Foreign Exchange Outlook pdf

13 Foreign Exchange Outlook Diverging central bank policy, uneven progress towards sovereign debt sustainability, political change, progress in Europe, growth in Asia, investors’ global

Index

Market Tone & Fundamental Focus 3

US/Canada 5

Europe 6

Asia/Oceania 8

Developing Asia 10

Developing Americas 11

Global Currency Forecast 13

Foreign Exchange

Outlook

Diverging central bank policy, uneven progress towards sovereign debt sustainability, political change, progress in Europe, growth in Asia, investors’ global search for yield and a low volatility market environment are the themes that are likely to drive the currency landscape in 2013

The North American outlook is complicated by uncertain fiscal drag, which has proven to be a significant business and market disturbance; however, for

FX markets, aggressive Fed policy combined with building growth momentum and favourable risk appetite supports the outlook for the CAD

In Europe, diminished tail risk and shifting market confidence helped to support EUR in the final few months of the year; however, bouts of uncertainty will likely continue to weigh on the currency in 2013; GBP’s outlook is more positive, but it is the Scandies whose outlook shines, as they benefit from relative central bank policy and sentiment

In Asia, the outlook for JPY has deteriorated materially as political uncertainty and rising concerns that the BoJ is in the midst of losing its independence weigh on what was already a difficult currency outlook CNY continues to appreciate; however, with a narrowed current account surplus and slower pace of FX reserve accumulation we expect only moderate strength in 2013

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Actual Q2a 12 Q3a 12 Q4 12 Q1 13 Q2 13 Q3 13 Q4 13 Q1 14

12.79 12.78 12.72 12.65 12.58 12.62

(*) Source: Consensus Economics Inc December 2012

AUDUSD USDMXN

USDJPY

Spot Price vs 100 Day Moving Average vs 200 Day Moving Average - (5yr Trend)

Consensus*

Mexican Peso

Consensus*

GBPUSD Consensus*

Consensus*

USDCAD Consensus*

Canadian Dollar

Australian Dollar

Global Foreign Exchange Outlook

Euro

Yen

Sterling

December 20, 2012

EURUSD Consensus*

74 81 88 95 102 109 116

200 Day

1.12

1.22

1.32

1.42

1.52

1.62

EUR/USD

100 Day

200 Day

1.36

1.51

1.66

1.81

1.96

100 Day

200 Day

0.90 0.98 1.06 1.14 1.22 1.30

USD/CAD

100 Day

200 Day

0.59

0.67

0.74

0.82

0.89

0.97

1.04

1.12

AUD/USD

1 00 Da y

2 00 Da y

9.7 10.8 11.9 13.0 14.1

100 Day

200 Day

Diverging central bank policy, uneven progress towards

sovereign debt sustainability, political change, progress in

Europe, growth in Asia, investors’ global search for yield

and a low volatility market environment are the themes

that are likely to drive the currency landscape in 2013

We expect diverging central bank policies to be a key FX

market focus in 2013 The US, Japan, Europe and the UK

are all leaning heavily on loose and aggressive monetary

policy to stimulate growth and offset tightening fiscal

con-ditions These policies are typically currency negative,

with Fed and BoJ policy the most aggressive from a

cur-rency perspective However, many of the other central

banks (particularly in the advanced economies) are facing

the reality of the risks that high household debt and

ele-vated housing prices pose to financial stability in a low

interest rate environment (Canada, Sweden, Switzerland,

Norway, etc.) Accordingly, even in an environment of sub

-trend economic performance and substantial external

headwinds, these central banks are completing easing

cycles and warning of the risks of higher interest rates

For currencies, these diverging central bank trends are

impossible to ignore

For North America, the US focus will be multifaceted,

re-volving around i) USD negative Fed policy, ii) fiscal drag

combined with the lack of a credible long-term fiscal plan

and iii) the improving but still modest growth outlook

Can-ada’s domestic fundamentals are uneven, and vulnerable

to what is a historically wide Brent–Western Canadian

select oil spread, but the central bank has maintained a

hawkish bias since the fall as household debt poses a risk

to financial stability and global investors as well as FX

reserve managers continue to view Canadian assets as

attractive, helping to drive positive Canadian dollar (CAD)

