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FX Pulse. Preparing for Volatility. Trade Recommendations. MS Major Currency Forecasts. Currencies. Global


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this report.


August 01, 2013


FX Pulse

Preparing for Volatility

Trading FX Markets:

We have re-established our bullish USD exposure

despite the Fed’s continued attempts at managing rate expectations while heading towards tapering.

Nonetheless, we resist getting back into long USDJPY positions at this stage. Weak Japanese data, the recent underperformance of local share markets and the fiscal tightening debate do not bode well for higher monetary velocity, which is a precondition for the JPY to resume its downward trend. Meanwhile, risky assets in developed markets may increasingly experience economic

headwinds, a spillover from emerging economies. Hence, we believe selected JPY crosses face downside potential over the next few weeks.

In This Week’s Edition:

First, we explore EUR supportive flows and discuss the

EUR outlook with respect to upcoming local risk events. Markets seem to be treating the outcome of the upcoming German General Election and the decision of the

Constitutional Court as non-events. We disagree and look to sell EURUSD near the important 1.3420 pivotal level.

Second, we investigate how NOK, SEK, and CHF would perform in a general or Euro Area-focused slowdown, though this scenario is not our base case. Should risk aversion rise markedly, we believe CHF would be most likely to appreciate due to its strong external position and safe haven status, while SEK could see pressure given its trade links, external liabilities, and high beta to risk.

Third, we explore why INR, ZAR, BRL, IDR and TRY

remain our preferred bearish EM currency picks. The EM currency bear market that has been in place for the past two years is likely to continue over the medium term, as the factors supporting BoP flows over the last decade continue to unwind. High inflation, large current account deficits, challenging capital flow prospects and weak EM growth will work against what we call the “Fragile Five”.

Trade Recommendations

Closed Trades Long EUR/CHF Short GBP/NZD Long AUD/USD Long SEK/JPY

Limit Orders Entry Stop Target

Sell EUR/USD 1.3300 1.3440 1.2700

Sell GBP/USD 1.5210 1.5420 1.4100

Sell EUR/JPY 131.50 132.80 121.00

Sell GBP/JPY 151.70 154.20 138.00

Buy USD/CAD 1.0300 1.0120 1.0800

Options Trades Entry Date Expiry Date Strike

Short EUR put/RUB call 25-Jul-13 25-Oct-13 40.500

Long EUR put/RUB call 25-Jul-13 25-Oct-13 42.000

Stopped at 1.2310 on 31-Jul-13 Close at WMR on 02-Aug-13 Stopped at 0.9025 on 31-Jul-13

Stopped at 14.90 on 31-Jul-13

See page 20 for more details. Changes in stops/targets in bold italics.

MS Major Currency Forecasts

3Q13 4Q13 1Q14 2Q14 EUR/USD 1.29 1.26 1.24 1.22 USD/JPY 103 107 110 114 GBP/USD 1.45 1.41 1.40 1.38 USD/CHF 0.98 1.02 1.06 1.09 USD/CAD 1.06 1.08 1.10 1.12 AUD/USD 0.91 0.88 0.86 0.84 NZD/USD 0.78 0.76 0.75 0.74 EUR/JPY 133 135 136 139 EUR/GBP 0.89 0.89 0.89 0.88 EUR/CHF 1.27 1.29 1.31 1.33 EUR/SEK 8.70 8.70 8.50 8.35 EUR/NOK 7.70 7.60 7.50 7.40

Note: Forecasts for end-of-period. G10 forecasts updated June 6, 2013

FX Market Overview P2

Underestimated EUR Risks P7

Risk-off Scenarios: Positioning in

NOK, SEK and CHF P12

EM Currencies: The Fragile Five P15

Strategic FX Portfolio Trade Recommendations P20

G10 & EM Currency Summary P23

Global Event Risk Calendar P25

FX Volatility/Carry Grids, Tactical Indicators P27

MS FX Positioning Tracker P30

Macro Forecasts P31


FX Overview

Ian Stannard, Meena Bassily

 We add short EURUSD, GBPUSD, EURJPY and GBPJPY positions along with bullish USDCAD strategies to our medium-term portfolio.

 This positioning represents a tentative and selective return to USD bullish trades following the recent corrective activity.

 Indeed, increased policy clarity and signs that the US is overcoming the recent soft patch in economic data…

 …should see USD resume the major recovery trend, in our view.

 The FOMC statement had a dovish tilt and still appears consistent with market expectations for QE tapering to start in September.

 ECB reaffirmed its dovish guidance. We maintain our medium-term EUR bearish view.

 We expect GBP to lead the way lower against a

strengthening USD, with the BoE directing market attention to the August 7 Quarterly Inflation Report and Guidance assessment.

 However, we remain cautious regarding the JPY and would await clearer signs of a turnaround before entering renewed bullish USDJPY positions.

 Underlying weakness in fundamentals will drive further weakness of EM currencies versus the USD.

 The most vulnerable currencies over the medium term are BRL, INR, IDR, ZAR and TRY, and we recommend accumulating long USD positions on any meaningful dips.

USD: Return to Trend

In recent weeks many of our trading recommendations have been aiming to participate in corrective activity following the strong trending moves witnessed in currency markets during the first half of the year. Policy uncertainty and data volatility were in many cases behind the pause in the major trends. However, with greater policy clarification a return to trading the major trends can now be contemplated, we believe. In this regard, the USD recovery trend will remain the dominant force, in our view, but at this stage we advise a cautious and selective return to USD bullish trading strategies.

We initially turn our attention to bearish GBPUSD and EURUSD strategies, but when it comes to USDJPY we still recommend exercising a higher degree of caution given we

continue to anticipate another move lower in the near term, and hence, would await clearer signs that a bottom has developed before re-entering bullish USDJPY strategies. Exhibit 1

GBPUSD Leading the Way Lower

1.30 1.40 1.50 1.60 1.70

Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15

MS Forecast Consensus Forw ard GBP/USD

Source: Morgan Stanley

We had focused our attention on AUDUSD for a potential corrective rebound, especially given the extent of bearish positioning that had developed within recent months. However, the AUDUSD correction has remain extremely limited, failing to achieve even the most modest of

retracement levels, keeping the overall bearish trend intact. Hence, we now look at switching our strategy back to selling AUDUSD rebounds, in line with the deteriorating AUD fundamentals. We also believe that the setback in USDCAD is providing an opportunity to participate in the longer term USD recovery trend. Although AUDCAD has accelerated to new cycle lows, we continue to look for the CAD to lag the USD recovery.

We add short EURUSD, GBPUSD, EURJPY and GBPJPY positions along with bullish USDCAD strategies to our medium-term portfolio.

Policy Clarification…

The global trend among central banks towards adopting forward rate guidance continues to gain momentum, with the FOMC delivering the expected dovishness to emphasize the separation in policy between the tapering of QE and interest rate policy. Indeed, the FOMC statement tilted dovishly, as we had expected, but in tone still fell well short of Chairman Bernanke’s Humphrey-Hawkins testimony. It leaves us more confident that the Fed will, barring very weak labour market data, start tapering its large-scale asset purchases in


September. At the same time, we see the Fed continuing to emphasize the separation of rate hikes and QE tapering, possibly introducing a lower inflation bound in its interest rate guidance and pushing back against rising yields.

The FOMC statement looks through the first-half softness to anticipate a growth pickup “from the recent pace” and continues to emphasize the stability of inflation expectations and temporary factors driving disinflation. Also, in a new twist, the statement noted that while housing has been

strengthening, mortgage rates have risen. But it immediately pushes back with stronger interest guidance “reaffirm”-ing (rather than “expect”-ing) that policy will remain highly accommodative for the foreseeable future, in effect

underlining again the separation of asset purchase policy and fed funds rate policy.

