Asia Focus: Intra-Asia portfolio flows, a weak link: Portfolio investment is one of the weakest links in intra-Asia economic integration. Despite its large savings, Asia has much of its surplus intermediated by and invested in the West. This helps to sustain the demand for Asian products, but may have also prolonged global imbalance and perpetuated immaturity and vulnerability of Asian financial markets. Asia needs to accelerate development and liberalisation of its capital markets, and stands to gain much from promoting intra-Asia portfolio investment.

Economy Highlights

India: The report on fuller capital account convertibility is encouraging, but gradualism is the key. In particular, it needs to set the priorities right. Reforms in fiscal, banking and the real sectors need to be accelerated in line with the introduction of fuller convertibility.

Singapore: We see higher growth, lower inflation and a stable SGD - the best of both worlds. Our 2006 growth target is raised to 7.3% from 6.5%, and we expect interest rates to stay in the 3.38-3.50% range until YE-06.

Taiwan: Export dependency exposes Taiwan to external shocks. However, the imminent threat remains with the domestic front, and there are few signs of rebound in domestic demand yet. The CBC is still likely to hike more this month, but may need to switch track later.

Thailand: Domestic demand growth is set to get worse in 2006, but a rebound in 2007 should not be underestimated, especially if private sector confidence is restored in time.

OVERVIEW

by Nicholas Kwan

Welcome back, IMF, but

- History seldom repeats itself
- But it will repeatedly punish those misread it
- As IMF revisits Asia, it needs to learn the history right

There is a Chinese proverb saying "receiving friends from afar is delightful." This month, Asia's valuable friends from the IMF and the World Bank will revisit the region - nine years after they held their first annual meeting in Asia in 1997, when the Asian Financial Crisis just started to unfold.

For sure, there are lots to celebrate and be delighted, especially for those crisis-hit economies, all of them should finally see their USD GDP return to their pre-crisis levels by the end of this year. This is provided Thailand maintains its positive, albeit moderating, growth momentum till year end. More so if its currency, along with other Asian counterparts, is to appreciate further as advised by the IMF. However, for individual Indonesians, Thais, Filipinos and Hong Kongers, they are still struggling to recover to their pre-crisis income levels as per capita GDP in these economies are still 1-7% lower in USD terms.

Skeptics may ask whether our friends in the IMF and World Bank will bring Asia another crisis with their second annual meeting in the region? People may recall that nine years ago, our friends from IMF had mumbled about Asia's tightly pegged exchange rates, in addition to all the flowering remarks about the region's miraculous success. This time, something sounds familiar is still ringing, albeit with the focus shifted from the smaller Southeast Asian currencies to the biggest one of developing Asia - the CNY. Will such mumbling signal another round of upheaval of the region's currencies? Is history going to repeat itself?

We don't think so. Asia has substantially transformed itself over the past nine years and significantly strengthened its own defence. However, there are still risks that history could be misread and problems misdiagnosed. History seldom repeats itself, but it does repeatedly punish those who don't learn from it. At this juncture, two of IMF's Asia readings would worth particular attention:

1. Does Asian currencies undervalue too much?

This has been 'the issue' for Asia for years, and is likely to be the focus of the G7/8 finance ministers/central bank governors meetings as well as the IMF/WB annual meetings in the coming week. Some even predict that the coming meetings could precipitate into another 'Plaza Accord' on the CNY, just like what had happened to the JPY in 1985 that drove the USD/JPY from 260 to 80 in 10 years.

Whether or not there will be an accord is uncertain, but one thing seems sure is that IMF would propose in the coming annual meeting to expand its services in providing 'exchange rate surveillance' to member economies. This is dubbed as a step forward in fulfilling IMF's role in safeguarding financial health of the global economy. This could be done by making regular assessments and comments on whether a member's currency is over or under valued, using moral suasion and/or other means to influence currency markets and prevent the buildup of major market misalignment.

