RGE Monitor – What Are The Key Questions for 2009?

Greetings from RGE Monitor!

North America

Does the U.S. Need a Dollar Policy to Prevent Dollar Crisis in the Face of Rising Public Debt?

• The Fed and Treasury are setting the stage for a disorderly adjustment of the Dollar by ignoring the external imbalance (Duy)

• A renewed fall of the dollar could deepen the housing crisis and economic weakening. Rate cuts would exacerbate dollar weakness. It may be necessary to consider currency intervention in the strategy for responding to the crisis (Bergsten). Given the nation's huge funding needs in the years ahead, a stable to gently rising USD would help keep attracting in much needed capital from abroad (BNY)

U.S. Long-Dated Treasury Yields Hit Record Lows: Are Bailouts a Hidden Buying Opportunity?

• What can happen: Concerns about sovereign credit risk from deteriorating US fiscal and monetary position, increased Treasury issuance, and the growth boost from bailouts can raise yields. On the other hand, worries that bailouts won't prevent deflation can depress yields

• What has happened: Long-term yields have been falling despite rising default risk signaled by widening CDS spreads. However, recent Treasury auctions reveal signs of indigestion from growing Treasuring issuance

U.S. Stocks: Where Is the Bottom?

• According to Tobin's q, S&P 500 is still too expensive relative to the cost of replacing assets. S&P may plunge another 55% to a trough of 400 by 2014 (CLSA)

• After RTC was established in 1989, it took 1 year for the stock market to bottom, 2 years for the economy to bottom, and 3 years for the housing market to bottom. Valuations are more attractive now but credit crisis worries will prevail. S&P 500 to bottom at c. 660 (Merrill Lynch)

Latin America

Can We Find a Trend for Latin Currencies in 2009?

• The Brazilian Real remains a source of concern on the inflation front, continuing to show a weakening bias after having depreciated over 30% in the last three months. While Brazil’s external indicators suggest the currency is overshooting, the persistent weakening is a present fact that at this point the authorities cannot ignore. Estimates of the historical pass-through from BRL movements to domestic consumer prices stand at around 8-10% after approximately one year. But there are good reasons to believe that this effect will be smaller this time around

• The Chilean peso (CLP) has discounted a sharp contraction in trade-linked currency flows, despite a relatively solid fiscal position. Interest rate differentials are not a CLP supporting factor in spite of the fact that the central bank has earmarked the fight against inflation as a key priority. The sharp commodity price adjustment anticipates a weakening prospect for Chile’s export sector. (Lloyds TSB)

• The Peruvian sol (PEN) has been quite stable, trading at an average rate of 3.04 per USD over the past month; during the recent wave of financial turmoil it has also experienced the lowest volatility amongst peer-group floating currencies within Latin America. The central bank will continue to heavily intervene in the foreign currency market if need be. We expect USD/PEN to close this year at 3.00 (MS)

Ten Years Later, LatAm May Default Again?

• Ecuador just announced a default on its external debt and the market is also worried about Argentina and Venezuela. There does not seem to be much light at the end of the tunnel for Argentina, but the government looks able to finance 2009. In Venezuela, the ability to pay should never be in question. The rest of the region looks financially sound to us. We would worry if governments looked to implement strong growth policies at any cost (BNP Paribas)

• The Argentine government has the resources to avoid the default in 2009, although given the external backdrop and current developments, demand for Argentine assets is likely to be limited, and there are still downside risks due to concerns about the deteriorating economy and the resulting increased fiscal stress. S&P downgraded Argentine debt [from B- to B w/ stable outlook] in the beginning of Nov emphasizing the critical balance between lower revenues, wide financing gap and an overall sharp slowdown in the economy. The government still has a cushion with potential to capture more resources from nationalization of pension funds and the possibility of a rollover of the PGs (Merrill Lynch)

Europe

Welcome to EMU@10: What Will the Next 10 Years Bring?

• A large majority of continental Europeans believe the euro could overtake the dollar in global importance in the next five years. The survey showed that Europeans would welcome a further expansion of the Eurozone beyond its 15 members, but highlighted fears among consumers that the euro has fuelled inflation – which they believe the European Central Bank has failed to control effectively (FT)

• EMU has been monetary success, less so an economic success in terms growth and other indicators. Increased imbalances among member states since start of EMU are a key challenge (Wolf)

Which Eastern European Economies Are Most Vulnerable To Global Turmoil? Why?

• Impact of global turmoil on Eastern Europe is becoming increasingly visible; several countries, including Hungary and Latvia, have already turned to the IMF for support

• Key vulnerabilities: widespread foreign currency lending, high current-account deficits, impact of slump in Eurozone on exports, banks’ heavy dependence on foreign borrowing

• Most vulnerable: Baltic states, Bulgaria, Romania, Hungary, Serbia

• Least vulnerable: Czech Republic, Poland, Slovakia

Asia Pacific

Could Japan Be Facing Deflation Yet Again?

