Asia Focus : Asian Consumerism, more, not less : As the US economy slows and Asia's export engine likely shifts to a lower gear, pressures are building on Asian consumers to take up the expected gap in growth momentum. In the previous cycle in 2001-03, attempts to pump prime consumption by some Asian economies ended up with thousands of bankrupt households. To encourage Asian consumers to spend more without repeating the previous pitfalls, we need to learn our lessons and get the policies right. Here, we highlight five.

Economy Highlights

China : China's Goldilocks economy appears neither too hot nor too cold. There are issues with China's economic data, but dig under the surface a bit and one finds an economy not growing much faster than last year - and may indeed be weakening.

Hong Kong : With GDP expected to have grown by 7.2% y/y in Q2-06, we are raising our 2006 GDP growth forecast to 7%, from the previous 6%. In 2007, growth should remain solid but closer to trend, settling on a more sustainable 4.5%.

Malaysia : Modest exports and consumption demand should see real GDP growth stabilises at about 5.3% y/y in Q2-06, but our 5.5% growth forecast for 2006 has some downside risks. Given shifting policy bias from price stability to economic growth, we now believe the overnight policy rate will peak at 3.75% in Q3-06.

Vietnam : Like China, entry to the WTO could bring an export bonanza. Unlike Indonesia, Vietnam cut its oil subsidies and prevented high oil prices from destabilising its currency. Despite higher interest rates, growth should stay firm at 8.8% in 2007.

OVERVIEW

by Nicholas Kwan

Summer break

- A calm summer may mask risks of sharper slowdown
- But threat of inflation should be limited
- While trade conflicts could be a benefit in disguise

Last summer, the Chinese yuan jumped out of its 12-year USD peg, unlocking a tight ring of dollar-linked Asian currencies. A mini-rupiah crisis then sent a shock wave across the region, underlining the potential perils of high oil price. Both events failed to derail Asia from its high-speed growth track. Instead, they served as timely wake up calls for Asia to adjust some of its untenable policies. Since then, exchange rates in Asia have turned more flexible, albeit only modestly, while several economies moved to abandon or amend their unsustainable fuel subsidies.

This summer, the Asian financial world has thus far enjoyed a quiet life, notwithstanding a sharp but short decline in emerging market risk appetite in May. Although the Fed's long-awaited pause in its two-year hiking cycle failed to inject new vigor into the Asian markets, it nevertheless signalled the near-closing of the Fed's back-to-neutral exercise and set the scene for a turn in the global economic cycle. At the minimum, the Fed's move confirmed a slowdown in the US economy, and likely containment of inflationary pressures. This would encourage or reinforce several Asian central banks' decisions or declared intention to hold or cut their policy rates, including the Bank of Thailand, Bank Negara Malaysia, Bangko Sentral ng Pilipinas and Bank Indonesia. For those more hawkish authorities like the Bank of Korea, Bank of Japan, People's Bank of China, Reserve Bank of India and Reserve Bank of Australia, they should also feel more relieved with less pressure to match US rate hikes when making their own policy decisions.

What promises do this quiet summer hold for Asia in coming months? And what surprises could it mask? We see a few:

1. Growth deceleration. Current market calmness is largely underlined by Asia's relatively robust growth momentum. Until recently, most Asian economies are still growing at above-norm velocity, ranging from 5.2% in Indonesia to 11.3% in China. However, signs are emerging that things will or need to cool, except for Indonesia which is recovering from last autumn's mini-oil shock. Pressure would largely come from the demand side, given expected weaker demand from the US, and elevated interest rates that may dampen domestic consumption and investment. In comparison, the damage of high oil prices and other supply side constraints on growth remain relatively benign.

While most Asian economies are expected to slow down gradually, some may risk more abrupt changes, especially China where concerns about overheating may prompt more aggressive austerity measures. In this respect, the current summer summit of the Chinese leaders where some key decisions could be made would warrant more attention. In comparison, concerns about another false recovery in Japan have largely faded, though a weaker 2.0% y/y growth in Q2 did remind the optimists that sustained rebound is not yet a given.

