Currency Outlook HSBC April 14

Currency

OUTLOOK MacroCurrency StrategyApril 2014

1. We believe it is time to be long EM particularly the fragile fi ve. Low volatility supports the long EM carry trade especially now that the current account adjustment is fully underway. 2. We think the EUR will succumb to the policy differences between the ECB and Fed. 3. We expect a big move lower in GBP as we fear that the UK balance of payments position will become problematic for the currency.

Draghi needs Swedish lessons Although the ECB has given greater attention to the threat posed by a strong EUR to its infl ation mandate, it still feels like an after-thought that will not be a trigger for action. Draghi needs to learn from the Riksbank and make it clearer that a stronger EUR means further easing.

The rise of the redback III As both RMB internationalisation and fi nancial reforms continue to accelerate, we think the expansion of the RMBs role in global reserve management is also likely to be faster than many expect.

Disclosures and Disclaimer This report must be read with the disclosures and analystcertifi cations in the Disclosure appendix, and with the Disclaimer, which forms part of it

Our three core calls

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Macro Currency Strategy April 2014

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Our three core calls (pg 3) 1. We believe the trade to have on now is to be long EM particularly the fragile five. Low volatility supports the long EM carry trade especially now that the current account adjustment is fully underway.

2. We think the EURwill succumb to the policy differences between the ECB and Fed. 3. We expect a big move lower in GBP as we fear that the UKbalance of payments position will become problematic for the currency as the year progresses.

Draghi needs Swedish lessons (pg 10) The ECB has given greater prominence to the role of the EUR in its quest for price stability, but the exchange rate still feels like an after-thought that will not be a trigger for action. Draghi should take a leaf from the Riksbanks book and make it clearer that if the EUR is stronger than expected, then it would quickly become necessary to provide an offsetting easing of monetary policy.

Rise of the redback III (pg 15) As China promotes greater use of the RMB in other parts of the world, trade settlement in the currency has expanded, RMB-denominated products have bloomed offshore and policymakers are opening up the large domestic financial market to foreign investors. Slowly but steadily, the RMB is going global. We look back to the rise and fall of reserve currencies and draw lessons for the growing RMB.

Platinum Group Metals outlook (pg 19) We are bullish on platinum prices and expect the average price to reach USD1595/oz in 2014. Three factors support our view: ongoing South African strikes which are further aggravating already tight production, good demand from the European auto sector and further anticipated strength in jewellery demand from China. We are also bullish on palladium prices, expecting average prices to reach USD825/oz in 2014, where global supply is also constrained.

Summary

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Dollar Bloc (pg 20) Reprieve for the CAD: USD-CAD continues to consolidate its gains from late-2013 and early this year, reflecting some degree of broader USD underperformance and better readings in recent Canada data. The risk is for consolidation to continue in the near-term, but we expect further USD-CAD declines as the year progresses.

AUD: this time is different: Recent developments on China, commodities and carry have pointed to a weaker AUD, yet the currency remains resilient. In September 2012 we witnessed a similar situation, although, back then, the dominance of risk on risk off environment was driving the exchange rate. Now, there is no equivalent dominant factor that can support the currency and we think AUD-USD will eventually succumb to rising rate expectations in the US.

NZD: care for carry: Since the start of the year the NZD has capitalized on the back of carry appeal as the RBNZ was the first DM central bank to raise rates this cycle. With further rate hikes already priced in, the focus is now on whether the RBNZ will deliver to the expectations, and we believe it will. However, as US rate expectations continue to rise, the importance of rate differentials in assessing the NZD-USD performance will grow.

Key events

Date Event

11 April World Bank and IMF Spring Meeting 16 April BoC rate announcement and Monetary Policy Report24 April RBNZ rate announcement 25 April France Sovereign Debt Rating Published by S&P25 April Italy Sovereign Debt Rating Published by Fitch28 April European Commission Presidency candidates debate in Maastricht30 April FOMC rate announcement 6 May RBA rate announcement 8 May BoE rate announcement 8 May ECB rate announcement 8 May Norges Bank rate announcement Source: HSBC Central Bank policy rate forecasts

Last Q4 2014(f) Q2 2015(f)

USD 0-0.25 0-0.25 0-0.25 EUR 0.25 0.25 0.25 JPY 0-0.10 0-0.10 0-0.10 GBP 0.50 0.50 0.50 Source: HSBC forecasts for Fed funds, Refi rate, Overnight Call rate and Base rate Consensus forecasts for key currencies vs USD

3 months 12 months

EUR 1.343 1.300 JPY 104.9 108.3 GBP 1.643 1.616 CAD 1.110 1.113 AUD 0.877 0.861 NZD 0.817 0.797 Source: Consensus Economics Foreign Exchange Forecasts March 2014

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The first quarter is now behind us. The question is what does the rest of the year herald?

1. Buy the fragile five The fall in volatility is a big plus for EM The main feature of the FX market so far this year has been the constant and relentless fall in volatility, with volatility in many currency pairs at year to date lows (charts 1 and 2). The main exception to this theme is the RMB, which has seen volatility rise. This however, is a policy choice rather than a market driven event. It is very hard to explain why we have had such a broad based fall in volatility, especially given heightened geopolitical risk and talk of higher rates in the US. Low volatility always has the seeds of its own destruction built into it. Low volatility encourages carry trades and as positioning grows and grows, position sizes become untenable. This eventually gives way to a sell off/drawdown, often driven by a political or economic event, and then higher volatility ensues.

However, it seems to us that we are now only at the beginnings of a carry cycle and a spike in volatility is therefore unlikely to be position driven. We have suggested that the best way to play this fall in volatility is to buy the high yielding fragile five currencies (TRY, ZAR, BRL, IDR, INR). Over time other investors follow, capital gains will then ensue and the cycle to an eventual drawdown would have begun. In our eyes we are only at the beginning of this process.

Current account confusion Did not matter / Mattered / Does not matter It is worth discussing the current account argument and what it means for FX as it seems to operating like an on/off switch. In essence there is nothing wrong with a current account deficit either on a personal or national level. On the personal level, take the example of a young dynamic person with bright prospects who wants to start their own business. Now this young person

Our three core calls

1. G3 vols are falling 2...And so is EM

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Source: HSBC, Bloomberg GHI is a composite implied volatility measure of USD, JPY and EUR

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has limited savings (S) but needs to invest (I) in order to realise future returns. By going into debt by using someone elses savings they can invest more than they have saved (I must be greater than S). This is sustainable because there is a high level of confidence that future earnings will be more than enough to pay off the debt.

The same thing happens on a country level the young and dynamic EM country offers superior rates of return but does not have enough local savings to invest to realise these future returns. So here too Investment must be greater than Savings and so the country imports capital and runs a sustainable current account deficit. When money is cheap and easy to come by this worked well perhaps too well. This describes the period from December 2008 when the Fed announced endless QE until 22 May 2013 when the Fed changed tack and first discussed tapering.

Fed the trigger for the drawdown The trigger for the drawdown and scramble out of EM and the birth of the fragile five was May 22nd 2013. Suddenly and dramatically the market saw the prospect of the quantity of money being

restricted and the price of money as measured by the 10-year bond rose dramatically. Capital went back to the US and the market became risk averse. Those vulnerable to a squeeze of global capital those with current account deficits suffered sharp falls in their currencies. The market then raised another awkward point: was the capital sent to these EM countries really being used for productive Investment? Perhaps it had been finding its way into Consumption. The combination of these factors saw the market start to force a current account (C/A) adjustment onto the fragile five.

