Currency Insights October 2014

CURRENCY INSIGHTS Foreign Exchange Forecast and Analysis

October 2014

Raging Bull Riding the Greenback as Global Monetary Policies Diverge

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CURRENCY INSIGHTS October 2014

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USD

Bulls in control as the Fed’s tightening cycle looms; though market sentiment warns of a pullback.

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2

08

CAD

Loonie at mercy of external forces with domestic economic fundamentals jammed in neutral.

10

EUR

How much further does the euro have to go?

12

GBP

Economic recovery in UK gathers momentum, underwrites strong Sterling.

Global Market Themes How will the USD bull story play out while monetary policies between the Fed, and ECB, BoJ continue to diverge?

IN THIS ISSUE 13

CHF

Stagnating growth and the potential for further accommodative monetary policy spurs flight from the Franc.

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14

16

JPY

AUD

Volatility and plunging Iron Ore crush the Pacific Peso.

Policymakers hemmed into a corner as Abe’s “third arrow” misses the mark.

17

NZD

RBNZ rate hikes couldn’t save the Kiwi as dairy prices nosedive.

19

CNY

Shifting policy framework questions China’s status as an engine of global growth.

Emerging Markets Caught between a rock and a hard place; can Emerging Markets escape the horns of dollar bulls?

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19

08 13 12

16 06

17 14 3

CURRENCY INSIGHTS October 2014

GLOBAL MARKET THEMES - Mark Frey, SVP Sales and Trading, Chief Market Strategist

Consensus is usually a pretty good thing. Shared consensus amongst nations, especially with respect to risks and a broader world view, is even viewed as an enviable goal in which to aspire. That said, absolute consensus, perhaps more so in markets than in politics, can be very dangerous. Indeed, absolute consensus amongst market participants often leads to a significant level of group-think, where dissenting views fail to enter any form of debate. Markets, like any other intellectual discipline, depend upon the open and free exchange of ideas and thoughts so as to allow for their refinement in terms of gaps in the analysis or data evaluated in their formation. When there are no dissenting views, the debate becomes less spirited and decidedly less healthy in terms of driving towards the “correct” answer.

To be clear, debate in the traditional sense within financial markets is often limited to the talking heads of business television, which is not exactly where you’ll find the most robust analysis and where style is often

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more important than substance. Though traders and asset managers aren’t all necessarily driven to offer flowery and well versed prose, they do nonetheless express a very clear market view whenever they step into positions to buy or sell. Markets are based on the interplay of these market views, where those that are articulated with the most force and conviction win the day, at least in the short-term. However, when the views being expressed are decidedly one-way in nature, such single-minded transaction flow often does only win in the short-term, as when everyone believes the market will only go one way, it doesn’t take very many dissenting views to erode the foundations of the trade in question.

The current market environment, in our view, may very well represent one of these situations. The global consensus view that the Big Dollar will remain fundamentally strong on a go-forward basis due to favorable monetary policy and diverging economic expectations is very well accepted. Sentiment with

CURRENCY INSIGHTS October 2014

respect to the USD, on a relative basis, is more positive today than at any point in recent memory.

Today’s dissenting views, ours included, are not so much focused on the idea that the Greenback could possibly recede but rather that it may simply not rally as materially as the broader market believes.

Assuming that we’re all sheep following the herd, let’s change the color of our wool from white to black for a moment. Experience tells us that certain market participants have built their careers on following the herd, precisely until they don’t. There are a great many traders who best express their market view by riding the trend until they feel that the prevailing trade has won the day and that every willing market participant has accepted the view expressed by the long and short positions they have placed. Only once it seems clear that the current sentiment can gain no further momentum and there are no further supporters to add to the trade in question do they reverse that view. In short, precisely when it seems that the market can

only go one direction; it often turns back and goes the other. This may be one of those times, but it may also be the first time in market history when all market participants agree that the USD can only go up.

Maybe.

“

Markets, like any other intellectual discipline, depend upon the open and free exchange of ideas and thoughts...

