Asia Focus

Asia

Call of the next 12 months
1. 1. A bumpy ride, but no crisis. As predicted in Jan, 2007 is turning out to be a year of volatile but respectable growth for Asia. Shocks from global risk re-pricing will linger, but contagion is limited and no crisis is likely given Asia's small exposure to US sub-prime mortgages, ample liquidity, strong external payments and low leverage. Any sharp US rate cuts could buoy short-term regional liquidity and sentiment, though weaker US demand will curb real sector growth modestly.
2. 2. Major portfolio shifts in response to risk re-pricing. Aside from a temporary sell-off driven by liquidity crunch outside the region, no mass exodus of funds out of Asia like the previous crisis is expected. To the contrary, Asia may attract more capital, both from outside and within the region, given its strong fundamentals. Asia's resilient investors, especially some sovereign funds, will also take advantage of the market turmoil to raise their investment in and outside the region.

Key Risks
1. 1. Sharp fall in US home prices and consumer demand, which will aggravate financial market volatility and weaken demand for Asian exports, on top of rising protectionism in the run-up to the November 2008 US presidential election. Although demand from the EU and China stays strong, any recession in the US (not our base scenario) could still dampen Asia's growth prospects significantly. Asia is more resilient, but not yet fully decoupled from the US, especially for those open economies with weak domestic demand.
2. 2. Policy mishap and asset bubbles are the largest domestic risks. Political transitions in China, Japan, Korea, Taiwan, Thailand, Pakistan, Bangladesh and Sri Lanka still carry significant uncertainty and may impede policy responses to challenges like rising inflation, brewing asset bubbles, weak investor confidence and others.

Key Macro Trends
1. 1. Growth to ease but stay above norm, especially for those with strong domestic demand and less-open capital accounts like China, India and Vietnam.
2. 2. Inflation to edge up, strong currency preferred to monetary tightening. Elevated food and energy prices and robust demand will create inflationary pressure across the region. No sharp tightening is likely given market uncertainties, except for China and India where monetary policies are less affected by external factors.


Australia


Call of the next 12 months Charts of the Year
1. Domestic strength to continue, supported by the tight labour market and expansionary budget. This, Chart 1: A tight labour market supports spending together with an upbeat business sector and thus
investment, will drive GDP growth higher to 3.8% this

2. RBAto hike. Inflationary risks from the buoyant
3.0
labour and housing markets are likely to prompt the 1.5
2.0
RBA to hike its OCR by 25bps again before year-end. 1.0
After this, we see steady rates throughout 2008, with 0.5

1.0risks on the upside. 0.0
0.020002001200320052007
3. AUD/USD to stabilise at around 0.79-0.82 as high Source: Bloombergyield is counteracted by external deficits. Risks are on the upside should the RBA hike rates more aggressively than expected.
Chart 2: Exports by destination, Jan-Jul 2007


China


Call of the next 12 months
-The US sub-prime turmoil has not impacted China…yet -Growth to remain strong over the next six to nine months -Inflation and asset price concerns to trigger more rate hikes
1. 1. The direct impact on China from the on-going US sub-prime turmoil has been limited, thanks to China's controlled capital account. Sentiment remains bullish and the stock market plots new highs. Policy makers may use indirect measures to deflate prices.
2. 2. Gradual 5-6% (annual) CNY appreciation despite growing trade surplus and inflationary pressure. Appreciation may accelerate in H1-08, but may pull back in H2 as growth eases and the trade surplus shrinks.
3. 3. The 17th Party Congress in Oct-07 will not signal any fundamental economic policy change, and we could see accelerated social spending. A successor to Party Secretary Hu Jintao may surface.

Key Risks
1. 1. Sharp sell-off in both equity and real estate markets. Although consumption and investment are probably not as tied to asset prices as in mature markets, a slump could still have serious psychological impact, hitting urban consumption and business confidence.
2. 2. Sharp credit deterioration set off by weak exports.

As the US and other export markets deteriorate, competition in the domestic market will rise. Producer margins may suffer and credit positions worsen.
3. US protectionism. The US Congress will likely pass legislation to label the CNY a "misaligned" currency in 2008. However, we do not believe the subsequent sanctions, if any, will be big enough to affect the broad swathe of China's exports to the US.
Key Macro Trends
1. 1. Growth to remain over 11% in the next 6-9 months, but H2-08 may see the beginning of a slowdown as export growth eases, confidence dissipates, and corporate profits shrink. Global commodity markets may react negatively, but we expect China to achieve a soft landing.
2. 2. The interest rate cycle to peak in Q2-08 as inflation and asset bubble concerns ebb in light of weaker overall growth momentum.
3. 3. Fiscal policy will become more important in H2-08 as growth eases and a debate on how to stimulate the economy starts. Fiscal activism may kick in 2009.


Hongkong


Call of the next 12 months
1. 1. Elevated interest rates to gradually trend lower. Lingering US sub-prime concerns, which pushed up USD LIBOR, has kept HIBOR under upward pressure of late. But we expect HIBOR to eventually ease, once the Fed starts cutting and LIBOR follows lower. Only then will domestic banks have room to start cutting their prime rates.
2. 2. Capital inflows from China to rise. China's pilot scheme to allow Mainland investors to directly invest in overseas equities, starting with Hong Kong stocks, will take time to materialise due to the lack of infrastructure and operating details. Given time, the scheme, along with QDII and others, could bring growing inflows.
3. 3. Asset prices to remain elevated despite increased volatility in stock and money markets. More importantly, the lagging property market could gain further traction amid lower interest rates and still robust domestic fundamentals.

Key Risks
1. 1. Extended squeeze and volatility in global credit and asset markets could erode local confidence and liquidity, undermining financial stability and growth prospects.
2. 2. A full-fledged US recession as financial turmoil spills over to the real economy, prompting protectionism in the US and cutting export prospects for HK.
3. 3. Aggressive Chinese austerity measures that may be introduced to rein in its super-speed economy. While a soft landing remains our base scenario, the risk of a hard/crash landing should not be overlooked and have its impacts underestimated.

Key Macro Trends
1. 1. Growth to ease but remain modest, despite rising US macro risk and growing financial market volatility. While export growth may ease with weaker US demand, strong domestic momentum and exports to China/EU should support the economy. Low leverage and flush liquidity should cushion any serious external shocks.
2. 2. Inflation to trend up in 2008, partly due to the base effect from property rate reductions this year, and partly due to higher import prices. While this is unlikely to become a serious macro concern, it may attract more noises from the underprivileged, reflecting widening disparity amid rapid restructuring of the economy and its labour market.


India


Call of the next 12 months Charts of the Year
1. Monetary policy decoupling. The recent weakness in US data and the associated financial market risks Chart 1: Smaller but still strong might make the Reserve Bank of India (RBI) adopt a
wait and see approach for now. However, strong
domestic growth and potential for rekindling of

FY08
inflationary pressures will prompt it to tighten again later. We expect 25bps hike in reverse repo and repo FY06rates and 50bps hike in CRR in Q1-08.
FY04
FY02
2. INR to weaken in near-term. Although we are long-
term INR bulls, near-term outlook will be clouded by
FY00
perception of risk and capital inflows may flicker in response to the degree of bad news hitting the global FY98scene. Hence, as rates remain stable in near term, FY96


Indonesia


Calls of the next 12 months
1. 1. Faster GDP growth as the economy further recovers from the steep hikes in domestic fuel prices and BI rate in H2-05. We expect GDP to rise by a real 6.1% in 2007 (the highest since the Asian financial crisis) and 6.3% in 2008 on the back of lower interest rates, additional fiscal stimulus and more public infrastructure spending.
2. 2. BI rate cuts to slow amid growing market volatility triggered by the US sub-prime turmoil. We expect rate cuts to resume with lower US rates, extending the 450bps cut between May-06 and July-07.
3. 3. IDR appreciation to slow in the rest of 2007 due to rising financial market volatility and a narrowing USD/IDR interest rate differential. However, given accelerating growth and improved external payments, the IDR should resume its appreciation trend in 2008 and reach sub-9,000 levels.