First and foremost the currency adjustment starts. The fall in the currency makes imports more expensive and exports more competitive the C/A mechanism is now underway. The currency is driven lower and lower to restore a healthy balance. Eventually reluctant central banks, fearing a currency problem and associated inflation, are forced to act. They are forced to raise rates. This is second stage of the process. Now the currency does not do all the heavy lifting since higher rates attract hot money and slows

3. Carry ends with a weaker currency a BoP adjustment starts with it

Source: HSBC

Stage 1 Weaker currency

Stag 2 Higher rates

Stage 3 Weaker economy

BoP adjustment Carry

Stage 1 Weaker economy

Stage 2 Lower rates

Stage 3 Weaker currency

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the currency fall. More importantly, these higher rates slow domestic demand thereby dampening imports. Hence the current account adjustment is fully underway, with first FX, then rates and lastly the real economy all playing their part.

The point as shown by the schematic (chart 3) is in a carry type world we go from stage 1 a weak economy to stage 2 lower rates and finally this causes the currency to weaken. Importantly, in the BoP adjustment we start with a weaker currency then move to higher rates and finally to a weaker economy. The weaker economy is an end point caused initially by the FX adjustment. Now that the economies are weakening some fear buying the currency, and that would be correct if we were in the carry world, but in the world of the BoP adjustment it is the end point of the adjustment and is not to be feared. In fact, it signifies that the adjustment is underway and the currency has done its job. So in our eyes the process is near completion in the fragile five. Couple this with low volatility and higher rates and these currencies are to be bought.

Differentiation will start soon So far we have seen a more or less collective rally in EM FX (chart 4), although, some currencies still remained under pressure given individual factors. RUB was sold-off aggressively due to the Russia-Ukraine stand-off, and the RMB volatility

has been driven by official policies rather than market driven events. Going forward, we expect greater differentiation. In Asia, we believe North Asian currencies will generally outperform South Asian currencies, given their stronger balance of payments position and comparative cheapness on long-term valuation measures. In LatAm, we recommend being long BRL to earn carry and we have turned more bullish on COP. Finally in EMEA, we like the TRY for its carry appeal and the uncertainty surrounding the elections is gone for now. The ZAR should also remain supported given the current account deficit has begun to show some improvement. We also like the CEE currencies.

2. EUR to come under pressure This is an important view given the size and the scope of the euro as a currency. However, from a consensus point of view it seems we are in the pack. The Bloomberg consensus has the euro falling to 1.31 by year end vs the HSBC 1.28 spot forecast. Here we feel the differences between the Fed and the ECB will drive the currencies. The Eurozone is coming very close to deflation with the latest CPI print at a mere 0.5% YoY(chart 6) whilst the Fed is on course to end QE and is even talking about higher rates at some point in the future. The EUR falling relies on the ECB

4. EM FX is making a comeback 5. Flows are starting to recover

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EM FX performace against the USD, 1 Feb - 31 Mar, %

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Total foreign portfolio flows into 10 EM countries, USD bnUSD bnUSD bn

Source: HSBC, Bloomberg Source: HSBC, IMF

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loosening monetary policy further and entering into some type of QE arrangement.

In essence, we believe that the EUR continues to be a carry trade where currency movements are largely determined by movements in relative rate expectations.

Our economists have long been of the view that the growth recovery in the Eurozone will not be strong enough to reverse the disinflation trend and that the ECB will have to resort to further stimulus in the coming months and eventually outright asset purchases to address the downside risks to price stability. At the same time, the Fed

is in a process of unwinding their asset purchases. Moreover, at their latest meeting the FOMC revised up their rate projections for 2015 and 2016 and Yellen signalled that the first rate hike could be delivered as soon as six months after the end of QE tapering (according to our expectations the hike could be delivered in H2 2015) . Chart 7 shows EUR-USD plotted against the expected gap between Eurozone and US 3M interest rates by the end of 2015. This illustrates clearly the potential for EUR-USD to be a lot lower.

6. Eurozone inflation is at its lowest rate since 2009

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Source: HSBC, Bloomberg, Eurostat

7. According to rate expectations EUR should be much lower


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EUR-USD Expected Dec'15 3M rate differential (EUR-USD, RHS) %

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3. Cable will fall This is perhaps our most controversial forecast and the price action is testing our resolve. There is no doubt that the UK economy has surprised to the upside, and this is pushing cable higher. For the moment the UK is winning the FX ugly contest. The debate on rates is now about whether the UK will raise rates late this year or after the elections which will be held in May 2015. So with the economy doing so well why dont we just go with the flow? Unlike our EM call we do NOT see a continuation pattern. Here we fear the UK balance of payments position will become problematic for the currency as the year progresses. In the UK the overall current account deficit remains huge. However, for the moment the market is choosing to ignore this aspect. We as forecasters have to decide what will become a major driver for the currency in the future and a current account deficit of 5.4% of GDP is high on our list. What is particularly disturbing is that a deficit of this size is usually associated with a late cycle blow out, not as a starting point of a recovery. On this basis we expect cable to fall to 1.50 by year end.

The UK economic upswing has been driven largely by consumption supported, not by rising

real incomes, but by a combination of dis-saving and wealth effects from a government-boosted housing market. We believe this imbalance in growth drivers will be echoed in rising concerns regarding the UKs sizeable current account deficit, which reached 5.4% of GDP in Q4 2013 (chart 8), the widest since 1989. That deficit took around 10 years of expansion to accumulate, and it is alarming place to be in the early stages of recovery.

For the most of 2013 and so far in 2014, GBP performance has been driven by carry considerations. Chart 9 shows GBP-USD plotted against expected differential between UK and US 3M interest rates by the end of 2015. The market has consistently brought forward its expectation of interest rate rises and has driven cable up. However, with the Fed gradually unwinding its asset purchases and signalling first rate hike in H2 2015 while the BoEs rhetoric is rates to stay low carry considerations may begin to move in the opposite direction. Moreover, strong consumption, which is at the heart of current UK recovery, will eventually falter as real earnings growth has actually been negative since 2009. Once this starts to happen, the UK economy will start to look weak again, and the markets expectations of the first rate hike would be

8. UK current account deficit reached its 1980s lows

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UK Current Account, % of GDP

Source: HSBC, ONS

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postponed driving the GBP-USD lower. However, the turn in rate expectations is only part of the story. In addition, GBP may find itself more in focus for its balance of payments fundamentals, a process that also points to considerable downside for the currency.

The nature of the UK current account financing explains why the currency is becoming more vulnerable. Large portfolio inflows into the UK during the crisis have become large outflows in recent quarters. Portfolio outflows have been mostly larger than direct investment inflows, which means short term financing flows have

been large enough to cover this capital flow deficit as well as the wider current account deficit. Chart 10 shows the short-term financing flows have indeed been building up. This is fine whilst the market believes the UK economic story but when this belief falters the fall in the currency will be fast and furious.

It is also clear from the chart that since last year the implied short-term financial flows have been narrowing. As soon as doubts about the sustainability of the UK recovery emerge, the short-term inflows will be undermined even further and GBP would face the double whammy

9. Rate differential fully explain cables move

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Expected Dec15 3M rate differentials (UK-US) GBP-USD (RHS)%


10. Short term inflows into the UK have become substantial

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of questions over the trade deficits sustainability alongside retreating interest rate hike expectations.

Conclusion: the three core calls Buy the fragile five EUR will come under pressure Cable will fall The fragile five call is playing out. Eventually this idea will get over crowded and carries the seeds of its own destruction but not yet.

The cable call is our most non-consensus call and the one that there is the most resistance to. There is no doubt GBP is winning the ugly contest but the nature of the recovery and the huge external imbalance will mean a severe correction at some stage this year.

Lastly, and most in line with consensus, we expect the relative policy differences between the ECB and Fed to undermine the euro.

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The good, the bad, and the troubling The ECB needs to learn from the Riksbank and become far more vocal about the threat posed by a strong currency to its inflation mandate. The link between a rising EUR and the rising probability of an offsetting monetary policy reaction needs to be made clearer and more credible. After all, like the ECB, the Riksbank does not target a specific level of the exchange rate or use it as a direct tool of policy. But there is a far greater willingness in Sweden to acknowledge that the currency could de-rail their forecast of rising inflation. An additional rate cut would be the likely and immediate response to any significant SEK strengthening. The ECB would do well to convince the markets of a similar trade-off if they do not want the EUR to thwart their inflation mandate.