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CURRENCY INSIGHTS October 2014

USD

- Mark Frey, SVP Sales and Trading, Chief Market Strategist

The Dollar Index has rallied nearly 7.5 percent over the past three months, driven ever higher by divergence in relative expectations with respect to both monetary policy and economic forecasts as we head towards the close of 2014. It seems rather clear and well accepted amongst market participants that the Federal Reserve will continue to tighten monetary conditions as the economy edges towards normalization, albeit at a pace akin to a melting glacier. While glaciers are said to be melting faster these days, the fact is we’ve been discussing the Fed’s decision on action reducing monetary accommodation for the better part of the last four years, a significant stretch of time. That said, it does indeed appear as though the moment will finally arrive sometime in the first half of 2015, though how aggressive the Fed will be is still up for much debate.

It’s not that the Fed is intentionally seeking to withhold valuable information. Rather, quite simply, the board members of the Federal Open Market Committee simply haven’t made up their minds, nor are they necessarily all in agreement with respect to the pace and direction of monetary tightening. The best we can determine is that the Fed will continue to allow economic data to shape and inform their decisions going forward. If the economy continues along the same meandering path towards economic normalization, it would be reasonable to expect the Fed to move on rates sometime in the second quarter.

The ECB is clearly grappling with still deteriorating economic fundamentals and the BoJ is again attempting to revive an economy that has not had a pulse for the better part of a generation. At the same time, policymakers in Australia and New Zealand, as well as a handful of other jurisdictions are actively seeking policies, in addition to their formidable jawboning, to drive their currencies lower in what can only be seen as a race to the bottom in terms of currency valuations.

From this perspective, it is almost impossible to formulate an outlook that isn’t decidedly USD bullish.

Indeed, expressing a contrarian market view at this point would be very similar to the experience of stepping in front of a speeding freight train for all of these reasons.

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Nevertheless, the Big Dollar has come an awful long way in a relatively short space of time. Positioning is bordering on the extreme in terms of overbought momentum that is clearly showing signs of fatigue.

While it is increasingly difficult to argue against the positive story taking hold in financial markets, it is also becoming increasingly difficult to argue that sentiment can become more bullish or that the USD could enjoy more favorable momentum. The problem for USD bulls that are betting on a generational run higher is that markets have a rather efficient ability to “price in” forecasted outcomes well before they actually materialize. The good news for the Dollar is largely already priced in and while the USD may indeed receive another push when the Fed does in fact move, it is really just the timing of such a movement and therefore the finer points of the price action that is yet to unfold. In short, the big run may have already come to pass and perhaps the point we should be debating is when we will see a turn. Perhaps when the long held rumor with respect to the Fed becomes fact, it will be time to fade the rally.

CURRENCY INSIGHTS October 2014

“

USD daily

...the Federal Reserve will continue to tighten monetary conditions as the economy edges towards normalization...

Economic Indicators

4.6

1.7

GDP

Inflation

5.9 Unemployment Rate

0.25 Central Bank Interest Rate

7

CURRENCY INSIGHTS October 2014

CAD

- Scott Smith, Senior FX Trader and Market Analyst

The penultimate quarter for 2014 was not kind to Loonie bulls. The USDCAD swiftly reversed course from the depressed levels seen in June, managing to retrace all of the losses accumulated over the previous quarter as capital flows bought a one-way ticket south of the 49th parallel. The underlying weakness in the Loonie compared to the greenback is more a function of changing expectations towards the global interest rate environment rather than fundamental weakness from a domestic perspective.

