Em Currencies 0610

Why we like Emerging Market currencies

Marshall Gittler
Chief Strategist, International
Deutsche Bank (Suisse) SA
22 June, 2010

Tel: +41(0)22 739 0463
e-mail: marshall.gittler@db.com

Why we like Emerging Market (EM) currencies on all time horizons
Short-term: China has started to allow its currency to appreciate.
That should allow other Asian countries to let their currencies rise as well
without losing relative competitiveness.
It may also spur speculation about upward pressure on EM currencies in
general.
Medium-term: We expect EM countries to raise rates & let their currencies
appreciate to restrain inflation.
One reason inflation is rising in EM countries is because of FX intervention.
Raising interest rates is one way to deal with inflationary pressures. Rising
interest rates should cause currencies to appreciate.
Allowing FX appreciation should also dampen inflationary pressures as well
as alleviating problems arising from intervention.
Long-term: Currencies tend to appreciate as countries grow richer.
Rising wealth in the developing world is likely to be one of the major global
trends over the next decade.
Global Investment Solutions Page 2

Why we like EM currencies
CNY appreciation, halted last year, has resumed

CNY was on an appreciating trend until the
global financial crisis hit in mid-2008 and the CNY has room to appreciate
government called a halt. Had they let it 8.00
USD/CNY: actual* vs previous trend
continue on the same path, it would currently
be around 26% stronger vis-à-vis the USD. 7.50
The government announced that it would
"further reform the exchange rate regime and 7.00
enhance the exchange rate flexibility" by
resuming the previously announced daily
6.50
trading bands (±0.5%) around the daily fixing
= 26%
rate announced by the Chinese government. USD/CNY appreciation
6.00
The currency appreciated by 0.45% on June May '07~Jul '08 trend
21st, the first day of trading after the news.
The market was forecasting the currency 5.50

would rise 2.3% over the next 12 months, vs *until Friday, June 18th
1.8% on the previous trading day. 5.00
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Source: Bloomberg Finance LP, DB Private Wealth Management


US-China trade tension pushed China to revalue

Tensions between the US and China
have been increasing as the US US trade deficit with China starting to widen again
Congress looks for an issue that
everyone can agree on, while China US trade with China
12m moving sum $bn
becomes more assertive in the world $bn
400 0
political arena.
350
Against this hostile background, Treasury -50
Secretary Geithner delayed the annual 300
Treasury report on currencies, which 250
-100
would probably have branded China a Balance (R)
“currency manipulator” and forced the US 200 Imports from China (L) -150
Exports to China (L)
to take retaliatory measures. He probably 150
did this to give China time to allow the -200
CNY to appreciate without seeming to 100

give in to foreign pressure. (Apparently, it -250
50
worked.)
0 -300
00 01 02 03 04 05 06 07 08 09 10



G20 meeting was the last straw

Pressure was building on China not only
from the US, but also from other CNY has been stable to lower since 2009
countries, including some other EM
1 Jan 2008 Recent movement of the Renminbi
countries. Brazil and India have publicly = 100 against various currencies
criticized China’s FX policy. 150
USD
That put China in a bind ahead of the EUR
140
June 26/27 G20 meeting, where China JPY
should be playing a leading role among 130
BRL

the developing nations. It was looking as MXN
INR
if the CNY would be a major topic of 120
discussion this weekend.
110
By allowing the CNY to appreciate again,
China has defused this issue for now. 100
The move does not satisfy those who
were looking for a large one-off 90

revaluation, and there are still questions
80
about how rapidly the government will 2008 2009 2010
allow the currency to appreciate.


Domestic pressures another incentive for China to revalue

Inflation continues to rise, led by food Real estate prices are rising again
% yoy
25 % yoy China inflation 14 China house prices vs money supply % yoy
27

20 12 25
House prices (L)
10 M2 Money supply (R)
15 CPI - general 23
CPI - food 8
21
10 6
19
5 4
17
2
0
0 15

-5 -2 13
2005 2006 2007 2008 2009 2010 2006 2007 2008 2009 2010


Domestic pressures also are forcing China to revalue. The main problem is that inflation is heating
up again, led by food. This is a lagging indicator of last year’s expansive monetary policy.
Food prices are not that responsive to monetary policy, but housing prices may be.