The good Some might argue that neither the Riksbank nor the ECB should be troubled by the prospect of a stronger currency. After all, the appreciation would likely be a reflection of improving economic prospects and a vindication of economic policy. Optimism regarding Swedens growth prospects is on the rise. The grounds for this upbeat view are largely built on the correct ingredients being in place for a recovery. Interest rates are low, household savings have been rebuilt, and some of this may get spent as confidence improves alongside employment gains. Hopes are further boosted by expectations of a revival in export demand as major trading partners see accelerating GDP growth. Similarly, Eurozone data suggests the worst is over, with GDP expectations for this year and next being pushed higher.

Draghi needs Swedish lessons

1. Eurozone and Swedish economic activity surprises are no longer surprising on the downside

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Eurozone activity Surprise Index Sweden activity Surprise Index, RHS


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Chart 1 shows HSBCs economic surprise index for Sweden in black and for the Eurozone in red. An upward sloping line suggests data is typically surprising to the topside. A downward sloping line, such as that seen during Q3 13 in the Eurozone and Q4 13 in Sweden, echoes an environment of activity shortfalls relative to consensus. These disappointing phases now appear to be over with the Eurozone once again over-delivering while in Sweden, upside and downside surprises are now largely offsetting.

the bad... But if rising growth prospects are the good news, the bad news for these central banks from a policy perspective is the continued low level of inflation. Chart 2 shows the Economic Surprise indices for CPI in Sweden and inflation in the Eurozone. Both lines are trending lower, illustrating the considerable undershoot of inflation relative to expectations.

Both central banks now face inflation far below their target of 2%, with the Eurozones at 0.5% YoY and Swedens negative at -0.6% YoY. The expectation for both sets of policymakers is that inflation will rise back towards target on the back of the improving economic upswing and the associated narrowing of the output gap. The ECB,

for example, recently forecast that inflation will hit 1.7% YoY in Q4 16. The Riksbank expects inflation back at 2% even earlier, in 2015.

However, much of the discussion evident in recent Riksbank minutes is centred on trying to explain why inflation has been so low. If policymakers are not certain why inflation has been so low, there is some understandable uncertainty about whether it will rise as anticipated. By contrast, the ECB still characterises the balance of risks around their inflation forecasts as being balanced, despite the legacy of persistent downside surprises in measures of price pressures around the Eurozone.

and the troubling. As in many circumstances when things are not behaving as anticipated, blame is apportioned elsewhere. In the case of Sweden, the strength of the SEK has featured prominently as a factor behind lower than forecast inflation. The exchange rate is still frequently cast, by policymakers, as the most likely threat to their expectations of a future rise in inflation. Riksbank deputy governor, Karolina Ekholm, noted that if the exchange rate is significantly stronger than forecast, then it is highly likely that she will advocate further repo-rate cuts for the

2. Inflation has surprisingly low in both the Eurozone and Sweden

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2% inflation target to be hit. Another deputy governor, Martin Floden, noted that if the krona appreciates more in the coming months than is forecastthis is a strong reason to conduct a more expansionary monetary policy. Both dissented against the recent decision to keep the policy rate unchanged.

In this way, the Riksbank has created a policy headwind to future SEK strength. Of course, they are not alone in doing this. The Reserve Bank of Australia successfully engineered a weaker AUD in 2013 through interest rate cuts and strident verbal intervention, characterising the AUD as uncomfortably high. New Zealand too has warned about the dangers of too strong a currency, and CAD weakness was broadly welcomed by policymakers in Canada. But in Sweden, the path of the exchange rate is particularly prominent in the debate.

The ECB could do well to mimic the Riksbanks more vocal approach, to make it clearer that the EUR is already a real headache for policymakers looking for inflation to rise back towards target. Admittedly, there has been some movement in this direction. President Draghi has noted that the EUR is increasingly relevant to the outlook for price stability and also provided a ready reckoner

on the sensitivity of inflation to movements in the exchange rate. They estimate that a 10% appreciation of the EUR knocks between 0.4-0.5% off the inflation rate.

In arriving at their inflation forecasts, the Riksbank has assumed a modest 1% appreciation of the SEK while the ECB has assumed an unchanged exchange rate. However, the Riksbank has expressed a clear willingness to act if their forecast for the exchange rate proves wide of the mark. Unusually for a G10 central bank, the Riksbanks profile for the future path of the repo rate is more hawkish than what the market currently prices in even after the recent downward revision to the repo path. These are shown in chart 3, with the Riksbanks path in red and the markets expectation, based on interest rate forwards, in black. Dovish revisions to the repo path in 2013 helped weaken the SEK. In addition, the Riksbank could of course cut the policy rate also.

The ECB should express a similar willingness to act if the EUR strengthens unexpectedly. A pain threshold of 1.45 is implied in Draghis ready reckoner (see Draghi reveals a euro target, 14 March 2014) but there is no effort to make such a level feel like a potential policy trigger. Instead,

3. Unlike most G10 central banks, the Riksbank is more hawkish than the market

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Sweden Repo rate, % Sweden Repo rate, Forward rate, %%%

Sw eden Repo rate, Riksbank forecasts, %

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the incremental shifts in rhetoric to give the EUR fractionally more prominence in the policy discussion are not delivering the same kind of cap to the EUR that the Riksbank has put on the SEK.

Pump up the volume All is not lost for the ECB. One advantage the ECB has over the Riksbank is that the policy threat may actually hold greater sway over the exchange rate. Charts 4 and 5 shows USD-SEK and EUR-SEK compared to the expected rate differential at the end of 2015. Recent price action shows that rate differentials have less influence on the exchange rate. Threatening to cut rates in response to a stronger SEK may not trouble markets as much.

By contrast, charts 6 suggests ECB action could help weaken the EUR. It shows the relationship between real interest rates and EUR-USD. If the ECB cut interest rates it would be consistent with a weaker EUR, especially if it also helped to push up inflation somewhat. Alternatively, were the ECB to announce some form of liquidity injection then the announcement effect on the EUR could be pronounced, particularly if the associated rhetoric made it clear that the exchange rate was a catalyst for the decision. The swift decline in the AUD once the RBA began to ease policy AND talk the currency lower is an example of how effective a two-pronged strategy can be. Only talking or only cutting rates would likely not be so powerful.

6. Lower rates would likely weaken the EUR

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4. USD-SEK no longer beholden to rate differentials 5. and neither is EUR-SEK

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Conclusion The ECB has given greater prominence to the role of the EUR in its quest for price stability, but the exchange rate still feels like an after-thought that will not be a trigger for action. Draghi should take a leaf from the Riksbanks book and make it clearer that if the EUR is stronger than expected, then it would quickly become necessary to provide an offsetting easing of monetary policy to ensure inflation projections remain on track. The EUR cannot be cast merely as an interesting part of the jigsaw. It has to be seen by the market as central to the debate if EUR strength is not to derail the ECBs already questionable hopes for accelerating inflation in the months ahead.

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Becoming a global currency As China promotes greater use of the RMB in other parts of the world, trade settlement in the currency has expanded, RMB-denominated products have bloomed offshore and policymakers are opening up the large domestic financial market to foreign investors. Slowly but steadily, the RMB is going global. But what does it mean to be a global currency?

History suggests that there are four key factors:

The size of the home economy: Chinas current share of global trade (12%, 2013) and GDP (12%, 2013) justifies a much greater use of its currency.

Deep and open financial markets: This is where China needs to do more. The onshore bond market is already of considerable size, even though it is largely closed to foreign investors. Policymakers in China understand that greater foreign participation in its domestic financial market will be a key step towards building the RMB as an investment currency. The future development of that market and its integration with the global financial system will be as important for the RMB as the birth of the interbank market was for the USD.

In particular, the liquidity, depth and ease of access of the onshore market will determine if the RMB can become a funding currency in the global interbank market in the future.

