Asia Focus: Easy Money, No Easy Solution: Asia is awash with excess liquidity, which could spell trouble ahead and risk derailing its high-speed growth. We believe liquidity is buoyant, but still far from excessive in most Asian economies, and the problem is not just confined to Asia. It is part of a global phenomenon and needs a global solution. While we believe central banks in the region generally need to tighten further, there is no one-size-fits-all solution. One common piece of advice on the liquidity threat, however, is for investors: they need to be more careful and less complacent in pricing risks.

Economy Highlights

China: Despite higher interest rates and a stronger CNY, the Chinese economy continues to defy gravity. While the heavy industry-led mode of expansion contradicts the government's long-term objective of shifting to a more sustainable and efficient development model, the near term concern remains on rising inflation and stock market exuberance.

Indonesia: Lower inflation may prompt BI to cut rates to 7.5% by YE-07. While GDP growth remains stable, it needs more structural reform to be sustained. However, the lack of parliamentary majority will continue to limit government successes.

Pakistan: Pakistan's investment-led expansion is facing three severe challenges: politics, liquidity and power shortages. Of these three, politics perhaps poses the most tangible threat. Liquidity risks are manageable as inflation is subsiding. The power situation is worrisome and will probably worsen before getting better.

Taiwan: The economy is poised for a mild rebound in H2-07, given the latest government measures to prop-up domestic demand ahead of the Legislative and Presidential elections. A tight labour market and strong equity prices should also support the expected recovery in consumer demand, prompting us to raise our GDP forecast for the year to 4.5% from 4.1%.

OVERVIEW

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

Liquidity calls for tighter policy

- Investor appetite for Asian assets stays strong
- Thanks to geopolitics, growth prospects, and liquidity
- This will likely force Asian central banks to tighten more

The first half of 2007 is characterised by investors' strong appetite for Asian assets and the shifting of central bank focus from the risk of growth slowdown to inflation. Both trends are likely to extend into H2-07, given our optimism on Asia and its currencies.

Strong appetite for Asian assets
Geopolitics, a potent source of market shocks in 2005 and 2006, thus far has only little impact in 2007. In fact, its development has been moving in a positive direction. Tensions in the Korean peninsular have subsided significantly, with the resumption of Six-Party talks and Pyongyang pledging to halt its nuclear activities and allowing the IAEA to inspect its facilities. Moody's also hinted that South Korea could be on the verge of a sovereign rating upgrade. In Thailand, the political environment is more challenging, with the uncertainties around the next general elections and caution towards public support of a draft Constitution. This has led to weak consumer and investor sentiment, but the silver lining here is that fundamental social stability remains largely intact, underlining a strong desire and support for normality among the general public. For Taiwan, the two key political parties are now moving towards preparing for the presidential election in 2008, with both sides confirming their candidates. A positive sign is that both candidates are advocating moderate policies and focusing on economics, rather than provoking Beijing or cross-straits confrontation.

With the absence of geopolitical surprises, investors have been focusing on potential external shocks, such as the sub-prime mortgage market in the US. The combination of the sub-prime market credit quality deterioration, and sharp correction of the Chinese market in late February spilled over into the global financial market, which led to a brief period of risk aversion amongst investors. Yet, buoyed by ample liquidity, investors were able to quickly find their footing and saw these corrections as opportunities to get into Asian assets again. In fact, benchmark stock indices in China, Hong Kong, Taiwan, South Korea, Singapore, Philippines, Malaysia and Indonesia all hit record highs in H1-07. Thailand also reached its post-financial crisis peak despite on-going political uncertainty and the authorities' effort to deter short-term capital inflows.

Moreover, this optimism overcame weak export data for Malaysia, Singapore and Taiwan in recent months. Exports of electronic and electrical products, bellwether industries for these three economies, have been weak. For Singapore and Malaysia, the headline export growth rate was supported by pharmaceuticals and commodities respectively. Without an equivalent industry offsetting the slowdown in electronics, Taiwan's export performance was the weakest in Asia, registering only 6.8% y/y growth in the first five months of the year. Yet, investors seem to be betting on such slowdown in exports as a temporary phenomenon, with the inventory correction coming to an end. After all, demand from Europe and Japan remains strong, and US economic fundamentals appear solid, despite recent concerns on CDOs and sub-prime mortgage. The outlook for Asian exports therefore remains positive. More importantly, domestic demand in Hong Kong, China, South Korea, Singapore, Malaysia and India is robust, which helps to reinforce investor confidence.

