2010 Annual Outlook Transitioning into A Brave New World Citigold citibankIndia Macroeconomics : Prospects 2010 WE EXPECT... © Upside surprises in industry to offset a weak summer crop, likely resulting in FY10 GDP growth of 6.296YoY ancarecovery to 7.896YoY in FYTIE, © Key concerns to be inflationary pressures, if food and fuel prices continue to rise and continued dollar inflows. This could likely make management of flows a challenge. On a positive note, we think clarity on divestments would help alleviate the fiscalsituation © While loan growth remains anaemic, better-than-exgected IIP data and rising WPI will kely prompt tightening by early 2010. On the rupee, our view remains that of a structural appreciationin the currency. WHAT'S HAPPENED SO FAR ‘© While itis early days yet, agriculture has surprised on the upside and as mentioned nour 20FY10 GOP update could result in ~SObps upside to our full year estimate of 6.2% Growth likely to post a recovery by FYI Lower agriculture output will likely be offset by stronger industrial production. With the 2009 Monscons being the worst in decades and the year being declared as an al-india drought year, overall agriculture growth is ikely to come in at -4%, However, Unlike past droughts, the impact should be muted due to (1) ongoing stimulus ‘measures, namely the national rural employment guarantee act, the farm waiver and the pay revision; and (2) the impact of new hydro-carbon discoveries coming on stream. GOP will ikely moderate in FY10, before posting a recovery in Fy. Despite the ‘momentum in industry growth, overall GDP in F¥10is likely to come in at 6.2% Vs 6.7% inthe previous year. Going forward, with the improvement in the macro-environment, we expect the investment cycle to regain momentum thereby resulting in FYI GOP. ‘growth coming in at 7.8%. Fiscal- some light at the end of the tunnel Deficits are els. The United Progressive Alliance's (UPA'S) first budget in its new term was a disappointment, with the FYT0 fiscal and revenue deficits pegged at 6.8% and 4.896 of GDP respectively. With expenditures crossing the RslOtrn mark, the headline deficit numbers are now back at levels last seen in 1991 ‘Adding on the state fiscal deficits an¢ off-balance sheet items, the deficit is now close to double-digit levels. However, post this fiscal year, we see reasons to be hopeful. On the revenue side key factors are () better growth thal would result in revenue buoyancy, (2) divestment proceeds, (3) a roll-vack in some fiscal stimulus measures such as lower excise duties (On the expenditure side, the leeway here appears to be in (1) the farm waiver, as most payments are likely fo be done by FYTO, and (2) arrears of the pay commission, which are likely to be paid out by FYTO. An added bonus could be the phase-out of some subsidies, possibly in the fertiliser & oll space, oExternal Sector - management of FX flows a key focus area Current Account will likely turn to a surplus in FY1I, While higher oil prices took their toll on the current account resulting in the deficit widening to 2.6% of GOP in FY09, new hydrocarbon discoveries coupled with lower prices are likely to result inthe CCAD narrowing to 0.8% of GOP in FYIO. We expect to see current account surpluses from FYII onwards, although an uptrend in invisibles could positively impact the numbersinF 10 as well Managing capital flows will be a key challenge. Dollar weakness and relatively higher tic growth coupled with monetary tightening sets the environment continuation of capital inflows. We believe that similar to FYO8, the RBI could once again be caught in the trap of the ‘impossible trinity’. In response to rising flows, we expect (1) the initial goal would be to re-build reserves that were run down during FY09, 2) some INR appreciation to offset inflationary pressures, and (3) although we do not exgect that India will impose ‘punitive controls’, one could see a reversal of Some measures taken last year. This could include tightening ECB and banking capital norms, reducinginterest rates on NRI Deposits, and encouraging capital outflows Monetary tightening to begin by early 2010 While current trends are still benign, inflationary pressures will likely mount in 2010. We expect the headline WP to rise to 696 levels by Marl0, fram 1.3% currently. However, two key risks are (1) Agriculture ~ a poor crop could add to pressures if prompt measures are not taken to release the buffer stock of food grains ang impart items. (2) Rising crude prices: given that transport and cooking