Asia Focus: Asian Politics, Perceptions and Reality: Politics is likely to occupy an increasing share of Asia's news headlines in the coming months with elections and rising tensions. It is important that investors have the information to understand and the right perspective to assess the impact of upcoming political events. We are no political scientists, but having on-the-ground presence give us an advantage in understanding the internal mechanics of Asian politics and avoiding some of the common mis-perceptions in assessing Asian political risk. A few non-consensus observations about China, Korea, Taiwan, Macau, and Southeast Asia are shared in this article.

Economy Highlights

China: Despite problems in the US and major financial markets, the Chinese economy continues its high growth and serves as an increasingly important driving force to the global economy. The stock market will be a political issue, while a new Politburo will contain Hu's successors.

Indonesia: Recently, inflation has accelerated unexpectedly, raising alarms within the central bank. BI is now likely to postpone and limit any policy rate cuts in the near future. Meanwhile, a solid external payments position and an improving banking sector should support healthy economic growth in 2008.

Singapore: The Singapore economy continues to defy gravity and grow above trend, despite its having expanded for the longest period since 1991 and being confronted by weak electronic exports and financial market turbulence triggered by the US sub-prime debacle. However, inflation is raising concerns about economic overheating and has prompted the MAS to opt for a stronger SGD.

South Korea: Strong asset price and robust demand from China and Europe have supported the Korean economy and kept the KRW on the strong side. But a rising threat of inflation may push the BoK to resume interest rate hikes next year.

OVERVIEW

Tai Hui
Regional Head of Economic Research, Southeast Asia
+65 6530 3464, Tai.Hui@sg.standardchartered.com

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

Beware of inflation and volatility

- Asia outperformed after the US sub-prime debacle, as predicted
- Thanks to strong fundamentals and buoyant liquidity
- But care is needed to manage rising inflation and volatility

In Asia, as we predicted two months ago in this column, initial market reaction to the US sub-prime woes was overdone and once investors were better able to access risk, markets rebounded. In fact, the speed of healing managed by the region's asset markets was much quicker than even we expected. The Fed's 50bps cut on Sep 18 drove benchmark indices of many Asian bourses to record highs, outperforming their counterparts in developed markets. While the Fed's cut was important, the region's strong fundamentals and ample liquidity constituted the foundation of this rapid rebound. However, as the Asian markets rally and liquidity accumulates, caution is needed to manage the growing risk of volatility and inflation.

Asia excels with fundamentals and liquidity
Since the 50bps cut in both the discount rate and the Fed Funds Target Rate by the Federal Reserve, the MSCI Asia ex-Japan index has gained 17% in USD terms, compared with 6% for the S&P 500, 7% for the FTSE 100 and 10% for the Nikkei 225. Asia's strong economic fundamentals, underlined by generally large external surpluses, healthy fiscal positions, de-leveraged household balance sheets, good corporate earnings and strong output growth, provided the base for this asset market out-performance. This also explains the relatively quick return of risk appetite, as indicated by our in-house SCB Risk Appetite Index.

Aside from fundamentals, ample liquidity is adding support to investor confidence. Our calculation of Asia money supply growth, a GDP-weighted average for the region, stood at 14% y/y for the nine economies, or 15.9% including China in Aug-07. Both figures are high by historical standard. This money growth is likely to accelerate with recent actions by some Asian central banks to cut interest rates. Thailand, Indonesia, and most recently the Philippines, are all in easing mode. On top of this, liquidity in the region is likely to be fuelled by Middle East petro-dollars, Japanese household savings (driven overseas by Japan's near-zero interest rates), and Mainland China's external surplus. The 45% year-to-date (ytd) gain of the Hang Seng Index and 85% gain in the H-share index for Chinese companies listed in HK are testimony of what markets can do when anticipating the arrival of fresh liquidity.

Liquidity-fueled asset inflation is by no means limited to equities. The real estate sector in Singapore is also benefiting from the explosive combination of liquidity and confidence. Riding on the back of Integrated Resort concept and the rise in expatriates' demand for housing, the official property price index has risen for 14 consecutive quarters. In Q3-07, the index registered a 27% y/y gain, with the top-end segment seeing an even more astonishing rise. Hong Kong has also seen the number of residential property transactions surge as the real interest rate declines and consumer sentiment improves.

