GEMS - Currency Turmoil - Into Stormy Waters

In this Report:Currency War?•InflationandExchangeRate•TheChineseYuan•TheUSDollar•SailingintoStormyWaters•

CurrencyTurmoil:IntoStormyWaters By Dr Yuwa Hedrick-Wong

Alert ReportMarch 2011

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Currency War?

Reportedly it was the Brazilian Finance Minister, Guido Mantega, who called the situation today “the era of currency war”. He was referring to the recent scramble by many countries to seek measures to limit the rise of the exchange value of their cur-rencies by erecting barriers to cap-ital flow. Against the backdrop of an uneven, as well as uncertain, global economic recovery, a strong currency is seen in many export-oriented markets as detrimental to export competitiveness, while also sucking in more speculative capital flow which then pushes up domestic inflation. As Chart 1 shows, across many emerging mar-kets there has, indeed, been signifi-cant currency appreciation against the US dollar during the course of 2010. In 2010 in Asia, Taiwan and Thailand led the way to impose capital controls on foreign invest-ments in their bond markets. Then Brazil followed by tripling its tax on foreigners’ purchases of bonds, from 2% to 6%. In many emerging markets, central banks are moving beyond merely buying-up excess US dollars to outright interven-tion in the exchange markets, in order to prevent their currencies from rising further. Earlier this year Chile announced that its central bank would buy up to US$12 bil-lion of foreign reserves and similar actions are being undertaken by the central banks of Peru, Mexico and Columbia. To dampen market speculation, Brazil has started to require its banks to cover 60% of their bets against the US dollar with

deposits at the Central Bank which receives no interest. Columbia and Peru have also started to tax interest payments to non-residents. This supposed era of cur-rency war shows the most anarchic aspect of the global economy, with each country fending for itself by whatever means necessary -- includ-ing the repeatedly tried and failed “beggar thy neighbour” policy. In the short term, it is difficult to assess the effectiveness of many of these policies; it is simply hard to know what the exchange rate would have been had such policies not been implemented. Over the longer term, however, there is no question that market distortions resulting from such policies, singly and cumulatively, would erode eco-nomic efficiency, impeding much needed investment in infrastruc-ture and industrial development in many emerging markets and hurt-ing their economic growth1.

1 This is because there is simply no way for

governments in these emerging markets to differentiate

what portion of the capital inflow is purely speculative, and

what portion is meant for real investment.

One of the root causes of the current situation is the specula-tive capital flow from the developed economies -- the US especially -- to the emerging markets, an issue which was discussed at some length in our January GEMS report.2 However, it takes more than just speculative capital inflow to cause the kind of turmoil that we are seeing today. GEMS believes that there are three other sets of funda-mental economic forces at work which are directly responsible for creating today’s currency turmoil. The first is the challenge of rising inflation, which is putting pressure on governments’ exchange rate policies in many emerging markets. The second is the China factor; how China manages its currency would in turn impact on the export performance of many countries in Asia and beyond, since for many of them, China has become their biggest export market in recent years. The third is the US dollar exchange rate itself and how it may

2 See At the Edge of Order and Chaos: the

Dynamics of Global Economic Recovery, GEMS Bellwether

Report, January 2011.

Chart 1. Currency Movements Against the US Dollar

* Estimates of appreciation against the US$ in 2010

(IMF)

