• We explore the outlook for the emerging giants, China and India
• Despite vast differences, in recent months both have faced a common set of challenges
• The global slowdown, excess liquidity and rising inflation will all test the policy response
• While near term risks are rising, the fundamentals remain excellent
• The price of oil is a global concern. In Africa, key vulnerabilities have temporarily resurfaced
• We examine the case of Ghana, an oil importer today, an oil exporter tomorrow
• Analysis inside on Brazil, Hong Kong, Japan, the Maghreb, Pakistan and the US
• Plus focuses on FX and commodities

Overview: China and India
India's saving and investment levels are rising towards China's. India's response to inflation has so far been slightly less effective than China's. Near-term risks are clearly rising in both, but the fundamentals remain excellent.

Africa: Ghana cedi - a decisive move through parity
Ghana's longstanding vulnerability to oil resurfaces. Amongst African currencies, the GHS is one of the most pressured. A short term blip, or long term weakness? We set out the parameters.

Middle East: The Maghreb three
Politically stable Tunisia and Morocco present investment opportunities. Despite its oil wealth, Algeria has been very slow to reform. Regional economic integration would help everyone.

FX: Back to reality
The correction in risk appetite is long overdue. US earnings projections still look overly optimistic vs. our view for a soft US in H2. June's FOMC statement caps the USD recovery for now. Failing inflation credentials continue to drive relative EM performance in Q3. We favour the SGD, CNY and BRL vs. INR, PHP and CLP.

Commodities: Corn: Blame the weather
Corn prices rallied in June on flooding in the US corn belt. The impact of the flooding will be felt in other grain markets. Prices should remain well supported in Q3-08 before trending lower thereafter.

Brazil: Mid-year inflation outlook: More fiscal effort please

Hong Kong: Dark cloud, silver lining

Japan: The rising risk of inaction

Pakistan: More turbulence ahead

US: Leading indicators point to more weakness

Forecasts and Sovereign risk tables

OVERVIEW

Stephen Green
Head of Research, China, +86 21 5887 1230 ext. 5223, Stephen.Green@standardchartered.com

Shuchita Mehta
Senior Economist, +91 22 2268 2325, Shuchita.Mehta@standardchartered.com

• India's saving and investment levels are rising towards China's
• India's response to inflation has so far been slightly less effective than China's
• Near-term risks are clearly rising in both, but the fundamentals remain excellent

Welcome to our world - China and India

One of the big ironies about the rise of Chindia (China and India), two of our biggest markets, in recent years, is that the two countries really are very, very different. It has become commonplace to mention them in the same breath. Both represent emerging economic giants, countries that are set to be even more important to the global economy in the future. A key part of both economies' success has been their rapid growth, which is necessary considering that both have huge populations. Until now, their economic stories have had little in common. Start with the fact that China's economy is three times as big - and getting bigger quicker. Its per capita income is double that of India on a purchasing power basis. USD 4088 compared to USD 2222 in 2005, the latest data we have. In part this is a reflection of India's largely agricultural economy, in contrast to China's established manufacturing economy. Even so, India's pace of growth has picked up in recent years as Chart 1 shows. Investment has dominated the recent fast growth in China, while India still faces a yawning infrastructure deficit. Nonetheless, India is clearly the leader when it comes to global services, and it scores more companies in the Fortune 500 than China. New Delhi tries every year to extricate itself a little bit from a large budget deficit, while Beijing has to work hard to spend all the money that pours into its Ministry of Finance.

Despite these huge differences, in recent months the two have faced a common set of big problems: a global slowdown, rising inflation, big FX inflows, excess liquidity, and pressure on their currencies to appreciate. And the way New Delhi and Beijing have managed these pressures are remarkably similar in many ways. Look past the short term and we cannot but notice that the kinds of policies that New Delhi is now pursuing are, slowly but surely, making India a little more like China every day. Higher savings, more investment and a better fiscal position (well, kind of), are some of the examples. Both though are finding the balancing act between growth and inflation tricky to manage; risks in both economies have risen considerably in the last six months and look set to remain elevated. For both the golden years of fast, untroubled growth, are over, at least for the moment.

Fast, but slowing growth
Both India and China are slowing, predominantly because of US weakness, cost pressures and domestic tightening measures (both raised interest rates in 2007, India two times, China five). So far in 2008, India has already raised rates twice by a total of 75bps (the repo rate is now at 8.5%). Needless to say, more aggressive rate hikes could still be in the offing in India and we still expect more hikes in China too, although the bank credit quota is doing the heavy lifting there at present. Even in this weak patch though, we see both countries still moving ahead: India should grow 7.4% y/y in fiscal 2008/09, China at 9.5% in 2008. There is a difference though - we think India should still be able to bounce back a bit in 2009/10 to 8.5%, but China will continue to decelerate. The impending government staff wage hikes in India could provide a boost to consumption. The Indian central bank (RBI) could quickly reverse its tightening bias gradually once inflation starts reverting towards 5% y/y in H2 2009. Corporates could still continue to build capacity in anticipation of future demand. In China's case, though, given the capacity issues that the global downturn will likely reveal, and the slow movement of the bureaucracy towards fiscal stimulus, it is hard to see a recovery in 2009. Indeed, the era of double-digit official growth in China may well be over. Pressure on Beijing, though, to loosen the credit quota will clearly rise as H2 progresses and the export sector continues to slow. We counsel clients though to prepare for its lasting till year end.