flows On the back of these trends, we expect the CAD to

appreciate modestly in 2013 The outlook for the Mexican

peso (MXN) is improving, particularly as the economy

recovers and the central bank maintains more hawkish

policy than the Fed

In the freely floating Latin American FX universe, the

Chil-ean (CLP) and Columbian (COP) pesos are not expected

to repeat their 8-9% 2012 returns The outlook for the

Pe-ruvian sol (PEN) is strong and could well outperform in

the Latam FX space The Brazilian real (BRL), which

proved the worst-performing currency in 2012, is

ex-pected to remain biased for weakness but contained

with-in the relatively stable range that characterized the

se-cond half of 2012

Europe is likely to be an ongoing theme; however, the

market will not suffer tunnel vision the way it did during

some periods in 2012 The outlook for the monetary union will be plagued by periodic bouts of uncertainty as political discussions threaten both the banking union and the ulti-mate path towards a fiscal union, and this will weigh on the euro (EUR) Helping to offset this is ECB policy, which

is unlikely to prove as aggressive or currency negative as Fed policy, and a focus on the material progress Europe has made over the last year Accordingly, the EUR is ex-pected to slowly trend modestly lower, closing 2013 at lower levels than it traded at in late December The British pound (GBP) is a less attractive play in 2013 than it was

in 2012 particularly as the UK’s rating is increasingly at risk, monetary policy is likely to remain expansionary and the UK’s economic outlook is weighed down by Europe However, we expect modest appreciation year-over-year

as the UK continues to benefit from European diversifica-tion flows, positive sentiment and a credible and estab-lished fiscal plan The outlook for the other European cur-rencies, particularly the Scandies, is more positive We have an appreciating trend built in for the SEK and NOK

In Asia, newly elected Japanese Prime Minister Abe had

a three-pronged campaign: 1) fiscal stimulus to help lift the economy, which could ultimately push its fiscal bal-ance even further into deficit and threaten the country’s credit rating; 2) implementing a 2% inflation target and maintaining support for aggressive BoJ policy; and finally 3) a hard line in the China/Japan territorial dispute To-gether these policies are likely to prove JPY negative Accordingly, we have revisited our 2013 year end USDJPY forecast and raised it from 87 to 90 In China, the stabilization of the economy and progress towards a more freely traded exchange rate is likely to keep the slow trend of appreciation in place We hold a 2013 6.10 year-end USDCNY target Political developments in Ko-rea combined with the won’s (KRW) relative undervalua-tion on a real effective exchange rate basis are likely to lead to an appreciating trend in 2013 For the Australian dollar, the outlook is positive, but currency gains are likely

to lag the CAD’s We expect growth in China to increase

to 8% in 2013, which would help support the Australian economy, this combined with US Fed policy should sup-port the AUD However, repeated warnings by the central bank that mining investment has peaked are difficult to ignore Accordingly, we look for modest AUD appreciation

in 2013

The most important risks to our forecasts include: 1) a sudden and unexpected spike in inflation; 2) geopolitically induced higher oil prices; 3) a hard landing in China or 4)

a political impasse in either Europe or the US which threatens the global economic recovery

MARKET TONE & FUNDAMENTAL FOCUS Pablo F.G Bréard +1 416 862-3876 Camilla Sutton +1 416 866-5470

