Asia Focus: Inflation With Asian Characteristics: Across Asia, central banks are getting increasingly hawkish. Judging from the sharp rise in asset prices across the region, few will dispute the need to tighten. But judging from the still benign consumer prices in many economies, some may wonder whether central bankers are over-reacting. We believe the dichotomy of asset and consumer price inflation will grow bigger, which could raise the risk of policy mis-diagnosis going forward. While inflation is primarily a monetary phenomenon, it cannot be tackled only by central banks. Asian governments need to take a more holistic and differentiated approach in their fight against inflation.

Economy Highlights

Hong Kong: Hong Kong's economic upturn is entering a new phase with the latest bout of equity market correction induced by US sub-prime woes. The latest round of market correction is likely to drive investors to a broader spectrum of assets, spreading the base of asset price appreciation.

India: While "overheating" talks seem to have withered, lurking in the background are threats as ominous as the three bears: rising trade deficits, abundant liquidity, and high non-fuel inflation. Thus policymakers might have to toil more to keep this 'Goldilocks' economy running.

Malaysia: The Malaysian economy is increasingly dependent on domestic drivers. While some analysts expect exports to rebound mildly in H2-07, much of the growth momentum will rely on consumer and investor demands, which we expect will keep the economy afloat and the central bank on hold.

Thailand: Reducing political uncertainty is likely to prompt an early pick-up in investment demand. This could reverse the current trend of excess liquidity, driving up interest rates in 2008 and pushing for an early removal of the remaining capital controls.

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

Market reactions overdone

- Asia is not fully decoupled from the US
- But market reaction to US sub-prime woes seems overdone
- Asia should excel once investors price risks better

The supposedly quiet summer break has been disrupted by the recent market turbulence, triggered by concerns over the US sub-prime mortgage problems and its potential impact on investor risk appetite and consumer demand in the US. While we believe Asia is still far from fully decoupled from the US, we also believe investors have over-reacted in the Asian markets recently. Notwithstanding uncertainties in the depth of the US sub-prime woes and our view that the US economy is set for a marked slowdown, we are confident that the global economy - and particularly Asia - is strong enough to withstand the expected US stress. While market volatility is set to rise with tighter liquidity and more realistic risk pricing, those with solid economic fundamentals and strong growth momentum should excel once investors better able to differentiate markets and price risks more appropriately. It is a welcome correction for markets, an opportunity for investors, and a challenge for many policymakers.

Keep things in perspective
Since last February when the US sub-prime problem first emerged, the market has yet to ascertain how big the hole is and what collateral damage it may inflict. From the sub-prime sector to the CDO market and hedge funds, downside surprises unfolded one after another, driving investors to become increasingly wary about the depth of the problem and its implication on the US and global economy and markets. It is too early to tell, to be honest, especially given the dynamic nature of financial markets. But there is no reason to panic also, at least not at this stage.

To put things into perspective, the sub-prime sector only accounts for a relatively small share (about 7% according to the Fed) of the mulit-trillion US mortgage market. While some issuers, investors and intermediaries were found swimming naked, there is no sign of any chain of collapsing institutions. In fact, major banks and corporates are generally well capitalised and cash rich. Heightened risk aversion has led to increasing market volatility, but the flight to quality has not led to system distress or a sharp contraction in credit, overall liquidity in the global financial system remains flush. In terms of the real economy, recent data indicates that growth momentum around the world remains solid, if not too strong. Along with a stronger-than-expected 3.4% US GDP growth in Q2-07, the IMF has raised its forecast for global economic growth this year recently, and Moody's has just upgraded the ratings of several Asian sovereigns.

Welcome correction, opportunity, and challenge
Even without the latest market turbulence, many Asian policymakers are looking for ways to cool down their asset markets, which have been scaling new highs with strong growth momentum and buoyant liquidity. Thailand, for example, has tried repeatedly to discourage capital inflows and curb the strength of the THB. China also worked very hard to dampen euphoria in its stock markets. The latest market correction therefore should be welcomed by many monetary authorities as a good chilling agent for their over-joyed investors.