However, the swift change in the outlook surrounding global monetary policy has wreaked havoc on those market participants betting on the prospect of a continuation in depressed volatility. Despite the approximate decline of 5% in value against the big dollar, the Loonie was one of the best performing developed market currencies over the third quarter, gaining against the EUR, AUD, GBP, and JPY. While the Loonie was the ‘cleanest dirty shirt’ outside of the United States over the third quarter, the road ahead from a domestic perspective is still one requiring careful navigation from policy makers at the Bank of Canada. There have been some encouraging gains for Canadian exports but the sector as a whole has yet to see the robust recovery associated with a weaker loonie which would otherwise result in a pickup in demand and better economic indicators from our main trading partner. Along those same lines, further work needs to be done transitioning the economy from one heavily reliant on consumer demand and household debt, to one of business investment and export growth. Credit debt to disposable income continues to remain elevated at 163.6%, which leaves consumers at heightened risk in the event of another economic downturn or unexpected interest rate hike. This increases the likelihood that further progress in Canada’s economic recovery will have to be driven by factors outside of consumer spending. As such, we feel additional macro-prudential policies towards combatting skyrocketing property prices will be the favoured over interest policy in the short-to-medium term, as the BoC recognizes “some degree of monetary stimulus will be required even after the output gap is closed.”

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With the outlook for domestic monetary policy firmly entrenched in the neutral position and expectations for the Federal Reserves’ tightening cycle somewhere in the middle of 2015, it is hard to argue against the prospects for a higher USDCAD from these levels. That being said, we feel the recent rally higher in USDCAD is close to reaching its short-term objective. In our view the market has overpriced the certainty of the Fed’s interest rate dot chart and the weight of the regional Fed President’s hawkishness. Yellen and Dudley don’t look ready to shed their dovish feathers just yet, and thus could take some of the momentum from the greenback parabolic rise over the next few months.

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The Loonie was one of the best performing developed market currencies over the third quarter, gaining against the EUR, AUD, GBP, and JPY.

CURRENCY INSIGHTS October 2014

CAD daily

Economic Indicators

3.1

2.1

GDP

Inflation

7.1

1.0

Unemployment Rate

Bank of Canada Rate

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CURRENCY INSIGHTS October 2014

EUR

- Darryl Hood, Options Dealer

And then it happened…

Our bearish stance on the euro has finally been vindicated. After trading at elevated levels for almost two years, the bottom fell out in September, and the currency plummeted through 1.30 – well on its way toward the mid 1.20’s. The two questions that need answering are firstly, why now? And secondly, how far can this go?

EUR daily

Though the Euro has contributed to this collapse, the currency itself hasn’t suffered to the extent that might have been expected. At least not as of yet it hasn’t, given the Eurozone’s economic performance coupled with the ECB’s recent attempts at stimulus to ease deflation concerns.

Growth for Q2 was confirmed as being nonexistent with a flat reading, whilst the German economy contracted during the same period. In September’s meeting, the ECB demonstrated further commitment to the inflationary cause by cutting both the base rate and the deposit rate by 0.1% to 0.05% and -0.2% respectively and announcing the start of asset backed security purchases from October. This change of tact to do whatever it takes, as hinted at by Draghi during his Jackson Hole speech, should keep rates at record lows for quite some time and keep the Euro on the back foot against most, if not all, its major peers.

In the States, the almost routine cut to the QE programme coupled with a possible rate raise prior to June 2015, as had been expected, saw the USD outperform all the majors with the dollar index spiking to highs not seen since June 2010.

In addition, political uncertainties in the UK and growth worries in China saw safe haven flows also help strengthen the currency.

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Economic Indicators

0.0 GDP

0.4 Inflation

11.5

0.05

Unemployment Rate

ECB Rate

CURRENCY INSIGHTS October 2014

With much of the move in EURUSD being driven

by USD strength and not yet a severe weakening of the Euro, the call for the pair to move significantly lower is due to substantial deterioration in the Eurozone combined with the belief that the ECB will continue aggressive measures to promote growth and inflation. All that against a backdrop of rate rises in the US to potentially occur sooner than the market is currently expecting.

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Though the Euro has contributed to this collapse, the currency itself hasn’t suffered to the extent that might have been expected...