Passing the liquidity buck
Central banks in Asia now seem to be more focused on the upside risk to inflation than downside risk to growth, compared to the start of the year. Consumer inflation in Asia remains relatively low, only China, Indonesia and India have headline consumer inflation above 3%, yet monetary growth in selected economies is high. As our theme article points out, some economies are flush with liquidity and this brings us back to the asset inflation mentioned above. The risk is that such liquidity could also feed through the system, leading to higher inflation to the broader economy. Of course, commodity prices, especially energy and food prices, are very much on central banks' radar screens as potential source of inflation. The tight labour market, due to strong demand to meet growing business volume, is also considered as a potential source of inflation.

As a result, the tightening bias of monetary policy around Asia has returned. The Bank of Korea is expected to restart raising interest rates to curb lending growth and pre-empt inflation risk. Despite low inflation, Bank Negara Malaysia has repeatedly said that the current rates are appropriate, implying reduced need to ease monetary policy. The Taiwan central bank raised its benchmark rediscount rate by 25bps in its Q2-07 MPC meeting, double that of its previous moves and our expectation. It also indicated that the current round of monetary tightening still has more to go. More reserve ratio hikes and lending rate hikes are expected in China given steady capital inflow, rising inflation, rapid investment and hyped stock market. The Bank of Japan is still refraining from giving a clear indication of the timing and magnitude of tightening, even though there is little doubt that the BoJ is also gearing up for a hike. Several BoJ board members have indicated the disadvantage and potential issues with keeping rates low for too long. The exceptions, as we have indicated in the past, are Indonesia and Thailand. Both central banks still have scope to cut their benchmark rates further to boost their domestic economies. However, we believe that both are also approaching the end of their rate cutting cycle.

Further to using interest rates and reserve requirements to manage domestic liquidity, some economies are also looking to eject excess liquidity from their own system to the global market. China, for example, is relaxing its restrictions on domestic investors investing in overseas financial markets via the Qualified Domestic Institutional Investor (QDII) scheme. Other economies are also looking into ways to allow domestic businesses or investors to invest more overseas in order to cut excess liquidity or reduce upward pressure on their currencies. While economies may pass the buck of liquidity around, the fundamental issue of a world flushed with liquidity remains unresolved. This suggests tighter monetary policy in some Asian economies going forward.

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

Easy money, no easy solution

- Liquidity is buoyant, but still far from excessive in most Asian economies
- The liquidity problem is part of a global phenomenon, and needs a global answer
- Central banks generally need to tighten more, investors also should be alerted

Asia is awash with excess liquidity, which could lead to trouble ahead and risk derailing its high-speed growth. This sounds familiar, like the prelude to the Asian financial crisis ten years ago, or even worse, given that excess liquidity now also exists in China and India, the two giants that escaped the previous crisis. We believe the above concern is genuine, but the worry appears overdone, especially in terms of the risk of any imminent crisis. Liquidity is buoyant, but still far from excessive in most Asian economies, and the problem is not just confined to Asia. It is part of a global phenomenon and needs a global solution. In fact, the excess liquidity situation is getting less rather than more serious as central banks tighten their monetary grips. While we believe central banks in the region generally need to tighten further, there is no one-size-fits-all solution. Specifically, the paces and tools of tightening should vary given the different situations and structures of the Asian economies. Policy makers would also need to be careful in differentiating between the threats of higher asset prices versus higher consumer prices - the dichotomy of inflation. One common piece of advice for investors is that they need to be more careful in pricing risks.

The problem of excess
Many of the benchmark equity indices in the region are setting new highs, property markets are reviving with record prices in the higher-end for some economies, and the carry trade is becoming even more fashionable. The risk of excess liquidity inflating demand and prices beyond sustainable levels is rising. However, to address the issue appropriately, we need to put it in the right context.

