Asia Focus: Environment: Asia's Achilles' Heel? : Asia's stellar economic performance raises millions of eyebrows, but it also faces numerous hurdles. One severe challenge is energy, not just its supply and security which are largely the concern of individual countries, but also emissions and environmental impacts that cut across boundaries and require regional and global efforts to tackle. How likely can Asia maintain its high growth trajectory without sliding down an environmentally destructive path? We believe it is possible, but needs more local and collective action, both by Asia and the advanced economies. In this respect, China and the EU offer some optimism.

Economy Highlights

Australia: Strong domestic demand prompted us to raise our 2007 GDP growth forecast to 2.8%, up from 2.5%. The tight labour market and buoyant housing activity suggest some upside risks to inflation and a likely 25bps hike by the RBA in Dec-07.

India: Tightened monetary grip should see the economy start easing soon. In fact, signs are already emerging that the economy is slowing. A soft-landing is within reach with just one more final interest rate hike, we believe.

Japan: Households are starting to consume, while the business sector remains in good shape. A more broad-based growth and some upward pressures on wages amidst a tight labour market should pave the way for a 25bps hike in the Overnight Call Rate in Q4-07.

Singapore: Strong service sector growth and sustained construction rebound boosted GDP by a real 6.1% y/y in Q1-07. We have raised our GDP growth forecast for 2007 to 6.8% from 5.5%. Sustained liquidity inflows are expected to keep local interest rates down, while a strong SGD should keep prices in check.

OVERVIEW

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

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

It is the US, stupid

- Events last month proved China is a smaller threat than the US
- Markets are now obsessed with the upside risk of higher US rates
- But the downside threats of weaker US demand are still alive

Between China and the US, which presents a bigger risk to Asia's sustainable growth? A month ago, most eyes were on the perceivably inevitable China correction and its likely jolt on Asia. Now, attention has shifted to the US. The latest rise in US Treasury yields, brought about by unexpectedly strong US data, have set off a swing in market expectations for a delayed Fed cut and subsequent setbacks in the Dow as well as most major Asian markets. In contrast, a 15% correction in Chinese equity prices over the past month engineered by successive measures like reserve ratio and lending rate hikes, a wider USD/CNY trading band, and a tripling of stamp duty, hardly sent a ripple across Asia, not even Hong Kong. Although predictability of events would make a difference in their impacts, the two incidents of the past month are a clear reminder that the US still commands more weight in Asia, hence deserving more attention of risk watchers and opportunity seekers alike.

Two contrasting sources of US risk
Unlike China, where risk is seen mainly from the side of overheating, risks from the US are perceived by markets as coming from both sides: an upside threat of higher inflation and delayed US rate cuts, or even a hike, and a downside risk of slow economic growth or worse, a housing market collapse. The recent spike in US Treasury yields highlighted the upside risk and its underlying threat to markets. For Asia, as monetary policy in many economies shadows the US in varying degrees, the risk of higher US interest rates translates almost instantly across the region, with a few exceptions.

To be fair, recent market reactions to higher US Treasury yields also partly echoed the markets' growing concern about tightening monetary conditions in Asia. For example, the Reserve Bank of New Zealand surprised the market by raising the policy cash rate by 25bps in its latest meeting. In Australia, where strong domestic demand boosted its GDP growth to a 3-year high in Q1-07, the Reserve Bank of Australia is likely to hold back any easing step and re-tighten later this year. In South Korea, although the Bank of Korea kept its call rate unchanged in the June MPC meeting, the governor's optimism on consumption and exports does add a layer of upside risk to interest rates in the medium term. Money market rates in Taiwan surged as the central bank pushed the New Taiwan dollar stronger to stem capital outflows and subsequently tightened liquidity conditions. Furthermore, tight monetary condition may not necessarily come from deliberate central bank policy. Hong Kong's interbank market rates tightened in late May, prompting concern over possible hikes by commercial banks on their prime and mortgage rates.

