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Economics Markets Strategy 3Q 2008 DBS Group Research 12 June 2008
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<strong>Economics</strong><br />
<strong>Markets</strong><br />
<strong>Strategy</strong><br />
3Q 2008<br />
<strong>DBS</strong> Group Research<br />
12 June 2008
3Q 2008<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
June 12, 2008<br />
Contents<br />
<strong>Economics</strong> On a clear day 5<br />
Currencies Slipping on oil & USD 23<br />
Yield Bearish 43<br />
Asian Equity Between <strong>the</strong> devil and <strong>the</strong> deep blue sea 56<br />
Greater China, Korea<br />
China Re-thinking CNY appreciation 70<br />
Hong Kong Rates bottom, good for inflation 76<br />
Taiwan Staying on track 82<br />
Korea Surviving 88<br />
Sou<strong>the</strong>ast Asia, India<br />
India Rising growth, inflation 94<br />
Indonesia Fingers crossed 100<br />
Malaysia Biting <strong>the</strong> bullet 108<br />
Thailand Politics over economics 114<br />
Singapore Inflation woes 120<br />
Philippines Back-tracking 126<br />
Vietnam Growing pains 132<br />
G3<br />
United States Forecasts rising 138<br />
Japan What virtuous cycle? 142<br />
Eurozone ECB eyes wages 148<br />
1
June 12, 2008<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Economic forecasts<br />
GDP growth, % YoY<br />
CPI inflation, % YoY<br />
2005 2006 2007 2008f 2009f 2005 2006 2007 2008f 2009f<br />
US 3.2 3.3 2.2 2.0 2.6 3.3 3.2 2.9 3.5 2.3<br />
Japan 1.9 2.4 2.0 1.6 1.6 -0.3 0.2 0.1 1.1 0.6<br />
Eurozone 1.6 2.9 2.6 2.0 2.0 2.2 2.2 2.1 3.0 2.1<br />
Indonesia 5.7 5.5 6.3 6.0 6.3 10.5 13.3 6.3 10.3 7.2<br />
Malaysia 5.0 5.9 6.3 5.1 5.8 3.1 3.6 2.0 4.5 3.3<br />
Philippines 4.9 5.4 7.3 5.4 6.0 7.7 6.3 2.8 9.0 4.8<br />
Singapore 7.3 8.2 7.7 6.0 6.8 0.5 1.0 2.1 6.4 2.8<br />
Thailand 4.5 5.1 4.8 5.0 4.7 4.5 4.6 2.2 6.4 2.8<br />
Vietnam 8.4 8.2 8.5 6.4 6.9 8.3 7.5 8.3 26.3 15.0<br />
China 10.4 11.1 11.9 10.0 9.0 1.8 1.5 4.8 6.5 4.5<br />
Hong Kong 7.1 7.0 6.4 5.2 4.7 1.0 2.0 2.0 5.0 4.0<br />
Taiwan 4.2 4.9 5.7 5.0 5.4 2.3 0.6 1.8 3.4 2.4<br />
Korea 4.2 5.1 5.0 4.6 5.0 2.8 2.2 2.5 4.6 3.0<br />
India* 9.2 9.7 9.0 8.6 8.6 4.4 5.4 4.3 6.8 4.9<br />
* India data & forecasts refer to fiscal years beginning April; inflation is WPI<br />
Source: CEIC and <strong>DBS</strong> Research<br />
Policy and exchange rate forecasts<br />
Policy interest rates, eop<br />
Exchange rates, eop<br />
current 3Q08 4Q08 1Q09 2Q09 current 3Q08 4Q08 1Q09 2Q09<br />
US 2.00 2.00 2.50 3.25 4.00 … … … … …<br />
Japan 0.50 0.50 0.50 0.75 0.75 107.6 107 108 109 110<br />
Eurozone 4.00 4.25 4.25 4.25 4.25 1.540 1.52 1.49 1.46 1.43<br />
Indonesia 8.50 9.25 9.25 9.25 9.25 9,325 9,500 9,600 9,700 9,800<br />
Malaysia 3.50 4.00 4.00 4.00 4.00 3.28 3.30 3.35 3.40 3.45<br />
Philippines 5.25 5.75 6.00 6.00 6.00 44.4 45.0 47.0 45.0 45.0<br />
Singapore n.a. n.a. n.a. n.a. n.a. 1.38 1.38 1.40 1.42 1.44<br />
Thailand 3.25 3.25 3.75 3.75 3.75 33.2 33.5 34.0 34.5 34.9<br />
Vietnam^ 14.00 15.00 16.00 16.00 14.00 16,621 16,740 16,860 16,990 17,120<br />
China* 7.47 7.47 7.74 8.01 8.28 6.91 6.80 6.75 6.70 6.65<br />
Hong Kong n.a. n.a. n.a. n.a. n.a. 7.81 7.83 7.85 7.85 7.85<br />
Taiwan 3.50 3.75 3.88 3.88 3.88 30.5 30.5 31.0 31.5 32.0<br />
Korea 5.00 5.00 4.75 4.50 4.50 1034 1075 1100 1075 1075<br />
India 8.00 8.25 8.25 8.25 8.25 42.8 43.0 43.5 42.5 42.5<br />
^ prime rate; * 1-yr lending rate<br />
Source: Bloomberg and <strong>DBS</strong> Research<br />
2
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
June 12, 2008<br />
Interest Rate Forecasts<br />
%, eop, govt bond yield for 2Y and 10Y, spread in bps<br />
11-Jun-08 3Q08 4Q08 1Q09 2Q09<br />
US 3m Libor 2.79 2.60 3.00 3.65 4.30<br />
2Y 2.81 3.59 4.00 4.42 4.66<br />
10Y 4.07 4.60 5.00 5.30 5.40<br />
10Y-2Y 127 101 100 88 74<br />
Japan 3m Tibor 0.84 0.75 0.75 1.00 1.00<br />
Eurozone 3m Euribor 4.96 5.05 4.85 4.65 4.50<br />
Indonesia 3m Jibor 8.98 9.40 9.40 9.40 9.40<br />
2Y 12.62 11.00 10.50 10.00 10.00<br />
10Y 13.50 12.50 12.00 11.50 11.50<br />
10Y-2Y 88 150 150 150 150<br />
Malaysia 3m Klibor 3.66 4.15 4.15 4.15 4.15<br />
3Y 4.04 4.40 4.20 4.00 4.00<br />
10Y 4.46 4.80 4.70 4.60 4.60<br />
10Y-3Y 42 40 50 60 60<br />
Philippines 3m Phibor 6.75 6.75 7.00 6.75 6.75<br />
2Y 8.35 8.50 8.75 8.75 8.75<br />
10Y 9.48 9.50 9.75 9.75 9.75<br />
10Y-2Y 114 100 100 100 100<br />
Singapore 3m Sibor 1.44 1.31 1.52 1.94 2.31<br />
2Y 1.27 1.60 2.20 2.40 2.65<br />
10Y 3.61 3.80 3.90 3.93 4.04<br />
10Y-2Y 234 220 170 153 139<br />
Thailand 3m Bibor 3.50 3.45 3.95 3.95 3.95<br />
2Y 4.66 4.70 4.80 4.90 4.90<br />
10Y 5.66 5.90 6.00 6.10 6.10<br />
10Y-2Y 100 120 120 120 120<br />
China 1 yr Lending rate 7.47 7.74 8.01 8.28 8.28<br />
2Y 3.72 4.00 4.25 4.25 4.25<br />
10Y 4.27 4.40 4.50 4.50 4.50<br />
10Y-2Y 55 40 25 25 25<br />
Hong Kong 3m Hibor 2.15 1.95 2.35 3.05 3.70<br />
2Y 2.66 3.02 3.69 3.87 4.08<br />
10Y 3.59 4.05 4.45 4.75 4.85<br />
10Y-2Y 93 103 76 88 77<br />
Taiwan 3m Repo 2.65 2.75 2.88 2.88 2.88<br />
2Y 2.31 2.25 2.50 2.50 2.50<br />
10Y 2.72 2.80 2.90 2.90 3.00<br />
10Y-2Y 42 55 40 40 50<br />
Korea 3m CD rate 5.36 5.20 4.95 4.70 4.70<br />
2Y 5.73 5.60 5.00 4.90 4.90<br />
10Y 5.94 5.80 5.30 5.30 5.30<br />
10Y-2Y 21 20 30 40 40<br />
India 3m Mibor 8.91 7.80 7.80 7.80 7.80<br />
2Y 8.10 8.40 8.40 8.40 8.40<br />
10Y 8.26 8.50 8.50 8.50 8.50<br />
10Y-2Y 16 10 10 10 10<br />
Source: Bloomberg and <strong>DBS</strong> Research<br />
3
<strong>Economics</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
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4
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong><br />
On a clear day<br />
• US demand growth has dropped to zero over a three year period. Oil<br />
prices have tripled over <strong>the</strong> same time frame. Disaster planners could<br />
not have invented a more testing scenario<br />
• Yet growth in Asia remains stronger than it should be even on a clear<br />
day<br />
• Demand, mostly Asian, explains both puzzles. Asian demand kept<br />
growth alive and demand ‘survived’ <strong>the</strong> rise in oil prices because it<br />
drove <strong>the</strong> rise in oil prices<br />
• Oil prices are driving inflation in <strong>the</strong> US and Europe. But data clearly<br />
show that <strong>the</strong> price of oil is no longer made in America or in Europe.<br />
It is made in Asia<br />
• G3 central banks may have to accept an inflation rate made in Asia too.<br />
That, or a permanently lower growth rate<br />
On a clear day, “Asia” ought to grow by about 7% per year. Some countries<br />
grow faster of course (<strong>the</strong> young turks like China and India), some slower (<strong>the</strong><br />
graduates of <strong>the</strong> early stages of development like Singapore, Hong Kong, Taiwan<br />
and Korea) and some in between, like Thailand, Indonesia and Malaysia. Put<br />
<strong>the</strong>m all toge<strong>the</strong>r though and in simple average terms – better than weighted<br />
average terms for many purposes – you’re talking about a 7% growth rate. On<br />
a clear day.<br />
But <strong>the</strong> skies haven’t been so great lately. In fact, Asia has collided head-on into<br />
what most have for a long time considered to be its two greatest threats to<br />
growth: a US on <strong>the</strong> brink of recession, or so it is said, and indisputably record<br />
high oil prices in real and nominal terms.<br />
World's largest oil importers and consumers<br />
mn bbls / year, 2006<br />
Country<br />
Imports (net)<br />
World<br />
rank<br />
Consumption<br />
World<br />
rank<br />
US 4,510 1 7,551 1<br />
Japan 1,836 2 1,883 3<br />
x China 1,225 3 2,628 2<br />
Germany 918 4 973 5<br />
x Korea 787 5 794 9<br />
France 690 6 716 12<br />
x India 627 7 939 6<br />
Italy 572 8 632 14<br />
Spain 570 9 581 16<br />
x Taiwan 343 10 347 19<br />
Ne<strong>the</strong>rlands 341 11 369 18<br />
x Singapore 301 12 305 22<br />
Turkey 228 13 244 23<br />
x Thailand 217 14 339 20<br />
Source: US EIA: http://tonto.eia.doe.gov<br />
Nomenclature<br />
References to Asia in<br />
this report adhere to<br />
<strong>the</strong> follow conventions:<br />
Asia 10: CH, HK, TW,<br />
KR, SG, MY, ID, TH,<br />
PH, IN<br />
Asia 9: Asia 10 less IN<br />
Asia 8: Asia 10 less IN<br />
and CH<br />
Asia Hi-tech5 (HT5):<br />
KR, TW, SG, MY, TH<br />
Asean 5: SG, MY, TH,<br />
ID, PH<br />
Asean 4: Asean 5 less<br />
SG<br />
Eurozone: EU12<br />
G4: Asia10, US, JP, EZ<br />
ECONOMICS<br />
David Carbon • (65) 6878 9548 • davidcarbon@dbs.com<br />
5
<strong>Economics</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Oil prices are at all<br />
time highs no<br />
matter what<br />
currency you<br />
measure <strong>the</strong>m in<br />
Take <strong>the</strong>m one at a time. The US is indeed growing far more slowly than normal.<br />
That’s not new, as we frequently point out, but it is serious. GDP growth has<br />
been falling steadily for four years. And while it is still positive, American<br />
demand growth – far more important to Asia than GDP growth per se – has not<br />
grown one iota for <strong>the</strong> past two quarters. Ten or twenty years ago, Asia might<br />
be flat on its back by now. So little wonder that everyone thinks <strong>the</strong> skies are so<br />
dark.<br />
Then <strong>the</strong>re’s oil. In US dollar terms, prices have doubled in <strong>the</strong> last 15 months<br />
and tripled since Jan05. They are now at record highs in nominal terms and real<br />
(inflation-adjusted) terms. This is not just a “weak dollar effect” so stronger<br />
local currencies aren’t going to solve <strong>the</strong> problem. Crude prices are at all-time<br />
highs measured in dollars, euros (/ECUs), deutschemarks, francs, pounds or any<br />
Asian currency unit. Of 20 key currencies in which we have priced oil in real<br />
terms, only in yen and Italian lira terms are real crude prices not quite back to<br />
Nov79 levels (<strong>the</strong> previous peak in real terms). But <strong>the</strong>y are not far off <strong>the</strong> mark<br />
ei<strong>the</strong>r.<br />
G3 (US, EZ, JP) real and nominal crude oil price<br />
Jun08=100, wtd avg spot price in local ccy terms, real deflated by country-specific CPIs<br />
100<br />
Nov79:<br />
86<br />
Jun08:<br />
100<br />
80<br />
60<br />
Feb74:<br />
56<br />
real<br />
wt avg price<br />
40<br />
Oct90:<br />
40<br />
20<br />
0<br />
nominal<br />
wt avg price<br />
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08<br />
Asia is home to 6 of<br />
<strong>the</strong> world’s 14<br />
largest oil<br />
importers<br />
High prices are a burden for importers of oil and Asia is home to 6 of <strong>the</strong> world’s<br />
14 largest (Table 1, p1). China is <strong>the</strong> world’s third largest net importer; Korea<br />
ranks fifth, India 7th, Taiwan 10th and Singapore 12th. Thailand is <strong>the</strong> world’s<br />
14th largest but, as a percentage of GDP (8%), it is Asia’s largest and most precariously<br />
placed given <strong>the</strong> run-up in prices. A doubling of oil prices would, in many a<br />
‘first principles’ calculation, cost <strong>the</strong> country eight percentage points of GDP.<br />
That would be a crippling blow for Thailand and for many o<strong>the</strong>r Asian countries,<br />
even with smaller oil deficits. And in an old-fashioned oil crisis, like <strong>the</strong> ones in<br />
1973-74 and 1979-80, <strong>the</strong> cost of such an price spike might just be that great.<br />
Thus, ei<strong>the</strong>r of <strong>the</strong>se obstacles – zero US demand growth or a doubling / tripling<br />
of oil prices – are by <strong>the</strong>mselves enough to make investors squirm and government<br />
officials tremble. But put <strong>the</strong> two toge<strong>the</strong>r and you’re talking about something<br />
altoge<strong>the</strong>r different. It’s <strong>the</strong> disaster scenario. Nothing more, nothing less.<br />
And it isn’t a hypo<strong>the</strong>tical ‘what if?’. Asia is right in <strong>the</strong> middle of it. Right<br />
here, right now.<br />
6
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong><br />
And yet, something is going right. Asia is in <strong>the</strong> middle of <strong>the</strong> disaster scenario<br />
and nothing is turning out disastrous. On <strong>the</strong> contrary, growth is stronger than<br />
it should be even on a clear day.<br />
Singapore reported 6.7% YoY growth in <strong>the</strong> first quarter. That’s one-third faster<br />
than what <strong>the</strong> government reckons to be potential. And it’s faster than it was<br />
three years ago, when US growth was 4% YoY (chart below) and oil prices were<br />
one-third what <strong>the</strong>y are today. Talk about bucking headwinds.<br />
But Hong Kong did even better. It reported 7.1% growth in <strong>the</strong> first quarter<br />
when 4.5% is normal for a clear day. China grew by 10.6%, probably above it’s<br />
potential rate, India by nearly 9%. Korea and Taiwan grew by about 6%, well<br />
above potential for economies of <strong>the</strong>ir income and technological levels. And<br />
Malaysia grew by 7.1% YoY! That’s faster than at any time in <strong>the</strong> last three<br />
years save for 4Q07 when it grew by 7.3%. Likewise for Thailand, which grew<br />
by 6.1%, its fastest rate in two years and nearly its fastest in three.<br />
Asia is in <strong>the</strong> middle<br />
of <strong>the</strong> disaster<br />
scenario and<br />
nothing is turning<br />
out disastrous<br />
Income and demand growth – Asia & US<br />
% YoY, 2qma, simple average<br />
8<br />
7<br />
6<br />
5<br />
4<br />
3<br />
Asia 10<br />
GDP<br />
Asia 8<br />
GDP<br />
(ex-CH, IN)<br />
7%<br />
6.3%<br />
2<br />
1<br />
US<br />
domestic demand<br />
1.5%<br />
1.6%<br />
0<br />
Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07<br />
What’s really interesting is that <strong>the</strong> skies didn’t darken just last night. The US<br />
has slowed – steadily and extensively – over <strong>the</strong> past 3.5 years (chart above). Oil<br />
prices are 3 times higher than <strong>the</strong>y were three years ago. And economic growth<br />
in Asia is ei<strong>the</strong>r still running above potential and/or, in <strong>the</strong> cases of Thailand<br />
and Malaysia, faster than at any time in <strong>the</strong> last 2-3 years.<br />
That isn’t impressive. It’s surreal. The environment is hell, <strong>the</strong> outcome sublime.<br />
What is Asia doing right? How can Asia be growing so well when US demand<br />
growth is zero and oil prices have tripled?<br />
The answer to both questions, we think, is demand. Asian demand mostly.<br />
Asian demand is driving Asian growth in <strong>the</strong> absence of <strong>the</strong> US. And Asian<br />
demand is key to <strong>the</strong> growth in global petroleum demand that appears to be<br />
mainly responsible for today’s higher oil prices.<br />
What explains <strong>the</strong><br />
puzzle? Demand<br />
growth, mostly<br />
Asian<br />
7
<strong>Economics</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Asia’s role in oil and aggregate demand represents a big change from <strong>the</strong> past.<br />
The US has long been <strong>the</strong> key driver of global growth but, as we have argued<br />
for <strong>the</strong> past 3 years, this role is rapidly being passed over to Asia. Asia is providing<br />
more and more of <strong>the</strong> world’s incremental demand growth each year and that,<br />
by definition, is what drives global growth.<br />
Asia is now <strong>the</strong><br />
single largest driver<br />
of global oil<br />
demand growth<br />
With respect specifically to oil, <strong>the</strong>re are two points to make. First, Asia’s demand<br />
is now <strong>the</strong> single biggest driver of global oil demand and second, it is increasingly<br />
apparent that <strong>the</strong> run-up in prices over <strong>the</strong> past five years is a function mainly<br />
of demand growth and not supply constraints. The persistent rise in oil prices<br />
running hand-in-hand with an equally persistent rise in global output (chart<br />
below) point plainly and compellingly to demand as <strong>the</strong> culprit behind higher<br />
prices, not supply.<br />
G4 – industrial production and crude oil price, 2002-2008<br />
Jan02=100, sa<br />
123<br />
wt avg G4 ccy unit / bbl, Jan02=100, Brent crude<br />
600<br />
118<br />
113<br />
108<br />
103<br />
IP<br />
(LHS)<br />
Oil price<br />
(RHS)<br />
500<br />
400<br />
300<br />
200<br />
100<br />
98<br />
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09<br />
0<br />
Output and oil<br />
prices rising in<br />
tandem points<br />
plainly to demand<br />
growth as <strong>the</strong><br />
driver of higher<br />
prices<br />
There are many implications from this but one important one is that any estimate<br />
of <strong>the</strong> “cost to growth of higher oil prices” that is based on <strong>the</strong> experience of<br />
past oil crises – when sharp supply contractions led to higher prices and contractions<br />
in output – are bound to be far off <strong>the</strong> mark. Higher oil prices are always a<br />
burden on growth but one that is qualitatively different when prices are driven<br />
upward by an expansion in demand as opposed to a contraction in supply. When<br />
driven by demand, <strong>the</strong> cost of higher oil is paid in real time, as you go. When<br />
driven by a pullback in supply, a hammer is lifted that soon falls. When it does,<br />
<strong>the</strong> growth cost is more visible, more measurable and very decidedly after-<strong>the</strong>fact.<br />
Times change. We are used to thinking of higher oil prices in terms of supply<br />
shocks and falling output. And we are used to thinking of <strong>the</strong> US as The Driver<br />
of global growth. But <strong>the</strong>se lines of thought are outdated.<br />
Demand – mostly Asian – explains why growth in <strong>the</strong> region has survived a<br />
three year slowdown in <strong>the</strong> US and a tripling in oil prices. It explains why, in<br />
<strong>the</strong> middle of <strong>the</strong> worst disaster planning scenario, <strong>the</strong>re’s no disaster. Growth<br />
is better than on a clear day. This is worth a closer look.<br />
8
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong><br />
Asian final demand as <strong>the</strong> driver of global growth<br />
This is key ground but it’s old ground for us so we’ll be brief. Readers looking<br />
for more detail are referred to a number of previous reports (1). The US slowdown<br />
is very old news. It started four years ago (see chart, p7). Worries of such have<br />
led to countless forecasts along <strong>the</strong> lines of: “for every percentage point drop in<br />
US growth, Asian growth is likely to drop by X percentage points”, where X was<br />
typically 2. All those exports from Asia running into China? They were merely<br />
being flipped around to <strong>the</strong> US, most said. All <strong>the</strong> final demand, it was said,<br />
was coming from <strong>the</strong> US. When that dried up, so too would Asia’s exports into<br />
China (and vice-versa).<br />
But starting in late-2004, <strong>the</strong> US began to slow (2). By late-05, growth had fallen<br />
by a full percentage point. Had Asian growth fallen by 2 percentage points?<br />
No. On <strong>the</strong> contrary, it had accelerated by a percentage point. Give it time,<br />
most said, give it time. But a year later and growth paths had diverged fur<strong>the</strong>r.<br />
A year after that, fur<strong>the</strong>r yet. After a full three years, US demand growth had<br />
fallen to a measly 1.5% YoY and Asia was still accelerating. This had never in<br />
history happened before.<br />
What happened? And why were <strong>the</strong> “two-fer-one” estimates so far off <strong>the</strong><br />
mark? The estimates were wrong because <strong>the</strong>y were made using data from a<br />
long time ago. A long time ago, US demand really did drive Asian supply and<br />
two-fer rules came pretty close to <strong>the</strong> mark. A long time ago, Asian demand<br />
was too small to drive it’s own growth, let alone global growth.<br />
But – and this is <strong>the</strong> biggest but in <strong>the</strong> last twenty years – Asia is no longer too<br />
small to matter. It has grown by 50% in <strong>the</strong> last five years alone. It’s still a lot<br />
smaller than <strong>the</strong> US (<strong>the</strong> relative sizes of domestic demand are about 100:40)<br />
but when you put an Asian growth rate – 7% on a clear day – on top of that 40<br />
cent base, what you find is that Asia generates almost as much new demand<br />
each year in dollar terms (or yen or yuan terms) as <strong>the</strong> US does. And it’s those<br />
dollars of new demand that, by definition, drive global growth.<br />
How much final / domestic demand Asia generates each year relative to <strong>the</strong> US<br />
is shown in <strong>the</strong> picture below. Hopefully this picture is familiar by now. Because<br />
we continue to believe that if <strong>the</strong>re is one single picture to bear in mind when<br />
one thinks about where Asia over <strong>the</strong> next 4-5 years, this is it. The picture is<br />
simple – one straight line, no intersections, no circles, no dips, no doos. No<br />
nonsense.<br />
Asia accelerated<br />
for three years<br />
while <strong>the</strong> US<br />
slowed. Never<br />
before in history<br />
did this happen<br />
The reason is<br />
simple: Asia is no<br />
longer too small to<br />
matter<br />
Asia 10 – incremental domestic demand growth converges on <strong>the</strong> US<br />
Incremental Asian DD growth as % of same in US, structural terms<br />
100<br />
90<br />
93 cents<br />
80<br />
70<br />
60<br />
50<br />
In 2008 for every<br />
dollar of fresh<br />
demand <strong>the</strong> US puts<br />
on <strong>the</strong> global table,<br />
Asia will put out 93<br />
cents<br />
40<br />
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08<br />
9
<strong>Economics</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
The rise in Asian<br />
demand is a<br />
structural one. It is<br />
not going to go<br />
away anytime soon<br />
And <strong>the</strong> numbers are compelling. Take <strong>the</strong> data point for this year, 2008, which<br />
reads 93 cents. That says that for every dollar of domestic demand generated by<br />
<strong>the</strong> US, Asia will generate 93 cents of <strong>the</strong> same. What’s <strong>the</strong> arithmetic? Simple.<br />
Assume that US domestic demand is 1 dollar in size. It grows by 3% on a clear<br />
day, thus generating 3 cents of new demand. Now turn to Asia. If <strong>the</strong> US is 1<br />
dollar in size, Asia’s is 40 cents in size. On a clear day, it grows by 7%, generating<br />
2.8 cents of fresh demand. That’s 2.8 cents for every 3 cents from <strong>the</strong> US, or 93<br />
cents on <strong>the</strong> dollar.<br />
What is key is how this ratio has changed over time. Back in 1990, <strong>the</strong> US<br />
generated more than twice as much new demand each year as Asia did. No<br />
wonder Asia went up and down whenever <strong>the</strong> US did. No wonder everybody<br />
said, when <strong>the</strong> US sneezes, Asia catches a cold. No wonder all those two-fer<br />
rules came about. All those rules, all those sayings were pretty much on <strong>the</strong><br />
mark. Twenty years ago.<br />
Today, <strong>the</strong> US no longer generates twice as much demand each year as Asia.<br />
Today it generates 7% more. And that’s on a clear day. On a bad day, like today,<br />
Asia already generates more demand than <strong>the</strong> US does (American demand growth<br />
has been zero for <strong>the</strong> past two quarters). But we haven’t shown <strong>the</strong> sick days in<br />
this chart because we want to stress that this change is a structural one – it has<br />
been occurring for <strong>the</strong> past 20 years and will continue for <strong>the</strong> next 20.<br />
Bottom line? It is this structural change, more than anything else, that explains<br />
how Asia managed to accelerate for three years while <strong>the</strong> US slowed. Asia is no<br />
longer too small to matter. Asian demand is driving Asia’s growth more than<br />
ever before and will, in ano<strong>the</strong>r year or two, be a bigger driver of global growth<br />
than <strong>the</strong> US. Plainly, it is <strong>the</strong> growth in Asia’s aggregate demand that underlies<br />
its growth in demand for oil, to which we now turn.<br />
Higher oil prices – demand-driven<br />
Take a look at <strong>the</strong> differences in <strong>the</strong> two charts below. Both plot <strong>the</strong> global<br />
supply of crude oil (in red, quantity terms) against <strong>the</strong> price (in grey, measured<br />
in avg USD, EUR/ECU and JPY terms, adjusted for inflation). The picture on <strong>the</strong><br />
left shows supply and price during <strong>the</strong> second oil crisis of 1979-84. Global<br />
supply falls by 15% thanks a drop in OPEC output of 55% between 1979 and<br />
1983. The price of oil triples in 13 months.<br />
Contrast that with <strong>the</strong> picture on <strong>the</strong> right – which shows oil supply and price<br />
over <strong>the</strong> past six years. Oil output expands steadily as <strong>the</strong> price triples over a<br />
four year period of time (annual average figures).<br />
Global oil production and price – 1979-84<br />
bil bbls/yr avg USD, EUR, JPY terms, CPI def, 79=100<br />
25<br />
225<br />
Global oil production and price – 2000-08<br />
bil bbls/yr avg USD, EUR, JPY terms, CPI def, 98=100<br />
32<br />
300<br />
24<br />
23<br />
real G3<br />
ccy<br />
price<br />
(RHS)<br />
200<br />
175<br />
150<br />
31<br />
30<br />
29<br />
supply<br />
(LHS)<br />
250<br />
200<br />
22<br />
21<br />
supply (LHS)<br />
125<br />
100<br />
28<br />
27<br />
real G3 avg<br />
crude price<br />
(RHS)<br />
150<br />
100<br />
20<br />
77 78 79 80 81 82 83 84<br />
75<br />
26<br />
00 01 02 03 04 05 06 07 08<br />
50<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong><br />
What’s <strong>the</strong> difference in terms of economics? Any textbook would say that <strong>the</strong><br />
first picture, 1979-84, is one of prices being driven by a contraction in supply.<br />
And it would say that <strong>the</strong> o<strong>the</strong>r picture, from 2002 to 2008, shows prices being<br />
driven north by an expansion in demand.<br />
And what would one expect for <strong>the</strong> direction of industrial output in <strong>the</strong>se two<br />
situations? That a contraction in oil supply would bring a sharp contraction in<br />
industrial output along with <strong>the</strong> surge in prices. Plainly, that’s what happened<br />
in <strong>the</strong> oil crises of 1973-75 and 1979-83. In 1973, oil prices rose by a factor of<br />
nearly four in six months and G3 industrial output dropped by 12% in very<br />
short order. In some countries, like Japan, industrial production fell by 20%. In<br />
<strong>the</strong> second oil crisis, prices tripled in <strong>the</strong> 12 months ending Nov79 and were<br />
subsequently maintained <strong>the</strong>re for <strong>the</strong> next three years. G3 industrial production<br />
fell for three years, by a total of 8%.<br />
G3 – industrial production and crude oil, 1973-75<br />
Nov73=100, sa<br />
wt avg ccy unit/bbl, Nov73=100, Brent<br />
G3 – industrial production and crude oil , 1979-84<br />
Jan80=100, sa<br />
avg ccy unit/bbl, Jan78=100, Brent<br />
100<br />
98<br />
96<br />
Oil<br />
price<br />
(RHS)<br />
400<br />
350<br />
300<br />
102<br />
100<br />
98<br />
Oil<br />
price<br />
300<br />
275<br />
250<br />
225<br />
94<br />
92<br />
90<br />
88<br />
IP<br />
(LHS)<br />
250<br />
200<br />
150<br />
100<br />
96<br />
94<br />
92<br />
Oil<br />
price<br />
triples<br />
in one<br />
year<br />
IP falls<br />
10%<br />
over 3<br />
years<br />
IP<br />
(LHS)<br />
200<br />
175<br />
150<br />
125<br />
100<br />
86<br />
Jan-72 Jan-73 Jan-74 Jan-75 Jan-76 Jan-77<br />
50<br />
90<br />
Jan-78 Jan-80 Jan-82 Jan-84<br />
75<br />
By contrast, when higher oil prices are driven by demand, one would expect to<br />
see a more gradual rise in price along side an uninterrupted rise in output –<br />
precisely <strong>the</strong> picture seen in <strong>the</strong> global economy since it last hit bottom in<br />
Dec01. One such picture (for <strong>the</strong> G4 overall) was shown on page 8. Two additional<br />
pictures of Asia – with and without China/India – are shown below.<br />
Asia 10 – industrial production and crude price<br />
Jan02=100, sa<br />
wt avg ccy price, Jan02=100, Brent<br />
Asia 8 – industrial production and crude price<br />
Jan02=100, sa<br />
wt avg ccy price, Jan02=100, Brent<br />
200<br />
600<br />
180<br />
600<br />
175<br />
150<br />
IP<br />
(LHS)<br />
500<br />
400<br />
160<br />
140<br />
IP<br />
(LHS)<br />
500<br />
400<br />
300<br />
300<br />
125<br />
100<br />
Oil<br />
price<br />
(RHS)<br />
200<br />
100<br />
120<br />
100<br />
Oil<br />
price<br />
(RHS)<br />
200<br />
100<br />
75<br />
02 03 04 05 06 07 08 09<br />
0<br />
80<br />
02 03 04 05 06 07 08 09<br />
0<br />
11
<strong>Economics</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Finally, consider Asia’s external balances. If oil prices are being driven north by<br />
global demand growth and rising trade flows, one would expect <strong>the</strong> earnings<br />
of <strong>the</strong> oil exporting countries to be recycled through <strong>the</strong> system (in <strong>the</strong> form of<br />
greater imports) more readily than when oil and o<strong>the</strong>r trade flows are being<br />
constrained. The hit to oil-importing countries’ current account balances should<br />
be much less than what <strong>the</strong> run-up in oil prices would suggest in isolation. That<br />
too, is what we find in Asia today.<br />
As a percentage of<br />
GDP, Thailand is<br />
Asia’s bigger<br />
importer of oil<br />
Since 2000, <strong>the</strong> run-up in oil prices has raised <strong>the</strong> oil deficit in most Asian countries<br />
by 2-4 percentage points of GDP. Thailand’s deficit widened to 8% of GDP in<br />
2007 from 4%, Taiwan’s widened to 5.3% of GDP from about 2%. Indonesia’s<br />
balance swung from a surplus of 1% of GDP to a deficit of 2.2%. Only Singapore<br />
managed to cut its oil deficit on this time frame.<br />
Asia – net oil imports as % of GDP<br />
% of GDP, excluding natural gas<br />
8<br />
6<br />
4<br />
2<br />
7.9<br />
7.4<br />
5.9<br />
5.3<br />
5.1<br />
4.1<br />
2.5<br />
2.2<br />
1.5<br />
2007<br />
2000<br />
0<br />
-2<br />
-1.4<br />
-2.1<br />
-4<br />
TH KR PH TW HK IN CH ID SG VN MY<br />
But Asia’s current account balances have not worsened on this time frame, even<br />
excluding China, whose surplus ballooned to 11% of GDP in 2008 from 1% in<br />
2001. On <strong>the</strong> contrary, <strong>the</strong>y have risen substantially fur<strong>the</strong>r into <strong>the</strong> black. For<br />
<strong>the</strong> Asia 8 (excluding Malaysia because it is an oil exporter) current account<br />
surpluses rose by an average of 3.2 percentage of GDP between 2001 and 2007 in<br />
Asia ex-China – oil and current acct balance<br />
% of GDP, ex-Malaysia (oil exporter)<br />
9<br />
8<br />
7<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
net oil imports<br />
current<br />
account<br />
surplus<br />
00 01 02 03 04 05 06 07 08<br />
Asean – oil balance and current acct balance<br />
% of GDP, ex-Malaysia (oil exporter)<br />
11<br />
10<br />
9<br />
8<br />
7<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
net oil imports<br />
current<br />
account<br />
surplus<br />
00 01 02 03 04 05 06 07 08<br />
12
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong><br />
spite of oil deficits that have widened by 2.1 points, on average. (see charts above<br />
and Appendix 1 for individual country data).<br />
Part of <strong>the</strong> reason for this is surely due to <strong>the</strong> fact oil exporters are raising <strong>the</strong>ir<br />
imports almost as fast as <strong>the</strong>ir export go up. They are not simply stashing <strong>the</strong>ir<br />
export revenues in Treasuries. Although current account data is not available (or up<br />
to date) for all large oil exporters, is available for many, including 6 of <strong>the</strong> world’s 7<br />
largest: Saudi Arabia, Russia, UAE, Norway, Kuwait and Venezuela. These countries<br />
have experienced large increases in <strong>the</strong> value of <strong>the</strong>ir petroleum exports. Net oil<br />
exports of this group (plus Mexico, ranked 10th in <strong>the</strong> world) rose to USD1000bn in<br />
2006 from about USD300bn per year in 2001-02. But <strong>the</strong>ir current account surpluses<br />
have risen by far less (chart below left). They have spent <strong>the</strong> lion’s share of <strong>the</strong>ir<br />
increased export revenues on increased imports (chart below right).<br />
There are three implications of all this. First, <strong>the</strong> current accounts on both sides of<br />
<strong>the</strong> oil trade support <strong>the</strong> view that it is demand growth, not supply contraction that<br />
is driving <strong>the</strong> rise in oil prices. Trade flows remain strong. Current accounts balances<br />
remain surprisingly strong among <strong>the</strong> oil-importing countries and surprisingly soft<br />
among <strong>the</strong> oil-exporting countries.<br />
Key petroleum exporters – external balances<br />
US$ bn/ year, SArab, Rus, UAE, Nway, Kwt, Vnz, Mex<br />
900<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
0<br />
Net oil<br />
exports<br />
Current<br />
account<br />
surplus<br />
98 99 00 01 02 03 04 05 06 07<br />
Key petroleum exporters – external balances<br />
US$ bn/ year, SArab, Rus, UAE, Nway, Kwt, Vnz, Mex<br />
900<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
0<br />
oil exports<br />
(net)<br />
Ex-oil imports<br />
(net, implied by<br />
current account)<br />
98 99 00 01 02 03 04 05 06 07<br />
Second, <strong>the</strong> cost to importing countries of higher oil prices is surely far lower<br />
than any back-of-<strong>the</strong>-envelope calculations based on oil deficits as a percentage<br />
of GDP would suggest. When oil exporters spend <strong>the</strong>ir increased earnings almost<br />
as fast as <strong>the</strong>y come through <strong>the</strong> door – unlike during <strong>the</strong> 1970s – and oil importing<br />
countries external balances get blacker instead of redder, it seems likely that<br />
dynamic gains are outweighing any losses from a higher oil price. Put differently,<br />
a higher oil price may be a step backward. But when it is generated by two<br />
forward steps of demand growth, <strong>the</strong> cost is already in <strong>the</strong> price. It is not<br />
lurking up ahead, as when surging prices are generated by a pullback in supply.<br />
Third, all this makes it plain that analysts should be careful about projecting a<br />
deterioration in Asia’s current account balances any time soon. Ditto for currency<br />
traders. A look at Asia’s data over <strong>the</strong> past six years is probably worth <strong>the</strong><br />
minute or two it takes.<br />
13
<strong>Economics</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Asian oil demand drives global oil demand<br />
Over <strong>the</strong> past five years, global oil consumption has grown by about 1.9% per<br />
year. That’s significantly faster than <strong>the</strong> 1.5% growth averaged between 1985<br />
and 2002. Where has <strong>the</strong> extra demand come from?<br />
Demand from <strong>the</strong><br />
US, Japan and<br />
Europe has fallen<br />
for three years.<br />
Demand from Asia,<br />
mostly China and<br />
India, has more<br />
than made up for it<br />
Not <strong>the</strong> US. Or at least not much. Demand <strong>the</strong>re is about 5% higher than in<br />
2001 but that was a recession year. On a clear day, US oil demand continues to<br />
grow by about 3/4% per year.<br />
Nei<strong>the</strong>r from Japan. Demand <strong>the</strong>re is 4% less than it was in 2001. Nor from<br />
Europe. Demand in Germany, France and Italy is down 4% since 2001 too. It<br />
has been falling in all four countries by about 1% per year since 1996 (charts<br />
below).<br />
So where has <strong>the</strong> new demand come from? Asia, mostly. Since 2001, Asia’s oil<br />
consumption has grown by some 1.3 trillion barrels, or 48% of <strong>the</strong> worldwide<br />
total (table next page). China and India account for about 60% of <strong>the</strong> growth<br />
in Asia.<br />
But a lot of smaller Asian countries have contributed to global consumption<br />
growth too. After China and India, Thailand is key with a 3% contribution to<br />
<strong>the</strong> total. Indonesia’s oil consumption growth (3% per year) turned that country<br />
from a net exporter into a net importer in 2003. Demand growth <strong>the</strong>re accounted<br />