Beware of rising inflation and volatility
Along with asset prices, consumer prices are also rising across Asia. Although our GDP-weighted average of Asian inflation remained at a tame level of below 4% y/y in Aug-07, it is clearly picking up momentum. China's inflation, at 6.5% y/y in Aug-07, was the highest since Dec-96 and more than four times last year's 1.5% average (although this was mostly food). Latest inflation figures from Indonesia, Malaysia, Philippines, Singapore, Thailand and Taiwan are all pointing upwards, albeit still at low levels.

The current bout of inflation has been brought about by a number of factors. Elevated oil prices are an obvious one. Global increases in food prices is another, which is partly due to bad weather and partly due to increased bio-fuel generation. For those economies with USD pegs or with currencies tracking the USD closely, the recent weakness of the greenback could also be leading to higher imported inflation. In the early phase of economic recovery in Asia, the rise in input prices was often absorbed by the retailers or wholesalers, as they were reluctant to pass on the higher costs to consumers. However, following several years of profit compression and a recovery in consumer confidence, higher raw material costs are translating more directly into higher retail prices.

The good news is that we expect both agricultural and oil prices to ease in coming months (see the October issue of Commodity Focus - Base metals; A five year view), which should provide some relief. However, considering the undercurrent of strong consumer demand, we believe the risk of inflation remains on the upside. As our forecast table on page 18 shows, we expect the pace of consumer price increases to pick up in 2008.

This will also have a bearing on the future policy of Asian central banks. We have repeatedly highlighted the decline in correlation between the policies of the Fed and Asian central banks. Given the current economic landscape, only two economies are expected to see lower interest rates - Indonesia and the Philippines. The latest move by the Monetary Authority of Singapore to marginally steepen SGD NEER's appreciation path is a signal that the central bank is focusing more on the inflation risk, rather than external demand uncertainty. In the next six months, we continue to expect central banks in China, Japan, India, South Korea and Taiwan to increase the cost of borrowing, albeit at different speeds.

Most likely, this round of asset and consumer price inflation will continue in the next 12-18 months. This may coincide with rising market volatility, brought about by over-buoyant activity in selected markets and unsteady investor risk appetite, given the uncertainties in the US housing sector and major money markets. It is therefore necessary for Asian central banks and policymakers to be more prudent in their policy, keeping a relatively tight bias.

ASIA FOCUS

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

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

Asian politics, perceptions and reality

- Asian politics is likely to turn hotter with growing elections and tensions
- Some common perceptions are far off reality
- On-the-ground feeling is important in reading Asian politics

Politics is likely to occupy an increasing share of Asia's news headlines in the coming months. From social unrest in Myanmar and street protests in Macau, to legislature and presidential elections in Hong Kong, South Korea, Thailand and Taiwan, to various congresses in China, and cross-border tensions in the Korean peninsula and the Taiwan Straits, the region has no shortage of potential political surprises. Some of these will be market moving and some not. Some may have only temporary impacts but some could be ground shaking. It is therefore important that investors understand, and have the right perspective to assess, the impact of these events. While the Asian economic growth story is well known, Asian politics are more challenging, if not impossible, to fully understand. We are no political scientists, but our benefit of having on-the-ground presence may give us an edge in understanding some of the region's internal mechanics and political risks. Among our few non-consensus observations are:

1. China's 17th Party Congress looks great, but tells us little
2. Tensions in Korea and Taiwan present more opportunities than risks
3. Macau's economic miracle hides serious problems
4. Political stability is deteriorating in Southeast Asia, but not governance

China's Congress looks great, but tells us little
Given its huge size and break-neck growth, China naturally dominates emerging Asia. Among all regular political events, the once-every-five-year National Congress of the Chinese Communist Party is indisputably the most important, given its power to approve the ruling party's top leadership, key policies and any change in the party's charter. In particular, the current 17th Congress, scheduled during Oct 15-21, is being presented as a watershed in China's political development. Specifically, the Congress is expected to formally vote into the party charter President Hu Jintao's ideas of "Scientific Development Perspective" and "Harmonious Society". This puts him on the same level, at least as a thought leader, as Deng Xiaoping or Hu's predecessor Jiang Zemin. Also, the expected announcement of new party leaders in the closing days will offer clues to the so-called sixth-generation leadership, Hu's successors. Yet few believe the Congress will trigger a sea change in policy, since much of the Congress' function is to endorse pre-agreed arrangements rather than to initiate new ones.