Institutional support and macroeconomic stability: the RMB scores well on both counts.

Policymakers appear to be walking the tightrope between ensuring stability to increase the appeal of the RMB as a reserve currency, while also guarding against creating a one-way carry trade opportunity for investors (see Asian FX comment: RMB: A balancing act, 28 February 2014).

Having a dominant incumbent reserve currency like the USD does not guarantee permanency or exclusivity. As financial reform continues in China, we believe the RMB will play a much more prominent role on the world stage.

Building economies of scale For the RMB, the internationalization process can be grouped into three broad steps: trade settlement, investment, and reserve currency.

Growth in trade settlement The first stage, establishing the RMB as a global trade settlement currency, has already gained substantial ground. The first RMB trade settlement scheme started in 2009 but the growth has been rapid, as China reported RMB4.6trn of such payments in 2013 (about 18% of Chinas total trade) For RMB trade settlement to achieve critical mass, trade settlement volumes will have to average at least USD2trn per annum, and comprise half of Chinas trade with the emerging world and one-third of total trade.

Capital markets and global investment The second stage of internationalisation is in global investment. The issuance of offshore RMB bonds and wider access to Chinas onshore capital

The rise of the redback III

Paul Mackel Head of Asian FX ResearchThe Hongkong and Shanghai Banking Corporation Limited +852 2996 [email protected]

Ju Wang Senior Asian FX StrategistThe Hongkong and Shanghai Banking Corporation Limited +852 2822 [email protected]

Dominic Bunning Senior FX StrategistThe Hongkong and Shanghai Banking Corporation Limited +852 2822 [email protected]

Julia Wang AnalystThe Hongkong and Shanghai Banking Corporation Limited +852 2996 [email protected]

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markets through R-QFII programmes are signs that Chinas authorities are committed to a further opening up of the capital account.

China is the largest recipient of foreign direct investment (FDI) in the developing world, with over USD117bn of inflows in 2013. At the same time, Chinese outward direct investment (ODI) hit a record USD90bn (excluding financial ODI).

For this stage of internationalisation, the Chinese authorities have taken a somewhat unconventional approach by allowing the creation of a liberalised RMB market offshore, which is distinct and separated from the existing onshore RMB market.

This unique process has led to a situation where the RMB market can be summed up as one currency, two markets (onshore and offshore) with three separate FX forward curves.

1. CNY: Onshore deliverable RMB The onshore CNY market is deliverable on current account and some capital account transactions. Market participants are mostly based onshore, though there is increasing access for offshore clients through schemes such as QFII.

As of 17 March 2014, the daily trading band for the USD-CNY spot rate was widened to +/- 2% from +/-1%. This was another step towards making the RMB more market driven and

reaffirmed policy makers commitment to speeding up financial reforms in 2004.

For the onshore FX forwards curve, there was historically little visibility on interest rate parity due to: 1) regulated interest rates and underdeveloped money markets; 2) a largely closed capital account that resulted in a large deviation between onshore and offshore interest rates for both the USD and RMB; and 3) balance of payments surpluses and significant one-way FX appreciation expectations.

Today, the relationship between onshore interest rates and the USD-CNY FX forwards curve is stronger, due to 1) liberalisation of onshore interest rate markets; 2) a wider range of capital account flow channels; and 3) shrinking FX appreciation expectations due to a smaller current account surplus and the fact the RMB is closer to equilibrium value than before.

But further capital account opening and the introduction of more investment focused participants in the FX markets will be needed to strengthen interest rate parity.

2. CNH: Offshore deliverable RMB The RMB first became officially deliverable in Hong Kong on 19 July 2010, new offshore RMB centres have since emerged and will continue to grow. Offshore RMB is fully fungible between

1. RMB curves two years ago showing different paths 2. have become more convergent

6.296.306.316.326.336.346.356.36

6.29 6.30 6.31 6.32 6.33 6.34 6.35 6.36

0.0 0.2 0.4 0.6 0.8 1.0

USD-CNY NDF USD-CNY USD-CNHUSD-RMB

Tenor (y ears)

7 March 2012

6.126.146.166.186.206.226.246.26

6.12 6.14 6.16 6.18 6.20 6.22 6.24 6.26

0.0 0.2 0.4 0.6 0.8 1.0

USD-CNH USD-CNY USD-CNY NDFUSD-RMB

Tenor (y ears)

Current


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different centres and there is little control over RMB flows between Hong Kong and other offshore RMB centres.

There are very few restrictions on opening CNH accounts in Hong Kong, effectively exposing the market to factors that dictate offshore demand for RMB. As such, the CNH market has a separate set of participants and thus a different set of demand and supply conditions from the onshore CNY. The key link with the onshore market comes via the increasing number of market participants with access to both the onshore CNY and the offshore CNH markets.

There is no official intervention in the USD-CNH exchange rate. The supply of CNH is indirectly calibrated through the management of the cross-border channels through which the RMB is allowed to flow purchases by individuals in Hong Kong, trade settlement, central bank swaps as well as various cross-border RMB investment schemes.

Onshore USD-CNY and offshore USD-CNH will converge over time as the channels between onshore and offshore widen and both curves better reflect interest rate dynamics (Charts 1 and 2). However, given there are still significant differences in terms of who can access each market, the depth of liquidity and FX intervention,

periods of wider divergence still can and will occur as seen in Q1 2014 when USD-CNH traded at its widest discount to USD-CNY since early 2013.

3. CNY NDF: Offshore non-deliverable RMB Before the establishment of the CNH, the USD-settled non-deliverable forward (NDF) market was the traditional way of gaining RMB exposure offshore. With onshore players prevented from participating, this is truly an offshore market.

However, the explosive growth of the offshore deliverable RMB market has meant the NDF market has assumed much less importance, a process likely to continue.

The main link between the NDF market and the onshore CNY market is that the NDF is priced off of the onshore USD-CNY fix. This is also one of the key factors separating the CNY NDF and CNH markets.

Historically, the NDF curve was largely an indication of RMB appreciation expectations given that there was no access to onshore interest rates. Since the introduction of the CNH market, however, the NDF curve has been more closely linked to the offshore deliverable curve as market participants can look for arbitrage opportunities across the two curves.

3. RMB deposit base picking up again in Hong Kong 4. CNH turnover is also rising quickly

Source: City of London, Monetary authority of Macao , BoK, MAS,CBC, RMB-business, CEIC, HSBC, Hong Kong, Taiwan, Korea as of Jan 2014, Macau as of Dec 2013, Singapore as of Oct 2013, Luxemburg as of Sep 2013, London as of Jun 2013

Source: HSBC

893215 172 86 47

15 3

262

02004006008001,0001,200

0200400600800

1,0001,200

HK

Taiw

an

Sing

apor

e

Maca

u

S Ko

rea

Luxe

mbou

rg

Lond

on

Offshore RMB deposits (HK includes CDs in grey bar), RMB bnRMB bnRMB bn

0

5

10

15

20

25

30

0

5

10

15

20

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Jul-10 Apr-11 Jan-12 Oct-12 Jul-13

USD bnMarket liqudity in Hong Kong

CNH spot CNH fwdUSD bn

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Gauging the progress Offshore RMB (CNH) liquidity has grown rapidly. RMB deposits in Hong Kong are now worth RMB893.4bn, while estimated daily FX market turnover in Hong Kong is around USD25bn in the FX spot and forwards markets. RMB trade settlement already accounts for 18% of total Chinese trade (Chart 3 and Chart 4). The size of outstanding CNH debt (including bonds and bank CDs) rose from RMB400bn from January 2013 to almost RMB600bn by the end of January 2014.

From here, the gradual integration and then convergence of onshore and offshore markets will continue to be driven by wider cross-border flow channels. Expansion of offshore RMB trading and settlement to a wider range of locations is also an inevitable part of the process. Inside China, the Shanghai FTZ will help develop an offshore RMB market within Chinas geographic territory, which could significantly increase the link between the offshore and onshore markets.