Thailand and Taiwan are other areas that could risk sharper downturn in coming quarters, given their weak domestic demand and heavy reliance on exports. Uncertainties in domestic politics are not helpful either, though a scheduled general election on October 15 could offer a chance to unlock Thailand from its year-long political stalemate and re-ignite its domestic growth engine. Taiwan, however, may be less fortunate, given mounting challenges faced by the president and a tough fight in this winter's local elections - a contest that includes the mayorship of Taipei and Kaohsiung and is dubbed as the most important elections before the 2008 presidential race. Things could get worse before they turn better.

Other than the above areas, growth in the rest of Asia is likely to stay solid. Even as slower growth is confirmed later this year, market sentiment is unlikely to set for a sea change as the growth landscape across the region should remain divergent.

2. Inflation acceleration. Despite slower growth, volatile oil and commodity prices and lagged price adjustments would drive prices higher before they stabilise. This is more so if asset prices rise higher with the still-abundant liquidity environment. This could keep individual central banks vigilant, or even risk a short period of monetary over-kill that may drive output lower than necessary. However, given a generally benign inflation picture in Asia as well as the G3, it is hard to perceive any sharp escalation in prices that would force central banks to stamp on the brake and drive economies into a tailspin.

It is possible that the phase of 'stagflation' may receive a wider audience later this year as price rises while growth slows, but it is unlikely to stand the reality test given the lack of serious supply-side constraints that would suffocate output and push up prices unrelentingly. Incidental supply disruption like hurricanes or refinery stoppages may send oil prices higher and aggravate inflation concerns, but a prolonged substantial escalation of oil prices that would unsettle the current growth-stability balance in Asia may require sharply acute disruption to the global oil market, probably due to wholesale geopolitical conflicts in the Middle East - a scenario not yet on our horizon.

3. Growing trade disputes and regional cooperation. Fall-off of the WTO Doha round negotiations, while widely anticipated, could be seen by some as a lost opportunity to restrain protectionism. However, given the US mid-term elections in November, a slowing economy and large trade deficit in the US, a rise in trade pressures in coming months is almost inevitable. China would remain the key and most convenient target of attack, both on its manufacturers and its currency. This will provide occasional source of tension and volatility in the markets, or even see a widening of the CNY daily fluctuation band, but is unlikely to accumulate into major shocks.

However, the Doha debacle would also contribute to accelerated development of regional and bilateral trade and economic cooperation - a benefit in disguise. Aside from new initiatives that may be raised in the regional forums like APEC, ASEM, ASEAN+3 and EMEAP in coming months, the upcoming IMF/World Bank annual meeting in Singapore could also see more intensified networking activities around Asia and beyond. Regionalism is set for an elevated momentum in the post-summer months.

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

Asian consumerism, more, not less

- Consumers in Asia need to spend and borrow more, not less
- Income and culture matter, but so do credit policies and systems
- Asia needs to bank the unbanked, and free the forced savings

As the US economy slows and Asia's export engine likely shifts to a lower gear, pressures are building on Asian consumers and investors to take up the expected gap in growth momentum. This is no stranger. In the previous cycle in 2001-03, similar challenges prompted several Asian economies to pump prime their domestic demand, primarily consumption, which ended up with tens of thousands of bankrupt households, many of them are still licking their wounds. This time, will Asian consumers make a difference? Asia's exceptionally high savings rate means there remains much room to spend more. But to achieve that without repeating the previous pitfalls, we need to learn our lessons and get the policies right.