Key Risks
1. Ineffective fiscal policy that fails to provide necessary support to growth, especially in infrastructure and local spending. This is important as the election year of 2009 gets closer. The government is aiming to accelerate GDP growth by increasing its budget deficit from 1.0% of GDP in 2006 to 1.6% in 2007 and 1.7% in 2008.
Key Macro Trends
1. 1. Consumption and investment recovery. Lower interest rates have helped stimulate household consumption and investment. Policy reforms (new tax and investment laws, etc.) and the government's USD 150bn infrastructure program are also likely to boost investment in H2-07 and 2008.
2. 2. Solid external payments position as strong commodity prices boosted exports by 14% to USD 53.6bn, raising the trade surplus of H1-07 to USD 19.7bn from USD 16.6bn in H1-06. Although imports also rose by 16% to USD 33.7bn in H1-07 and is expected to stay robust with the revival of real investment and growing consumption, we believe the current account balance should remain in surplus in 2008, supporting the IDR and cushioning the economy from future external shocks.


Japan


Call of the next 12 months Charts of the Year
1. Consumer confidence to return. This development has been much delayed, though it is relatively Chart 1: Cost-push inflationary pressures unrelated to the US sub-prime issue. With the Diffusion index: excessive - insufficient favourable employment outlook and a still healthy
Productioncapacity*
corporate sector, wages are set to rise, boosting points
-15

consumer confidence.
-10
2. Prices to rise. Production capacity and the labour -5market are tight, as suggested by both the data and
0
Tankan surveys. Cost-pull inflationary pressures are
5
likely to lead to higher consumer price inflation in
coming quarters. 10
15

3. We expect the BoJ to hike next year to bring 20interest rates back to neutral. We believe the BoJ will 25act upon the gradual pick-up in inflation, albeit slowly


Malaysia


Call of the next 12 months
1. MYR internationalisation to go slow and steady.
The looming general election, concerns about domestic growth momentum and global financial market stability, the complexity of the currency internationalisation process and the lack of clear consensus within the government suggest that moves in this direction are likely to be slow and steady.
1. 2. BNM to keep rates steady. Inflation is expected to pick up in late 2007 and 2008, preventing the central bank from cutting rates. Meanwhile, external uncertainty should also caution BNM from hiking rates, especially given the US sub-prime turmoil.
2. 3. Government to pursue expansionary fiscal policy ahead of election. To ensure steady growth momentum and positive sentiment amid growing external uncertainty, the government is likely to keep its pro-growth policy bias.

Key Risks
1. The US sub-prime turmoil and weak IT exports
present the greatest immediate threat to Malaysia's growth prospects. While this can be partly offset by growth in commodity exports and demand from Asia and Europe, a highly open economy allows little room for complacency.
2. Sizeable fiscal deficit that may crowd out the private sector and undermines the country's sovereign rating. While this has been kept at a modest 3.5% of GDP, the government’s inability to shrink it further at a time of good economic growth implies that further improvement will be difficult going forward, especially given the need to pump prime ahead of elections.
Key Macro Trends
1. 1. Strong consumer confidence boosted by favourable job market and income growth. This should remain the main growth driver in 2008.
2. 2. Rising inflation, reflecting strong demand and higher wages. This would prevent BNM from cutting rates. Also, we have raised our 2008 inflation forecast to 2.5%.
3. 3. MYR to strengthen gradually along with other Asian currencies and sustained capital inflows. This may help contain import inflation, while avoiding severe erosion of export competitiveness versus other Asian exporters.


Singapore


Call of the next 12 months Charts of the Year
1. Property market boom to persist with low real interest rates and strong income growth. Despite the Chart 1: Rising but still benign price-income ratio US sub-prime problem and sharp swings in equity and
credit markets, property demand stays strong. The price-income ratio and rental yield of residential property are still at benign levels. The wildcard is whether the government will take measures to curb prices.
2. 2. SGD NEER is expected to maintain its gradual appreciation trend. Despite greater global uncertainty, inflationary pressure should persuade the MAS to adhere to the policy of modest and gradual appreciation of the SGD.
3. 3. Further polarisation of the labour market driven by rapid growth of high value-added services but stagnant low-end industries. This, if unattended, could cause income disparity to widen, undermining growth sustainability and social stability.

Key Risks
1. 1. Rising labour and rental costs that threaten to undermine competitiveness. While general consumer prices are likely to remain well contained, higher rentals and salaries could increasingly undercut Singapore's cost advantage and competitiveness.
2. 2. Prolonged weakness of the IT sector, which remains the bellwether of the economy. Poor IT exports has kept Singapore among the region's worst export performers in 2007. While the drag was partly offset by strong performance of other sectors like pharmaceuticals, this may not be sustained if the current weakness of the IT sector is prolonged.

Key Macro Trends
1. 1. Tight labour market trend to continue. Strong economic growth will support employment growth and keep the jobless rate low. A significant proportion of the new jobs will be created in the service sector as manufacturing performance continues to lag. While imported talent may resolve part of the problem, this should be complemented by efforts to upgrade and retrain the local workforce so as to reduce the risk of a growing labour market mismatch and widening income disparity.
2. 2. Inflation to stay elevated, but still mild. Due to demand pull factors, higher public charges and taxes, consumer price inflation could break above 2%. As a result we have raised our full year inflation forecast to 1.5% and 2.2% for 2007 and 2008 respectively.


South Korea


Call of the next 12 months
-Strong growth despite the sub-prime saga -Domestic liquidity remains buoyant -MPC to hold now, and hike in 2008
1. 1. Growth momentum stays solid despite the US sub-prime problems and turmoil in the major financial markets. Domestic demand stays strong and exports remains robust, which could push GDP growth slightly higher in 2008.
2. 2. MPC to hold and hike later. While the uncertainties in global financial markets may keep the MPC on hold in the near term, rates are likely to trend higher in 2008 once the financial situation stabilises and inflation pressure builds with higher economic growth.
3. 3. KRW to stay strong, given sustained capital inflows and solid economic growth in 2008.

Key Risks
1. 1. Sharp decline in US demand triggered by the sub-prime problems. While no lasting contagion effect on the Korean financial markets is expected, the sub-prime issue could dampen US consumer demand and undercut Korean exports.
2. 2. Monetary overkill if the MPC raises interest rates too fast too much, being too preoccupied by the threat of domestic inflation and too complacent about the negative impact of the US sub-prime issue.
3. 3. Squeeze in liquidity, either due to a less favourable current account surplus, or high oil prices, or a more substantial contagion effect from the US sub-prime issue.

