Asia Focus: A new silk road in the making: Ten years after the 1997 Asian Financial Crisis, Asia has re-established itself as the world's growth magnet. Not only has it recharged its growth engine through intra-Asian trade, Asia is also fuelling its trade with other developing regions. Led by China and India, Asia's trade with Africa and the Middle East has been growing at phenomenal rates and is quickly spreading into investment and services. A new Silk Road is in the making that would tie the three regions tighter with huge growth opportunities.

Economy Highlights

Hong Kong: The Hong Kong economy continues to enjoy its best time in 10 years. While growth in 2007 may ease to more normal levels, wealth could spread wider to property and other asset classes. Inflation should remain contained. A new budget and Chief Executive may bring new vigor, new faces, with sustained policy.

India: We expect further rationalisation of the tax structure and expenditures in the FY07/08 budget (begins in April). The budget should be an expansionary package, focusing on the rural economy, social sectors and infrastructure. But monetary policy would remain tight, as evident from recent hikes in reserve requirements.

South Korea: As economic growth eases and inflation recedes, there is a growing risk of monetary overkill given the government's obsession with restraining property speculation, especially given the risk of pre-election policy errors. Initial progress in six-party talks may boost short-term optimism, but unlikely to prompt rating upgrades soon.

Thailand: The initial policy emphasis on curbing capital inflows seems misplaced. The authorities could use a strong currency and lower interest rates to boost domestic investment, preferably with more clarification on the political landscape and policy consistency to restore investor confidence. We now expect the BoT to cut rates in February and April.

OVERVIEW

Tai Hui
Economist, +852 2821 1039
Hui.Cheung-Tai@hk.standardchartered.com

Currency and Credibility

- Policy mishaps, not event risk, are key threats to Asia
- Thailand's experience is telling in this respect
- Elections offer mostly a short term fix, not long term cure

As we highlighted in our January edition of the Asia Focus, one of the key risks in 2007 for Asia as a whole is policy or political mishaps. One month into the year and we already have several examples where the credibility of central banks and governments were tested. Bank of Thailand's measures to curb the strength of the THB triggered a near-panic investor reaction, and subsequent reversal on some of the measures has only deepened policy uncertainty going forward. The Bank of Japan and the Chinese authorities are also in challenging times. The former disappointed the market by keeping rates unchanged in the January MPC meeting and the latter is in need of finding a way to cool investor euphoria without sending the stock market into a tailspin. The good news is that Asian authorities are monitoring and learning from these experiences as we speak.

Curbing currency strength
As we noted in previous Asia Focus issues, Asia would enter 2007 on a strong note, and indeed it has. Although there are some signs of moderation, the external environment remains supportive. With the robust external sector and the number of political events taking place or pending in Asia (see table 1), a major risk to economic performance is policy mismanagement. Thailand is one such example where the central bank introduced a 30% unremunerated reserve requirement (URR) on short term capital inflows on December 18 to curb the strength of THB. These measures triggered a 20% sell-off of the stock market in a day and were subsequently relaxed. However, the damage was done and confidence hard to rebuild. Since then, the SET index has remained one of the underperformers in the region. This suggests that given high level of risk appetite, investors are willing to give policymakers the benefit of the doubt when an event (coups, natural disasters, nuclear tests) occurs. Yet, they will be less forgiving if the uncertainty is triggered by the authorities themselves.

The good news is that other economies have learnt from the Thai experience, even though they are also concerned with the strength of their currencies. South Korea announced on January 15 new policies to relax rules restricting domestic companies investing overseas. This is effectively another way to curb the KRW's strength, i.e. by promoting outflows via capital account liberalisation rather than by restricting inflows. The Philippines is also contemplating reform in its foreign exchange practice in the direction of liberalisation, with the effect of limiting PHP appreciation. Malaysia has shown a more relaxed stance, with the BNM governor Zeti stating that a strong MYR is "not hurting exports" and she is "pleased with the orderly performance of the MYR".