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CURRENCY INSIGHTS October 2014

GBP

- David Starkey, Options Dealer and Senior Market Analyst

Sterling experienced a setback in Q3, pulling back broadly against many currencies, most notably the American Dollar. This activity was driven by the uncertainty of the Scotland independence referendum and an inconsistent Bank of England (BoE).

abroad, thereby masking domestic price pressures.

She went on to emphasise the importance of the BoE not being caught offside by a sudden spike in inflation should Sterling pull-back. Current BoE rate hawks Martin Weale and Ian McCafferty could find themselves with fresh reinforcements in the coming months.

While the end result saw Scotland choose to stay in the United Kingdom by a comfortable margin, polls in early September suggested a neck and neck race.

The event risk of what an independent Scotland might have meant for the UK caused currency markets to price in a steep Sterling discount. The discount in the British Pound was exacerbated by BoE Governor Mark Carney’s lack of clarity on the timing of interest rate hikes. Sometimes he was bullish, suggesting during media appearances that rate hikes might occur “sooner than markets have priced in” or before wages growth and inflation return to target. Other times he was decidedly bearish, like during the August Quarterly Inflation report, where he emphasised uncertainty about slack in the economy and thus was unwilling to discuss the timing of rate hikes. Financial markets being loath ambiguity further discounted the GBP.

The exception to the general outlook for the pound is the USD, which, in light of the US Federal Reserve’s most recent economic projections, the Greenback favoured.

Despite inconsistency elsewhere in his policy guidance, Carney has been steadfast that when rate hikes do begin, they will be slow and measured. Conversely projections from the Federal Reserve suggest that in the back half of 2015 the trajectory of rate hikes in the United States could be quite aggressive, giving Greenback the impetus to outperform.

As the sun starts to set on 2014 and Scotland independence appears now to the rear view mirror currency markets will refocus on data results. It’s true that soft growth for wages and below target inflation are threats to the local economy. However output, unemployment, and confidence results have been encouraging and point to a more robust recovery. As such, strong economic fundamentals are positioned to help Sterling remain elevated against most of the G10 through the remainder of this year and the first half of 2015.

The recent addition of economist Kristin Forbes to the BoE’s rate setting committee also lends itself to this outlook. Forbes in a recent interview positioned herself to be a bit of an interest rate hawk, noting that a strong Pound may have imported deflation from

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GBP daily

Economic Indicators

3.2

1.5

6.2

0.5

GDP

Inflation

Unemployment Rate

UK National Bank Rate

CURRENCY INSIGHTS October 2014

CHF

- Nick Colling, Senior Business Development Manager

The global economic environment has been conducive to a stronger USD, but can the recent run-up in the greenback continue? Against the Swiss Franc there is a good likelihood the underlying trend of USD strength will prevail, although progression may still be somewhat guarded into the end of 2014.

On the back of robust labour market conditions, the dollar index has reached highs not seen since June 2010, despite the fact that bond yields in the US have remained under pressure. With market participants beginning to position themselves for a tightening cycle from the Federal Reserve sooner than anticipated, this has driven the USD higher, though structural issues with other developed bond markets like the Eurozone and Japan has kept US denominated debt attractive for international investors.

With the pair spending most of 2014 on an upward trajectory, the path is unlikely to change between now and the end of the year. Pullbacks will likely be met with strong buying interest as an opportunity to get long for the continued move towards the par level. While the greenback may be ripe for a bout of consolidation in the short-term, the outlook for the Franc is not inspiring when assessing the relative positioning of the two economies.

CHF daily

While the economic backdrop in the US should continue to support the dollar, there is the risk that participants have overshot on bringing forward their rate hike expectations, with Fed Chair Janet Yellen still finding flaws with ancillary labour market indicators. As such, we feel the market might be undervaluing the dovish feathers Yellen and Dudley have, thus leaving the greenback vulnerable for a short-term pullback.