for ano<strong>the</strong>r 2% of <strong>the</strong> global rise between 2001-2006. Singapore, Vietnam,<br />
Taiwan and Korea all contributed significantly. Given <strong>the</strong>ir size, this means<br />
<strong>the</strong>y are all punching far outside <strong>the</strong>ir weight (table at side).<br />
These numbers are big but <strong>the</strong>y are averages over a five year period, which<br />
obscures much of <strong>the</strong> trend. By 2006, China and India were accounting for<br />
nearly 2/3rds of <strong>the</strong> global increase in petrol consumption. O<strong>the</strong>r Asian countries<br />
had cut <strong>the</strong>ir consumption modestly but Asia’s contribution to <strong>the</strong> global total<br />
had still grown to 60% (see Appendix A2).<br />
Asia is driving <strong>the</strong> growth in global oil demand. But <strong>the</strong> real story may be this:<br />
Asia’s consumption now (2006) accounts for 20% of <strong>the</strong> global total. And when<br />
you put its high growth rate (8% for China and 5% for Asia overall) in consumption<br />
demand on that bigger base, it starts to make a big difference to global totals<br />
very quickly.<br />
The bottom line is this: ei<strong>the</strong>r Asia’s oil demand growth slows significantly or<br />
global demand growth accelerates even more than it already has over <strong>the</strong> past<br />
five years. Whe<strong>the</strong>r production / supply could keep up with that acceleration in<br />
Global petroleum consumption<br />
bbls/ year, 2001=100<br />
140<br />
135<br />
130<br />
125<br />
120<br />
115<br />
110<br />
105<br />
100<br />
95<br />
90<br />
01 02 03 04 05 06<br />
CH, IN: 140<br />
Asia 9: 111<br />
US:<br />
JP, EZ: 96<br />
Global petroleum consumption<br />
bbls/ year, 1992=100<br />
210<br />
200<br />
190<br />
180<br />
170<br />
160<br />
150<br />
140<br />
130<br />
120<br />
110<br />
100<br />
90<br />
80<br />
92 94 96 98 00 02 04 06<br />
CH:<br />
206<br />
Asia ex-<br />
CH, IN:<br />
168<br />
US:<br />
120<br />
JP, EZ:<br />
94<br />
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demand is questionable. And if it cannot, we all<br />
know where prices are headed.<br />
At this point, we would like nothing more than to<br />
be able to say, “You know what? All this oil being<br />
consumed in Asia? It isn’t really being consumed<br />
in Asia. It’s really being consumed in <strong>the</strong> US. All<br />
that oil is simply going into <strong>the</strong> production of goods<br />
in China and elsewhere that are <strong>the</strong>n exported to<br />
<strong>the</strong> US. The final demand is in <strong>the</strong> US and when it<br />
slows, Asia’s (intermediate) demand for oil will slow<br />
too.”<br />
The thing is, US demand has slowed. For three<br />
years now. But oil demand, and oil prices, have<br />
been going up for five. So no dice. It’s not about<br />
final demand coming from <strong>the</strong> US or <strong>the</strong> G3. It’s<br />
about final domestic demand coming from right<br />
here in Asia. Go back to <strong>the</strong> chart at <strong>the</strong> bottom<br />
of page 9, <strong>the</strong> one we said is <strong>the</strong> single most important<br />
picture to bear in mind when you think about Asia<br />
over <strong>the</strong> next 4-5 years. It shows where <strong>the</strong> final<br />
demand is coming from. It shows that Asia’s final<br />
demand growth has almost surpassed that of <strong>the</strong><br />
US and very soon will. That picture of aggregate<br />
final demand says oil demand is not mainly about<br />
<strong>the</strong> US any more, directly or o<strong>the</strong>rwise. It’s about<br />
Asia. This is where <strong>the</strong> demand is.<br />
If you’re still not sure, consider <strong>the</strong> picture below.<br />
It shows motor vehicle population per 100 people<br />
in Asia and <strong>the</strong> G3. Nobody who’s ever been to<br />
Taiwan will be surprised to see it has <strong>the</strong> highest<br />
density of motor vehicles. I swear it still has more<br />
Drivers of global petroleum demand<br />
2001-2006<br />
(2)-(1) chg as avg<br />
(1) (2) (3) % of growth<br />
Cons Cons Change global rate<br />
2001 2006 06-01 total '01-'06<br />
mn bbls mn bbls mn bbls (%) (%)<br />
World 28,251 30,887 2,636<br />
China 1,795 2,628 833 32 8<br />
US 7,172 7,551 379 14 1<br />
SArab 586 781 195 7 6<br />
India 797 939 142 5 3<br />
Thai 256 339 83 3 6<br />
Russ 945 1,026 81 3 2<br />
Can 751 826 76 3 2<br />
Indon 393 445 52 2 3<br />
Spore 258 305 46 2 3<br />
Viet 65 100 35 1 9<br />
UK 637 668 32 1 1<br />
Twan 322 347 25 1 2<br />
HK 90 107 17 1 4<br />
Korea 778 793 15 1 0<br />
Malay 173 183 9 0 1<br />
Brazil 805 809 4 0 0<br />
Phil 127 124 -3 0 0<br />
France 749 716 -33 -1 -1<br />
Italy 670 632 -38 -1 -1<br />
Germany 1,027 973 -55 -2 -1<br />
Japan 1,969 1,883 -86 -3 -1<br />
Asia 11 5,054 6,310 1,255 48 5<br />
CH+IN 2,592 3,567 975 37 7<br />
GE, FR, IT 2,447 2,321 -126 -5 -1<br />
motorcycles per person than Vietnam (data is unavailable). The US comes in<br />
second place – <strong>the</strong> auto <strong>the</strong>re being more sacred than Mom and / or Apple Pie<br />
(although, surprisingly, if one looked at auto population alone, German per<br />
capital ownership is higher than in <strong>the</strong> US). But look who’s at <strong>the</strong> bottom of <strong>the</strong><br />
list. China, with a current density one-20th that of Taiwan and <strong>the</strong> world’s<br />
fastest per-capita growth rate of some 9.5% per year. Still think oil demand<br />
growth in Asia isn’t going to accelerate over <strong>the</strong> next 10 years?<br />
Motor vehicle population density, 2007<br />
motor vehicles per 100 people<br />
100<br />
90<br />
80<br />
70<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
90<br />
81<br />
63 62 62<br />
39<br />
34<br />
21<br />
19<br />
9 9<br />
6 5<br />
TW US MY JP GE TH KR ID SG IN HK PH CH<br />
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Cutting <strong>the</strong> fat<br />
If oil demand is going up from here and prices have already quintupled since<br />
2002, it’s a good thing that countries are growing more efficient with <strong>the</strong>ir oil<br />
use. Developed countries like <strong>the</strong> US, Japan and Germany have cut <strong>the</strong>ir oil<br />
consumption, per unit of real GDP, nearly in half since 1980. Some of <strong>the</strong>se<br />
gains are technological (more efficient factories, for example) while some of<br />
<strong>the</strong> gains are structural (fewer factories and more services).<br />
China has made<br />
Asia’s greatest<br />
strides in raising oil<br />
efficiency<br />
Global petroleum efficiency<br />
bbls consumed per unit of real GDP, 1980=100<br />
100<br />
95<br />
90<br />
85<br />
80<br />
75<br />
70<br />
65<br />
60<br />
55<br />
50<br />
80 82 84 86 88 90 92 94 96 98 00 02 04 06<br />
Asia10: 70<br />
JP: 60<br />
US: 55<br />
GE: 52<br />
In spite of Asia taking on <strong>the</strong> role as factory for <strong>the</strong> world, significant efficiency<br />
gains have been experienced here too. On average, Asian countries have cut oil<br />
consumption (per unit of real GDP) by about 30% since 2001. As one would<br />
expect, experience has varied widely.<br />
Asian countries<br />
have cut oil<br />
consumption per<br />
unit of real GDP by<br />
about 30% since<br />
2001<br />
Global petroleum efficiency<br />
bbls consumed per unit of real GDP, 1994=100<br />
110<br />
105<br />
100<br />
95<br />
Japan<br />
90<br />
India<br />
85<br />
80<br />
US<br />
75<br />
China Germany<br />
70<br />
93 94 95 96 97 98 99 00 01 02 03 04 05 06<br />
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China has cut its oil consumption by two-thirds since 1980. That’s Asia’s greatest<br />
efficiency gain but it surely says as much (or more) about how inefficient China<br />
was in 1980 as it does about how efficient China may be today. Still, gains are<br />
gains and a 65% improvement is a big move in <strong>the</strong> right direction.<br />
If anything, India highlights <strong>the</strong> point about China. It was no more developed<br />
than China in 1980 and has made relatively fewer gains. India has picked up <strong>the</strong><br />
pace more recently, however, and since 1994, average gains in China, India, <strong>the</strong><br />
US, Japan and Germany have all been similar and sizable (chart immediately<br />
above).<br />
Elsewhere in Asia experience has been mixed. Korea, Malaysia and <strong>the</strong> Philippines<br />
have made great strides in cutting oil consumption. Korea in particular stands<br />
out over <strong>the</strong> past 15 years (chart below). Most are aware that it has imported<br />
huge amounts of technology from Japan and <strong>the</strong> US over <strong>the</strong> past three decades<br />
and it certainly shows up in its efficiency gains since 1994. But <strong>the</strong> Philippines<br />
and Malaysia – far down <strong>the</strong> technological ladder – have made strides nearly as<br />
great as Korea’s. This may show that <strong>the</strong> bang for <strong>the</strong> buck is higher fur<strong>the</strong>r<br />
down <strong>the</strong> ladder where <strong>the</strong> ‘easier’ gains are often said to lie.<br />
Still, Indonesia and Thailand show <strong>the</strong>re is nothing automatic or easy about<br />
productivity growth and efficiency gains. Gains <strong>the</strong>re have been negative, on<br />
average, since 1994. Singapore’s gains have been modest and could reinforce<br />
<strong>the</strong> idea that <strong>the</strong> closer one is to <strong>the</strong> top, <strong>the</strong> harder it is to take <strong>the</strong> next step.<br />
Thailand and Indonesia have <strong>the</strong>ir work cut out for <strong>the</strong>m. They are among <strong>the</strong><br />
world’s largest consumers and importers of oil and stand to lose <strong>the</strong> most from<br />
higher oil prices (or gain <strong>the</strong> least from <strong>the</strong> growth in global demand that<br />
appears to be driving those prices) in <strong>the</strong> future. The dearth of efficiency gains<br />
<strong>the</strong>re since 1994 surely helps explains why GDP growth in both countries remains<br />
sub-par even ten years after <strong>the</strong> Asian financial crisis.<br />
But efficiency gains remain as important to <strong>the</strong> rest of Asia as <strong>the</strong>y do to Thailand<br />
and Indonesia. They have helped most Asian economies lower <strong>the</strong> price of oil<br />
in real terms and get <strong>the</strong> most out <strong>the</strong> growth in global demand since 2001.<br />
Plainly such gains are no less beneficial or important going forward.<br />
Petroleum efficiency improvements since 1994<br />
bbls consumed per unit of real GDP, 1994=100<br />
110<br />
100<br />
90<br />
80<br />
70<br />
best gains<br />
77 77 78 78<br />
71 73<br />
67 67<br />
solid gains<br />
81 81<br />
83 83<br />
86<br />
100<br />
negative<br />
gains<br />
102<br />
105<br />
60<br />
50<br />
40<br />
Korea<br />
Phil<br />
UK<br />
Malay<br />
Italy<br />
China<br />
Ger<br />
Japan<br />
US<br />
France<br />
India<br />
Twan<br />
Spore<br />
HK<br />
Thai<br />
Indon<br />
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Global growth<br />
survived <strong>the</strong> rise in<br />
oil prices because it<br />
drove <strong>the</strong> rise in oil<br />
prices<br />
Inflation presents a<br />
serious problem to<br />
central bankers<br />
everywhere. But<br />
more so in <strong>the</strong> G3<br />
than in Asia<br />
Will Asia immiserize <strong>the</strong> G3?<br />
Where does all this leave us? We have noted that disaster planners could not<br />
have invented a more hellish scenario for Asia than <strong>the</strong> current reality. US<br />
demand growth has fallen to zero over a three year period and oil prices have<br />
tripled over <strong>the</strong> same three years (and risen fivefold in five years). Yet ra<strong>the</strong>r<br />
than collapsing, Asia continues to grow better than it should even on a clear<br />
day.<br />
We have argued that demand – Asian demand mostly – explains both of <strong>the</strong>se<br />
puzzles. Asian final demand kept Asia on an acceleration path for 3 years while<br />
<strong>the</strong> US slowed. And demand, not supply, appears quite compellingly to be <strong>the</strong><br />
driving force behind <strong>the</strong> fivefold increase in oil prices that occurred over <strong>the</strong><br />
past five years.<br />
Moreover, <strong>the</strong> data clearly show that Asia accounts for <strong>the</strong> lion’s share of <strong>the</strong><br />
growth in worldwide oil consumption since 2001. Indeed China and India<br />
alone accounted for almost two-thirds of <strong>the</strong> global growth in oil consumption<br />
between 2005 and 2006. And while a portion of this was undoubtedly intermediate<br />
demand, <strong>the</strong> growth in Asia’s aggregate final demand – that which kept Asia<br />
accelerating for three years while <strong>the</strong> US slowed – suggests that Asia’s demand<br />
for oil was, likewise, made in Asia.<br />
In short, global and especially Asian growth ‘survived’ <strong>the</strong> rise in oil prices because<br />
it drove <strong>the</strong> rise in oil prices. An important corollary is that, unlike when prices<br />
surge due to a contraction in supply, <strong>the</strong>re is no hammer waiting to fall on<br />
economic growth. It has already dropped, bit by bit. Higher oil prices are a<br />
burden but when driven by an expansion in demand it is shouldered in real<br />
time – two steps forward, one step back. Two steps forward, one step back.<br />
And efficiency gains over <strong>the</strong> decades have helped make <strong>the</strong> backward steps<br />
smaller.<br />
Perhaps all this sounds too good to be true. New world this, new order that.<br />
Everything’s paid for, nothing to worry about. The hypo<strong>the</strong>tical disaster scenario<br />
became a reality and guess what? Growth accelerated to above potential rates<br />
and it’s still <strong>the</strong>re. We met <strong>the</strong> first enemy. We outgrew him. We met <strong>the</strong><br />
second enemy. It is us. Things are fine.<br />
Well....not completely. Inflation is on <strong>the</strong> rise and that presents a problem for<br />
many a central bank, not just, and probably not mainly, in Asia. In Asia, food<br />
has been <strong>the</strong> key driver of inflation over <strong>the</strong> past year but ex-food inflation is<br />
accelerating now too and will soon jump much more noticeably in countries<br />
like Indonesia, Malaysia and India, where oil-related subsidies have been cut<br />
sharply in recent weeks. They had become too expensive for governments to<br />
maintain.<br />
Inflation is rising in <strong>the</strong> US and Europe too, thanks mainly to higher oil prices.<br />
Eurozone (HICP) inflation has risen to 3.6% YoY, <strong>the</strong> highest since June 1992. US<br />
CPI inflation has risen to 4% YoY, <strong>the</strong> highest since July 1991, save for two short<br />
spikes (also oil related) in Sep05 and June06. With <strong>the</strong> latest surge in oil prices<br />
(Brent crude is up by 45% since <strong>the</strong> start of <strong>the</strong> year in USD terms) inflation is<br />
undoubtedly headed higher in <strong>the</strong> near term and central bankers on both sides<br />
of <strong>the</strong> Atlantic are already making noises about rate hikes.<br />
If you take <strong>the</strong> view that higher oil prices are due to temporary supply disruptions,<br />
<strong>the</strong>n hiking interest rates is probably not first-best policy, especially in <strong>the</strong> US<br />
where domestic demand growth is already at ground-zero. Inflation would, on<br />
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<strong>Economics</strong><br />
this view, fall back pretty quickly with or without rate hikes. So <strong>the</strong> good<br />
news is, few would be required / delivered and <strong>the</strong> consequences for growth<br />
would be minor.<br />
But if you take <strong>the</strong> view, as we have, that higher oil prices are being driven by<br />
expanding demand, <strong>the</strong>n <strong>the</strong> policy prescription and <strong>the</strong> prognosis for growth<br />
changes. A greater number of interest rate hikes would be required to tame<br />
inflation. A greater hit to growth would result. How much growth a country<br />
has to sacrifice would depend on its preferences toward inflation.<br />
In Asia, inflation of 4%-8% has been <strong>the</strong> norm and <strong>the</strong> consequences to growth<br />
of maintaining that sort of rate are probably minor. After all, ex-food inflation<br />
in Asia is still running at only its 20-year average rate, even after a fivefold<br />
increase in oil prices since 2003. Yes, it will no doubt rise a little above <strong>the</strong> 20-<br />
year average in <strong>the</strong> coming year but that happens, by definition, exactly half<br />
<strong>the</strong> time anyway. Getting back to average in Asia will be a comparatively easy<br />
and low-cost exercise.<br />
Compared to what? Compared to <strong>the</strong> US and Europe. Their preferences toward<br />
inflation run on <strong>the</strong> order of 2%, not 4% to 8%. If <strong>the</strong>y want to get inflation<br />
down to 2%, <strong>the</strong>y will surely have to sacrifice considerably more in <strong>the</strong> way of<br />
growth.<br />
Why? Because, oil prices are no longer Made in America, or in Europe. They<br />
are made in Asia. Europe, Japan and <strong>the</strong> US all cut <strong>the</strong>ir oil consumption over<br />
<strong>the</strong> past two years. Europe and Japan have been cutting it every year for a<br />
decade. That hasn’t cut global demand. Or prevented oil prices from quintupling.<br />
Or prevented US and European inflation from going up.<br />
US and European central banks could raise interest rates and that would probably<br />
lower aggregate demand in <strong>the</strong> US and Europe. GDP growth too. Alas, unless<br />
<strong>the</strong> G3 went truly into recession, it would do little to curb Asia’s demand for<br />
oil.<br />
So we seem to have entered yet ano<strong>the</strong>r brave new world. A lot of that going<br />
around lately. Asia is driving things – important things like <strong>the</strong> price of oil, its<br />
own rate of GDP growth and, increasingly, aggregate global demand growth<br />
as well. Given <strong>the</strong>se structural changes, is it really any surprise that it would<br />
begin to dominate global inflation rates ei<strong>the</strong>r?<br />
G3 central banks and politicians in particular may not wish to accept an inflation<br />
rate determined by Asian preferences. But to <strong>the</strong> extent <strong>the</strong>y attempt to fight<br />
it, <strong>the</strong>y would only lower <strong>the</strong>ir (own) economic growth. Eventually of course<br />
<strong>the</strong>y would capitulate. How much growth <strong>the</strong>y sacrifice on an unwinable war<br />
is anyone’s guess. But <strong>the</strong> ECB and <strong>the</strong> Fed are ei<strong>the</strong>r “new” or under new<br />
leadership, or both, so <strong>the</strong> fight could be an ugly one.<br />
Perhaps it’s not such a clear day after all.<br />
Oil prices are<br />
driving inflation.<br />
But oil prices are<br />
not made in<br />
America or in<br />
Europe. They are<br />
made in Asia<br />
G3 central banks<br />
may have to accept<br />
an inflation rate<br />
made in Asia too.<br />
That or a<br />
permanently lower<br />
growth rate<br />
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Endnotes<br />
1. See, for example, “Passing <strong>the</strong> Baton”, 15Jun06; “Asia driving, not decoupling”,<br />
22Sep06; “Asia-vu”, 16Jun07; “The ‘two-fer’ rules”, 14Sep07; “The best defence”,<br />
12Dec07.<br />
2. Measured in sequential, quarter-on-quarter terms, US growth peaked in 3Q03<br />
and began a four-year slowdown from <strong>the</strong>re. Measured in year-on-year term,<br />
<strong>the</strong> slowdown began in 4Q04 and has thus run for some 3.5 years.<br />
Sources:<br />
The source for all oil consumption and production data is <strong>the</strong> US EIA. This is annual data<br />
and it is available through 2006. Monthly import and export data of oil and petroleum<br />
products are generally available through April 2008 and <strong>the</strong> source is CEIC. Current<br />
account data for global oil exporting countries comes from IFS. Data for all o<strong>the</strong>r charts<br />
and tables are CEIC and Bloomberg . Estimates are by <strong>DBS</strong> Group Research.<br />
Appendix<br />
A1.<br />
Asia – net oil imports and current account balances<br />
as % of GDP, excludes natural gas<br />
(1) (2) (2)-(1) (3) (4) (4)-(3)<br />
C/A C/A C/A net oil M net oil M net oil M<br />
% of GDP % of GDP % of GDP % of GDP % of GDP % of GDP<br />
Avg 00-01 Avg 06-07 Change Avg 00-01 Avg06-07 Change<br />
CH 1.5 9.9 8.4 1.1 2.5 1.5<br />
HK 5.0 12.8 7.8 2.3 4.9 2.6<br />
TW 4.5 7.7 3.2 2.5 5.1 2.6<br />
KR 2.0 0.6 -1.4 5.5 7.4 1.9<br />
SG 12.8 23.0 10.2 2.7 1.7 -1.0<br />
MY 8.5 15.9 7.5 -1.9 -2.1 -0.2<br />
ID 4.6 2.8 -1.8 -1.0 2.2 3.2<br />
TH 6.0 3.5 -2.5 4.6 8.6 3.9<br />
PH -2.7 4.5 7.2 4.5 6.0 1.5<br />
IN -0.3 -1.0 -0.7 3.1 4.2 1.1<br />
US -4.0 -5.7 -1.7 1.0 2.1 1.1<br />
JP 2.4 4.4 2.0 1.6 3.6 2.0<br />
Aggregates exclude Malaysia, an oil-exporting country<br />
Asia 10 3.7 7.1 3.4 2.8 4.7 1.9<br />
Asia 9 4.2 8.1 3.9 2.8 4.8 2.0<br />
Asia 8 4.6 7.8 3.2 3.0 5.1 2.1<br />
Asean5 5.2 8.4 3.3 2.7 4.6 1.9<br />
ID, TH, PH 2.6 3.6 1.0 2.7 5.6 2.9<br />
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A2.<br />
Determinants of global petroleum demand<br />
2005-2006<br />
(2)-(1) chg as<br />
(1) (2) (3) % of growth<br />
Cons Cons Change global rate<br />
2005 2006 06-05 total '05-'06<br />
mn bbls mn bbls mn bbls (%) (%)<br />
World 30,532 30,887 355<br />
China 2,453 2,628 176 49 7.2<br />
SArab 730 781 51 14 7.0<br />
India 890 939 49 14 5.5<br />
Russia 1,006 1,026 20 6 2.0<br />
Brazil 791 809 19 5 2.3<br />
Germany 959 973 13 4 1.4<br />
Spore 293 305 12 3 4.1<br />
Viet 93 100 7 2 7.6<br />
HK 107 107 0 0 0.0<br />
Malay 183 183 0 0 0.0<br />
Phil 124 124 0 0 0.0<br />
Thai 339 339 0 0 0.0<br />
UK 670 668 -1 0 -0.2<br />
Korea 800 793 -6 -2 -0.8<br />
Twan 354 347 -7 -2 -2.0<br />
Italy 641 632 -8 -2 -1.3<br />
France 726 716 -10 -3 -1.4<br />
Canada 838 826 -12 -3 -1.4<br />
Mex 746 729 -18 -5 -2.4<br />
Indonesia 464 445 -19 -5 -4.0<br />
US 7,593 7,551 -42 -12 -0.6<br />
Japan 1,936 1,883 -53 -15 -2.7<br />
Asia (ex-CH, IN) 2,756 2,743 -13 -4 -0.5<br />
CH+IN 3,343 3,567 225 63 6.7<br />
Euro 3 2,326 2,321 -5 -1 -0.2<br />
G3 11,855 11,755 -100 -28 -0.8<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
FX: Slipping on oil & USD<br />
Asia:<br />
Much has changed during <strong>the</strong> second quarter<br />
Oil/inflation risks have overtaken global imbalances as a key<br />
international concern, leading <strong>the</strong> US and G7 nations to seek a stable<br />
USD<br />
Despite <strong>the</strong>ir resilience during <strong>the</strong> US subprime crisis, Asian<br />
currencies are not faring as well against high oil prices<br />
We have downgraded our outlook for Asia’s currencies and<br />
postponed <strong>the</strong> next phase of regional FX appreciation to 2H09<br />
CNY:<br />
HKD:<br />
TWD:<br />
KRW:<br />
SGD:<br />
MYR:<br />
THB:<br />
IDR:<br />
PHP:<br />
INR:<br />
The pace of appreciation will decelerate as overheating risks fade<br />
and oil/inflation risks displace global imbalances atop <strong>the</strong> G7 agenda<br />
Moving back to <strong>the</strong> upper half of <strong>the</strong> 7.75-7.85 band<br />
Our favorite currency. Improving cross-straits relations put<br />
economics back in focus<br />
As weak as its international liquidity position<br />
A higher USD/SGD is not inconsistent with an appreciating SGD<br />
NEER policy, especially during a US rate hike cycle<br />
Fundamentally strong but weighed down by politics<br />
Tracking Asian currencies lower, not helped by export growth falling<br />
below import growth<br />
Scope to weaken beyond 9500 when US rate hike cycle starts<br />
Typically gives back 45% of earlier gains when fundamentals turn<br />
south<br />
Consolidation normally follows correction, unless <strong>the</strong> stock market<br />
enters into a freefall<br />
VND: Full-year depreciation in 2008 is likely to be 5%-10%, not <strong>the</strong> 20%-<br />
40% expected by <strong>the</strong> market<br />
USD:<br />
EUR:<br />
Supported by rate hike expectations and policymakers signaling a<br />
desire for a ‘strong dollar’<br />
Downside risks from narrowing EU-US rate differentials<br />
JPY:<br />
From an unwinding of JPY carry trades, to USD recovery, to broad<br />
consolidation<br />
Philip Wee • (65) 6878 4033 • philipwee@dbs.com<br />
CURRENCIES<br />
23
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
USD adjustment & global imbalances – a pause before Phase III<br />
We believe that <strong>the</strong>re are three phases to <strong>the</strong> USD adjustment to address global<br />
imbalances, with each phase separated by a US interest rate hike cycle.<br />
Phase I took place between 2002 and 2004. The USD’s depreciation was led by<br />
major currencies, and not by Asian currencies. Many Asian countries were not<br />
ready to let <strong>the</strong>ir currencies appreciate because <strong>the</strong> global economy was just<br />
emerging from <strong>the</strong> Y2K manufacturing recession in 2001. The capitulation of<br />
<strong>the</strong> USD was triggered by a G7 meeting in Sep 2003, which called on China to<br />
free its exchange rate to address global imbalances. This was viewed as a policy<br />
shift towards a weak USD.<br />
The USD’s depreciation paused in in 2005. The USD recovered some of its hefty<br />
losses when it became evident that <strong>the</strong> US was raising interest rates more than<br />
initially thought. The Fed Funds Rate was eventually raised to 5.25% from 1.00%.<br />
Phase II is likely to have lasted between Nov 2005 and Mar 2008. The USD’s<br />
depreciation was more evenly spread between major currencies and Asian exchange<br />
rates. This was largely attributed to China abandoning its USD peg in Jul 2005,<br />
with <strong>the</strong> G7 nations persistently pushing for faster appreciation <strong>the</strong>reafter. The<br />
USD started to capitulate after <strong>the</strong> US subprime/credit crisis erupted in Jul 2007<br />
and led to aggressive US rates cuts from 5.25% to 2.00%.<br />
Over <strong>the</strong> next 6-12 months, we reckon that <strong>the</strong> USD will recover as <strong>the</strong> US starts<br />
to lifting rates again. We expect <strong>the</strong> Fed Funds Rate to start rising in 4Q08 into<br />
2Q09, lifting Fed Funds Rate from 2.00% to 4.00% by July. G7 nations, led by <strong>the</strong><br />
US, are also expected to push for a stable USD against major currencies to combat<br />
inflationary expectations from high commodity prices.<br />
Thereafter, we reckon Phase III to start in 2H09, with G7 nations resuming <strong>the</strong>ir<br />
call for trade-weighted appreciation in <strong>the</strong> Chinese yuan and o<strong>the</strong>r Asian currecies,<br />
notably those with large current account surpluses and robust foreign reserves.<br />
Put simply, we are likely to see <strong>the</strong>se Asian currencies appreciating not only<br />
against <strong>the</strong> USD, but also against major currencies like <strong>the</strong> EUR.<br />
Phase I - USD fall mainly vs major currencies<br />
Phase II - USD fall more evenly spread<br />
NZD<br />
EUR<br />
EUR<br />
PHP<br />
AUD<br />
CHF<br />
CHF<br />
THB<br />
GBP<br />
AUD<br />
CAD<br />
SGD<br />
JPY<br />
CAD<br />
KRW<br />
JPY<br />
THB<br />
MYR<br />
SGD<br />
NZD<br />
INR<br />
GBP<br />
IDR<br />
CNY<br />
TWD<br />
INR<br />
HKD<br />
CNY<br />
MYR<br />
Asian currencies in red<br />
G3 currencies in black<br />
O<strong>the</strong>r major currencies in gray<br />
TWD<br />
IDR<br />
KRW<br />
Asian currencies in red<br />
G3 currencies in black<br />
O<strong>the</strong>r majore currencies in gray<br />
PHP<br />
USD<br />
% ch vs USD<br />
Feb 2002 to Dec 2004<br />
HKD<br />
USD<br />
% ch vs USD<br />
Nov 2005 to Mar 2008<br />
-40 -20 0 20 40 60 80<br />
-40 -20 0 20 40 60 80<br />
24
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
2008 vs 2007 – what has changed?<br />
In our last quarterly, we warned that emerging market jitters have a habit to<br />
turning up in <strong>the</strong> second quarter, especially in years when economic and financial<br />
uncertainties are high. We were not convinced that Asian currencies could continue<br />
to ignore <strong>the</strong> weaknesses in <strong>the</strong>ir stock markets. With <strong>the</strong> exception of <strong>the</strong> Chinese<br />
yuan, <strong>the</strong> Singapore dollar and <strong>the</strong> Taiwan dollar, most Asian currencies did<br />
depreciate in 2Q08 (as at Jun 9).<br />
Even as we were correct about Asian currencies returning some gains in 2Q08,<br />
we no longer expect <strong>the</strong>m to resume <strong>the</strong>ir appreciation in 2H08.<br />
Over <strong>the</strong> course of <strong>the</strong> second quarter, it became evident that many of favorable<br />
factors that drove Asian currencies higher in past two to three years have weakened.<br />
Unlike <strong>the</strong> past couple of years, central banks in Asia are no longer intervening<br />
this year to prevent an appreciation in <strong>the</strong>ir currencies, but to sell dollars to<br />
defend <strong>the</strong>ir currencies.<br />
Below are some of <strong>the</strong> changes in <strong>the</strong> currency landscape this year.<br />
(1) Oil price shock & inflation<br />
While Asian currencies proved <strong>the</strong>ir resilience to <strong>the</strong> US subprime/credit crisis,<br />
<strong>the</strong>y turned out to be vulnerable to <strong>the</strong> oil price shock. Crude oil prices based<br />
on Nymex futures surged in 2Q08 to a record high of almost USD140/barrel on<br />
Jun 6, after breaking decisively above USD100 in March.<br />
Inflation requires strong policy responses to lower price pressures, which in<br />
turn, will trim economic growth. Improvements in fiscal finances will be less<br />
forthcoming as revenue collection slows with growth, while governments spend<br />
to support growth. Trade balances were also pressured by costlier imports and<br />
slower exports, leading current accounts in some countries to reverse from a<br />
surplus into a deficit position. For several countries, inflation also sparked unrests<br />
and increased political uncertainties. For some countries, this could lead to new<br />
governments.<br />
The change in this year’s landscape for Asia is best reflected by <strong>the</strong> sell-off in <strong>the</strong><br />
stock markets of its high-growth economies - China, India and Vietnam. As at<br />
Jun 10, China has returned 60% of its 2005-2007 rally, with India losing <strong>the</strong> least<br />
(41%) and Vietnam <strong>the</strong> most (85%).<br />
(2) A significant shift on G7’s exchange rate stance<br />
The desire for <strong>the</strong> USD to stabilize against major currencies was first expressed<br />
at <strong>the</strong> G7 meeting in Washington on Apr 11. The communique warned about<br />
Performance in 2Q08<br />
CNY<br />
SGD<br />
1.3<br />
0.8<br />
Stock markets of Asia's high growth economies<br />
Benchmark equity indices; Indexed: 1 Jan 05=100<br />
500<br />
China<br />
TWD<br />
HKD<br />
-0.3<br />
0.3<br />
400<br />
IDR<br />
MYR<br />
KRW<br />
THB<br />
INR<br />
PHP<br />
-6.4<br />
-6.9<br />
-5.2<br />
-4.2<br />
-2.0<br />
-1.2<br />
% ch vs USD<br />
9 Jun 08 vs 31 Mar 08<br />
-10 -5 0 5 10<br />
300<br />
200<br />
India<br />
Vietnam<br />
100<br />
0<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
25
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
sharp fluctuations in major currencies and <strong>the</strong>ir possible implications for economic<br />
and financial stability.<br />
As oil prices spiked in 2Q08, inflation became a serious policy challenge globally.<br />
By Jun 3, this oil/inflation spiral became a problem serious enough for Fed<br />
Chairman Bernanke to identify <strong>the</strong> USD as a risk to inflation and inflation expectations.<br />
Bernanke’s comments came one day after US Treasury Secretary Henry Paulson<br />
told Middle East countries not to abandon <strong>the</strong>ir USD pegs, reaffirming <strong>the</strong> US’s<br />
commitment to <strong>the</strong> USD as a reserve currency. On Jun 9, Paulson did not rule<br />
out intervention as a tool to stabilize <strong>the</strong> USD.<br />
The G7 meeting in June is likely to reinforce its early message for <strong>the</strong> USD to<br />
stabilize against major currencies. Although <strong>the</strong> communique is likely to continue<br />
calling for a trade-weighted appreciation in <strong>the</strong> Chinese yuan, <strong>the</strong> market believes<br />
that <strong>the</strong> CNY will slow its appreciation pace. This can be attributed to diminished<br />
overheating risks in China’s economy, as well as <strong>the</strong> G7 nations prioritizing <strong>the</strong><br />
global oil/inflation crisis over global imbalances.<br />
(3) US interest rates - from recession risks to inflation risks<br />
With <strong>the</strong> US Treasury curve normalizing to an upward sloping curve from March,<br />
<strong>the</strong> Fed has become comfortable with <strong>the</strong> market’s view that <strong>the</strong> worst was<br />
probably over for <strong>the</strong> US mortgage crisis. Believing that recession risks have<br />
diminished, at least relative to inflation worries, Bernanke began in June to<br />
shift <strong>the</strong> focus of monetary policy to prevent an erosion in longer-term inflation<br />
expectations.<br />
Subsequently, interest rate futures market started to discount <strong>the</strong> Fed to start<br />
taking back rate cuts this year. <strong>DBS</strong> is looking for Fed to begin hiking in 4Q08<br />
and lift Fed Funds Rate from 2.00% to 4.00% by July 2009. While this happens,<br />
we expect <strong>the</strong> USD to remain firm, as it did during <strong>the</strong> last rate hike cycle in<br />
2005.<br />
Currency revisions – postponing <strong>the</strong> next phase of Asian currency appreciation<br />
Taking into account our rising US interest rate profile and Asia’s weakened economic<br />
landscape, we have downgraded outlook for Asian currencies over <strong>the</strong> next 6-12<br />
months. We are not abandoning, but merely postponing our longer-term outlook<br />
for Asian currencies to appreciate. Like <strong>the</strong> rest of <strong>the</strong> world, Asia will be required<br />
to bite <strong>the</strong> inflation bullet in order to return to a path of sustainable noninflationary<br />
economic growth.<br />
Performance in 2007<br />
Performance in 2008 ytd<br />
PHP<br />
18.9<br />
TWD<br />
7.2<br />
INR<br />
12.3<br />
SGD<br />
5.7<br />
THB<br />
7.2<br />
CNY<br />
5.5<br />
CNY<br />
6.9<br />
MYR<br />
1.5<br />
MYR<br />
6.5<br />
THB<br />
1.4<br />
SGD<br />
6.2<br />
IDR<br />
0.8<br />
TWD<br />
0.3<br />
HKD<br />
-0.1<br />
HKD<br />
-0.3<br />
PHP<br />
-7.4<br />
KRW<br />
IDR<br />
-4.3<br />
-0.7<br />
% ch vs USD<br />
INR -8.0<br />
31 Dec 07 vs 31 Dec 06 KRW -9.4<br />
% ch vs USD<br />
9 Jun 08 vs 31 Dec 07<br />
-15 -10 -5 0 5 10 15 20 25<br />
-15 -10 -5 0 5 10 15 20 25<br />
26
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
The Good ...<br />
The three Asian currencies that have consistently held up so far this year were<br />
<strong>the</strong> Chinese yuan (CNY), <strong>the</strong> Singapore dollar (SGD) and <strong>the</strong> Taiwan dollar (TWD).<br />
These three currencies share one common feature. All three favour stronger<br />
exchange rates to fight inflation.<br />
Of <strong>the</strong> three currencies, we like <strong>the</strong> TWD most on a relative basis. As at Jun 9,<br />
<strong>the</strong> TWD is still <strong>the</strong> Asia’s best performing currency this year. Our optimism is<br />
based on <strong>the</strong> return of <strong>the</strong> Kuomintang government. Since <strong>the</strong> presidential<br />
elections in March, Cross-Straits relations have improved with policymaking<br />
returning focus towards boosting <strong>the</strong> Taiwan economy.<br />
On <strong>the</strong> o<strong>the</strong>r hand, we are wary of <strong>the</strong> SGD’s strong correlation with major<br />
currencies, which we expect will bow to <strong>the</strong> USD’s recovery especially when <strong>the</strong><br />
US start hiking rates again. At witnessed in 2005, a higher USD/SGD is also not<br />
inconsistent with an appreciating SGD NEER policy, which started in Apr 2004.<br />
... <strong>the</strong> Bad ...<br />
The three Asian currencies that have consistently underperformed this year were<br />