As far as the economics are concerned, the most uncertain outcome of the Party Congress is the speed, scale and scope of macro-economic tightening required for Q4 and 2008. As the Shanghai composite stock index powers through 6,000, many believe that more tightening, at least in the stock market, is necessary. However, some believe its implementation was deterred by the Congress itself, as no one wanted to rock the boat in the run-up. Some believe that such tightening will arrive earlier and stronger than generally expected. They take heart from the 50bps raise of bank Reserve Requirement Ratio announced by the central bank just two days before the Congress. Others reckon that the new People's Bank governor and securities chief will be risk adverse as they come into their jobs and will not aggressively seek tightening.

As usual, much attention will focus on the new nine-man Politburo Standing Committee line-up to be approved and disclosed on the final day of the Congress. This could be a surprise for some China watchers, at least in terms of the conventional wisdom a few weeks ago. Then, it was thought that Liaoning Party boss Li Keqiang, perceived by many as Hu's chosen successor, would be engineered onto the top leadership platform, in preparation for the 18th Congress in 2012. However, if reports are to be believed, the upset would be that the current Shanghai Party Secretary, Xi Jinping, will be elevated into the successor spot. Such an outcome would be a major signal that key decisions are still made through compromise between different factions within the Party. However, that said, the chances that this will affect policy are limited. Hu's more pro-distributionist agenda will likely still be rolled out over the next five years, assuming technical difficulties can be worked out.

North Korea and Taiwan are opportunities more than risks
Northeast Asia has long been seen as one of the world's most volatile areas, with North Korea wielding its new-found nuclear toys, and Taiwan repeatedly defying warnings from the Mainland and US against its swing towards independence. Interestingly, the one that seems most threatened by the DPRK's nuclear program is not South Korea, but its stronger allies located farther away. One might argue that Seoul's Sunshine Policy is unrealistic and amounts to wishful thinking, but part of the US projection of Pyongyang's threat is also arguably designed for domestic consumption.

On the other hand, Taiwan's threat to become formally independent may agitate the Mainland, but it has also annoyed its principal ally, the US. Perhaps the greatest achievement of these tensions is that they have brought the two competing giants, China and the US, together with a common interest in maintaining peace and working closer together. This achievement itself provides a very important platform for regional peace and cooperation. In other words, ironically the risks of sub-regional tensions have created greater stability and therefore opportunities across the region.

With the upcoming legislature and presidential elections in Taiwan, tensions are likely to escalate, putting more pressures on Taiwan's domestic economy and difficult cross-strait business. This, however, is unlikely to be sustainable, given the damage it does to the local economy and society. New leaders, whatever their political platform, will have clear incentives to rethink the confrontational approach towards the Mainland. We think the chances of a marked improvement in economic relations are high after Q1-08.

Macau's economic success hides big problems
Macau has recently undergone a miraculous resurgence. Boosted by its newly deregulated gaming business and related investment, GDP rocketed by a real 32% y/y in Q2-07, on top of a 26% growth in Q1 and a 16.6% expansion in 2006. For an economy with per capita GDP of USD 27,726, such a growth rate is phenomenal. Yet, rapid economic growth seems to have brought more alienation than joy to its half a million inhabitants. On the national day holiday, thousands of the underprivileged and disgruntled took to the streets, protesting about their inability to share in this economic success and the social distortions brought about by rapid economic change. While the rally in Macau was largely peaceful, it presented a clear challenge to the argument that economic success brings political peace - a belief widely held in Asia, especially in Mainland China.

Over the years, China has been pursuing fast economic growth to contain social discontent, but Macau's experience indicates that there is a limit to such a formula. In fact, growth-induced social tensions, such as the widening income gap, rising inflation, increasing pollution, as well as growing stress on families and traditional values, are emerging all over China. The Hu-Wen administration's stress on a "harmonious society" and "people-based" politics is a response to this. How far they can roll their programmes out from rhetoric in Beijing to action in the fields of Henan, coal mines of Shaanxi and smog-full streets of Chongqing will partly define how long the China miracle can last.

