Asia Focus: Global inflation? Don't blame China! Nor Asia! : Fears of inflation have raised financial market volatility. This worry has roots not only in the demand-side strength of the global economy, but also in fears that the low inflation environment created by the latest globalisation is coming to an end. Notably, China's production costs are rising and the Chinese yuan is appreciating. We believe the concern about China exporting inflation is grossly inflated. Though may be less than before, China is still exporting deflation. Other countries in Asia are even more deflationary, and recent inflation is more related to lax monetary policy in the major economies than to price pressures from China.

Economy Highlights

Australia : the Reserve Bank of Australia has done its job, a reasonably good job. We believe the cash rate has peaked and inflation is well contained, and the economy should cruise along steadily with solid domestic demand.

India : the Indian economy is now at cross-roads. Growth is too strong to be sustained and inflation is yet to be restrained. We expect the RBI to hike by another 25bps in its July 25th policy meeting.

Indonesia : Although BI led the region in this cycle and became the first to cut rates, weak public spending may still delay the turn of tides. While we keep our 5.5% GDP growth forecast for 2006, there are downside risks.

South Korea : With all cylinders firing, the Korean economy is heading for a higher 4.9% growth in 2006. The BoK has rightly stayed alert and set to hike rates further. While we see the recent tension with the North as a noise, it is important that it does not distract policymakers from the real risk of a monetary overkill down the road.

OVERVIEW

by Nicholas Kwan

Tough time sailing

- Now comes the real test for Asian central banks
- As economic growth peaks, but inflation yet to recede
- Plus the noises of high oil prices and tightening liquidity

For most of Asia, the latest economic up-cycle is over. China's break-neck 11.3% real GDP growth in Q2-06 could well be the last hurrah of the region. While Q2 growth statistics to be released for most other Asian economies in the coming weeks should continue to impress, they are expected to show a decelerating trend, rather than an accelerating path like that of China. In fact, markets generally see China's accelerating growth rate more as a risk than as an opportunity. This is rightly so, given the threat of overheating and growing macroeconomic imbalances that higher growth will imply, plus additional austerity measures that it would invite.

As the economic tides turn, central banks across Asia are going to face the real test to their ability to navigate through troubled waters. Broadly speaking, there are two groups of sailors:

1. For those who are slow in their action, there remains much to catch up and clean up. While economic growth should have peaked, inflation is most likely not. Worse still, because of inaction, other negative side-effects like current account deficits and resource bottlenecks are yet to fully unveil. This would make the sailing just more complicated and difficult.
   
   In fact, some might have already hit the wall, albeit still staying afloat, such as Indonesia. Others like China and India may be lucky enough to delay the call of nature and still sailing high and dry. But no matter who, for them to navigate into truly safe waters, there are more hard decisions to be made, and the time is close that these sailors need to bite the bullet or risk a bigger mess.
   
   To some extent, Indonesia should be in a better position than its two giant neighbours, given that it has learnt valuable but costly lessons from its own mistakes. The mini-rupiah crisis last autumn served as a timely wake up call for both Jakarta and the region. Thanks for that, Jakarta did make some of the hardest decisions, though involuntarily, and bit a big bullet. This has enabled Bank Indonesia to regain much credibility and investor goodwill, allowing it to become the first in the region to cut rates, albeit from excessively high levels. However, to reach the safe land, BI still needs to carefully time its rate cuts and be complemented by appropriate fiscal stimulus and business environment improvements.
   
   While on top of the region's growth league, China's to-do list is also likely to be the tallest. Despite a relatively early start in 2004, Beijing's stop-go austerity drive has yet to yield material results. Two rounds of 27bps hikes in lending rates (which are not fully matched by deposit rate changes), intermittent increases in bank reserve requirements, plus ad hoc austerity measures on selected sectors and areas have at best delayed, if not distorted, the arrival of severe macro-economic imbalances. It may be unfair to put the full blame on the People's Bank of China (PBoC), which obviously is hamstrung by its limited autonomy and the lack of effective monetary tools and markets to do its job. In this respect, the unwelcome news of dangerously high Q2 GDP growth may offer a benefit in disguise by strengthening the PBoC's hand in pushing more difficult decisions through the Chinese leadership. At the minimum, we expect another round of interest rate hike to come in as early as August. This is only a pain killer, not a bullet. But hopefully it would encourage China to take more effective medicines sooner rather than later.
   