<strong>the</strong> high yielders - Indian rupee (INR), Korean won (KRW) and <strong>the</strong> Philippine<br />
peso (PHP). Last year’s winners - INR and PHP - turned out to be this year’s losers.<br />
The KRW’s depreciation, which started in 2007, turned from bad to worse.<br />
Due to increased external borrowings over <strong>the</strong> past few years, KRW and INR are<br />
vulnerable any unwinding of JPY carry trades and shortages of USD liquidity. In<br />
terms of international liquidity position, <strong>the</strong> KRW is considered to be more<br />
vulnerable because external debt overtook foreign reserves in Korea, while India’s<br />
foreign reserves continued to outpace external borrowings. Both INR and PHP<br />
are more sensitive to downsides in <strong>the</strong>ir stock markets compared to <strong>the</strong> KRW.<br />
Since <strong>the</strong>y were <strong>the</strong> first to start, <strong>the</strong>se three currencies are also likely to be <strong>the</strong><br />
first to finish returning some of <strong>the</strong> past years’ gains to <strong>the</strong> USD. Once <strong>the</strong><br />
correction is completed, <strong>the</strong>se currencies have a track record of consolidating in<br />
a wide range, as <strong>the</strong>y await <strong>the</strong>ir peers in <strong>the</strong> region to do likewise.<br />
... and <strong>the</strong> Ugly<br />
The market is looking for <strong>the</strong> Vietnamese dong to suffer a devaluation of 20%<br />
to 40% over <strong>the</strong> coming year. For now, we do not consider this to be an imminent<br />
risks and sees a full-year devaluation of 5% instead in 2008. Although Vietnam<br />
has <strong>the</strong> worst inflation and trade deficit in Asia, FDI inflows still appear to be<br />
covering <strong>the</strong> latter.<br />
Political risks to watch<br />
There are three currencies with political risks that we are paying close attention<br />
to. (1) Post-election Thai baht (THB) is persistently troubled by rumours of ano<strong>the</strong>r<br />
military coup, which have <strong>the</strong> potential to distract <strong>the</strong> government from <strong>the</strong><br />
economy. (2) Post-election Malaysian ringgit (MYR) is worried about leadership<br />
challenges confronting its weakened prime minister. Barring political uncertainties,<br />
<strong>the</strong> MYR is actually a fundamentally sound currency that <strong>the</strong> US Treasury considers<br />
as undervalued. (3) The INR will be vulnerable if <strong>the</strong> protests to inflation and<br />
higher fuel prices become loud enough for <strong>the</strong> communist allies to pull its<br />
support from <strong>the</strong> government ahead of next year’s elections.<br />
27
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Fed Funds Rate<br />
forecast, eop<br />
Latest Prev<br />
Close 2.00 3.00<br />
2Q08 2.00 2.25<br />
3Q08 2.00 2.25<br />
4Q08 2.50 2.25<br />
1Q09 3.25 2.75<br />
2Q09 4.00 3.25<br />
3Q09 4.50 4.00<br />
4Q09 4.50 4.50<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
US dollar – weakness becomes an inflation problem<br />
The USD is likely to have completed its second phase of adjustment that started<br />
in Nov 2005. Unlike <strong>the</strong> first phase between 2002 and 2004, USD depreciation<br />
was not led by major currencies this time around. Instead, <strong>the</strong> burden was shared<br />
more evenly spread between major and Asian currencies. We reckon <strong>the</strong> third<br />
phase will be led by Asian currencies, where those with strong fundamentals<br />
are likely to appreciate not just against <strong>the</strong> USD, but also against <strong>the</strong> EUR and<br />
o<strong>the</strong>r G7 currencies.<br />
Before we enter into Phase III, <strong>the</strong> USD is likely to recover some lost ground<br />
from now into mid-2009, similar to 2005 when <strong>the</strong> US hiked rates. <strong>DBS</strong> is looking<br />
for Fed Funds Rate to rise from 2.00% to 4.25%, starting in 4Q08 into 3Q09.<br />
The most significant development in 2Q08 was growing belief amongst policymakers<br />
around <strong>the</strong> world that <strong>the</strong> “Weak USD” has become an inflation risk. For example,<br />
China blamed <strong>the</strong> deep US interest rate cuts for creating inflation in emerging<br />
markets. Increasingly, <strong>the</strong>re is belief that <strong>the</strong> increased liquidity to stabilize<br />
financial markets during <strong>the</strong> US mortgage/credit crisis facilitated speculation in<br />
commodity markets. The US rate cuts were seen responsible for weakening <strong>the</strong><br />
US dollar, which in turn, implied stronger Asian currencies or increased purchasing<br />
power from Asia for commodities.<br />
On Jun 3, Fed Chairman Bernanke highlighted that <strong>the</strong> “weak dollar”, in shaping<br />
inflationary expectations, is now a threat to its dual mandate to keep inflation<br />
stable and to create jobs. Bernanke’s comments affirmed <strong>the</strong> view that <strong>the</strong> Fed<br />
will no longer be looking to cut rates. Unlike past episodes, this should increase<br />
<strong>the</strong> USD’s resilience to renewed financial stress going forward.<br />
US Treasury Secretary Henry Paulson also visited <strong>the</strong> Middle East to reassure Gulf<br />
countries that <strong>the</strong> US was committed to <strong>the</strong> USD as a reserve currency. His goal<br />
was obviously to ensure that Gulf countries do not hurt <strong>the</strong> USD’s credibility by<br />
abandoning <strong>the</strong>ir USD pegs. For <strong>the</strong> first time in a long time, Paulson did not<br />
rule out intervention to stabilize <strong>the</strong> USD.<br />
That said, G7 nations have not abandoned <strong>the</strong>ir long-time call for USD adjustment<br />
to address global imbalances. Except that <strong>the</strong> stance has narrowed to <strong>the</strong> Chinese<br />
yuan and o<strong>the</strong>r Asian currencies with large current account surpluses to bear<br />
<strong>the</strong> adjustment burden. At its meeting in April, G7 nations warned that sharp<br />
fluctuations in (specifically) major currencies could threaten economic and financial<br />
stability at its April meeting. In short, G7 nations want <strong>the</strong>se Asian currencies to<br />
appreciate on a trade-weighted basis. Before this can happen, Asian currencies<br />
will need to deal with inflation first.<br />
Rise in oil prices are more aggressive<br />
compared to previous USD fall in 2002-04<br />
140<br />
120<br />
100<br />
80<br />
60<br />
40<br />
20<br />
0<br />
DXY index (rhs)<br />
Oil prices<br />
($/barrel, lhs)<br />
01 02 03 04 05 06 07 08<br />
130<br />
120<br />
110<br />
100<br />
90<br />
80<br />
70<br />
60<br />
Market is coming to our view for higher US rates<br />
% pa<br />
4.50<br />
4.25<br />
4.00<br />
3.75<br />
3.50<br />
3.25<br />
3.00<br />
2.75<br />
2.50<br />
2.25<br />
2.00<br />
1.75<br />
<strong>DBS</strong> forecast for<br />
Fed Funds Rate<br />
Fed Funds Futures<br />
as at Jun 9<br />
Fed Funds Futures<br />
as at Apr 30 (last cut)<br />
Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09<br />
28
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
Euro – relinquishing its anti-USD role<br />
The high of 1.6018 achieved by EUR/USD on Apr 22 is likely to be <strong>the</strong> peak for<br />
<strong>the</strong> next 6-12 months. Looking ahead, <strong>the</strong> EUR is set to lose its anti-USD role on<br />
expectations for <strong>the</strong> EU-US interest rate differentials to narrow, as well as a<br />
policy shift in G7’s exchange rate stance towards discouraging USD weakness.<br />
In our opinion, <strong>the</strong> EUR/USD’s rally during <strong>the</strong> US mortgage/credit crisis from Jul<br />
2007 to Apr 2008 did not reflect a strong EUR view, but a weak USD view driven<br />
by aggressive US rate cuts amidst steady EU rates. Between Sep 2007 and Apr<br />
2008, <strong>the</strong> Fed Funds Rate (FFR) fell from 5.25% to 2.00%, or half <strong>the</strong> ECB’s 4.00%<br />
refi rate.<br />
Looking ahead, we expect EU-US interest rate differentials to narrow, as <strong>the</strong>y<br />
always do after Eurozone loses its GDP growth advantage to <strong>the</strong> US. The Fed<br />
should start taking back rate cuts in 4Q08, initially as an exercise to normalize<br />
interest rates. The FFR is expected to rise to 4.50% by 3Q09 and reclaim its<br />
positive carry against <strong>the</strong> EUR. This is not an unreasonable prospect considering<br />
that US real interest rates, whe<strong>the</strong>r measured against headline CPI or core inflation,<br />
are significantly lower than <strong>the</strong>ir EU counterparts.<br />
There was also a major shift in <strong>the</strong> G7’s stance on exchange rates in 2Q08. At its<br />
meeting in April, G7 nations warned that sharp fluctuations in major currencies<br />
could threaten economic and financial stability. After EUR/USD rose above 1.50,<br />
Eurozone officials persisently complained about <strong>the</strong> EUR’s overvaluation and<br />
<strong>the</strong> USD’s undervaluation.<br />
Lending support here is <strong>the</strong> US-EU trade deficit, which is set to narrow for <strong>the</strong><br />
third straight year in 2008 to below USD100bn for <strong>the</strong> first time since 2003.<br />
Eurozone also reported a current account deficit of EUR17.8bn in 1Q08, its worst<br />
level since 2Q01. If this persist, it will be <strong>the</strong> first since 2001 that Eurozone<br />
posted a current account deficit.<br />
EUR/USD<br />
forecast, eop<br />
Latest Prev<br />
Close 1.56 1.55<br />
2Q08 1.55 1.48<br />
3Q08 1.52 1.50<br />
4Q08 1.49 1.54<br />
1Q09 1.46 1.50<br />
2Q09 1.43 1.49<br />
3Q09 1.45 1.48<br />
4Q09 1.46 1.48<br />
ECB refi rate<br />
forecast, eop<br />
Latest Prev<br />
Close 4.00 4.00<br />
2Q08 4.00 4.00<br />
3Q08 4.25 4.00<br />
4Q08 4.25 4.00<br />
1Q09 4.25 4.00<br />
2Q09 4.25 4.00<br />
3Q09 4.25 4.00<br />
4Q09 4.25 4.00<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
These initial currency complaints by EU officials initially fell on deaf ears, that is<br />
until <strong>the</strong> US Treasury and <strong>the</strong> Fed acknowledged in June that <strong>the</strong> weak USD was<br />
responsible for fueling inflationary expectations by boosting commodity prices,<br />
especially food and energy prices. Given that EUR accounts for 57.6% of <strong>the</strong><br />
weight in <strong>the</strong> <strong>the</strong> DXY (USD) index, this implies that <strong>the</strong> firmer USD sought by<br />
G7 to rein in commodity prices will inadvertently imply a weaker EUR.<br />
During <strong>the</strong> US rate hike cycle in 2005, EUR/USD returned close to 40% of its<br />
three-year rally from 2002 to 2004. If history repeats itself in <strong>the</strong> coming US<br />
tightening cycle, EUR/USD has potential to fall back towards 1.43 by mid-2009.<br />
EU-US policy rate spread to fall with GDP spread<br />
2<br />
1<br />
0<br />
-1<br />
-2<br />
-3<br />
EU-US<br />
GDP growth<br />
spread, % YoY<br />
EU-US<br />
policy rate<br />
spread, % pa<br />
96 97 98 99 00 01 02 03 04 05 06 07 08<br />
G7 seeks a firmer USD (or weaker EUR) should pull<br />
down commodity prices<br />
440<br />
420<br />
400<br />
380<br />
360<br />
340<br />
320<br />
300<br />
280<br />
260<br />
CRB index<br />
(lhs)<br />
Jan-07 Jul-07 Jan-08<br />
EUR/USD<br />
(rhs)<br />
1.65<br />
1.60<br />
1.55<br />
1.50<br />
1.45<br />
1.40<br />
1.35<br />
1.30<br />
1.25<br />
29
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Japanese yen – entering in a post-US crisis consolidation<br />
USD/JPY<br />
forecast, eop<br />
Latest Prev<br />
Close 107 103<br />
2Q08 107 105<br />
3Q08 108 100<br />
4Q08 109 98<br />
1Q09 110 100<br />
2Q09 109 100<br />
3Q09 108 101<br />
4Q09 106 101<br />
BOJ o/n target rate<br />
forecast, eop<br />
Latest Prev<br />
Close 0.50 0.50<br />
2Q08 0.50 0.50<br />
3Q08 0.50 0.50<br />
4Q08 0.50 0.50<br />
1Q09 0.75 0.75<br />
2Q09 0.75 0.75<br />
3Q09 1.00 1.00<br />
4Q09 1.00 1.00<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
We are looking for USD/JPY to enter into a broad consolidation, which normally<br />
takes place after <strong>the</strong> end of a US financial crisis. We do not expect <strong>the</strong> next US<br />
rate hike cycle to encourage a return to JPY carry trades because record high oil<br />
prices and inflation worries worldwide have resulted in a shift in G7’s stance on<br />
exchange rates.<br />
Over <strong>the</strong> past decade or two, <strong>the</strong> major peaks in USD/JPY were heralded by a US<br />
financial crisis in <strong>the</strong> US. This time, it was attributed to <strong>the</strong> US subprime/credit<br />
crisis. Interestingly, <strong>the</strong> peak in 1990 was also due to US housing woes known as<br />
<strong>the</strong> savings and loans crisis.<br />
As witnessed in past episodes, <strong>the</strong> initial fall in USD/JPY was fast and deep,<br />
resulting mainly from an aggressive unwinding of carry trades, often triggered<br />
by Fed rate cuts to stabilize financial markets. Based on daily closes, <strong>the</strong> fall in<br />
USD/JPY amounted to 27 yen during this crisis. The amount was between <strong>the</strong> 39<br />
yen fall seen during <strong>the</strong> Long Term Capital Management (LTCM) crisis in 1998,<br />
and <strong>the</strong> 19 yen fall during <strong>the</strong> WorldCom crisis. Thereafter, USD/JPY will bottom<br />
once it becomes evident that <strong>the</strong> worst was over for <strong>the</strong> US financial crisis. For<br />
this experience, USD/JPY’s bottom was established around 97 in March after <strong>the</strong><br />
Fed successfully pre-empted a potential fallout from Bears Stearns.<br />
Once a bottom is established, USD/JPY will embark on a post-recovery crisis. The<br />
LTCM and WorldCom experiences saw USD/JPY rebound by 9-13 yen from its<br />
low. This implies that today’s relief rally in USD/JPY should be limited to 106-<br />
110. Thereafter, USD/JPY should enter into a consolidation before resuming its<br />
fall, which historically came 4-5 quarters after its first bottom. Assuming March<br />
as <strong>the</strong> bottom for this episode, <strong>the</strong> consolidation is likely to last till 2Q09, and<br />
probably see USD/JPY mostly bound between 102 and 108 during this period.<br />
For <strong>the</strong> above scenario to work, <strong>the</strong> JPY must not reprise its role as a funding<br />
currency for carry trades as it did during <strong>the</strong> last US rate hike cycle from 2004 to<br />
2006. For carry trades to work, <strong>the</strong> environment must also be friendly for high<br />
yield currencies, which happen to be commodity currencies like <strong>the</strong> Australian<br />
dollar. Put simply, carry trades successful before <strong>the</strong> US crisis because <strong>the</strong> weak<br />
USD increased <strong>the</strong> purchasing power of Asian currencies and fueled speculation<br />
in commodities. Looking ahead, this is no longer <strong>the</strong> case. Inflation has started<br />
to erode <strong>the</strong> purchasing power of Asian currencies. US and <strong>the</strong> G7 nations are<br />
hinting strongly that <strong>the</strong> USD must stop depreciating (at least against major<br />
currencies) to rein in <strong>the</strong> record high oil prices seen threatening economic and<br />
financial stability.<br />
USD/JPY - big picture sees consolidation within big range before <strong>the</strong> next fall<br />
170<br />
160<br />
150<br />
S&L<br />
LTCM<br />
140<br />
130<br />
120<br />
110<br />
100<br />
WorldCom<br />
Subprime<br />
90<br />
80<br />
G3 interventions<br />
BOJ<br />
interventions<br />
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08<br />
30
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
Chinese yuan – appreciation pace to slow with diminished overheating risks<br />
We are reining back our expectations for CNY appreciation. The factors responsible<br />
for faster pace of appreciation since Jul 2005 have weakened in 2008. For 2008,<br />
we now expect CNY to rise by a smaller 8.1% appreciation against USD, compared<br />
to 12% previously. We have also slowed <strong>the</strong> appreciation for 2009 to 4.7% from<br />
5.5% previously. This should translate into a USD/CNY rate of 6.75 and 6.45 by<br />
<strong>the</strong> end of 2008 and 2009 respectively.<br />
Since its de-peg in Jul 2005, <strong>the</strong> CNY has been increasing its appreciation pace.<br />
Initial pressures came from <strong>the</strong> US-led G7 nations, triggered mainly by China’s<br />
ballooning trade surpluses and <strong>the</strong> widening bilateral US-China trade deficit. As<br />
time progressed, <strong>the</strong> pressures for faster CNY appreciation started to come more<br />
from domestic sources, namely as a need to pre-empt overheating pressures. By<br />
2007, China’s economy posted its fifth straight year of double-digit growth with<br />
inflation becoming a serious concern after it rose above 5% from Jul07. The<br />
Chinese stock market was <strong>the</strong> toast of equity investors, as <strong>the</strong> <strong>the</strong> Shanghai<br />
Composite Index increased almost six-fold between Jul 2005 and Oct 2007. Thanks<br />
to robust trade and capital inflows, foreign reserves surged to USD1.76 trillion<br />
in Apr08, a whopping trillion richer than <strong>the</strong> USD733bn posted in Jul05.<br />
Hence, it did not come as a surprise that <strong>the</strong> NDF (non-deliverable forward)<br />
market was pricing for faster and faster CNY appreciation throughout 2007 into<br />
1Q08. At its peak on Mar 13, <strong>the</strong> NDF market was projecting an appreciation of<br />
13% over <strong>the</strong> next 12 months. Since <strong>the</strong>n, that expectation has whittled to<br />
4.9% by Jun 11.<br />
So, what has changed? For a start, investors are finding it difficult to ignore <strong>the</strong><br />
struggling stock market, where <strong>the</strong> Shanghai Composite Index has fallen more<br />
than 70% from its peak. Like it or not, <strong>the</strong> stock market decline coincided with<br />
<strong>the</strong> slowdown in <strong>the</strong> economy. GDP growth decelerated for <strong>the</strong> second straight<br />
quarter to 10.6% in 1Q08, below 11% for <strong>the</strong> first time since 4Q05. Ano<strong>the</strong>r<br />
surprise was <strong>the</strong> trade surplus, which narrowed in <strong>the</strong> first four months from a<br />
year ago levels. The same narrowing was also seen in <strong>the</strong> bilateral US-China<br />
trade deficit. Understandably, <strong>the</strong> central bank is becoming comfortable that<br />
overheating risks have diminished.<br />
USD/CNY<br />
forecast, eop<br />
Latest Prev<br />
Close 6.92 7.10<br />
2Q08 6.90 6.90<br />
3Q08 6.80 6.70<br />
4Q08 6.75 6.50<br />
1Q09 6.70 6.30<br />
2Q09 6.65 6.26<br />
3Q09 6.55 6.21<br />
4Q09 6.45 6.16<br />
PBOC 1Y lending<br />
forecast, eop<br />
Latest Prev<br />
Close 7.47 7.47<br />
2Q08 7.47 7.74<br />
3Q08 7.47 8.01<br />
4Q08 7.74 8.01<br />
1Q09 8.01 8.01<br />
2Q09 8.28 8.01<br />
3Q09 8.28 8.01<br />
4Q09 8.28 8.01<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
Even so, <strong>the</strong>se factors are not sufficient to abandon <strong>the</strong> CNY’s appreciation bias.<br />
China is still reporting double-digit growth, foreign reserves are still rising strongly<br />
and trade surpluses are still wide. But <strong>the</strong>y are no longer flagging large overheating<br />
risks. With US and G7 no longer pushing hard for a weak USD because of <strong>the</strong> oil<br />
crisis, <strong>the</strong>re’s a case to scale back appreciation expectations for <strong>the</strong> CNY.<br />
Market sees CNY slowing appreciation pace<br />
China stocks anticipated GDP slowdown<br />
24<br />
22<br />
20<br />
18<br />
16<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
USD/CNY<br />
1Y NDF (rhs)<br />
% appreciation<br />
implied by 1Y NDF<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
USD/CNY<br />
Spot (rhs)<br />
8.50<br />
8.00<br />
7.50<br />
7.00<br />
6.50<br />
6.00<br />
5.50<br />
5.00<br />
4.50<br />
4.00<br />
3.50<br />
12.5<br />
12.0<br />
11.5<br />
11.0<br />
10.5<br />
10.0<br />
GDP growth<br />
(% YoY, lhs)<br />
Shanghai Comp<br />
Index (rhs)<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
7000<br />
6000<br />
5000<br />
4000<br />
3000<br />
2000<br />
1000<br />
0<br />
31
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
USD/HKD<br />
forecast, eop<br />
Latest Prev<br />
Close 7.81 7.79<br />
2Q08 7.81 7.80<br />
3Q08 7.83 7.77<br />
4Q08 7.83 7.75<br />
1Q09 7.85 7.78<br />
2Q09 7.85 7.78<br />
3Q09 7.83 7.78<br />
4Q09 7.80 7.79<br />
3M Hibor<br />
forecast, eop<br />
Latest Prev<br />
Close 2.15 2.14<br />
2Q08 1.75 1.75<br />
3Q08 1.95 1.85<br />
4Q08 2.35 1.85<br />
1Q09 3.05 2.63<br />
2Q09 3.70 --<br />
3Q09 4.20 --<br />
4Q09 4.15 --<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
Hong Kong dollar – peg intact despite surge in CNY deposits<br />
USD/HKD bottomed at 7.76 on Mar 17 and proceeded to rise above 7.80 again<br />
on May 20. Some market players blamed <strong>the</strong> HKD’s weakness on more Hong<br />
Kongers opening CNY deposits. Instead, we prefer to attribute this to <strong>the</strong> broad<br />
USD’s recovery on growing market belief that <strong>the</strong> worst was over for <strong>the</strong> US<br />
subprime/credit crisis.<br />
None<strong>the</strong>less, <strong>the</strong> rapid growth of CNY deposits in Hong Kong in 2008 has attracted<br />
sufficient attention to warrant some discussion. Since <strong>the</strong> start of this year, CNY<br />
deposits surged to CNY76.6bn by Apr08, more-than-doubled <strong>the</strong> CNY33.4bn reported<br />
in Dec07.<br />
The interest in CNY deposits as an alternative asset class was probably triggered<br />
by <strong>the</strong> sharp 35% fall in HK equities from Nov 2007 into Mar 2008. As China’s<br />
stock market fell 50% from its peak, earlier optimism surrounding <strong>the</strong> “throughtrain”<br />
scheme to allow individual mainland Chinese to invest directly in HK<br />
equities evaporated. Not surprisingly, CNY deposits started to make sense to<br />
Hong Kongers as <strong>the</strong>y turned <strong>the</strong>ir attention towards <strong>the</strong> divergent monetary<br />
policies of <strong>the</strong> mainland and <strong>the</strong> territory. While Hong Kong’s monetary policy<br />
was tracking <strong>the</strong> Fed in lowering interest rates, China was visibly accelerating<br />
<strong>the</strong> CNY’s appreciation to augment its fight against rising inflation and overheating<br />
risks.<br />
That said, this surge in CNY deposits is unlikely to pose a serious threat to <strong>the</strong><br />
HKD peg. As at Apr08, CNY deposits accounted for only 1.2% of total outstanding<br />
deposits in <strong>the</strong> territory. Looking ahead, we also expect HK interest rates to<br />
start rising with <strong>the</strong> Fed from 4Q08 into 3Q09. Meanwhile, China is starting to<br />
show signs that it may be looking to slow <strong>the</strong> CNY’s appreciation pace on signs<br />
overheating risks may be ebbing.<br />
In 2Q08, <strong>the</strong> HKD peg was not spared from speculation that Middle East countries<br />
are considering abandoning <strong>the</strong>ir USD pegs to fight inflation. The Hong Kong<br />
Monetary Authority (HKMA) duly ruled out changing <strong>the</strong> HKD peg to ease rising<br />
price pressures. The World Bank and <strong>the</strong> IMF reiterated <strong>the</strong>ir support for HK’s<br />
commitment to <strong>the</strong> peg.<br />
Looking ahead, we prefer to focus on broad USD trends, especially those against<br />
Asian currencies, in shaping <strong>the</strong> view for <strong>the</strong> HKD. We also reckon that <strong>the</strong><br />
world now considers record high oil prices a threat to <strong>the</strong> economic and financial<br />
stability in <strong>the</strong> world. Looking ahead, we reckon that G7 nations believe that<br />
ending <strong>the</strong> USD’s weakness against major currencies will be <strong>the</strong> first important<br />
step towards lowering oil prices.<br />
USD/HKD bottomed as USD recovered on hopes<br />
that worst is over for US financial crisis<br />
130<br />
125<br />
120<br />
115<br />
USD/HKD<br />
(rhs)<br />
7.84<br />
7.82<br />
7.80<br />
Bearish HK equities probably encouraged interest<br />
in CNY deposits<br />
35000<br />
30000<br />
25000<br />
Hang Seng<br />
Index (lhs)<br />
90<br />
80<br />
70<br />
60<br />
50<br />
110<br />
105<br />
100<br />
95<br />
USD/JPY<br />
(lhs)<br />
Jan-07 Jul-07 Jan-08<br />
7.78<br />
7.76<br />
7.74<br />
20000<br />
15000<br />
10000<br />
CNY deposits in HK<br />
(CNY bn, rhs)<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
40<br />
30<br />
20<br />
10<br />
0<br />
32
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
Taiwan dollar – moving towards closer ties and cooperation with China<br />
The TWD was <strong>the</strong> best performing currency in emerging Asia in 1H08. Most of<br />
<strong>the</strong>se gains were achieved in 1Q08 in celebration of <strong>the</strong> end of <strong>the</strong> Democratic<br />
Progressive Party’s (DPP) eight-year rule. Optimism first set in after <strong>the</strong> opposition<br />
Kuomintang (KMT) swept 86 out of <strong>the</strong> 113 seats at <strong>the</strong> Legislative Yuan elections<br />
on Jan 12. The DPP’s defeat was complete after KMT candidate Ma Ying-jeou<br />
won 58.45% of <strong>the</strong> votes at <strong>the</strong> presidential elections on Mar 22. Ma was inaugurated<br />
as Taiwan’s president on May 20.<br />
With <strong>the</strong> KMT in charge, investors are looking forward to better Cross Straits<br />
relations, which have been strained under <strong>the</strong> DPP’s rule. Despite <strong>the</strong> earthquake<br />
in China, Beijing extended an invitation on May 17 to KMT chairman Wu Pohhsiung<br />
to meet with China President Hu Jintao on May 26. This was a landmark<br />
meeting signaling warming ties because it was <strong>the</strong> first time in 60 years that <strong>the</strong><br />
leaders of <strong>the</strong> ruling parties in China and Taiwan met.<br />
Some of positive developments discussed so far included possible plans for China<br />
to move towards reducing <strong>the</strong> number of missiles aimed at Taiwan. In response<br />
to President Hu’s offer to reconsider not blocking Taiwan’s efforts for greater<br />
particpation in international activities (for example, attendance at <strong>the</strong> World<br />
Health Organization), Taiwan offered to reduce “chequebook diplomacy”.<br />
In affirming <strong>the</strong> resumption of dialogue between Taipei and Beijing, <strong>the</strong> above<br />
developments are important building blocks towards achieving President Ma’s<br />
pledge to build closer business ties with China to boost Taiwan’s economy.<br />
July will be an important month signaling <strong>the</strong> first important steps towards<br />
closer economic cooperation. Jul 4 is <strong>the</strong> day that weekend direct flights are<br />
scheduled to be launch between China and Taiwan. The Taiwan parliament is<br />
also working hard to finalise plans for full yuan convertibility in July. These<br />
developments are likely to pave <strong>the</strong> way for more Chinese to visit Taiwan as<br />
tourists and investors, as well as to encourage Taiwan to ease restrictions on<br />
investments by local companies in China.<br />
Overall, we are encouraged by <strong>the</strong> initial gestures by China and Taiwan in resuming<br />
dialogue and improving economic cooperation. While <strong>the</strong> TWD is unlikely to<br />
buck <strong>the</strong> trend of a USD recovery, we see scope for <strong>the</strong> TWD to maintain an<br />
advantage over o<strong>the</strong>r Asian currencies including <strong>the</strong> JPY on a relative basis.<br />
None<strong>the</strong>less, we do expect USD/TWD to maintain its traditionally strong link to<br />
USD/JPY. Unless Taiwan attracts huge capital inflows, USD/TWD should hold above<br />
<strong>the</strong> psychological 30 level until USD/JPY falls below 100 again.<br />
USD/TWD<br />
forecast, eop<br />
Latest Prev<br />
Close 30.4 30.7<br />
2Q08 30.4 31.0<br />
3Q08 30.5 30.5<br />
4Q08 31.0 29.5<br />
1Q09 31.5 30.5<br />
2Q09 32.0 30.4<br />
3Q09 31.5 30.2<br />
4Q09 31.0 30.0<br />
CBC discount rate<br />
forecast, eop<br />
Latest Prev<br />
Close 3.500 3.375<br />
2Q08 3.625 3.625<br />
3Q08 3.750 3.625<br />
4Q08 3.875 3.625<br />
1Q09 3.875 3.625<br />
2Q09 3.875 3.625<br />
3Q09 3.875 3.625<br />
4Q09 3.875 3.625<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
TWD & equities cheered by prospects for<br />
improving Cross-Straits relations<br />
10000 USD/TWD<br />
Presidential elections<br />
(rhs)<br />
Inauguration<br />
9500<br />
34<br />
33<br />
Larger influence on USD/TWD comes from<br />
USD/JPY<br />
125<br />
120<br />
USD/TWD<br />
(rhs)<br />
34<br />
33<br />
9000<br />
8500<br />
8000<br />
32<br />
31<br />
115<br />
110<br />
105<br />
32<br />
31<br />
7500<br />
TAIEX<br />
(lhs)<br />
Legislative<br />
elections<br />
30<br />
100<br />
USD/JPY<br />
(lhs)<br />
30<br />
7000<br />
Jan-07 Jul-07 Jan-08<br />
29<br />
95<br />
Jan-07 Jul-07 Jan-08<br />
29<br />
33
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
USD/KRW<br />
forecast, eop<br />
Latest Prev<br />
Close 1030 971<br />
2Q08 1035 1000<br />
3Q08 1075 980<br />
4Q08 1100 940<br />
1Q09 1075 980<br />
2Q09 1075 980<br />
3Q09 1050 982<br />
4Q09 1050 982<br />
BOK o/n call rate<br />
forecast, eop<br />
Latest Prev<br />
Close 5.00 5.00<br />
2Q08 5.00 5.00<br />
3Q08 5.00 5.00<br />
4Q08 4.75 5.00<br />
1Q09 4.50 5.00<br />
2Q09 4.50 5.00<br />
3Q09 4.50 5.00<br />
4Q09 4.50 5.00<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
Korean won – weakened international liquidity position<br />
We downgraded our forecast for KRW on Apr 24. Instead of expecting <strong>the</strong> KRW<br />
to appreciate against USD to 940 by end-2008, we see <strong>the</strong> risk for <strong>the</strong> KRW to<br />
depreciate to 1050-1100 in <strong>the</strong> second half of <strong>the</strong> year instead.<br />
Interestingly, <strong>the</strong> last time <strong>the</strong> KRW depreciated as dramatically as today was<br />
back in 2001-02. Like <strong>the</strong> Y2K crisis back <strong>the</strong>n, it was <strong>the</strong> subprime/credit crisis<br />
that threatened to push <strong>the</strong> US economy into recession. Both periods witnessed<br />
<strong>the</strong> Fed delivering inter-meeting rate cuts. But <strong>the</strong>re is one difference. Foreign<br />
reserves were rising to overtake foreign debt back <strong>the</strong>n. Today, external debt<br />
has already overtaken foreign reserves.<br />
The first hint of <strong>the</strong> KRW’s weakness surfaced during <strong>the</strong> US mortgage/credit<br />
crisis that broke out in Jul 2007. Despite aggressive cuts in US interest rates, <strong>the</strong><br />
KRW depreciated instead of appreciating. Ano<strong>the</strong>r disturbing development was<br />
<strong>the</strong> vulnerability of <strong>the</strong> KRW to unwinding of JPY carry trades or shortages of<br />
USD liquidity. Instinctively, we reckoned that <strong>the</strong>re was a weakening in Korea’s<br />
international liquidity position. Our investigations did not let us down.<br />
Over <strong>the</strong> past few years, Korean banks were aggressively expanding <strong>the</strong>ir loans<br />
books. But <strong>the</strong>re was one problem -- loans already exceeded deposits. To continue<br />
<strong>the</strong> practice of lending aggressively, banks borrowed heavily from foreigners to<br />
make up <strong>the</strong> funding gap. Why not? Back <strong>the</strong>n, <strong>the</strong> KRW was considered one of<br />
<strong>the</strong> best Asian currencies to invest in, while <strong>the</strong> JPY emerged as a funding currency<br />
for carry trades. This eventually led to gross external debt overtaking foreign<br />
reserves in 2Q06, with <strong>the</strong> debt-reserves shortfall widening to USD118bn in 4Q07.<br />
The last time <strong>the</strong> shortfall exceeded USD100bn was just before <strong>the</strong> 1997/98 Asian<br />
financial crisis.<br />
That said, we are not suggesting that Korea is about to enter into a crisis. The<br />
trigger for <strong>the</strong> Korean crisis in 1997/98 was <strong>the</strong> lack of foreign reserves to cover<br />
short-term external debt. Today, this is not <strong>the</strong> case, at least not yet. Even so,<br />
<strong>the</strong>re is little room for complacency ei<strong>the</strong>r. Left unaddressed, <strong>the</strong> rapid rise in<br />
short-term external debt is projected overtake foreign reserves by 2012. With<br />
international ratings agencies now concerned about <strong>the</strong> banks’ heavy reliance<br />
on short-term external borrowings, expect <strong>the</strong> government to introduce measures<br />
to address this issue.<br />
Under <strong>the</strong> circumstances, it did not bode well that <strong>the</strong> current account (CA)<br />
reported a deficit of USD5.2bn in 1Q08, contrasting sharply with <strong>the</strong> full-year<br />
USD6.0bn surplus in 2007. If <strong>the</strong> deterioration persists, this will be <strong>the</strong> first year<br />
that Korea posts a CA deficit after <strong>the</strong> Asian crisis.<br />
Korean banks are relying heavily on external<br />
borrowings to lend<br />
140 USD bn<br />
120<br />
100<br />
80<br />
60<br />
40<br />
20<br />
0<br />
-20<br />
-40<br />
Commercial banks'<br />
loans less deposits<br />
External debt,<br />
YoY difference<br />
01 02 03 04 05 06 07 08<br />
Korea needs to address its rising external debt<br />
450<br />
400<br />
350<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
0<br />
USD bn<br />
Gross external debt<br />
Gross external assets<br />
Foreign<br />
reserves<br />
Short-term<br />
external debt<br />
96 97 98 99 00 01 02 03 04 05 06 07 08<br />
34
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
Singapore dollar – a higher USD/SGD is not inconsistent with a rising SGD NEER<br />
Based on our expectations for <strong>the</strong> USD to recover some lost ground, as well as<br />
continued weakness in Asian currencies, we now see upside risks for USD/SGD to<br />
rise towards 1.44 in <strong>the</strong> next 6-12 months.<br />
Over <strong>the</strong> past two years, <strong>the</strong> market has become accustomed to associating a<br />
lower USD/SGD with a strong SGD NEER (nominal effective exchange rate) policy.<br />
More so after USD/SGD increased <strong>the</strong> pace of its fall with each tightening at its<br />
last two Monetary Authority of Singapore (MAS) policy reviews 1/ . We have no<br />
problem with this association as long as <strong>the</strong> USD is depreciating against <strong>the</strong> SGD<br />
NEER’s trade-weighted basket of currencies.<br />
At this point, we would also like to remind readers that USD/SGD can head up<br />
despite a strong SGD NEER policy. For example, USD/SGD rose from 1.6327 to<br />
1.6627 in 2005, even after MAS shifted in Apr 2004 to a policy of appreciating<br />
<strong>the</strong> SGD NEER at a modest and gradual pace. During 2005, after USD/SGD bottomed<br />
at 1.6180 on Mar 10, it surged 5.3% to 1.7051 on Nov 14 before resuming its<br />
downtrend. The reason for this was simple. The USD was firm because <strong>the</strong> US<br />
was in <strong>the</strong> process of raising interest rates from 1.00% to 5.25%. This led to a<br />
broad-based USD recovery against both major currencies and Asian currencies.<br />
Like today, record high oil prices became a problem for some Asian economies,<br />
and forcing neighbouring countries like Indonesia to cut fuel subsidies.<br />
Currently, we see upside risks in USD/SGD coming mainly from major currencies.<br />
Since <strong>the</strong> outbreak of <strong>the</strong> US subprime/credit crisis in Jul 2007, <strong>the</strong> SGD has<br />
broken ranks with Asian currencies and closely followed <strong>the</strong> major currencies<br />
stronger. To facilitate this dichotomous behaviour, <strong>the</strong> MAS had to re-center its<br />
SGD NEER policy band at its policy review in April.<br />
USD/SGD<br />
forecast, eop<br />
Latest Prev<br />
Close 1.37 1.38<br />
2Q08 1.37 1.41<br />
3Q08 1.38 1.38<br />
4Q08 1.40 1.35<br />
1Q09 1.42 1.38<br />
2Q09 1.44 1.37<br />
3Q09 1.42 1.37<br />
4Q09 1.40 1.36<br />
3M Sibor<br />
forecast, eop<br />
Latest Prev<br />
Close 1.44 1.31<br />
2Q08 1.16 1.13<br />
3Q08 1.31 1.14<br />
4Q08 1.52 1.13<br />
1Q09 1.94 1.49<br />
2Q09 2.31 2.79<br />
3Q09 2.67 2.30<br />
4Q09 2.64 2.60<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
This goes some way to explain why <strong>the</strong> MYR/SGD cross rate has weakened below<br />
