Asia Focus : Made in Asia: Where is the Country of Origin? : Regional economic integration is widely applauded as one major force behind Asia's economic miracle. This is particularly obvious in China's case, which has achieved phenomenal development and become a significant growth engine of the region. While few would dispute its long-term gain, regional integration still faces much resistance. One key problem is that as economic activities cut across borders, politics and social interests are still largely bounded by country boundaries. As China's experience indicates, for economies in the region to integrate deeper and broader, the concept of 'country of origin' would need to be redefined, if not abandoned.

Economy Highlights

India : We expect growth to slow down to 8.1% in FY07/08 as higher interest rates and a stronger INR gradually dampen domestic consumption and manufacturing. We also expect one more rate hike in Q2-07, but no major threats to growth.

Indonesia : Having cut its policy rate by 375bps in 11 months, BI surprised the markets by holding rates unchanged in April. We believe further cuts are likely in H2-07, but the move will be determined by US interest rates. GDP growth will be increasingly driven by policy reforms, rather than by further rate cuts.

Malaysia : With a general election expected before Q2-08 and inflation likely to remain tame, both fiscal and monetary policies should be supportive to growth in 2007, keeping the official 6% GDP growth target within reach.

Philippines : We have raised our 2007 GDP growth forecast to 5.1% on the back of solid domestic demand. The BSP may raise the "tiering rates" gradually to align with the headline policy rate. Meanwhile, mid-term elections and seasonal risk aversion may drive the peso weaker, albeit temporarily.

OVERVIEW

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

Volatile but not down

- Solid fundamentals supported financial market recovery
- But volatility will stay with concerns over US economy
- EU demand and lower rates should buffer downside risks

Following the market turbulence in early March, nearly all Asian equity markets have fully recovered their lost ground, with SE Asian markets outperforming their NE Asian counterparts in terms of year-to-date returns. Yet, there is little room for complacency as decline in risk appetite could return in Q2-07 and trigger further volatility. One such trigger could be the concerns over the US housing market and its general economy, however, we believe the downside risk should be mitigated by a rejuvenated Europe and generally strong fundamentals in Asia.

As highlighted in the last edition of the Asia Focus, investor appetite for investing in Asia would return after the initial, and misunderstood, panic, once they are reminded about Asia's robust economic fundamentals. Indeed, if one compares the year-to-date performance of Asian equity indices and our forecasts of economic growth across the region, high growth economies like Vietnam, Malaysia and Singapore generally enjoy strong equity market performance (Table 1). One clear exception is India, where the Sensex index has been an underperformer, due to investor concerns about high valuation and the central bank's hawkish stance - and rightly so - to curb excessive lending.

The "R" word
Yet the roller coaster ride may not be over. We have noted a seasonal decline in risk appetite in Q2 of the past four years, according to our in-house Risk Appetite Index, leading to significant market correction in some cases. Furthermore, both businesses and investors are watching the US closely following warnings, including from former Fed Chairman Greenspan, of an abrupt slowdown, or even recession, of the US economy. This concern is fueled by the Fed's post FOMC meeting statement of Mar 21, when the Fed emphasized the flexibility to react promptly to both upside and downside risks to the economy.

We previously noted that a moderating US economy, which is our core scenario, will have varying impact on individual Asian economies. The likes of Hong Kong, Singapore, Taiwan and Malaysia, with greater exposure to the US market, would be more affected by downside shocks from the US, especially compared with countries with strong domestic demand growth like India, China, and the Philippines.

Other than the domestic economy, Europe can also provide some buffering to weaker demand from the US. The value of exports from Asia to the EU is now comparable to exports to the US, with the former rising faster than the latter (Table 2). Improving demand from Europe, brought by the recovering economy, is responsible for this encouraging performance, and should help to partially offset softer demand from US consumers. This is also helped by the strengthening of the EUR against the USD, which has gained 9% y/y in Q1-07.