Taking reservations Despite restrictions on foreign investments, some foreign central banks are already starting to hold RMB in their reserves through channels such as the China Interbank Bond Market (CIBM) scheme and the Qualified Foreign Institutional Investor (QFII) programme.

Sovereign investors represent around 23% of the QFII quota, or around USD12bn, although there is no separate disclosure on the amount of investment. This suggests some investors already see the RMB as a viable reserve currency, although they currently hold only small amounts. It also indicates strong interest in and underlying demand for reserve asset diversification into RMB once the onshore market opens up.

However, for the RMB to continue to rise as a reserve currency, further improvement in accessibility to local markets will be needed. Initially policymakers were concerned that there might be excess inflows that could dilute monetary policy independence. However, portfolio inflows are a fraction of Chinas total balance of payments at the moment compared to current account and FDI-related flows. As Chinas current account gradually narrows as a percentage of GDP, those concerns may gradually dissipate.

The RMBs current position compares favourably with the rise of other global currencies historically in terms of economic reach, global trade involvement, policy support and stability. The capital markets are being opened up and although overall financial integration for China is still relatively small on a global scale, this is improving with the rise of the offshore RMB. In light of this, many central banks and reserves managers already see the RMB as a viable reserve currency, even if they only hold it on a small scale. But there needs to be greater access for foreign investors in local capital markets, even deeper global RMB liquidity and wider cross-border flow channels.

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This is an extract from the full report: Platinum Group Metals Outlook: Striking higher, 03 April 2014.

Platinum We continue to have a bullish bias towards platinum prices and expect the average price to reach USD1595/oz in 2014. Three factors support our view.

First is the likely impact on platinums supply/demand balances of the South African strikes. A little more than 60% of South Africas platinum production representing around 45% of global output has been idle since late January, due to industrial action against the three largest South African platinum producers. The strikes are further aggravating already tight production from South Africa and contributing to the markets production/consumption deficit.

Second, we expect good demand from the European auto sector where the more popular diesel-powered engines require heavier platinum loading, than gasoline engines.

Third, we anticipate further strength in jewellery demand from China as its growing middle class continues to seek out luxury goods. Taken together, these factors will further widen the expected demand/supply deficit for platinum and push prices higher.

Palladium We are also bullish on palladium prices, and we expect average prices to reach USD825/oz in 2014. We expect that persistent supply/demand deficits based on the impact of the South African strikes and declining Russian stockpile sales and relatively stagnant mine output in that country will lend support to palladium prices. According to our supply/demand model, we anticipate that palladiums production/consumption deficit will increase to around 959,000oz this year from 455,000oz in 2013. This represents a drop of around 101,000oz from the previous forecast deficit of 1.06moz for 2014. Additionally, we expect widespread recognition of deficits to encourage investor demand, possibly through the palladium-ETFs. Two new palladium ETFs have been launched this year, although the investor response to date has been limited. Persistent deficits represent a sharp reversal in market dynamics from earlier this century when the market regularly registered annual surpluses in excess of 1moz. The effects of consecutive years of deficits in 2012, 2013, and 2014 support our view that prices are likely to rally further from current levels.

Platinum Group Metals outlook

1. HSBC precious metals price forecasts (USD/oz)

2014f 2015f 2016f Long term

Platinum 1595 1850 1925 1800 Palladium 825 900 925 950

Source: HSBC

James Steel AnalystHSBC Securities (USA) Inc.+1 212 525 [email protected]

Howard Wen AnalystHSBC Securities (USA) Inc+1 212 525 [email protected]

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Reprieve for the CAD CAD has reversed some of its losses from late-2013 and early this year. Its recent strength reflects broader USD weakness and also better CAD data.

Inflation remains a key focus From mid-March, a series of Canadian data points have come in line or better than expected, countering some of the more downbeat economic forecasts and, for now at least, contrary to perceptions of near-term downside risks to growth and inflation. The inflation backdrop and outlook continues to be a key element for BoC policy expectations, and by extension for the CAD (chart 1). Whilst the latest inflation data showed February CPI down again on the month it was actually a little higher than expected. This helped to counter the perception that the Bank of Canada might feel compelled to adopt a more accommodative policy stance, perhaps in the form of a shift to an easing bias from a neutral bias, or a

more extreme move of cutting the overnight target rate. Indeed, in a 18 March press conference, BoC Governor Poloz said he could not rule out cutting policy interest rates. He said that, if the balance of risks were to shift so that the risk on the downside for inflation were increased, then we would need to reconsider.

Polozs comments did indeed get the markets attention and weighed temporarily on the CAD, contributing to USD-CADs push to new 4-1/2 year highs (1.1279) in mid-March. However, the aforementioned Canada inflation data did not support the notion that the BoC would turn more dovish, and was a contributing factor to the subsequent pullback in the currency pair. Looking ahead, the March inflation data on 17 April will again be important for the market but just prior to that on 16 April, the BoC has another interest rate decision and releases its quarterly Monetary Policy Report (MPR). Markets will be sensitive to forecast revisions on

Dollar Bloc

1. The CAD shows sensitivity to BoC policy expectations

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1.140.90

0.95

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1.05

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Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14

1yr CAD OIS swap, % (LHS) USD-CAD, inverted (RHS)%


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growth (Poloz already hinted that Q1 2014 growth will be lower than previously forecasted, due mostly to bad weather), inflation and the timing for closing the output gap. In addition, the January MPR contained specific language on the currency, noting that the CADs persistent strength will continue to pose competitiveness challenges for the countrys exporters. That description and outlook supported perceptions that the BoC welcomed the decline in the CAD, and markets will clearly be sensitive to if and how the currency is characterized in the upcoming MPR.

Canada data pulse has improved Other data releases in recent weeks have also beaten expectations. February retail sales rose 1.3% MoM, roughly double the expected gain and reversing the bulk of the 1.9% drop in December. January monthly GDP rose 0.5% MoM, a tenth better than expected and fully reversing the December 0.5% decline. Even Canadas trade position improved in the latest report, posting a CAD290m surplus, although that followed downwardly revised CAD340m deficit in January, originally reported at CAD180m. The March labour market data showed elements of more notable improvement. Employment rose 42.9K, above the 25K expected and following the 7K drop in February, although part-time positions made up the majority of the overall gain (rising 30.1K). Still, the addition of new jobs saw the unemployment rate fall to 6.9% from 7.0% in February, putting it back at the bottom of the 6.9%-7.4% range it has held in for the past two years. The outcome of these reports hardly sounds the all-clear for the CAD but they have helped to counter perceptions of a weaker economic backdrop and in so doing have encouraged some reversal of short-CAD positions in the market. Indeed, the latest IMM positions data on CAD futures shows that in the past few weeks, speculators have roughly halved what had

been sizeable short CAD positions, a rebalancing that has concurred with the currencys rebound.

USD underperforms USD movements naturally continue to play an important role in USD-CAD developments. The 19 March FOMC meeting and press conference were less dovish than expected boosting the USD broadly, including USD-CAD. However, those USD gains have not been sustained, partly because, in spite of tapering, the Fed is still engaged in sizeable asset purchases and as such it is adding liquidity to the market. Moreover, two weeks after the 19th March FOMC meeting, Fed Chair Yellen went out of her way to highlight various measures of weakness in the labour market, the associated slack in the economy, and the need for ample monetary stimulus for some time. That was followed by the minutes from the March FOMC meeting, which downplayed the significance of the higher median fed funds rate forecasts released at the meeting and made no mention of a six-month time frame between the end of QE and the beginning of the tightening cycle. Those events countered the hawkish sentiments stemming from the actual FOMC meeting and press conference, pressuring US yields lower and curbing some of the support they were otherwise lending the USD.