As December draws to a close, CAD is up 3.7% year-to-date, within reach of our December 2011 CAD forecast, which called for 4.0% appreciation in 2012 Looking out to 2013, we expect further CAD appreciation, with the currency closing the year at 1.04 (equating to 0.96 in USDCAD) From our perspective, relative monetary policy is the most important driver The Bank of Canada (BoC) has maintained a hawkish bias as the risks associated with household debt threaten financial stability; however, the domestic economic backdrop combined with external risks dampen the need for tighter policy in Canada Regardless of whether BoC policy is viewed as hawkish or neutral juxtaposed against Fed policy it suggests USD weakness and CAD appreciation On the fiscal front, the International Monetary Fund (IMF) expects Can-ada to generate a deficit of -3.0% of GDP in 2013, an improvement over the estimated 3.8% in 2012, but still a large im-balance The government’s plan, which is viewed credibly by markets, is to move towards a balanced budget by calen-dar year 2018 This compares favourably with the outlook for the US fiscal deficit, which the IMF estimates at 8.7% of GDP in 2012, declining to 7.3% of GDP in 2013, with no credible fiscal plan to move the US close to a balance budget Accordingly, current fiscal balances combined with their outlook should favour investment in Canada and hence support CAD GDP growth is typically a weak driver of FX, accordingly we are not concerned that Canada is expected to lag the

US in both 2013 and 2014, as it did in 2012 Traditionally, CAD has been viewed as a petrol currency; however, this is

an increasingly complex relationship There are three key components: 1) oil prices, which are expected to remain sup-portive of the Canadian economic backdrop; 2) the widening of the Brent-WTI spread, which is a weight against the Ca-nadian economy Canada exports oil prices below WTI levels (at CaCa-nadian Western Select), but still imports a significant portion of central and eastern Canada oil demands at Brent prices Accordingly as the spread widens, Canada is export-ing at far lower prices than it is importexport-ing at and creates a net drag to the economy 3) As US production increases, some have questioned what the impact on Canadian oil will be Balancing all these issues, we view oil prices as a neu-tral driver of CAD in 2013 Summing up, we expect CAD to strengthen year-over-year

CANADA Camilla Sutton +1 416 866-5470

Eric Theoret +1 416 863-7030

Currency T rends

Spot 20-Dec

Outlook Going Back

1.035 85.41 1.307 0.987

0.99

1.01

1.03

1.05

1.07

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

72.0 75.0 78.0 81.0 84.0 87.0

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

1.21

1.24

1.27

1.30

1.33

1.36

1.39

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

0.96 0.98 1.00 1.02 1.04 1.06

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

UNITED STATES - US GDP growth is constrained by the

uncertainty surrounding the ‘fiscal cliff’ negotiations in

Con-gress Business confidence is low and consumer

confi-dence, which had been gaining momentum, has softened

with the University of Michigan Confidence Index moving

down to 74.5 in December from 82.7 The outlook for

con-sumption has improved on gains in the jobs and housing

markets, however, retail sales figures have been patchy

(flat in November excluding autos) and households face

possible tax increases in the New Year hurting disposable

income The job market has some momentum with

non-farm payrolls adding almost 800,000 jobs in the past five

months, including another 146,000 in November The

un-employment rate moved down to 7.7%, from a peak of

10%, but this masks the decline in labour force

participa-tion as people become discouraged looking for work The

housing market also continues to turn around from

de-pressed levels, with housing starts heading towards

900,000 (from a low of 523,000 in 2009), while the

Case-Shiller Home Price Index has shown monthly increases

since March Meanwhile, business investment remains

de-pressed and contracted by 1.8% annualized in Q3, but

should benefit from eventual clarity of the fiscal issues,

re-inforced by the Fed’s aggressively accommodative

mone-tary policy Industrial production rebounded in November,

rising by 1.1% m/m, offsetting weakness in October due to

Hurricane Sandy However, the ISM Manufacturing Index

moved below 50 again, confirming that the outlook for

pro-duction continues to be mixed Even though the US will

outperform most other advanced economies next year, the

rebound remains weak in comparison to previous

post-recession recoveries This is largely because of the

ongo-ing fiscal drag, consumer deleveragongo-ing, and weak global

demand which limits any major improvements in the net

trade balance, all of which restrain potential US economic

growth

CANADA - The Canadian economy has lost momentum in recent quarters The slow pace of the US and global recov-ery, the persistent strength in the Canadian dollar and

