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FX Outlook
Understanding Foreign Exchange Reserves

Reserves diversification risk to USD overstated
A recurrent theme in the FX market undermining the USD is that central banks are diversifying their foreign exchange reserves out of the USD assets into other high yielding currencies. However, the latest quarterly report from the International Monetary Fund (IMF) shows that this concern is unfounded. The global official reserves of central banks are expanding rapidly and have more than doubled over the past five years. But looking at its currency composition, reserve holdings denominated in USD are rising along with holdings of the other three major G3 currencies — EUR, JPY and GBP. The data show limited evidence of reserve diversification out of the USD.

The key observations from the IMF data are as follows: At the end of 2006, the IMF estimated that global reserves reached a total of $5.02 trillion, an increase of 20.4 percent (or $853 billion) in the 12 months from year-end 2005. Out of this increase, EUR holdings grew $176 billion to $859 billion. However, USD holdings increased $508 billion to $2.16 trillion, representing 64.7 percent of the world's total allocated reserves of $3.33 trillion. In contrast, holdings of EUR represent only 25.8 percent of the total. GBP reserves came in third, accounting for merely 4.4 percent at $148 billion. Part of the gain by EUR and GBP may reflect appreciation of these currencies against the USD, rather than diversification.

The IMF data show that as global reserves grow, diversification can be achieved without hurting USD reserve accumulation. Reserve diversification is not a zero sum game. Even as China, Russia, and other Asian countries may begin to diversify a portion of their reserves into other high yielding currencies, demand for USD holdings might not be adversely affected as market participants have expected. Reserve managers will be careful about disruptive diversification strategies out of the USD. Such a move may hurt the return as the major bulk of their existing reserve holdings remain in USD.

Why do countries hold reserves?
According to the IMF, countries hold foreign exchange reserves to support a range of objectives including:

1) Assisting the government in meeting its foreign exchange needs and external debt obligations;

2) Supporting and maintaining confidence in the policies for monetary and exchange rate management, including the capacity to intervene in support of the national currency;

3) Maintaining a reserve for national disasters or emergencies to absorb shocks during times of crisis.

Why excess reserves?
Nations are encouraged to hold prudent amount of reserves to cover six months of import coverage and one year of foreign debt servicing. By these measures, the East Asian countries have been holding reserves far in excess of what is necessary and prudent. China and Hong Kong together account for almost a quarter of total central bank reserves in the world — at roughly $1.2 trillion. Japan is the next largest holder of reserves at $884 billion; Taiwan's reserves come in third at $267 billion; South Korea is next with $243 billion, followed by India with $190 billion. In contrast, the U.S. and the Eurozone hold only $41 billion and $188 billion, respectively. There are specific reasons for Asian nations' seemingly excessive accumulation.

First, during the 1997 to 1998 Asian crisis, several countries including South Korea and Thailand depleted their reserves, and others exhausted them to stem the crisis. One lesson for the Asian countries is to accumulate excess reserves to withstand an unforeseeable shock and a run on their currencies. Excess reserves help to buffer against destabilizing shifts in the risk appetite of investors as global capital markets become more integrated. For these countries, excess reserves bring stability.

Second, for some Asian countries such as China, Hong Kong and Malaysia, reserve accumulation may not be an active policy, but a by-product of preventing dramatic appreciation of their currencies or maintaining the peg to the USD. Third, in many Asian countries, growth has mainly been generated by exports and foreign investments, resulting in excess reserves. Lastly, in the case of Japan, the central bank accumulates reserves to counter domestic deflation.

USD remains prime reserve currency
Despite repeated concerns over reserve diversification from the USD, the greenback remains the prime reserve currency. Rather than diversifying between currencies, there is evidence that central banks are diversifying between asset classes. Latest data from BIS shows that U.S. Treasuries represent 73 percent of central banks' bond holdings in mid-2005, falling from 82 percent five years prior. Meanwhile, holdings of agency issues had risen to 22 percent from 15 percent during the same period.

In the end, the concentration of USD reserve holdings may reflect the underdeveloped capital markets of many developing countries, and the inability or unwillingness of their private sectors to recycle the country's trade surplus. As Asian developing countries run huge trade surpluses and attract substantial net capital inflows, central bank reserve accumulation will continue. Naturally, USD securities offer higher yields and liquidity for countries like Japan and China.