More room and much need to spend more
On August 9, the US Federal Reserve Board halted its back-to-neutral exercise, citing convincing signs of a slowing US economy and well-behaved inflation expectation. While markets remain divided in whether this will be a pause or peak of the two-year-old interest rate up-cycle (which we believe is the latter), the Fed's move underlined that US economic growth is at least shifting to a lower gear, and so would its import from Asia, if history is any reference. (Chart 1)

To sustain its economic momentum in light of a likely slowdown in exports to the US, Asia would need to accelerate its domestic growth engines with higher investment and/or consumption. On surface, Asia should have no problem to consume or invest more. A large savings-investment gap means that it has much resources to spend. Although much of this surplus came from its under-investment, as explained in the March issue of Asia Focus, Asia's generally high savings rates suggest that its consumers are somewhat too thrifty. In 2005, Asian consumers, including their governments, consumed 67.5% of their output. This is one-fifth or 18.5 percentage points (ppts) less than the Americans, and 10 ppts lower than the Europeans. If the Asian consumers were to spend as much (in GDP terms) as the West, they would have consumed an extra USD 1-1.8trn in 2005, more than the amount of forex reserve added by Asia during the year.

However, among the Asians, some like the Filipinos, Taiwanese, Japanese and Indonesians are consuming well close to the US or EU levels, while the Chinese, Singaporeans and Malaysians are far less. In fact, net of government spending, Chinese consumers spent only 38% of their output, barely half of the European level. (Chart 2) Given the divergent consumption patterns, several key lessons need to be learnt in promoting consumption in Asia.

Lesson #1: Income and culture matter, but not alone
Apparently, consumerism does not necessarily flourish with the income level of an economy. Low income countries like the Philippines, Indonesia and India have high consumption rates, while high income economies like Singapore and Malaysia are high savers. Similarly, it is questionable to expect Chinese consumers to spend more once a better social safety net is in place to protect their future livelihood. The Singaporeans, who boost one of the best funded social safety nets, are just as thrifty as the Chinese. Some may argue that cultural factors like Confucianism are in play. But even if it helps explain Asia's relatively high savings rate in general, it remains insufficient to explain the wide difference in consumption levels among the Asian economies. In fact, the most Confucian societies spread well across the consumption spectrum, from the top spenders (Japan, Taiwan), to the modest (Korea, Hong Kong) and the least (Singapore, China).

Lesson #2: Policies and systems are important
Among the Asian economies, the four NIEs (South Korea, Taiwan, Hong Kong, Singapore), plus Malaysia, have relatively well developed consumer financing systems, as witnessed from their high consumer debt to GDP and total loan ratios. (Chart 3) However, many of these economies are also recent or current victims of consumer credit bubbles, thanks to misguided policies and financial system weaknesses.

In Hong Kong, where mortgage financing is well developed and accounts for nearly 80% of household credits, a misguided housing policy aggravated the post-crisis slump of property market and sent residential property prices down by 70% during 1997-2003. As a result, one-third of the mortgages became negative equity and private consumption contracted for almost five straight years. Meanwhile, as weak mortgage and corporate loan demand drove banks to credit card customers, the lack of credit information facilitated the building of another credit trap. Credit card delinquency ratio tripled in four years. As a remedy, a centralised credit reference agency was established in 2004.

In South Korea, government policies to diversify bank lending (from the corporate sector) and boost consumption with special tax incentives contributed to the building of a credit card bubble in 2003. With a 22.9% CAGR of consumer loans between 2001 and 2005, its 64.8% consumer credit to GDP ratio is the highest in Asia. Unfortunately, credit promotion was not complemented with appropriate risk management and regulatory safeguards, resulting in a bust that saw the credit card delinquency rate ballooned 12 times in four years.

Lesson #3: Growth is a concern, when at high leverage
In Taiwan, like in Korea, consumer loans have been growing more rapidly than nominal GDP, resulting in a rise in the consumer loans to GDP ratio from 42.8% at end-2000 to 59% at end-Mar 2006, and a tripling of cash and credit cards delinquency ratio from 3.1% to 10.1% over the past 18 months. Aside from excessive consumer credit growth, the problem can also be attributed to intense competition in a fragmented market, loose regulation and inadequate attention to credit information. A common issue in Taiwan and South Korea is loan recovery and resolution, which was hampered by weaknesses in local bankruptcy rules and procedures, as well as moral hazard problems of debt restructuring and relief programmes.