Exhibit 2

US Initial Claims and USD TWI

Source: Reuters Ecowin, Morgan Stanley

…USD bullish

This is consistent with the recent mix of data, with the strong growth data and continued signs of improvement in the labour market data providing the right combination for the Fed to press ahead with tapering of QE at the September meeting, while the softer reading of the PCE allows the FOMC to still strike a dovish tone to keep rate expectations in check. We believe that this represents a bullish environment for the USD over the medium term, as the Fed continues to provide a supportive policy for the domestic economy, but slowing the growth of USD liquidity which has been used to fund broader global risk markets. We expect the US to increase its

attractiveness as a longer term investment destination, as has become evident with the cross-border M&A activity, where net announced deals now show a net inflow to the US. We take this measure a proxy for wider FDI flows, suggesting that a

longer term supportive environment for the USD is now developing. Hence, we look at a selective return to USD bullish positions.

Dovish ECB; Bearish EUR

Meanwhile, the ECB has reaffirmed its downward basis to rates, which given the recent robustness of data, including the rebound in the PMIs and the resilience of inflation, is probably as bold a step as can be expected at this point, especially when viewed within the broader context of political and constitutional constraints. Indeed, the ECB recognized the recent improvement in the eurozone data, while reiterating that growth risks are still to the downside. Overall, the ECB meeting does not appear to have provided any fresh impetus to the EUR, with even Draghi’s reference to rate hike expectations in money markets being unwarranted failing to generate a market reaction. This phrase is similar to that used by the BoE in its guidance message last month, and the lack of reaction in EUR markets is likely a function of EUR money markets being more focused on liquidity conditions currently. Our EUR bearish view also goes beyond the current ECB policy setting process, with German politics also likely to come back into focus as the German elections approach, adding to uncertainty. Also the German constitutional court ruling on the OMT could prove to be less flexible than previous rulings, in our view, with a tougher stance potentially leaving the perception that this particular policy tool is likely to prove ineffective (see Underestimated EUR Risks on page 7). Exhibit 3

EU-US 5-Year Risk Adjusted Yields and EURUSD

Source: Morgan Stanley

In such an environment, we would expect the EUR to come under renewed pressure as risk premiums in peripheral EMU would likely rise once again. In this scenario, risk adjusted yield spreads would increase in importance as far as a guide


for the EUR is concerned. We have already noted negative divergence from these indicators, which are now likely to start weighing on the EUR, we believe (see Exhibit 3).

GBP Leading the Way Lower

However, we would look for GBP to lead the way to the downside initially in an environment of renewed USD strength. The BoE did not produce a policy statement after the August meeting but referred to the August 7 publication of the Quarterly Inflation Report, where expectations for the introduction of forward rate guidance are likely to increase. Indeed, not even the recent better than expected UK economic data is likely to be enough to provide GBP with support, and we note the breakdown in the correlation between the Morgan Stanley UK Economic Surprise Indicator and GBP.

Exhibit 4

UK-US 10-Year Yield Differential and GBPUSD

Source: Reuters Ecowin, Morgan Stanley

One area where the UK data has been disappointing, from a policy perspective, is inflation, which has remained sticky and stubbornly above target. Although new governor Carney has avoided having to explain an overshoot during his first month at the helm, the risk has not gone away, and we expect inflation to remain at the upper end of the range over the coming year. However, the flexible approach to inflation targeting, as confirmed by Chancellor Osborne at the time of the budget, provides the room to implement guidance even in an environment of stubbornly higher inflation, especially as the upward pressure on inflation is being generated by external factors. Hence, UK real rate expectations are set to remain in extremely negative territory over the next couple of years. We expect GBP to maintain its position of having the most negative real rates among the G10 over the next couple of years, keeping GBP under pressure over the medium to longer term.

AUD – Switching Back to Bearish Strategies

We had focused on the AUD’s corrective potential in recent weeks given the extent of bearish positions, looking of a near-term AUDUSD rebound. However, the rebound has been far more muted than anticipated as the negative fundamental picture continues to build against the AUD. The more

sideways AUDUSD consolidation activity over the past month appears to have been enough to allow the extreme bearish positioning to unwind, clearing the way for renewed downward pressure to build.

Exhibit 5

Australian Terms of Trade and AUDUSD

Source: Reuters Ecowin, Morgan Stanley

Indeed, the deteriorating domestic Australian and international fundamentals are now expected to weigh more heavily on the AUD. The Australian terms of trade were flat in Q2, as revealed by the latest data, while the Australian commodity price index showed another sharp year-on-year decline in July, which will undermine support for the AUD further. Indeed, the continued weakness of commodity prices does not bode well for Australia’s terms of trade dynamics in Q3. The RBA continues to anticipate a decline in the Australian terms of trade and is pointing towards the currency to smooth the process of adjustment for the rest of the economy. Hence, the renewed dovish comments from the RBA’s Stevens would appear consistent with these developments, especially given the renewed weakness in the building approvals data and sharp decline in the Australian manufacturing PMI, which has reported its 25th consecutive month of contraction. Hence,

even within an environment of robust inflation readings, market expectations for further RBA easing are increasing triggering a resumption of the major AUDUSD downtrend. Moreover, the accumulation of weak data from Asia is also now an increasing headwind for the AUD. Although the


Chinese authorities have reaffirmed their commitment to growth and have continued a strategy of targeted stimulus measures, the changing composition of growth is likely to be a longer term underlying negative factor for the AUD, as the focus moves away from the historical investment/export led growth model towards more domestic and consumer orientated growth, which is less supportive for the AUD. AUDUSD has already reaccelerated lower with a move below the 0.9000 level opening the way for the major downtrend to be extended towards the 0.8600/0.8500 area over the medium term. However, we await a fresh rebound before re-examining bearish AUDUSD strategies at this stage. Exhibit 6

Nikkei and USDJPY

Source: Reuters Ecowin, Morgan Stanley

Caution with USDJPY

At this stage we are not including USDJPY in our selective return to bullish USD strategies. Indeed, we believe the JPY is still likely to gain some support in the near term. Renewed data weakness and an underperforming Nikkei are not providing the environment for sustained Japanese investor outflows, which we believe are required for the JPY to resume its weakening trend over the medium to longer term. While there has been some initial evidence that Japanese investors are being attracted by higher overseas yields, with the last four weeks of portfolio flow data showing purchases of overseas bonds, we believe that a resilient pickup in monetary velocity in Japan is still required to generate a sustained portfolio outflow. Hence, we refrain from re-entering long USDJPY positions at this point until more compelling evidence of a sustained turn around starts to emerge. However, despite this near-term caution we maintain our longer term bullish USDJPY view.

EM Currencies Facing Greater Risks

EM currency sensitivity has recently centered on the health of the US economy and the related policy actions of the Fed. This has caused dispersion in performance related to perceived sensitivities of currencies to a reduction in bond inflows, amongst other factors. However, we continue to believe the debate on the timing of QE tapering serves only as a catalyst for near-term direction, while underlying EM fundamental drivers will eventually set EM currencies on a depreciating path against the USD and other major currencies – and drive our relative preferences within EMFX.

Accordingly, our trading strategies across EM currencies have aimed to take advantage of what we believe is a more favourable technical backdrop for the asset class (see Global EM Investor: Technically Speaking, July 29, 2013), though we has also been factoring in this weak fundamental outlook. At the core of our bearish outlook for EM currencies is the deterioration of EM fundamentals, as represented by a slowdown (reversal in several cases) of FX reserve accumulation (see Exhibit 7), slowing GDP growth, balance sheet deterioration and pressure on credit ratings.