Thus, what will happen next to the reserve composition depends largely on the global supply of capital and liquidity. For most Asian countries to maintain high economic growth, export sectors need to perform well. Efforts by these governments to shift the growth driver to consumption will be a slow process. That means Asian central banks will be saddled with more and more USD to be invested. In addition, reserves will expand at an accelerated pace because of the subsequent need of currency intervention as export surges. All these imply that the global liquidity surplus will continue to grow significantly. From this angle, the U.S. assets and the USD are not under threat yet.

Fernand Kong, FX Trading Manager, SVB Silicon Valley Bank's Global Financial Services

Tech/Life Sciences/VCs
Data Center Demand
In another sign of Silicon Valley's tech recovery, data centers are being snapped up by investors who foresee a rising demand for data storage. The popularity of social Web sites such as YouTube, the ability of cell phones to send photos, and the increased record-keeping required by Sarbanes-Oxley legislation all mean more bandwidth is needed to store the data and handle the increasing Web traffic. CRG West, the real estate arm of the Carlyle Group formed to focus on data centers as a commercial real estate niche, is a ahead of the trend, having purchased data centers around the country in anticipation of the rising demand for storage. (San Jose Mercury News)

Government IT Spending
Continued squabbling between President Bush and the Democrat-controlled Congress will delay federal IT spending until 2009, warns a report from INPUT. Until this year, federal spending on IT had grown for 15 years, averaging about 6 percent annually. INPUT expects the rate of increase to drop by one-half in 2007 and 2008, a shortfall of about $5 billion over the next two years. Because spending over the next two years will be focused on system efficiencies through IT consolidation, companies that sell to the government should focus on innovation that reduces costs, simplifies management, or makes workers more efficient. (Red Herring)

Let There Be Light
MIT researchers have identified a set of genes found in marine microorganisms that can endow common bacteria with the ability to generate energy from light. Some bacteria use photosynthesis to make sugars, but others have an ability to harvest light by using light-activated proteins known as proteorhodopsins, which are similar to proteins found in human retinas. The findings have implications for both marine ecology and for synthetic biology, an emerging field that aims to design and build new life forms that can perform useful functions. The research could ultimately be used to genetically engineer bacteria that can more efficiently produce biofuels, drugs, and other chemicals. (MIT Technology Review)

Lack of NIH Funding
The head of Johns Hopkins Medicine is warning Congress that a lack of funding for the National Institutes of Health (NIH) could stifle medical research. After two years of hovering around the $27.5 billion mark in 2003 and 2004, NIH's budget decreased $34 million, to $28.5 billion, from 2005 to 2006. Stagnant funding has left eight out of 10 research grant applications without money, and NIH departments like the National Cancer Institute say they can only fund 11 percent of grant applications. When NIH's budget was doubled between 1998 and 2003, researchers were able to make advances in research related to Alzheimer's disease, cancer, HIV/AIDS claims a report titled "Within Our Grasp — Or Slipping Away? Assuring a New Era of Scientific and Medical Progress", authored by eight medical institutions. (Baltimore Business Journal)

Agricultural Biotech Proves Popular With Investors
With the growing interest in renewable biofuels, agricultural biotechnology developers that improve plant traits for food and fiber crops are enjoying interest from VC investors and partners in the energy business. The market for patented transgenic seeds is expanding about 20 percent a year, dominated by companies like Monsanto Co., who plan to replace their traditional agricultural chemicals businesses with genetically altered seeds. For example, Targeted Growth, a developer of plant gene technology, has partnered with Monsanto to incorporate gene traits that were developed for food crops into crops for ethanol production. Other venture-backed companies are now shifting gene research to create traits for better biomass for fuel. (MIT Technology Review)

Syndication More Common
After falling for two years in a row, the percentage of venture deals with five or more investors rose in 2006. About 21 percent of venture financings last year had more than four investors, up from 14 percent in 2005, according to VentureOne. Much of the syndication is occurring in third or later financing rounds. The capital needs of a company also influence the number of investors. Biopharmaceutical companies had five or more investors in 32 percent of their fundings, compared with 18 percent for software companies, which are much cheaper to build. Communications and network companies also consume a lot of cash, and their financings last year had five or more investors 31 percent of the time. (Wall Street Journal)

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April 2, 2007
Top 10 Tech Trends for 2007

Nick Berg, an associate with SVB Silicon Valley Bank, is our guest contributor this week.

