Currency Strategy Emerging Markets



Emerging Markets FX Roadmap

 EM currencies face an uphill struggle despite USD stability versus most major currencies

Thinking beyond the Fed

 The Fed matters but EM cyclical and structural issues have played bigger roles in driving local currency weakness  We take a closer look at the RMB’s regime change and currency themes within the LatAm and CEEMEA regions In this edition of the EM FX Roadmap we focus on the RMB’s new trading regime. Elsewhere in Asia, we also consider the risk factors for the MYR and the conditions needed for the currency to stabilise. Frontier currencies such as the LKR and VND have weakened too. We remain bearish on the CEEMEA currencies but still expect CEE outperformance relative to the high yielders, ZAR and TRY. Meanwhile, in LatAm the sharp depreciation in the currencies has made valuations look relatively more attractive. However, we believe their current weakness is justified and continue to see further depreciation pressures working against these currencies. The outlook for EM currencies remains challenging and the forces working against them have been heating up lately. The recent decision by the Fed to keep its policy rate steady need not bring much relief to EM FX. The volatility in EM FX during August was a reminder that in many instances, these currencies have more to worry about than just the Fed; hence our continued bearish stance.

22 September 2015 – Issue 126

View HSBC Global Research at: http://www.research.hsbc.com Issuer of report: The Hongkong and Shanghai Banking Corporation Limited

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Cyclical forces such as relatively softer growth, mild inflation, and slowing credit growth remain less supportive for many EM currencies. In addition, structural factors, in the shape of prolonged softness in global trade and high stocks of debt in many EM economies do not help much either. When taken together, EM currencies are likely to weaken further, in our view.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Contents EM FX: Thinking beyond the Fed HSBC Little Mac Valuation Ranges Appendix

LatAm at a glance 3 9 17

Model portfolio and trade recommendations

18

Asia at a glance

20

Trading the RMB in the new regime

21

China’s reserves: Down but not out

33

MYR: Tough questions

37

VND: Down goes the dong

47

LKR: Let it go

52

EMEA at a glance

55

CEEMEA FX and Rates: Feel the pressure

56

GCC currencies: Taking the strain

66

2

LatAm FX: Don’t believe the mirage of value

71 72

Real effective exchange rates

80

Key global economic and FX assumptions

86

Currency reference table

88

Emerging markets FX strategy biographies

89

Disclosure appendix

94

Disclaimer

95

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

EM FX: Thinking beyond the Fed  EM currencies face an uphill struggle despite USD stability versus

most major currencies  The Fed matters but EM cyclical and structural issues have

played bigger roles in driving local currency weakness  We take a closer look at the RMB’s regime change and currency

themes within the LatAm and CEEMEA regions

EM waiting for Godot The outlook for EM currencies remains challenging. Relief that the dreaded Fed tightening has once again been put off must be set against the likelihood that tightening remains likely at some point (Chart 1). In addition, the volatility in EM FX during August was a reminder that in many instances, these currencies have more to worry about than just the Fed (see EM FX Special: RMB & the EM world, 1. Pushing the Fed’s first rate hike into the future Jun-16

25 August 2015). Our long-standing caution towards EM currencies does not rely solely on fearing the Fed. After all, cyclical forces such as relatively softer growth, mild inflation, and slowing credit growth remain less supportive for many EM currencies. Furthermore, structural factors, in the shape of prolonged softness in global trade and high stocks of debt in many EM economies, do not bode well for a number of EM currencies (Chart 2).

2. EM currencies are reaching historic lows against the USD 130 120

Feb-16

110

Paul Mackel Head of EM FX Research The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Ju Wang Senior Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4340 [email protected] Dominic Bunning Senior FX Strategist HSBC Bank plc +44 207 991 8974 [email protected] Joey Chew Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected]

100 Nov-15

90 80

Aug-15

70 60

May-15 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Date when Fed rate hike is fully priced in Date when Fed rate hike is more than 50% priced in Source: HSBC, Bloomberg. Dates implied from Fed Fund Futures

50 Jan-00

Jan-03 Jan-06 Asia-USD LatAm-USD

Jan-09

Jan-12 Jan-15 EMEA-USD EM-USD

Source: HSBC, Bloomberg

3

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Although the outlook for EM currencies is still not yet compelling, their swift decline, particularly in recent months, has left many posing the question: how cheap has EM FX now become? Our newly released valuation metrics indicate that most EM currencies cannot yet be considered undervalued. This suggests to us there is still room for EM FX to weaken further.

In CEEMEA, the ILS and CEE-3 currencies are likely to outperform, despite FX intervention (the ILS and the CZK) and domestic policy challenges (the HUF and the PLN). The higher yielders (TRY, ZAR, and RUB) are not just more exposed to external forces, in our view, but also face greater domestic challenges. The TRY is additionally sensitive to heightened local political concerns.

We have also made revisions to our EM FX forecasts, factoring in greater local currency weakness (see Currency Outlook: GBP - the rise before the fall, 10 September 2015). Emerging markets currencies should stay on the back foot against G3 (the USD, EUR, and JPY) currencies. This reflects cyclical divergence between EM and developed markets (DM).

In LatAm, we place our faith on the MXN and to a lesser degree the CLP. Both have central banks that are likely to tighten soon but we would favour the MXN over the CLP, as the latter is still sensitive to lower commodity prices. Also, we maintain a preference for the BRL over the COP, provided there is no further fiscal slippage for the former. As such, the BRL’s political risk needs close monitoring. The COP has rallied recently on news the ISAGEN sale (local hydropower producer) can go ahead as well as firmer oil, but we remain bearish on the COP's medium term outlook on negative external balances and falling oil production.

Regional biases Within Asia, the RMB’s weakness and concerns about China’s economy has injected caution towards the KRW, TWD and the SGD, but these currencies remain fundamentally more robust. Intense fear surrounding the RMB is fading and it has room to recover in a broader EM perspective. We still see the INR and the PHP outperforming in the medium term. The underperformance of the MYR, the IDR, and to some extent the THB is likely to persist.

3. EM currencies feeling the pinch while major currencies have been stable versus the USD 114 112 110 108 106 104 102 100 Jan-15

Mar-15 USD-EM

Source: Bloomberg, HSBC

4

May-15

Jul-15

Sep-15

DXY Index

EM – looking under the hood Looking at the fallout from the recent Fed meeting is in vogue for the time being. We do not rule out that a short-term relief rally for EM currencies could emerge (see FOMC: FX market reaction, 17 September 2015). Our primary

4. The growth and inflation trend in EM has remained soft

8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% Jan-00

EM Growth and Inflation

8% 7% 6% 5% 4% 3% 2% 1% 0%

Jan-03 Jan-06 GDP (YoY)

Jan-09 Jan-12 Jan-15 CPI (YoY, RHS)

Source: Bloomberg, HSBC. Note. EM GDP and CPI is calculated as the average of the following countries: China, Singapore, Korea, India, Taiwan, Malaysia, Thailand, Philippines, Indonesia, Turkey, South Africa, Poland, Hungary, Czech Republic, Israel, Mexico, Brazil, Chile, Colombia and Peru

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

40.0

6. Credit growth is picking up only in some CEEMEA economies

Credit to non-bank pte sector (% y/y)

8.0

30.0

6.0

20.0

4.0

10.0

2.0

0.0

0.0

-10.0 -2.0 Mar-97 Mar-00 Mar-03 Mar-06 Mar-09 Mar-12 Mar-15 Asia CEEMEA Latam G3 (RHS) Source: BIS, HSBC

2011

2015

Source: BIS, HSBC

concern is that the story away from the Fed is less upbeat when considering cyclical and structural drivers. In our view, these help explain why EM currencies have underperformed the USD unlike most major currencies (Charts 3-4).

Cyclical/Structural issues From a credit perspective, the EM growth cycle had started to look frail from as early as in 2011 (Charts 5-6). Although credit cycles do not tend to reach maturity so quickly – it was only a few years since credit growth troughed in 2009 – many EM economies are vulnerable as they did not de-leverage during the financial crisis. Instead, they absorbed more liquidity from major global central banks' easing policies.

7. Most Asian economies have high leverage, as well as HUF and BRL 250

35 Credit growth (% y/y) 30 Slowing 25 20 15 10 5 0 -5

TRY BRL IDR INR THB SGD RMB PLN TWD PHP HUF KRW MYR MXN CZK RUB ZAR

5. Credit cycle in Asia and LatAm peaked in 2011

Credit, % GDP

HSBC economists have written at length about the unsustainability of their credit dependency (see Fred Neumann's Chart of the Week: Asia's troubling credit dependency, 5 June 2015). To put it simply, EM economies largely failed to deploy their capital in truly productive ways and this has manifested itself in record high credit intensity of growth. Thus, even as credit growth slowed in recent years, the EM debt burden only became larger (Charts 7-8). This challenging debt cycle is compounded by external risks factors. Globally, trade growth has slowed. The slowdown in China and fall in commodity prices have also hurt income of Asian and LatAm exporters disproportionately (see EM FX Special: RMB & the EM world, 25 August 2015).

8. In contrast, most CEEMEA economies have relatively lower levels of leverage 150

200

120

150

90

100

60

50

30

0

Credit, % GDP

0 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 RMB KRW MYR Corps

Source: BIS, HSBC

SGD TWD Households

THB

HUF Govt

BRL

'10 '15 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 '10 '15 INR

IDR PHP CZK PLN RUB TRY ZAR MXN Corps

Households

Govt

Source: BIS, HSBC

5

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

9. Export volumes have fallen EM subset: Exports (% y/y, 3mma)

30% 20% 10% 0% -10% -20% -30% Jan-07

Jan-09

Jan-11

Volumes

Jan-13

Local ccy

Jan-15 USD

Note: EM subset refers to Asia ex-China, Turkey and Brazil. Source: CEIC, HSBC

But it is no longer only China that is weighing on EM trade flows. Since Q2, EM economies have become the larger drag on one another's exports (Chart 10), constituting a synchronised negative feedback loop. Domestic demand has suffered as a result of high leverage and external challenges (Charts 11-12). Consumers have had to reduce other expenditure, notably on durable goods, while businesses reduced capex and pulled back on their hiring intentions. Of course, the generalised picture painted above does not apply to all EM economies. In fact, there are significant variations amongst the key regions: Domestic leverage levels are the highest in Asia, and coupled with China-related concerns,

11. Domestic demand is strengthening in CEE economies, but falling everywhere else… EM Domestic Demand Indicators

2.0

EU

Japan

China

Others (EM)

several domestic demand indicators have recently shown signs of modest contraction. The MYR, SGD, and THB appear particularly affected. In contrast, consumption in IDR and PHP, where leverage is relatively low, are holding up much better. In LatAm, only the BRL has domestic leverage levels that BIS has identified as above trend. That said, all are vulnerable to an inflation of their external liabilities from currency depreciation. The terms-of-trade shock has also affected income levels. With the exception of MXN, where exports (to the US) have been robust, domestic demand indicators across the region have retreated to levels last seen during the global financial crisis.

12. …especially for countries hit by a terms-of-trade shock

15%

1.0

Retail sales volume (% y/y) Rising

Slowing

10%

0.5

5%

0.0 -0.5

0%

-1.0

-5%

-1.5

-10%

Jan-03 Asia

Jan-06 CEE

Jan-09 MEA

Jan-12

Jan-15 LatAm

Note: Domestic demand indicators refers to the average standardised score of vehicle sales, retail sales and consumer confidence for each region, where data is available. Source: Bloomberg. HSBC.

6

US

Note: Exports in local currency. Source: CEIC, HSBC

20%

1.5

-2.0 Jan-00

Contribution to Asia ex-China exports 14% growth (% y/y, 3mma) 12% 10% 8% 6% 4% 2% 0% -2% -4% Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15

PHP* HUF CZK PLN MXN IDR ZAR KRW TRY INR* COP SGD CLP BRL RUB THB MYR*

40%

10. China is not the only drag on demand, intra-EM trade has also weakened

2011 Note: We used vehicle sales for PHP, INR and MYR. Source: Bloomberg. HSBC.

2015

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

The CEEMEA region is a mixed bag. The higher yielding economies are suffering from similar terms-of-trade and currency depreciation related problems as their LatAm counterparts. A combination of persistently high inflation and weakening growth will constrain policy makers. In contrast, the more Euro-centric currencies – CZK, HUF, PLN – stand out as relative bright spots in EM when it comes to their domestic growth engines (see CEEMEA FX and rates: Feel the pressures, 9 September 2015).

Conclusion – EM FX & further trend weakness We expect continued EM currency weakness. Cyclical and structural factors are expected to weigh further on them. The softer tone by the Fed at it latest meeting (17 September 2015) does not completely offset the underlying weaknesses facing many EM currencies. In our view, the noticeable divergence between how EM currencies and other major currencies trade versus the USD highlights how much the former’s challenges have materialized. In our view, this divergence could widen further, implying there is room for them to cheaper further. Despite the amount of EM FX weakness versus the USD over the past year, many of these currencies are not yet considered particularly ‘cheap’.

How low can they go? Although the outlook for EM currencies is still not yet compelling, their swift decline particularly in recent months has left many posing the question: how cheap have they now become? It is notoriously difficult to judge a single value to base a currencies fair valuation, namely because of the many different methods and inputs that can be used. This is key reason behind our new valuation measures. Rather than estimating a single fair

value level, these, instead, give a fair value range – the size of which will vary by currency pair. (See HSBC Little Mac Valuation Ranges: Now covering EM FX, 16 September 2015). The recent adjustment lower by EM currencies has clearly left them 'cheaper'. In our view EM currencies should not yet be considered extremely undervalued. Despite the decline in EM currency pairs thus far, our new HSBC PPP valuation metrics indicate that many of these are still within their fair value ranges suggesting there is further room for EM FX to move lower. It also true that these currencies have cheapened for good reason. After all, as mentioned earlier, in addition to the external risk events, cyclical forces remain less supportive for EM currencies. Furthermore, structural factors, in the shape of prolonged softness in global trade and high stocks of debt in many EM economies, do not bode well for the respective currencies either. Our new valuation measures suggest that LatAm currencies are only mildly under-valued. We still see room for more weakness in LatAm currencies, and recently shifted our forecasts lower accordingly (see Currency Outlook: GBP the rise before the fall, 10 September 2015). CEEMEA currency pairs are by and large fairly valued, apart from the ZAR, which comes across as the most undervalued currency with our new HSBC PPP framework. The TRY is also somewhat undervalued against the USD. However, the external environment is likely to remain challenging for these currencies, while the domestic backdrop is not showing much sign of improving either. In addition, this undervaluation could be rectified by high inflation in these economies rather than by a significant adjustment in the nominal exchange rates.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Table 1. HSBC Little Mac Valuation Ranges for EM FX Asia USD-CNY USD-IDR USD-INR USD-KRW USD-MYR USD-PHP USD-SGD USD-THB USD-TWD

Spot

Valuation Range

LatAm

6.3687 14450 66.758 1174.67 4.259 46.538 1.406 35.755 32.518

[6.45, 7.833] [11683, 14291] [62.566, 75.546] [1095.1, 1163.1] [3.3393, 3.7429] [44.925, 56.123] [1.2616, 1.536] [31.181, 37.355] [29.613, 30.243]

USD-BRL USD-CLP USD-COP USD-MXN

Spot

Valuation Range

CEEMEA

Spot

Valuation Range

3.945 680.25 2984.5 16.634

[2.4554, 3.2981] [555.58, 632.96] [2007.9, 2557.1] [13.47, 14.066]

EUR-CZK EUR-HUF EUR-PLN USD-ILS USD-TRY USD-ZAR

27.071 311.10 4.2083 3.9126 3.0121 13.360

[25.828, 29.833] [291.28, 314.18] [4.0628, 4.2162] [3.595, 3.9696] [2.2071, 2.6645] [9.9139, 10.845]

Source: HSBC, Thomson Reuters Datastream

Asian currency pairs, in comparison, are either within or at the lower end of their valuation band highlighting, perhaps, that the recent sell-off has not yet gone too far. Using this method, the MYR appears to be the most undervalued Asian currency versus the USD but we believe this will persist (Asian FX: Malaysian ringgit: Tough questions, 9 September 2015). Of particular interest given the recent fixing reforms is the fair value of USD-CNY. Currently USD-CNY is marginally below our lowest estimate of the currency pair's fair valuation of 6.4516. Given the inherent imprecision of PPP valuation, this indicates that there is no clear valuation signal for the CNY. This is consistent with China’s authorities belief that the RMB is currently near an equilibrium level (Chart 13).

13. USD-CNY HSBC Little Mac Valuation Range

115

USD-CNY REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 23.0% above spot

110

7.835

105 100 95 90 85 80 6.3700 6.37

70 1999

2004

Source: HSBC, Thomson Reuters Datastream

8

2009

2014

1.3% above spot

Current Spot (15 September 2015)

75 0

0.2

0.4

0.6

0.8

6.4516

1

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

HSBC Little Mac Valuation Ranges Using REERs for FX valuation Many institutions produce Real Effective Exchange Rate indices (REERs) which attempt to track the change in value of a currency against some representative basket of other currencies1. However, when using a REER to measure whether a currency is over/under valued, it is necessary to compare the current value of the REER to some reference value. Calculating REERs is a simple task – the difficulty in using them for FX valuation is deciding on which reference value to choose.

might believe that a five-year window was an appropriate choice whereas someone else might choose 10 years. These choices will regularly give contradictory valuations and there is no principled way to choose between them. Our methodology (detailed in the appendix) circumvents this problem by using all possible window lengths of five years and more. Each window choice gives a different valuation and we use the entire range of these valuations. If they all give a consistent valuation signal then this gives us some confidence of the direction of valuation.

