Asia Focus: As Japan awakes: Japan's recovery could offer the biggest upside surprise to Asia this year. Increased Japanese imports and bank lending could substantially offset the impact of an expected US slowdown. Longer run, renewed Japanese demand, capital and technology could fuel Asia's twin growth engines - China and India - to even stronger momentum.

Economy Highlights

China: 2006 is set for fast growth, low inflation and a crawling CNY, which is expected to rise and fluctuate more as market reform advances. The risks of a sharper slowdown, however, are concentrated in 2007-08.

India: The party continues as strong momentum sustains 06/07 growth at near 7%, while high savings supports investment and limits fiscal and current account deficits. Rising inflation will prompt higher rates and dampen consumption, but no upward spiral of interest rates is likely.

Malaysia: Strong IT exports and public investment, high oil and commodity prices will support growth at a resilient 5% in 2006. But rising inflation will push interest rates up by 100bps, curbing consumption and boosting the MYR.

Taiwan: IT demand should support export growth in H1-06. Gradual monetary tightening would dampen consumption, but prevent a bust in consumer debt.

OVERVIEW

by Nicholas Kwan

A year of turning tides

- Tides will turn as rates peak, oil prices plateau, Japan recovers
- Rising capital flows, shifting demand and Japan will boost Asia
- Beware of rising inflation, yield curve reversion and volatile flows

Despite generally slower growth and higher inflation, 2006 will be remembered as a year of turning tides, when US interest rates peak, oil and commodity prices plateau, and Japan's decade-long stagnation formally ends with an official departure from quantitative easing. For Asia, this spells more opportunities than risks, especially comparing with 2005 when the region was hit by a cross-continent tsunami, severe earthquakes, escalating threats of avian flu, record high oil prices and repeated interest rate hikes. If avian flu was what the Year of Chicken (2005) offerred to test Asia's resilience, the Year of Dog (2006) is likely to be the time when Asian economies bark loud and high to capitalise on its proven strengths, under three key regional developments:

1. Rising capital flows into and out of the region: we expect US interest rates to peak at 5% in Q2-06. However, lagging in the interest rate cycle and facing rising threats of inflation, most Asian central banks are likely to continue tightening, albeit mild and steady, in most of 2006. Widening interest rate differentials and relatively strong growth momentum will attract more capital into the region. Moreso as Asian currencies and asset prices are expected to rise.

Meanwhile, countries with large external surplus will accelerate their capital outflows by further deregulating their capital accounts. China, which is expected to see its forex reserves surpassing Japan's, should take braver steps in opening its capital account, such as the long-discussed QDII (Qualified Domestic Institutional Investor) scheme and more overseas acquisitions for strategic resources, similarly for India and other resource-short countries.

2. A shift of demand from external to domestic: with US demand expected to weaken, Asian exporters would need to shift their growth drivers to domestic demand before the current electronic upcycle runs out of steam. For some Asian economies, such a shift is not just a short-term cyclical switch in growth drivers, but also a strategic adjustment in their long-term growth strategy in pursuit for more sustainable development. This would involve significant policy adjustments in exchange, monetary and fiscal areas. Some high savers like China will have to boost consumption, promote consumer credits and improve income distribution. Some others like Thailand, Indonesia, Korea, and India will have to boost investment. This in turn will require accelerating privatization and financial sector reforms to mobilise private savings, and improving fiscal management to better allocate public resources.

3. Japan's recovery: the return of inflation and exit from quantitative easing will signal Japan's final departure from its decade-and-half economic malaise. While changes are likely to be gradual and cautious, this year may mark the return of a more confident Japan in Asia's economic scene. This will offer an important offset to the expected slowdown in the US, and a long-term propeller to Asia's growth and integration (see analysis in Asia Focus).

Riding on the above three major currents, investors should see opportunities in:

1. Short-term asset price hikes and longer term domestic demand growth: peaking of US interest rates and most commodity prices, including oil, would remove some major uncertainties in global business. This could unleash a strong drive for liquidity and spending across the region, pushing up asset prices, currencies, reinforcing confidence and providing new growth inertia.