In Malaysia, where the ratio of consumer credit to GDP also rose rapidly, from 31.2% to 47.4% between end-2000 and March 2006, there are rising concerns that things could go sour if unrestrained. In particular, credit card lending has been growing at over 30% y/y since mid-05, accounting for a rising share of consumer credits and accompanied by a higher delinquency ratio.

Lesson #4: Credit access is a prerequisite
Not all high credit growth areas are necessarily worrisome. Consumer loans in India grew by a CAGR of 16.4% between 2001 and 2005, and by 51% in the 2004/05 financial year. (Chart 4) In Indonesia, the corresponding growth rates were some 30%. But consumer loans are growing from a relatively low base in both places, with consumer loans to GDP ratios at 9% and 11% respectively. Similarly, China's break-neck 83% CAGR expansion of consumer credit during 1997-2005 is no cause for panic, given a low 12% consumer credit to GDP ratio.

There are two reasons behind the low level of credit penetration in these countries. First, availability of credit facilities. Consumer credit began in the Mainland only in the late 1990s with regulations allowing banks to extend mortgage loans. Commercial bank mortgage portfolio now amounts to only about 10% of total loans, compared with 20-40% in the more developed economies. Loans for education and car purchases are also recent phenomenon in China. As for credit cards, only 2% of household are card holders, compared to none five years ago.

Second, accessibility of credit facilities. According to the World Bank, China and India host the largest pool of un-banked population, primarily in the rural areas. Credit access in the rural areas are limited by infrastructure problems like the lack of bank branches and communication networks, low levels of income and education, and informal employment. To overcome these, special micro-finance institutions and credit systems need to be created.

Lesson #5: Forced savings needs to be freed
In Singapore and Japan, credit facilities are relatively well developed but consumer lending has remained stagnant for years. Their problems are both cyclical (having suffered prolonged recession and housing market distress) and structural (excessive forced-saving and an aging population that suppressed consumption and limited credit growth). To raise the contribution of these high savers to economic growth, they need to have their savings freed for more productive uses, as underlined by Singapore's recent efforts to deregulate its Central Provident Fund and liberalisation of Japan's pension fund industry.

In summary, there is no simple way to promote consumption in Asia. To a large extent, Asia's strong savings bias can be attributed to its relatively less developed consumer credit system and its large unbanked population in the countryside. This requires the development of special infrastructure and institutions, both would take time and efforts. In comparison, freeing the large savings in the more developed areas like Singapore and Japan would give the region a more imminent boost to its growth momentum.

CHINA

by Stephen Green

Goldilocks and our three growth proxies

- China's economy appears neither too hot nor too cold
- Recent GDP growth numbers might have created a false impression
- Our proxies give mixed signals, but none shows wholesale overheating

China's Goldilocks economy appears neither too hot nor too cold. There are issues with China's economic data, but dig under the surface a bit and one finds an economy which is not growing significantly faster than last year - and may indeed be weakening.

If we had a dollar for every time we were asked the question 'But how can you trust Chinese statistics?', or some such similar query, we would gladly give up our annual bonuses. The China statistics question is, of course, justified. The official numbers can often be misleading - and with serious consequences. Fixed asset investment numbers overstate investment (the growth number of 31.3% ytd in June is probably double the real investment rate), and tend to exaggerate growth in the first half of the year, thus tending to trigger all manner of spring panic in Beijing. The Consumer Price Index (CPI), up 1.0% y/y in July, likely understates inflation, giving the People's Bank a hard time convincing anyone that inflation is a real and present danger. And then there are the GDP numbers. Chart 1 shows the official real growth numbers, with 11.3% growth in Q2, the fastest in nine years. Cue screams of 'Run for your lives! China's economy is out of control!' from some quarters, and more unease in Beijing. The right reaction? We do not think so.