The two exceptions where rates are clearly falling are Indonesia and Thailand. Bank Indonesia cut its BI rate in its June meeting by 25bps to 8.5%, as expected, and suggested that further reductions are possible as long as inflation is manageable. With inflation falling faster than expected, rate cuts are still very much on the cards, albeit at a slower pace. In Thailand, following the Constitutional Court's ruling to dissolve the Thai-Rak-Thai Party, political uncertainty is likely to keep confidence on the back foot. Meanwhile, the Bank of Thailand is expected to apply lower rates in order to stimulate growth. In both countries, higher US rates present less of a threat to local market performance.

Cracks in the export pillar?
While markets seem preoccupied by the threat of higher US rates, there are also simmering concerns about the US downside risk. Specifically, exports to the US from the NIEs (Newly Industrialised Economies, i.e. Hong Kong, Taiwan, Singapore and Korea) and the ASEAN countries have eased in recent months. In Q1-07, US imports from the two zones grew by 4.5% and 6.6% year-on-year respectively, compared with 7.1% and 11% in H2-06.

In particular, export growth in Taiwan, Singapore and Malaysia consistently underperformed relative to market expectations (Chart 1). For Singapore and Malaysia, the pace of overall export expansion, on a year-on-year basis, has been volatile and hovering around zero since the start of the year. For Taiwan, export growth averaged 4% in April and May, much lower than the double-digit expansion seen for much of 2006. However, the export landscape for the rest of Asia remains benign. Hong Kong, China, Korea, Thailand and Indonesia are still enjoying double-digit growth. The base effect does little to explain the discrepancy since the strong performers also enjoy similar growth a year ago.

A plausible explanation is that Singapore, Taiwan and Malaysia have been responsible for the production of upstream components that would be assembled in other economies in Asia, especially China. However, evidence supporting this argument is mixed. On the positive side, semiconductor book-to-bill ratio is currently at one, indicating stable outlook to the sector as a whole. Singapore's exports to the US enjoyed strong expansion this year so far, up 12% y/y in the first four months of the year. However, its exports to China, Korea and Hong Kong have contracted. In contrast, Malaysia's exports to the US contracted by 19% in Apr-07, while exports to China grew 23%.

On these mixed set of data, one can draw the early conclusion that US demand from Asia is either stable, or slowing. Meanwhile, the contribution from exports to headline growth for Singapore, Malaysia, and Taiwan could fall, prompting them to be more dependent on domestic demand. This should not be a problem for Singapore and Malaysia, as both economies have seen good support from consumption and investment, as reflected by their Q1 GDP growth figures. Taiwan, however, could be in a more challenging situation as its domestic demand has yet to see a convincing rebound.

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

Environment: Asia's Achilles' Heel

- Energy, emissions, environment are key threats to Asia's sustainable growth
- They need to be addressed by both local and collective action
- Efforts by China and the EU offer some optimism, but need to be reinforced

Asia's stellar economic performance raises millions of eyebrows, but it also faces numerous hurdles. One severe challenge is energy, not just its supply and security which are largely the concern of individual countries, but also emissions and environmental impacts that cut across boundaries and require regional and global efforts to tackle. For example, if each person in China were to consume as much energy as the Americans do today, no one outside China will be left with any energy supply. At current trends, China will become the top emitter of greenhouse gases in the world and India will be the second among developing countries in about a decade. Air pollution, arising mainly from coal combustion and vehicular exhaust, is estimated to have caused about 100,000 excess deaths in India in 2000, and killed about half a million persons in China in 2003. It is obvious that Asia's rise under the traditional energy consumption model could cause huge environmental damage to the world and is quite unsustainable. How likely is it that Asia can maintain its high growth trajectory without sliding down an environmentally destructive path? We believe it is possible, but needs more local and collective action, both by Asia and the advanced economies. In this respect, China and the EU offer some optimism.