Diverging moves of Asian central banks
Our long held view of diverging monetary policy in Asia continues. China, India and Japan are still looking at higher rates. China raised its benchmark 1-year lending and deposit rates by 27bps on March 17 to 6.39% and 2.79% respectively to stem inflation and cool investment. Indication from the People's Bank of China officials and the upside risk to investment and inflation suggest lending rates in China could rise further in Q2-07. This is likely to be complemented by higher reserve requirement ratios, as evident from the latest 50bps hike slated on April 16. The Reserve Bank of India also raised its repo rate by 25bps to 7.75% and Cash Reserve Ratio by 50bps to 6.5% on March 30 in reaction to rapid lending growth and potential rise in liquidity. In Japan, the latest Q1-07 Tankan survey, and Feb-07 inflation data showing temporary return to deflation, is consistent with our view that the Bank of Japan is in no hurry to tighten monetary policy significantly, and we do not expect the next hike to come until Q4-07.

For the rest of Asia, we expect central banks in Thailand, Philippines and Indonesia to ease in Q2-07, in line with receding inflationary pressure and rising concerns over economic slowdown. The urgency for Bank of Thailand to cut rates is arguably more acute in order to restore consumer and investor confidence, as well as to curb the strength of THB. That said, recent rebound in oil prices may still keep central banks vigilant and maintain their bias against rapid rate cuts.

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

Made in Asia: where is the country of origin?

- Regional integration has propelled economic growth, but blurred country boundaries
- To pursue long-term gains, policymakers should abandon the 'country of origin' concept
- China's integration with Northeast Asia offers valuable lessons for itself and others

Regional economic integration is widely applauded as one major force behind Asia's economic miracle. This is particularly obvious in China's case, which has achieved phenomenal development and become a significant growth engine of the region. While few would dispute its long-term gain, regional integration still faces much resistance, spanning from workers trying to retain their jobs to firms struggling to keep their markets and governments scrambling to protect their own industries. One key problem is that as economic activities cut across borders, politics and social interests are still largely bounded by country boundaries. As China's experience indicates, for economies in the region to integrate more deeply and broadly, the concept of 'country of origin' would need to be redefined, if not abandoned.

From EU to NAFTA, the benefits of economic integration have been well documented and widely appreciated. Similarly, regional economic integration has contributed significantly to Asia's miracle in the past half-century. Behind the rapid growth in regional trade and investment flows is the massive relocation of industries across borders. Here, the experience of China versus Northeast Asia, where cross-border trade and investment integration was the most extensive, is of particular interests. Industries that embrace the inevitable trend of integration usually benefit from enhanced productivity and competitiveness in the longer term. But policies that are bounded by narrow "country" visions and follow protectionist practices usually suffer and pay heavily.

Wholesale penetration vs complete migration
Since the late 1970s upon the opening up of China, entrepreneurs from Hong Kong and Japan have started investing in China either as direct investors or middlemen for others. These were followed by Chinese diaspora from Southeast Asia and Taiwan, but always against their governments' advice due to then political hostility with China or economic concerns about the hollowing out of industries at home. Since the mid-1990s, South Korea caught on the China fever, led by the chaebols with increasingly internationalised brands. More recently, this trend was reinforced by large number of Japanese investors who are suppliers following the steps of their respective zaibatsu, or small-medium enterprises hard-pressed by Japan's decade-long stagnation in search of lower cost survival space.