10.2% 9.8%8.5% 8.4% 8.1%

3.0% 2.6%1.8%

ThaiBaht

JapaneseYen

Euro AustralianDollar

BrazilianReal

MexicanPeso

ChineseRMB

IndianRupee

GEMSSM



change in the future. Thus, any attempt to clarify the future of the currency markets must take account of how they may evolve and interact over the coming months and years. Inflation and Exchange Rate Speculative capital inflow does not automatically drive up inflation, as commonly assumed; the central bank and its monetary policy are the critical intervening variables. To skip all the technical details, the bottom line is whether the government (and/or the central bank) is prepared to allow capital inflow to drive up the exchange rate of its currency, or to intervene to suppress exchange rate appreciation. And if the policy is one of interven-tion, then the central bank has the choice of either sterilising or not sterilising the inflows. Should the decision be that of sterilisation, then the state of the commercial banks’ loan-to-deposit ratio be-comes an important factor in determining how amplified the transmission from capital inflow to domestic credit expansion (and therefore inflation) may become. If the central bank intends to suppress exchange rate apprecia-tion, it would monetise the balance of payments surplus that results from capital inflow. The actual mechanism involves the central bank buying foreign currencies and accumulating foreign currency assets on its balance sheet. If the intervention is not sterilised, there is then an equivalent increase in cash in local currency in the

domestic economy. Unsterilised inflows would drive up inflation directly as there is now more cash chasing the same amount of goods. Alternatively, if it is sterilised, there is an equivalent increase in central bank bills held by investors in the domestic economy (in Asia most typically held by commercial banks.) The latter is the most commonly seen transmission mechanism from capital inflow to domestic credit expansion in Asia. Holding central bank bills in turn inflates the balance sheets of commercial banks. Everything else being equal, this means commercial banks would experience a drop in their loan-to-deposit ratio. In Asia Pacific, banks’ loan-to-deposit ratios tend to be low, as Table 1 shows. The only exceptions are Australia and Korea where loan-to-deposit ratios are well over 100%. India is perhaps a third exception, where banks’ low loan-to-deposit ratio does not reflect the need (and an

obligation for state owned banks) to finance the government’s sizable, and rising, budget deficits. So effectively, the relatively low loan-to-deposit ratio in India overstates banks’ ability to lend. Faced with low and declin-ing loan-to-deposit ratios, it is therefore not surprising that commercial banks in Asia have been aggressively pushing loan growth. The credit expansion that resulted has been at the heart of the growing inflationary momentum in most Asian markets and is arguably much more powerful than a straightfor-ward increase of cash in circulation. In the second half of 2010, when faced with the choices of risking higher inflation or risking crashing exports (if exchange rates were allowed to rise), Asian governments chose to risk higher inflation. In terms of export growth, the gamble has apparently paid off. While the strong rebound in Asia’s exports in the first half of last year was due

Table 1. Loan to Deposit Ratio in Banks in Asia/Pacific

Average 4Q 2010 (%)Australia 127

China 68Hong Kong 61

India 72Indonesia 82

Japan 74Korea 115

Malaysia 77Philippines 57Singapore 75

Taiwan 73Thailand 88

(CEIC) GEMSSM



primarily to global trade normalis-ing after the drastic plunge in the aftermath of the 2008/09 crisis (even though Asian currencies were strengthening against the US dollar over the same period), the resilient export performance in Asia in the second half of the year was due in no small measure to the suppression of further appreciation of the exchange rate, which kept exports competitive. By 4Q last year, however, it was becoming apparent that inflation was accelerating, as shown in Table 2. While rising inflation is always a worry, it is worse when inflation is also food price related. Rising prices of food are a particular concern because the impact is disproportionately harder on the

poor. The lower the household income, the higher the percentage of disposable income spent on food, hence food price inflation becomes a very politically sensitive issue. Take Indonesia, for example, while the number of people living on less than a US dollar a day is estimated at “only” 8% of the population, the estimated number of people living with less than two US dollars jumps to 40% of the population! Table 3 summarises the estimated weight of food in the consumer goods basket that is used to calculate the con-sumer price index (CPI) in some key markets in Asia. The impor-tance of food prices in Asia there-fore makes the very idea of core inflation targeting (netting out food and energy in estimating core inflation) utter nonsense.