2. The rebound of Japan: current expectation of a slow gradual recovery in Japan may be correct, but estimates of its impact on Asia could be conservative. While Japan's overall growth may not jump wild, there could be strong upside surprises from its reemergence in Asia, especially in bank liquidity, imports, direct investment and even portfolio flows. Historically, a 1% rise in Japan's import demand for Asia could offset a 0.6% decline in US imports from the region. A 10% rise in Japan's bank lending to Asia will raise the region's money supply directly by 0.6%. Underestimating Japan's re-emergence would be a very costly mistake.

3. Proliferation of flows among the Asian emerging giants: trade and investment flows among key Asian economies like China, India and Korea should gain momentum, driven partly by their need to recycle external surpluses and to capture resources overseas. With more than a trillion USD in their reserves and deep hunger for energy and many other resources, these emerging giants are likely to go on their shopping spree.

Complacency is ill-afforded, as always. Specifically, the region needs to manage the risks of:

1. Inflation: high energy prices, strong capital inflows and growth momentum are likely to push up consumer and asset prices in many Asian economies. More opened capital accounts will limit central banks' ability to use monetary and exchange rate policies to tackle inflation. Indonesia got its first warning last year, though it managed to regain some initiatives lately. India, Thailand and Korea are also under pressure.

2. Interest rates: while we are confident US policy rate hikes will stop soon, we are less certain about the move of the currently inverted yield curve. Neither the conventional explanations of exceptional strong demand for long-bonds (by central banks and pension funds), benign inflation expectations, nor depressing growth outlook are convincing enough. The current anomaly may not last long and the yield curve could revert, probably in quite volatile ways. Beware of accidental death as things unwind, especially those carry trades that leverage on shaky differentials. In comparison, the risk of more-than-expected US rate hikes is easier to manage. Rates may go higher, growth may be lower, but the Fed and Asian central banks are unlikely to squeeze their economies into recession for just the shadow of inflation.

3. Rising and more volatile capital flows: as tides turn and liquidity buoys in Asia, countries with less solid fundamentals or weaker external payment positions could come under speculative pressure. High asset prices buoyed by strong capital inflows would also risk sharp corrections down the road. India, Indonesia and Korea saw their stock indices jump by 20-50% last year. The IDR, KRW and PHP have also appreciated substantially in recent months.

4. Other concerns remain in the US housing market, protectionism, oil prices, sino-Japanese disputes and cross-straits tension, . . . etc. Some of these would deserve more attention, but none presents insurmountable threat to Asia, which we will analyse in more detail in the coming issues.

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

As Japan awakes

- Japan's recovery could offer the biggest upside surprise to Asia this year
- Increased Japanese imports and lending could mitigate an impact of an expected US slowdown
- Longer run, renewed Japanese demand, capital and technology could fuel Asia's twin growth engines - China and India - to even stronger momentum

By this March, Japan would be celebrating the 17th quarter of its current upturn, the longest ever since the world's second largest economy officially dipped into recession in mid-1993. While we believe Japan' recovery would remain mild after an initial catch-up phase, it is about time the market pays heed to the likely impact of an awakening Japan on the world economy, especially Asia.

Specifically, Asia could benefit from renewed Japanese bank lending, increasing import demand from Japan, and sustained Japanese direct investment in the coming months. This could be followed by growing Japanese portfolio investment and more Japanese tourists as the recovery gathers momentum. We estimate that every 10% increase in Japanese bank lending to Asia could directly boost the region's money supply by 0.6%, and every 1% rise in Japan's import demand from Asia could offset a 0.6% downturn in US imports from the region.

The return of Samurai: windfall liquidity
In 2004, Japanese bank lending to Hong Kong rose by USD 3.2bn, up 14% y/y after years of decreases. In the same year, India, Indonesia, Korea, Malaysia, the Philippines and Thailand also saw strong rebound in lending by Japanese banks (Chart 1).

Between Q2-95 and Q3-03, Japanese banks withdrew about USD 300bn from Asia. In the late 1980s, Japanese banks used to contribute over 60% of total foreign bank lending in China and Thailand, and over 50% in Hong Kong, Singapore, Indonesia and Malaysia. To date, they account for less than 20% of foreign bank lending in these markets (Chart 2). No wonder some analysts argued that the 1997/98 Asian financial crisis was a collateral damage caused by Japanese banks' massive retreat from the region.