Though the macro environment has supported dollar bulls, the Swiss economy has largely failed to offset this, essentially grinding to a halt in the second quarter - allowing the USD to strengthen from a year low of 0.87 to an elevated level around the 0.96 handle. Swiss GDP is having trouble gaining traction after slowing to the unchanged mark, with the threat of deflation more prevalent than one of inflation. The growing concern surrounding the undesirable effects of inflation has brought with it the possibility of negative interest rates, which does not put the Franc on solid footing.

Unemployment is a bright spot for the economy, with the jobless rate in Switzerland looking stable at 3%, down 0.5% from January.

Economic Indicators

0.0

0.03

3.00

0.25

GDP

Inflation

Unemployment Rate

Swiss National Bank Rate

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CURRENCY INSIGHTS October 2014

JPY

- Scott Smith, Senior FX Trader and Market Analyst

The implementation of President Shinzo Abe’s third arrow as part of his ambitious economic reform plan has been lackluster to say the least. The government has overestimated the effect that a sales tax hike would have on the overall economy. While second quarter GDP was a write off as a result of the aforementioned consumption tax, economic production still slumped by more than forecast. This all made worse by the fact that preliminary indicators for the upcoming quarter are failing to signal a healthy rebound in activity.

A combination of sluggish structural reforms, an impending second consumption tax hike in 2015, and the expectation the Bank of Japan will have to fire up the printing presses once again, has caused the Yen to capitulate against the USD over the third quarter, with USDJPY gaining close to 8% and flirting with the 110 area.

Though the decline in the value of the Yen over the third quarter is not out of line with other developed currencies like the EUR, AUD, and GBP, policy makers in Japan seem to have backed themselves into a corner, and the path ahead is murky. The effects of the consumption tax hike are still disseminating throughout the economy, with household spending remaining depressed and industrial production struggling to show signs of life. The weaker Yen has helped large export intensive industries boost top line revenue which is starting to flow-through to hiring and wage growth, yet the intensity of the domestic currency depreciation has put excessive pressure on smaller companies.

It is also hitting consumers with higher prices as the cost of energy imports increases. We have argued previously that a weak Yen policy in not a panacea for the Japanese recovery, and this is starting to become a focal point for policy makers, many of whom are now starting to speak out against the negative impacts of a weakening Yen and urging large companies to pass on the benefits of a higher USDJPY to smaller companies.

While BoJ Governor Kuroda has yet to display discomfort with a USDJPY exchange rate around the 110 area, we feel the political rhetoric about stemming the Yen’s decline would intensify should the pair push above the 110 handle.

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JPY daily

Economic Indicators

-7.1

3.3

3.5

<0.10

GDP

Inflation

Unemployment Rate

Bank of Japan Rate

CURRENCY INSIGHTS October 2014

Although monetary policy trajectories between the Federal Reserve and the Bank of Japan are widening their divergence, and a rate tightening cycle from the Fed in mid-2015 will put further upward pressure on USDJPY; the short-term outlook is constructive for a consolidation in the pair. While we do recognize the technical pressures that could warrant time north of 110 if the psychological barrier is broken in the short-term, we feel the 8% depreciation in the Yen will take some pressure off the BoJ to increase their QE program imminently. In conjunction with the flexibility in policy granted to the BoJ with the depreciation of the Yen, market participants are discounting the dovish heavyweights on the Fed in Yellen and Dudley, with rate tightening expectations a tad ahead of where those two are feeling comfortable.

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Policy makers in Japan seem to have backed themselves into a corner, and the path ahead is murky.

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CURRENCY INSIGHTS October 2014

AUD

- Richard Breen, Manager – Treasury and Risk Management

It’s been an incredibly rocky third quarter for the AUD, which lost close to eight percent in eighteen days as volatility took off and the commodity currencies finally succumbed to USD strength. The plunge in Iron Ore also took its toll on the Aussie as well as ongoing concerns over the strength of the Chinese economy.

