Asia Focus: Asia needs to foster cross border talent flows : Asia is lagging behind the EU and America in unearthing the growth potential of human resource flows. The region exports mainly low-cost labour but fails to attract high-skilled talent. To compete, it needs to reduce socio-political barriers to labour flows and develop more open and diversified culture to attract and develop talent.

Economy Highlights

Hong Kong: Speculation over a HKD peg change may rise, but is doomed to fail. The HIBOR-LIBOR spread may shrink, but liquidity may also spread wider and stimulate activity in the property market. Q3-06 GDP growth should stay robust, underlining a resilient economy and solid outlook for 2007.

India: Strong domestic and external demand could have boosted Q3-06 GDP by 8.1% y/y, aggravating India's breakneck expansion. Given an overvalued INR, the RBI would need to hike its reverse repo rate further, probably by another 50bps, to curb inflation and prevent the economy from further overheating.

Japan: The business sector remains upbeat, but the pick-up in consumption and wages is somewhat delayed. We expect healthy corporate sector growth and a further improvement in labour market conditions to support consumption, allowing the Bank of Japan to tighten further before YE-06.

Malaysia: Relative to most economies in the region, Malaysia's current upturn may be more durable, but it is likely also to have passed its cyclical growth peak. We expect Q3-06 GDP to grow 5% y/y. This will call for a more expansionary fiscal policy and mild weakening of the MYR, but the policy interest rate should remain on hold.

OVERVIEW

by Tai Hui

Policy divergence

- China, India, Japan remain on a monetary tightening path
- Other central banks have more flexibility as oil prices ease
- Risk appetite is declining albeit from strong levels

The dust clouding over Asia's interest rate outlook is gradually settling and there is a clearer policy divergence amongst Asian central banks. The more prominent economies, namely China, India and Japan, are maintaining their tightening bias. For the rest of the region, the 20% decline in oil prices since August has helped to contain inflation risk in the near term, giving central banks more flexibility to loosen monetary policy if they choose to. Further to cutting interest rates, these central banks, especially Thailand and South Korea, may also be looking towards using the exchange rate as a tool to maintain growth. With the growing downside risk to the export cycle going into 2007, the bias towards monetary easing in Asia may become increasingly popular.

Tightening bias in China, India and Japan
These three economies are expected to look towards further tightening in the next 6-9 months. China raised its reserve requirement ratio (RRR) from 8.5% to 9.0% on Nov 3 to mop up excess liquidity in the economy, in turn to curb investment and lending. Future policy moves, either in the form of raising RRR or increasing benchmark lending and deposit rates, will be data dependent. However, as we only expect a minor reaction in the form of lower lending growth or fixed asset investment expansion as a result of the tightening so far this year, further tightening is on the cards. The central bank may prefer to adjust RRR, as this is the instrument that it has more control over, compared with an outright increase in interest rates, which requires the State Council's approval. We could see another 50bps increase in RRR to 9.5% before the year-end.

In India, Reserve Bank of India (RBI) raised its benchmark repo rate by 25bps to 7.25%, but kept reverse repo rate unchanged at 6% in its latest semi-annual monetary policy statement. The unusual move is seen as an act by the RBI to balance the risk of a US-led global slowdown and domestic overheating, the bias of the Indian central bank remains on the tightening side. Nonetheless, current economic growth remains above its long term trend (8.9% y/y in Apr-Jun 06 vs trend growth rate of 5.5%), with rapid money supply growth and rising domestic inflationary pressure. Further tightening will be needed to prevent the economy from overheating.

Bank of Japan (BoJ) is also preparing the markets for further rate hikes in the medium term. Governor Toshihiko Fukui's emphasis on adopting a "forward looking approach" on monetary policy making is consistent with our view that the central bank could move to raise its overnight rate once more before the year-end, as soon as the Nov 15-16 Monetary Policy Meeting. This would be the second hike since BoJ formally exited its 5-year old quantitative easing in Jul-06.