FX reserve accumulation fuelling money supply growth

One of the reason why monetary Money supply grows along with FX reserves
growth in China is so high is that the
45 $bn % yoy 40
China FX reserve accumulation vs
government intervenes heavily in money supply
40
35
the FX market to prevent the CNY
35
12m increase in China
from appreciating. It creates and FX reserves (L) 30
30
sells CNY and buys dollars. M1 (R) 25
25
If officials want to slow the pace of 20 20
monetary growth to cool the 15
15
economy, they will have to slow the 10
pace of reserve accumulation. 5
10

0 5
2002 2003 2004 2005 2006 2007 2008 2009 2010



The “Impossible trinity:” Countries can’t control everything at once

The problem for China (and other EM The impossible trinity
countries) is called the “Impossible
Trinity:” a country cannot control its Fixed exchange rate
exchange rate and maintain an
independent monetary policy while still
being integrated into the world
financial system through free capital
flows. It can only control two and must
let the market control the third.
Only 2 are
possible at
one time

Free capital Independent
flows monetary policy


Rising intervention fuels money supply growth, inflation

Rising money supply growth fuels inflation Asian countries reducing intervention
24 8
% yoy Asia: money supply vs inflation % yoy Change in FX reserves in AxJ
60%
Asia ex-Japan countries weighted by PPP
22 7 50%

20 Nominal broad money 6 40%
supply growth (L)
30%
18 Inflation (R) 5
20%

16 4 10%

0%
14 3
Six months previous
-10%
Latest month
12 2
-20%

a

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po
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hi

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In

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pi
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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

S'
Ta

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S.

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Ph

Many EM countries have chosen to control their exchange rates, but by doing so they lost control of
their monetary policy as they sold their currency and thereby increased the money supply.
This trend has been especially strong in Asia, where rising monetary growth has fuelled inflationary
pressures and given rise to fears of a financial bubble.
This may be one reason why several Asian countries have slowed their pace of reserve
accumulation recently despite the rising dollar. Money supply growth is slowing as a result.

India, Malaysia start tightening cycles as inflation rises; FX appreciating

38
% India policy rate, inflation & FX 9 % Malaysia policy rate, inflation & FX 3.1
16
40 3.2
14 7

42 3.3
12
5
3.4
44
10
3 3.5
46
8
3.6
1
6 48
3.7

4 50 -1
3.8

2 52 -3 3.9
2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010
RBI Reverse repo yield (L) India CPI (L) USD/INR (R, inverted) Malaysia overnight policy rate (L) Malaysia CPI (L) USD/MYR (R, inverted)


India and Malaysia have already started down this path. They have let their currencies appreciate
since the beginning of 2009, while the central banks of both countries recently started a tightening
cycle.


India, Malaysia, now Singapore; others to follow?
The Monetary Authority of Singapore (MAS)
surprised the market on 14 April by a Singapore NEER already outside its band
combined "recentering of the policy band at Estimated Singapore NEER
the prevailing level of the SGD NEER" 104 with upper and lower bands

(nominal effective exchange rate) and a shift
103
in the policy band’s slope to "modest and
gradual appreciation". This was the first time 102
MAS has adjusted both simultaneously and
thus was an aggressive tightening, in our 101

view.
100

MAS explained that Singapore’s recovery
“has been stronger than expected, and more 99

entrenched.” It said it expects the economy to
98
continue to improve and inflation to continue Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10

to rise for the rest of the year.
Source: Bloomberg Finance LP, Goldman Sachs, DB Private Wealth Management
We expect that other Asian countries are
thinking the same way but have been waiting
for China to move first before they too allow
further FX appreciation.


As short rates rise, FX should appreciate as well
We have seen how several Asian central
banks have begun to tighten policy to deal AxJ-USD 3m spreads is generally widening
with the inflationary threat. As a result, their
11 Spread of AxJ 3m rates vs USD 3m
short-term interest rates have been rising. 10
%

9
In the US however there is currently little fear 8
of higher inflation and the Fed has stated that 7 India
short rates are likely to remain low “for an 6 Indonesia
5 Korea
extended period of time.” 4 Malaysia
3 Philippines
The spread between short-term Asian 2 Singapore
interest rates and USD rates is rising as a 1
Taiwan
0
result. This widening interest rate differential -1
Thailand
is likely to support Asian currencies going -2
forward – and other EM currencies as well. -3
-4
-5
2007 2008 2009 2010



How did other Asian currencies react when CNY was floated in 2005?

