Kathleen Stephansen Jan 1010

The 2010 Euro Outlook January, 2010 Kathleen Stephansen Chief Economist

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Euro/USD: where to?

Euro Reference Exchange Rate: US Dollar EOP, USD/EUR

1.6

1.6

1.5

1.5

1.4

1.4

1.3

1.3

1.2

1.2

1.1

1.1 06 07 Source: European Central Bank /Haver Analytics

08

09

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The Euro Outlook • We believe the Euro-USD will be in a relatively tight range over the next 12 months, ending the year close to 1.50.

• Volatility is likely to dominate currency markets and the EUR-USD in particular, given the tension between positive and negative factors.

• The crisis has set in motion a more rapid adjustment in global imbalances.

We believe that the dollar is in a longer-term downward trend, adjusting to capital flows being directed to emerging economies and leading to reserve diversification that accompanies this adjustment.

• Historical perspective: The Euro has been a success. The challenge ahead is to restore growth without the benefit of the demand impulse from the peripheral countries.

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The end of the 2005 CNY/USD peg coincided with a sharp appreciation of the Euro/USD and is the manifestation of a currency redistribution away from the dollar.

Foreign Exchange Rate: European Monetary Union US$/Euro

Foreign Exchange Rate: People's Republic of China Yuan/US$ 1.6

8.4 EUR-USD (LHS) USD-CNY (RHS)

1.5 8.0 1.4 7.6 1.3 7.2 1.2

1.1

6.8 04 05 06 07 Sources: Federal Reserve Board /Haver Analytics

08

09

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Positive Euro factors

• Global rebalancing • Global FX diversification away from the USD; • Global liquidity; • Return to risk appetite; • The timing of the ECB monetary policy exit.

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Structural changes In adjusting to credit restraint, de-leveraging and restructuring of debt, private demand in the G-2 (US & UK) could be a restraining factor to the positive multiplier effects of recovering trade flows.

Specifically, we believe in the de-emphasis of the US consumer.

The burden then shifts to China to redirect its drivers of growth away from exports to domestic demand. This process has started already but will gain traction in years to come. We note that the other two major surplus/saver countries, Germany and Japan, show even smaller inclination than China in relying on consumption to drive growth.

This is a multi-year process demanding infrastructure build, followed by diversification towards services and consumption industries.

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Marked decline in the share of industrial countries’ consumption to global consumption Shares of Regional Consumption to World Consumption NJA

LATAM

Industrials (rhs)

12%

84%

11% 82% 10% 80% 9% 8%

78%

7% 76% 6% 74% 5%

Sources: 4% Bureau of Economic Analysis/Haver Analytics 93

94

95

96

97

98

99

00

01

72% 02

03

04

05

06

07

08

Sources: DataStream International; IMF; OECD

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US: Consumer-led growth is set to change Sector contribution to real GDP growth

Consumption

Fixed Investment

Net Exports

6.00 5.00 4.00 3.00 2.00 1.00 0.00 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -1.00 -2.00

Sources: BEA/Haver Analytics

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It is a dynamic we saw with China, whose contributions to global growth has risen steadily this past decade Chinese and US contribution to global growth in ppt (PPP weights) US Contribution

China Contribution

2

1.5

1

0.5

20 10 e

20 08 20 09 e

20 07

20 06

20 05

20 03 20 04

20 02

20 01

20 00

19 99

19 98

19 97

19 96

0

-0.5

-1

Sources: IMF/Haver Analytics

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China: The massive infrastructure build was first related to the 2008 Olympics, then to the development of the domestic economy Sector contribution to real GDP growth Consumption

Fixed Investment

Net exports

14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -2.0

Sources: China National Bureau of Statistics/Haver Analytics

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China’s current account surplus should decline, implying less aggressive purchases of US Treasuries, and a slowdown in demand for dollars China: BOP: Current Account Balance as a Percentage of GDP %

12

12

10

10

8

8

6

6

4

4

2

2

0

0 99

00

01

02

03

04

05

06

07

08

Source: State Administration of Foreign Exchange/Haver Analytics

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As Chinese demand continues to rise, it increasingly benefits NJA. NJA export share to China tripled over the period 19982009, jumping to 15.4% in 2009 from 4.8% in 1998 NJA Exports to ROW ($mln, LHS)

NJA Exports to China ($Mln, LHS)

Share of Exports to China (%, RHS)

15.0

1,415,000 1,215,000

13.0

1,015,000

11.0

815,000

9.0

615,000 7.0 415,000 5.0

215,000 15,000

3.0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Note: 2009 statistics cover the first 10 months of the year Sources: Datastream

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Upward pressures on Asian currencies against the USD implies intervention, thereby limiting the decline of the USD. A shift in trade flows would lead to FX reserve diversification