• Japan, which underwent deflation from 1999 to 2005, could be facing a protracted period of falling prices yet again

• Declining demand at home combined with an inflow of cheaper goods from abroad triggered by recent appreciation of the yen, could drive down prices into the feared deflationary spiral

• Deflation Drivers: 1) strength of yen vis-a-vis other major currencies, 2) falling commodity prices since July 2008, 3) domestic recession, 4) loss of export growth engine due to global downturn 5) anemic domestic demand, 6) sluggish wages

Can China Be An Engine of Global or Asian Demand Growth?

• China cannot save Asia from the global recession given that most final demand for Chinese products rests in G3. But countries better able to latch on to China’s domestic demand should be better able to weather the recession

• China may remain the most resilient economy in Asia, but it may not be that much of a support for the region and commodity exporters globally as most intra-asia trade has a final destination in the OECD. In 2008, a decline in intra-Asia trade was driven largely by a reduction in Chinese demand for processing trade inputs

• Chinese final demand accounts for only 6-7% of exports from Indonesia, Malaysia, the Philippines and Thailand. Exports to China are more significant for Japan, Korea, and Singapore, accounting for over 10% of exports (HKMA)

External Debt Burden: Is Korea Headed for Another Financial Crisis?

• Korea's ratio of external debt-to-exports, 77%, is more typical of countries with BBB ratings (such as India) rather than single-A ratings. Korean banks may have to pay higher coupons to retain access to the market in 2008. South Korea's short-term foreign loans amounted to $260.4 billion, more than the country's foreign reserves of $200.5 billion

• Korean banks' high reliance on wholesale funding is transmitting higher funding costs from global credit markets into the leveraged Korean economy. The foreign currency debt maturity profile of Korean financials show USD6.4bn maturing in Aug-Dec 2008 and USD13.2bn in 2009. Policy banks account for 75% of maturities (HSBC)

Middle East, Central Asia and Africa

MENA FDI Performance: Can Intra-Arab Investments be Sustained?

• Foreign investment into MENA and notably FDI flows increased substantially. FDI inflows into the MENA region more than quadrupled (from 14.1 billion USD to 69.6 billion USD) over the period 2003-2007. There has also been a substantial increase of intra-regional FDI, increasing by 60 billion USD between 2002 and 2006.

• On a sub-regional level, North African countries have been the net recipients of FDI, led by Egypt, receiving almost 52% of FDI in 2007, while Saudi Arabia and UAE have been largest recipients of FDI among the GCC countries (57% and 31% respectively)

• Yet, there exists a risk of reversal of flows in the midst of the current crisis. Intra-Arab FDI has already been adversely affected as a result of the hit that the Gulf economies have taken due to the global credit crisis. Egypt's FDI fell 44% in the first quarter of FY 2008/09 to $1.65 billion compared to $2.96 billion in the same period in 2007/2008. One third of Egypt's FDI comes from the GCC.

Could the Middle East Real Estate Boom Go Bust?

• The Middle East property boom of recent years was driven by growth, ample credit, negative real interest rates, population growth, but is now facing severe headwinds as some regional economies slow, global credit contracts and some supply shortages have eased, raising the risk of a bust in the countries most reliant on external credit.

• All markets are also expected to face price declines and slowdowns in the development of projects as speculative buying diminishes, demand eases and financing for both buyers and developers dries up. Shifting market conditions may also cause developers to focus more on end-users, particularly in the middle-income bracket that has been poorly served during the boom years - government policy actions may further support this

Global Issues

State of Global Imbalances: Will The Credit Crisis Finally Reduce Imbalances?

• Enforced increase in US domestic savings, reduction in surpluses by oil exporting regions may reduce current account imbalances. However, credit crisis could make imbalances intractable or lead to violent unwinding of imbalances.

• Wolf: Countries with large external surpluses import demand from the rest of the world while suppressing it at home. In a deep recession, this is a contractionary “beggar-my-neighbour” policy

Is the Commodity Super-Cycle Dead or Just Taking a Break?

• The low prices in commodities has led to production cuts and investment delays, sowing the seeds of a future supply crunch when commodity demand recovers

• Economic growth in developing countries argues for the eventual resumption of the secular bull market in commodities. However, the credit crisis may permanently restrict the ability to leverage, keeping the commodity supercycle's uptrend moderate compared to the pre-crisis run-up

How Will the Financial Crisis Shape Geopolitics in 2009?

• The financial crisis has the potential to accelerate several ongoing trends including restructuring of global economic institutions and rising nationalism and social unrest while freezing progress in democratization, and toughening the meeting of climate change targets

• Political uncertainty in Asia and other EMs may exacerbate financial market stress and make it more difficult to attract investment.

• The western-centered financial crisis may reinforce the perception that the U.S. and the EU are becoming relatively weaker, both in terms of hard and soft power. The plunge in oil prices will leave Russia, Iran and Venezuela short of cash and political clout

Islamic Finance: How Insulated From Conventional Finance Shocks?