Energy and emissions: the key environmental threats
Environmental issues are part of a globalization phenomenon. It is caused not only by energy and emissions, nor is it just confined to developing economies or Asia. Among all the major environmental threats like air pollution, water shortages, soil contamination and declining biodiversity, the ultimate or most damaging impact comes from climate change. Throughout human history, extreme climate events are the most important causes of human suffering. As far as current information can tell, the primary source of climate change is greenhouse gas emissions, predominantly carbon dioxide, which is largely from the use of energy. Fossil fuels are the main sources of emissions, although land use change, forestry and agriculture accounted for more than half of the greenhouse gases emissions in developing economies, according to the World Bank. To be fair, advanced economies emitted the most carbon dioxide, both in aggregate and in per capita terms. Yet, developing countries are more polluting in terms of emissions per unit of energy consumption, with India and China topping the list.

Over the past quarter-century, China's share in world carbon dioxide emissions from the consumption of fossil fuels was more than doubled, having risen from 7.9% of the world total in 1980 to 17.4% in 2004 (Chart 1). During the same period, the share of US edged down from 25.9% to 21.9%, and Europe's share dropped from 25.4% to 17.2%. These trends are partly due to the de-industrialisation of advanced economies, but also have much to do with the rapid industralisation of China. During 1986-95, China's use of electricity more than doubled. It has the fastest growing electric power industry in the world, adding two 500MW thermal plants every week, or the generating capacity of the whole UK grid each year. A similar trend was also evident in other parts of Asia, albeit at smaller scales. During the same period, the emission shares of Indonesia, Thailand and India also more than doubled.

Emissions: different measures
Although China's aggregate emission of carbon dioxide is significant, when calculated in per capita basis, its emission rate is still below world average and is only 18% of the US level (Chart 2). Until now, basically all Asians emit less carbon dioxide than the Americans, with the exception of Singaporeans, whose emission is amplified by the presence of a large refinery industry.

But China has the highest carbon dioxide intensity in terms of emission per unit output. According to the US Energy Information Administration, China emitted about 3.1 tonnes of carbon dioxide per thousand USD output (calculated in 2000 prices) (Chart 3). Other Asian economies are also relatively high intensity producers, including India (1.9 tonnes), Indonesia (1.6), Thailand (1.5) and Malaysia (1.4). Part of this is due to relatively large industrial structure of these economies, but a more important factor could be the type of energy being used.

China's problem is not because of its inefficient use of energy. In terms of energy consumption intensity, or consumption of energy per unit of output, China is actually lower than those of Singapore, Korea, New Zealand, Malaysia and the US, to name a few. Indeed, China has had impressive enhancement in its energy efficiency. In 2004, its consumption of energy per unit of output amounted to only 38% of the level in 1980.

Combining carbon dioxide intensity and energy consumption intensity, we get a measure of the amount of carbon dioxide emission per unit of energy consumption. This should net out most of the effect of economic structure differences. Looking at this indicator, it is obvious that developing economies are generally more polluting when they consume energy (Chart 4). India emitted 0.45 tonnes of carbon dioxide per 1000 BTU of energy it consumed, and China emitted 0.35 tonnes of carbon dioxide likewise. Advanced economies emitted less than 0.1 tonnes of carbon dioxide with the same amount of energy consumption. This is where improvement efforts should be focused on in developing economies. China can half its carbon dioxide emission if it is to improve its intensity to the levels of Indonesia or Thailand, not to mention to as low as in Japan.

One of the main reasons that China was not inefficient in using energy, but was emitting relatively much carbon dioxide is its reliance on coal, a primary energy that is highly polluting. Coal accounts for 80% of China's power, compared to 50% of America, and 70% of India. At current trends, China's carbon dioxide emissions from coal use will double by 2030. Globally, coal burning accounts for 40% of the carbon dioxide emissions from energy use. Hence, one key factor to reduce emissions is to reduce or improve the use of coal. In this respect, a number of initiatives are being undertaken by the Chinese authorities, including a tightening of the Energy Conservation Law, a Top 1000 Energy Consuming Enterprises Program, and ten Key Energy Conservation Projects to refit inefficient coal-fired boilers. More significantly, it has concluded a Near Zero Emissions Coal Agreement (NZEC) with the EU to develop carbon capture and storage technology for coal plants. On the demand side, the Chinese also make active use of the Clean Development Mechanism (CDM) under the Kyoto protocol, which was specifically designed to help reduce pollutants emitted by developing countries.