Of course, sharp and frequent market corrections could challenge system stability and undermine growth momentum of the weaker economies. However, this risk appears mild for most Asian economies. Fundamentally, most Asian economies have at least one strong leg to support growth and some have two. Hong Kong, China, India, Vietnam and South Korea are enjoying both strong exports and domestic demand (Chart 1). In fact, strong growth momentum has threatened price stability and forced the hands of many Asian central banks. For example, China raised its lending rate by 27bps on July 21, followed by a 50bps hike in the reserve requirement ratio on July 30. The Reserve Bank of India raised its cash reserve ratio by 50bps and removed the reverse repo ceiling of INR 30bn to enhance liquidity management. The Bank of Korea also raised its overnight call rate by 25bps to 4.75% in its July meeting.

Exports in Singapore, Malaysia and the Philippines are relatively weak, largely due to soft US demand and their product concentration, especially in electronics. Fortunately, domestic momentum in these countries is strong. Singapore is facing increasingly acute labour shortages. Its jobless rate fell to 2.4% in Q2-07, the lowest since Q1-01, after creating a record high 61,900 jobs in the quarter. While manufacturers are more cautious over their business outlook for the rest of the year, the service sector is unambiguously upbeat, according to the department of statistics business outlook survey. Malaysia's domestic confidence is also riding high. This and the prospect of higher inflation in H2-07 have persuaded Bank Negara Malaysia to hold the overnight policy rate unchanged in its July meeting and it is likely to hold this position for the coming months.

Local demand in Thailand and Indonesia remains subdued, but both are enjoying strong export growth, especially demand from China and the EU. This implies that a falloff in US demand may have only limited immediate impact. Both central banks are expected to ease monetary policy further, but at a more moderate pace. Meanwhile, the Thai authorities are still preoccupied by the challenge of a strong THB and large capital inflows. It announced six measures on July 24 to promote capital outflows, and pledged to come up with more if THB strength persists. The latest market turbulence would be seen as a favoured development.

Taiwan seems relatively worse-positioned for a US slowdown, given weak exports and soft domestic demand. Yet, traditionally its financial market is quite resilient to external shocks, thanks to a strong external payment position and relatively tight regulations. Also, we believe domestic demand could gather momentum in coming months. A tight labour market, strong equity performance, and pre-election spending are likely to cushion the economy from any short-term demand weakness. However, policymakers are still facing the long-term challenge of rebuilding a more sustainable growth platform. In the end, a more volatile market environment and uncertain US outlook could stiffen the authorities' resolve to look for policy breakthroughs.

ASIA FOCUS

Kelvin Lau
Economist, +852 2821 1033
Kelvin.K.H.Lau@hk.standardchartered.com

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

Inflation with Asian characteristics

- The dichotomy of asset and consumer price inflation raises the risk of policy mis-diagnosis
- Food and asset price inflation requires special attention in Asia
- Policy credibility and a differentiated but holistic approach are important

Across Asia, central banks are getting increasingly hawkish - except for a few like Thailand and Indonesia where earlier policy mistakes have dislodged their economies from the general growth track. Judging from the sharp rise in asset prices across the region, few will dispute the need to tighten. But judging from the still benign consumer prices in many economies, some may wonder whether central bankers are over-reacting. We believe the dichotomy of asset and consumer price inflation will grow bigger, which could raise the risk of policy mis-diagnosis going forward. While inflation is primarily a monetary phenomenon, it cannot be tackled only by central banks, especially in light of diverging price trends among assets, goods and services. Asian governments need to take a more holistic and differentiated approach in their fight against inflation.

Inflation: a threat or not?
Throughout Asia, almost all equity markets are booming. Since end-2006, the Shanghai Stock Exchange Composite Index has jumped over 70%, while the KOSPI of South Korea advanced 27%, on top of their 97-128% rise between 2003 and 2006. Measured by the MSCI Asia Pacific index, Asian equity prices have grown by 138% since Mar-03, or about 25% a year (Chart 1). Despite higher interest rates and threats from such factors as the US sub-prime problems, a clear moderation of equity prices is yet to emerge. Asset price inflation is all over Asia, a warning increasingly heeded by Asian central bankers.

