ms_ FX_Pulse_Dec2010 by manurich75017

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									                                                                       MORGAN STANLEY RESEARCH

                                                                       Global Currency Research Team
                                                                       For research analysts, please see contact list at the back of this material.

         December 9, 2010

Global                                                                 The Majors – Current Forecasts

         FX Pulse: 2011 Outlook                                         % Forecast Appreciation vs the USD

         How Much Further Can the                                                                                           GBP

                                                                             -4%                                                       CHF
         Can Be Kicked?                                                                                EUR

         Articles in this issue:

         How Much Further Can the Can be Kicked? In this                     -12%
         article, we present our top FX trade ideas for 2011 and our              Sep-10     Dec-10     Mar-11    Jun-11         Sep-11      Dec-11
         outlook for global currencies. We outline the major themes
                                                                       Source: Morgan Stanley Research estimates. Forecast revised on 9 Dec 2010.
         we think will drive global currency markets and present our
         best strategies to trade these themes. P.2
                                                                       Question of the Week*
         G10: Commodity FX in a World of EM Monetary                   Which G3 currency are you most bullish on for 2011?

         Tightening. Trends in emerging market economics have
         played a key role in driving G10 commodity FX                      JPY
         performance since the spring of 2009. The dollar bloc
         currencies have been among the strongest in the G10,
         despite sub-par recoveries in the core G10. P.24                   EUR

         G10: 2011 to Be a Year of Less (Correl. and Vol).
         The cross-market correlation surge tracked swap spreads,
         so our outlook for widening points to more diverse market
         performance. FX vol is more sensitive to Fed policy, and
                                                                                  0%       10%   20%     30%     40%       50%     60%       70%      80%
         the past two easing cycles suggest vol will be suppressed
         until hiking resumes – that is not in 2011. P.28              *We queried FX Pulse readers on this question this week; percentages based on
                                                                       113 responses. Source: Morgan Stanley

         EM FX: A Look into 2011. We maintain a positive view
         for EM currencies in 2011, given a strong global and EM
         growth outlook, sustained capital inflows and rising EM
                                                                       Also inside:
         inflation. P.31
                                                                             FX Discretionary Tradebook                                           P. 46
                                                                             Macro Risk Event Calendar – 2011 Outlook                             P. 47
         AXJ: Outlook for 2011. We outline our constructive
                                                                             2010: Year End FX Quiz                                               P. 49
         outlook on AXJ currencies for next year. P.40
                                                                             FX Forecasts                                                         P. 50
         Top FX Trade Ideas for 2011

         1) Long USD and GBP versus short EUR and JPY
         2) Short EUR/USD
         3) Short EUR/SGD
         4) Long MYR/JPY
         5) Long MXN versus EUR and USD
         6) Long RUB versus basket
         7) Long CHF, SEK, NOK versus EUR
                                                                       For important disclosures, refer to the
         8) Short USD/CNY 1-year NDF
                                                                       Disclosures Section, located at the end of
         9) Short AUD/CAD                                              this report.
                                                                                       MORGAN STANLEY RESEARCH

                                                                                       December 9, 2010
                                                                                       FX Pulse

How Much Further Can the Can Be Kicked?
Stephen Hull, Tim Davis, Emma Lawson and Gabriel de Kock
                                                                                       Top FX Trade Ideas for 20111
In this article, we present our top FX trade ideas for 2011 and
                                                                                       1. Buy USD and GBP; sell EUR and JPY, stop 95, target
our outlook for global currencies. Below, we outline the major
                                                                                       115 (spot 100)
themes we think will drive global currency markets and
                                                                                       This basket trade is to play a reversal in the trends in G4
present our best strategies to trade these themes.
                                                                                       currencies which began in the financial crisis in June 2007.
                                                                                       The pound and dollar have fallen by around 30% against the
Main Themes
                                                                                       euro and yen (Exhibit 2). We think this will start to reverse.
Will the US economy grow at a sufficient pace so that the                              Both Europe and Japan have recently suffered problems with
Federal Reserve will not need to add further stimulus beyond                           the strong levels of their currencies. Japan intervened earlier
that already announced?                                                                this year for the first time since 2004 while Europe has had
                                                                                       many problems with the peripheral countries and so far has
How much will Asian, particularly Chinese, authorities tighten
                                                                                       had to bail out Greece and Ireland, with Portugal now on the
policy to contain inflation? Will this create headwinds to global
                                                                                       radar. The strong currency has not helped, especially as we
growth? Will part of this process involve the authorities
                                                                                       estimate that the right price for the peripheral euro is 1.10.
allowing their currencies to strengthen along the lines that the
                                                                                       The UK meanwhile has grown by 8.0% annualized over the
G20 has desired at times in 2010?
                                                                                       last two quarters, the manufacturing PMI is running at 16-year
How much further will the crisis in Europe spread, will it reach                       highs and inflation is well above target and likely to remain
the core and what will be the policy response? Will the ECB                            there for the whole of next year. We expect the MPC to hike in
monetize? Will the euro break up?                                                      August. The UK is also addressing its fiscal deficit.
                                                                                       Meanwhile, we are bullish on USD as we’ll expand on below.
We discuss these issues in the following article.
                                                                                       Exhibit 2
Exhibit 1
                                                                                       Basket of Long USD, GBP versus EUR, JPY
Major Currency Forecasts
                                      2011                          2012
                Current      Q1      Q2      Q3        Q4   Q1     Q2      Q3    Q4
EUR/USD            1.32    1.25 1.21      1.18 1.20 1.22          1.22   1.22   1.22
USD/JPY              84      86      88      89        93    95    95      95    95        110
EUR/JPY             111    108     106     105    112       116   116    116    116
USD/CHF            0.99    1.01 1.02      1.02 1.02 1.03          1.05   1.07   1.07
EUR/CHF            1.30    1.26 1.24      1.20 1.22 1.26          1.28   1.30   1.30       100
GBP/USD            1.58    1.54 1.53      1.53 1.54 1.54          1.51   1.51   1.51
EUR/GBP            0.84    0.81 0.79      0.77 0.78 0.79          0.81   0.81   0.81
                                                                                                                            Basket of long USD, GBP
USD/CAD            1.01    1.02 1.03      1.00 0.98 0.98          0.98   0.98   0.98        90                              vs EUR, JPY
AUD/USD            0.98    0.93 0.90      0.93 0.95 0.97          0.98   0.98   0.98
NZD/USD            0.75    0.73 0.71      0.73 0.75 0.76          0.76   0.77   0.77
EUR/SEK            9.13    9.00 8.95      8.80 8.90 8.95          9.00   9.00   9.00        80
EUR/NOK            7.97    7.70 7.60      7.60 7.65 7.70          7.70   7.75   7.80             98   99   00    01    02      03   04   05   06      07   08   09   10

MS Dollar                                                                              Source: Morgan Stanley Research, Bloomberg
Index              73.6    77.3 78.8      79.2 79.1 79.1          79.5   79.6   79.6
                                                                                       2. Sell EUR/USD, stop 1.38, target 1.18 (spot 1.3175)
Broad USD
TWI                 101     102    103     102    102       100   100    100     99    The US economy is likely to significantly outperform Europe in
JPY TWI             379     369    361     355    337       327   326    324    323    2011. If the latest tax plan gets passed, we think it could
EUR TWI             103      99      97      94        95    96    96      96    96    expand by over 4.0% in 2011. The sovereign debt problems in
GBP TWI            81.6    82.9 83.8      84.9 84.4 84.0          81.9   81.8   81.7   the European peripheral countries are also likely to weigh on
Source: Morgan Stanley Research forecasts, Bloomberg                                   the euro and the ECB is likely to be a buyer of last resort.

                                                                                           All trades entered at 4pm WMR fix

.                                                                                                                                                                         2
                                                                      MORGAN STANLEY RESEARCH

                                                                      December 9, 2010
                                                                      How Much Further Can the Can be Kicked?

Already in recent weeks, we have seen very weak demand at             7. Buy CHF, SEK, NOK versus EUR, with stop 96, target
German government bond auctions, suggesting that investors            110, (spot 100)
are beginning to worry about funding a country whose                  The euro is likely to be hindered through at least the early part
liabilities might at some point include the broader currency          of 2011 until there is a satisfactory resolution of the current
union. Overall, we expect the ECB to have to expand its               sovereign crisis in the periphery and evidence that it is
balance sheet further as the contagion spreads.                       unlikely to spread to Spain. Until the markets have confidence
                                                                      in European policy, a risk premium on the euro is likely to
3. Short EUR long SGD, with stop 1.83, target 1.45 (spot
                                                                      develop as the risks grow that the ECB has to step in as
                                                                      lender/buyer of last resort. As monetary policy is perhaps
                                                                      likely to be left on hold for longer than would otherwise be the
4. Long MYR Short JPY, with stop 25.50, target 29.0 (spot
                                                                      case, we expect the currencies of the countries that closely
                                                                      rely on Europe for trade to perform well, especially those
SGD and MYR are our favourite picks in Asia, as both are
                                                                      exposed to Germany. We expect the European currencies to
great reflation trades (given the openness of their economies)
                                                                      strengthen against the euro, helping the trade-weighted euro
and both have hawkish central banks, strong economic
                                                                      to decline. We also expect SEK (125bp), NOK (50bp) and
fundamentals and very healthy balance of payments
                                                                      CHF (125bp) to hike rates in 2011.
positions. MYR should also benefit from a strong terms of
trade, being the only commodity exporter in the region. Those         8. Sell USD/CNY 1-year forward at 6.5250, target 6.30,
seeking relative value in the region could sell INR, THB or           stop 6.60 (6.52)
IDR as these currencies are overvalued, in our view, and their        One of the themes in the early part of 2011 is likely to be
central banks are behind the curve, especially INR and IDR.           Chinese tightening. As part of this process, the Chinese
INR is also vulnerable to further rises in energy prices.             authorities are likely to allow further CNY strength. We expect
                                                                      the CNY to trade to 6.20 by end-2011 against the USD from a
5. Long MXN versus EUR and USD, with stop 95, target
                                                                      spot price of 6.66 today.
110 (spot 100)
Mexico stands out from most of the EM world as one of the             9. Short AUD/CAD, stop 1.0250, target 0.90 (spot 0.9926)
countries that is least likely to intervene, given the currency’s     The Canadian economy is likely to get support from the
undervaluation. Indeed, currency strength is likely to help to        strength in the US economy, and we expect the BoC to hike
tighten monetary conditions amid rising inflation, and would          by 100bp in 2011. Australia is much more leveraged to the
allow the central bank to avoid hiking rates. The country’s           Asian economy, which will likely face headwinds (certainly in
strong links to the US are likely to bolster activity through 2011.   the early part of 2011) from policy tightening aimed at
                                                                      containing inflation in the region. We expect the RBA to hike
6. Buy RUB versus basket, with stop 36.50, target 33.50
                                                                      by 25bp in 2011. Location in this trade is very appealing at
(spot 35.4371)
                                                                      current levels.
We expect the RUB to start 2011 strongly. The currency has
significantly underperformed EM and other commodity
                                                                      Risk-Adjusted Returns in 2010
currencies for a while, making the current entry point
attractive, in our view. Indeed, some of the factors that have        The best risk-adjusted currency trade of the typical crosses
caused the currency’s depreciation appear to be abating, with         we forecast was to be short EUR versus SEK, which netted a
tighter monetary policy on its way and a more benign outlook          total return of 10.4% and a risk-adjusted return of 1.35
for capital flows. Inflows associated with the country’s              (Exhibit 3). Being short the euro featured in many of the top-
privatization program and the planned RUB Eurobond                    performing trades, three out of the top five, despite the fact
issuance should help too. What’s more, the central bank is            that the euro made a decent recovery from September
gradually moving away from the FX market, which should                onwards. Indeed, if it wasn’t for the Fed’s QE2 policy,
mean that the currency will begin to move more in line with           EUR/USD would probably have featured much higher up the
the balance of payments pressures. In other words, the RUB            list. The best-performing overall trade was to be long JPY and
should appreciate.                                                    short HUF, which achieved a total return of 20.96%.

                                                                      Interestingly, out of the top-performing currency pairs that we
                                                                      forecast, the top five (with the exception of USD/CNY) came
                                                                      from the major currencies. The best-performing risk-adjusted
    Made up of spot USD/JPY and 1yr USD/MYR NDF

                                                                                MORGAN STANLEY RESEARCH

                                                                                December 9, 2010
                                                                                How Much Further Can the Can be Kicked?

return outside of the G10 was to be short USD/CNY and                           Despite additional liquidity measures (QE2) being signalled by
USD/SGD. Indeed, being short EUR/JPY achieved a hefty                           the Federal Reserve in 3Q10 and there being US$120 billion
16.35% total return, which in terms of liquidity adjustment is                  of capital inflows (bonds and equities) to emerging economies
probably the best currency trade of 2010.                                       in 2010, there were some very disappointing currency trades.
                                                                                Short USD/BRL, USD/KRW, USD/INR and USD/TRY
Exhibit 3
                                                                                achieved very poor risk-adjusted returns as Exhibit 3 shows.
Risk-Adjusted Returns in 2010
                   Total return        Realized vol         Risk-adj. return
                                                                                US Dollar – Economy Key
EUR/SEK                 -10.42                7.69                    -1.35
USD/CNY                  -2.10                1.57                    -1.33     The outlook for the US economy will be one of the key factors
NZD/NOK                  13.00                9.98                     1.30     driving global currency markets in 2011. We approach 2011
EUR/CHF                 -10.97                8.56                    -1.28     thinking that the US economy is set to outperform the G4
EUR/JPY                 -16.35               13.00                    -1.26
                                                                                (Exhibit 4). The risks for growth seem to be skewed to the
AUD/NZD                   8.80                7.23                     1.22
USD/SGD                  -6.68                5.75                    -1.16     upside following the potential tax deal announced in the US,
EUR/ZAR                 -13.45               12.28                    -1.10     assuming it passes. Our baseline forecast is for the US
USD/PEN                  -1.84                1.79                    -1.03     economy to expand by 2.9% in 2011, but if this tax package is
AUD/USD                  13.67               13.68                     1.00     enacted, we think it is likely to boost growth by around 1.0-
NOK/SEK                  -6.10                6.30                    -0.97
                                                                                1.2pp to around 4.0% or higher in 2011. We expect Euroland
USD/TWD                  -4.77                5.00                    -0.95
USD/MYR                  -7.68                8.08                    -0.95     and Japan to expand by 1.5% and 1.0%, respectively. If we
AUD/CAD                   8.21                8.73                     0.94     are right, this should support the dollar and the unemployment
USD/JPY                  -9.59               11.09                    -0.87     rate is set to fall to 9.0% by end-2011 and to 8.0% by end-
EUR/TRY                  -8.08                9.55                    -0.85     2012 (in our baseline scenario). We think that this growth
USD/ILS                  -5.43                6.59                    -0.82
                                                                                performance will be sufficient for the Federal Reserve to end
GBP/JPY                 -12.53               15.37                    -0.82
EUR/CZK                  -5.11                6.33                    -0.81     its current buying program in June. If the tax cuts pass, it
EUR/RON                  -4.62                5.88                    -0.79     seems very unlikely that any further QE measures will be
USD/COP                  -6.42                8.74                    -0.73     needed in 2011, which will be bullish for the dollar.
GBP/CHF                  -6.91               10.33                    -0.67
EUR/USD                  -7.17               11.16                    -0.64     Exhibit 4
USD/HKD                   0.48                0.78                     0.62     Morgan Stanley GDP Growth Forecasts
USD/PHP                  -4.66                7.61                    -0.61
                                                                                                                 2009A      2010E   2011E   2012E   2013-17E
USD/HUF                  11.37               18.92                     0.60
GBP/SEK                  -6.33               10.85                    -0.58     GLOBAL                             -0.8       4.9     4.2     4.5        4.1
NZD/USD                   7.58               13.76                     0.55       G10                              -3.5       2.6     2.2     2.5        2.1
USD/MXN                  -5.53               10.90                    -0.51
                                                                                        United States              -2.6       2.9     2.9     3.2        2.5
USD/IDR                  -3.79                7.77                    -0.49
                                                                                        Euro Area                  -4.0       1.7     1.5     1.7        1.8
USD/ZAR                  -6.46               13.81                    -0.47
USD/CLP                  -4.25                9.98                    -0.43             Japan                      -5.2       3.7     1.0     1.7        1.0
EUR/GBP                  -3.78                8.96                    -0.42             United Kingdom             -5.0       1.7     1.6     2.0        2.0
USD/CAD                  -4.49               11.19                    -0.40             Canada                     -2.5       2.9     2.6     2.9        2.0
USD/RUB                   4.20               10.72                     0.39             Sweden                     -5.5       5.5     4.1     3.2        2.5
USD/CHF                  -3.78                9.69                    -0.39             Australia                   1.3       2.8     3.1     3.6        3.0
EUR/NOK                  -2.49                7.90                    -0.32
                                                                                  Emerging Markets                  2.3       7.4     6.4     6.6        6.1
USD/PLN                   5.73               18.73                     0.31
                                                                                     Asia ex Japan                  6.2       9.1     7.9     8.0        7.6
GBP/USD                  -2.93                9.82                    -0.30
USD/INR                  -2.32                7.91                    -0.29             China                       9.1      10.2     9.0     9.0        8.0
EUR/HUF                   3.04               11.00                     0.28          CEEMEA                        -4.8       3.7     3.8     3.9        3.7
EUR/PLN                  -2.18               10.91                    -0.20          Latin America                 -1.8       6.1     4.1     4.6        3.8
GBP/NOK                   1.96               10.16                     0.19     Source: Morgan Stanley Research forecasts

USD/BRL                  -2.44               12.82                    -0.19     One of the key aspects of the economy will be the labor
USD/CZK                   2.56               14.17                     0.18     market and, while the last employment report disappointed
USD/KRW                  -0.98               13.41                    -0.07
                                                                                relative to expectations, many lead indicators suggest
USD/TRY                  -0.65               11.78                    -0.05
PLN/CZK                   0.45                9.03                     0.05     improvement in the months ahead. Early indications are that
Source: Morgan Stanley Research, Bloomberg; Note: Returns to December 2, 2010   the next report could add 200,000 jobs. The leading indicators

                                                                                                MORGAN STANLEY RESEARCH

                                                                                                December 9, 2010
                                                                                                How Much Further Can the Can be Kicked?

such as average workweek and temporary help jobs have                                           Exhibit 7
decisively turned higher (Exhibit 5), and we would expect                                       Productivity Is Beginning to Exhibit a Normal Cycle
payroll growth to follow. Indeed, as can be seen in Exhibit 6,                                  Slowdown
private sector jobs took a big hit during the recession and the                                  Nonfarm Productivity Growth
                                                                                                 (SAAR, % Change)
gap between payrolls and output has widened significantly,                                         10
implying that productivity has risen sharply, which is typical
during a recession. However, once the productivity gains
begin to slow, hiring normally picks up, so we are in an                                            6
important transition phase in which payroll gains should start
to pick up. Although the latest pace of gains is currently                                                                                                    Long Run Trend
running below the average of the past nine cycles, it is slightly                                   2

ahead of the 1991 and 2001 recessions, which is                                                     0
encouraging, given the depth of the last recession (Exhibit 8).
With the above in mind, we believe that the Federal Reserve
won’t extend its QE program and the lows have been seen in                                              Mar-09        Jun-09       Sep-09    Dec-09      Mar-10        Jun-10    Sep-10
US yields. Both should support the USD.                                                         Source: Morgan Stanley Research, Bureau of Labor Statistics

Exhibit 5                                                                                       Exhibit 8
Leading Indicators Point to Improvement in the                                                  Job Growth Is Faster than After the 1991 and 2001
Labour Market                                                                                   Recessions
 Hours                                                                    Employees, 000s
                                                                                                 Private Payroll Employment
 34.8                                                                                    2800    (Cycle Trough=100)
 34.6                                                                                    2600

 34.4                                                                                    2400    108                                Average of Prior 9
 34.2                                                                                    2200                                       Current
 34.0                                                                                    2000                                       1991
 33.8                                                                                    1800
 33.6                                                                                    1600

 33.4                                                                                    1400    102
                                         Average workweek
 33.2                                                                                    1200
                                         Temp Help Jobs (rhs)                                    100
 33.0                                                                                    1000

 32.8                                                                                    800      98
     89     91    93     95    97    99     01     03      05             07        09                  -12      -8     -4     0       4     8     12    16       20     24     28   32    36
Source: Morgan Stanley Research, Bureau of Labor Statistics                                                                                                                           Months
                                                                                                Source: Morgan Stanley Research, Bureau of Labor Statistics
Exhibit 6
Employment and GDP                                                                              Will the Euro Survive 2011?
 Millions, sa                                       Trillions of Chained 2005$, saar
 117                                                                                     14     Arguably one of the main issues for currency markets in 2011
 115                   Private Nonfarm Payrolls                                                 will be the euro, not just about how it will perform but, on a
                       Real GDP (rhs)
                                                                                         13     much more serious note, will it even exist in its current
                                                                                                We think that concerns about the euro area breaking up are
                                        July 2003
                                                                                                probably overdone, but the currency union is going to be
                                                                                                tested further, and 2011 is likely to prove a tougher test than
 105                                                                                            2010. While we doubt that any country will leave the union
                                                                                                next year, the market is probably likely to build in an
                                                                                                increased risk premia to the euro for these risks and the
 101                                                                                     9
        97   98   99    00    01   02   03   04     05    06   07    08        09   10
                                                                                                probability of a country leaving has certainly increased.
Source: Morgan Stanley Research, Bureau of Economic Analysis, Bureau of Labor Statistics

                                                                                MORGAN STANLEY RESEARCH

                                                                                December 9, 2010
                                                                                How Much Further Can the Can be Kicked?

As we discussed last week (see “Euro Contagion”, FX Pulse,                      the euro would therefore decline. In other words, if the
December 2, 2010), there is no obvious fix for the euro area’s                  process of adjustment involves the core becoming less
problems as Germany is essentially much more competitive                        competitive, then the fair value of the euro would decline as
than most of the southern European countries. Inflation has                     the competitiveness of the overall union moves towards the
been much lower and productivity much higher in Germany                         periphery and away from the core. Our labour productivity
than many of the southern European countries, resulting in                      adjusted PPP model estimates fair value within the euro and
these countries becoming very uncompetitive (Exhibit 9). A                      suggests that fair value is EUR/USD 1.32 for the core and
change in this trend would be a positive for the euro, and it                   1.10 for the periphery (Exhibit 10).
might be that Germany has to tolerate higher inflation for a
                                                                                Exhibit 10
period as monetary policy is left artificially easier during the
                                                                                Fair Value for the Periphery Is Much Lower than the
crisis than the German fundamentals warrant.
Exhibit 9
Productivity and CPI in the Euro Area                                             25%
%                         Annual productivity growth                    CPI
Ireland                                          3.1                    3.8       20%
Greece                                           2.4                    3.4
France                                           1.6                    1.8       15%
Germany                                          1.4                    1.6
Portugal                                         1.3                    2.9       10%
Spain                                            0.7                    3.2
Italy                                            0.4                    2.4        5%
US                                               2.1                    2.8
Source: Morgan Stanley Research, OECD
Indeed, this is the process that probably needs to occur for
the euro to survive in the long run, and such an adjustment is                    -5%
probably needed for the benefit of the euro. Such a scenario                               GBP     GER     FRA    IRL      CHF    PRT      ITL   GRC     ESP

(where Germany has higher inflation for while) would erode                      Note: Misalignments based on LP-PPP Model
                                                                                Source: Company data, Morgan Stanley Research, OECD, Bloomberg
the competitiveness of the core and the overall fair value of

Exhibit 11
Labour Productivity Adjusted PPP Model
X-Rate                             USD/DEM             USD/FRF    USD/GRD       USD/IEP            USD/ITL         USD/ESP           USD/PTE           EUR/CHF
                                  Real Rate,     Real Rate,      Real Rate,   Real Rate,         Real Rate,      Real Rate,        Real Rate,
Dependent Variable                      PPI            CPI             CPI          CPI                CPI             CPI               CPI               Spot
Regressors                              log(P)          log(P)       log(P)       log(P)              log(P)            log(P)          log(P)            log(P)
Const.                                   0.36             1.37        4.85         -0.63               6.95              4.51             4.06             2.28
Coeff. of Labor
Productivity Differential)               0.71             0.37        1.13          0.46               0.55              0.68             1.04             0.64
Standard error                           0.37             0.30        1.28          0.21               0.43              0.35             0.36             0.14

R Squared (%)                           12.46             5.26        3.04        12.82                5.98              9.28           43.55                  85
t- Stat                                  1.92             1.20        0.89          2.17               1.29              1.95             2.91             4.50
Prob.                                    0.07             0.24        0.38          0.04               0.21              0.06             0.01             0.00

Current Fair Value
(2009 Ending)                            1.32             1.32        1.10          1.22               1.10              1.09             1.12             1.43
Spot                                     1.30             1.30        1.30          1.30               1.30              1.30             1.30             1.31
Misalignment (%)                        -1.50            -1.08       17.34          6.43              17.02             17.65           14.96              8.81
Source: Morgan Stanley Research

                                                                      MORGAN STANLEY RESEARCH

                                                                      December 9, 2010
                                                                      How Much Further Can the Can be Kicked?