Trading emissions away: the way out?
According to the Kyoto protocol, main European economies, Canada and Japan are under obligation to cut their carbon dioxide emissions to 5-8% below the 1990 levels by 2012. One of the ways they can do it is through the CDM. Under the CDM, economies that need to cut emissions can earn certified emission reduction (CER) credits by investing in emission reduction projects in developing economies. The rationale is that the impact of greenhouse gases emissions is not location-bounded but the costs of reducing emissions is generally lower in developing than developed countries. This can be viewed as a win-win arrangement. Developed countries can meet their reduction target with lower costs, whereas developing countries benefit from funding and technology transfers. China, India and Brazil are the major prospective host countries for CDM projects.

Projects give promises
The CDM projects approved in China as at Nov-2006 are expected to cut 0.6bn tonnes of carbon dioxide emissions, a 12.7% reduction from the 2004 level, by 2012. That also means China now already has a 30% share of the anticipated enlarged market in 2012. Using current prices, that 1.9bn CER credits translate into USD 1.4bn. The actual size is likely to be more than that, should protocol countries fail to cut down their own carbon dioxide emissions.

While countries like China aim to gain position as carbon emission credits suppliers, the road ahead is not even. First, they face difficulties in matching companies that need funds for CDM projects with those who want to buy credits. Second, the prices of carbon dioxide emission credits have been falling rapidly, because of too many permits issued, foreseen supply from developing economies and the expiry of the current commitment under Kyoto Protocol in 2012. The price per unit of emission credits (each equivalent to a tonne of carbon dioxide) on the EU Emissions Trading Scheme (ETS) dropped from over EUR 30 in mid-2006 to only EUR 0.53 recently. There are other issues need to be addressed such as the disproportion between the cost of reducing different kinds of greenhouse gases and the carbon dioxide equivalent they represent.

Notwithstanding the uncertainties, the benefit of and demand for such trading platforms are clear, especially given the EU's plan to reduce their carbon dioxide emissions to 20% below the 1990 level by 2020. Apart from the ETS, other trading platforms are being negotiated, such as emissions trading between Guangdong in China and Hong Kong that may cover pollutants other than carbon dioxide. Prospective host countries are likely to adopt a more proactive approach towards CDM projects once the uncertainties about the future of emissions trading are cleared. China has already been quite active in this aspect, and trying to educate local corporates and to bring potential suppliers to project investors, resulting in a large market share in the credits markets. To sustain the CDM and support the pursuit of a more sustainable growth model by China and Asia, a market of emission trading beyond 2012 is needed, whether under Kyoto or other framework.

AUSTRALIA

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

Down-under defies gravity

- We raised 2007 GDP growth forecast to 2.8% on domestic strength
- Labour and property pose moderate upside risks to inflation
- We expect the RBA to hike in Dec-07

Domestic consumption and investment momentum has surprised on the upside. Strong domestic demand will help the economy grow by a solid 2.8% this year, against our previous forecast of 2.5%. We continue to expect GDP growth at 3.2% for 2008. Meanwhile, the tight labour market and buoyant housing activity suggest some upside risks to inflation going forward, prompting the Reserve Bank of Australia (RBA) to act before year-end. We now expect a 25bps rate hike in Dec-07, bringing the Official Cash Rate (OCR) to 6.5%. Rates are likely to remain steady throughout 2008.

The Australian economy expanded by a strong 3.8% y/y in Q1-07, the fastest pace in 11 quarters. Growth was entirely supported by domestic demand (Table 1). Private consumption grew by a surprisingly solid 4.2% y/y, and investment growth also picked up to 5.8% y/y from 4.5% y/y in Q4-06. Looking ahead, we expect consumption to remain firm, supported by the increasingly tight labour market and the expansionary 2007/08 budget. The business environment is also largely favourable. Corporate profits continued to rise healthily, and the PMI has been in the expansionary territory for 15 months in a row, rising to 55.18 in May-07 (Chart 1). Capacity utilization is relatively tight, and business surveys point to moderate growth in capital expenditure in coming months.