   Compared to China, India seems to be sailing better, thanks to its more market-compatible financial system and the RBI's relatively stronger autonomy. However, less favourable macro economic fundamentals like a current account deficit and weak fiscal position limited the RBI's room to maneuver. A hot equity market and high oil prices further complicated the job of price stabilisation, especially when the government is still very much addicted to an expansionary fiscal path. Clearly, the RBI needs to do more, including another 25bps hike in its next policy meeting next week.
   
   For this first group of slow sailors, their testing time has yet to come. Given their sheer sizes, the stake is high for them to reach the safe land.
   
   
2. For those who are broadly on the mark or ahead of the curve, what they need now is to complete the landing so that they can dress up for the next party. But mindful this is not the time to party yet. Celebration is still too soon, though theoretically it should not be too far away.
   
   While surfing uphill is difficult, surfing down-slope is not automatic, especially when there are lots of disturbances like high oil prices, local and regional political troubles, and external uncertainties like US interest rate moves and exchange market volatilities. For most, the biggest test lies on when to make a policy shift and how quickly to drive rates downward.
   
   Based on growth dynamics, Thailand would be the first to make the downshift (excluding Indonesia whose rate moves were distorted by the mini-rupiah crisis), more so if domestic politics make unnecessary damage to the economy. South Korea, Malaysia and the Philippines should be moving close to a policy switch, given current growth momentum and inflation trends. However, devils are always in the details of specific factors like local politics, asset prices, and the balance between exchange rate and monetary management. The risk of monetary overkill or premature relaxation should not be overlooked.
   
   To some extent, Taiwan is in a unique position given its very different macro growth picture. Its one-engine growth pattern, where strong export growth was handicapped by weak domestic demand, adds to the vulnerability of the economy and complicated the hands of its central bank. While low inflation and weak domestic demand justifies a shift to more expansionary monetary policy, high liquidity and still strong growth momentum reinforced the drive for higher rates. While we believe the central bank will continue it gradual pace of tightening, the coming months will be an increasingly difficult time to navigate.
   
   Even for Hong Kong, where a linked exchange rate theoretically makes any interest rate moves a simple sailing with the US, navigation is far from straight forward. Buoyant liquidity has prevented local bank rates from moving in tandem with the US Fed since May. This in turn raises the risk of a delayed one-off adjustment when liquidity shifts offshore. Over the past two years, US Fed Funds target rate rose by 425bps, US prime lending rate increased by about 400bps, but HK prime rose by only 300-325bps.
   

ASIA FOCUS

by Gavin Redknap, Stephen Green, Cheung-Tai Hui

Global inflation? Don't blame China! Nor Asia!

- China is not exporting inflation, despite higher costs and a stronger CNY
- Asia is even more deflationary, given heavy hi-tech export contents
- Inflation is more due to lax monetary policy in the major economies

Fears of inflation have raised financial market volatility across the world. Concern about rising price pressures globally, and the subsequent reaction of the US Fed and other central banks, has triggered major downward corrections in equities, commodities and bond markets. This worry has its roots not only in the demand-side strength of the global economy, especially the US, but also in fears that the low inflation environment created by the latest intense bout of globalisation is coming to an end. Notably, China's production costs are rising and the Chinese Yuan is appreciating (well....). We believe the concern about China exporting inflation is grossly inflated. While the picture is complex, the facts are clear:

- China is still exporting deflation, though may be less than before.
- Other countries in Asia are even more deflationary.
- A stronger CNY has only marginal, if any, effect on foreign prices.
- Recent inflation is more related to lax monetary policy in the major economies than to price pressures from China.