Which reference value?

Valuing currencies, or currency pairs?

One could, in theory, decide on a time period over which you viewed the currency as being fairly valued and simply use the REER value at that time as the reference value. This is deeply unsatisfying though since how can one determine over which period the currency was fairly valued? A more common approach is to use a moving average value of the REER as the reference.

The discussion above has focussed on using a REER to investigate whether a currency is over or undervalued. However, in the FX market it is currency pairs which are traded rather than single currencies. So rather than trying to value a currency pair by separately valuing each currency, we instead use a single currency pair REER2. As well as being a more direct method for valuing a currency pair, it is also simpler since no weighting scheme needs to be specified.

Whilst using a recent average as the reference value does not require the circularity of defining a period when the currency was at fair value, it does not avoid making an arbitrary choice of window length to use for the moving average. One person

1 Indeed, we calculate HSBC REERs which are updated in our Currency Outlook and Currency Roadmap documents. Please see https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=stwbxuj1r r&n=240077.PDF for details on the two different basket weighting schemes we use.

2 Some would argue that the “effective” in REER only applies when the index measures the change in value of a currency against a basket of other currencies and thus our “single currency pair REER” is just an “RER”. However, we call our indices REERs anyway since (i) the terminology “REER” is far better known than “RER” in the market and (ii) there’s nothing magical about any specific choice of basket so if this troubles you then you can just consider these REER indices to have a basket weighting scheme of 100% for one currency.

9

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

USD-CNY HSBC Little Mac Valuation Range

115

USD-CNY REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 23.0% above spot

110

7.835

105 100 95 90 85 80 6.3700 6.37

70 1999

2004

2009

2014

1.3% above spot

Current Spot (15 September 2015)

75 0

0.2

0.4

0.6

0.8

6.4516

1

Source: HSBC, Thomson Reuters Datastream

USD-IDR HSBC Little Mac Valuation Range

130

USD-IDR REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 14407.5000 14408

0.5% below spot

Current Spot (15 September 2015)

120

14332

110 100 90 80 70 18.7% below spot

60 50 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

11716

1

Source: HSBC, Thomson Reuters Datastream

USD-INR HSBC Little Mac Valuation Range

120

USD-INR REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 13.9% above spot

75.62

110

100 90 66.4025 66.403

Current Spot (15 September 2015)

80

70

60 1999

5.7% below spot

2004

Source: HSBC, Thomson Reuters Datastream

10

2009

2014

0

0.2

0.4

0.6

0.8

62.628

1

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

USD-SGD HSBC Little Mac Valuation Range

120

USD-SGD REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 9.3% above spot

115

1.5343

110 105 1.4032

100

Current Spot (15 September 2015)

95 90 85

10.2% below spot

80 75 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

1.2602

1

Source: HSBC, Thomson Reuters Datastream

USD-THB HSBC Little Mac Valuation Range

140

USD-THB REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 3.7% above spot

37.317

130 36.0005 36.001

120

Current Spot (15 September 2015)

110 100 90 13.5% below spot

80 70 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

31.149

1

Source: HSBC, Thomson Reuters Datastream

USD-TWD HSBC Little Mac Valuation Range

130

USD-TWD REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

125

32.5690 32.569

Current Spot (15 September 2015)

120 115 110

7.0% below spot

105

9.0% below spot

30.276 29.645

100 95 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

1

Source: HSBC, Thomson Reuters Datastream

11

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

USD-KRW HSBC Little Mac Valuation Range

120

USD-KRW REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

115 1186.4500 1186.5

110

Current Spot (15 September 2015)

105

1.7% below spot

1166.4

100 95 90 7.4% below spot

85

1098.1

80 75 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

1

Source: HSBC, Thomson Reuters Datastream

USD-MYR HSBC Little Mac Valuation Range

100

USD-MYR REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 4.3085

Current Spot (15 September 2015)

95 90 85 80

13.2% below spot

75

3.7401

70 65 60 55 1999

22.6% below spot 2004

2009

2014

0

0.2

0.4

0.6

0.8

3.3368

1

Source: HSBC, Thomson Reuters Datastream

USD-PHP HSBC Little Mac Valuation Range

140

USD-PHP REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 20.1% above spot

56.148

130

120 110 100

46.7700 46.77

Current Spot (15 September 2015)

90

80 1999

3.9% below spot 2004

Source: HSBC, Thomson Reuters Datastream

12

2009

2014

0

0.2

0.4

0.6

0.8

44.945

1

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

USD-BRL HSBC Little Mac Valuation Range

220

USD-BRL REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

3.8624

Current Spot (15 September 2015)

200 180

14.8% below spot

160

3.2912

140 120 100 80 60 1999

2.4503

36.6% below spot 2004

2009

2014

0

0.2

0.4

0.6

0.8

1

Source: HSBC, Thomson Reuters Datastream

USD-CLP HSBC Little Mac Valuation Range

160

USD-CLP REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 687.2250 687.23

Current Spot (15 September 2015)

150 140

7.9% below spot

130

632.76

120 110 100 19.2% below spot

90 80 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

555.4

1

Source: HSBC, Thomson Reuters Datastream

USD-COP HSBC Little Mac Valuation Range

160

USD-COP REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

3031.5500 3031.6

Current Spot (15 September 2015)

150 140 130

15.4% below spot

120

2565.2

110 100 90 80 70 1999

33.6% below spot 2004

2009

2014

0

0.2

0.4

0.6

0.8

2014.3 1

Source: HSBC, Thomson Reuters Datastream

13

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

USD-MXN HSBC Little Mac Valuation Range

115

USD-MXN REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 16.7737 16.774

Current Spot (15 September 2015)

110 105 100 95 90

16.3% below spot

85 19.8% below spot

80 75 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

14.043 13.448

1

Source: HSBC, Thomson Reuters Datastream

EUR-CZK HSBC Little Mac Valuation Range

110

EUR-CZK REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 10.3% above spot

29.878

100

90

27.0855 27.086

80

Current Spot (15 September 2015)

70

60 1999

4.5% below spot

2004

2009

2014

0

0.2

0.4

0.6

0.8

25.867

1

Source: HSBC, Thomson Reuters Datastream

EUR-HUF HSBC Little Mac Valuation Range

100

EUR-HUF REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

95

0.4% above spot 311.9500 311.95

90

313.31

Current Spot (15 September 2015)

85 80 75 6.9% below spot

70

290.47

65 60 1999

2004

Source: HSBC, Thomson Reuters Datastream

14

2009

2014

0

0.2

0.4

0.6

0.8

1

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

EUR-PLN HSBC Little Mac Valuation Range

105

EUR-PLN REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

100 95

0.3% above spot 4.1955

4.2098

Current Spot (15 September 2015)

90 85

3.3% below spot

80

4.0579

75 70 65 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

1

Source: HSBC, Thomson Reuters Datastream

USD-ILS HSBC Little Mac Valuation Range

125

USD-ILS REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

120

2.2% above spot

115

3.8844

3.9701

Current Spot (15 September 2015)

110 105 100 95

7.4% below spot

3.5954

90 85 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

1

Source: HSBC, Thomson Reuters Datastream

USD-TRY HSBC Little Mac Valuation Range

160

USD-TRY REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER

3.0297

Current Spot (15 September 2015)

140

120 12.8% below spot

2.643

100 80

60 27.7% below spot 40 1999

2004

2009

2014

0

0.2

0.4

0.6

0.8

2.1892 1

Source: HSBC, Thomson Reuters Datastream

15

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

USD-ZAR HSBC Little Mac Valuation Range

200

USD-ZAR REER (Jan 1999 = 100) Estimate of current REER value Various Averages of REER 13.4852 13.485

Current Spot (15 September 2015)

180 160 140 120

19.8% below spot

10.811

100 80 26.7% below spot 60 1999

2004

Source: HSBC, Thomson Reuters Datastream

16

2009

2014

0

0.2

0.4

0.6

0.8

9.8821 1

Currency Strategy Emerging Markets 22 September 2015 – Issue 126

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Appendix Procedure to calculate the HSBC Little Mac Valuation Ranges We create single currency pair REERs, beginning at 100 in January 1999. We calculate average values of the REER for all recent time windows which are at least five years in length3. We use the spot moves since the most recently available inflation data to estimate the value of the REER today4. For each average value of the REER calculated in step 2, we calculate what value of the exchange rate would move our estimated value of the REER today (step 3) to the average. We use this value as one of our estimated PPP values. The range of the entire set of the estimated PPP values (step 4) constitutes our HSBC Little Mac Valuation Range for this currency pair.

3

The maximum window length over which we calculate an average value is from January 1999 to today. We make the assumption that the most recently observed y-o-y change in CPI will also be the y-o-y change observed for this month in estimating this REER value.

4

17

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Model portfolio and trade recommendations 2015 EM trade recommendations

Trade Short EUR-INR 1mth NDF Short EUR-PLN Short EUR-HUF Short USD-TRY Short TWD-THB 1mth NDF Short USD-CNH 12m DF Short SGD-IDR 3m NDF Short EUR-CNH Long USD-TWD Short USD-KRW Long USD-ILS Short USD-CNH 12m DF Long USD-ZAR Short AUD-CNY 1m NDF Long CLP-COP 2m NDF Short PLN-HUF Long MYR-THB 3mth Short CAD-MXN Long USD-ILS Short SGD-THB Short USD-CNH 12m DF Long TRY-ZAR Long SGD-TWD 1m NDF Long EUR-HUF Short SGD-JPY 3m

Entry date

Entry level

8-Jan-15 12-Jan-15 12-Jan-15 12-Jan-15

75.00 4.2770 319.30 2.2900

NDF Settle/ Target/ value date Stop Target Closing Stop (where level level Rate based on: appl.) 74.25 71.50 4.3400 4.1500 324.50 309.00 2.3400 2.1900

71.50 4.3400 324.50 2.3400

NDF 2/12/2015 Spot N/A Spot N/A Spot N/A

Approx. carry points per day

Positive/ negative carry to date

Status

N/A 0.0003 0.0122 0.0007

Included 0.02% 0.01% 0.20%

Took profit on 1/18/15 S/L reached on 1/15/15 S/L reached on 1/15/15 S/L reached on 1/19/15

Trade Original Notional Nominal Stop (USD or P&L (ref. only) Scale equivalent) 4.90% -1.43% -1.59% -1.94%

76.50 4.34 317.00 2.31

Profit/ (Loss) (USD)

Capital P&L At Risk CAR (bp) (USD) (bps)

1 2,500,000 122,377.62 1.22% 1 2,500,000 (35,840.32) -0.36% 1 2,500,000 (39,780.13) -0.40% 1 2,500,000 (48,456.47) -0.48%

-

0.00% 0.00% 0.00% 0.00%

13-Jan-15

1.0355

1.0475 1.0100

1.0475

NDF 2/17/2015

N/A

Included

S/L reached on 1/28/15

-1.15%

1.0475

1

2,500,000 (28,639.62) -0.29%

- 0.00%

13-Jan-15

6.3880

6.4170 6.3300

6.4170

DF 1/15/2016

N/A

Included

S/L reached on 1/18/15

-0.45%

6.4200

2

5,000,000 (22,596.23) -0.23%

- 0.00%

23-Jan-15 9400.0 9600.0 8900.0 9600.0 5-Mar-15 6.9000 6.9000 6.6000 6.6000 10-Mar-15 31.6000 31.3000 32.3000 31.3000 19-Mar-15 1113.00 1113.00 1075.00 1096.50 19-Mar-15 3.9900 3.8800 4.2000 3.8800

NDF 4/27/2015 NDF 6/9/2015 NDF 4/12/2015 NDF 4/23/2015 Spot N/A

N/A N/A N/A N/A 0.0000

Included Included Included Included 0.00%

S/L reached on 2/12/15 T/P reached on 3/11/15 S/L reached on 3/19/15 T/P taken on 4/10/15 S/L reached 4/28/15

-2.08% 4.55% -0.95% 1.50% -2.76%

9600.0 7.0500 3.8800 1130.00 3.8800

1 1 1 1 1

2,500,000 2,500,000 2,500,000 2,500,000 2,500,000

-

31-Mar-15 6.4240 6.4500 6.3500 6.4265 9-Apr-15 11.8400 11.5800 12.3500 12.1400

DF Spot

4/5/2016 N/A

N/A -0.00190

Included -0.78%

Closed on 4/13/15 T/P taken on 5/29/15

-0.04% 1.75%

6.45 11.5800

1 2,500,000 1 2,500,000

13-Apr-15

4.6530

4.7500 4.4000

4.7500

NDF 5/15/2015

N/A

Included

S/L reached 4/16/15

-2.04%

4.7500

1

15-May-15 23-Apr-15

4.1020 75.05

4.0350 4.2500 76.15 72.85

4.0350 75.05

NDF 6/17/2015 Spot N/A

N/A -0.0004

Included -0.03%

S/L reached on 4/21/15 Closed at entry on 6/17/15

-1.63% -0.03%

9.6000 9.1500 12.2000 12.5500 4.0000 3.7820 24.0000 25.1470

DF 7/28/2015 Spot N/A Spot N/A DF 6/26/2015

N/A 0.0008 0.0000 N/A

Included 0.25% 0.00% Included

T/P taken on 5/4/15 T/P taken on 6/5/15 Closed on 6/22/15 Closed at maturity 6/26/15

24-Apr-15 9.0200 9.1500 28-Apr-15 12.6320 12.8500 15-May-15 3.8280 3.7400 26-May-15 25.0800 25.5000

(52,083.33) 113,636.36 (23,734.18) 37,619.70 (68,922.31)

-0.52% 1.14% -0.24% 0.38% -0.69%

0.00% 0.00% 0.00% 0.00% 0.00%

(972.54) -0.01% 43,824.05 0.44%

- 0.00% - 0.00%

2,500,000 (51,052.63) -0.51%

- 0.00%

4.0350 76.15

1 2,500,000 (40,833.74) -0.41% 1 2,500,000 (753.42) -0.01%

- 0.00% - 0.00%

1.44% 0.90% -1.20% -0.27%

8.8000 12.85 3.7400 25.5000

1 2,500,000 36,031.04 0.36% 1 2,500,000 22,581.24 0.23% 1 2,500,000 (30,041.80) -0.30% 1 2,500,000 (6,660.83) -0.07%

-

1 1

- 0.00% - 0.00%

10-Jul-15 22-Jul-15

6.3800 4.5640

6.4100 6.3200 4.4700 4.7500

6.4100 4.4700

DF 7/14/2016 Spot N/A

N/A 0.00056

Included 0.34%

S/L reached on 7/28/15 S/L reached on 8/18/15

-0.47% -1.72%

25.5000 4.4700

2,500,000 (11,700.47) -0.12% 2,500,000 (43,075.54) -0.43%

27-Jul-15 28-Jul-15 21-Aug-15

22.98 309.50 86.90

22.65 23.80 304.75 319.00 86.90 80.00

23.26 311.80 86.04

NDF 8/31/2015 Spot N/A DF 11/25/2015

N/A 0.01218 N/A

Included -0.20% Included

Took profit on 8/21/15 Open Stop lowered on 8/26/15 Total Nominal P&L:

1.20% 0.54% 1.00% -2.0%

22.6500 1 2,500,000 29,917.32 304.75 1 2,500,000 13,597.81 90.00 1 2,500,000 24,988.38 Total P&L on $10m capital: (60,570.04)

0.00% 0.00% 0.00% 0.00%

0.30% - 0.00% 0.14% 57,834 0.58% 0.25% 24,988 0.25% -0.6% 82,823 0.83%

Italics = Live Trades Notes: NDF currencies are traded using NDF dates, with target levels based on the outright forward for the value date of the trades. Deliverable currencies are traded spot and rolled daily, with positive/negative carry shown. Assumed capital under management = USD10 million. Leverage scale: 1=25%, 2=50%, 3=100%, 4=150%, 5=200%, 6=250% Source: HSBC

Recap Our EM Model Portfolio is down 0.6% on our notional capital with a nominal 2.0% loss. Our Sharpe Ratio over the life of the fund has improved to 0.76, while the long-term performance of our EM FX Portfolio is shown in the adjacent chart. Our 2015 trades are detailed in the table above, with live trades shown in italics and detailed below.

HSBC EM FX Portfolio historical cumulative return on capital 80% 70% 60% 40% 30% 20% 10%

Source: HSBC

18

Clyde Wardle Senior EM FX Strategist HSBC Securities (USA) Inc. +1 212 525 3345 [email protected]

50%

0% Jan-05

Paul Mackel Head of EM FX Research The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected]

Jan-07

Jan-09

Jan-11

Jan-13

Jan-15

Murat Toprak EMEA FX Strategist HSBC Bank plc +44 20 7991 5415 [email protected]

Currency Strategy Emerging Markets 22 September 2015 – Issue 126

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Current open trades Long EUR-HUF We have argued that the changes in Hungary’s monetary policy framework have been conducive to a weaker currency (see HUF: Running out of puff, 17 June 2015). We believe that the adoption of a new (3-month deposit) policy rate, which became effective in September, the limited access to 2-week deposit instruments and the objective of facilitating government financing are likely to: 1. Create too accommodative monetary conditions, particularly relative to domestic macro dynamics 2. Weaken the inflation targeting policy 3. Create conditions for a weak HUF policy Therefore, we recommend being long EUR-HUF.