Central bank independence
Further to taking new measures on the capital account to maintain currency competitiveness, investors will also be watching the independence of central banks closely. The Bank of Japan disappointed the market in its January MPC meeting by keeping rates unchanged after prepping the market for a move, with 3 of its MPC members voting for a hike. While one could argue that recent economic data has been mixed, the market perception is that the hike was shot down by the government, despite repeated reiteration by government officials that monetary policy is set by the central bank, not least because of the upcoming elections to the House of Councillors (upper house) on July 22.

Meanwhile, several Asian central banks are either engaging in or considering monetary policy easing, in which case they are likely to face little opposition from the government. Bank Indonesia is well on its way in reducing interest rates, having cut its benchmark BI rate twice by 25bps each so far in 2007. The Bank of Thailand delivered its first 25bps rate cut in this cycle in its January MPC meeting, with the disguise of shifting its policy 14-day repo rate to the more liquid 1-day repo rate. We also expect that the next move in interest rates in the Philippines and Malaysia will be down, although they are not expected to cut until Q2-07 and Q3-07 respectively. The recent surge in oil prices could persuade the policymakers to err on the cautious side in the near term.

Popping bubbles
After a 70% surge in the Shanghai Composite Index in H2-06, the challenge for the Chinese authorities is to calm investor enthusiasm without triggering a panic sell-off and jeopardising consumer confidence. This will be a delicate balance to strike. Several officials have already issued stern warnings to individual investors about the risk of an overheated stock market and they were partly successful in forcing for a correction. Still, without effective measures to curb excess liquidity in the market and given insufficient outlets for individuals to invest their wealth, the stock market is likely to remain an important destination for the new found wealth. In fact, moral suasion without hard backup measures can invite extra volatility to the market and be risky. In the medium to long run, more structural reforms will be needed to resolve such issues, including policies to allow domestic residents to invest overseas via some regulated scheme. To relieve pressures on capital inflows, adjustments in trade policy, such as cutting back or abolishing export rebates, could be implemented and this would have considerable implications to businesses that have been dependent on the rebate as a source of income.

Further to concerns on the real economy, upcoming elections could also lead to policy changes that introduce uncertainties. As highlighted in table 1, there will be parliamentary elections in Vietnam, Philippines, Japan, Taiwan and Thailand this year, if Bangkok manages to push through a new constitution on time, as well as presidential elections in India, Vietnam and South Korea. China's ruling communist party is also up for its five-year re-election cycle later this year, which arguably is more important than parliamentary or government realignments. While not all elections will trigger policy uncertainty, we believe that the situation in Taiwan, South Korea and Thailand should be closely monitored. Experience in the past suggests that economic reforms normally could be implemented later, rather than sooner, ahead of key elections. Also, one could expect more short-term fixes, rather than long-term reforms.

ASIA FOCUS

Frances Cheung
Economist, +852 2820 3609
Frances.Cheung@hk.standardchartered.com

Nicholas Kwan
Regional Head of Research, Asia; +852 2821 1013
Nicholas.Kwan@hk.standardchartered.com

A new silk road in the making

- Led by China and India, a new Silk Road is in the making
- Asia's trade engine is enriching not just itself, but also its neighbouring regions
- Strong complementarity boosted trade between Asia, Africa, and the Middle East

Ten years after the 1997 Asian Financial Crisis, Asia has re-established itself as the world's growth magnet. Not only has it recharged its growth engine through intra-Asian trade, Asia is also fuelling its trade with other developing regions. Led by China and India, Asia's trade with Africa and the Middle East has been growing at phenomenal rates, up 18% and 24% p.a. respectively during 2001-2005, twice the 10% growth rate of world trade and even faster than the 14.5% annual expansion of intra-Asian trade.