Key Macro Trends
1. 1. Stable growth momentum supported by solid domestic demand and still robust exports. While it may be too early to tell the actual impact of the US sub-prime issue on the real economy, the firing of both export and domestic growth engines should keep the Korean economy running at reasonable speed in the next 6-12 months, more so given growing pre-election spending.
2. 2. Still ample domestic liquidity despite some shortages in foreign funding, which is partly driven by the policy to reduce short-term foreign borrowings as a way to stabilize the KRW.
3. 3. Rising inflation pressure, especially in service charges and asset prices. Both cost push and demand pull forces are in play, which will ultimately force the BoK to resume hiking in 2008.



Thailand



needs
Call of the next 12 months Charts of the Year
1. THB to weaken. The Thai baht is expected to reverse its strengthening trend to become weaker, less Chart 1: Turning tides because of the global financial turmoil but more due to
domestic development. The current account surplus, which has been supporting the THB, will shrink with growing import demand as investment accelerates.
2. 2. Liquidity to tighten. An improving political situation could prompt an early pick-up in investment, to be led by state enterprises. Higher funding needs would then reduce surplus liquidity and push up market interest rates.
3. 3. Likely removal of the remaining capital controls.

Since most public investment is funded by bonds, which are still subject to the 30% URR restriction, the BoT may have to lift its remaining capital controls to reduce funding costs.


Vietnam


Call of the next 12 months Charts of the Year
1. High growth strategy reinforced. Similar to China, a controlled and under-developed capital account Chart 1: VND to stay weak cushioned Vietnam from any obvious impact from the
US sub-prime shock. If anything, concerns about the potential falloff in US demand may reinforce the government's pursuit of its pro-growth policy, despite the growing threat on inflation.
2. 2. More active money market operations to absorb excess liquidity. Barring higher interest rates and before the development of a more comprehensive monetary framework, the central bank would have only limited tools.
3. 3. VND depreciation trend intact, with further buildup of forex reserves. The government is expected to continue its gradual VND depreciation policy to support exports. A current account surplus and FDI inflows would therefore boost forex reserves further. This may invite greater inflation and more VND appreciation pressure.

Cost push inflation is back

Overview: The two worlds of inflationpp.3 - 4 Across the emerging world, rising food and energy prices are forcing many central banks to tighten policy. Some
believe it also makes a case for higher rates in the US. But two wrongs do not make a right! Because rates were
too low in good economic times does not mean they should be pushed too high in bad economic times!

Asia: Testing time pp.5 - 7 Rising inflation presents the most important threat to Asian economies. It is critical to differentiate between the
different sources of price pressure. The risk and cost of policy conflicts and misdiagnosis is high, and rising.

Middle East: Breaking the resource cursepp.8 - 10 Higher oil prices are providing the GCC with significant windfall gains. The absorptive capacity of the region is
increasing, but the 'resource curse' has not been broken yet.

FX: Asian REER update pp. 11 - 12 Most Asian REERs are below their pre-crisis levels. The exceptions are the INR, CNY, SGD and THB. We see the
long term positive fundamentals remaining in place. The theme of current account surplus currencies
outperforming deficit currencies has shone through well. The next phase of the more open economies being hit by
the global slowdown should weigh the most on the TWD, SGD and MYR.

Commodities: Crude oil demand destruction elusivepp. 13 - 14 Crude oil prices spike on USD weakness and geopolitical risks. Speculation is an issue, but not the only factor
driving up prices. Oil prices to remain high as demand destruction proves elusive.

Abu Dhabi: Turning black gold into gold p.15 - 16
Brazil: More good newspp. 17 - 18
China: After the earthquake pp.19 - 21
New Zealand: Too easy for comfort pp.22 - 23
Singapore: Juggling to soft land pp.24 - 25
Forecasts and Sovereign risk tables pp.26 - 30

The two worlds of inflation
Across the emerging world, rising food and energy prices are forcing many central banks to tighten policy. These pressures are more severe in some economies than others, with South Asia a particular worry, as seen from recent further tightening in India and Pakistan. Yet not all countries are resorting to higher rates. Some, like China, prefer tighter loan quotas, as they are fearful of attracting inward speculative flows if rates rise too far. But China, India and a number of other countries also need to face up to the issue of energy subsidies, as they continue to subsidise the full cost of higher oil prices from feeding through into their markets. Whilst credit crunch worries overhang markets in the West, firm growth and rising costs are pushing central banks across the emerging world to tighten policy. Across the emerging world, where growth is strong, interest rates have either risen or need to rise further. Whether it is South Africa, across South Asia, the Middle East or parts of East Asia tight or tighter monetary policy is needed. There is no argument.

East: not just inflation, but di-flation
Across Asia, whilst the immediate inflation threat should not be under-estimated or played down, di-flation may be a better description of the conflicting issues being seen across the region. For whilst inflation is evident in food and energy prices, there is still intense competitive pressure in many other areas. Although inflation appears to have only become a recent concern, the reality is that inflation has been an issue for some time, although not in the headline price indices.

In recent years, we have seen a combination of factors lead to low headline inflation and, in turn, relatively low interest rates, particularly in the West. Whilst headline inflation rates were low, there was inflation in terms of asset prices, particularly real estate. Yet given that central banks in the West had not kept monetary policy tighter amid the positive supply-side shocks, asset price inflation became evident. Some might argue that this means central banks should tighten policy in response to rising asset prices. But what it really suggests is that central banks should be aware of the impact of positive supply shocks and should have aimed to keep headline inflation lower. One could use a similar line of argument to suggest that governments should run fiscal surpluses in times of economic boom; cyclically adjusted. Now, we are seeing inflation in terms of rising food and energy prices. This poses big problems for not only central banks but governments across Asia, as rising food prices hit the poor.

Whether higher food and energy prices feed through into higher inflation depends crucially on wages, and to some degree on inflation expectations, and also on whether central banks accommodate the pick-up in inflation. If wages do not increase then rising food and fuel prices will reduce the amount of money that people have to spend on other items. This, in turn, would likely see retailers and corporates take any increase in costs, such as fuel, on their margins. Hence the di-flation word that is used currently across some Asian countries.

However, if one looks at manufacturing and other areas there is intense competitive pressure. Supply chain optimisation is taking place, as firms try and squeeze costs. According to US import price data, China is getting more expensive, though not the most important source of import inflation (Chart 1). However, if the CNY appreciates further, then goods coming out of China will become even more expensive. Yet, the goods in China are taking market share, displacing others. Overall, China has moved from being deflationary to being modestly inflationary in terms of what it produces. And in terms of what it needs and consumes, as the economy grows and income levels rise, it is becoming more inflationary.

But in the West, the situation is more different. Although cost push inflation is back, the financial and economic environment is very different. Yet, it is the rise in costs that has recently created a gathering bandwagon for higher interest rates in the West. The European Central Bank (ECB) talks tough, signaling a one-off rate hike, as does the Bank of England. Even the Federal Reserve has appeared more hawkish. We believe there is a genuine risk of higher rates in Europe and the UK, but we don't think the US can afford a hike any time soon, though it may like to be seen as ready - probably for the sake of lending support to the dollar. Although parts of the US economy are doing well, such as big firms, the export sector and many farmers, the fragile financial sector and poor prospects for consumers should still concern the Fed; the jobs data, in particular, strike us as key (Chart 2).
In recent years, CPI figures around the world should have been renamed China Price Indices, such was the impact of that country on global inflation. Strong deflationary pressures were exported. Faced with such a positive supply side shock central bankers in the West should really have had tighter monetary policies. They didn't. As headline inflation stayed low, asset price inflation was rampant.
Now we have a negative supply-side shock in the form of high food and energy prices.

