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Currencies: a delicate imbalance

The world's currencies are grossly misaligned today. To combat domestic inflation, Asian currencies may soon appreciate sharply, a shift with potentially dramatic consequences for global growth and financial markets. Changes in the "delicate imbalance" of global currencies bear both risks and opportunities for private investors.

  • Rising inflation, particularly in Asia and some oil-rich nations, may force these countries to let their weak currencies rise against the US dollar and the euro.

  • A costlier currency will make these countries' exports more expensive on the global market.

  • Global production will likely slow short term as exporters' prices rise, but this shift should eventually benefit European and US exporters.

  • These developments pose risks to certain assets. Bonds are vulnerable to higher inflation. Some emerging market equity and real estate prices could take a tumble as a result of a sharp currency appreciation.

In its new report entitled "Currencies: a delicate imbalance", UBS Wealth Management Research examines the dynamics of the situation, its historical evolution and some scenarios for possible outcomes. A system that has been largely in place for more than thirty years may be on the cusp of great change. The balance of global currencies is set to shift - bringing with it problems for global markets, which investors should brace for. In a global economy, there are few topics more compelling themes for investors today than Currencies.

In the report, UBS Wealth Management Research predicts a significant increase in the value of the currencies of certain Asian and oil-producing countries. Currencies that are pegged at competitive rates to the US dollar may appreciate sharply to stamp out domestic inflation. The new report says that this could drag on global growth, as Asian exports become less competitive. China, for instance, has become a global manufacturing powerhouse, but a rising Chinese yuan will hurt Chinese exports.

Production capacity outside Asia will be unable, initially, to meet demand. These shifts should eventually benefit other regions - particularly the Eurozone, but also the US - as their industries adjust to take up the slack.

In the short term, a sharp appreciation of today's weak currencies could slow global economic growth and fuel a further pickup in inflation. Developed countries' bond markets would likely weaken as inflation increases. UBS WM Research believes the risk of a sharp currency appreciation is not reflected in the price of many emerging market equities and real estate at present.

Misalignments in currency markets reflect global imbalances
Several emerging market currencies are either pegged to, or in a managed relationship with, the US dollar, especially the Chinese yuan, other major Asian currencies, and most of the currencies of the Gulf Cooperation Council. Because their currencies are tied to the US dollar at competitive rates, these countries have enjoyed strong economic growth, high and increasing current account surpluses, enormous foreign exchange reserve accumulation, and buoyant financial and real estate markets. Overall, the combination of steadily accumulating foreign exchange reserves, strong demand for currencies of commodity-exporting countries, and the extended success of "carry trades" have produced profound misalignments in currency markets.

Building inflation pressures may trigger a massive realignment
By the end of 2007, inflation was also beginning to accelerate in countries with pegged currencies. An increasingly accommodative US monetary policy, designed to stimulate domestic economic growth, has served only to add to inflation pressures in these countries and to escalate the reserve accumulation problem. According to the report, authorities may need to permit their currencies to appreciate against the US dollar as a way to tighten monetary policy and keep inflation contained.

Sharp exchange rate realignment to pressure global growth
A sudden appreciation of US dollar-pegged currencies would likely have negative consequences for the global economy, according to UBS Wealth Management Research. Ultimately, the structural realignment of manufacturing and production centers resulting from changes in competitiveness would take time to unfold, making a near-term reduction in global growth and an increase in inflation likely. Europe would eventually benefit from a depegging of Asian currencies versus the US dollar, as a more competitive euro bolsters Eurozone exporters. A slower currency adjustment, meanwhile, would shield Asian economies from painful adjustments in the short term, but may also lead to more problems, such as asset price bubbles, in the longer run.

Risk of global imbalances is not reflected in financial markets
The threat of depegging and the risks of present currency imbalances are not reflected in the price of higher-risk assets, such as emerging market equities and real estate, and certain commodities, such as base metals and energy. Developed countries' bonds are poorly positioned for a potential increase in global inflation rates. And while developed country equity markets are not expensive on a historical basis, past comparisons may not be relevant during periods when the global risk premium is rising. Overall, UBS Wealth Management Research recommends that investors remain alert to opportunities that might arise from a delayed adjustment to currency shifts, but to hold a broadly diversified and defensive portfolio that protects against the risks posed by these imbalances.

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