There are several definitions of liquidity. It can mean how quickly assets can be turned into cash on the balance sheet. It can also refer to the ability to trade assets without triggering significant price changes. The current concern or focus is, however, on the overall monetary conditions including money supply and interest rates that contribute to too much money chasing after too few goods or assets. But the balance-sheet concept is also relevant, particularly for corporates, as they contributed to the pick-up in savings for advanced economies, which in turn helps boost funds in the markets.

Money supply is rising rapidly in many places. Our measure of Asia's broad money supply (MS) growth picked up from below 6% y/y during early 2005 to near 10% recently (Chart 1). In the longer-term, money supply growth should be in line with nominal GDP growth, assuming velocity is constant. We have tried to derive an MS/GDP ratio for Asia using GDP-weighted average. But the true picture is masked by the fact that China has a much lower ratio than Japan but the former has been increasing in nominal economic size rapidly while the later shrank. So the resulting ratio using GDP-weighted average has a significant downward bias. Also, mixing data from economies at different stages of development, especially in terms of monetary systems, would risk including too much noise into the analysis. For example, a transition economy like China would normally see its MS/GDP ratio rising as the economy becomes more moneterised. In contrast, economies that suffered from severe deflation like Hong Kong and Japan naturally see their MS/GDP expand with the collapse of GDP.

From another perspective, we try to look at individual ratios (Chart 2). In China, this ratio rose from around 50% ten years ago to 73% of late. In Hong Kong, the ratio rose from below 200% in the mid-1990s to 350% recently, as foreign capital poured into this small economy betting on CNY appreciation and subscribing to buoyant IPOs. The rise in this ratio for Japan has been less obvious, from around 200% in 1998 to 236% last year, and largely was caused by the decline of GDP. Those for South Korea, Singapore and Taiwan also rose by 14-36% in the past decade, but this can hardly be qualified as excessive given that the annual expansion of their MS/GDP ratio is less than 3.5%. In fact, for most of the Southeast Asian economies like Indonesia, Malaysia, Thailand and the Philippines, their MS/GDP ratios have declined or barely changed over the past decade. Therefore it is debatable whether money supply in Asia has been rising exorbitantly and resulting in "excess" money in these markets.

From a broader perspective, concern about rapid monetary expansion is not confined to Asia. Our measure of G15 money supply growth, which includes major economies such as the US, EU and the UK, rose from below 7% in mid-2004 to around 10% of late. Other measures of liquidity also show accelerating trend. For example, the growth of US monetary base plus international foreign reserves picked up from 10% in early 2006 to nearly 20%.

Sources of 'excess'
Is this the so called "money glut" or a "saving glut"? The two concepts are interrelated or indeed the two sides of the same coin. The former starts with the US saving too little but borrowing too much, which results in the huge trade deficits and dollar inflows into Asia. Asian governments, in order to curb the appreciation of their currencies, need to buy dollars and flood their local markets with liquidity, leading to the high money supply growth. The saving gluts argument starts with Asia saving too much but investing too little locally, thus resulting in a large trade surplus which ends up with huge forex reserve buildup that floods the global financial markets. Clearly, both are referring to the same phenomenon, and the dispute is over the causality, which is difficult to assess.

In an earlier issue of Asia Focus, we provided a detailed analysis on why Asia is not saving too much, but investing too little (Mar-06). Asia's savings rate has been quite steady at between 32-34% of GDP over the past decade. But the investment rate declined from 33% in the mid-1990s to 22% now. The gap between the two is reflected in the huge trade surplus. There can be many reasons behind this. First, corporates had been restructuring their balance sheets after the Asian Crisis, and this past experience makes them conservative in their investment plans even when most of them have fully recovered. Second, the lack of a comprehensive safety net, appropriate credit channels or investment opportunities in some markets encourages people to save but not invest enough. With much savings but lack of desired physical investment, money naturally flows into financial assets and real estate.

Loose monetary conditions is another cause of ample liquidity. Technological advancement and globalization that allows better supply-chain management have added much to productivity in the past decades. This contributed to higher global growth without too much inflationary pressures, and has allowed central banks to maintain interest rates at low levels. Real interest rates in major economies had been extremely low or negatives from 2002 to mid-2006 (Chart 3).