We believe this could be a misguided effort. Studying and managing exchange rates is always a risky business. Despite all the highly sophisticated models and theories being developed, assessing the 'fair value' of a currency and forecasting its exchange rate movements, especially in terms of timing and direction of exchange rate changes, remain a highly imprecise science. In this aspect, almost no institution can claim authority, not even the central bank of the respective currency. One wonders an added voice of IMF would confuse or contribute more to market rationality and stability.

The problem is not restricted to short-term exchange rate development. For example, it is debatable whether the Plaza Accord, by pushing the JPY up 3 folds in 10 years, had truly contributed to a better global exchange regime and financial system. Many would argue that the Accord is actually one key factor behind Japan's super-asset bubble in the late 80s and its decade-long malaise since the mid-1990s.

Will history repeat itself? Quite unlikely. Thanks to the Plaza Accord, it would be difficult to convince China, Asia as well as other members that another accord on the CNY is advisable. It is understood that the 'surveillance' proposal is being resisted by many Asian countries, as rightly so.

2. Does Asia accumulate too much forex reserves and save too much?

Another key issue to be discussed in the upcoming G7/8 and IMF/WB meetings is global imbalance and its diagnosis. Again, Asia is under focus, as expected. Arguments are that Asia, China in particular, has exported too much (thanks to their undervalued currencies) but imported too little, i.e. saving too much and spending too little, resulting in the accumulation of too much forex reserves and leading to growing global imbalances.

To address this, the IMF is proposing to introduce a 'multilateral surveillance' framework. This differs from its traditional 'bilateral surveillance' practice, which relies on sending teams of IMF experts to an individual member country to conduct regular (Article IV) health checks, providing diagnosis and recommendations to address specific systemic issues of the member. In the new 'multilateral' framework, surveillance work would be done across several countries, covering key players of specific issues and providing advices to the group as a whole. This appears a more comprehensive approach to tackle global or multilateral issues, which fall closer to the mandate of IMF comparing with activities that focus mostly on domestic issues of individual members. However, a good approach works only if the problems are correctly diagnosed.

As we have analysed in our Asia Focus (March and April issues), Asia is partly responsible for the global imbalance, but not all, nor even the major part. Last year, Asia only accounts for 18.5% of the combined trade deficits of EU and NAFTA. Asia has saved much, but not because spending too little, but investing much less than before. This is partly due to the need to replenish balance sheets of both the public and private sectors after crisis. Another underlining factor is Asia's urge to build up reserves as safeguard against external shocks, given the lack of effective multilateral safety net during the previous crisis. This can be seen as partly due to Asia's under-representation in the multilateral agencies. In this respect, the 'voice and quota' agenda of the coming annual meeting which calls for bigger voting power and says for key developing countries like China and Korea in IMF/WB may partly address the concern and would be a move in the right direction. However, without a more balanced analysis on the issue of global imbalance, using the 'multilateral surveillance' approach to address Asia's over-saving problem could be another misguided recipe.

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

Intra-Asia portfolio flows, a weak link

- Portfolio investment is the weakest link in intra-Asia integration
- It reflects Asia's immature financial markets and their vulnerability
- To address this, much needs to be done, and much to be gained

The degree of intra-Asia integration in terms of portfolio investment is much lower than trade or direct investment. Less than 10% of Asia's USD 2.8trn holding of foreign portfolio assets at end-2004 are Asian assets. This is not surprising given relatively small sizes of Asian capital markets, limited availability and variety of quality financial products, restricted access to non-resident investors, and relatively weak financial infrastructure. This also underlines the fact that much of Asia's surplus saving is intermediated and invested in the West. This helps recycling Asia's large trade surplus back to the deficit runners, especially the US, sustaining their demand for Asian products. However, it is questionable whether this has also prolonged global imbalance. Worse, to the extent that this has limited Asia's ability to intermediate and invest its own savings, it could have perpetuated the immaturity and vulnerability of Asian financial markets. From this perspective, Asia needs to accelerate development and liberalization of its capital markets, and stands to gain much from promoting intra-Asia portfolio investment.