While this would be interesting big picture, it is likely to take a   debt situation in many parts of Europe, can be improved.
number of years for relative competitiveness to adjust and,           Raising the size of the EFSF is unlikely to solve the problem if
given Europe’s current problems, the market is not going to           interest rates remain this high, as the crisis countries need
wait that long. Indeed, as we have recently seen with Ireland,        cheap financing to overcome their debt problems.
despite the government being funded well into next year,
                                                                      As monetary transfers between countries are politically
financial markets have been able to force a bailout. In the
                                                                      unpalatable, and it is unlikely that bond holders will be able to
near term, it seems to us that for the pressure to come off the
                                                                      take a hit in one sector without this causing contagion
euro, a more sustainable approach to fiscal policy will be
                                                                      elsewhere (e.g., if Irish bank debt holders were forced to take
required which enables burden-sharing and somehow
                                                                      a hit, then Portugal bond holders would likely react strongly).
involves the recapitalization of banks. With the German
                                                                      This leaves the ECB perhaps holding the key to the euro’s
regional elections looming in late February/early March, this
                                                                      future and there is a substantial risk that the ECB have to
seems extremely unlikely as Germany would incur the largest
                                                                      increase their asset purchases as we mentioned above.
cost of any further integration of the euro area. Indeed, in
terms of where the ‘end game’ for the euro area is, we                One of the complications of the current situation, however, is
suspect that policy-makers will tend to continue to be fairly         that the German elections will be held starting in late
‘reactive’ to developments. Overall, the current crisis could         February. The German economy is performing very well.
deepen either via contagion to Portugal then Spain, or due to         Indeed, it is booming on some estimates such as the IFO,
funding issues in the early part of 2011, or perhaps around           which hit its highest level since 1969 in November. Some form
the Irish elections in early March when the latest budget might       of printing might be necessary in 2011 to secure the euro, and
get discarded by a new government.                                    Germans might well be opposed to it. It is hard to see how
                                                                      such conflicts could be resolved.
With this in mind, we believe that the crisis in the periphery
could deepen and ultimately result in the ECB stepping in as a        When one considers the size of the government deficits
buyer of last resort to support the peripheral bond markets,          (Exhibit 12), the redemptions in 2011 (see Appendix) and the
thereby expanding its balance sheet significantly.                    size of the banking debts and cross-border lending (Exhibit
                                                                      14), then at some point in 2011 the market will look towards
Outlook for the Euro                                                  the end game. This is particularly the case as financial
                                                                      markets have found a means to undermine the euro by selling
We spent much of the last 12 months being bearish on the
                                                                      the peripheral government paper and are therefore raising
euro, only becoming bullish against the dollar in late August,
                                                                      funding costs and creating a vicious spiral whereby the debt
reflecting the Federal Reserve’s change of stance. Initially,
                                                                      levels also grow as interest payments rise.
the euro overshot our 1.36 target and once again it was
notable, like last year, that Euroland seems to encounter             Overall, we think that at some point in 2011, the ECB will
problems when the currency is significantly overvalued. Of            have to step in and buy up debt and expand its balance sheet
course, the recent episode has not been helped by the slow            from the current level of €1.9 trillion. Although such an
response to the Irish problems, suggestions by German                 outcome might give the euro some near-term relief, the euro
Chancellor Merkel that bond holders should share the burden           is likely to be punished as a printer and, overall, we forecast
of losses, and a shift in stance by the ECB since the summer,         that it will fall towards fair value (EUR/USD1.22) and beyond
as it has started to slowly implement its exit strategy. Any          to 1.18 later in the year. However, we believe that the ECB
further thoughts of burden-sharing are likely to hinder the           will be reluctant to pursue this policy and is likely to want to
euro.                                                                 put as much pressure as possible on the governments to
                                                                      resolve the issue through fiscal policy.
The basic flaws in the euro and the lack of a political union –
and most importantly a federal tax system – have certainly            In the latest November crisis, policymakers acted too slowly
come to the fore. The EFSF fund helped to create a promising          and have not yet resolved the problems. In effect they have
framework whereby countries could receive a bailout.                  only really kicked the can down the road, in our view, and risk
However, once it came into operation, we were disappointed            public opinion severely turning against the European Union.
with the severe interest rate of 5.8% imposed upon Ireland
which will not solve Ireland’s situation in the long term. With
this in mind, it will be hard to see how Europe’s banking
debts, which are as large and as problematic as the sovereign

                                                                                                     MORGAN STANLEY RESEARCH

                                                                                                     December 9, 2010
                                                                                                     How Much Further Can the Can be Kicked?

Exhibit 12                                                                                           Exhibit 13
General Government Budget Balance (% GDP)                                                            General Government Budget Balance (% GDP)
                                 2007A     2008A      2009A    2010E     2011E      2012E                                             2007A     2008A     2009A      2010E    2011E      2012E

        United States              -2.9      -6.3     -11.3    -10.3       -8.7       -7.4                    United States              61.8    70.0      84.6       90.0     93.3       95.0
        Euro Area                  -0.7      -2.0      -6.3      -6.3      -4.8       -3.9                    Euro Area                  66.4    70.1      79.2       84.1     86.7       87.8
             Germany                0.2       0.0      -3.2      -3.7      -2.9       -2.5                        Germany                64.9    66.3      74.5       74.7     75.1       75.1
             France                -2.7      -3.3      -7.5      -7.7      -6.2       -5.3                        France                 63.8    67.5      78.1       83.0     86.6       88.7
             Italy                 -1.5      -2.7      -5.3      -5.1      -4.0       -3.2                        Italy               103.5     106.1     115.8      118.6    118.5      118.0
             Spain                  1.9      -4.1     -11.2      -9.1      -6.2       -5.4                        Spain                  36.2    39.7      53.2       62.7     68.0       73.4
             Netherlands            0.1       0.6      -5.4      -5.8      -4.0       -2.9                        Netherlands            45.3    58.2      60.8       65.6     66.1       66.8
             Belgium               -0.4      -1.4      -6.1      -4.8      -4.6       -4.5                        Belgium                84.2    89.8      96.3       98.7    100.6      102.2
             Greece                -6.7      -9.6     -15.4      -8.1      -7.7       -6.9                        Greece              105.0     110.3     126.8      142.4    153.4      154.8
             Austria               -0.5      -0.5      -3.5      -4.2      -3.6       -3.3                        Austria                59.5    62.5      67.5       70.5     72.1       73.2
             Finland                5.2       4.1      -2.5      -3.1      -1.7       -1.2                        Finland                35.3    34.2      43.9       49.1     51.3       52.9
             Portugal              -2.8      -3.0      -9.4      -7.3      -5.3       -4.5                        Portugal               62.7    65.3      76.1       83.4     88.7       93.2
             Ireland                0.0      -7.3     -14.4    -33.1       -9.3       -8.4                        Ireland                25.0    44.3      65.5      102.3    119.0      124.2
        Japan                      -2.4      -4.1     -10.2      -9.6      -8.9       -8.1                    Japan                   187.7     194.7     217.6      225.8    234.1      238.6
        United Kingdom             -2.7      -6.7     -11.3      -9.5      -7.6       -5.6                    United Kingdom             43.6    55.8      71.3       76.7     80.9       82.8
        Canada                      1.4       0.0      -5.5      -3.7      -2.1       -1.3                    Canada                     65.0    69.7      82.8       83.7     84.1       83.6
        Sweden                      3.5       2.2      -1.1      -1.2      -0.4           0.9                 Sweden                     39.9    37.6      41.6       38.7     36.5       34.0
        Australia                   1.9       1.1      -3.4      -4.1      -2.6       -0.5                    Australia                  15.3    14.3      16.6       20.9     24.1       25.3
Source: Morgan Stanley Research forecasts                                                            Source: Morgan Stanley Research forecasts
Note: The general government budget balance includes all levels of government (federal,              Note: The general government budget balance includes all levels of government (federal,
regional, local) as well as the social security system.                                              regional, local) as well as the social security system.

Exhibit 14
Cross-Border Lending as a Percentage of Creditor GDP
Summary % of GDP              Austria        France     Germany         Ireland           Italy Switzerland        Spain      Sweden       Eurozone             US            UK         Japan

Greece                             0.9          2.2            1.1          3.9            0.0         0.6            0.1          0.1           1.0           0.0            0.5              0.0
Ireland                            1.2          1.7            4.2          N/A            0.7         3.6            1.0          0.9           2.2           0.4            5.8              0.4
Portugal                           0.5          1.6            1.1          2.6            0.2         0.6            5.7          0.1           1.5           0.0            1.0              0.0
Spain                              1.9          6.4            5.5         13.0            1.3         2.4            N/A          0.8           4.3           0.4            4.6              0.4
Italy                              6.0         16.6            4.6         19.8           N/A          2.6            2.4          0.3           6.2           0.2            3.0              0.7
GIIPS                            10.5          28.6           16.6         39.2            2.2         9.6            9.1          2.2          15.3           1.1           14.9              1.6
Euro-zone                        44.5          49.4           36.2         78.7           26.4        69.2          16.9          48.6          36.2           5.8           44.4              8.6
Eastern Europe                   58.8           5.8            4.6         12.5            7.9         3.0            0.6         16.1           7.9           0.4            2.0              0.4
Note: Lending on an ultimate risk basis
Source: Morgan Stanley Research, BIS, IMF

The next ECB president will have a fairly tough time
                                                                                                     It’s Worth Holding Some DKK Just in Case
particularly if the ECB does start to buy more debt, as the
union and its monetary policy risk looking increasingly                                              While we do not forecast that the euro will break up, the
inappropriate for the core, especially Germany. If the next                                          probability has certainly risen in 2010 and we doubt that
ECB president is not German and the ECB starts to behave                                             policy-makers will come up with a long-term solution anytime
less like the old Bundesbank this might lead to a higher risk                                        soon, as we discussed above. One fairly cheap way of
premium being priced into the euro. The identity of the new                                          positioning for a break-up of the euro would be long DKK on a
president will be an important focus for the FX market in the                                        forward basis against the euro with the idea being that if
run-up to September 2011.                                                                            Germany did leave the euro, then the Danes are most likely to
                                                                                                     want to peg against a strong currency. We estimate that the
                                                                                                     DKK is fairly valued against the euro (Exhibit 15) like
                                                                                                     Germany but unlike many of the peripheral countries as
                                                                                                     Exhibit 10 shows.

                                                                           MORGAN STANLEY RESEARCH

                                                                           December 9, 2010
                                                                           How Much Further Can the Can be Kicked?

Exhibit 15                                                                 Exhibit 16
EUR/DKK Is Fairly Valued                                                   China Input Prices PMI Are at Strong Levels
 EUR/DKK                                                                    Index
 8.40                                                                       80

 8.20                                                   EURDKK              70
                                                        Fair Value
 7.40                                                                       20

 7.20                                                                       10

 7.00                                                                        0
        85   87   89   91    93   95    97   99   01   03   05   07   09     Jan-05 Oct-05 Jul-06 Apr-07 Jan-08 Oct-08 Jul-09 Apr-10
                                                                           Source: Morgan Stanley Research, Bloomberg
Source: Morgan Stanley Research; Bloomberg

                                                                           Exhibit 17
Goodbye QE, Hello QT?                                                      Real CNY Has Appreciated 25% over the Past 5 Years
Printing, or quantitative easing as it is marketed by the world’s           Index
major central banks, has been a key driver of FX markets and
could well be again in 2011, with the ECB possibly having to                120
expand its balance sheet further. We also wonder, however, if
quantitative tightening (QT) from China might be a major theme              110
for the FX market in 2011. Not only is the tightening likely to
come from China, but the whole Asian region has rising                      100

inflation (Exhibit 16) at a time when arguably monetary
conditions are too loose. This is especially important for the
foreign exchange market as Asia faces a clear policy dilemma                 80
of what do about rising inflation. It seems that we will get
exchange rate appreciation, but for investors the key is                     70
                                                                                     94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
whether this comes via real or nominal appreciation. The                   Source: Morgan Stanley Research; BIS
implications are very different for investors, with the former
                                                                           Exhibit 18
being bearish and the latter being bullish for the currency. The
Chinese renminbi is an interesting case in point. While there              World FX Reserve Accumulation
is much hype about the ‘weakness’ of the CNY in policy-                     USD, bn
making circles, on a real basis the CNY has appreciated by                                     2005
24% over the last five years (Exhibit 17) compared with 18%                                    2006
                                                                            1200               2007
on a nominal basis.
                                                                            1000               2008
Asian currency performance is going to hinge on whether the                  800
individual central banks raise rates but also the extent to                  600

which they allow their currencies to appreciate. Currency                    400

appreciation was certainly resisted in 2010. As Exhibit 18                   200

shows, there has been a record increase in foreign exchange                      0

reserves so far in 2010. We estimate that global central banks              -200
have accumulated about US$1.4 trillion of foreign exchange
                                                                                       1   2      3     4     5     6      7     8     9     10      11   12
reserves this year (to November), more than the previous                                                                                            Month
                                                                           Note: Cumulative FX reserve accumulation by month since start of year.
record for 2007.                                                           Source: Morgan Stanley Research, Bloomberg

                                                                                           MORGAN STANLEY RESEARCH

                                                                                           December 9, 2010
                                                                                           How Much Further Can the Can be Kicked?

For now these reserves have been accumulated to offset the                                 Exhibit 21
natural appreciation of many of the EM currencies where                                    Chinese Monetary Conditions Are Still Fairly Easy
inflows have typically been the greatest. We can see from
                                                                                            10                  CNY MCI; 12/1996 = 0 (Ratio = 2.5)
Exhibit 20 that the three-month rolling cumulative inflows to
Asian ex-Japan equities have been a record US$35 billion,
                                                                                                                                                REER Impact
but central banks have soaked up much of the inflows.                                        6
                                                                                                                                                Rates Impact
                                                                                             4                                                  MCI
There is little reason to think that this might change in 2011.
However, if policy-makers fail to prevent a rise in inflation,
then the bullish story could unravel. Indeed, our monetary
conditions index for China shows that overall monetary                                      -2

conditions are still fairly easy, given the low level of real rates                         -4

(Exhibit 21).                                                                               -6

Exhibit 19
                                                                                              1996      1998       2000       2002      2004        2006       2008   2010
Around 50% of USD Are Held Abroad                                                          Source: Morgan Stanley Research, EcoWin, Bloomberg
                                                                                           With the economy expanding at a fairly rapid pace and with
 50%                Proportion of USD abroad, taken on                                     the authorities wanting to slow the economy against a
                    a cumulative basis from 1999
                                                                                           background of pressure from the G20 for surplus countries to
 45%                                                                                       allow their currencies to appreciate, we think that the CNY will
                                                                                           perform well in 2011. We are looking for a 6.0% appreciation
                                                                                           against a strong USD so the opportunity against EUR
 35%                                                                                       according to our forecasts is fairly substantial. We are
                                                                                           forecasting that USD/CNY will fall to 6.20 by end-2011 and
 30%                                                                                       5.82 by end-2012.
                                                                                           G20, Still Plenty to FEER?
        99   00      01     02      03     04     05      06    07      08   09       10
                                                                                           While the Geithner plan for formulating current account
Source: Morgan Stanley Research, Bloomberg, IMF COFER                                      targets has not got any traction yet among the G20, the
                                                                                           principle is interesting for the foreign exchange market in that
Exhibit 20
                                                                                           there is still pressure on global policy-makers to allow the
Inflows to AXJ Equities
                                                                                           market to determine exchange rates and a desire to reduce
 USD bn
                  AxJ Total 3M Cumulative Flow                                             excess global imbalances.

                                                                                           With this in mind, we thought it would be interesting to calculate
                                                                                           what would be the necessary exchange rate adjustment if a
   20                                                                                      current account-targeting regime were to be implemented. Or,
                                                                                           in other words, what exchange rate levels might be needed
                                                                                           for countries to have a current account surplus of 4% of GDP,
                                                                                           as Treasury Secretary Geithner would like.
                                                                                           Although these are not our currency forecasts, using this
  -20                                                                                      framework we conclude that EM currencies need to adjust
                                                                                           most, especially in Asia. SGD is by far the most undervalued
                                                                                           in FEER terms by 30% and MYR by around 25% (Exhibit 22).
  -40                                                                                      Given that both countries run a current account surplus of
   May-00         May-02         May-04          May-06        May-08        May-10
                                                                                           more than 10% of GDP, a 4% target might not be realistic, but
Source: Morgan Stanley Research, Bloomberg                                                 it provides a framework for thinking about where currencies
                                                                                           might trade if they floated more freely. We estimate that CNY
                                                                                           needs to appreciate by around 11% against the USD (5.97)

                                                                                               MORGAN STANLEY RESEARCH

                                                                                               December 9, 2010
                                                                                               How Much Further Can the Can be Kicked?

for its current account surplus to reach 4.0% of GDP from the                                  The burden of adjustment is certainly on Asia. RUB, SAR and
average that the IMF now projects at 6.3% between 2011 and                                     ILS also need to strengthen as well as Switzerland in this
2015. Interestingly, according to our forecasts, the CNY will                                  framework. The likes of AUD, NZD, BRL, ZAR and TRY would
probably get to these levels by 3Q12.                                                          likely weaken in this world. While some of the extreme
                                                                                               adjustments that we discuss above are unlikely to occur
Exhibit 22
                                                                                               quickly, we think that the pressure on the currencies with
FEER Estimates & Over/Undervaluation
                                                                                               large current account surpluses will continue. If any of these
                    IMF CA                                                        Deviation
                                                                                               central banks tighten monetary policy, then the inflows of
             Forecast (2011-         FEER -          FEER -                      (from long
                15 Average)       Scenario 1      Scenario 2       Current      term FEER)     capital would be even greater than the huge current accounts,
Country                           Short term      Long Term           Spot                     putting long-term upward pressure on the currencies, and the
G10                                                                                            FX market is likely to continue to push these currencies to
AUD                    -4.4%             0.94            0.92         0.99             7.9%    appreciate.
CAD                    -2.2%             1.04            1.04         1.01             2.7%
CHF                    10.7%             0.89            0.80         0.98           -20.2%
                                                                                               The Outlook for G3 Capital Flows
EUR                     0.4%             1.38            1.42         1.33            -6.1%
GBP                    -1.5%             1.59            1.61         1.58            -1.6%    As part of our annual outlook, we take a closer look at the
JPY                     2.1%            81.29           78.48        83.11            -5.7%    broad basic balance of payments (BBoP) data for the G3, and
NOK                    16.2%             5.84            5.66         5.98            -5.4%
                                                                                               we forecast these annually as part of our currency outlook.
NZD                    -5.9%             0.72            0.68         0.76            11.7%
                                                                                               We use the BBoP as a proxy for the commercial demand for a
SEK                     5.9%             6.66            6.35         6.86            -7.7%
USD (%)                  -2.9                                                                  currency, and we generally expect that surpluses are
Latam                                                                                          associated with a strengthening of the underlying currency. As
ARS                      1.2%           3.97            3.92         3.98             -1.5%    such, we use the concept as an input to our forecasting
BRL                     -3.2%           1.76            1.78         1.68              5.7%    process. A strong BBoP might be one of the factors that
MXN                     -1.4%          12.67           12.70        12.40              2.4%    causes a currency to move a long way from fair value.
CLP                     -2.2%         500.38          496.26       477.25              3.9%
COP                     -2.0%        1845.39         1851.72      1881.10             -1.6%    To track developments in the BBoP at this time of year, we
PEN                     -2.1%           2.83            2.84         2.82              0.6%    forecast the outlook for the BBoP, and taking a view on the
VEF                      8.2%           4.34            4.28         4.29             -0.2%    likely outlook for G3 capital flows gives us an idea of how
CEEMEA                                                                                         strong the underlying demand for the currencies is likely to be.
CZK                     -0.5%          18.10            17.75        18.84            -5.9%
                                                                                               Of course, trying to forecast cross-border capital flows is a
HUF                     -0.8%         199.13           197.11       208.56            -5.6%
ILS                      5.0%           3.50             3.44         3.62            -5.0%
                                                                                               tough task, given the size of global capital markets.
RUB                      2.3%          30.04            29.14        31.06            -6.4%    For 2010, we had some fairly aggressive forecasts for the
ZAR                     -6.1%           7.28             7.35         6.89             6.5%
                                                                                               broad balance, particularly in the US and Japan (Exhibit 23).
SAR                      7.3%           3.67             3.56         3.75            -5.1%
PLN                     -2.7%           2.95             2.91         3.02            -3.6%
                                                                                               We expected a fairly dramatic improvement in the US BBoP in
RON                     -5.1%           3.23             3.20         3.23            -0.7%    2010, looking for the deficit to narrow to close to 1.4% of
TRY                     -5.8%           1.52             1.55         1.48             5.1%    GDP, which given a starting point of a current account deficit
Asia ex Japan                                                                                  of 4.1% of GDP would have been fairly impressive. This was
INR                    -2.7%           45.01           45.04        44.65              0.9%    one of the reasons we were bullish on the USD during 1H10.
IDR                    -0.6%         8382.36         8322.30      9002.50             -7.9%    We calculate with the most recently available data and using
CNY                     6.3%            6.45            5.97         6.65            -10.8%
                                                                                               the latest TIC data as a proxy for the BoP data that the US is
MYR                    12.0%            2.62            2.45         3.14            -24.6%
                                                                                               running a deficit of about 2.1% of GDP, down from 4.5% in
TWD                     8.9%           27.78           26.01        30.11            -14.7%
SGD                    16.3%            1.05            0.96         1.30            -30.4%    2009.
HKD                     8.6%            6.91            6.40         7.76            -19.3%
PHP                     2.7%           42.50           41.00        43.59             -6.1%
KRW                     2.3%         1127.29         1086.86      1131.35             -4.0%
THB                     1.2%           29.69           28.63        30.05             -4.8%
Source: IMF WEO (Oct 2010), BIS, Morgan Stanley Research
Note: Negative Value indicates undervaluation; the currency will have to appreciate to reach
equilibrium. The IMF forecasts are based on REERs remaining constant at levels as of end
Aug 2010. We have adjusted REER targets to account for changes since then.

                                                                                                  MORGAN STANLEY RESEARCH

                                                                                                  December 9, 2010
                                                                                                  How Much Further Can the Can be Kicked?