Most Asian currencies underperformed the
CNY in the days after the USD peg was Other currencies outpaced CNY after 2005 unpegging
dropped in 2005. Movement of Asian currencies vs USD
120 22 July 2005
However, after a few months, the = 100

currencies generally appreciated more than 115
CNY KRW IDR
the CNY (except for INR).
INR SGD THB
The Chinese Yuan did not move during the 110

2008 crisis (as seen on pgs. 3 and 5).
105

100

95

90
Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06



Other EM countries also feeling inflationary pressure
Inflation is turning up in Latin
Inflation turning up in Latam, Asia; slowing in EMEA
America. The high level of inflation
12
in Eastern Europe and the Middle % CPI inflation rates
weighted by GDP at PPP
East (EMEA) has been coming 10

down recently, but it remains
8
relatively high.
6
Rising interest rates (which should
help EM currencies to appreciate) 4

and rising currencies are two of the
2
ways that we expect EM central
banks to deal with the inflationary 0
G3 (inc UK) East Asia (ex Japan)
danger. Latam EMEA
-2
2004 2005 2006 2007 2008 2009 2010



Capital controls are not likely to be a long-term solution
Some countries have tried capital
Capital controls didn’t work for THB or BRL
controls as another way of dealing
with the “impossible trinity,” that is, 115
4m before date of
keeping hold of FX and monetary imposition = 100

policy by restraining capital flows. Week when controls BRL

110 were imposed
Previous attempts at controlling FX (19 Dec '06 for THB)
rates through capital controls have
generally proved ineffective. Brazil 105
tried something similar back in
THB (9/06
2008, but it had only a temporary to 4/07
effect. Thailand also tried to 100
restrict inflows in 2006, but this too
caused only a short-term plateau
in the upward trend. 95
Dec-07 Feb-08 Apr-08 Jun-08
We see this as a way of slowing
the trend, but not defeating it. Source: Bloomberg Finance LP, DB Private Wealth Management


EM currencies likely to appreciate as EM countries get wealthier
As countries become more
Richer countries tend to have richer currencies
developed, their export sectors
become more efficient & more Currency valuation vs GDP
20%
competitive and labor costs start to
Brazil Hungary
rise. Other sectors have to raise their 10% Turkey
Czech
wages too in order to keep pace. As a

Currency over/undervaluation
based on Economists' Big Mac index
0%
result, wages – and price levels – Colombia
Chile
tend to rise1. -10%
Argentina

If wages and price levels rise -20% Poland
Mexico
simultaneously, it means that the -30%
Indonesia South Africa Russia
purchasing power of the currency
-40%
rises relative to that of other countries. Thailand Malaysia
Philippines
-50%
We expect rising prosperity in EM to China

be one of the major economic themes -60%
0 5,000 10,000 15,000 20,000 25,000
of the next decade. Rising FX rates
GDP/capita (based on PPP)
should accompany this trend.
1This is known as the “Balassa-Samuelson effect” Source: Bloomberg Finance LP, IMF, DB Private Wealth Management


Other reasons for EM currencies to appreciate

Growth gap: Growth potential in the G7
countries has been further reduced by the crisis
but also by structural factors. The already EM countries forecast to grow faster than DM
strong growth lead of the EMs, especially in 14% Annual growth rate
Asia, should therefore continue to widen. 12%
at PPP Forecast

Relative importance of exports is declining. 10%

In some countries domestic consumption is 8%
becoming increasingly powerful driver of 6%
economic growth. This means that the
4%
importance of a weak exchange rate for exports
2%
is declining.
0%
Solid fundamentals (this applies above all to
-2%
EM Asia and Latin America). 1980 1985 1990 1995 2000 2005 2010

Capital inflows: Privatisations are in the Advanced economies Emerging and developing economies

pipeline in several countries (India, Malaysia),
as well as the largest share offers ever (Brazil, Source: IMF World Economic Outlook

China). Huge infrastructure projects (India,
China) should also attract foreign capital.