Some believe it makes a case for higher rates in the US. But two wrongs do not make a right! Because rates were too low in good economic times does not mean they should be pushed too high in bad economic times!
Yes there has been a small rise in inflation expectations and that needs to be taken into account. But where are the rampant wage increases? After most people have paid their higher food and fuel prices they have little to spend! In this environment many firms will have to take higher energy costs on the chin, and see their margins squeezed. Higher rates in the UK or US now would hit hardest those unable to cope, whether small firms or hard-up households, and probably for no real gain.
Thankfully the Fed's mandate explicitly takes this into account, but not the Bank of England's or the ECB.

Politicians in the West should watch closely to ensure that central banks behave in a responsible way that merits their independence and their mandate.

Asia
Nicholas Kwan
Regional Head of Research, Asia, +852 2821 1013, Nicholas.Kwan@standardchartered.com

Testing time
Over the past few months, Asian central banks and finance ministries have been busy responding to the rising threat of inflation. This threat has been supercharged by sharp jumps in oil and food prices, and further complicated by the simmering risks of social discontent and economic decline. While we remain optimistic that Asia in general will weather the current storm relatively unscathed, there are growing risks that need to be avoided. In particular, governments need to differentiate carefully between the different sources of inflation and the different tools needed to address the problems. They also need to strike a delicate balance between price stability and economic growth. The risk of a costly misdiagnosis is high, and rising.
Different sources of inflation

From Korea to India, consumer price inflation has been rising since mid-2007, as shown in Chart 1. Driven by record high prices of oil and food, inflation in many places is now running at decade or historical highs. For instance, Singapore, traditionally the icon of price stability in the region, is now suffering from the worst inflation in more than a quarter of century, reaching 7.5% y/y or tripling the rate of less than a year ago. Vietnam, on the other hand, had inflation running at 25.2% y/y in May, the highest on record and also more than three times the rate prevailing a year ago.

While food and fuel are generally blamed for the latest jump in CPI across the region, there are more devils behind the surge. These have complicated the hands of central banks. First is liquidity. In fact, well before the latest impacts of food and fuel become apparent, many Asian economies had been suffering from (or enjoying) excess liquidity, both from internal and external sources. Until late last year, much of the impact from excess liquidity was a happy one - rising asset prices - mainly equity and partly property - with relatively stable consumer prices. This has made Asian investors wealthier, at least on the books, and borrowers more aggressive. While most central banks responded by tightening monetary policy and some by adjusting their exchange rates and regulation of capital flows, generally speaking there was a lack of urgency in dealing with the issue given its relatively benign impact on consumer prices. In fact, some central banks were even accused by vested interests of spoiling the party with 'unnecessarily' tight credit.

Fortunately, Asia's emerging asset bubbles started to deflate since last autumn, partly because of successive monetary tightening but also because of the global financial turmoil. The correction in Asian equity prices over the past six months, ranging from -15% to over 60% (see Chart 2), has helped to prevent bigger bubbles emerging, but it is not problem free. For some markets like Vietnam, sharp and deep decline in asset prices has undermined investor confidence and triggered large capital outflows, putting pressure on the currency and destablising the wider financial system. Of course, Vietnam's problem goes deeper than a simple bubble. The country requires broader monetary and fiscal measures to restore its macroeconomic balance, but its experience highlights the potential pitfalls of unrestrained asset inflation and reminds us of the need to keep liquidity in check.

Another related and potentially more damaging source of trouble are inflation expectations. Once unleashed, this animal could play havoc with economic stability by triggering a continuous adjustment of prices, especially wages.

Middle East
Marios Maratheftis Serene Gardiner
Regional Head of Research, MEPNA, +9714 508 3311 Oil Products Analyst, +9714 508 4039 Marios.Maratheftis@standardchartered.com Serene.Gardiner@standardchartered.com

Breaking the resource curse
Higher oil prices are adding to inflationary pressures throughout the world, but perhaps more importantly they are creating substantial risks to growth. This brings back memories of the 1970's oil price hikes and the inflationary spiral those created. Most significant economic recessions since the Second World War have been created by inflation. The world is right to be concerned. However, sentiment in the Middle East and in particular the Gulf Cooperation Council (GCC) countries, is different. Their economies are booming, and there is little of the concerns of the west here. Here are three things to bear in mind when one thinks about oil, the region and the future.

First, oil prices are inherently volatile, and in the past fast oil price rises were followed by a collapse, which brought GCC economies down with it. Despite the efforts of the GCC economies to diversify, oil prices remain important. Second, the ability of GCC economies to absorb the windfall gains is as important as the price level itself. Severely constrained absorptive capacity will limit the benefits of the boom. We measure that capacity by looking at four factors: education, technology, financial market development and the quality of institutions. On each of these measures, we believe, things are improving. Third, the abundance of resources is not a guarantee of financial success. Historically, resource rich countries have underperformed thanks to the 'resource curse'. Aware of this threat, the authorities are aggressively diversifying. This is, however, a long-term transition.

Asian Real Effective Exchange Rate (REER) Update
The two charts next page show the Real Effective Exchange Rates (REERs) for the key currencies in the region. It is useful to look at exchange rates from an inflation adjusted trade weighted basis as this is more of a meaningful measure for policymakers to look at when deciding policy. Also the figures below are directly comparable between countries because all the indices have been rebased to January 1996. We note the following key points:
1) Most Asian REERs are below their pre-crisis levels. The exceptions are the INR, CNY, SGD and THB. We see
the long term positive fundamentals remaining in place 2) The theme of current account surplus currencies outperforming deficit currencies has shone through well 3) The next phase of the more open economies being hit by the global slowdown should weigh the most on the
TWD, SGD and MYR 4) The biggest decliner was the KRW which is 19% down from the high set in July 2007 5) Normally an underperformer TWD REER performance now matches the MYR
First it should be noted that there is still room for long term REER appreciation in Asia. There are four currencies shown below where the REERs have risen to above the pre-Asia crisis level. These are the CNY, INR, THB and SGD. In the case of the PHP the recent worsening in the fundamentals and weakening of the currency follows a strong rally dating back to 2005.

Second the current account deficit currencies in Asia have been clearly the worst performers since mid-07. The INR and KRW have been leading the way in this regard, being followed by the worsening situation in the PHP. Meanwhile the MYR and TWD REERs have stayed more steady while the SGD has been well supported. In H208 however we expect the driving theme to be the impact of the global slowdown. We expect the focus be on punishing those currencies most exposed to total trade. This implies negative pressure on the SGD, MYR, TWD, in H2-08 while the KRW, CNY and INR may outperform in the region given their smaller exposure to global growth. Compared to the start of the year when we called for this switch in focus from c/a deficit vs. surplus currencies to those most exposed to a global slowdown the current worry is over inflation pressures. While these inflation concerns remain in place there will be a delay in the shift in focus onto externally exposed economies.

As we have been stressing for some time we expect Asian currencies to be affected by the impact of the US slowdown. We expect this to play out in Q4-08 to Q1-09 rather than immediately. In this context the key currencies which have been doing better so far (MYR, SGD and TWD) may become the underperformers in this environment given their exposure to total trade. China is also likely to slow, leading to a knock on impact on the region. Therefore we expect to see more REER weakness in these currencies, particularly if Singapore switches away from an appreciation bias for the SGD NEER.

The most dramatic mover since the middle of last year is without a doubt the KRW REER. From the peak in July 2007 it has lost 19% on this basis. It is therefore encouraging that policymakers are wary of tolerating more weakness given the knock on impact on inflation. Also note that the benefits of a weak currency on the trade balance are rightly seen as being less than in previous years. Korean goods are less commoditised than in years gone by due to rapid rises up the value chain.