Improving profits in Japanese companies have contributed to reducing bad loans in Japanese banks. Non-performing loans (NPL) of mega banks have dropped from a peak of 8.4% in 2002 to the latest 2.4%. Capital adequacy ratios (CAR) of all banks rose from below 8% in Q1-90 to 11.6% last year. Domestic lending by Japanese banks stopped falling for the first time in eight years this January. While there are still concerns over the health of the smaller regional banks, the mega banks are generally in good shape and some are taking a more aggressive stance in their international presence. This is evident from Tokyo Mitsubishi UFJ's recent interest in taking a strategic stake in the Bank of China.

It is hard to expect Japanese banks to rebuild their Asian presence to their pre-crisis levels any time soon, but their sheer size means any 10% increase in Japanese bank lending to Asia could boost the region's narrow money supply by 0.6% directly. Should Japanese banks resume its lending to pre-crisis level, total foreign bank loans in Asia will be boosted by a quarter and Asia's money supply will rise by 14%.

Made-for-Japan: highly elastic demand
Japan's import demand is highly pro-cyclical (Chart 3). Since 1996, Japan's share in Asia's exports has dropped by 3.7 percentage points to 11.1% in 2004, making it the third largest market for Asian exports, down from the second position in 1996 (Table 1). However, as Japan's demand rises with its economic recovery, demand for Asian exports should also increase. In fact, it is estimated that the income elasticity of Japan's imports from Asia is much higher than one. This would particularly benefit Indonesia and the Philippines, where Japan absorbs over 21% of their exports. We estimate that a 1% rise in Japan imports from Asia can roughly offset a 0.6% drop in US imports from the region.

Made-in-Asia: growing with deregulation
Japanese direct investment in India has been rising steadily since the start of last year, from USD 26mn in Q1-05 to USD 70mn in Q3-05. Korea, Taiwan and Thailand also saw strong pickup in Japanese FDI inflows in Q3-05. While Japan's FDI in Asia is driven more by growth and opportunities in recipient economies, improving corporate financial health back home should allow more aggressive expansion overseas.

In aggregate, Japanese direct investment accounts for about 10% of total FDI inflows into Asia. But its share in specific countries could be much higher. For example, Thailand has over 80% of its FDI inflows in 2004 come from Japan (Table 1). With China's banking sector due to open and privatization programmes accelerating in India and Indonesia, we could see more active Japanese investment in these countries this year.

In search of yield: appetite of the aged
As Japan exits from quantitative easing, along with the expected peaking of US interest rates, change in interest rate differentials and improving economic prospects in Japan will encourage more capital flows into Japan. However, the change in Japan-US interest rate differential should not be overstated, since it is unlikely the BoJ will go for a quick and significant rate hike, given the nascent recovery and absence of inflationary pressure. More likely it will first scale back its current account target before pushing up the yield curve.

More importantly, as the Japanese economy recovers further, liquidity inside Japan will accelerate and risk appetite of Japanese investors will also rise, driving more Japanese capital abroad to search for better return. This is especially true for pension funds and insurers who are hard pressed by an aging population and need to recoup their losses suffered during the deflation years. This will result in increasing flows into and out of Japan at the same time. Last year, foreigners bought about JPY 2.3trn of Japanese securities, while Japanese purchased JPY 16.7trn of foreign assets.

Unfortunately, Asia traditionally is not a favourable choice of Japanese portfolio investors. However, Asia did get larger shares of Japanese portfolio outflow before the 1997 crisis, at 6.2% in 1996, compared with less than 1% now (Chart 4). If Asia were to regain its share of Japanese portfolio money to the pre-crisis level, that would mean an additional inflow of USD 12bn, representing around 14% of annual net inward portfolio flow into the Asian economies. Look for more liquidity and volatility as Japan's risk appetite rises.

Retreat revisited: welcome back
One last but modest source of surprise could come from tourism. Since peaking out in 1996 with 25 million departures, Japanese tourists have retreated substantially from the world. In Asia, the number of Japanese visitors has rebounded to previous peak since 2000 but growth remains marginal in most Asian destinations. It is likely that any modest increase in tourist revenue will have to wait until a broader recovery unfolds in Japan. Japan accounts for around 10-15% of Asia's visitors and provides about USD 12bn in tourist revenue a year. This may not offer a huge boost to the Asian economies, but could be a significant swing factors for selected spots like Phuket or Bali.

