economics report morgan stanley no, the sky is not falling usd structurally sound, but may weaken...

Economics Report

Morgan Stanley

No, the Sky is Not Falling

USD structurally sound, but may weaken for cyclical reasons.

April 2006

Stephen L. Jen [email protected]

Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.Please see important disclosures at the end of this report.

April 2006

Currency Economics

[email protected] +44-20-7425-8583 Please see important disclosures at the end of this report.2

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Slide 18

Slide 22How much will the dollar ‘need’ to fall?

China’s CNY policy

4. Dollar the hegemonic currency

3. Excess savings in Asia

2. ‘De facto dollar zone’

1. USD index not overvalued

April 2006

Currency Economics


The USD is no longer over-valued

Source: Morgan Stanley Research

USD Actual and Long Run (Non-Linear) Fair Value

60

70

80

90

100

110

120

130

USD Misvaluation Confidence Based on Long Run Fair Value (Non-Linear Filter)

-100%

0%

100% Undervalued

Overvalued

April 2006

Currency Economics


Valuation Matrix – G10


Q4 2005 EUR/USD USD/JPY EUR/JPY GBP/USD EUR/CHF EUR/GBP EUR/NOK EUR/SEK USD/CAD AUD/USD NZD/USDQ-End Spot 1.18 118.03 139.23 1.72 1.55 0.69 7.99 9.39 1.17 0.73 0.68PPP - CPI 1.12 99.84 109.08 1.63 1.38 0.68 7.62 8.65 1.42 0.62 0.54PPP - PPI 1.16 82.86 108.15 1.80 1.36 0.66 8.66 8.90 1.17 0.69 0.63PPP - TPI 1.22 106.97 136.44 1.61 1.63 0.76 8.24 8.73 1.43 0.62 0.51SP - CPI/Long 1.06 96.58 109.75 1.63 1.43 0.69 7.78 9.02 1.50 0.62 0.55SP - CPI/Short 1.10 101.31 108.98 1.63 1.40 0.68 7.68 8.70 1.46 0.62 0.54SP - PPI/Long 1.16 80.85 108.31 1.91 1.44 0.67 8.64 9.09 1.22 0.69 0.63SP - PPI/Short 1.15 82.96 108.08 1.79 1.40 0.66 8.66 8.90 1.21 0.70 0.64MM - Flex 1.05 140.78 92.49 1.62 1.31 0.71 8.17 8.12 1.27 0.62 0.55MM - Sticky 1.07 143.19 92.49 1.61 1.31 0.68 8.17 8.12 1.30 0.65 0.55RID - Short 1.24 104.67 134.50 1.59 1.63 0.71 8.65 8.48 1.23 0.74 0.60RID - Long 1.21 100.84 127.89 1.58 1.52 0.78 8.26 8.31 1.21 0.74 0.60BEER I 1.46 108.52 143.70 1.70 1.46 0.70 8.15 9.15 1.17 0.79 0.68BEER II 1.48 109.72 146.77 1.67 1.46 0.70 8.15 9.15 1.17 0.76 0.68

Median 1.16 101.31 109.08 1.63 1.43 0.69 8.17 8.73 1.23 0.69 0.60Mean 1.19 104.55 117.43 1.67 1.44 0.70 8.22 8.72 1.29 0.68 0.59Weighted Mean 1.20 97.86 109.94 1.69 1.39 0.70 8.17 8.86 1.25 0.67 0.60

High 1.48 143.19 146.77 1.91 1.63 0.78 8.66 9.15 1.50 0.79 0.68Low 1.05 80.85 92.49 1.58 1.31 0.66 7.62 8.12 1.17 0.62 0.51

02/03/2006 EUR/USD USD/JPY EUR/JPY GBP/USD EUR/CHF EUR/GBP EUR/NOK EUR/SEK USD/CAD AUD/USD NZD/USDCurrent spot 1.20 116.13 139.16 1.75 1.57 0.69 8.03 9.47 1.13 0.75 0.67% Misalignment 3.45% 14.62% 27.57% 7.00% 9.46% -0.49% -1.79% 8.51% -7.65% 7.61% 11.14%

Preferred Model RID(2) SP(1) PPP(1) SP(3) PPP(1) BEER(1) BEER(1) SP(3) BEER(1) SP(3) SP(4)