Governments can choose not to suppress exchange rate appreciation, of course. In the Asia Pacific region, there is actually a full spectrum of exchange rate policies on display. At one end of the spectrum is Hong Kong, where the currency peg to the US dollar means that the Monetary Authority of Hong Kong operates a strict regime of exchange rate control to maintain the peg. At the opposite end is Australia where the Reserve Bank of Australia does not monetise the balance of payment surpluses at all, thus allowing the Australia dollar to float freely to where the current and capital accounts are balanced. Consequently, the value of the exchange rate of the Australian dollar against the US dollar, which has risen by 11% on average over 4Q, 2010, has the effect of keeping Australian inflation in check. The import price index accordingly dropped 3.8% Q-on-Q in 4Q, leading to the overall “tradables” component of the consumer price index increasing by only 0.3% Q-on-Q. Thus, the higher ex-change rate of the Australian dollar

Table 2. Accelerating Inflation

Average CPI YoY Growth Rate 2009 2010China 1.9% 4.8%India* 3.6% 8.5%

Indonesia 4.8% 5.3%Malaysia 0.6% 1.9%

Philippines 3.1% 3.9%Singapore 0.6% 3.0%

Taiwan -0.2% 1.5%Thailand -0.9% 3.5%

(*wholesale price index, CEIC)

GEMSSM

Table 3. Weight of Food in CPI

Indonesia 32%Thailand 33%

China 33%India 46%

Philippines 50% (Government Statistics)

GEMSSM



against the US dollar has insulated Australia from higher US dollar denominated food commodity prices. This in turn means, every-thing else being equal, that the Reserve Bank of Australia could slow its pace of interest rate hikes. So in most emerging markets governments do have options in terms of choosing to control the exchange rate or infla-tion. The conundrum is that they cannot do both. That is the deep dilemma of monetary policy in the international context3 and the situation is made more complex because of the China factor. 3 Robert Mundell won a Nobel Prize of

economics working out the so called “unholy trinity”, where

the government can choose any combination of two of three

desirable options, but never all three: freedom to manage

the interest rates, a convertible currency, and a stable

exchange rate.

The Chinese Yuan The job of many emerging market governments in monetary policy has been made more compli-cated by having to keep a wary eye on the exchange rate movement of China’s yuan. This is due to the rising importance of the China market as an export destination for these emerging markets in recent years. As shown in Chart 2, China is today a very important market for the rest of Asia and beyond. In GDP terms, exports to China accounted for as much as 14% in Taiwan and 2% and 1.5% respec-tively for South Africa and Brazil, at the lower end. Significantly, rising portions of their exports to China today are meant for domestic consumption, as opposed to

supplying the export-oriented manufacturing industries. Accord-ing to estimates made by the Asian Development Bank (ADB), while some 40% of exports to China from other emerging markets in 1998 were components used as inputs for China’s export industries, by 2008 this had dropped to 27%. In other words, more and more imports are being consumed domestically in China. The China market has become even more important in the aftermath of the 2008/09 crisis. Chart 3 shows the contrast between growth of overall exports and growth of exports to China over the period of 3Q 2009 and 2Q 2010 for Indonesia, Malaysia, Singapore and Taiwan. In the case of

14%10%

4%2% 2% 1.5%

40%

27%

Taiwan S. Korea Australia Japan S. Africa Brazil 1998 2008

Chart 2. Rising Dependence on the China Market

Exports to China in 2010 (estimates) as % of GDP

( GEMS )

Component exports to China

as % of total exports from

Asia( ADB )