Governance is more than political stability
In Southeast Asia, politics is traditionally more turbulent. The military coup last year proved to be a major set back for Thailand, not only in terms of political stability, but also for its economy, as investor and consumer sentiment plunged, and major infrastructure projects were put on hold. Military coups also affect the Philippines - which has faced two attempts since president Gloria Arroyo came into office in 2001, in addition to the recurrence of election violence that claimed over 120 casualties in May.

Indonesia has undergone a no-less challenging (if not traumatic) political transition over the past decade. Starting with the fall of President Suharto in 1998 after 32 years in office, and the breaking away of East Timor in 1999, power has been devolved away from the central government. The first direct presidential elections were held in 2004. The election was hailed as the first peaceful transition of power in Indonesia's history. While great progress has been made, the country continues to be plagued by ethnic and religious conflicts, as well as terrorist threats. In view of these, it is not surprising to see that over half of the 13 Asian economies surveyed by the World Bank saw their perceived political stability drop over the past decade, with Taiwan, Thailand, Indonesia and the Philippines posting the most significant falls (Chart 1).

However, if we look beyond political stability, the picture is somewhat different. Measured by the World Bank's Worldwide Governance Indicator (WGI), which includes six factors: "Political Stability", "Voice and Accountability", "Government Effectiveness", "Regulatory Quality", "Rule of Law" and "Control of Corruption", governance in Asia, including Southeast Asia, has seen some improvements in recent years. This helps explain Asia's enviable economic advancement, which has a strong correlation with the WGI (Chart 2). Understandably, aside from general political stability, curbing corruption, promoting accountability and upholding regulatory quality are the keys to facilitating a conducive environment for businesses to operate within, and for economies to prosper.

A clear example is Thailand, where political stability has deteriorated substantially. However, there has only been a marginal decline in government effectiveness, regulatory quality and the rule of law. In fact, with military rule, one might argue that social order has improved. While no substantial progress has been made in corruption charges against some key officials of the former government, the control of corruption has nevertheless tightened. Overall, while business confidence remains damp, normal economic activities have not been severely disrupted and the economy is managing reasonable growth. After a year's juggling, a new constitution has been born and there are high hopes that the upcoming general elections in December will see a peaceful return to civilian rule. While a new government and a new constitution will take time to establish, we do expect a coalition government to emerge, which would be good enough to facilitate an economic rebound in 2008.

In Indonesia, while occasional terrorist threats may keep the country looking unsafe, law and order have broadly improved and the new electoral system has become entrenched. For some, the government's drive against corruption may have gone too far and is disrupting normal activity. Clearly, there is a significant improvement in accountability under a more decentralised political system, government effectiveness and regulatory quality also see some progress (Chart 3).

CHINA

Stephen Green
Senior Economist, +86 21 5887 1230 extn.5223
Stephen.Green@cn.standardchartered.com

Jason Chang
Economist, +86 21 58871230 ext. 5675
Jason.Chang@cn.standardchartered.com

America slows, China grows

- Fast growth continues; limited worries about US impact
- Stock market will be a political issue after October
- New Politburo line up, with successors likely in place

Despite problems in the US and major financial markets, the Chinese economy continues its fast growth and serves as an increasingly important driving force to the global economy. Real GDP grew officially by an eye-popping 11.5% y/y in the first half of this year, the strongest since 1995 (Chart 1). However, we think even this probably under-estimates growth by a few percentage points. Concerns have arisen again about China's ability to keep sprinting as inflation threatens, to survive a US slowdown which could hit exports, and to maintain real sector growth while anyone with any spare cash seems focused entirely on the stock market. We remain bullish though, at least in the short term, expecting the economy to grow another 11.5% y/y in H2-07 on stable investment and higher private consumption growth. Inflationary pressures are still mild, but will push the People's Bank of China (PBoC) to hike once more in 2007, by 27 bps, and two more times in Q1-08. Yet, this is unlikely to dampen growth sharply.