its 0425-0.452 range, while <strong>the</strong> EUR/SGD cross rate appears to be establishing<br />
stable 2.10-2.18 trading range. This should not come as a surprise since Malaysia<br />
is still Singapore’s largest trading partner in Asia, while Eurozone has overtaken<br />
<strong>the</strong> US as <strong>the</strong> largest amongst <strong>the</strong> developed economies.<br />
Unless <strong>the</strong> MAS is seeking to re-center its band before its next policy review in<br />
October, we urge readers to pay close attention to EUR/USD, whose fall is likely<br />
to push up USD/SGD.<br />
1/<br />
In Oct 2007, <strong>the</strong> MAS “slightly” increased <strong>the</strong> appreciation pace of <strong>the</strong> SGD NEER policy band.<br />
This was followed by a re-centering of <strong>the</strong> SGD NEER band in Apr 2008. Both tightening were<br />
aimed at reining in inflation, which rose to a 26-year high of 7.5% in Apr08.<br />
SGD has been tracking major currencies since<br />
<strong>the</strong> start of <strong>the</strong> US crisis<br />
104 Performance of USD vs currencies<br />
Indexed: 15 Jul 07 = 100<br />
102<br />
100<br />
98<br />
96<br />
94<br />
92<br />
90<br />
88<br />
86<br />
Major currencies<br />
(implied by DXY index)<br />
Asian currencies<br />
(implied by ADXY index)<br />
SGD<br />
Jul-07 Oct-07 Jan-08 Apr-08<br />
USD/SGD & SGD NEER can diverge occasionally<br />
108<br />
106<br />
104<br />
102<br />
100<br />
98<br />
96<br />
94<br />
2005 US<br />
rate hike<br />
cycle<br />
Re-centering<br />
Appreciation<br />
pace increased<br />
USD/SGD (rhs)<br />
Start of strong SGD policy<br />
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08<br />
SGD<br />
NEER<br />
(lhs)<br />
1.75<br />
1.70<br />
1.65<br />
1.60<br />
1.55<br />
1.50<br />
1.45<br />
1.40<br />
1.35<br />
1.30<br />
35
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
USD/MYR<br />
forecast, eop<br />
Latest Prev<br />
Close 3.27 3.18<br />
2Q08 3.27 3.25<br />
3Q08 3.30 3.15<br />
4Q08 3.35 3.00<br />
1Q09 3.40 3.15<br />
2Q09 3.45 3.14<br />
3Q09 3.40 3.14<br />
4Q09 3.35 3.13<br />
BNM o/n policy rate<br />
forecast, eop<br />
Latest Prev<br />
Close 3.50 3.50<br />
2Q08 4.00 3.50<br />
3Q08 4.00 3.50<br />
4Q08 4.00 3.50<br />
1Q09 4.00 3.50<br />
2Q09 4.00 3.50<br />
3Q09 4.00 3.50<br />
4Q09 4.00 3.50<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
Malaysian ringgit – dominated by political uncertainties<br />
As predicted in our previous quarterly, <strong>the</strong> appreciating MYR corrected in 2Q08.<br />
The MYR appreciated to 3.1280 against <strong>the</strong> USD on Apr 23, its strongest level<br />
since Oct 1997. Like o<strong>the</strong>r Asian currencies, <strong>the</strong> MYR succumbed to a stronger<br />
USD on market expectations for <strong>the</strong> US to start taking back its rate cuts as early<br />
as 4Q08. Domestically, <strong>the</strong> MYR was also undermined by post-election political<br />
uncertainties, <strong>the</strong> key risk confronting <strong>the</strong> MYR this year<br />
Uncertainties emerged after <strong>the</strong> ruling Barisan Nasional (BN) coalition lost its<br />
two-thirds parliamentary majority at <strong>the</strong> general elections held on Mar 8. The<br />
coalition also ceded control of 5 out of <strong>the</strong> 13 states to <strong>the</strong> opposition. Since<br />
<strong>the</strong>n, PM Abdullah Badawi has been facing increasing pressures to step down.<br />
His predecessor, Mahathir Mohamad, quit <strong>the</strong> United Malaysia National Organization<br />
(UMNO) on May 20 in protest of Badawi’s leadership. Oppositon leader Anwar<br />
Ibrahim declared his intention to seize power by persuading BN lawmakers to<br />
defect to his coalition. Anwar is hoping that <strong>the</strong> unpopular fuel price hikes<br />
would hasten <strong>the</strong> fall of <strong>the</strong> BN coalition. For now, <strong>the</strong> prime minister’s fate is<br />
expected to be decided at <strong>the</strong> UMNO annual congress due in Dec 2008.<br />
Adding to political uncertainties here is <strong>the</strong> government’s decision to reform<br />
fuel subsidies on Jun 4. While this is positive for cushioning Malaysia’s fiscal<br />
finances against record high international energy prices, <strong>the</strong> subsequent 41%<br />
jump in petrol prices and 63% rise in diesel prices are likely to add to inflation.<br />
To ease <strong>the</strong> pain on consumers, <strong>the</strong> government intends to widen <strong>the</strong> social<br />
safety net for <strong>the</strong> poor, encourage government department to save costs, widen<br />
<strong>the</strong> list of price-controlled items and make a decision by August whe<strong>the</strong>r to<br />
reduce road toll rates.<br />
Politics aside, we do expect <strong>the</strong> fuel price hikes to lift inflation to 5.8% YoY in<br />
Jun08. Inflation has already doubled to 3.0% YoY in Apr08 from 1.4% in Jun07.<br />
Hence, Bank Negara Malaysia (BNM) is now expected to hike its overnight policy<br />
rate by 50bps to 4.00%, which will be its first rate move since May 2006.<br />
As for <strong>the</strong> MYR, <strong>the</strong> KL stock market index will become an important gauge of<br />
investor sentiment to domestic politics. In <strong>the</strong> end, we expect BNM to maintain<br />
control of <strong>the</strong> exchange rate and keep <strong>the</strong> MYR aligned to Asian currencies.<br />
Without <strong>the</strong> political uncertainties, <strong>the</strong> MYR would have been a strong currency.<br />
Unlike many of its Asian peers, Malaysia’s trade surpluses are not threatened by<br />
costlier energy imports, thanks to its net oil exporter status. In its latest semiannual<br />
currency report, <strong>the</strong> US Treasury considers <strong>the</strong> MYR an undervalued currency<br />
based on its large current account surpluses and low domestic investment.<br />
MYR is no longer ignoring downside risks in stocks<br />
1700<br />
1600<br />
1500<br />
1400<br />
1300<br />
1200<br />
1100<br />
1000<br />
900<br />
USD/MYR<br />
(inverted, rhs)<br />
KL Composite<br />
index (lhs)<br />
3.10<br />
3.20<br />
3.30<br />
3.40<br />
3.50<br />
3.60<br />
3.70<br />
3.80<br />
Trade surpluses held up against record oil prices<br />
MYR bn<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
800<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
3.90<br />
-4<br />
96 97 98 99 00 01 02 03 04 05 06 07 08<br />
36
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
Thai baht – tracking Asian currencies lower<br />
The sharp appreciation of <strong>the</strong> THB in <strong>the</strong> first 3.5 months of 2008 can be attributed<br />
to <strong>the</strong> return of democracy to Thailand in Dec/Jan and <strong>the</strong> end of capital controls<br />
in Feb. Since peaking at 31.00 on Mar 19, <strong>the</strong> THB has been weakening with its<br />
counterparts in Asia. In reviewing <strong>the</strong> THB, we find that <strong>the</strong> factors that were<br />
responsible for a stronger THB in <strong>the</strong> past two years have weakened in 2008.<br />
In 2006 and 2007, <strong>the</strong> appreciation pace of <strong>the</strong> THB quickened against <strong>the</strong> USD.<br />
This was easily explained by <strong>the</strong> aggressive build-up in foreign reserves, which<br />
started to overtake external debt from Apr 2006. One major contribution to <strong>the</strong><br />
foreign reserves was <strong>the</strong> current account balance, which reversed from a deficit<br />
into a surplus in 2006, and proceeded to report a record USD14.9bn surplus in<br />
2007. Playing a major role here was export growth exceeding import growth.<br />
Interest rate cuts in 2007 also helped real GDP growth to rise for four straight<br />
quarters to above 6% YoY in 1Q08. Quarterly inflation stayed low below 3%<br />
YoY in 2007. Equally important is <strong>the</strong> appreciation in Asian currencies in <strong>the</strong><br />
past couple of years, thanks to aggressive US rate cuts.<br />
Several things changed in 2008. The most important challenge comes from record<br />
oil prices, which is hurting both inflation and <strong>the</strong> trade balance.<br />
The customs trade balance reversed from a surplus into a deficit totaling USD3.0bn<br />
in <strong>the</strong> first four months. This was attributed to a 39.6% YoY surge in imports<br />
outstripping export growth of 21.4% during this period, which contrasted with<br />
<strong>the</strong> 8.7% import growth and 18.0% export growth posted in 2007. Take note<br />
that USD/THB was range-bound between 38.2 and 42.0 when import growth<br />
overtook export growth in 2004 and 2005.<br />
Between Aug07 and May08, headline CPI inflation surged to 7.6% YoY from<br />
1.1%, while core inflation quadrupled to 2.8% from 0.7%. With <strong>the</strong> policy rate<br />
at 3.25%, <strong>the</strong> Bank of Thailand (BOT) will be increasingly pressured to hike rates<br />
to keep core inflation within <strong>the</strong> official 0-3.5% target band. Unfortunately, <strong>the</strong><br />
central bank is facing resistance to hike rates from <strong>the</strong> new government’s progrowth<br />
economic policy. If policymakers fail to agree here, inflation has <strong>the</strong><br />
potential to spark social unrest and add fuel to coup rumours.<br />
In <strong>the</strong> end, we anchor our THB view on one thing that policymakers agree upon.<br />
Both <strong>the</strong> BOT and <strong>the</strong> finance ministry believe that <strong>the</strong> THB should be aligned<br />
to Asian currencies. Given our expectation for <strong>the</strong> USD to stay firm into 2Q09 on<br />
<strong>the</strong> back of US rate hikes, we see USD/THB extending its rise towards 35 in <strong>the</strong><br />
next 6-12 months.<br />
USD/THB<br />
forecast, eop<br />
Latest Prev<br />
Close 33.1 31.6<br />
2Q08 33.0 33.0<br />
3Q08 33.5 32.0<br />
4Q08 34.0 30.0<br />
1Q09 34.5 31.0<br />
2Q09 34.9 30.9<br />
3Q09 34.1 30.8<br />
4Q09 33.4 30.7<br />
BOT 1D repo rate<br />
forecast, eop<br />
Latest Prev<br />
Close 3.25 3.25<br />
2Q08 3.25 3.25<br />
3Q08 3.25 3.25<br />
4Q08 3.75 3.75<br />
1Q09 3.75 4.00<br />
2Q09 3.75 4.25<br />
3Q09 3.75 4.25<br />
4Q09 3.75 4.25<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
THB falls when export underperforms imports<br />
% YoY 3mth move ave, spot<br />
40<br />
USD/THB<br />
(inverted, rhs)<br />
30<br />
20<br />
10<br />
0<br />
-10<br />
-20<br />
-30<br />
Export growth<br />
less import growth<br />
04 05 06 07 08<br />
30<br />
32<br />
34<br />
36<br />
38<br />
40<br />
42<br />
44<br />
Policymakers must agree to deal with inflation<br />
% YoY, % pa<br />
8<br />
7<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
-1<br />
Fed Funds Rate<br />
BOT policy rate<br />
TH<br />
core CPI<br />
00 01 02 03 04 05 06 07 08<br />
TH CPI<br />
37
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Indonesian rupiah – moving above 8700-9500 range<br />
USD/IDR<br />
forecast, eop<br />
Latest Prev<br />
Close 9310 9160<br />
2Q08 9300 9300<br />
3Q08 9500 9000<br />
4Q08 9600 8700<br />
1Q09 9700 9000<br />
2Q09 9800 9000<br />
3Q09 9500 8980<br />
4Q09 9300 8980<br />
BI benchmark rate<br />
forecast, eop<br />
Latest Prev<br />
Close 8.50 8.00<br />
2Q08 8.75 8.00<br />
3Q08 9.25 8.00<br />
4Q08 9.25 8.00<br />
1Q09 9.25 8.00<br />
2Q09 9.25 8.00<br />
3Q09 9.25 8.00<br />
4Q09 9.25 8.00<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
Since 2006, Bank Indonesia (BI) has successfully kept USD/IDR stable in a broad<br />
range between 8700 and 9500. We think that this is about to change.<br />
Despite oil prices surging to USD98/barrel from USD61 in 2007, depreciation<br />
pressures on <strong>the</strong> rupiah were offset by a number of factors. To a great extent,<br />
<strong>the</strong> central bank’s ability to maintain a stable rupiah could be attributed to <strong>the</strong><br />
reflationary environment that followed <strong>the</strong> aggressive fuel price hikes in Oct<br />
2005. As inflation eased from a high of 18.4% YoY in Nov 2005 to a stable range<br />
between 5.3% and 7.0% from Oct 2006 to Dec 2007, <strong>the</strong> central bank lowered<br />
interest rates from 12.75% to 8.00%.<br />
During <strong>the</strong>se two years, <strong>the</strong> Jakarta stock market delivered annual gains of more<br />
than 50%, correctly betting on economic growth to return to pre-crisis levels<br />
above 6%. Meanwhile, foreign reserves started to accummulate at a faster rate<br />
from 2006, and overtook private sector external debt in 2007. The merchandise<br />
trade surplus was strong at almost USD40bn in 2006 and 2007, well above <strong>the</strong><br />
average USD26bn posted in <strong>the</strong> previous eight years. This helped to assuage<br />
concerns about Indonesia’s net oil importer status. Of course, it did not hurt<br />
that <strong>the</strong> USD was weak internationally from <strong>the</strong> aggressive rate cuts during <strong>the</strong><br />
US mortgage/credit crisis that started in Jul 2007.<br />
Unfortunately, this did not last. The positive factors responsible for rupiah stability<br />
in <strong>the</strong> past couple of years started to deteriorate in 2008. As at Jun 2, <strong>the</strong> stock<br />
market has fallen by 12% since <strong>the</strong> start of <strong>the</strong> year, in line with waning consumer<br />
confidence. Oil prices have become a problem as <strong>the</strong>y extended <strong>the</strong>ir ascent to<br />
as high as USD133/barrel on May 21. Apart from lifting inflation to double-digit<br />
levels by May08, high oil prices started to strain fiscal finances as well as to<br />
narrow <strong>the</strong> trade surplus. BI brought forward its policy meeting by two-days to<br />
May 6 and lifted <strong>the</strong> reference rate by 25bps hike to 8.25%. To alleviate <strong>the</strong><br />
pressures on fiscal finances from record high oil prices, <strong>the</strong> government raised<br />
fuel prices by 28.7% on May 24, leaving <strong>the</strong> door open for more hikes and fuel<br />
subsidy cuts should <strong>the</strong> oil prices continue to climb unabated.<br />
Under <strong>the</strong> circumstances, <strong>the</strong> rupiah will be vulnerable if <strong>the</strong> US embarks on a<br />
rate hike cycle, like in 1999-00 and 2004-06. Starting from 4Q08 into 3Q09, <strong>DBS</strong><br />
expects <strong>the</strong> Fed to raise interest rates from 2.00% to 4.25%. Hence, it will become<br />
more challenging for BI to keep USD/IDR within its 8700-9500 range. Taking into<br />
account that rupiah depreciation has become more muted with each cycle, we<br />
reckon that <strong>the</strong> upside for USD/IDR will be limited to 9800-10000 by mid-2009<br />
before coming down again.<br />
USD/IDR rises during US rate hike cycle<br />
% pa, spot<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
USD/IDR<br />
(rhs)<br />
Fed Funds Rate<br />
0<br />
99 00 01 02 03 04 05 06 07 08<br />
12000<br />
11000<br />
10000<br />
9000<br />
8000<br />
7000<br />
6000<br />
5000<br />
4000<br />
3000<br />
Jakarta stocks - first losses since 2001<br />
Jakarta Composite Index, % YoY annual changes<br />
70<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
-10<br />
-20<br />
2008 data: % ch YTD as at Jun 2<br />
01 02 03 04 05 06 07 08<br />
38
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
Philippine peso – deep retracement on less favorable fundamentals<br />
In our last quarterly, we expected USD/PHP to head up in 2Q08, as it normally<br />
does during <strong>the</strong> second quarter of <strong>the</strong> year. We also reined in our bullish PHP<br />
expectations because <strong>the</strong> factors that were responsible for <strong>the</strong> PHP’s three-year<br />
rally between 2005 and 2007 have started to weaken. The deterioration was,<br />
however, not severe enough for us to abandon our expectations for PHP to<br />
appreciate for a fourth year. Back <strong>the</strong>n, <strong>the</strong> USD continued to be stressed by <strong>the</strong><br />
US mortgage/credit crisis.<br />
None<strong>the</strong>less, <strong>the</strong> PHP’s weakness in 2Q08 turned out to be more significant than<br />
we had expected. Unlike past years, Bangko Sentral ng Pilipinas’ (BSP) interventions<br />
were aimed at curbing currency depreciation, and not to slow appreciation.<br />
More worryingly, USD/PHP traded above <strong>the</strong> accelerating depreciation band<br />
that it has been tracking during 2005-2007. After reviewing <strong>the</strong> factors that<br />
were responsible for <strong>the</strong> PHP’s appreciation during 2005-2007, our findings suggest<br />
that <strong>the</strong> PHP is no longer likely to appreciate for a fourth straight year in 2008.<br />
What changed? The PHP’s rally during 2005-2007 was characterized by rising<br />
economic growth and falling inflation. Both <strong>the</strong> budget and current account<br />
balances improved significantly. Foreign reserves increased sharply, thanks also<br />
to strong contributions from overseas foreign worker remittances. As investor<br />
confidence increased, <strong>the</strong> stock market entered into a bull run. The USD was<br />
also weak against Asian currencies, especially after China abandoned its currency<br />
peg in Jul 2005.<br />
In 2008, <strong>the</strong>se fundamentals turned less favorable. The economy is unlikely to<br />
repeat last year’s stellar performance. To support growth, <strong>the</strong> Arroyo government<br />
abandoned its goal to balance <strong>the</strong> budget in 2008. Slower growth propsects are<br />
likely to pressure <strong>the</strong> budget deficit wider by slowing revenue collection and<br />
increasing government spending. Meanwhile, inflation reared its ugly head,<br />
no thanks to higher international commodity prices. Owing to more expensive<br />
food and energy imports, <strong>the</strong> trade deficit has already widened to USD2.1bn in<br />
1Q08. On a positive note, OFW remittances are still growing, and this should<br />
take some pressure off <strong>the</strong> current account.<br />
Historically, USD/PHP is known to retrace about 45% of large moves, like it did<br />
in 1997/98 and 2000/01. Like <strong>the</strong>se two episodes, <strong>the</strong> PHP is currently confronting<br />
an uncertain global economy. Assuming that <strong>the</strong> same 45% retracement takes<br />
place, USD/PHP could extend its rise to 47 before entering into a broad consolidation,<br />
possibly between 41 and 47. If export competitiveness becomes a priority with<br />
<strong>the</strong> government, <strong>the</strong> consolidation range could be narrow at 45-47 instead.<br />
USD/PHP<br />
forecast, eop<br />
Latest Prev<br />
Close 44.2 41.2<br />
2Q08 44.5 42.5<br />
3Q08 45.0 41.0<br />
4Q08 47.0 39.0<br />
1Q09 45.0 41.0<br />
2Q09 45.0 41.0<br />
3Q09 43.0 41.0<br />
4Q09 43.0 41.0<br />
BSP o/n call rate<br />
forecast, eop<br />
Latest Prev<br />
Close 5.25 5.00<br />
2Q08 5.25 5.00<br />
3Q08 5.75 5.00<br />
4Q08 6.00 5.00<br />
1Q09 6.00 5.00<br />
2Q09 6.00 5.00<br />
3Q09 6.00 5.00<br />
4Q09 6.00 5.00<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
USD/PHP - 45% retracements after big currency moves, before entering into a consolidation<br />
60<br />
55<br />
45% retracement<br />
of 1999-00 rise<br />
50<br />
45<br />
45% retracement<br />
of 1997-98 rise<br />
40<br />
35<br />
30<br />
25<br />
47% retracement of 1993-94 fall<br />
20<br />
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08<br />
39
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Indian rupee – still sensitive to downside in Indian equities<br />
USD/INR<br />
forecast, eop<br />
Latest Prev<br />
Close 42.7 40.4<br />
2Q08 43.0 41.5<br />
3Q08 43.0 40.5<br />
4Q08 43.5 39.5<br />
1Q09 42.5 40.5<br />
2Q09 42.5 40.6<br />
3Q09 42.0 40.3<br />
4Q09 42.0 40.3<br />
RBI repo rate<br />
forecast, eop<br />
Latest Prev<br />
Close 8.00 7.75<br />
2Q08 8.00 7.75<br />
3Q08 8.25 8.00<br />
4Q08 8.25 8.25<br />
1Q09 8.25 8.25<br />
2Q09 8.25 8.25<br />
3Q09 8.25 8.25<br />
4Q09 8.25 8.25<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
The Indian rupee (INR) has transformed from being Asia’s top performing currency<br />
last year to become one of its worst currencies this year. As at Jun 9, <strong>the</strong> INR has<br />
depreciated 8.0% year-to-date against <strong>the</strong> USD, in contrast to <strong>the</strong> full-year gain<br />
of 12.3% posted in 2007. Like it or not, <strong>the</strong> improving fundamentals responsible<br />
for appreciating <strong>the</strong> INR in <strong>the</strong> past few years have weakened in 2008.<br />
The most conspicuous source of INR weakness this year came from capital outflows.<br />
For <strong>the</strong> first time since 1998, net investments by foreign financial investors or<br />
FIIs turned negative. In <strong>the</strong> first five months of 2008, net investments fell by<br />
INR118bn, after having doubled to USD809bn in 2007 from an average INR414bn<br />
in <strong>the</strong> previous three years.<br />
In this regard, we were correct to link <strong>the</strong> INR’s vulnerability to its weak stock<br />
market, one of this year’s worst performing bourses in Asia. Pressure on <strong>the</strong> INR<br />
should intensify if <strong>the</strong> Sensex falls fur<strong>the</strong>r towards <strong>the</strong> level of <strong>the</strong> Dow Jones<br />
Industrial Average. The stock market’s weakness is consistent with headline GDP<br />
growth moderating back towards levels posted in 2005. One area of concern is<br />
industrial production, where growth has decelerated for four consecutive quarters<br />
to 5.7% YoY in 1Q08, after peaking at 12.5% in 1Q07.<br />
Ano<strong>the</strong>r worry is <strong>the</strong> unabated rise in oil prices, which is pressurizing both <strong>the</strong><br />
trade deficit and inflation. Having surged to 8.24% YoY on May 24 from 3.07%<br />
YoY on Oct 13, WPI inflation has scope to trend higher towards double-digit<br />
levels after <strong>the</strong> latest fuel price hikes in June. Inflation has scope to increase<br />
political uncertainties if <strong>the</strong> government’s communist allies decide to withdraw<br />
support ahead of <strong>the</strong> next general election due in May 2009. Meanwhile, costlier<br />
energy imports are likely to lead to ano<strong>the</strong>r significant deterioarion in <strong>the</strong> trade<br />
deficit to USD90bn in calendar 2008 from USD71.3bn <strong>the</strong> previous year.<br />
That said, we still consider <strong>the</strong> INR to be a structurally sound currency over <strong>the</strong><br />
medium-term. At USD310bn in Mar08, foreign reserves are more than sufficient<br />
to cover total external debt, which last stood at USD201bn in 4Q07. Foreign<br />
direct investments (FDI) have remained strong, and should help to cushion <strong>the</strong><br />
foreign portfolio outflows.<br />
The INR has scope to consolidate in a broad range between 40 and 43 after it<br />
returned some gains chalked in <strong>the</strong> previous 1-2 years. That happened in 2005<br />
during <strong>the</strong> last US rate hike cycle. On <strong>the</strong> policy front, <strong>the</strong> INR is caught between<br />
<strong>the</strong> twin goals of price stability and restoring competitiveness. Unlike 2005, we<br />
are mindful that <strong>the</strong> stock market is more vulnerable because of outflows, and<br />
will downgrade <strong>the</strong> INR if we see FDI weakening as well.<br />
INR has been sensitive to weak Indian stocks<br />
Benchmark stock indices, spot<br />
25000<br />
20000<br />
15000<br />
10000<br />
5000<br />
0<br />
USD/INR<br />
(rhs)<br />
Sensex<br />
(lhs)<br />
02 03 04 05 06 07 08<br />
50<br />
48<br />
46<br />
44<br />
42<br />
40<br />
38<br />
First time since 1998 that witnessed FII outflows<br />
Net inflows from FIIs, INR bn<br />
900<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
0<br />
-100<br />
2008 is cumulative Jan-May data<br />
97 98 99 00 01 02 03 04 05 06 07 08<br />
40
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currencies<br />
Vietnam dong – bears emerge<br />
The VND is under pressure from persistent double-digit inflation and a sharply<br />
widened trade deficit. This is a far cry from <strong>the</strong> Aug 2007 to Mar 2008 period<br />
when Vietnam was touted as <strong>the</strong> latest Asian Tiger to follow <strong>the</strong> path of China<br />
and India. Between 2007 and 2008, <strong>the</strong> VND has transformed from being one of<br />
Asia’s more promising currency to become Asia’s most worrying exchange rate.<br />
Unlike 2006 and 2007, Vietnam stocks have been depreciating steadily since<br />
4Q07. By early June, <strong>the</strong> stock market effectively wiped out all gains achieved<br />
during <strong>the</strong> bull run from Aug 2007 to Mar 2008. As at Jun 9, <strong>the</strong> Ho Chi Minh<br />
Stock Index fell to 379, its lowest level since Feb 2006.<br />
The deterioration in <strong>the</strong> merchandise trade deficit has become too large to<br />
ignore. The trade gap totaled USD14.4bn in <strong>the</strong> first five months of 2008, exceeding<br />
<strong>the</strong> full-year deficit of USD12.4bn (17.4% of GDP) posted in 2007.<br />
Of course, a large trade deficit does not necessarily imply a balance of payments<br />
crisis. Foreign direct investments (FDI) have also risen and matched <strong>the</strong> increase<br />
in <strong>the</strong> trade deficit. Cumulative FDI amounted to USD14.7bn in Jan-May 2008.<br />
Like India, a wider trade deficit did not translate directly into a similarly significant<br />
wider current account (CA) deficit in Vietnam over <strong>the</strong> past few years, thanks to<br />
an improving services balance and increases in net transfers. That said, <strong>the</strong> government<br />
has warned that <strong>the</strong> CA deficit could be as wide as 6.5% of GDP and we expect<br />
a figure closer to 15% of GDP. On a positive note, foreign reserves are still<br />
strong and likely to have exceeded total external debt in 2007.<br />
None<strong>the</strong>less, <strong>the</strong>re is little room for complacency. Since May, international ratings<br />
agencies have, one after <strong>the</strong> o<strong>the</strong>r, been downgrading <strong>the</strong> outlook for Vietnam’s<br />
debt ratings to negative. The government must rein in persistent double-digit<br />
inflation before it begins to impact investor confidence and lead to significant<br />
outflows. CPI inflation more-than-tripled to 25.2% YoY in May08 from 7.3% <strong>the</strong><br />
same month a year ago. This had led to more labor strikes at foreign companies<br />
clamouring for higher wages to keep up with inflation.<br />
USD/VND<br />
forecast, eop<br />
Latest Prev<br />
Close 16621 --<br />
2Q08 16650 --<br />
3Q08 16740 --<br />
4Q08 16860 --<br />
1Q09 16990 --<br />
2Q09 17120 --<br />
3Q09 17250 --<br />
4Q09 17380 --<br />
SBV prime rate<br />
forecast, eop<br />
Latest Prev<br />
Close 14.00 --<br />
2Q08 14.00 --<br />
3Q08 15.00 --<br />
4Q08 16.00 --<br />
1Q09 16.00 --<br />
2Q09 14.00 --<br />
3Q09 14.00 --<br />
4Q09 14.00 --<br />
Latest close on Jun 11<br />
Prev close on Mar 12<br />
Overall, <strong>the</strong> rapid deterioration in both <strong>the</strong> trade deficit and inflation suggests<br />
an overheating economy. Tough measures will be needed to rein in credit expansion<br />
and fiscal spending, as well as reforms to streng<strong>the</strong>n financial institutions and<br />
capital markets. The VND will also need to depreciate to regain some of <strong>the</strong><br />
competitiveness eroded by inflation, as well as to counter <strong>the</strong> deterioration in<br />
<strong>the</strong> trade sector. Hence, <strong>the</strong> government’s decision on Jun 10 to devalue <strong>the</strong><br />
VND by 2% and hike interest rates to 14% from 12% should be viewed as <strong>the</strong><br />
first steps in <strong>the</strong> right direction.<br />
VND finally succumbed to falling stocks<br />
1200<br />
1100<br />
1000<br />
900<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
Ho Chi Minh<br />
stock index<br />
(lhs)<br />
USD/VND<br />
(inverted, rhs)<br />
Jan-06 Jan-07 Jan-08<br />
15800<br />
15900<br />
16000<br />
16100<br />
16200<br />
16300<br />
Not a balance of payments crisis yet<br />
USD bn<br />
40<br />
30<br />
20<br />
10<br />
0<br />
-10<br />
-20<br />
-30<br />
-40<br />
2008 is extrapolated<br />
from Jan-May data<br />
Foreign direct<br />
investment<br />
Current<br />
account<br />
Merchandise<br />
trade balance<br />
01 02 03 04 05 06 07 08<br />
41
Currencies<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Currency forecasts<br />
11-Jun 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09<br />
EUR/usd 1.5553 1.52 1.49 1.46 1.43 1.45 1.46<br />
Fwd 1.54 1.53 1.53 1.52 1.52 1.51<br />
Poll 1.54 1.50 1.46 1.50 1.46 1.41<br />
usd/JPY 106.83 107 108 109 110 108 106<br />
Fwd 107 106 106 105 105 104<br />
Poll 104 105 104 100 103 106<br />
usd/CNY 6.9184 6.80 6.75 6.70 6.65 6.55 6.45<br />
Fwd 6.87 6.77 6.65 6.60 6.52 6.44<br />
Poll 6.79 6.65 6.55 6.45 6.38 6.30<br />
usd/HKD 7.8089 7.83 7.85 7.85 7.85 7.83 7.80<br />
Fwd 7.79 7.78 7.77 7.76 7.75 7.74<br />
Poll 7.80 7.80 7.80 7.78 7.78 7.77<br />
usd/TWD 30.360 30.5 31.0 31.5 32.0 31.5 31.0<br />
Fwd 30.2 30.0 29.8 29.6 29.3 28.9<br />
Poll 30.0 30.0 29.7 29.9 29.6 29.2<br />
usd/KRW 1030 1075 1100 1075 1075 1050 1050<br />
Fwd 1033 1034 1034 1033 1031 1029<br />
Poll 1000 980 975 975 961 947<br />
usd/SGD 1.3707 1.38 1.40 1.42 1.44 1.42 1.40<br />
Fwd 1.37 1.36 1.36 1.35 1.35 1.35<br />
Poll 1.35 1.34 1.33 1.33 1.32 1.30<br />
usd/MYR 3.2700 3.30 3.35 3.40 3.45 3.40 3.35<br />
Fwd 3.28 3.27 3.27 -- -- --<br />
Poll 3.15 3.10 3.08 3.15 3.10 3.05<br />
usd/THB 33.080 33.5 34.0 34.5 34.9 34.1 33.4<br />
Fwd 33.5 33.7 33.8 -- -- --<br />
Poll 31.9 31.2 30.9 32.8 31.9 30.9<br />
usd/IDR 9300 9500 9600 9700 9800 9500 9300<br />
Fwd 9539 9746 9952 -- -- --<br />
Poll 9200 9150 9100 9050 9025 9000<br />
usd/PHP 44.200 45.0 47.0 45.0 45.0 43.0 43.0<br />
Fwd 45.9 46.3 46.1 -- -- --<br />
Poll 42.5 42.1 41.3 42.0 41.4 40.8<br />
usd/INR 42.700 43.0 43.5 42.5 42.5 42.0 42.0<br />
Fwd 43.2 43.4 43.6 44.0 44.1 44.2<br />
Poll 41.2 40.6 40.8 41.9 41.3 40.8<br />
usd/VND 16621 16740 16860 16990 17120 17250 17380<br />
Fwd 18651 19733 20772 -- -- --<br />
Poll 16300 16200 16100 17300 16875 16450<br />
GBP/usd 1.9633 1.94 1.92 1.90 1.88 1.86 1.88<br />
Fwd 1.94 1.92 1.91 1.90 1.90 1.89<br />
Poll 1.96 1.92 1.88 1.87 1.86 1.85<br />
AUD/usd 0.9467 0.94 0.92 0.90 0.88 0.86 0.88<br />
Fwd 0.93 0.92 0.91 0.90 0.89 0.88<br />
Poll 0.94 0.92 0.89 0.88 0.87 0.85<br />
NZD/usd 0.7557 0.75 0.73 0.71 0.69 0.67 0.69<br />
Fwd 0.74 0.73 0.73 0.72 0.72 0.71<br />
Poll 0.75 0.73 0.71 0.67 0.68 0.68<br />
usd/CAD 1.0199 1.03 1.05 1.07 1.09 1.11 1.09<br />
Fwd 1.02 1.02 1.02 1.02 1.02 1.02<br />
Poll 1.03 1.05 1.08 1.07 1.08 1.09<br />
<strong>DBS</strong> forecasts in bold red. Poll are median forecasts from analysts collated by Bloomberg as at 11 Jun 2008<br />
42
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> Yield<br />
Yield: Bearish<br />
• US: We believe Treasury yields will rise more than 100bps in <strong>the</strong> remaining<br />
months of this year. With improving economic growth, inflationary<br />
pressures that may not be temporary, and increasing bond supply, we are<br />
bearish on <strong>the</strong> US bond market, which we think will have to discount<br />
substantial Fed tightening for 2009<br />
• SG: With <strong>the</strong> Fed rate cut cycle having come to an end, upward pressures<br />
are building on SGD rates. A rise in US Treasury yields in 2H08 on <strong>the</strong> back<br />
of more aggressive Fed rate hike expectations is expected to put SGS yields<br />
under upward pressure<br />
• HK: As <strong>the</strong> HKD remains credibly pegged against <strong>the</strong> USD, HKD rates continue<br />
to track USD rates. Moreover, as USD/HKD forwards continue to reflect a<br />
HKD appreciation bias, Hibor-Libor spreads continue to be steady<br />
• KR: Stagflation dynamics are keeping <strong>the</strong> Bank of Korea on hold and <strong>the</strong><br />
market guessing whe<strong>the</strong>r <strong>the</strong> next move from <strong>the</strong> central bank will be up<br />
or down. The market will likely struggle for direction in 3Q08<br />
• TW: Chances are that <strong>the</strong> CBC’s rate hike cycle is not yet over and that <strong>the</strong><br />
central bank will lift <strong>the</strong> benchmark rediscount rate to 3.875% from 3.5%<br />
over <strong>the</strong> next three meetings. We expect bond yields to be under upward<br />
pressure in 2H08<br />
• TH: While <strong>the</strong> Bank of Thailand has kept its policy rate unchanged in 2Q08,<br />
a rate hike scenario has been gaining momentum. Given that <strong>the</strong> sell-off in<br />
2Q08 has taken yields to levels that reflect a good chance of significantly<br />
tighter monetary policy conditions, <strong>the</strong> sell-off in front-end yields should<br />
come to an end soon<br />
• ID: Long-end Indonesian Government bonds are a buy. We expect yields to<br />
fall in 2H08 and <strong>the</strong> curve to steepen, as policy rates are unlikely to rise to<br />
13% again<br />
• PH: Bangko Sentral ng Pilipinas on June 5 lifted its policy rates by 25bps to<br />
rein in inflationary expectations. This is bad news for <strong>the</strong> bond market and<br />
means yields will remain under upward pressure. A sharp rise from current<br />
levels is however unlikely, given that <strong>the</strong> bulk of <strong>the</strong> sell-off in <strong>the</strong> bond<br />
market has already occurred<br />
• MY: With rate hikes having been discounted at <strong>the</strong> front end of <strong>the</strong> yield<br />
curve and investors being better compensated for inflation risks, we believe<br />
yields are unlikely to rise much from current levels<br />
• IN: The direction of gilt yields remains a tough call, but we remain<br />
comfortable with our rate hike forecast. Inflation risks are even more<br />
prominent now after <strong>the</strong> hike in diesel and petrol prices earlier this month<br />
and <strong>the</strong> growth outlook is not weak enough to keep <strong>the</strong> RBI on hold<br />
• CH: Against our expectation, government bond yields continue to trade<br />
sideways as <strong>the</strong> market refuses to discount <strong>the</strong> rate hikes we expect. We<br />
think that <strong>the</strong> market is too complacent about inflation and rate hike risks<br />
YIELD<br />
Jens Lauschke • (65) 6224 2574 • jensjoerg@dbs.com<br />
43
Yield<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
US Treasury yields<br />
are likely to rise<br />
sharply<br />
US: Bearish Treasuries<br />
We believe Treasury yields will rise more than 100bps during 2H08. With improving<br />
economic growth, inflationary pressures that may not be temporary, and increasing<br />
bond supply, we are bearish on <strong>the</strong> US bond market, which we think will have<br />
to discount substantial Fed tightening for 2009.<br />
Much argues for a substantial sell-off in bonds. If <strong>the</strong> US economy picks up and<br />
credit conditions improve in 2H08 and 2009, <strong>the</strong> Fed will have to remove <strong>the</strong><br />
policy accommodation that is currently in place with Fed Funds at 2% (see <strong>the</strong><br />
US economics section for details). We are confident that growth should improve,<br />
thanks to:<br />
a) continued noncyclical core consumption growth<br />
b) relatively strong foreign demand<br />
c) fiscal injections equivalent to 1.75% of GDP now coming on stream<br />
d) a housing sector that will subtract progressively less from growth in <strong>the</strong> coming<br />
quarters<br />
e) lower interest rates<br />
Moreover, <strong>the</strong>re is <strong>the</strong> risk of an inflation psychology developing among consumers,<br />
which suggests that even if <strong>the</strong> economy only grinds forward in <strong>the</strong> coming<br />
quarters, <strong>the</strong> Fed might raise rates to prevent inflation from becoming an entrenched<br />
phenomenon embedded in <strong>the</strong> economy.<br />
Specifically, as growth improves to 2.5-2.75% (saar) in 2H08 and maintains at<br />
this pace in 2009, we expect <strong>the</strong> Fed to hike Fed Funds by 50bps to 2.5% in 4Q08<br />
and by 175bps to 4.25% in 2009. Fed tightening of this magnitude is not priced<br />
into <strong>the</strong> yield curve, which means <strong>the</strong> front end will have to steepen if <strong>the</strong><br />
market comes around to <strong>the</strong> view that policy rates have to rise considerably.<br />
Judging from recent history, 2Y yields could rise to 200bps above Fed Funds (i.e.<br />
to 4%) in 2H08, before <strong>the</strong> Fed even starts to hike interest rates (Chart 1).<br />
Chart 1: UST 2Y Yield - Fed Funds<br />
%pa<br />
bps<br />
Chart 2: UST 10Y Yield - Fed Funds<br />
%pa<br />
bps<br />
7<br />