Mervyn King, Governor of the Bank of England, recently remarked that 'in China...some indicators are showing upward pressures on export prices. And in turn that is raising our import prices, over and above the increases result from higher energy costs.' Donald Kohn, Vice Chairman of the US Fed, also stated that while China, amongst others "probably has exerted a modest deflationary force" on US inflation in recent years, the effects "could dissipate or even be reversed" going forward.

According to the BoE, the main source of data supporting Governor King's observation of rising price pressures out of China comes from Hong Kong, where import prices for goods originating from China have been inflationary since late 2003 (Chart 1). Re-exports, which make up almost 90% of HK's total exports, and of which two-thirds originate from China, has seen similar but more modest inflationary trends.

While this may reflect more expensive Chinese exports, an alternative explanation is that some HK companies, which have vertically integrated their supply chain with manufacturing capabilities in the mainland, are using transfer pricing to push up export prices artificially, in order to gain from a CNY appreciation, or to hedge their CNY payable risks.

Meanwhile, US import data points to consistent deflation in goods arriving from China (Chart 1). Part of this could rest in different methodologies used to measure import prices in HK and the US; another likely reason is that the US is importing a different mix of goods from China than HK. In the latter case, it follows that China is exporting inflation in some goods sectors but not in others.

Diverging price trends of low-end and high-tech goods
Based on US data, import prices of low-tech, low value goods usually associated with China are picking up, with both US imports of footwear and toys now in inflationary territory (Chart 2). China accounts for about 40% of footwear and up to 75% of toys imported by the US, by far the most significant producer and therefore the key price driver. Meanwhile, more high-tech goods sectors remain soundly in deflation.

These US trends are logical. Costs of production in China are rising, brought about by higher labour costs (partly thanks to higher minimum wages), raw material and land costs, and (some limited) greater environment protection. In the past, large buyers in the US and Europe have been able to dictate prices, but this is changing subtly as some exporters gained pricing power with improved market positions. However, the trend for high-tech products is different. Based on export price indicators derived from value and volume data of selected Chinese exports, prices of Chinese durable or high-tech goods are declining, though progressively less so. Over-capacity and competition are forcing down domestic prices of Chinese air conditioners, TVs and electronic products - but less deflation than in the previous five years. This is notwithstanding rapid quality improvements, implying that actual deflation is even more than the price data shows (Chart 3). While wage pressures in China's coastal areas are rising, it is likely to be compensated by a rise in productivity as workers shift to higher value-added production. That, along with ongoing improvements in quality, has allowed deflation in high-tech goods to persist.

So, then, the evidence on Chinese price pressures is somewhat mixed - low cost goods are edging into inflationary territory, but higher-tech goods (which make up an increasing part of China's export mix) are not. The point about high-tech goods deflation also has a broader regional implication. To some degrees, this explains why US import deflation from the wider Pacific Rim area is larger than from China, as exports of major Pacific Rim economies like HK, Korea, Singapore, and Taiwan are more dominated by high-value electronics goods. Supply chain optimisation now across Asia is keeping the prices of a whole host of export goods down.

Whether the pace of technological change will continue is somewhat uncertain, but there is little to suggest that it will not. If so, the deflationary trend emanating from major exporters of high-tech products, principally Asia, should continue. Also as China becomes an ever more important source for high-tech goods production, it could well be that the country will exert an increasingly deflationary rather than inflationary force over time.

Impact from the CNY remains limited
Could a rising Chinese Yuan (CNY) prompt an inflationary shift in Chinese export prices? Over time the CNY will appreciate on its trade-weighted basis. But the recent experience of the US, where import prices from China have failed to exert any upward pressure despite a 3%-plus appreciation in the CNY vs the USD since mid-2005, suggests that the impact may be small.

We estimate that a 5% rise in the CNY would raise just 0.1% of final US consumer prices. Given the Chinese authorities' insistence on reforming its exchange rate regime gradually, appreciation of the CNY will likely occur far too slowly to have any significant meaning for the conduct of monetary policy in the industrialised economies. On trade-weighted basis, the CNY now is weaker than at the end of last year.