Export volume growth did pick up. But as import volume grew more rapidly, net exports continued to be a drag to overall growth. Nevertheless, the benefits from the external sector is likely to be passed through in the form of export earnings, which were stronger than we had expected as commodity prices failed to recede. This has contributed to the continued improvement in the terms of trade for Australia. The income filtered through into the economy will help support domestic demand further. On the back of strong domestic demand, we have revised our 2007 GDP growth forecast higher to 2.8% from 2.5%. Our 2008 GDP growth forecast remains at 3.2%.

Upside risks to medium-term inflation
CPI inflation slowed to 2.4% y/y in Q1-07, the slowest pace in two years. However, headline easing in inflation was mainly brought about by stable prices of tradables. Inflation of non-tradables remained at above 3% y/y (Chart 2). We see upside risks to inflation in the medium-term from the vivid labor and housing markets.

The jobless rate fell to a record low of 4.2% in May-07, despite a record high labour participation rate of 65% (Chart 3). This is partly due to technical changes in the calculation method of labour statistics, but admittedly the labour market has been turning tighter. The economy added 39,400 jobs in May-07, bringing the annual rate to 310,000, the highest since Aug-05. The wage cost index rose by 4.1% y/y in Q1-07, slightly above the RBA's informal comfort zone.

The housing market seems to have shrugged off the recent increases in mortgage rates following the RBA policy rate hikes last year. The number of home loan cases has been rising month-on-month since Dec-06, and investment-related home lending also rebounded in Apr-07 after a brief drop in Mar-07. While rising income can justify part of the rises in house prices, households are gearing up with a growing debt burden. The housing affordability index dropped to a record low of 97.8 in Mar-07. The house price to disposable income ratio is also hovering around historically high levels according to the RBA. On the back of these cost-push and asset price inflationary pressures, we expect CPI inflation to pick up going into 2008.

RBA to hike again later
The RBA turned less hawkish in its quarterly Monetary Policy Statement (MPS) released in May, following the soft Q1 CPI numbers. That trimmed market expectations for a near-term rate hike. Yet, the market turned excited again upon recent strong prints of economic data including business confidence, housing market indicators and the employment report. The market is now even pricing in some chances of a hike as early as Jul-07. Judging from the strong economic performance of the economy and the underlying inflationary risks, we now believe that the central bank will hike rates once more before year-end. Previously we expected rates to be steady throughout this year. We have also revised our AUD Libor forecasts accordingly (Table 2).

The issue is when the RBA is going to take action. The ease in headline CPI inflation will buy the central bank some time and we are not expecting a near-term hike. The RBA is likely to closely monitor the Q2 CPI and wage costs index, which are due out on Jun 25 and Aug 15 respectively. We expect inflation to edge up slightly in Q2, but a more obvious pick-up may need to wait until Q3. The federal election, likely to be in November as the ruling party tries to win voters in the meantime, will complicate the matter. We expect the RBA to hike the Official Cash Rate (OCR) by 25bps to 6.5% in Dec-07 after the election, and keep it on hold throughout 2008. Should Q2 inflation prove to be much stronger, the RBA may act sooner, but that is not our core scenario.

INDIA

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

Signs of cooling

- Strong manufacturing drove GDP up 9.4% in 2006/07
- But signs of slowdown are emerging
- Expect one more final rate hike to ensure a soft landing

The Indian economy is running close to its cyclical peak. A tightened monetary grip should see the economy start easing soon, settling on a lower but more sustainable path in coming months. In fact, signs are already emerging that the economy is slowing from its breakneck 9.4% growth achieved in 2006/07. A soft-landing is within reach with just one more final interest rate hike, we believe.

India reinforced its growth story as it posted a 9.4% real GDP growth for FY 2006/07, following a 9% growth in the previous year. Such high growth rates were witnessed only once in 1988/89 when the economy expanded by 10.1% after a drought struck year. Strong growth in the services and manufacturing sectors dwarfed the measly performance of the agriculture sector, which remains the Achilles' heel for the economy (Table 1).