fuel prices are administered, the extent of the impact on inflation would degend largely on the extent to which prices are raised. This would be a balancing act between raising fuel prices and in‘lation, vs keeping them constant and imposing fiscal strain/under-recoveries for oil companies. We expect rates to be tightened by 125bps over the year. While loan growth remains anaemic, better-than-expected IIP data and rising WPI wil likely prompt tightening oy carly 2010. We maintain our call of 125bps tightening in 2010 as inflation is primarily supply-side driven and excess tightening would have implications for the rupee. Financial markets Yields could breach 8% levels if inflation surprises. While our base case is that of Yields rising to 775%-8% levels, inflation breaching 8% could result in more aggressive monetary tightening and yields edging to 8.5% levels. A few points that may prevent yields from spiking are: (1) the market is pricing in a tighter liquidity environment next year. (2) Although the cushion available via un-winding the MSS is no longer available (outstanding MSS at Rs!88bn), this could change depending on capital inflows. (3) Lastly, the RBI nas enough levers available to make sure that there is ‘enough captive demand for bonds. Rupee likely to continue along appreciation path. With the underlying theme of dollar weakness and relatively strong domestic growth, we see the INR trending to Rs44/USS and Rs41/USS in Mar10 and Marit respectively: However, similar to other EM assets, there would be atussle between risk on’ and 'isk off 2India Equity Strategy : Road Ahead 2010 India's economy is back on the growth path, but the high fiscal and monetary costs involved are not yet factored completely into the market. Is ita platform, or a springboard, for growth? - India’s economy never did dip deep ~ andit has come out pretty strong, clearly suggesting that it caught achillrather than a flu. So,is the patient still convalescing, orisit out of bed ang aumping iron? We believe the patient isup and about, but thatithas not yet regained full vigour. Risk appetites alittle dimmed, fiscal flexibility isa little reduced, andinterest rates are only going in one direction. Stil, India appears well-positioned to go for growth-the riskis that the market's exgectations for the pace of that growth willbe disappoints The investment cycle has stabilized - the capital market cycle has helped and will remain a key driver. Urban consumption has kicked in with a vengeance, but rural remains a risk because of the monsoon. And while hopes are high to attain fiscal stability (perhaps too high), the data remain weak and are in need of more decisive Government action -such as divesting state-owned assets in a determined anc speedy fashion, In short, there's a fair amount of good happening in the economy = the pick-up is relatively broad-based and balanced and, unlike in 2007, the recovery should be reasonable rather than breakneck (and thus more sustainable). It does not come free - But the rapid return to reasonable growth has come at a cost ~ the fiscal deficit has jumped on an already high leverage that the Government carries, and easy money raises the spectre of inflation (1396 only 18 months ago). These factors, individually and collectively, betoken higher interest rates, possibly ahead of peer nations. Equity markets are undoubtedly pricing in some of this overhang - and the risks to the stll-stablising economic recovery ~ but we probably won’t know how accurately until early to mid 2010. Playitsafe Leading into 2010, we would be a little defensive in constructing a portfolio - nat too ‘squeamish but prepared to keep some powder dry until therate interest and fiscal risks play out. That opportunity should present itself in the first half of 2010, in our view. A re-run of 2009s not likely, however ~ the upcoming opportunity willbe more nuanced and the gains will be smaller. ut it will be an opportunity nonetheless, and it will be worth waiting for any near-term falls to maximize the returns. In any case, on a longer return horizon, the economic revival would overwhelm near-term rate risks, Buy what sells - We expect demand in india to be solid in 2010 and beyond, but that it willbe harder to find than in the booming 2003-2008 years. And we believe the market will be prepared to pay for it (and that businesses will make profits on it - unlike in 2003-08). So, the tnemes we Believe wil play out are: a) Urban consumption - the fear is gone, lifestyle upgrades are unlikely to be