Productivity growth has been outpacing that of the US for the last decade and so we still see the long term trend for the KRW REER to be up. However while government policy certainty remains an issue we are cautious on the KRW. Indeed it was only in late May that policymakers switched from a weak to a stronger KRW bias and this seems to only be because of the previous losses. For now we expect to see a range in USD-KRW between 1,000-1,050.
The TWD REER is also worthy of attention. In previous updates we have stressed the trend of a gradual depreciation trend in the TWD, in contrast to most other regional currencies which were trending higher. Now there may be a change in this trend given the structural changes expected over the coming years from the increased economic links with the mainland. The same kind of positive impact on the economy could be felt as that seen in Hong Kong, particularly from investment flows.
The Hong Kong dollar REER has now taken the place of the JPY at the bottom of the list. This is not a major surprise given the USD peg. Rising inflation has not been enough to counter this trend. The danger is that the loose nature of monetary conditions, with a weak REER and negative real interest rates, leads to a bubble type conditions in asset and other prices, which would eventually lead on to a bust. We stress that this is not currently the situation but the conditions are in place for overheating pressures to emerge. Given the peg to the USD there is limited flexibility for policymakers to deal with this potential problem. For now it is a case of watch this space. There needs to be very strong evidence that switching away from the USD is a better option than keeping it. Right now the case for a change is not strong enough in our view.
In his first comment on the USD for a long time, Federal Reserve Chairman Ben Bernanke said that the USD's decline had contributed to inflation and inflation expectations and that both the Fed and the US Treasury were watching foreign exchange market developments closely. He added that Fed policy, as well as the economy's underlying strength "will be key factors ensuring that the dollar remains a strong and stable currency." Such comments are likely to support the market view that the Fed will not cut interest rates further. He warned that higher inflation expectations could become "self confirming" and are thus a "significant" upside risk to price stability. Taken at face value, such comments are seen by the market as an attempt to jaw-bone the USD higher. More likely the Fed is just trying to push for a USD stability given it is an important part of managing inflation and inflation expectations. Moreover, his reference to the fact that both the Fed and US Treasury continue to monitor foreign exchange markets closely is an implicit threat that actual intervention may be used if such inflation expectations

THB Lowered to Neutral from Overweight*

Thai baht

* = For the next 3-6 months: Leveraged funds: Short if 31.00-17 holds Real Money Funds: Marketweight vs. standard FX benchmarks Corporates: Neutral vs. forwards

Summary
Standard Chartered Bank has lowered its FX rating on the Thai baht (THB) to Neutral from Overweight. Thai growth has picked up due to higher political clarity and strong exports. However, we forecast that GDP growth will slow to 4.5% in 2008 from 4.8% as the weaker global environment will gradually hit Thai exports. Meanwhile, weak exports and booming imports due to 1) strong private and government domestic demand and 2) high costs of fuel imports will drag down the current account (C/A) surplus. We are forecasting that the full-year C/A balance/GDP will turn into a deficit in 2008 of -0.5% from a surplus of 6.5% in 2007. Downside risks to global asset markets on the back of the U.S. recession and the global credit crisis could outweigh local positives such as reduced political uncertainty and pickup in domestic demand. In sum, we expect a correction in the THB over the next 3-6 months. However, we remain bullish medium term on the THB given strong medium term growth prospects, reduced political risks. Thus, any such sustained short-term correction should be seen as a buying opportunity.

FX Economics: A Mixed Picture
Growth: Picking up – for now

The Thai economy expanded by 4.8% for full-year 2007 compared to 5.1% in 2006. However, real GDP growth picked up in Q4 to 5.70% y/y and 1.8% q/q SA from 4.80% and 1.50%. Business and consumer confidence indicators have improved since last autumn in anticipation of more political clarity and export growth has been holding up well. Going forward, Standard Chartered Bank expects growth to slow to 4.5% in 2008 from 4.8%, well below the government’s target of 6% growth. One reason why Thai exports have been holding up well compared to its regional peers is that Thailand’s exposure to electronics is less significant. (Electronics accounts for around 33% of total exports in Thailand whereas the number is 62% for Philippines, 50% for Malaysia and 40% for Singapore). However, with the U.S. economy entering into a recession this year weakness in electronics is likely to filter further down into other consumer goods which Thailand is exporting. Rice exports only accounted for around 2.3% of Thai exports in 2007 and hence higher rice prices will not be enough to slow down the USD export value of other commodities. We forecast that Thai exports will slow to 7.1% in 2008 from 18.1% in 2007. Given that exports account for 69% of GDP that will be a drag on economic growth. Expansive fiscal policy by the new government in the form of tax breaks for individuals, listed companies and SMEs and the government’s planned mega projects will provide some caution against the weaker global environment. We judge that it will add 0.5% to growth this year.

Inflation: Still Heading Higher

March headline CPI came out at 5.3% from 5.4% whereas core CPI rose slightly to 1.7% y/y from 1.5% y/y. The driving force behind higher headline CPI has been higher food prices and

transportation costs.

Current account surplus: Turning into a deficit. For full-year 2007, we estimate that Thailand recorded a C/A surplus of 6.5% up from 1.6% in 2006. The driving force was a jump in the trade surplus which rose to 4.9% of GDP in 2007 from 0.5% in 2006. Standard Chartered Bank expects that the C/A will turn into a deficit in 2008 of -0.5% of GDP. The main

Political developments: Stable for now

Political risk has clearly been reduced after the installation of the newly elected government led by the People Power Party (PPP). However, there are still a few factors that could bring political uncertainty back to the market. Potential political risk could come from 1) the electoral fraud case against Mr Tiyapairat the deputy leaders of the PPP, 2) the possible disbanding of the Chart Thai and Matchima Thipataya parties after some members were disqualified for vote buying in the general election on 23rd December 2007 and 3) the proposed amendment of the 2007 Constitution. These developments could bring political uncertainty

back in focus, and stall the progress of the recovery in domestic demand.

FX Model Valuation
As a reality check, we try to examine exchange rate valuation from the perspective of traditional FX fair value equilibrium models. On their own, they provide little short-term prescriptive power. However, they may give a clearer picture of whether or not a currency should appreciate or depreciate over the medium to long term.

REER Approach: SELL
The real effective exchange rate (REER) is a function of the price or inflation differential and the nominal effective exchange rate (NEER). The relationship between Purchasing Power Parity (PPP) and REER is a close and important one. The core idea is that if PPP is seen to hold over the long term then the REER should remain constant. That said, over the short term the REER can fluctuate significantly.

Standard Chartered Bank’s THB REER shows the THB at 111.59 as of February 2008. The THB is now well above the average since 1995 of 97.46. We have noted that since mid-05 the THB REER has caught up significantly with other AXJ currencies and it is now one of the 5 best performers since January 1996 among the 10 most traded AXJ currencies. As such, the THB looks like a sell on a REER basis given higher inflation rate than its trading partners and fast nominal appreciation of the THB since mid-05.
Monetary Approach: NEUTRAL

Linked in with PPP is the Monetary Approach to exchange rates. According to this, a change in money supply growth results in a change in price, which leads to a change in the exchange rate via PPP. Higher money supply growth would be presumed to lead to higher price growth, which should be offset by exchange rate depreciation to maintain PPP.