Short SGD-JPY 3m We recommend selling SGD-JPY 3m, targeting 80 with a stop loss of 86.9. Rising expectations for a delay to the Fed’s rate hike cycle have caused the SGD to appreciate in the near term. The SGD is sensitive to changes in the broad USD due to the central bank’s NEER framework. Expectations that the Monetary Authority of Singapore will ease monetary policy in October are rising, and we believe EM currencies will stay on the back-foot vis-à-vis the G3. Going short SGD-JPY, which is only 6% below an almost 30-year high, offers good risk-reward, in our view. The trade costs 1.5% in annualised carry, which is still relatively low compared to other JPY crosses. The SGD is among the more liquid currencies in Asia, which would make the trade easier to manage if volatility shoots up further.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Asia at a glance Currency CNY

Offshore RMB HKD INR

IDR

KRW

MYR

PHP SGD

TWD THB

VND

Source: HSBC

20

Key points  Sentiment around the RMB has improved as policymakers reiterate that they are not purposely weakening the currency to boost exports and that they do not want to start or join any sort of "currency war".  We believe the RMB should trade with greater two-way flexibility over time. As the exchange rate becomes more market-oriented, the onshore and offshore RMB FX curves should converge with greater consistency. Our year-end USD-CNY forecast is 6.50.  We believe onshore-offshore convergence remains the medium-term theme. This will resume when market participants become more used to the new RMB regime, negative sentiment on China eases, and financial reforms pick up pace again.  We expect the Linked Exchange Rate System to remain in place for the time being. A stronger USD would likely gradually lift the HKD away from the strong side of the band.  Low commodity prices and declining headline and core CPI prints will likely prompt the RBI to make a cut at its 29 September meeting despite weaker-than-expected monsoon rains.  Despite upside risks to USD-INR, we remain optimistic about the INR to be a regional outperformer based on sound monetary and FX policy and stable fundamentals.  We remain cautious on the IDR given its relatively weak external fundamentals, external debt that may not be well-matched by FX assets or hedges, low market liquidity and depth, and the current account deficit.  Although the IDR has held up better (q-t-d) than many of its high-yielding EM peers amid recent external volatility, the bias is for USD-IDR to rise over time.  The BoK kept policy rates on hold in September but continued to project a dovish stance. This is in line with our view that Korean policy bias is for currency under-performance in order to help lift weak exports.  HSBC's economics team now expects the BoK to cut interest rates in Q4 although the central bank will be watchful of interest rate normalization by the Fed later this year.  We have raised our forecast to 4.30 by end-2015. Downside risks for the MYR could extend if there is: 1) a further decline in palm oil prices, 2) a global risk-off event, or 3) political uncertainty and macro risks.  The MYR may look undervalued and although there maybe signs of a turnaround if external demand picks up, a significant retracement is unlikely as the BNM will likely tilt towards building more reserves.  Economic growth in the Philippines has struggled to meet expectations. With very little room for both monetary and fiscal policy manoeuvre, the BSP may be more comfortable with some currency weakness.  Despite this, we expect the BSP to be prudent in allowing the PHP to weaken gradually.  The People’s Action Party won the general election taking more than 70% of total votes. In our view, this election and its outcome holds little significance for the SGD or the upcoming MAS meeting in October as economic concerns are not at the fore and policy continuity will likely be maintained.  We think, the MAS is assessing softer regional and domestic cyclical conditions and balancing it against Singapore’s medium-term structural constraints. At present, we expect the MAS to keep policy unchanged in October and maintain the gradual and modest appreciation stance for the SGD NEER.  There are rising expectations that the CBC will cut its policy rate in its 24 September meeting. This, added to the TWD’s underperformance seen post the 11 August Chinese fixing reform, will likely keep upside pressures on for USD-TWD in the near term.  Despite foreign capital outflow in recent months, the BoT has signalled that its preferred level for USD-THB is to be raised further after the depreciation of the RMB. We do not believe the BoT will aggressively build FX reserves from here, though it may not lean against the wind as much as it had earlier.  After China’s fixing reform, we believe the State Bank of Vietnam should accommodate further weakness in the VND if it wants to ensure its exporters remain competitive with China. The possible Fed lift-off later in the year will be another challenge.  We expect USD-VND to rise another 2% in 2015 to end the year at 22,800.

Recommendation Q4 2015 spot Neutral

Risk to forecast

6.50

Stronger

Neutral

7.80

Neutral

Neutral

67.0

Stronger

Neutral

14400

Weaker

Neutral

1220

Stronger

Neutral

4.30

Weaker

Neutral

47.1

Neutral

Short SGD-JPY 3m

1.43

Neutral

Neutral

33.0

Weaker

Neutral

36.4

Weaker

Neutral

22800

Weaker

Neutral

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Trading the RMB in the new regime  The RMB is becoming ever more market-determined…  …altering the dynamics of the currency  We expect the RMB to be more ‘data-dependent’ and forecast

USD-RMB at 6.50 for the end of 2015

This is an excerpt from Asian FX Focus: Trading the RMB in the new regime, published 18 August 2015.

The RMB – the story so far… Just a few weeks after the 10th anniversary of the RMB’s de-peg from the USD, China took another giant step on the path to liberalising its currency. On 11 August 2015, the People’s Bank of China (PBoC) raised the USD-CNY mid-price (the fixing) by nearly 2% to 6.2298 from 6.1162, the largest one-day change in the history of the reference rate (Chart 1).

The sudden and unexpected move was described by the central bank as a ‘one-off adjustment’ to bring the reference rate closer to the spot price and part of the much-awaited fixing reform. These changes were aimed at making the reference rate more market-oriented. In an accompanying statement, the PBoC announced that market makers are now required to submit fixing quotes to the CFETS (China Foreign Exchange Trading System) with reference to the previous day’s USD-CNY spot market closing price, in conjunction with due considerations for supply and demand in the market, as well as movements in major currencies.

1. Fixing reform paves way for China’s exchange regime to move towards a truly managing floating mechanism

2. Onshore and offshore basis has narrowed

6.55

1800

11 Aug 2015: Fixing reforms introduced

6.45

17 Mar 2014: Band widened to +/-2%

6.35 6.25 6.15 6.05 5.95 Aug-11 Fix

1600

Paul Mackel Head of EM FX Research The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Ju Wang Senior Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4340 [email protected] Joey Chew Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Alastair Pinder Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 1672 [email protected]

pts

1400 1200 1000 800

16 Apr 2012: Band widened to +/-1%

600 400 200

May-12 Feb-13 USD-CNH

Source: Bloomberg, HSBC

Nov-13 Aug-14 USD-CNY Close

May-15 Band

0 10-Aug

17-Aug

24-Aug 31-Aug 7-Sep USD-CNH - USD-CNY spread

14-Sep

Source: Bloomberg, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

The indications so far suggest the new USD-CNY fixing mechanism is far more market-orientated: the announced fixings since 11 August have been close to the previous day’s closing prices in the onshore spot market. Finding near-term stability…

The changes in the exchange rate mechanism and the considerable uncertainty surrounding the RMB’s FX policy initially led to an unprecedented amount of volatility in both the CNY and CNH markets. However, in our view, the market may be approaching some form of near-term equilibrium, judging from two indicators: 1

The opening rate of the onshore spot market is now closer to the fixing rate. In the first two days of the new CNY fixing regime, onshore spot opened aggressively higher than the fixing rate – 0.5% higher on 11 August and 1.5% higher on 12 August. However, market makers now appear to have a better sense of onshore FX demand and supply, and corporates have also become calmer.

2

The onshore and offshore basis has narrowed significantly from around 1,800 points on 12 August to around 300 points now (Chart 2). This shows that offshore market sentiment is improving; thereby, allowing cross border arbitrage flows to remove some of the onshore-offshore price differences.

…with some policy help

The PBoC has played a key role in helping the market find some short-term stability. Indeed, since the onshore USD-CNY 'fixing' mechanism was changed, there have been media reports of FX intervention. In particular, market participants have been fixated with the onshore USD-CNY ‘fix’ and the behaviour of the onshore spot rate into its close at 4:30pm local time (Charts 3-4). Regulatory changes have taken place too. The PBoC now requires banks trading FX forwards onshore to set aside reserves equivalent to 20% of the nominal value of new long USD-CNY forward contracts executed by their clients (Reuters, 1 September 2015). The base nominal value will be 50% of nominal value for options and 100% for all other forward and swap deals. The USD reserves will be held by regulators for a year, at zero interest rate. The new regulation is expected to be implemented from 15 October 2015. Reuters calculates that if the year-to-date pace of long FX forward contracts continues, banks may need to prepare USD5.3bn of reserves per month. We believe such a regulation should make it more costly to buy USD forwards onshore. This could shift transactions into the spot market, or perhaps into the offshore forward market. However, given

3. Long-term picture of USD-CNY spot volume

4. Lately, USD-CNY volume concentrated in the last 30 minutes of trading

60

60

50

Spot volume USDbn

50 40

40

30

30

20 10

10

0 Jul-14 Oct-14 Jan-15 USD-CNY daily volume

Source: Bloomberg, HSBC

22

Apr-15

Jul-15 Average

14-Jul 18-Jul 22-Jul 26-Jul 30-Jul 03-Aug 07-Aug 11-Aug 15-Aug 19-Aug 23-Aug 27-Aug 31-Aug 04-Sep 08-Sep 12-Sep

20

0 Apr-14

Spot volume USDbn

USD-CNY volume 16:00 - 16:30 USD-CNY volume 09:30 - 16:00 Source: Bloomberg, CEFTS, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

5. August registered record USD selling by the PBoC

125 USDbn 100 75 50 25 0 (25) (50) (75) (100) (125) Feb-11 Feb-12

6. USD-CNY and the fix rate have historically diverged significantly 1.0% 0.8% 0.6% 0.4% 0.2%

Feb-13

Feb-14

Feb-15

Nominal chg in spot FX reserves Estimated central bank intervention Source: Bloomberg, CEIC, IMF, HSBC *Valuation effect based on COFER weights

that the offshore market's FX implied yields are still higher than onshore, the regulation initially inhibited the degree of convergence between the onshore and offshore curves. PBoC also seems to have intervened in both spot and FX forward market aggressively according to media report and its spot intervention was evident by the drop in August FX reserves (Chart 5 and also see Asian FX: China's reserves: Down but not out, 7 September 2015). Indeed, many of the recent actions by the authorities to stabilize the RMB may appear at odds with the stated policy intention to move towards a more market-based FX regime. However, we note that these are consistent with the official rhetoric arguing against excessive RMB volatility following the fixing reform. Also, they are not completely against international practices. The IMF, for instance, acknowledges some capital control measures are acceptable for emerging markets amid extraordinary market conditions. We believe China remains committed to broader goals of capital account liberalisation, RMB internationalization, and FX reforms. In fact, the authorities made several related policy relaxations in recent weeks – for example, increasing onshore market access to foreign banks by allowing them to make transactions related to direct investments

0.0% CNY MYR KRW THB INR TWD PHP IDR Absolute difference between spot (vs USD) and fixing between Jan-14 - Aug-15 Source: Bloomberg, HSBC

(and not only for current account transactions); publishing the USD-CNY reference rates five times a day, as per IMF suggestion; lifting caps for RMB cash pool scheme, as well as removing quotas for companies to raise funds in the overseas bond and loan markets. While all these measures are focused on attracting FX inflows and/or encouraging two-way RMB denominated cross-border flows, we note China's capital account liberalization has always been designed so that it would counter prevailing market flows to prevent excessive FX moves. We believe China is still firmly committed in financial and capital account reforms. The RMB will increasingly become more marketdetermined, and hence volatile, notwithstanding some current policy actions suggesting otherwise. It could thus relax its stance when it believes the market has become more balanced.

What has changed? The evidence suggests that the new fixing reform has transformed the behaviour of the RMB (Chart 1). The new fixing mechanism marks a major change from the previous USDCNY fixing regime.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Out with the old… Previously, there has been a lack of transparency in the daily USD-CNY fixing. The official CFETS description of the old fixing mechanism was as following: “The CFETS, authorised by the PBoC, calculates and publishes the central parity of [the] RMB against the USD and other major foreign currencies on each business day. It enquires prices from all liquidity providers before the opening of the market on each business day, excludes the highest and lowest offers, and then calculates the weighted average of the remaining prices in the sample as the central parity of the RMB against the USD for the day. The weights are determined by the CFETS in line with the transaction volumes of the respective liquidity providers in the market, as well as other indicators, such as the performance of market-making.” On the surface, the CFETS’ description of the derivation of the fixing is not too different from the process in other currencies’ fixings. However, as the weights behind each bank’s contribution to China’s fix are unknown to the market and there is no specific reference to any specific market price, the final published rate may turn out

7. The USD previously counted for a dominant share of the CNY’s basket

different from the transacted spot rates in the market. In fact, the difference between the RMB fixing and spot has been known to be much higher than most other currencies, which would suggest the fixing is heavily influenced by non-market forces (Chart 6). As such, China’s currency regime was most recently classified by the IMF as a “crawl-like arrangement” with a “de-facto exchange rate anchor” to the USD. That is in contrast to China’s official description of its exchange rate regime, which it says is a “managed float” with reference to a “basket of currencies” (including the USD, the EUR, the JPY, the KRW, the SGD, the MYR, the RUB, the AUD, the THB, and the CAD, i.e., the currencies of China’s top 15 trading partners). Statistical evidence often agrees with the IMF’s de-facto classification (see Frankel, 2009 and Ma and McCauley, 2010). For example, our estimates suggest that movements in the broad USD could explain more than 85% of the changes in the USD-CNY reference rate most of the time since 2006 (Chart 7), prior to last week’s change. Moreover, there appears to be a policy preference for USD-CNY stability when there is greater financial market uncertainty.

8. A +/-2% (4% wide) daily trading band ought to offer enough flexibility

Est. weight in CNY fix 7.80

100% 80%

1.00

Days when daily FX move exceeds 4%

7.30

60% 6.80 40% 20% 0% Jan-07 USD

USD-CNY (RHS)

6.30 5.80

Jan-09 Jan-11 Jan-13 Jan-15 EUR JPY unexplained

Source: Bloomberg, HSBC. Note: This data represent our estimates of the weights for different currencies in the previous USD-CNY fix, the reference rate, to a basket of currencies as of 10 August 2015.

24

0.00 Jul-05

Jul-07 AUD

Jul-09

Jul-11 JPY

Source: Bloomberg, HSBC. Note moves are vs. the USD.

Jul-13 EUR

Jul-15

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

9. The RMB is stretched by the REER measure 40%

10. China has delivered significant efforts in rebalancing 13 Current account as % of GDP %

Latest REER vs LT ave Overvalued

30%

9

20%

5

10% 0%

1

-10% -20%

-3

-30% -40% CNY

Undervalued KRW SGD

TWD

Unadjusted valuation

JPY

EUR

USD

Productivity-adjusted

Source: BIS, Conference Board, HSBC

…and in with the new The past week’s fixing reform essentially overhauled the system. With market makers fixing quotes now having a key emphasis on the reference to the previous day’s closing USD-CNY spot rate, the central bank has allowed market forces to play a much greater role in determining the fix. Going forward, the RMB should become a true “managed floating” currency with at least a +/-2% daily trading band for the USD-CNY surrounding the fixing. Ideally, we would like to see the details of the fixing process (including the weights of each bank’s quote), as well as the indicative quotes submitted by the onshore market markers, being disclosed to the public. Eventually, when China is ready to relinquish further control over its exchange rate, it can consider switching to a more transparent fixing process, based on say, average/median transaction prices, or auction prices, as opposed to surveyed quotes. This would allow market forces to have an even greater influence on the onshore fixing rate and make it more comparable to fixings of other currencies (Appendix 1). Meanwhile, with the fixing becoming more market-oriented, the significance of the daily trading band will decrease. Theoretically, the

-7 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 China

US

Japan

EU

Source: Bloomberg, HSBC

current +/-2% band (i.e., a total width of 4%) ought to be wide enough – even freely floating currencies seldom experience that kind of daily volatility (Chart 8). For example, the AUD and the EUR moved by more than 4% in a single day only during the 2007-08 global financial crisis. Therefore, while we believe eventually the 2% band will also be removed to let the currency evolve into a free floating exchange rate, the urgency to widen the band further has already eased. Over time the fix itself should also lose significance as a FX policy tool as the market increasingly accepts that the reference rate is market-determined.