Exhibit 23
G3 Broad Basic Balance of Payments Estimates
                                                                               2006             2007             2008            2009     2010YTDA         2010F     2011F
                                                        Broad balance          -558             -484              -680            -635          -310        -200       -347
                                               Broad balance, % GDP             -4.2             -3.4              -4.7            -4.5          -2.1        -1.4       -2.3
                                                       Narrow balance          -804             -762              -692            -512          -689        -450       -547
                                              Narrow balance, % GDP             -6.0             -5.4              -4.8            -3.6          -4.7        -3.2       -3.6
                                              Current account, % GDP            -6.0             -5.1              -4.7            -3.2          -4.1        -4.1       -3.2
 US (USD bn)

                                                      Current account          -803             -718              -669            -378          -491        -500       -497
                                                                   FDI            -2              -44               -23           -134          -198           50        -50
                                                          Equity flows             2               83                97              73            54          25       100
                                                           Bond flows           244              195                -85           -195           324         225        100
                           Net sales of foreign bonds by US residents          -228             -219               159            -145            -80       -200       -150
                       Net purchases of US Corp Bonds by foreigners             518              384                -51           -131            -29        250        100
                     Net purchases of US Agency Bonds by foreigners               26               -9             -173               -6           -14          25        -25
                         Net purchases of US Treasuries by foreigners            -72               39               -20              86          448         150        175
                                                        Broad balance           101                70             -241               30           -93          65      -169
                                               Broad balance, % GDP              1.2              0.8              -2.6             0.3          -1.0         0.7       -2.2
 Eurozone (EUR bn)

                                                       Narrow balance          -170               -79             -374            -124          -214          -90      -219
                                              Narrow balance, % GDP             -2.0             -0.9              -4.1            -1.4          -2.3         1.0       -2.8
                                              Current account, % GDP            -0.1              0.1              -1.5            -0.8          -0.9         0.6       -0.9
                                                      Current account            -10               11             -134              -50           -82          60        -69
                                                                   FDI         -160               -90             -240              -74         -132        -150       -150
                                                          Equity flows            91             102                  5              37            -4          30          0
                                                           Bond flows           181                48              128             117           125         125          50
                                                        Broad balance          21.5             17.1             -24.3           -13.0         -14.6         -7.8       -3.8
                                               Broad balance, % GDP              4.2              3.3              -4.8            -2.7          -3.0        -1.6       -0.8
 Japan (JPY trn)

                                                       Narrow balance          13.4             19.0                5.7             7.7         12.6        12.2         8.2
                                              Narrow balance, % GDP              2.6              3.7               1.1             1.6           2.6         2.5        1.7
                                              Current account, % GDP             3.9              4.9               3.3             2.8           3.5         3.5        2.8
                                                      Current account          20.0             25.1              16.4            13.5          17.0        17.2       13.2
                                                                   FDI          -6.6             -6.0            -10.7             -5.9          -4.4        -5.0       -5.0
                                                          Equity flows           5.6              2.5            -13.8             -1.7          -0.2        -5.0        0.0
                                                           Bond flows            2.5             -4.4            -16.3           -18.9         -27.1       -15.0      -12.0
Note: 2010Y TD shows annualized data. US 3Q data are estimated using adjusted TIC data. Japanese data are seasonally adjusted.
2010F shows the forecast originally published in last year’s FX Outlook on December 17, 2009.
2011F shows Morgan Stanley forecasts for 2011.
Source: Morgan Stanley Research, Bloomberg, ECB, MoF, BEA, DataStream

The US current account deficit is fairly stable and is therefore                                  Exhibit 24
fairly easy to predict versus the other components of the                                         US Net Investment Income Balance
BBoP. The US current account numbers continue to reveal a
                                                                                                    % of GDP
surplus on the net investment income balance (Exhibit 24),                                          1.6
despite the fact that foreign investors are buying more US
assets to fund the external deficit than US investors are
buying overseas. Essentially, US citizens have been much                                            1.2

more astute at investing overseas than those who have put                                           1.0
capital into the US. Net investment income has been running
at around US$40 billion a quarter in 2010, up from around
US$30 billion in 2009, suggesting that US investors’ rate of
return on capital is running in double digits compared with                                         0.4
foreign investors’ returns on US investments, which are                                             0.2
probably below 5%. This also reflects the fact that most
inflows to the US go into low-yielding assets, such as the front                                           70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
end of the yield curve, while US investors tend to invest in                                        -0.2

higher-yielding assets.                                                                           Source: Morgan Stanley Research, Datastream, Bloomberg

                                                                           MORGAN STANLEY RESEARCH

                                                                           December 9, 2010
                                                                           How Much Further Can the Can be Kicked?

In 2011, we expect the recent weakness of the trade-weighted               expect net equity inflows in the US to pick up as the economy
dollar along with stronger demand overseas than domestically               recovers, helped by the fact that investors are generally
to help to support the US trade balance.                                   underexposed to US equities. We expect positive net bond
                                                                           inflows, although these are likely to be somewhat weaker than
While the overall BBoP improved, the breakdown was
                                                                           this year, with bonds generally unlikely to perform as well
somewhat different than our expectations. Notably, foreign
                                                                           following the big decline in yields in 2010 and narrowing of
direct investment outflows have been somewhat
disappointing, recording a record deficit so far this year, which
on an annualized basis is running at close to US$200 billion.
                                                                           Euro-Zone BBoP – Set to Deteriorate?
US corporates have been exporting more capital than at any
time in recent years. Our M&A pipeline charts show that the                The euro-zone BBoP continues to be a fairly benign story,
net balance of pending inflows and outflows from the US is                 with the deficit in 2010 contributing to weakness in the euro
currently running a small surplus, suggesting that in 2011 FDI             for large parts of 2010. Ironically, we forecasted the most
trends should improve in the US (Exhibit 25).                              difficult parts of the BBoP to forecast, portfolio flows and FDI,
                                                                           accurately in 2010. These parts were in line with our
Exhibit 25
                                                                           projections a year ago while the current account forecast
US M&A Pipeline Currently Running Small Surplus
                                                                           explained the entire miss. While the BBoP was fairly dull
 USD bn
                                                                           overall, it was interesting to observe that the euro area never
                           Completed net flows                             really suffered capital outflows during the crisis phases.
                           Pending net flows
 120                                                                       Indeed, the biggest portfolio inflows to the euro area were in
                                                                           April and May of this year.
                                                                           In 2011, we expect a significant deterioration in the broad
                                                                           balance for Euroland as the market starts to worry about the
                                                                           sustainability of the euro and invests elsewhere (either in Asia
                                                                           or the US where growth prospects are much better and
                                                                           possibly even the UK if it is successful in reining in its fiscal
 -40                                                                       deficits without creating a double-dip). The dangers
                                                                           associated with further quantitative easing in Euroland are
 -80                                                                       also likely to hinder flows into the bond market, and it seems
       99    00   01    02     03    04      05   06   07   08   09   10   likely that investors are going to be reluctant to buy peripheral
Source: Morgan Stanley Research, DealLogic
                                                                           bonds despite the attractiveness of their yields. Indeed, even
We calculate that portfolio flows (bonds and equities) were                the German bond auctions have started to do fairly badly.
weaker than anticipated in 2010 on an annualized basis                     With the euro area likely to underperform in terms of growth,
(using TIC data for recent readings beyond 2Q), although they              and given the growing likelihood that the problems in
were much stronger than in prior years. Bond flows continue                peripheral Europe will spread to the core, this could
to dominate and are set for a record in 2010, annualizing at               undermine investor confidence.
US$324 billion more than our expected US$225 billion. The
breakdown of this was somewhat different than our                          Our M&A pipeline calculations suggest that there is likely to
expectations, with net purchases of US Treasuries recording                be continued outflow from foreign direct investment (Exhibit
a substantial US$448 billion gain, probably helped by the                  26).
softening of the US economy mid-year and expectations of                   With the euro still overvalued, we expect the BBoP to
further support from the Fed via its increased purchases. As               deteriorate in 2011, perhaps significantly. We expect the
we discuss below, Japanese investors have been very big                    deficit to rise to €169 billion (2.2% of GDP), and this should
buyers of foreign bonds in 2010, most of which are probably                weigh on the euro.
US Treasuries. Net corporate bond flows remain fairly weak
(US$29 billion), probably relating to the lack of yield available
on these assets.

In 2011, we expect the US BBoP to remain on an improving
trend and look for a BBoP deficit of 2.3% of GDP in 2011. We

                                                                                               MORGAN STANLEY RESEARCH

                                                                                               December 9, 2010
                                                                                               How Much Further Can the Can be Kicked?

Exhibit 26                                                                                     Japanese investors appear to have been reluctant to sell yen
Cross-Border M&A Flows to the Euro Area Are Flat                                               when they have been buying foreign assets, generally buying
 USD bn                                                                                        foreign bonds on a currency-hedged basis. However, as the
                                                                                               returns on US bonds are likely to be lower next year, we
  150                                                                                          suspect that Japanese investors will try to enhance their
                                                                                               returns by taking FX risk. We also expect that Japan will see
                                                                                               fairly flat flows into equities, with the cyclical environment
   50                                                                                          likely to favor Japan’s export-oriented economy, especially if
    0                                                                                          the yen trend starts to reverse. However, we believe that
                                                                                               there’s little hope of the stock market outperforming in a
                                                                                               region where growth is much stronger elsewhere and the yen
 -100                                                                                          is substantially overvalued on a trade-weighted basis.
        99   00     01    02      03     04   05   06    07   08    09      10
                                                                                               In 2011, we again expect Japan to fully recycle the current
                  Completed net flows                     Pending net flows                    account surplus of 2.8% of GDP, with the BBoP projected to
Source: Morgan Stanley Research, DealLogic
                                                                                               be in deficit by 0.8%.
Exhibit 27
The Euro-Zone Broad Balance                                                                    Japan’s Opposing Forces (Emma Lawson)
 % GDP                          Broad Balance 12ma                                    Index    We anticipate the global higher yield environment as one in
   6                                                                                     120
   5                            ECB Eurozone TWI (rhs)                                         which the JPY may face some headwinds.
   3                                                                                    110    The near-term support arises from the continued compressed
                                                                                        105    level of policy interest rates (Exhibit 28). With G10 policy rates
   0                                                                                    100
                                                                                               likely to remain at relatively low levels, the JPY is not favored
                                                                                               as a funding currency.
  -3                                                                                    90     Exhibit 28
                                                                                        85     USD/JPY Held Low by Low Global Policy Rates
  -6                                                                                    80
                                                                                                       USD/JPY                                                                  bp
     00      01       02      03        04    05    06     07      08      09    10              130                                                                                 75
Source: Morgan Stanley Research, ECB, Bloomberg                                                  125
                                                                                                                                            USD/JPY (lhs)                            65
                                                                                                                                            US 2yr - JN 2yr / 2yr Vol (rhs)          55
Japanese BBoP – Current Account Recycled                                                         115
The Japanese broad basic balance was weaker than we
                                                                                                 105                                                                                 35
anticipated in 2010, with the deficit running at 3.0% of GDP so                                  100
far this year compared with our expectations for a deficit of                                     95
1.6%. The main theme continues to be bond outflows, which                                         90

easily surpassed those of previous years. While the MoF                                           85

weekly capital flow data show a slight reversal in this trend,                                    80                                                                                 -5
                                                                                                   Jan-07   Jul-07   Jan-08   Jul-08   Jan-09   Jul-09      Jan-10     Jul-10
we expect this to ‘normalize’ in 2011, mainly as US Treasuries                                 Source: Bloomberg, Morgan Stanley Research
and global bonds in general are unlikely to perform as well
                                                                                               The existence of deflation in Japan brings about a double-
going forward. In 2010, 10-year yields fell from 3.9% in
                                                                                               edge sword. In a world that faces inflation, JPY has some
January to 3.2% currently, having been as low as 2.33% in
                                                                                               support from its relatively high level of real interest rates. The
October. With the Fed now embarking on QE2 with renewed
                                                                                               latest headline inflation numbers are slightly misleading as
determination to raise inflation as well as growth, yields seem
                                                                                               they include a rise in tobacco taxes. However, the underlying
unlikely to decline much, especially after the latest proposed
                                                                                               rate of CPI inflation remains negative. This leaves Japan’s
tax cut.
                                                                                               real policy rate below that of Australia and New Zealand but
Despite the Japanese BBoP deficit, the yen hasn’t weakened                                     above the rest of the G10. Again, this provides some modest
overall in 2010, although it did earlier in the year, reaching 95                              support. This may be short-lived as the G10 (ex-G3), and EM,
in USD/JPY in May. One of the factors behind this was that

                                                                                              MORGAN STANLEY RESEARCH

                                                                                              December 9, 2010
                                                                                              How Much Further Can the Can be Kicked?

become more comfortable with raising their policy rates                                       faces, and the moderation in income earned in 2010 may
commensurately with inflation.                                                                push for a faster underlying asset allocation change in 2011.
                                                                                              We believe that the risks of a rise in capital outflow, seeking
JPY is unlikely to get any additional support from low yields,
                                                                                              higher yields, are greater than the reverse. Japan’s ageing
from current levels, but significant depreciation is likely once
                                                                                              population is retiring and pension and insurance funds have
global yields rise.
                                                                                              higher required rates of return in order to fund that retirement.
Japan’s weak domestic economic growth outlook and                                             These higher rates are unlikely to come from within Japan, as
likelihood of further monetary easing, in a stronger global                                   evidenced by the net investment balance, and funds are likely
economy, suggest that investors are likely to seek greater                                    to seek better returns offshore. While the rate of change in
returns. As the BoJ faces increased political pressure to                                     asset allocation is glacial, we believe that it should remain a
address moribund economic growth and entrenched deflation,                                    structural headwind for the JPY.
there is a risk of further monetary easing by the BoJ. This is
likely to come in the form of an increased asset purchase                                     The Pound Is Sound, No Can-Kicking Here (Tim
program, and in clear contrast to policy-makers outside of the                                Davis)
                                                                                              While the US is arguably kicking the can down the road with
While JPY did not weaken consistently in the original                                         fiscal easing, Europe is kicking the can down the road by not
episodes of Japan’s QE, there are a number of differing                                       dealing with its debt problems aggressively enough, and Asia
factors now, compared to in the past. We do acknowledge                                       being slow to deal with inflation and allowing its currencies to
that, due to the fact that Japan finances its fiscal deficit                                  appreciate, the UK looks somewhat ‘ahead of the game’.
domestically, the pressures on the currency from such a
                                                                                              Our GBP view for the year ahead is underpinned by two key
policy are perhaps less than elsewhere in the G3.
                                                                                              themes: valuation and getting the budget deficit under control.
Japan’s external position is now weaker than it was (Exhibit                                  We think that the pound will outperform the euro and yen in
29) and we show that the broad balance of payments remains                                    2011.
negative on a trend basis. This is as opposed to the typically
                                                                                              Our valuation metrics indicate that GBP is the only currency
positive/balanced position during much of the QE of the early
                                                                                              within the G10 that is currently undervalued against the USD.
part of the decade. The risk is that with the BoJ increasing its
                                                                                              Against the euro, GBP’s undervaluation is even more acute
purchase program, it may attract equities inflows, which was
                                                                                              (Exhibit 30). We estimate that GBP is around 1 standard
the cause of the recent sharp move to inflows in October.
                                                                                              deviation cheap compared to the euro, with fair value at 0.76.
Exhibit 29                                                                                    We expect GBP’s discount to fair value to fall through 2011
Japan’s Broad Balance Position                                                                and forecast EUR/GBP to trough at 0.77 as some of the large
 % GDP                                                                                        depreciation following the onset of the financial crisis is
                                                                                              Exhibit 30
                                                                                              EUR/GBP Fair Value
   0                                                                                           EUR/GBP
  -5                                                                                                                                 EUR/GBP
                                                                                               0.95                                  Median fair value
                                                                                                                                     Standard deviation
                     Japanese broad balance
 -20                 3 month moving average                                                    0.80

 -25                                                                                           0.75
       00    01    02     03     04      05     06     07     08     09      10
Note: Broad balance of payments includes the current account, FDI and portfolio flows. Data    0.70
are seasonally adjusted.
Source: Bloomberg, Morgan Stanley Research                                                     0.65

Japan’s net international income balance has risen since the                                   0.60

1990s; Japan earns more on foreign income than it provides                                     0.55
                                                                                                      90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
to foreign investors in Japan. That is not surprising, but it does                            Source: Morgan Stanley Research, Bloomberg
underpin some of the long-term structural issues that Japan

                                                                     MORGAN STANLEY RESEARCH

                                                                     December 9, 2010
                                                                     How Much Further Can the Can be Kicked?

The fallout from the financial crisis left the UK with its biggest   export destination for UK goods. We think that this will
peacetime budget deficit, with the deficit ballooning from a         constrain the GBP’s rise against the USD.
manageable 2.3% of GDP in 2006/07 to an unsustainable
                                                                     Australian Dollar (Emma Lawson)
11.1% in 2009. The government appears determined to
reduce the deficit and, based on the OBR’s latest estimates,         The Australian dollar is likely to face initial headwinds arising
the budget deficit is expected to fall to 1% of GDP by 2015          from its high beta currency role and the uncertainty pressuring
(Exhibit 31). This fits in well with the coalition’s aim for the     EUR, but then stabilise in line with the better commodity
cyclically adjusted budget deficit to be balanced by 2015/16.        outlook and only modest EM tightening path. The risk is that it
We think that the market will reward the UK for doing the right      recovers more rapidly than envisaged.
thing and taking action to get the budget deficit under control.
                                                                     The AUD tends to be buffeted by global uncertainty, perhaps
Exhibit 31                                                           unfairly, but it retains its mantle as a barometer of risk
UK’s Budget Deficit to Be Brought Under Control                      sentiment. It is also susceptible given it remains a core long,
                                                                     profitable position, easily unwound in a period of uncertainty.
 % GDP
 12.0                                                                We view the uncertainty of the events in the euro area, and its
                          Budget deficit
                                                                     weighing on EUR, as a source of initial weakness in the AUD.
                          OBR's latest forecasts (Autumn 2010)
                                                                     This is coupled with the market’s initial unease with the
                                                                     tightening expected in EM, particularly China. While we do not
                                                                     believe that China will tighten more than necessary, it is likely
  4.0                                                                to be enough to moderate economic growth to 9% in 2011
                                                                     from 10.2% in 2010. This is likely to generate unease with the
                                                                     AUD through the first quarter, and until there is more
  0.0                                                                confidence that China will not cause a substantial slowdown.
                                                                     Australia’s domestic economy is, necessarily, going through a
 -4.0                                                                period of structural change. With the rise in the terms of trade,
        63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 14        there is a re-setting of the drivers of growth towards the
Source: Morgan Stanley Research, Haver, OBR                          external sector and investment and away from domestic
Fiscal consolidation will inevitably have an impact on growth,       consumption. Given the structure of domestic leverage and
and we expect GDP growth to take a hit of around 1%                  the housing market, this may generate some currency
because of the fiscal tightening planned for 2011/12 for             softness with the moderation in domestic economic indicators.
example. However, even with a below-consensus forecast for           It is also likely to keep the RBA confined to one more interest
UK GDP growth next year, our economists still expect the UK          rate hike only. Indeed, the RBA characterise present interest
economy (1.6%) to grow slightly faster than the euro-zone            rates as more than neutral; at 4.75% that is below what is
(1.5%). Further, as the UK rebalances its economy, the               typically considered neutral in Australia. This is likely due to
structural changes should lay the foundations for more               both the leverage in the household sector and rising bank
sustainable growth in the future.                                    margins, as well as the tightening in monetary conditions
                                                                     associated with a stronger currency. As such, the AUD is
Inflation has remained stubbornly high in the UK, but wage
                                                                     unlikely to pick up much additional yield support while its
growth has remained subdued and inflation expectations have
                                                                     peers are hiking over the year.
only recently begun to pick up, two factors that the MPC
watches closely. So far, the MPC has not felt it necessary to        After the initial adjustment to the risk events that we foresee,
act to combat inflation, but our economists expect wage              the AUD is likely to be supported and see modest
growth to pick up and inflation expectations to increase,            appreciation as a result of further terms of trade gains. Our
leading to a first hike in August. With the Fed and the ECB          commodities team is relatively sanguine on EM tightening and
both unlikely to raise rates through 2011, the pound is likely to    looks to further commodity price gains. Our Australian
gain support if this is right.                                       economists believe that Australia’s terms of trade will rise
                                                                     4.9% from the 15.4% gain in 2010. The risk is that these gains
However, the UK is not totally immune from problems in
                                                                     are greater than expected, and the AUD is provided with
Europe. Indeed, UK banks have lent an amount equivalent to
                                                                     additional tailwinds.
5.8% of UK GDP to Ireland while the euro-zone is the biggest

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    How Much Further Can the Can be Kicked?

New Zealand Dollar (Emma Lawson)                                    rise in a world of abundant liquidity, CAD should stay well
We expect NZD will also struggle against the USD in 2011 but
should outperform AUD in the first half of the year. Many of        Exhibit 32
the concerns we hold surrounding AUD apply to the NZD,              We Expect the BoC to Hike by 100bp in 2011
although in a little less extreme way.
                                                                     Policy rate, %
The NZ domestic economy is facing some challenges with the           5.00                   2011 Hikes (MS Forecasts)

slowing of domestic demand and a sluggish recovery over the          4.50                   Current Rate
course of 2010, despite the better terms of trade. This is likely
to keep the RBNZ modest in their hiking cycle over the
coming year, recommencing hikes in mid-2011. The risk is
that they are delayed.                                               2.00

The key will be how comfortable the market is with the               1.50
tightening occurring in EM, particularly China. As NZ is tied to
the soft commodities, and these are expected to face less
upward pressure in the coming year, there may be modestly








less impetus for outperformance over the year. However, over
time, with China adjusting its economy towards domestic-led
growth, there should be long-term structural support for the        Source: Morgan Stanley Research forecasts

NZD and its exports.                                                The risk factor to bear in mind for CAD is that it is closely tied
                                                                    to bouts of market risk-aversion, which are likely to continue
CAD: The Dark Horse for 2011 (Yilin Nie)                            next year as European sovereign woes linger. As such, we
                                                                    believe that CAD pullbacks on these sentiment shake-ups
CAD was an underperformer in the dollar bloc this year,
                                                                    offer good buying opportunities. Short AUD/CAD is one of our
largely on the back of muted commodity prices (BoC’s
                                                                    top trades for 2011. This relative value trade should stay
commodity index has fallen this year) and persistent concerns
                                                                    somewhat insulated from the volatile moves in the majors. It
about the US economy. But the dynamics are shifting and
                                                                    positions for the divergence we expect to see between US
increasingly supportive for CAD next year. We believe that
                                                                    and China – where growth is picking up and liquidity is
CAD is ripe for a catch-up in the USD bloc against AUD and
                                                                    increasing in the US, growth is easing and liquidity is being
NZD. We also like CAD longs against EUR and JPY next
                                                                    withdrawn in China. AUD/CAD is the ideal proxy for this trade.
year, as Canada continues to lead in growth and rate
                                                                    We target 0.90 in this pair.
differentials. For USD/CAD, we see the pair staying close to
parity, forecasting 1.03 by mid-2011, against a strong USD.
                                                                    Switzerland: More Strength Likely (Stephen Hull)
Most important for Canada is the US. There, the growth
                                                                    The CHF remains one of our favorite currencies. We estimate
outlook is improving, thanks to abundant stimulus from
                                                                    that the CHF is roughly fairly valued at current exchange
monetary and fiscal fronts, putting Morgan Stanley’s estimate
                                                                    rates. The economy also has favorable debt and current
of US GDP next year near 3%. As US consumption picks up,
                                                                    account situations and is unlikely to be hampered by as much
Canada should see increasing benefit as one of its major
                                                                    regulation as many other parts of the world. Given this
trading partners. Domestically, we are forecasting Canadian
                                                                    background and with a friendly tax environment, in contrast to
GDP at 2.6% next year – this is slower than this year’s pace,
                                                                    the ongoing austerity measures that are taking place in many
but still represents a healthy pace of growth, led by domestic
                                                                    parts of Europe, the CHF is likely to attract further capital
demand. Net exports will continue to be a drag and
                                                                    inflows. The economy is also in good shape, and if it was not
represents the biggest risk to growth, but a healthier US
                                                                    for the SNB’s concern about currency strength, it would
consumer may help to blunt some of the drag. As the
                                                                    probably be raising interest rates, given the strength of
recovery continues in Canada, the BoC is likely to restart
                                                                    monetary growth (Exhibit 33) and leading indicators (Exhibit
tightening next year. Morgan Stanley sees four hikes from the
                                                                    34). We expect EUR/CHF to fall to 1.20 in 2011.
BoC next year, beginning in 1Q. This is one of the steepest
tightening profiles in the G10 (Exhibit 32). As Canadian yields

                                                                                          MORGAN STANLEY RESEARCH

                                                                                          December 9, 2010
                                                                                          How Much Further Can the Can be Kicked?