Thailand February M1, M2 and Monetary Base growth is at 8.42% y/y, 1.88% y/y and 7.04% y/y. By comparison, Eurozone February M3 growth is at 11.3% y/y and U.S. M3 growth is at 8% y/y. As such, this suggests a neutral signal for the THB.

Mundell Fleming Approach: NEUTRAL Thanks to the work of Robert Mundell and J. Marcus Fleming, we know that certain combinations of monetary and fiscal policy create specific exchange rate conditions. The Mundell-Fleming model illustrates how combinations of monetary and fiscal policy changes can cause temporary changes in the balance of payments relative to an equilibrium level. The exchange rate therefore becomes the transmission mechanism by which equilibrium is restored to the balance of payments

The current policy mix of Thailand is loose fiscal policy and loose monetary policy. This policy combination should lead to current account balance deterioration whereas the impact on real yields is ambiguous. The implication for the exchange rate depends on whether the C/A balance dominates the capital account. Due to the capital controls the C/A has since end-06 dominated the capital account in Thailand. We expect that the capital account will gradually become more important than the C/A on the back of the lifting of the capital controls. On balance the signal looks neutral for the THB.

Interest Rate Approach: NEUTRAL
Thanks to the seminal work of the economist Irving Fisher, we have the Interest Rate Approach to exchange rates, which focuses on interest rate and inflation differentials. Under the International Fisher Effect, the difference in interest rates should equate to the expected change in the spot exchange rate. Thus, a currency with a higher interest rate should depreciate proportionally relative to another with a lower interest rate.
The policy interest rate in Thailand is currently 3.25%. This compares with 2.25% in the U.S. and 4.00% in the Eurozone. As such, this is neutral for the THB.

Balance of Payments Approach: BUY
Under the balance of payments’ approach, changes in national income affect both the current and capital account, causing a predictable reaction in the exchange rate to restore balance of payments’ equilibrium. Under this, a change in national income results in a change in the current account balance, leading to a change in real interest rates and capital flows. As national income rises, so import demand increases causing the current account balance to deteriorate, all else being equal. On the capital account side, a rise in national income must be accompanied by a rise in real interest rates. If the current account dominates, the currency should depreciate, while if the capital account dominates the currency should appreciate.

Going forward, we expect national income to pick up in Thailand from Q3-08 onwards. This should lead to deterioration in the C/A balance, all else equal, as import demand increases. On the capital account side, an increase in national income should be accompanied by a rise in real interest rates attracting capital inflow. Since end-06 the C/A account has dominated the capital account due to the capital controls. Over the coming 3-6 months we would expect the capital account to gradually become more important than the C/A. On balance this suggests a buy signal for the THB.

From Inflation to Growth

FX Strategic Overview
Our call for the U.S. economic downturn to be longer and deeper than the markets currently expect leaves us still expecting further USD weakness in Q2 at least. The credit crisis is a major swing factor, particularly on the issue of when it has passed the worst point. Given the deteriorating fundamentals we are unconvinced by the latest rally in sentiment.

SCB FX Leveraged Model Portfolio
We continue to make respectable progress. Year to date, the SCB FX Leveraged Model Portfolio has a cumulative simple return of +9.47%. We currently hold one trade recommendation - short USD-SAR via 6M forward outright and are looking for other opportunities in Asia, Africa and G10.

SCB FX Real Money Portfolio
The SCB FX Real Money Portfolio remains positive year to date despite a recent setback in early April. It currently stands at +1.6% (non annualised) since re-entering positions based on our end Q2 forecasts.

Options Strategy
We look at three trade ideas in the Korean won (KRW), Indian rupee (INR) and Singapore dollar (SGD). We expect implied vol in the KRW curve to calm once the 9 April Parliamentary election is out of the way.

Corporate Hedger
Treasurers are becoming increasingly uneasy over market forecasting and volatility. We stress the importance of relative central bank hawkishness over inflation in driving the majors, particularly the Euro and the Australian dollar.

Correlations
We examine the evolution of the relationship between the Japanese yen (JPY) and other Asian regional currencies. With the Standard Chartered Risk Appetite Index now in risk averse territory, the pressure on the JPY from capital outflows has fallen.
FX Forecasts and Forecast Review pp. 10 - 11 We revised our broad USD call to expect a weaker USD throughout H1 and a temporary rebound in H2 2008. We also see some more INR strength in the very short term to help fight inflation.

FX Focus
CLP: Longer term upside for one of the world's best performing currencies year-to-date NGN: Strong balance of payments and portfolio inflows leave the naira well placed

Under Pressure

FX Strategic Overview
Standard Chartered Bank reiterates the call that GCC countries should and will revalue their currencies against the USD over the next few months. While a trade-weighted basket would be ideal, this seems unlikely for political reasons. However, inflationary pressures continue to mount and the Federal Reserve continues to cut rates, putting ever-increasing pressure on the GCC to revalue.

SCB FX Leveraged Model Portfolio
We continue to make solid, if cautious progress. Year to date, the SCB FX Leveraged Model Portfolio has a cumulative simple return of +6.72%. We continue to hold one trade recommendation - short USD-SAR via 6M forward outright and are looking for other opportunities in Asia, Africa and G10.

SCB FX Real Money Portfolio
The SCB FX Real Money Portfolio has had a good start to the year. Having hit its take profit rule as more than 50% of Q1 FX forecasts were traded through, we currently stand +2.34% (non annualised). We are not reoptimising and re-entering just yet as we think there could be better re-entry levels in coming days.

Options Strategy
The inversion in several implied vol curves appears to offer good opportunities, notably in USD-KRW, USD-TWD, USD-INR, USD-JPY and EUR-USD. This month, we examine 3M digitals in USD-JPY and 6M call spreads in USDINR.
Corporate Hedger pp. 8 Treasurers will need to be opportunistic, but conservative in managing AXJ translation risk. We expect a USD rebound against the majors in Q2 and Q3.

Correlations
Risk appetite is fading, weighing on high-beta EM currencies. However, current account surplus currencies will outperform in this environment. The correlation between GBP-USD and EUR-USD continues to decline as GBP underperforms.

FX Forecasts and Forecast Review
We revised our USD forecasts lower against the majors to take account of persistent downside momentum and perceived official tolerance, while still anticipating a temporary USD rebound in Q2/Q3.

FX Focus
We expect TWD to retrace as political gains give way to economic concerns ZAR: Further losses are likely as the economic outlook continues to worsen


The Need for Change to GCC Pegs Remains
We reiterate our call for a revaluation of GCC currencies in the coming months. While a revaluation followed by a switch to a trade weighted targeting regime would be ideal, we believe the second best solution of keeping the peg following a revaluation is more realistic. The economies of the GCC are suffering the consequences of their current policy set-up due to a decoupling between the domestic economies and that of the anchor currency (the U.S.). The longer the problem is not dealt with the harder the adjustment will be.

If introduced a trade weighted basket would not need to be too complicated. Two currencies, the EUR and USD, would suffice. However, we do not detect that there is enough appetite in the Gulf to depeg from the USD, at least not at the moment when the USD is facing so much pressure. GCC currencies like to stand by a friend, in this case the USD, when the friend is need. Our view is that a significant step revaluation is the second best and most likely solution and we maintain our call for a significant revaluation of GCC currencies in coming months. The debate in the region on currency reform is resurfacing.

It Should be Easier to Manage a Boom
It is positive at least to see GCC countries booming even at a time when the outlook elsewhere is not so rosy. But the boom needs to be managed. Real interest rates are now negative. One does not really need to look that far back to understand the problems cheap credit can create. It was not so long ago when the US economy was awash in liquidity.