Long-term equilibrium Although the RMB has seemingly found some near-term stability, there remains considerable uncertainty over the future direction of the RMB in the longer run. We are of the opinion that the RMB will face some depreciation pressures in the next couple of years due to cyclical factors. The long-term equilibrium level, however, will likely be dynamic, depending on both external and domestic factors. At the PBoC’s briefing on 13 August, the central bank repeated its intention to keep the currency basically stable at an equilibrium level. Although

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

it wouldn’t comment explicitly on which level that is, the PBoC suggested that it looks at: 1

Balance of payments

2

Economic fundamentals

3

Effective exchange rate for its assessment on currency valuation

This basically means the medium- and long-term equilibrium is dynamic, as we believe. We have argued in the past that currency valuation is more an art than a science (Asian FX Focus: RMB: The top 10 questions, 29 July 2014). For example, the US Treasury still argues that the RMB is undervalued, given China’s current account surplus and relatively higher productivity growth. However, on the other hand, the IMF recently changed its view – its external balance analysis suggests that the RMB is no longer undervalued. Meanwhile, another common market practice of measuring FX valuation is by looking at the deviation of a currency’s REER from its longterm average (Chart 9). If the deviation is within 10%, then many would judge a currency to be fairly valued. However, if the REER deviates substantially (30% or more) from its long-term average, then concerns may be warranted around a currency’s valuation. Headline REER data do suggest the RMB is more than 30% overvalued from its average level since 1994. However, after adjusting for China’s relative productivity gains, which grew significantly more than others in the past two decades, the overvaluation would only be a little over 10%. Based on this measure, we would argue there is not enough evidence to say the RMB is significantly overvalued (Chart 9).

26

However, we also believe that the RMB has appreciated enough to correct its excessive external surplus. This can be seen from the trend of current accounts in major economies since before the financial crisis (Chart 9). After narrowing from its highs in 2007, China’s current account surplus is now in line with Europe and Japan, whereas the current account in the US has narrowed significantly from the lows. Based on our assessment of domestic and global factors, including residual unhedged FX positions and diverging monetary policy between China and the US, we still see some further cyclical pressure working against the RMB in the coming years. However, the depreciation pressures should be manageable from a macroeconomic policy perspective, given China’s current account surplus and large stock of FX reserves. Our year-end 2015 forecast for USD-CNY is 6.50 (Asian FX Special: More volatility – a permanent fixture, 12 August 2015).

International ramifications China accounts for a greater share of world trade than any other country. Therefore, the devaluation of the RMB obviously has important implications for other economies, not just China (Asian FX Special: More volatility – a permanent fixture, 12 August 2015). So far, most policy makers have viewed China’s exchange rate reform as a step toward a more market-oriented FX regime rather than purposefully weakening its currency, although policy makers have warned of the possible negative impact on global FX markets and trade. The US Treasury, for instance, said on 11 August that: “While it is too early to judge the full implications of the change in the [PBoC] reference rate, China has indicated that the changes announced today are another step in its

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

exchange rate regime will greatly enhance China’s monetary policy room.

move to a more market-determined exchange rate…any reversal in reforms would be a troubling development.” Importantly, the IMF welcomed this change and continued to encourage China to put in place an “effectively” floating exchange rate before fully liberalising its capital account. Moody’s suggested that China’s new fixing mechanism is credit positive as it will increase currency flexibility and support China’s capital account liberalisation. The IMF’s welcome gesture carries great significance. In fact, we believe the PBoC is accelerating reforms partially to raise the possibility of the RMB’s inclusion in the IMF’s SDR basket. Although it is not explicitly mentioned, it is nevertheless understood that a reserve currency cannot be a highly managed one, which could potentially deviate from its underlying fundamental value, thereby, resulting in eventual instability. We also believe exchange rate reforms are complementary to ongoing capital account liberalisation and indicate that China is committed to full convertibility in the near future. As more capital flows go through the FX market, we believe the PBoC will find it harder to manage the USD-RMB spot rate. A more flexible

11. Weak economic data prompted the PBoC to ease monetary policy 90

2.5% 2.0%

75 70 Jan-10

4.0%

3.0%

80

China data much weaker than expected Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 HSBC China Economic Activity Surprise Index China benchmark deposit rate (RHS)

Source: Bloomberg, HSBC

Other countries across Asia have expressed their concerns about the RMB’s depreciation but have generally agreed that exchange rate reforms are the right steps for China to take.

Key signposts ahead – the RMB is now data-dependent With a new FX regime in which onshore USD-CNY has greater flexibility, the RMB should become ‘more data-dependent’. In this context, we outline the key events over the next few months that could lead to greater RMB volatility (Table 1). For obvious reasons, it used to be that the RMB was less sensitive to external events compared to other currencies; however, that is increasingly likely to change, especially if the onshore market will have extended trading hours. In particular,

12. The RMB and other EM currencies are important to the USD index 3.5%

85

We have been arguing that Beijing should not fear floating the exchange rate. With China’s low currency mismatch and its potential to eventually borrow abroad, largely in RMB, the risk of financial instability stemming from currency depreciation and volatility is low and falling (Rise of Redback Special: Why it's time for an even freer RMB, 20 July 2015).

Weights in Fed's broad USD index 100% 80% 60% 40%

1.5%

20%

1.0%

0% 1975 1980 1985 1990 1995 2000 2005 2010 2015 Japan China

Euro area Rest of Asia

Rest of G10 Rest of EM

Source: Federal Reserve, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Table 1. Upcoming key events for the RMB Date

Events (Bold = key events)

22 September 23 September (09:45 HKT) October October 1-7 October 5-6 October 7 October 9-11 October 13 October 14 October 15 October (09:30 HKT) 19 October (10:00 HKT) 23 October (09:45 HKT) 7 November November/December 15-16 November Before the end of 2015

Chinese President Xi Jinping makes first state visit to the US Caixin China Manufacturing PMI (Preliminary) China’s 5th Plenary Session Formal recommendations on the new SDR basket by IMF staff PRC National Holiday G20 Trade Ministers Meeting China FX reserves for September Annual meeting of the IMF and the World Bank Group China trade balance China CPI US Treasury report to Congress on exchange rate policies due (actual release date may vary) China 3Q15 GDP Caixin China Manufacturing PMI (Preliminary) China FX reserves for October IMF Board decision on the new SDR basket expected to be finalised G20 Leaders Summit China International Payment System (CIPS) launch

Source: IMF, Bloomberg, HSBC

we see five broad key signposts that could have a decisive impact on the direction of the RMB: 1. China macroeconomic data

The market will be watching China’s economic data releases intensely. If activity data continue to disappoint, we believe it will only heighten expectations of further monetary easing by the PBoC (Chart 11). Indeed, HSBC’s economics research team currently forecast the PBoC to cut the one-year lending rate by another 25bp and see a further 200bp reduction in the reserve requirement ratio (RRR) in the remainder of 2015. With the RMB seemingly more flexible and market-orientated, the transmission mechanism between monetary policy and the currency may be more pronounced than we have seen previously. 2. US economic data

Just as important as China’s economic data will be the data from the US over the coming weeks. Further evidence that the US labour market is improving will only increase the possibility that the Fed decides to pull the tightening trigger. HSBC does not expect the Fed to move until December 2015; however, once again, the new market-orientated RMB exchange rate may be more sensitive to signs of cyclical economic divergence between the US and China.

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3. Political events

The importance of China’s FX policy for the global economy is unquestionable. This is clearly visible by the share of the RMB in the Federal Reserve’s broad USD index (Chart 12) – the share of the RMB in the index is almost the combined weight of the EUR and the JPY. As such, further periods of RMB depreciation could trigger FX tension elsewhere, which may lead to political ‘condemnations’ of China’s FX policy and encourage some countries to become more actively engaged in a ‘currency war’. Whilst this is not our base-case scenario, the risks are certainly present and, therefore, it is important to watch political events ahead, in particular, the upcoming President Xi’s visit to US in September. Any signs that policy makers in the US or other major countries are becoming seriously concerned about the pace of the depreciation of the RMB could lead to additional uncertainties in the financial market, especially if it causes the Fed to postpone its potential rate hike. The IMF’s SDR decision will also be closely watched, including the Executive Board’s decision on the prosed extension of the current SDR basket later this month and its formal review on the composition and valuation of the SDR basket towards the end of the year.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

13. Monitor hot money outflows…

14….as well as market development indicators

USD bn 120 100 80 60 40 20 0 -20 -40 -60 -80 -100 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Hot money flows Services trade, income & non-FDI flows Trade balance Banks' FX purchase

2000

Source: CEIC, HSBC

Source: CEIC, HSBC

4. FX flow data

The likely FX outflows, triggered by the PBoC’s fixing reform, will also need to be monitored. However, as we have written before, corporates’ FX deleveraging started as early as 2Q14, which makes them less vulnerable to currency depreciation this time round. According to our estimates, cumulative hot money outflows have reached USD420bn since 2Q14 (Chart 13), reversing much of the inflows since 2012. We think China should not be overly fixated on its external debt. After all, China’s current stock of foreign currency debt, scaled by GDP and/or FX reserves, is not particularly high compared to other EM countries. Indeed, China has already started borrowing abroad in its own currency, in CNH, via trade credit, bank deposits, loans and bonds. This trend will likely only grow as capital controls are further liberalised. 5. Market development data

Other indicators of market developments will also be important for the RMB. These include RMB trade settlement, offshore yuan deposits and offshore bond issuance (Chart 14). With one-way RMB appreciation expectations no longer prevailing, these measures will provide the litmus tests for the offshore yuan market. Foreign demand for yuan-denominated assets could also slow down initially on RMB depreciation

Offshore RMB deposits RMB bn

RMBbn

600 500

1500

400

RMB trade settement 1000

300 200

500

100

0 Jan-11

0 Jan-12

Jan-13

Korea Taiwan RMB trade settlement (RHS)

Jan-14

Jan-15

Singapore HK

expectation. However, we believe this would only be a temporary phenomenon, and demand for Chinese assets will eventually return as the RMB finds its new equilibrium level. This has tended to be the case for all other major currencies, and the RMB should not be an exception. We have argued before that with the introduction of more cross-border channels, most of which are denominated in RMB, the movement of RMB between onshore and offshore will become more dependent on capital account flows (RMB liberalisation: last few hurdles, 16 June 2015). With the PBoC reducing its control on the spot exchange rates and still committing to full capital account convertibly, we should expect the offshore RMB interest rates to increasingly follow the onshore market. Under China’s current macro context this should lead to lower interest rates in the offshore market, which will help corporates to denominate their borrowings in the yuan. As Chinese corporates expand into overseas markets, encouraged by the “One Belt, One Road” programme, more RMB will be brought to overseas markets through cross boarder lending. However, even for the offshore yuan asset markets, China’s decision to let the market find the true value in the yuan should also gradually remove the risk premium in the FX forward

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

15. Asia currencies have outperformed

16. EM countries’ exports destination

120

100%

110

80%

100

60%

90

40%

80

20%

70

Asia-G3

EMEA-G3

LatAm-G3

Source: Bloomberg, HSBC

curves and, therefore, reduce FX hedging cost. This should enhance foreign investors’ confidence in investing in China in the future.

Conclusion – trading the new regime The PBoC’s fixing reform marks a new era for the RMB in which market forces will play a much greater role in determining the value of the currency. These changes will have far-reaching consequences, not just for the RMB but also for many other currencies. We expect the trading dynamics of the RMB to change considerably as the currency becomes more ‘data-dependent’ and also more sensitive to domestic monetary policy. It is also likely the RMB will be susceptible to external risk events, such as the looming Fed tightening cycle. As a result, we believe the RMB will see permanently higher two-way volatility from hereon. Greater flexibility in the RMB will also likely feed through to structurally higher volatility for other Asian currencies. With the market no longer expecting one-way RMB appreciation, we suspect Asian currencies will find it challenging to sustain their outperformance against G3 currencies and EM counterparts like they have done over the last decade (Chart 15), especially when their growth and inflation mix is less supportive.

30

USD

JPY

ZAR

TRY

RUB

BRL

MXN

THB

TWD

PHP

EUR

SGD

MYR

Jul-13

IDR

Jul-11

KRW

Jul-09

INR

0% Jul-07

CNY

60 Jul-05

Exports by destination, % GDP

CNY

Source: Comtrade, HSBC

In particular, currencies that are far more leveraged on China for exports (Chart 16), such as the KRW, the TWD, the BRL and the ZAR in the emerging markets, will be more sensitive to a weaker RMB. There is a growing risk that some of these countries, especially those with a smaller currency mismatch (Korea and Taiwan, for instance), become increasingly tolerant of local currency depreciation. For the RMB itself, we expect to see three key developments:  Permanently higher RMB volatility (Chart 17). Note, however, even after the recent depreciation, the RMB’s volatility remains low, compared to most major currencies.  The three RMB curves (onshore USD-CNY, offshore USD-CNH and USD-CNY NDF) will converge further to one curve (Chart 18). The NDF market’s significance will drop further.  The FX-implied yields will gradually track onshore interest rate closer. It is important to stress that these three trends will only materialise if the PBoC continues to reduce its presence in the FX market and China pursues it liberalisation of the capital account. Undoubtedly, we believe there still remains great uncertainty about what a freer yuan actually means for China and global financial markets;

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

17. The RMB’s volatility is rising 25

18. Moving towards one curve system

6.90

3-month implied volatility (%) RUB

20

Tenor (years)

USD-RMB

6.70 6.50

15

NZD AUD MXN CHF CAD SGD

10

RMB*

5

0

JPY

GBP

6.10 5.90

Average daily FX turnonver (% total)

HKD

0

6.30 EUR

10

20

30

40

Source: BIS, HSBC. *RMB vol refers to CNH vol

0.0

0.5

1.0

1.5

USD-CNH

USD-CNY NDF

USD-CNY onshore

2% band on spot

2.0

Source: Bloomberg, HSBC

however, for sure, near-term volatility in both the RMB and global FX markets will be unavoidable. While the FX reforms have made the RMB less easy to predict going forward, we don’t believe this would derail the currency’s internationalisation process. This is because we don’t believe China is making the changes to purposefully weaken its currency to boost trade share and hurt the interests of foreign investors. A more flexible yuan exchange rate increases China’s monetary policy room and reduces the risk of systemic imbalances in a full capital account convertible scenario. We believe this will enhance market participants’ confidence over time. Finally, the fixing reform itself highlights China’s commitment to both RMB internationalisation and capital account liberalisation. By giving up control in the spot exchange rate against the USD, China will be more equipped to meet the challenges in a full convertible scenario.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Appendix 1. Comparing RMB fixings with fixing mechanisms of other Asian currencies

USD-SGD and USDTHB USD-IDR

Onshore fixing

Offshore fixing

Deliverable fixing

NA

NA

Volume-weighted average price (VWAP) of inter-bank spot transactions as collated by the Association of Banks in Singapore (ABS). NA

The IDR fix is taken two days prior to value date and is the rate published by Bank Indonesia at 10:00am Jakarta time. It is a weighted average rate of USD-IDR spot transactions traded in the inter-bank market by commercial banks during the data capture window of 08:00-09:45am. The cut-off time for data capture is 09:45am. USD-MYR The onshore spot benchmark is based on the arithmetic mean of the mid-points of the MYR spot rate submitted by contributing banks. Submission occurs from 10:55am to 11:00am local time. USD-INR The fixing is a rate that is derived by a poll anytime in a five-minute window between 11:30am and 12:30pm two business days prior to value date. The RBI will decide on the number of onshore banks to poll. It is published at 1:30pm on the RBI’s website. USD-TWD The TWD fixing is a snapshot of the onshore market price at 11:00am Taipei time two NA business days prior to value date. USD-CNH NA NA The spot fix is based on rates supplied by panel banks selected by the Hong Kong Treasury Markets Association. The contribution is for the rate at which the bank would transact at 11am HKT. The highest and lowest three rates are removed and the arithmetic average of the remaining contributions is taken as the reference rate. There must be at least 14 contributed rates received to perform the fixing. It is published at 11:15am HKT. USD-CNY The CFETS, authorised by the PBoC, calculates and publishes the central parity of NA RMB against the USD and other major foreign currencies on each business day. It enquires prices from all liquidity providers before the opening of the market on each business day, excludes the highest and lowest offers, and then calculates the weighted average of the remaining prices in the sample as the central parity of the RMB against the USD for the day. The weights are determined by the CFETS in line with the transaction volumes of the respective liquidity providers in the market, as well as other indicators, such as the performance of market-making. These weights are not published. G7 WM/Reuters fixing at 4pm UK time is calculated by extracting the median bid and currencies* offer rates at 15 second intervals from 2 minutes 30 seconds before 4pm to 2 minutes 30 seconds after the fix time. Source: Central banks, Reuters, HSBC. *Note G7 currencies have many fixings and WM/Reuters fixings are just one set of them.

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China’s reserves: Down but not out  China reported FX reserves for August with the headline data

falling to USD3.56tn from USD3.65tn previously…  …and are at their lowest point since August 2013  Reserve adequacy fears are misplaced, in our view

This is an edited excerpt, combined from Asian FX: China’s reserves: Down but not out, published 7 September 2015. China released its FX reserves data for the month of August, showing headline FX reserves fell USD94bn to USD3.56tn. This is the largest monthly drop of FX reserves on record, and reserves have now dropped to August 2013 levels. If we adjust the nominal decline in FX reserves for valuation effects, we estimate that the People’s Bank of China sold roughly USD107bn to stabilise the RMB in August, amid heightened concerns over the economy and uncertainty over the currency's fixing reforms.