New GDP data, new problems
On top of the usual problems, China's growth statistics have indeed become more challenging since the National Bureau of Statistics' (NBS) GDP revisions. There is a new line of numbers for production-side GDP, which more or less added another 0.5 percentage points (ppts) to nominal growth each year back to 1994, cumulatively finding USD 300bn worth of extra activity. (Table 1) The majority of this gap came through price adjustments. The official growth numbers come from the production side. But on the expenditure side, we have only got new numbers for 2004 and 2005, and it is unclear when the historical series will come out. Expenditure side growth have always tended to be higher than production numbers - so pushing them up by the same margin means the gap between the two lines remains, which would be weird (which line do we trust?), but if they are not pushed up, why not? If this was not enough, there are all manner of conspiracy theories out there - one says the GDP deflator is manipulated for political ends, another that the new NBS leaders want to produce a more realistic set of growth numbers, the previous ones being unrealistically low, and that 11.3% was the first shot.

Story from the proxies
So what can we do? Avert our eyes from the GDP numbers, and look at a number of proxies for growth. Regular readers will recognise our freight index, shown in Chart 2, the idea behind it being that the amount of stuff being moved around China on road, rail and plane is a pretty good coincidental indicator of economic activity. It collapsed during the SARS crisis of 2003, rebounded sharply, and has since remained high. It tells us that the economy is still growing fast, but some weakening might have occurred in Q2. It does not suggest over-heating.

Chart 3 shows our new industry production indices, one for consumer durables (colour TVs, washing machines, fridges, and cars) and the other for metals (steel, copper and aluminum products). This index is also based on units, rather than value of production, so there is no interference from price changes. There has been little growth in durables production over the last couple of years (which is strange given strong retail demand), and even this weakened in H1-06, while metals production growth has accelerated, and continues to remain strong. The divergence in paths suggests over-capacity pressures building upstream. Targeted administrative controls in these sectors are apparently being ramped up again with a new National Development and Reform Commission (NDRC) edict for localities to investigate new projects and stop those which are not in accordance with national policy. Our index will measure how effective that turns out to be (not very, is our guess). But overall these indices do not suggest over-heating either.

The third proxy involves inventories and is shown in Chart 4. We have aggregated inventory data in both light and heavy industry, and since the original data is priced in CNY, we have deflated it using the producer price index. The two lines make interesting viewing. The 2003-04 period saw negative inventory growth, reflecting strong demand, with a SARS-related upturn in inventories which was then absorbed in H2 2003. However, in H2 2005 inventory growth went into positive territory, suggesting weakening demand (because of an administrative investment squeeze perhaps), but has recently softened, backing the idea of a mild resurgence in demand. But not over-heating.

Our indices are coincidental indicators. In short, our three proxies show an economy that is giving off different signals, some suggesting mild weakening, some mild strengthening. But put together they undermine the view that things are falling apart and the centre cannot hold. The one very black cloud on the horizon is CNY policy, but apart from that China's economy is rumbling along nicely.

HONG KONG

by Tai Hui

Cyclical Strengths, Structural Needs

- GDP set to grow at 7% in 2006, and moderate to 4.5% in 2007
- Cyclical slowdown will prompt more structural debates
- Cooperation and competition hold the key to future

With GDP expected to have grown by a real 7.2% y/y in Q2-06 or 7.7% in H1, we are raising our full-year GDP growth forecast to 7%, from the 6% predicted in Feb-06. Going forward, growth should remain solid but closer to trend, settling on a more sustainable 4.5% in 2007. However, peaking of US interest rate should offer some short-term stimulus to asset markets, contrasting the slowdown in real sectors. In the longer run, slower growth should facilitate or force for more structural improvements, which are welcome and necessary.

Benefiting from global trade growth
Hong Kong's merchandise exports expanded 5.2% y/y in Q2-06, the slowest quarter since Q2-02 (Chart 1). In line with that, Hong Kong's total trade growth also moderated, coinciding with a slowdown in China's total trade growth which is highly correlated with Hong Kong's GDP trajectory (Chart 2). This underlines the prominent role of China-related trade intermediation activities in the Hong Kong economy. Aside from traders and export-manufacturers, several pillar industries like logistics, financial services, and professional services are also closely related to trade performances. In fact, the strongest global trade and economic growth in over three decades has propelled Hong Kong to become one of the strongest performers in Asia in recent years. This has prompted S&P to upgrade Hong Kong's long-term foreign currency sovereign rating to AA from AA- in July, a move in tandem with a rating upgrade for China.