Dangerously high inflation
Both India and China are tightening because of inflation. Inflation in India hit a 13-year high of 11.63% y/y in June, more than 600bps above the RBI's comfort zone, as Chart 3 shows. China's CPI moved up 7.7% y/y in May. In China, most of the current push in CPI shown in Chart 4 is coming from food (although we are more concerned about non-food; factory gate prices are now rising >8% y/y). In India, while food prices are rising too the big driver of the wholesale price index is fuel and raw materials, which are filtering down to the household level more quickly than in China. Fuel prices were hiked in India in February (by a nominal 3-5% for gasoline and HSD) and more recently in June (by 9-17%), while Beijing recently hiked retail gas prices by almost 17% in June, after a 20% move in November 2007. Both governments have tried to delay these hikes but with global oil likely to remain above USD 120 for the next few months, more hikes will have to come. If India passes on the full impact of global oil prices to the local consumer, inflation could easily approach 25%. What is even more worrying in India's case is that since aggregate demand is still strong, wages are rising. In China, manufacturing wages are rising too - although we are happy with wages going up at the same pace as GDP growth and do not see this as a signal for a wider inflation break-out, at least for the moment. We are concerned though with upstream inflation falling on households. Post Olympics, retail energy prices still have at least 20-30% to rise.

Greater caution on the exchange rate
Just as Beijing seems to have become more cautious about the exchange rate in recent months, so has New Delhi. After moving by 4% against the USD in Q1, the CNY dawdled in May. However, Beijing then pushed forward with its appreciation policy. In Q2 it did 2.2% against the USD. Most importantly, though, the CNY's nominal effective exchange rate moved 1% and 3.7% in Q1 and Q2 respectively. We now see USD-CNY reaching 6.55 by year end, but that said, the risks are clearly on the slow side, as the export growth engine splutters. The six months USD-CNY NDF on July 7 was pricing in only 6.68, suggesting the market thinks Beijing will only do another 2.6% in H2.

The INR has had a more volatile time of it. It strengthened by almost 7.5% in 2007/08. And this is in spite of the RBI's aggressive intervention (it bought USD 78bn or 25% of outstanding FX reserves in 2007/08) to stem appreciation. Since then the INR has shed all its gains and is back to its end-March 2007 level. The portfolio inflows which drove the currency up have evaporated - indeed they have reversed for this year. The INR seems to be bearing the brunt of the current account adjustment. Imports remain buoyant not only because of the bigger oil import bill (India imports roughly 70% of its oil, China 50%) but because other imports are growing too. Another factor is India's interest rates; they have been too low in recent years. Now the economy is paying the price. But even as inflation drives policy rates higher, the INR may not benefit till aggregate demand pressures abet and inflation falls. It could weaken more before this happens.

Fast credit growth, now slowing, but not enough
India's credit growth was fast in 2007, 30% y/y, while China's was slow in comparison, 16%, though this is the fifth year of strong credit growth in an already liquid economy. Both are now focused on bringing that down in order to control inflation - but neither has done enough. Indian loan growth is still rising at 26% y/y, and money supply (M3) is growing at 21% y/y, well outside the RBI's comfort zone of 16.5-17.0%. As a result we expect more hikes in the banks' cash reserve requirement (CRR), which has already been hiked by 125bps (to 8.75%) since January 2008, as Chart 5 shows. In China, the CNY reserve requirement is now 17.5%, and while it will also inevitably be hiked again soon, the key tool in play now is the relatively crude, but also more effective, credit quota. Chart 6 shows it having some effect in real terms. (Credit growth was 15% y/y in May, although in real terms it is down below 10%). But even that, we have argued, is only half-effective, given the widespread use of entrustment loans, underground financing, etc. In India one could never even attempt to introduce such a quota - the banks are too commercial. That said, moral suasion and increased risk weights and capital requirements can be used. So far, when all is said and done, China does seem to be doing a better job in tightening policy.

India exporting more manufactured goods
One of the most encouraging stories of the past few months has been the rise of Indian exports of processed goods. They have boomed, a significant change from the previous dominance of agricultural exports. This has been useful in preventing a massive ballooning of the trade deficit on the back of high oil prices and other imports. Trade has grown as a proportion of GDP, with imports now equivalent to 20% of GDP, exports 14%. (Of course, India is only a few steps along the road that China took in the 1980s, to a place where total trade is now equivalent to 64% of GDP in China.) But like China, India's exposure to a slowing US economy is more limited. Last year, only 14% of exports were to the US, compared with 23% for China.

There is another important contrast to draw here. Too much of India's export growth in FY 2007/08 has been driven by commodity prices. If these were to decline, then the overall trade deficit would likely sharpen, although this would also depend on the price of oil products, of which India is a major importer. China, in contrast, would see its surplus rise again if commodity prices fell, but this would be because of a falling import bill.

