Under Pressure

FX Strategic Overview
Standard Chartered Bank reiterates the call that GCC countries should and will revalue their currencies against the USD over the next few months. While a trade-weighted basket would be ideal, this seems unlikely for political reasons. However, inflationary pressures continue to mount and the Federal Reserve continues to cut rates, putting ever-increasing pressure on the GCC to revalue.

SCB FX Leveraged Model Portfolio
We continue to make solid, if cautious progress. Year to date, the SCB FX Leveraged Model Portfolio has a cumulative simple return of +6.72%. We continue to hold one trade recommendation - short USD-SAR via 6M forward outright and are looking for other opportunities in Asia, Africa and G10.

SCB FX Real Money Portfolio
The SCB FX Real Money Portfolio has had a good start to the year. Having hit its take profit rule as more than 50% of Q1 FX forecasts were traded through, we currently stand +2.34% (non annualised). We are not reoptimising and re-entering just yet as we think there could be better re-entry levels in coming days.

Options Strategy
The inversion in several implied vol curves appears to offer good opportunities, notably in USD-KRW, USD-TWD, USD-INR, USD-JPY and EUR-USD. This month, we examine 3M digitals in USD-JPY and 6M call spreads in USDINR.
Corporate Hedger pp. 8 Treasurers will need to be opportunistic, but conservative in managing AXJ translation risk. We expect a USD rebound against the majors in Q2 and Q3.

Correlations
Risk appetite is fading, weighing on high-beta EM currencies. However, current account surplus currencies will outperform in this environment. The correlation between GBP-USD and EUR-USD continues to decline as GBP underperforms.

FX Forecasts and Forecast Review
We revised our USD forecasts lower against the majors to take account of persistent downside momentum and perceived official tolerance, while still anticipating a temporary USD rebound in Q2/Q3.

FX Focus
We expect TWD to retrace as political gains give way to economic concerns ZAR: Further losses are likely as the economic outlook continues to worsen


The Need for Change to GCC Pegs Remains
We reiterate our call for a revaluation of GCC currencies in the coming months. While a revaluation followed by a switch to a trade weighted targeting regime would be ideal, we believe the second best solution of keeping the peg following a revaluation is more realistic. The economies of the GCC are suffering the consequences of their current policy set-up due to a decoupling between the domestic economies and that of the anchor currency (the U.S.). The longer the problem is not dealt with the harder the adjustment will be.

If introduced a trade weighted basket would not need to be too complicated. Two currencies, the EUR and USD, would suffice. However, we do not detect that there is enough appetite in the Gulf to depeg from the USD, at least not at the moment when the USD is facing so much pressure. GCC currencies like to stand by a friend, in this case the USD, when the friend is need. Our view is that a significant step revaluation is the second best and most likely solution and we maintain our call for a significant revaluation of GCC currencies in coming months. The debate in the region on currency reform is resurfacing.

It Should be Easier to Manage a Boom
It is positive at least to see GCC countries booming even at a time when the outlook elsewhere is not so rosy. But the boom needs to be managed. Real interest rates are now negative. One does not really need to look that far back to understand the problems cheap credit can create. It was not so long ago when the US economy was awash in liquidity.

In this note we look at some of the most popular arguments which are being made against any change in the current FX regimes, and we dismiss them. In an environment where government spending is high, oil prices are above USD 100pb and monetary conditions are ultra loose, inflation will continue to rise. We view rising inflation as the biggest risk to achieving sustainable growth. Monetary policy needs to tighten. A revaluation is the way to achieve these tighter conditions.

Housing is not only a Domestic Factor when you are Importing Building Materials
A popular argument in the region is that the main driver of inflation is the housing market which is completely unrelated to the currency policy. This is not entirely true. First, construction materials are mainly being imported. It has been estimated by Moody's that in the second half of 2007 the price of cement increased by 40% and that of steel by 25%. The rising cost in housing is not just a domestic factor. The weak currency is making the imports of materials even more expensive.