The overall impact: surprisingly small
Given the diverging trends of different Chinese export products and measured moves of the CNY, the overall impact of Chinese exports on global inflation is much smaller than is generally perceived. For example, imports constitutes around 14% of US GDP, and China accounts for 14% of US imports. Assuming a 100% pass through of price changes, a 1% rise in Chinese export prices will impact headline US inflation by just 0.02%. In Europe, the impact is even smaller. A 1% rise in Chinese export prices will raise UK inflation by 0.01%. In Japan, the impact would be 0.03%. Of course, the reality is more complex - margins and costs of producers and distributors along the goods chain need to be taken into account.

The impact from a rise in inflation in Asia generally, especially via its specialisation in high tech goods manufacturing, would be somewhat greater. Yet even here the overall impact on final CPI inflation can be seen to be relatively small. Within US CPI, for instance, 'information processing ex telephone services' and 'personal computers and peripheral equipment' have shown a significant tendency for deflation over recent years. This deflation trend, while becoming weaker, still persists. Yet, with these two groups accounting for only 0.9% of the weighting within the CPI index, the effect on overall inflation remains small (Chart 4).

The indirect inflation effects may be more significant. Trends in Chinese export prices should be somewhat indicative of price trends in other low cost producers. There is also some evidence to suggest that domestic producers set their prices in line with imports that act as close substitutes. The impact of a strongly growing Chinese economy is already being felt in global inflation due to the fact that demand from there has helped to drive commodity prices, and particularly oil prices, higher over the past year or so.

The culprit vs. the scapegoat
By contrast, services inflation, clearly not influenced by China or Asia, accounts for close to 60% of US CPI. Of that, 'owner equivalent rents', statistician's proxy for the cost of home ownership, are adding 0.8% to CPI now, from 0.5% last August. The Fed is, literally, far more likely to find sources of inflationary pressures closer to home than it is to see them from China. While in isolation the comments made by both Governor King and Vice Chairman Kohn may, technically, both be correct, taken together the message of China exporting inflation is misleading.

In summary, China is not exporting inflation, and may not do so any time soon. Its effect, and the wider deflationary effect of Asia generally, is subsumed on a cyclical basis at least by domestic price pressures in each and every economy. Policymakers and markets should not become overly concerned with the potential inflationary impact of China on the global economy.

AUSTRALIA

by Frances Cheung

Rates peaked, economy to cruise along

- Inflation to stabilize, despite concerns
- RBA has done its job, cash rate to stay at 5.75%
- Domestic demand stays firm, but not exports

The Reserve Bank of Australia (RBA) has done its job, a reasonably good job. At 5.75%, we believe the cash rate has peaked and inflation is well contained. While exports remain a drag, the economy should cruise along steadily with solid consumer demand and still strong business investment. We expect this imbalance of growth to continue, but GDP growth in 2006 should stay at a respectable 2.8% before moderating to 2.3% in 2007.

Job is done
Recently, RBA Deputy Governor Stevens remarked that the central bank has "the flexibility to wait for a little longer for further information", and that its inflation target of 2-3% "is not a hard-edged band with electric fences." We are pleased to see a patient RBA and we believe upcoming data will confirm that inflation is well contained and the RBA has done its job without suffocating the economy. However, with inflation still hovering near the upper limit of the RBA's 2-3% target and consumption demand remains strong, we also believe the RBA would keep its cash rate at 5.75% throughout the year, and not ease till Q1-07.

Our confidence of inflation peaking comes from four factors:

1. Capital expenditure remains upbeat and should raise production capacity further, progressively reducing the inflationary pressure from high levels of capacity utilization.

   

2. More people are entering the labour force in response to tight labour market conditions that have driven the unemployment rate to a 30-year low of 4.9%. Recently, the rise in labour costs decelerated, and wage increases are largely concentrated on the mining sector.