low-er prices for key domestic resources are weighing on man-ufacturing output and export earnings Despite a continued large surplus in commodities trade, growing deficits in man-ufactured goods and services have pushed Canada’s cur-rent account shortfall to around $70 billion, or 4% of GDP Business confidence and investment intentions remain rea-sonably positive, but the volatile and uncertain global eco-nomic and financial environment is tempering capital spending, and scaling back some resource expansion plans While the pace of job growth so far remains healthy, concern over high household debt burdens has contributed

to more moderate consumer spending and household bor-rowing Home sales have slowed steadily since the spring

as high prices and a tightening in mortgage rules have eroded affordability, notwithstanding generationally low borrowing costs This in turn has begun to moderate the pace of new homebuilding Federal and provincial public sector restraint also is expected to remain a drag on growth through 2014, though to a smaller degree than in many other advanced nations Overall, the Canadian economy is expected to post moderate growth of 1.7% in 2013, picking

up to 2.3% in 2014 as improving global economic condi-tions support higher commodity prices, stronger exports and corporate earnings, and rising business capital invest-ment Headline and core inflation rates have moved back toward the lower end of the Bank of Canada’s 1-3% target range, with underlying price trends restrained by modest wage growth, limited retail pricing power and Canadian dollar strength

CANADA AND UNITED STATES Adrienne Warren +1 416 866-4315 Fundamental Commentary Devin Kinasz +1 416 866-4214

M ONETARY P OLICY C OMMENTARY Derek Holt +1 416 863-7707

UNITED STATES - We expect the Fed to continue with its

current pace of asset purchases (US$85/bn per month) for

some time yet, although in light of Chairman Bernanke’s

statement that the Fed will adjust the monthly pace of

pur-chases in response to economic data and economic

condi-tions – including fiscal policy developments – it is fairly

diffi-cult to have policy certainty with respect to Fed asset

pur-chases over a medium-term horizon Similarly, we expect

markets will view the Fed’s interest rate thresholds as

con-sistent with its earlier date-based guidance over the coming

months; however, there is risk that this could erode and

add confusion into markets over time, particularly if the Fed

stops publishing the expected date of policy firming of the

FOMC participants in its projections We see risk that the

size of the Fed’s monthly purchases could begin to impact

market liquidity if the current pace continues into 2014

CANADA - We continue to expect the Bank of Canada (BoC) to remain on hold into 2014 with risks of a longer pause contingent on the trajectory of the economy and global monetary policy conditions We anticipate that the transition from Governor Carney to a new governor will be smooth, and that markets will continue to expect interest rate policy stability during the leadership change Recent data have continued to demonstrate that the Bank of

Cana-da is wise to raise the “two-sided” risk emanating from im-balances in the household sector – with the emphasis on downside risks The BoC refers to this as “the biggest do-mestic risk” which is consistent with our long-held view as well This is one factor contributing to our view that the out-put gap will continue to reflect spare capacity in the Cana-dian economy through Scotiabank’s forecast horizon

EURO ZONE - Progress on the banking union, the future framework of the European Union, Fed policy and short cover-ing have helped to support EUR in the final month of the year However lookcover-ing out to 2013, there are significant EUR downside risks that are difficult to ignore; bouts of political uncertainty, economic contraction and negative headlines are likely to weigh heavily on fragile market sentiment driving a small depreciation in EUR in 2013 We hold a Q1 2013 fore-cast of 1.30

UNITED KINGDOM - Sterling is a less attractive play in 2013 than it was in 2012 particularly as the UK’s rating is increas-ingly at risk, monetary policy is likely to remain expansionary and the UK’s economic outlook is weighed down by Europe However, we expect modest appreciation year-over-year as GBP continues to benefit from European diversification flows, positive sentiment (with the CFTC reporting in mid-December a net long GBP holding of US$2.8 billion) and a credible and established fiscal plan We hold a Q1 2013 target of 1.62

SWITZERLAND - Plagued by weak growth, deflation and economic ties into the euro zone, the Swiss outlook is chal-lenged In response, the Swiss National Bank (SNB) remains committed to the EURCHF 1.20 floor, which the market views as credible The SNB does not foresee the economy exiting deflation until 2014 and even then inflation remains subdued at just 0.4% Accordingly, we expect the floor to remain in place through 2013