Asian consumers, however, are not overly upset by the trend, even though many are getting uneasy at the lurking threat of higher costs of living down the road if asset price inflation continues (Chart 2). Although high prices of oil and commodities had once surfaced as the top concern of consumers and policymakers, the threat of much higher and prolonged consumer price inflation never materialised, except in Indonesia where policy mistakes contributed more than anything else to a sharp but short spike in prices. Recently, however, many Asian consumers were hit by sharply higher food prices and the concern about consumer price inflation resurfaced. Are we in for a prolonged inflationary period, or just another short spike in isolated products? Will the dichotomy of high asset prices and stable consumer prices last long to keep both investors and consumers happy? Or is it close to a tragic end such as that witnessed in 1997-98?

We believe the dichotomy of asset and consumer price inflation can last for a long period and grow wider, but needs careful management to avoid the pitfall of full-blown inflation or a sharp asset price correction. From a macro perspective, inflation is primarily a monetary phenomenon, i.e. too much money chasing after too few goods. However, from the micro angle, not all goods are the same and different markets have different pricing mechanisms, which would lead to different price trends, particularly between consumer goods and assets.

It is not too difficult to explain why Asian equity prices are rising, given the region's much improved economic fundamentals, outstanding growth, and abundant liquidity. The ground for such a broad-based upturn has been set since mid-2003, when most part of Asia withstood the curse of SARS and sustained its recovery from the 1997-98 Asian financial crisis and the 2001 bursting of the global IT bubble. However, unlike the pre-crisis period of the mid-1990s when almost all kinds of Asian assets were hotly sought-after, much of the current rise is confined to equities and currencies. Real estate, traditionally the most sought-after asset by Asians and host of the largest pool of Asian wealth, has remained relatively benign. Only until very recently have selected properties (usually the high end sector) in selected Asian cities enjoyed a good ride in prices. For many Asian homeowners, current market values of their holdings are still some way off from records (see Asia Focus, March 14, 2007 issue).

This dichotomy of equity and property prices is not too difficult to explain, given the different nature of the two asset classes. While prices of both need to be supported by good earnings (prospects) and cheap funding, equity has the clear advantage of high liquidity and relatively low transaction costs, although in most cases, its leverage may be more restricted (depends on availability of financing and development of derivatives). These make equity a more natural choice of investment at the early stage of an economic recovery, when the outlook remains unclear and investor confidence stays low. The relatively larger amount and longer period of commitment required for property investment would also deter its quick rebound after a crisis, especially given the restrictions on foreign investment in properties prevailing in most Asian economies. Within the different types of stocks and properties, quality and affordability may further differentiate their price movements. While high quality and high earning stocks are normally more favoured, the same is true for properties where high-end and high yield units would be more sought after, especially in the early stage of a recovery when income disparity widens as a result of the previous economic crisis, leaving a smaller number of the rich (or super rich) who can afford to re-enter the market. From this perspective, before the general property market joins the party, the current round of Asian price inflation remains some distance from the previous peaks.

Theoretically, consumer confidence should rise in line with investor bullishness, if not earlier. The same factors of good growth, solid fundamentals and flush liquidity will boost consumer demand. The difference here is on the supply side. While the supply of assets, especially quality assets, is relatively constrained, the supply of consumer goods is much more elastic, especially given the entry of new suppliers like China, India and Vietnam to the world market and rapid improvements of technology and productivity in recent years. Like assets, the supply of high end consumer products could be more restricted by skill, brand and patents. Hence their prices may rise faster than the general consumer goods at times of good economic growth, leading to further dichotomy between consumer goods. In fact, the same dichotomy also exists between prices of different goods and services, often leading to complaints about the mismatch between official inflation data and actual price hikes experienced by individual consumers. Barring serious supply side constraints, a sharp and general increase in consumer prices would be difficult.

Inflation with Asian characteristics
To the extent that Asia's development is closely associated with the global economic and liquidity cycle, its inflation picture and challenges are not too different from the rest of the world, except for two distinct features which would require careful management of policymakers.