reversed (for the most part), and hey, the job market appears to have opened up, too, and b) IT services demand - the World's corporates have not invested for a few years: the ones wha have survived, and there are many, would emerge from their shells and get on with life, resulting in more aggressive outsourcing. We also believe the Government will continue to invest into the rural and social sectors - some will be in the form of handouts, but there should be enough ahysical investment and infrastructure creation to provide a sustained ‘opportunity for investment, monsoon risks notwithstanding Rising rates still pose a meaningful risk to the markets and the broad economy. ‘Sell what borrows - We believe the rate risk is being underestimated ~ not necessarily, inits possible impact (which we think will be only moderate for the real wor'd) but by recent sector performance, in which rate-cyclicals have moved up (as if rising rates drive up stock ices, rather than push them down). This outperformance of the banks (most clearly) andreakestate developers (to alesser extent) willbe the very reason for their underperformance in the more immediate term, in our view. 0GLOBAL EQUITIES A Sustained, But Uneven Global Recovery With almost all major economies exiting recession in the secend and third quarter of 2009, the initial bounce in global output appears solid across major economies and regions of the world. However, follewing this stimulus driven bounce, Citi analysts expect recovery to become much mere uneven with Asia ex-Japan expected to generate the strongest growth and Europe and Japan generating the weakest. Thus, while optimism regarding the global recovery has been building over the second haif of 2009 and the momentum of recovery is likely to translate into continued strong ‘growth data in many regions of the wor'd in eariy-2010, Citi analysts express caution as the apparently synchronous recovery of 2009 is expected to transform into a more uneven growth pattern around the world through the remainder of 2010. For Asia exvapan the trends of 2009, are expected to continue in 2010. Large monetary and fiscal stimulus combined with relalively healthy banking systems, competitive exchange rates and inter-regional economic integration have spurred a strong V-shaped rebound that s expected to be sustained in2010-M. Asia Ex-Japan has, accounted for approximately 25% of global growth in the last 10 years and might account for as much as 40% of global growth in 2010-1, ‘A more gradual medium-term recovery is expected in Europe and Japan. The euro area recovery is expected to be capped by poor credit availability and corporate retrenchment, the strong euro and, in some Economic and Monetary Union (EMU) ‘countries, major fiscal restraints. For the US, previous imbalances in housing, household savings and corporate aver-expansion have largely corrected. Despite only slowly improving crecit availabilty, a fairly solid recovery is ikely in 2010-1 though the mecium: term fiscal outiook is a big policy challenge. Equities - Moving Into The Earnings Recovery Phase In 2010 ‘As we exit2009, Citi analysts believe 2010 is the year in which we will begin to see earnings recovery. Thus, while price-earnings (PE) multiples expanded even as earnings estimates were cut through much of 2009, 2010 is expected to be characterised by more stable or even declining PE multiples and for the first time in this cycle, sing earnings expectations, In particular, Citi analysts note that the recovery phase may see increased volatility compared to that seen during the multiple expansion phase. However, should such volatility arise, they view such market setbacks as opportunities in the recovery phase of the market. Moreover, where top-down strategies such as buying sectors tr themes are appropriate in the multiple expansion phase, the recovery phase (in 2010 as expected by Citi analysts) historically sees more bottom-up, stock-level strategies drive returns in markets us Citi analysts do not expect a powerful upturn that might be anticipated after such @ deep and long slide, but believe a moderate turn that can nd a gradival retreat from maximum policy support seems increasingly likely. Diminishing drags from financial markets and housing suggest that the positive GOP growth is likely to be sustained. The path for monetary policy is complicated by the uncertainties surrounding the exit from near-zero rates and the Federal Reserve's (Fed) expanded balance sheet. Active retreat is expected to begin later next