With easy money, investors are taking more aggressive approaches in their investment, as reflected in the narrowing of spreads between bonds in emerging markets and the US, and the prevalence of carry trades. It is difficult to gauge how large carry trades are. The percentage share of foreign banks' borrowing in total outstanding amount in Japan's Call Money Market - short-term money market - may shed some light on how fashionable this type of trades is. The share rose from a low of 2.9% in mid-2004 to over 40% now (Chart 4 ).

The inflation dichotomy
Yet, as central banks are turning more hawkish since mid-2006, even when headline inflation has eased, monetary conditions have been turning tighter. While CPI inflation remain tame even against the backdrop of ample liquidity, asset price inflation seems to have picked up more, which is a concern for central banks. In Singapore and South K orea, residential property prices are posting double-digit growth, rising much faster than general consumer prices. First, healthy corporate operating ratios mean companies are absorbing part of the increases in costs through margin squeeze, resulting in contained CPI inflation. Second, this also reinforces the view that at least part of the rises in asset prices are driven by liquidity, as excess money will naturally flow into assets rather than consumer goods. In previous issues, we have argued that in terms of valuation, property prices in Asia are not too demanding.

Thus far, policy makers are being cautious in monitoring if asset price inflation will feed through to inflation in the broader economy. Policy makers are also being prudent to twist the monetary conditions in anticipation for any inflationary threat triggered by swift changes in market liquidity that may contribute to an abrupt turnaround in financial markets. The Reserve Bank of Australia (RBA) remained hawkish, though keeping rates on hold, on the back of inflation pressure next year. The Reserve Bank of New Zealand surprised the market by raising its headline policy rate to 8% in anticipation of possible inflationary risk in 2008 or even as far away as in 2009. The Fed shrugged off softening economic growth and focused on inflation pressure from the tight labour market. The European Central Bank signaled more hikes to come. These are timely reminders to investors who are too complacent about risks.

Invest more, not save less
In the longer-term, the issue of under-investment needs to be addressed, which cannot simply be achieved through monetary policy. When central banks try to keep deposit rates low in order to discourage savings, funds flow into the "undesired" equity and property markets. Then policy makers may need to raise rates back to correct the dis-incentives to save. The fundamental problem is the lack of viable investment projects, or the lack of an effective channel to pool funds to them. This, again, requires more development in the financial markets, such as infrastructure financing.

CHINA

Jason Chang
Economist, +86 21 5887 1230 extn.5675
Jason.Chang@cn.standardchartered.com

No sign of slowing

- Strong investment and exports may have raised GDP by 10.6% in Q2-07
- Rising food prices and stock market exuberance remain a concern
- We expect the PBoC to hike rates again in Q3, and more in 2008

Despite higher interest rates and a stronger CNY, China's economy continues to defy gravity, maintaining its double-digit growth pace with the support of strong investment and exports. While the heavy industry-led mode of expansion contradicts the government's long-term objective of shifting to a more sustainable and efficient development model, the near term concern remains on rising inflation and stock market exuberance, as indicated in the Q2 meeting statement of the People's Bank of China (PBoC) Monetary Policy Committee (MPC), which called for a subtle change in policy from a 'prudent' monetary policy to one of 'moderate tightening'. With major economic indicators continuing to power ahead and the CPI, especially food prices, likely to rise higher, we expect the PBoC to raise its 1-year lending and deposit rates by 24 bps and 27 bps respectively in Q3, along with a few more reserve ratio hikes.

Strong investment and net exports
China's economy continues to power ahead. Urban fixed asset investment, supported by strong corporate profit and bank lending, rose 25.9% y/y in January-May, up from 25.3% in Q1-07. Investment in heavy industries, especially non-ferrous metals and machinery, grew at over 50% y/y in January-May. These undermine the government's efforts to shift to a more sustainable growth model with better energy conservation and environmental protection. To cool down investment, the PBoC has raised interest rates twice, on Mar 18 and May 19 respectively. Yet, there remain few signs of any imminent investment slowdown.

