Morgan Stanley Sees 10% Dollar Drop, Recommends Yuan

By Sandy Hendry

May 29 (Bloomberg) -- The U.S. dollar may drop another 10 percent on a trade-weighted basis by the end of next year, prompting traders to price in a stronger Chinese yuan, Morgan Stanley said.

“If market participants start believing that a sharp dollar decline is likely then we would expect increased questioning of the sustainability of U.S. currency pegs,” analysts led by Yilin Nie wrote in a report dated yesterday. An “increase in capital flows in such an environment would put severe upward pressure on the yuan,” they wrote.

The Dollar Index, which tracks the currency against the euro, yen, pound, Swiss franc, Canadian dollar and Swedish krona, tumbled 3.7 percent last week on concern the U.S.’s AAA credit rating may be jeopardized by record bond sales. It rose 0.4 percent this week.

Morgan Stanley said investors should buy forwards in the yuan and Hong Kong dollar, noting that the two currencies’ exchange-rate links would not have to break for the trade to make money. “Markets only need to price in the risk of a break,” the report said.

Yuan Halted

China has kept yuan appreciation in check since July to support exports after the economy’s growth rate slowed to 6.1 percent in the first quarter, the least in almost a decade. U.S. Treasury Secretary Timothy Geithner pledged last week that the U.S. will urge China to allow more gains in the yuan, even after the currency rose 21 percent since a peg to the dollar was ended in July 2005.

The yuan’s 12-month non-deliverable forward has gained 9 percent since Dec. 1 to 6.695 per dollar on speculation a weakening U.S. currency would prompt China’s government to resume a policy of allowing appreciation. The spot rate has risen just 0.8 percent in that time to 6.828.

Forwards are agreements to buy and sell assets at current prices for delivery at a specified time and date. Non- deliverable contracts are settled in dollars.

Hong Kong has linked its dollar to the U.S. currency since 1983, allowing it to trade 5 cents on either side of HK$7.80. The exchange rate has held around the HK$7.75 upper limit of its permitted range since October.

Morgan Stanley also recommended buying the yen, Canadian dollar and Norwegian krona against the dollar.

To contact the reporter on this story: Sandy Hendry in Hong Kong at shendry@bloomberg.net