Exhibit 33                                                                                support the currency. In all, growth and rate differentials,
Money Supply Differentials Support the CHF                                                favorable valuations and capital inflows should provide
                                                                                          tailwinds for SEK next year, in our view. The BBoP remains
 EURCHF                                                                          %, yoy
                                                                                          healthy in Sweden also.
 1.75                                                                               15
                                                                                          Exhibit 35
 1.65                                                                               10    Bond Inflows Support SEK
                                                                                                                  Foreign activity in Swedish bonds
 1.55                                                                               5
                                                                                           300                                                                         7.50

                                                                                           200                                                                         8.00
 1.45                                                                               0                                                                                  8.50
 1.35                                                                               -5                                                                                 9.50
                                                                                           -200                                                                        10.50
 1.25                                                                               -10
    Jan-01    Apr-02    Jul-03    Oct-04   Jan-06   Apr-07    Jul-08    Oct-09             -300                                                                        11.00
                                                                                               Mar- Feb- Jan- Dec- Nov- Oct- Sep- Aug- Jul- Jun- May- Apr- Mar- Feb-
              EUR/CHF              EUR minus CHF money supply differential (rhs)                98   99   00   00   01   02   03   04   05   06   07   08   09   10
Source: Morgan Stanley Research, Bloomberg
Exhibit 34                                                                                Source: Morgan Stanley Research, Statistics Sweden, Bloomberg
                                                                                          Exhibit 36
KoF Leading Indicator Points to Swiss Growth
                                                                                          Swedish Broad Basic Balance of Payments
 %, yoy                                                                          Index
 5.00                                                                              3.0     % GDP
  4.00                                                                             2.5
                                                                                   2.0      30                              Swedish broad balance
                                                                                            20                              BBoP 12mma
  1.00                                                                             0.5      10

  0.00                                                                             0.0
                                                                                   -1.0    -10
 -3.00                                                                             -2.0
                                      GDP           KOF (rhs)                                    98    99   00   01    02    03    04    05    06    07   08   09      10
 -4.00                                                                             -2.5   Source: Morgan Stanley Research; Statistics Sweden; Bloomberg
         01    02      03    04      05      06     07       08    09      10
                                                                                          While SEK has enjoyed a strong run, NOK lagged its
Source: Morgan Stanley Research, Bloomberg
                                                                                          Scandinavian peer in 2010. Indeed, for most of the year, oil
                                                                                          had traded flat, economic growth was unimpressive, CPI was
Scandinavia Fundamentally Solid (Calvin Tse)
                                                                                          soft, and the Norges Bank carried a dovish tilt. However, if the
While short EUR/SEK has enjoyed the best risk-adjusted                                    right factors come into play, we believe that NOK will
return in the G10 this year, we believe that it will continue to                          outperform in 2011. Oil, growth and inflation data will
appreciate against the common currency next year as well.                                 therefore be key pillars needed to support the currency. With
Indeed, our economists forecast Sweden to post the strongest                              regards to oil, our commodities team forecasts crude to trade
growth in the G10 at 4.1% in 2011. While 2010 growth has                                  at an average rate of US$100/barrel next year. This should
been robust, leading indicators have recovered in a V-shaped                              inherently support NOK, as a very significant part of the
fashion and currently sit at multi-year highs, suggesting                                 Norwegian economy is driven by its export of commodities.
continued strength going forward. Moreover, we expect the                                 Should this come to fruition, we believe that upward pressure
Riksbank, the only central bank in the developed market with                              will be put on both growth and inflation. We also believe that
a true tightening bias heading into the new year, to hike by                              there is scope for Norges Bank to surprise to the hawkish
125bp in 2011. As seen in Exhibit 35, capital flows, most                                 side, especially as the markets are not pricing in a hike until at
specifically demand for Swedish bonds, have also helped to                                least 3Q11. Moreover, as deficits come to the fore of the

                                                                                                            MORGAN STANLEY RESEARCH

                                                                                                            December 9, 2010
                                                                                                            How Much Further Can the Can be Kicked?

markets’ attention, NOK will likely shine bright, as it is in the                                           Objective Currency Index
unique position of having both a large current account surplus
                                                                                                            As part of our outlook, we have updated our objective
as well as fiscal surplus (Exhibit 37). Investors are likely to
                                                                                                            currency index (OCI) framework to see how the major
reward NOK for its strong balance sheet and fiscal prudence
                                                                                                            currencies rank. The OCI consists of five fundamental
in a time of heightened global uncertainty, especially in the
                                                                                                            categories which we think influence FX markets: economic
European periphery.
                                                                                                            growth, inflation, fiscal balances, interest rates and valuation,
We therefore believe that though the Scandinavian currencies                                                and we rank them individually. Exhibit 38 displays the results,
will outperform EUR next year, the larger returns will come                                                 which show the Scandies come out best, followed by Australia
from NOK. Finally, although we believe that the Scandinavian                                                and Switzerland, with Japan, the euro area and New Zealand
currencies will appreciate versus EUR next year, we                                                         at the bottom of the pile. Interestingly, the UK and US rank
acknowledge that both NOK and SEK will likely command risk                                                  level with Canada, which is interesting, given that many
premia due to its strong trade and economic ties with the                                                   investors continue to see CAD as one of their favorite
euro-zone. As such, we forecast both currencies to                                                          currencies.
underperform against USD in 2011.
                                                                                                            Risks to the Outlook (Emma Lawson)
Exhibit 37
Norway: Fiscal Deficit/Surplus (% GDP)                                                                      There are a number of key risks to our 2011 outlook, with the
                                                                                                            greatest being the possibility of policy errors. With the G3
  % GDP
  20                                                                                                        running extraordinary policy easing, the process to increase,
                                                                                                            or decrease, from current levels is likely to be a difficult one.
  15              2010 (Forecast)   2011(Forecast)                                                          In contrast, EM are facing inflationary pressure, and with DM
  10                                                                                                        remaining subdued, the potential for too much, or too little,
                                                                                                            may create quite significantly different paths for currencies.

                                                                                                            While the central scenario is for China to tighten just enough
                                                                                                            to tackle higher domestic inflation, its ability to ensure a light
                                                                                                            touch as it manages the process through a plethora of micro
 -10                                                                                                        measures is well known and respected. However, there are



                                                                                                            risks that higher inflation means there is more tightening than

                                                                                           Euro Area




                                                                                                            presently expected.

Source: Morgan Stanley Research, IMF

Exhibit 38
G10 Objective Currency Index
                                OECD                                   Govt Gross                                                          FX
       Grand                     LI % gth gth     GDP M3 CPI    CPI Fisc bal Issue % Fiscal Fiscal CB Real                Rate Rate  FX Fair   FV   FX
        Total Rank GDP C/AT uet 6 mth sum rank CPI Def gth sum Rank % GDP       GDP Sum Rank rates Rates 10 yr Volatility Sum Rank 2010 Value Sum Rank
NOK       13      1    7     1 2         2    12      1    7    3    5              15         5        1    1    2     1    3     2    3      6      14    1     2    8     10     5
SEK       19      2    4     3 8         1    16      2    5    6    7              18         6        3    3    6     3    5     6    7      8      26    4   6.5    3    9.5     4
AUD       20      3    1     7 4         5    17      3    2    2    4               8         1        4    4    8     4    1     1    2     20      24    2     8   10     18    10
CHF       26      4    8     2 1         7    18      4    9    9    2              20         7        2    2    4     2    6     3    8     12      29    7     8    4     12     6
CAD       28      5    3     9 7         8    27      7    4    4    3              11         3        5    5   10     5    3     4    6     14      27    6     6    7     13     7
GBP       28      5    6     6 6         9    27      7    3    5    1               9         2        8    8   16     8    6     9    5     10      30    9   3.5    2    5.5     2
USD       28      5    5     8 9         4    26      6    8    8    6              22         9       10    9   19     9    9     8    4      4      25    3   3.5    1    4.5     1
NZD       32      8    2    10 5       10     27      7    1    1 10                12         4        6    6   12     6    2    10    1     16      29    7   6.5    9   15.5     8
EUR       32      8   10     5 10        6    31    10     6    7    8              21         8        7    7   14     7    8     7    9      2      26    4     1    5      6     3
JPY       43    10     9     4 3         3    19      5 10 10        9              29        10        9   10   19     9   10     5   10     18      43   10    10    6     16     9
Source: Morgan Stanley Research; Bloomberg
Note: Numbers above bars denote rank out of 15 data series observed.

                                                                           MORGAN STANLEY RESEARCH

                                                                           December 9, 2010
                                                                           FX Pulse

Greater-than-Expected China (EM) Tightening                                positive on the other safe haven, CHF, due to the ongoing
If a tighter policy stance is required in China, and in EM in              pressures in the euro area.
general, there are significant risks to those currencies which
                                                                           EM Capital Flows Reverse
are leveraged to China, and EM, growth. Investors have
                                                                           2010 has seen a significant rise in the investment flows into
proxied EM growth through holding AUD and NZD in
                                                                           EM equities and FI/FX (Exhibit 40). The better economic
particular. These currencies are heavy exporters to Asia,
                                                                           outlook for EM over DM, and the associated expected better
especially China, liquid, flexible and have a carry advantage.
                                                                           returns, are the clear drivers of these moves and are
In this way they have benefited from those flows which wish to
                                                                           expected to continue through 2011. However, if these flows
invest in AXJ but for various reasons cannot or do not wish to.
                                                                           were to reverse, there may be a greater-than-expected boost
As a result, they are arguably overvalued on a long-term                   to G10 currencies. In particular, this may support the USD
measure, investors are overweight and they may lose their                  more than presently expected.
commodity price prop. We see the risks as more heavily
                                                                           Exhibit 40
skewed to the AUD and NZD, rather than the other
                                                                           EM Flows Were Very Strong in 2010
commodity currencies of CAD and NOK, due to the regional
proximity (Exhibit 39); the difference in valuation and                       bn
positioning shows that investors have had a clear preference
for these regional currencies.                                               6000

Exhibit 39
Commodity FX Export Share to Asia                                            2000

 % of exports to Asia                                                              0
 40                                   Australia
                                      Canada                                -4000
                                      New Zealand
                                      Norw ay                                    Jan-04     Jan-05     Jan-06     Jan-07     Jan-08   Jan-09   Jan-10
 25                                                                        Note: Total flows combine the equities and FX/FI flows.
                                                                           Source: EPFR, Morgan Stanley Research
                                                                           These flows may reverse for a number of reasons. Many
                                                                           investors have invested in EM debt in order to benefit from
                                                                           local currency appreciation, as much as capital appreciation.
  5                                                                        If the expected currency appreciation is not forthcoming, it
  0                                                                        may be a trigger for outflows. Capital controls and an
      94 95 96 97        98 99 00 01 02 03          04 05 06 07 08 09 10   increased management of EM currencies is one potential key
Note: Year rolling sum as a % of total exports                             trigger for such a reversal of EM inflows.
Source: Morgan Stanley Research, IMF DOTS

The weakening domestic economy in Australia suggests that                  While the discussion of EM capital controls and currency wars
this may be a very significant risk for AUD. The RBA is setting            has died down post the G20 summit, it has the potential to
policy for the overheating, export-oriented minerals sector; as            become a key topic again if EM inflation continues to rise. A
such, a loss of demand from greater-than-expected tightening               key concern for EM policy-makers has been the inflationary
in China would see a rapid adjustment in Australian interest               effects of EM capital inflows resulting from the easing policies
rate expectations and the AUD. The NZD is also at risk, given              in the DM, particularly the US. We believe that EM policy-
the continued softness of the domestic economy, although the               makers are uncomfortable with inflation that arises from
RBNZ has been more cautious in setting interest rate policy.               accommodative DM policy and may seek to stem that inflation
                                                                           by using more coordinated capital controls.
In the event that there is more tightening by EM than
expected, which weighs on commodity prices and global                      Of course, if inflation rises enough to warrant a tighter
growth expectations, the beneficiaries are likely the safe-                domestic policy response, some local currency appreciation
haven currencies of JPY and the USD. We are already                        would be welcome. In such a scenario, there is a fine balance
                                                                           between tightening for domestic policy and encouraging more

                                                                                                      MORGAN STANLEY RESEARCH

                                                                                                      December 9, 2010
                                                                                                      FX Pulse

inflows. There are some concerns that a modest interest rate                                          Euro Area Crisis
tightening and currency appreciation would attract even more                                          A more currency-specific risk is a vicious spiral in the
inflows. In such a case, it may raise the risk of capital                                             sovereign debt stresses in the euro area. While the base case
controls. This way, policy can be set for domestic conditions                                         is for the euro area to continue to manage the sporadic
but inflows can be discouraged. With a rise in capital controls,                                      upheavals in periphery debt and eventually reach a stable
investors may be wary of having capital locked in, or the                                             outcome, the tail risks of a more extremely bearish outcome
expected return declines due to higher taxes.                                                         remain.

On the other hand, too much EM tightening in response to the                                          There are a number of channels through which a substantial
inflation concerns may cause outflows, as expected returns                                            and sustained deterioration in the EUR could come about.
decline. This is akin to the risk scenario outlined above. Of                                         The first is that rising tensions in the periphery require a
course, a continued rise in US yields might make the                                                  broader distribution of bailout funds. This does a number of
risk/reward of investing overseas deteriorate and capital might                                       things. It uses the existing finite funds available, and it
stay in the USD.                                                                                      reduces the number of countries contributing to the EFSF.
                                                                                                      The EFSF has a built-in cushion against some countries not
Not Enough Policy Tightening
                                                                                                      being able to meet their obligations (those who receive
Inflationary pressures are rising in EM and DM is expected to
                                                                                                      funding are removed from the list of contributors and
follow modest recovery paths. One of the key features of
                                                                                                      contributors are required to contribute 120% of the money
2010, compared to where we started the year, was the lack of
                                                                                                      needed). However, if the extreme worst case is that the
policy normalization, given lackluster G3 economies. This has
                                                                                                      bailouts extend beyond Spain, then there is an ever-
left those front-runners in the growth and inflation stakes
                                                                                                      increasing burden on the core. If the cost of core debt begins
possibly a little behind the curve (Exhibit 41). Hesitation to
                                                                                                      to rise significantly, due to sovereign concerns and not
tighten monetary policy due to an uncertain global backdrop,
                                                                                                      inflation, we believe that it is likely to weigh on the EUR faster
or the fear of attracting greater inflows, is potentially behind
                                                                                                      than presently expected.
the increased inflationary pressures already seen.
                                                                                                      The eventual end game appears to be one of fiscal union.
If policy-makers, globally, fail to normalize policy, then we
                                                                                                      Given the likely sovereignty issues involved, this could take
may continue to see compressed policy rates and steeper
                                                                                                      some time to establish. With a number of euro area countries
interest rate curves, as well as abundant liquidity. This favors
                                                                                                      facing very fine political margins, the risk of political policy
the high-beta currencies of AUD, NZD and possibly EUR,
                                                                                                      error, or at least tension, is high. Bailing out the periphery or
while the USD underperforms.
                                                                                                      applying increasingly stringent deficit-reduction policies is not
Exhibit 41                                                                                            popular or voter-friendly. This raises the risks of opposition to
G10 Policy Rates Are Lagging Inflation, as a Whole                                                    euro area policy in the best case, by creating uncertainty, and
                                                                                                      in the very worst case a country threatening to pull away from
                                                                                                      the euro. The break-up of the euro area is not something we
                                                                                                      believe will occur in this timeframe, but markets pricing in this
                                                                                                      risk, if it is perceived as non-zero for any of the factors above,
  3                                                                                                   is likely to be a headwind for the EUR.
  2                                                                                                   US Has Problems of its Own
                                                                                                      The US economy is anticipated to be recovering, assisted by
                                                                                                      the Fed’s asset purchase scheme and increased certainty
  0                                                                                                   surrounding income tax relief. The economic data have been
           G10 Policy Rate                                                                            improving and leading indicators rising. The market believes
 -1        G10 CPI
                                                                                                      that the Fed may even not have to follow through with the
 -2                                                                                                   whole of the US$600 billion purchase scheme. Given this, we
  Jan-00    Jan-01   Jan-02   Jan-03   Jan-04   Jan-05   Jan-06   Jan-07   Jan-08   Jan-09   Jan-10
                                                                                                      see the USD recovering against the G10 currencies in
Note: G10 policy rate and CPI inflation are GDP-weighted.
Source: Bloomberg, Morgan Stanley Research                                                            general.

                                                                                                      The greatest risk for the USD, as a whole, would be further
                                                                                                      lackluster performance once the benefit of the present

                                                                  MORGAN STANLEY RESEARCH

                                                                  December 9, 2010
                                                                  FX Pulse

accommodative policy wears off. Market concerns over the          from the fiscal forces seen elsewhere, but it brings about a
potential for monetization of the US debt may have foreign        measure of mutual dependence. If holders of those reserves
investors requiring a premium for holding US debt, be it in the   are concerned about US sovereign debt and/or monetary
form of higher interest rates and/or a weaker USD. We saw         policy which may place the long-term value of the currency, or
signs of this prior to the announcement of QE2, which was         the debt, under pressure, then this may provide a greater-
well flagged.                                                     than-expected negative force on the USD.

The USD has the relative luxury of being the world’s most
significant reserve asset. This protects the USD, somewhat,       We acknowledge the contribution of Vinayak Seshasayee to this article.

                                                                                                                                         MORGAN STANLEY RESEARCH

                                                                                                                                         December 9, 2010
                                                                                                                                         FX Pulse

Appendix: Peripheral Europe Redemption Schedule
                        Greece                                    Portugal                                  Spain                                    Italy                                    Ireland
                                                Cum                                  Cum                                       Cum                                        Cum                                   Cum
                      EUR    Cumulative           %              EUR    Cumulative     %                          Cumulative     %                           Cumulative     %               EUR                   %
           Date       (bn)     (EUR bn)         GDP     Date     (bn)     (EUR bn)   GDP       Date    EUR (bn)     (EUR bn)   GDP      Date    EUR (bn)       (EUR bn)   GDP      Date     (bn)   Cumulative   GDP

        24-Dec       0.39            0.39       0.2                                         17-Dec        8.67         8.67    0.8   15-Dec        8.18           8.25     0.5

                                                                                                                                     20-Dec        1.02           9.27     0.6
                                                                                                                                     31-Dec        9.00          18.27     1.2
          Total      0.39                               Total    0.00                          Total      8.67                          Total     18.27                            Total    0.00
        11-Jan       0.02           0.41     0.2      21-Jan     3.40         3.40    2.0   21-Jan        8.65        17.33 1.6      14-Jan        7.50          25.77     1.6   14-Jan     2.05         2.05   1.3
        14-Jan       3.04           3.45     1.5      18-Feb     3.52         6.92    4.0   18-Feb        7.77        25.10 2.4      31-Jan        9.90          35.67     2.2   14-Feb     1.15         3.20   2.0
        21-Jan       1.17           4.62     2.0      18-Mar     3.30        10.22    5.9   18-Mar        6.50        31.59 3.0      01-Feb       18.68          54.36     3.4   14-Mar     1.55         4.75   2.9
        18-Feb       0.39           5.01     2.1      15-Apr     4.67        14.89    8.6    21-Apr       6.20        37.80 3.6      15-Feb        7.70          62.06     3.9   18-Apr     1.25         6.00   3.7
        18-Mar       1.78           6.79     2.9      15-Jun     4.96        19.85   11.5    30-Apr      15.54        53.34 5.0      22-Feb        1.47          63.53     4.0   11-Nov     4.39        10.39   6.4
        20-Mar       8.56          15.35     6.6       22-Jul    1.79        21.64   12.5   20-May        6.45        59.79 5.6      28-Feb        9.59          73.12     4.6
        30-Mar       0.18          15.52     6.7      19-Aug     1.36        23.00   13.3   17-Jun        4.18        63.97 6.0      07-Mar        2.50          75.62     4.7
         05-Apr      1.00          16.52     7.1      23-Sep     1.41        24.41   14.1    18-Jul       1.42        65.39 6.1      15-Mar       16.44          92.06     5.8
         15-Apr      2.40          18.92     8.1      21-Oct     1.37        25.78   14.9     22-Jul      4.25        69.64 6.5      15-Mar        8.15         100.20     6.3
        13-May       0.39          19.31     8.3      18-Nov     0.87        26.65   15.4    30-Jul      15.49        85.13 8.0      31-Mar       11.60         111.80     7.0
        18-May       6.59          25.90    11.1                                            19-Aug        7.13        92.26 8.7      31-Mar        9.11         120.91     7.6
        31-May       0.42          26.32    11.3                                            23-Sep        5.28        97.54 9.2       15-Apr       8.25         129.16     8.1
        20-Aug       6.82          33.14    14.2                                             21-Oct       8.21       105.76 9.9       29-Apr       9.00         138.16     8.6
        19-Dec       1.17          34.31    14.7                                             31-Oct      14.09       119.85 11.3     01-May       14.57         152.72     9.5
                                                                                            18-Nov        3.73       123.58 11.6     16-May        6.05         158.77     9.9
                                                                                            16-Dec        2.66       126.24 11.9     31-May        8.50         167.27    10.5

                                                                                                                                     15-Jun        6.60         173.87    10.9
                                                                                                                                     30-Jun       12.15         186.02    11.6
                                                                                                                                       01-Jul      0.68         186.70    11.7
                                                                                                                                       15-Jul      1.84         188.54    11.8
                                                                                                                                       15-Jul      7.50         196.04    12.2
                                                                                                                                     01-Aug       20.20         216.24    13.5
                                                                                                                                     15-Aug        7.15         223.39    14.0
                                                                                                                                     01-Sep       17.94         241.33    15.1
                                                                                                                                     15-Sep       14.50         255.83    16.0
                                                                                                                                     15-Sep        7.70         263.53    16.5
                                                                                                                                     30-Sep       13.55         277.08    17.3
                                                                                                                                      14-Oct       7.15         284.23    17.8
                                                                                                                                     01-Nov        0.03         284.26    17.8
                                                                                                                                     01-Nov       15.48         299.74    18.7
                                                                                                                                     15-Nov        6.05         305.79    19.1
          Total     33.92                               Total   26.65                         Total     117.57                         Total     287.52                            Total   10.39
Source: Morgan Stanley Interest Rate Strategy

                                                                   MORGAN STANLEY RESEARCH

                                                                   December 9, 2010
                                                                   FX Pulse

G10: Commodity FX in a World of EM Monetary Tightening
Gabriel de Kock                                                    Exhibit 1
                                                                   G10 FX Performance vs USD (%) since Mar 09 and
EM Trends a Key G10 FX Driver in 2010-11                           31 Dec 09
Trends in emerging market economics have played a key role          60                                                                       60
in driving G10 commodity FX performance since the start of                     2 Mar 09 - 8 Dec 10
                                                                    50                                                                       50
the recovery in the late spring of 2009. The dollar bloc                       31 Dec 09 - 8 Dec 10
currencies have been among the strongest in the G10 over            40                                                                       40
the past year, despite sub-par recoveries in the core G10,          30                                                                       30
because buoyant commodities demand from EM Asia has
boosted the exports and currencies of commodity producers           20                                                                       20

worldwide (Exhibit 1).                                              10                                                                       10

Events in emerging markets should be major commodity FX              0                                                                       0
drivers again in 2011. The economic outlook in the G10 is
                                                                    -10                                                                      -10
fundamentally the same: Deleveraging and fiscal headwinds                   EUR     GBP     JPY       NOK   CHF   CAD   SEK    NZD    AUD
will continue to restrain growth, compelling central banks to      Sources: Haver and Morgan Stanley Research.
counter disinflationary forces with highly accommodative
policies. In many emerging markets economies, by contrast,         appetite. In this environment, the G10 commodity currencies
the recovery has exhausted excess capacity, kindling inflation     (and high-beta more broadly) could sell off sharply, reaching
pressures and putting monetary authorities on a tightening         attractive levels to establish longs.
                                                                   EM Buoyed Commodity FX in the 2-Speed Recovery
Against this backdrop, some investors worry that EM central
banks may tighten policy too forcefully, stunting the world        Since the start of the global recovery in the spring of 2009,
recovery, derailing the commodities boom and, with it, the         emerging market economies have far outpaced the G10 core
rally in EM and G10 commodity currencies. Others, with equal       (Exhibit 2). The large industrialized nations have closely
conviction, fret that EM authorities facing massive capital        tracked the sluggish norm for recoveries that follow severe
inflows will err on the side of too much FX intervention, run      financial crises as the balance sheet destruction wrought by
into difficulties controlling domestic liquidity and experience    the crisis restrained consumer demand and bank lending. In
real FX appreciation through a surge in inflation, rather than     the emerging world, which, outside Eastern Europe has
orderly nominal gains.                                             Exhibit 2

Our baseline global economic forecast treads a fairly benign       EM Growth Outperformance Continues: Industrial
path between these extremes: EM central banks tighten              Production (Jan 07=100), 2007-Oct 10
policy to stave off the inflation threat, thereby prolonging the     130                                                                    130
recovery and doing little damage to global growth. In this
scenario, commodity currencies remain well-supported, but do         120                                                                    120
                                                                                   E M Asia
not post outsized gains, and the G10 safe havens, USD, JPY                         L atAm
and CHF, lose ground.                                                110           C EE                                                     110

The transition to our benign medium-term scenario may offer
                                                                     100                                                                    100
some of the most lucrative FX trading opportunities of 2011.
Uncertainty about the pace of, and fallout from Chinese policy
                                                                      90                                                                    90
tightening, likely will plague markets early in 2011, much as it
did after PBoCs reserve requirement hikes early this year.
                                                                      80                                                                    80
And, also repeating early-2010 history, concern about the                 Jan -07 Ju l-07 Jan -08 Ju l-08 Jan -09 Ju l-09 Jan -10 Ju l-10
EMU sovereign debt crisis should further undercut risk             Sources: Haver and Morgan Stanley Research.