Exports also shows no sign of abating, up 27.8% y/y during Jan-May 07. Efforts to promote imports and curb exports, such as lowering export VAT rebates and gradual CNY appreciation, have thus far had little success. China's exports to the G3 economies remains solid, up 24% y/y during Jan-May. Exports to the EU was particularly strong, having grown 37.1% y/y and surpassed China's exports to the US in Feb (for the first time) and May. Import growth remains stable, running at around 20% y/y. As a result, the trade surplus remains large and it reached USD 66bn in Q2, a 74% y/y rise. On the back of strong growth in investment and net exports, we expect real GDP growth to remain strong at 10.6% y/y in Q2.

Inflationary pressures are yet to ease
Driven by high food prices, particularly pork and eggs, CPI inflation accelerated to 3.4% y/y in May, the highest since Mar-05. On top of rising demand, higher food prices were also due to higher costs of animal feed and a 'blue-ear' pig epidemic. Food prices are likely to stay high until late Q3 or early Q4 when supply responses initiated by the government in H1 start to take effect. Ex-food inflation remains tame, but is also under increasing upward pressure given elevated energy prices and limited productivity gains in low value-added goods. A recent PBoC research paper predicted that CPI will rise 3.2% y/y in 2007, above PBoC's target of 3%. Some economists even believe that CPI is actually in the region of 4-6% instead of today's 3-4%, arguing for more interest rate hikes. We believe that inflationary pressures will persist in the short term but will ease in Q4, bringing official inflation to average 3% y/y in 2007, though the risks of it breaking higher are present.

Stock market exuberance
Another big thing on Beijing's policy agenda is the stock market. Following the tripling of stamp duty to 0.3% in late May, the Shanghai and Shenzhen stock markets have both experienced big swings, reflecting more nervous sentiment. So far the Shanghai A-share Composite Index is down by 20% from its peak. The possible move by the State Council to lower or remove the 20% interest rate income tax (recently approved by the National People's Congress) may well keep investors uneasy. However, its impact should not be exaggerated. A complete removal of the 20% interest rate tax would raise deposit return by 60bps. Based on the latest inflation data, real deposit rate would still be negative (3.06% for 1-year deposit rate vs. 3.4% inflation). Despite further relaxation in the QDII scheme, domestic investors still have only very limited investment channels. With strong 42.1% y/y corporate profit growth in Jan-May, it would still be difficult to expect a large exodus of funds from the stock market.

PBoC to hike again in Q3
As we have previously highlighted, we believe the PBoC has become more skeptical about the importance of the interest rate differential between China and the US. This means forecasting rates now is trickier than before. Considering the more hawkish stance expressed in the Q2-07 MPC meeting statement of the PBoC, especially regarding strong growth, rising inflationary pressures, and the stock market exuberance, we expect the PBoC to raise the 1-year lending and deposit rates by 24 bps and 27 bps respectively in Q3-07, and to hike the reserve ratio to 14% by end-07. We believe pressure for higher rates will continue in 2008 and the PBoC may have to raise rates further.

INDONESIA

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

Lower rates, but reforms are key

- Lower inflation may prompt BI to cut rates to 7.5% by YE-07
- GDP growth remains stable, but needs reform to sustain
- The lack of parliamentary majority limits government successes

The positive impact of continual interest rate cuts is increasingly felt on the real economy, which has been severely affected by sharp hikes in fuel prices and interest rates in Q4-05. Lower inflation also gives Bank Indonesia (BI) more room to cut its BI rate, but the burden of economic stimulation needs to shift further from BI to the government, which has pledged to accelerate policy reforms and improve investment climate further. While the government's commitment to reforms is strong, it lacks the parliamentary majority needed to ensure their approval and implementation. Investment and GDP growth are likely to remain below potential in 2007.