Oil price drop allows greater focus on growth
For other Asian economies, central banks are increasingly mindful of their economies' growth prospects in 2007. They have been given more room to manoeuvre with the 20% correction in oil prices since August. Bank Indonesia (BI) has been leading the way, delivering its sixth interest rate cut this year in its November meeting. Since Apr-06, the BI reference rate has fallen from 12.75% to 10.25%. More cuts are expected in Dec-06 and Q1-07 as inflation continues trending lower, allowing room for further cuts.

In the Philippines, Bangko Sentral ng Pilipinas (BSP) kept the headline overnight borrowing rate unchanged at 7.5% at its Nov 2 MPC meeting, but introduced rate tiers, offering lower interest on large deposits. This is seen as effectively easing monetary policy, in line with the BSP's view that inflationary pressure is waning.

Meanwhile, central banks may also look towards exchange rates to maintain monetary policy stability. The South Korean government has been warning of the KRW's strength against the USD and the JPY. This came amid rising concern from the Bank of Korea of sharp rise in apartment prices, which constrain the central bank's ability to use monetary policy to maintain growth even though domestic consumption is going through a soft patch. The Bank of Thailand is also working to prevent further strengthening of the THB. Not least because the currency is at a multi-year high on the NEER basis, but also to prevent any unwelcome impact on the Thai export sector amid a more challenging global environment in 2007. Along the same lines, Singapore is also expected to shift its SGD NEER stance from gradual appreciation to neutral in Apr-07.

It is also important to note that maintaining stable exchange rate is not only targeting the USD, but also against other Asian currencies, such as South Korean authorities' emphasis on the JPY/KRW cross. As we anticipate the JPY and CNY to lead appreciation in Asia against the greenback, other Asian currencies may follow suit or remain watchful of its neighbours.

From risk loving to consolidation
Both Asian currencies and equities have seen strong support on the back of the markets perception of strong economic fundamentals. Benchmark indices in Hong Kong, Singapore, India and Indonesia have hit record high in November, and the rest of Asia has also seen their cyclical-high since the Asian financial crisis. As highlighted in last month's overview, such strong performance took place amid politically turbulent time in Thailand, Taiwan and Korea, reflecting investor confidence in the region. This is consistent with our SCB Risk Appetite Index, which shows very high level of risk-loving sentiment amongst investors. Yet looking forward, this is also consistent with the risk of consolidation. While financial markets continue to see the Asia economic glass as half full, we are cautious over the lack of fresh positive fundamental factors that would justify further gains in such markets. This implies additional importance to economic data such as exports and domestic demand, as the financial market is likely to seek for clues on the turning points in the current cycle. In our view, this is not a matter of 'if', but a matter of 'when'.

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

Asia needs to foster cross border talent flows

- Asia is lagging behind the EU and America in unearthing the potential of its human resources
- Asia exports mostly low-cost labour and needs to attract more high-skilled talent
- More accommodative labour policy and open culture is needed to promote talent flows

Over the decades, Asia has made remarkable economic progress through fostering intra-regional trade and investment flows, but it remains lagging behind in unearthing the growth potential of its most valuable and abundant resource: human capital. While Asia's labour-surplus economies are benefiting from the increasing world demand for labour and talent, receiving USD 63bn a year in remittance from several million overseas workers and tens of millions of emigrants, the shares of remittance to economic output are very low except for the Philippines. For the labour-short economies in Asia, although they recruit as many as 70% of their foreign workforce from Asia, they are lagging behind in the global race to compete for talents. Socio-political barriers and relatively closed culture limited many Asian economies from fully enjoying the benefit of cross-border talent flows. Polices are needed to encourage more and better exchanges of human resources, both intra and inter-regional.

Human resources: a key but complex factor in regional integration
One critical element in regional economic integration is cross-border flows of human resources, both of high-skilled talent and low-cost labour, either permanently as migrants or temporarily as contract workers, students and visitors. In Europe and North America, where economic integration are well ahead of Asia, free flows of merchandise, services, capital and information are accompanied by increasingly free flows of human resources, as illustrated by the expansion of the EU and successive relaxations in US immigration policy.