The manufacturing sector was the show stealer as it continued to grow strongly in double digits. This tied up very well with the chugging growth witnessed in the Index of Industrial production (IIP) which grew at 12.9% y/y in Mar-07, much higher than market consensus. The growth in IIP was driven mainly by capital goods, reflecting still strong investment demand (Chart 1). In 2006/07, gross fixed capital formation grew by 29.5%, continuing its acceleration trend after having grown by 26.3% in 2004/05 and 28.1% in 2005/06. Non-oil imports remained strong on the back of heavy capital goods imports. A strong INR that allowed producers to import more cheaply also helps.

Emerging signs of slowing
Despite these strong numbers and an above-expectation 9.4% GDP growth rate, we believe that the economy is already slowing down. First, the surprise was mainly on account of significant upward revisions for the previous quarters and not because of an unexpected acceleration in growth in the last quarter. In fact, the 9.1% growth in the last quarter of 2006/07 was very much in line with our 9% expectation. Also if we compare the quarter to quarter figures, growth has moderated from a high of 10.2% in Q2 to 9.1% in Q4. Interest rate sensitive sectors like finance, real estate and business services have softened over the quarters (Table 1).

The non-food credit growth rate has slowed to 27.2% y/y from a high of 33% touched in the last fiscal year. Though a part of it is reflective of the seasonal downturns and an elevated base, the drop is significant enough to underline a slowdown. Since October 2004, non-food credit growth has always hovered above 30%, and it is the first time to dip below the 30% level for two consecutive months. We expect this trend to continue as the impact of higher interest rates on consumption and production becomes more apparent. One of the leading local commercial vehicle manufacturers is reportedly planning to cut production as demand for its product got hit by higher interest rates. A few leading indicators like vehicle sales also point in the direction that interest rate hikes have started having an impact on consumption demand as well as business sentiment (Chart 3).

A closer look at IIP sub-components indicates that the index of consumer durables has showed constant signs of softening. Few business sentiment indices like that of the Reserve Bank of India (RBI) and the National Council of Applied Economic Research (NCAER) indicate a drop from 4.4% and 3.9% last year to -1.6% and 3.2% respectively.

One of the reasons why a significant slowdown is not yet apparent in the manufacturing sector is that existing production plans normally respond with a lag to tightening measures. Also the support of foreign financing has made the interest rate channel less effective. However we expect the majority of manufacturers to respond more actively in coming quarters as the tight liquidity situation bites deeper, especially since Mar-07. Monetary aggregates like non-food credit and money supply growth have slowed for a couple of months, and a similar trend can be expected for the real indicators too.

Inflation easing, despite temporary rebound
Inflation, the key metric, finally landed within the comfort zone of RBI at 4.85% for the week ended May 26. This was mainly due to lower food prices and smaller increase in the manufactured products' index. Although we expect headline inflation to bounce back temporarily above 5% in the very near future, it is simply a matter of time when it will nestle down again in the tolerance zone. (Also see OTG India: Upside Inflation risks dated June 8, 2007 for more detailed discussion on inflation).

Though we do acknowledge that this is not the best scenario where all concerned areas have shed the "not so preferred exuberance", there are clear signs of the economy cooling off. These signs were clearly missing in the past months and to dismiss all of them as blips might not be justified. Another round of rate hike, more as an insurance policy, should be enough to steer the economy to a lower but more sustainable growth platform, with a lower inflation rate in the current fiscal year. Obviously the long term scenario would eventually depend on real sector reforms more than anything else.

JAPAN

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

Consumers are back, gradually

- Consumption is picking up, but not wages yet
- Business sector growth stays solid
- BoJ to hike O/N Call Rate by 25bps in Q4-07

Japanese households are starting to consume, while the business sector remains in good shape. This development is conducive to a more sustainable growth path. Looking ahead, wages continue to be a crucial transmission medium, as the rise in overall household income hitherto came in the forms of irregular payment. A more broad-based growth and some upward pressures on wages amidst a tight labour market should pave the way for the Bank of Japan (BoJ) to tighten again. We continue to expect a 25bps hike in the Overnight Call Rate in Q4-07, when consumer prices are expected to register more obvious increases.