Second, labour costs are also increasing. GCC countries are relying heavily on imported labour. Foreign workers have seen the purchasing power of their earnings diminish over the past year, not only because of the higher inflation but also because of the weakness of GCC currencies vs. currencies like the Indian Rupee (INR). The result is higher wage demands, which is translating into even higher construction costs and more pressure on the housing market.
Finally, the availability of what effectively is free credit, when one looks at real interest rates, is more than likely to increase the pressure on the housing market from the demand side. Credit growth in the region is rapid, for example in the U.A.E, consumer debt increased by almost 40% y/y in 2007.

How Much is Your Money Worth?
There is also an argument that a revaluation will hurt the region because of oil income and USD based investments. Oil proceeds might feel higher because of the weaker currencies, but in terms of value they are not. Income from oil and from returns on USD investment is worth less internationally because of the weakening USD and less domestically because of rising inflation. The idea that a weak currency would boost incomes when it comes to the purchasing power of this income is merely a case of money illusion. This is not so different to feeling richer by printing more money. An OPEC study explains that 73% of oil revenue was lost between 1970-2004 because of the weakening USD and rising inflation. It is not only important to see what the income level is but it is also important to see the purchasing power of this income.

Creating a Stable Environment for International Investors
Saudi Arabia wants to become a top 10 Foreign Direct Investment (FDI) destination in the world by 2010. Advocates of the status quo argue that a revaluation would jeopardise investment inflows. Inflation and rising costs are a much bigger risk for FDI than any revaluation. For a country to become an attractive investment destination macroeconomic stability is paramount. Take for example Turkey. For a number of years Turkey was one of the least popular investment destinations in the world. Those were times of macroeconomic instability and high inflation. However, in the past three years, when the Turkish authorities finally managed to get inflation under control, foreign investment in Turkey soared. FDI in Turkey was increasing at a time when the Turkish Lira (TRY) was showing impressive gains. The stronger currency was not an impediment to FDI. On the contrary, it was indicative of the success of the country. Over the past three years, which were years of significant TRY strength, Turkey attracted more FDI than in the previous 20 years combined.

The two top FDI destinations in the world in 2007 were China and India. The currencies of both countries appreciated in that year. The main reason why the authorities in China and India tolerated stronger currencies was to fight rising inflation. The Chinese yuan (CNY) appreciated by 6.4% and the INR by more than 12% in 2007. The currency adjustment has clearly not made China and India less attractive destinations.

Macroeconomic stability, regulatory environment and the prospects of GCC economies will be key when it comes to attracting FDI, not an undervalued currency.
Kuwait was Right to Scrap the Peg

Kuwait decided to scrap its peg to the USD and introduce a currency basket in May 2007. Critics claim that if Kuwait's decision to scrap the USD peg last year was correct, inflation should have stopped rising. The latest inflation figures from October 2007 show inflation at 7.26%. The rise in inflation and this growth in the money supply have been used as criticisms over Kuwait's decision to scrap the US dollar (USD) peg and the introduction of a currency basket in May 2007.

Before one criticises the decision, one needs to bear in mind two important arguments. First, inflation has indeed risen, but it is still significantly lower than inflation in the U.A.E and Qatar. It is also important to take into consideration that inflation could have been much higher than 7.26% had the authorities kept the USD peg.

Second, the Kuwaiti dinar (KWD) has appreciated against the USD by 6.22% from the introduction of the basket to 4th March. This is not enough. It is also worth considering that the KWD currency basket we monitor is below the highs it reached earlier this year. In other words the authorities have allowed the KWD to appreciate vs. the USD, but not by enough to compensate for the sharp drop in the value of the USD vs. other currencies. At least the Kuwaiti authorities have the flexibility to accelerate this pace of appreciation. Given the inflationary pressures and the growth in monetary aggregate, it is likely to see more KWD appreciation against the USD in the near future.