However, unlike trade and capital flows, cross-border movements of people involve more complicated and sensitive social, economic and political issues like population and labour policies; social security and infrastructure support; religious, ethnic and cultural conflicts; housing, education and medical services...etc. Recent restrictions imposed on workers from new EU members like Bulgaria and Romania to work in the old-EU countries demonstrated such difficulties. Data on human flows are also less readily available and more difficult to compare, making the study and analysis of cross-border human flows a more difficult task than trade and capital market analyses. The risk of mis-managing cross-border human flows is substantial, but the benefit from improving human capital management is also phenomenal. It is important for Asia to better understand and position itself for this important component of regional integration.

Regional integration boosts migrants
One issue in studying cross-border human flows is illegal immigrants, estimated at 12mn in the US and probably more in Europe, which by definition is impossible to ascertain and study. Excluding this, the broadest definition for migrants as adopted by the United Nations is population not born in their country of residence, including both permanent or temporary migrants like contract workers, students, refugees, etc. According to the UN, there are around 191mn migrants in the world in 2005, the largest group - 64mn - resides in Europe, while Asia and North America each hosts 53mn and 44mn respectively.

Over the decade, the migrant population remains quite stable at 2.9% of the world's total population, notwithstanding globalisation and advances in communication and transportation. However, regions undergoing rapid integration, i.e. EU, North America and East Asia, have their migrant population growing much more rapidly than their total population over the past decade, while other regions saw their migrant population shrinking or growing slower than their total population.

Europe, Asia and North America are the most favoured destinations for migrants, hosting 33.6%, 28.0% and 23.3% of the world's total migrants at end-2005 (chart 1). But Asia's share has been declining over the years, from a high 37.7% in 1960. Much of Asia's decline can be attributed to Europe's booming migrant population in the late 1980s, when EU integration accelerated with relaxing regulations on labour mobility within the continent.

Relative to local population, Oceania is the number one migrants recipient, with 15.2% of its total population being migrants (chart 2). The corresponding figure for Asia is minimal at 1.4% (note this has already taken into account intra-regional movements). By occupation, around a quarter of the migrants working in Sweden are professionals, 19.3% of those in Switzerland, 17.9% in Canada and 16.5% in the US (chart 3). By comparison, only 10% of migrants in Hong Kong are professional, and a meagre 1.9% in Malaysia. These suggest that Asia is lagging behind in the race for talent.

Within Asia, there is a clear divide among different economies in terms of human flows: the more developed and labour-short economies like Japan, Taiwan, South Korea, Hong Kong, Singapore and Malaysia, and the less developed and labour-surplus economies like China, India, Indonesia, Vietnam, Thailand, and the Philippines. Incomplete estimates put the total foreign population in the six labour-short economies at about 5.5mn in 2005, of which about 70% are from other Asian countries, especially Indonesia, Philippines and Thailand.

Interestingly, the most popular destination of Asian outgoing talent and labour on temporary employment contracts is the Middle East. Nearly 40% of outgoing land-based Filipino workers went to the Middle East in 2005, and 26% to Asia (chart 4). Within Asia, Hong Kong is the top destination, where many Filipinos work as domestic helpers. Of Indonesian outgoing workers in 2004, 72% went to the Middle East/Africa and 28% to Asia. For Thais, 84% of them went to Asia (over 50% to Taiwan), and 14% to the Middle East in 2004. However, a large portion of Asia's inward remittances comes from the Americas. This is because workers are generally better paid in the Americas, and that America has a large population of Asian permanent emigrants, many of them are top talents. In terms of occupation, most of the temporary outgoing migrants are still working in relatively low-end jobs, namely domestic helpers, clerks, and production workers (though many of these production jobs are classified as skilled jobs). There are signs that Asian migrants are increasingly employed in professional fields, such as teachers, nurses and engineers. Of the new hires of overseas workers from the Philippines in 2005, 22.5% were professionals. But if the stock of all overseas workers is taken into account, professional jobs still amount to a minority share.