Given that we believe China's trade growth will moderate further with a slowing US economy and the Doha debacle of WTO trade talks, Hong Kong's headline GDP growth is likely to ease from the high point of 7-8% to a more sustainable level of 4-5% in 2007. This should help to keep inflation at bay, which we believe would stabilise at 2.5% in 2006, and to a lower 1.7% in 2007 as reduced rental pressure of the past few quarters filters through the consumer price index. The growth in rental index has cooled from a high 13% y/y in Oct-05 to 5.5% in May-06.

Consumer confidence reaching a plateau
Domestically, retail sales are still expanding at a pace of around 6%, despite slower growth in tourist arrivals. Stable property market and jobless rate provide support to local consumer confidence. The outlook of the former is likely to be brightened by the peaking of US interest rates in the near term, which should help to revive dampened transaction activities seen in the past 2-3 quarters. In fact, given severe supply shortages and abundant liquidity, property prices could set for a sharp short spur once investors' concerns about interest rate and growth uncertainties are cleared.

For the labour market, the pace of job growth has slowed from 3.6% in mid-04 to around 2% in Q2-06. This is partly a reflection of soft demand for workers in construction and manufacturing, which is unlikely to improve much given ongoing shift of the economic structure to services and the lack of major construction projects. Meanwhile, easing GDP growth would also likely cap labour demand, as illustrated by the high correlation between nominal GDP growth and employment growth in Chart 5. Without more structural improvements in the labour market, further decline in jobless rate should be limited, and is likely to face growing resistance as it dips below 5%.

Cyclical cool down to reveal structural issues
With economic growth set for a cyclical slowdown in coming quarters, some of the structural issues facing the future development of Hong Kong could resurface. The consultation over the introduction of a new Goods and Services Tax (GST) has recently induced heated debate within the community. Slower growth ahead could renew the urgency to tackle some of the structural issues like a narrow tax base and rigid labour markets, forcing for more profound review of Hong Kong's long-term competitiveness.

One structural issue facing the Hong Kong economy is its positioning relative to other Chinese cities. Recently, there are concerns that public listing of Chinese companies in Hong Kong could take a backseat now that the Shanghai stock market has resumed an uptrend and restarted new listing activities. We believe such concerns are overdone since companies choose to list in Hong Kong not only to raise capital, but also to take advantage of Hong Kong's strong governance and regulatory framework to provide international investors with more confidence. This is particularly important for Chinese companies that are reaching out to the international market - a trend likely to grow as the Chinese economy becomes more international.

In comparison, a more pressing issue for Hong Kong would be to enhance its economic access to and cooperation with the Mainland, especially the Pearl River Delta, but also including other key regions like the Yangtze River Delta and the Bohai Economic Rim. To survive and excel, Hong Kong needs to expand its economic hinterland and improve its services. It is not competition that would strangle Hong Kong, but the lack of it. Without competition, there will be less pressure to improve.

MALAYSIA

by Joseph Tan

Shifting bias, lower targets

- Our OPR target was cut from 4% to 3.75% recently
- Q2 GDP should grow at 5.3% y/y, on par with Q1 growth
- We maintain our 5.5% 2006 growth target, with downside risks

Modest exports and consumption demand should see real GDP growth stabilises at about 5.3% y/y in Q2-06, but the 6% official growth target for full-year 2006 is likely to be missed. Even our 5.5% growth forecast has some downside risks. This may partly underline Bank Negara's recent decision to keep interest rates on hold, despite the risk of leaving real rates in negative territory. Given shifting policy bias from price stability to economic growth, we now believe the overnight policy rate will peak at 3.75% in Q3-06, 25 bps lower than our previous forecast.