A weak link in intra-Asia economic integration
While Asia is its own largest direct investor and largest trade partner, Asia seems loosely connected if one follows portfolio investment. Intra-Asia portfolio investment, including equities and bonds, amounted to USD 259bn at end-2004. This accounted for a meagre 9.2% of Asia's total USD 2.82trn holding of foreign portfolio assets (5.8% if Australia and New Zealand are excluded) at end-2004, shy of the 64.2% within the European Union.

Among the different portfolio assets, intra-Asia equity holdings are relatively more popular, accounting for 13.5% of Asia's total foreign equity holding, but still only a quarter of the intra-EU level of 55%. Intra-Asia bond holdings are even smaller, accounting for only 7.6% of Asia's total foreign bond holding, or around one-tenth of the EU's 69% level. Other than reflecting Asian investors' lack of interest in papers issued by their neighbours, this also underlines the region's generally under-developed bond markets.

The bulk of Asia's foreign portfolio holdings are in the US and EU, representing 31.8% and 35.5% of Asia's total foreign portfolio investment respectively at end-2004 (Chart 1). As of end-2004, Asia held USD 898bn in US equities and bonds, and USD 1,001bn in EU securities. In reciprocal, US and EU investors held USD 727bn and USD 798bn respectively in Asian securities, resulting in a net holding of USD 394bn of US/EU securities by Asian investors at end-2004. Overall, Asia held USD 763bn worth of net non-Asian portfolio asset at end-2004.

One caveat in reading the above stock data is that they are affected not just by historical flows, but also by investment returns and valuation changes. However, Asia's net portfolio asset holding still broadly underpins its position as a net financier in the global capital markets. This is in line with other related statistics. For instance, between 2001 and 2004, Asia's foreign portfolio assets increased by USD 1.12trn, USD 220bn more than the USD 0.9trn increase in foreign portfolio liabilities during the same period. More recent US Treasury data also reveal Asia's strong appetite for US securities. In 2005, Asia bought a net USD 87.1bn long-term US securities, up 84% from 2004. In the first half of 2006, the purchase amounted to USD 60.3bn (Chart 2).

This is no news on Asia financing the under-saved West. While Asia maintains large trade surplus with the US and EU, there have been net portfolio outflows from Asia to these two regions to fund their imports. In fact, such recycling of Asia's trade surplus is critical to sustain the demand for Asian products and maintain global trade flows. However, to the extent that such surplus recycling model has perpetuated global imbalance and Asia's dependence on capital markets in the West to intermediate and invest Asia's own savings, one wonders whether it is a healthy long-term phenomenon.

Risk and liquidity tradeoff
Among the Asian capital markets, Australia absorbed the largest amount or over one-third of the USD 259bn intra-Asia portfolio investment at end-2004. This has partly to do with Australia's relatively developed fixed income market. In fact, it is interesting that much of Asia's foreign portfolio assets are in bonds, representing about 73% of the total foreign holdings. This is in contrast with the structure of most Asian capital markets which are heavily biased towards equities. It seems Asian investors have a geographical bias of preferring to invest in relatively high risk domestic equities, but liquid and high graded foreign bonds - an interesting point to note in promoting intra-Asia portfolio investment.

An interesting contrast is Japan, which has only 2.2% of its inward portfolio investment sourced from Asia. This may not appear too surprising, given the huge sizes of the Japanese capital markets. But the USD 20.5bn Asian holding of Japanese securities is small even in absolute terms, compared with USD 26.5bn and USD 24.5bn in Malaysia and Korea respectively. Japan's prolonged economic malaise and near-zero interest rates that undermined the attractiveness of its stocks and bonds to foreign investors are clearly one factor, but not sufficient to explain the relative conservativeness of Asian investors compared with the West. One wonders if it has more to do with Asian investors' preference for foreign capital markets with better governance and less risks - something similar to the hints offered by the Australian market.