Fueling Asia's twin growth engines
For more than a decade, Japan's influence on Asia has been waning. As the Japanese economy gradually recovers, we are likely to see Japan reasserting itself in the region. This would offer a timely boost to the region in the near term, given expected slowdown in the US. More importantly, it may provide a new source of regional growth in the longer run. Japan's resurgence will offer the region with a renewed source of final demand, capital and technology - a fuel much needed for sustaining the momentum of Asia's twin growth engines: China and India. Of course, hurdles exist in this resurgence, such as political tensions with China and Korea. But history of the past quarter-century clearly demonstrates that Asia, including Japan, benefits more from closer economic integration than isolation. To make Japan's recovery sustainable, closer ties with Asia is not just natural but necessary.

CHINA

by Stephen Green

A year of being dull, for a change

- 2006 set for fast growth, low inflation and a crawling CNY
- CNY to rise and fluctuate more as market reform advances
- The risks of a sharper slowdown are concentrated in 2007-08

2006 looks set to be a really dull year for China. But dull in a good way. Gone is the excitement of 2005, when analysts battled over the CNY, when inflation hawks worried about huge FX inflows, when Cassandras rumbled on about a hard landing, and we all worried late into the night about US-China relations. In the end, the CNY question now looks settled, inflationary pressures have dissipated, FX inflows appear to be slowing, and analysts are still waiting for a significant landing of any sort. And US-China relations, at least as far as the CNY is concerned, look a bit healthier too.

Remains as Asia's growth champion
China looks set to grow faster than any other country in Asia, again; we are looking for 9.4% real growth on top of the CNY 18.2trn (USD 2.3trn) output in 2005. Chart 1 shows the revised GDP growth numbers on the production side, compared with the previous unrevised numbers. The new GDP series not just raised China GDP by about USD 300bn, but also raised the growth rate by about half a percentage point. Our in-house freight index, which we use as a proxy for overall growth, strengthened in 2005 from H2-04, as Chart 2 shows. It now signals stable growth, above the average rate over the last five years.

Fixed asset investment looks steady, thanks to a smaller investment deflator. But we suspect it will weaken in real terms given slowing profit growth and weaker export demand. The gentle downturn in export growth is cause for concern. But investment will clearly not collapse. Instead, it will turn more internally focused. Fixed asset investment grew 25.7% in nominal terms in 2005, compared to 26.6% in 2004. Construction investment will continue to grow, but a little below the 28% y/y in nominal terms in 2005, as China renovates its cities. Urban investment rose at 27.2% in 2005 in nominal terms, compared to 'only' 18.0% in rural areas. We expect those rates to converge as the government's rhetorical commitment to rebuilding the 'new socialist countryside' is converted into real spending.

Consumption also looks strong. Urban household expenditure was growing more strongly in real terms than at any time since the mid-1990s. Urban disposable income rose 9.6% in real terms in 2005, up 1.9 percentage points on 2004. And the real estate deflator rose 7.6%, adding wealth to household balance sheets. Even Shanghai's residential transaction volumes revived in Q4 -05 after a six-month hiatus. Elsewhere, expect house price inflation to match nominal economic growth. This and other consumption drivers (lower rates of unemployment, real wage growth in the manufacturing sector, and a general sense of optimism about the country's prospects) will remain in place in 2006. Year-on-year inflation, both CPI and PPI, have stabilised at low levels, with food prices having stabilised and more raw materials supply coming on stream.

On the CNY, most onshore economists believe that USD/CNY will move by 3% over the year, carrying on the trend seen since the one-off revaluation in July 2005. Our YE-06 forecast is 7.85, with the pace of appreciation and volatility increasing as the market maker system and forwards market mature. The CNY's nominal effective exchange rate shows considerable strength against Euro and Yen in 2005 (as the USD strengthened). Given the competitiveness of Chinese exports it will take a much more aggressive move to bring overall export growth below 15% y/y. The first interest rate swaps licence was out - but given the lack of an onshore curve (which makes pricing impossible), the administrated bank interest rate environment (which limits demand) and the lack of fixing (a technical, but essential, requirement), the IRS market too will take time to develop significantly. If pressure from the US rises again, widening the official band to +/-1% might be enough to satiate Congress, but do not expect it to make one jot of difference to what a colleague likes to call the 'Great Crawl of China'.

The test is in 2007-08
So in 2006, expect to be bored by more stories of China growing strongly. The more exciting story is around the corner in 2007-08, when deflationary pressures from over-capacity may come to the fore, export markets may slow as global liquidity dries up, and greater numbers of new non-performing loans may start clogging up China's banking system again. We do not expect a rout, but these factors could combine to drag real growth down below the 8-9% range.