GEMSSM



Indonesia, for instance, while overall exports grew strongly at 50%, this pales in comparison to growth exports to China, at 175%. Given the importance of China as a market for exports from emerging markets in Asia (and elsewhere), it is not surprising to see that many governments in these markets manage their currencies with the Chinese yuan in mind. Just as they do not wish to see their currencies appreciate too far or too fast against the US dollar, nor would they wish to see the same against the yuan. In this context, how China manages its exchange rate against the US dollar affects not only the bilateral trade and capital flows between China and the US, but also a large number of

markets worldwide that have become more dependent on China’s demand for their exports. A decade ago, the situation was a lot easier as China more or less pegged the yuan to the US dollar. However, since then things have become a lot trickier. In mid-2005 China started to loosen the yuan’s peg to the US dollar which had been in force for the previous 24 months. From mid-2005 to the end of 2010 the yuan has appreciated against the US dollar by an average of about 5% per annum. But the average does not tell the whole story; it appears that China is prepared to let the yuan rise faster when there is a need to slow down the overheated economy, as it did in 2007 when

the yuan was appreciating at an annualised trade-weighted average of about 15%. However, when global demand for China exports weakens, as it did in 2009, the yuan then stays pegged to the US dollar. So a key priority for how China manages its exchange rate is its domestic growth rate, pure and simple. It is because of this domes-tic priority that China has frequent-ly been accused of currency manipulation, especially by US law makers. The Chinese government, of course, sees things very differ-ently; they see it as a gradual and controlled process of currency appreciation and liberalisation and that it should be left to the Chinese government to dictate its timing

Chart 3. Rising Dependence on the China Market

YoY growth, 3Q 2009 – 2Q 2010

( estimated with CEIC data )

50%40%

52%36%

175%

120%105%

90%

Indonesia Malaysia Singapore Taiwan

total export growth growth of exports to China

GEMSSM



and pace. There is, however, no dispute that the yuan is underval-ued against the US dollar. The only question is by how much. There are three widely accepted technical economic models for estimating the extent to which a currency is over- or under-valued against another currency.4 In GEMS’ opinion, the most relevant one in terms of understanding how currency affects a country’s export competitiveness is the so called productivity model, which calcu-lates the “real effective exchange

rate” (REER), which in turn is based on estimates of how unit labour costs compare between the two countries in question. Apply-ing this model to China’s yuan, it appears that it is undervalued by about 12% against the US dollar in 2010, which is, significantly, a lot less than estimates arrived at by applying the other two models5. REER takes account of the differential between inflation in the US versus inflation in China, focusing on relative changes in wages and productivity in the tradable sector between the two countries, the unit labour cost. 4 These are (i) the equilibrium model, (ii) the

purchasing power parity model, and (iii) the productivity

model.

5 Estimates by the equilibrium model and the

purchasing power parity model are undervaluation of 45%

and 25% respectively.

While American wages have stayed almost flat in the past five years, Chinese manufacturing wages have risen at their fastest pace in over a decade and have even outstripped productivity growth over the past few years. When these differences are accounted for it appears that the Chinese yuan has appreciated by about 50% against the US dollar since the mid-2005, much higher than its appreciation in nominal terms of 24%. Faster wage growth in China is likely to be the norm over the coming years.6 Apart from China’s demographic shift, which will see a dwindling supply of younger workers for the next decade, higher wages are also an explicit policy objective of the government, seen as an important factor to support domestic con-sumption growth. This in turn will mean that the appreciation of the yuan (in nominal terms) may well be slower over coming years than a lot of people might have expected. Slower yuan appreciation means less wriggle-room for many emerging markets in their attempt to main-tain a competitive currency against the US dollar and the Chinese yuan at the same time. So the Chinese yuan will likely add to, instead of reduce, the complexity of the task of exchange rate management for many countries. Finally, it is worth making the point that the much hyped story of the rise of the yuan as a new global reserve currency is premature by at least two decades, 6 This very important issue will be the topic of a

future GEMS report.