SWEDEN - The outlook for SEK is supported by what we expect is the conclusion of the Riksbank easing cycle, an im-proving growth profile and the outlook for risk sentiment However, sentiment is fragile and SEK will be vulnerable during periods of EUR weakness EURSEK traded in a broad range during the last quarter of the year, weakening the im-portance of technical signals We expect EURSEK to close Q1 2013 at 8.45

EUROPE Camilla Sutton +1 416 866-5470 Currency Outlook Eric Theoret +1 416 863-7030

1.32 1.63 1.21 8.62

Currency T rends

20-Dec

Outlook Going Back

1.20

1.25

1.30

1.35

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

1.53 1.56 1.58 1.61 1.63

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

GBPUSD

1.20

1.21

1.22

1.23

1.24

1.25

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

8.10 8.25 8.40 8.55 8.70 8.85 9.00 9.15

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

EURO ZONE - Real economic weakness, which was

ex-pected to materialize earlier in the year as suggested by

depressed PMI and sentiment surveys, has taken hold in

the euro area in the final months of 2012 After averaging a

monthly gain of 0.1% m/m from January through August,

industrial production took a sharp turn downward, collapsing

1.9% in September-October The payback from a resilient

third-quarter GDP performance in the largest economies of

the euro area (driven largely by one-off calendar effects) will

elicit sharp GDP contractions in the final quarter, with

nega-tive carry into the New Year Nevertheless, there are

tenta-tive signs of a turning point; recent survey data saw

im-provements in the Ifo and ZEW expectation indexes, as well

as the PMIs We continue to anticipate that a tenuous

re-covery will emerge in mid-2013, though on account of the

worse expected performance in the fourth quarter of 2012,

we have trimmed our GDP expectation for next year to

-0.1% (from 0%) We maintain our 2014 forecast at 1.0%

Tail risks have been reduced by major central bank policy

and recent Eurogroup agreements on Greece and the

bank-ing union However, several uncertainties remain, includbank-ing

elections in Italy and Germany, progress on fiscal

consoli-dation, bank credit conditions, currency dynamics and

com-modity prices At present we remain of the view that under

this scenario, and with inflation expected to remain

con-sistent with price stability, the European Central Bank will

leave interest rates unchanged through 2014

UNITED KINGDOM – Despite considerable economic data volatility in the fourth quarter, the pound sterling continues

to gain The currency has climbed roughly 2.5% vis-à-vis the US dollar since mid-November, bringing it to a near-term high close to 1.63 Recent support has come from US monetary policy, tentative progress on the euro area bank-ing union, and a slight hawkish lean by the Bank of England

in the minutes of the latest Monetary Policy Committee meeting One factor threatening the sterling’s gradual ap-preciation trajectory is the recent decision by S&P to return the nation’s prized “AAA” sovereign credit rating to negative watch, matching the outlook of the other major rating agen-cies and suggesting a 1-in-3 chance of a downgrade in the next two years S&P cited concerns about the economic growth outlook and higher than projected borrowing require-ments (as government deficit targets were recently pushed back) On the economic front, developments have been erratic Likely offsetting a second straight drop in industrial production in October (which carried over into petroleum-dependent manufacturing industries, risking a triple-dip re-cession situation) was a substantial gain in construction output, which jumped 8.3% m/m in October Though labour market conditions remain solid, growth in retail sales has slowed sharply, averaging 0.8% y/y in October-November, down from 2.4% in the third quarter Inflation remained un-changed at 2.7% y/y in November Gas price and utility bill hikes will boost the headline rate in the coming months