1. Food price inflation. Unlike the West, more than half of Asia's population are farmers or rural inhabitants. Food accounts for a large proportion, usually one-third or more, of their consumption, but also a major source of their income (Chart 3). This makes recent increases in food prices a highly delicate socio-economic and political issue. While some farmers may be happy to see their produce command better prices, others could be upset by higher prices of seeds, animal feed, meat and other food products. Also, gains by farmers would be pains for urban dwellers, especially the urban poor whose expenditure is dominated by food and basics. In that sense, the current increase in food prices poses a bigger threat to general price stability than the rise in oil and commodity prices. This is especially the case for economies with a relatively low urbanisation rate or a large low-income population, which means that it presents a bigger challenge to Asian policymakers than to their counterparts in the West that are more urbanised and of higher income. Analysts who put too much emphasis on the conventional 'core' inflation, which excludes food and energy, could risk missing a very important part of the inflation picture in Asia. In rural Asia, non-core inflation is core.

2. Asset price inflation. Asia's current boom in asset prices reflects as much the strong demand for Asian assets as the under-developed status of Asian asset markets. First, the sharp rise in Asian equity prices reflects the lack of depth in Asian equity markets or the limited supply of quality securities. Second, the concentration of interest in equities underlines the lack of breadth in Asian capital markets or the shortage of other efficient and liquid investment tools like bonds and derivatives. While significant reforms since the 1997-98 financial crisis have addressed some of the weaknesses like regulatory loopholes, weak capital base and risk management of financial institutions, poor governance, much remains in terms of the development of new investment tools and markets, especially in terms of the accumulation and allocation of investment funds to long-term productive uses like infrastructure and industrial development. Failure to address these issues could risk repeating the previous pitfall of asset market overheating, which would be no less damaging than high consumer price inflation.

Not just an issue for central bankers
Although inflation is primarily a monetary phenomenon, it should not be left just to the central bankers. It is important that central banks do their job in keeping an appropriate level of liquidity within the system, but it is also critical that other parts of the government have their shares of the burden. In the Asian context, two issues are of particular importance:

1. Policy credibility. To begin with, the central bank needs to be credible and unambiguous in communicating its policies. In that respect, central bank independence is essential. Perceived pressure exerted by other government agencies or dilution of central bank power like the decision on critical interest rates are very damaging. Worse still if central bank decisions were reversed or overruled. Credibility takes time and efforts to build but is easy to lose. It is the most important asset of a central bank. In general, Asian central banks are late starters and need lot more effort to develop and preserve their credibility.

2. A holistic and differentiated approach. Given Asia's under-developed financial markets and diverse economic structure, there is no simple single monetary tool that central banks can rely on to do its job. With rapid financial market development and reforms in Asian economies, especially in terms of capital account opening and financial market deregulation, central banks need to sharpen their ability to deploy specific monetary tools like open market operations, policy rates, reserve requirements and liquidity ratios to address specific financial and price issues. It also needs to work closely with other government agencies, especially the ministry of finance, other financial sector regulators, investment promotion, tax and planning authorities to achieve more efficient accumulation and allocation of resources. Monetary policy is important, but it can't resolve all price problems by itself. For example, the recent increase in pork prices in China cannot be effectively resolved by higher interest rates or reserve requirements.

HONG KONG

Kelvin Lau
Economist, +852 2821 1033
Kelvin.K.H.Lau@hk.standardchartered.com

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

Benefiting from growing volatility

- Growing equity market volatility unlikely to weaken growth
- Instead, it may prompt investors to diversify into property
- Inflation to stay soft, but trend up in 2008

Hong Kong's economic upturn is entering a new phase, not so much with the celebration of the Special Administrative Region's (SAR) 10th anniversary, but more with the latest bout of equity market correction induced by US sub-prime woes. Unlike a decade ago when growing market volatility set off an exodus of investors and crippled the economy, the latest round of market correction is likely to drive investors to a broader spectrum of assets, spreading the base of asset price appreciation from equity to property and other assets. While this may keep concern about asset price inflation alive, prices should be reasonably supported by strong income growth on the back of solid domestic and external demand, as well as growing capital inflows under the QDII and other factors. If anything, high inflation, including both asset and consumer prices, may only emerge as a prime policy concern later next year. However, some technical adjustments have prompted us to fine-tune our inflation forecasts.