year, contingent on confidence in a sustained recovery with supportive financial conditions and a consensus that inflation s unlikely to slow further. Equity market gains in 2010 are likely to be uneven and Citi analysts see potential for the S&P 500 to spike above 1,200 during earlier parts of the year before backing off Their year-end 2010 forecast for the S&P 500 and Dow Jones Industrial Average currently stands at 1175 and 11150 respectively. Equity markets should benefit from a backdrop of earnings driven by inventory re-stocking, a better (though still subdued) ‘employment environment, and the consumption benefits of some restored wealth via stronger financial markets. All of these dynamics are expected to bolster equities ritially, especially if money flows begin to chase returns, as has often been the case in the past.But Uneven Global Recovery Europe Following strong GDP growth in the second half of 2009, a modest recovery with low inflation is expected in 2010 and 2OIl. The European Central Bank (ECB) is anticipated to keep interest rates on hold until early 2011. With deleveraging inthe euro area banking sector and also in the household and corporate sectors the exit fram monetary and fiscal stimulus rmeasuresis likely to be gradual In Cit’ opinion, recovery may not be fully priced into the equity market. Valuations do not look stretched, and equities appear to offer value relative to risk-free assets, The coming quarters should be increasingly about confirmation of recovery rather than expectation. Overall, global economic recovery, a robust corporate profit recovery, attractive valuations, and improving demand for UK and European equities are likely to drive returns over the next 12-18 months. Citi analysts’ yearend 2010 target for the Dow Jones Stoxx 600 and FTSE 100 currently stands at 260 and 6,000 respectively Japan After an anticipated temporary pause in activity early next year, the Japanese economy is likely to return to a growth ath somewhat above the potential growth rate of the economy (+0.5 to +,0%) in 2010, mainly driven by a steady increase in exports, particularly to Asia. But deflation could persist well into 2071 amid substantial economic slack anc declines in unit labour costs. Japan's fiscal condition is Unikely to improve over the next couple of years, but high private savings could keep long-term interest rates relatively ‘ow in the near future. The Bank of Japan (Bo.)'s expected to maintain the current policy rates (0.1%) untillate-20'. Citi analysts expect the Japanese equity market to head higher alongside global equity markets in 2010, as the global economy continues to recover, Their TOPIX fair value estimates currently stand at 950 and 100 for end-March 2010 and year-end 2010 respectively. Citi analysts think environmental technologies look promising as they foresee ‘market growth in next-generation autos, photovoltaic power generation, nuclear power, zero-emission housing, and energy efficient machinery. Asia-Pacific exJapan With Asian economies leading the global recovery in 2009, Citi analysts expect Asian economies to lead the withdrawal ‘from the crisis-related stimulus through much of 2010. As a resull, more moderate expectations for equity returnsin 2010 's required, leaving Citi analysts expecting 2 modest 9-14% riseinthe MSCI Asia-Pacific exvJapan index Moreover, they expect that the first half of 2010 should fare better than the second half as economic growth incicators remain strong while year-on-year comparisons remain attractive against the challenging backdrop of the first half of 2009. They continue to expect the North Asian markets of Hong Kong, Korea and Taiwan to lead this first semester rally, while South East Asian markets are broadly expected to lag, Although growth appears strong in China and India, valuations remain the key challenge for investors, This more cautious outlook for the new year is driven largely by the valuation picture within Asia. At 2:h book value, Asian equities now price a relatively mature economic cycle by historicalstandards. Indeed, since1974, Asian equity markets have not reached this valuation one year into economic recovery. Such valuations tend to be more consistent with years3-5 of renewed growth Citi analysts also note the growing discussion over the prospect of a coming emerging market/Asian asset bubble. While they do not discount the potential in the future, an analysis of bubbles experienced around the world over the past 35 years, with the exception of the 1998-2000 cycle, shows