1500 1400

52

India Rupee-USD (RHS) Thai Baht-USD (RHS) Korea Won-USD (LHS)

48

1300

44

1200

40

1100

36

1000

32

900

28 06 07 Sources: BOK, BoT, RBI /Haver

08

09

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EM countries, whose currencies are under upward pressure, incur FX reserves accumulation that is set to continue Intl Liquidity: EM Foreign Exchange (NSA, EOP, Tril.US$) 4.000 3.500 3.000 2.500 2.000 1.500 1.000 0.500

Ja n00 Ju l-0 Ja 0 n0 Ju 1 l-0 Ja 1 n02 Ju l-0 Ja 2 n03 Ju l-0 Ja 3 n04 Ju l-0 Ja 4 n05 Ju l-0 Ja 5 n0 Ju 6 l-0 Ja 6 n07 Ju l-0 Ja 7 n08 Ju l-0 Ja 8 n09 Ju l-0 9

0.000

Sources: Bloomberg Financial Markets/Haver Analytics/

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‌ which is linked to the rise in global liquidity and risk appetite Quantitative Liquidity Measures (percent of G3 GDP) Base Money Plus Reserves

Reserves

Base Money

12

10

8

6

4

2

0 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1 -2

Sources: Bloomberg Financial Markets/ Eurostat/Haver Analytics/Merrill Lynch.

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Synchronized growth brings a return to risk appetite VIX and PMIs Global PMI (LHS)

VIX (Inv. Scale- RHS)

60.00

10.00 9.00

55.00 8.00 50.00

7.00 6.00

45.00 5.00 40.00

4.00 3.00

35.00 2.00 30.00 Jan-06 May-06Sep-06 Jan-07 May-07Sep-07 Jan-08 May-08Sep-08 Jan-09 May-09Sep-09

1.00

Source: WSJ; Markit/Haver Analytics

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‌ A positive for the Euro

US$/EUR

VIX (Inv. Scale RHS) 10.00

1.5800 9.00 1.5300 8.00 1.4800 7.00 1.4300 1.3800 1.3300

6.00 5.00 4.00 3.00

1.2300

2.00

1.1800

1.00

Ja n: 20 06 M ay :2 00 6 S ep :2 00 6 Ja n: 20 07 M ay :2 00 7 S ep :2 00 7 Ja n: 20 08 M ay :2 00 8 S ep :2 00 8 Ja n: 20 09 M ay :2 00 9 S ep :2 00 9

1.2800

Source: WSJ; Markit/Haver Analytics

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Foreign appetite for US assets has slowed movv12m<LT001GN> Net foreign purchases of US assets, 12-month moving average, $ Mil. movv12m<LT001KN> movv12m<LT001MN> movv12m<LT001PN> 100000

80000

100000 Net Foreign Purchase of US Fedral Agencies Net foreign Purchase of US Stocks Net Foreign Purchase of US Treasurys Total

80000

60000

60000

40000

40000

20000

20000

0

0

-20000

-20000 99 00 01 02 03 04 05 06 Sources: TREASURY, TREASURY, TREASURY, TREAS /Haver

07

08

09

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European appetite for US assets has slowed the most Net European (including the UK) purchases of US assets, 12-month moving average, $ Mil.

Europe: Net Fgn Transactions of Long-Term Securities 12-month MovingAverage

Mil.$

45000

45000

37500

37500

30000

30000

22500

22500

15000

15000

7500

7500 00 01 02 03 04 05 Source: Department of Treasury /Haver Analytics

06

07

08

09

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The ECB exit strategy has begun, ahead of the Fed, which should lead to a gradual widening pressure on Europe-US yield spreads UK Japan US Euro

BOE

6

6

5

5

4

4

3

3

2

2

1

1

0

0 07 08 Sources: BoE, BoJ, FRB, ECB /Haver

09

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Negative Euro Factors

• Euro area growth differentials with the US; • Euro area needs rebalancing of growth; • Perceived Sovereign Risk fears.

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Growth differentials between the US and the Euro area favor the USD, replacing the risk aversion/USD relationship US Real Gross Domestic Product (SAAR, Bil.Chn.2005$) % Change Annual Rate

Euro area Real Gross Domestic Product (Mil.Chn.00.Euros) % Change Y/Y

7.00%

4 6.00% 5.00%

3

4.00%

2

3.00%

1

2.00%

0 1.00%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 -1

0.00% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 -1.00%

-2

-2.00%

-3

-3.00%

-4

Note: Aladdin projections in Red Sources: Bureau of Economic Analysis/Statistical Office of the European Communities/Haver Analytics

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Collapse in growth in smaller countries GDP year-on-year % change

6 4

Euro Area Portugal Spain

6

12

4 8

2

2

0

0

-2

-2

-4

-4

-6

-6 01 02 03 04 05 06 07 08 09 10 11 Sources: Statistical Office of the European Communities /Haver Analytics

Euro Area Greece Ireland

12

8

4

4

0

0

-4

-4

-8

-8 01 02 03 04 05 06 07 08 09 10 11 Sources: Statistical Office of the European Communities /Haver Analytics

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Loss of competitivenessâ&#x20AC;Ś

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…And deterioration in the Euro area fiscal outlook…

Euro area General Government Balance-to-GDP 2008

2009 (est.)