Canada politics Political developments in Canada in the past month are worth noting, although we would not overemphasize the implications for the CAD. First, Canadas Finance Minister Jim Flaherty unexpectedly resigned for health reasons on 18 March. That too was put forth as a factor behind the CADs brief mid-March weakening and while Mr. Flaherty was a fine steward of the countrys finances, the budget process and Canadas longer term path towards fiscal balance is more institutionally ingrained, going beyond one individual. That said, new Finance Minister

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Joe Oliver will be at least somewhat under the markets microscope as he settles into the role, and the markets could be sensitive to comments he makes on the CAD (if he comments on the currency at all). Note too that Olivers first budget was very much in line with expectations, forecasting a return to annual budget surpluses in 2015/16. And while we and others have highlighted CAD negatives for a number of months, Canada continues to sport the best fiscal position in the G7, and that is one important, supportive condition for the currency over the medium and longer term. Separately, the provincial election in Quebec saw the ouster of the separatist Parti Quebecois from a ruling majority in the National Assembly, with the Quebec Liberal Party winning a clear majority of seats. The outcome further reduced the already-limited prospect that the dwindling separatist movement in Quebec would gain momentum in a manner that might be destabilizing for the CAD and Canadas economy more broadly.

Conclusion USD-CADs pullback in early-April has seen it fall below 1.0900 to its lowest levels since mid-January, and we would not rule out the risk for further near-term declines given some of the recent developments noted above. And in that regard, the 1.0750 breakout area from 7 January looks to be potentially important support. The risk is for further consolidation for USD-CAD in the near-term, but we continue to expect further USD-CAD gains as the year progresses, given the low inflation and sluggish growth backdrop Canada and eventually more sustained USD firmness as the Fed winds down and completes the current round of QE.

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AUD: this time is different The Three Cs, China, commodities and carry, have recently been capturing market attention. We saw a few softer data releases from China, a substantial drop in iron ore prices and a hawkish tone from the Fed. So, of late, developments on these fronts have pointed to a weaker AUD. Yet the currency has appreciated 4.4% since the beginning of the year. In September 2012 we witnessed a similar situation, when the Three Cs suggested that the AUD should go down but the currency remained resilient. Back then we showed that the dominance of risk on risk off environment was driving the exchange rate (see AUD: surfing the risk wave, Currency Weekly, 18 September 2012). However, now, although the strength of RORO has risen from the lows seen in 2013, it is still at very subdued levels compared to 2012. We think this time is different. There is no equivalent dominant factor that can support the AUD in the face of the Three Cs and the currency will eventually come down.

China China weakness has been a centre of market attention for the past couple of months. Chart 1 shows the HSBC China PMI manufacturing. Both the headline and the output components have fallen and remain below the key 50 level since the beginning of the year. Moreover, since the start of

the year, concerns have been growing regarding Chinas financial system. A possible default of China Credit Trust (CCT) created some uncertainty around the widespread assumption that these wealth management products carry an implicit guarantee from state banks and the government. Further, news of a Shanghai Solar Energy firm defaulting on onshore corporate debt and of a, later avoided, bank run on Jiangsu Sheyang Rural Commercial Bank contributed to the growing stresses in the countrys financial system. Yet despite this more downbeat view, the impact on the AUD, a liquid proxy for the Asia growth story, has been muted.

Commodities The developments in second C have been related to the concerns about slowing demand from China. The price of iron ore, Australias largest export by volume, saw a sharp drop following disappointing China export numbers in early March, falling overall 14% since the start of the year (chart 2). However, while the AUD fell on the news, it seemed to weather this effect very quickly.

1. China PMI manufacturing has slipped recently 2. Iron ore price has been hit by concerns over China

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55

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HSBC China headline PMI manufcaturingHSBC China PMI output

100

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100

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120

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Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14

China import benchmark iron ore price, USD permetric tonne

Source: HSBC Source: HSBC, Bloomberg

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Carry The third C, carry, is the main factor that should determine the AUD fortunes, and should see it lower. At its 4 February meeting the RBA spoke of a period of stability in interest rates' for the first time since the beginning of the current easing cycle. Since then, the stance has not changed. The Fed added another 10bn of tapering since their January meeting, raised the Fed funds rate projections and even talked about higher rates at some point in the future. Chart 3 shows AUD-USD plotted against the expected gap between Australia and US 3M interest rates by the end of 2015. The chart shows that AUD-USD movements have previously been partially

explained by movements in relative rate expectations. However, recently AUD-USD has gone up, while rate expectations have gone down. Back in September 2012 we witnessed a similar situation, when China was slowing, commodity prices were falling and the carry story was not playing in a favourable direction for the AUD. At that time, the resilience of the AUD was explained by the on-going dominance of the risk on risk off (RORO) factor in driving the currency. However, now the RORO phenomenon is no longer dominant. Although RORO has recently made a come back (chart 4), it is still at a very low level compared to where it was in 2012. Moreover, as chart 5 illustrates, the AUDs

4. Despite a recent rise, RORO index is still low 5. AUD is practically uncorrelated to RORO

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90 92 94 96 98 00 02 04 06 08 10 12

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AUD correlation with RORO factor


3. According to rate expectations, AUD-USD should be going down

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0.780.810.840.870.900.930.960.991.021.05

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AUD-USD Expected Dec'15 3M rate differentials (AUD-USD), RHS %


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relationship with RORO has been very close to zero of late.

So why does the AUD remain resilient in light of the three Cs and the absence of influence of the RORO? The reason perhaps, lies in the fact that Australia has recently had a run of better data, while US data has been distorted by adverse weather conditions during the January-February period.

Overall, despite an improving domestic picture and unwarranted concern over a China hard landing, in our view, we still continue to see AUD-USD lower as the year progresses targeting 0.86 by the end of 2014. We see the stance of the RBA, in terms of a period of stable rates and preference for lower AUD, as the main driver of the currency. We think that the AUD-USD will succumb to rising rate expectations in the US. Moreover, the RBAs unwillingness to tolerate high AUD should limit upside potential for AUD-USD.

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NZD: care for carry Since the start of the year the NZD has been a clear outperformer in the G10 space appreciating 5.5% against the USD. Such an outstanding performance is not of great surprise given that the RBNZ was the first developed world central bank to raise rates this cycle. With further rate hikes already priced in, the next test for the NZD will be whether the RBNZ delivers on market expectations. We believe that the central bank will deliver more than market expects. Nevertheless, we acknowledge that it is not purely New Zealand rate expectations that matter. As the US rate expectations continue to rise, the importance of rate differentials in assessing the NZD-USD performance will grow.

The rally in the NZD we saw after the (expected) first hike suggests that, going forward, the currency is likely to be supported even if the RBNZ only matches expectations. With the market currently looking for another 75-100bp over the next 12 months, we are ahead of that, expecting rates to be at 3.75% (chart 1). This supports our stronger-than-consensus view on the NZD over the next year.

However, to assess the strength of the NZDs carry appeal one needs to look at relative rate expectations. At its 19 March meeting, the FOMC reduced the monthly pace of asset purchases by another 10bn, making it USD55bn from April, and shifted the Fed funds rate projections upwards. Moreover, new Fed chair Janet Yellen said that the first rate hike in the US could be as soon as six months after the end of tapering, which is much sooner than the market was expecting at the time. Chart 2 illustrates the NZD-USD exchange rate plotted against the differential in 3M Dec15 rate expectations between New Zealand and US. While the relationship might not be perfect, it still shows that movements in NZD-USD tend to follow movements in rate differentials. Therefore, while the hikes from the RBNZ are already in the price, the Fed can still surprise with more hawkish comments and/or forecasts thus driving the differential down. This in turn could limit upside potential for NZD-USD.

In light of the above, we see the NZD supported for the rest of the year. However, rising US rate expectations may dampen any significant upside potential for the NZD-USD from the current 0.866 level and we target 0.88 by the year end.

