China : We think the central bank's efforts to tighten liquidity will push up lending rates and take some of the froth off investment in 2006. Moderate CNY appreciation will have a mild dampening effect too.

Indonesia : Having bitten the bullet and reshuffled his economic team, President Yudhoyono has turned last August's IDR mini-crisis half-way into a blessing in disguise. In the coming months, it is essential that the government makes more determined moves to boost infrastructure and investor confidence.

Korea : Strong growth momentum and a more hawkish central bank are likely to drive interest rates higher, but this would also mean that the subsequent rate cut may come early, as soon as next February.

New Zealand : The economy is slipping into a technical recession. The government's policy options are narrowing. By insisting no policy response before clear evidence of inflation peak-out, the RBNZ may lag in the next down-cycle.

OVERVIEW

by Mike Moran

Credibility and Continuity

- Strong Q1-06 growth to underpin solid fundamentals, but ample liquidity will force Asian central banks' hands further.
- Market confidence comes from policy credibility and continuity.
- Hu's US visit to offer no surprises, but has accelerated concrete progresses in trade and finance.

Over the past month, many Asian currencies and markets once again scaled new highs. Strong economic growth, solid trade and investment flows, ample liquidity all contributed to the exuberance. But more importantly, investor confidence was underscored by policy credibility and continuity of the Asian establishments, rather than by confidence in individual policymaker. In the same respect, the significance of President Hu Jintao's upcoming US visit lies not so much on Hu's personal achievement, but on the developments put in motion in the run-up to his visit.

It is testament to Asia's new and improved fundamentals that events of recent months have failed to shake confidence in the region. The most recent example is the political tensions in Thailand, leading to Prime Minister Thaksin's resignation earlier this month. Ten years ago, street protests and conflicts of this magnitude would have sent shudders down the spines of foreign investors as they rushed for the exits. But not so this time. The THB is actually 3% stronger than it was before the political impasse erupted and markets are still not sure who will form the next government as yet. Thailand's benchmark SET stock index even made new highs of 770 following Thaksin's resignation.

Solid growth and ample liquidity
There is no mistaking that regional economies remain solid. China reported a super-charged 10.2% y/y GDP growth in Q1-06, followed by Singapore's 9.1% y/y growth, the strongest in nearly 2 years. Q1 growth reports for Korea in April and HK, Japan, Thailand in May will further underscore our optimism in the region. We have been bullish on Asia's domestic demand story since 2005 and see no evidence this is changing. Indeed, signs of sustained export demand are boosting the region's trade numbers again, underpinning capital inflows and FX reserves, which has almost two-thirds of the world's total held in Asia (including Japan). This continued flow of liquidity may improve Asia's external ratios, but it is also feeding directly into asset markets too. Monetary policy is still too loose and more tightening from Asia's central banks, with the exception of Bank Indonesia, is inevitable. We note that MXAS and MXASJ indices are retesting pre-1997 highs, and are already triggering renewed debate and concern within the market and policymakers.

Confidence comes from credibility and continuity
The unflappability of investor confidence so far, despite recent upheavals, has much to do with the strengthening in policy credibility and continuity that allows far less volatility when personnel and political changes are brought about. In Thailand's case, even after the necessary by-elections have taken place by the end of April, the likelihood is that Thaksin's successor will not deviate far from the current platform of economic liberalisation and structural reform (ex-Finance Minister and Deputy PM Somkid Jatusripitak is a strong candidate in this mold) put in place when Thaksin came to power in 2001.

In Korea, the change over in central bank governorship, Lee Sung Tae taking over from Park Seung, also passed with little incident. Again, the theme is policy credibility and continuity. Lee is a career central banker, his personality and views are well-known in the market and the establishment and his policies are closely aligned with the departing Park. Sentiment in Asia, despite recent volatility, is driven not only by sound fundamentals and outlook for growth, but also the perception that macroeconomic policies will stay both credible and continual even when changes do arise, expectedly or otherwise.