In this note we look at some of the most popular arguments which are being made against any change in the current FX regimes, and we dismiss them. In an environment where government spending is high, oil prices are above USD 100pb and monetary conditions are ultra loose, inflation will continue to rise. We view rising inflation as the biggest risk to achieving sustainable growth. Monetary policy needs to tighten. A revaluation is the way to achieve these tighter conditions.

Housing is not only a Domestic Factor when you are Importing Building Materials
A popular argument in the region is that the main driver of inflation is the housing market which is completely unrelated to the currency policy. This is not entirely true. First, construction materials are mainly being imported. It has been estimated by Moody's that in the second half of 2007 the price of cement increased by 40% and that of steel by 25%. The rising cost in housing is not just a domestic factor. The weak currency is making the imports of materials even more expensive.

Second, labour costs are also increasing. GCC countries are relying heavily on imported labour. Foreign workers have seen the purchasing power of their earnings diminish over the past year, not only because of the higher inflation but also because of the weakness of GCC currencies vs. currencies like the Indian Rupee (INR). The result is higher wage demands, which is translating into even higher construction costs and more pressure on the housing market.
Finally, the availability of what effectively is free credit, when one looks at real interest rates, is more than likely to increase the pressure on the housing market from the demand side. Credit growth in the region is rapid, for example in the U.A.E, consumer debt increased by almost 40% y/y in 2007.

How Much is Your Money Worth?
There is also an argument that a revaluation will hurt the region because of oil income and USD based investments. Oil proceeds might feel higher because of the weaker currencies, but in terms of value they are not. Income from oil and from returns on USD investment is worth less internationally because of the weakening USD and less domestically because of rising inflation. The idea that a weak currency would boost incomes when it comes to the purchasing power of this income is merely a case of money illusion. This is not so different to feeling richer by printing more money. An OPEC study explains that 73% of oil revenue was lost between 1970-2004 because of the weakening USD and rising inflation. It is not only important to see what the income level is but it is also important to see the purchasing power of this income.

Creating a Stable Environment for International Investors
Saudi Arabia wants to become a top 10 Foreign Direct Investment (FDI) destination in the world by 2010. Advocates of the status quo argue that a revaluation would jeopardise investment inflows. Inflation and rising costs are a much bigger risk for FDI than any revaluation. For a country to become an attractive investment destination macroeconomic stability is paramount. Take for example Turkey. For a number of years Turkey was one of the least popular investment destinations in the world. Those were times of macroeconomic instability and high inflation. However, in the past three years, when the Turkish authorities finally managed to get inflation under control, foreign investment in Turkey soared. FDI in Turkey was increasing at a time when the Turkish Lira (TRY) was showing impressive gains. The stronger currency was not an impediment to FDI. On the contrary, it was indicative of the success of the country. Over the past three years, which were years of significant TRY strength, Turkey attracted more FDI than in the previous 20 years combined.

The two top FDI destinations in the world in 2007 were China and India. The currencies of both countries appreciated in that year. The main reason why the authorities in China and India tolerated stronger currencies was to fight rising inflation. The Chinese yuan (CNY) appreciated by 6.4% and the INR by more than 12% in 2007. The currency adjustment has clearly not made China and India less attractive destinations.

Macroeconomic stability, regulatory environment and the prospects of GCC economies will be key when it comes to attracting FDI, not an undervalued currency.
Kuwait was Right to Scrap the Peg

Kuwait decided to scrap its peg to the USD and introduce a currency basket in May 2007. Critics claim that if Kuwait's decision to scrap the USD peg last year was correct, inflation should have stopped rising. The latest inflation figures from October 2007 show inflation at 7.26%. The rise in inflation and this growth in the money supply have been used as criticisms over Kuwait's decision to scrap the US dollar (USD) peg and the introduction of a currency basket in May 2007.

Before one criticises the decision, one needs to bear in mind two important arguments. First, inflation has indeed risen, but it is still significantly lower than inflation in the U.A.E and Qatar. It is also important to take into consideration that inflation could have been much higher than 7.26% had the authorities kept the USD peg.

Second, the Kuwaiti dinar (KWD) has appreciated against the USD by 6.22% from the introduction of the basket to 4th March. This is not enough. It is also worth considering that the KWD currency basket we monitor is below the highs it reached earlier this year. In other words the authorities have allowed the KWD to appreciate vs. the USD, but not by enough to compensate for the sharp drop in the value of the USD vs. other currencies. At least the Kuwaiti authorities have the flexibility to accelerate this pace of appreciation. Given the inflationary pressures and the growth in monetary aggregate, it is likely to see more KWD appreciation against the USD in the near future.

BoT lifts remaining capital controls, effective from March 3

BoT lifts remaining capital controls, effective from March 3
The Bank of Thailand (BoT) finally decided to lift its remaining capital controls, effective from March 3. This is in order to restore foreign investor confidence. The BoT cited widespread expectations of the removal of capital controls, which had recently eroded the effectiveness of the 30% unremunerated reserve requirement (URR) in curbing baht appreciation. Below is a brief summary of the regulatory changes accompanying the removal of the URR:

(1) Encourage portfolio investment abroad by increasing the foreign investment limit for the Securities and Exchange Commission (SEC) to USD 30bn to allocate to securities companies, mutual fund companies, and individual investors (through investment with private funds or securities companies).

(2.1) Reduce the limit for domestic financial institutions to borrow THB from non-residents (for transactions with no underlying trade) to no more than THB 10mn.

(2.2) Increase the limit for domestic financial institutions to lend THB to non-residents for transactions with no underlying trade to THB 300mn (from THB 50mn previously).

(3) Revise the structure of Non-Resident Baht Account (NRBA) by segregating into Non-Resident Baht Account for Securities (NRBS) and Non-Resident Baht Account (NRBA) so as to help monitor fund flows of non-residents. Under the new structure, the transfer of baht between the same types of accounts is allowed, while the transfer between different types of accounts is prohibited.

How will this affect the Thai baht and two-tier market?
Following this event, we expect that the appreciation of Thai bath onshore (THO) will continue in the near term as the current account surplus is expected to persist over the coming months (although narrowing over time, given the higher demand for capital goods imports in order to facilitate mega projects from H2 08). In Jan 08, with export growth still strong, Thailand reported a current account surplus of USD 1.396bn. Fears of further THO appreciation will force Thai exporters to continue to be heavy net sellers of foreign exchange. In addition, it is likely that volatility in the THO will increase as capital flows in and out of Thailand will become larger in the absence of capital controls.

As for the differential between the Thai baht in the onshore and offshore markets, it is now likely to narrow given the potential for higher baht liquidity in the offshore market due to measures 2.1 and 2.2. Measure 2.1 suggests that offshore investors who have baht liquidity (but with no underlying trade) will now be able to lend up to THB 10mn to domestic financial institutions. This means that offshore investors who have baht liquidity will have to lend more in the offshore market instead. Given measure 2.2, domestic financial institutions are now allowed to lend THB to non-residents for transactions not supported by an underlying trade up to a revised limit of THB 300mn (from THB 50mn previously). Therefore, both measures should increase baht liquidity in the offshore market going forward, allowing USD-THB offshore to rise closer to USD-THB onshore. Yet, it is still unclear whether the two-tier market will be eliminated or converged. The BoT is expected to clarify this with more details on Non Resident Baht Accounts (NRBA) in a meeting called with all commercial banks on Monday 3rd March.