The drivers
Urban fixed asset investment (FAI), China's biggest growth engine, has stayed stable and fast. It rose 26.7% in the first eight months of 2007 compared to the same period in 2006. As administrative controls remain loose and corporate profitability stays strong, recent interest rate hikes have failed to make a noticeable dent on business sentiment or investment behaviour. Growth of local government and private investment projects (which account for 90% of total investment) rebounded to a 28.4% increase in the first eight months compared to the same period last year, offsetting a sharp decline in central government projects. (Due to inflated land prices and other factors, FAI numbers usually overstate the rate of growth of investment - we believe the actual growth rate is likely to be around 18% y/y at present.) With ever greater numbers of domestic commercial banks being listed, there is now a greater need for banks to issue more loans and maximize profitability (net interest income accounts for some 80% of PRC bank profits). New bank loans for the first eight months totaled CNY 3.07trn (USD 409bn), exceeding the annual quota of CNY 3.0trn (USD 400bn). However, it seems that the PBoC has tightened its credit controls on the banks in the last couple of months (the draft market is very tight, for instance), and has used fixed placement of central bank bills that offer lower-than-market yields to punish banks which lend out "too much". A total USD 94bn of these bills have been issued so far this year, compared to USD 33bn in 2006. Private consumption has become stronger, with retail sales growing 2-3 percentage points (ppts) faster than last year on strong household income growth. Regarding exports, there are clearly risks to China from a US slowdown, but since only 20% of China's exports end up in the US, as long as Europe and the emerging world remain robust, China should be fine.

The worries
Of growing concern though is the stock market, which continues to hit new highs on the back of ample liquidity, strong profit growth and popular belief that CNY appreciation means stock prices have to rise - forever. Average historical price-earnings ratio hit 59 times in August (Chart 4), although many analysts argue that many companies deserve such high valuations on the basis of expected earnings growth of 30%+ y/y in the next three years. Most of the domestic analysts we speak to are concerned, but very few seem to be cutting positions - and are instead trading simply on momentum. What could reverse sentiment? Sharply slower profit growth at a handful of large blue-chip stocks could do it, but this looks unlikely in the short term. It is possible that after the 17th Party Congress (see below) the leadership will re-assess its attitude and start talking the market down - and pushing state firms to sell still non-traded legal person shares into the market as a practical step. Up until now, Beijing has taken a very cautious, indirect approach to deflating the market - hiking interest rates (Chart 5) and expanding QDII products. (On the later, we are happy to report that our QDII outflow forecast for 2007, USD 10bn, has already been broken, with four funds being raised for offshore equity-focused investment raising USD 15bn in the last few weeks.) It could get more aggressive if Beijing senses risks growing. However, property prices would likely then get a boost from mild share falls, creating a dilemma for Beijing.

And the unknowns
Finally, the 17th Party Congress was imminent at the time of writing. The new line up of the Politburo Standing Committee (PSC), the nine-man senior leadership team, looks set to change. Party Secretary Hu Jintao and Premier Wen Jiabao will retain their seats, but at least one of their likely successors may be appointed; Xi Jinping, who is running Shanghai, and Li Keqiang, currently running Liaoning province, look to be the most likely successors to the top two jobs. Working out what economic policy is likely to follow from the reshuffle, however, is tricky. Promotion is based on competence, party discipline and networks, not so much policy views (which are unknown in many cases). Over the next five years, however, we should see more meat put on the bones of the welfare state agenda that President Hu has set out. There seems to be wide-consensus on the need for that, even if the detail of how to deliver such services is still debated.

INDONESIA

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

The temporary return of inflation

- Higher inflation makes BI cautious on further rate cuts
- But inflation is unlikely to dampen the growth recovery
- We have raised our inflation and growth forecasts

Inflation has accelerated unexpectedly, raising alarm within the central bank, Bank Indonesia (BI). Despite a 50bps cut in the US Fed Funds Target Rate (FFTR) in Sep-07 and expected further cuts in Q4-07, BI is now likely to postpone and limit any policy rate cuts in the near future. However, this is unlikely to impede the recovery of the real economy, given previous aggressive easing. Meanwhile, a solid external payments and an improving banking sector should mean healthy economic growth in 2008.

The return of inflation
Inflation has surprisingly risen from 6.1% y/y in Jul to 6.5% in Aug and to 7.0% in Sep. We now expect inflation to remain high at around 7.0% in Oct and Nov, before coming down to 6.6% by YE-07 (our previous forecast was 6.0%). There are three notable inflationary factors:

1. Ramadhan. During the fasting season of Ramadhan in Sep and Oct, consumer spending will rise and push up prices.
2. Aggressive BI rate cuts. BI cut its policy rate aggressively from 12.75% in May-06 to 8.25% by Jul-07, accelerating the M2 growth from 14.9% y/y at YE-06 to 18.0% by Jul-07. This exceeds real GDP growth by a wide margin.
3. Weaker IDR. Before its rebound after the US rate cut in Sep, the IDR had steadily weakened in H1-07, pushing up import prices.