thal parabolic moves in equity markets ("bubbles") tend to occur only after month 30 of the recovery, and {generally during mid-cycle growth slowdowns experiences in G3 economies. These slowdawns tend to make Asian growth assets more attractive and draw large amounts of capital into the relatively smaller markets of Asia, As a result, while they do not discount the potential that Asia/emerging markets may be the epicentre of the next global bubble, they believe the probability of seeingit occurin 2010 is very slight. China Leading the globe into recovery, China's economic recovery remains on track for 2010, While loan growth is expected to moderate in the coming year, the estimated 18-20% growth expected by Citi analysts is likey to continue to provide ample liquisity to achieve the near 10% GOP growth forecastin 2010, The Renminbi (RMB) is expected to become the focus of Chinese policy as well as investors in the coming year. The Chinese government may be hesitant to seek strength in the RMB and the most likely policy move is a shift to a peg to a basket of currencies rather than the US dollar, allowing for a more gradual appreciation pace. Gradual appreciation however creates the prospect of hat money flows, supporting and potentially driving asset prices higher in China, and suggests a higher-beta orientation in Chinese equities. Korea The resilience of Korea's domestic demand in 2009 leaves Cit analysts forecasting a strong and broad-based 47% GDP ‘growth in 2010. The rapid recovery of the Korean labour markel looks likely to continue to bolster private consummation growth while the re-acceleration in exports in late-2009 is expected to provide added economic momentum in the coming year. Against this backdrop, modest policy tightening is expected from the Bank of Korea, though fiscal policy in Korea is likely to maintain its current expansionary stance. With relatively cheap valuations and continued economic momentum into 2010, Citi analysts see ‘opportunities as banks begin to see the benefits of declining credit costs and rising margins while consumer and cyclical companies are anticipated to see benefits from on-going cyclical recovery. Taiwan Though optimistic on the near- term outlook for Taiwan, Cit analysts take 2 more cautious medium-term View. In the near-term, strong liquiity flows are expected to dictate market performanceWhile earnings momentum remains positive in early-2010, However, moving into the second half of 2010, earnings headwinds in the technology sector in particular, may pose greater challenges to the market as a whole. More speciticaly, rising tax rates, a strengthening Taiwan dollar and the absence of inventory restocking momentum by end- 2010 create a potential overhang to the 12-month return prospects in Taiwan. More secularly, progress towards Improving cross-straits relations has shifted to a more visible process, reducing the prospect for incremental surprises for themarkets. Central & Eastern Europe, the Middle East and Africa (CEEMEA) Poor credit availability and limited chances of a strong export, rebound point to a modest economic recovery in 2010. For ‘many countries in the region, the pre-crisis drivers of GDP growth were heavily related to the availability of credit, particularly by foreign lenders. Looking into 2010, banks are likely to be cautious about expanding their local balance heels in most CEEMEA economies, and so. domestic spending may find ttle support from credit availability. Nonetheless, CEEMEA equities have lagged other emerging ‘market regions and now look attractively valued an a relative basis. Fund flows into emerging market equities have been boosted by the weak USD and recovery in investor risk appetite, and a continuation of these flows is believed to lend ‘support to equity marketsin the region. Citi analysts however rote that equity markets in the region could face a number of challenges - 1) the vigour of economic recovery, which remains uncertain; 2) the prospects for a tightening of monetary policy, where interest rate hikes could potentially pose a threat to equity markets; and 3) potentially lower commodity prices, which are an important component of the ‘earnings base of the region. Disappointments on any of these fronts could pose a challenge to equity markets in the first part ofthe year. Latin America With ample global liquidity going into 2010, the recovery prospects for Latin Americais expected to be well supported, but could present policymakers with new challenges. Citi analysts believe