Exhibit 7

Annual EM FX Reserve* Growth About to Turn


(10) (5) -5 10 15 20 25 30 35

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

AXJ (ex China) CEEMEA LatAm

Source: Haver *Growth rates calculated using constant exchange rates.

These pressures have become more acute in an environment where DM monetary policy is potentially pulling capital away from EM. As the exhibit below shows, a steep rise in net portfolio flows toward EM equity and debt markets supported EM currencies between 2009 and early 2011, as QE was in play and the growth differentials between the EM and DM world were on the rise. As QE heads toward the exit (timing being of secondary importance) and growth differentials narrow (according to our economists’ aggregated forecasts),


portfolio flows will not provide currencies the same level of support.

EM countries will need to work harder to attract capital back by improving the productivity dynamic and investment climate in their economies. Further adding to depreciation pressures on EM currencies is the more specific China slowdown-related risks – which may cause a further deterioration in the terms of trade of several economies. We explore these issues in greater detail in this week’s article: EM Currencies: Medium Term Risks Still High, page 15. Exhibit 8

EM Currencies Have Depreciated as Net Portfolio

Flows Have Been Declining as %GDP

-2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 01 02 03 04 05 06 07 08 09 10 11 12 13 80 85 90 95 100 105 110 115 120 Debt Inflow Equity Inflow

Debt and Equity Outflow EM Net Portfolio Inflow USD/EM (RHS, reversed)

4Q rolling sum, %GDP

EM Depreciation

As such, we believe it is necessary to differentiate between markets on the basis of (1) whether there is a push for structural reform, (2) how vulnerable externally a country is to a slowdown of capital inflows, and (3) specific vulnerabilities to a China slowdown. Taking this framework, we see the most vulnerable currencies over the medium term as being BRL, INR, IDR, ZAR and TRY, and we continue to recommend accumulating long USD positions versus these currencies on any meaningful dips.


Underestimated EUR Risks

Hans Redeker

 The EUR has gained 10% in trade-weighted terms over the past year, despite poor economic performance in EMU.

 The rising EUR is not supported by stronger credit, suggesting monetary conditions have tightened.

 The ECB shrinking its balance via LTRO repayment is an inadequate response to EMU’s struggle to repair balance sheets, but…

 …deflationary flow characteristics in EMU’s capital markets suggest the EUR will only come under selling pressure should the ECB ease policy or the EMU head towards a full blown debt crisis.

 US credit markets are functioning, suggesting central bank policy will eventually diverge and pressure EUR/USD.

 The current low EUR volatility is insufficient given EMU’s risk calendar.

 Chancellor Merkel’s chance of maintaining her current coalition has increased.

 Hopes that Germany could take more aggressive action to support the periphery after the election are misplaced.

 The German Constitutional Court decision concerning the OMT is not yet priced in as a risk factor.

 EUR/USD near 1.33 offers a selling opportunity.

The EUR’s Rise

The EUR has appreciated in trade-weighted terms over the course of this year, which is at odds with Euroland’s lackluster economic performance (see Exhibit 1). To overcome relative economic weakness, EMU requires accommodative monetary conditions, including a weak exchange rate. Private sector borrowing declined by 1.6%Y last month, the fastest pace since the introduction of the EUR, which does not bode well for the investment and employment outlook. Simply said, underlying corporate and private households’ cash flow conditions are too weak to support investment without access to credit. With investment likely to remain low, the

employment picture will also remain bleak. As such, we remain skeptical regarding the recent rebound of EMU’s leading indicators.

Exhibit 1

EUR Strength Seen on the Crosses, Not vs. USD

Source: Reuters EcoWin, Morgan Stanley

Exhibit 2 illustrates the ratio of investment to consumption, which has continued to fall, suggesting labor market conditions remain weak. In this respect, hopes of an economic rebound from rising leading indicators seem premature. Instead, we are cautious that leading indicators are diverging from the performance of credit growth. Since 2010, there were several periods in which it seemed economic leading indicators were diverging from the credit trend. In all of these cases, credit dominated, and leading indicators slowed. In spring 2011, the ECB even hiked rates in response to stronger forward indicators, which turned out to be a policy mistake. Only when credit demand and leading indicators point in the same direction is the economy ready to deal with tighter monetary conditions including a higher EUR. So far, this condition is not met.

Exhibit 2

EMU: Falling Investment / Consumption Ratio

Predicts Labour Market Weakness

7% 8% 9% 10% 11% 12% 13% 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 22% 23% 24% 25% 26% 27% 28% 29% 30%

Unemployment (Inverse scale) Investment/Consumption (RHS)


Exhibit 3

EMU: Diverging Trend between Falling Credit

Supply and Leading Indicator Will Not Last

Source: Reuters EcoWin, Morgan Stanley

Unfortunately, global aggregate demand has declined, and with emerging market economies often facing the

consequences of overinvestment and the end of the export-oriented growth model, the performance of the global economy depends heavily on economic performance in the US. Consequently, investment flows will become increasingly USD focused, weighing particularly on EM currencies while pushing USD higher.

Euro Markets’ Deflationary Trading Characteristics

While many emerging and commodity currencies including the AUD have traded lower, the EUR stands out due to its relative strength. However, euro strength combined with global demand weakness suggests EMU exports will remain weak. The lack of exports to support growth and contracting credit demand suggest EUR will eventually need to weaken, with declining EMU leading indicators providing the catalyst. However, a detailed look into EUR cross-border flows suggests that matters are more complicated. The EUR behavior is not just the result of relative economic

performance. Similar to the JPY experience in the early 90s, currency weakening will require either central bank

engineering or a market revolt due to asset outflows in response to overly tight macro conditions. The reason the EUR has not reacted strongly to cyclical factors and remains relatively stable is that EMU-based investors are developing typical trading characteristics for a deflationary economy. The understanding of these flows will allow us to get an idea of when and if the EUR may come under selling pressure.

Understanding EUR Flows

EMU banks that face difficulties in obtaining external fundings have left an increasing share of their foreign holdings

currency un-hedged, effectively running a EUR short position. This position creates the permanent threat of EUR-supportive repatriation flows. These flows are particularly relevant at the end of accounting periods.

Meanwhile, Euroland has experienced a significant current account swing, suggesting commercial EUR offerings have converted into demand. Exhibit 3 shows the evolution of the EMU’s current account compared to EMU’s export activity. There are mainly two factors driving EMU’s current account surplus. EMU’s net liability position experienced cheaper funding conditions, reducing coupon payments abroad. This effect is minor. More important is the sharp autonomous decline of EMU domestic demand, which contributed overwhelmingly to the current account balance moving into positive territory. Only a very small portion of EMU’s current account surplus was ‘earned’ by better exports . Recently, EMU’s export performance has suffered, and is now flat compared to last year. A current account surplus mainly supported by softer demand is symptomatic for deflationary economies.

Exhibit 4

EMU’s Current Account Swing Due to Deflation

Source: Reuters EcoWin, Morgan Stanley

European banks running substantial euro funded asset positions abroad combined with the current account surplus have created commercial EUR demand. Of course, commercial demand only determines the direction of FX if portfolio and FDI-related flows do not outbalance commercial flows. As ageing societies build capital stock to generate sufficient retirement income, capital accumulation has become larger, increasing the importance of portfolio-related cross-border flows relative to commercial flows globally.


