Global Markets

1. June, 2008 Global Markets The Dollar and non domestic investment flow to the US

2. Cross border financial politics • By January 2002 the USD stood at its strongest levels since 1986. However, the start of 2002 saw a marked shift in the political landscape. • International criticism of the Japanese MOF’s campaign of verbal intervention (and occasional physical intervention) and the BOJ’s policy of “quantitative easing” • The US was not the only country to complain. Comments emerge from a number of Asian nations, most notably China. The PBOC governor calls for Japan to take action "to prevent the continued devaluation of the JPY from causing widespread currency devaluations by Asian countries." • Japan reacted in kind. Finance Minister Shiokawa criticises the perceived weakness of the CNY relative to the “strength” of the Chinese economy. • While Japan, China and the US were squabbling about who should have the weakest currency, the Euro-zone was worrying about the persistent weakness of the EUR. • China proved willing to oblige. Finance Minister Xiang: "I will suggest to the relevant leaders in our government that we don't want to put all our eggs in one basket, but should consider buying more EURs sooner." • Others just as keen to encourage the EUR’s role as a reserve currency. New York Federal Reserve Bank President William McDonough noted that he would like to see the EUR join the USD "as an immensely important and strong reserve currency."

3. One clear “loser” in all this

4. Resistance proved futile • September 2003: US pushes change to G7 communiqué (calls for greater currency flexibility) • USD/JPY falls nearly 10% in aftermath. • November 2004: US ignores European and Japanese calls for joint intervention. Policy of “benign neglect”. • USD/JPY collapses to JPY102 while EUR/USD hits USD1.35 (up 50% from Jan 2002). • July 2005: China revalues currency and moves to managing it against a basket of currencies • USD/CNY now down 16% since July05.

5. FX reserve managers behaved rationally • According to the IMF, in the first quarter of 2002 total FX reserves globally stood at just over USD 2 Trn. Out of this amount the Fund knew how USD 1.57 Trn of reserves had actually been allocated with 71% being held in USDs and 19.7% in EURs. • By the second quarter of 2007 total FX reserves had jumped to USD 5.7 Trn (i.e. nearly 3 times the amount held five years earlier) while the USD now only represented 64.7% of known holdings. The EUR’s share, in contrast, now came to 25.5%. • All the available evidence indicates that the phenomenal growth in FX reserves over the past five years has been accompanied by a notable push to diversify away from the USD and into the EUR. It seems clear that managers took the European pleas at the end of 2001 seriously.

6. The list goes on…. • Just some of the FX reserve managers that have expressed a preference for reducing their exposure to the USD over the past three years: • United Arab Emirates: Looking to convert up to 10% of its foreign exchange reserves from USDs to EURs. This is double the target the bank had previously set. • Qatar: Prime Minister Sheikh Hamad bin Jassim bin Jabr al-Thani says that around 40% percent of the QIA’s estimated USD 50 Bn portfolio is invested in EURs and another 20% in currencies including GBP. He notes: "Before we are almost 99% in USDs. Since two years we are 40% USD." • Sweden: The Riksbank says that it has boosted the level of EUR holdings from 37% to 50% in its FX reserves . It reduces the level of USD holdings from 37% to 20%. • South Korea: Finance Minister Han Duck-soo says: "Asian countries have accumulated substantial forex reserves which are going into Wall Street and US Treasuries. This may not be the most efficient way of using those resources." • Russia: Central bank chairman Sergei Ignatyev says that their FX reserves are currently made up 50% of USDs and 40% EURs with the rest held in GBP and JPY. This compares to a previously disclosed 25-30%. • Italy: The Bank of Italy says in its half-year report that it has raised the GBP share of its FX reserves to 24% up from zero in 2004. In contrast, USD holdings were cut from 84% to 63% while the JPY share fell from 14% to 10%. • Singapore: The Government of Singapore Investment Corporation’s Managing Director for Public Markets, Ng Kok Song, says that the corporation will raise the proportion of assets invested in emerging markets to 20% from 15% currently as returns worldwide shrink. • New Zealand: A spokeswoman for the Reserve Bank of New Zealand says that the bank bought JPY because Japan's economic outlook has improved. • Thailand: Central Bank Governor Tarisa Watanagase says that the bank is shifting out of the USD.

7. However…. • Between the start of 2002 and today the average Fed Funds target rate has been just 2.8%. The average level of headline inflation through this period has been 3%. • USD was not the only thing to be impacted by the accommodative policy settings through the past six-and-a-half years (USD index has dropped 37%) • Over the same period price of oil moved from $20 a barrel to $139 a barrel (CRB more than doubles over same period). • The only period of stability in the oil market comes between August 2005 and June 2007 as the fed continues to tighten monetary policy (the average target rate through this period was 4.81%). • Price of oil doubles over past twelve months as Fed has cut policy aggressively. • Currency markets increasingly reflect relative inflationary expectations (EUR has outperformed as yield curve has turned negative – opposite story for the USD).

8. Coincidence?

9. The Fed and the Treasury recognize the problem… • Change in G7 communiqué in April first sign of a change of attitude. • Articles in the FT & Wall Street Journal make it clear that the US administration was leading an international effort to put a floor under the falling USD. • Subsequent comments from Fed Chairman Bernanke make it clear that he is both concerned about the inflationary consequences of a weaker USD and also intends to start tightening policy sooner than expected. • Fed Funds futures move to price in a 50bp hike in target rate by end of October and the yield curve flattens. • President Bush states: “We want the USD to strengthen”. • Treasury Secretary Paulson mentions the word “intervention” in an interview with CNBC.

10. ..too little, too late? • Fed Funds rate likely to remain at highly accommodative levels for the remainder of this year (even by the standards of the past six-and-a-half years). • Would take 300 basis points of hikes to get policy to the sorts of levels that have contained energy prices during the course of this decade. • Willingness of foreign central banks to support concerted currency market intervention to weaken their own currencies against USD in face of heightened global inflationary pressures may be low unless Fed institutes aggressive series of rate hikes in support. • FOMC probably unwilling to acquiesce given likely negative impact on equity markets. • Willingness to support Treasury may also be low after many years of seeing requests to the US to support the USD being pushed aside. • Most likely outcome still a rally in the EUR against the USD. However, a turn around in energy prices could significantly alter this picture