Apart from Australia and Japan, other favourite destinations of Asian investors are Hong Kong, Singapore and South Korea where the financial markets are more mature and liquid (Chart 3). Aside from liquidity and risk concerns, proximity and historical linkages are other key factors driving intra-Asia flows, as evident from the cases of Hong Kong versus China, and Singapore versus Malaysia.

Actual vs proxy investors
From Asia's perspective, 12.6% of Asia's foreign portfolio liabilities are owed to Asian investors, again a minority compared with investors from the US and EU, who accounted for 35% and 39% of the holdings at end-2004. It is ironic that while Asian investors are keen to invest in the West, the West is also keen to invest in Asia. The only exception appears to be China, where the largest source of inward portfolio investment is Asia, contributing to over half of the total inward portfolio investment in China (Table 1).

On surface, China attracted relatively few investments from the US or the EU as compared to other Asian economies. This appears reasonable given the capital restrictions in China, which allowed only limited foreign investments in local securities. Westerners who are less familiar with the Chinese market may be deterred by ambiguous regulations and limited accessibility. However, the figures could be misleading since many of the largest Chinese companies are listed overseas, mainly in Hong Kong as H-shares. Capital raised by these companies would be counted as sourced from Asia (Hong Kong) when repatriated back to the mainland, even though their ultimate holders could be from the West. Given series of mega IPOs of Chinese companies now lining up in the Hong Kong Stock Exchange, Asia will remain China's dominant investment source for some time to come. However, as indicated by the heavy presence of Western institutional investors in the H-share IPOs, it is likely that many of the so-called Asian investors in Chinese papers are actually non-Asian.

The maze, however, may go even more puzzling. Many of the Asia dedicated funds managed by financial institutions in the West are funded by Asia money. Since current portfolio data are based on residence of the immediate rather than ultimate holders, it is possible that a sizeable amount of the portfolio investment made by Western institutions is actually investment made on behalf of Asian investors. While this may offer some comforts in the sense that Asian investors might have a stronger-than-perceived interest in Asian papers and that intra-Asia portfolio investment could be bigger than what it seems, it also exposes one key weakness of the Asian investment landscape, i.e. Asian investors may depend more heavily than perceived on Western financial intermediaries to channel and invest their savings, both in the West and Asia.

It is not surprising to see Asian investors prefer to invest in the West given limitations of Asian capital markets like their relatively small sizes, limited availability and variety of quality financial products, restricted access to non-resident investors, and relatively weak financial infrastructure. However, Asian investors' reliance on Western intermediaries to invest in Asia could underpin the weaknesses of Asian intermediaries, probably in their capability or governance, or both. From this perspective, Asia not just needs to accelerate development and liberalisation of its capital markets, but also its financial intermediaries. It has much to do, but also much to gain in promoting intra-Asia portfolio investment.

INDIA

by Shuchita Mehta

Convertibility, gradualism and priority

- Convertibility plan favourable, but gradualism is key
- Also, priority needs to be right
- Fiscal, banking and real sector reforms are prerequisites

The Committee on Fuller Capital Account Convertibility (FCAC) recently submitted its recommendations to the Reserve Bank of India (RBI). We concur with the committee's view that now is not the best time to implement FCAC and a phased approach is desirable. However, the three-phase five-year time frame - 2006-07 (Phase I), 2007-09 (Phase II) and 2009-2011 (Phase III) - might still be ambitious given the pace of reforms and the fact that we are at the peak of the global economic cycle. Setting up appropriate safeguards might be necessary, and these need to be dynamic in nature. We believe that reforms in the real economy remain a priority and convertibility will act as an enabler. While the measures suggested in the report are less path breaking (Table 1), given that RBI has already been relaxing controls, overall, caution is advisable.