Inward-looking EMU Investors

However, in the case of EMU, we see institutional investors such as banks, trusts, insurance companies and pension funds investing increasingly within the eurozone and into national asset classes. Spanish entities buy

EUR-denominated Spanish sovereign bonds, Italian accounts buy BTP’s and German households convert portfolio holdings into EUR-denominated German real estate. This inward

investment focus is typical for a deflationary economy. A good example is Italy. Italy’s deflation set in long before the start of EMU debt crisis in March 2010. Italian banks focused

increasingly on sovereign bond investments instead of lending to the private sector. Hence, the ambitious EUR valuation currently expressed in FX markets is to some degree the result of deflationary investment characteristic founds in EMU markets (see Exhibits 5 and 6).

Exhibit 5

EMU: Basic Balance on the Rise, but Stocks


Source: Reuters EcoWin, Morgan Stanley

Exhibit 6

…as Banks Engage in National Carry Trades

Instead of Lending to Private Entities

(Italian Banks Claims against the Sovereign % of Balance Sheet)

Source: Haver Analytics, Morgan Stanley

Japan Could Afford Deflation; EMU Cannot

Japan has proven that deflation and currency overvaluation can stay in place for a long time. Today, we investigate the

likelihood that the EUR trades lower either with the help of the ECB or due to increasing deflationary pressures finally taking a toll on unsustainable debt levels and driving a crisis-related euro decline. There are good reasons for both scenarios, we think, as the status quo of a higher EUR in a low volatility environment is unlikely to last long. EMU seems to have to choose between crisis or excessive monetary accommodation, which both will work against the EUR in the long term. Unlike EMU’s current situation, Japan was able to cope with deflation in the early 90s. Its foreign asset position generated income, supplementing weak domestic income levels. This not only helped maintain high living standards, but also meant Japan ran excess savings, which allowed Japan’s sovereign to fund its exponentially rising debt at ever cheaper rates. During Japan’s deflation, Japanese 10-year yields declined from 6.5% to 0.55%. Nonetheless, deflation reached its limits when debt service costs relative to GDP started to rise despite falling bond yields. It took Japan two decades to reach this limitation. EMU does not have this luxury, we think. Exhibit 7

Japan: Falling Debt Service Costs Delayed Public

Balance Sheet Burden Increase

Source: Reuters EcoWin, Morgan Stanley

We cite two reasons. First, EMU has foreign net liabilities and its income balance has only recently turned positive. In contrast to Japan in the early 90s, there is little income generated from foreign investments. Second, the ECB does not act as lender of last resort, suggesting credit risks determine a substantial part of sovereign funding costs. While core-European funding costs may fall further due to relatively low credit risk, debt sustainability concerns in the periphery are likely to keep the cost of funding in peripheral countries high unless EMU introduces a fiscal union, which would implicitly allow the ECB acting as a lender of last resort.


Debt and Policy Errors

When negotiating the first Greek haircut last year, European authorities implicitly suggested debt levels above 120% of GDP are not sustainable. Sovereign debt relative to GDP averages 92% in the eurozone with a number of peripheral countries running debt to GDP ratios close to or above the critical 120% level, as illustrated in Exhibit 8. EMU’s lackluster deflationary economic performance will keep credit risks elevated, suggesting peripheral countries will find it difficult to reduce their funding costs sufficiently to make their high debt levels affordable.

Exhibit 8

EMU’s Debt Burden on the Rise

Country Government debt (% of GDP)

Luxembourg 22.4 Finland 53.6 Netherlands 72 Austria 74.2 Malta 75.4 Germany 81.2 Cyprus 86.9 Spain 88.2 France 91.9 Euro Area 92.2 Belgium 104.5 Ireland 125.1 Portugal 127.2 Italy 130.3 Greece 160.5

Source: European Commission

Japan was able to make its increasing debt levels affordable due to lower funding costs. Here EMU’s position is more challenging should inner EMU bond yield spreads stay high. LTRO repayments shrunk the ECB’s balance sheet. When the repayments occurred, the market interpreted this as EUR bullish. However, historical analysis suggests the ECB might have made a policy error, which could have significant consequences. When there is a debt cycle, central bank policy must address the legacy assets of the previous credit boom. When the private sector is highly levered and bank asset quality is dubious, credit demand and supply cannot flourish. Banks have no appetite to increase balance sheets and the private sector has no desire to add to already high debt levels. Before lending can restart, banks and the private sector must repair their balance sheets.

Lessons from the Past

The 1920s/30s debt cycle provides some interesting insights. In the US, credit stayed weak until the US government gave up on the gold standard, which restricted the Fed’s balance sheet growth. Once the Fed’s balance sheet started to grow and take on the legacy assets that the private sector created

during the credit boom of the 1920s, credit demand and supply started to function again. The UK and Japan had similar experiences, while France kept the gold standard and hence the BOF balance sheet remained restricted for longer. As a result, France remained in depression with credit demand and supply absent.

Since global trade was depressed due to rising tariffs, meaningful spillover effects from expansionary towards weaker economies were limited. This put the onus on central bank policy, and makes the 1920/30s debt cycle a valuable lesson for understanding which central bank approaches were successful and which were not. The post-1933 Fed was successful in generating economic growth of 10%, with the exception of 1938. On the other hand, France, which remained committed to the gold standard, remained economically weak.

US Is Back in Business; EMU Stands Aside

The EMU is currently behaving like France in the 1920s/30s. In light of the shrinking ECB balance sheet, it does not surprise us that bank credit is contracting. The US, with its more aggressive expansionary approach, has experienced higher lending growth. Corporate bank issuance activity shows this difference well. While US corporates issued about US$1.1 trillion this year, EMU corporate bond issuance was only 10% of the US activity. In the US, credit markets seem to work, while credit markets in EMU remain impaired. As long as the ECB remains restrictive and global growth subdued, EMU will find it difficult to develop the escape velocity to overcome deflation.

Exhibit 9 shows accumulated corporate bond issuance since 2010. Of course, the US corporate bond market is big and has been an established funding tool for decades. However, since the introduction of the EUR, the euro-denominated bond market has increased its liquidity and size, closing the gap when compared with US markets. Consequently, EMU’s corporate bond market has become an increasingly important funding tool.

Exhibit 10 compares yearly changes of the amount of outstanding bonds in Euroland and the US. While private sector bond net issuance in the US is rising, EMU has experienced continued weakness here.

Hence, current market optimism concerning the EMU growth outlook is overblown and due for correction later this year, in line with our economists’ expectation for a lackluster rebound. Moreover, any negative surprises could influence ECB thinking.


Exhibit 9 Should this change fail to materialize, EMU markets may adjust to a higher risk profile, we think. In addition, a defeated SPD is likely to explore the reason for its renewed defeat. The SPD has often voted with the current German government, especially on EMU issues. The SPD and to a lesser degree the Greens struggle with lacking differentiation compared to the CDU. The new Parliament could the SDP no longer voting along

government lines. Consequently, Chancellor Merkel might have to ‘nurse’ her own majority, pushing her policies more towards the euro-skeptic camp. The market has not priced in this risk.

US Corporate Bond Issuance Is Booming, EMU’s

Markets Lag, as…

However, the upcoming German Constitutional Court (CC) decision concerning the OMT is the biggest risk for EUR bulls. Last year, the CC decided on the ESM, providing a market-favorable verdict in autumn 2012. This year, the market is assuming a similar outcome, which might be too optimistic. The court hearing was not as smooth as many anticipated for the ECB and the German government, as the judges

repeatedly interrupted the defense of the OMT program. Should the ECB apply the OMT, the ECB’s balance sheet would experience an asymmetrical increase in peripheral risk.