that central banks in the region may be pressured to hike rates sooner, while fiscal policymakers may soon begin to withdraw some of the stimulus enacted in 2009, Aiter the substantial gains of 2009 — the strongest year for Latin American equities since 1991, Cit’s base case for 2010, remains positive although the pace of gains is anticipated to ‘be much slower than 2009, as is typical of the second year of a bull market, Citi analysts believe that the anticipation of higher US rates could trigger a correction in the first half of 2010, and create anew entry opportunity 06 ‘A Sustaned, But Uneven Global Recovery Brazil Citi estimates 2010 GOP growth of 5%, with an upward bias to this forecast given the consistent signs of improvement in the labour market as well as in crecit concessions. The output gap is likely to continue to narrow in coming quarters, and interest rate hikes may be required by around Aprl 2010, when capacity, use is likely to reach levels that could pressure consumer inflation. Overal, the central bank is expected to increase the Selic rate by 200 bps in 2010, through SO bps increments. On fiscal policy, the deterioration in fiscal position seen in 2009. is anticipated tobe partially offset by a recovery in tax revenues as activity rebounds, reducing the risks on this front. Brazil remains Citi analysts’ favoured market within Latin ‘America based on expectations of a strong economic recovery ‘and limited upside to interest rates next year. They exaect the Brazilian equity market to continue its strong performance in 2010, and see potential for the Brazilian Bovespa to reach 180,000 by the year-end. =COMMODITIES ‘The outlook for the global economy continues to improve and fund flows into commodities have been rising following a sharp pullback in the second half of 2008. Upward revisions to gl {and anticipated subdued inflation and hence low interest rates, combined with an ‘overall weak USD view, provide a constructive backdrop for commodities in 2010. ENERGY: Citi remains positive on the outlook for oll and are forecasting for the West ‘Texas Intermediate (WT) crude oil price to average at US$80.50/bbI for 2010 and US$85.00/bal for 2011 and 2012. Key risks to the outlook are () still substantial product overhang, (2) investor interest in oil and oil products may not grow as quickly as projected, and (3) further deterioration of Organisation of the Petroleum Exaorting Countries (OPEC) compliance discipline and disagreements about quota. For natural gas, a combination of potential coal-to-gas switching and high storage inventories may see average spot prices this US winter bound between US$375-US$5.25/mmBtu A recovery in industrial demand is anticipated to lead to higher prices in the long term, Citi analysts forecast US natural gas prices to average at US$4.90/mmBtu for 2010, US$5.50/mmBtu for 2011 and US$5.80/mmBtu for 2012. The main risks to the forecasts are to the upside and could materialise if the US adopts stringent carbon cap-and-trade legislation (which benefits natural gas relative to coal) or current driling improvements prove to be short-ived BASE METALS: Citi analysts think the base metals complex appears fully priced and see prices in a broad range over the course of 2010. Chinese demand continues to be strong for metals, particularly from the auto sector. But at the same time, accumulated inventory also remains at elevated levels. Catalysts for base metals to move higher include (1) a surge in ex-China demand as advanced industrial economies gain traction and/ or (2) production cutbacks to reduce inventory levels particularly in aluminium, zinc and nicke! PRECIOUS METALS: Precious metal prices have risen in 2009 with Gold a favourite for those wishing to buy a 'non-currency’ with inflation- and credit-grotection characteristics. Central bank buying has also been a notable feature with China increasing its gold reserves ay 75% in the second quarter of 2009. Even so, at US$31 billion, gold hoidings account for only 1.5% of China's total reserves, among the lowest in the world and is a potentially important source of longer-term support for gold on the prospect for further buying by China. Citi analysts expect gold prices to average US$1162/oz for 2010, USS1,133/0z for 2011 and US$1,033/oz in 2012. Silver prices continues to track gold driven by the key factors in common to both markets - jewellery ‘and investor demand. Citi analysts however see potential for silver to outperform gold given its superior leverage to the industrial cycle. They