While outgoing migrants can reduce the problem of unemployment and poverty at home in the near term, the loss of human capital may have a long-term negative impact on economic development, especially the top talents who are the most able to emigrate. On the former, remittance inflows is a frequently cited tangible benefit resulting from outgoing migrants. World remittances increased by 127% to USD 232bn in 2005 from USD 102bn in 1995, far greater than the 51% increase in world nominal GDP in USD terms during the period (from USD 29.4trn to USD 44.5trn). Meanwhile, the share of these remittances to developing countries rose from 57% to 72%. In absolute amounts, India was the top recipients of remittances in 2005, receiving USD 21.7bn. This was followed by China (21.3bn), Mexico (19.0bn), the Philippines (13.4bn) and France (12.7bn). Totally, Asia received about USD 66bn in inward remittances in 2005. For Asia, except for the Philippines where workers' remittance amount to around 13.6% of GDP, the shares of remittances to economic output as reflected in the balance of payments are surprisingly low. For example, remittance inflows amounted to a negligible 0.7% of GDP in Indonesia, 0.8% in Malaysia and 1.1% in Thailand (chart 5).

That may make some labour-exporting countries even more worried about the balance between benefits and potential drawbacks on sending workers abroad, especially those skilled workers. But on the optimistic front, home countries can also benefit from knowledge transfers. This is where the policy focus should be. While governments may be tempted to adopt "restrictive" policies such as taxing outgoing migrants, delaying skilled workers' departure through compulsory services, establishing various councils or organisations to promote knowledge transfer or cooperation in development and education, increasiing the attractiveness of working at home countries may be more effective. In the longer term, a more accommodative socio-political environment and a more open culture would be critical to encourage the inflow or return of talent.

HONG KONG

by Tai Hui

Perception and reality

- Speculation on a HKD peg change may rise, but is doomed to fail
- HIBOR-LIBOR spread may shrink; property market to turn more active
- Q3-06 GDP to underline a resilient economy, and solid outlook

Following the world's largest IPO, the outlook for interest rates and the HKD peg will come under the spotlight in coming months. We have long argued that the USD/HKD peg will remain in place in the foreseeable future, regardless of the development in the CNY exchange rate regime. We remain cautious of the upside risk to HKD interest rates in coming months, especially in Q1-07 when seasonal factors may trim the HIBOR-LIBOR spread. Meanwhile, the real economy is expected to register a solid 6.5% y/y growth in Q3-06, up from the 5.2% in Q2-06, underlining the resilience of the economy and a solid 4.5% growth outlook in 2007.

Challenging the market view
Following the USD 19bn listing of ICBC in late October, interest rates in the local money market eased. The 3M HKD HIBOR traded just below 4.0% in mid November, 70bps lower than the year-high of 4.7% seen back in June. This prompted commercial banks in Hong Kong to reduce their prime lending rates for the first time since Q3-04. The current market thinking is that the spread between USD and HKD interest rates will persist, given ample liquidity in the system. Also, speculation around appreciation of the CNY, and it reaching parity with the HKD, could induce more liquidity. Consequently the HIBOR-LIBOR spread is unlikely to narrow soon, and perhaps may widen even further. Expectations of stronger Asian currencies, especially the JPY, could also prompt investors to sell USD/HKD.

This view may prove to be correct between now and YE-06, but seasonal factors could prompt some convergence between USD and HKD interest rates in early 2007. As chart 1 shows, the spread between 3M USD LIBOR and 3M HKD HIBOR narrowed in Q1-05 and Q1-06, by 150bps and 30bps respectively. This can be partly explained by seasonal factors like tight liquidity during the Chinese New Year and annual bonus periods, as well as usually below average listing activities in the first quarter of the year.