Industry relocation has different impacts on their home economies due to different policy responses adopted by their respective authorities. The sizes of local manufacturing sectors relative to GDP reveal some distinct differences across these economies (Chart 1). In Hong Kong, the manufacturing sector shrank from 22.8% of the economy in 1980 to a meagre 3.4% in 2005. In reality, even this 3.4% is an overestimation, since many Hong Kong 'factories' hardly have a machine but a computer in their workshops, mostly for design or sales functions. Hong Kong manufacturers now employ over 10 mn workers in the Mainland, 10 times more than their Hong Kong employees in the peak period of the mid-1980s. Manufacturing may be extinct in Hong Kong, but it has flourished in the Mainland with a strong linkage back home in terms of profit remittances and demand for services. Simply put, it has grown out of Hong Kong's boundary. Taiwan also experienced falling presence of the manufacturing sector, but its corresponding figures dropped only from 39.8% to 25.4% during the same period. One may claim this as a success in the island's effort to resist wholesale relocation of industries across the Straits. However, restrictive cross-strait barriers have forced many Mainland-destined investors to completely migrate from the island, leaving little connection with and benefit feedback to Taiwan.

The nature of manufacturing activities also makes a difference in development. In Hong Kong, most of the production were of labour-intensive, low value-added kind, which meant there were not much incentive to retain them. In Taiwan, while production is more concentrated at the electronic sector, they were mostly of OEM (original equipment manufacturer) nature, which meant it was not too difficult for the production process to be replaced by factories elsewhere. According to surveys by Taiwan's Ministry of Economic Affairs, the overseas production ratio for exports orders rose from 16.7% in 2001 to 40% in 2005, reflecting the continued relocation of production activities.

Vertical specialisation vs horizontal diversification
In Korea, the wave of relocation started in the mid-1990s following the signing of the treaty of amity between China and Korea. Much of the trade and investment flows were concentrated in electronics (Chart 2). But this has little impact on Korea's manufacturing sector, which maintained a relatively stable share of the economy. This can be partly explained by Korea's success in vertical specialisation. For example in the electronic industry, stages of production include product development, parts/accessories (semiconductors) manufacturing, assembling, quality control and packaging. The third stage of assembling was labour-intensive and was among the first to be relocated to low-cost countries. Then the second and final stages were also gradually moved out of the home country. Retaining product development at home is seen as crucial to maintaining its status as the manufacturing giant. According to World Bank statistics, R&D expenditures averaged 2.64% of GDP in Korea during 1996-2003, higher than the world average of 2.36% and the 2.54% for high-income economies. Separately, in a sequential production process, the cost of making an error in any of the stages can be huge especially towards the end of the process. Doing the final stage at home can ensure product quality as well as provide job opportunities locally. Between 1998 and 2005, the import share of intermediate goods from China to Korea rose from 24% to 37%. This reflected that Korean firms did retain part of the final production process at home.

The impact of industry relocation on Japan has also been less severe with the manufacturing sector still accounting for 22.7% of GDP in 2005, against 29.8% in 1980. Here, size would make a difference given Japan's relatively huge industrial base. Also, Japan has gone through similar vertical specialisation. Surveys by Japan's Ministry of Economy, Trade and Industry showed that while production of components, assemblage and sales have been moving out of Japan, nearly 80% of R&D activities are still carried out within Japan. R&D as a share of GDP was high at 3.15% during 1996-2003. Apart from this, Japan saw another interesting development in its manufacturing industry. There has been a shift to "horizontal business network", featuring full line of production process operated overseas and domestically for different products under the same company. The relocation of the whole production lines of selected goods, mainly labour-intensive ones, spares capacity and labour for production of goods which cost much in transportation domestically. This development helps create jobs and maintain the importance of the manufacturing sector. To resist wholesale relocation of industries without undermining their competitiveness, Korea and Japan have been careful in looking beyond the border to capture the maximum comparative advantage.

Falling employment, improving productivity
Relocation of production process allows division of labour not only among various products, but also among different stages of production of the same product, thus allowing corporates to leverage more on comparative advantages. This can foster trade, improve productivity and ultimately lift the living standards of the economies involved. But one often-cited drawback is the lost of local jobs. Employment in the manufacturing sector as percentages to total employment did drop over the years for Northeast Asian economies. This also happened in the US and Europe as a result of de-industrialisation. This is not necessarily a bad thing. Indeed, employment shares have been falling more rapidly than output shares in the manufacturing sector for Hong Kong, Japan and Korea, pointing to improving productivity in the sector (Chart 3).