This follows on from USD selling pressures that started rising notably in July. There are still some unknowns with this data. First, FX reserve data does not show the activity by the PBoC in its FX forward book. Despite media reports of the central bank using FX swaps in August, we may not obtain an indication as to the amount of such activity until end-September, when PBoC releases details on its reserves in the IMF's standard template. Second, estimated valuation effects could be inaccurate if China's portfolio allocations by currency deviate significant from the allocations as per the IMF's COFER

1. August registered record USD selling by the PBoC

2. Hot money outflows still dominate with corporates reducing their net FX liabilities

125 USDbn 100 75 50 25 0 (25) (50) (75) (100) (125) Feb-11 Feb-12

USD bn 120 80 40 0 -40 -80 -120 -160 -200 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 "Hot money" flows Services trade, income & non-financial FDI flows Trade balance Banks' FX purchase

Feb-13

Feb-14

Feb-15

Nominal chg in spot FX reserves Estimated central bank intervention Source: Bloomberg, CEIC, IMF, HSBC *Valuation effect based on COFER weights

Paul Mackel Head of EM FX Research The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Ju Wang Senior Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4340 [email protected] Joey Chew Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected]

Source: Bloomberg, CEIC, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

survey (which we use in our estimation). Lastly, it is next to impossible to estimate income effects or other idiosyncratic movements in FX reserves. Hence, it is not until China releases its Q3 balance of payment data (sometime in early November) will the actual amount of FX intervention be known. August drawdown in China’s FX reserves is indeed large but contrary to some thinking of late, we do not see China’s FX reserve adequacy being a major concern (Reserve adequacy & the RMB, 1 September). Adequacy levels can vary substantially for economies with different currency regimes and degrees of capital controls. China's fixing reform implies that the PBoC now has a choice to let the exchange rate adjust more to relieve pressures on reserves, if necessary. Meanwhile, existing capital account restrictions suggest that capital flight is unlikely to spiral out of control. Although the PBoC has been leaning against RMB depreciation pressures recently, this should prove temporary. The RMB needs to trade with greater volatility and to reflect expectations of policy divergence between the Fed and the PBoC. We see gradual RMB weakness emerging with our year-end USDCNY call at 6.50.

3. Q-series have been stable USD bn 100

Reserves had the largest monthly drop in August, likely on corporate outflows China's reserves fell sharply in August by USD94bn, the largest monthly drop on record. After taking into account a positive valuation effect (given the appreciation in the EUR and JPY), we estimate that PBoC could have sold USD107bn in August (Chart 1), in an effort to stabilize its currency after the fixing reform on August 11. In our view, FX outflows were likely dominated by corporates’ FX de-leveraging activities. This will be reflected as outflows from the "other investment" account (which comprises of movements in FX deposits, loans and trade credit) in the balance of payments (Q3 data expected to be released in November). In comparison, the current account and net FDI should have remained in surplus. Portfolio flows appear fairly stable, with the QFII quota largely unchanged in August, RQFII quota raised by RMB4bn, and the Stock Connect scheme actually registering small net inflows, while China has stopped issuing QDII quotas since March (Charts 3-4).

Reserve adequacy not an imminent concern China’s FX reserves have fallen 10% from a year ago, although the decline is a more moderate 6%, after adjusting for valuation effects. Due to this 4. …and so were stock connect flows

China, accumulated foreign investement

RMB bn 500

80

400

60

300

40

200

20

100

0

0

180 RMB bn 160 140 120 100 80 60 40 20 0 Dec-14 Feb-15

03 04 05 06 07 08 09 10 11 12 13 14 15 QFII USD Source: CEIC, HSBC

34

QDII USD

Apr-15

Jun-15

Cumulative South-bound flows Cumulative North-bound flows

RQFII RMB (RHS) Source: CEIC, HSBC

Aug-15

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

unprecedented decline, there has been more discussion about whether China's reserves are sufficient to cover its potential liabilities. China's short-term external debt is around USD1.18tn as of March 2015, of which the portion that is denominated in foreign currencies amounts to around USD660bn, by our estimates. There are also other liabilities to consider. China's largest foreign liabilities are actually related to the stock of FDI, which stands at roughly USD2.75tn (as of March 2015). Part of this is retained earnings that could be repatriated (Chart 5). Although the potential claims on reserves appear daunting, the probable claims under most circumstances are likely to be smaller. After all, China still has some restrictions on capital outflows via quotas and administrative regulations, which implies significant capital flight is unlikely to spiral out of control. Indeed, the latest PBoC measures on reserve requirements for FX purchases in derivatives, which could raise the costs for corporates to buy FX forwards, should lead to a slower pace of FX outflows (see RMB: FX policy fighting back for now,

1 September 2015). Moreover, China's fixing reform implies that the PBoC now has a choice to let the exchange rate adjust more to relieve pressures on reserves, if necessary. Finally, we note that China still runs an annual current account surplus of nearly USD300bn. There is no single optimal metric of reserve adequacy for any economy, much less than a one-size-fits-all approach for comparison across economies. Even so, China, by most standard metrics, still appears to have one of the strongest external balance sheets in the region. The only indicator that China is relatively weaker comes down to the measure of FX reserves-to-M2 ratio. That said, we note that it is highly unlikely Chinese residents will be able to shift a large amount of RMB deposits into foreign currencies, given the size of the China’s economy (hence, the necessity to retain RMB for use) and the still-limited FX conversion channels (i.e., annual quota of USD50k per person). There are also concerns that China's FX reserves, even if adequate, may not be liquid enough to cover potential outflows in the near

Table 1: Conventional FX reserve adequacy measures1

July 2014 Import cover, months Ratio to ST external debt2, % Ratio to M23, % Ratio to IMF metric (floating)4, % Ratio to IMF metric (fixed)5, % July 2015 Import cover, months Ratio to ST external debt, % Ratio to M2, % Ratio to IMF metric (floating), % Ratio to IMF metric (fixed), %

CNY

INR

IDR

KRW

MYR

PHP

SGD

TWD

THB

24 554% 21% 276% 155%

8 325% 18% 150% 93%

7 221% 31% 131% 88%

8 278% 18% 135% 84%

7 112% 26% 131% 89%

13 739% 45% 228% 149%

9 25% 49% 67% 58%

19 247% 35% 236% 155%

8 258% 32% 213% 136%

24 310%* 17% 213% 123%

9 390% 19% 163% 100%

8 223% 31% 119% 81%

9 320% 18% 138% 86%

5 95% 22% 104% 71%

13 549% 44% 217% 143%

9 24% 46% 63% 54%

20 256% 34% 222% 147%

8 280% 31% 198% 126%

Notes: 1) Boxes shaded in light red reflect the failure to meet the recommended adequacy level for the respective indicator. The conventional minimum benchmark for import cover is three months. The "Greenspan-Guidotti" rule suggests a 100% cover of short-term external debt. A 15-20% cover ratio for broad money is generally deemed sufficient. The IMF said that reserves in the range of 100-150% of the relevant composite metric are considered broadly adequate for precautionary purposes. We use the latest available FX reserves (the foreign currency and securities component of official foreign reserves, which would otherwise also include gold holdings and IMF deposits) in our calculations. 2) It is important to note that not every economy reports short-term external debt by the same reporting standards. The Philippines only switched to the 2013 IMF EDS definition in Q4 2014, and China adopted the convention in Q2 2015. Hence, there could be differences in the ratios for the two economies between July 2014 and July 2015 (a sharp drop in cover ratios) that are solely due to data issues. 3) We use M3 for India, and DBU and ACU M2 for Singapore. 4) The IMF's composite metric is calculated as follows: 30% of ST external debt + 15% of "other liabilities" + 5% of broad money + 5% of annual export receipts. "Other liabilities" refer to portfolio liabilities and other investment liabilities, as per IIP data, less ST external debt (to avoid double-counting). See IMF's paper: http://www.imf.org/external/np/pp/eng/2014/121914.pdf 5) For fixed exchange rate regimes, the weighting pattern for the metric is adjusted to: of ST external debt + 20% of "other liabilities" + 10% of broad money +10% of annual export receipts. None of the able EM Asia currency regimes are regarded as fixed, de jure or de facto, by the IMF, so this is metric is only for reference. Source: HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

5. China's external liabilities (External debt and FDI)

6. China holds other liquid assets apart from USTs

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0

1.2

2.5

1.0

2.0

USD bn Assets

0.8

1.0

0.4 0.2

0.5

0.0

0.0 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14

ST ext debt

IIP ODI/FDI

Portfolio

Other investment

Reserves

China's holding of USD assets

1.5

0.6 Liab

USDtrn

USD: Trade credit USD: Other (deposits) RMB: Deposits RMB: Other (loans)

Treasuries Corporates and other bonds Others

Source: CEIC, HSBC

Agency bonds Stocks

Source: US Treasury TIC data

term. Again, we believe that there are flaws with this logic. While it is true that China only has about USD1.27tn of its FX reserves in US Treasuries (as of June), it has other liquid USD assets such as US Agency debt, corporates bonds and equities (Chart 6). We believe China also has liquid non-dollar assets, mostly in EUR, as well as in GBP and JPY. Furthermore, the valuation of these non-dollar assets, which fell sharply over the past year, and was another reason for the drop in headline reserves, could start to ease from hereon.

comfortably hold much fewer FX reserves than it has today. As such, we expect China to resume its plan for FX reserve diversification over the medium term - using reserves to recapitalize policy banks and support corporates' overseas expansion. A more independent monetary policy and FX reserve diversification will help China to find better uses for its excessive domestic savings (Charts 7-8).

Here today…gone tomorrow? Looking beyond the near-term volatility in the RMB, we believe that PBoC's decision to change the onshore fixing mechanism on 11 August 2015 is a key step towards an effective, free-floating regime eventually. In our view, this will, over time, mean that the PBoC can 7. FX reserves to free up monetary policy…

8. …which will help China allocate its savings more efficiently

% 4,500 USD bn 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15

60

15

50

10

40

5

30

0

FX reserves (LHS) RRR: Smaller banks Source: CEIC, HSBC

36

24 22 20 18 16 14 12 10 8 6 4

20 Jan-83

Jan-93

Jan-03

Current account surplus, % GDP, rhs Savings, % GDP

RRR: large banks

Investments, % GDP Source: CEIC, HSBC

-5 Jan-13

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

MYR: Tough questions  We consider the risk factors for MYR, the conditions for it to

stabilise, and some policy options if things worsen quickly  The probable claim on FX reserves is not as high as some believe

and external fundamentals are not as bad as in 1997  The trend is still seen as upwards for the USD-MYR, we raised

our forecast to 4.30 by end-2015

This is an edited excerpt, combined from Asian FX Focus: MYR: Tough questions, published 9 September 2015.

Q1: Will USD-MYR rise further? USD-MYR has already gone above our earlier year-end forecast of 4.15. Many look to key USD-MYR levels during the Asian financial crisis as a gauge for how much higher the currency pair can go. From that perspective, the next key levels for USD-MYR are 4.71 – the historical high in closing levels, which was reached on 8 January 1998 – and 4.88 – the historical high in intra-day levels, which was reached on 7 January 1998 (according to Reuters). However, we believe that this historical comparison of bilateral exchange rates can be misleading – this time around, the broad USD is appreciating also on its own merits (widening growth differentials and monetary policy divergence with most parts of the rest of the world), whereas its strength during the mid-1990s was more a reflection of EM-specific weakness (LatAm crisis, Asian crisis). In other words, it is possible for USD-MYR to go into uncharted

territory – indeed, that has already happened for a number of other EM currency pairs. Up until recently, the rise in USD-MYR since Q3 2014 can be said to be more a function of broad USD strength than idiosyncratic MYR weakness (Chart 1). The risk is that countryspecific risk factors (elaborated below) become more dominant in driving USD-MYR from here. In our view, some of these factors may already be partly reflected in the currency level. We raise our USD-MYR forecast to 4.30 for end-2015 and 4.40 for end-2016 (from 4.15 and 4.30, respectively). It is very difficult to quantify a "worst case" scenario. A historical perspective suggests we are not there yet: the MYR depreciated by around 35% on a NEER basis over 11 months during the Asian financial crisis in the late 1990s, whereas that index is only down by around 11% over the past 12 months (Chart 2). We believe it is more difficult for the MYR to spiral rapidly out of control today than in 1997-98, given the policy of non-internationalisation of the currency after the Asian financial crisis (see Q4).

Paul Mackel Head of EM FX Research The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Ju Wang Senior Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4340 [email protected] Joey Chew Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Alastair Pinder Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 1672 [email protected]

Ultimately, the "worst case" scenario will be one decided by policymakers. We believe their

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

1. USD-MYR started to diverge from the broad USD trend since July 130

Jul-14=100

reverse scale

125

90 92

120

94

115

96

110

98

105

Jun-15

100

100

95 102 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 USD TWI USD-MYR MYR NEER, RHS Note: We use the Fed's USD trade-weighted index. Source: CEIC, HSBC

2. Idiosyncratic MYR weakness only became more dominant recently, and there is still a long way to fall MYR NEER index

105 100 95 90 85 80 75 70 65 60

Jul-15 Aug-15

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Sep-14=100 Mar-97=100 Source: CEIC, HSBC

"tolerance limit" is determined by the economic costs of MYR depreciation, rather than considerations of any specific USD-MYR or MYR NEER levels. If that "tolerance limit" is breached, the authorities may have to implement more administrative measures to curb MYR depreciation (see Q3 for some examples).

What are some of the downside risks factors for the MYR? 1. A deeper terms-of-trade shock

USD cannot help shore up palm oil export revenue in MYR terms, like it had for the fuel trade balance over the past year. Palm oil exports account for around 8% of Malaysia's exports, and although they were down 10% y-o-y in H1, they are still the main contributor to the trade balance (Chart 4). If crude palm oil prices stay at average August levels (MYR1900/mt) for the rest of the year, and export volumes do not improve, we estimate that the current account balance could be lower by MYR4bn in H2, compared to H1 (MYR18bn).

Oil prices took another step-down in July and August. More importantly, palm oil prices came under significant pressure too (Chart 3). Malaysia's palm oil exports are priced in MYR, unlike oil and gas products that are denominated in USD. Hence, MYR depreciation against the

2. A sustained rise in global risk aversion,

3. Malaysia's petroleum and crude palm oil prices have fallen sharply quarter-to-date

4. Composition of Malaysia's exports and trade balance (H1 2015)

120

USD/bbl

100

MYR/mt

2500 2300

leading to significant foreign capital reversal

The MYR is sensitive to external developments

100%

200%

80%

150%

60% 80

2100

60

1900

40% 20%

Malaysian crude oil ("Tapis")

Source: Bloomberg, HSBC

38

Crude palm oil (RHS)

8% 7% Exports

Crude oil Palm oil

70%

50%

54%

0%

0% 40 1700 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15

100%

-50% -100% Trade balance Refined petroleum MTE

LNG Others

Note: MTE refers to machinery, electronics and transport equipment Source: CEIC, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Thousands

5. Foreigners have unwound a large portion of their earlier inflows into Malaysia's stock market over the past year 6

MYR bn

MYR bn

4

60 50

2

40

0

30

(2)

20

(4) (6)

10

(8) Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

0

6. Foreign holdings of MGS remain very high and are at risk of being pared down in the coming months 180 MYR bn 160 140 120 100 80 60 40 20 0 Jan-08 Jul-09

because of the openness of the economy and the large foreign positions in Malaysia's equity and government bond markets. While foreign holdings of equities and of BNM bills have already fallen sharply (Charts 5-6), that has not been the case for their investments in government bonds. In fact, foreigners bought MYR22bn of MGS and GII between July 2014 and June 2015. The selling only started in July (MYR3bn) and August (MYR7.5bn). HSBC FI strategy estimates that if active bond fund managers reduce their weighting of MGS by 1%-2% relative to the benchmark, that could trigger an additional MYR13bn-30bn of outflows (8%-18% of foreign holdings) in the coming months (see Tide of change for Malaysia bonds, 13 August 2015). This is comparable to what happened during the "Taper tantrum" in 2013 – a decline of MYR19bn, or 13% of the foreign holdings then, over three months. In a more severe scenario, amid significant institutional and retail redemption in bond funds, we recall that foreign MGS positions halved over 11 months during the global financial crisis in 2008-09. 3. Political uncertainty spills over into policy risk

It is difficult to gauge the impact of political uncertainty on MYR depreciation thus far. Although we calculate that the correlations between USD-MYR and other key explanatory

Jan-11

Jul-12

Jan-14

Jul-15

Foreign holding of BNM and treasury bills Foreign holding of MGS and GII USD-MYR (reversed, RHS)

Foreign equity flows Accumulated flows from 2010 (RHS) Source: CEIC, HSBC

2.8 3.0 3.2 3.4 3.6 3.8 4.0 4.2 4.4

Source: CEIC, HSBC

factors earlier – commodity prices, broad USD strength – have fallen recently (Chart 1), but that pattern could also reflect BNM's initial reluctance in allowing the 3.80 level to break in July, and then the disruption to Asia FX after China's fixing reform announcement on 11 August. We believe politics will become more significant for the currency if policy risks and economic costs start to materialise as a result. The ratings agencies are monitoring the government's fiscal consolidation progress (note: the 2016 budget will be tabled on 23 October). Given the market’s focus on Malaysia's FX policy, we believe the succession plan for Governor Zeti (her terms matures in April 2016) will also be closely watched. FDI inflows remained robust in H1 and it will be taken negatively if they fall sharply in H2 – although it will be difficult to separate the impact of politics from economic considerations – the moderation in growth, for example.