As we argued in a recent Special Report, the government is already spending vast sums on the countryside, and has achieved some notable successes already - scrapping the Agriculture Tax and reinforcing free primary school education in rural areas are the two most important. Subsidies are increasing rapidly. However, if overall growth were to slow, job growth would slow, migrant labour wages could fall back in real terms after recent gains, and the stresses in the countryside would increase. This could get quite exciting - but not in 2006.

INDIA

by Shuchita Mehta

Party continues: some risks, overall positive

- Strong momentum to sustain 06/07 growth near 7%
- High savings to support investment and limit deficits in fiscal and current account
- Higher rates to dampen consumption, but no upward spiral

A rising savings rate should support the strong investment momentum and keep India growing at around 7% in 06/07, limiting the deficits in fiscal and current accounts. While interest rates are likely to rise with higher inflation and dampen consumption growth, no upward spiral in rates are expected.

In February 2005, we wrote that India will experience acceleration in growth in 05/06 and emerge as one of the fastest growing economies in the region. Our base case assumptions have come true. The recently released estimates from the government put 05/06 (ending March) GDP growth at 8.1% y/y, up from 7.5% reported in 04/05 and ahead of our forecasts of 7.8%.

Although there is enough economic momentum yet to be unleashed, our concerns are materialising as well - mounting inflationary pressures, rising current account deficit and pressures on interest rates. Risks in the form of decelerating global growth and higher rates suggest cyclical pressures on growth as well as on capital inflows. These negatives are unlikely to either create overheating pressures on the economy (and hence spiraling interest rates) or create a risk to the balance of payments position. Thus, we expect near 7% GDP growth in 06/07.

Favorable savings-investment trends
Recently, government's statistical office, Central Statistical Organization (CSO), puts the savings rate for 2004/05 at 29.1%, up from 28.6% for 2003/04.

Together, investment has also grown to 30.1% of GDP in 2004/05 from 27.2% in the previous year. Though lower than some of its other regional peers, India's investment rate has surpassed 30% for the first time since the 1950s. Within investment, public sector investment is beginning to look up, accounting for near 7% of GDP, while private sector investment is a stronger 8% of GDP.

We draw out the following conclusions from these trends. First, the current savings and investment rates are compatible with a GDP growth rate of near 7-8.5%. The planning commission of India assumes incremental capital required to produce one unit of output (ICOR) for India at 3.58% for 2002-07. In a straight forward analysis, savings rate divided by the ICOR (measure of efficiency in use of capital) would give the implied growth rate.

Second, as expected growth is acquiring a more capital-intensive dimension. Investment rate probably rose to near 32% of GDP in 05/06, based on our expectations on current account deficits (near 2.3% y/y) and unchanged savings rate.

Anecdotal indicators such as capital goods imports (up 32.5% y/y in April-Oct 05) and domestic capital goods production (up 15.9% in Apr-Nov 05) also suggest a rising investment rate. The surge in credit to deposit ratio (to 70%), slew of equity issuances and continued borrowings by companies overseas also indicate accelerating investment cycle. Government is also keen to speed up public investment and develop credible public-private partnership models to ensure that infrastructure does not become a binding constraint.

Third, once again India is exhibiting an investment rate higher than savings, resulting in higher current account deficits and pressures on interest rates. While we maintain our call for another rate hike in April (25bps) and acknowledge some upside risks to our rate assumptions, interest rates are unlikely to spiral upwards.

This is because savings growth is expected to be healthy going forward. India's per capita income in real term has grown by 5-7% in the past couple of years. Moreover, a favorable demographic profile (50% of population below the age of 30) and improved trends in corporate and public savings, augur well for the positive momentum in savings. Notwithstanding the detrimental impact of high oil prices on current account balances, this should cap current account deficit below 2.5% of GDP in 05/06 and below 1.5% in 06/07.

At the same time, prospects for foreign direct investment have improved and recent surveys by AT Kearney and UNCTAD suggest increased investment interest and policy environment is incrementally more favourable.

Finally, in comparison with other countries in the region, India's ICOR is among the lowest. Although this suggests relatively lower investment, India's growth momentum is also sustained by improvement in productivity. This fact is vindicated by India's success in the services arena - business services, financial services, trade, and to some extent manufacturing.