Hu's US visit
The high profile event of the month will inevitably be President Hu Jintao's US visit from April 18-21. But those expecting fresh initiatives or breakthroughs to materialise from the list of US-Sino grievances will most likely be disappointed. As is often the case, key developments leading up to high-level bilateral talks of this nature can be as significant, if not more, than the talks themselves. This certainly seems to be the case with Hu's visit. Markets have played up the significance of this date since late last year, becoming a popular lightning rod for speculative attention as well as a convenient point of reference for a host of conspiracy theories. But in reality, the significance of Hu's visit comes not from the talks itself, but the progress made through the posturing and concessions granted in preparation for those talks. Several key developments have been accelerated due to the urgency generated by Hu's visit.

1) Senators' Schumer and Graham's China visit, scheduled ahead of Hu's trip, has helped quieten the frenzy of protectionist rhetoric that was threatening to boil over. Their discussions with Beijing have clearly improved the depth of policy understanding especially on the need to develop China's onshore FX market as a precondition towards a more liberal FX regime. Postponing their bill till September effectively buys China more time to implement change but doesn't let China off the hook. For now, the Grassley-Baucus bill may assume the role of standard bearer for the protectionist lobby, but it is a substantially weaker bill that runs little risk of upsetting the applecart.

2) In return, China appears to be allowing greater CNY volatility. The average weekly standard deviation of the onshore CNY close has slowly increased this year from less than 0.2% in Q4 last year to over 0.5% in April. The CNY has continued to strengthen vs. the USD too, reaching new highs of 8.0050 on April 12, and it is only a matter of time before the psychological 8.00 level is broken. But its relevance will be confined to being a milestone rather than a signal for change in CNY policy. Our core view for 3% CNY appreciation this year still seems consistent with Beijing's focus on improving FX infrastructure and gradual liberalisation. More progress should be expected on this in coming months.

3) Liberalising capital outflows will serve as a 'quick fix' to alleviate pressure on the CNY before more fundamental solutions can be implemented. China's USD 5bn shopping spree at Boeing is not going to be the only choreographed deal that will see China making big ticket purchases from US companies - other deals, including Microsoft and Texas Instruments, are also in the pipeline. But potentially more significant are the new proposals announced by SAFE on April 14 that will raise quota limits of FX holdings by onshore corporates and individuals effective May 1. Qualified banks will also have greater scope in collecting onshore FX holdings to fund offshore fixed income assets. The lure of more attractive offshore yields, in spite of strengthening CNY, should alleviate pressure on the CNY to a degree but certainly not solve the issue.

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

Intra-Asia trade leads growth

- Global imbalance is rising, but not because of Asia
- China is the prime driver of intra-Asia trade, which propells Asia's growth
- More FTAs and India will sustain intra-Asia trade and economic integration

Asia is no longer the world's single largest trade surplus accumulator. In fact, its merchandise trade surplus is tapering. But trade deficits of North America and EU are still growing. In this respect, Asia, especially China, will remain the target of trade disputes with the US and EU. While China serves as Asia's export platform to the rest of the world, it has also become the single most important driver of intra-Asia trade, which in turn is the region's most important growth source since the Asian financial crisis. Going forward, while the region's overall trade surplus may taper, Asia's growth momentum is likely to be sustained by growing regional economic integration, facilitated by a maze of bilateral/regional free trade agreements, as well as strong growth inertia in China and India.

The good news: Asia as number two
For the first time in a decade, high oil prices has allowed the Middle East to overtake Asia as the largest trade surplus region, estimated at USD 211bn in 2005 against Asia's USD 174bn. For the same reason, the Commonwealth of Independent States (CIS) led by Russia also amassed a USD 126bn trade surplus in 2005, twice the level in 2003. In fact, other developing economies in Africa and Latin America also enjoyed sharply higher trade surpluses, up 180% and 40% respectively in 2005 largely due to strong commodity prices. Meanwhile Asia's trade surplus is tapering and now one-eighth less than its 1998 peak of USD 200bn (chart 1).