Is there a limit to BNM's tolerance for MYR depreciation? Although the BNM has rightly said that currency flexibility is a shock absorber for the economy against terms of trade deterioration and other external challenges, there could eventually come a point whereby the costs of currency depreciation become too high to tolerate. There are two main economic costs stemming from a weaker

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Table 1: Some estimates of MYR undervaluation

Methodology

Assessment date Exchange rate (bi/multi-lateral) Estimated MYR undervaluation, %

The Economist

IMF

Peterson Institute for International Economics

HSBC (using The Conference Board's TFP estimates and BIS REER indices)

The Big Mac Index (Adjusted; based on PPP theory)

Staff's assessment (based on its External Balance Analysis and regressions)

Fundamental Equilibrium Exchange Rates

Deviation in (productivity-adjusted) REER from a long-term average (since 1994)

July 2015 USD-MYR

End-2014 MYR REER

April 2015 MYR NEER USD-MYR

36%

8-18%

3.7%

16.2%

July 2015 MYR REER MYR REER (TPF-adjusted) 4.1%

6.9%

Source: The Economist (http://www.economist.com/content/big-mac-index), IMF (http://www.imf.org/external/np/pp/eng/2015/062615a.pdf);, Peterson Institute for International Economics (http://www.iie.com/publications/interstitial.cfm?ResearchID=2787), HSBC

currency: 1) higher imported inflation; and 2) an increase in external debt burden. Both costs, if sufficiently large, could affect consumption, investment and employment, thereby overall economic growth. In our view, a material and persistent overshooting of inflation from BNM's forecast (2%-3%) could potentially incite a monetary policy response, while substantially weaker growth (forecast: 4.5%-5.5%; 5.3% ytd) could trigger more decisive measures to stabilise the MYR (see Q3 for examples). That said, BNM does not appear worried about the external debt servicing capacity of Malaysian corporates as yet – most companies it had surveyed either have natural or financial hedges in place (see Quarterly Bulletin, Q2 20155, published 13 August 2015).

Q2: What is the MYR's "fair value"? Conventional currency valuation metrics – the IMF's external balance analysis, the Peterson's Institute for International Economics' Fundamental Equilibrium Exchange Rate analysis, and the Economist's Big Mac index – all suggest that the MYR is under-valued (Table 1). Our method of first adjusting the BIS's

5 http://www.bnm.gov.my/index.php?ch=en_press&pg=en_press_all&a c=3250&lang=en

40

MYR REER for relative productivity growth visà-vis its trade partners, and then comparing that to a long-term average, also indicates that the MYR is broadly undervalued. But we have to stress that currency valuation assessment is an art, rather than a science. A currency's "fair value" is a dynamic and qualitative judgement. It is likely to be in flux, as underlying fundamentals change on the back of an external shock, for example. In any case, undervaluation could persist for a long time. It is more useful to discuss the conditions under which the MYR can start to stabilise, and maybe even regain some ground. We do not expect a swift and significant turnaround even if all the conditions are fulfilled, however. BNM intends to rebuild FX reserves when the opportunity arises again, which would be very prudent in our view. Our forecast of USD-MYR at 4.40 for end-2016 should be seen in this context.

What are the conditions for the MYR to stabilise? 1. An improvement in the outlook for commodity prices

While MYR depreciation can mitigate the loss of fuel export income (in MYR terms), that is not a sustainable solution for the economy. Investment growth, and eventually employment, will be affected if the outlook for commodity prices remains bleak. Resources-related industries

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

7. Malaysia's capital goods exports have outperformed the region, reflecting the product/destination mix and support from currency underperformance

8. Onshore and NDF liquidity conditions for USD-MYR have deteriorated recently

MTE export volumes (% y/y, 3mma) 25% 20% 15% 10% 5% 0% -5% -10% -15% Jan-13 Jul-13 Jan-14 Jul-14 CNY KRW MYR THB

500 400 300 200 100 0 -100 -200 -300 -400 Jan-15

Jan-15

Jul-15 TWD

Persistently low commodity prices will also affect the government's balance sheet (30% of revenues are oil-related). The silver lining is that petroleum subsidies were removed this year, which could potentially save the government some MYR10bn-20bn (the equivalent of 4%-8% of revenue) per year (Reuters, 21 November and The Sun, 29 November). 2. Stronger external demand

The weaker MYR has probably helped Malaysia's non-commodity exports to outperform many others in the region (Chart 7). But due to weak global demand, even an outperformance could only provide a modest cushion to growth. The Malaysian economy is very open. According to 2011 input-output tables from the OECD, the share of foreign value-added in its total final demand is about 45%, which is amongst the highest in major advanced and emerging economies (second only to Singapore in Asia).

80 60 40 20 0 Mar-15

May-15

Jul-15

Sep-15

NDF bid-ask spread (RHS) Offshore-onshore spread - 1m forward

Source: CEIC, HSBC

comprise 23% of Malaysia's GDP and nearly 15% of formal employment in 2014.

100

Source: Bloomberg, HSBC

transactions in the inter-bank market plunged (MYR82bn in July, down 30% from the average in H1). The bid-ask spreads have also widened in both onshore forwards and offshore NDFs, while the basis between the two became large and volatile (Chart 8). Positioning in FX derivatives – as suggested by risk reversals – remains very one-sided in favour of USD calls. There were local media reports of a clampdown on certain USD-buying transactions recently (The Sun, 20 August 2015), which have been refuted by BNM. We believe the authorities are not imposing fresh prohibitions, but they are strengthening regulatory checks and the enforcement of existing rules (refer to BNM's FX administration rules6). The administrative burden for FX purchases has likely risen as a result, which may have been reflected in higher transaction costs and lower market liquidity.

3. More normal liquidity conditions in the onshore and offshore NDF markets

The restoration of exchange rate equilibrium requires conducive market conditions. Recently, the turnover of onshore spot USD-MYR

6

http://www.bnm.gov.my/index.php?lang=en&ch=en_newfea&pg=en_ newfea_overview&ac=355&eId=box1

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

Q3: What are some of Malaysia's FX policy options? BNM has a low level of FX reserves, but concerns of "inadequacy" are overblown Malaysian policymakers appear to be on the right path now, in our view. BNM has allowed more flexibility in the exchange rate since August, as opposed to holding it steady at the 3.80 level all through July. As a result, FX reserves (i.e. excluding gold, SDR and deposits at IMF) fell only USD1.9bn in August (in fact, they rose by USD0.5bn in the last two weeks of August, to USD86.4bn), compared to a decline of USD8.6bn in July (Chart 9). We believe that persistent intervention at a fixed exchange rate level tends to be counter-productive: it usually leads to more speculation and over-shooting in the exchange rate later. There are concerns that the low level of FX reserves will be a serious constraint on BNM, as those may be inadequate to meet potential capital outflows and smooth market volatility. We disagree. As we discussed in the recent Policy Dashboard (1 September 2015) traditional reserve adequacy metrics are flawed – they do not account for foreign assets in the private sector (which Malaysia has). In any case, those measures nevertheless indicated that when the MYR

9. BNM resumed its policy bias for currency flexibility in August – it even managed to purchase some USD 2.0

USD bn

3.00 3.20

0.0

3.40

-1.0

3.60

-2.0

3.80

-3.0

4.00

-4.0

4.20 4.40

Jul-13

Jan-14

Jul-14

Jan-15

Change in BNM FX reserves USD-MYR (RHS, reverse scale) Source: Bloomberg, HSBC

42

Jul-15

Malaysia's short-term external debt is indeed high (USD92bn as of end-June 2015), but not all the debt has immediate claim on FX reserves. Corporate short-term external debt (22% share) probably has the highest priority. But even that is largely in the form of trade credit, which is partly supported by export earnings (for trade credit on imports of intermediate goods, for example). The lion's share of short-term external debt is owned by banks (72% share, of which 28% comes from non-resident deposits and the remaining 44% from offshore inter-bank borrowing; Chart 10). But crucially, banks have near offsetting amounts of assets – claims on offshore banks and foreign investments. According to the BNM, a large component of banks' short-term external debt (and offsetting foreign assets) is related to their centralisation of foreign currency liquidity management – offshore subsidiaries of Malaysian banks place excess FX liquidity with the headquarters in Malaysia to manage (and purchase US Treasury 10. Potential claims on FX reserves are not as high as some believe, under most circumstances

1.0

-5.0 Jan-13

started weakening in Q3 2014, Malaysia's reserves were lower than others in the region, but nevertheless (slightly) above the minimum levels deemed necessary for meeting potential balance of payments shocks. Whether reserves ultimately proved to be enough for precautionary reasons is yet to be determined.

160 140 120 100 80 60 40 20 0

USD bn

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 ST interbank loans Corp ST ext debt Foreign bond holdings

Non-resident deposits Foreign bill holdings FX reserves

Note: Portions of stacked column with black outlines constitute short-term external debt. Source: CEIC, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

bills, for example). As such, we see little risk with this portion of short-term external debt, barring a major, global financial crisis and liquidity crunch. Some may include foreign holdings of BNM bills and MGS as potential claims on FX reserves. But here, we must point out that foreign positions are unlikely to be entirely liquidated, even in a worst case scenario (see Q1), and that BNM is more likely to allow the currency to adjust (weaker) rather than drain its reserves to facilitate foreign selling. We also believe BNM could augment its FX reserves through the following ways: 1. Use FX swaps. In July, BNM acquired a net short FX forward position of USD1bn (having ceased to be net long FX forwards since November 2014). We note that many other EM central banks have net short FX forward positions. For example, Indonesia is currently net short USD8bn forwards, Korea was net short USD11bn forwards at one point during the global financial crisis, and India was net short USD33bn forwards (including longer-dated swaps) after the "taper tantrum" in 2013. 2. Tap into existing currency swap lines with other central banks. Malaysia is part of the Chiang Mai Initiative Multilateralization (CMIM) arrangement with the other ASEAN+3 members (ASEAN plus China – including Hong Kong – Japan and Korea). The arrangement provides financial support in USD through local currency swap transactions. 30% of the maximum drawable amount by any member is quick disbursing (i.e. within two weeks following the swap request notice by a member to the council) and without the need for an IMF program. This means Malaysia can access up to USD6.8bn of USD liquidity (30% of USD22.76; with 6 months maturity).

BNM also has bi-lateral arrangements with the People's Bank of China – to swap MYR90bn for RMB180bn – and with the Bank of Korea – to swap MYR15bn for KRW5tn. But since those arrangements are not for USD liquidity, their usage will be more limited. For example, RMB trade settlement accounts for just 2% of the total trade between China and Malaysia (Xinhua, 23 July 2015). Malaysia and Thailand signed a MoU to establish the direct settlement of bilateral trade and direct investment in their local currencies on 27 August. While this is not a policy measure that would help the current situation, it is a good approach to diversify from the economy's USD needs over the medium term.

Administrative measures if the situation destabilises significantly Prime Minister Najib Razak formed a special economic team to formulate strategies to maintain economic growth and stabilise financial markets. The team is led by Economic Planning Minister Abdul Wahid Omar and will include leaders of major corporations (for example, CIMB, Maybank, and Khazanah) as well as a couple of academics. In our view, the government should focus on policies and structural reforms that would enhance Malaysia's growth potential so as to attract more stable and longer-term FX funding into the economy – i.e. FDI inflows. But if the MYR destabilises further and starts to have a notable negative impact on the economy (see Q1), the authorities may have to consider more immediate measures, such as provide higher interest rates and tax incentives to stem outflows, and encourage the repatriation of residents' foreign assets.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

11. FX deposits onshore have not picked up as much as some may think

12. Malaysia does not have a large net external liability position today

120

150% 125% 100% 75% 50% 25% 0% -25% -50% -75% -100% -125% -150%

MYR bn

110 100 90 80 70 60 Jan-14

Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 FX deposits FX deposits, holding USD-MYR at July-14 level

Source: Bloomberg, HSBC

We have a few suggestions: 1. Establish a facility that gives a premium over prevailing market rates for domestic institutions with excess liquidity. This will provide an alternative avenue for local corporates and individuals intending to shift MYR deposits into foreign currency deposits or to offshore accounts. The cost of the facility could be fiscalised, but should be managed without jeopardising the fiscal consolidation plan. Interestingly though, FX deposits onshore have actually not picked up by that much this year, after adjusting for valuation effects (Chart 11). 2. Provide the private pension fund, Employees' Provident Fund (EPF; or KWSP in Bahasa) special incentives in exchange for it to repatriate some of its more liquid foreign assets. Since EPF assets are not government assets, but private sector employees' assets, an adequate yield would need to be provided, taking into account EPF's opportunity costs. EPF has about MYR145bn worth of foreign assets (23% of AUM), largely in overseas equities. In H1 2015, the EPF's investment income was MYR22bn, which represented a 15% y-o-y increase. 3. Give tax incentives for Malaysian companies that repatriate their excess foreign currency

44

% GDP External Assets

External Liabilities 1990 1993 1996 1999 2002 2005 2008 2011 2014 ODI/FDI Portfolio investments Other investments FX reserves Net IIP

Note: IIP prior to 2001 are HSBC estimates, based on BoP data. Source: CEIC, HSBC

earnings and assets, and to foreign companies to front-load their FDI inflows. 4. BNM could raise policy interest rates, although there would be a cost to economic growth. We believe that modest hikes are unlikely to be effective, considering that MGS yields are on the lower end of the scale within EM. However, with the economy already under downward pressure from lower commodity prices, high household leverage, and the implementation of GST in April, significant rate hikes are also unfeasible. In our view, a policy rate hike will only be considered by the BNM if inflation surprises significantly on the upside (see Q1). HSBC economists do not expect rate changes by the BNM this and next year (see Su Sian Lim’s: Economics: Malaysia central bank watch: On hold for longer, 4 September). 5. Direct the sovereign wealth fund, Khazanah Nasional, to repatriate some of its foreign assets. As of end 2014, Khazanah has about MYR60bn of overseas assets.

Q4. Will there be a re-pegging of the MYR or capital controls? BNM officials and the Prime Minister's office have given repeated reassurances that a currency peg and capital controls will not be re-introduced. We believe that is in the best interests of Malaysia.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

A currency peg without controls on capital outflows, implemented at a time when the market believes the central bank does not have adequate foreign reserves, would be futile – it would only lead to increased speculation. But capital controls would undo the remarkable financial progress that Malaysia has made over the past decade – its domestic debt market is the third largest in Asia and it has the most developed sukuk market globally. The stakes for Malaysia are much higher today, than in 1998. In any case, it is important to note that Malaysia actually still has some capital controls in place today, left from the 1998-2005 period (Table 2). The authorities have taken pains to ensure that there is no offshore MYR market today, which was sizeable in the 1990s. To this end, they have maintained restrictions on MYR financing for transactions offshore, and permit non-residents to borrow in MYR only for certain types of onshore transactions (e.g. fixed assets investments in Malaysia). The remittance, payment, and delivery (via forwards and swaps) of MYR to offshore entities are also regulated – these are generally not allowed for non-current account transactions (although the hedging of underlying MYR investments by non-residents is permitted). In addition, the conversion of MYR into foreign currencies for residents' investments abroad is

subject to approval, once passed a stipulated limit (e.g. MYR50mn for a corporate group per year). These controls suggest that there are more "circuit-breakers" for a rise in USD-MYR today, than there were during the Asian financial crisis.

External fundamentals today are not as bad as during the Asian financial crisis We also believe the external fundamentals in Malaysia today are not as bad as it has been in the period leading up to the Asian financial crisis (see MYR: Not as bad as some think, 3 July 2015). Crucially, Malaysia now has about MYR535bn of overseas direct investment assets, USD240bn of foreign portfolio assets, and MYR265bn of "other investment" assets (currency, loans and trade credits), on top of its official FX reserves. In aggregate, Malaysia's foreign assets roughly match its foreign liabilities today, in sharp contrast to its large net liability situation in 1997 (Chart 12). Furthermore, although its current account surplus has shrunk significantly, we still expect Malaysia to receive about USD8bn-10bn of net foreign currency receipts this year, as opposed to a net deficit of USD4bn-5bn in 1996-97. This suggests that currency mismatch at the overall corporate level is less of a problem today. Indeed, the excess of corporates' short-term external debt to the annual

13. Corporates' currency mismatch in their debt vs. revenue management is not as bad today compared to 1997

14. Banks' external liability-to-asset positions are also much improved today

120 100 80 60 40 20 0 -20 -40 -60 -80

300%

MYR bn

1991

1995 1999 2003 2007 2011 2015 Current account balance Corp short-term ext debt Excess of debt over C/A, % FX reserves (RHS)

Source: CEIC, HSBC

120% 100% 80% 60% 40% 20% 0% -20% -40% -60% -80%

250% 200% 150% 100% 50% 0% Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11 Dec-14 Banks' FX external liab-asset ratio Onshore FX loan-deposit ratio Source: CEIC, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

current account balance is 12% of FX reserves today, compared to a ratio of about 50% then (Chart 13). That said, there could be distributional effects, if FX debt is concentrated in certain industries that are simultaneously facing more pressures on the revenue front, for example the commodity-related companies. Similarly, Malaysian banks' external asset-liability position is also in a better shape today – the banking system's external liability-to-asset ratio and onshore FX loan-to-deposit ratio are both below 100%, whereas these ratios were much higher in the 1990s (Chart 14). This is important since a vulnerable banking system can propagate and amplify economic shocks.