Furthermore, as we do not expect the USD/HKD peg to be altered in the foreseeable future, despite the strengthening of the CNY, temptation to arbitrage will limit the interest rate differential between USD and HKD. The Hong Kong Monetary Authority has repeatedly stated that there is no justification and it is inappropriate for the HKD to be pegged to the CNY in the medium term. We believe any formal links between the HKD and the CNY will require the latter to be convertible at the capital account, as well as China having a more proactive and mature monetary policy framework. For now, the USD/HKD link remains the preferred option.

As a result of seasonal factors and greater certainty of the HKD peg, we continue to highlight the upside risk to HKD interest rates. The current level of USD/HKD forward, at almost -900 pips for 1 year discount, is the greatest since the HKMA introduced the fine-tuning measures in May 05 (chart 2) when it added a floor to USD/HKD exchange rate at 7.75. We continue to question the sustainability of such a wide discount.

Q3-06 GDP to underline resilience
Following a less exciting 5.2% real GDP growth in Q2-06, the HK economy has seen a rebound in H2-06. Both internal and external drivers are functioning well. Domestically, consumer sentiment is upbeat with a falling jobless rate. Value of retail sales in Q3-06 expanded by 7.7% y/y (chart 3), compared with 6.7% y/y in Q2-06 and is the strongest growth since Q1-05. Robust personal consumption is likely to persist in coming quarters, especially if it is met with a revival of activities in the residential real estate market. We remain optimistic over the outlook for the HK property market, despite the lacklustre activity in the past 18 months (chart 4). The underlying decline in supply, alongside with stable demand, should continue to provide support to prices. Market perception of peaking borrowing costs should also prompt potential buyers to consider entering the market.

Externally, export growth rebounded from 5.2% y/y in Q2-06 to 8.4% y/y in Q3-06 (chart 5). Healthy expansion in container throughput, prompted by strong trade growth in the mainland, also boded well for the trade service sector. This growth could ease to mid-to-high single digit in 2007. Deceleration in tourism growth continues with HK facing greater competition from other popular destinations, including Macao. Q3-06 tourist arrival growth was 6.3% y/y, lower than 8.7% y/y in Q2-06 and 13.7% y/y in Q1-06.

The rebound in both exports and domestic spending implies that real economic growth in Q3-06 is likely to outperform the previous quarter. We anticipate growth in Q3-06 to rebound to 6.5% y/y and maintain our full year forecast of 7% for 2006. In 2007, tamer US demand is likely to push HK to a more moderate growth path. Yet, given a less hostile interest rate and oil price environment, and sustained growth momentum in Asia, especially China, Japan and India, HK should easily stay close to its long-term growth trend of about 4.5% in 2007.

INDIA

by Shuchita Mehta

More tightening on the cards

- Q3-06 GDP could have expanded by a strong 8.1% y/y
- Higher rates and strong INR needed to curb inflation
- Reverse repo rate to rise 50bps to 6.5% by Mar 07

India is like a fast moving train, those onboard do not realise how fast they are moving, but the people watching them pass certainly do, and could be surprised. Thus far 2006/07 can be described as the "India year" - both industrial and GDP growth have consistently surprised markets on the upside. We recently raised our GDP growth forecast to 7.5% y/y in 2006/07 from 7.0%, but admittedly the revised forecast now appears somewhat conservative. In line with break-neck growth, inflationary pressures are rising, infrastructure bottlenecks are becoming ever more apparent, and asset prices (notably equity and real estate in specific segments) have reached historic highs. This unprecedented pace of expansion will require further monetary tightening to arrest runaway growth. We believe the reverse repo rate will be raised by another 50bps to 6.5% by the end of the current fiscal year, i.e. Q1-07.

Q3-06 GDP growth to reach 8.1% y/y
India will be releasing its Q3-06 (Q2 2006/07) GDP data on Nov 30. Given the 11.4% y/y growth in industrial production in Sep-06, against a 9.7% market expectation, industrial production for Q3-06 has grown by 11.3% y/y - the fastest pace since Q2-97. Moreover, services sector indicators such as cellular subscriptions, tourist arrivals, civilian air traffic, cargo carriage, software earnings, deposit mobilisation by banks, etc. suggest double digit growth in the services sector. Higher non-farm sector output expansion (10.5% y/y expected versus 10.3% in Q2-06) also points to a higher Q3-06 GDP growth rate than Q2-06. But agriculture which still accounts for almost 20% of overall GDP is expected to be affected by a contraction in sowing of the autumn crop due to erratic and unevenly distributed rains during the monsoon season. We thus expect Q3-06 GDP to expand 8.1% y/y, slightly lower than the 8.9% y/y growth recorded in Q2-06.