The bad news, however, is that trade deficits of the US and EU have not shrunk. Instead, they are widening at accelerating paces. This implies no likely reduction in trade fictions in the near future, even though it is getting clearer that the more apparent trade adjustment failure came from the deficit runners rather than Asia.

China: devil or saint?
Within Asia, China is likely to remain as the centre of trade disputes, given its huge bilateral trade surpluses with the US and EU, reported at USD 114bn and USD 102bn respectively in 2005 by the Chinese source. However, part of China's trade surplus with the US and EU came from its role as the export platform for the rest of Asia, as indicated in China's widening trade deficit with the rest of Asia (chart 2). Between 2005 and the pre-crisis year of 1996, China's annual trade surplus increased by USD 90bn. During the same period, its annual trade deficit with Japan, Korea, Taiwan and Singapore increased by USD 57bn, largely due to massive increase of export processing operations from these areas in China. As a result, an increasing portion of Asia's trade surplus now ends up with China, while much of China's surplus ends up with the US and EU.

Aside from serving as an export platform, China has also become an increasingly important end-market for the rest of Asia. While it is difficult to differentiate between products sold to China for export-processing purposes and those for China's own consumption, China's customs data indicates that about half of its imports are for domestic uses. This is especially the case for raw materials and machinery imports such as fuel from Indonesia and Singapore, timber from Malaysia and Indonesia, iron ore from Australia, and machinery from Japan, Korea and Taiwan. As a result, China has been the highest growth market for most Asian exporters over the past decade, with its share in total exports of these economies more than doubled (chart 3). China is now the largest export market in Asia, ranked top in Hong Kong, Korea and Taiwan, second in Japan and India, and third in Thailand and the Philippines.

China's strong imports from Asia has raised new demand in these economies, partly offsetting their concerns that strong competition from China and massive migration of industries to the Mainland would hollow out their economies. Rather than simple relocation of jobs and factories, reorganisation of supply chain and the subsequent intra-regional trade flows have facilitated better specialisation and more efficient resource allocation across Asia, promoting regional economic integration and growth - something similar to what has been and still happening in the EU and NAFTA (North America Free Trade Area).

Intra-regional trade as a growth driver
Between 1996 and 2005, intra-Asia trade grew by an annual average 8.5%, higher than the world average and intra-regional trade growth of the other two major economic regions: EU and NAFTA (chart 4). This is notwithstanding the sharp economic recession and severe trade disruption suffered by most Asian economies during the 1997-99 financial crisis. In fact, trade accounted for the most important factor of Asia's post-crisis recovery. Between 1996 and 2005, aggregate trade surplus of ex-China Northeast Asia (Japan, Korea, Taiwan and Hong Kong) increased by USD 61bn, while that of the ASEAN5 (Indonesia, Malaysia, Philippines, Singapore and Thailand) rose by USD 96bn. Much of these trade surpluses were driven by trade with China, as explained earlier. Within Asia, trade related to China, i.e. intra-Greater China and intra-Northeast Asia, grew well above other non-China regions like the ASEAN5 (chart 4).

FTAs and India to drive further growth
Compared with that of the EU and NAFTA, intra-Asia trade still accounts for a relatively small share of the region's total trade (chart 5). This underlines the relatively early stage of economic integration within Asia, but also implies that growth potential for intra-Asia trade and economic integration remains substantial. Aside from China, two other factors are likely to drive further growth in intra-Asia trade and integration.

First is the proliferation of bilateral and regional free trade agreements (FTAs) in Asia, which is part of a wider global trend due to disappointment upon the failure or stagnant of multilateral trading system. In Asia, the rise in FTAs is also driven by the Asian crisis, which raised the need to increase regional economic cooperation. Since 2001, over 14 new FTAs have entered into force, centering around Singapore, China and Thailand. More FTAs are being initiated or under negotiation, such as China's proposals to New Zealand and Australia, and ASEAN's talks with Japan, Korea, Australia and New Zealand. These existing and future FTAs will effectively put every Asian economies into a maze of regional trade web.