The enhancement is particularly striking in Korea. Productivity gained by over 40% from the low in the early 1990s. This is another piece of evidence that Korean manufacturers have been very successful in vertical specialisation, concentrating in higher value-added production stages. In Taiwan, falling productivity can be explained by the set-up of local factories in response to relocation of large firms, which created jobs. This can be seen as partly a result of its restrictive policy that failed to keep the most productive firms at home. Overall, there has been no obvious correlation between the jobless rates and the extent of relocation in the economies we look at here (Chart 4). During the first waves of relocation from Japan, Hong Kong and Taiwan in the 1980s, the jobless rates for Hong Kong and Taiwan were falling steadily while that of Japan remained stable. In the second waves which included Korea since the mid-1990s, jobless rates in these economies fluctuated a lot, due more to global economic cycles, the Asian Financial Crisis and SARS.

Many economies have gone through relocation of manufacturing activities without significant negative impact on unemployment, though with material impact on the structure of employment. Moreover, productivity of the manufacturing sector and trade flows have been enhanced. Policies should focus on fostering closer trade relationship to benefit from FDI-related trade, specialising on higher-value added production, or shifting to other segment of economic activities. To achieve that and to resist the pressure to protect local industries and retain uncompetitive jobs, policymakers need to broaden their economic vision beyond the 'country' boundary. When products are virtually made in Asia to capture comparative advantages, it is hard to define their 'country of origin'. The experience of China and Northeast Asia is not unique. It will be broadened to other areas as the Chinese economy continues to globalise, and will likely be repeated in other places like India, especially if it is to become the next China.


INDIA

Anubhuti Sahay
Economist, +91 22 2268 3182
Anubhuti.Sahay@in.standardchartered.com

Growth to moderate

- RBI seems to have shifted its currency stance
- We expect one more rate hike in Q2 2007
- Slower exports and consumption to cap growth at 8.1%

We expect growth to slow down to 8.1% in FY07/08 against 8.7% last year. Higher interest rates and a stronger INR will gradually dampen domestic consumption and manufacturing - the growth engines in FY06/07. While we expect one more interest rate hike in Q2 2007, we see no major threats that would reverse India's growth story in the foreseeable future.

A shift in RBI's INR stance?
Over the past week, Reserve Bank of India (RBI) has been more tolerant towards a stronger currency. The INR traded to an eight year high of 42.845/USD on April 10, up more than 4% in less than a month. This was in sharp contrast to earlier days when it aggressively defended the INR from strengthening. This seems to be a significant shift in the central bank's stance, though permanence of this tolerance still needs to be monitored.

Given current concern about inflation, a stronger currency that translates into cheaper imports and supplements domestic supply may not be a bad idea. Although prices of primary products may fall in coming months, inflationary pressure from manufacturing side may persist (Chart 2). In such a scenario, a stronger currency would restrain supply push inflation at least in the near term. The flip side of this is that it penalises the export sector which is already suffering a slow down. Export growth has eased from 29.5% y/y in April-Dec 2005 to 22.5% in the same period last year and to sub-10% in the past 3 months (Chart 3). However, since the Indian economy is driven less by exports but more by domestic consumption, a slowdown in exports will have only limited impact on India's growth momentum. With containment of inflation as its top priority, we believe the RBI will allow the INR to stay strong, trading short-term export competitiveness for more stable prices.

One more rate hike in Q2
We have recently revised our forecast for Indian interest rates, adding one more 25bps hike for both repo and reverse repo rates in Q2-07. We now expect the repo and reverse repo rates to peak at 7.75% and 6.25% respectively. We also forecast another 25bps increase in cash reserve ratio (CRR) over a similar time frame. This is in view of RBI's concern about rising domestic liquidity driven by continued strong inflows from external commercial borrowing and foreign direct investment.