Fiscal and banking sector reforms needed
Earlier this year, we had suggested that much work still needs to be done before fuller convertibility (see OTG dated 20th March 2006). We based our assessment on the urgent need to bring about fiscal consolidation and banking sector reforms.

First, while the external debt and liquidity situation continues to improve (Chart 1), the public debt burden has risen significantly over the years. Total (center and state) public debt to GDP ratio was almost 82.1% of GDP as of Mar-05, up by nearly 20% of GDP over the past decade. Overall fiscal deficits are also high (Chart 2). To meet its objective of fiscal consolidation, the central government aims to adhere to the deadline of reducing the fiscal deficit to 2% of GDP (currently 4.1%) and zero primary deficit by 2009. However, in the current year itself, given the huge outlay requirements the central government deficit has already crossed 58% of the budgeted 3.8% of GDP, which Standard and Poor's raised as a concern. While the government has initiated several reforms to improve tax collections, the social spending requirements are significant. Further, any deceleration in economic activity could slow down revenue accretion.

Second, while banking sector balance sheets have improved significantly over the years - the gross nonperforming asset ratio fell to 5.2% as at Mar-05 from above 15% as at Mar-97 - the banking industry is still fragmented, and further improvement in efficiency needed. A related issue remains the phased reduction in cash reserve and statutory liquidity ratio requirements, which would complement a lower fiscal deficit and strengthened risk controls in the banking system. This will likely be a gradual process. Finally, the extent of financial intermediation needs to rise, and the various financial markets need to be more integrated.

FCAC not an end in itself
Given the imperative of job creation and the need to push up the living standards of a billion plus people, India needs to push growth higher on a sustainable basis. There is an increasing consensus in policy circles that India should attract more investments from overseas to supplement domestic savings. However, despite strong growth performance, it has not been able to attract enough foreign direct investments (currently at 1% of GDP) relative to its size or requirements.

While fuller capital account convertibility is a means to realise the full potential of the economy, the country still needs other reforms to attract the type of flows India requires. Several changes on the ground are needed including freer foreign direct investment limits in sectors such as retail, insurance, etc. This will require significant amount of consensus building. Furthermore, improvement in overall infrastructure facilities both via direct government investments and through public-private sector partnerships is desirable.

The World Bank's 'ease of doing business' database (2006) does not paint a good picture for India (Table 2). While the country has seen improvement in its ranking to 134 from 138, it still remains in the lower deciles. Transaction costs are high and businesses face hardships in enforcing contracts or downscaling. Closing a business takes years (notably the longest in South Asia). Overall, these stumbling blocks need to be addressed.

A predominant portion of the 400mn labour force is in the unorganised sector and only about 30mn people form the organised labour market. Adopting FCAC in one go can potentially have disruptive consequences. A larger proportion of the economy needs to enter the organised work space.

Finally, monetary policy instruments and operations will need to be re-examined. The committee recommends active use of open market operations and intervention in the foreign exchange market. It proposes continued use of the Liquidity Adjustment Facility (LAF) to manage short-term liquidity and Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) to manage medium-term liquidity. However, we would be keen to see an explicit inflation targeting. Further, as inflation differentials narrow and the economy realises productivity gains, we would recommend nominal effective exchange rate targeting (NEER) rather than an REER based approach.

SINGAPORE

by Joseph Tan

The best of both worlds

- We see higher growth, lower inflation and a stable SGD
- Our 2006 growth target is raised from 6.5% to 7.3%
- Interest rates should stay in the 3.38-3.50% range until YE-06

Strong economic growth and benign inflation allowed Singapore to enjoy the best of both worlds, prompting us to raise our 2006 GDP growth forecast. We now see real GDP growth to reach 7.3% in 2006, up from our original 6.5% and close to the high end of the government's revised 6.5-7.5% range forecast.