1. HSBC vs market NZ rate expectations 2. Relative rate expectations drive NZD-USD

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1y r NZD OIS swap, %

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NZD-USDExpected Dec'15 3M rate differentials (NZD-USD), RHS

%


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G10 at a glanceCHF Switzerland: Trapped

0.60.81.01.21.41.61.8

1.01.11.21.31.41.51.61.7

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EUR-CHF (LHS) USD-CHF (RHS)

The CHF's role as a safe haven should continue to ensure it remains supported given ongoing geopolitical tensions regarding Ukraine, and also some lingering concerns about the future pace of China economic growth. The upside for the CHF will be constrained, of course, by the

SNB's continued commitment to its exchange rate floor, and the recent SNB meeting underlined that the floor remains a key element of monetary policy. For now, these Ukrainian and Chinese issues are offsetting the

persistent improvement seen in Eurozone peripheral markets which might otherwise have pushed EUR-CHF somewhat higher. However even in the absence of such concerns, we remain sceptical that the Eurozone growth upswing will be sufficiently marked to encourage Swiss investors and corporates to recycle their large current account surplus into fresh investments abroad. As a result, we do not expect rallies above 1.25 in EUR-CHF to prove sustainable.

Source: Bloomberg

EUR-NOK Norway: Regaining its poise

7.07.58.08.59.09.510.010.5

7.07.58.08.59.09.5

10.010.5

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The NOK has regained some stability after a traumatic 2013. The downside surprises on activity are no longer so common, which has helped push rate expectations higher over the last couple of months. The central bank recently revised up slightly its projections for the likely path of interest rates, reflecting somewhat higher inflation and a weaker than expected NOK. Nonetheless, our forecasts for NOK strength remain rather

modest. One problem for the currency is that while economic growth is strong, it is not accelerating to the same extent as many of its G10 peers. Modest upward revisions to rate expectations stopped the rot in the NOK, but there is little sense the Norges Bank is about to turn hawkish. The NOK's lack of liquidity is also a complicating factor,

ensuring the currency behaves more like an EM FX than a G10 play. Recently, this has helped the NOK as the market is newly enthusiastic about carry plays amid lower volatility, and our bullishness on EM FX is echoed in a stronger NOK forecast.

Source: Bloomberg

EUR-SEK Sweden:

8.08.48.89.29.610.010.410.811.211.612.0

8.08.48.89.29.6

10.010.410.811.211.612.0

Jan-

02Ja

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See Draghi needs Swedish lessons, page 10

Source: Bloomberg

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We started the year with the view that differentiation would be the main theme in Asian FX. High yielding currencies were expected to outperform the low-yielders in Q1, despite being structurally less sound, before the lower yielders strong fundamentals came to the fore as the year went on.

So far, we have seen the regions two high yielders the IDR and the INR outperform the rest of Asian FX. And there may be some room for this outperformance to last in the near term.

1. Q1 generally benefits higher yielding Asian currencies

-3.0%

-2.0%

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JPY

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Q2 Q3 Q4 Q1Av erage change vs USD, last 10 years

Source: Bloomberg, HSBC

The reason for this relative optimism boils down to the improved fundamentals for both these currencies. In Indonesia, inflation has been tracking lower as domestic demand starts to slow. Meanwhile, liquidity in the onshore spot market has improved, yielding some confidence for the currency. Similar improvements have been witnessed in India. The current account deficit has seen a sharp improvement on the back of import restrictions on non-productive items such as gold. This improvement, combined with lower inflation and a commitment to tight monetary policy has led to greater portfolio inflows to both currencies.

Elections, however, continue to be a major event risk for both the currencies. The long term structure of underlying flows needs to improve for these currencies to do better in a more sustained manner, and much will therefore depend on the reform process after the elections are over.

Lower yielding currencies have faced some challenges due to concern over volatile US rates as the Feds tapering continues. This concern only starts to ease in April helped by favourable seasonality, before picking up again in May and June (Asian FX: April Fool's?, April 9 2014). We still hold the view that many of these currencies have stronger external balances than their higher yielding peers, which should leave them less exposed to US monetary tightening. But valuations are more stretched for many, and hence we still expect to see the majority of USD-Asia head higher through the rest of 2014.

Additional pressure for the region comes from a softening China macro-economic outlook. This could remain challenging in Q2 due to the tendency for softer data and the potential for tighter RMB liquidity. The recent USD-CNY band-widening and more volatile CNY takes away another anchor for USD-Asia, especially for the likes of KRW, TWD, SGD and MYR.

Despite its recent weakness, we remain fairly constructive on the RMB in 2014, especially given the solid current account surplus and supportive interest rate differentials. However, appreciation will be much more volatile in nature than it has been in recent years, which we consider as a healthy development for the RMB to go global.

Asia regional overview

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Asia at a glanceUSD-CNY China (CNY): Breaking one-way expectations

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The PBOC announced on 15 March widening of the daily trading band of the USD-CNY to +/-2% from a previous +/-1% around the daily mid-point fixing, as of 17 March. This came amidst a period of acute RMB weakness and consistently higher USD-CNY fixings than the market has been expecting. In our view this had been driven by policy makers aiming to curb one-way appreciation expectations around the RMB. The wider trading band will still act as something of a daily

circuit breaker, to help slow pressures on either side. The fact the band widening happened right after the completion of the NPC shows that policy makers are determined to deepen financial reforms on all fronts. This implies a greater tolerance towards higher volatility. The longer-term direction of the RMB will continue to depend

on the underlying fix and the underlying flow picture, the latter of which we think remains positive. We still expect RMB appreciation but the path will be more volatile.

Source: Bloomberg

USD-CNH China (CNH): Preparing for the Shanghai Free Trade Zone

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Following the initial proposal for Shanghai FTZ from the PBoC in December 2013, further details were announced in February 2014. On 21 February, details were announced regarding individual

RMB settlement, offshore borrowing, intragroup cross-border sweeping, current account centralised payments and collections in the SFTZ. Others included RMB-denominated financial assets and

precious metals trading in CFETS and the Shanghai Gold Exchange by SFTZ entities and offshore institutions. We continue to expect a quick pace of FX internationalisation and liberalisation in 2014. In addition, on 26 February 2014, the PBoC liberalised interest

rates on foreign currency deposits of up to USD3m in the SFTZ. This measure is perceived as a concrete step towards full scale interest rate liberalisation.

Source: Bloomberg

USD-SGD Singapore: FX policy should remain supportive

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As we head into the MAS's bi-annual meeting, we expect FX policy to continue with a gradual appreciation stance for the SGD NEER band. This is a more hawkish stance than many other central banks in the region. Our estimates suggest that the authorities were selling USD through most of 2013 and have continued to do so in 2014. We also think that the SGD will be better placed than many

others in ASEAN to withstand likely USD strength. This is because the SGD's external balances remain the most supportive in EM Asia. Singapore's net International Investment Position shows the economy as a strong net creditor. And the majority of Singapore net liabilities are in the form of FDI, which is traditionally stickier than portfolio assets. This represents a good time to look for opportunities to position

long the SGD versus the likes of the THB, MYR and PHP. The SGD's strong external balances and net asset position suggest it should continue its longer-term trend of appreciation versus the ASEAN currencies.

Source: Bloomberg

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Asia at a glance continued USD-INR India: A pre-election rally?

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The INR has strengthened considerably in the last few weeks, on the back of equity and debt inflows which coincided with the pre-election optimism. India started heading to the polls on 7 April. The final results will be announced after 16 May. Meanwhile, the INR's fundamentals have also improved. The

trade deficit has fallen due to a sharp drop in gold imports over the past few months. Also, both CPI and WPI inflation have eased, giving some room to the RBI to hold rates. Going forward, the election outcome should play an important

role in determining the trajectory of the INR. A strong coalition with a workable mandate would be the best possible outcome for the INR as it would pave way for much-needed structural reforms. FX policy would be another important factor. We take note of RBI Governor Rajan's recent comments that INR versus the USD at 55 was 'too strong'. We believe FX policy will become steadily more resistant towards local currency strength from current levels.

Source: Bloomberg

USD-IDR Indonesia: Too good to last?