Growth to remain stable
On August 30, the government is going to release its Q2-06 GDP data. We expect the economy to have expanded by 5.3% y/y, same as Q1, with the manufacturing sector being the major growth contributor. (Chart 1) Industrial output grew 6.0% y/y in Q2, slightly higher than the 5.8% in Q1. But Q2 trade surplus halved from the Q1 level as export growth eased to 11.5% y/y in Q2 from 13.7% in Q1. Domestically, private consumption growth should moderate further to 6.7% y/y from the 7.5% pace in Q1 as the interest rate hikes in February and April began to bite.

Going forward, growth is unlikely to exceed 6% as forward looking indicators for the key electrical and electronic sector, which is about 70% of the manufacturing base, is suggesting a slowdown. (Chart 2) This, coupled with a moderation in domestic demand, actually presents some downside risks to our current 2006 growth forecast of 5.5%, which is also the current market consensus. In this respect, the government would have a difficult time meeting its own target growth rate of 6% for full-year 2006.

Negative interest rate, real or unreal?
On the price front, CPI inflation stayed high at 4.1% y/y in Q2 (versus 3.8% in Q1) due to a 23% hike in fuel prices and a 12% rise in power tariffs. This effectively leaves the current level of real interest rate at negative territory for 14 months. (Chart 3) In an environment, when the rate of return on savings and real wage growth are negative, consumers will be encouraged to borrow more or save less to sustain their current consumption patterns. In both cases, future consumption will be affected. Negative real interest rates also affect lending behaviour of banks and credit quality of borrowers, which is drawing attention from rating agencies. (Chart 4) These are supposed to be the economic "distortions" that central bank governor Zeti was alluding to in June when she said that interest rates need to be aligned with domestic and financial conditions.

Yet, other factors seem to be at play behind. On July 28, just four days before the latest monetary policy meeting, BNM remarked that interest rates need not rise if inflation is due to rising costs and not demand-driven. Subsequently, the Overnight Policy Rate (OPR) was kept unchanged at 3.50%. The move caught a large part of the market by surprise, as many in the market were expecting a 25bps hike prior to the comments.

Inflation peaking? or not?
BNM noted in its following monetary policy statement that domestic inflation should have peaked and is expected to be lower in the remaining half of 2006. This statement should be examined from two angles. First, from a year on year basis, inflation will definitely be lower from August onwards due to base effect, given the 19% hike in fuel prices in August 2005. But from the month on month angle, inflation has been expanding on an average 0.3% m/m since April 2004. While the momentum of price increases has not speeded up month on month, with June 2006's inflation only at 0.2% m/m, prices are nevertheless still rising.

From an economic perspective, given that real interest rates - based on current rather than expected inflation - are still negative, we would argue that interest rates are still below neutral and there is a good case for nominal interest rates to rise further. Even assuming BNM's inflation target of 3.5-4.0% for 2006, another 50bps hike of the OPR would seem necessary to bring real rates to or above zero.

One more insurance hike of the OPR
Of course, policy decisions are more than simple rules and calculations. With the US economy setting for slower growth and export prospects clouded by the Doha debacle, the BNM may see the need to shift its policy bias more from price stability to growth, especially given uncertainties in domestic politics around the current and former prime ministers. We expect BNM to adopt a hike only when there are strong evidences of necessity. Against this backdrop, we have revised down our OPR target for 2006 from 4% to 3.75%, with a 25bps "insurance hike" expected in the August 25 policy meeting to provide at least a modest buffer above the rate of inflation before pausing. (Table 1)

VIETNAM

by Joseph Tan

Like China, Learn from Indonesia

- Like China, WTO entry could bring an export bonanza
- Unlike Indonesia, high oil prices fail to destabilise the VND
- Sustained reform should support growth at 8.8% in 2007

Like China, entry to the World Trade Organisation (WTO) could bring Vietnam an export bonanza. This is timely to cushion an expected slowdown in global economy. Unlike Indonesia, high oil prices fail to undermine Vietnam's payments position as its crude oil exports exceeded its oil product imports. More importantly, it learnt from Indonesia the need to limit its oil subsidies. While this may see higher inflation and require more interest rate hikes, the VND should stay stable and support a higher 8.8% GDP growth next year, more so given a reform-minded leadership.