It remains debatable whether regional trade agreements help or hinder trade liberalization, which depends very much on the details - coverage, nature and enforcement. Preferential agreements among limited number of parties can potentially inhabit the processes of cross-border production which has been central to Asia's integration. Moreover, FTAs varies from highly concrete terms to broad aspirations, which of course will deliver different results. In Asia, many FTAs have gone beyond trade in goods, and cover services, investment facilitation and financial cooperation, including many WTO-plus commitments. While actual impact of such FTAs remains unclear, or too early to measure, their proliferation and broadening scopes would help force for more concessions in multilateral platforms, fostering intra-regional trade growth and integration.

India is another hot spot in Asia's trade, albeit with a much lower magnitude than China. It accounts for just over 1% of total intra-regional trade in Asia, and around one-tenth of China's trade with the region. However, India's trade growth with Asia is phenomenal, up over 30% annually between 2002 and 2005. In particular, China's imports from India grew by 63% annually, while exports by 50%.

The products traded with India are somewhat different from those among the rest of Asia. Raw and basic materials like fuels, mineral ore, animal and vegetable oils constitute the dominant parts of India-Asia trade. While the acceleration in trade growth in India over the past year was led by the services sector, trade in goods showed strong momentum as well. In manufacturing, India is characterized with skill-intensive and large-scale production. Despite its low wages and strong productivity, India's share of world trade remains low, hindered by high tariffs, poor infrastructure and high regulatory burden. Here bilateral or regional FTAs should help in pushing ahead domestic reforms and trade openness in India.

CHINA

by Stephen Green and Jason Chang

Tight credit, low inflation, slow investment

- The PBoC is keeping a tighter rein on liquidity
- Supply factors will keep inflation lower than expected
- These may dampen investment, but not across-the-board

China's economy used to run on a simple credit tap. Pump more money in and it grows; restrict the flow of funds and it slows. It is all about the volume of credit available, rather than the price of funds. With interest rate liberalisation, things are gradually changing, although the amount of credit is still crucial. Although credit is being extended faster than the credit quota should dictate, we think the central bank's (PBoC) efforts to tighten liquidity will force up lending rates and take some of the froth off investment in 2006. Moderate CNY appreciation will have a mild dampening effect too.

Price matters
China's economy was re-fueled mid-flight last year, as evident from its super-charged 10.2% y/y GDP growth in Q1-06. This was not due to a renewed credit boom (though construction got a shot in the arm), as chart 1 shows. It was however, no doubt helped by a reduction in the price of credit. What caused this? It was the influx of money from outside China, through the trade account and other avenues. Most of the dollars in the trade surplus gets converted into CNY and then put on deposit, giving banks more funds to lend. Of course, these flows have been going on for a while: what changed in mid-2005 was the PBoC's decision to reduce its sterilisation operations - meaning more of those funds found their way into bank deposit accounts. With banks competing to lend funds, de facto lending rates fell. Chart 2 shows this reduction in the cost of funds from 7.5% Q2 2005 to 6.1% in Q4 2005.

But the summer bounty quickly passed as the PBoC started mopping up liquidity in Q4 after a successful exchange rate reform. Chart 3 shows the commercial banks' excess reserves - funds held on deposit at the PBoC in excess of the 7.5% they must hold for regulatory reasons. The higher they are, the more liquid the banking system. The lack of the usual spike in Q4 last year shows the PBoC had successfully withdrawn the liquidity it released in summer. Between October 2005 and March 2006 the central bank had raised over-night rates by 50bps - something that would make headlines in the US, but was scarcely noticed in China.