                                                                             MORGAN STANLEY RESEARCH

                                                                             December 9, 2010
                                                                             FX Pulse

Exhibit 3                                                                    Exhibit 4
World Industrial Production and CRB Commodity                                CAD & Commodity Price-Based Fair Value, 1987-10
Spot Price Index (Yr/Yr % Chg), 1980-Nov 10
                                                                              1.7                                                                      1.7
   20                                                                  50     1.6                                                                      1.6
                  IP ( Left A xis)                                     40
   15                                                                         1.5                                                                      1.5
                  CRB (Right Axis)                                     30
   10                                                                         1.4                                                                      1.4
                                                                              1.3                                                                      1.3
    5                                                                  10
                                                                              1.2                                                                      1.2
    0                                                                  0
                                                                              1.1                         USDCAD Fair Value                            1.1
   -5                                                                         1.0                                                                      1.0
                                                                       -20                                USDCAD - Actual
  -10                                                                         0.9                                                                      0.9
                                                                                    87      90       93        96        99        02      05    08
  -15                                                                  -40
        80   83    86     89     92    95     98   01   04   07   10         Sources: Bank of Canada, Haver and Morgan Stanley Research.

Sources: Haver and Morgan Stanley Research.
                                                                             Exhibit 5
escaped the worst fallout from the crisis, consumer demand                   AUD & Commodity Price-Based Fair Value, 1987-10
has recovered to pre-recession norms and, along with
exports, powered a powerful surge in industrial activity.                     1.05                                                                    1.05
                                                                                                  AUDUSD Fair Value
Against this backdrop, the dollar-bloc currencies have broadly                0.95                                                                    0.95
                                                                                                  AUDUSD - Actual
outperformed their G10 peers over the course of the global                    0.85                                                                    0.85
recovery, as activity in the industrial engines of EM Asia boost
the demand for commodities. Indeed, the rise in commodity                     0.75                                                                    0.75
prices that has fuelled the commodity FX rally since the start                0.65                                                                    0.65
of the recovery in the late spring of 2009 lines up closely with
the EM Asia-led recovery in industrial activity (Exhibit 3).                  0.55                                                                    0.55

There has been significant discrepancy between CAD’s                          0.45                                                                    0.45
performance on the one hand and AUD and NZD’s on the                                  87     90      93        96        99        02    05     08
other, with AUD rallying twice as much as CAD from its March                 Sources: RBA, Haver and Morgan Stanley Research.
2009 cyclical trough. This divergence lines up closely with the
                                                                             Exhibit 6
price increases posted by the commodities that dominate the
                                                                             NZD & Commodity Price-Based Fair Value, 1987-10
Australian, Canadian and New Zealand export baskets. Key
Canadian export prices, notably natural gas and timber have                    0.85                                                                   0.85
lagged those of Australia’s bulk commodities (particularly coal                                    NZDUSD Fair Value
and iron ore) and New Zealand’s dairy products (Exhibit 4).                    0.75                NZDUSD - Actual                                    0.75

In fact, econometric analysis suggests that the dollar bloc
                                                                               0.65                                                                   0.65
currencies are fairly valued given the market prices of their
key export commodities. Exhibits 4, 5 and 6 show fair values                   0.55                                                                   0.55
based on cointegrating analyses of the long-term relationships
between the inflation-adjusted bilateral commodity FX                          0.45                                                                   0.45
exchange rates vs. the USD and the inflation adjusted values
of their commodity export basket. The charts show CAD                          0.35                                                                   0.35
slightly rich to its USD/CAD fair value at 1.06, AUD fairly                           90      93          96        99        02        05      08
valued at 99c and NZD somewhat cheap to its 84c fair value.                  Sources: Haver and Morgan Stanley Research.
Notably, the analyses confirm that the commodity price nexus
is likely to be key for the dollar bloc currency impact of EM
economic developments in 2011.

                                                                     MORGAN STANLEY RESEARCH

                                                                     December 9, 2010
                                                                     FX Pulse

Goldilocks Reconsidered                                              Exhibit 7
                                                                     G10 Deleveraging in Action: Consumer Borrowing
One and a half years into the recovery, the world economy
                                                                     (Yr/Yr % Chg), Latest 12 Months vs 2002-07 Average
stands at a crossroads. Consumers in most of the G10
economies continue to delever aggressively, with consumer               1                                                                      1

credit running well below (as much as 13% in the US) its               -1                                                                      -1
2002-07 average pace (Exhibit 7). Moreover G10
                                                                       -3                                                                      -3
governments, having run record peacetime deficits in an effort
to cushion the collapse of private demand in 2008-09, will be          -5                                                                      -5
pursuing modestly contractionary budgets, the US excepted if
                                                                       -7                                                                      -7
the President and republican leadership’s budget compromise
becomes law.                                                           -9                                                                      -9

As a result, core G10 central banks continue to pursue super-        -11                                                                       -11

accommodative policies in response to below-potential
                                                                     -13                                                                       -13
economic growth and wide margins of excess capacity. We                      USD   N ZD AU D N OK G B P EU R C AD C H F            SEK   JPY
see the Fed continuing its large-scale asset purchases               Note: National numbers are weighted by PPP GDPs.
                                                                     Sources: Haver and Morgan Stanley Research.
through mid-2011, the ECB continuing full allotment tender
auctions to support peripheral EMU bank funding and the BoJ          Exhibit 8
purchasing modest amounts of private assets.                         EM Capacity Pressures: Industrial Production (%
                                                                     Deviation from Post-1990 Trend), 1991-3Q10
In contrast, robust economic growth has eroded excess
productive capacity in the in the emerging world tilting inflation    10                                                                       10
risks to the upside and putting monetary policy on a tightening
track (see Exhibit 8 and page 31 – EM outlook).                         5                                                                      5

Against this backdrop, many investors worry about the
                                                                        0                                                                      0
prospect of policy error in the emerging world; that EM
policymakers might tighten policy too forcefully – holding back
                                                                       -5                                                                      -5
the world recovery and interrupting the commodities uptrend.
Alternatively, policymakers facing upward currency pressure
                                                                     -10                                                                       -10
form robust capital inflows may continue to intervene heavily
in the FX market, allowing excessive liquidity expansion that        -15                                                                       -15
fuels a significant pickup in inflation.                                         Developed Economies
                                                                                 Emerging Markets
                                                                     -20                                                                       -20
Benign Baseline Constructive for Dollar-Bloc FX                             91   93     95     97      99     01        03   05   07   09
                                                                     Sources: Haver and Morgan Stanley Research.
Our baseline forecast calls for very cautious 2011 tightening
by EM central banks. Policymakers are wary of attracting
short-term capital inflows that would put upward pressure on         Our forecast for very cautious policy tightening points to
their currencies at a time when they remain uncertain about          modest slowdown in EM economic activity to a 6.4% year-
the vigor and sustainability of exports to the G10.                  over-year pace from an estimated 7.4% in 2010. Our forecast
                                                                     for the G10 similarly is very benign with slower Japanese
In AXJ, we expect policy rates to rise by 0.8 percentage
                                                                     growth largely accounting for GDP growth slipping to 2.2%
points to 5.8%, GDP-weighted, in 2011, with India, Indonesia
                                                                     from 2.6% in 2010. Moreover, most of this decline likely will
and Korea leading the way with 100-basis-point policy rate
                                                                     disappear if the budget compromise between the President
hikes over the year. And in Latin America, we see do not see
                                                                     Obama and the Republican leadership passes Congress.
Banxico tightening policy at all, while the COPOM in Brazil is
                                                                     The global inflation forecast also is benign with global
only 1.75% away from our end-2011 target for the SELIC rate
                                                                     consumer prices accelerating by 0.1 percentage point to
after tightening by 200 basis points in 2010.

                                                                   MORGAN STANLEY RESEARCH

                                                                   December 9, 2010
                                                                   FX Pulse

Unsurprisingly, Morgan Stanley’s commodity analysts believe        Our view that setbacks would be buying opportunities in part
that our global economic outlook is constructive for               reflects our assessment that the level of commodity prices,
commodity prices. They currently forecast that oil will break      rather than proxy trades that drive valuations to unsustainable
above $100/b sometime in 2011 and average $100 for the             levels account for the market valuations of the dollar bloc
year, that base metals prices will increase between 5% and         currencies. But more importantly, the historical experience
9%, and that softs would slip somewhat from elevated levels        shown in Exhibit 9 suggests that the likelihood of a serious
associated with the past year’s losses of wheat crops.             Chinese policy error of the sort envisaged is low. Over the
                                                                   1990-2010 time frame, Chinese policy tightening (as
This set of forecasts: solid growth, low inflation, rising
                                                                   measured by the required reserve ratio) has been associated
commodity prices and gains in equities amid accommodative
                                                                   with rising commodity prices and vice versa. In short, China
monetary conditions is constructive for the commodity
                                                                   tightened policy when the global economy and commodity
currencies generally and the dollar bloc in particular.
                                                                   prices were advancing rapidly, boosting domestic inflation,
                                                                   and eased when global activity was decelerating. Tellingly,
Will China’s Policy Tightening Derail Commodity FX
                                                                   over this period, China’s policymakers did not make policy
or Present Buying Opportunities?
                                                                   mistakes that were serious enough the derail commodity
Our broad macroeconomic outlook suggests that the G10              prices and commodity FX. Given this track record such
commodity currencies could post moderate gains against the         mistakes would be a tail risk, but not a central case scenario.
USD by end-2011. Yet, the early weeks of 2011 could bring a        If these patterns hold again, Chinese policy tightening should
temporary commodity FX setback driven by a deterioration in        offer buying opportunities
risk sentiment. Beyond the episodic flare-ups in risk aversion
driven by the ongoing EMU sovereign debt crisis, the timing,
                                                                   Exhibit 9
pace and impact of China’s policy tightening most likely will be
                                                                   China Bank Required Reserve Ratio and CRB
the key source of EM policy uncertainty in 2011. On balance,
                                                                   Commodity Price Index, 1990-Oct 10
such episodes should not be seen as harbingers of sustained
weakness but as buying opportunities, in G10 commodity FX,         20                                                                     500
particularly AUD, which gets punished most severely by                         Required Reserve Ratio (Left Axis)
China-related policy uncertainty.                                  17
                                                                               CRB (Right Axis)                                           450

From a G10 FX perspective, in our view the most important
concern is that the Chinese authorities make a serious policy      14
mistake, tightening too aggressively, significantly slowing
domestic economic activity and imports, thereby undercutting
economic growth throughout the region and undercutting
commodity prices. Indeed, the FX price action following
China’s surprise reserve ratio hikes in January and February         8
this year, which sent AUD falling 5% in a couple of weeks,
suggest that the G10 commodity currencies along with BRL             5                                                                    200
and ZAR, would be vulnerable in a bout of uncertainty about              90    92   94     96    98     00     02     04   06   08   10
Chinese monetary policy. In the parlance of the day “the           Sources: CRB, Haver and Morgan Stanley Research.
China proxy trades will get killed.”

                                                                       MORGAN STANLEY RESEARCH

                                                                       December 9, 2010
                                                                       FX Pulse

G10: 2011 to Be a Year of Less (Correlation and Volatility)
Ron Leven                                                              Exhibit 1
                                                                       Evolution of Cross-Market Correlation
    The cross-market correlation surge tracked swap spreads, so
     our outlook for widening points to more diverse market

    FX volatility is more sensitive to Fed policy, and the past two
     easing cycles suggest vol will be suppressed until hiking
     resumes – that is, not in 2011.

    Our favorite trades for 2011 are selling correlation between
                                                                       Source: Bloomberg, Morgan Stanley Research
     EURJPY and EURCAD and selling 2Y GBPUSD volatility.
                                                                       Exhibit 2
                                                                       Evolution of FX Correlation With Other Markets
Correlation Finally Feeling the Pull of Gravity
In “G10: The Beta the Better”, which appeared in last year’s
final FX Pulse (December 17), we projected that the unusually
high beta – i.e., cross-market correlation with equities – would
fade in 2010. In fact, cross-market correlation remained
unusually high through much of this year but our outlook may
finally be panning out in the final quarter of the year. Exhibit 1
shows cross-correlations between key market benchmarks
over the past three months and the past year. The higher
                                                                       Source: Bloomberg, Morgan Stanley Research
(absolute value) correlation is shown in bold, and with only
one exception, CRB versus SPX, the vols are lower over the
past three months. And bond market correlations are sharply
                                                                       Or Is it the Pull of Bond Rates?
lower across the board.                                                As shown in Exhibit 3, both the correlation of JGBs with the
                                                                       US bond market and the EUR correlation with stock prices
Exhibit 2 goes through the same exercise of looking at the
                                                                       roughly tracked the narrowing of the spread between 10Y
trend of indicative currencies’ performance against the USD
                                                                       swap rates and US Treasuries. In our view, the link between
as correlated with key asset markets. Note in this exercise we
                                                                       the two is because the spread is a sensitive barometer of the
replace the CRB with crude oil (CL1) since this (and copper)
                                                                       willingness of investors to engage in risk-taking; it is one of
are the dominant commodities for driving exchange rates.
                                                                       the inputs to Morgan Stanley’s Global Risk Demand Index
Again, higher correlations are bolded and the overall pattern
                                                                       (GRDI). As demand for risky assets became extreme, risky
is very similar to the trends in cross-market correlation. For
                                                                       assets became more correlated.
the most part, 3M correlations are below 1Y correlations; the
exceptions are European currency performance, which is still           The narrowing of swap spreads was roughly aligned with the
highly correlated with equities, and CAD performance, which            decline of US bond rates to record lows, so the delay in
remains tightly linked to oil. And the decline in correlation has      correlation breaking down seems to be tied to the extended
been particularly large versus bond markets.                           downtrend in bond rates. Exhibit 3 also suggests that the
                                                                       break in JPY correlation is leading swap spreads while EUR
                                                                       correlation is lagging. But if, as Morgan Stanley projects,
                                                                       rates trend higher and spreads widen next year, the
                                                                       breakdown in correlation should persist.

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    FX Pulse

Exhibit 3                                                           Exhibit 5
Currency Correlations and Swap Spreads                              Fed Rate Cycles and Volatility

                                                                       90                                                             9
                                                                       80                                                             8
                                                                       70                                                             7
                                                                       60                                                             6
                                                                       50                                                             5
                                                                       40                                                             4
                                                                       30                                                             3
                                                                       20                                                             2
                                                                       10                                                             1
                                                                        0                                                             0
Source: Bloomberg, Morgan Stanley Research
                                                                        1990              1995             2000         2005   2010

VIX Rules in Vols – Well, Most of the Time                                                        VIX             Fed Funds

While the magnitudes are different, FX vol trends largely
                                                                    Source: Bloomberg, Morgan Stanley Research
parallel movement in the VIX. EUR vols are currently being
elevated by the European sovereign crisis. But it is rare for vol   As rates declined, the market calmed down, and the trend is
trends to diverge for more than a few months, so we think it is     for lower volatility until the Fed starts tightening. As Morgan
valid to use the VIX as a proxy for the general trends in           Stanley forecasts the Fed to be on hold until the first half of
volatility across the foreign exchange markets.                     2012, this would point to vols drifting lower over the next year
                                                                    to the lows seen in 1995 and 2006. For most currencies,
The interplay between the Fed rate cycles and market                this would imply that vols will be heading back towards
volatility has been similar in this and the prior two episodes.     single-digit territory in 2012.
The onset of a Fed easing cycle is associated with a sharp
spike in market volatility – a motivation for the Fed initiating    Exhibit 6

easing was a sell-off in stocks.                                    EURJPY and EURCAD Correlation
Exhibit 4
The VIX and Currency 3M Implied Volatility

                                                                    Source: Morgan Stanley Research

Source: Morgan Stanley Research

                                                               MORGAN STANLEY RESEARCH

                                                               December 9, 2010
                                                               FX Pulse

Favorite Correlation Trade for 2011                            Favorite Volatility Trade for 2011
Since we expect correlations to break down in 2011, we         In line with the historical trend, FX vol has generally been
recommend selling relatively high implied correlation pairs.   trending lower over the course of 2010. Exhibit 7 shows that
Based on the metrics to isolate correlation extremes           GBPUSD vols are sharply lower than during the financial
presented in the October 21 FX Pulse (see “A New Twist on      crisis and have had a modest downtrend over the course of
Correlation”), the best value pair to sell is EURJPY versus    2010. In the absence of a Fed rate hike, we would expect vols
EURCAD. We recommended selling a 1Y correlation swap on        to continue drifting lower in 2011 and head back towards the
November 9 at a bid of 28%. Although realized correlation      8-10% range that prevailed before Lehman failed. As also
has remained stable, implied is now offered at 35%, making     shown, while 2Y implied vol came off the 2008 highs last year,
for a better entry point. As shown in Exhibit 6, short-dated   it has stalled at year-ago levels and is now historically out of
realized correlation remains around 40%, but it has recently   line with realized 3M vol. As shown in Exhibit 8, 2Y implied vol
come off and we would look for a move back towards the         is also historically misaligned with 3M implied vol, which has
negative correlation that has prevailed for the past several   been quick to react to the declining trend in realized vol.
years. While 1Y correlation could theoretically realize at
                                                               A 2Y vol swap in GBPUSD is now bid at 12.7%, slightly above
100%, it has not exceeded 40% over the past five years.
                                                               realized 2Y vol, which is around 12.0%, and not far below the
Exhibit 7                                                      15% realized peak that occurred around mid-year. Hence, we
GBPUSD Implied Volatility                                      see attractive risk/reward in selling a 2Y vol swap to position
                                                               for a secular downtrend in FX vol during 2011.

                                                               Exhibit 8
                                                               GBPUSD Implied Volatility Curve

Source: Morgan Stanley Research

                                                               Source: Morgan Stanley Research

                                                                      MORGAN STANLEY RESEARCH

                                                                      December 9, 2010
                                                                      FX Pulse

EMFX: A Look into 2011
  Morgan Stanley & Co.                Rashique Rahman                 CEEMEA is likely to underperform, with the CEE portion of
  International plc                   +44 20 7677-7295
                                                                      the region posting the worst performance, particularly in 1Q,
                                      James Lord
                                      +44 20 7677-3254                owing in large part to Peripheral Europe (PE) concerns and
  Morgan Stanley & Co.                Vitali Meschoulam               our expectations of a decline in EUR/USD.
  Incorporated                        +1 212 761-1889
                                                                      Exhibit 2
                                                                      EM Currency Basket versus EUR and USD (Equally
     We maintain a positive view on EM currencies in 2011, given     Weighted, % Change)
      a strong global and EM growth outlook, sustained capital             0
      inflows and rising EM inflation.                                  -1
     AXJ currencies have the strongest profile, with MYR and           -2
      SGD the likely outperformers.                                     -3
     We are less bullish on CEEMEA, given the spillover from the       -4
      weak EUR, but we remain constructive. RUB is our highest          -5
      conviction pick.                                                  -6
     LatAm currencies should perform well as commodity prices          -7
        rise, but we are wary of intervention from the authorities.     -8
                                                                                  EM Appreciation
        MXN should outperform.
                                                                                   Spot         Q111        Q211         Q311       Q411
We have a positive view on EM currencies in 2011.                               AXJ Basket     CEEMEA Basket       LatAm Basket   EMBasket
                                                                      Source: Morgan Stanley Research
We see the EM currency basket (equally weighted EM
currencies funded by an equally weighted 50-50 EUR USD                So, what are the main features for 2011 that drive our EM
basket) appreciating by 6% in 2011, with most of the                  currency views?
performance occurring in 1H11.
                                                                      Three main catalysts inform our view:
Exhibit 1
                                                                      1.       A renewed global – specifically EM – growth impulse;
EM Currency Basket versus EUR and USD
                                                                      2.       Sustained capital inflows to EM economies;
                                                                      3.       Accelerating EM inflation.

   95                                                                 To a large extent, market drivers are interrelated and some
                                                                      are carry-overs from what dominated in 2010. Relatively tepid
                                                                      economic growth prospects and easy monetary policies in
                                                                      developed markets (DM) – coupled with what we argue is a
                                                                      renewed growth impulse within EM – suggest that we will
   85                                                                 continue to see sustained inflows into emerging economies
                                                                      and markets.

   80                                                                 On an outright basis, EM growth in 2011 is likely to moderate.
    Jan-08            Jan-09       Jan-10          Jan-11             Morgan Stanley Economics sees EM real GDP growth at
Source: Morgan Stanley Research                                       6.4% for 2011, compared to 7.4% for 2010, and broadly
                                                                      recognizing the fact that growth likely peaked in 2Q10 (see
We see most of the EM currency gains coming against the
                                                                      Global Forecast Snapshots: 2011 Outlook: Rebalancing,
EUR – 10% for the EM currency basket – given the
                                                                      Reflation and Reconciliation, December 8, 2010).
expectation that EUR will remain weak throughout the
forecast horizon, in line with our EUR/USD view.

We expect AXJ currencies to outperform.

                                                                                     MORGAN STANLEY RESEARCH

                                                                                     December 9, 2010
                                                                                     FX Pulse

But for the markets, we argue that it’s momentum (rate of                            Furthermore, regardless of the merits, DM policy-makers are
change) that counts. Indeed, the rate of change in key macro                         expected to continue calling for more flexibility with EM
variables for EM tends to be a leading indicator of                                  currency arrangements (i.e., appreciation), particularly China
macroeconomic activity, and also tends to lead the leading                           – in an effort to shift output towards domestic consumption
indicators of economic activity – such as the OECD leading                           and further moderate external surpluses.
indicators. Moreover, it has been a reliable leading indicator of                    This does not in itself presuppose a more aggressive
the direction in market momentum.                                                    appreciation of AXJ currencies, particularly of the CNY. But it
Our Macro-Dynamic Trend Indicator (MDTI) – which                                     is likely to be associated with it, as in the case of CNY (and
measures the momentum in macro-fundamentals for EM –                                 other EM currencies) appreciation may serve to tighten
has stabilised and is turning positive, for the first time since                     monetary conditions in light of rising inflation.
2Q10. This is important, in our view. It suggests a supportive                       And though CNY appreciation must be seen increasingly in
fundamental backdrop for EM risk.                                                    light of prospective monetary policy tightening in China –
Exhibit 3                                                                            which may give way to considerations of moderating the pace
EM Macro-Dynamic Trend Indicator (MDTI) versus                                       of growth, on balance more assertive CNY appreciation would
OECD EM Leading Economic Indicator versus Real                                       likely act as an accelerant for EM currency performance.
GDP Growth (%)                                                                       In part, the appreciation of the CNY on a trade-weighted basis
                                                                                     would likely provide room for other EM central banks to be
  15                                                                            90
                                                                                     more comfortable with domestic currency appreciation, on
                                                                                     relative competitiveness grounds vis-à-vis China.
  10                                                                            70
                                                                                     Such a scenario should also tend to favor the AXJ and
   5                                                                                 commodity export-oriented crosses that benefit from Chinese
                                                                                     import demand.
                                                                                     Exhibit 4
                                                                                     Model and Actual EM CPI
  -5                                                                            20

                                                                                10    9.0

 -10                                                                            0
   Jul-05        Jul-06           Jul-07    Jul-08       Jul-09        Jul-10

       EM OECD Leading Indicator           EM real GDP            EM MDTI (RHS)       7.0
Source: Morgan Stanley Research
Though it is likely too soon to say if the global economic
recovery has firmly regained upward momentum, the data out                            5.0
of China specifically – and the US – have been similarly
encouraging of late – and November manufacturing PMI
surveys for EM in aggregate suggest a reversal in trend                               3.0
towards more expansionary, from more contractionary since                               Jan-05     Jan-06     Jan-07     Jan-08 Jan-09   Jan-10   Jan-11
2Q10.                                                                                                                  Act     Pred

China is likely to continue to be a focal point, given the need                      Source: Morgan Stanley Research
for monetary tightening there. The rise in inflation and extent
                                                                                     And what of the prospect of EM inflation more broadly?
of credit expansion are cause for concern for the PBoC, which
has responded by tightening monetary policy, via hiking                              Based on our empirical work, we anticipate acceleration in
reserve ratio requirements and interest rates.                                       aggregate EM inflation into 2Q11 (see EM Profile: The Near-
                                                                                     Term Path for EM Rates, November 5, 2010). This likely leads
Our economist for China, Qing Wang, sees real GDP coming
                                                                                     to a more aggressive pricing-in of monetary policy tightening
in at 9% and inflation peaking at 5.5% in mid-2011 before
                                                                                     and, similarly, more openness of EM central banks to tolerate
decelerating to 4% by year-end, with three 25bp rate hikes
through mid-2011 (see China Economics: 2011: A Year of                               a measure of domestic currency appreciation as a means of
Reflation, November 21, 2010).                                                       tightening monetary conditions outside of raising policy rates.

