Asian Tigers - Alive and Roaring December 2003

1. Asian Tigers - Alive and RoaringDecember 2003 Ade Odunsi

2. Part 1Global Backdrop

3. Global Backdrop • Like it or not, Asia is deeply entangled in the US’s massive external imbalance • Willingness of Asia to extend cheap credit to the US government and consumer • Asian saving has helped fund tax cuts and credit growth in the US • A post-bubble US recession has largely been avoided • This has supported US consumption of Asian manufactured goods • The “mother of all vendor financing deals” (David Bowers, Merrill Lynch Research) • Imbalances however are reaching worrisome levels

4. Asian Resurrection • Asia is only 11% of the world economy but is growing 2.5x as fast • Over the 2001-2003 period China represents only 4% of Global GDP but contributed 17.5% to Global GDP growth!

5. If You Scratch My Back... • Asian trade deficit with US excluding Japan $179bn (of which China $114bn!) • Current Account = Capital Account • Asia purchased $161bn of US securities over the past 4 quarters (30% of CA deficit)

6. A Quick Word on China • US Bilateral trade surplus has jumped by 50% over the last 3 years (>$100bn) • 50% of exports to US are foreign companies - FDI • Imports from China are not direct substitutes for US goods • China has emerged as the leading manufacturer of labour-intensive goods • China runs a trade deficit with the rest of the world • The shift in manufacturing jobs abroad has been happening since the 1950’s • The money comes straight back - China owns >$120bn of Treasuries

7. Part 2 Why are We Concerned?

8. The Elephant in the Corner • CA deficit reaches $520bn - never bet against the US consumer!

9. US Dependence on Foreign Capital • “Foreign capital” increasingly means Asian capital • Asia bought $23bn of US assets in September alone

10. “Hot Money” Dominates • The upturn in the US stock market this year has not convinced foreigners to make long-term investments in the US • At the peak of the bubble, US equity inflows from overseas reached $200bn

11. It’s a Little Known Fact... The rally in the US Equity market is domestically driven! TIC = US Treasury International Capital System • Significant funding of the CA deficit is by foreign Central Banks (>$1 trillion) • Bank of Japan is the largest buyer of Treasury securities (> $130bn this year) • Net foreign buying of corporate bonds has outstripped Treasury securities over the last 12 months - the search for yield • A worrying development: foreign net purchases of US financial assets dropped from $62bn in August to $16bn in September

12. Pent-up Demand Not in US • There are three common conditions to a lasting pickup in private demand • Rising confidence and low real interest rates are met in each of the G3 • Private financial surpluses in Japan are 5% of GDP; 3% in the Eurozone (2003); -1% in the US

13. Part 3 What Does This All Mean?

14. Reality Check • This financing arrangement between Asia and the US has benefited both • Asia needs US demand just as much as US needs Asian capital • Talk of protectionist policies by the US are largely political • The ‘basic’ problem with the deficit is that it is HUGE • Low yields on US assets make the deficit increasingly difficult to finance • How does the US recovery sustain itself? • The problem ‘officially’ recognised at the G7 meeting in September 2003 - this likely marks the beginning of the end of this dynamic

15. What Is Our View? Rising local activity will enable Asia to grow out of its CA surplus • ‘Competitive reflation’ has boosted Asian economies • Aggressive FX intervention by Asian Central Banks to limit currency appreciation and maintain competitiveness (also limited ability to sterilise) • Lower interest rates • Massive growth in Asian FX reserves (Treasuries: $15bn/month on average) • But rising employment and utilization rates pushing up inflation • Business is booming and Asian consumers have a large pool of savings • Strong economic outlook will be the catalyst for acceptance of currency appreciation in Asia • THE END GAME: redistribution of growth from the US to Asia. Asian consumers will be the main drivers of demand

16. The Flip Side • Slower US growth (…but Q3 GDP growth 8.2%) • Higher returns in Asia attract capital from US securities markets • US interest rates adjust higher resulting in lower demand • Fed committed to keeping short-term interest rates low • The US dollar must devalue to maintain balance • Imbalances correct gradually

17. Deja Vu • The Plaza Accord (1986) • Trade weighted USD index peaked in Feb ‘01 and has fallen 23% • EURUSD FX rate has fallen 42%

18. What Else Could Happen? • Massive US recession? • Fed to keep interest rates ultra-low for an extended period • Competitive reflation in Asia results in a major inflation shock, impacting real rather than nominal exchange rates • A combination of all 3 factors • In everyone’s interest to engineer a slooowwww adjustment

19. Part 4 Money Talks

20. The FX ‘Virtual’ Market • Huge (For comparison, US Treasuries $400bn/day) • Liquid • Sophisticated • Highly automated • Fast • Unregulated (!?*) • 24 hour global market Source: BIS Central Bank Survey 2001

21. FX as an Asset Class • Massive increase in interest in FX as an asset class i.e. currency speculation • Driving component of many investment bank’s recent profitability • FX is not cyclical - consistently profitable! 1) Trending markets - US dollar in a long-term structural decline 2) Quest for alpha 3) A search for ‘alternative’, non-correlated assets 4) A little known fact - FX is a less risky asset • What are chances of the FX rate going to zero? • CB’s tend to intervene if volatility gets too high

22. But FX is a Zero-Sum Game, Right? • Another little known fact - not every participant in the FX market is a profit maximizer! • Central Banks For example:- Bank of England ‘defending’ the pound in 1992- Bank of Japan sales of Yen for US dollars this year have exceeded $130bn Yen has still strengthened by over 12%! • International corporations • Private individuals • Professional currency managers make up less than 1% of daily turnover SIGNIFICANT PROFIT POTENTIAL!

23. Show Me the Money • Buy Asian equities • India • Thailand • Taiwan

24. Show Me the Money • Chinese Renminbi (CNY) is a pegged currency (8.2771 CNY per USD) • Active ‘off-shore’ forward market (non-deliverable market)

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