• Proponents of Islamic finance suggest that its focus on asset-based not debt finance keeps it immune from global financial market turmoil. However, issuance is exposed to devaluation of the underlying assets (especially property) and to a broader liquidity shortage which has led to a reduction in both islamic and conventional debt issuance

• The Islamic bond (sukuk) market received a double blow in 08, suffering from a global liquidity freeze and a controversy over which types of sukuk are compliant with Islamic law hit the market. Global sukuk (Islamic bond) issuance dropped 60% to $15.2 billion between January and October 2008 compared with the same period in 2007 as global liquidity dropped and a controversy over which types of bonds are compliant with Islamic law erupted. Demand from financial institutions, insurance companies, and pension funds across Islamic and non-Islamic countries may boost demand in the long-term but low oil prices and regional liquidity may suppress demand in 2009

The Future of Investment Banking: What Might It Look Like?

• When Goldman Sachs (GS) and Morgan Stanley (MS) became bank holding companies in Sep 2008, it seemed to mark a historic shift; the end of an era in investment banking. Following JPMorgan's takeover of Bear, the collapse of Lehman and Bank of America's purchase of Merrill Lynch, it was the culmination of a year that had turned the financial world upside down. What lies ahead for the industry both from a business model perspective and an appropriate regulatory structure is debatable.

• Rather than being forced to change in order to comply with commercial banking regulations, GS and MS could end up changing the commercial banking landscape to fit their businesses. While GS and MS have been given a 2 year exemption from current commodity regulations restricting commercial banking activity in the industry, with a further three in the offing, MS has applied for the exemptions to extend beyond the 5 year window. Some believe that current restrictions will be permanently removed, opening the commodities markets to further incursion by other commercial banks (The Banker)

The Shrinking Hedge Fund Industry: From $2 Trillion To $1 Trillion By 2009?

• Between 1990 and last year the industry’s assets under management grew almost 50-fold, to nearly $2 trillion. Now industry executives predict that assets could fall by 30-40%, as clients stampede for the exit. The number of funds, which climbed to over 7,000 as a generation of financiers headed for the gold-paved streets of Mayfair in London and Greenwich, Connecticut, could fall by half (Economist)

• The global hedge-fund industry lost $64 billion of assets in November, with an index tracking its performance declining for a sixth month as economies in Asia and Europe joined the U.S. in recession (Eurekahedge)

• Hedge fund assets worldwide shrank by 9 percent to $1.56 trillion in October, the lowest level in two years, after investors withdrew cash and stock markets declined(FinWeek)

• Investors pulled $40 billion from hedge funds in October, according to Chicago-based Hedge Fund Research Inc., while market losses cut industry values by $115 billion. Investors withdrew $22 billion from funds of funds, which pool money to invest in hedge funds. About 350 hedge funds shut down in the first half of 2008, up 16 percent from 303 a year earlier, according to data compiled by Chicago-based Hedge Fund Research Inc.

M&A: Will It Ever Be the Same ?

• Since the beginning of the credit crisis in August 2007, many activities that were part and parcel of investment banking have undergone seismic shifts and contractions. Deal volume in Mergers and Acquisitions (M&A), and the overall ability of companies to bring a deal to conclusion is one such area:

• Global merger volume dropped by almost a third in 2008, ending five years of deal growth as a lack of available credit, plunging stock markets and a worldwide financial crisis undermined companies' ability to make acquisitions. Global merger volume totaled $2.89trillion, marking the lowest annual volume since 2005. A record number of previously agreed deals -- over 1,100 -- were canceled in 2008 (Reuters)

EUR: Just a Temporary Rally Versus the USD?

• Portfolio rebalancing, fund repatriation from CEE and Latam back to Europe, and thin markets have pushed the USD significantly lower but the USD will not see sustained weakness as a funding currency until risk appetite improves (BNP Paribas)

• Repatriation flows and pro-active policy can see USD rewarded in 2009. The question is whether the USD should be punished for a large budget deficit or rewarded for an aggressive stimulus package. With budget deficits deteriorating around the world, we suspect growth concerns will win out and the USD to strengthen (ING)

Sovereign Wealth Funds and Foreign Exchange Reserves: Slower Growth and More Conservative Asset Allocation in 2009?

• Reduction in the oil price and slowing capital inflows to emerging markets reduced inflows to sovereign wealth funds after August 2008 while equity and alternative asset class losses likely eroded past investment gains meaning sovereign wealth funds may actually manage less today than they did a year ago despite record inflows to oil funds for much of this year. Going forward, the rate of growth of sovereign investors might slow considerably (Ziemba).

• The trend of rising foreign reserve accumulation (which have grown from $2 tr at the start of this decade to near $7 tr) appears to have peaked, amid the global slowdown. Major reserve holders in Asia - Japan, Taiwan, India, Brazil, S.Korea and oil-producing countries (correction in oil prices) face headwinds; reserve accumulation is much slower than in H208.Global foreign exchange reserve accumulation has stalled and possibly reversed in the third and fourth quarters with only China and a few oil exporters (Saudi Arabia, Libya, Algeria) still adding reserves - these may now be spending reserves. Other countries ( Russia, India etc) are now spending their reserves by intervening in Fx markets

• Even as governments receive fewer inflows they may privilege liquid assets needed to support their financial sector and provide stimulus to other sectors, thus diverting diversification plans. However funds that privilege domestic economic development may continue to make significant purchases.

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