Inflation, on the other hand, should stay within our predicted 1.6% in 2006 and 1.2% next year. This should encourage the MAS to hold its policy steady without more aggressive appreciation of the Singapore dollar or further tightening of local liquidity. In fact, with the US interest rates peaked, SIBOR should ease, albeit gradually, in coming months.

Manufacturing stronger than expected
Singapore's Q2-06 real GDP growth rate was raised from the initial flash estimate of 7.5% y/y to 8.1%. The upward revision was once again due to strong but volatile pharmaceutical production. The volatility in the manufacturing sector has worked its way into the headline GDP figure in recent quarters and is proved challenging to discern underlying trends. (Chart 1)

Previously, Singapore's manufacturing performance was heavily dependent on export orders of electronic products. On a global basis, the outlook stemming from that sector is suggesting a softening of Singaporean exports and production in H2-06 (Chart 2).

Nevertheless, the strength in the manufacturing sector in Q2 pushed GDP data higher. Coupled with the 10.8% y/y expansion in Q1, average growth for H1-06 amounted to 9.5% y/y. This good performance prompted the official forecast to be raised from the initial 5-7% range to 6.5-7.5%. While we hold to the view that growth in H2-06 will soften as Singapore's key trading partner - the US - moderates, the strong growth clocked in H1 has already lifted full year average growth up. As such, we are revising upwards our 2006 GDP growth target to 7.3% from 6.5% previously. On a year on year basis, growth will also moderate due to the high base in H2-05 and we expect real GDP growth in Q3 and Q4 2006 to expand 6.0% y/y and 4.2% respectively (Chart 3).

Benign inflation allows MAS to stay put
On the inflation front, the Monetary Authority of Singapore (MAS) expects inflation to fall within 1-2% for 2006 and to moderate further in 2007. We expect inflation to be 1.6% and 1.2% in 2006 and 2007 respectively. Despite this benign inflation environment, upward pressure to inflation continues to come from high oil prices. This, coupled with a stronger CNY, is leading to speculations that the MAS will allow the SGD Nominal Effective Exchange Rate (NEER) to adopt a more aggressive appreciation stance at the October policy meeting. We disagree.

First, with the US economy exhibiting signs of slowing, oil prices are actually pressured downwards. Second, the appreciation of the CNY will open up "headroom" within the SGD NEER as the CNY is a key constituent of the trade-weighted basket. Currently, the SGD NEER is close to the topside limit of the band, with CNY strength, the band would shift up and allow SGD to strengthen without breaching the limit, saving MAS from adjusting the band. (Chart 4)

Third, monetary policy is set under a medium term view and if the MAS expects inflation to moderate, it does not warrant a more aggressive appreciation stance. We reiterate that the MAS is likely to keep its current policy of modest and gradual SGD appreciation at the October policy meeting.

SIBOR to track US rates down
On the interest rates front, loan demand continues to rise but at a pace that is insufficient to push rates significantly higher. (Chart 5) This, together with a pause in USD rates, has actually caused the 3M SGD SIBOR to ease from 3.56% to 3.50%.

What could possibly tighten liquidity temporarily is funding for the USD 3.6bn Las Vegas Sands casino project, but USD 1.4bn bridge financing has already been raised, and the rest has a year to be raised. The over-riding factor affecting the interest rate outlook in Singapore is USD rates.

As the incoming data affirms the slowing in the US economy, markets will begin to posture for interest rate cuts. We are expecting the first interest rate cut from the US Federal Reserve to take place in Q3-07. We expect the 3M SGD SIBOR to stay in a tight range until YE-06 before falling gradually in 2007.