SWITZERLAND - In the context of a relatively sound local

economic environment, rising imbalances in the mortgage

and real estate markets, and remaining external

uncertain-ties linked to the euro crisis and US fiscal situation, the

Swiss National Bank (SNB) will maintain a neutral bias

around its EURCHF 1.20 minimum exchange rate policy

through 2013 At the last policy meeting in mid-December,

the bank recognized that as the announcements of vast

monetary accommodation by major central banks have

helped to calm risk sentiment in global financial markets

since the summer, pressure on the franc has also eased

Nevertheless, the currency is still considered strong, with

persistent demand for safe Swiss assets bringing the yield

on ten-year bonds down to 0.33% on December 10th (a

global record low) An impressive 1.4% y/y output gain in

the third quarter was driven by a temporary revival in

ex-ports, which is expected to be reversed in the final quarter,

limiting the overall advance in 2012 to around 0.8% Despite

substantial growth in monetary aggregates in recent

months, the bank contends that there is no risk of inflation in

the foreseeable future, given continued spare capacity in

the economy, an expected increase in unemployment and

stable inflationary expectations The annual pace of

defla-tion reaccelerated in November, from -0.2% y/y in October

to -0.4% The SNB remains concerned about the effect of

an extended period of low interest rates on the domestic

real estate market and banking sector

SWEDEN - With the enduring debt crisis in the euro area weighing more heavily on the Swedish economy, the na-tion’s monetary authorities have employed further policy accommodation, lowering the benchmark repo rate to 1.00% at the central bank meeting on December 18th We anticipate that this latest cut marks the bottom of the current easing cycle (a cumulative 100 basis points over the last year), and that the Riksbank will begin to normalize rates by early 2014 The decision was underpinned by the marked loss of economic momentum in the second half of the year – specifically, on the domestic front (external demand has been lacklustre all year) Real GDP growth slowed from 1.3% y/y to 0.7% in the third quarter, and further slowing is implied by declines in industrial production and orders and services production in October Household and business confidence is deteriorating, as is the outlook for the labour market, and the Riksbank considers consumption and in-vestment to be weak The bank’s forecast for growth in

2013 was lowered considerably, from 1.8% to 1.2% (the projection for 2012 was left at 0.9%) Furthermore, the threat of inflation has emerged in recent months, with the headline rate falling below zero in November, to -0.1% y/y, for the first time in three years The krona has followed a gradual weakening trend since August, though we expect the currency to regain strength in 2013 on the back of the nation’s strong public finances, triple-A credit rating, and comparatively robust growth profile among EU members

Fundamental Commentary Sarah Howcroft +1 416 862-3174

JAPAN - The outlook for JPY has deteriorated; the newly elected Prime Minister Abe is expected to increase fiscal stimu-lus at the risk of pressure from rating agencies and global investors, while making aggressive changes at the BoJ, includ-ing the implementation of a 2% inflation target Finally, the territorial dispute with China poses economic risks Sentiment has turned rapidly against the yen, with the CFTC reporting a record short yen position of US$14 billion We hold a Q113 USDJPY target of 85

CHINA - CNY broke away from trading at the upper end of its trading band after onshore authorities finally stepped in to provide liquidity for what had been an unbalanced market since early November The stabilization in China’s economy has engendered CNY buying pressures on rising expectation for modest appreciation Policymakers appear content to allow CNY trading to evolve in a more market-determined manner, but still constrained within its daily trading limit We

expect USDCNY to close Q113 at 6.25

AUSTRALIA - The Australian economy is supported by tight monetary policy, limited fiscal tightening and stabilization in the outlook for China This combined with the FX impact of Fed policy has encouraged bullish investor sentiment In mid-December the net long AUD position (as reported by the CFTC) stood at a record high of US$10.9 billion Meanwhile, the low market volatility environment is encouraging the return of carry trades Accordingly, the outlook for AUD is bright, but dampened by fears over a peak in mining investment We hold a modest Q113 target of 1.05

NEW ZEALAND - Investor sentiment is increasingly bullish towards NZD, with the net long position at a record high of US$2.1 billion We are concerned that the market has gotten ahead of itself and the rally is too stretched, accordingly, even though NZD should see modest appreciation in 2013, we expect the first quarter to be disappointing, with NZDUSD closing at 0.81

ASIA/OCEANIA Camilla Sutton +1 416 866-5470 Currency Outlook Sacha Tihanyi + 852-2861-4770