RBA Meeting Statements were basically unchanged throughout the quarter as was their language about the strength of the AUD, “high given the decline in commodity prices and offering less assistance than would normally be expected in achieving balanced growth in the economy.” The Bank is caught in a very difficult position with relatively benign growth outside of mining, yet is challenged with a housing market that is running extremely hot. At a Senate enquiry last week, RBA Assistant Governor hinted that macro prudential measures to curb speculative activity in the housing market could be introduced in the very near future. It could be that the RBA is taking lead from the RBNZ but it seems unlikely that interest rates will go anywhere for a while.

Economic data was mixed with the Australian Bureau of Statistics who changed their methodology for employment calculations. We saw a rise in the unemployment rate from 6.0% to 6.4% in July and then a move back down to 6.1% in August with a record high of 121,000 jobs added. No one believed the numbers. Consumer and Business confidence remains subdued; the feedback we’ve been receiving from companies across a range of industries is that most are in a cautious mode and hiring/CAPEX intentions have been shelved until a pick-up in activity is seen.

The Australian economy is likely to go through a period of sub trend growth for the foreseeable future and we hope the drop in the AUD will offer some assistance.

The RBA will be less likely to ease further given the frothy property market and a change in language in their Statements could cause some AUD strength accordingly. One thing is for certain, the AUD will move conversely with volatility. Remember that it is expensive to short the AUD if it isn’t moving south quickly.

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The speed of the drop in the AUD over the past few weeks caught many off guard, us included, but it is a reminder that this is how the Aussie trades. The old adage “up the stairs and down the elevator” is as relevant as always.

AUD daily

Economic Indicators

3.0

3.1

GDP

Inflation

6.1

2.5

Unemployment Rate

Reserve Bank of Australia Rate

CURRENCY INSIGHTS October 2014

NZD

- Richard Breen, Manager â&#x20AC;&#x201C; Treasury and Risk Management

Like its Tasman cousin, the NZD had a very tough run in to quarter end after almost printing a fresh post float high on the back of the RBNZ rate hikes, and then dropping close to thirteen percent in two months. There were a number of catalysts but it really boiled down to a burst of volatility and USD strength that knocked carry/commodity currencies.

Dairy prices have declined a whopping 49% from their February peak, weighing heavily on the economy just like the falling Iron Ore price has done for Australia. The decline in the NZD will offset some of these losses, but it needs to fall much further for most of the diary sector to just break even. Fonterra has continually downgraded its forecast for dairy prices and the latest downgrade is expected to shave two percent off GDP (in notional terms). Clearly this is a big problem for the New Zealand economy.

Policymakers are extremely concerned about the strength of the currency and have been quite vocal with ex FX dealer and Prime Minister chipping in saying fair value is closer to 0.6500. Evidence that the RBNZ has been an active seller in recent months (it sold NZ$500m in August) added to the bearish sentiment on the NZD and while it is a very small amount in terms of the size of the market, it highlights just how sensitive the currency can be to such news when it is falling. A good play by the RBNZ and one they will be happy with.

The rest of the economy continues to show signs of cooling after inflationary pressures forced the RBNZâ&#x20AC;&#x2122;s hand and even the property market has started to pull back. The introduction of macro prudential measures may have taken some of the pressure off but it is more likely that demand cooled after houses became just too expensive.

The New Zealand economy is also likely to face a difficult time ahead with fundamental data weakening, consumer and business confidence moving lower and key export commodities under pressure. It would appear that a weaker currency is the answer, but the

NZD offers some of the most attractive carry against EUR, JPY and to some extent USD, so a decline in volatility is likely to see demand for the currency return once more.

NZD daily

Economic Indicators

3.4

2.3

5.95

3.75

GDP

Inflation

Unemployment Rate

Reserve Bank of New Zealand Rate

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CURRENCY INSIGHTS October 2014

EMERGING MARKETS

- Karl Schamotta, Director, FX Research and Strategy

For more than thirty years, the global economy has staggered from one asset price bubble into the next.

From Japan in the eighties, East Asia and Silicon Valley in the nineties, to the suburbs of America in the early aughts, nearly all were preceded by a surge in liquidity, a drop in risk premia, and a collapse in volatility expectations.