300<br />
7<br />
500<br />
6<br />
200<br />
6<br />
400<br />
5<br />
4<br />
3<br />
2<br />
100<br />
0<br />
-100<br />
5<br />
4<br />
3<br />
2<br />
300<br />
200<br />
100<br />
0<br />
1 Fed Funds Target Rate<br />
UST 2Y - Fed Funds (RHS)<br />
0<br />
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06<br />
-200<br />
-300<br />
1<br />
Fed Funds Target Rate<br />
UST 10Y - Fed Funds (RHS)<br />
0<br />
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06<br />
-100<br />
-200<br />
Using <strong>the</strong> current regression relationship between 2Y and 10Y yields as a rough<br />
guide, a rise in <strong>the</strong> 2Y yield to 200bps above Fed Funds (i.e. 4%) would put 10Y<br />
yields at least 300bps above Fed Funds (i.e. to 5%), implying a flattening of <strong>the</strong><br />
44
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> Yield<br />
Chart 3: 2Y UST Yield - FFR vs 10Y UST Yield - FFR<br />
Chart 4: 10Y UST Yield vs 2Y UST Yield - FFR<br />
Y = 10Y UST Yield - Fed Funds (bps)<br />
350<br />
y = 0.666x + 157.56<br />
300<br />
250<br />
Forecast<br />
200<br />
from 30 Apr 08<br />
150<br />
100<br />
last 60 trading days<br />
50<br />
0<br />
-200 -100 0 100 200 300<br />
X = 2Y UST Yield - Fed Funds (bps)<br />
10Y UST Yield (%pa)<br />
5.50<br />
5.00<br />
4.50<br />
A<br />
Forecast<br />
Current<br />
4.00<br />
B C<br />
A: Jun07 to Dec07<br />
3.50<br />
B: Dec07 to Mar08<br />
C: Mar08 to Currnet<br />
3.00<br />
-200 -150 -100 -50 0 50 100 150 200 250<br />
2Y UST Yield - Fed Funds (bps)<br />
2Y/10Y curve to 100bps from 120bps currently (Charts 2 & 3). While <strong>the</strong> current<br />
regression relationship based on <strong>the</strong> last 60 trading days is likely biased towards<br />
low 10Y yields (i.e. <strong>the</strong> regression line is too flat), a yield level of 5% for <strong>the</strong> 10Y<br />
yield also looks reasonable on a scatter plot based on <strong>the</strong> last 250 trading day<br />
(Chart 4).<br />
Singapore: Upward pressures are building on SGD rates<br />
With <strong>the</strong> Fed rate cut cycle having come to an end, upward pressures are building<br />
on SGD rates. A rise in US Treasury yields in 2H08 on <strong>the</strong> back of more aggressive<br />
Fed rate hike expectations is expected put SGS yields under upward pressure.<br />
Higher SGS yields are, hence, likely by year end, even if SGD money market<br />
rates remain low until <strong>the</strong> Fed starts to lift its target for Fed Funds in 4Q08. That<br />
said, SGS yields are unlikely to rise as fast as <strong>the</strong>ir US counterparts, resulting in<br />
wider spreads between SGS and UST rates (Chart 5).<br />
In response to <strong>the</strong> expected flattening in <strong>the</strong> 2Y/10Y US Treasury curve, <strong>the</strong> 2Y/<br />
10Y SGS curve should flatten too. Given our expectation that USD/SGD will rise<br />
in <strong>the</strong> months ahead and reach 1.40 by year-end, <strong>the</strong>re is, in fact, <strong>the</strong> possibility<br />
that <strong>the</strong> 2Y/10Y SGS curve flattens relative to <strong>the</strong> 2Y/10Y UST curve. This is<br />
because trends in <strong>the</strong> currency markets could entail higher SGD money market<br />
rates.<br />
US Treasury yields<br />
are likely to lead<br />
SGS yields higher<br />
Chart 5: UST/SGS 2Y & 10Y vs Libor-SOR 12M<br />
bps<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
UST/SGS 2Y Spread<br />
UST/SGS 10Y Spread<br />
Libor 12M - SOR 12M Spread<br />
0<br />
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08<br />
Chart 6: SGS 2/10 Spread vs UST 2/10 Spread<br />
bps<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
0<br />
-50<br />
SGS 2/10 Spread<br />
UST 2/10 Spread<br />
-100<br />
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08<br />
45
Yield<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Hong Kong: Still credibly pegged<br />
As <strong>the</strong> HKD remains credibly pegged against <strong>the</strong> USD, HKD rates continue to<br />
track USD rates. Moreover, as USD/HKD forwards continue to reflect a HKD appreciation<br />
bias, Hibor-Libor spreads continue to be steady and a sharp rise in Hibors relative<br />
to Libors is unlikely (Charts 7 & 8).<br />
Chart 7: USD/HKD Spot & Forwards<br />
HKD per 1 USD<br />
7.90<br />
7.85<br />
7.80<br />
7.75<br />
Current<br />
forward path<br />
for USD/HKD<br />
7.70<br />
Jan-06 Jan-07 Jan-08 Jan-09<br />
Chart 8: USD/HKD Spot - 7.75 vs Libor-Hibor 12M<br />
pips<br />
1200<br />
1000<br />
800<br />
600<br />
400<br />
200<br />
USD/HKD Spot - 7.75<br />
Libor 12M -Hibor 12M (RHS)<br />
0<br />
Jan-07 Jul-07 Jan-08<br />
bps<br />
160<br />
140<br />
120<br />
100<br />
80<br />
60<br />
40<br />
20<br />
0<br />
-20<br />
Hence, our outlook for Fed Funds implies that Hibors are likely to rise in 4Q08<br />
and 2009. Moreover, as Treasuries are likely to sell-off sharply in 2H08 in anticipation<br />
of substantial Fed tightening, Exchange Fund Notes too will be under upward<br />
pressure in <strong>the</strong> coming months. In o<strong>the</strong>r words, we expect <strong>the</strong> notes to continue<br />
to track our rough fair value estimates (defined as UST yield - 12M money market<br />
rates differential) higher (Charts 9 & 10).<br />
Chart 9: EFN 2Y Yield<br />
%pa<br />
5.5<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
1.5<br />
1.0<br />
+50bps<br />
-50bps<br />
2Y EFN Yield<br />
0.5 Fair Value (2Y UST - 12M Libor/Hibor<br />
0.0<br />
May-05 May-06 May-07 May-08<br />
Chart 10: EFN 10Y Yield<br />
%pa<br />
5.5<br />
+50bps<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
-50bps<br />
10Y EFN Yield<br />
2.5<br />
2.0<br />
Fair Value (10Y UST - 12M Libor/Hibor spread)<br />
1.5<br />
May-05 May-06 May-07 May-08<br />
Korea: Rate cuts needed?<br />
Stagflation dynamics are keeping <strong>the</strong> Bank of Korea on hold and <strong>the</strong> market<br />
guessing whe<strong>the</strong>r <strong>the</strong> next move from <strong>the</strong> central bank will be up or down.<br />
Until May <strong>the</strong> market was leaning towards rate cuts, but non-action and <strong>the</strong><br />
absence of any rate cut signal from <strong>the</strong> BOK at <strong>the</strong> May 8 monetary policy<br />
46
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> Yield<br />
Chart 11: Equipment Investment and Inventory<br />
%YoY<br />
25<br />
20<br />
15<br />
10<br />
5<br />
Chart 12: Trends in Bank Lending<br />
KRW tr<br />
450<br />
400<br />
350<br />
300<br />
Household Debt<br />
Loans to Companies<br />
0<br />
-5<br />
-10<br />
Equipment Investment<br />
Inventory<br />
250<br />
200<br />
-15<br />
May-03 May-04 May-05 May-06 May-07<br />
150<br />
Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07<br />
meeting caused a rapid adjustment in expectations. Yields rose sharply to levels<br />
that reflect expectations for tighter policy for <strong>the</strong> remainder of this year.<br />
While <strong>the</strong> domestic economy, domestic demand in particular, is exhibiting some<br />
signs of a slowdown, <strong>the</strong> Bank of Korea kept rates on hold in May as exports<br />
continue to post robust growth and financial institutions’ lending continues to<br />
show a steady increase. (Charts 11 & 12).<br />
We think <strong>the</strong> BOK will deliver one 25bps rate cut later this year and ano<strong>the</strong>r one<br />
in 1Q09, but economic conditions have to deteriorate for this to materialize.<br />
With growth unlikely to fall sharply below potential (we expect full year growth<br />
of 4.6% this year, compared to potential of about 4.5%), bank lending still<br />
strong and inflation rising, this is far from being a done deal.<br />
For <strong>the</strong> bond market <strong>the</strong> above means that <strong>the</strong> market will likely struggle for<br />
direction in 3Q08. Market participants now read <strong>the</strong> BOK as reluctant to cut<br />
rates and it would take significant downside surprises in <strong>the</strong> data or clear signals<br />
from <strong>the</strong> Bank of Korea to price rate cuts into <strong>the</strong> yield curve again. That said,<br />
a continuation of <strong>the</strong> sell-off is probably less likely than a bond rally, given that<br />
economic momentum is slowing and exports have been and appear to remain<br />
<strong>the</strong> only key positive. We expect yields to be under downward pressure in 2H08<br />
and <strong>the</strong> curve to exhibit a weak steepening bias (Chart 13 & 14).<br />
The Korean bond<br />
market will likely<br />
struggle for<br />
direction in <strong>the</strong><br />
coming months<br />
Chart 13: 3Y KTB Yield vs 10Y KTB Yield<br />
%pa<br />
6.3<br />
6.0<br />
5.8<br />
5.5<br />
5.3<br />
5.0<br />
4.8<br />
3/10 Spread<br />
10Y KTB Yield<br />
3Y KTB Yield<br />
4.5<br />
Jun-07 Oct-07 Feb-08<br />
bps<br />
40<br />
30<br />
20<br />
10<br />
0<br />
-10<br />
-20<br />
Chart 14: KTB 3Y Yield vs KTB 10Y Yield<br />
KTB 10Y Yield (%pa)<br />
6.25<br />
6.00<br />
5.75<br />
5.50<br />
5.25<br />
5.00<br />
steepening<br />
4.75<br />
Last 100 trading days<br />
Last 10 trading days<br />
4.50<br />
4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.25<br />
KTB 3Y Yield (%pa)<br />
47
Yield<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
More rate hikes<br />
from <strong>the</strong> CBC likely<br />
Taiwan: More rate hikes in <strong>the</strong> pipeline<br />
Rate hike expectations have been raised in 2Q08 as growth momentum remains<br />
strong and inflation is rising sharply. 1Q08 GDP of 6.1%YoY was balanced, with<br />
domestic demand and net exports contributing 3.2ppt and 2.9ppt respectively<br />
to <strong>the</strong> headline GDP number. Investment recorded a rebound of 5.8%YoY, while<br />
private consumption stayed stable at 2.1%YoY.<br />
Inflation stood at 3.71%YoY in May and is likely to rise fur<strong>the</strong>r after Taiwan’s oil<br />
refiners in <strong>the</strong> same month raised gasoline prices, ending <strong>the</strong> price freeze since<br />
<strong>the</strong> second half of last year. The official forecast for 2008 inflation has been<br />
lifted to 3.3% from 2.0%, and <strong>the</strong> official estimate of GDP now stands at 4.8%,<br />
versus 4.3% previously. We see full-year inflation at 3.4% and full-year GDP at<br />
5.0%.<br />
With inflation risk as <strong>the</strong> key concern and <strong>the</strong> CBC projecting growth to stay<br />
near potential this year (close to <strong>the</strong> 10-year average of 4.3%), policy rates are<br />
likely to be lifted fur<strong>the</strong>r.<br />
It is likely, <strong>the</strong>refore, that <strong>the</strong> CBC’s rate hike cycle is not yet over and that <strong>the</strong><br />
central bank will lift <strong>the</strong> benchmark rediscount rate to 3.875% from 3.5% over<br />
<strong>the</strong> next three meetings in end June, end September, and end December.<br />
As money market rates, deposit rates and new loans rates are at 2.0-3.0% currently,<br />
fur<strong>the</strong>r policy rate hikes of 37.5bps in total would only lift <strong>the</strong> inflation-adjusted<br />
real rates back to zero. Monetary conditions would remain supportive of economic<br />
growth.<br />
Given this outlook for monetary policy, we expect bond yields to be under<br />
upward pressure in 2H08. Front end onshore swaps have already moved higher<br />
to discount fur<strong>the</strong>r rates hikes.<br />
Chart 15: Rediscount Rate, 3M CP & Onshore Swaps<br />
%pa<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
1.5<br />
Rediscount Rate CP 3M<br />
1.0 TWD IRS 1Y<br />
TWD IRS 2Y<br />
0.5<br />
May-06 Nov-06 May-07 Nov-07 May-08<br />
Chart 16: Rediscount Rate, CP 3M, 2Y & 10Y TWGB<br />
%pa<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
1.5<br />
1.0 Rediscount Rate TWgov 2Y<br />
CP 3M<br />
TWgov 10Y<br />
0.5<br />
Apr-05 Apr-06 Apr-07 Apr-08<br />
The rate hike<br />
scenario has gained<br />
momentum in<br />
Thailand ...<br />
Thailand: Strong economic momentum bolsters case for rate hikes<br />
While <strong>the</strong> Bank of Thailand has kept its policy rate unchanged in 2Q08, a rate<br />
hike scenario has been gaining momentum. As headline inflation has risen to<br />
6.2%YoY and economic indicators still signal a sustained recovery in domestic<br />
demand (Charts 17 & 18), a string of rate hikes is now priced into <strong>the</strong> front end<br />
of <strong>the</strong> Thai yield curve.<br />
Real GDP grew 5.6%QoQ saar in 1Q08 and is up 6% YoY in non-seasonally<br />
adjusted terms. Real private consumption (54% of GDP) growth remained weak,<br />
48
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> Yield<br />
Chart 17: Inflation<br />
%YoY<br />
8.0<br />
7.0<br />
CPI<br />
Core CPI<br />
6.0<br />
5.0<br />
4.0<br />
3.0<br />
2.0<br />
1.0<br />
0.0<br />
Jun-03 Jun-04 Jun-05 Jun-06 Jun-07<br />
Chart 18: Private Consumption and Investment<br />
%YoY<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
Private Investment<br />
-5<br />
Private Consumption<br />
-10<br />
Nov-01 Nov-03 Nov-05 Nov-07<br />
but should improve from 3.2% (four quarter average). Real investment (22% of<br />
GDP) growth remained robust at 5.8% (four quarter average) and exports continued<br />
to outpace imports (net exports account for about 15% of GDP).<br />
That means growth momentum has not deteriorated in 1Q08 while inflation<br />
risks have become more prominent, which suggests <strong>the</strong> central bank should be<br />
more inclined to hike interest rates. We retain our forecast for rate normalization<br />
to begin, starting 4Q08 assuming <strong>the</strong> political situation remains stable enough<br />
and US recession worries fade. As 2008 growth is still expected to be better than<br />
2007, we think some policy accommodation can be removed. We expect <strong>the</strong><br />
central bank to take its key policy rate to 3.75% from 3.25% in 4Q08 and hold at<br />
this rate throughout 2009.<br />
As we had expected <strong>the</strong> market has moved to reflect <strong>the</strong> probability of substantial<br />
policy action (Charts 19 & 20). The 2Y yield has risen sharply to 4.5%, or almost<br />
150bps above <strong>the</strong> policy rate. Spreads are now close to those seen between mid-<br />
2004 and end-2005, when spreads between <strong>the</strong> policy rate and 2Y yields averaged<br />
90bps.<br />
Given that <strong>the</strong> sell-off in 2Q08 has taken yields to levels that reflect a good<br />
chance of significantly tighter monetary policy conditions, <strong>the</strong> sell-off in frontend<br />
yields should be coming to an end. This suggests that bearish flattening<br />
pressure on <strong>the</strong> 2Y/10Y curve bond curve is likely to give way to steepening<br />
forces. With inflation and political uncertainty rising, we think <strong>the</strong> curve is<br />
more likely to steepen than flatten.<br />
... and yields are<br />
unlikely to rise<br />
much fur<strong>the</strong>r in<br />
3Q08<br />
Chart 19: Thgov 2Y - 1-day Repo<br />
%pa<br />
6.0<br />
5.0<br />
4.0<br />
3.0<br />
2.0<br />
1.0<br />
1-day Repo<br />
THgov 2Y - 1-day Repo (RHS)<br />
0.0<br />
Nov-03 Nov-04 Nov-05 Nov-06 Nov-07<br />
bps<br />
200<br />
150<br />
100<br />
50<br />
0<br />
-50<br />
-100<br />
-150<br />
Chart 20: 2Y vs 10Y THgov yield<br />
%pa<br />
8.0<br />
7.0<br />
6.0<br />
5.0<br />
4.0<br />
3.0<br />
2.0<br />
1.0<br />
THgov10Y<br />
THgov2Y<br />
1-day Repo<br />
0.0<br />
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08<br />
49
Yield<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
With 10Y IDR yields<br />
in <strong>the</strong> 12-13%<br />
range, we think<br />
government bonds<br />
are a buy<br />
Indonesia: Sell-off is over<br />
With <strong>the</strong> Indonesian government having raised <strong>the</strong> price of subsidised fuel by<br />
an average 28.7% in May, market attention is now fixated on <strong>the</strong> question of<br />
whe<strong>the</strong>r this is enough to save <strong>the</strong> budget from collapsing under <strong>the</strong> weight of<br />
growing subsidy bills. We reckon it is not, if <strong>the</strong> price of oil averages more than<br />
$115/barrel in 2H08 (see economics section for details).<br />
Bond investors seem to be sceptical too, judging by <strong>the</strong> fact that 10Y yields<br />
have entered <strong>the</strong> 12-13% range, within which <strong>the</strong> policy rate peaked in 2006,<br />
when <strong>the</strong> government lifted fuel prices by 126% (Charts 21 & 22). Now, after<br />
<strong>the</strong> sell-off, <strong>the</strong>re is value at current levels. We don’t expect yields to rise much<br />
above current levels, even if international oil prices rise fur<strong>the</strong>r and <strong>the</strong> Indonesian<br />
government is forced to adjust subsidies a second time.<br />
Hence, we think long-end Indonesian Government bonds are a buy. We expect<br />
yields to fall in 2H08 and <strong>the</strong> curve to steepen, as policy rates are unlikely to<br />
rise to 13% again. We currently think that Bank Indonesia will lift rates to only<br />
9.25% in <strong>the</strong> coming months and hold at that rate well into 2009.<br />
That said, as <strong>the</strong> currency outlook is deteriorating with Fed rate hikes likely in<br />
4Q08 and 2009 (see currency section for details), we think that <strong>the</strong>re is <strong>the</strong> risk<br />
that Indonesian government bonds fail to rally and actually come under fresh<br />
upward pressure.<br />
Chart 21: 10Y IDgov Yield vs Policy Rate<br />
%pa<br />
Chart 22: 2Y IDgov, 10Y IDgov & Spread<br />
%pa<br />
14<br />
bps<br />
400<br />
15<br />
13<br />
12<br />
2/10 Spread (RHS)<br />
2Y IDgov Yield<br />
10Y IDgov Yield<br />
350<br />
300<br />
250<br />
11<br />
10<br />
200<br />
9<br />
7<br />
10Y IDgov Yield<br />
1M SBI<br />
5<br />
Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08<br />
8<br />
6<br />
Nov-06 Feb-07May-07Aug-07Nov-07 Feb-08May-08<br />
150<br />
100<br />
50<br />
0<br />
The Philippines: Rate hikes on <strong>the</strong> horizon<br />
Bangko Sentral ng Pilipinas on June 5 lifted its policy rates by 25bps, citing<br />
indications that supply-driven inflationary pressures are beginning to feed into<br />
demand. Policy makers are seeing early evidence of second-round effects and<br />
<strong>the</strong> need to act promptly to rein in inflationary expectations.<br />
Headline CPI inflation in May was up 9.6%YoY, continuing to threaten <strong>the</strong> BSP’s<br />
inflation targets for 2008 and 2009, which stand at 7.0-9.0% and 4.0-6.0%, respectively.<br />
Rate hike concerns are justified given that headline CPI inflation has risen to<br />
8.3%YoY in April, but we don’t think an aggressive tightening cycle lies ahead<br />
(Chart 23). Real GDP has slowed sharply in 1Q08 to 5.2%YoY from 6.4%YoY in<br />
4Q07 as <strong>the</strong> economy expanded at only 0.8%QoQ sa in 1Q08. That is among <strong>the</strong><br />
slowest since 2001.<br />
50
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> Yield<br />
Chart 23: 2Y PHP yield vs Headline CPI Inflation<br />
%pa, %YoY<br />
20<br />
18<br />
16<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
CPI<br />
2Y PHgov yield<br />
0<br />
Jan-99 Jan-02 Jan-05 Jan-08<br />
Chart 24: 2Y PHgov & 10Y PHgov - 3M Phibor<br />
10Y Phgov - 3M Phibor (bps)<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
0<br />
y = 1.4127x + 113.58<br />
Last 800 trading days<br />
2Y/10Y curve tends to<br />
steepen when 2Y rises<br />
above 3M Phibor<br />
-100<br />
-200<br />
-200 0 200 400 600 800<br />
2Y Phgov - 3M Phibor (bps)<br />
Moreover, while liquidity conditions remain ample, excess reserves continue to<br />
be placed with <strong>the</strong> BSP, suggesting that <strong>the</strong>re is little risk of overly aggressive<br />
and inflationary bank lending. As <strong>the</strong> central bank reported in its 1Q08 inflation<br />
report, SDA placements stood at P591 billion in Mar08, up from last year’s level<br />
of P53 billion and total volume of banks’ placements with <strong>the</strong> BSP under <strong>the</strong><br />
RRP window stood at P248 billion in Mar08, down from last year’s level of 307.8,<br />
but still high compared to levels prior to 2005 (Chart 25).The more than tenfold<br />
increase in SDAs followed <strong>the</strong> policy measures implemented by <strong>the</strong> BSP in May<br />
last year to rein in strong liquidity growth. Then, trust entities of BSP-supervised<br />
financial institutions were allowed to make placements in <strong>the</strong> SDA facility.<br />
Given slowing growth, <strong>the</strong> fact that inflation is mainly due to cost pressures and<br />
that it is unlikely that <strong>the</strong>re will be inflationary bank lending, we think <strong>the</strong> BSP<br />
will not hike rates aggressively. We expect ano<strong>the</strong>r three rates hikes of 25bps at<br />
<strong>the</strong> three coming policy meetings.<br />
This is bad news for <strong>the</strong> bond market and means yields will remain under upward<br />
pressure. A sharp rise from current levels is, however unlikely, given that <strong>the</strong><br />
bulk of <strong>the</strong> sell-off in <strong>the</strong> bond market has already occurred (Chart 26). The 2Y/<br />
10Y curve looks flat given <strong>the</strong> new yield levels, suggesting that steepening is<br />
probably more likely than flattening, unless yields fall sharply relative to money<br />
market rates (Chart 24).<br />
Policy rates are<br />
likely to rise<br />
fur<strong>the</strong>r in <strong>the</strong><br />
Philippines as <strong>the</strong><br />
central bank reins<br />
in inflationary<br />
expectations<br />
Chart 25: Outstanding RRPs<br />
PHP bn<br />
350<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
0<br />
Jan-00 Jan-03 Jan-06<br />
Chart 26: O/N Repo & Rev. Repo vs 2Y & 10Y<br />
%pa<br />
16<br />
14<br />
12<br />
10<br />
8<br />
6<br />
O/N Reverse Repo<br />
O/N Repo<br />
2Y PHgov<br />
10Y PHgov<br />
4<br />
May-05 May-06 May-07 May-08<br />
51
Yield<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
MGS yields are<br />
likely to rise<br />
fur<strong>the</strong>r in <strong>the</strong><br />
near-term<br />
Malaysia: Policy risks now clearly towards rate hikes<br />
As we had expected, bond yields rose in 2Q08 as <strong>the</strong> market moved to reflect and<br />
compensate for inflation risks following comments from <strong>the</strong> government in May<br />
that it will seek ways to increase fuel prices. Concerns that subsidy adjustments<br />
would stoke inflation and prompt rate hikes sent yields higher (Charts 27 & 28).<br />
MGS yields are likely to rise somewhat fur<strong>the</strong>r in <strong>the</strong> near-term, after subsidies<br />
were adjusted earlier this month.<br />
With petrol prices having been raised by 41% and diesel prices 63% higher, our<br />
projections show that headline CPI inflation is expected to rise sharply to about<br />
5.8%YoY in June, which should lift full year inflation to about 4.5%YoY. The<br />
impact on growth will be mixed. Overall growth is expected to moderate to<br />
5.1%YoY for <strong>the</strong> year, down from our previous forecast of 5.8%YoY.<br />
We now think that policy tightening is needed to anchor inflation expectation<br />
and to prevent second round effects of <strong>the</strong> price increases. We expect Bank Negara<br />
to hike its policy rate by 50bps to 4% at <strong>the</strong> next policy meeting in July and <strong>the</strong>n<br />
hold at that rate well into 2009.<br />
With rate hikes being discounted at <strong>the</strong> front end of <strong>the</strong> yield curve and investors<br />
being better compensated for inflation risks, we believe yields are unlikely to rise<br />
much fur<strong>the</strong>r from current levels. In fact, given that we only expect a one-off<br />
adjustment in policy rates, receiving positions in onshore swaps look attractive.<br />
Interestingly, MGS yields have not risen as sharply as swap rates, which suggests<br />
long positions in bonds are not as attractive as receiving positions in swaps. MGS<br />
yields could rise fur<strong>the</strong>r.<br />
Chart 27: 3Y MGS Yields vs 10Y MGS Yields<br />
%pa<br />
5.5<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
Spread (RHS)<br />
MGS 10Y<br />
MGS 3Y<br />
bps<br />
150<br />
125<br />
100<br />
75<br />
50<br />
25<br />
Chart 28: O/N Policy Rate & Klibor 3M vs MYR IRS<br />
% pa<br />
O/N Policy Rate<br />
5.0<br />
Klibor 3M<br />
MYR IRS 1Y<br />
MYR IRS 2Y<br />
4.5<br />
MYR IRS 3Y<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
0<br />
May-05 May-06 May-07 May-08<br />
2.5<br />
May-05 May-06 May-07 May-08<br />
India: Still a rate hike story<br />
The direction of gilt yields remains a tough call, but we remain comfortable with<br />
our rate hike forecast. We expect ano<strong>the</strong>r rate hike of 25bps in <strong>the</strong> repo and<br />
reverse repo rates before year end. Inflation risks are even more prominent now<br />
after <strong>the</strong> hike in diesel and petrol prices earlier this month and <strong>the</strong> growth outlook<br />
is not weak enough to keep <strong>the</strong> RBI on hold.<br />
On <strong>the</strong> Inflation front, WPI inflation stands at a 3.5-year high of 8.1%YoY and is<br />
likely to rise above 9%YoY as <strong>the</strong> fuel price adjustments should push inflation<br />
higher by 1 percentage point (Chart 29).<br />
52
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> Yield<br />
Chart 29: WPI<br />
%YoY<br />
10<br />
9<br />
8<br />
7<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
Nov-00 Nov-02 Nov-04 Nov-06<br />
Chart 30: Repo & Reverse Repo vs 2Y & 10Y Gilt Yields<br />
%pa<br />
9.0<br />
8.0<br />
7.0<br />
6.0<br />
5.0<br />
4.0<br />
2Y INgov Yield<br />
10Y INgov Yield<br />
1-day Repo<br />
Reverse Repo<br />
3.0<br />
Apr-05 Apr-06 Apr-07 Apr-08<br />
On <strong>the</strong> growth front, consumer demand has rebounded strongly and <strong>the</strong>re remains<br />
a robust upward trend in industrial production (<strong>the</strong> sharp fall in <strong>the</strong> YoY chg<br />
measure is misleading due to base effects). We expect full year growth to be<br />
8.6%, i.e. near potential. We doubt <strong>the</strong> higher fuel costs will slow growth in<br />
India. Admittedly, investment spending slowed in 1Q08 but we see this as a<br />
pause in spending on fears of US recession. The rebound in consumption should<br />
lead to a pick up in investment too.<br />
Hence, we maintain our call for one 25bps rate hike in <strong>the</strong> repo and reverse repo<br />
rates from <strong>the</strong> Reserve Bank of India before year end and we still think that a<br />
sell-off in bonds is more likely than a rally (Chart 30). Sentiment in <strong>the</strong> bond<br />
market in 2H08 will continue to be dominated by inflation concerns.<br />
Moreover, supply concerns remain, with <strong>the</strong> combined centre and state fiscal<br />
deficit currently in excess of 8% of GDP and set to worsen next year. As customs<br />
duty on crude oil and petroleum products and duties on diesel and petrol were<br />
cut earlier this month, <strong>the</strong> fiscal position is going to worsen by an estimated<br />
INR 230bn. In addition, <strong>the</strong> remaining petroleum subsidies will mean that <strong>the</strong><br />
government has to issue oil bonds worth INR 950bn or 1.7% of GDP.<br />
Lastly, India liberalized external commercial borrowing regulations and eased<br />
limits on foreign investment in domestic government and corporate bonds. The<br />
external commercial borrowing limit was raised to USD 50mn from USD 20mn<br />
earlier. Foreign investment limits in government and corporate bonds have been<br />
raised to USD 5bn and USD 3bn respectively from USD 3.2bn and USD 1.5bn<br />
earlier. These measures are positive for <strong>the</strong> bond market, but are unlikely to<br />
have a significant effect.<br />
A sell-off in <strong>the</strong><br />
Indian gilt market<br />
continues to be<br />
more likely than a<br />
rally<br />
China: Bonds should compensate for rate hike risk<br />
Against our expectation, government bond yields continue to trade sideways as<br />
<strong>the</strong> market refuses to discount <strong>the</strong> rate hikes we expect. In o<strong>the</strong>r words, we<br />
think that <strong>the</strong> market is too complacent about inflation and rate hike risks.<br />
Consumer prices were up 8.5%YoY in April, despite <strong>the</strong> government controlling<br />
prices of gasoline, diesel, jet fuel, coal, power and o<strong>the</strong>r materials, and could<br />
stay elevated until end of <strong>the</strong> year. Should price pressures in <strong>the</strong> coming months<br />
remain similar to those over <strong>the</strong> last twelve months and <strong>the</strong> CPI index rises by<br />
0.6%MoM, YoY inflation will stay around 8% (Chart 31).<br />
Chinese bonds<br />
should compensate<br />
for rate hike risks<br />
53
Yield<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
This, combined with <strong>the</strong> fact that GDP growth remains strong, suggests that<br />
policy risks remain tilted towards tightenig and this risk should be reflected in<br />
swap rates and bond yields. With front end swap rates at 4.49%, <strong>the</strong> same level<br />
as 3M Shibor, that risk clearly is not priced in (Chart 32). We continue to expect<br />
bond yields to rise. We forecast <strong>the</strong> 1Y lending rate to be raised by 25bps in<br />
4Q08, 1Q09 and in 2Q09 to 8.28% from 7.47% currently.<br />
Chart 31: Headline CPI Inflation<br />
%YoY<br />
if MoM % changes = 0.6<br />
10.0<br />
Current<br />
8.0<br />
6.0<br />
4.0<br />
2.0<br />
if MoM % changes = 0.4<br />
0.0 36-month average of MoM changes = 0.34<br />
12-month average of MoM changes = 0.60<br />
-2.0<br />
Apr-06 Apr-07 Apr-08 Apr-09<br />
Chart 32: 1Y IRS vs 3M Shibor & 1Y Deposit Rate<br />
%pa<br />
5.0<br />
4.8<br />
4.6<br />
4.4<br />
4.2<br />
4.0<br />
3.8<br />
3.6<br />
3.4<br />
3.2<br />
1Y Deposit Rate<br />
3M Shibor<br />
1Y Onshore IRS (vs 3M Shibor)<br />
3.0<br />
Jul-07 Oct-07 Jan-08 Apr-08<br />
Sources: Data for all charts and tables are from Bloomberg and <strong>DBS</strong> Research.<br />
54
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> Yield<br />
Interest rate forecasts<br />
%, eop, govt bond yield for 2Y and 10Y, spread bps<br />
11-Jun-08 3Q08 4Q08 1Q09 2Q09<br />
US Fed Funds 2.00 2.00 2.50 3.25 4.00<br />
3m Libor 2.79 2.60 3.00 3.65 4.30<br />
2Y 2.81 3.59 4.00 4.42 4.66<br />
10Y 4.07 4.60 5.00 5.30 5.40<br />
10Y-2Y 127 101 100 88 74<br />
Japan O/N Call Rate 0.51 0.50 0.50 0.75 0.75<br />
3m Tibor 0.84 0.75 0.75 1.00 1.00<br />
Eurozone Refi Rate 4.00 4.25 4.25 4.25 4.25<br />
3m Euribor 4.96 5.05 4.85 4.65 4.50<br />
Indonesia BI Reference Rate 8.50 9.25 9.25 9.25 9.25<br />
3m Jibor 8.98 9.40 9.40 9.40 9.40<br />
2Y 12.62 11.00 10.50 10.00 10.00<br />
10Y 13.50 12.50 12.00 11.50 11.50<br />
10Y-2Y 88 150 150 150 150<br />
Malaysia O/N Policy Rate 3.50 4.00 4.00 4.00 4.00<br />
3m Klibor 3.66 4.15 4.15 4.15 4.15<br />
3Y 4.04 4.40 4.20 4.00 4.00<br />
10Y 4.46 4.80 4.70 4.60 4.60<br />
10Y-3Y 42 40 50 60 60<br />
Philippines O/N Reverse Repo Rate 5.25 5.75 6.00 6.00 6.00<br />
3m Phibor 6.75 6.75 7.00 6.75 6.75<br />
2Y 8.35 8.50 8.75 8.75 8.75<br />
10Y 9.48 9.50 9.75 9.75 9.75<br />
10Y-2Y 114 100 100 100 100<br />
Singapore .. .. .. .. .. ..<br />
3m Sibor 1.44 1.31 1.52 1.94 2.31<br />
2Y 1.27 1.60 2.20 2.40 2.65<br />
10Y 3.61 3.80 3.90 3.93 4.04<br />
10Y-2Y 234 220 170 153 139<br />
Thailand O/N Repo 3.25 3.25 3.75 3.75 3.75<br />
3m Bibor 3.50 3.45 3.95 3.95 3.95<br />
2Y 4.66 4.70 4.80 4.90 4.90<br />
10Y 5.66 5.90 6.00 6.10 6.10<br />
10Y-2Y 100 120 120 120 120<br />
China 1 yr Lending rate 7.47 7.74 8.01 8.28 8.28<br />
1yr deposit rate 4.14 4.41 4.68 4.95 4.95<br />
2Y 3.72 4.00 4.25 4.25 4.25<br />
10Y 4.27 4.40 4.50 4.50 4.50<br />
10Y-2Y 55 40 25 25 25<br />
Hong Kong .. .. .. .. .. ..<br />
3m Hibor 2.15 1.95 2.35 3.05 3.70<br />
2Y 2.66 3.02 3.69 3.87 4.08<br />
10Y 3.59 4.05 4.45 4.75 4.85<br />
10Y-2Y 93 103 76 88 77<br />
Taiwan Rediscount Rate 3.50 3.75 3.88 3.88 3.88<br />
3m Repo 2.65 2.75 2.88 2.88 2.88<br />
2Y 2.31 2.25 2.50 2.50 2.50<br />
10Y 2.72 2.80 2.90 2.90 3.00<br />
10Y-2Y 42 55 40 40 50<br />
Korea 7d Repo 5.00 5.00 4.75 4.50 4.50<br />
3m CD rate 5.36 5.20 4.95 4.70 4.70<br />
2Y 5.73 5.60 5.00 4.90 4.90<br />
10Y 5.94 5.80 5.30 5.30 5.30<br />
10Y-2Y 21 20 30 40 40<br />
India 1d Repo 7.75 8.25 8.25 8.25 8.25<br />
3m Mibor 8.91 7.80 7.80 7.80 7.80<br />
2Y 8.10 8.40 8.40 8.40 8.40<br />
10Y 8.26 8.50 8.50 8.50 8.50<br />
10Y-2Y 16 10 10 10 10<br />
55
Asian Equity <strong>Strategy</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Asian Equity: Between <strong>the</strong><br />
devil and <strong>the</strong> deep blue sea<br />
• Our base case scenario of a very weak first quarter but no recession is<br />
slowly being panned out, but markets have overstated recession fear and<br />
risk appetite remains very low. With US recession risks fading we<br />
recommend a portfolio shift towards more beta<br />
• We expect some volatility in <strong>the</strong> short term as <strong>the</strong> shift from US growth<br />
fears to inflation fears is expected to drive up US bond yields and streng<strong>the</strong>n<br />
<strong>the</strong> USD. Soaring oil prices adds to <strong>the</strong>se fears. While US growth fears have<br />
somewhat subsided, fear of higher inflation in Asia dampening growth<br />
and driving up interest rates are turning <strong>the</strong> table around to a US recovery<br />
and Asia slowdown story. However a mild slowdown in Asia need to be<br />
seen in <strong>the</strong> context of a high base in recent years and still above potential<br />
growth levels for most countries<br />
• In view of new Asia headwinds of higher oil prices, inflation and interest<br />
rates , we now prefer <strong>the</strong> developed markets of Singapore, Taiwan, Hong<br />
Kong and Korea, where fiscal positions are stronger and downside risks to<br />
economic growth forecasts are comparatively lower. Emerging markets in<br />
ASEAN as well as India run <strong>the</strong> risks of policy missteps, weak fiscal position<br />
and political uncertainty undermining investors' confidence<br />
• We are overweight in Singapore, Taiwan and China-H; benchmark weight<br />
in Hong Kong and Korea; and underweight in Malaysia, Thailand,<br />
Indonesia, and India<br />
Fig. 1: Regional GDP growth<br />
12<br />
10<br />
8<br />
%<br />
China<br />
India<br />
ASIAN EQUITY<br />
Note: The weightings<br />
which we refer to in<br />
our Equity <strong>Strategy</strong><br />
outlook are not<br />
necessarily consistent<br />
with <strong>the</strong> equity<br />
“weightings” being<br />
used in our Asian<br />
Tactical Asset<br />
Allocation. The latter<br />
refer to specifically<br />
constructed<br />
benchmarks for asset<br />
allocation purposes.<br />
6<br />
4<br />
2<br />
0<br />
Asia (8)<br />
US<br />
Japan<br />
EZ<br />
2003 2004 2005 2006 2007 2008f 2009f<br />
Source: <strong>DBS</strong>. Asia (8) includes countries of Hong Kong, Singapore, Malaysia, Thailand,<br />
Indonesia, Philippines, Korea and Taiwan. Simple average is taken.<br />
Joanne Goh • (65) 6878 5233 • joannegohsc@dbs.com<br />
56
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Asian Equity <strong>Strategy</strong><br />
Mildly positive<br />
We are raising <strong>the</strong> outlook for Asian equities from<br />
a cautious stance in <strong>the</strong> second quarter to mildly<br />
positive as it becomes more apparent that <strong>the</strong> US<br />
will avoid recession.<br />
Risk appetite remains very low as depicted in shrinking<br />
trading volume and foreigners' net sell position<br />
since early 2006. 1Q08 US GDP data is an important<br />
sign that recession fears were overstated; our analysis<br />
also finds that inflation fears might be overstated<br />
this time. Rising oil price remains <strong>the</strong> biggest risk<br />
right now, but has varying impact on <strong>the</strong> economies<br />
of Asia.<br />
New fed fund forecast; US non-consensus GDP<br />
growth reiterated<br />
<strong>DBS</strong> economics maintains its projection of 2% US<br />
GDP growth for 2008 that is implied from first<br />
quarter growth of 0.9%, 1.5 in Q2, 2.5% in Q3<br />
and 2.75% in Q4. Our economist has removed <strong>the</strong><br />
last rate cut forecast for <strong>the</strong> year and added two<br />
rate hikes in 4Q08, and more rate hikes to 4.5%<br />
in 2009 as US interest rate normalisation takes its<br />
course after drastic rate cuts by <strong>the</strong> Fed in <strong>the</strong><br />
past nine months.<br />
Between <strong>the</strong> devil and <strong>the</strong> deep blue sea<br />
The implications for Asia equities are that US growth<br />
slowdown will be less than mostly feared but interest<br />
rates are set to rise. We recommend a portfolio<br />
shift towards more beta to growth with a focus<br />
on managing interest rate risk in Asian countries.<br />
