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.