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The IDR has been one of the best performers in the EM FX space in 2014. Lower inflation and monetary tightening have improved the IDR's real rate profile. Also, an improving trade picture has been supportive of the IDR. However, we are sceptical about whether this will last. China's slowing demand for commodities and the impact of the

recent mineral ban could make it difficult for exports to outperform from here. Moreover, a lot will depend on whether subsidised fuel prices will be increased again. We believe the upcoming elections will be a key factor as to

whether long-term reforms can be rolled out to improve underlying flows for the IDR. Recent optimism for the IDR on the back of Joko Widodo's nomination might not be sustained after the elections. FX policy will also be crucial. If FX reserves are built out in a more sustainable manner, then it would be a better sign for longer term IDR stability.

Source: Bloomberg

USD-KRW South Korea: Starting to shine again

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The KRW has performed very well since late March. Alongside the pick-up in the trade balance, as historically occurs after February, there have also been sizable capital inflows into the local bond and equity markets. These factors are likely to continue in our view and should be

enough to balance out equity dividend outflows due in April (likely worth around USD3bn before 16 April). A significant amount of outstanding USD deposits onshore also mean locals have a lot of USD to sell. We note that USD-KRW has a strong historical tendency to fall in April and this seems likely to be the case again. However, it seems likely that FX policy could play a stronger

role in curbing currency strength from here, as it has done in the past when USD-KRW fell towards the 1050 level, especially if CNY and JPY continue to come under pressure. FX reserves rose by around USD3.5bn in March despite USD-KRW trading broadly sideways, suggesting authorities maintain a preference to curb currency appreciation.

Source: Bloomberg

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Room to differentiate The start of this year has been characterized by continued outflows of capital from EM that have accelerated as a result of a cocktail of poor political and economic events. Political tensions in Thailand and Ukraine were compounded by weaker than expected data from China and the US, as well as the Argentine central banks decision to allow the ARS to depreciate 15% last month. Beyond the ARS, the worst performer year-to-date has been the CLP, followed by the COP, both down around 5%. The MXN and BRL are only down a little over 2% while the PEN is off just 1%.

This broadly fits with our view that the CLP is the most vulnerable currency in the region, exposed to declining interest rate differentials, concerns over domestic tax policy changes, and slowing Chinese growth. The COPs fundamentals support a more stable price action as growth is rebounding and flows remain resilient, but with the CB still buying dollars and officials consistently touting the need for a weaker currency, it will be hard for the COP to rally unless broader EM sentiment improves.

The MXN and BRL have reasons to outperform other EM currencies, and we believe this trend can continue. Mexico offers a strong cyclical growth story (HSBC 2014 GDP forecast is at 4.1%). Beyond that, the structural reforms enacted last year bode well for longer-term improvements in Mexicos potential growth. A recovery in the US should also help Mexican exports. We recently took profit on our long MXN vs CLP

trade after Moodys upgraded Mexicos sovereign debt rating to A3 from Baa1. Meanwhile, we see the BRLs pace of depreciation moderating in 2014 and outperforming other EM currencies based on higher interest rate differentials, relatively cheap valuations, and steady intervention from the BCB (USD1bn per week). While Brazil has many structural problems to address before we can call an end to the depreciation trend of the BRL, we still see it trading more stably in a risk-off period supported by the factors above and also by how expensive it is to short.

We expect the PEN to keep outperforming the region. While Perus central bank (BCRP) may marginally increase its tolerance for a weaker PEN as its trading partners currencies soften, BCRP is also mindful of the private sectors relatively high exposure to USD-held debt. As such, we expect intervention to continue to hold USD-PEN around the 2.80-2.83 area.

Finally, our outlook for the ARS is for more weakness to come. Rapidly dwindling FX reserves, an appreciating currency on a real, inflation-adjusted basis, as well as continued capital outflow pressures, all call for further weakening of the ARSs nominal rate vs the USD. We do not consider it sound for the authorities to defend the 8.0/USD rate indefinitely due to the high cost of reserves sales this would require. Moreover, the lack of nominal anchor (in the absence of tight fiscal policy) keeps pressures for a weaker ARS ahead.

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Latin America at a glance USD-BRL Brazil: An interesting carry proposition

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BRL volatility has continued to consolidate in recent weeks helped by daily BCB sales of USD via swaps. In rhetoric and action, the authorities continue to signal comfort with a stable FX. As volatility has declined, the appeal of the BRL carry has

increased given the considerable improvement in interest rate differentials. The BRL volatility-to-carry ratio of 1 is double that of peers like the MXN, CLP, or COP. While the BCB appears to be approaching the end of the tightening cycle (at least for now), we still see the bias for interest rate differentials to rise not fall as inflation is stubbornly running near the top of official target. We also believe that the BCB will continue intervening to contain FX volatility in order to prevent a deterioration of inflation expectations in the middle of an electoral year. We do not see much room for BRL appreciation, but we find the

total return proposition of being long BRL very compelling for the above reasons.

Source: Bloomberg

USD-CLP Chile: Under pressure from various fronts

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Our view that the CLP will underperform against both the USD and the rest of the LatAm currencies has been playing out. We believe this underperformance will continue due to: a)

Lower copper prices and subsequent weaker terms of trade; b) Narrowing of the interest rate differential between the CLP and USD; and c) Political uncertainties associated with the proposed changes tax and, possibly, foreign investment policies. Private sector external debt is also the highest in the region, at 40% of GDP (double the next highest country, Peru), which means further CLP weakness could induce more stress via this channel. Going forward we see China economic data as being the key

variable setting CLP sentiment. Slowing China growth will likely weigh on commodities, weakening Chiles terms of trade and putting additional downward pressure on the CLP. Any further rate cuts could also serve to undermine the currency.

Source: Bloomberg

USD-ARS Argentina: Look for more depreciation

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We remain defensive the ARS directionally but disengaged from a strategy perspective. As long as policies to control inflation are not introduced, the risks are for more currency weakness to come. While the timing of the next leg higher in USD-ARS is difficult to

predict, we would be biased to call for a move sooner rather than later. This is because we think that the current pace of USD sales by the BCRA is unsustainable. The longer the central bank (BCRA) tries to defend a stable ARS at 8.0/USD, the higher the probability we would assign to another stepped move higher in USD-ARS down the line. This would be counter-productive in the goal of limiting reserves drain and calming expectations, in our view. At the margin, the government can rely on new regulations to

increase FX supply in the short term, but this would be only a temporary stop-gap to further depreciation. We have recently revised our year-end forecast to ARS10.0/USD from 8.5.

Source: Bloomberg

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Consolidation time High-yielding currencies in CEEMEA have recouped January losses thanks to central banks policy and reducing political risk premiums. We do not see this rally extending in the near term. The TRY and ZAR are likely to consolidate, while the RUB may resume its downward trend. In low-yielders space, we see value only in the HUF. Others currencies such as PLN and ILS are likely to continue to trade in narrow ranges.

The Turkish central bank is clearly pleased by the recent substantial TRY appreciation. The CBRT has drastically tightened monetary conditions to defend the currency. A stronger currency will contribute to ease inflationary pressures and improve CBRTs credibility. However, it is not certain that the central bank would welcome further and substantial TRY gains. The CBRT has to manage a complex equation where growth and export performances also play an important role. It is worth recalling that the TRY real effective exchange is a key parameter and the CBRT may focus again on it. If the TRY stays at current levels, the REER will mechanically rise significantly in coming months. That would raise again the question of TRYs valuation and may lead to some loosening of monetary conditions. We do not think that an outright rate cut is possible any time soon but a loosening of liquidity conditions is likely. Overall, we are now neutral on TRY after having been bullish. But the TRY should continue to outperform its regional peers thanks to high-carry and continuous macro-rebalancing.

The ZAR has also strengthened since February. The 50bp rate hike delivered by the SARB has increased the carry appeal but the fundamental domestic driver has been the sign o

Currency Outlook HSBC April 14

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