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    FX Pulse

Rising inflation in EM economies is due in large measure to         CEEMEA
the rise in commodity prices – food and energy in particular –
which itself will likely create winners and losers in 2011,           We are less bullish on CEEMEA compared to the rest of EM,
favoring Latin America and Russia over AXJ and CEE.                    which is primarily the result of the expected weakness of the
                                                                       EUR, which will likely impact on the CEE.
Further supporting the case for EM currencies in 2011 is the
prospect of ongoing strong and steady cyclical and structural         Nevertheless, growth outperformance, diverging monetary
                                                                       policy and continued high capital inflows should help CEEMEA
capital inflows. Cyclical drivers relate to push and pull factors
                                                                       currencies appreciate next year.
– relative interest rate and growth differentials; structural
drivers relate to relative portfolio allocation shifts out of DM      RUB is our strongest conviction pick and we expect the
and in to EM.                                                             currency to reverse its recent underperformance over the
                                                                          coming quarters.
We forecast upwards of US$1 trillion in net private sector
inflows into EM economies in 2011, similar to the outcome for
2010. This includes both portfolio flows and FDI.                   We remain bullish on CEEMEA FX for 2011, but there will be
Our favorable view for EM currencies and risk markets for           considerable divergence across the region. As with broader
2011 is predicated on: (1) well-anchored core market yields;        EM, we see most of the gains coming in 1H11. Similarly,
and (2) sovereign risk-related developments that, even if           continued growth outperformance versus the developed
inducing market volatility, are broadly contained so as not to      world, anticipated policy tightening and strong capital inflows
pose systemic risks. We see these two aspects as the main           will likely support gains for regional FX.
risks. In both cases, given that EM economies remain reliant        The main risks are external, with the problems in the euro-
on external funding, well-functioning funding markets in DM         zone periphery in particular likely to weigh on markets for
are a prerequisite for macro and market stability for EM.           some time to come.
In all, we believe that performance will be strong for EM           Accordingly, there should be periods of volatility, with EM
currencies in 1H11, driven by these factors – and our               currencies potentially depreciating sharply during these periods
forecasts reflect this.                                             of concern about Peripheral Europe. CEEMEA currencies are
                                                                    likely to suffer the most during these periods, particularly if the
We are particularly constructive on AXJ currencies, which           catalysts for a sell-off are related to the euro area, but also
have the strongest outlook compared to other EM. The solid          because the CEEMEA region generally has large external
outlook is based on a relatively supportive global economic         financing requirements. Nevertheless, periods of risk-aversion
backdrop, positive regional macro-dynamics and a reasonably         ought to be temporary setbacks in what we expect be a good
healthy balance of payments (BoP).                                  year for CEEMEA FX. We expect the largest gains to be had
Moreover, valuations should not be an impediment to AXJ’s           versus the EUR, as illustrated in Exhibit 5.
uptrend, as most (but not all) AXJ currencies are reasonably        Exhibit 5
valued, in our view.                                                CEEMEA FX Outlook (Cumulative Changes, %)
That said, we are mindful that AXJ currencies will be                 6
susceptible to large counter-trend moves next year, induced
by global ‘risk-off’ events, lagged policy responses to regional
inflation and the implementation of further capital controls.         2
Within the AXJ bloc, we think that the MYR and the SGD will           0
likely outperform, while the INR, IDR and THB may lag.
For more on AXJ currencies, please see page 40.


                                                                           Spot    Q111 Q211          Q311 Q411 Q112 Q212 Q312 Q412
                                                                                  USD/CEEMEA            EUR/CEEMEA  CEEMEA Basket

                                                                    Source: Morgan Stanley Research

                                                                                MORGAN STANLEY RESEARCH

                                                                                December 9, 2010
                                                                                FX Pulse

Most of the weakness on the USD/CEEMEA leg of the                               However, these economies are moving into next year from a
forecasts is explained by the CEE region, which trades very                     high base, so some slowdown from 2010’s robust
closely with the EUR. With the EUR expected to be weak                          performance is to be expected. Morgan Stanley is expecting
throughout most of 2011, the profile for the USD/CEE crosses                    Russia to post the fastest pace of growth in 2010, which is
shows significant weakness for CEE (see Exhibit 6). But more                    one of the reasons why we are bullish the RUB. Indeed, being
broadly, the strong USD environment that we expect should                       long RUB versus the basket is one of our higher conviction
limit the performance of the rest of the CEEMEA region (TRY,                    trades, and is included in our top ten trades portfolio for 2011.
RUB, ZAR and ILS) as well versus the USD.
                                                                                Capital Flows to Pick Up
Exhibit 6
CEE FX Outlook (Cumulative Changes, %)                                          One of the main reasons why we anticipate a strong
                                                                                performance for EM assets next year is the outlook for capital
                                                                                inflows. As we highlighted earlier, we anticipate that capital
                                                                                flows will pick up considerably in 2011, and CEEMEA should
                                                                                be a beneficiary.
   2                                                                            Capital flows have not yet reached the same levels seen
   0                                                                            during the boom times of 2007 and early 2008 (see Exhibit 8).
  -2                                                                            But this is unsurprising, given that current account deficits
  -4                                                                            have fallen dramatically since then, while the rapid
  -6                                                                            accumulation of external debt by households in the CEE
  -8                                                                            region is unlikely to be seen again.
        Spot    Q111    Q211      Q311    Q411   Q112    Q212    Q312    Q412   Exhibit 8
                      USD/CEE            EUR/CEE        CEE Basket              Capital Flows to CEEMEA (USDbn)
Source: Morgan Stanley Research
Improved Growth Performance                                                         75
The performance of CEEMEA FX should continue to be
bolstered by growth outperformance versus the developed                              0
world. Our economists expect 2011 to be a stronger year than                        -25
2010 in terms of real GDP growth. Of the major currencies in                        -50

the region, the only economies where we expect growth to be                         -75

lower next year are Turkey and Israel (see Exhibit 7).                            -100
Exhibit 7                                                                         -150
CEEMEA Growth Forecasts (2010 and 2011)                                                   Q103    Q104     Q105        Q106      Q107       Q108       Q109   Q110

                                                                                                 FDI       Portfolio          Derivatives          Other      Total
                                                                                Source: Haver, Morgan Stanley Research

                                                                                And with foreign investors likely to allocate an increasing
                                                                                proportion of their portfolios to EM markets in the coming
                                                                                year, portfolio investment is likely to pick up.

                                                                                Monetary Tightening to Benefit CEEMEA FX
                                                                                Although our economists do not anticipate significant
                                                                                monetary tightening for the year ahead, strong growth and
                                                                                generally higher inflation should result in rates markets pricing
        CZK     HUF      ILS      PLN    RON     RUB    ZAR     TRY     Av.     in a greater degree of monetary policy tightening.
                          2010                           2011
Source: Morgan Stanley Research

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    FX Pulse

This is a good combination for FX, which should help to             Exhibit 9
propel currencies to stronger levels on a trade-                    Private Sector External Debt Redemptions (US$mn)
weighted/basket basis. Meanwhile, rates in the developed
world seem likely to stay low, with the Fed implementing             16,000
further QE over much of 2011.                                        14,000

Intervention Risks Localized
We see the risk of capital controls and intervention in
CEEMEA FX markets as less significant than in other regions,
and specific to three markets – Turkey, South Africa and               6,000
Israel.                                                                4,000

The central banks of these countries have been actively trying         2,000
to limit the extent of appreciation of their currencies recently,            0
and we expect this to continue into 2011, given the likelihood                   Jul-10   Sep-10 Nov-10          Jan-11   Mar-11 May-11
of further strong capital inflows and the recent rapid              Source: CBR, Morgan Stanley Research
appreciation of their currencies. We expect the rest of the
region to be less resistant to currency appreciation.               The flows relating to external debt repayments have been
                                                                    among the drivers of RUB weakness in recent months. With
Russia, in particular, has been defending its currency recently     this pressure easing, we feel that there is scope for RUB to
and would likely welcome currency appreciation as a way to          resume an appreciation trend.
help tackle rising inflation.
                                                                    Third, capital inflows should pick up. The government’s
RUB – Highest Conviction Pick                                       planned US$3 billion RUB-denominated Eurobond should
                                                                    attract significant foreign interest. While the launch was
Although our forecasts suggest faster gains for TRY and ILS         originally scheduled for earlier this year, market turbulence
throughout much of 2011, we have greater conviction in our          appears to have pushed back the date into 1Q11. The launch
call for RUB strength. Indeed, the risks surrounding the            of this benchmark bond should encourage further
outlook for TRY and ILS are greater, in our view. We                development of the RUB Eurobond market, and RUB
anticipate steady gains for the RUB for several reasons.            Eurobond issuance from the corporate sector is likely as well.
First, we anticipate monetary tightening from the Central Bank      Exhibit 10
of Russia (CBR). The CBR has been dovish in recent                  Gap Between EM and RUB Basket to Close
quarters, pledging to see through the increase in prices to
                                                                       120                                                                42
focus on sluggish growth.
But, with growth picking up and likely to gather steam, the            115                                                                40
CBR is verbally responding, suggesting that actual rate hikes
are in the pipeline. We expect this process to support RUB in          110
the coming months. Second, the redemption profile for
external debt is much more benign in the first couple of                                                                                  37
quarters of 2011 than it has been recently (see Exhibit 9).                                                                               36

                                                                       100                                                                35


                                                                         95                                                               33
                                                                          Jan-09     May-09   Sep-09     Jan-10       May-10    Sep-10
                                                                                         EM basket (LHS)              RUB Basket (RHS)

                                                                    Source: Bloomberg, Morgan Stanley Research

                                                                    What’s more, Russia’s US$30 billion privatization plan is
                                                                    kicking into gear and should generate some foreign interest

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    FX Pulse

In all, our Russia economist, Alina Slyusarchuk, expects            Latin America
Russia’s capital account to see net inflows of around US$10
billion (around 0.6% of GDP). Combined with an expected               Absent a coordinated resolution to the global imbalances, 2011
current account surplus of 2% of GDP, this suggests                    is likely to be characterized by ongoing currency tension in the
                                                                       region, as most countries look to stave off meaningful currency
substantial upside pressure on the RUB.
Fifth, the CBR is gradually withdrawing from the FX market
                                                                      Commodity currencies are likely to do well initially in the new
and should throughout 2011 widen the trading band and
                                                                       year, as QE2 extends the current bout of global liquidity.
reduce the level of interventions around the edges of the
corridor. This reduced intervention from the CBR should mean          Though driven by different forces, MXN should again
that the currency reflects balance of payments pressures               outperform, as growth prospects in the US improve.
more meaningfully.                                                    China may well become the tipping point, as more pronounced
                                                                       CNY appreciation would likely provide greater flexibility for the
Finally, the underperformance of the RUB versus EM has left
                                                                       region’s policy-makers in terms of domestic currency strength.
the currency at an attractive technical entry point for medium-
term trades.

CEEMEA Risks Are Mostly External                                    Broad Trends Remain in Place in Early 2011
The most significant risk to our bullish CEEMEA FX view is          As we head into the end of 2010 and the beginning of 2011,
external. A serious deterioration of the situation in the euro-     the panorama for Latin American currencies remains eerily
zone could spark significant capital outflows from the              familiar. Broadly speaking, with advantageous growth
CEEMEA region. In general, the external positions of the            dynamics in EM (relative to DM) and large (growing) rate
various countries in the region are more favorable than they        differentials between the two, EMFX is poised to continue to
were back in 2007/08. But for some countries, the stock of          outperform on a basket basis.
central bank reserves is still not high enough to assuage
                                                                    And while Latin American currency performance may lag Asia
concerns about the ability of a country to finance itself during
                                                                    to some extent, the region is likely to outperform CEEMEA as
an external funding crisis (see Exhibit 11).
                                                                    the European malaise likely impinges upon perceptions of risk
Exhibit 11                                                          in Europe.
Reserves/(ST Ext Debt + Current Account Deficit)
                                                                    Continuing inflows into Latin America, however, will carry
                                                             21.6   risks. We expect that material bouts of currency appreciation
                                                                    will likely be met with increasingly assertive currency
                                                                    measures and intervention, as policy-makers scramble to
                                                                    ‘protect’ what they see as dwindling competitiveness amid a
                                                                    lackluster global economic environment. This is likely to usher
                                                                    in a period of greater volatility for Latin American currencies
                                                                    generally speaking. We discuss the specifics of intervention in
                                                                    the country outlooks below.
                                                                    The Regional Roadmap
    0                                                               Though the region’s currencies are likely to outperform on a
         TRY      PLN      ZAR       HUF   CZK   RON   ILS   RUB    basket basis, the travails in the European periphery are likely
                                                                    to prompt a continuation of broader-based USD strength –
Source: Haver, Morgan Stanley Research
                                                                    making for less spectacular relative performance of most Latin
Should funding markets dry up, then we believe that all the         American currencies versus the USD in late 1Q11.
fundamental positives we mention above would play second
                                                                    But following a peak of relative weakness in 2Q11, we expect
fiddle to the inability of corporates and governments to
                                                                    Latin America to again retake strengthening momentum
refinance their debts, and currencies would likely depreciate
                                                                    against the USD into year-end or until there is a clearer
                                                                    indication of the timing of policy rate normalization in the US

                                                                                                      MORGAN STANLEY RESEARCH

                                                                                                      December 9, 2010
                                                                                                      FX Pulse

and elsewhere in DM. Latin America stands to gain from a                                              attempting to mitigate currency strength of late. Indeed, our
relatively sanguine growth outlook for EM as a whole and                                              China economist, Qing Wang, expects the Chinese authorities
from what is likely to continue being a relatively supportive                                         to adopt a more accommodative stance vis-à-vis currency
environment for global commodities.                                                                   appreciation, as one tool of many deployed to contain rising
In this context, we expect commodity currencies like COP and
PEN to carry over their solid performance into next year – with                                       Inflation in EM broadly speaking is also likely to come into
the clear caveat of course that both of these countries are                                           play at some point later in 2011, which could potentially affect
intervening and could at some point reinstall capital controls.                                       future decisions regarding capital controls, in our view. For
While CLP is likely to follow suit at the start of the year, the                                      Latin America, though this issue may become relevant at
currency’s momentum may decrease towards 4Q11, as the                                                 some point, inflation continues to seem relatively subdued in
hiking cycle comes to a close and the economy retakes a                                               most countries and thus is unlikely to be enough to drive
more sustainable growth path.                                                                         policy-makers towards less resistance to currency
                                                                                                      appreciation for now.
Though the trajectory for MXN and BRL is likely to be similar
in the beginning of the year – with both currencies trending                                           Finally, a more constructive and cooperative resolution of the
stronger – the latter is likely to be materially more volatile due                                    current global imbalances could also relieve some of the
to the ongoing threat of a new round of capital controls or                                           tension that has built up over inflows into Latin American
other measures designed to slow currency appreciation.                                                currencies over the course of this year. But given early
                                                                                                      indications thus far in different global fora, a coordinated
Indeed, Mexico continues to stand out as the country least
                                                                                                      solution continues to be elusive at best.
likely to intervene among the large economies in the region.
This fact won’t be lost on investors, in our view, partially                                          Exhibit 13
informing our positive outlook for MXN into next year.                                                Change in REER versus CNY Since 2005
Exhibit 12
EMFX Intervention Scorecard
   South Africa
Czech Republic                                                                                            30
         Brazil                                                                                           10
      Thailand                                                                                           -10
        Taiwan                                                                                           -20
  South Korea                                                                                            -30












                  -10       -8          -6   -4   -2   0   2   4         6          8         10
            Strong macro/market                                    Weak macro/market justification
            justification for strong-                                  for strong-side intervention   Source: Morgan Stanley Research
            side intervention

Source: Morgan Stanley Research
                                                                                                      Brazil’s Conundrum
The Wildcard                                                                                          Bolstered by a positive terms of trade shock, improving
                                                                                                      foreign direct investment flows and rising interest rate
Though we expect the current status quo characterized by
                                                                                                      differentials, BRL has all the elements in place for
resistance to further material currency strength to be the norm
                                                                                                      strengthening in 2011. However, despite these factors, our
into early 2011, there are important considerations that could
                                                                                                      Latin American economics team expects the authorities to
affect the state of affairs considerably.
                                                                                                      continue to intervene in currency markets – not only through
Namely, the potential for a meaningful revaluation of the CNY                                         direct intervention in the spot market, but also returning to use
by the Chinese authorities could take substantial pressure off                                        reverse currency swaps – and cannot rule out further hikes in
central banks in Latin America that have been tirelessly                                              the IOF tax on fixed income inflows.

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    FX Pulse

After all, there is widespread concern among the authorities        Colombia’s Moment
that the strength in BRL – in trade-weighted, inflation-adjusted
                                                                    We see strong currency appreciation in Colombia throughout
terms now at its strongest level in more than two decades – is
                                                                    2011. In addition to the broad themes mentioned above, our
partially responsible for the growing disconnect between
                                                                    Colombia economist, Daniel Volberg, sees the country
robust consumer demand (bolstered by the currency’s gains)
                                                                    benefitting from two additional factors.
and sluggish domestic production (hit by rising imports). Our
Latin American economist, Gray Newman, believes that this           First Colombia is likely to continue to enjoy the dividends from
‘Growth Mismatch’ is likely to continue to drive the policy         rising oil output and exports, and the associated very strong
response in 2011.                                                   foreign direct investment inflow. Second, it should benefit
                                                                    from continued reform momentum.
The tension between strong drivers of currency strength being
                                                                    These trends are likely to lead to another year of COP
partially offset by policy response is likely to ultimately
                                                                    outperformance, despite the fact that policy-makers are likely
produce some gains in BRL – at least until there is a clearer
                                                                    to fight currency strength. Indeed, Daniel sees a risk of capital
sign that the economic outlook (and policy rate path) of
                                                                    controls that may introduce further volatility to the FX market.
developed markets is beginning to normalize. But given these
                                                                    But because COP tends to be driven more predominantly by
tensions, we expect to see a good degree of volatility in BRL.
                                                                    the FDI dynamics outlined above, we do not feel that currency
                                                                    measures are likely to change the trend.
Find Strength in Numbers
                                                                    Exhibit 14
For the small, open economy commodity producers – Chile,            FDI in Colombia and Peru
Colombia and Peru – we see several factors keeping
currencies well supported during 2011. We see three broad
                                                                                 Colombia (Inward FDI, $ million)
 Strong global growth should maintain commodity prices at
  elevated levels. The prices of metals – both precious and           8,000      Peru (Inward FDI, $ million)

  industrial – are near or beyond the mid-2008 peak. And soft
  commodities are just shy of the peak reached pre-crisis,            6,000

  while oil remains at historically elevated levels. Therefore,
  the terms of trade – the ratio of export to import prices – for     4,000

  these countries have soared to near record highs, a move
  usually associated with currency strength.                          2,000

 These countries should enjoy a solid macro environment,                 0
  with economic expansion that remains on track while inflation            Dec- Sep-   Jun-   Mar-   Dec-   Sep-    Jun-   Mar-   Dec-   Sep-   Jun-   Mar-   Dec-   Sep-
                                                                            00   01     02     03     03     04      05     06     06     07     08     09     09     10
  pressures appear limited. While there is heterogeneity in the     Source: Morgan Stanley Latin America Economics
  pace of expansion among these economies, all are expected
  to grow above the 4.2% average that our economists                Steady Sailing for Peru
  forecast for the global economy in 2011. And the strong           We expect PEN’s slow yet steady appreciation trend to
  economic growth is underpinned by domestic demand                 remain in place in 2011. The rationale for PEN’s performance
  momentum. In addition to the strong growth dynamic,               is fairly similar to that of the other commodity exporters we
  inflation is expected to remain on target (see “Latin America     have discussed – macroeconomic stability, FDI and
  in 2011: Risks to Abundance, Risks of Abundance”, This            supportive commodity prices.
  Week in Latin America, December 6, 2010).
                                                                    Of note, however, the country will hold presidential elections
 Our Latin American economists expect strong foreign direct        in April, which could have a material impact on the currency if
  investment inflows to continue next year. The abundance of        the left-leaning Ollanta Humala is able to gain ground with the
  natural resource endowments should support continued              electorate, which seems unlikely at this point. In fact, Daniel
  investment in commodity extraction infrastructure. The strong     Volberg sees scope for a potential for an upside surprise post-
  FDI inflows should more than finance the current account          elections in April as a new administration could be well poised
  deficits in Chile and Colombia, and augment the current           to pursue a structural reform agenda, which would clearly be
  account surplus that our economists forecast for Peru.            PEN-positive.

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    FX Pulse

Positive Outlook for CLP – Watch for Intervention                   In the current environment, MXN also stands out as being
                                                                    relatively more insulated from the European imbroglio, due to
Chile and the CLP are also set to benefit from a supportive
                                                                    the currency’s weak correlation to the EUR; trade links are
global backdrop in the coming months. As our Chile
                                                                    relatively limited between Mexico and Europe.
economist, Luis Arcentales, points out, the central bank’s
ongoing hiking cycle, which aims to normalize interest rates –      As our Mexico economist, Luis Arcentales, points out, though
which had been very stimulative – over the course of 2011           Mexico has not enjoyed the type of positive terms of trade
should also help to promote positive momentum for CLP in            shock or domestic-led recovery seen in other major Latin
the early part of the year.                                         American economies, there are reasons for optimism about
                                                                    the economic outlook – and the exchange rate – in 2011.
But, as elsewhere in the region, outsized gains in the CLP are
                                                                    Mexico’s economy seems uniquely positioned to take
likely to be capped by the credible risk of central bank
                                                                    advantage of our US team’s call for a solid expansion in US
intervention and/or other currency measures. Over the last
                                                                    industrial output, where the link to Mexico is strongest. In turn,
few months, CLP has outperformed peers including PEN and
                                                                    the Mexican economy should see another year of good
COP precisely because the government has thus far shied
                                                                    growth, with external strength gradually leading to an
away from intervention. But this situation is likely to change as
                                                                    improvement in domestic-focused areas of the economy.
the currency continues to strengthen, in our view.
Moreover, given the openness of Chile’s economy, with our           Exhibit 15

US team expecting the Federal Reserve to start tightening in        Latin America Terms of Trade (sa, 2007 = 100)
early 2012, Chilean pension funds – which are major players
in the market – are likely to anticipate this reversal and add
pressure to CLP as early as end-2011.                                                     Mexico
                                                                      110                 Brazil
Mexico an Interesting Outlier                                                             Peru
                                                                      100                 Argentina
Mexico continues to stand out in Latin America as being
among the least likely to intervene in currency markets to            90
stave off currency strength in the current environment. Our
positive outlook for MXN is therefore predicated on our view          80
that the authorities have little reason to intervene, given
MXN’s substantial relative undervaluation.                            70

Indeed, from the perspective of the Mexican authorities, in a
world increasingly concerned about rising inflation, currency         60
                                                                            3Q04   1Q05    3Q05   1Q06   3Q06   1Q07   3Q07   1Q08   3Q08   1Q09   3Q09   1Q10   3Q10
strength can help tighten monetary conditions at the margin,
                                                                    Source: Morgan Stanley Latin America Economics
potentially allowing the central bank to remain on hold. We
believe that this is their bias, given the relatively weak
domestic demand dynamic observed to date.