Volatility in <strong>the</strong> short term<br />
In <strong>the</strong> short term, volatility in <strong>the</strong> US bond markets<br />
and USD could spill over to <strong>the</strong> equities market,<br />
as <strong>the</strong> shift in mindset from growth fears to inflation<br />
fears are driving up US bond yields and streng<strong>the</strong>ning<br />
<strong>the</strong> USD. Soaring oil prices have added to <strong>the</strong>se<br />
fears. Our view is that inflation fears could be<br />
overstated, just as were recession fears at <strong>the</strong> beginning<br />
of <strong>the</strong> year. The Fed rate hikes we have pencilled<br />
in are premised on <strong>the</strong> rates being normalized<br />
after <strong>the</strong> pre-emptive cuts in <strong>the</strong> past 9 months.<br />
Hopeful of a second half recovery<br />
We are hopeful of a second half Asian <strong>Equities</strong><br />
market recovery premised on:-<br />
1. US economic growth of c. 2% in <strong>the</strong> second<br />
half; rapid rate cuts and stimulus package to provide<br />
stability and save <strong>the</strong> US from drifting into recession;<br />
2. Asian domestic demand should hold up in <strong>the</strong><br />
face of external weakness, underpinning economic<br />
and earnings growth in <strong>the</strong> region;<br />
3. Valuation becoming attractive again after three<br />
years of multiple expansion; and<br />
4. Asia's comparatively stronger growth should<br />
continue to attract funds flow into <strong>the</strong> region.<br />
Macro environment deviates<br />
The macro environment in Asia envisaged in our<br />
base case scenario in our 2Q strategy, however,<br />
has deviated on three fronts. We now make our<br />
allocation changes in response to lower external<br />
risks and rising concerns on <strong>the</strong> domestic macro<br />
front.<br />
Inflation overshoot<br />
Firstly, inflation has overshot on <strong>the</strong> upside. However,<br />
core inflation remains low, whilst higher energy<br />
and food prices are driving headline inflation.<br />
Asian equities will find relief later as headline<br />
inflation starts heading south. While <strong>the</strong> timing<br />
of when inflation will start coming off is difficult<br />
to predict, consensus expectations of around July<br />
(generally expected due to <strong>the</strong> year-on year effect)<br />
may be slightly too optimistic, probably by a quarter.<br />
We do not think inflation risks will be extended<br />
beyond next year nor will higher inflation pose a<br />
significant threat to Asia's growth, barring <strong>the</strong><br />
unpredictable movement of oil prices. <strong>DBS</strong> <strong>Economics</strong><br />
has raised inflation forecasts for 2008 for most<br />
Asian economies, but growth forecasts remain largely<br />
intact.<br />
Fig. 2: Higher food & energy prices are driving up<br />
inflation<br />
%<br />
200<br />
150<br />
100<br />
50<br />
0<br />
-50<br />
-100<br />
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08<br />
Food Commodities<br />
Source: Datastream, IFS<br />
Crude Oil<br />
57
Asian Equity <strong>Strategy</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Potential downside risk to growth forecasts?<br />
Simply, if forecast 2008 CPI is subtracted from long<br />
term nominal GDP growth to determine <strong>the</strong> implied<br />
real GDP growth, 2008 growth forecasts look high<br />
compared to <strong>the</strong> implied growth forecasts.<br />
Fig. 3: Implied real GDP growth, derived from paring<br />
off 2008 inflation from long term potential nominal<br />
growth<br />
LT potential growth<br />
2008 forecast<br />
(1) (2) (3) (4) (3) - (4)<br />
(%)<br />
China 8.2 3.8 12.3 6.5 5.8 10.0 -4.2<br />
Singapore 5.1 2.2 7.4 6.0 1.4 5.1 -3.7<br />
Indonesia 5.7 5.2 11.3 10.3 1.0 5.9 -4.9<br />
Hong Kong 4.1 3.0 7.3 5.0 2.3 4.7 -2.4<br />
Thailand 4.7 3.2 8.1 6.4 1.7 4.7 -3.0<br />
Korea 4.2 2.8 7.1 3.7 3.4 4.5 -1.1<br />
Taiwan 4.2 2.0 6.2 3.4 2.8 4.1 -1.3<br />
Malaysia 5.3 2.3 7.7 4.5 3.2 5.5 -2.3<br />
India 8.1 4.8 13.2 6.8 6.4 7.7 -1.3<br />
Source: Consensus <strong>Economics</strong> Inc. for LT growth<br />
forecasts, <strong>DBS</strong><br />
Fig. 4: Downside risks spreaded out in all Asia markets.<br />
Countries with stronger fiscal position should have <strong>the</strong><br />
ability to pump prime and policy flexibility to manage<br />
risks if needed<br />
% %<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
Indonesia<br />
Real<br />
GDP<br />
Singapore<br />
CPI<br />
China<br />
Nom.<br />
GDP<br />
Thailand<br />
Hong Kong<br />
<strong>DBS</strong> CPI<br />
forecast<br />
Malaysia<br />
* Implied<br />
GDP<br />
growth<br />
Taiwan<br />
Consens<br />
us GDP<br />
growth<br />
forecast<br />
India<br />
Korea<br />
Downside<br />
risks to<br />
growth<br />
Implied*<br />
Consensus GDP forecast<br />
Difference<br />
Source: Consensus <strong>Economics</strong> Inc., <strong>DBS</strong>. * Implied from<br />
long term nominal potential growth minus 2008<br />
inflation forecasts<br />
0<br />
-1<br />
-2<br />
-3<br />
-4<br />
-5<br />
-6<br />
Fig. 5: Table of inflation<br />
2005 2006 2007 2008f 2009f<br />
US 3.3 3.2 2.9 3.5 2.3<br />
Japan -0.3 0.2 0.1 0.8 0.2<br />
Eurozone 2.2 2.2 2.1 3.0 2.1<br />
Indonesia 10.5 13.3 6.3 10.3 7.2 <br />
Malaysia 3.1 3.6 2.0 4.5 2.0<br />
Philippines 7.7 6.3 2.8 9.0 4.8 <br />
Singapore 0.5 1.0 2.1 6.4 2.8<br />
Thailand 4.5 4.6 2.2 6.4 2.8<br />
China 1.8 1.5 4.8 6.5 4.5<br />
Hong Kong 1.0 2.0 2.0 5.0 4.0<br />
Taiwan 2.3 0.6 1.8 3.4 2.4<br />
Korea 2.8 2.2 2.5 4.6 3.0 <br />
India* 4.4 5.4 4.3 6.8 4.9<br />
Source: <strong>DBS</strong>. Up / down arrows denote revisions made<br />
since last quarter<br />
Fig. 6 : Table of real GDP growth<br />
GDP growth, % YoY<br />
2005 2006 2007 2008f 2009f<br />
US 3.2 3.3 2.2 2.0 2.6<br />
Japan 1.9 2.4 2.0 1.5 2.1<br />
Eurozone 1.6 2.9 2.6 2.0 2.0 <br />
Indonesia 5.7 5.5 6.3 6.0 6.3 <br />
Malaysia 5.0 5.9 6.3 5.1 6.0<br />
Philippines 4.9 5.4 7.3 5.4 6.0 <br />
Singapore 7.3 8.2 7.7 6.0 6.8<br />
Thailand 4.5 5.1 4.8 5.0 4.7 <br />
China 10.4 11.1 11.9 10.0 9.0<br />
Hong Kong 7.1 7.0 6.4 5.2 4.7<br />
Taiwan 4.2 4.9 5.7 5.0 5.4<br />
Korea 4.2 5.1 5.0 4.6 5.0<br />
India* 9.0 9.6 9.0 8.6 8.6<br />
Source: <strong>DBS</strong>. Up / down arrows denote revisions made<br />
since last quarter<br />
Countries with pro-growth policies and strong reserves<br />
and budget balance can afford to pump-prime<br />
<strong>the</strong> economy to sustain growth, o<strong>the</strong>rs might not<br />
be able to do that. As such we now prefer <strong>the</strong><br />
developed markets of Hong Kong, Singapore, Taiwan,<br />
and Korea, where fiscal positions are stronger and<br />
downside risks to economic growth forecasts are<br />
more benign. Emerging markets in ASEAN are least<br />
favored.<br />
58
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Asian Equity <strong>Strategy</strong><br />
Fig. 7: Table of policy rate forecasts<br />
current 3Q08 4Q08 1Q09 2Q09<br />
US 2.00 2.00 2.50 3.25 4.00<br />
Japan 0.50 0.50 0.50 0.75 0.75<br />
Eurozone 4.00 4.25 4.25 4.25 4.25<br />
Indonesia 8.50 9.25 9.25 9.25 9.25<br />
Malaysia 3.50 4.00 4.00 4.00 4.00<br />
Philippines 5.25 5.75 6.00 6.00 6.00<br />
Singapore* 1.44 1.31 1.52 1.94 2.31<br />
Thailand 3.25 3.25 3.75 3.75 3.75<br />
China 7.47 7.47 7.74 8.01 8.28<br />
Hong Kong* 2.15 1.95 2.35 3.05 3.70<br />
Taiwan 3.50 3.75 3.88 3.88 3.88<br />
Korea 5.00 5.00 4.75 4.50 4.50<br />
India 8.00 8.25 8.25 8.25 8.25<br />
Source: <strong>DBS</strong>. Up / down arrows denote revisions made<br />
since last quarter. First published for 2Q09 figures. * 3-<br />
month interbank rate used. Current as of June 11.<br />
Fig. 8: Table of exchange rate forecasts<br />
current 3Q08 4Q08 1Q09 2Q09<br />
Japan 107 106 107 108 109<br />
Eurozone 1.55 1.52 1.49 1.46 1.43<br />
Indonesia 9,319 9,500 9,600 9,700 9,800<br />
Malaysia 3.27 3.30 3.35 3.40 3.45<br />
Philippines 44.4 45.0 47.0 45.0 45.0<br />
Singapore 1.37 1.38 1.40 1.42 1.44<br />
Thailand 33.1 33.5 34.0 34.5 34.9<br />
China 6.92 6.80 6.75 6.70 6.65<br />
Hong Kong 7.81 7.81 7.83 7.84 7.85<br />
Taiwan 30.4 30.5 31.0 31.5 32.0<br />
Korea 1,025 1,075 1,100 1,075 1,075<br />
India 43.1 43.0 43.5 42.5 42.5<br />
Source: <strong>DBS</strong>. Up / down arrows denote revisions made<br />
since last quarter. First published for 2Q09 figures.<br />
Current as of June 10.<br />
Grappling with Oil<br />
Having said that, rising inflation particularly from<br />
higher energy prices, will have a varying impact<br />
on <strong>the</strong> economies in Asia. Countries that are still<br />
subsidizing fuel prices including Indonesia, Malaysia<br />
and India have cut subsidies by 28.7%, 40% and<br />
10%, respectively (average, depending on fuel<br />
category). This does not bode well for <strong>the</strong> inflation<br />
trend to soften soon in <strong>the</strong>se countries. Interest<br />
rates are likely to rise, whilst fear of social instability<br />
and <strong>the</strong> potential for fur<strong>the</strong>r subsidy cuts will<br />
dampen sentiment. This comes at a time when<br />
<strong>the</strong> political scenes in <strong>the</strong>se countries are becoming<br />
less stable. Indonesia and India will hold <strong>the</strong>ir<br />
general elections next year, while Malaysia's ruling<br />
party just lost its 2/3 majority win in <strong>the</strong> last elections<br />
and political upheaval is budding.<br />
Most importantly, <strong>the</strong>se three countries run large<br />
budget deficits that if left unchecked coupled with<br />
ballooning subsidies because of higher oil prices,<br />
could lead to rating downgrades.<br />
We now have underweight recommendations for<br />
<strong>the</strong>se three countries.<br />
Dollar rebound<br />
Secondly, with <strong>the</strong> pause in <strong>the</strong> US monetary easing<br />
cycle, <strong>the</strong> USD might not weaken as much as in<br />
<strong>the</strong> first half this year. And some Asian currencies<br />
may find difficulty streng<strong>the</strong>ning. Hence, <strong>the</strong>re are<br />
threats of higher Asian interest rates if currencies<br />
cannot help tame inflation. We have pencilled in<br />
more rate hikes or brought forward <strong>the</strong> rate hikes<br />
for some.<br />
The only country for which we still have a rate cut<br />
forecast is Korea. Our modelling suggests that a<br />
weaker currency and lower interest rates are positive<br />
drivers for Korea's 12-month forward return. Hence,<br />
in line with a positive outlook to <strong>the</strong> growth scenario,<br />
we are raising Korea to Neutral from Underweight.<br />
(See section on Korea)<br />
Rising bond yields<br />
Thirdly, bond yields are expected to rise from here<br />
as <strong>the</strong> bond market starts to price in rate hikes.<br />
We expect <strong>the</strong> US 10-year bond yield to rise to 5%<br />
from 3.8% currently. The implications for equities<br />
are that equities will be deemed expensive in a<br />
rising interest rate environment, but our stress test<br />
suggests that <strong>the</strong> bond / earnings yield relationship<br />
is still within <strong>the</strong> one standard deviation band.<br />
Fig. 9: US / Asia ex-Japan earnings yield ratio - proforma<br />
at US 10-year bond yield = 5%<br />
2.0<br />
1.8<br />
1.6<br />
1.4<br />
1.2<br />
1.0<br />
0.8<br />
0.6<br />
0.4<br />
(x)<br />
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08<br />
Source: <strong>DBS</strong>, Datastream, Bloomberg<br />
<strong>Equities</strong><br />
expensive<br />
<strong>Equities</strong><br />
cheap<br />
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Fig. 10: Key drivers<br />
Countries Positive drivers Negative drivers<br />
Singapore Valuations are attractive in a historical context. Downgrades High beta, financial services and direct investment growth<br />
already in <strong>the</strong> price, domestic growth still intact. Less affeced will be affected by global growth slowdown<br />
by inflation; government has ability to pump prime; ongoing<br />
projects should continue to drive investment growth. Interest<br />
rates should rise slower than o<strong>the</strong>r countries; demand for<br />
offshore marine servivces remain strong;<br />
Hong Kong<br />
Malaysia<br />
Broad based economic expansion; rising rates in syn with<br />
inflation cycle<br />
Overhang on fuel price subsidy removed; politcal uncertainty<br />
provides opportunity for change; CPO prices stable<br />
Most affected by rise in US interest rates as well as austerity<br />
measures in China<br />
Political uncertainty to delay investment spending with <strong>the</strong><br />
withdrawal of fiscal stimulus previously budgetted<br />
Thailand<br />
Weak THB to help exports sector which has been a big<br />
contributor to growth<br />
Higher inflation, interest rates and politic uncertainty to bite<br />
into domestic demand recovery; no end in sight for<br />
Indonesia Coal and energy sector still attracting FDI and in demand Removal of subsidy to affect spending and fear that more<br />
cuts might be needed; inflation to rise above double digit<br />
and interest rates to rise; fear of weakening rupiah<br />
China<br />
Korea<br />
Good growth; strong domestic consumption and demand,<br />
urbanisation and reconstruction needs to sustain high level<br />
gowth<br />
Fiscal stimulus on <strong>the</strong> way; weak won and interest rate cuts<br />
to help exports sector; exports sector geared to US recovery<br />
Fur<strong>the</strong>r tightening in fear of overheating; inflation overshoot<br />
Still weak domestic demand and confidence due to financial<br />
strains of falling property prices<br />
Taiwan Improving cross-straits relationship; Tech sector to improve<br />
from US recovery; attractive valuations<br />
India Growth is still forecast to be close to 9% Monetary tightening to cool overrun inflation; twin deficits<br />
means fiscal constraints and weak currency; risks of policy<br />
mis-step compromised by politics<br />
Emerging<br />
ASEAN<br />
Infrastructure needs to sustain investment spending<br />
Overrun inflation, weak currency due to USD rebound, rising<br />
interest rates to tame inflation, political uncertainty adds to<br />
domestic woes; fear of weakening currency augmenting<br />
outflows spiralling to fur<strong>the</strong>r weakness. Budget constraint on<br />
fiscal spending. High oil prices to affect sentiments and<br />
spending; domestic demand story is questionable now<br />
North Asia<br />
Relatively exports dependent which means better prospects<br />
in a US recovery scenario; inflation rate still below 5% which<br />
are comparatively lower. No urgency to raise rates<br />
Relatively exports dependent<br />
Source: <strong>DBS</strong><br />
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Risk appetite<br />
If <strong>the</strong> retracement from <strong>the</strong> high of 4Q 2007 is<br />
due mainly to a loss of risk appetite or a rise in<br />
equity risk premium because of a deterioration<br />
in <strong>the</strong> external environment, a gradual return to<br />
normalcy would bring markets back to pre-crisis<br />
levels. Our risk appetite assessment model (introduced<br />
in 4Q07) suggests that risk appetite has fallen <strong>the</strong><br />
most since September 2007 in Singapore, Hong<br />
Kong and China. But it has indeed improved in<br />
Taiwan. The implications are that all things being<br />
equal, we will see that an improvement in risk<br />
appetite should benefit countries that were most<br />
heavily penalized.<br />
Deteriorating domestic conditions in Thailand and<br />
a rising interest rate environment for Hong Kong<br />
suggests that a return to pre-crisis levels for <strong>the</strong>se<br />
countries is unlikely. Hence, we are downgrading<br />
<strong>the</strong>se two markets. We are upgrading Singapore<br />
because domestic conditions are intact. The current<br />
risk profile and key drivers for each of <strong>the</strong> markets<br />
are summarised in Fig. 12 and 10.<br />
Fig. 11: Change in implied equity risk premium<br />
Current end 3Q07 Difference<br />
ERPs (%):<br />
Singapore 12.0 5.0 7.0<br />
Hong Kong 6.2 0.4 5.8<br />
China 7.3 1.8 5.5<br />
Malaysia 12.7 9.9 2.8<br />
India 3.6 1.1 2.5<br />
Asia ex-Japan 6.2 3.9 2.3<br />
Indonesia 3.4 1.4 2.0<br />
Thailand 6.5 5.0 1.5<br />
Korea 3.6 2.7 0.9<br />
Taiwan 6.3 8.9 -2.6<br />
Source: <strong>DBS</strong> calculations<br />
Statistical analysis: Impact of higher oil price, bond<br />
yields and stronger USD on markets and stocks<br />
The impact falls disproportionately on different<br />
sectors in <strong>the</strong> stocks market. As a statistical test,<br />
we calculate <strong>the</strong> correlation of weekly changes in<br />
Asia market indices and sectors with changes in<br />
oil prices, bond yields and USD index, using data<br />
from 1990 till present. The correlation coefficient<br />
is probably too low to be significant, but could<br />
be used as a relative comparison. The findings are<br />
summarized below:<br />
Impact on <strong>Markets</strong><br />
Fig. 13: Asia indices’ sensitivity to oil price, bond yields<br />
and US$ strength<br />
Top 3 markets<br />
Positively correlated<br />
Oil Bond<br />
yields<br />
US$<br />
strength<br />
Top 3 markets<br />
Negatively correlated<br />
Oil Bond<br />
yields<br />
US$<br />
strength<br />
H-sh STI STI TWI SET H-sh<br />
KLCI KOSPI TWI STI KLCI HSI<br />
Sensex H-sh SET KOSPI TWI KLCI<br />
0.06 0.3 -0.01 -0.05 0.08 -0.11<br />
0.04 0.13 -0.02 -0.01 0.11 -0.1<br />
0.03 0.12 -0.05 0.00 0.11 -0.07<br />
Source: Datastream, <strong>DBS</strong> calculations<br />
Not surprisingly, <strong>the</strong> H-share index, which has a<br />
larger composition of commodity and oil stocks,<br />
is positively correlated to oil prices. The perception<br />
of Malaysia as a net exporter of oil also kept <strong>the</strong><br />
index relatively positive to oil prices, although it<br />
might have become only a marginal net exporter<br />
in recent years. The presence of plantation stocks<br />
probably explains <strong>the</strong> link as well. The relatively<br />
higher proportion of energy stocks in Sensex explains<br />
<strong>the</strong> presence of Sensex among <strong>the</strong> top 3.<br />
Fig . 12: Current risk profile and sensitivity<br />
Improving Decreasing<br />
ERPs (%): 1 2 3.4 3.6 4 6.2 7.3 10 12 12.7<br />
Singapore 7,487 6,866 6,095 5,993 5,796 4,838 4,431 3,592 3,093 2,938<br />
Hong Kong 37,533 34,432 30,582 30,074 29,088 24,305 22,268 18,078 15,583 14,811<br />
Malaysia 3,009 2,768 2,468 2,428 2,351 1,978 1,818 1,489 1,292 1,231<br />
Thailand 1,248 1,149 1,025 1,008 977 822 756 619 537 512<br />
Indonesia 2,902 2,680 2,402 2,366 2,294 1,944 1,793 1,480 1,291 1,232<br />
China 22,961 21,040 18,655 18,341 17,730 14,766 13,503 10,907 9,362 8,884<br />
Korea 2,257 2,070 1,838 1,807 1,748 1,459 1,335 1,081 930 883<br />
Taiwan 13,118 12,072 10,771 10,600 10,266 8,646 7,954 6,527 5,674 5,409<br />
India 18,813 17,270 15,346 15,092 14,599 12,194 11,166 9,044 7,773 7,379<br />
Asia ex-Japan 928 852 756 744 719 601 551 447 385 365<br />
Source: <strong>DBS</strong>, Datastream, Bloomberg. Note that <strong>the</strong> calculations uses a 10-year DDM, with 2008 and 2009 growth<br />
forecasts used (<strong>DBS</strong>V if covered, consensus o<strong>the</strong>rwise) and long term nominal GDP growth forecasts for <strong>the</strong> 3rd - 10th<br />
year, terminal P/E of 12x, risk-free rate using 10-year or equivalent domestic bond yield, and average historical payout<br />
ratio. Shaded cells indicate current index levels and <strong>the</strong> inferred equity risk premium accordingly,<br />
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The interpretation of rising US bond yields can<br />
be viewed on two fronts - from a rising inflationary<br />
pressure view point, or outlook for a stronger<br />
than expected US growth accompanied by benign<br />
inflation fears. In view of this we believe <strong>the</strong><br />
positive impact of rising bond yields on <strong>the</strong> Singapore<br />
market makes <strong>the</strong> most sense as Singapore interest<br />
rates do not necessarily move in tandem with<br />
<strong>the</strong> US as it has a managed currency policy. A<br />
more positive outlook for US and global growth<br />
should bode well for Singapore stocks.<br />
The STI is also least impacted by a strong USD,<br />
probably due to a relatively larger portion (vs.<br />
<strong>the</strong> rest of <strong>the</strong> region) of USD earnings from <strong>the</strong><br />
offshore marine sector and SIA. Moreover, <strong>the</strong><br />
SGD is pegged to a basket of currencies that includes<br />
<strong>the</strong> USD. The SGD will weaken less than <strong>the</strong> rest<br />
of <strong>the</strong> region when <strong>the</strong> USD streng<strong>the</strong>ns.<br />
The negative correlation can be analysed from<br />
a top down view. Impact of rising oil prices are<br />
stronger in <strong>the</strong> TWI, STI and KOSPI, which all<br />
seem to be industrial nations that rely heavily<br />
on oil imports. Thus, profit margins will be impacted<br />
by higher oil prices. Rising bond yield impact is<br />
greater for <strong>the</strong> SET and KLCI, which are so termed<br />
as "emerging" markets where currencies (and hence<br />
foreign fund outflow) are vulnerable during periods<br />
of rising yields and volatility. The interpretation<br />
of <strong>the</strong> impact of a strong USD is interesting. One,<br />
<strong>the</strong>y are markets which currencies are pegged<br />
(CNY and MYR) at some period in time. If <strong>the</strong><br />
USD weakness is associated with stronger commodity<br />
prices, <strong>the</strong>n it suggests a reason for <strong>the</strong> H-shares<br />
and <strong>the</strong> KLCI to be negatively impacted by a<br />
strong USD.<br />
Impact on Sectors<br />
Fig. 14: Asia ex-Japan sector indices’ sensitivity to oil<br />
price, bond yields and US$ strength<br />
Top 3 sectors<br />
Positively correlated<br />
Oil Bond<br />
yields<br />
US$<br />
strength<br />
Oil/Eq<br />
Svs/Dst<br />
Aero/D<br />
efence<br />
Consu<br />
mer<br />
Gds<br />
Basic<br />
Mats<br />
S/W &<br />
Comp Svs<br />
Tch H/W &<br />
Eq<br />
Top 3 sectors<br />
Negatively correlated<br />
Oil Bond<br />
yields<br />
US$<br />
strength<br />
Tch<br />
H/W & Eqt Ivst<br />
Eq Ins<br />
Elt ro/El H/C Eq<br />
ec Eq & Svs<br />
Life Fd &<br />
Insura Drug<br />
nce Rtl<br />
Mining<br />
Gen<br />
Retailers<br />
Tobacc Auto & Personal<br />
o Part s Goods<br />
Utilities<br />
0.2 0.18 -0.02 -0.04 -0.03 -0.15<br />
0.1 0.17 -0.03 -0.01 0.06 -0.15<br />
0.08 0.16 -0.04 -0.01 0.06 -0.15<br />
Source: Datastream, <strong>DBS</strong> calculations<br />
Direct links can be found with <strong>the</strong> oil & gas services<br />
sector, which benefits from rising oil prices. The<br />
tech sector, which are normally USD earners will<br />
also benefit from a strong USD. The negative impact<br />
on margins for manufacturers are evidenced in <strong>the</strong>ir<br />
negative impact on oil.<br />
Where higher oil prices coincide with strong economic<br />
growth and low unemployment - <strong>the</strong>re will be structural<br />
shifts due to a stronger desire to live nearer to town<br />
or residential areas with convenient public transport.<br />
This should support property prices in Singapore<br />
and Hong Kong. Meanwhile, with <strong>the</strong> removal of<br />
fuel price subsidies, Malaysians might consider moving<br />
closer to cities ra<strong>the</strong>r than drive 2 hours between<br />
work and office. Governments, such as in Malaysia<br />
and Thailand, will also be encouraged to build better<br />
mass transportation infrastructure.<br />
In <strong>the</strong> bond market, expectations of rising bond<br />
yields should attract flow of funds from <strong>the</strong> bond<br />
markets to <strong>the</strong> equities market.<br />
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Country asset allocation recommendations and<br />
changes<br />
Overweight markets: China-H, Taiwan, Singapore<br />
Underweight markets: Malaysia, India, Thailand,<br />
Indonesia<br />
Neutral markets: Hong Kong, Korea<br />
Singapore: Upgrade to Overweight from Benchmarkweight<br />
Singapore remains <strong>the</strong> cheapest market in <strong>the</strong> region,<br />
based on <strong>the</strong> number of standard deviation away<br />
from historical average of consensus 12-month forward<br />
P/E (see Fig. 15). There was a lot of uncertainty in<br />
<strong>the</strong> 'E', specifically fear of more downgrades, but<br />
that has been largely priced in. Consensus now<br />
expects negative earnings growth for 2008 instead<br />
of 4% growth early this year, and 10% in September.<br />
1Q08 results were mixed but generally met expectations.<br />
Fig. 15: Regional markets' 12m fwd P/E: No. of standard<br />
deviation away from average - Singapore is <strong>the</strong> cheapest<br />
market based on historical trend<br />
Singapore<br />
Taiwan<br />
Malaysia<br />
Thailand<br />
Indonesia<br />
AXJ<br />
Korea<br />
China 'H'<br />
Hong Kong<br />
India<br />
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5<br />
Cheap<br />
Expensive<br />
Source: Datastream, Bloomberg, <strong>DBS</strong> calculations. Average<br />
and standard deviations from 1993 - present.<br />
Going forward we expect <strong>the</strong> Singapore economy<br />
to experience a modest slowdown y-o-y in 2Q and<br />
3Q before recovering in <strong>the</strong> 4Q. Engines of growth<br />
should remain in services and construction, refinery<br />
and offshore marine sectors.<br />
Inflation should come off in <strong>the</strong> next few months<br />
as year-on-year effect of <strong>the</strong> GST hikes in July last<br />
year diminish. However price level should remain<br />
elevated and continue to hurt consumer spending.<br />
The moderation in <strong>the</strong> GDP we expected is in private<br />
consumption. While high inflation will slow private<br />
spending, we believe <strong>the</strong> strong reserves and social<br />
fiscal balance will be a safety net for <strong>the</strong> needy<br />
Fig. 16: Singapore earnings growth downgraded<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
%<br />
2009 earnings<br />
growth<br />
2008 earnings<br />
growth<br />
Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08<br />
Source: IBES, <strong>DBS</strong> calculations<br />
and less of a social concern for Singapore.<br />
The impact of macro changes on Singapore equities<br />
should be minimal in our view, and selective on<br />
sectors that are sensitive to such changes. We now<br />
forecast higher bond yields with a flattening yield<br />
curve and a stronger USD.<br />
Singapore bond yields have risen in recent weeks<br />
in tandem with US bond yields. Recently, an extraordinary<br />
case of poor auction response to Singapore 10-<br />
year treasury bonds lifted yields by 100bps. With<br />
our new US Fed funds forecast (50bps hikes in 4Q08<br />
and 75bps in 1Q09) we expect <strong>the</strong> Singapore long<br />
bond yields to rise ano<strong>the</strong>r 50bps by year end and<br />
35bps in 1Q09, taking bond yields from 3.4% currently<br />
to 4.15%. Among stocks under our coverage, 48%<br />
of <strong>the</strong>m are offering more than 3.4% dividend<br />
yield, and 40% more than 4.15%. But investing<br />
for dividends may not be an appropriate strategy<br />
in a rising bond yield environment.<br />
We expect <strong>the</strong> USD to streng<strong>the</strong>n as <strong>the</strong> Fed easing<br />
Fig. 17: Singapore exchange and interest rates<br />
forecasts<br />
(% )<br />
Fed<br />
funds<br />
3m<br />
SIBOR<br />
12m<br />
SIBOR<br />
SGS<br />
2Y<br />
SGS<br />
10Y<br />
SGD /<br />
USD<br />
current 2.00 1.36 1.91 1.24 3.64 1.37<br />
3Q08 2.00 1.31 2.06 1.60 3.80 1.38<br />
4Q08 2.50 1.52 2.27 2.22 3.90 1.40<br />
1Q09 3.25 1.94 2.69 2.40 3.93 1.42<br />
2Q09 4.00 2.31 2.81 2.65 4.04 1.44<br />
3Q09 4.50 2.67 3.02 2.66 3.92 1.42<br />
4Q09 4.50 2.64 2.89 2.42 3.79 1.40<br />
Source: <strong>DBS</strong><br />
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Asian Equity <strong>Strategy</strong><br />
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cycle comes to an end followed by rapid tightening<br />
to normalize interest rates.<br />
Fig. 19: Singapore GDP growth and inflation<br />
20 %<br />
%<br />
10<br />
We summarise <strong>the</strong> top and bottom three sectors<br />
15<br />
GDP growth (L)<br />
8<br />
Fig. 18: Singapore sector indices’ sensitivity to oil price,<br />
bond yields and US$ strength<br />
10<br />
6<br />
Top 3 sectors<br />
Positively correlated<br />
Oil Bond<br />
yields<br />
US$<br />
strength<br />
Top 3 sectors<br />
Negatively correlated<br />
Oil Bond<br />
yields<br />
US$<br />
strength<br />
5<br />
0<br />
4<br />
2<br />
Oil/Eq<br />
Svs/Dst<br />
Eqt Ivst<br />
Ins<br />
Mining<br />
Persona<br />
l Goods Eqt Ivst Ins<br />
Aero/D<br />
efence<br />
Mining<br />
Fd & Drug<br />
Rt l<br />
Ind. Met &<br />
Mines<br />
Inds<br />
Eng<br />
M edia<br />
Lif e<br />
Insuran<br />
ce<br />
Mobile<br />
T/Cm<br />
H/C Eq<br />
& Svs<br />
Inds<br />
Eng<br />
Mining<br />
Oil/Eq<br />
Svs/Dst<br />
Con & Mat<br />
0.2 0.26 0.10 -0.05 0.00 -0.26<br />
0.14 0.21 0.04 -0.04 0.06 -0.18<br />
0.11 0.21 0.04 -0.03 0.07 -0.16<br />
Source: Datastream, <strong>DBS</strong> calculations<br />
in Singapore where performances are highly or<br />
least correlated to (i) rising oil prices, (ii) bond<br />
yields, and (iii) stronger USD.<br />
The conviction calls are to raise weighting for offshore<br />
marine sector, and reduce for Telcos. Selective investment<br />
trusts in USD earnings should benefit from <strong>the</strong><br />
dollar strength.<br />
We favor <strong>the</strong> property sector as an inflation hedge.<br />
While we believe physical property prices has room<br />
to fall 20% on average due to <strong>the</strong> spike last year,<br />
property stocks are trading at 30% discount to<br />
<strong>the</strong>ir RNAVs, which imply property prices could<br />
drop 50%. However, we believe this is unlikely,<br />
and would happen only during an economic downturn.<br />
Real interest rates in Singapore remain in negative<br />
territory, and economic growth is still expected<br />
to stay healthy with a relatively tight employment<br />
-5<br />
-10<br />
90 92 94 96 98 00 02 04 06 08<br />
Source: CEIC<br />
Fig. 20: Singapore real rates vs property prices<br />
Index<br />
200<br />
Inflation rate (R)<br />
Source: CEIC. Real rates using 3-month SIBOR minus CPI<br />
inflation<br />
Fig. 21 : Singapore unemployment rate vs wage growth<br />
16<br />
12<br />
180<br />
160<br />
140<br />
120<br />
100<br />
8<br />
80<br />
60<br />
40<br />
20<br />
0<br />
-6<br />
90 92 94 96 98 00 02 04 06 08<br />
%<br />
Property Price Index (L)<br />
%<br />
Real rates (R)<br />
0<br />
-2<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
-4<br />
4<br />
0<br />
-4<br />
-8<br />
96 97 98 99 00 01 02 03 04 05 06 07<br />
Unemployment rate<br />
Source: CEIC<br />
Wage growth<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Asian Equity <strong>Strategy</strong><br />
Fig. 22: Singapore property / banks relative performance<br />
vs inflation rate<br />
Index %<br />
160<br />
8<br />
140<br />
120<br />
100<br />
80<br />
60<br />
40<br />
20<br />
0<br />
90 92 94 96 98 00 02 04 06 08<br />
Property / Banks relative performance (L)<br />
Inflation (R)<br />
Source: <strong>DBS</strong>, Datastream, Bloomberg<br />
market at 1.8% unemployment rate. Reflation should<br />
still be on track if economic growth remains strong<br />
and under a negative interest rate environment.<br />
Korea: Upgrade to Neutral from Underweight<br />
Korea is raised to Neutral following our expectations<br />
for a weaker won and forecast for cuts in Korean<br />
policy rates. Moreover, with <strong>the</strong> weaker-than-expected<br />
1Q GDP growth, growth fears has intensified among<br />
policy makers. And <strong>the</strong> new government could be<br />
rolling out fiscal stimulus, including rate cuts to<br />
bolster domestic demand. We still think <strong>the</strong> "747"<br />
economic pledge is ambitious, but <strong>the</strong> Korean government<br />
did lower growth potential to 6% from 7%. The<br />
new government should be working towards achieving<br />
this goal while continuing policy efforts to boost<br />
growth. Emphasis will be placed on revitalizing investments<br />
and domestic consumption, reinforcing competitiveness,<br />
and discovering new growth engines. Tax cuts and<br />
expansion of tax deductions, regulatory reforms and<br />
innovation of public companies, stabilising interest<br />
rates and exchange rates and support to boost exporters'<br />
competitiveness and stabilise current account balances<br />
are in <strong>the</strong> action plan for 2008.<br />
7<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
-<br />
(1)<br />
(2)<br />
Fig. 23: Singapore / Hong Kong financials relative<br />
performance vs Fed funds rate<br />
% %<br />
80<br />
6<br />
60<br />
40<br />
20<br />
0<br />
-20<br />
-40<br />
0<br />
01 02 03 04 05 06 07 08<br />
Singapore / Hong Kong Financial sector relative performance<br />
yoy%<br />
Fed funds rate (RHS)<br />
Source: <strong>DBS</strong>, Datastream, Bloomberg<br />
Fig. 24: Singapore vs Hong Kong residential property<br />
price index<br />
Index<br />
450<br />
400<br />
350<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
90 92 94 96 98 00 02 04 06 08<br />
Singapore<br />
Hong Kong<br />
Source: <strong>DBS</strong>, Datastream, Bloomberg<br />
5<br />
4<br />
3<br />
2<br />
1<br />
Hong Kong: Downgrade to Benchmark-weight from<br />
Overweight<br />
We have less preference for Hong Kong now because<br />
of its sensitivity to US interest rates, which are expected<br />
to rise from 4Q08 onwards. Since <strong>the</strong> Fed started<br />
to cut rates in August 2007, Hong Kong financials<br />
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Asian Equity <strong>Strategy</strong><br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
have out-performed Singapore financials. We believe<br />
this will reverse as soon as <strong>the</strong> Fed starts to hike<br />
rates.<br />
Malaysia: Downgrade to Underweight from Benchmarkweight<br />
Malaysia is downgraded due to its "safe haven"<br />
qualities - it should outperform in a low risk appetite<br />
environment but underperforms when risk appetite<br />
is rising. Its safe haven status is mainly derived<br />
from comparatively lower foreign participation<br />
in its market, and hence, less foreign selling against<br />
a backdrop of risk aversion. The market will need<br />
support from local investors.<br />
Political tension in Malaysia has escalated following<br />
<strong>the</strong> loss of 2/3 majority by <strong>the</strong> ruling party. The<br />
current PM is under pressure from his own UMNO<br />
party to step down, while <strong>the</strong> opposition party<br />
claims that it has potentially enough defectors from<br />
UMNO to secure a majority in parliament. Regardless<br />
of <strong>the</strong> outcome, we believe <strong>the</strong> market will be<br />
nervous in <strong>the</strong> near term and investor sentiment<br />
will be muted until <strong>the</strong> situation is resolved.<br />
Local sentiment has also taken ano<strong>the</strong>r beating<br />
now that fuel price subsidy has been cut. We expect<br />
inflation and interest rates to rise in <strong>the</strong> near term.<br />
The economy grew at a robust rate of 7.1% y-o-y<br />
in Q108. Effects of pump priming from last year<br />
have boosted government spending and private<br />
consumption, but weaker growth was registered<br />
in investments. We expect a slowdown in investment<br />
spending as political uncertainty looms. Private<br />
consumption should also be dampened by higher<br />
fuel prices. We downgrade 2008 GDP growth to<br />
5.2% from 5.8%.<br />
Thailand: Downgrade to Underweight<br />
We downgrade Thailand to Underweight on <strong>the</strong><br />
back of falling consumer confidence.<br />
Thailand's 1Q GDP growth was below our expectations.<br />
Specifically private consumption and investment<br />
appears to have contracted on a quarterly basis.<br />
Domestic demand recovery were milder than we<br />
had expected. Our economist has revised down<br />
economic growth forecasts to 5.0% from 5.6% for<br />
2008, and 4.7% from 5.2% for 2009.<br />
Runaway inflation has also become less manageable<br />
in Thailand now. Full year inflation has been raised<br />
to 6.4%. Although this was caused mainly by food<br />
inflation, <strong>the</strong> government has allowed some local<br />
utilities such as transportation and utilities to raise<br />
prices. A few local banks had also raised lending<br />
rates recently. Our forecast calls for a 50bps hike<br />
in policy rates in 4Q08, and a rising interest rate<br />
environment is not conducive for P/E expansion,<br />
according to <strong>the</strong> statistical model by our Thai Research<br />
team.<br />