While acknowledging the positive impact of lower US interest rates on IDR strength and growth prospects, BI said its interest rate policy will depend on the domestic inflation outlook. We believe the next BI rate cut, by 25bps to 8.0%, will be postponed from Nov to Dec. Thereafter, we expect the BI rate to be cut further to 7.5% in Q1-08, and to 7.0% in H2-08, with risk of a less aggressive cut in H2-08 to 7.25%.

Limited impact of slower rate cuts
The economic impact of delayed rate cuts should be limited. The economy is recovering gradually from the mini-IDR shock in H2-05 when domestic energy prices and BI rates were hiked sharply. There are, for example, indications that the banking sector is accelerating its lending to the real sector. Banks' loan-to-deposit ratio has increased to 67.3% (the highest since the economic crisis in 1998) in Aug-07 from 53.3% at YE-06. With bank credit growing by 21.8% y/y in Aug-07 (vs. 14.1% in 2006), the BI target of 22% in 2007 should be achieved.

Partly due to higher bank lending, GDP growth rose to 6.3% y/y in Q2-07 (vs. market expectations of 6.1%) from 6.0% in Q1. Growth was broadly driven by consumer spending (4.7% y/y growth in Q2-07 vs. 4.5% in Q1), fixed investment (6.9% vs. 7.0%) and exports (9.8% vs. 8.9%). Consumer spending and fixed investment strengthened on the back of lower BI rates, while exports benefited from high commodity prices. Given the government's ambitious infrastructure program (toll roads and power projects are finally being launched) and its decision to accelerate the fiscal stimulus by raising its budget deficit target to 1.6% of GDP (from 1.1%) in 2007, the government is optimistic that its GDP growth target of 6.3% this year will be achieved. We are more cautious than the government, and have revised our GDP growth forecasts to 6.1% in 2007 and 6.3% in 2008 from our original 6.0% for both years.

Payments balance remains solid
While GDP growth is rising, the balance of payments remains solid. The trade surplus rose to USD 27.1bn in the first eight months of 2007 vs. USD 26.4bn in the same period in 2006. Exports rose 13.3% to USD 73.3bn while imports rose 16.9% to USD 46.8bn. The decline in the trade surplus in oil/gas by 65.2% to USD 614mn was more than compensated for by a rise in the non-oil/gas trade surplus by 7.6% to USD 26.5bn.

Meanwhile, Indonesia's current account surplus surprisingly rose to USD 5.6bn in H1-07 from USD 4.5bn in H1-06. On top of the stronger trade surplus, net worker remittances from abroad also rose, albeit slightly, to USD 2.5bn from USD 2.2bn over the same period. We expect the current account surplus to fall to USD 9.2bn (vs. BI forecast of USD 9.9bn) in 2007 from USD 9.6bn in 2006, which means Indonesia's FX reserves will rise to USD 54.8bn by YE-07 from USD 52.9bn in Sep-07 and USD 42.6bn at YE-06.

Stronger investment and imports
We believe the current account surplus will gradually fall, as real investment accelerates. The government has already said that investment approvals have finally reached pre-crisis (1998) levels, which implies higher future imports of capital goods and raw materials. In the Jan-Aug 07 period, approved FDI (excluding oil and gas, as well as financial sector) rose 157% to USD 31.1bn vs. the same period last year, while approved domestic investment rose 51% to USD 16.2bn. The combined actual investment by foreign and domestic investors rose to USD 11.7bn or 123% higher than the same period last year. With the expected acceleration of the government's USD 150bn infrastructure program, which has an important bearing on the 2009 elections, we expect real investment to continue rising well into 2008.

SINGAPORE

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

Alvin Liew
Economist, +65 6427 5229
Alvin.Liew@sg.standardchartered.com

October Surprise!