GDP growth in FY06/07 was driven largely by consumption and manufacturing. With higher policy interest rates, we do expect a slowdown in consumption demand. As evident from market data, official rate hikes have translated into higher commercial lending rates, especially in the retail market. This in turn has led to decline in auto sales and home loan enquiries. With another rate hike, we expect these sectors to cool down more significantly as they are highly leveraged. Other consumption demand is also expected to slow down as money becomes dearer.

However, consumption would still be supported by higher wages, which are sticky in nature. According to one recent salary survey conducted by a leading local private consulting firm, salaries rose between 12% and 16% in 2006, and are expected to rise at a rate of 14.5% in FY07/08. The survey covers 600 companies across 21 industries but does not include the agriculture sector, where the majority of the Indian population is employed.

As far as manufacturing demand is concerned, companies do seem to be worried about the rate hikes and their timing. But in general they seem reluctant to roll back their expansion plans on two counts. First, external commercial borrowings by corporate remain strong. As per the latest data available, external commercial borrowings accounted for 34% of net capital inflows during April-Dec 2006 vis-à-vis an outflow last year. This is likely to remain a major source of funding. Second, if the rate of return in the industry is still higher than the cost involved, an increase in capital cost may not deter them from going on.

According to one of the latest surveys of business leaders conducted after the latest rate hike, 89.5% of the respondents indicated that they would not scale down their business projections for FY07/08, and 57.9% expected to add more capacities during the rest of the year.

One possible offset for the slowdown in urban expenditure could be an increase in rural income levels boosted by infrastructure spending. However a small budgetary outlay of USD 5.5bn falls far below the requirement of USD 320bn estimated for the next five years. Without accelerated infrastructure spending and more aggressive structural reforms, the Indian economy is likely to settle on a slower, though still enviable, real GDP growth of 8.1% in FY07/08.

INDONESIA

Fauzi Ichsan
Senior Economist, +62 21 5799 9117
Fauzi.Ichsan@id.standardchartered.com

Reforms reinforce rate cuts

- Monetary policy shifts from cutting rates to promoting loans
- Weak fiscal stimulus and poor investment climate remain the hitch
- Policy reforms are progressing, but need to do more

Having cut its policy rate by 375bps in 11 months, Bank Indonesia (BI) surprised the markets by holding rates unchanged in April. We believe further cuts are likely in H2-07, but the move will be determined by US interest rates instead of domestic factors. GDP growth will be increasingly determined by policy reforms, not by further rate cuts.

End of aggressive rate cuts, but not monetary easing
As the "one-off" impacts of the sharp fuel price hikes in 2005 dissipate, inflation fell progressively from 17.1% y/y at YE-05 to 6.5% by Mar-07. Easing inflation, stable US interest rates, relative IDR strength and improving payments position (FX reserves has risen by USD 17bn since Sep-05 to USD 47.2bn in Mar-07) have given BI the confidence to cut BI rate from 12.75% at YE-05 to 9.0% by Mar-07. BI, however, surprised the markets by maintaining BI rate unchanged on April 5.

Given limited scope for inflation decline and little impact of previous rate cuts, BI seems changing its tactics by relaxing bank lending regulations to promote monetary expansion. Despite repeated rate cuts, bank lending grew by only 14% in 2006, down from 22.7% in 2005. BI relaxed the legal lending limits for banks financing infrastructure projects, it also loosened rules on cross-defaults on bank debts, and offered incentives to small-medium enterprise lending. BI insisted that the relaxations in lending rules - many of which introduced after the banking crisis of 1998 - are consistent with its medium-term strategy to consolidate the banking sector. But the moves also partly addressed the government's concern that banks are parking their excess liquidity mainly in Sertifikat Bank Indonesia (SBI) and government bonds, rather than providing credit to the real economy. While we believe the tactical change may not imply the end of BI rate cuts, lower rates are now contingent on US rate cuts, most likely in H2-07. We maintain our YE-07 BI rate forecast at 8.0%, with the risk of slower-than-expected cuts.