                                                                                MORGAN STANLEY RESEARCH

                                                                                December 9, 2010
                                                                                FX Pulse

AXJ: Outlook for 2011
Stewart Newnham and Yee Wai Chong                                               will play an important role in reflating the global economy next
         We outline our constructive outlook on AXJ currencies for
          next year.                                                            The World to Grow Above Trend in 2011
                                                                                Our economics team forecasts that the world economy will
Introduction                                                                    grow at a healthy 4.2% pace next year. Admittedly, this would
                                                                                mean a moderate deceleration from the expected 4.9% rate
We have a constructive view on AXJ currencies for 2011. Our                     this year. However, it would still imply that the global economy
outlook is based on a relatively supportive global economic                     would continue to grow above trend in 2011.
backdrop, positive regional macro-dynamics and a reasonably
                                                                                Exhibit 2
healthy balance of payments (BoP). Moreover, valuations
should not be an impediment to AXJ’s uptrend, as most (but                      AXJ versus G7 Industrial Growth
not all) AXJ currencies are reasonably valued, in our view.                              (% Y/Y)
That said, we are mindful that AXJ currencies will be
                                                                                                                                    "We Believe AXJ's Currency Returns
susceptible to large counter-trend moves next year, induced                       10                                                 are Closely Linked to the Pace of
                                                                                                                                              Global Growth"
by global ‘risk-off’ events, lagged policy responses to regional                   5
inflation and the implementation of further capital controls.
Within the AXJ bloc, we think that the MYR and the SGD will
likely outperform, while the INR, IDR and THB may lag.                             -5

Exhibit 1                                                                         -10
                                                                                                                                  G7 IP Growth
USD/AXJ                                                                           -15
        (USD/AXJ)                                                                                                    ADXY

                                                                                        95          97       99         01           03          05         07          09       11
                                                     "Sideways Range
                                                      (May-Sep '09)"            Source: Bloomberg, Morgan Stanley Research
                                                                                Exhibit 3
                                                                                Average AXJ Performance Through the Business
                                                                                Cycle (1994 to Date)
                                     Range                                                                    " The Sweet Spot of the
   95                                                                                                        Cycle for AXJ Currencies"
                                                   End-2011 USD/AXJ    -2.75%                Y
                                                      Target: 91.9                                                   -0.9%Y

    Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
                                                                                                         B    C                                        B         C
Source: Bloomberg, Morgan Stanley Research

Support from the Global Business Cycle                                              A                                         D           A                                  D

We expect AXJ currencies to remain supported by the global
economic backdrop next year. For sure, the world economy                                           +0.2%Y         -4.2%Y
                                                                                                                                                      Segments of the
remains fragile – the US consumer is deleveraging and                                                                                                 Global Business
Euroland’s credit turmoil is creating substantial fiscal drag.
Nevertheless, we believe that monetary policy in the West will                  Source: Bloomberg, Morgan Stanley Research
remain extremely accommodative in 2011 in order to arrest
these disinflationary pressures. The net effects of this should
keep liquidity plentiful in the global economy, which we think

                                                                                                        MORGAN STANLEY RESEARCH

                                                                                                        December 9, 2010
                                                                                                        FX Pulse

The Link Between Global Growth and AXJ                                                                  exchange rates are all likely to weigh on regional current
Currencies                                                                                              account balances next year. Our economics team therefore
                                                                                                        projects that the AXJ external surplus will narrow to 2.9% in
If our team’s global scenario pans out, then we believe that it
                                                                                                        2011 from an anticipated 3.4% of GDP in 2010. Nevertheless,
bodes well for export-dependent Asia. The link between AXJ
                                                                                                        most of AXJ will still continue to display the positive macro-
currencies and the global business cycle is strong, in our view.
                                                                                                        dynamic of above-trend growth and external surplus next
Exhibit 2 demonstrates the tight correlation between the two.
                                                                                                        year, which is associated with positive currency returns, in our
Moreover, we think that AXJ will remain in the sweet spot of the
                                                                                                        view (see Exhibit 4).
global cycle next year. Exhibit 3 shows a stylized world
business cycle (split into four segments: A, B, C and D). Our
                                                                                                        BoP Support from Both Trade and Financial Flows
research indicates that AXJ currencies tend to outperform the
best in segment B (1%Y average return). That is, when the                                               Moreover, we believe that AXJ currencies will find support
world economic expansion has moved beyond its recovery                                                  from both sides of the BoP ledger. That is, we think that both
stage, but continues to grow above trend.                                                               the regional current and the financial account will be in
                                                                                                        surplus next year. We have already mentioned above that the
AXJ Growth to Outpace the World                                                                         regional current account is projected to remain in surplus next
                                                                                                        year. But we think the financial account could also be in
Within the global economic expansion, we expect the AXJ
                                                                                                        surplus for three reasons: 1) regional outperformance; 2)
region to outperfom. Our economics team forecasts that the
                                                                                                        divergence between US and AXJ monetary policies; and 3)
regional GDP growth for AXJ will remain above-trend next
                                                                                                        capital flight from the US dollar.
year (8.2%), owing to the favorable external demand
backdrop as well as the liquidity-supported domestic boom.                                              1. Relative Growth Outperformance
Some regional policy tightening is anticipated to curb the                                              The region’s strong, above-trend GDP growth is likely to
reflation/inflation of the economy, but we think that the                                               attract ongoing capital flows to the region’s capital markets, in
oncoming policy restraint is likely to be only relatively modest.                                       our view. Even though AXJ equity markets have already
As a result, our economics team forecasts that AXJ GDP will                                             outperformed strongly since the March low of 2009 (up 127%
slow only moderately from the expected 9.5% pace this year.                                             from the low), regional equity valuations are still at reasonable
                                                                                                        levels, with price-to-book valuation at only its long-term
Exhibit 4
                                                                                                        average (see Exhibit 5).
Macro-Dynamics for 2011: Growth versus Trade
                                                              (C/A-to-GDP, %)
                                                                                                        Exhibit 5

                    "We Forecast that Most of AXJ Remains
                                                                           SGD ('11F)                   MSCI Asia Pacific Ex-Japan Index: Price to Book
                      in the Positive Macro Dynamic Next
                                      Year"                                                                 (P/B)
                                                            15                                            3.5
                                                                       MYR ('11F)
                   "Neutral Macro                                              "Positive Macro
                     Dynamic"                                                     Dynamic"                3.0
                                                             TWD ('11F)                                                                       +2 sd
                                                                                                          2.5                                +1 sd
                                                              5     THB ('11F)
                                                                    PHP ('11F)
                                                                      CNY ('11F)                          2.0                            (97-08 Average)
                                                       HKD ('11F)
                                                                      KRW ('11F)
                                                                                       (GDP-Trend, %)
                                                                            IDR ('11F)
                                                                                                          1.5                                 -1 sd
  -10        -8         -6           -4           -2              0   INR ('11F)   2         4
                   "Negative Macro                                              "Neutral Macro
                                                                      US ('11F)   Dynamic"                                                   - 2 sd
                      Dynamic"                               -5                                           1.0                                          "AXJ Stock Markets are Fairly Valued, in Spite
                                                                                                                                                          of the Strong Rally Since March 2009"
Source: Bloomberg, Morgan Stanley Research forecasts
                                                                                                                97   98   99   00   01      02    03       04   05   06     07    08     09    10
Positive Macro-Dynamics
                                                                                                        Source: Bloomberg, Morgan Stanley Research

At the same time, we expect that AXJ’s external balances are
likely to remain in surplus next year. That said, some
moderation is to be expected: the combined effects of strong
domestic demand, higher commodity prices and stronger

                                                                                                        MORGAN STANLEY RESEARCH

                                                                                                        December 9, 2010
                                                                                                        FX Pulse

2. Monetary Policy Divergence                                                                           (REERs) are close to, or below, their long-term averages. The
We believe that interest rate differentials will also help direct                                       two exceptions are the IDR and the THB, which are
capital flows towards AXJ. As highlighted above, we expect                                              extensively overvalued, in our view (i.e., close to 2sd above
regional central banks to continue their tightening cycles next                                         their long-term average). As a result, we believe that they may
year. The prospects of rising demand-pull pressures on prices                                           have limited ‘headroom’ for further appreciation. In contrast,
(caused by strong economic activity) and cost-push pressures                                            the KRW and TWD are significantly undervalued, which
(from rising commodity prices) are likely to compel                                                     suggests that their fundamentals are further enhanced by a
policymakers in the region to raise interest rates next year. In                                        gravitational pull to fair value.
contrast, we expect the Fed to continue to ease policy (via
                                                                                                        Exhibit 7
further QE) over the course of most of 2011, given the
                                                                                                        REER: Deviation from 20-Year Average
softness of the US recovery. The divergence between US and
AXJ monetary policies is therefore likely to continue, in our                                              3.0
                                                                                                                 (REER Z)

                                                                                                                                            "The THB and IDR are Stretched More
view. The effect of which should help drive USD/AXJ lower                                                                                     Than +2sd Above their Long-term
(see Exhibit 6).                                                                                           2.0
                                                                                                                            + 2sd

Exhibit 6                                                                                                  1.0
USD/AXJ versus 3m US-AXJ Interest Differentials
    (USD/AXJ Index)                                            (Interest rate differential, %)
  112                                                                                            -1.4

  110                                                                                                     -1.0
                                                                                                 -1.6                                       "The KRW, TWD and SGD are Trading
  108                   3M US-AXJ IR Differential
                                                          "Diverging US and AXJ                                                                    on Cheap Valuations"
                                (RHS)                                                                     -2.0
                                                        Monetary Policies are Driving                                        - 2sd
  106                                                   USD/AXJ Lower, in Our View"              -1.8
  104                                                                                                     -3.0
  102                                                                                            -2.0               KRW      TWD     SGD   MYR       CNY     INR      PHP         IDR   THB
                                                                                                        Source: Bloomberg, Morgan Stanley Research
              USD/AXJ                                                                            -2.2
               (LHS)                                                                                    Macro Risks for 2011
   94                                                                                                   While AXJ currencies are supported by a broad base of
   92                                                                                            -2.6   fundamentals in 2011, there are risks: we are mindful that
    Jan-09   Apr-09   Jul-09   Oct-09   Jan-10      Apr-10   Jul-10   Oct-10      Jan-11                AXJ currencies could be susceptible to large counter-trend
Source: Bloomberg, Morgan Stanley Research
                                                                                                        moves over the course of next year (as they were in 2010).
3. Capital Flight from the US Dollar                                                                    We believe that there are three potential catalysts for an AXJ
Moreover, we expect the unorthodox nature of the Fed’s                                                  correction: a) global ‘risk-off’ events, b) lagged policy
monetary policy will itself continue to spur ongoing ‘capital                                           responses to regional inflation, and c) the implementation of
flight’ from the US. Indeed, capital flight may reaccelerate next                                       further capital controls.
year as the Fed has already hinted that since the US
                                                                                                        a. Global ‘Risk-Off’ Events
consumer deleveraging process may be prolonged, the Fed
                                                                                                        We think that AXJ remains susceptible to global ‘risk-off’
will need to undergo further rounds of QE. Apprehension of
                                                                                                        events. The regional economy has a high-beta sensitivity to
this further money printing may drive more investor capital out
                                                                                                        changes in global economic conditions and is also subject to
of the US, in our view. Some of this is likely to find a home in
                                                                                                        the vagaries of ‘hot money’ flows. We think that the ongoing
the AXJ region, where the implementation of monetary policy
                                                                                                        credit turmoil in Euroland is likely to impact AXJ on both of
is orthodox and consumer, corporate and government
                                                                                                        these fronts. As a result, AXJ currencies may have an
balance sheets are all relatively sound.
                                                                                                        unsteady start to 2011. Looking further out, the risk-off events
                                                                                                        could arise closer to home. For example, a hard landing in
                                                                                                        China (induced by policy tightening) and further tensions
We do not believe that valuations will be an impediment to the                                          between North and South Korea could be catalysts for a
AXJ’s broadly supportive fundamentals. Exhibit 7 shows that                                             sharp reduction in investor risk appetite in the AXJ region.
the majority of AXJ currencies are reasonably valued, if not
undervalued. That is, most AXJ real effective exchange rates

                                                                                                           MORGAN STANLEY RESEARCH

                                                                                                           December 9, 2010
                                                                                                           FX Pulse

b. Monetary Policy Risk for 2011                                                                           MYR: We believe that the MYR is in a strong position to
The AXJ rally could also be undermined if regional monetary                                                outperform in the oncoming inflationary and rising commodity
policy lags behind inflation. We believe that most AXJ central                                             price environment. First, the MYR will be bolstered by the
banks are already starting to fall behind the curve. Exhibit 8                                             BNM’s hawkish policy stance on inflation, in our view. Exhibit
shows that, with the exception of BNM, AXJ central banks                                                   8 indicates that BNM has been the most pro-active in the
have rates below their Taylor Rule1. Thus, we are concerned                                                region in fighting inflation – it was the first central bank to
that if there is no swift policy response, inflation may                                                   tighten in the cycle and is the only central bank in AXJ to have
accelerate next year, which may undermine the investment                                                   raised rates over and above its Taylor Rule. Moreover, we
conditions in the region (i.e., squeeze price margins, lower                                               see no reason why BNM would now ‘let up’ on its tightening, if
real bond yields, etc.).                                                                                   inflation pressures intensify further next year. Second, we
                                                                                                           believe that the MYR stands to benefit from a terms-of-trade
Exhibit 8
                                                                                                           shift caused by rising commodity prices that may well
AXJ: Policy Rate Deviation from Taylor Rule
                                                                                                           accompany the general price inflation. This is because
         (Deviation From Taylor Rule, %)
    6                                                                                                      Malaysia is the only net commodity exporter in the region with
                   "BNM is the Only Central Bank in AXJ to
                                                                                                           20.6% of total exports that are commodity-related. Third, we
    4             Have Policy Rates that are Above the Rate           "Policy Rates Above Taylor Rule"     believe that MYR has the strong core fundamentals of positive
                       Prescribed by the Taylor Rule"
                                                                                                           macro-dynamics and healthy BoP. End-2011 target: 2.80.

                                                                                                           SGD: The SGD shares several similar fundamentals to that of
              BNM           BoT            CBC      BoK         BSP          BI         PBoC         RBI
                                                                                                           the MYR, in our view. Like the MYR, the SGD is buttressed by
    -2                                                                                                     a hawkish monetary authority. (Recall that the MAS surprised
                                                                                                           the market by its hawkishness on both its policy
    -4                                                                                                     announcements this year.) Moreover, the SGD also has the
                                                          "Policy Rates Below Taylor Rule"                 strong core fundamental support of positive macro-dynamics,
                                                                                                           healthy BoP as well as cheap valuations (see Exhibit 7). End-
    -8                                                                                                     2011 target: 1.20.
Source: Bloomberg, Haver Analytics, Morgan Stanley Research
                                                                                                           Middle Ranks
c. Risk of Capital Controls
We believe that the implementation of further capital controls                                             We think the AXJ currencies that will occupy the middle ranks
could further mar the investment conditions in the region next                                             of next year’s returns generally have sound fundamentals, but
year. The risk is that policymakers may complement their                                                   are hampered by their own particular risks.
policy tightening in 2011 with capital controls in order to stem
                                                                                                           TWD: In our opinion, the TWD has impressive core
the hot money flows that could be attracted by higher interest
                                                                                                           fundamentals: very cheap valuations, positive macro- dynamics
rates. Regional policymakers are already concerned that the
                                                                                                           and a healthy BoP (with a twin current and financial account
current pace of financial inflows is a potentially destabilizing
                                                                                                           surplus). However, the TWD’s upside has been successfully
force from a macro-prudential perspective. Hence, we are
                                                                                                           contained by the CBC’s intervention this year, and we think that
concerned that further measures may be taken to restrict the
                                                                                                           the policy constraints will continue next year. That said, we
inflow (and outflow) or foreign capital. Thailand, Korea and, to
                                                                                                           recognize the upside risk that the CBC takes a step back in its
a lesser extent, Taiwan and Indonesia may be the first to
                                                                                                           FX intervention as it redirects its policy away from stabilizing the
tighten capital control measures, in our view.
                                                                                                           TWD and towards raising rates to fight inflation. Under this
                                                                                                           scenario, the TWD could match the performance of our top
Top Picks for 2011
                                                                                                           picks. End-2011 target: 28.6.
Within AXJ, we favor the MYR and SGD. Both are currencies
                                                                                                           KRW: The KRW is also underpinned by the core
of open economies and hence are likely to benefit greatly
                                                                                                           fundamentals of positive macro-dynamics, reasonably healthy
from a global reflation. However, they have their own
                                                                                                           BoP and cheap valuations. On this latter point, we highlight
distinctive supports as well:
                                                                                                           the fact that the KRW has one of the cheapest valuations in
                                                                                                           the region (see Exhibit 7). We therefore believe that there is a
 For further details on our Taylor Rule calculations, see AXJ: The Impact of Policy                        strong ‘gravitational pull’ working on the KRW in the
Tightening, July 16, 2010.

                                                                    MORGAN STANLEY RESEARCH

                                                                    December 9, 2010
                                                                    FX Pulse

background. Indeed, the recent sell-off following the tensions      mindful that Indonesia’s inflation trends could be a catalyst for
surrounding the military exchange with North Korea would            a correction. CPI is likely to start the year above 6% and may
suggest that the KRW is in a strong position to start the year      move higher as food and energy prices rise. End-2011
in ‘catch-up’ mode if the political risk premia continue to fade.   target: 9,450.
However, concerns of capital controls and a lagged policy
                                                                    THB: The THB looks likely to be the best-performing currency
response to rising inflation somewhat mar the outlook for
                                                                    in 2010, not only in AXJ but also in the whole of EM (11.2%
KRW, in our view. End-2011 target: 1,050.
                                                                    YTD). However, we do not believe that it can sustain its high
CNY: Our China economics team believes that the CNY’s               performance in 2011. An important impediment for the THB
appreciation will speed up next year. The core fundamentals         next year is its valuation. Exhibit 7 shows that its REER is the
are certainly in place with positive macro-dynamics and a           most stretched in the region (+2.4 above its long-term
healthy BoP. Moreover, anticipation that monetary policy will       average), which suggests that there is little headroom for the
have to tighten more aggressively to arrest the acceleration in     THB to appreciate next year. Further, we believe there is a
inflation has lifted the team’s outlook for the CNY next year.      risk that the Thai authorities will reintroduce capital controls in
However, we note that TWI CNY could appreciate in a strong          2011, which may significantly undermine investor sentiment
USD/G10 environment without USD/CNY moving significantly            (see THB: Close to its Peak, September 17, 2010). End-2011
lower. End-2011 target: 6.20.                                       target: 32.0.
PHP: We think that the PHP will remain in the middle of the         INR: We believe that the INR will underperform the region
pack next year. Its core fundamentals of positive macro-            next year. Its weak disposition comes from the softness of its
dynamics and improving BoP are offset by somewhat                   core fundamentals: expensive valuations, neutral macro-
expensive valuations. Moreover, we are mindful that the             dynamics (with above-trend growth, but a large current
Philippines is the most susceptible to food inflation in the        account deficit) and an unfavorable BoP situation with India
region (see “AXJ: Trading Agriflation in the FX Markets”, FX        highly dependent on financial inflows to balance the ledger.
Pulse, April 24, 2008), which may mean that it could                However, we think that the INR will be especially prone to
underperform in a rising commodity price environment. We            downside risks in a rising inflation and commodity price
also have concerns about the deterioration in fiscal discipline,    environment. The RBI is arguably already the most behind the
which may mean that the Philippines continues to face a fiscal      curve in its fight against inflation (see Exhibit 8). Moreover,
drag next year. End-2011 target: 42.0.                              rising energy prices have had a significant impact in widening
                                                                    its external deficit in past cycles. Hence, India’s macro-
Underperformers of 2011                                             dynamic and BoP positions may be at further risk in 2011, in
                                                                    our view. That said, the INR’s high carry should help to
We believe that the IDR, THB and INR will underperform next
                                                                    mitigate any potential declines next year, in our view. End-
year. All three currencies are characterized by expensive
                                                                    2011 target: 46.0.
valuations, which limits their upside gains and leaves
significant downside exposure. Moreover, the IDR and INR
                                                                    Bottom Line
are also susceptible to lagged policy responses to further
inflation surprises.                                                We think that the AXJ’s primary uptrend will extend into 2011.
                                                                    Global reflation provides a favorable backdrop for the export-
IDR: We think that the IDR will lag behind the AXJ rally next
                                                                    dependent region next year. Moreover, positive macro-
year. While Indonesia’s macro-dynamics are currently positive
                                                                    dynamics and reasonably healthy BoP are likely to be
and its BoP healthy, valuation and inflation are likely to be
                                                                    powerful factors in sustaining the AXJ rally, in our view.
strong counteracting forces for the IDR, in our view. We
                                                                    Valuations are generally not a hindrance for further
believe that the IDR’s valuation is extremely stretched –
                                                                    appreciation. However, AXJ currencies could be susceptible
Exhibit 7 indicates that its REER is 2.1sd above its long-term
                                                                    to large counter-trend moves next year from global ‘risk-off’
average. Moreover, signs of overvaluation are manifest in the
                                                                    events, lagged policy responses to regional inflation and the
local equity market too (price-to-book valuation of 4.6x). Not
                                                                    implementation of further capital controls. Within the AXJ bloc,
only do these stretched valuations limit further upside gains,
                                                                    we like the MYR and the SGD and think that the INR, IDR and
but we think they increase the downside risk to any underlying
                                                                    THB may underperform (see Exhibit 9).
deterioration in the fundamentals. In this regard, we are

                                                                             MORGAN STANLEY RESEARCH

                                                                             December 9, 2010
                                                                             FX Pulse

Exhibit 9
USD/AXJ: Forecasts for 2011
                                Spot                Dec-10         Mar-11   Jun-11      Sep-11   Dec-11   YTD-10*   End-11*
  USD/CNY                        6.66                 6.60          6.50     6.40        6.30     6.20      -2.4      -7.0
  USD/HKD                        7.77                 7.75          7.75     7.75        7.75     7.75      0.2       -0.2
  USD/IDR                       9,021                8,750         9,115     9,227       9,338    9,450     -4.8       4.8
  USD/INR                        45.1                 44.5          45.0     45.3        45.7     46.0      -3.2       2.0
  USD/KRW                       1,145                1,075         1,115     1,093       1,072    1,050     -1.1      -8.3
  USD/MYR                        3.15                 3.05          3.05     2.97        2.88     2.80      -8.6     -11.0
  USD/PHP                        43.8                 43.0          43.2     42.8        42.4     42.0      -5.0      -4.1
  USD/SGD                        1.32                 1.28          1.28     1.26        1.23     1.20      -6.3      -8.8
  USD/THB                        30.2                 30.0          30.5     31.0        31.5     32.0      -9.8       6.1
  USD/TWD                        30.2                 30.5          29.7     29.4        29.0     28.6      -5.7      -5.2
Source: Bloomberg, Morgan Stanley Research forecasts; *%Y change

                                                                                                            MORGAN STANLEY RESEARCH

                                                                                                            December 2, 2010
                                                                                                            FX Pulse

FX Discretionary TradeBook: 2010
Global FX Strategy Team

Tactical Trade Recommendations and Portfolio Composition
                                                         Nominal   Risk                Entry      Entry                                          Portfolio                                                       CHF
Trade Recommendation                                     Weight Allocation             Date       Level    Current   Target      Stop           Contribution                     Last w eek
                                                                                                                                                                                 Current                         MS AxJ
Hold Long MS AxJ Index                                     5%            -2%           14-Oct     113.50   112.26    120.00      110.95                -5bp

Hold Short EUR/CHF                                        15%           102%           25-Oct     1.3606   1.3024    1.2800      1.3950                66bp

Cash                                                      80%                                                                                                                                                    EUR

Portfolio Volatility (based on 1m implied volatility, 3m realised correlation, % ann)                                                                1.55%                -20%       -10%     0%       10%    20%

Source: Morgan Stanley Research; Notes: (1) Stops are based on the WMR fixing. (2) The portfolio represents hypothetical, not actual, investments. For more details regarding calculations, please
see “Reading FX Tactical Trade Performance” at the back of FX Pulse. Our FX Performance Data Package contains complete performance statistics. (3) Reported returns are unleveraged. (4) In
the case that trade allocations are increased, entry levels are a weighted average. * Global Risk Demand Index – US Pat. No. 7,617,143.