Thus far, strong output growth has been supported by rapid expansion in domestic consumption demand and investment activities, along with reasonably strong export growth. This broad-based expansion underlines strong corporate earnings, supporting the strong appetite for Indian securities from both local and overseas investors. Since the market correction last May, overseas portfolio investments have grown by more than USD 5.5bn. Other capital inflows too have been strong. The decline in global oil prices since August also boosted market sentiment with an improving external payments position. Oil accounted for nearly 5.6% of GDP in 05/06 and has contributed almost 33% to India's import bill in H1 06/07. All these factors have helped the INR to be a star performer among its peers since mid-July.

Inflation lurking
Yet, all is not well! Inflation has been on the rise both at the wholesale and consumer price levels, despite the notable fall in global oil prices. Shortages of key food items such as wheat have driven up primary product prices, while strong demand momentum have helped manufacturers pass on higher costs to the consumers. Headline inflation based on wholesale prices has been higher than 4.5% y/y since August. It is expected to cross 6% towards end-Dec 2006 and may peak only around Feb-07. Moreover, money supply has been growing close to 20% for most part of the year and incremental credit-to-deposit ratio reached 81%. We believe as long as inflation remains close to or higher than the RBI tolerance range of 5-5.5% and credit growth remains strong, threats of overheating will remain.

To some extent, monetary tightening is already underway via the strengthening of the INR (on an REER basis INR is more than 8% overvalued, versus less than 2% in July). Given its sharp appreciation against a basket of currencies, the INR might hurt the trade sector over the medium term. Going forward, we believe the INR is unlikely to outperform other currencies significantly. A blend of currency strength and higher interest rates is likely to be used to keep inflationary pressures at bay.

In conclusion, we believe the RBI is likely to raise its reverse repo rate by 25bps before YE-06. This could be repeated in its quarterly monetary policy meeting at the end of Jan-07, especially if economic growth is to remain strong. Thereafter from the second quarter of 2007, an expected deceleration in global growth together with a potential peak-out in inflation rates could persuade the central bank to hold rates steady.

Despite notable expansion of its export sector, India remains relatively more insulated to a US-led slowdown than its regional peers. As overall monetary condition in India is still accommodative, it is unlikely the RBI will begin cutting rates along with the Fed, which we expect to be in Q3-07. All these factors should slow down India's GDP growth from above 8% currently to a more sustainable 6.5-7.5% in the coming quarters - which is still among the fastest globally.

JAPAN

by Frances Cheung

Consumers hold the key

- Business sector remains upbeat
- But the benefits need to be felt by consumers
- We continue to expect a rate hike before year-end

Business sector developments in the economy have been surprising on the upside, while the pick-up in consumption and wage seems to have been delayed. Looking ahead, with a continued healthy corporate sector and broadly favorable labour market conditions, wages will edge up gradually, providing support for consumer confidence and domestic consumption. On monetary policy, we maintain our view that the Bank of Japan (BoJ) is to hike its Overnight Call Rate by 25bps to 0.5% by year-end, as prices continue on an uptrend, and the economy is growing in line with the BoJ's expectation.

Continued upbeat business sector
Business sector momentum in the Japanese economy continues to hold up well. Corporations now see the first "insufficient capacity" in ten years, as reflected in the Q3 Tankan survey (chart 1). Capacity utilisation rose to a record high of 107.1 in Aug. The utilisation ratio for the production of general machinery was even higher at 126.1, suggesting companies may be replacing their obsolete capital equipment to improve efficiency. Meanwhile, industrial production rose by a strong 5.9% y/y in Aug, the fastest pace in 2 years, followed by a still strong 5.2% growth in Sep. In an environment where the corporate profits outlook remains upbeat but capacity is getting tighter, the need to build up inventory to meet demand will continue to push forward business investment plans. Strong private investment, together with exports and inventory build-up, compensated for the softening of consumption in Q3, supporting the economy to expand by 0.5% q/q.