Going forward, we expect de facto loan rates to rise moderately, we estimate 7% in Q1 2006. Money market rates are still rising, with the overnight repo expected to approach 2% by year end (that's another 50bps). Why? Our main reason is the aggressive sterilisation of FX inflows since Q4 2005. Growth of the new base money created by FX inflows has slowed considerably in Q4. That will also mean slower M2 growth. As shown in chart 4, FX inflows normally cause an increase in M2 about four months later. We would not be surprised if M2 growth eases to 14% y/y by year end from 18.8% in March 2006. However, the PBoC will likely not force up interest rates dramatically, because its number one priority is the exchange rate, i.e. managing a gradual appreciation and introducing more flexibility into the USD/CNY rate.

Inflation to ease with bumper harvest
China's consumer price inflation (CPI) can be seen as largely a grain phenomenon. When grain prices go up, pig prices go up too, and CPI reacts. Chart 5 shows a crude correlation - the difference between the growth rates of GDP (or aggregate demand) and grain production, versus CPI a year later. The more grain production does not keep pace with GDP or demand growth, the higher CPI in the following year. In comparison, the normal mechanism of monetary stimulus feeding through to inflation does not work well in China because bank lending rates have a PBoC-set floor and an annual loan quota. Asset price inflation, however, particularly houses, is rising rapidly again.

With that in mind, we believe the market's current inflation expectation is overdone. Why? First, a good harvest last year means grain and meat prices will grow only moderately this year. Rural subsidies will boost farm production. Second, the prospects for energy price reform causing CPI to rise are distant, however regrettable that is from a policy perspective. Third, we face over-capacity in a number of key industries, including steel and cement. Our forecast for CPI in 2006 is 1.2%, well below the market's view of 2-3%.

Investment to slow, but not across-the-board
What does all this mean for corporates in 2006? De facto lending rates will rise, gradually, while CPI looks low and stable. As a result, real interest rates, one of the key considerations for investment, will rise gradually. This should serve to pinch private sector investment. Two things complicate that view though. First, many firms have built up healthy balances of retained earnings - and do not rely on the drip feed of the banks like before. Second, the development of what we call China's new 'two-track funding economy'. More companies are gaining access to funds at money market rates rather than bank rates - through short-term corporate bills, drafts, entrustment loans. Corporate cost of fund could be reduced by 200-300 bps when they borrow from money market than from banks, and the scale of this funding is increasing rapidly. Such companies will face, obviously, more incentives to invest. This means that the PBoC will likely have to reduce liquidity more if it wants monetary policy to remain moderately restrictive in 2006.

INDONESIA

by Fauzi Icshan

Blessing in disguise

- Financial markets rallied on BI and government austerity measures
- But GDP growth is slowing due to higher inflation and interest rates
- Government needs to boost infrastructure and investor confidence

Having bitten the bullet and reshuffled his economic team, President Yudhoyono has turned last August's IDR mini-crisis half-way into a blessing in disguise. In the coming months, while high interest rate and inflation will dampen economic activities, renewed market confidence and strong capital inflows could provide Indonesia with a new growth platform. It is essential that the government grasps this opportunity with more determined moves to boost infrastructure spending and investor confidence.

Financial market exuberance
In response to the IDR mini-crisis in Aug-05, Bank Indonesia (BI) hiked its policy rate by 425bps and the government raised fuel prices by 126%. The austerity measures and subsequent cabinet reshuffle sharply revived market confidence. In Q1-06, the IDR rose to 9,000 from 9,850 to the USD, one of the world's best performers. Meanwhile, the JSX index hit new highs and the bond market rallied with strong capital inflows.

Trade surplus almost doubled from USD 4.7bn in Q3-05 to USD 8.1bn in Q4-05 as oil/gas imports dropped by 26% (to USD 3.7bn from USD 5.0bn) after the fuel price increases. With domestic fuel prices now closer to international prices, fuel smuggling, which had cost the country over USD 2bn in 2005, has also been significantly reduced. As a result, FX reserves rebounded to a new record high of USD 40.5bn by Mar-06, up from USD 30.2bn in Sep-05. Given large capital inflows and current account surplus, we have thus revised our USD/IDR forecast to 8,500 from 9,000 by YE-06.