April 2006

Currency Economics


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April 2006

Currency Economics


De facto Dollar zone

Source: BEA, Morgan Stanley Research

Trade Balance Against:World Non USD Zone

US -6.0% -3.2%USD Zone -2.3 NA - Asia only -2.4 NA

April 2006

Currency Economics


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April 2006

Currency Economics


Feldstein-Horioka a bit less puzzling

Feldstein-Horioka’s 1960-1974 sample: β = 0.89

I/Y

S/Y45-degree line

A1

A2

B1

B2

β (1960-1979) β (1980-2004)

OECD 0.60 0.33EU 0.52 0.13Asia ex-Japan 0.56 0.39Latin America 0.36 0.27

I/Y(i, t) = α(i) + α(t) + β (S/Y)(i,t) + ε(i,t)

April 2006

Currency Economics


Excess Savings in Asia

C/A surpluses exploded after the Asian Crisis in 1997/98

Asia’s savings rates have been ultra-stable …

But investment rates have been extraordinarily volatile

Asian C/A surpluses Savings and Investment

Source: CEIC, Morgan Stanley Research

Source: CEIC, Morgan Stanley Research

0

2

4

6

8

10

12

14

1990 1992 1994 1996 1998 2000 2002 2004

Per

cent

of

GD

P

Japan

SE Asia

North Asia

18

20

22

24

26

28

30

32

34

36

38

1990 1992 1994 1996 1998 2000 2002 2004

Pe

rce

nt

of

GD

P North Asia Savings

North Asia Investment

SE Asia Investment

SE Asia Savings

April 2006

Currency Economics


Abundant External Financing

0

20

40

60

80

100

120

140

1999 2000 2001 2002 2003 2004 2005F 2006F

Japan

Euro-area

China

AsiaAsia

C/A as relative percentage of US C/A

OPEC OPEC

Euro-area Japan

China

Japan

AXJC

OPEC

2006 est.41.9%USD

337.1bn

2006 est.44.9%USD

361.7bn

Rest of World

Source: IMF WEO

April 2006

Currency Economics


As wrong as the JGB call in ‘98

Mirror images

• Because of the extremely high level of public debt, RE may be degenerating.

• Private savings may more than offset public dis-savings.

Ricardian Equivalence Sort of Held in Japan Watch the Corporates, Not Households

Source: DataStream and Morgan Stanley Research

-12

-8

-4

0

4

8

12

16

FY90 FY92 FY94 FY96 FY98 FY00 FY02

Private Sector Savings

Public Sector Savings

(as % of GDP)

Net Savings Position of Private/Public Sector

-60,000

-40,000

-20,000

0

20,000

40,000

60,000

80,000

FY90 FY92 FY94 FY96 FY98 FY00 FY02

Total Private

Non-Financial

Financial

Households

(billion yen) Net Private Sector Savings

April 2006

Currency Economics


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April 2006

Currency Economics


Globalisation of the goods

market

vs

Globalisation of the asset

markets

April 2006

Currency Economics


The Dollar is special, especially to Asia

Official Private

Medium of Exchange Intervention Vehicle

Store of Value Reserves Banking

Unit of Account Peg Invoice

Source: Kenen (1983)

The Dollar's Facilitating Role

As International Money

April 2006

Currency Economics


Two-dimensional Reserve DiversificationUSTs most liquid sovereign market

Source: US Federal Reserve, IMF, BIS, BEA, US Treasury, Morgan Stanley Research

Diversification in two dimensions

Not necessarily USD negative


Source: BIS, DataStream, US Federal ReserveNote. US Sovereign bonds include Agency or quasi-government bonds (USD3.5 trillion) in addition to US Sovereigns (USD5.7 trillion)

Sovereign

Sovereign bonds

excluding JGBs Corporate

Bonds BondsMarket Value

US 40% 57% 57% 47%Japan 30.0% 0.0% 16.1% 12.7%EMU 23.1% 32.9% 21.6% 19.4%

Germany 4.9% 7.0% 2.9% 4.1%France 5.0% 7.1% 5.4% 5.4%Italy 6.5% 9.2% 4.9% 2.7%Netherlands 1.2% 1.7% 1.3% 1.8%Belgium 1.4% 2.0% 0.9% 0.9%Ireland 0.2% 0.3% 1.1% 0.4%Spain 1.9% 2.7% 4.1% 2.3%Portugal 0.4% 0.6% 0.4% 0.2%Greece 0.9% 1.3% 0.0% 0.4%Austria 0.4% 0.6% 0.4% 0.5%Luxembourg 0.0% 0.0% 0.0% 0.1%Finland 0.3% 0.4% 0.3% 0.7%