- Growth continues to accelerate in the midst of the longest upcycle since 1991
- The risk of overheating is rising and has forced the hands of MAS
- SGD to appreciate faster in the near term, but downside risks remain

The Singapore economy continues to defy gravity and grow above trend, despite its having expanded for the longest period since 1991 and being confronted by weak electronic exports and financial market turbulence. However, rising inflation and higher business costs are raising concerns about overheating and has prompted the MAS to opt for a stronger SGD. While such measures may help to contain import price pressures, more efforts may be needed to curb asset price inflation and reduce supply side constraints. In any case, given that the economy has already grown for 17 quarters non-stop, a moderation in growth would appear inevitable, and necessary, going forward. From a breakneck growth speed of about 8% in 2007, we expect Singapore's real GDP growth to moderate to 5.7% in 2008.

Growth is still strong
Like China, Singapore's growth momentum seems unstoppable. Real GDP growth, having reached 8.2% y/y in the first three quarters of 2007, is likely to accelerate further and surpass last year's 7.9%. A broad-based recovery and a more diversified economy has contributed to an extended upcycle which is now in its 18th quarter and is still running at a high 9.4% y/y in Q3-07, following an enviable 8.7% growth in Q2.

Following the lead of the services and construction sectors, manufacturing production also recorded significant improvement in Q3-07, having grown 12.3% y/y after an 8.3% growth in Q2. Aside from the strong performance of the bio-medical and transport engineering sectors, electronics also seems to have embarked on a gradual recovery, as reflected in the manufacturing and non-oil domestic exports data.

Construction activity remains buoyant, although the pace of expansion was slightly lowered to 15.5% y/y from 18.8% in Q2. The services sector also performed well in Q3 with an 8.1% growth, thanks to a resilient financial sector that survived the recent global market turmoil, strong tourist inflows and robust domestic demand. On a q/q seasonally-adjusted basis, which better reflects an economy's growth momentum, GDP expanded at an annualized 6.4% in Q3-07. This is lower than the 14.4% in Q2 but underlines a sustained expansion cycle that has become the longest since 1991.

Going forward, we are confident that growth should be sustained in H1-08. However, we also aware that there are downside risks from any severe slowdown in the US or higher oil prices. In any case, we believe a slowdown in Singapore's growth momentum is likely in the coming quarters. While electronics exports may revive from the doldrums, growth is unlikely to be strong given a weakening US economy. Meanwhile, growth of the current drivers like bio-medical, transport engineering, finance, construction and property sectors could moderate given the high base being built and tight supplies, especially in human resources. We expect growth to ease to 7.3% y/y in Q4-07 and reach 8.0% for the full year, which is at the high end of the official forecast. As for next year, we maintain our full year forecast of 5.7%, due to our expected moderation in external demand and rising factor costs. This is still closer to the top of the MAS' 4-6% forecast range.

Concerns about overheating
CPI inflation has accelerated in recent months largely due to a higher-than-expected pass-through of the July GST (Goods and Services Tax) hike from retailers to consumers. Of course, higher commodity prices also added to the inflation pressure. In view of the likely impact of GST hike and the base effects of energy and car prices, the MAS has raised its inflation forecast and now expects headline CPI to rise by 3.5% y/y in H1-08. This higher inflation forecast, together with strong increases in real wages and higher residential and office rentals, are raising the spectre of overheating. Although the MAS seems to believe that inflationary pressures will ease to 2-3% in H2-08, partly due to dissipating impact of the GST-hike in mid-2007, it nevertheless remains alert to the threat.

Forcing the hands of the MAS
In its October Monetary Policy Statement, the MAS maintained its FX stance of a "modest and gradual appreciation" of the Singapore dollar (SGD) NEER policy band. However, the MAS also raised "slightly" the slope of the band. This is the first policy adjustment since Apr-04 and reflects underlying concerns about inflation. We believe the MAS will now allow 2.5% yearly appreciation of the SGD, up from 2.0% previously. With the prospect of CPI rising above 3% towards YE-07, we believe the SGD NEER will stay at the stronger end of the band.

However, we still believe that there are significant downside risks to US growth. For small open economies like Singapore, the negative impact from this should not be under-estimated. Therefore, we could at some point see the SGD NEER move back below the centre of the band. Should the US plunge into a sharper slowdown, it could revive concerns about Singapore's growth prospects, and even reverse the "steepening" slope perhaps even as early as the April MAS review.