84.3

Currency T rends

Spot 20-Dec

Outlook Going Back

6.23

1.05 0.83

75.5

77.5

79.5

81.5

83.5

85.5

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

6.20 6.25 6.30 6.35 6.40

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

0.96

1.00

1.03

1.07

1.10

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

0.74 0.77 0.79 0.82 0.84

Dec-11 Feb-12 Apr-12 Ju n-12 Aug-12 Oct-12 Dec-12

JAPAN - Japan’s weakening economic fundamentals and

improved Chinese growth prospects are driving a

correc-tion in the Japanese yen’s value, which has been tradicorrec-tion-

tradition-ally supported by persistent investor risk aversion and

mar-kets’ flight-to-liquidity dynamics We expect Japanese real

GDP to grow by 1.7% in 2012, and to record only a modest

average gain of 1% in 2013-14 as the tsunami-related

re-construction boom vanishes A change in political

leader-ship is taking place Following general elections held on

December 16th the opposition Liberal Democratic Party

(LDP) is returning to office With its junior partner, the New

Komeito party, the LDP will hold a two-thirds majority that

will allow it to push through legislation relatively easily

Shinzo Abe, the leader of the LDP and the forthcoming

prime minister, has been a very vocal support of further

monetary and fiscal stimulus, despite the fact that Japan’s

government finances are weak, with the debt-to-GDP ratio

likely to surpass 245% in 2013, and that the central bank’s

independence may be at risk Policymakers are seeking to

ward off deflation, to encourage a decline in longer-term

interest rates, and to provide a boost to private spending

Deflationary pressures are persistent, with consumer prices

dropping from year-earlier levels since June 2012 (the

headline inflation rate was -0.4% y/y in October) We

antici-pate that inflation remains dormant in 2013 before picking

up slightly to ½% y/y in 2014

CHINA - China’s economic outlook continues to improve with real GDP, sentiment indicators, industrial production, and retail sales indicating that a revival, albeit modest, is imminent We expect China’s output growth to reach 8% in

2013 from 7.7% in 2012, and to accelerate to 8⅓% in

2014 Inflation will likely pick up moderately from the No-vember level of 2.0% y/y, reaching 3.3% y/y by the end of

2013 Nevertheless, persistent deflationary pressures fur-ther up the distribution chain (producer prices dropped 2.2% y/y in November) alleviate any near-term concerns regarding significant upside pressure on prices Against this backdrop, we have made a minor revision to our ex-pectations regarding China’s monetary policy path We now assess that the People’s Bank of China’s benchmark 1 -year lending rate has reached its cyclical bottom at the current level of 6.0% Monetary tightening will likely com-mence in the first quarter of 2014, taking the policy rate to 6.6% by the end of that year China’s new leadership, led

by Xi Jinping (expected to take over the country’s

presiden-cy in March 2013) and Li Keqiang (set to become the premier), continues to highlight the need for a more bal-anced approach to economic development that prioritizes consumption over investment and exports Such progress would also improve stability and growth in China and the Asian region at large Nevertheless, we expect any ad-vancement on economic reforms to be gradual in nature

AUSTRALIA - The Australian dollar continues to be

sup-ported by relatively strong economic fundamentals, a

triple-A sovereign credit rating, still-wide interest rate

differ-entials relative to other advanced economies, and portfolio

investment inflows While the peak in resource investment

is approaching and monetary easing has taken Australian

interest rates to record lows, an imminent, though gradual,

revival of the Chinese economy together with strengthening

investor sentiment should support the currency through

2013 Inflation will likely continue to climb higher in the near

future from the third quarter level of 2.0% y/y, partly

reflect-ing the introduction of a carbon tax in July 2012;