For good and for bad, both economies receive lots of FX inflows
India received large FX inflows in 2007. In FY 2007/08, almost USD 30bn of portfolio inflows, plus more FDI and corporate borrowing (which together made up 54% of the total capital flows). In 2008, portfolio inflows and corporate borrowing are slowing sharply. Global investors have turned sour on Indian markets on policy credibility issues. The current account too does not add comfort in the near-term and the deficit could easily touch 3.0% of GDP. Yet, in spite of weaker portfolio inflows and deteriorating current account, foreign direct investors have kept their interest in India alive with their eye on India's long term structural strengths. China's tighter capital controls have not prevented the economy becoming similarly flush with outside funds. Most is coming from trade, as well as FDI, while only a limited amount is coming from corporate borrowing since this is restricted. We forecast a current account surplus of USD 398bn for 2008, 9.1% of GDP. FX flows continue to grow fast, some USD 330bn in total in the first four months alone. Beijing is scared of all the 'hot' money leaving, with some analysts arguing there is anywhere between USD 500-1,500bn ready to leave. We question the methodology behind such calculations - and believe the low-bound estimate to be the ball-park figure. That said, all the worry about hot money is now overblown - the central bank has a huge amount of liquidity tied up on its own balance sheet, which it can release if money starts to leave. Moreover, in a crisis, as 1997 in Asia taught us, it is households you have to worry about, not financial institutions. If households lose confidence in their currency (a very low probability event for China), then you have a real problem. No one in China seems to be considering that factor yet.

Both countries are using the full panoply of sterilisation instruments to insulate themselves from the effects of these inflows - reserve hikes, sterilisation bonds (issued by the central bank but count as the MOF's liability in India) and reverse repo operations by the central bank. Ultimately though, the success of such policies is measured by the rate of credit expansion - and in both, especially India, this is still running too high, as we argued above.

Higher savings in India, financing higher investment
Short-term exigencies aside, India seems to be also solving one key challenge: its savings rates are rising. Not to China levels, perhaps, but this is still really significant as savings can finance investment. In 2007/08 India's savings rate was 34.8% of GDP, thanks to higher corporate and government saving, as well as stable household savings. Investment has risen as a result, from around 20% of GDP five years ago to 34% today. India still needs to be a bit more of a dragon here, as 30% of agricultural output is still wasted before reaching market because of the lack of infrastructure, and the country also has a power deficit of some 15% at times of peak demand. Investment in China is officially 42% of GDP. Its overall savings rate is still high too, 50% of GDP in 2007, which means overall investment can remain elevated for quite some time yet. As we pointed out recently though, in real terms fixed asset investment is slowing.

Fast tax revenue growth
India got round to a big tax reform in 2003, and the benefits have been significant, with revenues as a proportion of GDP rising from 8% in FY2002 to 11.4% in FY 2007/08. As a result, the fiscal deficit is declining, to less than 3.0% of GDP in FY 2007/08. The official aim, unlikely to be met we think, is 2.5% in FY 2008/09. There is a big catch here though - the huge subsidies on oil and fertilisers are currently being accounted for as off-budget items. Including these and other potential slippages (from slowing growth, on budget interest payment increases) in the FY 2008/09 overall deficit could be a staggering 7%. We show this problem in Chart 7. This is clearly not good news. In contrast, China's big tax reform is now almost 15 years old, and its benefits have been huge. Fiscal revenues rose 32% y/y in 2007, and continue at this pace. China ran its first official budget surplus last year too, 0.7% of GDP, and although Beijing is officially planning a small deficit in 2008, it looks likely to achieve another surplus, as we show in Chart 8. Plenty of ammunition for spending in a slowdown. The one thing we do wonder about though is what China's local government books are really in, given the fact that many have financed local projects through off-balance sheet investment corporations. The banks in many areas too have been dragooned into partly financing local projects, and there is little transparency about this. That said, when bad loans rise, as they certainly will, starting in the export rich areas of Guangdong, a banking crisis seems an unlikely scenario. Having USD 1.7trn and rising as one's FX reserves creates a huge cushion, and another round of capital injections and bailouts is possible.

More alike, but still stuck between growth and inflation
Higher saving, more investments, plus more manufactured exports. In these respects, India is looking a bit more like China these days, and that will support more growth over the next decade. However, challenges remain, particularly on the fiscal side for India. That said, the era of plane sailing for China has also come to an end. Neither New Delhi nor Beijing has quite worked out how to handle the inflation that their growth is now unleashing. India has used more market tools, including both the exchange rate and interest rates, but still seems behind the curve. Equities and the currency could take more hits as a result. China has taken a more planned approach to the problem, resisting any significant appreciation and controlling bank lending. And yet, its inflation situation is still dangerously poised and small and medium-sized firms are suffering. The stock market is still 50% off, and real estate prices looks vulnerable in a number of cities. Beijing also has to deal with a lot more FX inflows - and potential outflows over the next few years. Much of the fears associated with these are exaggerated, but they are still clearly playing on Beijing's nerves. As far as hot money is concerned, at least, India is in much better shape.

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