forecast silver prices to average USS18.50/az for 2010, US$I7.8O/oz for 2011 and USS16.10/02 for 2012 BULK COMMODITIES: Demand for coking and thermal coals likely to remain strong as steel mills in China run at high capacity and Organisation for Economic Co-operation and Development (OECD) demand rebounds. With the onset of an early winter and likely snowy weather in China, coal prices are likely to remain robust in 2010. China's reduced exports and higher import levels are key to the positive coal views as supply remains under pressure with port and rail bottlenecks in Australia, Canada and South Arica. China's increased production costs driven by safety and consolidation also continue to underpin international prices. Citi analysts forecast coking coal prices to average US$134/t for 2010 and US$140/t for 2011 and 2012, and forecast thermal coal prices to average USS7S/t for 2010 and USSBS/t for 2011 and 2012. AGRICULTURE: Rising supply and elevated stock levels are likely to keep corn and wheat prices under pressure in the near term, but a recovery in demand as the global economic recovery takes hold could lend some support further out. Citi analysts forecast corn prices to average US$3.73/bu for 2010, US$4.04/bu for 2011 and US$4.10/bu for 2012, and forecast wheat prices to average US$477/bu for 2010, USS5.08/bu for 2011 and USS5.21/bu for 2012. Soybean and soybean oil are also expected to suffer from elevated supply but prices are likely to be suaported from rising US demand, elevated crude oil arices and expectations for a weaker USD later in 2010. Citi analysts forecast soybean prices to average US$957/bu for 2010, US$9I7/bu {or 2011 anc US$9.42/bu for 2012, and forecast soybean cil prices to average US$O.40/Ib for 2010, US$0.42/lb for 2011 ané US$O.43/lb for 2012." onFOREIGN EXCHANGE USD: USO remains in an overall bear market. Four major factors underpin USD weakness: 1. Fiscal debt - Stimulus spending and @ sharp rise in the government deficit are likely to curtail USD's appeal as the dominant currency for reserve managers. 2. Trade deficit - Despite a 32% decline in USD against G10 units between 2002 and November 2009, the external adjustment has only just begun, suggesting more USD depreciation ahead. 3. USD carry trade - Almost 09 interest rates are spurring investors to fund purchases of risk assets via cheap USD borrowing. This is underpinning the current risk rally 4, Globalisation ~ As trade diversifies geographically, USD's dominance in trade finance is waning. That said, overstretched positioning amid little consolidation in the risk rally so far gives some reasons to expect a near term USD rebound. The trigger could come from 2 sources: (1) a correction in the current risk rally ~ a failure by the current stimulus-Ied growth to transition to a private sector- led recovery, or (2) sharper-than-expected tightening of Fed interest rates that reduces the appeal of carry trades, Citi analysts think (1) appears more likely at this juncture. EUR: EUR has been the key beneficiary of reserve managers switching out of USD. Euro area policymakers have so far offered ite resistance to recent EUR gains and upside surprises to Euro area economic data could yet see further gains in EUR, However, more longer term credit concerns among European banks that may see the European Central Bank (ECB) extend its liquidity expansion program ane the prospect for renewed RMB appreciation by the People's Bank of China (P80C) in late 2010 could take pressure off EUR to bear the brunt of USD weakness, and suggest that EUR may peak versus USO in 612 months time. GBP AND CHF: GBP has rebounded moderately versus EUR despite deteriorating UK economic data. Citi analysts suspect this retracement from the highs of 0.941 on 13 October 2009 has more to do with positioning than fundamentals. Euro area less UK swap rate differentials did move slightly lower but the shift in EUR/GBP has been much greater. Already, this shift in rate cifferentials is starting to reverse and the drop in EUR/GBP is likely tobe short lived. The extension of quantitative easing by the Bank of Engiand (BoE), and likely fiscal tightening next year are likely to hamper the UK growth outlook as well as GBP inits bid to keep pace with other GIO units. CHF is expected to stay range bound versus EUR given the intervention stance of the Swiss National Bank (SNB). PY: JPY is likely to remain strong due to (1) likely sustained deflation in Japan that makes the real value of USD/JPY much higher than it appears nominally, and (2) with USD rates anticipated to be lower than JPY rates, USD would be the preferred alternate to fund carry trades, The key risk to the ‘strong JPY’ view is if the Fed lfts rates significantly enough o8 to make investors revert back to JPY as the funding currency or PBOC moves to appreciate the RMB thus taking pressure off JPY to bear the adjustment of further USD weakness. That said, Cit! analysts note that itis historically rare for JPY to weaken during a US recovery phase. DOLLAR BLOC: AUD has been the key beneficiary of the positive risk trade within the commodity bloc. It is also supported by trade gains from higher commodity prices resulting from strong Chinese demand. And with domestic growth rebounding strongly, Australia has been the first within the G10 to raise rates. Momentum remains strong and AUD is expected to reach parity with USD over the next three manths. NZD has been dragged higher by AUD even though New Zealand!’s economic outlook is less rosy than Australia’s and the Reserve Bank of New Zealand (RBNZ) is only likely to commence tightening by March 2010 at the earliest. CAD is the least favoured amon bloc. Spare capacity, projected deflation and CAD strength concerns suggest monetary tightening before June 2010 is unlikely. Risks to the commodity bloc currencies though include (1) China reducing its commodity buying as export demand fails to recover; (2) a correction in the current risk rally and (3) the Fed ultimately lifting rates. the very near term, the prospects for a correction in the risk rally could pare back commodity unit gains. ASIA Emerging Markets: Asia emerging market currencies are expected to continue to aporeciate to long-term equilibrium levels. The region has experienced some noise on capital restrictions recently, out Citi analysts think the measures Undertaken so far are still too mild to thwart the underlying appreciation trend, The focus remains on RMB and apareciation pressures are likely to come from three sources: (1) USD depreciation, (2) further improvement in China's trade balance or higher capital inflows; and (3) continuing efforts to “internationalise” the currency. The PBOC appears to have begun “sounding out" the prospect of a resumption of RMB appreciation. However, Citi analysts expect any RMB appreciation to be gradual, Meanwhile, KRW and INR are expected to lead in the shart to medium term. The Indian economy has notched up several positive surprises, while @ quick turnaround in Korea's economy may prompt early monetary tightening. The region's main laggard is likely to be PHP due to election risks, reform agenda, and post-election =Economic Growth & Inflation Forecasts ‘oor Tf 2009F _2010F 20nF 2009F | _Z010F 20nF Glebal 21% 3.2% 3.4% 14% 25% 2.6% us 2.6% 27% 31% 0.3% 2.0% 12% Europe “3.8% 15% 15% 0.3% 12% 15% Japan 5.3% 15% 1.5% 1.3% 1.5% 0.3% Latin America 2.0% 3.5% 35% 1.6% 19% 23% Emerging Europe 5.7% 2.9% 42% 31% 5.6% 62% Middle East & North Africa 1.8% 3.4% 45% 9.2% 6.8% 79% Asia 51% 7.8% 77% 1.0% 3.6% 41% China 87% 9.8% 9.0% 0.6% 3.0% 3.8% Hong Kong 3.2% 40% 5.0% 0.5% 1.8% 2.0% India 62% 7.8% 25% 27% 5.0% 45% Indonesia 43% 55% 6.0% 5.0% 6.2% 67% Malaysia 2.0% 5.2% 5.0% 0.696 23% 3.0% Philippines 1496 31% 48% 31% 3.7% 44% Singapore 13% 6.5% 519% 0.3% 2.8% 21% South Korea 0.1% 47% 5.0% 27% 2.0% 3.2% Taiwan 3.5% 43% 5.0% 0.7% 0.9% 15% Thailand 3.3% 42% 5.0% 4.0% 25% 3.5% Source: Forecasts fram Ci Investment Research and Anaya, 9 f 23 November 2008 Exchange Rate Forecasts (vs. USD) 1010 2010 ‘3010 4010 Europe. 162 ier 160 157 Japan 84 84 85 86 uK 175 169 162 159 Australia 100 099 ose ost china 675 6.70 6.65 6.62 Hong Kong 775 775 775 275: India 440 43.0 425 as Indonesia 2900 000 9300 2400 Malaysia 3.25 327 325 3.28 Philippines 465 459 455 448 Singapore 134 135 135 136 South Korea 1075 1075 1050 1050 Taiwan a5 a8 32.0 32.3 Thallane 325 32.4 323 32.0 Source: Foecssts frm it investment Research and Arayss, a of 23 November 2008 Interest Rate Forecasts current 1910 2010 3010 4a10 us 0.1396 013% 013% 013% 1.00% Europe 1.00% 1.00% 1.00% 1.00% 1.00% Japan 2.1096 21096 0.108% 010% 010% australia 3.75% 4.25% 4.50% 5.00% 5.50% uK 0.50% 0.50% 0.50% 1.00% 150% ‘Source Forecasts from iti vestment Reseach an Analisis, 35 of 23 Noverbe” 2008, Curent ates 35 of December 2008.Disclaimer Citi analysts" refers to investment professionals within Citi Investment Research and Analysis anc Global Markets (CGM) and voting members of the Citi Global Investment Committee. 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