Consumption picking up
Recent indicators from the household sector are painting a more bullish picture for the economy. While consumer confidence remained below the watershed level of 50, household spending has been rising year-on-year since the start of this year, a clear reversal from declines in 2006 (Chart 1). Q1 GDP report also showed a 0.9% q/q rise in consumption, following a strong 1.1% q/q growth in Q4-06, with particularly heavy spending in durable goods and services.

Meanwhile, the labour market is turning increasingly tight, with the number of employed rising steadily and the jobless rate falling further to a 9-year low of 3.8% in Apr-07 (Chart 2). The Tankan survey (short-term economic survey of corporates) showed that Japanese companies now see the most severe shortage in labour supply in 14 years.

Capex slows, but business in good shape
The pick-up in consumer spending is timely in reinforcing the growth momentum of the business sector and making the current economic up-cycle more sustainable. Operating ratios of Japanese companies continued to improve (Chart 3). According to the Q1-07 Tankan survey, companies are largely upbeat about their current conditions and outlook, with over 60% of the responding companies seeing conditions as favourable. While companies still see excess supply in the goods market, this excess is diminishing. Wages are likely to go up as the business sector remains in good shape.

Meanwhile, investment growth may slow down as the inventory cycle matures (Chart 4), and as companies shift their focus to enhancing returns from expanding capacity, which does not necessarily mean they are less optimistic about their business outlook. Against this backdrop, domestic consumption is likely to take up a bigger role in propelling economic growth going forward.

Risks of deflation low
While CPI inflation dipped briefly into negative territory recently, other measures of price and inflation suggest that it is unlikely for the economy to go back to a deflationary spiral. Domestic corporate goods prices rose by 2.2% y/y in May-07 and corporate services prices by 1.1% y/y in Apr-07. Meanwhile, the tight production capacity and labour market conditions as suggested by the Tankan survey should point to some cost-push pressures in coming quarters (Chart 5). The Bank of Japan (BoJ), paying particular attention to the positive output gap, is also quite confident that general price levels in the economy will continue on an uptrend.

BoJ to act in Q4-07
Recent economic developments are turning increasingly favourable for the central bank to take action before year-end. BoJ Governor Fukui's recent hawkish comments also fueled market speculation for an early move. We however continue to see the next move to be more likely to come in Q4-07 rather than Q3. While the central bank's intention to bring interest rates back to neutral - can be somewhere around 2.0-2.5% judging from the economic fundamentals - is obvious, it needs yet more concrete data, especially on the price front, to convince investors they are making the right move, in our view. The House of Councilors election in July, the negligible CPI inflation and headline wage growth are all obstacles to an early BoJ move.

On Fukui's comments, we would caution against reading too much into them. First, his comment that the BoJ "can raise rates even when prices are falling" may just be another way of saying there is no predetermined timing for rate hikes. Second, Fukui was also very hawkish back last Sep/Oct, sending confusing signal to the market. Third, we believe it is difficult for the BoJ to have a preset timetable for policy actions, given the complexity of different policy and political considerations.

More likely, BoJ's actions are data driven. In its half-yearly report released in Apr-07, the central bank revised downward its FY 2007 core CPI forecasts from 0.4-0.5% to 0.0-0.2%, and expected it to hover around zero in coming months. We expect CPI inflation to pick up gradually, averaging 0.4% y/y in Q3 and 0.6% y/y in Q4, on firm domestic demand. By then the BoJ will have the bargaining chips to raise the Overnight Call Rate by 25bps to 0.5%. Should prices rise or the economy develop at a faster pace than expected, the BoJ may hike rates earlier in Q3, but this will likely be after the election.

