake image of
solvent banking system. But again, recognition of non-performing loans is simply postponed to the future.
Meanwhile, somebody has to pay maintenance costs for the empty property. And nominal level debt is not reduced.
Problems are simply deferred over time assuming economy will pick up over time. Anecdotal evidence shows that
real estate developers are, however, having increasingly hard time in the market. Non-performing loans of
developers reached 8% and most of them find it increasingly difficult to pay even their interest payments.

2) Housing market adjustment is far from complete

House prices index

index, 2004=100










04 05 06 07 08 09 10

US House Price Index (FHFA) Spain House Price Index

The house price index in Spain has dropped by mere 13% since its peak in 2008. But both the magnitude of price
bubble and time scope during which the bubble was forming, exceeds what we have seen in US. The house price
index has certainly further down to go. According to Credit Suisse, the nationwide rental yields imply a house P/E of

© ATWEL International, s.r.o. Page 11

30x, making rental housing uneconomic, and implying overvaluation of house prices by at least 30%. Due to lower
interest payments that are mostly variable, the households find it more affordable to stay in their homes. Yet as we
know from Japan's case, improved affordability does not warrant a halt to deflation of insane prices. Although
interest payments may be lower, the average Spanish household faces 50% higher ratio of house price / annual
household income than its counterparty in US, taking it to full 7 years of household income to repay the house.
Average housing market implies only 4.5 times household income to repay the house.

The backlog of unsold homes remains very sizeable. As much a 1.3 million houses in Spain sit unoccupied. Assuming
the pace of sales remains at current level and no new homes are built, it would take until 2015 to clear the market.
In case the demand for houses returns to the pre-crisis period, we still face at least two more years of market
clearing process when prices will be falling as supply outweighs demand.

3) Economic prospects for next few years are extremely poor

In the past Spanish growth was primarily driven by cheap credit and real construction. Now, when the boom period
is over, Spain is caught with twin deficits and very low competitiveness (as much as 15% price adjustment would be
needed for unit labor costs to match Germany).

According to latest estimates, debt to GDP should rise above 70% in 2011 (almost 30% gain in 3 years) and primary
government balance is expected to remain deep in 6% deficit by 2011. Any fiscal adjustment will necessarily be a
drag on GDP and employment growth in the short term.

Unemployment level reached 18.8% and should stay at relatively high level for considerable period of time as the
construction sector will remain weak. (At the peak of the housing bubble, Spain was building 2/3 of all houses in the
EU). As much as 34% of young male aged 24 are jobless. Unemployment is the most important barometer for future
health of banking sector and level of delinquencies.

Funding costs for banks are another major risk. Competition for risk has become very high in Spain, as the overall
loan to deposit ratio is >150% and smaller banks do not have access to capital markets. Two largest commercial
banks in Spain already offer 4% deposit rate. This clearly results in a margin risk. Sovereign risk, which has been on
the rise for Spain, also increases banks' cost of funding.

4) What banks are we shorting ?

In our shorting strategy, we will utilize equal weight approach. We would probably avoid shorting Banco Santander
and BBVA due to their strong balance sheets and income stream from Latin America (Brazil and Mexico). It is possible
to go long SAN and BBVA, while shorting the pure domestic banks (Banco Popular, Bankitier, Banco Pastor, Banco
Sabadell - may be hard to borrow, and Banco Valencia). Another strategy can be just to focus on shorting the pure
domestic banks. Further, we will create a basket of several real estate developers as almost no new homes are being
built, price pressures will prevail and interest payments will have to be met. We will consider shorting companies
such as Realia Business, Metrovacesa, Inmobiliaria del Sur, Sotogrande, Testa Inmuebles, and Reyal Urbis.

When we looked at the relationship between 5Y CDS on Spain and 4 domestic banks (without SAB which is hard to
short), an interesting and tight relationship emerged. For those who believe CDS on Spain will rise further, this may
be an interesting strategy.

© ATWEL International, s.r.o. Page 12


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Company provides this document for educational purposes only and does not advise or suggest to its clients or other subjects to buy or sell any
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Educational methods of the Company do not take into consideration financial situation, investment intentions or needs of other persons and
therefore do not guarantee specific results. Company and its employees may purchase, sell or keep positions in shares or other financial
instruments mentioned in this material and use strategies that may not correspond to strategies mentioned in this material.

© ATWEL International, s.r.o. Page 13