On March 27, 2007, The Churchill Club held its annual Top Ten Tech Trends Debate, moderated by Tony Perkins (Creator and Editor-in-Chief of AlwaysOn), with an impressive panel of venture capitalists that included John Doerr (Partner, Kleiner Perkins Caufield & Byers), Steve Jurvetson (Managing Director, Draper Fisher Jurvetson), Roger McNamee (Co-Founder, Elevation Partners), and Joe Schoendorf (Partner, Accel Partners). Holding with the tradition of past years, the audience was given cards to vote in favor or vote in disagreement of each prediction. Here is a brief summary of those predictions:
1)Fragmentation of Mobile Devices — Mr. McNamee predicted that the market for mobile devices will undergo traumatic fragmentation with a proliferation of new design centers. In the next two years, radical new mobile devices will emerge providing all available media, entertainment, and productivity applications directly to the consumer.
Panel criticism: Users don't want a belt full of mobile devices as they have a fundamental need to conserve battery size and weight on their person.
Audience agreement: 50 percent.
2)New Broadband Network — Mr. Doerr predicted that the FCC will authorize at least one new broadband network in the next year, breaking the current duopoly. Virtually free broadband service will allow mobile devices to rapidly displace PCs. Moreover, he stated the "single most important thing" that the U.S. can do for economic development in the next ten years is to make broadband freely available.
Panel criticism: Previous attempts at passing similar legislation have failed.
Audience agreement: 90 percent.
3)Web 2.0 Shakeout — Mr. Perkins predicted that in the next year, consumer Web 2.0 companies will begin experiencing down rounds of venture funding. The $1.65 billion acquisition of YouTube and the preponderance of Web 2.0 conferences are signals that a large speculative bubble exists and that deflation is imminent.
Panel criticism: There is currently an abundance of money in venture capital and a strong commitment to this sector.
Audience agreement: 50 percent.
4)Moore's Law Will Bifurcate — Mr. Jurvetson predicted that Moore's law will continue, but that technological advances in memory will precede advances in logic by several years. Mobile devices will drive an "unstoppable demand" for "ungodly" amounts of storage at low power.
Panel criticism: Major breakthroughs have been elusive in making memory from self-assembling nanotechnology materials.
Audience agreement: 80 percent.
5)Global Power Shift — Mr. Schoendorf predicted that globalization and the rising economic power of BRIC nations (Brazil, Russia, India, and China) will profoundly impact current business. Companies will expand their focus to include global customers, markets, and competitors.
Panel criticism: While India has excellent demographics for future productivity (three workers to every retiree), China has a deficit of women which could cause a demographic crisis in the future.
Audience agreement: 90 percent.
6)Active Media — Mr. McNamee stated that consumers are choosing active media over passive media, which will erode the power of today's media companies and require a re-engineering of the advertising business. As advertisers adapt to new media, they will willingly trade control of the medium for efficacy in ad campaigns.
Panel criticism: Major advertising companies still receive most of their revenue from passive media.
Audience agreement: 80 percent.
7)Enterprise Web 2.0 — Mr. Perkins predicted that Web 2.0 functionality will move into the enterprise and media worlds. Young people entering the workforce will drive demand for collaboration tools — such as instant messaging and wikis — in the office.
Panel criticism: Large enterprise and media giants may fight this change to minimize security risks.
Audience agreement: 95 percent.
8)Synthetic Life Forms — Mr. Jurvetson predicted that the first synthetic life form (a bacteria) will be created in the next two years shaking our fundamental beliefs and revolutionizing several industries. These microbes will efficiently create biofuels, medicines, and other materials.
Panel criticism: None. As Mr. Doerr stated "synthetic biology is the great new platform".
Audience agreement: 95 percent.
9)The Brain — Mr. Schoendorf predicted that radical new treatments will emerge as scientists shift away from the concept of mental illness. In the future, treatment of mental health conditions will be driven by a deeper understanding of brain disorders caused by physical flaws that arise in the brain itself.
Panel criticism: None.
Audience agreement: 95 percent.
10)Going Green — Mr. Doerr predicted that Congress will send President Bush mandatory cap and trade legislation for greenhouse gas emissions this year. If that happens, it will accelerate the "green revolution".
Panel criticism: It still may not be enough to stop global warming given the rapid urbanization in the world. Mr. Doerr stated that China currently emits 3.3 gigatons of carbon emission per year; however, if China continues on its rapid expansion, emissions could surpass 23 gigatons by 2050 — more than the rest of the world today.
Audience agreement: 90 percent.