Assets in demand
Hong Kong's macro-economic backdrop remains highly favourable. Notwithstanding uncertainties around the US economy, exports grew at a strong 11% y/y in June and 10.4% during H1-07. Domestically, consumption demand remains robust, with retail sales up 14.3% y/y in June or 9.3% in H1-07. A tight labour market keeps the unemployment rate at 4.2%, the lowest in over nine years which lends support to higher wages, especially in finance, trade and tourism. Residential property transaction volume rose an impressive 36% y/y in H1-07, while prices rose 8.8% y/y in Jun-07 after staying stagnant for most of 2006 (Chart 1).

As for equities, the Hang Seng Index had been regularly making fresh highs prior to the onset of the latest bout of market correction. The good news is that HIBOR rates have been trading at benign levels still (Chart 2), reflecting a limited extent of capital outflows and little risk of seeing anything more sinister than a healthy market adjustment for the time being. Given a modest P/E ratio of about 16x and expected good corporate earnings, equity prices should remain reasonably supported, especially if China's QDII programs allow more capital inflows into the Hong Kong market. To the extent that the latest bout of market volatility raises the risk awareness of investors, some investment funds may be diverted from equities to other assets, such as property. This should be welcomed as it would help to calm the euphoria in stocks and broaden the base of asset market recovery.

Inflation: low but not so low
On the surface, Hong Kong is enjoying the best of both worlds: high growth and low inflation. CPI inflation stayed at a low 1.3% y/y in Jun-07 and is likely to remain subdued in Q3. Much of the price stability came from the housing component which accounts for one-third of the CPI basket and is benefiting from a one-off property rates cut in Q2-3 after a larger-than-expected budget surplus. However, this also means that inflation should pick up more evidently once the tax relief is over. This is especially the case given a few other factors in play.

First is the rise in property prices and rentals. After a sharp strong rebound from distressed levels in the post-SARS period, property prices in Hong Kong have remained stagnant in most of 2006 and lagged relatively behind other asset markets. By mid-07, residential property prices and rentals were still 42% and 28% respectively below their previous peaks in late-97. Recently, both prices and rentals are moving up at an annual speed of 8-10%, driven by sustained economic and income growth, and increasing supply-demand imbalance. However, a full reflection of this increase in the CPI numbers may have to wait until late 2008, when the impacts of the property rate relief and deferred deflation-adjustment in public housing rentals are over.

Second is higher import prices from China. A stronger CNY and higher prices of Chinese products, such as food, will gradually filter through to Hong Kong consumer prices (Chart 3). However, we need to keep things in perspective. Given that China only supplies about 15% of Hong Kong's demand for consumer goods, which in turn accounts for about 30% of the CPI basket, a 10% rise in China-sourced consumer goods will only raise CPI by 0.45 percentage points even assuming a full pass-through.

More likely, the drive on inflation will come from domestic factors, especially personal and public services which are accounting for an increasing share of consumer spending, as is usually the case when an economy becomes more affluent and consumers look beyond basic needs (Chart 4). Due to the property rate relief factor, we now see a lower 1.8% inflation in 2007, down from our original 2.0% forecast. The same factor will contribute to higher inflation in 2008 once the base effect unfolds. Subsequently, we raise our inflation forecast for 2008 to 2.8% from 1.7%. However, for inflation to become a prime policy concern, it may have to wait till late 2008.

INDIA

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

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

Not yet a Goldilocks economy

- Overheating concerns diminish as inflation recedes
- But strong growth momentum keeps inflows supported
- More CRR hikes and tightening expected

Consider today's India: A "Goldilocks economy" neither too hot (inflation) nor too cold (growth). It seems like a far cry from India of FY 06/07 when almost every financial article talked of "the tiger on fire". While "overheating" talks seem to have withered, lurking in the background are threats as ominous as the three bears: rising trade deficits, abundant liquidity, and high non-fuel inflation. Thus policymakers might have to toil more to keep this Goldilocks running.