U.K. 2.9% 4.1% 0.7% 10.4%Switzerland 0.5% 0.7% 0.3% 3.0%Sweden 0.7% 0.9% 0.6% 1.2%Australia 0.4% 0.6% 2.2% 2.4%New Zealand 0.0% 0.0% 0.0% 0.1%Canada 2.4% 3.5% 2.1% 4.0%

Amounts outstanding

Depth and Liquidity of the MarketsOf Various Potential Reserve Assets(In percent of total market caps)

Equities

20%

30%

40%

50%

60%

70%

80%

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

TIC NYFRB BIS IMF NIIP

USD Share of Official Reserve Holdings

Corporate Bonds

Agency

Sovereign

USD G3 G4-G10

Asset

Currency

April 2006

Currency Economics


Weak evidence of wholesale diversification

I II III IV Ip IIp IIIp IVp

All countriesTotal foreign exchange holdings 3,298,997 3,346,175 3,442,890 3,749,063 3,858,660 3,948,534 4,052,712 4,170,580 Allocated reserves 1/ 73.5% 72.4% 71.8% 70.4% 69.4% 68.6% 67.5% 67.4% Claims in U.S. dollars 67.4% 67.7% 67.2% 65.8% 65.5% 66.1% 66.4% 66.5% Claims in pounds sterling 2.7% 2.7% 3.1% 3.4% 3.6% 3.6% 3.7% 3.7% Claims in Japanese yen 4.0% 3.9% 3.6% 3.8% 3.8% 3.6% 3.7% 3.6% Claims in Swiss francs 0.2% 0.2% 0.2% 0.2% 0.2% 0.1% 0.1% 0.1% Claims in euros 23.7% 23.6% 24.0% 25.0% 25.1% 24.9% 24.4% 24.4% Claims in other currencies 1.9% 1.8% 1.9% 1.8% 1.8% 1.6% 1.7% 1.6% Unallocated reserves 2/ 36.1% 38.0% 39.3% 42.0% 44.1% 45.7% 48.1% 48.4%

Industrial countriesTotal foreign exchange holdings 1,268,588 1,258,727 1,269,547 1,314,596 1,301,681 1,294,605 1,281,605 1,292,249 Allocated reserves 1/ 99.8% 99.7% 99.7% 99.7% 99.7% 99.6% 99.6% 99.5% Claims in U.S. dollars 73.7% 73.9% 73.3% 71.5% 72.1% 73.7% 73.7% 73.7% Claims in pounds sterling 1.3% 1.4% 1.8% 1.9% 2.1% 2.1% 2.1% 2.1% Claims in Japanese yen 3.6% 3.5% 3.4% 3.6% 3.3% 3.3% 3.4% 3.3% Claims in Swiss francs 0.2% 0.3% 0.1% 0.1% 0.2% 0.1% 0.1% 0.1% Claims in euros 19.4% 19.2% 19.6% 20.9% 20.4% 19.1% 19.0% 19.2% Claims in other currencies 1.8% 1.7% 1.8% 2.0% 1.9% 1.7% 1.7% 1.6% Unallocated reserves 2/ 0.2% 0.3% 0.3% 0.3% 0.3% 0.4% 0.4% 0.5%

Developing countriesTotal foreign exchange holdings 2,030,409 2,087,449 2,173,344 2,434,467 2,556,978 2,653,929 2,771,107 2,878,331 Allocated reserves 1/ 57.0% 56.0% 55.4% 54.6% 53.9% 53.5% 52.7% 53.0% Claims in U.S. dollars 60.6% 61.1% 60.9% 60.2% 59.4% 59.3% 60.1% 60.5% Claims in pounds sterling 4.2% 4.1% 4.3% 4.9% 5.0% 4.9% 5.1% 5.1% Claims in Japanese yen 4.4% 4.4% 3.9% 4.1% 4.3% 3.9% 3.9% 3.8% Claims in Swiss francs 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% Claims in euros 28.5% 28.3% 28.7% 29.0% 29.6% 30.1% 29.1% 28.8% Claims in other currencies 2.0% 1.9% 1.9% 1.6% 1.6% 1.6% 1.7% 1.6% Unallocated reserves 2/ 43.0% 44.0% 44.6% 45.4% 46.1% 46.5% 47.3% 47.0%