if not longer. It is true that since last June the Chinese government has allowed China’s importers to pay their imports in yuan (to anyone who is prepared to accept it as payment) and authorised an initial list of 365 Chinese compa-nies to sell their exports in yuan. By December last year, the number of Chinese companies authorised to do so jumped to over 67,000, a reflection of the government’s sense of ease regarding the results of the experiment. By the end of Novem-ber last year, it was estimated that some US$58 billion of trade had been settled in yuan. Of this, it is important to note that about 80% are foreign buyers of Chinese exports who were accepting yuan for payment and that only 20% were foreigners paying yuan to buy Chinese exports. Currency specula-tion is clearly a motive here. With the market generally believing that the yuan will continue to appreciate the incentive to accept and hold yuan is naturally stronger than the incentive to sell it. Much of the yuan that has left China has been accumulated in Hong Kong. The pool of yuan deposits in Hong Kong today is estimated as high as US$50 billion. Hong Kong now has a very active yuan market, where it can be bought and sold. Bonds have also been issued in yuan (the so called “dim sum” bonds). Internationalis-ing the yuan in this fashion is, however, a far cry from the yuan becoming a true global reserve currency. For the yuan to become such, as it has often been noted,

“...it will be at least two decades into the future [...] before the Chinese yuan can be said to qualify as a true global reserve currency.”



four basic pre-conditions would need to be met. The first is that the currency in question would need to be fully convertible. The second is that the country in question would have to have a fully open capital account. The third is that it would need to have a sufficiently deep and liquid global pool of the currency in question for any buyer and seller anywhere to transact instantaneous-ly in that currency.7 The fourth, which is closely related to the third pre-condition, is that the domestic capital markets of the country in question would also need to be sufficiently deep and liquid. China today does not meet a single one of these four pre-conditions and it will be at least two decades into the future, perhaps longer, before the Chinese yuan can be said to qualify as a true global reserve currency. The US Dollar An unstated premise of all the talk about currency war is that the decline of the US dollar will continue. Should the US dollar rally in the near term, however, a great deal of the concerns over currency appreciation against the US dollar would evaporate. As vividly demonstrated during the 2008/09 crisis, the exchange value of the US dollar is closely correlated to risk aversion. This is because, after all the sound and fury about the decline of the US dollar, it remains a safe haven for global investors. The weakening of the US dollar over the course of 2010 was

7 The Japanese yen failed to meet the third pre-

condition in spite of Japan being the second largest economy

in the world for over three decades before overtaken by

China recently.

due to the fact that risk appetite had been rising. With quantitative easing, money fund managers were under pressure to seek higher yields and they poured investment into equities and the property sector in the emerging markets. And in the short term, their bet was self-fulfill-ing; as asset prices in emerging markets rose, they attracted more investment inflow, leading to yet higher asset prices. However, the game may be up in 2011. A number of developments in the global economy in 2011 could quickly turn risk appetite into risk aversion. The first is the deepening of the Eurozone crisis. As GEMS has argued elsewhere8, Portugal will need a bail out and the restructuring of the crisis countries’ debts in the Eurozone is all but inevitable. Apart from very severe impacts on Europe’s banking sector where re-capitalisation by governments is needed (and in some instances outright nationalisa-tion of banks required) the fallout will be renewed market turmoil and uncertainty. Meanwhile, rising inflation and interest rates in emerging markets will start to put a brake on growth, and in some markets, speculative capital inflows could quickly reverse to outflows with some asset prices collapsing as 8 See GEMS February 2011 report, Euro’s Fate:

and does it matter to Asia?

a result. The risk appetite of the market will then quickly revert to risk aversion. With risk aversion, it is then back to the flight to safety, which means to the US dollar. The case of flight to safety is further bolstered by the size of the “dollarised economy” beyond the US. This dollarised economy includes all exporters and commod-ity producers who price their exports in the US dollar and governments which peg their currencies (as in Hong Kong) to the US dollar. Table 4 shows estimates of the dollar’s share of the world totals in foreign exchange transac-tions, international reserves, cross-border bank deposits and loans, which are much higher than the US share of world GDP, estimated to be 25%. In a global economy riddled with uncertainty, the world needs the US dollar more than ever. This is why GEMS believes that the US dollar will remain, for the foreseeable future, the only global reserve currency. All the loose talk of the decline of the US dollar is entirely premature.

