Statistics for RMB OTC Closing Values in 2006

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1 Bracing For More RMB Volatility Summary n Post IMF/G7 meetings, RMB continued to maintain a steady strengthening trend but in rising volatility, as talks of a one-off move gave way. We expect such RMB gradualism to extend into 27 and has lowered our end-26 call to 7.85/USD from 7.78 earlier, while we look for further strengthening to 7.55 by end-27. n After the implementation of policy and administrative measures since April to counter overheating, recent data are showing signs of softening though still far from meeting official targets. We see risk of just a more PBoC interest rate hike by end-26 to ensure moderation is on track. n Economic growth is still expected to be above-1% in 26 but into 27, lagged effect from tightening measures should see China's growth expanding at below historical growth rate of 9.9%. RMB Maintains Appreciation Trend Throughout 3Q6, the RMB strengthened against the USD in a choppy manner as a number of major events came and went, including the first anniversary of RMB revaluation (21 Jul), US Treasury Secretary Henry Paulson's speech on global economy and currency (13 Sep) G7/IMF/WB meetings (16-2 Sep), and Paulson's official visits to China (19-22 Sep). It is apparent that the US' stance on the RMB has shifted as the new US Treasury Sec takes on a softer approach compared to his predecessor John Snow. While the appreciation trend is clear, the RMB's moves have become more volatile as the authorities continued to emphasize more "flexibility" in the currency and no more one-off revaluation in the RMB. This was reiterated clearly by China's Premier Wen Jiabao on 5 Sep, just ahead of the G7/IMF meetings: a market-driven and increased flexibility for the RMB, and "no more surprise adjustment" in RMB exchange rate. As such, it is not surprising to see rising volatility over the past two months, as the RMB hit new highs. On 28 Sep, the RMB central parity fixings broke another key level and hit post-revaluation high of against the USD vs the day before, for a gain of 2.7% since the 2% revaluation on 21 July last year. Statistics for RMB OTC Closing Values in 26 Period Number of Biggest % change in Smallest % change in Average % change in Standard months RMB vs. USD RMB vs. USD RMB vs. USD Deviation 1 Jan - 28 Feb Mar - 31 Jul Aug - 28 Sep Source: Bloomberg; UOB Statistics for RMB Daily Fixings in 26 Period Number of Biggest % change in Smallest % change in Average % change in Standard months RMB vs. USD RMB vs. USD RMB vs. USD Deviation 1 Jan - 28 Feb Mar - 31 Jul Aug - 28 Sep Source: Bloomberg; UOB 1

2 More telling is that daily volatility, as measured in standard deviation and trading range, has expanded significantly since the beginning of the year, as shown in the tables. Note that so far the USD/RMB moves have stayed well within the ±.3% trading band, although the magnitude has increased significantly. For instance, on the OTC market, the biggest moves earlier this year were kept within.6-.9% but have risen to around.25% by the Aug-Sep period. Standard deviation, a more accurate measure of volatility, has risen to close to.1% by Aug-Sep, more than 3 times as volatile compared to early this year. Going forward, the USD/RMB pair is expected to see more volatility as the PBoC continues to maintain a two-way trade on the currency (or avoiding a one-way bet), and to prepare for the currency's eventual free float and full convertibility of the capital account (which would be years away). Under the traditional macroeconomic framework (the so called "impossible trinity" or "policy trilemma", formally known as the Mundell-Flemming model), the central bank would have to let the currency float if it intends to maintain independent monetary policy and full capital mobility. With a one-off revaluation off the table, one potential risk is a widening of the USD/RMB trading band, as the daily fluctuations hit closer the limits, as shown in our tables. PBoC governor Zhou Xiaochuan reiterated on 21 Sep that there is "no fixed timetable" on band widening. In line with the current PBoC's tightening stance to moderate growth and the need to address global imbalances, we see the RMB to stay on its gradual appreciation course against the USD. However, the road ahead for the RMB is expected to be a bumpy one, as the authorities attempt to avoid the appearance of a one-way bet on the currency and any remaining expectations of another one-off revaluation. Going by the general view, a 3-5% annual appreciation of the RMB against the USD is unlikely to hurt Chinese exporters' bottomlines severely. OTC Market Daily Parity Fixings RMB Volatility Measure 26 Standard Deviation Against this background, we believe that our earlier call for RMB at 7.78/USD by end-26 - which represents a.2. total cumulative gain of 6.3% since the July revalution - may be overly aggressive. We thus revise down our end- 26 RMB forecast to 7.85 against the USD (27 Sep spot: 1 Jan - 28 Feb 1 Mar - 31 Jul 1 Aug - 28 Sep 7.92), or a cumulative gain of 5.5% since Jul 5, and a further 4% strengthening to 7.55/USD by end-27 (vs. earlier projection of 7.7). The USD/RMB non-deliverable forward market is also pricing in similar trends, with the 3-month NDF currently looking for USD/RMB at 7.83 and 12-month NDF at USD/RMB Daily Trend USD/RMB Non-deliverable Forwards (NDF) USD/RMB Jul 5 Nov 5 Mar 6 Jul M NDF 6M NDF 12M NDF USD/RMB Jan 6 Mar 6 May 6 Jul 6 Sep 6 2