While Africa and the Middle East are feeding Asia's need for fuel and minerals, Asia is supplying the two regions with basic manufactures. Currently, Asia absorbs half of the Middle East's exports, and one-sixth of Africa's. Conversely, Asia supplies about one-fifth of both regions' imports. This complementary trade relationship is getting stronger and quickly spreading into investment and services, as evident from China's active investment in Africa and the influx of Middle East petrodollars into Asia. A new Silk Road is in the making that would tie the three regions tighter with huge growth opportunities.

China and India taking the lead
During 2001-2005, China's trade with Africa grew by 30% p.a., quadrupling in five years, while its trade with the Middle East expanded by 27% annually. India's exports to Africa and the Middle East also grew by 25% p.a. during that period, though its imports from the two regions increased by a more modest 13% p.a. China has been particularly active in soliciting closer relationship with Africa. Last November, Beijing hosted 48 African heads of state in the China-Africa Cooperation Forum, where it has pledged to double its financial assistance to Africa in three years. This month, Chinese President Hu Jintao visited eight African nations from Sudan to South Africa, his third visit to the continent in four years, having signed over 50 bilateral trade and economic agreements with his hosts. Similarly, high level visits between China and the Middle East are rising in frequency, along with booming trade and investment flows.

In comparison, India's official interaction with Africa and the Middle East is less intense, but its economic presence in the two regions are more penetrating, given their strong historical and socio-economic ties. Trade between other parts of Asia (such as South Korea, ASEAN5 and Japan) and Africa/Middle East are growing at more moderate speeds of 12-14% p.a. during 2001-2005. However, these are still higher than their trade growth with the rest of the world, especially for Japan whose total trade grew by only 5.3% p.a. during 2001-2005.

Asia-Africa trade: small but beautiful
During 2001-2005, Asia's exports to Africa rose by 19.4% a year, while Africa's exports to Asia grew by 14.9%. Around 70% of Africa's exports to Asia are fuel and minerals, and 80% of Asia's exports to Africa are manufactured products. Despite rapid trade growth, Africa is still a relatively minor trade partner for Asia, accounting for less than 2% of Asia's total trade in 2005. However, its share in Asia's fuel and minerals trade is relatively more significant. For example, China sourced 23% of its imported fuel from Africa in 2005, though Africa only supplied 3.5% of China's total imports. For Asia as a whole, Africa supplied 5.6% of Asia's imported fuel and mining products. Given that Africa has 9.4% of the world's proven crude oil reserves and currently accounts for 11.4% of global crude oil production, the potential for further development in trade or investments between the two regions should not be overlooked.

Asia-Middle East trade: fueled by fuels
Middle East is another and a larger source of energy for Asia. Indeed, the flows of fuel from the Middle East to Asia dominate the flows in the world, accounting for 17.5% of world trade in fuel in 2005, up 44% over 2004. Total trade flows between Asia and the Middle East amounted to USD 370bn in 2005, which is over three times the USD 103bn between Asia and Africa. Reciprocally, Asia is the Middle East's major exports market, absorbing over 50% of its merchandise goods. Again, 88% of the Middle East's exports to Asia were fuel and mining products in 2005, with China getting 39% of its imported fuel from the Middle East. On the other hand, as in the case with Africa, 84% of Asia's exports to the Middle East were manufactured products in 2005. From China's statistics, its exports of manufactured products to countries in the Middle East or Africa were mainly textiles and clothing, machinery and electrical equipment.

Traditionally, Europe is the biggest supplier of manufactured goods for Africa and the Middle East, but this position is being eroded gradually by Asia. In 2005, Europe supplied 54.7% of Africa's manufactures imports, down from a 59% share in 2000. During the same period, Asia's share in Africa's manufactures supply rose from 20.3% to 25.8%, up 5.5 percentage points (ppt) and contrasting Europe's 4.3 ppt decline. However, the shift in manufacture sources in the Middle East is less apparent. During 2000-2005, Europe's share in Middle East manufactures supply dropped by only 1.6ppt from a 42.5% share in 2000 to 40.9% in 2005. Over the same period, Asia's share in supplying manufactures to the Middle East only grew marginally from 29.1% to 29.2%.