TAIWAN

by Tai Hui

Need to boost domestic engine

- Export dependency exposes Taiwan to external shocks
- There are few signs of domestic rebound yet
- CBC likely to hike more, but may need to switch track later

Our concern that the Taiwan economy being overly dependent on net exports is underlined by the Q2 economic data. Domestic demand, including personal consumption, government spending and investment, was a net burden on headline growth. Cautious consumers and worried businesses are unlikely to defy gravity in the near term. This continues to expose the island to global economic volatilities. Although the immediate outlook of exports is still positive, Taiwan lacks the necessary buffer to support headline growth if the US or the Mainland China slows down more than anticipated. That said, the central bank's desire to bring monetary policy back to neutral is likely to lead to another 12.5bps hike in its Q3 monetary policy meeting at end-September. This would add to the difficulty of economic navigation in coming quarters.

Flying with a single engine
The Taiwan economy expanded by 4.6% y/y in Q2-06, slightly above our expectation but in line with the slowing trend observed across Asia. Investment and government spending contracted on a year-on-year basis and cut 1.61 percentage points (ppts) off headline growth (Table 1). Personal consumption expenditure, while showing positive y/y growth, expanded at its slowest pace since Q2-03, when SARS hit the island. Fortunately, net exports came to the rescue and boosted growth, contributing 5.4 ppts to overall real GDP growth.

Consumer confidence fell to its lowest since 2001 (Chart 1). The breakdown of the index suggests households are concerned with the negative impact from higher commodity prices, following hikes in fuel prices and electricity tariffs. Household financial situation and uncertainty regarding Taiwan's economic outlook are also worrying consumers and hence limiting spending. Good news is that the stock market volatility in May/June did not have a major impact on consumer confidence and falling jobless rate is also helping to offset some of the negative sentiment. Deterioration in consumer credit seems to have eased in recent months according to credit card and cash card delinquency ratios (Chart 2). However, a clear rebound in consumer confidence may take some time, especially as the global economy is moderating.

From the business point of view, recent political events in Taiwan could continue to undermine investment intention. More importantly, the peaking of global economic performance could either delay investment spending, or encourage businesses to invest in other low cost locations to reduce costs. This suggests that growth contribution from investment is likely to remain limited, although it could return to positive territory on a y/y basis.

In summary, Taiwan will remain dependent on exports with the current trajectory of slow recovery in consumption and investment. However, with a slowing global economy and the current electronic cycle likely at its peak, this growth driver could become less reliable in 2007. Hence, there is a greater sense of urgency to seek new ways to boost domestic demand in order to protect the island against external shocks. Given the current political landscape, it would be difficult for the government to implement any major measures to boost confidence. This suggests the burden of growth promotion could shift towards the monetary side.

Between a rock and a hard place
So far, the central bank, CBC, has been focusing on inflation and money supply expansion. Its baby-step adjustments since Sep-04 have brought its benchmark discount rate from 1.375% to 2.50%, with eight quarterly hikes (one by 25bps, and seven by 12.5bps). While the total magnitude of interest rate adjustments may still fall short of its peer in the region, we believe inflation pressure on the island is largely contained. As highlighted above, demand side pressure is not particularly strong and much of the risk now comes from the supply side, especially oil prices which would not be effectively addressed by liquidity tightening.

As Chart 3 illustrates, headline inflation in H1-06 has been kept below 2%. Although it has been creeping up in Q2, this is partly related to food price inflation. Once that component is taken out, the overall trend of inflation remains stable. Hence, the CBC can afford to take a more balanced stance between tackling inflation and facilitating growth, which is in line with the regional trend of peaking rates.

Taking various arguments into account, we believe the CBC is still likely to raise its discount rate by 12.5bps in its Q3 MPC meeting at the end of September. This could be repeated in Q4-06, provided that the slowdown in growth is not excessive. However, as we enter 2007, the moderation in global growth could persuade the central bank to hold rates steady. Given that monetary conditions remain accommodative, there is less need to cut rate any time soon. But the CBC needs to stand ready to rescue the economy should its single engine runs into glitches.