...but the missing link has to be fixed
The key for a sustainable economic recovery in Japan, as we have been emphasising, is whether the optimism in the business sector will be shared by the household sector. Thus far, the development on this front is not particularly encouraging. Overall household spending dropped by 6.0% y/y in Sep, the biggest drop in five years. Consumer confidence, after touching the water-shed level of 50 in April for the first time on record, has been falling back in recent months (chart 2). Subdued headline wage growth was the main reason behind weak confidence and thus consumption.

Nevertheless, looking ahead, we are still optimistic. Labour market conditions have been improving broadly, with the number of jobs available and employment rising moderately. The slight edging-up in the jobless rate should not be a major concern as it was still relatively low historically. While contractual cash earnings have been moving sideways, over-time earnings have been rising quite steadily (chart 3). Corporations may be reluctant to raise regular pay for now amidst high commodity and energy prices. But with these input prices stabilising and companies facing increasing labour shortages, it is only a matter of time for the benefits from the healthy business performance to spread to the household sector through wage rises, thus supporting consumer spending. A virtuous cycle of production, income and spending is gradually taking shape. This development is important for a sustainable recovery in Japan, where private consumption amounted to 57% of GDP, relatively low compared to other advanced economies.

Against this backdrop of ongoing economic development, prices are expected to continue on an uptrend, with the continued tight labour market pointing to cost-push pressures. While the revision exercise of the CPI basket has scrapped about 0.5 percentage point out of CPI y/y changes, we share the view of the BoJ that the trend of gradual pick-up of inflation remains intact. Indeed, according to the BoJ, part of the downward revisions is not due to the change in basket components, but the calculation method for existing items. The effect of the latter will disappear after the first year.

BoJ preparing market for a hike
We reiterate our long-held view that there will be another rate hike from the Bank of Japan (BoJ) before the end of 2006. The major consideration behind the BoJ's decision to keep rate unchanged in the October MPC meeting was not economic fundamentals, but market expectations, in our view. That explains why Governor Fukui came out with very hawkish post-meeting comments: to prepare the market for a rate hike soon. Fukui said that the central bank "will not wait for risks to appear in taking policy actions", and "will adopt a forward-looking approach to avoid drastic policy changes". This was followed by Watanabe, Vice-Minister for Economic and Fiscal Policy, saying the "Japanese economy is improving considerably" and "markets are factoring in possible central bank acts". Indeed, the market turned more hawkish after these comments and priced in higher money market rates (chart 4).

The BoJ needs to raise rates at a timely manner, to make room for cuts when the economic cycle turns. A more difficult issue is to pin down where the neutral policy rate is likely to be. With the BoJ's latest estimates of potential GDP growth at 1% to 1.5% y/y, neutral interest rates can be as high as 2.5% if we assume an inflation of 1% y/y. Current monetary conditions are too loose in view of the economic fundamentals, more so given the JPY is at a 20-year low on a real effective exchange rate basis.

MALAYSIA

by Joseph Tan

Modest growth + weak MYR = stable rates

- We expect Q3-06 GDP to expand 5.0% y/y, vs 5.9% in Q2-06
- Lacklustre MYR performance limits BNM's ability to cut rates
- 2007 will see either lower growth or larger fiscal deficit

Relative to most economies in the region, Malaysia's current economic upturn may be more durable, benefiting from relatively more balanced domestic and external demands and a comparatively more stable exchange and interest rate environment. While growth momentum has stayed strong in Q3-06, headline growth number may moderate from the 5.9% y/y achieved in Q2-06 due to a higher base of comparison. In that sense, Malaysia will be no different from most other Asian economies in having already passed its cyclical growth peak. While GDP growth may moderate going forward, policy interest rate may stay on hold. This will call for a more expansionary fiscal policy and mild weakening of the MYR in 2007.