Table 2: Major capital control measures imposed on 1 September 1998, and their subsequent relaxation Capital controls

(Partial) relaxation of measures

(Aug-97) Residents allowed to enter into non-commercial-related currency swap transactions with non-residents up to a limit of USD2mn (no limits previously) A requirement was introduced to repatriate all ringgit held offshore by 1 October 1998. Offshore banks were prohibited to trade in ringgit assets (allowed with limits previously). All purchases, sales, borrowing and lending of ringgit can only be transacted through authorized resident financial institutions Approval requirement was imposed to transfer funds between nonresidents' MYR accounts onshore (freely allowed previously). The use of funds was also limited to the purchase of goods and services, as well as MYR assets in Malaysia (no restrictions previously) Resident banks (also corporates and individuals) were prohibited from granting ringgit credit facilities to non-residents (previously subject to limits for different types of foreign customers, and offshore usage was generally permitted)

Apr-03: No restrictions on forward transactions with non-residents that are supported by firm underlying commitment to receive MYR Post-2005: Most restrictions on offshore MYR trading still stand. Buying and selling of MYR through non-resident banks are allowed only for the settlement of trade with residents

Dec-02: The use of funds was expanded to allow conversion into foreign currencies for repatriation abroad. Post-05: Restrictions on fund transfers between external accounts, and the use of their MYR funds, remain Jul-01: Non-residents could obtain MYR financing only for activities to do with the real sector in Malaysia, including purchase of immovable property. Apr-04: Foreign banks and MNCs were permitted to raise MYRdenominated bonds in Malaysia. The MYR funds can be used in Malaysia or overseas (but converted into foreign currencies). A 12-month waiting period for non-residents to convert MYR proceeds Feb-99: The 12-month waiting period was replaced with a graduated from the sale of Malaysian securities (no such restrictions previously; system of exit levy. The levy was 30% if the repatriation took place less than 7 months after investment, 20% if repatriated in 7-9 months; and Note that the restriction is for the principal of investments in shares, 10% if 9-12 months. No levy after 12 months. bonds, and other financial instruments, and does not apply to the principal of property investments and FDI, and income streams from all Jan-01: All exit levies were abolished investments) A prior approval requirement beyond a certain limit for all residents Apr-04: Limits for fund managers' were raised (individuals, corporates, banks, fund management companies) to Post-2005: No limits for investments that do not involve conversion from invest abroad in any form (previously applied only to corporate MYR into foreign currencies. Also no limits for residents without MYR residents with domestic borrowing) borrowing. Those with outstanding MYR loans can freely invest up to MYR50mn per year for a group of companies, and up to MYR1mn per year for individuals All imports and exports were required to be settled in foreign currency Apr 03: Limits on the retention of exporters' foreign currency proceeds (MYR settlement allowed previously) and repatriated onshore for were raised conversion into MYR within six months Post-2005: Settlement can be undertaken in MYR too Source: IMF Working Paper 06/51 (https://www.imf.org/external/pubs/ft/wp/2006/wp0651.pdf), BNM, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

VND: Down goes the dong  The State Bank of Vietnam devalued the VND by 1% and widened

the USD-VND trading band to +/-3%...  …in an attempt to maintain competitiveness in an environment of

a weaker RMB  We raised our USD-VND forecasts and expect the exchange rate

to end the year at 22,800

This is an edited excerpt, combined from Asian FX: VND: Down goes the dong, published 19 August 2015. The repercussions of China’s CNY fixing reforms are being felt across Asian currencies, with the VND, in particular, facing mounting pressure Since China reformed the CNY fix on 11 August, the State Bank of Vietnam (SBV) has widened the trading band twice, from +/-1% to +/-3%, and also raised the mid-rate of USD-VND by 1%. The VND has responded accordingly, falling nearly 3% against the USD over the past week (Chart 1).

1. VND has been under mounting pressure USD-VND 22600 22300 22000 21700

We believe the SBV may have to depreciate the VND by a further 2% by the end of the year, as a weaker RMB provides an increasingly challenging environment for Vietnamese exports. We raise our 2015 and 2016 year-end targets for USD-VND to 22,800 and 23,300, from 21,830 and 22,300, respectively.

Alastair Pinder Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 1672 [email protected]

What has happened?

[email protected]

The SBV announced that it has increased the mid-rate of USD-VND by 1%, the third time it has devalued the VND this year. In addition, the SBV also decided to widen the band to +/-3%. This is the second time in less than a week that the central bank has widened the trading band – the SBV widened the band to +/-2% from +/-1% on 12 August. The changes mean that, the new USD-VND mid-rate is 21,890 with the upper 2. HSBC USD-VND forecasts

21400

Q3-15

21100 20800 Jan-14

Joseph Incalcaterra Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4687

May-14 USD-VND

Source: Bloomberg, HSBC

Sep-14

Jan-15 VND FIX

May-15 Band

Q4-15

Q1-16

Q2-16

Q3-16

Q4-16

New

22,500

22,800

23,000

23,000

23,300

23,300

Old

21,830

21,830

22,300

22,300

22,300

22,300

Source: HSBC forecasts

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

4. Vietnam also competes with China for exports 50%

Competing on exports

10%

-30% INR THB VND

HKD

MYR

KRW

INR

COP

PHP

MXN

0%

Imports - Primary goods Exports - Primary goods

Source: Bloomberg, HSBC

Trade correlation index Source: UNCTAD, HSBC

ceiling at 22,547 and the exchange rate floor at 21,233 VND/USD.

Why has the SBV devalued the VND? The move by the SBV to devalue the VND highlights the acute challenges the currency is facing at the moment. It also marks a notable shift in FX policy from a central bank which at the beginning of the year said it did not want the VND to weaken more than 2% against the USD in 2015. The recent reforms in the CNY’s fixing mechanism and the subsequent depreciation of the RMB are probably the most important reasons behind the SBV’s decision to let the currency weaken. After all, China is an important trade partner for Vietnam, accounting for 21% of total trade. A weaker RMB would exasperate fears of declining exports to China, which in turn could

5. The VND had been one of the better performers this year… Performance vs USD 0% -2% -4% -6% -8% -10% -12% -14% -16%

push Vietnam’s trade balance further into deficit. Of even more concern is that China is a significant export competitor of Vietnam (Chart 4) especially on manufacturing goods. The SBV highlighted in its statement that the depreciation of the VND was a necessary step to ensure Vietnam exporters remain competitive in international markets. Fears that the exchange rate is hurting Vietnam’s export competitiveness are well grounded. The central bank’s decision to ensure stability in the currency has actually meant the VND had been one of the strongest performing Asian currencies in 2015, prior to the recent devaluation and band widening (Chart 5). This has meant that on both a NEER and REER basis, the VND has appreciated substantially (Chart 6). In fact, we estimate that the VND has appreciated 9% y-o-y on a nominal

6. …leading to strong appreciation of its REER and NEER 130

Index: 2010 =100

120 110 100 90

TWD CNY INR VND PHP SGD KRW THB IDR MYR 01-Jan-15 - 10 Aug-15 Source: Bloomberg, HSBC

48

10%

LKR

TWD KRW SGD PHP MYR IDR Imports - Manufacturing goods Exports - Manufacturing goods Net Balance

20%

THB

-20%

30%

CNY

-10%

40%

IDR

0%

BDT

3. China is an important trade partner for Vietnam 20% Trade with China (as % GDP)

11-Aug-15 - today

80 Jan-10

Jan-11

Jan-12

VND - REER Source: Bloomberg, HSBC

Jan-13

Jan-14 VND - NEER

Jan-15

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

7. Low inflation and high real rates provide further room for currency weakness

8. Vietnam's reserve adequacy is low 6

20%

#months

USDbn

5

15%

30

4

10%

20

3

5%

2

0%

1

-5% Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Real OMO rate

OMO rate

0 Dec-06

10 0 Jun-08

effective exchange rate basis, the fastest rate of appreciation since 2000. It was also indicated by the SBV that the decision to devalue the VND was a pre-emptive move to reduce pressure on the currency prior to the possibility of the Fed embarking on its tightening cycle before the end of this year. Unlike a few years ago, the State Bank of Vietnam also has more room to accommodate depreciation in the VND. Inflation is at historical lows, thanks partly to the fall in global oil prices, so there are fewer concerns that weakness in the exchange rate will feed through into soaring prices. Furthermore, higher real interest rates also reduce the risks from domestic outflows (Chart 7).

What’s next for the VND? The sharp depreciation in the VND over the past week reflects the external headwinds that have been working against the currency. Most important is the recent weakness in the RMB. As we have written previously, we expect the RMB to depreciate further as the PBoC allows the exchange rate to become more market determined while also pursuing its policy of monetary easing (see Asian FX Special: More volatility - a permanent fixture, 12 August 2015 ). In our view, this will also mean the SBV will have to accommodate further weakness in the VND if it

Dec-09

Jun-11

Dec-12

Jun-14

SBV International Reserves (USDbn) Import Cover (LHS)

Inflation (YoY)

Source: Bloomberg, HSBC

40

Source: UNCTAD, HSBC

wants to ensure its exporters remain competitive with China. Furthermore, if the Fed begins to lift rates this year, the VND could face additional outflow pressures. The SBV obviously has its FX reserves which it can use to maintain some currency stability. But the comments from Ministry of Finance Vice Minister, Vu Thi Mai, in April that the Vietnamese government could borrow money from the central banks’ reserves ( source Chichphu.vn):has dented investor confidence in the VND further and could lead to a loss of credibility in the SBV (see Vietnam: dipping into reserves?, 21 May 2015). Although the SBV has improved its FX cover, its reserve adequacy is already low by most conventional measures (Chart 8). If the SBV’s foreign exchange reserves are used for financing government projects, this would leave the central bank with less ammunition to help it stick to its commitment. Nevertheless, we do not think the VND will weaken aggressively from here. The Vietnamese economy has actually been one of the bright spots in Asia. Domestic demand has been picking up, and more balanced BoP flows, coupled with low inflation and higher real rates, should allow the FX policy to become more flexible in its ability to manage periods of USD demand. Furthermore, Vietnam’s high external debt limits the room for the central bank to let the currency weaken too fast.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

9. Vietnam has seen Asia’s best export performance

15

% y-o-y, 3mma

10

10. Manufacturing has contributed most of Vietnam’s export growth 25

%-point contribution to export growth

20

5

15

0

10

-5 5

-10

0

-15 VN SL HK CH TH SK PH TA ID SG MY IN Export growth y-o-y 3mma (Latest) Source: CEIC, HSBC

As such, we have decided to revise our forecast and now expect the VND to depreciate against the USD by a further 2% in 2015e, and then an additional 2% in 2016e. Our year-end forecast for USD-VND is 22,800 for end 2015 and 23,300 for end 2016.

Economics implications Vietnam has stood out recently as being one of the only Asian economies to boast strong export data. On a 3-month rolling y-o-y basis, it is the only country with positive growth by a wide margin (Chart 9), even though the global trade pie is not growing. Vietnam has been able to take advantage of its labour-intensive competitive advantage in manufacturing to gain market share and has proactively pursued free-trade agreements. As we show in Chart 10, manufacturing and manufacturing parts have been the main contributors to overall exports, particularly in recent years. Moreover, Vietnam stands out sharply from its ASEAN neighbours that have been hard hit by the commodity cycle. That said, we believe policymakers are sensitive to competitive pressure from China and are wary of any loss of thrust from this important engine of growth. Vietnam is running an overall trade deficit in 2015 y-t-d (although it was positive in 2014) as it imports most of the capital goods needed for investment, however, the bilateral

50

Food

Pre WTO Commodities

After Manufacturing

2013-2014 Manufacturing parts

Source: CEIC, HSBC

deficit with China is particularly large (Chart 11). China accounts for roughly 10% of Vietnamese exports but 30% of imports, a proportion that has increasingly grown in China’s favour. In the first seven months of 2015, the bilateral trade deficit grew 30.2%, reaching USD19.4bn, according to Vietnam customs data, a record high. Although a part of this reflects imports of electronics and industrial components that are necessary for supply chain integration and capital investment in Vietnam, a sizeable share is in garments and footwear – where Vietnamese goods compete with Chinese equivalents. Moreover, Vietnamese goods are increasingly competing with China in international markets, and there is a fair degree of competition with China in nascent industries that Vietnam is trying to develop – notably automobile production and shipbuilding. From an economic fundamental point of view, the economy can handle the devaluation – the third round this year. Vietnam’s perennial headache – inflation – has moderated to record-lows in recent months (Chart 12), dragged down by lower transportation costs (a function of 5 cuts this year to RON 92 petrol prices). The pass-through of the weaker VND to headline inflation should be manageable, especially as energy prices stay low. Moreover, the Ministry of Finance recently released a document instructing regional finance departments to improve the management of

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

transport fees, in order to prevent increases and ensure that further oil price reductions are passed onto consumers. This should help keep inflation pressures contained. As our FX colleagues point out above, the devaluation and band-widening is not only for exports. It is partly to accommodate future volatility alongside the Fed’s lift-off as early as September (although HSBC’s Chief US Economist, Kevin Logan, forecasts a move in December). The recent devaluation, together with a further 2% devaluation this year as forecast by HSBC’s FX strategists, is unlikely to put much pressure on the domestic financial system seeing that short-term external debt levels are small and manageable (Vietnam has the third-lowest short-term debt coverage ratio in Asia, although the total stock of external debt has risen at a fast pace in recent years). Instead, it should ensure that Vietnam’s exports do not lose their competitiveness versus regional peers. That said, Vietnam is unlikely to independently devalue its currency to help exports as it boasts a fundamental trade advantage based on low labour costs, infrastructure development and a proactive expansion of free trade agreements by the government (Korea FTA, TPP, and AEC). Accordingly, any further devaluation of the VND this year will likely be a reflection of exogenous factors.

11. The trade deficit with China has grown to record levels

-5,000

USDm, reverse axis

12. Inflationary pressures have moderated notably over the past two years, giving the SBV flexibility to devalue

% of exports, 3mma 35

-4,000 -3,000

25

-2,000 15

-1,000 0

5 04 05 06 07 08 09 10 11 12 13 14 15 Trade balance w/ China China share exports China share imports

Source: CEIC, HSBC

% y-o-y 30.0 25.0 20.0 15.0 10.0 5.0 0.0 11 -5.0 10 -10.0 -15.0 CPI

% y-o-y

12

13

Foods and foodstuffs

14

15

30.0 25.0 20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 -15.0

Transportation

Source: CEIC, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

LKR: Let it go  The LKR depreciated over 3%, after the central bank reportedly

allowed the exchange rate to be more market-determined  We believe this is a necessary move, as Sri Lanka's balance of

payments and reserves position have been under strain  We raised our USD-LKR forecasts to 141 by year-end (from 134)

and 145 by end-2016, in view of the expected monetary policy divergence between the CBSL and the Fed

This is an edited excerpt, combined from Asian FX: LKR: Let it go, published 4 September 2015. Bloomberg reported (citing Deputy Governor Nadal Weerasinghe) that the Central Bank of Sri Lanka (CBSL) will cease to give a daily reference rate for USD-LKR from 4 September, and let the market play a greater role in determining the exchange rate. The central bank will only intervene when necessary, to curb excessive volatility. An official circular has not been posted on the central bank’s website. But in any case, the de jure exchange rate arrangement has been a floating regime since 2001.

1. The LKR buckled under…

The USD-LKR exchange rate opened at 137.50 this morning, indicating a 2.0% depreciation in the LKR from the last day’s close. The LKR has since weakened further amid higher than usual volatility. The 3% depreciation today is the largest since 16 March 2012 (4.6%; Chart 1). We believe this is a prudent step by the CBSL in allowing flexibility in the exchange rate, and we had discussed this in a report published earlier this year (see Asian FX Focus: Back to front, 30 April 2015). The "impossible trinity" suggests an economy cannot target a fixed exchange rate while maintaining an independent interest rate 2. …as loose monetary policy… 45 40 35 30 25 20 15 10 5 0

% y -o-y

45 40 35 30 25 20 15 10 5 0 CPI

Source: Bloomberg, CEIC, HSBC

52

Source: CEIC, HSBC

Credit

Paul Mackel Head of EM FX Research The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Ju Wang Senior Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4340 [email protected] Joey Chew Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected] Alastair Pinder Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 1672 [email protected]

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

policy and an open capital account at the same time. Indeed, Sri Lanka has seen several episodes of balance of payments challenges over the past few years, for example in H1 2012. Today, the CBSL appears to have chosen monetary policy independence over exchange rate control. This choice, however, should be sustained, or policy may be at risk to losing credibility and potentially lead to greater speculation against the currency. The central bank has to balance between allowing flexibility and smoothing volatility in the market - it sounds familiar these days. The highly managed LKR exchange rate regime has come under some stress as the central bank embarks on a looser monetary policy stance (Chart 2), while the broad USD was gaining strength ahead of the Fed's impending rate hike. Amid strong import growth and foreign portfolio outflows, the balance of payments recorded a deficit of USD800mn in H1 2015, compared to a surplus of USD2bn in H1 2014 (Charts 3-4). Consequently, FX reserves fell from USD8.2bn at the start of the year to USD6.8bn as of end-July (Charts 5-6). Considering that it has USD4.3bn of external debt repayments to make over the next 12 months, FX reserves were running low for a managed currency regime.