Fast but fragile economic growth
Over the year, the Indonesian economy has recovered gradually from the mini-rupiah crisis in H2-05. Real GDP growth rebounded from 5.0% y/y in Q4-05 to 6.1% in Q4-06. However, performance of the economy in Q1-07 poses questions on the sustainability of the recovery. Real GDP growth in Q1-07 eased marginally to 6.0% y/y. Household consumption fell by 0.5% on a quarter-on-quarter basis, down from a 1.9% q/q growth in Q4-06. Likewise, fixed investment (23% of GDP) shrank by 5.9% q/q in Q1-07, down from 8.1% q/q growth in Q4-06. Investment growth also eased sharply from 31.4% y/y to 7.0% y/y.

Without stronger domestic demand, especially investment, the current recovery may not be sustainable, let alone meet the government's 6.3% real GDP growth target in 2007 and president Yudhoyono's pre-election target of 6.6%. The latest business indicators also cast doubt on the strength of the current recovery. For example, car and motorcycles sales in May-07 were still around 25% lower than their peaks before the fuel price hike in Q4-05. The good news is that the poverty rate has come down to 16.6% of the population in Jun-07 from 17.8% a year earlier, though it is still higher than the 16.0% rate seen before the fuel price hike. Likewise, unemployment rate has retreated to 9.8% from 10.3% over the same period, though high underemployment casts doubt on the real progress.

There is only so much that BI can do...
Real investment remains weak despite a total of 450bps cut in BI rate over the past 15 months. While lower rates have raised bank credit growth to 17.4% y/y in Apr-07 from 14.1% at YE-06, it is still significantly lower than the post-97 growth record of 31% reported in Sep-05 before the fuel price hike. On the good news, there are indications that lending has accelerated further in Q2-07 and that banks' loan-to-deposit ratio has surpassed 60%, up from 53.0% in Dec-06. But the rise was contributed by higher consumer loans rather than by investment.

While there is still room for further BI rate cuts, it is likely to be limited given the risk of inflation. BI now expects inflation to be at the lower end of its 5-7% range forecast by YE-07. With inflation edging down to 5.77% y/y in Jun, we have revised our inflation forecast to 5.5% y/y in Q4-07 from 6.2%. Lower expected inflation, coupled with IDR stability, has convinced us that there is now a bigger scope for further BI rate cut to 7.5% by YE-07 vs. our previous forecast of 8.0%. However, rate cuts alone will not be enough to boost real investment and GDP growth.

...while the government could do much more
It is increasingly obvious that more fundamental policy reforms are needed to boost real investment. Given that economic growth in the first half of president Yudhoyono's five-year term has been dampened by natural disasters and austerity economic measures, he needs to accelerate real investment before the next presidential election in 2009. In this respect, the government recently made a few announcements:

1. New investment law. Details of the law were explained in Asia Focus, Apr-07 issue. Some concerns were raised, however, over the "negative investment list", which caps foreign ownership in the fixed-line telecom sector at 49% and the mobile-phone sector at 65%. Luckily, the list does not apply retroactively and no foreign investors (e.g. Temasek) have to reduce their investments.
2. New tax law. Parliament has passed one of the three planned tax laws (please see Indonesia economic indicators, Jun-07), which basically strengthens taxpayers' legal standing in the tax office.
3. Revival of privatisation program. The government is now planning to privatise 30% of Bank Negara Indonesia (BNI) for USD 1bn in Aug-07. It also plans to privatise two more state enterprises in Sep-07, before proposing to parliament to divest 20 more.

On top of the above measures, much remains to be done to improve the country's investment climate. The government, for example, has yet to revise the pro-labor manpower law. The biggest hurdle to rapid reforms has been the lack of parliamentary majority of the coalition government. As such, many of the reforms were diluted by political compromises (like the negative list under the new investment law). Given the slow pace of reforms, the government's GDP growth targets of 6.3% in 2007 and 6.8% in 2008 are unlikely to be achieved.

PAKISTAN

Ahsan Chishty
Economist, +92 21 2442008
Ahsan-Javed.Chishty@pk.standardchartered.com

And now the Rubicon...

- Pakistan's investment-led expansion is crossing the Rubicon
- But it faces three obstacles: politics, liquidity, power shortages
- Among the three, politics is the most challenging

Pakistan's investment-led expansion is facing three severe challenges: politics, liquidity and power shortages. Of these three, politics perhaps poses the most tangible threat. Liquidity risks are manageable as inflation is subsiding. The power situation will probably worsen before getting better in early 2008.