Source: Morgan Stanley Research, Dealogic, Bloomberg

Exhibit 10

…Indicated by Diverging Trends of Net Issuance


Source: Reuters EcoWin, Morgan Stanley

According to the constitution, it is Parliament’s right to decide fiscal issues. However, should the ECB have to accept a haircut on its peripheral holdings, it would be taxpayers who bear the financial consequences. Germany holds 27% of the ECB balance sheet and would have to cover 27% of potential losses. Hence, the OMT program has the potential to reduce Germany’s fiscal autonomy. It is possible the CC could ask the Parliament to vote on the OMT, providing the ECB with limits on the OMT program. Accordingly, the OMT would become an instrument with limitations. When the ECB president suggested on July 26, 2012 to do ‘whatever it takes to save the euro’, he might have had an unlimited approach in mind. Should the CC limit the use of the OMT, this instrument will lose its credibility. The ECB would have to look at policy alternatives.

German Event Risks

Ahead of the German general election on September 22, it is not surprising to see progress on EMU policies slow. However, hopes that the German government could become more constructive after the election may be misplaced. Opinion polls suggests a tight race between the Conservative/Liberal and Socialist/Green block, but the chance that the current CDU/FDP coalition finds sufficient electoral support has steadily increased over recent weeks. However, should the current coalition come back into power, hopes that Chancellor Merkel will have to team up with the Social Democratic Party (SPD) and or even the progressive Greens will be disappointed. Both the SPD and the Greens include the creation of a redemption fund in their election manifestos and are more open to supporting peripheral countries. Hence, it is understandable that markets are optimistic, especially for peripheral assets reflecting a change in Chancellor Merkel’s coalition partner.

When we called for a higher EUR last summer, we argued that the prospect of the ECB increasing its balance sheet by shifting legacy assets from the periphery onto it own balance sheet would create a bullish outlook for peripheral assets without cheapening the credit in core countries. The EUR rallied. Now the ECB may have to return to a more symmetrical approach such as QE, another LTRO, rate cuts, and forward guidance. All these measures would work against the EUR.


All in, we see the EUR entering troubled waters this autumn and we suggest current market calmness offers attractive levels to go short EUR. The USD remains our preferred asset currency for long-term investors.


Risk-off Scenarios: Positioning in NOK, SEK and CHF

Dara Blume

 We look at how CHF, SEK and NOK would behave in two risk-off scenarios: a general and an EMU-centered slowdown.

 From a trade perspective, SEK and CHF are the most exposed, in our view, with SEK more likely to be impacted in a general slowdown, and CHF in a eurozone-centered one.

 From a financial flows perspective, CHF is relatively the safest, followed by NOK and SEK.

 From a bank funding perspective, NOK’s smaller financial sector offers it protection, while SEK’s reliance on wholesale funding places it at risk.

 However, traditional betas suggest CHF would outperform in a risk-off scenario, while NOK would underperform.

 We would expect CHF to be the strongest performer in an extreme risk-off scenario, with SEK likely to be the weakest.

Though we maintain our call for a second-half recovery, we acknowledge the rising risks to the global growth

environment. We’ve highlighted the implications of a slowdown in EM (see Sunday Start, June 16, 2013), which

are only exacerbated by risks to credit in China and rising rates in the US (see Implications of Rising US Dollar and China Slowdown for EM, July 22, 2013). At the same time,

political uncertainty has risen in Euroland. Developments in Portugal, Greece and Italy have attracted market attention, leading to concerns that a re-emergence of tensions in the euro area could prompt another risk-off scenario.

Though neither a general nor a eurozone-focused slowdown is our base case, in this article, we consider how currencies would behave under each scenario. In particular, we examine CHF, a traditional safe haven, and NOK and SEK, which served as ‘quasi safe havens’ during the heights of the euro area crisis, would respond. We look at each country’s trade and financial flows, as well as its financial sector funding, and put these in the context of the currencies’ traditional trading behavior to analyze the expected performance under each risk scenario.

Under an extreme general risk-off scenario, we would expect CHF to outperform NOK and SEK, given traditional market betas and a stronger net debt position. This performance would be amplified under a re-ignition of eurozone political tensions leading to a slowdown, despite the fact that

Switzerland would be most at risk economically under this scenario. This is in line with the results of previous reports we’ve written (see What Makes a Safe-Haven Safe?August

11, 2011). The SNB’s EURCHF floor provides protection against CHF appreciation but should the risk environment deteriorate sufficiently, the floor could be challenged. SEK would be the worst performer should there be a resurgence in euro area political tensions leading to a slowdown, we believe, and long USD/SEK would be an attractive position to hedge against this scenario. We would avoid NOK/SEK as a hedge, as NOK has recently been trading with a higher beta to risk than SEK, and its smaller financial markets make it less likely to get a safe haven bid. Under both scenarios, we would expect all three currencies to underperform USD, and to outperform AUD and NZD.

External Trade: SEK and CHF Most Exposed

Exhibit 1

Export Destination (Share of Total Exports)

Switzerland Sweden Norway

Core EMU 35% 33% 36% Other G10 17% 26% 18% UK 5% 8% 26% US 11% 5% 5% Peripheral EMU 11% 5% 6% Eastern Europe 5% 8% 4% Other EM 16% 13% 5%

Source: Haver Analytics, Morgan Stanley Research

Exhibit 2

Export Sector (Share of Total Exports)

Switzerland Sweden Norway Food and Animal

Products 3% 3% 5% Crude Materials and Chemicals 27% 12% 5% Manufactured 37% 46% 14% Commodities 4% 7% 55% Services 29% 30% 22%

Source: Haver Analytics, Morgan Stanley Research

Norway, Sweden and Switzerland are small, open

economies, with exports composing 35-55% of GDP. Their export destinations are also fairly similar, with advanced economies the market for 80% of trade in Sweden and Switzerland and 90% in Norway. This lower exposure to EM could provide Norway some support in the event of an EM-driven general growth decline. Norway’s exports are largely


focused on the oil sector – over 50% of exports are commodities, and a portion of the services and

manufacturing exports are also oil related. While this places NOK at risk should oil demand fall sharply in a general risk-off move, we believe it would take a particularly steep drop in prices for NOK to be substantially affected, and highlight that relatively inelastic demand should help dampen the impact of the downturn.

A general downturn, particularly if caused by a slowdown in China, could have a larger impact on Sweden. While 3% of Swedish exports go to China, a further 10% go to Germany – and many of these exports are used as inputs in German manufactured goods, which in turn are sent to China. We believe SEK would therefore be most at risk in a general slowdown, though CHF too would face difficulties given the high share of Swiss exports in financial services and luxury goods. Switzerland exports a higher share of goods to the US, however, which could help cushion CHF against a general global growth slowdown as the US would likely outperform in such a scenario, given the US is currently a main driver of global growth, and is likely to attract foreign investment flows, supporting the US economy.

In a eurozone-focused slowdown, the story would be slightly different. Again, from a trade perspective, NOK would be relatively well protected in this scenario – oil demand is fairly inelastic, and peripheral countries consume only 5% of Norwegian exports. Switzerland could feel more pain in this scenario, as 10% of its exports go to the European

periphery, while the impact on SEK would be largely via the spillover to the core, and specifically Germany.

Financial Flows: CHF Relatively the Safest

Norway and Switzerland have the largest external asset positions in the G10, while Sweden is roughly average, with net liabilities of 14% of GDP. Sweden’s financial account is clearly the most vulnerable of the three to a rise in interest rates (which could trigger a global slowdown), particularly as its liability position is largely in debt instruments. However, unlike Norway and Switzerland, Sweden’s equity investors could repatriate their net external assets in the event of a global slowdown, which would help dampen the impact of a rate-driven global slowdown, though it would likely not be enough to completely protect the currency.