Reasons to invest in EM currencies through EM bonds: improved risk profile
EM debt burden is falling EM demographics still improving
110 Dependency ratios
%
Public debt
90 # of children and elderly as a % of working-age population
as % of GDP
100

80
90 Advanced economies
Forecast Forecast
Emerging and developing economies
80 70

70
60

60

50
50

40 40
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
30
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Developed countries Developing countries (ex least developed)

EM debt levels are likely to fall as a percent of GDP over the next five years while DM debt levels
soar, according to the IMF. Yet the pension burden that DM countries face is still far away. In fact, EM
countries could even afford higher debt levels, thanks to their higher growth potential. Productivity
increases, positive demographics, liberalization and deregulation give EM better long-term growth
potential than in DM. The combination of higher growth, and thus greater sources of revenue for debt
servicing, and much lower debt levels should further reduce the historical spreads paid on emerging
market debt.
Source: IMF World Economic Outlook Source: United Nations World Population Prospects 2008 Revision, DB PWM

Reasons to invest in EM currencies through EM bonds: higher return potential

Yields are generally higher in EM
bond markets than in DM bond EM bond yields are generally higher than DM
markets. That not only means greater 14 % EM vs DM 10yr bond yields
income, but also more room for price 12

appreciation if yields decline and 10
EM countries
greater cushion if interest rates move 8 DM countries

up. 6

4
Yet some EM countries have a lower
2
risk of being downgraded (or looked at
0
another way, a greater possibility of

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countries that offer lower yields.
These include Brazil, South Africa, Data as of 22 June 2010
India, Colombia, Mexico and Russia, Source: Bloomberg Finance LP, IMF, DB Private Wealth Management

among others.


Reasons to invest in EM currencies through EM bonds: liquidity, diversification

Rapid development, growing size, importance and liquidity of these markets
Local Currency bonds have overtaken hard currency bonds in importance. Over the
past five years the local market has grown by 18.8% p.a. compared to 8% p.a. for hard
currency bonds. In addition to fixed coupon bonds, there is also an increasing supply of
inflation linkers.

Positive diversification
Local bond markets are driven above all by domestic factors, such as the fiscal
situation, inflation, external balances, etc., rather than US or ECB monetary policy,
which affect many other asset classes globally.


The new world will be more like the old world

India and China are reclaiming their historical role in the world economy

Share of World GDP
100%
Rest of world
80%

60% Europe & N. America
Japan
40% India

20%
China
0%
0 500 1000 1500 2000
Year

The emergence of the EM countries is more of re-emergence. For most of history,
China and India have been the major forces in the global economy.
Source: Angus Maddison, The World Economy

Which ship would you rather be on?

The ship used by
Chinese Admiral Zheng
He in 1405 compared to
Columbus’. The Ming
Dynasty's fleet of giant
ships predates the
Columbus expedition
across the Atlantic by
some 85 years.

Photograph of the display in the China Court of the Ibn Battuta Mall in Dubai. Source: Wikipedia

Strategy recommendations
Pure FX
Carry trades that involve borrowing in developed-country currencies and investing
the funds in EM currencies.
FX indices to take advantage of FX appreciation.
Bonds
We expect higher short-term rates in EM countries. Shorter-maturity bonds should
hold up better than the long end during a tightening cycle. Later in the cycle, switch
into longer-maturity bonds after rate hikes dampens inflation expectations.
Index-linked bonds would benefit from currency appreciation plus growth rates (and
hence inflation rates) that are likely to be higher than in the developed countries.
Real assets
Real assets, such as property, or claims on real assets, such as stocks, can be
bought now in currencies that we believe are likely to appreciate in the future.


Important notes
Private Wealth Management offers wealth management solutions for wealthy individuals, their families and select institutions worldwide. Deutsche Bank
Private Wealth Management, through Deutsche Bank AG, its affiliated companies and its officers and employees (collectively “Deutsche Bank”) have
published this document in good faith and on the following basis.
This document has been prepared without consideration of the investment needs, objectives or financial circumstances of any investor. Before making an
investment decision, investors need to consider, with or without the assistance of an investment adviser, whether the investments and strategies
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Furthermore, this document is for information/discussion purposes only and does not constitute an offer, recommendation or solicitation to conclude a
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