Table 4. US Dollar’s Share of World Total, 2010 Estimates

Foreign Exchange Transactions 85%International Reserves 63%

Cross-Border Bank Deposits 58%Cross-Border Bank Loans 52%

US Share of World GDP (nominal) 25% (IMF) GEMSSM



“stormy waters”. This is because the system today in which world cur-rencies are exchanged is one with-out any anchors. In the Bretton Woods system set up after the Second World War, world currencies (out-side of the then-Soviet bloc) were tied to the US dollar, which in turn was tied to gold. Capital movement between countries was severely constrained under post-war condi-tions and most countries focused on managing their monetary policy, which was considered to be far more important for their domestic economies. That system collapsed in 1971, and ever since, nothing has been put in place to replace it. It did not matter that much at first, however in the three decades since then, more and more countries lifted capital control and world trade grew on average by some 8% a year. At the same time, the size of the foreign exchange market expanded by about three times the rate of the growth of trade. Furthermore, financial mar-kets worldwide have become more integrated as a result of financial globalisation, with freer flow of capital in and out of emerging mar-kets. And, yet, the system remains one without any anchors and is a patchwork of different exchange rate regimes coupled together with varying degrees of capital control. On paper, some 40% of the world’s currencies are supposedly “floating”, yet in reality, many are still heavily managed (as they are in many of the Asian markets discussed above).

Sailing into Stormy Waters Today’s currency turmoil can be explained at its most funda-mental level as a result of the need to rebalance the highly unbalanced global economy in the aftermath of the 2008/09 global financial crisis. In the decade leading up to the crisis, cheap currencies in emerging markets (especially against the US dollar, but also against the euro) were a key component in keep-ing capital cheap and savings high, which in turn drove excess produc-tion and rising exports, along with chronic current account surpluses. The flip side of this was excess credit growth and mounting debts in the developed economies made possible by the abundant supply of capital and cheap consumer goods from emerging markets, leading to low or no domestic savings and debt-fueled consumption, and chronic current account deficits. The good news is that the global economy is indeed rebalanc-ing itself today. Emerging markets have responded to weakening global demand for their exports by in-creasing domestic demand, both in terms of investment and consump-tion. China actually subsidised household purchases of consumer durables in 2009 and 2010 and this has produced faster wage increases in response. Households in the US and UK, on the other hand, are rebuilding their savings and paying-down debts. But the rebalancing is going to be a long and gradual process, and certainly painful, and it could take years before we see

concrete results. To make things more complex, governments everywhere are keen to maintain economic growth in the short term, very anxious to avoid slipping back into recession. So there is a yawn-ing gap between the longer term objectives of global rebalancing and the shorter term imperative of maintaining economic growth. In the US, for example, deleveraging by households and businesses is being offset by increasing public sector debts. The Federal Reserve’s priority is to inflate asset prices to avoid the risks of deflation and a double-dip recession through quan-titative easing. It will allow the dollar to find its price level in the rest of world, whatever that may be.

The volatile currency mar-kets reflect this policy inconsistency between longer term rebalancing (accepting painful adjustments) and short term priorities (maintaining growth at all costs) in both emerg-ing markets and the developed economies. As we argued above, rising risk aversion this year could quickly reverse the slide of the US dollar, relieving much of the pres-sure on emerging market curren-cies experienced last year. So the currency war metaphor is not only over blown, but highly misleading. A more appropriate metaphor for the state of the world’s currencies is, as stated in the title of this report,

“For the foreseeable future, this state of currency “anarchy” is unlikely to change.”