From trade to investment
The deepening relationship among the regions goes beyond trade, and most notably to direct investment. This is mainly from Asia to Africa or the Middle East in infrastructure and the energy and resources sector, but also from the Middle East to Asia. China's intention to tap into Africa's resources is obvious, as suggested by its pledged investment in Africa's biggest copper producer, for example. Malaysia is also having a deal to develop Iran's gas fields and LNG plants. Such investments are beneficial to the recipient countries with new employment and more diversified economic activities. Given the low female labour participation rates of just over 30% in the Middle East and North Africa, the potential for increased employment and thus a lift to overall income is substantial. The Middle East is also keen on attracting more foreign investment to help industrial diversification away from its heavy reliance on energy exports. The United Arab Emirates (UAE) has been putting much effort to develop industries such as cement, building materials, fertilisers, foodstuffs, garments, furniture, processed metals etc. Along with increased trade flows, commercial services, including travel agencies and restaurants, are blossoming too.

On the other hand, the Middle East is also active in investing in Asia with its surplus petrodollars. Statistics on these kinds of activities are far from comprehensive. But to cite some examples, Middle East investors are among the biggest buyers of the multi-billion dollar IPOs (initial public offerings) of Chinese banks. There have also been large transactions on Middle East investors buying into telecommunication companies in Hong Kong. Lately, Middle East investors seem to be interested in Asia's real estate and construction sectors as well.

While starting from different bases, economic linkages between the Middle East and Asia, and those between Africa and Asia are to be fostered by huge and matching needs and supplies. There are challenges as always, here mainly on the liberalisation of trade and investment policies. These can be improved multilaterally, but also bilaterally as evident by the establishment of FTAs (Free Trade Agreements) or special economic zones between the regions, such as those between Thailand and Bahrain, Singapore and Jordan, and China and Zambia of late.

HONG KONG

Tai Hui
Economist, +852 2821 1039
Hui.Cheung-Tai@hk.standardchartered.com

Firing all cylinders

- Growth well supported by both domestic and external demand
- Asset price boom to spread, but inflation remains contained
- A new budget and new CE to bring new faces, but old policies

The Hong Kong economy continues to enjoy its best time in 10 years, with all round growth in exports, consumption and investment, record high stock prices, rising wages, falling unemployment and benign inflation. In 2007, while growth is expected to ease to more normal levels, wealth could spread wider as the current boom in stock prices filters through to property and other asset classes. Notwithstanding a strong CNY and rising asset prices, inflation should remain contained. The recent rise in HIBOR should also be temporary. A new budget and the Chief Executive election in March may bring new vigor and faces to the administration, but is unlikely to see fundamental policy changes given the almost certainty of the current CE's victory.

All round growth
The Hong Kong economy ended 2006 on a high note with strong growth in both exports and domestic demand. Retail sales in Dec-06 grew 11.8% y/y, the highest growth in the Christmas month since 1993. Consumer sentiment was buoyed by a strong equity market and the prospects of salary increase and decent bonuses. Retained imports of capital goods rose 26% y/y in Q4-06, underlying strong investment demand. Externally, robust trade with China kept export growth at 13.7% y/y in Dec-06.

This good momentum is expected to persist at least into the H1-07. While we will not be surprised to see some slowing in exports and mild consolidation in the equity market following the earning report season, strong income growth and confidence, plus buoyant liquidity, should keep domestic demand robust. Specifically, there are early signs that investor interest is spreading wider to other asset classes, especially real estate. A more diversified asset boom could reinforce the positive wealth effect and support sentiment, sustaining both consumption and investment growth. This is important in offsetting an expected moderation in exports and tourism, which is officially forecast to grow by 4.6% in 2007, down from 8.1% in 2006.