Until four weeks ago, the same pattern was playing out across the currency markets. Driven by a thirst for yield, asset managers were shifting massive amounts of capital into the emerging markets, driving sovereign yields downward, and implied volatility levels to historic lows. Exchange rates had staged a remarkable rebound after last year’s ‘taper tantrum’, with many investors appearing blissfully unaware of the fundamental shifts occurring under the surface of the global economy.

In last quarter’s Insights piece, we warned that this was not sustainable - and indeed, it wasn’t.

Through September, a string of positive economic data releases finally convinced market participants that the US economy was accelerating. The greenback rallied higher, crushing carry trades and sucking global capital into the centre of the financial system. Commodity prices collapsed across the spectrum, and emerging market currencies were devastated.

The dollar’s outperformance clearly triggered the bloodbath, and it is tempting to consider this a temporary setback in what has been a seemingly unstoppable rise to dominance. We suspect something more fundamental is afoot, however.

After spending more than a decade selling raw materials to an increasingly unbalanced China while attracting massive capital flows as the darlings of the investment world, many emerging market countries have become far too vulnerable to exogenous forces. Productivity gains have not kept pace with growth, and foreign bond holdings are sitting near record levels.

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As global imbalances shift, China’s appetite for non-food commodities is falling, and the liquidity tide that has long lifted all boats is retreating.

We expect that outperformance in the developing world will return in the longer term as a vast new middle class continues to expand and global supply chains broaden further - but we don’t believe that the heady days of the last decade will return anytime soon.

Thus, while we suspect the dollar will reach overbought levels in the coming quarter and undergo corrective price action, we don’t expect a full rebound in all currencies. The emerging markets are caught between a rock and a hard place, and are unlikely to wriggle free for years to come…

CURRENCY INSIGHTS October 2014

CNY

- Karl Schamotta, Director, FX Research and Strategy

The sound of shattering China has broken the calm across the global financial markets.

After the country’s stimulus –by stealth programme appeared to boost growth earlier this year, a series of data releases through August and September suggested that a more fundamental shift is well underway. While the government’s attempts to boost infrastructure spending, lower rates and increase liquidity have helped to stimulate activity in some sectors, an ongoing crackdown on corruption, curbs on local government borrowing and falling real estate prices have acted to dull the impact on the broader economy.

From that broader perspective, the changes occurring are positive. China has become far too reliant on an increasingly outmoded growth model, with rising debt and unproductive investment propelling it toward an inevitable reckoning.

in China’s trade surpluses, and would be broadly supported by entrenched political and economic interest groups. However, it would constitute a doublingdown on a failing growth strategy and would widen the international imbalances that have emerged as the European Union, Japan and the United States have been racing to the currency bottom over the past two years.

In short, devaluation cannot be ruled out.

As such, we expect that market participants will continue to reassess China’s role. From the world economy’s growth engine and the financial system’s lender of last resort, the country is rapidly becoming a source of global instability.

CNY daily

Good medicine is often bitter, however.

The impact has been profound. Plunging commodity prices have taken a toll on asset values from Australia to Brazil. Raw materials exporters are having difficulty swallowing the painful changes that are needed to stabilize economic activity, and currency traders have pre-empted policy shifts, triggering sharp price adjustments across the foreign exchange markets.

Within the country itself, investment sentiment has soured, prompting a surge in capital outflows. The renminbi has crept ever closer to the lower end of the central bank-managed currency band over the past month. This has created attractive hedging opportunities for multinationals with CNY-denominated payables, but there is an increasingly large risk that the People’s Bank of China intervenes to drive the exchange rate down more aggressively in the coming months.

Economic Indicators

2.1

2.2

4.1

6.0

GDP

Inflation

Unemployment Rate

People’s Bank of China

This would help to alleviate some of the competitive challenges that have contributed to a drastic reduction

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CURRENCY CURRENCY INSIGHTS INSIGHTS October January2014 2013

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