Meanwhile, Norway’s external assets provide it protection against rising interest rates, particularly as it has minimal reliance on short-term foreign funding. However, many of its external assets are held by the global pension fund, and

therefore, in a period of risk aversion, it is more likely these holdings would be reallocated overseas than repatriated. In addition, Norway’s small financial markets would likely limit safe haven flows. As such, while Norway’s external assets would likely protect it against a general downturn, it is unlikely to appreciate under such a scenario.

Switzerland’s external asset position reflects its safe haven characteristics. Half of its foreign assets are composed of reserves accumulated to prevent currency appreciation. It has net equity liabilities, meaning that foreign investors could be sellers of Swiss equities in a period of general risk aversion. However, any equity market outflows would likely be offset by safe haven inflows into deposits. The larger risk for Switzerland is that should interest rates rise, this could weigh on banks’ short-term external funding. However, from a financial account perspective, CHF would be likely to stay supported, and even appreciate, during a global downturn. Exhibit 3

Export Sector (Share of Total Exports)

FDI Equity Debt Other Reserves Total Switzerland 65.99% -40.54% 94.85% -50.58% 82.05% 151.77%

Sweden 5.59% 19.68% -62.86% 13.67% 9.55% -14.37%

Norway 5.63% 71.16% 16.70% -10.63% 11.37% 94.22% Source: Haver Analytics, Morgan Stanley Research

Should flare-up in eurozone tensions create a eurozone-focused slowdown, all three countries would likely see financial account inflows, in our view. Sweden’s equity investors may repatriate some of their euro area equity investments, while the Swedish government bond market is the largest of the three countries, and therefore there is the highest scope for debt inflows. Both of these would support SEK. In Switzerland, a worsening of eurozone tensions could lead some euro area investors in Swiss equities to unwind their holdings, but the increase into deposits and debt instruments could offset the equity outflow, given Switzerland’s safe haven characteristics. Finally, in Norway, foreign participation in markets is low, so the impact of eurozone investors unwinding positions would be minimal, while at the same time, the Global Pension Fund is unlikely to repatriate EUR holdings into NOK. There could be a small safe haven flow into NOK, but given the size of financial markets relative to those in Sweden and Switzerland, NOK could see the least support on this front.

Bank Funding: NOK Relatively the Safest

The main problem facing banks in Norway, Sweden and Switzerland is high levels of household debt. Central banks in all three countries have addressed this in commentary, and in Switzerland and Norway, the central banks have


Bringing in Beta

implemented macroprudential measures to lean against

financial imbalances (see Financial Stability, Central Banks, and Currencies, March 28, 2013). For banks in all three countries, mortgages make up a very large share of the balance sheet, and therefore, all three banks could see their assets pressured should a general growth slowdown cause problems in the local housing markets, despite the fact that banks in the three countries are well capitalized. Problems in the banking sector would have the largest impact in Sweden and Switzerland, where bank assets/GDP are 438% and 415% of GDP, respectively (see Credit Strategy: Cautious Improving: IG Fundamentals Update, July 26, 2013). In Norway, bank assets are only 120% of GDP, which is the lowest in Europe.

We must also consider traditional market behavior, and how it relates to the results we have found. We believe CHF should remain supported by financial flows in a risk-off environment, and the strength of this would likely outweigh any concerns about the banking sector or trade. This is supported by current market behavior. CHF trades with a negative beta to risk, in line with its traditional safe haven status. It also appreciated during the euro area crisis before the SNB implemented the EUR/CHF floor.

Interestingly, though SEK is typically considered the higher beta Scandinavian currency, and our analysis suggests it is more vulnerable on trade, financial flows, and bank exposure, NOK has traded with a higher beta to risk (here measured by the MSCI global) recently (see Exhibit 4). It’s also notable that SEK got a safe haven bid against the EUR during the euro area crisis, while NOK did not see the same level of support (see Exhibit 5). This market relationship suggests to us that indeed, as we found before, NOK is not a safe haven currency, and might not outperform SEK in a risk-off scenario, despite its apparent protection.

Banks could face further difficulties due to a downturn in global risk appetite from their reliance on wholesale funding. All three countries have high wholesale funding ratios, though we note that the loan to deposit ratio is the lowest in Switzerland, suggesting funding for Swiss banks could be somewhat more stable. On the other hand, Sweden is most reliant on wholesale funding. Concerns about the global growth environment could lead investors’ appetite for funding these banks to fade somewhat.

Exhibit 4

3M Rolling Correlations (vs. USD)

-30% -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% Jan-12 Fe b-1 2 Ma r-1 2 Ap r-1 2 Ma y-1 2 Jun-12 Jul -1 2 Aug -12 Se p-1 2 Oc t-1 2 Nov -1 2 Dec -1 2 Jan-13 Fe b-1 3 Ma r-1 3 Ap r-1 3 Ma y-1 3 Jun-13 Jul -1 3




A slowdown in euro area would impact the banks via both of the channels mentioned above, as it could have impacts on households’ ability to repay mortgages and could also dampen eurozone investors’ desire to offer banks wholesale funding. Indeed, BIS data suggests that around 40% of external bank funding in Switzerland and Sweden comes from the euro area. For Norway, this is much lower at 23%, which should also protect Norway somewhat in the case of a eurozone downturn.

Moreover, an escalation in the eurozone could also threaten banks’ external assets. According to the BIS, Swedish and Swiss euro area assets make up roughly 50% of GDP, with peripheral assets composing 17% and 20% of GDP in each country respectively (data are not available for Norway).

Source: Bloomberg, Morgan Stanley Research

Exhibit 5

Euro Area CDS against SEK, CHF and NOK

100 105 110 115 120 125 130 135 140 145

Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13

0 100 200 300 400 500 600 700 800 900


The one advantage banks could have under this scenario would be an increase in deposits, which we have seen particularly in Switzerland. Moreover, given that the

Scandinavian and Swiss banks are relatively well capitalized, European investors may actually see investment into these banks as a relatively safer trade than in banks with lower capital ratios, limiting the unwind of wholesale funding.

Source: Bloomberg, Morgan Stanley Research All currencies against EUR, 100 = Jan 2010


EM Currencies: The Fragile Five

James Lord

 The EM currency bear market that has been in place for the past two years is likely to continue over the medium term, as the factors supporting BoP flows over the last decade continue to unwind.

 Currencies will be held back by high inflation, large current account deficits, challenging capital flow prospects and potentially weak EM growth. The prospective normalization of Fed monetary policy simply exacerbates these underlying fundamental weaknesses.

 BRL, IDR, INR, TRY and ZAR will likely remain under medium-term pressure, and we continue to recommend accumulating long USD positions versus these currencies on any meaningful dips.

 Rate hikes and FX intervention only provide breathing room, and we continue to highlight the importance of structural reforms to attract capital on a sustainable basis. Future differentiation on these grounds will likely be high. MXN remains the bright spot.

EM currencies have had a torrid time in recent months, depreciating significantly against the USD and on a trade weighted basis. While price action has of course been more volatile, recent weakness simply extends the bear market in EM currencies that has been in progress for the last 2 years. Exhibit 1

EMFX Bear Market Goes Beyond Fed Tapering Risk

80 85 90 95 100 105 110 115 120

Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13


Source: Bloomberg, Morgan Stanley

The factors which have afflicted EM currencies should be familiar to investors. The long term trend has been driven by

the deterioration in current account positions – driven by subdued DM growth, falling commodity prices, a slowing China and, importantly, deterioration in external

competiveness related to elevated real exchange rates and high inflation. All this means that the various factors that have led to the long-term trend of FX reserve accumulation are starting to go into reverse, with growth rates in FX reserves likely to turn negative soon.