SOUTH KOREA

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

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

Eunhye Yoon
Research Assistant, +822 3702 5072
Eunhye.Yoon@scfirstbank.com

Won on demand

- High asset prices support consumption, but also inflation
- A strong KRW may curb import prices and offer some comfort
- Longer term, the BoK will have to resume hiking

Partly boosted by the second North-South summit held in Pyongyang early this month, and partly buoyed by government pump-priming in the run-up to the Dec-07 presidential elections, sentiment in South Korea has stayed positive despite the threats of US slowdown and global financial market turbulence. Strong asset price and robust demand from China and Europe have supported the Korean economy and kept the KRW on the strong side. However, the rising threat of inflation may ultimately push the Bank of Korea (BoK) to resume interest rate hikes, probably in as early as Q1-08.

Resilient economic growth
Strong economic fundamentals and limited direct exposure have kept the Korean economy relatively unscathed by the US sub-prime crisis, even though its stock market experienced the same roller-coaster ride as most other equity markets. As of Oct 15, the benchmark KOSPI index had more than recovered the loss it had suffered since early August.

In the real sector, exports dropped by 0.4% y/y in Sep-07, largely due to public holidays that came earlier and were longer than the previous year. Net of holidays, daily exports actually increased by 17% from USD 1.3bn in Aug-07 to USD 1.52bn in Sep. While exports of consumer goods like home electronics and autos were dampened by weak US demand, exports of capital goods like ship, steel and machinery were boosted by strong demand from the EU, China and the Middle East. Going forward, the payback of less holidays in the subsequent month implies that export growth should rebound in Oct-07.

Wealth effect boosts consumption
At home, improving consumer demand in luxury goods and food items supported retail sales. Sales of department stores turned around from a 1.5% y/y decline in Aug-07 to a 3.5% increase in Sep. Meanwhile, sales of large scale discount stores accelerated from 4.3% y/y to 6.0%. Part of this was due to strong employment growth in services, which offset sluggish manufacturing demand for labor and kept the overall unemployment rate at bay. However, a more important factor is the positive wealth effect from strong asset prices. Judging from a rising shipment/inventory ratio, demand remains strong and the economy should stay in its upcycle in the near term.

Threats of inflation
Core inflation and service prices have stabilised recently, but rental charges continue to rise, mainly due to the pass through of a higher property tax. The average property tax rate increased from 0.6% to 1.0% as a result of recent government measures to curb real estate speculation. Even though rental accounts for only 9.8% of the CPI basket, there is a risk that it could raise the cost of business operations and trigger wider price increases. On top of this, this elevated prices of oil, food and other commodities also threaten to push up inflation.

Won on demand
Notwithstanding the threat of inflation, we believe the BoK is likely to refrain from raising its policy interest rates, in the near future. This is evident from the BoK governor's recent comments, which emphasised the need to be vigilant about the downside risks of external demand. Of course, political concerns in the run-up to the presidential elections could be a factor also. As an alternative, a strong KRW may be used to curb import prices and general inflation, which seems a sensible policy in the near term given the threat of imported inflation from higher oil and commodity prices.

Higher rates expected in 2008
Going into 2008, however, a strong KRW may not be sufficient to hold prices steady, especially as domestic price pressures from non-tradables like rental, and services kick in. By then, elevated asset prices may also warrant more restraints on domestic liquidity. Although there have been some shortages in foreign currency (mainly USD) liquidity in the aftermath of the sub-prime problems, KRW-based liquidity has remained ample. These will likely prompt the BoK to resume its hiking cycle, more so when the elections are over. This may keep inflation contained at 2.6% in 2008, up from a modest 2.4% this year. However, in the unlikely event of a recession in the US that drags the global economy into a sharper-than-expected downturn, monetary policy in Korea may switch into easing mode, taking interest rate and the KRW lower.

Presidential elections not a non-event
Of course, the upcoming presidential elections may have a bearing on future economic policies. On the surface, there are only marginal policy differences between the key candidates of the ruling United New Democratic Party (Chung Dong-young, a former unification minister) and the major opposition Grand National Party (Lee Myung-park, previously the mayor of Seoul). However, the devil is probably in the details. For example, Lee's pledge to allow industrial groups to invest in financial firms could spur significant restructuring of the economy. Also, his idea of cutting the corporate tax to 20% (from 25%) would have a very different impact from Chung's 20% cut in the oil consumption tax.

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