A mixed bag
The Prime Minister's Economic Advisory Council (EAC) projected GDP growth for FY 07/08 at 9%, on the back of 9.4% in FY 06/07. This brought cheers to the bulls as it indicated that the party might still be on! Also, if local press is to be believed, growth in FY 06/07 might have fared even better than 9.4%. The government is reported to be looking to revise the FY 06/07 GDP growth to above 10%.

It is still too early to judge the EAC projections since current economic data is sending quite a mixed signal. Vehicle sales, non-food credit growth, inflation and consumer durable demand have weakened. In the Reserve Bank of India's first quarter policy report, the term 'overheating' was dropped and the policy note acknowledged some moderation in aggregate demand. But the note also highlighted its discomfort with high money supply growth, inflation expectations, and demand side pressures. Meanwhile, a buoyant 11% y/y increase in the Industrial Production Index (IIP) and a 36% rise in imports in Jun-07 underlined the strong growth momentum, especially in the manufacturing sector.

The three bears
As the debate continues on whether India is slowing, policymakers are facing new challenges:

1. The baby bear: Widening trade deficit. Weak trade balance remains the Achilles' heel for India. Close on the heels of a trade deficit of 7.2% of GDP in FY 06/07, the gap widened to 8.2% of GDP in Q1 of FY 07/08. This was due to slower export growth and a whopping 50.4% jump in non-oil imports. As India continues to grow at a fast pace, and the INR remains more than 14% overvalued on a real effective basis, this trend will likely persist. From a balance of payments perspective, a wider trade gap is not as threatening as other current account flows (remittances, services flows), especially when capital inflows remain strong, but there are obvious implications for the broader economy. Exports now contribute to a significant proportion of manufacturing and GDP. A larger trade gap will undercut growth.

2. The mama bear: The liquidity deluge. It is unlikely that the global sources of liquidity will be cut off any time soon. Neither the US nor Japan are likely to raise rates significantly near-term. Meanwhile, the Gulf and China are running huge current account surpluses that are looking for an investment home, with India seen as an attractive destination.

According to EAC projection, capital flows are expected to go up by 30% y/y to USD 58bn. This is in line with our estimate of USD 50bn (5% of GDP), and is based on the expectation of an almost doubling of foreign direct investment, along with strong portfolio inflow and modest increase in external borrowings.

This would require more active sterilisation (either through MSS, CRR or OMO) if the RBI wants to hold the INR steady. Chances are it will be tough for the RBI to maintain M3 growth at its targeted 17-18%. Thus it is no surprise that the recent monetary policy statement also highlighted "liquidity management" as the top priority. If inflows turn out to be stronger, the CRR may rise even more than our expected 50bps.

An important implication of the above is that any meaningful widening of the trade and current account deficits on the back of a stronger currency will be over-ridden by capital inflows. This will ensure that the INR will stay firm in the near-term, though the appreciation spree witnessed in Apr-07 may not repeat itself. This would only compound the trade issue.

3. The papa bear: Lurking threat of inflation. Late last week, the RBI's deputy governor expressed concern that management of capital inflows poses a challenge to the central bank's priority of price stability. With broad money growing at 21% y/y, the threat of inflation remains real, especially given elevated oil prices and domestic non-fuel inflation (over 6%). Even though wholesale price inflation is almost 230bps off from the 6.69% peak in Jan-07, inflationary expectations could firm up again, especially in the latter half of FY 07/08.

The hawkish undertone of the RBI's July policy review and post-meeting comments indicate that more tightening is in the pipeline. Our call of one more rate hike of 25bps in repo and reverse repo rates in the second half of FY 07/08, along with another 50bps increase in the CRR, should cool things down a bit.