SINGAPORE

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

Party continues

- We raised 2007 GDP growth forecast to 6.8% from 5.5%
- Strong inflows are expected to cut 3M SIBOR to 2.25% by end-07
- We see the SGD to strengthen to 1.49 versus USD by end-07

Strong service sector growth and a sustained construction rebound boosted Singapore's GDP by a real 6.1% y/y in Q1-07, defying gravity and prompting the government to raise its full year growth forecast for 2007 by half a percentage point to 5.0-7.0%. We believe this new target is well attainable and we have also raised our own GDP growth forecast for 2007 to 6.8% from 5.5% before. Despite higher growth, sustained liquidity inflows are expected to keep local interest rates down, while a strong SGD should keep prices in-check, at least in the medium term. These may sound too good to be true, but for the time being, things are likely to stay rosy in Singapore.

Upward revisions
Final Q1 GDP growth figures were little changed from the initial estimates at 6.1% y/y and 7.6% q/q. The figures surprised the markets on the upside as consensus was expecting the final Q1 GDP to be revised down on softer exports and industrial production. Much of the growth was attributable to the services and construction sectors. The services sector contributed approximately 5 percentage points of the 6.1% seen in Q1 while manufacturing and construction accounted for the remaining. Within services, financial services was the star performer expanding a whopping 12.9% y/y building on the already strong performance of 11.1% y/y clocked in Q4. Undoubtedly, the current bull-run in the equity market (Chart 1) has been a major contributor to growth in the sector. On construction, the sector expanded 9.7% y/y as the two casinos and numerous private residential projects are fueling a mini construction boom.

The stronger than expected showing from the domestic economy prompted the Ministry of Trade and Industry (MTI) to upgrade its growth forecast for 2007 from 4.5-6.5% previously to 5.0-7.0%. This is the second time this year that the MT upgraded its outlook. What wrong-stepped the markets was the strength of the domestic economy. For an economy whose external sector is 388% of GDP, the slowdown in exports will have a material impact on growth (Chart 2). Now that the leading indicators are looking to trend up, H2-07 growth will most probably be stronger than H1 and we are revising our 2007 GDP forecast from 5.5% to 6.8%.

Liquidity to drive rates lower
Despite the better economic outlook, we do not expect interbank rates to be rising. Interest rates in Singapore are largely driven by fund flows. At the recent 8th Singapore Roundtable, a paper was presented on the monetary framework and drew interesting views from private sector economists and policymakers, providing an insight into Monetary Authority of Singapore's thinking. The paper argues for a case that positive structural changes to the economy have made the SGD the de facto Swiss franc of the east and more inflows can be expected. The stability of the SGD over the past two decades has anchored inflation expectations and is increasingly making it a reserve/hard currency. The paper suggested that in such an environment it was appropriate to reconsider the exchange rate policy. The suggestion was not to abandon the current Basket, Band, Crawl (BBC) but to widen or soften the bands i.e. not intervene strictly whenever there is a breach of the bands and to augment the BBC with a more active interest rate policy.

Current low interest rates are a result of the policy trilemma where a central bank can only manage its interest or exchange rate and not both in an open capital account system. Given strong liquidity inflows (Chart 3), the MAS' ability to manage local interest rates would be limited if it were to maintain its exchange rate targets. This is precisely why the MAS said that there has been no change to its exchange rate policy and it does not seek to influence interest rates even though it hoped low rates will deter speculative buying of SGD. We believe the MAS will keep its SGD appreciation policy unchanged in H2-07.

However, low rates at this time could potentially send the wrong signal of an "easing" policy direction, especially when the asset heavy economy is facing asset price inflation. Nevertheless, the MAS appears unwilling to explode its balance sheet to mop up liquidity and interest rates have fallen subsequently (Chart 4). In this situation, we can expect more volatility in the interest rate market, as seen by the recent pullback in interbank rates as liquidity shrank ahead of the summer holidays. The pullback was in line with our expectations but clearly unlikely to retrace to the previous levels. As such, we have adjusted our forecasts accordingly (Table 1).

On the currency, the SGD is a major beneficiary from the inflows into equities and property markets. We see the current pullback in USD/SGD and indeed USD/Asia as only temporary and expect the carry trade to resume once the summer holiday period is over. We expect the USD/SGD pair to trade to 1.49 by year end from the current level of 1.53 despite our lower SIBOR forecasts. This is largely due to sustained inflows into the local equity and property markets on strong economic fundamentals and in anticipation of further asset price gains.

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