Performance on Recommended Discretionary Currency Portfolio and Market Benchmark
                 Total return (YTD)              2.19%
                                                                 Total Return, Index
                 Annualised Total Return         2.33%           135                                                                          MS FX Strategy
                 Annualised Standard Deviation   4.27%                                                                                     Discretionary Portfolio
                 Annualised Sharpe Ratio          0.55
                 Total return                    3.60%           125
   12m rolling   Standard Deviation              4.24%           120
                 Sharpe Ratio                     0.85           115
                 Annualised Total Return         4.47%           110
                 Standard Deviation              4.95%
 Since inception                                                 105
                 Sharpe Ratio                     0.90                                                                                                               Barclay Currency Fund Index
                 % of months profitable          61.3%           100
                 Max cumulative loss                               95
                 (17 May 2006 - 24 July 2007)                      90
                 Months to recover                  4
                                                                        2004               2005             2006          2007                  2008                         2009                  2010
                 Max monthly loss                -2.36%

Simulated Managed Account Monthly Gross Performance - %
     Year           Jan          Feb            Mar             Apr                May             Jun       Jul       Aug          Sep                 Oct                   Nov               Dec          Year return
     2004                                                                          2.03           -0.73      1.42     -1.07        -0.90                0.23                  0.80              0.44           1.57%
     2005           0.28         0.11           0.68            -0.63              2.08            1.39     -0.20      1.84         1.62                0.15                  0.85              0.17           8.35%
     2006          -1.11         1.70           4.36            -0.37              1.24           -0.44      0.52     -1.47        -0.85               -0.84                 -0.58             -0.01           2.16%
     2007          -0.75        -0.77          -1.08             0.94              0.36           -2.02      1.07      2.75         1.26                0.45                  1.16             0.18            3.56%
     2008           1.07         2.25           2.72            -1.41             -0.53           1.28      -0.17     -0.24        -0.86                3.12                  0.62             0.87            8.72%
     2009           0.74        -0.97          -0.15            -1.09              0.50           -0.87      0.30      0.22         2.00                0.77                  1.27             0.55            3.27%
     2010          -0.01        -0.27           1.71             1.13              1.39           -0.86     -2.36      0.95         0.67               -0.49                 0.28              0.06            2.19%

Source: Morgan Stanley Research Notes: The figures for the FX portfolio approximate the monthly return of holding the recommended trades with the recommended weights. All figures are
estimated and gross (without reduction for expenses and fees) and no interest on cash holdings is included. Reported returns are not levered.

                                                                                              MORGAN STANLEY RESEARCH

                                                                                              December 9, 2010
                                                                                              FX Pulse

Macro Event Risk Calendar – 2011 Outlook
Christine Tian and Yilin Nie
          Country/                               Morgan Stanley
Date      Currency   Event                            Forecast Market        Last     Our comment

 1-Jan     EUR   Estonia joins the eurozone
           INT   5 non-permanent UN Security Council members take seats               South Africa, India, Columbia, Germany, Portugal assume seats
   *       INT   First tranche of IMF/EU/bilateral loans to Ireland                   Need indicator that Ireland will pass its 2011 austerity budget (our base case) to begin loan
           INT   France assumes G8/G20 presidency for 2011                            French President Sarkozy will assume G8/G20 presidency; France will host G8/G20 summits
           INT   Hungary assumes Presidency of Council of the EU                      Until June, as part of the rotating Presidency of the Council of the European Union
           SEK   Oeystein Olsen replaces Svein Gjedrem as Norges Bank Governor        May increase role of NOK strength in decision making
           USD   Fed's 2011 voters assume voting seats                                Plosser, Evans, Fisher, Kocherlakota gain votes; Rosengren, Pianalto, Bullard, Hoenig lose votes
 5-Jan     USD   112th US Congress begins                                             New House Republican majority, Senate Democratic majority take seats; expect gridlock
10-Jan*    INT   Chinese Pres Hu Jintao to visit US (DC)                              Date not confirmed; state visit in January w/ US Pres Obama
17-Jan     EUR   Eurogroup/Ecofin meeting                                             Eurogroup meets the first day; Ecofin meets the following day
21-Jan*    CAD   BoC Monetary Policy Report                                           Includes forecasts for growth and inflation
23-Jan     EUR   Portugal Presidential Election                                       Incumbent center-right Pres. Cavaco Silva leads polls by wide margin; likely to keep position
25-Jan     GBP   GDP (4Q 2010)                                 0.5%Q         0.8%Q
26-Jan     INT   World Economic Forum (Davos, Switzerland)                            Theme: "Shared Norms for the New Reality"
28-Jan     USD   GDP (4Q 2010)                                   4%Q         2.5%Q
 4-Feb     AUD   RBA Statement on Monetary Policy                                     Includes forecasts for growth and inflation
14-Feb     EUR   Eurogroup/Ecofin meeting                                             Eurogroup meets the first day; Ecofin meets the following day
           JPY   GDP (4Q 2010)                                 -0.2%Q        0.9%Q
15-Feb     EUR   Eurozone flash GDP estimates (4Q 2010)                               Includes individual country flash GDP estimates for core and peripherals
16-Feb     GBP   BoE Quarterly Inflation Report                                       Includes inflation projections on which MPC bases its rates decisions
18-Feb     INT   G20 Fin Mins and CB Governors mtg (Paris)                            Prefigures the G20 heads of state meeting 3-4 November
20-Feb     EUR   German state elections begin                                          Elections in various states to 18 September, determines makeup of upper legislative house
28-Feb     CAD   GDP (4Q 2010)                                  2.6%Q        1.04%Q
 1-Mar     CHF   GDP (4Q 2010)                                               0.7%Q
   *       EUR   Irish general elections                                              Ruling Fianna Fail likely to lose majority due to bailout; date uncertain but before St Patrick's Day
 2-Mar     AUD   GDP (4Q 2010)                                 0.8%Q         0.2%Q
10-Mar     NZD   RBNZ Monetary Policy Statement                                       Alongside RBNZ rate decision; updates forecasts for growth and inflation
14-Mar     EUR   Eurogroup/Ecofin meeting                                             Eurogroup meets the first day; Ecofin meets the following day
16-Mar     NOK   Norges Bank Monetary Policy Report                                   Alongside Norges Bank rate decision; includes projected interest rate path
19-Mar     CNY   China Development Forum (Beijing)                                    Sponsored by the Development Research Center of the State Council
11-Apr     INT   18th ASEAN Summit (Jakarta)                                          To 16 April
15-Apr*    INT   IMF World Economic Outlook                                           Semi-annual update of world economic forecasts
16-Apr     INT   IMF/World Bank Spring meeting (DC)                                   To 17 April
22-Apr*    CAD   BoC Monetary Policy Report                                           Includes forecasts for growth and inflation
27-Apr     GBP   GDP (1Q)                                      0.2%Q
28-Apr     INT   OECD Parliamentary Budget Officials mtg (Stockholm)                  To 29 April; network of Parliamentary budget officials of OECD countries
           JPY   BoJ Outlook for Economic Activity and Prices Report                  Semi-annual report updates growth and inflation forecast
           USD   GDP (1Q)                                      2.9%Q
6-May      AUD   RBA Statement on Monetary Policy                                     Includes forecasts for growth and inflation
11-May     GBP   BoE Quarterly Inflation Report                                       Includes inflation projections on which MPC bases its rates decisions
13-May     EUR   Eurozone flash GDP estimates (1Q)                                    Includes individual country flash GDP estimates for core and peripherals
16-May     EUR   Eurogroup/Ecofin meeting                                             Eurogroup meets the first day; Ecofin meets the following day
23-May     INT   OECD Week 2011 (Paris)                                               To 27 May; will include semi-annual update of OECD economic outlook forecasts
30-May     CAD   GDP (1Q)                                        4%Q
31-May     CHF   GDP (1Q)
1-Jun*     INT   G7/G8 summit (Deauville, France)                                     Date not confirmed but will occur in June; G7/G8 has shifted most power to G20
 6-Jun     INT   OECD Working Party of Sr. Budget Officials mtg (Luxembourg)          To 7 June, network of Budget directors and key executive branch officials of OECD countries
 9-Jun     NZD   RBNZ Monetary Policy Statement                                       Alongside RBNZ rate decision; updates forecasts for growth and inflation
14-Jun     EUR   Eurogroup/Ecofin meeting                                             Eurogroup meets the first day; Ecofin meets the following day
22-Jun     NOK   Norges Bank Monetary Policy Report                                   Alongside Norges Bank rate decision; includes projected interest rate path
  1-Jul    INT   Poland assumes Presidency of Council of the EU                       Until December, as part of the rotating Presidency of the Council of the European Union
 22-Jul    CAD   BoC Monetary Policy Report                                           Includes forecasts for growth and inflation
 26-Jul    GBP   GDP (2Q)                                      0.3%Q
 29-Jul    USD   GDP (2Q)                                        3%Q
 5-Aug     AUD   RBA Statement on Monetary Policy                                     Includes forecasts for growth and inflation
10-Aug     GBP   BoE Quarterly Inflation Report                                       Includes inflation projections on which MPC bases its rates decisions
16-Aug     EUR   Eurozone flash GDP estimates (2Q)                                    Includes individual country flash GDP estimates for core and peripherals
31-Aug     CAD   GDP (2Q)                                      2.1%Q
 1-Sep     CHF   GDP (2Q)
    *      EUR   Greek Parliamentary elections

                                                                                                MORGAN STANLEY RESEARCH

                                                                                                December 9, 2010
                                                                                                FX Pulse

          Country/                                         Morgan Stanley
Date      Currency     Event                                    Forecast Market   Last   Our comment

15-Sep NZD        RBNZ Monetary Policy Statement                                         Alongside RBNZ rate decision; updates forecasts for growth and inflation
24-Sep INT        IMF/World Bank Autumn meeting (DC)                                     To 26 September
 1-Oct*INT        IMF World Economic Outlook                                             Semi-annual update of world economic forecasts
 19-OctNOK        Norges Bank Monetary Policy Report                                     Alongside Norges Bank rate decision; includes projected interest rate path
21-Oct*CAD        BoC Monetary Policy Report                                             Includes forecasts for growth and inflation
 23-OctCHF        Swiss Parliamentary Election                                           For seats in both the upper and lower houses
 24-OctINT        19th ASEAN Summit (Bali)                                               To 29 October
 25-OctGBP        GDP (3Q)                                   0.1%Q
27-Oct*JPY        BoJ Outlook for Economic Activity and Prices Report                    Semi-annual report updates growth and inflation forecast
 27-OctUSD        GDP (3Q)                                   3.1%Q
 1-Nov*NZD        New Zealand General Election                                           Must be held by 7 Jan 2012; most likely in 2H 2011; voting for 50th NZ Parliament
 3-Nov INT        G20 Summit (Cannes, France)                                            To 4 Nov; starting in 2011 G20 summits will be held annually rather than biannually
 4-Nov AUD        RBA Statement on Monetary Policy                                       Includes forecasts for growth and inflation
12-Nov*EUR        Danish referendum on EU opt-outs                                       Key item up for vote is Denmark's opt-out of an obligation to eventually join the Eurozone
       INT        APEC summit (Honolulu, HA)                                             To 13 Nov
15-Nov EUR        Eurozone flash GDP estimates (3Q)                                      Includes individual country flash GDP estimates for core and peripherals
16-Nov GBP        BoE Quarterly Inflation Report                                         Includes inflation projections on which MPC bases its rates decisions
30-Nov CAD        GDP (3Q)                                   2.8%Q
1-Dec CHF         GDP (3Q)
8-Dec NZD         RBNZ Monetary Policy Statement                                         Alongside RBNZ rate decision; updates forecasts for growth and inflation

  * Denotes dates approximate; estimates based on past years.
  Source: Morgan Stanley Research

Central Bank Rate Decisions – 2011 Outlook
                        Fed                ECB                BoJ         BoE            BoC             RBA             RBNZ             Norges           Riksbank             SNB

 January                 26                 13                 25          13            18                -               27               26                  -                 -

 February                 -                  3                 17          10             -                1                -                -                 15                 -

 March                   15                  3                 15          10             1                1               10               16                  -                 17

 April                   27                  7                7,28          7            12                5               28                -                 2                  -

 May                      -                  5                 20           5            31                3                -               12                  -                 -

 June                    22                  9                 14           9             -                7                9               22                  -                 16

 July                     -                  7                 15*          7            19                5               28                -                 5                  -

 August                  9                   4                 19*          4             -                2                -               10                  -                 -

 September               20                  8                 16*          8             7                6               15               21                 7                  15

 October                  -                  6               7,31*          6            25                4               27               19                 27                 -

 November                2                   3                 21*         10             -                1                -                -                  -                 -
 December                13                  8                 19*          8             6                6                8               14                 20                 15
         * Denotes dates uncertain; estimates based on past years.
         Source: Morgan Stanley, central bank websites

                                                                  MORGAN STANLEY RESEARCH

                                                                  December 9, 2010
                                                                  FX Pulse

2010 Year-End FX Quiz
1. All of the following are real financial instruments except:    8. Which of the following is NOT a hobby pursued by a G20
(A)   Panda bond
(B)   Dim sum bond                                                (A) European Council President Van Rompuy – author of
(C)   Samurai bond                                                Flemish haikus
(D)   Teriyaki bond                                               (B) Canadian PM Harper – designer of children’s footwear
                                                                  (C) Japanese PM Kan – inventor of mah-jong point
2. The only American leader to appear on a US coin during         calculation machine
his own lifetime was:                                             (D) Indonesian President Yudhoyono – writer of chart-topping
                                                                  love songs
(A)   Alexander Hamilton
(B)   Millard Fillmore                                            9. If caught counterfeiting currency in the United States in
(C)   Calvin Coolidge                                             1850, the legal system could subject you to:
(D)   Dwight Eisenhower
                                                                  (A)   The wagging finger of shame
3. Kim Il Sung has appeared on which following denomination       (B)   Exile to the Philippines
of North Korean currency:                                         (C)   Tarring and feathering
                                                                  (D)   Ten years hard labor on a naval man-of-war
(A) 100 Won note
(B) 500 Won note                                                  10. Recently, the Washington Toxics Coalition found trace
(C) 1000 Won note                                                 amounts of the chemical BPA on currency. Exposure to BPA
(D) 5000 Won note                                                 has been linked to:
(E) All of the above
                                                                  (A)   Obesity
4. Though it’s small in population, New Zealand is a big player   (B)   Stunting
in certain markets. It produces 31% of the world’s…               (C)   Hallucinations
                                                                  (D)   All of the above
(A)   Sheep’s wool
(B)   Yogurt                                                      11. Bacon has served as a valid currency at one time in:
(C)   Kiwifruit
(D)   Hobbits                                                     (A) The Confederate States of America
                                                                  (B) Ireland
5. According to the IMF, which pair of countries grew faster      (C) The International House of Pancakes
than China in 2009?                                               (D) None of the above

(A)   Afghanistan and Ethiopia
(B)   Nigeria and East Timor
(C)   Azerbaijan and Zambia
(D)   New Guinea and Vanuatu

6. Which country recorded the highest inflation in history?

(A)   Brazil, 1993
(B)   Zimbabwe, 2008
(C)   Hungary, 1946
(D)   Germany, 1923

7. Which institution has issued the highest nominal value of
currency since its founding?

(A) The US Federal Reserve Bank
(B) The Reserve Bank of New Zealand
(C) Parker Brothers
(D) The Hong Kong Monetary Authority

                                                                                                     MORGAN STANLEY RESEARCH

                                                                                                     December 9, 2010
                                                                                                     FX Pulse

Morgan Stanley Global Currency Forecasts
                                                       2011                                                  2012                            Fair                   Averages**
                   Current         1Q            2Q            3Q           4Q           1Q           2Q             3Q          4Q                       2010e         2011e        2012e
EUR/USD                1.32        1.25         1.21           1.18        1.20          1.22         1.22           1.22        1.22        1.22           1.32         1.22         1.22
USD/JPY                 84          86           88             89          93            95           95             95          95           96            88           88           95
EUR/JPY                111         108          106            105         112           116          116            116         116          117           116          107          115
USD/CHF                0.99        1.01         1.02           1.02        1.02          1.03         1.05           1.07        1.07        1.10           1.05         1.02         1.05
EUR/CHF                1.30        1.26         1.24           1.20        1.22          1.26         1.28           1.30        1.30         1.34          1.38         1.24         1.28
GBP/USD                1.58        1.54         1.53           1.53        1.54          1.54         1.51           1.51        1.51        1.61           1.54         1.54         1.52
EUR/GBP                0.84        0.81         0.79           0.77        0.78          0.79         0.81           0.81        0.81         0.76          0.86         0.79         0.80
GBP/CHF                1.55        1.56         1.57           1.56        1.56          1.59         1.58           1.60        1.60        1.76           1.61         1.56         1.59
USD/CAD                1.01        1.02         1.03           1.00        0.98          0.98         0.98           0.98        0.98         1.20          1.03         1.01         0.98
AUD/USD                0.98        0.93         0.90           0.93        0.95          0.97         0.98           0.98        0.98        0.71           0.92         0.93         0.97
NZD/USD                0.75        0.73         0.71           0.73        0.75          0.76         0.76           0.77        0.77         0.59          0.72         0.73         0.76
AUD/NZD                1.32        1.27         1.27           1.27        1.27          1.28         1.29           1.27        1.27        1.21           1.27         1.27         1.28
AUD/CAD                0.99        0.95         0.93           0.93        0.93          0.95         0.96           0.96        0.96         0.86          0.94         0.94         0.95
NZD/CAD                0.75        0.74         0.73           0.73        0.74          0.74         0.74           0.75        0.75        0.71           0.74         0.74         0.75
AUD/JPY                82.6        80.0         79.2           82.8        88.4          92.2         93.1           93.1        93.1         68.8          80.3         81.6         92.3
EUR/CAD                1.33        1.28         1.25           1.18        1.18          1.20         1.20           1.20        1.20        1.47           1.37         1.24         1.19
EUR/AUD                1.34        1.34         1.34           1.27        1.26          1.26         1.24           1.24        1.24         1.71          1.45         1.32         1.25
EUR/SEK                9.13        9.00         8.95           8.80        8.90          8.95         9.00           9.00        9.00        9.01           9.55         8.94         8.98
EUR/NOK                7.97        7.70         7.60           7.60        7.65          7.70         7.70           7.75        7.80         8.53          8.02         7.68         7.72
USD/SEK                6.92        7.20         7.40           7.46        7.42          7.34         7.38           7.38        7.38        7.38           7.21         7.32         7.37
USD/NOK                6.05        6.16         6.28           6.44        6.38          6.31         6.31           6.35        6.39         6.99          6.05         6.29         6.34
NOK/SEK                1.14        1.17         1.18           1.16        1.16          1.16         1.17           1.16        1.15        1.06           1.19         1.16         1.16
MS Dollar Index        73.6        77.3         78.8           79.2        79.1          79.1         79.5           79.6        79.6         83.2          77.0         78.6         79.5
Broad USD TWI         101e         102          103            102         102           100          100            100          99          N/A           103          102          101
JPY TWI               379e         369          361            355         337           327          326            324         323          N/A           369          363          331
EUR TWI                103          99           97             94          95            96           96             96          96          N/A           105           97           96
GBP TWI                81.6        82.9         83.8           84.9        84.4          84.0         81.9           81.8        81.7         N/A           80.8         83.5         82.5
USD/ZAR                6.90        6.90         7.00           7.35        7.50          7.75         7.90           7.90        8.00        8.92           7.34         7.13         7.83
EUR/CZK                25.1        24.8         24.5           24.2        24.0          23.8         23.5           23.3        23.3         N/A           25.3         24.2         23.5
EUR/HUF                278         273          267            265         265           265          265            260         255          N/A           276          269          262
EUR/PLN                4.04        3.90         3.85           3.80        3.75          3.75         3.70           3.65        3.55         N/A           3.99         3.85         3.69
EUR/RON                4.30        4.30         4.30           4.25        4.20          4.15         4.10           4.05        4.00         N/A           4.21         4.27         4.10
RUB basket            35.46       34.50        34.30          34.20       34.00         33.90        33.70          33.60       33.50         N/A          34.86        34.42        33.74
USD/RUB               31.01       31.01        31.34          31.64       31.19         30.85        30.66          30.57       30.48         N/A          30.42        31.32        30.73
USD/ILS                3.62        3.65         3.62           3.60        3.62          3.61         3.59           3.57        3.55         N/A           3.93         3.63         3.59
USD/TRY                1.51        1.50         1.47           1.50        1.47          1.48         1.50           1.51        1.53         N/A           1.51         1.49         1.50
PLN/CZK                6.22        6.36         6.36           6.37        6.40          6.35         6.35           6.38        6.56         N/A           6.33         6.28         6.38
USD/CNY                6.66        6.50         6.40           6.30        6.20          6.11         6.01           5.92        5.82         N/A           6.77         6.40         6.01
USD/HKD                7.77        7.75         7.75           7.75        7.75          7.75         7.75           7.75        7.75         7.77          7.77         7.75         7.75
USD/IDR               9,020       9,115        9,227          9,338       9,450         9,538        9,625          9,713       9,800       12,712         9,086        9,236        9,626
USD/INR                45.2        45.0         45.3           45.7        46.0          46.5         47.0           47.5        48.0         N/A           45.8         45.5         47.0
USD/KRW               1,139       1,115        1,093          1,072       1,050         1,033        1,015           998         980        1,091          1,157        1,094        1,015
JPY/KRW               13.57       12.97        12.42          12.04       11.29         10.87        10.68          10.51       10.32        11.34         13.18        12.44        10.71
USD/MYR                3.14        3.05         2.97           2.88        2.80          2.76         2.73           2.69        2.65        3.57           3.22         2.96         2.73
USD/PHP                43.7        43.2         42.8           42.4        42.0          41.6         41.3           40.9        40.5         52.3          45.1         42.8         41.3
USD/SGD                1.31        1.28         1.26           1.23        1.20          1.19         1.18           1.16        1.15        1.46           1.36         1.26         1.18
USD/TWD               30.10       29.70        29.40          29.00       28.60         28.20        27.80          27.40       27.00        31.37         31.53        29.38        27.80
USD/THB               30.08       30.50        31.00          31.50       32.00         32.80        33.50          34.30       35.00       39.10          31.72        31.05        33.53
USD/BRL                1.70        1.71         1.68           1.67        1.65          1.70         1.80           1.75        1.75         2.40          1.76         1.69         1.74
USD/MXN               12.45       12.25        12.30          12.20       12.20         12.50        12.80          12.40       12.30       12.61          12.64        12.26        12.49
USD/ARS                3.98        4.10         4.15           4.20        4.30          4.25         4.15           4.10        4.00         4.57          3.91         4.15         4.16
USD/VEF                4.29        4.30         4.30           4.30        4.30          4.30         4.30           4.30        4.30         N/A           4.25         4.30         4.30
USD/CLP                474         470          480            480         500           510          520            515         510          N/A           511          480          513
USD/COP               1,903       1,790        1,750          1,750       1,720         1,725        1,750          1,700       1,650         N/A          1,898        1,775        1,715
USD/PEN                2.82        2.80         2.75           2.68        2.62          2.60         2.57           2.53        2.50         N/A           2.83         2.74         2.56
Forecasts were updated December 9, 2010.                                                                                                                                 N/A = Not Available
*Fair values are based on data as of 3Q10 due to data lags. See An Update of Fair Values or more information.
**Averages calculated from daily data; a = Actual; e = Morgan Stanley Research Estimates                                                                    Source: Morgan Stanley Research
Broad USD TWI is the Federal Reserve Broad Dollar Index (current is an estimation based on current spot); JPY TWI is the Bank of Japan Nominal Effective Exchange Rate (current is an estimation
based on current spot); EUR TWI is the ECB Daily Nominal Effective Exchange Rate; GBP TWI is the Bank of England Effective Exchange Rate Index

                                                                                                   MORGAN STANLEY RESEARCH

                                                                                                   December 9, 2010
                                                                                                   FX Pulse

Global FX Strategy Team
Head of Global FX Strategy (London)                       Stephen Hull, Executive Director                                  (44 20) 7425-1330

Currency Strategist (New York)                            Gabriel de Kock, Executive Director                            (212) 761-5154
Currency Strategist (New York)                            Ron Leven, Executive Director                                     (212) 761-3413
Currency Strategist (New York)                            Yilin Nie, Associate                                                 (212) 761-2886
Currency Strategist (New York)                            Christine Tian, Analyst                                         (212) 761-5970

Currency Strategist (London)                              Tim Davis, Analyst                                                   (44 20) 7677-1692
Currency Strategist (London)                              Calvin Tse, Analyst                                                 (44 20) 7677-0761

Currency Strategist (Hong Kong)                           Stewart Newnham, Executive Director                            (852) 2848-5320
Currency Strategist (Hong Kong)                           Emma Lawson, Vice President                                      (852) 3963-0509
Currency Strategist (Hong Kong)                           Yee Wai Chong, Associate                                         (852) 2239-7117

Morgan Stanley entities: London – Morgan Stanley & Co. International plc; New York – Morgan Stanley & Co. Incorporated.; Hong Kong – Morgan Stanley Asia Limited.

                                                                                          MORGAN STANLEY RESEARCH

                                                                                          December 9, 2010
                                                                                          FX Pulse

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