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No, the Sky is Not Falling USD structurally sound, but may weaken for cyclical reasons. April 2006 Stephen L. Jen Stephen.Jen@morganstanley.com.

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  1. No, the Sky is Not FallingUSD structurally sound, but may weaken for cyclical reasons. April 2006Stephen L. Jen Stephen.Jen@morganstanley.com Morgan Stanley 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.Please see important disclosures at the end of this report.

  2. 1.USD index not overvalued 3. Excess savings in Asia 2.‘De facto dollar zone’ China’s CNY policy 4. Dollar the hegemonic currency How much will the dollar ‘need’ to fall? Slide 2 Slide 5 Slide 7 Slide 12 Slide 18 Slide 22

  3. The USD is no longer over-valued Source: Morgan Stanley Research

  4. Valuation Matrix – G10 Source: Morgan Stanley Research

  5. 1. USD index not overvalued 3. Excess savings in Asia 2.‘De facto dollar zone’ China’s CNY policy 4. Dollar the hegemonic currency How much will the dollar ‘need’ to fall? Slide 2 Slide 5 Slide 7 Slide 12 Slide 18 Slide 22

  6. De facto Dollar zone Source: BEA, Morgan Stanley Research

  7. 1. USD index not overvalued 3. Excess savings in Asia 2.‘De facto dollar zone’ China’s CNY policy 4. Dollar the hegemonic currency How much will the dollar ‘need’ to fall? Slide 2 Slide 5 Slide 7 Slide 12 Slide 18 Slide 22

  8. Feldstein-Horioka a bit less puzzling Feldstein-Horioka’s 1960-1974 sample: β = 0.89

  9. Excess Savings in Asia Asian C/A surpluses Savings and Investment Asia’s savings rates have been ultra-stable … But investment rates have been extraordinarily volatile Source: CEIC, Morgan Stanley Research C/A surpluses exploded after the Asian Crisis in 1997/98 Source: CEIC, Morgan Stanley Research

  10. Abundant External Financing Source: IMF WEO

  11. As wrong as the JGB call in ‘98 Ricardian Equivalence Sort of Held in Japan Watch the Corporates, Not Households Source: DataStream and Morgan Stanley Research Mirror images • Because of the extremely high level of public debt, RE may be degenerating. • Private savings may more than offset public dis-savings.

  12. 1. USD index not overvalued 3. Excess savings in Asia 2.‘De facto dollar zone’ China’s CNY policy 4. Dollar the hegemonic currency How much will the dollar ‘need’ to fall? Slide 2 Slide 5 Slide 7 Slide 12 Slide 18 Slide 22

  13. Globalisation of the goods market vs Globalisation of the asset markets

  14. The Dollar's Facilitating Role As International Money Official Private Medium of Exchange Intervention Vehicle Store of Value Reserves Banking Unit of Account Peg Invoice Source: Kenen (1983) The Dollar is special, especially to Asia

  15. USTs most liquid sovereign market Two-dimensional Reserve Diversification Diversification in two dimensions Source: Morgan Stanley Research Not necessarily USD negative Source: BIS, DataStream, US Federal Reserve Note. US Sovereign bonds include Agency or quasi-government bonds (USD3.5 trillion) in addition to US Sovereigns (USD5.7 trillion) Source: US Federal Reserve, IMF, BIS, BEA, US Treasury, Morgan Stanley Research

  16. Weak evidence of wholesale diversification

  17. Holdings of US Treasuries All Holders Foreign holders Source: BEA and Morgan Stanley Research Source: BEA and Morgan Stanley Research

  18. 1. USD index not overvalued 3. Excess savings in Asia 2.‘De facto dollar zone’ China’s CNY policy 4. Dollar the hegemonic currency How much will the dollar ‘need’ to fall? Slide 2 Slide 5 Slide 7 Slide 12 Slide 18 Slide 22

  19. A ‘CNY Event’ in H1 2006

  20. Accelerating rate of crawl of USD/CNY Daily Damping Coefficient (20D MA) Daily Rate of Crawl (20D MA)

  21. Pre-Funding of Future Private Flows • China’s private sector’s holdings of foreign financial assets are extremely low in absolute terms, relative to GDP, and relative to those of Japan and Korea. • Using innocuous assumptions, it would not be difficult to imagine scenarios where cumulative private sector outflows could total US$0.5 trillion in five years’ time. (Scenario 6 below)

  22. 1. USD index not overvalued 3. Excess savings in Asia 2.‘De facto dollar zone’ China’s CNY policy 4. Dollar the hegemonic currency How much will the dollar ‘need’ to fall? Slide 2 Slide 5 Slide 7 Slide 12 Slide 18 Slide 22

  23. Wrong to ask the dollar to do all the work • Don’t just ask the question, ‘how much will the dollar need to correct?’ • Ask also whether the implied exchange rates make any sense, or are ‘acceptable.’ If the answer to this second question is ‘no,’ then the answer to the first question must not be correct or relevant.

  24. US household saving ratio (S) can be explained by three factors: (1) household stock market wealth ratio (SE) (2) household real estate wealth ratio (RE) (3) US long bond yield (TB) Our estimation results suggest that: The explanatory variables account for 80% of the total savings rate variability during the last 50 years. 2. Savings are particularly sensitive to housing wealth. Simulated Fed fund hikes along with gently decreasing Household and Equity wealth ratios would imply a positive saving rate turn by end 2006. Actual and Fitted Values (1953Q2-2005Q2) Explaining the US household saving rate Source: BEA, Morgan Stanley Research Estimates “Fed Fund Hike” Along With Decreasing Residential and Equity Wealth Scenario Simulation Source: Morgan Stanley Research Estimates

  25. The world is ‘balancing up’ US X/M

  26. Biography Stephen Jen is a Managing Director at Morgan Stanley and serves as the Global Head of Currency Research for the firm. Prior to joining the firm, Stephen spent four years as an economist with the International Monetary Fund in Washington, DC,. In addition, Stephen was actively involved in the design of the IMF’s framework to provide debt relief to highly indebted countries. Stephen has also worked for the Board of Governors of the Federal Reserve and the World Bank and has been a lecturer at the Massachusetts Institute of Technology and Georgetown University’s McDonough School of Business. Stephen holds a PhD in Economics from the Massachusetts Institute of Technology, with concentrations in International Economics and Macroeconomics. He also earned a BSc in Electrical Engineering summa cum laude from the University of California, Irvine.

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