   

3. Corporates are still capable to absorb a significant part of the rises in costs, as evident from the fact that the rise in final product prices are considerably milder than those at the primary or intermediate stages. While corporate profit growth has decelerated, the still healthy profit margins and expected easing in commodity prices mean producers can still mitigate the pass-through of higher costs onto consumers.

   

4. Impact from previous rate hikes is yet to be fully felt. While inflation may still rise higher to 3.1% y/y in Q2-06, it is unlikely to be sustained. Tight money, lower commodity prices and further consolidation of the housing market should see price pressures easing gradually in the second half and bring the whole year average inflation to 2.9%

A steady cruiser
In Q1-06, the Australian economy expanded by 3.1% y/y, maintaining its steady rebound since Q1-05 when GDP growth dipped to a 6-quarter low of 2%. Growth was supported by rising private investment and buoyant consumption, but a widening trade deficit drew Australia apart from its Asian neighbours, many of them are busy restraining their trade surpluses.

Merchandise exports grew rapidly by 23.3% y/y in value during Q1-06, buoyed by high commodity prices that improved Australia's terms of trade. Export volume, however, increased much more moderately by only 1.8% y/y in the period, resulting in only marginal contribution to real output growth. However, higher export earnings do help reduce current account deficit and raise nominal incomes of business and household sectors, supporting domestic demand.

On the domestic front, private consumption maintains a solid momentum, but growth in business investment is expected to decelerate. Private consumption rose by 2.9% y/y in Q1-06, up from 2.6% in Q4-05. Recent indicators like retail sales, which rose 6.2% y/y in Apr-May 06, suggest that momentum of consumption growth is still solid, especially given favourable employment condition and tax cuts. However, monetary tightening and the gradually cooling housing market should limit any strong pick up in spending. Overall, the housing market is still a bit soft. While there was some rebound in home loans in May, this was in part resulted from the intense competition among lenders, which offer discount on mortgage rates and higher (up to 100%) financing. The number of loans to first-home buyers as a proportion of all loans fell to 17.4% in May from 18.8% in April, reflecting that some of the loan growth was due to refinancing activities. Meanwhile, building approvals dropped 11.7% y/y in May.

Over the past two years, business investment has been driven by high commodity prices that boosted the mining and resources sectors. Various surveys show that business conditions remain favourable. However, as we expect commodity prices to ease in H2-06, business investment growth should decelerate as well. We expect investment growth to moderate to a real 8% y/y for the whole year, as compared to 12% in Q1-06. This should keep the Australian economy growing at a decent 2.8% in 2006, completing a non-inflationary rebound before lower commodity prices and weaker exports allow a new phase of monetary easing to phase in next year.

INDIA

by Shuchita Mehta

At the cross-roads

- Growth is too strong to be sustained
- Inflation is yet to be restrained
- RBI likely to hike another 25bps this month

The Indian economy is now at crossroads. On the one hand are the positive surprises on the growth front, on the other are the risks associated with strong growth in the form of higher inflation and weak current account balance. These imbalances are manifesting in the form of higher interest rates, feeble local equity market sentiment, and a weaker currency. Furthermore, negative surprises on the fiscal front as government follows an expansionary fiscal policy have added to concerns on interest rates. As a result, the yield on the benchmark 10-year paper has risen by 80-90 bps since the beginning of the fiscal year in April. We believe it is important that economic growth slows down to more sustainable levels to stabilize sentiment on the local markets.

Growth momentum: too strong for comfort
Industrial performance has been spectacular so far. In the first two months of the fiscal year, the index of industrial production has grown by 9.8% y/y on the back of a 10.9% expansion in manufacturing output. This stellar performance of the manufacturing sector is supported by the export sector (where 75% of exports are manufactured goods) and domestic investment activity. Exports grew 19% y/y during Apr-May 2006, driven largely by exports to the US and selected Asian destinations like South Korea.

Growth of the services sector, which accounts for 54% of GDP, is equally robust. Bank deposits increased by 21.7% y/y as at mid-2006, while credit growth ran at near historical high of 33.1% y/y. Railways transport volume grew at a healthy 15.9% y/y in the April-June quarter. The number of mobile phone subscribers jumped 73% y/y in Q2-06, following a 64% growth in the previous quarter.