In a nutshell, in 06/07 contribution of investment to GDP is set to rise further, albeit at a slower rate. This should sustain demand for working capital and keep non-retail demand for loans strong. At the same time, higher interest rates could dampen consumption modestly.

MALAYSIA

by Joseph Tan

Growth is secured, worry about inflation

- 2006 GDP growth will remain at a resilient 5.0%
- Inflation will force for a 100bps rise in Overnight Policy Rate
- Ringgit remains undervalued and could rise significantly

With growth in 2005 well secured, Malaysia will remain one of the most resilient economies in Asia. In 2006, growth is likely to be supported by strong tech exports and public demand, plus high energy prices and a diversified economy. Yet, rising threats of inflation will likely push interest rates higher, curbing consumption and supporting the ringgit.

Tech cycle to support H1-06 growth
With industrial production expanding 5.1% in Q4, GDP growth in 2005 is likely to surpass our above-consensus forecast (5.3%) and even the official estimate of 5.0-5.5% (Chart 1). This momentum will likely reverse the growth pattern for 2006. Last year, the first half was weak because the global technology sector was going through a soft patch which impacted countries that rely heavily on the manufacturing and export of electronic products and components such as Taiwan, South Korea, Singapore and Malaysia.

Based on US book-to-bill ratio, the current tech upcycle should have sufficient strength to carry these economies through much of H1-06 (Chart 2). In Malaysia's case, the electrical and electronic manufacturing sector accounts for more than 60% of the total manufacturing base and we see the manufacturing sector expanding 5% y/y in 2006. However, forward looking indicators seem to suggest a slowing tech demand in H2-06.

Benefits from oil and agriculture
Malaysia's growth profile however differs from the other economies because of the presence of fairly large mining and agricultural sectors, which are alternative growth drivers that will add further diversification to the economy.

High oil prices benefit Malaysia on two fronts. First, high oil prices will help directly the mining and resource sector. But increasingly, high oil prices are prompting the search of alternative fuels like palm oil to blend with petroleum for use as bio-diesel. Malaysia is among the world's largest manufacturers of crude palm oil. Hence, high oil prices are also supporting the agricultural sector (Chart 3).

Domestic demand in Malaysia has also been resilient in 2005 with private consumption expanding at an 8.1% y/y 4qma (4-quarter moving average) pace in Q3-05. Domestic consumption however has been led by the private sector which expanded 9.5% y/y 4qma in Q3-05. Government expenditure has slowed from a high expansion rate of 8.4% y/y in 2004 to the average pace of 3.1% y/y in the first three quarters of 2005 - a consequence of fiscal consolidation under the new administration which cut the budget deficit to 3.8% of GDP in 2005.

While we expect domestic consumption to remain fairly strong in 2006, expanding 8%, the composition from the private and government sectors will be different. Given that we expect a total of 100bps hike in the Overnight Policy Rate (OPR) in 2006, private consumption should ease. However, the soon-to-be-announced 9th Malaysia Plan will see a pick up in government expenditure in 2006, which will compensate for the slowing in private spending.

Another headwind to growth apart from interest rate hikes will come from the US. With the US Federal Reserve having done a total of 350bps of interest rate hikes since June 2004, we expect the US economy to moderate gradually in the coming quarters. This moderation will slow growth across Asia as US remains a key export market. But in Malaysia we expect this to be modest thanks to the above-mentioned mitigating factors. On balance, we expect growth in 2006 to be 5.0% y/y.

Higher rates to curb inflation but support MYR
Recent comments from central bank governor Zeti has reaffirmed our earlier warnings that inflation remains the biggest threat to the economy. Zeti said that inflation which is above 3% is considered high and is being monitored closely. December's inflation at 3.5% y/y means that real interest rates in Malaysia are still negative (Chart 4) and monetary conditions are still highly accommodative. We have always favoured interest rates to be raised earlier rather than later given the time needed for policy filter-through. We reiterate our call that interest rates would be raised 25bps each at the February, April, May and July policy meetings. A steady and measured hiking stance gives certainty to both the markets as well as businesses, raises the level of preparedness and reduces volatility. If both businesses and markets are communicated clearly to, the negative impact on economic growth resulting from uncertainty will be minimised and the gradually tighter liquidity conditions can then achieve the twin goals of sustainable growth amidst price stability.

