FX implications of China's rate hike (page 2 of 2)

7To repeat, we have three big calls for 2005 - a weaker dollar, changes to the CNY and MYR pegs and a sharp pickup in FX implied volatility. Recently, much of the dollar's necessary adjustment to reflect the widening U.S. current account deficit has taken place against European currencies. Asia is starting to play catch up but we expect this to accelerate in 2005, albeit after a modest dollar bounce in Q1.

In the immediate aftermath of the China rate hike, the market's initial reaction was to take both the dollar and global bond yields sharply higher. Since then, both have retraced lower as investors reassess the implications for global markets. We remain of the view that current global economic imbalances will necessitate a further dollar depreciation in 2005. Our call that the rate hike increases rather than decreases the prospect of a CNY band widening/revaluation is very much in line with this view. To date, the dollar adjustment has not happened against the CNY, but it will (to a modest extent). Rising expectations for this will add to upside pressure in Asian currencies. Note that overnight U.S. Treasury Secretary John Snow said the rate hike was "consistent with moves toward more sophisticated management of their financial institutions and macroeconomic objectives. This is a clear advance to use interest rate mechanisms to play a larger role in achieving macroeconomic objectives."

Implications for Asian currencies are mixed overall. Renewed speculation about a CNY revaluation in 2005 should boost capital inflows, to the benefit of these currencies. In the medium term China's strategy of simply stopping investment is not sustainable. Thus, we believe that policy makers want to use this rate rise as a more effective way to moderate investment. We still believe GDP growth in 2005 will be 8.5% y/y. However, other analysts view this rate rise as an additional means of cooling the economy. We disagree: we see this as a shift from targeted to more broad based measures. Expect global markets to continue to debate the issues over the next few days and weeks, which may lead to choppy range trading. In sum, our thoughts on how China's rate hike impacts the dollar and other exchange rates - both developed and emerging -are as follows:

•Dollar weakness remains the bias despite the market's initial reaction
•Our expectation of a CNY band widening/revaluation in 2005 further supports our call for dollar weakness
•USD set to weaken further against Asian currencies on expectations for a CNY revaluation
•China's demand for Asian exports and commodities will remain strong near term, though it may slow modestly...
•...but a series of rate hikes could trigger portfolio outflows from those countries very dependent on exporting to China

In terms of specific implications for each client type:

Leveraged funds:
· Maintain core short USD-CNY NDF outright positions, but trim trading positions
· Add to short USD-MYR positions
· Consider long EUR-AUD call spreads or long EUR-CLP call spreads as a way to express global slowdown in 2005

Real money:
•Maintain core USD underweight positions given macro outlook, but trim trading positions on increased volatility
•Outside of the USD, continue to focus on downside value in EURCHF and EURSEK
•Stay broadly long ASEAN currencies, but these would be vulnerable if this is the first of a series of rate hikes...
•...As would AUD, NZD, BRL and CLP
•Long EUR-CLP may be a good way to express a bearish view on China-related commodities

Corporates:
•EUR-based corporates should raise hedging ratios against CLP, BRL, AUD from the end of
the year
•USD-based corporates with Asian currency earnings should reduce hedging ratios for next 6
months
•Asian-based corporates should increase hedging ratios against the USD for the next 6
months