GCC Pegs towards flexibility

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1 <PreApprovalCheckList><PriceChecked>false</PriceChecked><GreyListChecked>false</GreyListChecked><CertificationsComplete>false</CertificationsComplete><SADisclosuresEntered>true</SADisclosuresEntered></PreApprovalCheckList> January January 28 GCC Pegs towards flexibility Global Currency Strategy MLPF&S gcg_strategy@ml.com Trading ideas and investment strategies discussed herein may give rise to significant risk and are not suitable for all investors. Investors should have experience in FX markets and the financial resources to absorb any losses arising from applying these ideas or strategies. Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page Analyst Certification on page

2 Pressure and resistance Pressure and resistance GAP % (latest)* GAP % average RI (latest) RI average Basic Balance /GDP (%)** Asia HKD RMB MYR SGD PHP KRW 7 13 INR EMEA RUB Latam ARS GCC Saudi A Qatar N/A UAE N/A Note: *GAP (latest) is for Sep 27. **Basic balance is current account plus GDP. The gauge of appreciation pressure (GAP) is a weighted average of FX appreciation and reserves accumulation. The resistance index (RI) measures the share of reserves accumulation in the GAP. An immovable peg should have a reading of 1, a free regime a reading of zero. Source: "World Economic Outlook," IMF, April 27. CEIC, Bloomberg, Merrill Lynch China Rising pressure, falling resistance 1 = Fixed, = free float weighted change in FX & reserves, yoy RI, left GAP, right Jan-5 Jul-5 Jan- Jul- Jan-7 Jul-7 Source: Merrill Lynch, IMF The pressure for appreciation is very high in the GCC, Russia, Argentina, and Asia Pressure through the basic balance likely to be sustained Resistance is high; but falling in Asia 2

3 A. Alternative Anchors Inflation targeting Inflation Target (%) Current Real interest targeting? (5yr average) inflation (%) rate (% ) HKD No (.7) RMB No circa 3% preferred INR Explicitly preferred important KRW Since PHP January 22 4% MYR No circa 3% preferred SGD No, but is major circa 2% concern SAR No (3.) KWD No (2.) 4.8. QAR No (.) AED No (4.3) RUB No, but plans 8% for 21 ARS No <1 preferred 18* -4.3 Note: Argentina's estimated inflation. Official figures put it at 8.4% yoy. Source: Central bank websites, Bloomberg, Merrill Lynch Saudi and Kuwait inflation rises % yoy % yoy Saudi Arabia Kuwait Jul-2 Jul-3 Jul-4 Jul-5 Jul- Jul-7 Source: Ecowin, Merrill Lynch With the US diminishing in importance as a trading partner, FX baskets attract In some cases (Asia in particular) the move to inflation targeting has been important We believe rising inflation makes currency flexibility far more attractive 3

4 B. Benefits %yoy GCC macro diversification Non oil GDP Oil GDP 12 1 Import prices % yoy 3mma % yoy 3mma 8 Korea Singapore (food) E -2 Jan-5 Jul-5 Jan- Jul- Jan-7 Jul-7 Source: IMF, Merrill Lynch Note: equally weighted average of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE. Source: CEIC, Merrill Lynch. Increasing FX flexibility helps in the diversification of economic growth. E.g. Malaysia and the GCC as they move away from manufacturing and oil, respectively Greater FX flexibility (appreciation) addresses inflationary pressure from a falling USD, high import prices, and domestic over-heating 4

5 C. Costs Sterilization costs (% of GDP) Current sterilization cost Central bank capital I/Rate shock cost FX shock cost Central bank independ. KRW IDR 1.* PHP THB INR MYR RMB.4.1** ARS -.5 NA RUB 1.5 NA Note: Column 1 shows the current sterilization cost as a percentage of GDP (negative numbers represent a cost). Column 2 shows central bank capital (and/or net worth) as per the last published numbers (from Annual reports). *Indonesia is required to retain capital at roughly.4% of GDP (specifically 3% of the monetary liabilities). **China has capital alone, net worth is not known. Column 3 shows the average increase in cost in the event local interest rates (1Y tenor), rise by 1bps relative to the returns on FX.. Column 4 shows the cost as a percentage of GDP of a 1% appreciation of the home currency against the currencies of the FX reserves. Column 5 provides a subjective sense of central bank independence. 1 is highly independent, 5 is not independent at all. Source: CEIC, Merrill Lynch Capital controls are prejudicial to financial sector diversification GCC money supply growth Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan- Jan-7 Sterilized intervention to maintain currency stability also imposes costs, or unsterilized currency intervention boosts money supply, leading to inflation % yoy % yoy Bahrain Kuwait Saudi Arabia Oman Source: Ecowin, Merrill Lynch

6 Global imbalances adjusting Global balances (USD bn) Structural C/A Sustainable/ mediumterm C/A Imb. Prev. imb. G1 total US Non-US Q2 27 EM LatAm Asia EMEA RoW Note: RoW is rest of the world with the GCC assumed to be the biggest portion. Source: Merrill Lynch COMPASS required % rise in USD REER Percent 2 15 Undervaluation Overvaluation COMPASS required percent rise in REER Note: The chart shows the required change in the real effective exchange rate to close the gap between the structural and sustainable current account estimates. Source: Merrill Lynch G1 imbalance deficit down to USD181bn from USD27bn previously EM surplus imbalances show that currencies are still undervalued As of Q2 27, USD only 3.7% overvalued on a global real trade-weighted basis

7 Consensus and Risks Consensus: Expects a USD rebound to lessen the pressure on GCC pegs; sees only modest China like move in the GCC Consensus: Prices RMB adjustment at 8.5% in 1 year, versus 1.2% in MYR Risk: Change requires proactive policy choice Risk: Slowing US could reorient policy towards growth, not inflation Risk: Capital controls in the event of portfolio flows surge Risk: FX under-valuation could be eroded via inflation In conjunction with other themes: Trade 1: Long the KWD and AED versus the USD Trade 2: Long RUB versus USD Trade 3: Long MYR versus RMB Trade 4: Short USD-SGD 7

8 Quarterly Forecasts EM Currencies Spot Mar 8 Jun 8 Sep 8 Latin America USD-BRL USD-MXN USD-CLP USD-COP 1,995 2, 2,5 2,1 2,2 2,25 2,3 2,35 2,35 USD-ARS USD-VEF USD-PEN Emerging Europe EUR-PLN EUR-HUF EUR-CZK EUR-SKK USD-RUB USD-ZAR USD-TRY EUR-RON USD-EGP USD-ILS USD-AED USD-KWD USD-SAR USD-QAR Asian Bloc USD-KRW USD-TWD USD-SGD USD-THB USD-HKD USD-CNY USD-IDR 9,322 9,1 9, 8,9 8,8 8,9 9, 9, 9, USD-PHP USD-MYR USD-INR Source: Merrill Lynch. Forecast as of 23 January 28. Spot exchange rate as of previous London close. The left of the currency pair is the denominator of the exchange rate. In January 28, Venezuela replaced the Bolivar (VEB) by the Bolivar Fuerte (VEF). The VEF equals the VEB divided by 1. 8 Dec 8 Mar 9 Jun 9 Sep 9 Dec 9

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