For the foreseeable future, this state of currency “anarchy” is unlikely to change. The US dollar will continue as the de facto reserve currency of the global economy, but the Federal Reserve, the ultimate manager of the US dollar, has a mandate that is purely domestic: price stability and growth. Further-more, as the US’ global economic dominance steadily diminishes, bouts of market anxiety – and hence volatility -- will become more frequent. There is simply no sub-stitute for the US dollar on the ho-rizon. The Chinese yuan is at least two decades away from being able to serve as a genuine global reserve currency and the eventual fate of the euro remains in doubt, depend-ing on how the Eurozone crisis gets resolved.9 While there is no cur-rency war, nor is there any currency peace. The global economy will have currency turmoil in store for the foreseeable future.9 GEMS’s view on the Euroezone crisis is

presented in the February 2011 report, Euro’s Fate: and does

it matter for Asia?

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Appendix A: A Note on the Japanese Yen

The focus of this GEMS report does not really cover the Japanese yen, even though the Japanese economy re-mains one of the largest in the world. The sad truth is that the yen today does not really add to, nor subtract from, the volatility of the world currency markets in any significant way. This is a direct reflection of the fact that the yen has never been internationalised and it matters even less in recent years.

Since the 2008/09 crisis, the Bank of Japan has been resisting the same quantitative easing policy that the Federal Reserve has been conducting. As a result, the yen has been appreciating against the US dollar. And yet Japanese exports have continued to perform well. How could this be so? It turns out that the top tier export-oriented Japanese manufacturers today have mas-sively increased the proportion their overseas production capacity. In the consumer electronics sector, for example, this is estimated that about 40% of production capacity is located outside of Japan.

Overseas production has provided the Japanese industries with a buffer against the strong yen. Table A1 shows the thresholds of the yen exchange rate against the US dollar beyond which margin squeeze will result. In industrial machinery, for example, the yen has to appreciate to around 75 per versus the US dollar before operating profit starts to fall. However, this does not mean that a higher yen has no impact on Japanese cor-porate profits; Sony, a leading consumer electronics manufacturer and exporter, reported that its net income in 4Q last year was down by 8.6% year-on-year, and the strength of the yen is partly to blame, along with weaker overall global demand levels for flat-panel TVs, a Sony stable.

Table A1. The Yen and Japan’s Export Competitiveness

Sector Yen’s exchange level when operating profit starts to fallShipping & heavy equipment 85 yen per US dollar

Automobile 84 yen per US dollarIndustrial electronics & components 78 yen per US dollar

Industrial machinery 75 yen per US dollar (Daiwa Institute of Research, 2010)

One can argue that the yen/US dollar exchange rate may not be the most important factor for Japan today, with the rise of competitors like South Korea and increasingly China too. In capital goods and high-end consumer electronics, for instance, Korean exporters compete head-to-head with Japanese exporters in third markets. Japan lost a great deal of market share in 2009/2010 when the Korean won depreciated against the Japanese yen by some 30%.

Appendix B: Indicative Trends of Exchange Rate Movement

GEMS does not pretend to be an expert in exchange rate forecasting, however, based on analysis of economic fundamentals, we have a view on the directional trends of the key currencies over the next 12 months, as shown in Table B1. Even if these indicative currency trends are indeed achieved over the next 12 months the path to get there will inevitably be very volatile -- lots of zigzagging. The timing of exchange rate fluctuation is especially difficult to predict, even if the directional change is correctly anticipated. So the direction and level of change expressed in Table B1 should be viewed with great caution.

Table B1. Exchange Rate Trends – Directional

4 Q, 2010 average Possible % of Cumulative Change in 12 months

Euro/US$ 0.74 - 12% to -16%Yuan/US$ 6.66 - 3% to -5%

Rupee/ US$ 44.81 - 4% to -6%Yen/US$ 82.54 + 2% to +4%

Ringgit/US$ 3.11 - 2% to -5%Singapore$/US$ 1.30 + 3% to +4%

Won/US$ 1,132.35 -2% to -5%Rupiah/US$ 8,962.97 -5% to -10%Peso/US$ 43.63 - 3% to -5%

Australia$/US$ 1.01 -4% to -6%Baht/US$ 29.99 -2% to -4%

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GEMS - Currency Turmoil - Into Stormy Waters

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