neverthe-less, we expect the headline rate to remain within the

Re-serve Bank of Australia’s (RBA) target range of 2-3%

through 2014 Following a benchmark interest rate cut to

3.0% in early December, we assess that the current easing

cycle has now reached its bottom, with the RBA likely to

begin to normalize monetary conditions in the final quarter

of 2013 Australia is one of the fastest-growing economies

in the developed world, with the resources sector

continu-ing to be the key economic motor We estimate that real

GDP will advance by 3½% in 2012, with growth averaging

slightly less than 3% in 2013-14 The output pace slowed

slightly to 0.5% q/q (3.1% y/y) in the third quarter of 2012

from 0.6% q/q (3.8% y/y) in the April-June period, reflecting

slower household expenditure growth and cutbacks in

pub-lic spending

NEW ZEALAND - Initial signs are emerging that New Zea-land’s economic momentum will be picking up in the near term Improving housing market conditions and recovering consumer confidence point to forthcoming gains in house-hold spending Domestic demand continues to be the main economic driver, driven by earthquake-related reconstruc-tion investment; meanwhile, subdued external condireconstruc-tions will continue to weigh on the overall economic outlook as the country’s exporters battle with still-weak global demand and an elevated currency We expect New Zealand’s real GDP to expand by around 1⅔% this year, followed by a modest acceleration to 2⅓% in 2013 The Reserve Bank of New Zealand will likely maintain an accommodative mone-tary stance in the coming quarters, keeping the Cash Rate unchanged at a record low of 2.5% at the next policy meet-ing on January 30th Following the December 6th meeting, monetary authorities noted the improved global outlook, and assessed that the excess capacity in the domestic economy will be eliminated by the end of 2013 An eco-nomic revival will increase inflationary pressures, taking the headline rate to the central bank’s 2% target midpoint in

2013 from the third quarter 2012 level of 0.8% y/y Despite

a large – and widening – current account deficit (averaging 5% of GDP in 2012-13), the New Zealand dollar remains at

a historically high level vis-à-vis the US dollar as the coun-try continues to offer more attractive rates of return than most other advanced economies

ASIA/OCEANIA

Fundamental Commentary Tuuli McCully + 1 416 863-2859

INDIA - With the RBI holding policy through December and signaling greater ease with inflation, rate cuts remain on tar-get for Q1 2013, a factor that has helped interest in both equities and government fixed income However, INR remains challenged by a very weak current account position which continues to leave it at the whim of portfolio flows This makes the positive sentiment that should follow the resumption of an easing cycle fairly beneficial for the rupee We target 52.25 by the end of next year

KOREA - KRW continues to make new highs as official resistance to won appreciation has only managed to slow the pace of gain QE-related market forces have been significant drivers of portfolio flows into Korea, as the rolling monthly inflows to equities have reached six month highs while the current account has rebounded to exert further pressure The new government promises to bring a more tolerant view of KRW appreciation, a feature that helps to underpin our bull-ish outlook We forecast USDKRW at 1050 by Q4 2013

TAIWAN - TWD continued to see appreciation, though in a very moderate fashion as volatility in USDTWD fell to a multi -year lows in December The recent stable, strong CNY fixing levels have helped make TWD gains more palatable to the onshore authorities, and while Taiwan’s economy has failed to achieve escape velocity, export indications are im-proving in line with production, justifying a somewhat stronger TWD We doubt however that TWD can be any kind of outperformer over the next year, and target 28.75 by Q4 2013

HONG KONG - HKD has traded at the strong-side convertibility undertaking of the HKMA for the most sustained period

of time since 2009, reflecting strong QE-driven capital inflows; the Hang Seng Index has been the top regional performer since the announcement of QE3 Not only can the HKMA indefinitely maintain the current required interventions to de-fend the strong side of the band, we see no risk that the peg is dropped in the foreseeable future We target USDHKD at 7.75 through 2013

DEVELOPING ASIA

Currency Outlook Sacha Tihanyi + 852-2861-4770

1075

29.06 7.75 54.85

Currency T rends

Spot 20-Dec

Outlook Going Back

48 00

50 00

52 00

54 00

56 00

58 00

10 65

10 95

11 25

11 55

11 85

28 70

29 05

29 40

29 75

30 10

30 45

7.74 7.75 7.76 7.77 7.78 7.79

For Fundamental Commentary on developing Asian economies, please refer to our Foreign Exchange Outlook ,

December 2012, at www.scotiabank.com