A strong IDR helped to cut headline inflation to 15.7% y/y in Mar-06 from 17.1% in Dec-05. The government's decision to suspend electricity tariff hike also should help reduce inflation, probably to the lower end of BI's 7-9% target range by YE-06. While we believe the BI rate has already peaked at the current 12.75% level, the likelihood of another 25bps hike in the US Fed Funds target rate would caution BI to start cutting rates gradually only in Q3-06, when a downward inflationary trend and IDR stability are more certain. We expect BI rate to be cut by 25bps every month in H2-06 to 11.25% by YE-06.

Real sector pains
While financial markets rallied, the real sector was hit by the sharp hikes in interest rates and fuel prices. As inflation jumped from 7.8% y/y in Jul-05 to 18.4% in Nov-05, real household consumption growth slowed to 4.2% y/y in Q4-05, while unemployment rate rose to 10.9%. GDP growth slowed from 5.6% in Q2-05 to 4.9% in Q4-05. Although the government was quick to provide cash reliefs to 15.5mn poor households and limited the risk of social unrest from fuel price increases, household consumption is likely to remain weak and the economic slowdown would continue in H1-06.

To reflate the economy, the government needs to boost its spending or promote private investment. Theoretically, a saving of USD 7-10bn (2.5-3.5% of GDP) from fuel subsidy cuts should allow the government to spend more in infrastructure. However, the lack of a clear majority in parliament would affect the government's ability to push through key projects. President Yudhoyono's widespread anti-corruption drives, while good and necessary in the long-run, have affected the policy implementation in key ministries. Also, increasing regional autonomy has put infrastructure projects under local governments, many of which are lack of implementation capability. As such, the government's ability to raise infrastructure spending is limited. We expect the budget deficit to rise to only 1.0% of GDP in 2006.

Meanwhile, efforts to promote private investment would need to tackle several obstacles such as legal uncertainty, labor rigidity, regional autonomy, poor infrastructure, tax and customs issues. The government has introduced an investment policy package to simplify investment, licensing and customs procedures and to introduce tax incentives for investment in certain sectors and regions. It also proposes to abolish taxes on some agricultural products, improve services at regional tax offices and remove local taxes that hinder FDI, including the repeal of 700 local taxes and levies that are incompatible with national laws. It also tries to introduce a new investment law and revise the labour law.

Government holds the key
While the government is moving in the right direction, actual implementation of investment reforms is likely to encounter much difficulties. Labour law revisions that propose to give employers more flexibility in downsizing workforce have prompted large, though peaceful, protests in urban centres. Given substantial fiscal savings and strong support for the new economic team, the government is in a strong position to push through its reform agenda, including the investment policy. One encouraging start is the settling of disputes between US oil giant Exxon-Mobil and state oil company Pertamina over the Cepu oil block and moves to resolve problems in other high-profile investment projects. While the pace of reforms may be slower than expected, we expect the gap between market optimism and reality to narrow.

KOREA

by Chongwoo Chun

Higher rates, early reversal

- Strong growth momentum reinforces BoK's hawkish stance
- We raise the peak level of call rate to 4.50% from 4.25%
- But also expect an early rate cut in February 2007

Strong growth momentum and a more hawkish central bank are likely to drive interest rates higher, pushing the policy call rate to 4.5% by August 2006, up from our original forecast of 4.25% by this May. However, this would also mean that the subsequent rate cut may come early. We now forecast the next interest rate down-cycle to start as soon as next February and would bring the call rate back to 4.0%, the current level, by May 2007.