Thailand

by Usara Wilaipich

Confidence is key

- Domestic demand growth is set to get worse in 2006
- But a rebound in 2007 should not be underestimated
- If private sector confidence is restored in time

Given prolonged political stalemate and weakening domestic demand, there are growing concerns that the Thai economy may decelerate well beyond 2006. While things are likely to get worse before they get better, we believe an early rebound in growth momentum is possible and 2007 could see higher GDP growth than 2006. The key is a quick restoration of confidence, which is not easy, but possible.

Unlocking the political deadlock
The Thai economy grew by 4.9% y/y in Q2-06, down from a revised 6.0% y/y in the previous quarter. This was attributed to a slowdown in private consumption and investment in response to high oil prices and domestic political uncertainty. The same factors are likely to drag the economy down further in the rest of the year.

In terms of politics, the current impasse is set to last for a few more months. One good news was that the Senate had finally selected a new Election Commission (EC) on September 8, defying speculations that it would miss the appointment deadline and lead to further delay of the election. However, with only one month left to prepare for the next general elections scheduled on October 15, the EC may still see it as too tight and decide to amend the Election Decree to postpone the poll. Even if the general elections are to be carried out on schedule and allow a new parliament and government to be formed, uncertainties remain in how the political landscape will be reshaped and how policies will be affected. This implies that a clear unlock of the current political stalemate may still be months away. As such, GDP growth would decelerate further in H2-06 and bring full-year 2006 GDP growth to 4.1%, down moderately from 4.5% in 2005.

In 2007, it is doubtful whether an impressive export performance can be repeated amid cooling global demand, given expected slowdown in the US and, to some extent, China. It is therefore imperative that Thai policymakers focus more on domestic demand as means to maintain growth momentum. This will present a great challenge, but a few positive factors may be in play.

Government stands ready to pump prime
First, the caretaker government is well aware of the need to pump prime the domestic economy and is preparing the groundwork for actions. The FY2007 budget is being drafted with a deficit of THB 150bn, or 2.0% of GDP. Total spending is budgeted at THB 1.55trn in the next fiscal year, a 14% increase from the THB 1.36trn in FY2006. Emphasis is on maintaining public infrastructure investment, which would support employment and investor confidence.

On the monetary policy front, the Bank of Thailand (BoT) is clearly shifting its focus from price stability to growth, having stopped tightening after raising its policy rate for 13 times to 5.0%. We believe the next move in interest rate would be a cut. Once inflation peaks and clearly heads south, the BoT would turn more aggressive in relaxing its monetary grip, more so if economic growth momentum decelerates further. We expect the BoT to start slashing its policy rates in H2-07.

Private sector confidence is key
For the private sector, the issue is not so much the ability to spend, but the confidence to do so. While uncertain economic outlook and high oil prices are part of the deterrents, the bigger confidence dampener is local politics. However, depressed spending amid growing income is building up pent-up demand, which could unleash strong growth impetus once confidence is restored.

Until now, slower economic growth has not seriously eroded private sector wealth, which is critical for any quick rebound. Average household income has increased considerably in the past years along with strong economic growth, sharp rebound in Thai stocks, and rising farm income. Since 2003, the SET stock market index has almost doubled. Commercial bank deposits have risen at double digits of near 12%.

In the business sector, corporate balance sheets have improved significantly with substantial de-leveraging and higher rates of return (Chart 4). In 2002, publicly-listed non-financial companies registered an 11% loss on assets. In Q1-06, they reported a 19.2% gain. Accordingly, debt-to-equity ratio has been reduced from above 2.5x in 2002 to 1.2x in Q2-06. This improved financial position, along with high operating ratio and limited spare capacity, would put pressure on companies to invest, once confidence returns.

While substantial hurdles remain, we should not under-estimate the growth momentum that could be unleashed once we reach the end of the tunnel, especially before serious damage is made to confidence and private sector financial health. That is also why we believe the Thai economy could grow at a faster 5.2% in 2007 than the current year.

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