Exhibit 2

Annual EM FX Reserve* Growth About to Turn Negative

(10) (5) -5 10 15 20 25 30 35

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

AXJ (ex China) CEEMEA LatAm

Source: Haver *Growth rates calculated using constant exchange rates and represented as percentage point contribution to the total

Against this already challenging backdrop, the

prospective normalisation of Fed monetary policy simply exacerbates the risks. EM economies are already having hard enough time attracting foreign currency inflows (whether export revenues or capital flows), and rising US Treasury yields simply supply another reason for capital to flow back to the US. See EM FX Strategy Update: Tapering EMFX

Exposure, June 4 2013.

The following exhibit shows a ranking of EM currencies based on how they are affected by a number of variables that we consider important for the medium-term outlook: inflation, REER levels, exposure to industrial metal prices (a proxy for China rebalancing risks), balance of payments reliance on fixed income flows, current account positions and our metric of overall external vulnerability (External Coverage Ratio). We normalise these metrics into z-score terms and provide an overall ranking based on a simple average.


Exhibit 3

Ranking Vulnerabilities*

CPI REER Net Indus Metal Exp C/A FI Flows ECR Av.

CLP -0.33 0.13 3.31 0.94 0.31 0.50 0.69 TRY 1.44 -0.32 -0.59 1.34 0.70 1.06 0.40 PEN -0.69 0.65 1.65 0.85 - -0.63 0.34 IDR 0.97 0.54 -0.03 0.41 -0.20 0.66 0.30 BRL 1.15 0.65 0.09 0.64 -0.70 -0.05 0.25 MXN 0.02 -0.71 -0.27 0.13 1.95 0.64 0.23 ZAR 1.03 -2.41 0.52 1.15 0.78 0.92 0.16 INR 1.97 -0.31 -0.26 0.78 -1.17 0.52 0.15 COP -0.39 1.21 -0.27 0.50 -0.50 0.28 0.07 THB -0.21 1.20 -0.59 -0.27 -0.04 -0.26 0.01 PLN -1.16 -0.81 -0.23 0.50 1.62 0.57 -0.01 CZK -1.22 0.28 -0.46 0.15 0.83 0.69 -0.02 RUB 0.97 1.59 -0.07 -0.78 -1.06 -2.57 -0.04 HUF -0.10 -0.47 -0.36 -0.90 -0.50 0.59 -0.26 ILS -0.92 0.76 -0.26 -0.50 -1.28 0.06 -0.32 MYR -0.75 0.13 -0.55 -1.46 - -0.64 -0.44 KRW -0.63 -1.32 -0.84 -1.15 0.43 -0.13 -0.50 SGD -2.22 -0.31 -0.25 -0.20 -0.58 TWD -1.16 -0.80 -0.80 -2.32 -1.16 -2.22 -1.03

Source: Bloomberg, Haver, Morgan Stanley Research

*Higher Av value indicates greater risk; normalised data in z-scores terms

There is of course a degree of overlap in a number of these metrics, but each is important in its own right, in our view, and deserves separate consideration. Even so to prevent

excessive bias to external vulnerability we give half as much weight to the C/A and our External Coverage Ratio as we do to the other variables. In following sections, we go through our rationale for including these variables.

The results show a number of currencies that are vulnerable, including CLP, TRY, IDR, PEN, BRL, ZAR and INR. We discount the ranking for Mexico for two reasons. First, its vulnerability centres on a high reliance on fixed income flows rather than any broad-based vulnerability. Second, we think that Mexico’s ability to attract capital will be high compared to other markets given its push forward on structural reform measures. While PEN and CLP are certainly vulnerable, risks for these currencies stem primarily from the very high scores associated with the commodity price channel and China, which possibly overstates the riskiness of these currencies compared to others.

The Fragile Five: BRL, IDR, ZAR, INR and TRY

Meanwhile, BRL, IDR, ZAR, INR and TRY will face headwinds over the medium term from various factorsranging from high inflation, high REERs, external vulnerability from initial conditions, and vulnerability to further external deterioration based on a heavy reliance on fixed income flows and/or China related risks.

The risks associated with these particular five currencies are also evident from the fact that central banks in these countries have been among the most aggressive in their bid to support their currencies.

Of these five, South Africa is the only one that has not seen rate hikes ZAR, but this is mainly due to the central bank’s non-interventionist philosophy in terms of exchange rate management.

Exhibit 4

Which Currencies Have Received Official Support*?

-12% -10% -8% -6% -4% -2% 0% 2%


R AR S HUF THB INR RU B MYR PE N CZK VE F MXN KRW SGD CLP PLN TW D ILS -50,000 -40,000 -30,000 -20,000 -10,000 0 10,000

Change in FX reserves over May and June, %April stock USDm (RHS)

Source: Haver, Morgan Stanley *Grey bar indicates those economies which have seen rate hikes. Changes in FX Reserves may also reflect valuation adjustments (including gold prices)

India has lost less reserves compared to others, but support measures have also been backed up by reform measures aimed at curbing the current account deficit and attracting capital flows, thus easing some of the pressure for the central bank.

Keeping It Simple: High Inflation Is Bad for

FX, Particularly Amid a Large C/A Deficit and


In an environment of strong and growing global demand, central banks will care less about expensive currency valuations. Growth in global demand would drive growth in global trade, which is a process that benefits everyone. However, in a world where global demand is stagnant and global trade volumes are flat-lining, currency valuations come into play to a greater extent as policy makers fight to take a larger share of the demand pie.

Countries that have higher inflation than their trading partners are more likely to run into currency valuation problems, sooner or later. As such there is a risk that currencies in higher inflation economies see greater nominal depreciation as policy may becomes more biased toward preventing real appreciation, particularly if the economy suffers from a large current account deficit and an already elevated REER. Indeed, without adjustment in the nominal exchange rate, countries with high inflation will naturally see their currencies


appreciate in real terms, potentially posing a risk to growth and further deterioration in trade and current account positions.

As the following chart shows, Indonesia, South Africa, Brazil, Russia, Turkey and India are all expected by MS to have the highest rates of inflation over the next 18m. As such, these countries will need to see a greater degree of nominal depreciation in order to prevent real exchange rates from appreciating faster than peers. This places IDR, ZAR, BRL, RUB, TRY and INR at an immediate disadvantage. Exhibit 5

High Inflation Suggests Underperformance


MS 2013 CPI Forecast (%, y/y) MS 2014 CPI Forecast (%, y/y)

Higher Inflation Suggests FX Underperformance

Source: Morgan Stanley

The pressure this poses on RUB is arguably less severe than others given Russia’s large oil-related current account surplus. Indeed the value of the RUB has little bearing on its ability to compete in the oil market, given that oil is priced in USD. Nevertheless, to the extent that policy makers may worry about the risks that a high REER pose to the non-oil export sector, high inflation clearly raises risks of policy being biased to a weaker RUB.

Of course, currency depreciation is not a sustainable way of improving external competitiveness. Ultimately the higher inflation that is generated by currency weakness will undermine competitiveness sooner or later again. Nevertheless, the alternative of allowing real appreciation risks exacerbating external imbalances for those economies that suffer from them which is perhaps a worse alternative.