Need to stimulate lending and public spending ...
Despite aggressive rate cuts, GDP growth slowed to 5.5% in 2006 from 5.7% in 2005, as domestic demand was hit hard by the hikes in fuel prices and BI rate in Q4-05. Growth in household consumption slowed to 3.2% in 2006 from 4.0% in 2005, while that of investment plunged to 1.4% from 9.0%. GDP growth did rebound in H2-06, mainly due to bigger net exports, benefiting from higher export commodity prices and weaker import demand. Although public spending also accelerated, it remained well below potential and budget.

In 2006, the central government had a budget deficit of 1% of GDP, but according to the World Bank, the central and regional governments have some USD 15bn (4.0% of GDP) in unspent funds. Since a third of central government's expenditure is fund transfers to regional governments, which failed to spend most of it due to bureaucratic bottlenecks and the lack of project management capabilities, the fiscal deficit has not created the needed stimulus to GDP growth. Ironically, the regional governments normally parked their cash surplus in SBIs, worsening the excess liquidity condition. As of Feb-07, the stock of SBIs reached IDR 250trn, or 7.5% of GDP.

... and to accelerate policy reforms
It is increasingly obvious that BI itself cannot boost growth to the government's ambitious target of 6.3% in 2007. To stimulate bank lending and spending, more fundamental policy reforms are needed to ease bureaucratic red-tape and boost investor confidence. In this respect, the government is making progress in implementing its policy reform package announced in H1-06. In Mar-07, it pushed through parliament the long-awaited investment law, the first major legislation since President Yodhoyono came to power in 2004. Among other things, the law (1) guarantees against nationalisation; (2) abolishes caps on foreign equity stakes; (3) provides tax incentives - including accelerated depreciation; (4) extends land use permits for foreign investors to 95 years from 30; and (5) transforms the national coordinating board for investment (BKPM) into a "one-stop" facilitator to help reduce red-tape.

While the new investment law shows the government is moving in the right direction, a significant improvement in investment climate would require the support of other reforms, especially a revision in the pro-labour manpower law and a new tax law that reduces tax burdens, increases transparency and improves enforcement like tax refund. In addition, both the central and regional governments need to improve their ability to implement their budgets, especially the ambitious USD 145bn infrastructure program.

Without the "discipline" imposed by an IMF program and government control of parliament, progress on policy reforms is likely to be slow. We still, however, expect GDP growth to rise to 6.0% in 2007. Lower interest rates, lower inflation, stable IDR, some improvements in regional governments' fiscal management and gradual implementation of the government's infrastructure program are likely to provide growing support for growth - though not to the level desired by the government.

MALAYSIA

Joseph Tan
Economist, +65 6530 3464
Joseph.Tan@sg.standardchartered.com

Steady it goes

- Election spending to support 2007 GDP growth at 6%
- BNM to turn more relaxed, but risks of slow motion
- MYR liberalisation to boost FX markets, but not exports

With a general election expected before Q2-08 and inflation likely to remain tame, both fiscal and monetary policies should be supportive to growth in 2007, keeping the official 6% GDP growth target within reach. However, contrary to government projection that private sector will be the prime growth driver in 2007, we believe public spending will have to shoulder a larger contribution to growth. This is especially so given our more reserved view on the speed of MYR internationalisation, and the effects of a strong MYR on export growth.