The engine
The Pakistan economy expanded by 7.02% in FY07 (ended in March 2007) against 6.6% in FY06. The prime growth propeller was investment. Gross domestic capital formation expanded by 20.6% y/y, against 17.6% in FY06. Private sector investment grew by a notable 19.6% y/y, boosted by an expanding middle class (which now accounts for about 60% of total income against 56% in FY04), rising real income, strong remittance growth and recovering domestic savings. Going forward, however, we believe investor confidence will be tested by three challenges: 1) political elections, 2) liquidity management and 3) power shortages.

River crossing
Many people believe this is a year of living dangerously in Pakistan, given the severe political challenges ahead. Much of the tension is circled around the legitimacy of the current regime, especially the soon-to-be-announced timetable for parliamentary and presidential elections. The exact sequence of the two elections is critical but also a chicken and egg puzzle. Constitutionally, the President's term runs out before the parliament's, which implies that the sitting assembly may be allowed to re-elect the President. The opposition has voiced concern about the arrangement, along with the US administration, an important strategic ally of the current regime. But until now, this appears to be the road most likely.

Aside from some social disturbances in Karachi in mid-May, political uncertainty has yet to impact on investor and consumer confidence. In fact, the most likely scenario of a re-election of President Musharraf will probably buoy business sentiment, although, disturbances in the lead up to the elections in the urban areas might blunt investor confidence and delay business expansion plans. For instance, a one day shutdown of Karachi could cut GDP by 0.1%. More radically, a change in leadership or a delay in elections, though a highly improbable event, may lead to a pull back in the significant public investment planned.

No walk, just talk?
In midst of elevated political risk, the economy is experiencing a veritable positive money supply shock. Net foreign assets in FY07 grew by USD 2.5bn, taking broad money growth to above 16% against the original target of 13.5%. This, together with an expansionary fiscal policy (read OTG: Pakistan on June 11, 2007) and partial sterilisation, left the central bank with an itchy trigger finger. Lately, central bank commentary was laced with hawkish tapestry and the Governor recently stated that demand pressure from populist fiscal measures would need to be controlled with appropriate rates.

We, however, believe that the walk might be drearier than the talk. The odds are evenly stacked as far as inflation risks are concerned. Headline CPI is within the central bank's adjusted comfort band. Core inflation in May stood at 4.7% y/y, against 5.2% y/y in the prior month. The central bank's concerted effort to keep excess demand in check is paying off, with the increment of aggregate credit down 27% y/y. Additionally, a significant food surplus in FY07 is likely to limit the rise in food prices. Hence, we expect inflation to settle at 6.2% y/y in FY08, against 7.5% currently. However, strong capital inflows may still lead to tighter statutory liquidity measures and further crowd out private sector advances. Given sluggish credit expansion, more monetary tightening could have torrid impact on investment.

Power off
It has been a summer of woes for the average household. Currently, daily power shortage in the country oscillates between 750MW to 1250MW, leading to 5-6 hours load shedding. This deficit can potentially rise to over 2000MW in coming quarters. Over the years, power infrastructure has been grossly neglected while electricity demand has advanced at an 8-10% annual pace. Currently, Pakistan's total installed capacity is 19GW, against over 110GW in Thailand. Even though installed capacity outstrips demand (15-16GW), inefficient grid systems, theft and poor load management have led to supply shortages.

So far, the brunt of power shortages has been borne by the residential sector as the government tries to keep the commercial/industrial capacity running. Industry has also been saved by self-installed generators, which added around 594MW of supply - or 1000MW in 2 years. However since most of these are thermal based, higher fuel costs have accentuated industry woes. Additionally, new capital formation has to account for captive capacity, higher energy costs and consequently a lower return on capital. A worsening of the power shortage is likely to make business decisions more difficult. There is some hope - new capacity of 300-400MW will be available within the next 6 months. The first instance of a power surplus may emerge in 2008-09 when 22 other power projects are expected to come online.