— Nick Berg, associate, SVB Silicon Valley Bank

Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
Economic Calendar
Economic Calendar
General Economy
Higher Inflation, Weaker Spending = Stagflation?
The Fed's job isn't getting easier. Consumer prices increased at the fastest pace in six months during February, while consumer spending slowed to the weakest in six months, according to government data released Friday. The Fed's preferred measure of core inflation — the core personal consumption price index - rose 0.3 percent in February, the biggest gain since August, the Commerce Department reported Friday. Core inflation matched economists' expectations. On a year-over-year basis, core inflation ticked up to 2.4 percent from 2.2 percent, moving further away from the Fed's comfort zone of around 2 percent. (MarketWatch)

Market Looks for Strong Jobs Report
Employment has proved far more resilient than the housing market, and one strategist expects the new batch of data this week on job creation to show continued stability. Brett Hammond, chief investment strategist at TIAA-CREF, the fund manager in New York, estimates that the economy added 115,000 jobs in March, less than the 130,000 forecast in a Bloomberg poll of economists. Current job seekers, he said, include homeowners looking to extricate themselves from trouble as mortgage rates rise and home prices appear vulnerable to a decline. (New York Times)

Sales of Subprime Mortgage Bonds Plunge
Sales of bonds backed by subprime mortgages are tumbling as investors and bankers, concerned about rising delinquency rates, pull back from what had been one of Wall Street's fastest growing businesses. About $64.8 billion of securities backed mainly by loans to people with poor credit or high amounts of debt were issued this year through March 22, down 36 percent from $100.9 billion in the same period last year. Lehman Brothers Holdings Inc., Countrywide Financial Corp., and Morgan Stanley were last year's three biggest issuers of securities backed by subprime mortgages and home equity loans, according to Citigroup. (Bloomberg)

Money Markets
Yields Are Up, and Might May Stay Up
The run may be over for Treasuries this year. The economy's continued growth may limit how much, and even if, the Federal Reserve can cut interest rates, according to Wall Street's biggest bond firms. Treasuries gained 1.4 percent in the first quarter, the most since 2004, as investors bet the central bank will cut its target for overnight loans between banks at least twice from the current 5.25 percent. According to a current Bloomberg survey, the Fed will reduce borrowing costs just once, because inflation will remain too fast to allow more than one reduction in borrowing costs. (Bloomberg)

Bond Futures Soon Bigger Than Bonds
Treasury futures, the most active contracts on the Chicago Board of Trade, may surpass trading in notes and bonds for the first time next year as money managers use more derivatives to boost returns. A record 60.5 million contracts changed hands in February, the equivalent of $6.62 trillion of Treasuries. Wall Street's biggest firms handled about $9.57 trillion of bonds, according to Federal Reserve data. Futures more than doubled in the past five years and, at the current pace, will overtake trading in the cash securities during 2008. (Bloomberg)

Stable Price Expectations Doesn't Mean Stable Inflation
Richmond Fed President Jeffrey Lacker said policy makers must be wary of relying on consumers' and investors' price expectations to pull down an "uncomfortably high" inflation rate. While not explicitly calling for higher interest rates, Lacker yesterday reiterated his concern that inflation may fail to slow. "As I said last year, the longer we go out without a noteworthy decline in inflation, the more risk we run in entrenching expectations where they are," he told reporters following a speech in Richmond. (Bloomberg)


Forward Yield Curve
Forward Yield Curve
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