2010 (f)

5

0 BE

DE

IE

GR

ES

FR

IT

CY

LU

MT

NL

AT

PT

SI

SK

FI

-5

-10

-15

Sources: OECD/Haver Analytics

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â&#x20AC;Ś Have led to sovereign fears, a negative for the Euro Greece: 10-Year Government Bond Yield %

Germany: 10-Year Government Bond Yield % 6.00

6.00 Greece Germany

5.25

5.25

4.50

4.50

3.75

3.75

3.00

3.00

2.25

2.25 02 03 04 05 Sources: Financial Times /Haver Analytics

06

07

08

09

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The fiscal situation has deteriorated in the US as well, dampening the negative effect on the Euro/USD Budget deficits (-)/surpluses (+) by fiscal year (as a percentage of gross domestic product)

2.0

20 10 (f)

20 08

20 06

20 04

20 02

20 00

19 98

19 96

19 94

-2.0

19 92

19 90

0.0

-4.0 -6.0 -8.0 -10.0 -12.0 Source: Congressional Budget Office

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â&#x20AC;Ś With the accumulation of debt at both the Federal Federal Government: Liabilities: Credit Market Instruments SA, Bil$

8000

8000

7000

7000

6000

6000

5000

5000

4000

4000

3000

3000 03

04

05

06

07

08

09

Source: Federal Reserve Board /Haver Analytics

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â&#x20AC;Ś And State and Local Government Levels State & Local Govt: Liabilities: Credit Market Instruments SA, Bil$

2400

2400

2200

2200

2000

2000

1800

1800

1600

1600

1400

1400 03

04

05

06

07

08

09

Source: Federal Reserve Board /Haver Analytics

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Historical Perspective

â&#x20AC;˘ The success story

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Euro declines rapidly against the USD, then rebounds strongly USD/EUR 1.6 From 1999-2002 the Euro was trading in electronic markets and the FX market

1.5 1.4 1.3 1.2 1.1

The European Currency Unit (ECU), a theoretical "basket" currency, is used as a proxy for the Euro when calculating the USD/EUR exchange rate, pre-1999

1 0.9

After 2002 the Euro was fully deployed and national currencies were withdrawn from circulation

Jan-09

Jan-08

Jan-07

Jan-06

Jan-05

Jan-04

Jan-03

Jan-02

Jan-01

Jan-00

Jan-99

Jan-98

Jan-97

Jan-96

Jan-95

Jan-94

Jan-93

Jan-92

Jan-91

0.8

Sources: Bloomberg/Cumberland Advisors

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The Euroâ&#x20AC;&#x2122;s success measured by its rapid expansion: After ten years, 11 became 16 1999

2001 - 2009

2011 - 2015

Original Member Countries

Later Entries

Legally Obliged to Join in Future

Austria Belgium Finland France Germany Ireland Italy Luxembourg Netherlands Portugal Spain

Greece (2001) Slovenia (2007) Cyprus (2008) Malta (2008) Slovakia (2009)

Estonia (2011) Lithuania (2011) Latvia (2012) Poland (2013) Czech. Republic (2013) Hungary (2013) Bulgaria (2015) Romania (2015)

Sources: The EuroArea, European Central Bank, w w w.ecb.int/euro/intro/html/map.en.html; Where Eastern Europeans Stand on EuroAdoption, Thompson Financial, w ww.forbes.com/feeds/afx/2009/01/22/afx595 1139.html; January 2009 Reuters poll of analysts on euro adoption dates

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International debt issued in Euros and USD is roughly equal Amounts outstanding of international bonds and notes, by type, sector and currency (in billions of US dollars) 14000 Euro

12000

US dollar

USD billions

10000 8000 6000 4000

2000 0 1993

1995

1997

1999

2001

2003

2005

2007

Sources: BIS Quarterly Review: 'June 2009

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Global cash outstanding in Euros Is Greater than in USD 1090 990 Euro Circulation in USD 890

USD Circulation

US Dollar

790 690 590 490 390 290 190 Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Note: Euro area (changing composition) - Net Circulation - number of banknotes/coins in circulation (for banknotes it has to be calculated, and equals created notes less destroyed notes less stocks of the NCB) - Banknotes - All denominations - 1st design - Stock - denominated in Euro. Sources: Federal Reserve Bank of St. Louis, European Central Bank, and Cumberland Advisors

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