Stable domestic demand supports growth
Malaysia's Q4-06 GDP growth came in exactly in line with our expectation at 5.7% y/y, closing the full year 2006 GDP growth at 5.9%, marginally above the official target of 5.8%. Much of the growth came from a steady 6.6% y/y expansion in private consumption and a 9.9% rebound in investment, the latter was partly contributed by a low base effect. Although export growth weakened to 4.1% y/y, corresponding decline in import growth kept a decent 12.7% increase in net exports, which contributed one percentage point to GDP growth. Robust domestic demand in Q4-06 provides the economy with a solid base to start in 2007, and we expect growth to reach 6%, same as the government's projection but more bullish than the 5.5% market consensus.

Public stimulus to drive growth
One key difference we have with the government's view, however, is the growth drivers. While the government expects growth to be led by the private sector, we see growth to be driven more by the government itself. A major factor here is that we believe export demand will moderate and weigh heavily on production (Chart 1). In this environment, it is difficult to see the private sector to spend and invest more. The government projects that private investment will rise 10.4% on the back of fresh investment in oil and gas, up from last year's 9.7%.

Our confidence in public stimulus came from the expected general election, which is likely to be called before April 2008, when the political ban on former Deputy PM Anwar expires. We believe growing government spending in infrastructure may boost development expenditure by as much as 24% y/y, or up to MYR 45bn. However, this also means that the 2007/08 fiscal deficit target of 3.4% (of GDP) is likely to be exceeded, especially given a one percentage-point cut in corporate tax rate (from 28% to 27%) and lower oil prices that would affect oil royalties (Chart 2).

Low inflation to keep interest rates on hold, or lower
On inflation, a higher base raised by the Mar-06 fuel price hikes should keep year-on-year inflation in coming months to stay low, probably below 3% (Chart 3). This would offer comfort to Bank Negara (BNM), which expects inflation to fall between 2.0-2.5%, and encourages it to keep its Overnight Policy Rate unchanged at the April 27 policy meeting. However, for BNM to shift to a more relaxed monetary stance, it may require more significant softening in the external environment along with lower US rates, probably in H2-07. That said, the risks are that BNM could hold policy steady for the rest of 2007 as credit expansion is still high by regional standards and further easing could risk higher delinquency in the future (Chart 4).

MYR liberalisation vs internationalisation
Recently, Malaysia further liberalised the MYR, notably in three areas. First, the limit on bank's net open FX positions - previously capped at 20% of capital - is totally removed. Second, unit trusts and insurance companies are now allowed to invest overseas up to 50% of their assets, up from the previous 30% limit. Third, local companies are now once again allowed to borrow in foreign currency - a removal of another key capital control measures introduced after the Asian Financial Crisis. These measures will raise the volume of FX transactions and deepen the FX market. They have also fueled speculation that the MYR could be internationalised in as early as YE-07, which is premature, in our view.

We believe MYR internationalisation should be preceded by three conditions: 1) Strong and stable foreign exchange reserves; 2) A strong and stable banking sector backed by deep domestic capital markets; 3) A credible central bank. While the first condition might have been met, the second would still take time to achieve. The third condition is measured in terms of effectiveness of policy, market actions and communication. When a currency is fully internationalised, trading volume and volatility will invariably increase. As such, the central bank's ability to signal and communicate with the markets will become more important, and hopefully more effective than direct intervention. We see the likely time line for full internationalisation in 2-3 years and share the authorities' gradualist approach in this matter. Nevertheless, given strong market response to bullish MYR comments by the PM and the central bank, we have revised our YE-07 USD/MYR forecast to 3.40 from 3.50 previously. This in turn underlines our more reserved view on the contribution of exports to growth.

PHILIPPINES

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

Consumers' call

- We raised 2007 GDP forecast to 5.1% on solid consumption
- Tiering rates to be raised to mop up liquidity
- Politics remain stable, but may weaken the peso temporarily

The domestic economy started the year on a firm note, with overseas workers (OFW) remittances rising strongly. Also, the labour market is broadly supported by the buoyant service sector. These should cushion the impact of slowing exports and keep economic growth solid. As such, we have revised upward our 2007 GDP growth forecast to 5.1% from 4.7% previously. With inflationary pressure subsiding but bank loan reviving and liquidity remaining ample, the Bangko Sentral ng Pilipinas (BSP) is likely to raise the "tiering rates" gradually to align with the headline policy rate. Meanwhile, mid-term elections and seasonal risk aversion may drive the peso weaker, albeit temporarily.