Solid growth momentum despite a strong KRW
Robust shipment orders and strong consumer confidence indicate that Korea's four-quarter-old recovery is still full of momentum. The producer shipment index rose by 9.4% y/y in the first two months of 2006, while the consumer expectation index of the National Statistical Office (NSO) stayed near its 12-month high of 103.4 in March (chart 1). Strong demand for semi-conductors drove industrial production up by 12.6% y/y and supported a 5.1% y/y rise in retail sales during the January-February period. Meanwhile, strong demand from China supported export growth at 11% in Q1-06. Despite slowing US growth and higher interest rates, there remains no clear slackening in the current twin-engine recovery led by exports and consumption. In fact, a high manufacturing operation ratio of over 80% and increasing machinery orders also point to rising investment demand in the industrial sector (chart 2), though weak construction growth remains a drag on a full-blown investment recovery.

Given the solid growth inertia, concerns about a strong KRW dampening Korea's competitiveness and near-term growth prospects are taking a backseat. Instead, a strong currency is seen as supporting the recovery of domestic demand by keeping imports cheap and inflation low. Increased outsourcing, particularly to China, also help to lower input costs and keep Korean products competitive. This may be why the BoK has remained relaxed and largely absent from the FX market.

Potential threats to inflation
With growth seems secured, policy attention is naturally falling on price stability. Subdued movement of the CPI housing sub-index and increased agricultural output have kept both the headline and core CPIs relatively stable in recent months. However, housing prices and rental have rebounded modestly since mid-2005. Thanks to ample liquidity and economic recovery, housing affordability has improved. Meanwhile tightened regulations on the housing market have aggravated the shortage of housing supply in and around Seoul, pushing up rental (Jeonse) prices. These factors are likely to feed through to CPI later this year.

As the economy recovers, the ratio of broad money M3 to GDP also rises steadily. Since bottoming out in Q2-05, liquidity has been rising across the market (chart 3). With growing income and expected higher domestic demand, both money supply and demand are likely to rise further. This could raise the threat of inflation if the growing volume of liquidity is not appropriately managed.

More importantly, current rebound of the economy is pushing up service employment, which is likely to add pressure on wages and service charges. With services accounting for over half of the CPI component, this could push up core inflation going forward (chart 4).

Preemptive or over-aggressive?
These factors appear to have reinforced the hawkish stance of the new BoK governor and his new monetary policy committee (MPC), both have vowed to act preemptively on perceived threats of inflation. In particular, the MPC is expected to adjust its mid/long-term inflation target from the current 2.5-3.5% lower, attributing to structural changes of the economy that would warrant a more stable inflation environment for sustainable growth (chart 5). This, in turn, could see the BoK taking a more aggressive stance to prevent any perceived inflationary threat from breaching its reduced targets. Given the above considerations, we believe the BoK will raise its policy call rate by two more 25bps steps, from the current 4.0% level to 4.25% in May and then to 4.5% in August.

While an additional 25bps hike (from our original forecast) should not break the back of the Korean economy, its necessity is likely to be a close call and could well serve as the catalyst to a new down-cycle of the Korean economy. This is especially so if an end to the current electronic up-cycle and a general global slowdown starts to unfold in H2-06.

While the current aggressive stance of the BoK has reinforced the strength of the KRW, it is likely that the reverse will also be true once BoK's preemptive moves shift growth to a lower gear and force for a change in its policy emphasis from price stability to growth. This may happen in as early as next February. We expect the BoK to start cutting its call rate from 4.5% to 4.25% in Feb-07, and then to 4.0% in May 2007. The KRW, however, could react well in advance of the rate moves, retracing to about 980/USD towards YE-06 and 990 by Q1-07.

NEW ZEALAND

by Mike Moran

In denial

- Business confidence points to rising risks of a technical recession, albeit a mild one
- RBNZ might have erred by delaying action until a clear peak-out in inflation
- Monetary easing could start in Q3, with cumulative 75bps easing by year end

New Zealand is inclining towards a technical recession. As early as last summer, growth was on the wane. GDP growth in Q3-05 disappointed at +0.1% q/q, the weakest in over 2 years. This was followed by a 0.1% q/q contraction in Q4-05, confirming our suspicion. The government's policy options are narrowing, yet the Reserve Bank of New Zealand (RBNZ) remains tight lipped, keeping its cards close to its chest. By insisting no policy response before clear evidence of inflation peak-out, the RBNZ may lag in the next down-cycle.