TAIWAN

Tony Phoo
Economist, +886 2 6603 6338
Tony.Phoo@tw.standardchartered.com

Consumer spending to spice up H2 growth

- Anecdotal data suggests likely consumption rebound in H2
- ...supported by a new personal bankruptcy law
- ...a positive labor market and strong equity prices

The economy is poised for a mild rebound in H2-07, given the latest government measures to prop-up domestic demand ahead of the Legislative and Presidential elections. A tight labour market and strong equity prices should also support the expected recovery in consumer demand, prompting us to raise our GDP forecast for the year to 4.5% from 4.1%.

In Q1-07, GDP grew by a real 4.1% y/y, marginally higher than the 4.0% increase posted in Q4-06. The external sector again provided much of the support to GDP growth in Q1-07 (Chart 1). While private consumption remains morbid, it nonetheless managed to increase 2.3% y/y in Q1-07 due to base effect. We believe consumer spending is poised for a recovery near-term, given the recent government measures to shore up consumer confidence, stellar equity market performance and continuing improvement in labor market condition.

Consumption may strengthen in H2-07
Stronger private consumption growth is the key to our positive outlook for Taiwan during H2-07. Importantly, we expect consumer spending to receive a much needed boost with the passing of the 'personal bankruptcy law', which limits creditor bank's ability to seek early foreclosure of debtor's residential property, lending support to overall consumer confidence. The government, in our view, expects the new law to help contain social discontent following an earlier decision requiring distressed credit and cash card holders to negotiate with card issuers on settlement. The move, which affected 20mn active credit card and 3.1mn cash card accounts, had far greater social and economic impact than expected. Many distressed card holders took to the street, and domestic auto sales plunged by 31% y/y in 2006 as banks tightened consumer lending fearing rapidly deteriorating asset quality (Chart 2). Private consumption was particularly hard hit and rose by a tepid 1.45% y/y in 2006, about half the 2.75% pace in 2005 and down from a high of 4.46% in 2004. The new law may help the government to redress the cash and credit card issues ahead of the year-end Legislative election and Mar-08 Presidential election.

According to the Financial Supervisory Committee (FSC), outstanding credit and cash card loans as at end Apr-07 amounted to TWD 316bn and TWD 154bn respectively, representing a mere 1.9% and 0.9% of total bank lending. Although the delinquency ratio for cash cards stood at 6.37% at Apr-07, much higher than the average NPL ratio of 2.35% for all loans, the delinquency ratio for credit cards has already dropped from 3.38% a year ago to 2.37%.

Meanwhile, private consumption is likely to also gain support from the steadily improving labor market outlook, alongside the slow but firmly rising wage growth. Annual wage growth in the industrial and services sectors averaged 2.5% y/y in Q1-07. This is largely credited to the buoyant real estate sector, robust manufacturing activity and growing retail and wholesale trade services. As a result, unemployment rate averaged 3.84% during the first five months of this year, down from 4.1% and 3.9%, respectively, in 2005 and 2006 (Chart 3). Given that the economy currently creates more jobs than it loses, we expect head-line unemployment rate to further decline in H2-07, helping to lift overall consumer confidence and spending for the coming months (Chart 4).

Impact from the latest CBC rate hike to be minimal
Although the Central Bank of China (CBC) raised its benchmark re-discount rate and the required reserve ratio for foreign currency deposits to 3.125% and 5% respectively on June 22, we reckon that the impact on consumption and investment should be minimal considering that the rate hikes were limited and largely anticipated.

The key message behind the CBC move, in our view, is to deter speculators from using the TWD as a funding currency (see OTG-Asia, Taiwan stays on tightening path). In fact, foreign investors responded favorably and piled up on Taiwan equity, raising the benchmark TAIEX by 13% in Q2-07. Given the dominance of retail investors, sustained strong equity performance will boost consumer spending going forward. Historically, the TAIEX has strong correlation with private consumption (Chart 5).

Upward revision of our 2007 growth forecast
In view of the likely rebound in consumer spending, which accounts for over 55% of GDP, coupled with recent measures the government has taken to boost the equity and FX markets, we believe that GDP growth in H2-07 will fare better than we originally expected. We now expect GDP growth for the year to reach 4.5% y/y, up from our original prediction of 4.1%.

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