3 While the IMF/WB meetings came to pass without creating much wave on the FX front, event risks ahead have been greatly diminished with the US Treasury Sec Paulson taking a different and less hardened approach in dealing with global imbalances and the RMB. We believe the efforts by US politicians such as senators Lindsey Graham and Charles Schumer's in pursuing a vote on the punitive trade bill against China to have minimal impact on the RMB given that the US president could delay the legislation if he is convinced that China is making progress on currency reform. Similarly, the risk that the semiannual US Treasury's "Report to Congress on International Economic and Exchange Rate Policies" would raise the "currency manipulation" issue has also diminished for now. Key Events Ahead on RMB 8-11 October China Communist Party s Central Committee annual meeting October/November US Treasury s semiannual report on International Economic and Exchange Rate Policies 7 November US mid-term elections Source: News wires China s Key Policy Measures on RMB and Economic Overheating 3 Aug 26 PBoC raised reserve requirements for foreign currency deposits to 4% from 3%, effective 15 September. 18 Aug 26 PBoC raised lending and deposit rates by 27bps, effective 19 Aug. The 1-year benchmark lending rate was raised to 6.12% from 5.85%, and the 1-year deposit rate was increased to 2.52% from 2.25%. 21 July 26 PBoC raises banks reserve requirement ratio by 5bps to 8.5%, effective 15 August. 16 June 26 PBoC raises banks reserve requirement ratio by 5bps to 8.%, effective 5 July. 29 May 26 Cabinet issues package of measures to deter property speculation, including 3% of downpayment from 2%. 27 April 26 PBoC hikes benchmark 1-year lending rate by 27bps to 5.85% but deposit rates stay unchanged. This is the first hike in 18 months. 21 July 25China unpegs and revalues RMB by 2.1%, moving from to 8.11 per USD. 28 Oct 24 PBoC hikes interest rate for the first time in 9 years, moving 1-year lending rate up 27bps to 5.58%, and 1-year deposit rate up 27bps to 2.25%. Source: PBoC; CEIC; news wires Further Growth Moderation Going into 27 With successive PBoC's hikes in banks' reserve requirement ratios and interest rates since April to head off an overheating economy, recent data suggest that the impact of these policy moves is slowly being felt. The closely watched fixed asset investment (FAI) data has slowed to 29.1%y/y in Jan-Aug, from 3.5%y/y in Jan-Jul. For the month of Aug alone, overall FAI decelerated sharply to 21.5%y/y from 27.4%y/y in Jul and 33.5%y/y in Jun, the slowest since Dec 24. One observation is that current overheating environment is relatively benign compared to early 24 when overall FAI growth rates were running at well above 3%y/y pace in the first half. Nevertheless, the latest figures continued to stay above government forecast of 25% for the FAI in 26. 1Y Lending and Deposit Rates China 1Y Working Capital Lending Rate China 1Y Deposit Rate % Jan 3 Jan 4 Jan 5 Jan 6 3

4 At the same time however, excess liquidity from the build up in foreign exchange reserves continued, with another trade surplus of US$18.8bn in Aug, vs. previous record high of US$14.6bn in July. China's foreign reserves have increased by an average of US$19bn per month so far in 26, well above the US$9.3bn monthly average in While this reflects China's growing clout as a manufacturing centre in Asia, the resulting forex inflows also create a flush liquidity condition in China. Fixed Asset Investment Growth 4 As a comparison, the monthly average of US$19bn increase in foreign exchange reserves is equivalent to RMB152bn, or close to 38% of the average monthly increase in M2 money supply. Put another way, the forex inflows have had the effect of adding.58% point to China's monthly M2 growth this year. While M2 slowed 3 2 Jan 4 Jan 5 Jan 6 to 17.9%y/y in Aug from 18.4%y/y in July, it remains above official target of 16% for 26. Given the average M2 growth of 18.7%y/y in the Jan-Aug period, it implies a sharply lower M2 growth of just 1.6%y/y per month for the Sep-Dec period in order to achieve the official 26 forecast of 16% Fixed Asset Investment FAI: New Construction %y/y China: Foreign Reserves China: Foreign Reserves, Monthly Flows China: Foreign Reserves (USD bn) China: Foreign Reserves (USD bn) Average Monthly Flows: Jan 1 Jan 2 Jan 3 Jan 4 Jan 5 Jan 6-2 Jan 1 Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 However, pace of slowing down in recent data has been quite moderate and we see risk for one last rate hike of 27bps by end-26, to bring the benchmark 1-year borrowing rate to 6.39%. With US interest rate expected to pause for now, there is little room for the Chinese authorities in raising interest rate, as further rate hikes are likely to exacerbate more funds inflows due to the positive rate differential. Increased domestic interest rates also encourage banks to lend out more due to the higher margins, thus defeating the purpose of monetary tightening. GDP Growth Source: CEIC As such, we only assign a probability of 6% for the next Chinese rate hike. Instead, we see the PBoC relying more 1Q 3 4Q 3 3Q 4 2Q 5 1Q 6 on administrative measures to direct lending away from "undesirable" sectors (such as low-value added and inefficient sectors), as well as to pursue on the FX front to strengthen the RMB as part of the larger solution GDP (y/y%) 4

5 On the economic growth front, China's latest data point to firm growth momentum in 2H6. We maintain China's growth forecast at 1.4% in 26 from 1.2% in 25 (data revised up from 9.9% in August). This implies 9.9%y/y pace in 2H6, which is consistent with the average annual growth rate of 9.9% over the period of Going forward, we see China's economic expansion to moderate to around 9% in 27 on lagged effect from rate hikes and administrative measures, as well as the higher base in 26. Note that with China's 11th five-year Plan (26-21) targets annual average growth rate of 7.5%, this implies an average growth rate of just above 6% for the remaining period of if our forecast for 27 pans out. 5