We maintain our call for aggressive rate cuts by the BoT
As highlighted in our OTG (Full lifting of URR is only a matter of time, 11 February 2008), we believe that the BoT has to manage the USD-THB interest rate spread to reduce the positive carry of the THB over the USD after lifting the capital controls. This is in order to mitigate the speed of THO appreciation. We expect the US Federal Reserve to cut rates aggressively over the coming months, taking the Fed Funds target rate to 1.0% by end Q3 08. If the BoT keeps its policy rate unchanged at 3.25%, the widening spread between the THB over the USD will inevitably add to appreciation pressures on the THO. In order to reduce the speed of THB appreciation, the BoT is therefore likely to consider cutting policy rates in the coming months. We maintain our view that the BoT is expected to cut rates by 25bps in each of the five MPC meetings from Apr-08 to Oct-08, taking the benchmark 1-day repo rate down from the current level of 3.25% to 2.00%.

Further implications from the new measures

Further implications from the new measures
Thailand
The end of the 30% unremunerated reserve requirement (URR) on bond investment, as well as a number of measures aimed at improving offshore Thai baht (THB) liquidity announced on 29-Feb have caused the onshore and offshore Thai baht (THO and THB respectively) to converge. This is likely to remain the case in the foreseeable future. While the government is also expected to bring out new policies to curb Thai baht appreciation, other near-term factors convince us that the outlook for THO is positive and as a result
Standard Chartered Global Research has revised its USD-THO forecast to reflect this positive outlook.

These positive factors include the USD-THO interest rate differential to remain in favour of the THO in coming months, capital inflow in view of lower interest rates, and the current account continues to stay positive in the near term, and be more dominant over the capital and financial
account net inflow.

Revised USD-THO forecast (previous forecasts in brackets)
Q1-2008 Q2-2008 Q3-2008 Q4-2008
(32.75) (33.25) (33.50) (34.00)
Source: SCB Global Research

How it all started…
To begin our discussion on what will change after the BoT lifted the remaining capital controls, it is important to recall the remaining capital controls imposed since 18-Dec-06, which can be summarised as below.

(1) All non-resident purchases of Thai baht onshore (THO) are subjected to a 30% URR, with the exception for payment of good and services, repatriation of investments abroad by residents, long-term foreign direct investment into Thai companies, equity investments on the Stock Exchange of Thailand, stock index futures on the Thailand Future Exchange, transactions by development organisations, and government external borrowing.

(2) Exemptions were also extended to fully-hedged foreign borrowing for long-term investment, hedged inter-company loan, hedged packing credit (less than 180 days), hedged investment in government bonds, debentures, bills of exchange & promissory notes, and hedged investment in mutual funds.

(3) Foreign investors were required to set up separate Special Non-resident Baht Accounts for their investments in securities (called SNS), bonds (called SND), and trade (called SNT). Under such

special accounts, foreign investors are also required to sell the Thai baht they received after liquidating their investments, and exchanging for foreign currencies in the on-shore market only.

A closer look at the new set of rules
The BoT finally decided to lift the remaining capital controls, effective from 3-Mar. In parallel, the BoT introduced additional measures, which are summarised in our On the Ground released on 29-Feb, in order to promote more outflows.
In addition to that we want to use this opportunity to provide some clarification on the measures, especially on Non-Resident Baht Account, after the 30% unremunerated reserve requirement (URR) was lifted.

(1) Non-resident Baht Account is now divided into 2 types:
(1.1) Non-resident Baht Account for Securities (NRBS) for investment in securities and other financial instruments such as equity instruments, debt instruments, unit trusts, financial derivatives transactions traded on TFEX, AFET including sale proceeds, returns, and related payments from such investments
(1.2) Non-resident Baht Account (NRBA) for general purposes such as trade, services, direct investments, investment in immovable properties, loans, and other transactions
(2) Transfer between Non-resident Baht Account
The transfer of baht within the same type of accounts is allowed, while the transfer between the different types of account is prohibited. Meanwhile, day-end balance is still capped at THB 300mn for both NRBS and NRBA.
This implies that:
(2.1) Baht fund in NRBS cannot be transferred to NRBA, and vice versa
(2.2) Baht fund in a NRBA can be transferred to any other NRBA
(2.3) Baht fund in a NRBS can be transferred to any other NRBS

(3) Non-resident foreign exchange transactions without underlying
Non-residents are now allowed to execute foreign exchange transactions without underlying. However, it is still subjected to the following rules from the BoT.
(3.1) Total outstanding balance undertaken by each financial institution of all transactions which result in providing baht liquidity to non-residents without underlying must not exceed THB 300mn per group of non-residents (previously capped at THB 50mn).
(3.2) Total outstanding balance undertaken by each financial institution’s borrowing baht from nonresidents without underlying must not exceed THB 10mn per group of non-residents

(4) Request for unwinding of hedging transactions
Non-resident can seek the BoT’s approval to unwind their hedging contracts with their counterparties, as they were required to hedge in order to be exempted from the 30% URR. Upon receiving the application, the BoT will consider the request for approval within 15 working days.

Two-tiered market has now converged
What was in the past under capital controls? Under previous rules by the BoT, “financial institutions shall withhold 30% of foreign currencies purchased or exchanged against baht from their customers as reserves except in certain cases such as – goods, services, direct investment, investment in stocks, investment in immovable properties, and loans, investment in debt instruments and unit trusts which have been fully

hedged. This suggests that non-resident was restricted to trade baht onshore with no underlying, or they will be otherwise subjected to the 30% URR rules.

Inflows into Thailand interest rate markets could continue
The lifting of the URR, along with possible rate cuts by the central bank, is a positive development for Thai interest rate markets. Of course the positive knee jerk reaction to local interest rates following the lifting of the URR has already taken place. However, given the prospect of that more overseas investors could now include Thai financial assets in their benchmarks, and the fact that we expect BoT to cut its 1-day repo rate by a collective 125bps from 3.25% currently to 2% by end-2008 as highlighted in our OTG (BoT lifts capital controls, 29 February 2008), the portfolio inflow should be Thai baht positive near term. Thailand has already experienced a large net bond portfolio inflow in Q4-2007 in anticipation of the lifting of the capital controls after a significant outflow Q1-Q3-07 (see Chart 2). The lifting of the capital controls may continue to attract inflows to the Thai interest rate markets, and hence supportive for the THO near term.

Current account to dominate capital account for now
The trade balance narrowed significantly in Jan-08 to USD 170mn from USD 1,069mn in Dec-07. This reflected much higher imports of capital goods and oil-related products. However, Thailand reported a still solid current account surplus of USD 1,396mn in Jan-08 from USD 1,661 mn in the previous month due to a very large net services and transfer account of USD 1,226mn. However, the current account surplus is likely to narrow later in the year as the trade balance deteriorates due to a combination of factors. These include 1) sluggish exports due to weak demand from Thailand’s top export markets, the US and derived demand from Asia, and 2) stronger imports given large demand for capital good imports to facilitate mega-infrastructure projects from H2-08. As the current account surplus narrows, the capital account will become more important. That is at the time where exporters are likely to become less aggressive sellers of USD-THO. Meanwhile, there will be higher demand for buying USD-THO from importers. Together with potential greater portfolio investment abroad by domestic investors as well as state owned enterprises swapping their foreign currency lending into local currencies, as proposed by the MoF, we should see the risks of more corrections in USDTHO later in H2-08.