Concern about inflation overdone
Higher asset prices and a stronger Chinese yuan (CNY) have prompted growing concern about rising inflation. Ironically, inflation was still a much desired phenomenon until two years ago when Hong Kong was struggling to divorce from its 6-year deflation nightmare. We believe inflation may rise higher, but the current concern is overdone. Asset price inflation may be a concern, given a 40% jump of the Hang Seng Index over the last year. However, property value, which holds the largest share of household wealth, barely moved last year. It is therefore important that liquidity could spread wider to other asset classes.

In terms of consumer price inflation, the impact from a stronger CNY should be very limited. Given an expected 4% annual appreciation of the CNY and a 25% weight of food (consumed at home) and consumer goods in the consumption basket, even assuming China accounts for half of the supplies and a 100% pass-through of CNY appreciation to retail prices, it would only add 0.5% to CPI inflation. Rentals, which account for 30% of the CPI basket and are rising at 5% y/y, are more important. Since rental growth has decelerated from 13% y/y in late 2005 to 4.1% in Nov-06, its contribution to CPI inflation is declining. Moreover, public rental units, which cover 40% of the population, will have their rents waived for one month and cut by 11% later this year. This will dampen CPI inflation going forward.

Local interest rates could still rise in the near term
Local interest rates have seen some upside pressure in recent weeks, as we have warned at the end of 2006. Investors are more convinced that the USD/HKD peg will remain in operation in the foreseeable future as USD/CNY strengthens beyond USD/HKD. The broad USD strength against Asian currencies, especially the JPY, have reduced the USD/HKD forward discount. This trend could continue in Q1-07, offering further upside risks to HIBOR. In H2-07, interest rates could resume its downtrend driven by a combination of lower US rates and ample liquidity. Although, speculation on the HKD peg is likely to recede, the economy should remain flush with liquidity given the robust fundamentals, HK's financial market as a proxy to investing in China and a growing outflow from China as the capital account becomes more liberalised.

Budget and CE election: new face, old policy
An improved fiscal position should allow the upcoming budget on Feb 28 to be more taxpayer friendly. Modest tax relieves are expected but no major policy initiative is likely given the looming change of government in mid-07. While some new faces are expected in the next administration, the chance of a new Chief Executive other than the incumbent Donald Tsang to be elected by an 800-member election committee on March 25 is almost zero, in our view. Tsang has pledged to cut taxes and boost infrastructure spending. A long-term strategy to enhance Hong Kong's competitiveness in line with China's new five-year-plan is also tabled, but much of the initiatives are work-in-progress. What could make a difference under the new administration is if these initiatives are taken up by a group of more competent and decisive officials, which is probably what Tsang's election campaign is striving for.

INDIA

Shuchita Mehta
Economist, South Asia, +91 22 2268 3235
Shuchita.Mehta@in.standardchartered.com

Budget to keep its focus

- FY07/08 budget to remain expansionary
- Focus will stay on rural, social and infrastructure sectors
- Reduced deficit should support the government bond market

We expect further rationalisation of the tax structure and expenditures in the FY07/08 budget (begins in April), to be announced on 28 February. The budget should be an expansionary package, focusing on the rural economy, social sectors and infrastructure. However, like the previous year the fiscal responsibility mandate will impose constraints on how much the government can spend. The FY07/08 fiscal deficit may fall further to 3.4% of GDP, translating to a gross borrowing of INR 1.45trn, down from INR 1.53trn in FY06/07. This should support government bond yields amid concerns over further monetary tightening and high inflation.

Fiscal deficit continues to decline
Over the past years, exceptionally strong economic growth, ongoing tax rationalisation, and spending controls have eased the central government's fiscal stress. All the key deficit indicators have shown improvement in the recent past (chart 1). Total expenditure has declined while tax collections improved as a share of GDP since FY03/04. In the first nine months of FY06/07, the fiscal deficit contracted 12.4% y/y versus a budgeted 1.6% growth. This has helped lower government borrowings - the central government has until now borrowed INR 1.39bn, lower than its scheduled borrowing of INR 1.44trn (INR 1.534trn full year) to date. In FY06/07 the fiscal deficit is expected to fall to an estimated 3.6% of GDP (3.8% budgeted), down from a peak of 6.2% in FY01/02. Better fiscal management is also visible in state finances and has helped consolidate public debt, albeit at higher levels.