With higher inflation and a deteriorating political<br />
situation, we do not expect consumer confidence<br />
to continue to rise. Indeed, <strong>the</strong> latest set of consumer<br />
confidence data saw its first dip after 5 consecutive<br />
months of expansion since <strong>the</strong> elections in December.<br />
Our SET index target is now revised down to 840.<br />
Indonesia: Downgrade to underweight<br />
We also downgrade Indonesia to Underweight<br />
as inflationary pressure mounts and <strong>the</strong> pressure<br />
to cut fuel subsidy has become more intense. Although<br />
<strong>the</strong> market has largely priced in <strong>the</strong> recent fuel<br />
hike, we believe that <strong>the</strong> market might not have<br />
priced in for more fuel hikes, which is quite possible<br />
if oil price keeps rising. On <strong>the</strong> macro front, we<br />
believe inflation and interest rate will overshoot.<br />
We are selectively overweight in <strong>the</strong> coal and energy<br />
sector.<br />
China 'H': Maintain overweight<br />
We are maintaining our overweight position for<br />
China 'H' shares. China's flexible policy options<br />
in managing and balancing inflation and overheating<br />
risks are commendable in our view, and are less<br />
likely to produce unexpected shocks like runaway<br />
inflation or a severe downturn in <strong>the</strong> economy<br />
from aggressive tightening measures. In our assessment<br />
of country allocation, policy flexibility is a key<br />
criteria in times when Asian markets are facing<br />
inflationary and external weakness headwinds.<br />
We expect inflation to stay high in <strong>the</strong> near term,<br />
contributed mainly by food inflation which is due<br />
to agricultural supply and transportation disruption<br />
in <strong>the</strong> snowstorm and earthquake hit areas. O<strong>the</strong>r<br />
than that, a lot of domestic prices, primarily fuel<br />
prices and transportation charges remain largely<br />
subsidized and have been stable. Recent developments<br />
in o<strong>the</strong>r Asian countries when <strong>the</strong>y removed oil<br />
price subsidy is causing concern for China if it<br />
were to lift its subsidy program soon in view of<br />
<strong>the</strong> rising oil prices. While it is in one of <strong>the</strong> long<br />
term plans to liberalise prices of basic items we<br />
believe it will be delayed until inflationary pressures<br />
subside. Even so, <strong>the</strong> large reserves and budget<br />
surplus position should still be comfortable for<br />
China to do that, notwithstanding <strong>the</strong> huge post-<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Asian Equity <strong>Strategy</strong><br />
earth quake reconstruction costs. The restructuring<br />
of <strong>the</strong> telecom industry is a sign that its many<br />
de-regulation plans remain on track.<br />
Economic growth is broadly in line with government<br />
plans to maintain domestic demand growth. Retail<br />
sales and fixed asset investment growth remain<br />
strong, lending support to our domestic story.<br />
Manufacturing and exports are showing signs of<br />
slowdown as external demand slows, and administrative<br />
measures to remove export tax rebates impacted<br />
exporters, and lesser value-add industries that China<br />
wanted to phase out or needed consolidation.<br />
All in all, it suggests China should be moving<br />
towards a soft landing in terms of inflation and<br />
growth. We believe tightening measures should<br />
still be on <strong>the</strong> cards, such as interest rate hikes,<br />
increase in reserve requirement ratio and currency<br />
appreciation. But <strong>the</strong> pace will be slower than<br />
last year.<br />
The broad macro and policy trend is supportive<br />
of H-shares in our view. And we should be less<br />
concerned about tightening measures, but more<br />
on administrative measures targeted at selective<br />
sectors.<br />
Taiwan: Maintain Overweight<br />
We are maintaining our overweight position for<br />
Taiwan as domestic demand growth remains on<br />
track, confirmed by Q108 GDP data. Both domestic<br />
demand and net exports contributed 3.2ppt and<br />
2.9ppt, respectively, to overall growth of 6.1%<br />
y-o-y. Investments rebounded with 5.8% growth,<br />
and we expect a sustained recovery in investment<br />
in 2H08 on <strong>the</strong> back of supportive policy stimulus<br />
measures. Cross-straits talks has also been progressing<br />
smoothly.<br />
The recent lifting of <strong>the</strong> temporary control on<br />
oil price should not be taken out of context as<br />
<strong>the</strong> freeze in hikes was temporary. However, like<br />
many o<strong>the</strong>r Asian countries, inflation risks remain<br />
<strong>the</strong> key concern due to higher food and energy<br />
prices. With better growth prospects, we believe<br />
Taiwan has <strong>the</strong> capacity to raise rates by 37.5bps,<br />
which will only lift inflation-adjusted real rates<br />
back to <strong>the</strong> zero level. Monetary conditions should<br />
remain supportive of economic growth.<br />
The outperforming sectors in Taiwan were domestic<br />
demand sectors including banks, insurance and<br />
chemicals, while <strong>the</strong> electronics sector underperformed.<br />
We expect <strong>the</strong> domestic sector to outperform but<br />
a gradual recovery in <strong>the</strong> US should bode well<br />
for <strong>the</strong> electronics sector. Valuations in <strong>the</strong> electronics<br />
sector are at a discount to <strong>the</strong> market.<br />
Fig. 25: Table of performance and valuations for key<br />
sectors in Taiwan<br />
12m fwd P/E (x)<br />
12m fwd<br />
Performance (% )<br />
Avg Std. No. of DY Growth<br />
Sector 3m YTD Current PE Dev. SD. (% ) (% )<br />
Cons. Discre -1.4 0.6 15.0 11.7 2.3 1.4 2.1 7.5<br />
Cons. Staples -3.4 3.9 22.3 16.9 2.7 2.0 2.9 150.5<br />
Energy 0.8 -6.2 16.2 12.6 1.9 1.9 4.7 -14.8<br />
Financials -1.0 20.2 16.9 14.0 1.8 1.5 2.4 35.5<br />
Industrials -4.6 9.8 16.4 12.0 2.6 1.7 2.5 2.4<br />
IT 2.0 -8.5 13.1 15.7 4.7 -0.6 3.1 10.3<br />
Materials -3.1 0.3 11.3 11.0 2.4 0.1 5.2 1.2<br />
Telcos -4.3 13.3 14.3 11.1 2.0 1.6 2.3 13.6<br />
MSCI Taiwan 0.0 -1.4 13.5 13.9 2.9 -0.2 3.2 10.9<br />
NTD 0.2 6.9<br />
Source: IBES, Datastream, Bloomberg<br />
India (Maintain Underweight)<br />
We are maintaining our underweight stance for<br />
India as higher inflation has now become a very<br />
sensitive issue in Indian politics. While high inflation<br />
and calls for more policy tightening are <strong>the</strong> general<br />
phenomenon among Asian countries, <strong>the</strong> issue is<br />
complicated in India especially in light of upcoming<br />
elections in 2009.<br />
While runaway inflation is a main threat to overheating<br />
risks, <strong>the</strong> lack of flexible policy options will make<br />
it difficult for India to manage it wisely; this is<br />
evidenced in <strong>the</strong> policy mis-steps in <strong>the</strong> last few<br />
months, including <strong>the</strong> curb on foreign flows, volatile<br />
exchange rates, <strong>the</strong> hiking of interest rates of sorts,<br />
and <strong>the</strong> recent call for curbs on futures contracts.<br />
India's current account deficit is expected to widen<br />
as a weaker INR and higher import prices drive up<br />
import costs, and slower capital inflow and exports<br />
due to <strong>the</strong> weaker external environment reduce<br />
inflows. That should raise <strong>the</strong> red flag on its twin<br />
deficit position. India recently hiked fuel price by<br />
10% on average, hopefully to help reduce <strong>the</strong> deficit.<br />
But this means that inflation will run high in <strong>the</strong><br />
near term.<br />
With a stronger USD view now and a slowdown<br />
in capital inflow, we have turned cautious on <strong>the</strong><br />
INR. With so much uncertainty surrounding its monetary<br />
policies, we believe India equities are unlikely to<br />
outperform.<br />
Our economist believes that growth is still on track<br />
to reach 8.6% this year despite concerns about <strong>the</strong><br />
slower exports and industrial production in recent<br />
months. With that in mind, we may review India<br />
again after <strong>the</strong> threat of higher inflation and policy<br />
mistakes subside. For India to move in <strong>the</strong> right<br />
direction, we need to see confidence in policy directions<br />
without being compromised by political pressure.<br />
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Asian Equity <strong>Strategy</strong><br />
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Index targets, returns, key trades and risks<br />
We continue to look for a second half recovery<br />
in our index targets. US growth fears have subsided<br />
and short term volatility from runaway inflation<br />
are overshadowing our targeted returns towards<br />
<strong>the</strong> year end. India’s underweight needs to be<br />
taken into <strong>the</strong> context of its relatively high volatility;<br />
and Hong Kong our preference for Chinese stocks<br />
listed in Hong Kong . Key risks to our targets remain<br />
with <strong>the</strong> uncertainty in <strong>the</strong> US financial crisis and<br />
higher oil prices.<br />
We also present key trade ideas within each of<br />
<strong>the</strong> countries.<br />
Fig. 26: Index targets and key trades<br />
10-Jun %<br />
Current Target Target<br />
Level 2008 Return Key trade ideas<br />
Taiwan 8370 11000 31.4 Domestic demand recovery and cheap Tech valuations on US recovery<br />
H-share 12790 16000 25.1 Potential liberalisation of energy price to benefit petroleum and power sector<br />
Hong Kong 23376 28000 19.8 HK office sector<br />
India 14889 17500 17.5 Infrastructure<br />
Singapore 3033 3450 13.7 Offshore marine, property, hotels<br />
Korea 1774 1950 9.9 Fiscal stimulus for domestic recovery and exports sector<br />
Indonesia 2374 2600 9.5 Coal and plantations<br />
Thailand 792 840 6.1 Exports and defensive<br />
Malaysia 1231 1200 -2.5 Plantations, oil & gas<br />
Asia ex-Japan* 585 694 18.6<br />
Source: <strong>DBS</strong><br />
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<strong>Economics</strong>: China<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
CN: Re-thinking CNY<br />
appreciation<br />
• Evidence since Jul 21, 2005 suggests appreciation of <strong>the</strong> CNY has nei<strong>the</strong>r<br />
curbed <strong>the</strong> trade surplus nor tamed inflation. On <strong>the</strong> contrary, it has<br />
complicated <strong>the</strong> management of monetary policy. Appreciation has not<br />
only invited more hot capital inflows, but encouraged <strong>the</strong> growth of foreign<br />
currency loans<br />
• It is difficult to control lending without raising <strong>the</strong> cost of capital amidst<br />
an inflationary environment. Higher reserve requirement ratios and <strong>the</strong><br />
imposition of a credit quota have not controlled loan growth<br />
• In light of our upward revision on Fed funds rate and a 6.5% 2008 inflation<br />
forecast for China, we now expect benchmark lending rate hikes (of 27bps<br />
each) in 4Q08, 1Q09 and 2Q09. Should this happen, <strong>the</strong> pace of CNY<br />
appreciation must be slowed down sufficiently to around 3%-4% in 2009<br />
to reverse <strong>the</strong> ‘appreciation expectation factor’<br />
• While this may be unappealing to <strong>the</strong> market now, <strong>the</strong> risk of not changing<br />
<strong>the</strong> policy mix soon would inevitably lead to more aggressive rate hikes in<br />
<strong>the</strong> future<br />
CHINA<br />
Exports to <strong>the</strong> US<br />
and EU have been<br />
declining<br />
Negative income shock hurts exports more than a streng<strong>the</strong>ning CNY<br />
There is little evidence to suggest that <strong>the</strong> narrowing in China’s trade surplus so<br />
far this year is attributable <strong>the</strong> appreciation of <strong>the</strong> CNY. While a strong currency<br />
– on top of rising material and labor costs – have probably hurt exporters, most<br />
of <strong>the</strong> pain has probably come from <strong>the</strong> global slowdown.<br />
Exports to <strong>the</strong> US and EU<br />
have been declining (Chart<br />
Chart 1: China exports by destination<br />
1). The Asian financial crisis % YoY, 3mma<br />
70<br />
in 1998 and <strong>the</strong> bursting<br />
Asia EU USA<br />
of <strong>the</strong> ‘tech bubble’ in 2000/<br />
01 demonstrated that China’s<br />
exports suffer when its<br />
60<br />
50<br />
trading partners experience<br />
economic downturns. For 40<br />
instance, China’s export<br />
growth dropped to 0.5% 30<br />
in 1998 and 7.0% in 2001<br />
from 21.0% in 1997 and<br />
28.0% in 2000 – suggesting<br />
that a ‘negative income<br />
20<br />
10<br />
shock’ could be an effective 0<br />
tool to curb China’s trade Apr-00<br />
surplus.<br />
Apr-02 Apr-04 Apr-06 Apr-08<br />
Chris Leung • (852) 3668 5694 • chrisleung@dbs.com<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: China<br />
There is considerable academic evidence that <strong>the</strong> rising value of <strong>the</strong> CNY tends<br />
to reduce imports ra<strong>the</strong>r than to increase <strong>the</strong>m. Econometric estimation of China’s<br />
import elasticity always results in a ‘negative’ sign in studies from organizations<br />
like <strong>the</strong> World Bank, <strong>the</strong> IMF and <strong>the</strong> BIS. These studies reflect <strong>the</strong> dominance of<br />
‘processing imports’ included within China’s total imports (more than 50% in<br />
2007) as well as <strong>the</strong> ongoing vertical integration with <strong>the</strong> rest of Asia. So tradable<br />
goods produced by Asian economies complement China’s exports to a greater<br />
extent than substitutes. Put simply, if exports decline due to a streng<strong>the</strong>ning<br />
CNY, this will be counteracted by a corresponding reduction in imports.<br />
CNY appreciation<br />
tends to reduce<br />
imports, ra<strong>the</strong>r<br />
than to increase<br />
<strong>the</strong>m<br />
Does CNY appreciation slow inflation?<br />
The claim that inflation can be tamed through currency appreciation is increasingly<br />
unconvincing. Headline CPI averaged 8.0% YoY in 1Q08, up significantly from<br />
2.7% in 1Q07. Both inflation indices, CPI and PPI, have shown highs of 8.5%<br />
YoY and 8.1% YoY respectively in Apr 2008 despite <strong>the</strong> faster pace of currency<br />
growth (Chart 2). Indeed, evidence suggests little relationship between <strong>the</strong>m<br />
since Jul 21, 2005. NEER shows that CNY only grew 5% between Jul 2005 and Apr<br />
2008. In real effective exchange rate or REER terms <strong>the</strong> figure is around 9%<br />
(Chart 3).<br />
Chart 2: Inflation<br />
% YoY<br />
11<br />
CPI<br />
9<br />
7<br />
PPI<br />
5<br />
3<br />
1<br />
-1<br />
-3<br />
-5<br />
Latest: Apr08<br />
-7<br />
Oct-99 Feb-01 Jun-02 Oct-03 Feb-05 Jun-06 Oct-07<br />
Chart 3: CNY REER<br />
Indexed 2000=100<br />
125<br />
120<br />
115<br />
110<br />
109<br />
105<br />
100<br />
95<br />
90<br />
85<br />
80<br />
75<br />
1990 1993 1996 1999 2002 2005 2008<br />
Food and energy prices are still <strong>the</strong> wild cards<br />
It remains unclear, however, whe<strong>the</strong>r inflationary pressures will result in <strong>the</strong> CPI<br />
falling below 5% YoY in 2H08 from 8% in 1H08. At this time, many economists<br />
predict that prices will start to stabilize in 2H08, basing <strong>the</strong>ir arguments on <strong>the</strong><br />
‘high-base’ effect carried over from 2H07. However, <strong>the</strong> Sichuan earthquake<br />
tragedy may put upward pressure on food prices over <strong>the</strong> next few months as<br />
pork, rice, wheat and corn account for 10.4%, 7.3%, 4.2% and 3.5% respectively<br />
of <strong>the</strong> nation’s gross output.<br />
Even if consumer inflation stabilizes, <strong>the</strong> currency can’t do much until food<br />
supplies return to normal. A stronger CNY will not help to lower food prices<br />
when shortages are due to domestic factors. CPI-based inflation in 2H08 looks<br />
set to range within 6.0%-7.0% YoY compared with 8% in 1H08. And inflation<br />
for <strong>the</strong> whole of 2008 could be at least 6% YoY - much higher than <strong>the</strong> official<br />
projection of 4.8%.<br />
Even if CPI<br />
stabilizes,<br />
normalization of<br />
food supplies will<br />
take more credit<br />
than <strong>the</strong> currency<br />
factor<br />
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<strong>Economics</strong>: China<br />
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Meanwhile, oil prices have risen<br />
to USD135/barrel. Crude oil<br />
prices in China are nearly three<br />
times more than in 1981 (even<br />
after adjusting for inflation)<br />
and demand continues to<br />
increase (Chart 4).<br />
While a streng<strong>the</strong>ning CNY<br />
will help to alleviate <strong>the</strong> rising<br />
costs of oil imports, demand<br />
will remain strong if domestic<br />
prices continue to be distorted<br />
by state subsidies. This, will,<br />
in turn, prompt <strong>the</strong> government<br />
to import more, sustaining oil<br />
demand and prices, which <strong>the</strong>n<br />
leads to calls for a stronger<br />
currency again. A classic vicious<br />
circle.<br />
Chart 4: Growing trade deficit of oil<br />
USD bn<br />
-<br />
(5)<br />
(10)<br />
(15)<br />
(20)<br />
(25)<br />
(30)<br />
(35)<br />
Trade deficit of crude petroleum oil (LHS)<br />
Brent (RHS)<br />
% YoY<br />
70<br />
-10<br />
-20<br />
1Q05 4Q05 3Q06 2Q07 1Q08<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
Persistent currency<br />
appreciation led to<br />
capital inflows and<br />
encouraged foreign<br />
currency borrowing<br />
Interest rate policy is crippled by <strong>the</strong> streng<strong>the</strong>ning CNY<br />
Persistent currency appreciation has enticed ‘hot capital’ to flow into China.<br />
Foreign currency reserves jumped from USD403bn in 2003 to USD1.53trn in 2007,<br />
representing a near four-fold increase in four years. Yet <strong>the</strong> reserve requirement<br />
ratio (RRR) only began to increase more frequently in 2007 (Table 1). Meanwhile<br />
in 1Q08, foreign reserves shot up by USD159bn to USD1.68trn, exceeding <strong>the</strong><br />
sum of both trade surplus and actual utilized foreign direct investment by a<br />
whopping USD85bn.<br />
As a result, <strong>the</strong> persistent upward pressure on domestic money supply prompts<br />
<strong>the</strong> People’s Bank of China (PBOC) to continue raising <strong>the</strong> reserve requirement<br />
Table 1: China's monetary measures<br />
Announced: 1Y lending rate 1Y deposit rate Reserve requirement<br />
8-Jun-08 -- -- -- -- +1.0% 17.5%<br />
12-May-08 -- -- -- -- +0.5% 16.5%<br />
16-Apr-08 -- -- -- -- +0.5% 16.0%<br />
18-Mar-08 -- -- -- -- +0.5% 15.5%<br />
16-Jan-08 -- -- -- -- +0.5% 15.0%<br />
20-Dec-07 +27 bps 7.47% +27 bps 4.14% -- --<br />
08-Dec-07 -- -- -- -- +1.0% 14.5%<br />
10-Nov-07 -- -- -- -- +0.5% 13.5%<br />
13-Oct-07 -- -- -- -- +0.5% 13.0%<br />
14-Sep-07 +27 bps 7.29% +27 bps 3.87% -- --<br />
06-Sep-07 -- -- -- -- +0.5% 12.5%<br />
21-Aug-07 +27 bps 7.02% +27 bps 3.60% -- --<br />
30-Jul-07 -- -- -- -- +0.5% 12.0%<br />
20-Jul-07 +27 bps 6.84% +27 bps 3.33% -- --<br />
18-May-07 +18 bps 6.57% +27 bps 3.06% +0.5% 11.5%<br />
29-Apr-07 -- -- -- -- +0.5% 11.0%<br />
05-Apr-07 -- -- -- -- +0.5% 10.5%<br />
17-Mar-07 +27bps 6.39% +27 bps 2.79% -- --<br />
16-Feb-07 -- -- -- -- +0.5% 10.0%<br />
05-Jan-07 -- -- -- -- +0.5% 9.5%<br />
03-Nov-06 -- -- -- -- +0.5% 9.0%<br />
18-Aug-06 +27 bps 6.12% +27 bps 2.52% -- --<br />
21-Jul-06 -- -- -- -- +0.5% 8.5%<br />
27-Apr-06 +27 bps 5.85% +27 bps 2.25% -- --<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: China<br />
ratio (RRR) to mop-up excessive liquidity, despite <strong>the</strong> tragedy in Sichuan. O<strong>the</strong>r<br />
than those banks operating in <strong>the</strong> vicinity of <strong>the</strong> epicenter, all o<strong>the</strong>r banks throughout<br />
<strong>the</strong> country will be adopting a new RRR of 17.5%, starting on Jun 25. Looking<br />
ahead, it is likely that <strong>the</strong> RRR will increase fur<strong>the</strong>r to 19% in 3Q08. Even so,<br />
elevating <strong>the</strong> RRR without raising <strong>the</strong> cost of capital in tandem, does not seem<br />
to be enough to bring down inflationary pressure in this cycle.<br />
Real deposit rates have been falling with each increase in inflation. So have<br />
lending rates in real terms. Yet, <strong>the</strong> authorities fear that raising interest rates<br />
will encourage even more ‘hot capital’ inflows that will lead to more currency<br />
appreciation pressures.<br />
To control lending without raising <strong>the</strong> cost of capital, fur<strong>the</strong>r administrative<br />
tools would have to be introduced to augment past measures. New CNY lending<br />
for <strong>the</strong> first four months has already amounted to CNY1.8trn, already hitting<br />
around 50% of <strong>the</strong> CNY3.6trn target for 2008, <strong>the</strong> amount by which new loans<br />
increased in 2007 (Chart 5). There was also a sharp increase in foreign currency<br />
loans in 1Q08 (Chart 6) to take advantage of a streng<strong>the</strong>ning CNY. Fixed-asset<br />
investment did not really decelerate in any meaningful way, at least when compared<br />
with 2007.<br />
Although many argue that raising interest rates cannot tame inflation, a negative<br />
real rate environment would certainly help sustain aggregate demand. If nei<strong>the</strong>r<br />
exchange rates nor interest rates can solve <strong>the</strong> problem, <strong>the</strong> best solution is to<br />
To control lending<br />
without raising <strong>the</strong><br />
cost of capital,<br />
fur<strong>the</strong>r<br />
administrative<br />
tools would have to<br />
be introduced<br />
Chart 5: Financial institution: new yuan lending<br />
CNY, bn<br />
4,000<br />
3,500<br />
3,000<br />
2,500<br />
2,000<br />
1,500<br />
1,000<br />
500<br />
Chart 6: Financial institution foreign currency loans<br />
% YoY<br />
65<br />
55<br />
45<br />
35<br />
25<br />
15<br />
5<br />
0<br />
2000 2002 2004 2006 Apr08 ytd<br />
-5<br />
Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
wait for food supplies to normalize without raising rates. This is a route that<br />
will nei<strong>the</strong>r upset <strong>the</strong> state banks nor drag down domestic demand. The downside<br />
of this is that no one can be certain that food and energy prices will come down<br />
substantially in <strong>the</strong> next six months. If <strong>the</strong>se prices remain at <strong>the</strong>se high levels,<br />
inflation expectations will be driven up even fur<strong>the</strong>r, subsequently increasing<br />
inflationary pressures.<br />
Fed’s rate hike cycle in 4Q08- an opportunity for <strong>the</strong> PBOC to resume rate increases<br />
The PBOC may well be waiting for <strong>the</strong> Fed to kick-off <strong>the</strong> rate hike cycle. Our<br />
US economist expects <strong>the</strong> Fed funds target rate to increase by 50bps in 4Q08,<br />
followed by a total of 75bps lift in 1Q09. This will be <strong>the</strong> best time for China to<br />
play catch-up in hiking interest rates. If <strong>the</strong> annual inflation rate for 2008 indeed<br />
exceeds 6%, compared with 1Y lending and deposit rates currently standing at<br />
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<strong>Economics</strong>: China<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
7.47% and 4.14% respectively, it is not unreasonable to project that hikes on<br />
domestic rates will resume. We now look for hikes (27bps each) in 4Q08, 1Q09<br />
and 2Q09.<br />
If <strong>the</strong> priority is to tame inflation, raising interest rates to slow domestic demand<br />
should be a more effective measure, <strong>the</strong> proven route taken in 1992-94. However,<br />
CNY appreciation must be slowed sufficiently to around 3%-4% in 2009 to reverse<br />
<strong>the</strong> ‘expectation factor’.<br />
While this may be unappealing to both policymakers and investors right now,<br />
<strong>the</strong> risk is that by not changing <strong>the</strong> policy mix sooner ra<strong>the</strong>r than later, <strong>the</strong><br />
inevitable hike may need to be greater than if rates are increased now. Indeed,<br />
weakening domestic demand may yet prove to be <strong>the</strong> ultimate solution to <strong>the</strong><br />
ongoing inflationary problems in China.<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: China<br />
China Economic Indicators<br />
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real GDP growth 11.9 10.0 9.0 10.5 10.3 10.1 9.5 9.2 9.0<br />
GDP by expenditure: current price<br />
Private consumption 14.9 15.8 13.5 17.4 17.2 14.4 14.0 13.5 12.9<br />
Government consumption 19.1 19.5 16.5 21.0 21.0 18.0 18.0 17.5 17.0<br />
Fixed asset investmt growth (ytd) 25.8 23.0 20.0 25.9 23.0 23.0 20.0 18.0 17.5<br />
Retail sales - consumer goods 16.8 18.4 16.3 20.6 17.5 18.0 17.5 16.0 15.5<br />
External<br />
Exports (USD bn) 1,218 1,474 1,769 306 359 398 410 401 423<br />
- % YoY 26 21 20 22 22 20 21 18 18<br />
Imports (USD bn) 956 1,203 1,516 265 287 325 326 327 356<br />
- % YoY 21 26 26 28 26 26 24 24 24<br />
Trade balance (USD bn) 262 269 252 41 71 73 84 74 67<br />
Current account balance (USD bn) 372 450 520 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP 11 11 11 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Foreign reserves (USD bn, eop) 1,528 1,882 2,195 n.a. n.a. n.a. n.a. n.a. n.a.<br />
FDI inflow (USD bn, YTD) 83 85.4 60 27.4 24 20 14 15 28<br />
Inflation & money<br />
CPI inflation 4.8 6.5 4.5 8.0 8.0 5.0 5.0 4.5 4.0<br />
RPI inflation 3.8 5.8 3.5 7.4 7.0 4.8 4.0 3.5 3.0<br />
M1 growth 21.0 17.7 17.0 18.3 18.0 17.5 17.0 17.0 16.5<br />
M2 growth 16.7 15.8 15.0 16.3 16.2 15.8 15.0 15.0 14.5<br />
O<strong>the</strong>r<br />
Nominal GDP (USD bn) 3,280 4,232 4828 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Fiscal balance (% of GDP) 1.5 2.0 2.2 n.a. n.a. n.a. n.a. n.a. n.a.<br />
* % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
CN – nominal exchange rate<br />
CNY per USD<br />
7.80<br />
7.70<br />
7.60<br />
7.50<br />
7.40<br />
7.30<br />
7.20<br />
7.10<br />
7.00<br />
6.90<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
CN – policy rate<br />
%, 1-yr lending rate<br />
7.5<br />
7.0<br />
6.5<br />
6.0<br />
5.5<br />
5.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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HK: Rates bottom, good for<br />
inflation<br />
• First quarter GDP data surprised on <strong>the</strong> upside at 7.1% YoY, maintaining<br />
<strong>the</strong> pace in 4Q07. The external sector, a drag on growth last year, was more<br />
resilient than expected despite a weak US<br />
• Going forward, we continue to expect consumption to grow above trend,<br />
but less than in 2007<br />
• Our revised Fed forecasts imply that Hong Kong interest rates would be<br />
heading up as soon as 4Q08. We would be looking at a nominal prime<br />
lending rate of about 5.75%-6.00% in 4Q08 or real rate of about a mild<br />
1.5%-1.7%<br />
• This will be positive for Hong Kong in light of current high inflation<br />
Domestic economy<br />
remained strong...<br />
...while <strong>the</strong><br />
external sector<br />
was more resilient<br />
than expected<br />
1Q GDP surprised at 7.1% YoY<br />
First quarter GDP data surprised on <strong>the</strong> upside at 7.1% YoY, maintaining <strong>the</strong><br />
pace in 4Q07 (6.9% YoY) (Chart 1). On a sequential basis, GDP growth rose 7.2%<br />
(QoQ, saar). Domestic demand held up decently. Investment edged higher to<br />
8.9% YoY, helped by <strong>the</strong> rebound in expenditure on building and construction<br />
of <strong>the</strong> public sector, which jumped 16.3% YoY. Private consumption growth<br />
registered a healthy 7.9% YoY, but is clearly cooling off from <strong>the</strong> peak in <strong>the</strong><br />
latter half of 2007.<br />
The external sector, a drag on headline growth last year, was stronger than<br />
expected despite <strong>the</strong> weak US. Goods exports rose 10.5% YoY in 1Q08 on <strong>the</strong><br />
back of sustained demand from Europe, Asia and o<strong>the</strong>r emerging economies<br />
(Chart 2). In fact, year-to-date (Jan-Apr 2008) merchandise exports growth rose<br />
11.5% YoY, stronger than <strong>the</strong> same period last year, leading us to adjust our<br />
HONG KONG<br />
Chart 1: Real GDP growth<br />
%-pt contribution to GDP growth<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
PCE<br />
GCE<br />
-4 Investment<br />
Changes in Stocks<br />
Net Exports<br />
GDP, YoY<br />
-6<br />
4Q05 3Q06 2Q07 1Q08<br />
Chart 2: Exports by country<br />
%-pt contribution to export growth, YoY 3mma<br />
China Europe ASEAN USA O<strong>the</strong>rs<br />
13<br />
11<br />
9<br />
7<br />
5<br />
3<br />
1<br />
-2<br />
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08<br />
Connie Tse • (852) 3668 5695 • connietsecy@dbs.com<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: Hong Kong<br />
full-year exports forecast slightly higher to 8%. These figures are in favor of our<br />
view that <strong>the</strong>re is an ongoing structural change in <strong>the</strong> world’s final demand,<br />
that is, Asian demand is driving global growth nearly as much as <strong>the</strong> US and<br />
may soon surpass it.<br />
Softer, but still healthy, domestic-demand led growth<br />
Going forward, we continue to expect domestic consumption to maintain abovetrend<br />
growth, but as mentioned before, it is unlikely to be as spectacular as<br />
2007. Investor sentiment was clearly dampened by <strong>the</strong> turmoil in global markets.<br />
Money supply and loan growth retreated back from <strong>the</strong> peak in 4Q07 to slower,<br />
but more sustainable levels (Chart 3). Meanwhile, <strong>the</strong> development of <strong>the</strong> labor<br />
market was in-line with our earlier projections. In <strong>the</strong> first four months of this<br />
year, unemployment (s.a.) stalled at around <strong>the</strong> 3.3%-3.4% levels (Chart 4), indicating<br />
that <strong>the</strong> labor market has remained tight, but fur<strong>the</strong>r improvement seems to be<br />
ra<strong>the</strong>r limited this year. Employers are more cautious in hiring amidst <strong>the</strong> global<br />
uncertainties. Accordingly, payroll growth might start to stagnate in <strong>the</strong> third<br />
quarter and lag behind increases in inflation. But this will unlikely last in <strong>the</strong><br />
longer-term, assuming inflation will show signs of leveling off in 4Q08.<br />
Chart 3: Money supply and loan growth<br />
% YoY, 3mma % YoY, 3mma<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
M3 (LHS)<br />
HKD Loans (LHS)<br />
HSI (RHS)<br />
-10<br />
-20<br />
-5<br />
-30<br />
Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
70<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
Chart 4: Labor market<br />
% YoY %<br />
Employment (LHS)<br />
7<br />
2<br />
Nominal Payroll (LHS)<br />
6<br />
Unemployment Rate (RHS)<br />
3<br />
5<br />
4<br />
4<br />
3<br />
2<br />
1<br />
0<br />
7<br />
-1<br />
8<br />
-2<br />
Latest: Apr08<br />
-3<br />
9<br />
Jun-01 Jul-02 Aug-03 Sep-04 Oct-05 Nov-06 Dec-07<br />
5<br />
6<br />
Inflation to accelerate in 3Q08…<br />
Consumer inflation has surprised<br />
on <strong>the</strong> upside, mainly because<br />
of higher import prices. Accordingly,<br />
we have adjusted our 2008<br />
consumer inflation forecast higher<br />
to 5.0% YoY from 3.8% earlier.<br />
As of April, CPI inflation edged<br />
up to 5.4% YoY (Chart 5). Like<br />
<strong>the</strong> rest of <strong>the</strong> world, Hong Kong<br />
was not spared from <strong>the</strong> surge<br />
in global oil nor food prices, and<br />
<strong>the</strong> weak Hong Kong dollar made<br />
imports even more expensive.<br />
The prices of both Brent and WTI<br />
crude oil have climbed above<br />
USD130/bbl. Not only do car<br />
Chart 5: CPI<br />
%-pts contribution to CPI YoY<br />
6.5<br />
Food Non Food<br />
5.5<br />
4.5<br />
3.5<br />
2.5<br />
1.5<br />
0.5<br />
Latest: Apr08<br />
-0.5<br />
May-06 Oct-06 Mar-07 Aug-07 Jan-08<br />
CPI inflation has<br />
surprised on <strong>the</strong><br />
upside owing to<br />
higher import<br />
prices<br />
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<strong>Economics</strong>: Hong Kong<br />
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owners have to spend increasingly more on fuel, <strong>the</strong> persistently high energy<br />
prices have also pressured public transport companies to call for fare hikes.<br />
After giving <strong>the</strong> go-ahead for an increase in taxi fares, <strong>the</strong> government has<br />
approved five of six bus fare rise applications, followed by increases in ferry<br />
fares (effective July).<br />
Meanwhile, food prices have continued to rise alongside that of China’s (Chart<br />
6), accelerating at an 11% (YoY, 3mma) pace by April. The snowstorm disaster in<br />
China earlier this year made it difficult for food prices to come down, and <strong>the</strong><br />
latest Sichuan earthquake is likely to prolong inflation expectations. Sichuan<br />
has been known to be one of China’s significant agricultural areas, specifically<br />
grain and pork. Under <strong>the</strong>se circumstances, it may take a longer-than-expected<br />
period, probably ano<strong>the</strong>r quarter or two, for imported food prices from China<br />
to normalize - absent fur<strong>the</strong>r unforeseen and negative surprises.<br />
But if we take a closer look at <strong>the</strong> breakdown, inflation does not seem to be<br />
exclusively a food and fuel price story. Housing rentals, which explain nearly<br />
one-third of inflation, have been rising steadily too (Chart 7). Negative real<br />
mortgage rates have helped keep property prices afloat. Even with government’s<br />
property tax (rates) waiver, housing inflation reached 5.5% YoY by Apr08.<br />
Chart 6: Food prices<br />
% YoY % YoY<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
CN: CPI: Food (LHS)<br />
HK CPI: Food (RHS)<br />
Latest: Apr08<br />
-5<br />
-4<br />
Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
Chart 7: Residential property<br />
1999=100<br />
140<br />
130<br />
120<br />
110<br />
100<br />
90<br />
80<br />
70<br />
Property Price Index<br />
Property Rental Index<br />
60<br />
Latest: Apr08<br />
50<br />
Jun-01 Sep-02 Dec-03 Mar-05 Jun-06 Sep-07<br />
... before leveling off on higher interest rates and a stronger currency<br />
As Hong Kong runs a currency peg with <strong>the</strong> USD, <strong>the</strong> government has to resort<br />
to fiscal measures when it comes to tackling inflation. The fact that monetary<br />
policies are indirectly tied to that of <strong>the</strong> US has been a concern to many in this<br />
inflationary cycle, as easing in Fed funds rate would increase inflationary risks<br />
in Hong Kong. In <strong>the</strong> past eight months, Hong Kong’s interest rate movements<br />
and its inflation cycle have gone out of synch. Hong Kong’s prime lending rate<br />
dropped by a total of 250bps alongside <strong>the</strong> Fed’s rate cut cycle, while CPI inflation<br />
on <strong>the</strong> o<strong>the</strong>r hand, more than tripled (Chart 8).<br />
But what if <strong>the</strong> latest developments in <strong>the</strong> US suggest that <strong>the</strong> Fed might take a<br />
brea<strong>the</strong>r in June? Our US Economist’s view is that consumption will hold up and<br />
<strong>the</strong> slowest growth in <strong>the</strong> US lies in <strong>the</strong> past, not up ahead. In fact, our Fed<br />
forecast has been revised. We now look for 50bps of Fed hikes by year-end and<br />
ano<strong>the</strong>r 75bps of hikes in 1Q09. This implies that Hong Kong interest rates<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: Hong Kong<br />
would be heading up as soon<br />
as 4Q08. Hence, Hong Kong’s<br />
real prime lending rate would<br />
return to <strong>the</strong> positive territory.<br />
We are looking at a nominal<br />
prime lending rate of 5.75%-<br />
6.00% in 4Q08 or a mild real<br />
rate of about 1.5%-1.7%.<br />
Good news for <strong>the</strong> economy?<br />
Probably not to those who<br />
are still paying off <strong>the</strong>ir home<br />
mortgages (most mortgages<br />
are set with reference to <strong>the</strong><br />
prime rate), but on <strong>the</strong> inflation<br />
front, this could be a positive<br />
development as interest rate<br />
movements would be more<br />
in synch with <strong>the</strong> inflation<br />
cycle (Chart 8).<br />
Chart 8: Inflation vs prime lending rate<br />
% YoY<br />
10<br />
5<br />
0<br />
-5<br />