3. …fuelled domestic demand… 100

Some may see this event as another EM central bank engaging in competitive devaluation but we disagree. We do not believe CBSL's primary motivation to allow the currency to adjust (weaker) is to boost exports. Sri Lanka is not an export-oriented economy and the high import content of industrial production and exports dilutes any boost to net exports from currency depreciation. Moreover, Sri Lanka's high level of external debt, largely owed by the government, is a constraint on policymakers' ability to engage in a "currency war", even if they have that intention. The track record of the LKR exchange rate and its underlying external fundamentals suggest that the risk is usually for an overshooting in depreciation expectations, after an adjustment. But we believe the CBSL has probably chosen a relatively opportune time to relax its currency regime now. The central bank had just, on 2 September, received the proceeds - USD1.1bn - from its currency swap arrangement with the Reserve Bank of India signed on 17 July 2015. A stronger war chest would help deter speculation. It is also doing so after the recent conclusion of the parliamentary elections which could potentially lead to more FDI and portfolio inflows (see Economics: Sri Lanka: Parliamentary election results - a workable coalition led by UNP, 18 August). Had the adjustment been delayed

4. …and led to a deterioration in the balance of payments

import growth, % y/y, 3mma

3

75

2

50

1

25

0

0

-1

BoP breakdown, quarterly

-2

-25 -50 Jan-11

USDbn

Jan-12 Jan-13 Oil imports Capital goods

Source: CEIC, HSBC

Jan-14

Jan-15 Consumer goods

-3 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Current account Portfolio Errors

Net FDI Other investment BoP balance

Source: CEIC, HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

further, say after the Fed hikes rates, the disruption and volatility in the exchange rate could have been higher. We raised our USD-LKR forecast to 141 by end-2015 and 145 by end-2016. That would imply a 7.0% depreciation for the full calendar year (following 0% adjustment in 2014) and 3% for 2016. Assuming that the central bank maintains this policy of currency flexibility, we expect the currency to weaken slightly further for the rest of this year, as the strong momentum in imports could persist for some time yet while the volatility in external market conditions could be less conducive for foreign portfolio inflows. The more modest adjustment next year is in part due to our economist's constructive view on Sri Lanka's medium-term economic growth and development, which could lead to more stable inflows to support the balance of payments. Comparing these with the expected changes in our forecasts for other Asian currencies, such as the INR, the LKR no longer looks too out-of-sync, in our view.

5. FX reserves have held steady, just barely, with the help of currency swaps

6. But with rising external debt payments and imports, FX reserve adequacy is now the lowest in years

USD bn 9 8 7 6 5 4 3 2 1 0 Jan-10 Jan-11

7.0

Source: CEIC, HSBC

54

6.0

Import cover, adjusted for ST ext-debt, no. of months

5.0 4.0 3.0 2.0 1.0

Jan-12 Jan-13 FX Reserves

Jan-14

Jan-15

0.0 Jan-10

Jan-11 VND

Source: CEIC, HSBC

Jan-12

Jan-13 LKR

Jan-14

Jan-15 BDT

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

EMEA at a glance Currency CZK

HUF

ILS

KZT

PLN

RUB

RON

TRY

UAH

Key points  EUR-CZK has been trading close to the Czech central bank’s (CNB) floor of 27.0 on the back of stronger macro data and external risk-off sentiment, with the CNB intervening to defend the floor.  The CNB remains committed to maintaining the floor until H2 2016, and recently lowered its inflation forecasts for 2016, despite higher growth forecasts.  We think the EUR-CZK floor will remain under pressure, especially as domestic data and wage growth remain strong.  We believe the shift to a new 3-month policy rate (from a 2-week rate before) could be HUF negative as it weakens the inflation-targeting framework, could lead to looser HUF liquidity, and may create an environment where a weak HUF is more tolerable to policymakers.  New regulations to bring down banks’ short-term external debt also provide evidence that the central bank (NBH) wants to lower Hungary’s vulnerability to a weaker HUF.  We believe the NBH is showing an increasing preference for a weaker currency, and we see EUR-HUF at 325 by the end of this year.  The BoI has suggested that unconventional easing is unlikely outside of exceptional circumstances.  Some of the recent domestic data – GDP at just 0.3% y/y in Q2 and August inflation at -0.4% y/y – has surprised to the downside, but the BoI will likely remain on hold for the time being, in our view.  Despite ongoing FX intervention, we think it will be difficult for USD-ILS to shift its trend without more significant policy easing; therefore, we see USD-ILS at 3.70 at year-end 2015.  The KZT moved to a free-floating FX regime on 20 August, with an initial 30% depreciation vs. the USD.  While the timing was unexpected, it was driven by macroeconomic fundamentals; Kazakhstan is an oilexporter with large exports to Russia and China, whose currencies have recently depreciated.  We have long believed that a significant depreciation was needed to align the KZT with its macroeconomic fundamentals; we now see USD-KZT at 300 by end-2015 and 325 by end-2016.  We believe that higher political risks and the possibility of significant changes in fiscal and monetary policies later this year and into 2016 are PLN-negative.  Portfolio flows will likely provide the strongest swing factor for the currency with the current account largely in neutral territory. There will also be a rising focus on the repayment of FX loans, which could significantly impact the FX reserves position.  We see EUR-PLN rising to 4.35 by year-end 2015.  We think the RUB has further to fall, despite an already sizable adjustment versus both the USD and on a real effective exchange rate (REER) basis.  Soft global demand and downside risks to China’s outlook suggest Russia’s terms of trade may remain under downward pressure, helping to justify the decline in the RUB.  Russia’s high inflation differential versus its trading partners is likely to persist, suggesting that the nominal exchange rate will need to adjust weaker; we now see USD-RUB at 72 by year-end 2015.  We remain of the view that the RON does not offer any value.  The Romanian central bank maintains a dovish monetary policy, making the RON unattractive.  The central bank favours a broadly stable RON.  New elections will be held on 1 November after the AKP (the largest party) was unable to form a coalition with either the CHP or the MHP. Current polls suggest a majority will be difficult to achieve.  The political inertia is being matched by monetary policy inertia, with the lack of a bold reaction to FX weakness being a key difference in recent months compared to the past.  With inflation on the rise and the central bank standing pat for now, there is a risk that TRY depreciation could accelerate, particularly if global factors remain challenging.  The National Bank of Ukraine (NBU) keeps the UAH in an unofficial USD-UAH21-23 band, using FX interventions and tight capital controls to hold the band.  The local elections in the Eastern Ukraine could become a new stumbling block to implementation of the Minsk agreements, despite the ceasefire.  Ukraine has struck the deal on a 20% nominal haircut on its old bonds but the treatment of the USD3bn Eurobond sold to Russia is likely to complicate matters.

Recommendation End 4Q 15 spot

Risk to forecast

Neutral

EUR/27.3

Stronger

Long EUR-HUF

EUR/325

Stronger

Neutral

USD/3.70

Weaker

Neutral

USD/300

Weaker

Neutral

EUR/4.35

Stronger

Neutral

USD/72

Stronger

Neutral

EUR/4.40

Weaker

Neutral

USD/3.10

Weaker

Neutral

USD/25.00

Weaker

Source: HSBC

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

CEEMEA FX and Rates: Feel the pressure  We remain bearish overall on the region but still see CEE

outperformance relative to the higher yielders  This is based on domestic dynamics, external vulnerabilities, and

recent price adjustments relative to long-term averages  We have lowered our forecasts for the ZAR, TRY, and RUB after

they weakened faster than we expected

relative to their long-term averages. CE currencies have adjusted only slightly but this appears justified given strong macro fundamentals.

This is an excerpt from CEEMEA FX and Rates: Feel the pressure, published 9 September 2015. On a relative rather than directional basis, CEE currencies have outperformed the higher yielding currencies in the region (RUB, TRY, and ZAR). Following the sharp recent FX movements, particularly in the latter currencies versus the USD, it is worth considering whether this relative performance has run its course. In our view, it has not. We still believe that CEE currencies, with their stronger external positions and domestic growth fundamentals, will outperform those currencies whose main positive differentiator is their high carry. We now look for even greater weakness in the high-yielding currencies after they depreciated further and faster than we originally expected. Our analysis is based on three main factors: 1

56

Real effective exchange rate deviations vs. long-term averages do not look extreme: High-yielding currencies have generally not weakened in a particularly extreme manner

2

External environment: This will likely remain challenging with elevated market volatility, which points to outperformance by currencies with better current account positions and lower capital financing or external debt requirements.

3

Domestic dynamics: Local factors are more supportive of growth in CEE while other economies face greater cyclical and structural challenges.

Deviations not “really” extreme After the volatile moves we have seen in many CEEMEA currencies in recent months, it is worth taking a step back and looking at whether recent currency depreciation in our region has actually been that extreme. We compare the BIS Real Effective Exchange Rates (REERs) with where they were a year ago and also against a five-year

Murat Toprak CEEMEA FX Strategist HSBC Bank plc +44 20 7991 5415 [email protected] Dominic Bunning CEEMEA FX Strategist HSBC Bank plc +44 20 7992 2113 [email protected]

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

1. Most CEEMEA currencies have not adjusted that much in REER terms 5%

2. Carry does not seem attractive after adjusting for volatility 1.0

0% -5%

0.8

-10%

0.6

-15%

0.4

-20%

0.2

-25%

Implied 1m carry -vol ratio, vs USD

0.0

-30% CZK

ILS

HUF PLN

12m % change in REER

ZAR

TRY RON RUB vs 5y Ave

Source: BIS, HSBC

average (Chart 1). The data has been updated from July (the latest available BIS data) using FX spot movements which account for the majority of each currency’s basket. On these measures, only the RUB has weakened significantly. The RUB depreciation has come at a time when oil prices have declined significantly and economy contracted further. As such, recent weakness does appear justified, in our view. Elsewhere, although the ZAR and the TRY have adjusted sharply and have hit all-time lows versus the USD, it is not immediately obvious to us that these levels present particularly good buying opportunities, especially when considering how they have moved versus their trading partners. Meanwhile, CEE currencies have outperformed the USD-bloc currencies. The REER adjustments have been mild as macro fundamentals are strong. We believe their outperformance many continue for the time being.

External environment still bodes badly One of our strongest views this year has been that it was still too early to go long EM carry currencies (see EM FX Roadmap: Between a rock and a hard place, 25 May 2015). Although one of our key risks (a steeper US yield curve) has not materialised, the external environment has

-0.2 CZK

HUF Latest

PLN

ILS

RUB

30d prior

TRY

ZAR

1y prior

Source: Bloomberg, HSBC

remained extremely choppy for CEEMEA FX. The latest source of external volatility has come through China (see CEEMEA FX: Risks from the redback, 12 August 2015) and the underperformance of the commodity and current account deficit currencies in CEEMEA has been largely as we expected. There is little evidence that carry currencies will start to look more attractive in the near future. When adjusting for volatility (both implied and realized), we do not view the carry on offer as particularly alluring, even among the high yielders (Chart 2). In our view, broader market volatility is likely to remain elevated through the rest of 2015 and beyond as the FX market adjusts to China’s new exchange rate regime and the Fed potentially embarks on a hiking cycle. This will create ongoing challenges, particularly for those currencies in need of capital funding or external debt repayments (see EM FX Special: RMB & the EM world, 25 August 2015). While the ZAR, TRY, and RUB may be more exposed than others to these dynamics, we think even the likes of the PLN and HUF will likely see depreciation pressures versus DM currencies, due to the large foreign ownership in their bond markets and their foreign debt repayment schedules. Only the CZK and ILS appear to have more positive external dynamics, and even in

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

3. PMIs show CEE-3 in a stronger position… 57

4. …and they are driven by resilient domestic demand 15

PMI Index

Retail sales, % y /y

10

55

5

53 51

0

49

-5 -10

47 CZK

HUF Latest

PLN

RUB

TRY

CZK

ZAR

HUF

12m average

PLN Latest

Source: Bloomberg, HSBC

RON

ILS

RUB

TRY

ZAR

12m average

Source: Bloomberg, HSBC

those two places, FX policy is likely to fight significant local currency outperformance.

CEE-3: Domestic dependability

less positive for the USD-bloc economies, where more deep seated concerns abound. These range from electricity shortages in South Africa, to political (and geopolitical) concerns in Turkey and overdependence on oil in Russia.

The external environment points to broad CEEMEA weakness versus DM currencies, but the respective domestic economic stories suggest CEE currencies and the ILS should be much more resilient. Growth has been a lot stronger in these economies than in their USDbloc counterparts (RUB, TRY, ZAR) in recent quarters. More timely indicators of local sentiment and demand – such as the PMIs and retail sales – are also much more positive for CEE and the ILS (Charts 3-4).

Conclusion

The CEE’s positive growth dynamics could remain in place given that eurozone economic data appears to be bottoming out relative to expectations, and with ongoing QE aiming to further support the recovery. But the outlook is

Even with some relative outperformance by CEE FX, we still favour being long DM currencies relative to most CEEMEA FX. The likes of the PLN and HUF are likely to outperform the ZAR and TRY, in our view, but we still see them weakening

On top of this, the latter three economies also all face structurally high inflation, and pressures have not abated as much as hoped despite the global disinflationary environment. This will make it harder for authorities to loosen monetary policy to support domestic growth. For CEE economies, policy makers have a greater degree of flexibility given their soft inflation outlooks and resilient output.

Table 1. HSBC FX forecasts

USD-TRY (New) Old USD-ZAR (New) Old USD-RUB (New) Old EUR-PLN EUR-CZK EUR-HUF Source: HSBC forecasts

58

Q4 15

Q1 16

Q2 16

Q3 16

Q4 16

3.10 2.80 14.20 12.80 72.00 65.00 4.35 27.30 325

3.15 2.80 14.30 12.80 73.00 66.00 4.35 27.30 325

3.15 2.80 14.50 12.80 75.00 67.50 4.35 27.30 325

3.15 2.80 14.60 12.80 75.00 68.50 4.35 27.00 325

3.18 2.80 14.70 12.80 78.00 70.00 4.35 27.00 325

Currency Strategy Emerging Markets 22 September 2015 – Issue 126

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versus the EUR in the coming months. Meanwhile, we have lowered our forecasts for the ZAR, TRY, RUB versus the USD. These pairs have moved even further and faster than we originally expected. The external environment is likely to remain challenging for these currencies, while the domestic backdrop is showing few signs of improvement. Our new FX forecasts are summarised in Table 1 and detailed country pages follow this piece.

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Currency Strategy Emerging Markets 22 September 2015 – Issue 126

TRY: Political and monetary policy inertia to push TRY lower The TRY has reached new all-time lows in recent weeks. Besides the global headwinds, the collapse of coalition talks and the announcement of a new election on 1 November amid geopolitical tensions has been a major driver of the currency. Political risk factors are likely to keep the TRY under downward pressure, in our view. New elections may have two types of negative implications for TRY: 1

The likely political inertia in the next two months is particularly unwelcome given Turkey’s existing macro vulnerabilities and the security issues that the country faces.

2

It remains unclear if a new election will unblock the political situation. Opinion polls suggest that there has been some increase in support for the AKP, but they do not provide a clear signal if the party would be able to secure a simple majority in parliament (276 out of 550 seats). The likelihood of another hung parliament is not small.

A similar sort of inertia seems to be also at play on the monetary policy side. The central bank made minors changes to its policy in August. Yet, the TRY REER rate has fallen below levels which had triggered strong monetary responses in the past. The

5. Polls on voting intentions and June election results 45 40 35 30 25 20 15 10 5 0

%

The Central Bank of the Republic of Turkey (CBRT) announced that the monetary policy framework will be simplified in response to Fed policy normalisation. In principle, this would be a positive reform. However, it has to be combined with higher interest rates. The scale of tightening (if any) that would come with the change of the framework is unknown. In any case, the market remains cautious given the dovish nature of the CBRT. The adequacy of monetary conditions with inflation is very topical. This is all the more true since headline and core inflation are already on the rise and favourable basis effects, which contained the rise of inflation so far, will disappear in Q4. Recent currency weakness is likely to exacerbate price pressures even if the fall in commodity prices is a mitigating factor. Therefore, a sudden and sharp acceleration in inflation cannot be ruled out. This could be a major trigger for another round of TRY depreciation, particularly in the global context. Overall, we see USD-TRY moving to 3.10 by year-end.

6. The REER has reached historical lows 130

Index

Index

TRY REER

Overvaluation territory>112?

120 115

115 110

105

105

95

Source: HSBC, IPSOS, MAK, Metropol, ANDY-AR, Gezici, ORC, Sonar, AKAM

120

110

100

100

HDP Others June election results

130 125

125

AKP CHP MHP Average of June-Aug polls

60

lack of a bold reaction to FX weakness has been a key feature this year. One can argue this can be explained by the fact that the TRY was not the only EM currency to weaken this year. But Turkey’s idiosyncratic risks have been behind the TRY’s REER underperformance and we think that monetary policy inertia was partly responsible.

+350bp Undervaluation +400bp Oc t 11 territory