Focus of expenditure to remain unchanged
Similar to previous budgets, we expect the government to maintain its focus on the same areas given the fiscal responsibility mandate of the union government. Specifically, the rural, social and infrastructure areas should remain the priorities.

Despite the optimistic growth story of India, the rural economy, particularly the farm sector, has been an underperformer. For FY06/07, the farm sector grew by an estimated 2.7% y/y, a far cry from the 9.2% overall GDP growth. For years, the farm sector has suffered from poor rural infrastructure - lack of irrigation facilities, roads, electricity, availability of cheap credit etc. While the government has tried to address these issues in recent years, much still needs to be done. A related issue is providing jobs to the rural unemployed. Last year, a rural employment guarantee scheme was launched for the underprivileged youth in 200 pilot districts. This project might extend to another 50 districts in FY07/08 with the aim of covering the entire rural sector over five years. Moreover, with near 70% of the population still in rural areas, viable job opportunities in manufacturing need to be explored. The government may seek to further clarify its Special Economic Zone policy.

While India has made some progress in the recent past in terms of social sector indicators, it continues to lag its East Asian peers. In addition to the rural-urban divide, serious gender gap and regional differences exist. The current government has, in its charter, given due emphasis on improving social sector spending, but spending on health, water and education remain dismally low. The lack of trained manpower in the services sector is much talked about and debated in industry circles, causing rapid rises in wages and salaries in sectors like information technology, financial services etc. A related issue is that of primary education. The government now spends less than 4% of GDP in education and this ratio needs to go up to at least 6% with special emphasis on primary education.

Infrastructure spending remains a major weak spot constraining India's successful transition to its aspirational 10% growth. While the government has taken corrective steps to address the issue, such as creating a framework for greater public private partnership, setting up a funding vehicle and freeing up some foreign investment limits, much work still needs to be done. According to the Prime Minister, India needs over USD 320bn (of which USD 150bn in foreign funding over the next 5 years) to meet infrastructure needs.

Higher rates, respectable growth
Despite recent hikes in Cash Reserve Requirement (CRR, 50bps in Dec 06 and 25bps each on Feb 17 and Mar 3), and public spending controls, bank lending is still expanding at a feverish 30% y/y and M3 is growing at a brisk 21.4%. Inflation is still on a rise. Thus the central bank might choose to keep liquidity tight and another 25bps hike in repo and reverse repo rates are likely, along with a 25bps hike in CRR. However, we believe a gross borrowing program of INR1.45trillion can sail through in the current environment. This is because banks are dangerously close to the statutory 25% floor in GoIsec holdings/equivalents (banks have been paring down exposure to bonds to extend credit), which will provide additional demand for bonds, in addition to the insurance firms. An expansionary budget should support GDP growth at a respectable 8.1% in FY07/08, slightly lower than our 8.7% forecast for FY06/07. However, should the government announce a larger than expected borrowing program, it might put a much more severe strain on liquidity and interest rates.

SOUTH KOREA

Chongwoo Chun
Senior Economist, +822 3702 5045
Chongwoo.Chun@scfirstbank.com

Nicholas Kwan
Regional Head of Research, Asia; +852 2821 1013
Nicholas,Kwan@hk.standardchartered.com

Landing softly, with risk

- The economy is easing
- Inflation is stabilising, same for liquidity
- Pre-election policy errors are the major risk

As economic growth eases and inflation recedes, there is a growing risk of monetary overkill given the government's obsession with restraining property speculation - a drive underlined by policy confusion in the run up to the December presidential elections. While short-term liquidity remains high, overall liquidity is stabilising, especially given a shrinking current account surplus. This should ultimately contain the Bank of Korea's hawkish stance. We maintain our view that the overnight call rate should have already peaked at 4.50%. But there is a modest chance of a one more 25bps tightening. The near-term risk to the Korean economy is likely from pre-election policy mistakes.