Solid labour income supports growth
Over the past year, domestic consumption contributed substantially to overall growth in the Philippine economy (Table 1). This was largely driven by strong OFW remittances, which amounted to over 10% of GDP, on top of better job prospects in the service sector. On the supply side, buoyant business process outsourcing (BPO) activities supported a 7.0% y/y service sector growth in Q4-06, continuing the sector's uptrend started since Q2-06. Meanwhile, both the manufacturing and construction sectors maintained a modest 4-5% y/y growth in Q4-06, partly driven by strong exports. Looking ahead, we expect OFW remittances this year to maintain a strong 10-13% growth, taking into account the increasing number of workers with higher-end jobs. Local labour market conditions are also broadly supportive, with job creation being concentrated in the services sector.

Yet, investment remained tame in recent quarters. Currently, investment amounted to about 15% of GDP in the Philippines, comparing to over 20% in Malaysia and Indonesia and more than 40% in China. Clearly, the government needs to boost infrastructure spending and improve the investment environment. In our view, it would be a misguided policy for the government to focus too much on balancing the budget, which is running a deficit of only 1% of GDP - a level well acceptable both from an economic and a credit-rating perspective. We expect fiscal deficits to remain stable at 1.1% of GDP this year and narrow to 0.6% of GDP next year. To assess the financial strength of an economy, it is more relevant to look at the government's revenue raising capability, its debt/GDP ratio, external balances and growth prospects.

On the external fronts, growth of merchandise exports slowed to single-digit in recent months, down from its cyclical peak of over 20% in mid-2006. Much of the slowdown can be attributed to easing demand from the US, which absorbs 18.3% of Philippines' exports and is the country's largest market. With US GDP growth expected at 1.5% this year, further decline in export growth is likely. Meanwhile, with an expected 2.5% real GDP growth this year in Japan, which is the second largest market with a 16.3% export share, it should offer a mild support to Philippine exports. Overall, we expect growth of real exports to slow by around 4 ppt this year, cutting GDP growth by 1.6 ppt.

The introduction of the tiering interest rate system makes the interpretation of monetary policy less straight forward. With easing inflationary pressures, the next move of the headline policy rate is likely to be down. However, market focus would be on the tiering system, which may have a more significant impact on money market rates. Upon the introduction of the tiering system last November, money market rates dropped by around 50bps immediately. The central bank has recently commented that money market rates are too low, and that will distort investment and consumption signals. In our view, the BSP is likely to "moderate" the tiering system in Q2, gradually raising the rates to the headline policy rate level and drain excess liquidity in the market. This, together with other measures including possible extension to the special deposit accounts (SDA) (e.g. allowing non-bank FIs to park funds at the central bank at the higher rates under the SDA) to mop up liquidity, is likely to push short rates higher.

Politics may pressure the peso, temporarily
Given strong opposition to the use of constitutional assembly (Con-Ass), it is likely that any constitutional change will be facilitated through a constitutional convention (Con-Con). In the former, congressmen and senators are the ones to amend the constitution. In a Con-Con, people will elect their delegates (probably done in conjunction with the May-07 elections) to amend the constitution. This means that development under Con-Con will be more gradual.

Overall political situation in the Philippines remains relatively stable, though the run-up to the congressional elections in May-07 may prompt higher risk premium, especially if it coincides with seasonal risk aversion evident in past few years. As such, the peso may come under some pressure in Q2, and money market rates are likely to trend higher. Nevertheless, our core scenario is for the elections to proceed smoothly, boosting investor sentiment and strengthening the peso with modest economic growth and external balances.

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