The last quarter of 2006 will be an exciting time for Vietnam with the likely accession into the WTO. Accession has been delayed for a full year following disagreement over terms with Vietnam's key trading partner, the US. The breakthrough came when, in May this year, an accord was signed on Vietnam's terms of entry into WTO with the US. The accord led to President Bush's push to normalise trade ties with Vietnam that gained unanimous support from the Senate and repealed a 15-year cold war era law that required an annual review of Vietnam's trade status. The vote now goes to Congress and is expected to be concluded before Bush's visit in November to Vietnam.

WTO accession to spur growth in 2007
Accession into WTO is important for Vietnam as it now faces quota restrictions on its second largest export revenue earner after crude oil - textiles and garments. Improving market access could lead to increased exports which is a key growth driver. (Chart 1) This is timely given the prospect of slowing global demand and the setback in exports of aquatic products (Vietnam's third largest export earner) inflicted by a typhoon earlier this year. GDP growth in H1-06 came in at 7.4% y/y, down from 7.8% in the same period of 2005. (Chart 2) While WTO accession in late 2006 would mean that it would not contribute meaningfully to growth for 2006, 2007 should see a positive payback. With this in mind, we have revised down our 2006 growth forecast to 8.2% from 9%, and have raised our 2007 growth target to 8.8% from 8.5% previously.

On the inflation front, CPI has been falling gradually year on year in H1-06 as the bird flu induced price increases abate. However, our previous 7% inflation target for 2006 is likely to be missed as authorities raised fuel prices by 9% for the second time in 2006 this month, after having spent USD 425mn on fuel subsidies in the first seven months of 2006. (Chart 3) Vietnam suffers from the same problem as Indonesia where the lack of refining capacity forces it to export crude oil and import refined products. With sustained high oil prices, we now expect inflation to average 7.7% y/y in 2006, up from our earlier forecast of 7%.

A stable VND, higher rates
Unlike Indonesia, Vietnam is not facing any serious pressures on its external payments. Vietnam's export of crude oil exceeds the import of refined petroleum, resulting in an oil trade surplus. (Chart 4) In any case, the VND is a highly regulated currency and is not fully convertible. The State Bank of Vietnam (SBV), the central bank, allows only limited daily fluctuation of +/- 0.25% on the USD/VND pair. The currency is managed more like a crawling peg versus the USD rather than a float. (Chart 5) With limited payments pressure, depreciation of the VND is unlikely to be more than 2% per annum versus the USD. We expect the VND to remain broadly stable, trading around the current level of 16,000 VND versus the USD throughout the rest of 2006.

Monetary conditions are still loose despite the SBV's tightening stance. The real level of interest rates, which is currently close to zero, will be negative after the recent fuel price hike by the authorities as the base lending rate currently stands at 7.5%. The new Vietnamese government also views inflation as a key challenge for the economy, as indicated by National Assembly Chairman Trong who said that the strong increase in prices had negatively influenced production and people's lives. Against this backdrop, we expect a further 50bps hike from the SBV in 2006 to check inflation.

Reform momentum reinforced
On the political front, Vietnam's ruling communist party recently concluded its five-yearly congress. Following the National Assembly, new nominations to the politburo were recently accepted. Key changes to the politburo include the appointment of Nguyen Minh Triet and Nguyen Tan Dung as President and Prime Minister respectively. Triet is well known for his participation in attracting foreign investment and the subsequent development of southern Vietnam, while Dung, who has been Deputy PM since 1997, was also at one point doubling as SBV governor. Both have been long involved in Vietnam's reform process and their appointments were well anticipated by the markets. The new leadership is pro-reform and business friendly and we expect policies that favour foreign investment and development to continue.