Year-to-date, the MYR has gained significantly versus the USD, but it has weakened against most Asian currencies (Chart 5). This likely still keeps the MYR below fair value and leaves much room for gains in 2006. A key turning point for USD/MYR will come after Q1 2006 when the Fed pauses and Malaysia continues to hike.

TAIWAN

by Tai Hui

Hot outside, cool inside

- Export outlook positive in H1-06 due to strong IT demand
- Gradual monetary tightening to caution consumers
- Improving employment and good export growth should prevent a bust in consumer debt

Leading indicators suggest an optimistic H1-06 for exports, but we are cautious about private consumption as households are mindful of their financial position as well as the general economic outlook. This is likely to be a negative factor on overall economic growth in 2006. The wildcard will be gross fixed capital formation, which has been expanding at slow pace since 2005. High level of capacity utilisation suggests new investment is needed, but this would be set against the backdrop of migration of manufacturing to low-cost areas, especially the Mainland. Meanwhile, the central bank is expected to pursue gradual monetary tightening to keep inflation at bay.

IT rebound provides optimism
Taiwan's growth in H1-05 was weighed down by weak export performance due to inventory run-down by customers. The situation reversed in H2-05, and this set a positive tone to export growth at least for the first half of 2006. As shown in Chart 1, semiconductor book-to-bill ratio is still close to 1 and consistent with high single-digit growth in Taiwan's total exports. The Semiconductor Industry Association (SIA) also forecasts better revenue growth in 2006 compared with 2005. The SIA foresees sales growth to rebound to 7.9% in 2006 from 6.8% in 2005. This should bode well for Taiwan, where almost 50% of its exports consist of electrical and machinery products.

Growing caution from consumers
Taiwan consumers are increasingly cautious as indicated by two separate surveys. The first is the Consumer Confidence Index (CCI) of the National Central University. Although the survey shows confidence has stabilised, the respondents were particularly concerned over the economic climate and the household financial situation, as reflected by the two sub-indices shown in Chart 2. They are still relatively upbeat on employment opportunity as well as the outlook of the stock market.

The second indicator is the Masterindex of Consumer Confidence, compiled by Mastercard. This index painted a much more cautious picture of consumer confidence, with the H2-05 reading the lowest since SARS in 2003. A similar point with the CCI survey is that respondents were downbeat over the outlook of the economy. However, the respondents of the survey were also pessimistic over the prospects of the labour market.

Unemployment rate, currently at 4%, is at its lowest since early 2001. However, with the hollowing out of manufacturing to the Mainland, it is questionable how far jobless rate could decline in the future. This is not unique to Taiwan. Many economies in the region are facing the same structural transformation as more production capacity is being relocated to the Mainland.

Household debt burden, especially associated with cash cards and credit cards, has been grabbing headlines in recent months. The good news is that consumer loan growth has declined steadily since mid-05, as shown in Chart 3. This, together with improving employment and robust export growth, should help prevent a Korean style consumer bust. However, the household debt issue is likely to constrain consumption growth in Taiwan over the next 12-18 months.

Investment as the wildcard
One swing factor in our forecast is gross fixed capital formation. It is a volatile component of growth and it made little contribution in 2005. We expect investment to remain relatively subdue in 2006 due to steady migration of manufacturing capacity out of the island. However, the risk to our view is probably on the upside for two reasons. First, capacity utilisation in Taiwan manufacturing has already reached a multi-year high. The reading of 81.2% in December 2005 was the highest since the late 1980s. Hence, there is pressure for businesses to add capacity if they continue to produce in Taiwan. Secondly, with greater emphasis on marketing and R&D, companies may invest in these areas.

Gradual tightening to bring real rates to positive
The Central Bank of China (CBC) is expected to continue with monetary tightening in 2006. While both headline and core inflation is contained for now, as shown in Chart 4, real rediscount rate is still in negative territory. Moreover, money supply (M2) growth was 6.5% y/y in December and averaged 6.3% in Q4-05, both were above the central bank's 5.5% target (Chart 5). This suggests further tightening is likely for the central bank to bring monetary policy from accommodative to neutral.

However, given the uncertain outlook of domestic demand, the central bank would tighten with caution. We therefore anticipate the CBC to move in steps of 12.5bps each quarter in 2006, bringing the rediscount rate to 2.75% by the end of the year.

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