2004 2005

April 2006

Currency Economics


Holdings of US Treasuries

Foreign holders All Holders

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04

Federal Reserve US ChinaJapan OPEC OtherTotal

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003

Total

Federal Reserve

US

Foreigners

Source: BEA and Morgan Stanley Research Source: BEA and Morgan Stanley Research

April 2006

Currency Economics


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April 2006

Currency Economics


A ‘CNY Event’ in H1 2006

7.70

7.75

7.80

7.85

7.90

7.95

8.00

8.05

8.10

8.15

7/21

/200

5

8/15

/200

5

09/0

7/20

05

9/30

/200

5

10/2

5/20

05

11/1

7/20

05

12/1

2/20

05

01/0

4/20

06

1/27

/200

6

2/21

/200

6

3/16

/200

6

04/1

0/20

06

05/0

3/20

06

5/26

/200

6

6/20

/200

6

7/13

/200

6

08/0

7/20

06

8/30

/200

6

9/22

/200

6

10/1

7/20

06

11/0

9/20

06

12/0

4/20

06

12/2

7/20

06

7.70

7.75

7.80

7.85

7.90

7.95

8.00

8.05

8.10

8.15

USDCNY trend 2 USDCNY trend 3 USDCNY USDCNY trend 1

Gear 1

Gear 3

Gear 2

8.00

8.02

8.04

8.06

8.08

8.10

8.12

Actual Fitted

"Gear2/Gear1" ratio=2.2

"Gear3/Gear2" ratio=2.3

April 2006

Currency Economics


Accelerating rate of crawl of USD/CNY

-0.001

-0.0008

-0.0006

-0.0004

-0.0002

0

-0.02

0.00

0.02

0.04

0.06

0.08

0.10

0.12

Daily Rate of Crawl (20D MA)Daily Damping Coefficient (20D MA)

April 2006

Currency Economics


Pre-Funding of Future Private FlowsIn mlns In % In mlns In % In mlns In %of USDs GDP of USDs GDP of USDs GDP

1982 64 0.0% 151 0.2% 14,280 1.3%1983 798 0.0% 280 0.3% 33,910 2.8%1984 2,653 0.0% 331 0.4% 70,500 5.6%1985 1,019 0.0% 922 1.0% 137,660 10.2%1986 1,509 0.0% 2,148 2.0% 257,930 12.8%1987 2,294 0.8% 2,663 2.0% 373,970 15.4%1988 3,484 0.9% 3,779 2.1% 507,600 17.2%1989 4,584 1.1% 5,086 2.3% 667,840 22.6%1990 5,655 1.5% 6,638 2.6% 756,130 24.9%1991 6,898 1.8% 7,928 2.7% 869,370 25.0%1992 11,348 2.6% 9,014 2.9% 920,700 24.3%1993 16,345 3.0% 11,340 3.3% 998,280 22.9%1994 18,725 3.6% 16,281 4.1% 1,108,350 23.1%1995 20,646 2.9% 22,740 4.7% 1,216,910 23.1%1996 23,388 2.8% 33,738 6.5% 1,340,970 28.6%1997 26,850 3.0% 37,067 7.8% 1,414,090 32.9%1998 33,314 3.5% 43,805 13.8% 1,533,950 39.0%1999 45,623 4.6% 46,721 11.5% 1,710,650 38.3%2000 57,846 5.4% 52,242 11.4% 1,825,560 38.5%2001 85,386 7.3% 60,184 12.8% 1,970,850 47.3%2002 99,999 7.9% 67,833 12.4% 2,088,820 52.5%

2003 96,863 6.9% 75,594 12.5% 2,293,870 53.4%

China Korea Japan

Year to see FDI and Additional% Nominal % Annual RMB US$300 bln portfolio inv. outflows

Scenarios Growth Appreciation in outflows in % GDP in US$ blns.1 10% 0% 10 7.0% $2042 10% 5% 6 7.0% $2643 10% 0% 5 10% by 2010 $2924 10% 5% 4 10% by 2010 $3775 10% 0% N/A 15% by 2010 $438

6 10% 5% N/A 15% by 2010 $566

• China’s private sector’s holdings of foreign financial assets are extremely low in absolute terms, relative to GDP, and relative to those of Japan and Korea.