Inflation: still on an uptrend
Since the beginning of the year, headline inflation based on wholesale prices has risen by more than 100 bps to near 5%. This rise in inflation has come on the back of one-off adjustments in domestic prices of diesel and gasoline as well as significant rise in the prices of primary food articles. The government has expressed concerns over inflation and has as a result allowed freer imports of certain essential food items.

Prices of primary products should be better contained when new crops hit the market and import supply increases. However, headline inflation is likely to rise higher in the coming months for three reasons:

1. Global oil prices are on the boil again, and domestic fuel prices are still not fully aligned to international levels yet. Given a worsening fiscal position and the need to improve energy efficiency, further increases in domestic fuel prices seem necessary.
   
   
   

   

2. Money supply growth remains too high for comfort. M3 expanded by 18.1% y/y in Jun-06, moderated from the 88-month high of 21.3% reached in Mar-06 but still higher than most time of the past five years. The impact of excessive liquidity would take time to digest.
   
   
3. Strong domestic demand as reflected by a robust 20.4% y/y rise in vehicle sales in Q2-06, and a 27.7% y/y growth in domestic commercial credits in Apr-06.

In fact, inflation rates measured by both consumer and wholesale prices are on an uptrend, with the former hitting 6.1% and the latter touching 4.8% y/y lately, representing their 6-year and 13-month highs respectively. Overall, we expect wholesale price inflation to brush past Reserve Bank of India's (RBI) tolerance band of 5-5.5% towards mid-August.

Expect another 25bps hike in policy rates
The above developments have obvious implications for monetary policy. Given the risks of inflation, RBI is expected to hike yet again in its July 25th policy meeting. We expect the reverse repo rate and the repo rate to be raised both by 25bps to 6% and 7% respectively.

There is a modest probability that RBI may keep rates on hold in the upcoming meeting given concerns that aggressive rate hikes might dampen economic growth too much, especially after the sharp correction in asset prices recently. Should RBI choose to keep rates on hold, other measures such as further tightening of prudential norms are likely. However, we do not expect RBI to hike the Cash Reserve Ratio (CRR). Although, balances in reverse repo auctions are high, aggregate liquidity in the system has been going down on the back of monetary stabilisation scheme (MSS) unwinding.

While the government has followed a growth-oriented strategy, rising inflation and higher interest rates are expected to restrain the government from more aggressive fiscal pump priming. This, along with the prospects of more moderate global growth, is expected to curb India's GDP growth to a more sustainable 7% for 2006/07 from 8.4% in the previous year. Reduced macro imbalances could then offer more support to the INR, but we remain bearish for the INR in the near-term.

INDONESIA

by Fauzi Icshan

Rates cut, tides to turn later

- BI led the region in this cycle and became the first to cut rates
- But weak public spending may delay the turn of tides
- Our 5.5% GDP growth forecast for 2006 stays, but with downside risk

Even before the US Fed Funds target rate has reached its peak, Bank Indonesia has started cutting its BI policy rate from the peak of 12.75% in May-06. This reflected both BI's confidence that inflation has peaked and the central bank's concern that economic growth may decelerate further, a result of the sharp hikes in fuel prices and interest rates in Q4-05. We expect these confidence and concern would drive further cuts in BI rates to 11.5% by YE-06, especially if the IDR stays steady at about 8,500 to the USD as we have predicted. This should engineer a mild rebound in GDP growth in as early as Q2-06. But risk is on the downside that tides may turn later rather than sooner given weak public spending.