Lower growth in Q3-06 due to higher base
Malaysia will be releasing its Q3 GDP on Nov 23, ahead of the Nov 24 monetary policy announcement. With the recent release of a 3.6% y/y rise in September industrial production, versus a 5.5% consensus (chart 1), market expectations for Q3-06 GDP growth are likely to adjust downwards. Average industrial production growth for Q3 was only 5.0% y/y and loan growth of commercial banks has eased from 19% y/y in Q2-06 to 13% in Q3. However, trade surplus grew by MYR 3.5bn in July-Aug over a year ago, equivalent to a 2.7% growth in Q3 GDP. This may substantially offset any slowdown in domestic demand. However, given a higher base in Q3-05 when GDP grew 1.2 percentage points faster than the previous quarter, we expect Q3-06 GDP growth will moderate to about 5.0% y/y, down from the 5.9% y/y growth recorded in Q2.

As Q3-06 GDP growth moderates, it is highly likely that the newly revised official 2006 growth target of 5.8% will be missed. GDP grew an average 5.7% y/y in H1-06. If our forecast is correct, we would expect both the market consensus and the official target to gravitate closer to our full year target of 5.5% after the release of Q3 GDP data.

Interest rate to stay unchanged till H2-07
Recent comments by Governor Zeti on Nov 7 reaffirmed our view that interest rates have peaked in Malaysia when she said that inflation is beginning to abate but interest rates are still at an appropriate level to support the economy. In fact, a softer Q3 GDP figure could fuel speculation that Bank Negara Malaysia (BNM) might cut interest rates as early as Q1-07, we think that is unlikely.

The MYR's performance from May 17 - the period following the initial bout of risk aversion in global markets - has been dismal (chart 2). The rift between the former and current prime ministers and its political undercurrent, plus relatively low nominal and real interest rate levels, have weak-footed the MYR. Should BNM cut interest rates to spur growth, it would most certainly send the MYR to the bottom of the league table in Asia. The poor performance of the MYR versus regional currencies also means that BNM cannot rely on it as a meaningful tool against inflation.

Fortunately the retracement in oil prices in the past two months (chart 3) has reduced external price pressures and has given BNM some breathing space. Lower oil prices reduce the need for the government to scale back oil subsidies and raise fuel prices. Meanwhile, year on year measures of inflation will fall further in Q4-06 when the one-off impact of the fuel price hike in August 2005 is fully absorbed. Moving forward into 2007, inflation will fall further after March as the base moves higher once again due to the March 2006 fuel price hike.

Real interest rates in Malaysia have finally moved back into positive territory, after having stayed negative for fifteen months (chart 4). However, given a weak MYR, an interest rate cut may come only after the US Fed makes a move, which we expect to be in H2-07.

Something has to yield: growth or deficit
Monetary constraints will shift the policy lever to fiscal in the coming months, as underlined by a more expansionary 2007 Budget. The budget projects a 24.3% y/y rise in gross development expenditure to MYR 44.5bn, yielding a deficit of 3.4% of GDP (chart 5) with key measures like a 1% cut in the corporate tax rate to 27%. However, there are downside risks. The budget projects 2007 GDP growth at 6% and fiscal revenue to rise 11.8% y/y, with 40% coming from oil royalties. With falling oil prices, lower corporate taxes and slower exports, the deficit target would be tough to achieve. While we share the official 2007 growth forecast at 6%, the risks are to the downside. Should Malaysia keep to its intended expenditure against the backdrop of lower oil royalties, the deficit could be higher than expected - which is fine. We prefer a higher than projected deficit as a result of keeping to spending plans so as to lean against the winds of economic weakness rather than keeping religiously to the deficit target. Besides, the shortfall is unlikely to result in a rating downgrade and could be recouped in the latter half of the 9th Malaysia Plan.