On track of a soft landing
The Korean economy continues to moderate. Real GDP growth eased further to 4.0% y/y in Q4-06 from its cyclical peak of 6.1% in Q1-06. Growth momentum eased in all sources. Domestic demand's contribution to GDP growth declined to 2.9 percentage points (ppt) from 5.3ppt in Q1-06, while contribution by net exports dropped to 1.3ppt from 2.4ppt in Q2-06. Both consumption and investment demand weakened, though a 2.9% y/y growth in Q4-06 construction lifted its contribution from negative to positive territory (Chart 1).

Incidental factors might have aggravated the slowdown in Q4-06. For example, auto-worker strikes and warm weather had dampened industrial output and consumer spending in Q4-06. Conversely, a late Lunar New Year (LNY) this year that falls in Feb rather than Jan may have inflated exports in Jan-07. However, given the prospects of slower US growth and impacts of higher domestic interest rates, GDP growth in 2007 is likely to ease further, although a positive leading composite index implies the slowdown in growth should be mild and brief.

Inflation easing, but liquidity looks high
Slower GDP growth and lower oil prices should keep inflation in check in 2007, though increases in public service charges may limit the decline. Both core inflation and service price inflation are stable or heading south (Chart 2). We expect headline inflation to average 2.3% in 2007, falling in the lower range of the BoK's 2.5-3.5% target. One outstanding concern is asset price inflation and liquidity, as noted by the recent upsurge in M1 (Chart 3). However, overall liquidity expansion appears to be moderating, as indicated by the easing in less-liquid money supply (Net M3 and M2) growth. A shrinking current account surplus, which dropped to USD 6.1bn in 2006 from USD 15bn in 2005, also limited liquidity growth. To the extent that short-term liquidity growth reflects more speculative demand, especially in real estate, the recent hike in reserve ratios and tighter mortgage regulation should have some dampening effect. CD rates have gone up and the ratio of mortgage to total household loans seem to be stabilising (Chart 4).

The risk of domestic policy blunders
There is no denying that housing prices and rentals (Jeonsei) have been on an uptrend (Chart 5). Part of this can be attributed to previous government control measures that had discouraged supply and caused a subsequent decline in housing inventories. Improved housing finance facilities have also fueled housing demand. In response, the government has introduced new measures to boost the supply of rental units and reduce demand in the central Seoul area through government subsidies and tax incentives. Yet, it remains unclear how effective such measures would be, especially in the near term and given its negative fiscal implications.

This raises the risk of more policy blunders, particularly as the December presidential elections get closer. Deteriorating support for the current administration may also raise the risk of ad hoc policy making, as noted in the previous housing measures and policies regarding foreign strategic investment. If the latest real estate anti-speculation regulations fail to yield concrete results, the government may resort to more draconian measures, including another 25bps hike in the overnight call rate. The most likely timing of such a move, if it were to happen, would be Q2-07. This is in consideration of the time required to assess the effectiveness of the latest real estate measures and the risk of tightening too close to the presidential elections.

For the time being, we maintain our view that the BoK has done its course and the current call rate of 4.50% should be the cyclical peak. However, the risk is that a further hike in Q2-07 may coincide with falling exports and weakening domestic demand, becoming the straw that breaks the camel's back. In this respect, the near-term risk to the Korean economy may come from within. This is especially the case given recent progress in the six-party talks, where Pyongyang agreed to denuclearise in exchange for aids. While the devil remains in the detail, especially actual implementation, optimism should rise in the near-term, though rating upgrades are unlikely soon.

THAILAND

Usara Wilaipich
Senior Economist, +662 724 8878
Usara.Wilaipich@th.standardchartered.com

Lower rates, stronger investment needed

- Thailand should stimulate investment to curb THB appreciation
- Early rate cut expected to offer near-term growth support
- Business confidence holds the key

Given the increasing focus on the THB's strength, it seems that the initial policy emphasis on curbing foreign capital inflows is misplaced. The authorities could focus on boosting domestic investment, with the help of a strong THB and low interest rates. While the central bank can continue to cut rates in coming months, the bigger challenge for the authorities will be to restore business confidence. This needs more clarification on the political landscape and policy consistency.