MALAYSIA

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

Domestic demand drives growth

- Exports have been disappointing in H1-07
- This was offset by strong domestic demand
- BNM likely to hold rates steady in the medium term

The Malaysian economy is increasingly dependent on domestic drivers. While some analysts expect exports to rebound mildly in H2-07, much of the growth momentum will rely on consumer and investor demands, which we expect will keep the economy afloat and the central bank on hold. In fact, we believe the next move of Bank Negara Malaysia (BNM) is up rather than down, but probably in as late as H2-08.

Weak external demand
Within Asia, Malaysia's export sector is among the worst performers. Exports grew by 1.1% y/y in H1-07, the lowest since H1-02. This was largely due to poor US demand, which contracted 7.5% y/y in the first four months of the year. Luckily, this was partly offset by a healthy 8.8% expansion of sales to the EU and a phenomenal 40.9% gain in China. In our view, the above geographical growth differentials underline more than the cyclical aspect of the country's export cycle. They reflect uneven performance of the key markets in this current economic cycle and the shift of final assembly for electronic products to China. With the US semi-conductor book-to-bill ratio at 0.94 in Jun-07, which is still far from the expansionary zone, there is no convincing sign of a rebound for the time being. A deteriorating US sub-prime mortgage market could also undermine US demand and delay the recovery in exports.

Local spenders boosting service sector
The good news is that domestic demand in Malaysia remains robust, and is likely to remain the key growth driver in the foreseeable future. In the latest Q2-07 quarterly survey of the Malaysia Institute of Economic Research (MIER), a local think tank, both the consumer sentiment index and business condition index were very upbeat. The retail survey index is at an 11-quarter high and the residential property sentiment index is at an all time high since the index was introduced in Q2-01. These bode well for sustained strength in domestic demand. From the investment perspective, PM Abdullah Badawi's MYR 200bn five-year spending programme, equivalent to 40% of Malaysia's annual GDP, is also likely to lead the way.

In terms of sector performance, manufacturing is likely to be weighed down by slow exports. Industrial production growth has been below par in 2007 so far, dampened by decline in manufacturing despite relatively good growth in mining output. The silver lining is that strong domestic demand is translating into robust economic activity in the services sector, offsetting weaknesses in industry. Retail and wholesale trade, finance, real estate services and tourism are performing well and likely to stay strong. We believe the economy expanded by a real 5.5% y/y in H1-07, and is well on track to achieve our full-year GDP growth target of 6%.

Central bank to maintain its steady hand
Our view of renewed strength in the Malaysian economy in the near term is consistent with the central bank's latest monetary policy statement. In its July meeting, BNM left its overnight policy rate unchanged at 3.5% and saw growth to be sustained for the rest of the year. More importantly for policy direction, the central bank sees inflation edging up in H2-07 due to a combination of internal and external factors.

We agree with BNM's view of inflation risk in H2-07 for several reasons. Externally, food prices are driving inflation higher in many economies across the region, notably China. Recent rises in oil prices brought on by concerns over capacity constraints should also add to upside pressure at least in the near term. From within, buoyant domestic sentiment and strong money supply growth are also supportive of price increases. MIER's Q2-07 consumer sentiment survey also suggests that inflation expectations remain elevated. We expect official inflation to reach 2.2% y/y in Q4-07, which is consistent with the BNM's 2007 inflation forecast of 2%-2.5%.

On balance, improving growth prospects and rising inflation risks have significantly weakened the case for BNM to cut interest rates and could gradually swing the pendulum in the direction of hiking. As a result, we expect the central bank to hold rates steady until mid-2008, and may hike with inflationary pressure in its next move. This suggests the MYR should remain supported from the perspective of yield differentials. The BNM's comfort with a stronger MYR is also constructive to the currency's strength.

Meanwhile, discussion and speculation over the internationalisation of the Malaysia ringgit will undoubtedly continue. Our view remains that this process will be gradual and dependent upon the prevailing market conditions. With experience in recent years as a guide, investors are likely to welcome liberalisation of financial markets. However, there is no extra reward to those who achieve this quickly. On the contrary, those going back and forth with their financial market development are more likely to lose investor confidence and invite trouble.