BRL, ZAR, IDR, INR and TRY all have C/A issues. With the

exception of Russia, all the high-inflation economies have C/A worries. Preventing these external imbalances from

deteriorating has been a policy priority for many countries. A

rising REER for TRY, BRL, ZAR, INR and IDR would raise the risk of C/A deterioration. Colombia, Peru and Chile have growing C/A issues which could undermine their currencies, but the risks are less acute given lower inflation.

Exhibit 6

High CPI & High C/A Deficit Raises FX Pressure

MYR TWD TRY INR IDR BRL ZAR 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 -10.0 -5.0 0.0 5.0 10.0 15.0 Current Account Forecast (% GDP)

201 4 C P I F or ec as t ( % )

Higher pressure for FX adjustment

Lower Pressure for FX Adjustment

Source: Morgan Stanley

BRL, RUB and IDR have elevated REERs. Current

valuations are clearly important, too. Countries that have elevated REERs and high inflation face a more immediate need to encourage nominal adjustment in their exchange rates. We use deviations of REER from 10y averages as a (admittedly imperfect) proxy for valuations. The below chart shows these deviations, along with MS CPI forecasts for 2014. Of the high-inflation economies that we highlighted previously, BRL IDR and RUB show a higher deviation than average from the average REER level of the last 10y. Valuation is less of a threat for INR and TRY but could soon become so again given inflationary pressures. On this REER basis, valuation appears less of a headwind for ZAR. Exhibit 7

High CPI & High REER also Presents FX Risks

MYR TWD TRY INR IDR BRL ZAR 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 -10.0 -5.0 0.0 5.0 10.0 15.0

Current Account Forecast (% GDP)

20 14 C P I F or ec as t ( % )

Higher pressure for FX adjustment

Lower Pressure for FX Adjustment


Otherwise, CNY, SGD, COP and THB all have relatively elevated REERs – though, with lower than average inflation. These REER measures are calculated using CPI adjustments to nominal exchange rates. Using alternative measures such as unit labour costs would give another indication of export competitiveness, and we suspect would indicate greater concerns over competitiveness.

CLP, PEN & ZAR Particularly at Risk from Further

Industrial Metal Price Declines

All EM economies are at risk from a slowdown in the pace of China’s growth. Nevertheless, some have more direct linkages than others. Those more directly at risk are those that would suffer should commodity prices continue to decline as China rebalances away from investment-led growth (our AXJ colleagues highlight that the price impact of China’s commodity demand has been much greater in the industrial metals area than elsewhere (see Asia Pacific Economics: Asia Insight: What Could the Risk of a China Slowdown Mean for Asia?, June 28 2013), as well as those that export directly to China.

The raw EM export numbers do not capture the full extent of the relative risks for currencies, in our view. Indeed, those that are more heavily reliant on China for the export of machinery and raw materials are more at risk than those which export more consumption-based products and services. This may mean KRW and TWD are less at risk than it first appears. The below chart simply highlights the risks involved in terms of commodity price declines. As is clear, further declines in price of industrial metals poses a significant risk for PEN, CLP and ZAR.

Exhibit 8

Who Is at Risk from Falling Industrial Metal Prices?


Net Export of Industrial Metals (% GDP) Source: UNCTAD, Morgan Stanley

Fed Policy Creates Capital Flow Challenge,

particularly for Those with Low Coverage of

External Liabilities

The prospect of the Fed tapering its asset purchases raises questions over the sustainability of capital flows into EM, particularly at a time when much of EM is struggling to sustain decent growth. As we and others have discussed at length, bonds have contributed significantly to overall balance of payments flows in EM over the last few years. Mexico, Poland, South Africa and Turkey are in the top 5 in terms of reliance on bond market flows, and we suspect Malaysia is too (though the data are not fully comparable). Brazil, Indonesia and India (in particular) have relied less on foreign purchases of bonds for overall inflows on the balance of payments.

Exhibit 9

Who Has Benefited the Most from Fixed Income Inflows?

0 2 4 6 8 10 12 14 16


TW D RUB BR L HUF CO P IDR THB CLP PHP KRW TRY ZA R CZK PLN MX N 0 20 40 60 80 100 120 140 160 180

Portfolio debt security inflows since 2Q09, %GDP USDbn (RHS)

Source: Haver

The capital flow risks extend beyond just bond flows though, with rising US Treasury yields on the back of higher expected US growth raising question market about capital flows in general to EM.

The cost and availability of external funding for EM has become more prohibitive, which means that those countries

that have the largest external funding requirements will face more pressure for currency adjustments. Of course, this is closely related to the size of current account deficits, which we discussed earlier. However, funding is also required to roll over existing external debt. We calculate total external funding requirements by summing the current account deficit, short term external debt and amortizations of medium-term debt coming due in the next 12m. We compared these liabilities to the stock of FX reserves at the central bank to give an


assessment of whether central banks will allow currency adjustment to prevent the loss of FX reserves. This is our External Coverage Ratio. As shown in our rankings in Exhibit 1, Turkey and South Africa score particularly badly in this respect, with Indonesia not far behind.

The Importance of Structural Reforms

Emerging Markets have not had to work so hard in order to attract capital over the past 10 years, as various combinations of attractive yields, strong growth and loose DM monetary policy have meant that capital easily flooded in. Now with the tide turning the other way, EM needs to work harder in order to attract capital, or at least soften the blow.

Using FX reserves does little except smooth the trend and is ultimately an impotent tool to prevent currency depreciation in the face of systemic balance of payments pressures. Hiking interest rates is more effective, but in the current context also only buys some breathing room for EM. Indeed, with growth already weak, hiking rates risks a steeper downturn and further capital flight.

Central banks that opted for the interest rate tool in prior years (such as in Turkey in 2012) were more readily able to control the currency in the face of pressure because that pressure was typically short lived, and against a background of increasingly accommodative DM monetary policy and large bond inflows into EM. Now, with DM policy heading in a less accommodative direction and more systemic medium term BoP issues, the interest rate tool will be less effective in maintaining currency stability, particularly given the growth implications already mentioned.

The most sustainable way to improve capital flow prospects is for governments to engage in structural reform, enhance competitiveness and boost growth potential. Because of the ease with which EM has attracted capital over

past 10 years, reforms have been on the back burner. Now, they are at the centre of our attention and we believe countries that engage in structural reform efforts will see currency and broader asset price outperformance.

Mexico and (to Some Extent) India Pushing Ahead

This is why we are less concerned about the fate of MXN, despite the obvious risks associated with its dependence on fixed income portfolio flows. Mexico’s reform agenda will mean that MXN is likely to outperform over the long term, and we would use any dips caused by fears over Fed tapering as an opportunity to rebuild exposure for the long term. Mexico is one of the few countries that are pushing ahead in this respect. We have seen India respond to the weakness in its currency by accelerating reforms in certain areas, easing restriction on certain forms of capital inflow, which is

encouraging. But ultimately more will need to be done in order to boost the investment climate and productivity, and the ability of the economy to attract long-term capital.

Elsewhere, we see limited progress. Against the backdrop of the risks that we have highlighted that we think will cause underperformance for BRL, IDR, TRY and ZAR, we have seen little in the way of serious reform measures that make us more comfortable about the medium-term prospects of these currencies.

Adding to the medium risks, in 2014 India (May), South Africa (April-June), Brazil (Oct) and Indonesia (midyear) will all hold general elections, while Turkey will hold a

Presidential election. This election calendar raises the risks that tough reforms will be placed on the back burner,

diminishing the prospects for a meaningful currency recovery. See Indonesia Economics: Asia Insight: Why the Next Election Is More Important Than the Last, July 30 2013) for the risks involved for Indonesia.


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