BoT's key policy focus remains on the currency
A key policy focus of the Bank of Thailand (BoT) has been, and looks likely to remain, the remarkable appreciation of Thai baht (THB), which has strengthened almost 9% against the USD since Oct-06. Given that the export sector was the sole source of economic growth in 2006 amid weak domestic demand, the urgency to maintain export competitiveness seems to have convinced the BoT to announce on Dec.18, 2006 the introduction of a 30% unremunerated reserve requirement (URR) for foreign capital inflows. Abrupt reaction from investors on the stock market has prompted the central bank to relax the URR for equity investment in listed stocks, and later, for fully hedged foreign currency loans by businesses. As a result, only foreign investment in the bond market and real-estate mutual funds are now subjected to the URR. The government has also pledged that the URR is only a temporary measure, as well as announcing measures to relax domestic investment overseas.

In any case, we remain of the view that the real answer to address THB appreciation is not by imposing new capital controls, which goes against the grain of the global trend of capital account liberalisation. Not only should the government encourage outflows by cutting restrictions on domestic investors and corporates to invest abroad, it should also boost domestic investment, which would lead to more imports and reduce the country's trade surplus.

The ghost of the Asian financial crisis
It is understandable why the authorities are concerned with the recent strength of the THB, which undermines export competitiveness and risks destabilising the local financial markets. The painful experience of the 1997-98 Asian financial crisis is still fresh and frightening. Hence, the authorities were eager to act pre-emptively. Of course, the external position now is much stronger than ten years ago. Thailand runs a healthy trade surplus and it has a forex reserve large enough to cover its total foreign debt.

The latest measures by the BoT and the Finance Ministry to protect domestic interests could undermine foreign investor confidence. The flip-flopping of the URR rules reflects that foreign investors could be less forgiving towards policy mishaps. Meanwhile, amendments of the Foreign Business Act that restricted foreign control on local business through nominees have raised confusion, especially given repeated exemptions. Such policy damage will need more time to heal than those triggered by event risk, such as the military coup of last September.

Investment as a way to contain THB appreciation
To rebuild credibility, the authorities will need to adopt more market savvy measures to serve its policy objectives. We believe boosting domestic investment is a way to kill two birds with one stone. First, manufacturing capacity utilisation is running at a 10-year high, averaging 74% in 2006. Fresh investment will create more room to grow, not to mention the opportunity to upgrade and improve efficiency. Second, stronger investment will reduce dependency on exports as a growth driver. Third, and arguably the most important for the BoT, higher investment will lead to more imports and help reduce trade and current account surpluses. This in turn will reduce the upside pressure on the THB.

Boosting investment to support economic growth and reduce THB appreciation is not just good in theory, but arguably being put into practice. The BoT has started easing monetary policy by shifting the benchmark interest rate from 14D to 1D repo with a lower (25bps) target rate in its Jan-07 MPC meeting. We expect the BoT to reduce rates further in February and April (see OTG report today for details), bringing the 1D repo rate to 4.25%.

Yet, a bigger challenge to boosting domestic investment is to restore business confidence. The business confidence index and its investment components are still hovering around five-year lows. Policy consistency and political stability are the critical ingredients to restore such confidence. Amendments of the Foreign Business Act are hard to be reversed, but its damage could still be reduced through widening the scope of exemptions - a tactic used by the BoT on its URR requirements. A more taxing issue is the political environment, including security conditions in Bangkok after serial boom blasts on New Year's eve, pending a court ruling on the viability of major political parties alleged with election frauds, the drafting and referendum of a new constitution, and the general election that follows. Humps abound, which also means the authorities need to get their acts together quickly.

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