Disappointing fiscal spending
Real GDP growth slowed from 5.6% y/y in Q3-05 to 4.9% in Q4-05 and 4.6% in Q1-06. Consumer spending has slowed from 4.2% y/y in Q4-05 to 3.2% in Q1-06. While we expect GDP growth may pick up slightly to 4.7% y/y in Q2-06 and to 5.5% for the whole of 2006 (vs. government's revised target of 5.9%), the risk is on the downside given the government's inaction. Indeed, economic slowdown in H1-06 could be less severe had the government spent its budget on time. In H1-06, the government only disbursed less than 22% of its annual budget, resulting in a small fiscal deficit of IDR 3.5trn (USD 390mn), vs. a full-year target of IDR 42.4trn (1.4% of GDP). By June-06, the government was reported to have idle funds of more than IDR 70trn, thanks to the fuel price hike, IDR appreciation and slow government spending. Finance Minister Sri Mulyani Indrawati also admitted that the government's tough anti-corruption campaign has deterred public officials from speeding up public projects.

To stimulate economic growth and FDI, the government has introduced several policy packages on infrastructure development, investment climate improvement and financial sector consolidation in H1-06. But the lack of implementation details failed to impress investors. Indeed, widespread labor protests forced the government to back-track from its pledge to revise the pro-labor manpower law. As a result, planned FDI was only USD 3.1bn in the Jan-May 2006 period, up only 5% from a year ago. Slow implementation of the policy packages means that any significant impact on FDI may only materialise in 2007 and beyond.

Given weak fiscal stimulus and FDI, the burden of economic stimulation naturally falls on the monetary side, as evident from VP Kalla's call for BI to cut interest rate every month. While BI has started cutting rates in May, it has been careful not to unsettle market stability, pausing in June-06 amid increased emerging market volatility. In light of weak credit demand, which grew 2.4% y/y in the first five months of 2006 against 9.4% during the same period in 2005, BI Governor Burhanuddin Abdullah cautioned that it was caused more by the impact of high fuel prices rather than high interest rates, and any rate cut needs to be compatible with the real sector's ability to absorb additional liquidity.

Signs of tides turning
Aside from slower GDP growth, most other macro indicators are improving. Inflation has steadily fallen from a peak of 18.4% in Nov-05 to 15.5% in Jun-06 and we expect it to fall further as a strong IDR caps import prices and weak consumer demand limits domestic inflation. A sharp deceleration of inflation is likely in Q4 when the "one-off" base effect of last October's fuel price hike dissipates. We expect inflation to ease to 7.3% by YE-06.

Trade surplus grew to USD 15.3bn in the first five months of 2006 from USD 10.2bn a year ago. Exports rose 13.4% y/y to USD 38.4bn, while imports fell 2.1% to USD 23.1bn. Higher fuel prices capped Indonesia's energy imports, while slower economic growth curbed imports of raw materials (75.8% of imports) and capital goods (15.1%). Accordingly, we have raised our 2006 forecasts for trade surplus to USD 26bn and current account surplus to USD 5.3bn, up from USD 22.8bn and USD 3.0bn respectively in 2005.

Improving external payments has raised Indonesia's FX reserves from USD 34.7bn at end Dec-05 to USD 44.2bn by May-06, encouraging BI to prepay half of Indonesia's USD 7.5bn debt to the IMF, four years ahead of schedule. While the prepayment subsequently reduced FX reserves to USD 40.1bn by Jun-06, a positive current account should support the USD/IDR to stay at around 8,500 by YE-06.

Our cautiously optimistic view on Indonesia is increasingly shared by the market. Citing macroeconomic improvements like improved balance of payments, rising FX reserves, falling fiscal deficit and public debt as a portion of GDP, the US rating agency Moody's recently raised Indonesia's sovereign risk rating to B1 from B2, with a stable outlook. Clearly, the worst is over and Jakarta is well on track to a gradual turnaround, although the tides could turn faster if the monetary engine could be supported by a more forceful fiscal arm.

SOUTH KOREA

by Chongwoo Chun, Nicholas Kwan

Virtual noises vs. real risks

- Growth forecasts raised, but inflation stays lower
- BoK to stay guarded, and set to hike once more
- North is just a noise, but rates are the real risks

Once again, Korea captured international news headline after North Korea test fired seven missiles and the UN Security Council agreed to sanction Pyongyang's missile programme. While the event underlines potential geopolitical tensions in the region, it is unlikely to disrupt the strong growth momentum now underway in the South, where we expect a higher 4.9% GDP growth in 2006. However, it is important that attention of policymakers would not be distracted from the real risk facing the South Korean economy, i.e. a monetary overkill down the road.