Governor Bollard's latest comments in the RBNZ's March bulletin clearly stated the central bank did not intend to cut interest rates this year unless inflation pressures ease substantially from its projections. We believe this is already happening but may take several more months to come through in the data. But until it does, the domestic economy will continue to deteriorate, albeit at a moderate pace. Pressure for a monetary response will likely build in the meantime, but it could take till Q3, either the Sept 14 or Oct 26 MPCs, before the RBNZ deem conditions pervasive enough to start the easing cycle.

The long, slow grind
Sentiment surveys paint a picture of weakening confidence. The findings from the New Zealand Institute of Economic Research's monthly survey suggest conditions are clearly worsening. Of the 551 companies surveyed, 54% expect to see the economy deteriorate further over the next 6 months. Also, 35% expect profitability to decline over the next 3 months. Businesses have already talked of recession in recent months with these fears seemingly confirmed despite attempts by the central bank to downplay this risk. The 10.6% decline in NZD/USD has lifted some of the gloom for exporters but the underlying outlook is still going to be defensive. The key risk is that profit projections remain depressed for the foreseeable future with pessimism feeding directly into weaker private sector investment as businesses defend margins.

Serious about inflation
Despite the clear deterioration in growth, the RBNZ has up till now offered little comfort. In reining in the demand explosion during the boom years of 2003 and 2004, domestic interest rates, both on a nominal and real basis, are among the highest within the OECD. The decelerating impact on growth is now evident in the real economy. Meanwhile, the central bank's attention remains very much focused on inflation. Latest CPI figures for Q1 show inflation running at 3.4% y/y, outside the policy target band of 1-3%. This is the third consecutive quarter inflation has run beyond the upper limit. But there should be no mistaking where the RBNZ's policy priorities lie - as demonstrated by the decision to continue raising rates by a cumulative 50bps last October and December at a time when almost all economic indicators were pointing down. Getting inflation back within range is therefore a necessary precondition before monetary easing is likely to even make the central bank's agenda.

Price pressures may have peaked
It may not be long before this precondition falls into place. Inflation pressures may well have peaked. The NZIER's last report showed 55% of respondents cited poor sales as the main cause limiting expansion, 30% reported difficulty in finding appropriately skilled labour, down from 36% in February. Easing wage pressures will supplement the moderation in consumer inflation in coming months.

A buoyant housing market, once a key driver for household wealth, is also moderating. Mortgage rates have climbed steadily since 2003 (chart 4), both for fixed and floating payers. As a result, sales volumes are falling back below 2005 levels whilst median price growth also slowed sharply. The more cautious property outlook will dampen consumer and new credit growth.

Rate cuts by Q3
Given our view that inflation pressures will begin to ease, the prospect of monetary easing will grow over the next few months. The RBNZ is in no hurry yet. They will want to see evidence that CPI data is indeed falling back within their target range. The fact that the economy is slowing, rather than collapsing, also buys them time. This suggests the RBNZ may not be in a position to start cutting rates until possibly Q3. Since CPI data is released on a quarterly basis, this narrows the window of opportunity the central bank has in adjusting policy in light of fresh data. With the Q2 CPI report due in July expected to show further decline in inflation, the likelihood is the RBNZ will be comfortable enough to begin cutting rates by the Sept 14 or October 26 MPC meetings to 7.0%. We expect another 50bps cuts in Q4, leaving policy rates ending the year at 6.5%.

The wild card, of course, remains in global crude prices. Oil futures have crept higher again. Another round of higher crude prices could delay the RBNZ's decision to ease policy. This risk could pose further problems for the weak current account position, leaving currency and credit ratings vulnerable.

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