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Asian Tigers - Alive and Roaring December 2003. Ade Odunsi. Part 1 Global Backdrop . Global Backdrop. Like it or not, Asia is deeply entangled in the US’s massive external imbalance Willingness of Asia to extend cheap credit to the US government and consumer

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Asian tigers alive and roaring december 2003 l.jpg

Asian Tigers - Alive and RoaringDecember 2003

Ade Odunsi


Part 1 global backdrop l.jpg

Part 1Global Backdrop


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Global Backdrop

  • Like it or not, Asia is deeply entangled in the US’s massive external imbalance

  • Willingness of Asia to extend cheap credit to the US government and consumer

  • Asian saving has helped fund tax cuts and credit growth in the US

  • A post-bubble US recession has largely been avoided

  • This has supported US consumption of Asian manufactured goods

  • The “mother of all vendor financing deals” (David Bowers, Merrill Lynch Research)

  • Imbalances however are reaching worrisome levels


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Asian Resurrection

  • Asia is only 11% of the world economy but is growing 2.5x as fast

  • Over the 2001-2003 period China represents only 4% of Global GDP but contributed 17.5% to Global GDP growth!


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If You Scratch My Back...

  • Asian trade deficit with US excluding Japan $179bn (of which China $114bn!)

  • Current Account = Capital Account

  • Asia purchased $161bn of US securities over the past 4 quarters (30% of CA deficit)


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A Quick Word on China

  • US Bilateral trade surplus has jumped by 50% over the last 3 years (>$100bn)

  • 50% of exports to US are foreign companies - FDI

  • Imports from China are not direct substitutes for US goods

  • China has emerged as the leading manufacturer of labour-intensive goods

  • China runs a trade deficit with the rest of the world

  • The shift in manufacturing jobs abroad has been happening since the 1950’s

  • The money comes straight back - China owns >$120bn of Treasuries


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Part 2 Why are We Concerned?


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The Elephant in the Corner

  • CA deficit reaches $520bn - never bet against the US consumer!


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US Dependence on Foreign Capital

  • “Foreign capital” increasingly means Asian capital

  • Asia bought $23bn of US assets in September alone


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“Hot Money” Dominates

  • The upturn in the US stock market this year has not convinced foreigners to make long-term investments in the US

  • At the peak of the bubble, US equity inflows from overseas reached $200bn


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It’s a Little Known Fact...

The rally in the US Equity market is domestically driven!

TIC = US Treasury International Capital System

  • Significant funding of the CA deficit is by foreign Central Banks (>$1 trillion)

  • Bank of Japan is the largest buyer of Treasury securities (> $130bn this year)

  • Net foreign buying of corporate bonds has outstripped Treasury securities over the last 12 months - the search for yield

  • A worrying development: foreign net purchases of US financial assets dropped from $62bn in August to $16bn in September


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Pent-up Demand Not in US

  • There are three common conditions to a lasting pickup in private demand

  • Rising confidence and low real interest rates are met in each of the G3

  • Private financial surpluses in Japan are 5% of GDP; 3% in the Eurozone (2003); -1% in the US


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Part 3 What Does This All Mean?


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Reality Check

  • This financing arrangement between Asia and the US has benefited both

  • Asia needs US demand just as much as US needs Asian capital

  • Talk of protectionist policies by the US are largely political

  • The ‘basic’ problem with the deficit is that it is HUGE

  • Low yields on US assets make the deficit increasingly difficult to finance

  • How does the US recovery sustain itself?

  • The problem ‘officially’ recognised at the G7 meeting in September 2003 - this likely marks the beginning of the end of this dynamic


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What Is Our View?

Rising local activity will enable Asia to grow out of its CA surplus

  • ‘Competitive reflation’ has boosted Asian economies

    • Aggressive FX intervention by Asian Central Banks to limit currency appreciation and maintain competitiveness (also limited ability to sterilise)

    • Lower interest rates

    • Massive growth in Asian FX reserves (Treasuries: $15bn/month on average)

  • But rising employment and utilization rates pushing up inflation

  • Business is booming and Asian consumers have a large pool of savings

  • Strong economic outlook will be the catalyst for acceptance of currency appreciation in Asia

  • THE END GAME: redistribution of growth from the US to Asia. Asian consumers will be the main drivers of demand


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The Flip Side

  • Slower US growth (…but Q3 GDP growth 8.2%)

  • Higher returns in Asia attract capital from US securities markets

  • US interest rates adjust higher resulting in lower demand

  • Fed committed to keeping short-term interest rates low

  • The US dollar must devalue to maintain balance

  • Imbalances correct gradually


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Deja Vu

  • The Plaza Accord (1986)

  • Trade weighted USD index peaked in Feb ‘01 and has fallen 23%

  • EURUSD FX rate has fallen 42%


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What Else Could Happen?

  • Massive US recession?

    • Fed to keep interest rates ultra-low for an extended period

  • Competitive reflation in Asia results in a major inflation shock, impacting real rather than nominal exchange rates

  • A combination of all 3 factors

  • In everyone’s interest to engineer a slooowwww adjustment


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Part 4 Money Talks


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The FX ‘Virtual’ Market

  • Huge (For comparison, US Treasuries $400bn/day)

  • Liquid

  • Sophisticated

  • Highly automated

  • Fast

  • Unregulated (!?*)

  • 24 hour global market

Source: BIS Central Bank Survey 2001


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FX as an Asset Class

  • Massive increase in interest in FX as an asset class i.e. currency speculation

  • Driving component of many investment bank’s recent profitability

  • FX is not cyclical - consistently profitable!

    1) Trending markets - US dollar in a long-term structural decline

    2) Quest for alpha

    3) A search for ‘alternative’, non-correlated assets

    4) A little known fact - FX is a less risky asset

  • What are chances of the FX rate going to zero?

  • CB’s tend to intervene if volatility gets too high


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But FX is a Zero-Sum Game, Right?

  • Another little known fact - not every participant in the FX market is a profit maximizer!

  • Central Banks For example:- Bank of England ‘defending’ the pound in 1992- Bank of Japan sales of Yen for US dollars this year have exceeded $130bn Yen has still strengthened by over 12%!

  • International corporations

  • Private individuals

  • Professional currency managers make up less than 1% of daily turnover SIGNIFICANT PROFIT POTENTIAL!


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Show Me the Money

  • Buy Asian equities

    • India

    • Thailand

    • Taiwan


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Show Me the Money

  • Chinese Renminbi (CNY) is a pegged currency (8.2771 CNY per USD)

  • Active ‘off-shore’ forward market (non-deliverable market)


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Disclaimers

The analyst(s) responsible for covering the securities in this report receive compensation based upon, among other factors, the overall profitability of Merrill Lynch, including profits derived from investment banking revenues.

Copyright 2003 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). All rights reserved. Any unauthorized use or disclosure is prohibited. This report has been prepared and issued by MLPF&S and/or one of its affiliates and has been approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is regulated by the FSA; has been considered and distributed in Australia by Merrill Lynch Equities (Australia) Limited (ACN 006 276 795), a licensed securities dealer under the Australian Corporations Law; is distributed in Hong Kong by Merrill Lynch (Asia Pacific) Ltd, which is regulated by the Hong Kong SFC; and is distributed in Singapore by Merrill Lynch International Bank Ltd (Merchant Bank) and Merrill Lynch (Singapore) Pte Ltd, which are regulated by the Monetary Authority of Singapore. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Additional information available.

Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). MLPF&S and its affiliates may trade for their own accounts as odd-lot dealer, market maker, block positioner, specialist and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or short position in any securities of this issuer(s) or in related investments. MLPF&S or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report.

This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

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