THAILAND

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

Tides turning: tighter liquidity ahead

- Reducing political uncertainty could spur investment demand
- Higher funding needs would see liquidity tighten in 2008
- Market interest rates may rise unless the BoT lifts capital controls

Reducing political uncertainty is likely to prompt an early pick-up in investment demand. This could reverse the current trend of excess liquidity, driving up interest rates in 2008 and pushing for an early removal of the remaining capital controls.

Politics: getting better
Thailand's political situation seems to have turned for the better since May 30, when the Constitution Tribunal dissolved the largest Thai Rak Thai party (TRT) and banned all its 111 executive members, including former Prime Minister Thaksin, from politics for 5 years. Notwithstanding several major rallies staged by Thaksin's supporters in protest of the verdict, socio-political stability has been broadly maintained and the threat of serious unrest gradually subsided. Meanwhile, the chance of a draft Constitution surviving a referendum (scheduled on August 19) is rising, as indicated by recent surveys of public opinion and support pledged by the three major political parties (the Democrat, Chat Thai, and Mahachon). The passage of a new Constitution would smooth the way for a general election to be held on schedule in Dec-07 and the return to civilian rule. This improvement in the political outlook, if sustained, could drive an early rebound in investment and lead to significant changes in Thailand's economic picture in 2008.

Liquidity: reversing from excesses
One likely impact of an improving political and investment environment is on Thailand's liquidity condition. According to the Bank of Thailand (BoT), daily average excess liquid assets held by commercial banks had increased from THB 260bn in Jan-06 to THB 440bn in May-07 (Chart 1). While strong capital inflows contributed substantially to the build up of excess liquidity in 2006, a widening current account surplus was a major liquidity source in recent months as imports contracted amid weak domestic demand and exports stayed robust (Chart 2). Clearly, politics is the culprit of deteriorating consumer and business sentiment that led to the weakening of domestic demand. This is also evident in the slowdown in growth of commercial bank lending, which cut the loan-to-deposit (L/D) ratio from 90.9 at end-2005 to 85.7 in May-07 (Chart 3).

Looking ahead, however, the amount of excess liquidity in the banking system could drop in 2008, leading to a reversal in Thailand's liquidity condition and a very different economic landscape. There are two factors in play:

1. On the demand side, there are emerging signs that investment demand is reviving with the improving political outlook. This is especially evident in the public sector, which is supported by a more expansionary budget in FY2008 with a deficit of THB 165bn. Progress in two areas are of particular significance. First, state-owned energy and petrochemical producers have received approval to invest about THB 130bn in 2008. Second, the long-delayed THB-160bn mass-transit project is now scheduled to kick off in the beginning of 2008. Since 70% of the mass-transit project will be financed by local funding, it would absorb substantial excess liquidity in the system.

Meanwhile, several capital-intensive industries in the private sector are facing increasingly tight production capacity and growing pressure to invest and expand. As shown in Table 1, petroleum, vehicles, and chemical industries are all running at over 80% capacity. Once political concerns recede, combined with lower interest rates, we could see private investment picks up strongly in 2008, leading to higher funding demand and reducing excess liquidity.

2. On the supply side, an improving political backdrop could attract more capital inflows. However, rising investment is likely to raise imports of capital goods, undercutting the current account surplus, especially if it is reinforced by any recovery in consumer demand. While we do not expect the BoT to tighten anytime next year, market interest rates may stop declining or even trend up in 2008 amid increasing funding demand. This is especially the case if the BoT's latest moves to curb capital inflows gradually take effect. Recently, the BoT has extended the period of Thai residents retaining their forex receipts offshore from 120 days to 360 days; raised the limit of outward remittances for individuals to USD 1mn per person per year for various purposes; and allowed listed companies to invest abroad up to USD 100mn per year. Given a 200bps differential between the policy rates of Thailand and the US, there are reasonable incentives for parking money offshore (Chart 4).

Of course, one uncertainty in the liquidity equation is how much new inflows will be attracted by the improving political and economic picture, especially in equity and direct investment which are free from most capital controls. However, given that most public investment are likely to be funded by bonds, which are still subject to the 30% URR restrictions, the BoT may need to review and lift its remaining capital controls in order to prevent any sharp reversal in market interest rates next year.

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