• Using innocuous assumptions, it would not be difficult to imagine scenarios where cumulative private sector outflows could total US$0.5 trillion in five years’ time. (Scenario 6 below)

April 2006

Currency Economics


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April 2006

Currency Economics


Wrong to ask the dollar to do all the work

Current

Spot 20% 30% 40% 90%

EUR/USD 1.21 1.5 1.7 2.0 12.1

USD/JPY 118 94 83 71 12

USD/CNY 8.00 6.4 5.6 4.8 0.8

GBP/USD 1.74 2.2 2.5 2.9 17.4

% USD deval

Author Date Title Main Result

M. Obstfeld & K. Rogoff

2000 “Perspectives on OECD Capital Market Integration: Implications for US Current Account Adjustment”

16% RER depreciation will be needed to eliminate the CA

M. Mussa 2004 “Exchange Rate Adjustments Needed to Reduce Global Payments Imbalances”

RER needs to depreciate 20% to reach a CA of 2%.

S. Edwards 2005 "Is the US Current Account Deficit Sustainable? And If So How Costly Is Adjustment Likely to Be?"

A “sustainable" CA would imply a 28% cumulated depreciation in the TWI RER.

O.Blanchard, F. Giavazzi, & F.Sa.

2005 “The US Current Account and the Dollar” The required real depreciation of the dollar to eliminate the CA deficit is in the range of 40 to 90%, depending on the role of valuation effects.

M. Obstfeld & K.Rogoff

2005 “The Unsustainable US Current Account Position Revisited”

A rebalancing of the CA requires 20-25% of TWI RER.

• Don’t just ask the question, ‘how much will the dollar need to correct?’

• Ask also whether the implied exchange rates make any sense, or are ‘acceptable.’ If the answer to this second question is ‘no,’ then the answer to the first question must not be correct or relevant.

April 2006

Currency Economics


Explaining the US household saving rate

• US household saving ratio (S) can be explained by three factors:

(1) household stock market wealth ratio (SE)

(2) household real estate wealth ratio (RE)

(3) US long bond yield (TB)

• Our estimation results suggest that:

1. The explanatory variables account for 80% of the total savings rate variability during the last 50 years.

2. Savings are particularly sensitive to housing wealth.

• Simulated Fed fund hikes along with gently decreasing Household and Equity wealth ratios would imply a positive saving rate turn by end 2006.

Actual and Fitted Values (1953Q2-2005Q2)

-2

0

2

4

6

8

10

12

1953Q2 1962Q2 1971Q2 1980Q2 1989Q2 1998Q2

Percent

Fitted savings rate

US private savings rate

“Fed Fund Hike” Along With Decreasing Residential and Equity Wealth Scenario Simulation

Date RE SE TB S

2005Q4 2.201 0.661 4.65 -1.036

2006Q1 2.179 0.655 4.70 -0.738

2004Q2 2.157 0.648 4.95 -0.370

2006Q3 2.136 0.641 5.05 -0.059

2006Q4 2.114 0.635 5.25 0.284

Source: BEA, Morgan Stanley Research Estimates

Source: Morgan Stanley Research Estimates

April 2006

Currency Economics


The world is ‘balancing up’

0.6

0.7

0.8

0.9

1

1.1

Q1.19

90

Q1.19

91

Q1.19

92

Q1.19

93

Q1.19

94

Q1.19

95

Q1.19

96

Q1.19

97

Q1.19

98

Q1.19

99

Q1.20

00

Q1.20

01

Q1.20

02

Q1.20

03

Q1.20

04

Q1.20

05

US X/M

April 2006

Currency Economics


Biography

Stephen Jen is a Managing Director at Morgan Stanley and serves as the Global Head of Currency Research for the firm.

Prior to joining the firm, Stephen spent four years as an economist with the International Monetary Fund in Washington, DC,. In addition, Stephen was actively involved in the design of the IMF’s framework to provide debt relief to highly indebted countries. Stephen has also worked for the Board of Governors of the Federal Reserve and the World Bank and has been a lecturer at the Massachusetts Institute of Technology and Georgetown University’s McDonough School of Business.

Stephen holds a PhD in Economics from the Massachusetts Institute of Technology, with concentrations in International Economics and Macroeconomics. He also earned a BSc in Electrical Engineering summa cum laude from the University of California, Irvine.

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