Domestic demand recovery sustained
On surface, Korea's economy is growing remarkably well. Both cylinders of exports and domestic demand are firing. Strong sales of consumer goods underlined robust consumer demand. Notwithstanding the disruption of strikes in April, sales of durables rose 8.4% y/y in May and grew by an average 9.3% in the first five months of 2006. Business investment, despite its volatile nature, has been growing at about 6% y/y recently based on the index of equipment investment - almost double the levels in 2005. Given cyclically low unemployment rate (3.4% in May-06), stable household income growth (4.6% y/y in Q1-06), and high industrial capacity utilization (80.5% in May-06), strong domestic demand could boost real GDP growth to 4.9% in 2006, up from our original 4.6% forecast.

Exports stay strong, but not due to FTA
In the external sector, export growth accelerated to 17.1% y/y in Q2-06 from 10.6% in Q1. Demand from China and Southeast Asia, two of the largest markets for Korean products, stayed robust with 12.3% and 14.5% y/y growth respectively during the first five months of 2006. Sales are boosted by demand for IT products, cars and ships.

In comparison, ongoing negotiation of the US-Korea Free Trade Agreement (FTA) has little impact on Korea's export performance, despite a seemingly promising picture projected by the media. Current focus of the negotiation is on the opening up of Korea's agricultural, services, and auto sectors, in exchange for wider access to the US market, including better safeguards against the use of anti-dumping measures. One tedious issue is Korea's demand to allow products produced by South Korean firms in North Korea's Kaesung special area to be covered by the FTA. This issue alone will ensure the negotiation to be a protracted one, especially after the recent missile tests.

Differentiating noises from risks
With both domestic and export engines running at high speed, attention of Korea's policymakers is rightly focusing on preventing the economy from overheating. A strong KRW and high interest rates are therefore the natural preference, on top of selected measures like property market restraints. The government has also reacted thoughtfully to the perceived threats from the North, maintaining its engagement policy and preventing the noise from being misread as imminent risks that would seriously undermine local and foreign confidence.

However, this task of risk management is getting more difficult going forward, with the major risk being a monetary overkill. In particular, the combination of a strong KRW and high interest rates could serve as a circuit-breaker rather than just a growth-dampener. Thus far, a strong KRW has not choked off the Korean export engine. To the contrary, it helps to dampen the inflationary impact of higher oil and commodity prices. Meanwhile, a 100bps hike in Korean interest rates since October 2005 has also done no obvious damage to domestic demand, and presumably contributed to a benign inflationary environment, keeping headline inflation at 2.6% y/y and core inflation at 2.1% (June-06).

However, as the economy expands further and global commodity prices stay firm, inflationary pressure is likely to rise, more so given the time lag required for price pass-through, still high money supply growth and a lower base of comparison in H2-05. These are likely to keep the central bank vigilant, as reflected by its latest move to consider lowering its target inflation range from the current 2.5%-3.5%. Nevertheless, given a subdued 2.4% in H1-06, inflation may average only 2.6% in 2006, compared to our original forecast of 3.3%.

While we believe one more hike in the Overnight Call Rate is justified and inevitable, any more aggressive moves could risk an over-kill. This is because of the potential weaknesses we see behind Korea's export and domestic sectors. Externally, weaker demand from the US, which imported only 3.4% y/y more from Korea in Jan-May 06, could lead to broader slowdown in Korean exports later, more so if China's austerity drives higher. Domestically, demand could suffer from several factors, including higher property taxes due in H2-06, wealth losses from the recent 15% decline in stock prices, and higher interest burdens on household borrowers, majority of them are on floating rates. Despite apparent strength of the Korean economy, it is only six quarters out of its consumer distress and the balance sheets of many households are yet to be fully repaired.

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