CPI (LHS)<br />
Prime lending rate (RHS)<br />
%, pa<br />
13<br />
out of<br />
sync 12<br />
-10<br />
1Q90 1Q96 1Q02 1Q08<br />
Assuming <strong>the</strong> US economy is out of <strong>the</strong> woods (no recession at least), and China<br />
is able to engineer an orderly and gradual slowdown - which is our base case<br />
scenario - <strong>the</strong>re is less to worry about on <strong>the</strong> economic growth front. By <strong>the</strong>n, in<br />
light of inflation, higher interest rate levels would be seen as a catching up<br />
process. The economy will likely to have withstood <strong>the</strong> projected interest rate<br />
hikes assuming real GDP growth of at least 4% YoY.<br />
Import prices in Hong Kong may soften following Fed’s rate hike cycle because<br />
firstly, on reduced inflationary pressure from China, a major import destination.<br />
When Fed rates go up, <strong>the</strong> People’s Bank of China (PBOC) will likely utilize this<br />
opportunity to catch up with domestic interest rate rises, hence, taming inflation<br />
(refer to China: Rethinking <strong>the</strong> strategy of CNY appreciation). Previously, <strong>the</strong><br />
Fed’s 225bps of rate cuts have made it ‘harder’ for <strong>the</strong> PBOC to deal with inflation<br />
by raising local rates because of <strong>the</strong> widening rate gap between <strong>the</strong> USD and<br />
CNY. Officials were concerned that rate hikes would aggravate speculative inflows<br />
into China, fur<strong>the</strong>r fanning inflation in <strong>the</strong> process.<br />
Secondly, by <strong>the</strong>n, <strong>the</strong> Hong<br />
Chart 9: Real Effective Exchange Rate<br />
Kong dollar will unlikely be<br />
as weak as it was in <strong>the</strong> first Jan 2000=100<br />
half of <strong>the</strong> year, which should<br />
84<br />
also help ease imported inflation.<br />
Earlier this year, <strong>the</strong> weakness 82<br />
of <strong>the</strong> USD, and hence HKD,<br />
continued to fuel imported 80<br />
inflation. In real effective<br />
USD/HKD<br />
78<br />
exchange rate terms, <strong>the</strong> HKD<br />
fell by some 4% in 1Q08, 76<br />
compared to last year’s 5.6%<br />
depreciation for <strong>the</strong> whole of 74<br />
2007 (Chart 9). According to<br />
72<br />
research by <strong>the</strong> Hong Kong<br />
Latest: Mar08<br />
Monetary Authority, <strong>the</strong> 70<br />
estimated contribution of Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07<br />
exchange rate depreciation was<br />
0.6 ppts in 2007, or about 20%<br />
of <strong>the</strong> underlying inflation in that year.<br />
As such, <strong>the</strong> potential bottoming of Fed rates in 2Q08 followed by Fed rate<br />
hikes in 4Q08 may put a halt to a fur<strong>the</strong>r weakening of <strong>the</strong> USD, and hence, <strong>the</strong><br />
11<br />
10<br />
9<br />
8<br />
7<br />
6<br />
5<br />
4<br />
Higher interest<br />
rates should help<br />
lower inflation<br />
Import prices to<br />
soften<br />
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<strong>Economics</strong>: Hong Kong<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
HKD. We expect <strong>the</strong> HKD to move with <strong>the</strong> USD’s rebound against both EUR &<br />
JPY (refer to Currencies).<br />
Of course, this outlook is not without risks. At <strong>the</strong> end of <strong>the</strong> day, <strong>the</strong> degree of<br />
inflationary pressures can be alleviated will hinge greatly on <strong>the</strong> trend of global<br />
prices. There is only so much <strong>the</strong> exchange rate can do, especially if global oil/<br />
commodities prices continue to soar at this pace.<br />
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<strong>Economics</strong>: Hong Kong<br />
Hong Kong Economic Indicators<br />
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP growth (06P) 6.4 5.2 4.7 7.1 4.8 4.8 4.3 4.7 5.8<br />
Private consumption 7.8 5.8 4.6 7.9 6.2 5.4 3.8 5.5 3.7<br />
Government consumption 2.3 2.4 2.5 0.3 1.8 3.6 4.1 3.8 3.7<br />
Gross fixed capital formation 4.2 5.7 4.7 8.9 2.3 4.6 7.3 6.3 8.6<br />
Net exports (HKD bn) 160 170 181 41 25 58 46 39 28<br />
External (nominal)<br />
Merch exports (USD bn) 345 372 402 83 91 99 100 89 97<br />
- % YoY 9 8 8 10 8 7 7 7 7<br />
Merch imports (USD bn) 368 402 436 90 100 105 109 97 108<br />
- % YoY 10 9 8 12 9 8 8 8 8<br />
Trade balance (USD bn) -23 -29 -34 -7 -9 -6 -9 -8 -11<br />
Current acct balance (USD bn) 28 25 28 - - - - - -<br />
% of GDP 13.5 11.0 11.3 - - - - - -<br />
Foreign reserves (USD bn, eop) 153 165 175 - - - - - -<br />
Inflation<br />
CPI inflation 2.0 5.0 4.0 4.6 5.6 5.4 4.3 4.2 4.1<br />
O<strong>the</strong>r<br />
Nominal GDP (USD bn) 207 228 248 - - - - -<br />
Unemployment rate (%, sa, eop) 4.4 3.4 3.4 3.4 3.4 3.5 3.4 3.4 3.4<br />
* % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
^ Balance on goods and services<br />
HK – nominal exchange rate<br />
HKD per USD<br />
7.84<br />
HK – policy rate<br />
%, base rate<br />
8.0<br />
7.82<br />
7.80<br />
6.0<br />
7.78<br />
7.76<br />
4.0<br />
7.74<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
2.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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<strong>Economics</strong>: Taiwan<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
TW: Staying on track<br />
• We have lifted <strong>the</strong> 2008 inflation forecast to 3.4% from 2.2%, reflecting<br />
<strong>the</strong> surge in crude oil prices and <strong>the</strong> new government’s deregulation of<br />
domestic oil prices<br />
• We maintain our 2008 GDP forecast at an above-consensus 5.0%. Although<br />
inflation would hurt consumption, investment recovery is expected to<br />
be sustained on <strong>the</strong> back of improving investor sentiment, warmer crossstrait<br />
economic ties and <strong>the</strong> new government’s promotion of infrastructure<br />
construction<br />
• With inflation risks outweighing growth risks, we project <strong>the</strong> central<br />
bank to extend its rate hike cycle to <strong>the</strong> year-end. Hikes of 12.5bps per<br />
quarter are expected at each of <strong>the</strong> next three MPC meetings in June,<br />
September and December<br />
TAIWAN<br />
Strong exports and<br />
defensive financial<br />
markets are in line<br />
with expectation<br />
1H08 Recap<br />
The economy moved smoothly through <strong>the</strong> first half of <strong>the</strong> year in spite of US<br />
weakness and global financial market turmoil. In line with our expectations,<br />
exports managed double-digit growth during Jan-May (averaged 17.5% YoY),<br />
helped by still-robust demand from China and o<strong>the</strong>r emerging markets. Meanwhile,<br />
despite generally weakening capital flows since <strong>the</strong> US subprime crisis, Taiwan<br />
experienced rising foreign capital inflows and <strong>the</strong> repatriation of domestic capital<br />
outflows in 1H08. Investor optimism has been reinforced following <strong>the</strong> opposition<br />
KMT party’s winning of <strong>the</strong> presidential election in March, which laid <strong>the</strong> ground<br />
for a stable political climate, closer cross-straits ties and <strong>the</strong>refore brighter economic<br />
outlook. Foreign exchange reserves jumped as much as USD 19.8bn in Jan-May,<br />
in sharp contrast with <strong>the</strong> USD 4.2bn increase recorded during <strong>the</strong> whole year of<br />
2007. The Taiwan dollar appreciated an impressive 6% year-to-date, and <strong>the</strong><br />
TAIEX also well outperformed <strong>the</strong> regional stock markets.<br />
The GDP report showed that<br />
<strong>the</strong> economy expanded by<br />
a decent and balanced 6.1%<br />
YoY in 1Q08 (Chart 1). Net<br />
exports and domestic demand<br />
contributed almost equally<br />
to <strong>the</strong> overall growth (2.9ppt<br />
and 3.2ppt respectively).<br />
Exports of goods and services<br />
rose a steady 11.4%, not very<br />
different from 11%-13%<br />
registered in 3Q-4Q07. Private<br />
consumption also remained<br />
stable at 2.0%, close to its<br />
trend rate over <strong>the</strong> past eight<br />
quarters. Fixed investment<br />
showed notable resilience,<br />
bouncing back to 5.8% from<br />
<strong>the</strong> temporary setback in 4Q07.<br />
Chart 1: Solid growth<br />
% YoY<br />
12<br />
8<br />
4<br />
0<br />
-4<br />
-8<br />
PCE<br />
GFCF<br />
GDP<br />
GCE<br />
Net Exports<br />
1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08<br />
Ma Tie Ying • (65) 6878 2408 • matieying@dbs.com<br />
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<strong>Economics</strong>: Taiwan<br />
Inflation becomes a near-term risk<br />
The unexpected development in <strong>the</strong> first half mainly<br />
is higher inflation. Headline and core CPI inflation<br />
both remained sticky so far this year, around 3.8%<br />
YoY and 3.1% respectively (Chart 2). Although import<br />
prices have eased somewhat thanks to <strong>the</strong> appreciation<br />
in <strong>the</strong> Taiwan dollar, <strong>the</strong> upside risks have risen<br />
again due to <strong>the</strong> fur<strong>the</strong>r surge in global crude oil<br />
prices. Moreover, <strong>the</strong> new government has removed<br />
<strong>the</strong> temporary controls on domestic oil prices imposed<br />
by <strong>the</strong> former administration over <strong>the</strong> past six months.<br />
A hike ranging from 12-16% on gasoline and diesel<br />
fuel prices was announced on May 27, while <strong>the</strong><br />
future domestic oil prices will be adjusted monthly<br />
based on <strong>the</strong> international prices benchmark. Also,<br />
a 21% hike on electricity prices has been scheduled<br />
to follow suit in July. Considering that oil and electricity<br />
account for 3.3% and 2.2% respectively of <strong>the</strong> CPI<br />
basket, and <strong>the</strong> hikes would spill over onto o<strong>the</strong>r<br />
oil-linked prices such as transportation costs, we<br />
have lifted 2008 inflation forecast to 3.4% from<br />
2.2% projected one quarter ago.<br />
Chart 2: Sticky inflation<br />
% YoY<br />
6<br />
5<br />
CPI Core CPI<br />
4<br />
3<br />
2<br />
1<br />
0<br />
-1<br />
-2<br />
-3<br />
May-00 May-02 May-04 May-06 May-08<br />
The cost-push inflation is expected to develop into a near-term threat to <strong>the</strong><br />
nascent recovery in domestic demand. We think <strong>the</strong> adverse impact would largely<br />
fall on consumers especially wage-earners as purchasing power is squeezed. The<br />
rise in inflation has dragged real income growth into <strong>the</strong> negative territory ever<br />
since 4Q07, and should continue doing so in <strong>the</strong> remainder of this year (Chart<br />
3). Largely ascribed to <strong>the</strong> deterioration in inflation expectations, consumer<br />
confidence has weakened again in May following a temporary rebound during<br />
<strong>the</strong> election period (Chart 4). We think <strong>the</strong> elevated inflationary pressure would<br />
offset <strong>the</strong> positive factors such as better post-election economic climate and <strong>the</strong><br />
dissipating fallout of credit and cash card crisis, which would hence delay <strong>the</strong><br />
recovery in private consumption to 2009 (ra<strong>the</strong>r than 2H08 as we previously<br />
expected).<br />
Higher-thanexpected<br />
inflation<br />
would delay<br />
consumption<br />
recovery<br />
Chart 3: Real income growth falling to negative<br />
% YoY, 3mma<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
-1<br />
Average Monthly Regular<br />
Earnings (inflation adjusted)<br />
Chart 4: Consumer confidence hurt by inflation<br />
120<br />
100<br />
80<br />
60<br />
40<br />
-2<br />
-3<br />
20<br />
Consumer confidence<br />
Level of Commodity Prices<br />
-4<br />
Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08<br />
0<br />
May-02 May-04 May-06 May-08<br />
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<strong>Economics</strong>: Taiwan<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Investment<br />
recovery is likely to<br />
sustain<br />
The negotiations<br />
with China on<br />
tourism and<br />
transportation<br />
issues are<br />
progressed<br />
smoothly<br />
Still, growth drivers on <strong>the</strong> way<br />
Despite <strong>the</strong> downside risks caused by inflation, we maintain our 2008 GDP forecast<br />
unchanged at 5.0%, as we think <strong>the</strong> new government’s policy stimulus will<br />
bode well for a sustained investment recovery in 2H08.<br />
The blueprint planned by <strong>the</strong> new government centers on streng<strong>the</strong>ning economic<br />
ties with China and promoting infrastructure investment in <strong>the</strong> island. The new<br />
president Ma Ying-jeou has pledged to establish weekend direct charter flights<br />
and allow <strong>the</strong> direct entry of tourists from China starting from July. As we pointed<br />
out previously, <strong>the</strong>se two are relatively mature proposals reflecting improving<br />
cross-strait economic relations, as <strong>the</strong> negotiations on related technical details<br />
have already moved forward over <strong>the</strong> last two years. Since <strong>the</strong> ending of presidential<br />
elections in March, interactions between Taiwan’s new leaders and China’s top<br />
government officials have been warm. The bilateral dialogue between <strong>the</strong> semiofficial<br />
Straits Exchange Foundation (Taiwan) and <strong>the</strong> Association for Relations<br />
across <strong>the</strong> Taiwan Strait (China), which has been suspended for almost a decade,<br />
is now scheduled to resume on June 11-14. The weekend charter flights and<br />
tourism issues will be <strong>the</strong> focus of this meeting, and a formal official agreement<br />
is likely to be formulated successfully according to newswire reports. We stay<br />
optimistic in this regard. Tourism revenue alone (brought by 3000 China tourists<br />
per day) is estimated to add annual GDP growth by 0.4ppt (Chart 5). The positive<br />
effect on investment, employment and income growth in related industries<br />
would be even more significant.<br />
Chart 5: Tourism revenue to grow<br />
%<br />
2.0<br />
1.5<br />
1.0<br />
0.5<br />
Visitors Arrivals (RHS)<br />
Tourism revenue/GDP<br />
mn,<br />
persons<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
Chart 6: Saving-investment gap widening<br />
%<br />
31<br />
29<br />
27<br />
25<br />
23<br />
21<br />
19<br />
17<br />
Saving / GDP<br />
Investment / GDP<br />
0.0<br />
1991 1994 1997 2000 2003 2006 2009F<br />
0<br />
15<br />
1997 1999 2001 2003 2005 2007<br />
Infrastructure<br />
investment could<br />
be funded through<br />
<strong>the</strong> private sector<br />
The new president also promised to promote <strong>the</strong> “I-Taiwan 12 infrastructure<br />
projects” over <strong>the</strong> next eight years, which amount to a total of TWD 4trn (3% of<br />
GDP per year). We concur that investment is a much-needed driver for Taiwan’s<br />
economy. The external-internal imbalance has widened for years - trade surplus<br />
stayed persistently strong, but investment has been massively relocated overseas<br />
due to sluggish confidence on domestic politics and <strong>the</strong> long-term trend of<br />
globalization. As a result, <strong>the</strong> saving-to-investment gap has widened sharply,<br />
from 2.8% (of GDP) in 2000 to 9.5% in 2007 (Chart 6). It is true that <strong>the</strong> infrastructure<br />
investment plan targeted by <strong>the</strong> government appears somewhat ambitious in<br />
light of its still-weak fiscal position (-0.2% of GDP in 2007) and rising fiscal<br />
burden resulting from fuel subsidies this year. Never<strong>the</strong>less, we think <strong>the</strong> official<br />
proposal of raising 1/3 funds from <strong>the</strong> private sector (via <strong>the</strong> BOT model) is<br />
feasible. Moreover, <strong>the</strong> leading role played by <strong>the</strong> government in increasing<br />
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<strong>Economics</strong>: Taiwan<br />
investment should be valued, in terms of helping restore investor confidence in<br />
<strong>the</strong> island.<br />
Taking into account <strong>the</strong> above positive factors, we expect <strong>the</strong> revival in investment<br />
especially private investment to sustain into 2H08 and 2009. Combined with <strong>the</strong><br />
downside risks on private consumption, <strong>the</strong> overall GDP growth is likely to slow<br />
moderately towards 4% in 2Q-3Q08 and <strong>the</strong>n bounce back to 5% from 4Q08.<br />
Monetary policy: <strong>the</strong> CBC takes a long-term perspective<br />
Taiwan’s central bank (CBC) maintained monetary tightening over <strong>the</strong> past three<br />
quarters, in contrast to <strong>the</strong> aggressive Fed rate cuts and <strong>the</strong> wait-and-see approach<br />
adopted by most Asian central banks. We think <strong>the</strong> CBC is taking a long-term<br />
perspective. At <strong>the</strong> 1Q monetary policy committee meeting in March, <strong>the</strong> CBC<br />
remained comfortable with growth outlook this year, saying that <strong>the</strong> 4.3% growth<br />
projected by <strong>the</strong> government think-tank National Statistics is “close to <strong>the</strong> 10-<br />
year growth average”. By contrast, <strong>the</strong> CBC cited inflationary pressures as <strong>the</strong><br />
key reason for rate hikes, which is no surprise given that <strong>the</strong> current inflation<br />
rates of 3-4% are far above <strong>the</strong> 10-year average of less than 1%.<br />
Compared to one quarter ago, <strong>the</strong> National Statistics has upgraded <strong>the</strong>ir 2008<br />
growth forecast to 4.8% from 4.3% after <strong>the</strong> release of 1Q GDP report, and<br />
lifted inflation forecast to 3.3% from 2.0%. Clearly, this means <strong>the</strong> official view<br />
is that inflation risks have fur<strong>the</strong>r risen and growth risks are lower than <strong>the</strong>y<br />
previously feared. Consequently, chances are high that <strong>the</strong> CBC will place inflation<br />
as <strong>the</strong> top policy concern and extend <strong>the</strong> rate hike cycle. Apart from <strong>the</strong> 12.5bps<br />
rate hike projected for June, we have added two more 12.5bps hikes into our<br />
policy forecast for 2H08, which will lift <strong>the</strong> benchmark rediscount rate to 3.875%<br />
by <strong>the</strong> year-end.<br />
The short-term money market rates, deposit rates and new loan rates are currently<br />
below inflation and also policy rate, at merely 2-3% (Chart 7). Even after fur<strong>the</strong>r<br />
hikes of 37.5bps, real rates would only get closer to <strong>the</strong> zero level. Moreover,<br />
capital inflows is unlikely to fade substantially going forward. Taiwan should<br />
remain attractive to foreign investors and domestic investors staying offshore<br />
as <strong>the</strong>y bet on increasing integration with <strong>the</strong> mainland over <strong>the</strong> medium term.<br />
Consequently, market interest rates should continue to edge upward at a more<br />
gradual and moderate pace than policy rate in <strong>the</strong> coming quarters. In sum,<br />
liquidity conditions should remain supportive to economic growth, despite <strong>the</strong><br />
possibility of more rate hikes.<br />
The official<br />
forecasts of<br />
inflation and GDP<br />
growth have both<br />
been lifted<br />
Expect more rate<br />
hikes ahead, but<br />
liquidity conditions<br />
should remain<br />
supportive to<br />
economic growth<br />
Chart 7: Real rates still negative<br />
% YoY, % pa<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
CPI<br />
Rediscount Rate<br />
New Loans Rate<br />
Deposit Rate: 1 Yr<br />
May-98 May-00 May-02 May-04 May-06 May-08<br />
Chart 8: External position streng<strong>the</strong>ning<br />
USD bn<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
Current Account<br />
Financial Account<br />
Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08<br />
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<strong>Economics</strong>: Taiwan<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Taiwan Economic Indicators<br />
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP growth 5.7 5.0 5.4 6.1 4.0 4.5 5.3 4.8 5.5<br />
Private consumption 2.6 2.2 3.2 2.0 2.0 1.7 3.0 3.0 3.2<br />
Government consumption 0.8 1.9 2.0 1.7 1.8 2.0 2.2 2.0 2.0<br />
Gross fixed capital formation 2.4 5.8 6.1 5.8 3.0 5.1 9.2 5.2 7.4<br />
Net exports (TWDbn, 01P) 2040 2357 2677 561 545 540 712 625 614<br />
Exports (% YoY) 8.8 8.6 8.7 11.4 10.2 7.2 6.0 6.5 7.5<br />
Imports (% YoY) 3.7 6.5 7.1 9.0 8.0 5.0 4.4 4.9 6.0<br />
External (nominal)<br />
Merch exports (USDbn) 247 282 321 64 70 72 75 72 78<br />
- % chg 10.1 14.1 14.0 17.6 17.3 12.0 10.7 11.8 12.0<br />
Merch imports (USDbn) 219 257 292 61 65 66 65 67 72<br />
- % chg 8.2 17.2 13.6 26.0 17.4 14.5 12.4 10.1 11.7<br />
Trade balance (USD bn) 27 30 36 3 5 6 10 5 6<br />
Current account balance (USD bn) 32 31 37 - - - - - -<br />
% of GDP 8.3 7.2 8.3 - - - - - -<br />
Foreign reserves (USD bn, eop) 270 301 319 - - - - - -<br />
Inflation<br />
CPI inflation 1.8 3.4 2.4 3.6 3.9 3.9 2.1 3.4 2.6<br />
O<strong>the</strong>r<br />
Nominal GDP (USDbn) 383 428 445 - - - - - -<br />
Unemployment rate (%, sa) 3.9 3.9 3.8 3.9 3.9 3.9 3.9 3.8 3.8<br />
* % growth, year-on-year, unless o<strong>the</strong>rwise specified<br />
TW – nominal exchange rate<br />
TWD per USD<br />
33.5<br />
33.0<br />
32.5<br />
32.0<br />
31.5<br />
31.0<br />
30.5<br />
30.0<br />
29.5<br />
6/10/2007 9/9/2007 12/9/2007 3/9/2008 6/8/2008<br />
TW – policy rate<br />
%, rediscount rate<br />
5.0<br />
4.0<br />
3.0<br />
2.0<br />
1.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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<strong>Economics</strong>: Korea<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
KR: Surviving<br />
• Despite strong exports, domestic demand growth has fallen due to higher<br />
energy prices, financial market volatility and political troubles<br />
• But <strong>the</strong>re is room for both fiscal and monetary stimulus to help <strong>the</strong> economy<br />
survive <strong>the</strong> current difficulties<br />
• We have lowered our 2008 GDP forecast to 4.6% from 4.8% last quarter,<br />
but maintain our 2009 forecast at 5.0% for now<br />
1Q08 Recap<br />
GDP growth slowed to a sub-par 3.3% (QoQ saar) in 1Q08, significantly down<br />
from <strong>the</strong> robust 6%-7% rates of <strong>the</strong> previous three quarters (Chart 1). Exports<br />
preformed well in line with our expectations, but domestic demand deteriorated<br />
unexpectedly. Private consumption growth fell to 1.8%, <strong>the</strong> slowest pace since<br />
<strong>the</strong> 2004 credit card crisis. Fixed investment declined 3.4% QoQ saar, marking<br />
<strong>the</strong> sharpest contraction over 13 quarters.<br />
Chart 1: Growth slowed on domestic demand<br />
% QoQ saar<br />
18<br />
14<br />
10<br />
6<br />
2<br />
-2<br />
-6<br />
GDP PCE GFCF<br />
-10<br />
1Q03 4Q03 3Q04 2Q05 1Q06 4Q06 3Q07<br />
Chart 2: Labour market deteriorating<br />
%YoY,sa<br />
2.5<br />
2<br />
1.5<br />
1<br />
0.5<br />
0<br />
%, sa<br />
Employment<br />
4.5<br />
Unemployment Rate (RHS)<br />
May-04 May-05 May-06 May-07 May-08<br />
4<br />
3.5<br />
3<br />
2.5<br />
The labor market also lost steam. Employment growth dropped to below trend<br />
levels earlier this year while <strong>the</strong> jobless rate has started to rise since March<br />
(Chart 2).<br />
KOREA<br />
Still exposed to external risks<br />
The markets (including us) have been focusing on assessing <strong>the</strong> impact of exports<br />
slowdown on Korean economy as a result of US subprime crisis. There are two<br />
o<strong>the</strong>r external risks - oil prices and financial market volatility – which have been<br />
underestimated previously. Global crude oil prices continuously broke record<br />
over <strong>the</strong> past few months and now stand at all-time highs of USD130/barrel. The<br />
adverse effects from oil prices on economic growth emerged fast in Korea, as it<br />
Ma Tie Ying • (65) 6878 2408 • matieying@dbs.com<br />
88
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: Korea<br />
is one of <strong>the</strong> few countries in <strong>the</strong> region adopting floating oil pricing mechanism,<br />
while <strong>the</strong> oil-intensive industry is also important for Korea compared to its<br />
counterparts such as Hong Kong and Singapore. High oil prices squeeze consumer<br />
purchasing power and corporate profit margins. From a macro perspective, <strong>the</strong><br />
surge in oil prices has resulted in <strong>the</strong> worsening of terms-of-trade.<br />
Meanwhile, concerns over external debt have also triggered some volatility in<br />
financial markets amid global financial turmoil. Short-term external debt has<br />
risen since 2006 and reached 16% of GDP in 2007, double <strong>the</strong> steady 8% pace<br />
seen in 2000-2005 (Chart 3). Importantly, foreign reserves remain sufficient to<br />
cover such a debt level, substantially different from <strong>the</strong> situation ahead of Asian<br />
financial crisis. More importantly, a large portion of today’s external debt is<br />
caused by <strong>the</strong> banks’ hedging of long-USD positions following <strong>the</strong> exporters’<br />
USD forward selling, which is also different from decade ago when companies<br />
heavily borrowed from overseas to fund domestic investment expansion. We<br />
do not think <strong>the</strong> problem of external debt is alarming, but markets are pricing<br />
in higher risk premium. Short-term money market rates have risen, boosting<br />
bank lending rates by an additional 20bps since <strong>the</strong> last BOK rate hike in Aug07<br />
(Chart 4). The Korean won depreciated sharply since March and accumulated a<br />
loss of 10% (against USD) by beginning-June. Higher borrowing costs and weaker<br />
currency should both have played a role in weighing down domestic demand.<br />
Oil prices hit<br />
domestic demand<br />
quickly<br />
External debt is not<br />
high but triggered<br />
financial volatility<br />
Chart 3: External debt rising<br />
%<br />
20<br />
15<br />
10<br />
5<br />
Short-term External Debt / GDP<br />
Short-term External Debt /<br />
Foreign Reserve (RHS)<br />
%<br />
350<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
Chart 4: Lending rates elevated<br />
%<br />
10<br />
8<br />
6<br />
4<br />
2<br />
Policy Rate<br />
Lending Rate: New Loans<br />
CD Rate: 3m<br />
0<br />
1995 1997 1999 2001 2003 2005 2007<br />
0<br />
0<br />
May-00 May-02 May-04 May-06 May-08<br />
And, some internal noises<br />
Since <strong>the</strong> government agreed in April to lift bans on imports of US beef, <strong>the</strong>re<br />
has been widespread criticism due to public worries over <strong>the</strong> beef safety. Opponents<br />
have held large-scale street protests demanding that <strong>the</strong> US deal be scrapped or<br />
renegotiated.<br />
Combined with <strong>the</strong> oil prices pain and financial volatility, public sentiment has<br />
been hit fur<strong>the</strong>r. Consumer confidence which started to weaken since March<br />
dropped sharply in May, touching its lowest level ever since 2004 (Chart 5).<br />
The intensifying protests finally triggered political storm. The Prime Minister<br />
and <strong>the</strong> entire Cabinet offered <strong>the</strong>ir resignations on June 10, holding <strong>the</strong>mselves<br />
responsible for <strong>the</strong> dispute. It is reported that <strong>the</strong> president will accept <strong>the</strong><br />
resignations selectively and a cabinet reshuffle is likely to occur soon next week.<br />
The beef deal<br />
caused protests and<br />
a cabinet reshuffle,<br />
fur<strong>the</strong>r hitting<br />
public sentiment<br />
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<strong>Economics</strong>: Korea<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
A solid fiscal<br />
position provides<br />
scope for increasing<br />
expenditure and<br />
lowering taxes<br />
Policy rates have<br />
returned to 2000<br />
levels; real rates are<br />
positive<br />
Fiscal stimulus to counter slowdown<br />
In face of <strong>the</strong>se difficulties,<br />
<strong>the</strong> Ministry of <strong>Strategy</strong> and<br />
sa<br />
Finance (MOSF) has taken<br />
110<br />
a string of fiscal stimulus<br />
measures in recent months.<br />
These include tax rebates and<br />
100<br />
subsidies to relieve <strong>the</strong> impact<br />
of high oil prices on lowincome<br />
consumers and selfowned<br />
businesses (KRW10.5 90<br />
trn, 1.2% of GDP), and budget<br />
reallocation to help growth<br />
and job creation (KRW2.5trn, 80<br />
0.3% of GDP). Also, it is<br />
reported that <strong>the</strong> government<br />
is seeking a supplementary 70<br />
budget and planning to bring<br />
forward corporate tax cuts<br />
into this year (5ppt over <strong>the</strong><br />
next five years as previously scheduled).<br />
Indeed, Korea has registered consecutive years of fiscal surplus since 2000, and<br />
last year’s surplus has reached a record high of 3.8% of GDP. Solid fiscal position<br />
should have provided scope for <strong>the</strong> government to increase spending and lower<br />
tax burden this year. We think <strong>the</strong> general direction of expansionary fiscal policy<br />
is justified and could be maintained ahead, despite some uncertainties on <strong>the</strong><br />
implementation timeliness caused by <strong>the</strong> upcoming cabinet reshuffle.<br />
Monetary stimulus: room also remains<br />
The Bank of Korea (BOK) has kept <strong>the</strong> policy rate unchanged at 5.0% so far this<br />
year, balancing concerns of slower growth with higher inflation. Minutes of <strong>the</strong><br />
April MPC meeting showed that 2 of 6 members voted for a 25bps rate cut,<br />
saying that “a preemptive rate cut could keep <strong>the</strong> economy from slowing given<br />
inflation is expected to moderate ahead”. Thoughts of rate cuts have been deterred<br />
by <strong>the</strong> continued acceleration in inflation, which broke 4% since April. In <strong>the</strong><br />
absence of a sign showing inflation is peaking, <strong>the</strong> BOK would have to cautiously<br />
stay on hold for a few more<br />
months, in order to avoid<br />
intensifying public inflation<br />
expectations.<br />
Never<strong>the</strong>less, we think room<br />
remains for <strong>the</strong> BOK to ease<br />
monetary policy and support<br />
economic growth, if<br />
necessary. The BOK’s rate<br />
hike campaign over <strong>the</strong> past<br />
three years has already taken<br />
policy rates back to normal.<br />
With deposit and lending<br />
rates now at 5.5%-7.0%,<br />
Korea’s rates remain positive<br />
in real terms, in contrast<br />
with <strong>the</strong> negative real rates<br />
seen in most Asian economies.<br />
Indeed, <strong>the</strong> BOK has been<br />
Chart 6: The BOK moving ahead of <strong>the</strong> curve<br />
% pa, % YoY<br />
10<br />
Chart 5: Sentiment weakening<br />
8<br />
6<br />
4<br />
2<br />
Consumer Expectation<br />
BSI<br />
May-03 May-04 May-05 May-06 May-07 May-08<br />
Policy Rate<br />
CPI<br />
Lending Rate: Newly Extended<br />
Deposit Rate: Newly Extended<br />
0<br />
May-00 May-02 May-04 May-06 May-08<br />
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<strong>Economics</strong>: Korea<br />
moving ahead of <strong>the</strong> curve (Chart 6). Last year for instance, <strong>the</strong>y hiked rates as<br />
early as 3Q07 when growth had risen above potential for merely one quarter,<br />
and inflation stayed fairly stable at <strong>the</strong> lower-end of policy target (2.5-3.5%).<br />
Thanks to <strong>the</strong> well-controlled consumer prices last year (2.5%), <strong>the</strong> inflation<br />
average from Jan07 to May08 is 3.0%, only at <strong>the</strong> middle point of <strong>the</strong> policy<br />
target (which is set for inflation average in 2007-2009). Indeed, a forward-looking<br />
central bank should understand that cost-push inflation will unlikely sustain<br />
very long as growth will also be dragged. The BOK is likely to make rate decision<br />
based on growth trend, more than <strong>the</strong> lagging inflation data.<br />
The BOK is likely to<br />
focus more on<br />
growth than on<br />
inflation<br />
Meanwhile, recent years of strong capital inflows, currency intervention and<br />
monetary sterilization have left <strong>the</strong> BOK with large amount of foreign reserves<br />
(27% of GDP, vs. 6% in 1996) and monetary stabilization bonds (17% of GDP, vs.<br />
4% in 1996) (Chart 7). It appears that <strong>the</strong> BOK has injected liquidity into financial<br />
system ever since 4Q07 to tame <strong>the</strong> rises in market interest rates, as evidenced<br />
by <strong>the</strong> gradual declines in <strong>the</strong> amount of outstanding MSBs (Chart 8). Also, <strong>the</strong><br />
Chart 7: The BOK has <strong>the</strong> capacity of intervention<br />
%<br />
35<br />
Foreign Reserve / GDP<br />
30<br />
MSBs / GDP<br />
25<br />
20<br />
15<br />
Chart 8: The BOK discharging liquidity<br />
won trn<br />
200<br />
150<br />
100<br />
10<br />
5<br />
50<br />
Outstanding MSBs<br />
0<br />
1991 1993 1995 1997 1999 2001 2003 2005 2007<br />
0<br />
Apr-98 Apr-00 Apr-02 Apr-04 Apr-06 Apr-08<br />
BOK has <strong>the</strong> capacity to intervene <strong>the</strong> FX market and prevent <strong>the</strong> won from<br />
excessive depreciation, if required. In fact, <strong>the</strong> won’s sharp drop in March-May<br />
was partly fuelled by <strong>the</strong> government’s earlier enthusiasm of using a weaker<br />
won to stimulate exports. Since <strong>the</strong> BOK heavily intervened in late-May and<br />
<strong>the</strong> government reduced <strong>the</strong> talks on <strong>the</strong> benefits of a weaker won, <strong>the</strong> won/<br />
dollar rate has stabilized.<br />
Overall, we think Korea still has sufficient fiscal and monetary instruments to<br />
help it survive <strong>the</strong> current difficulties. Growth is likely to remain low this quarter<br />
and <strong>the</strong> next given <strong>the</strong> prevailing external and internal headwinds. The timing<br />
of a recovery would largely hinge on <strong>the</strong> implementation of fiscal stimulus,<br />
and BOK policies. We downgraded 2008 GDP growth forecast to 4.6% from<br />
4.8%, but maintain 2009 forecast at an above-potential 5.0% for now.<br />
The timing of<br />
growth recovery<br />
hinges on <strong>the</strong><br />
implementation of<br />
fiscal stimulus<br />
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Korea Economic Indicators<br />
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP (00P) 5.0 4.6 5.0 5.7 4.8 4.3 3.8 4.3 4.8<br />
Private consumption 4.5 2.7 3.2 3.4 2.9 2.2 2.2 2.5 3.0<br />
Government consumption 5.8 2.7 3.1 4.0 2.6 2.9 1.5 2.5 2.8<br />
Gross fixed capital formation 4.0 1.1 3.9 0.3 0.4 1.9 1.8 3.5 4.2<br />
Net exports (KRW trn) 87 108 124 25 26 30 28 30 30<br />
Exports 12.1 13.5 12.6 11.7 16.2 16.3 10.0 14.6 10.3<br />
Imports 11.9 11.1 12.1 9.2 13.8 13.9 7.8 13.0 8.9<br />
External (nominal)<br />
Merch exports (USD bn) 371 448 524 99 116 113 119 118 133<br />
- % YoY 14.1 20.7 16.8 17.4 24.8 25.3 15.7 18.2 14.8<br />
Merch imports (USD bn) 357 443 510 105 113 109 116 117 127<br />
- % YoY 15.3 24.2 15.0 28.2 28.1 26.4 15.7 10.7 12.3<br />
Trade balance (USD bn) 15 5 14 -6 3 5 3 1 7<br />
Current account balance (USD bn) 6 -3 5 - - - - - -<br />
% of GDP 0.6 -0.3 0.5 - - - - - -<br />
Foreign reserves (USD bn, eop) 262 265 276 - - - - - -<br />
Inflation<br />
CPI inflation 2.5 4.6 3.0 3.8 4.8 5.5 4.3 3.3 2.4<br />
O<strong>the</strong>r<br />
Nominal GDP (USD bn) 970 942 959 - - - - - -<br />
Unemployment rate (%, sa) 3.2 3.2 3.1 3.0 3.2 3.2 3.2 3.1 3.1<br />
* % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
KR – nominal exchange<br />
KRW per USD<br />
1,060<br />
1,040<br />
1,020<br />
1,000<br />
980<br />
960<br />
940<br />
920<br />
900<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
KR – policy rate<br />
%, target rate<br />
5.5<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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<strong>Economics</strong>: India<br />
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IN: Rising growth, inflation<br />
• We forecast above-consensus GDP growth of 8.6% in FY08 and expect<br />
ano<strong>the</strong>r 25bps increase in rates by Sep08<br />
• Core inflation could remain above <strong>the</strong> RBI’s comfort level for <strong>the</strong> next 12<br />
months. It would be a mistake to brush aside inflation readings as “supply<br />
side” or “not domestically led” or merely “basis effects”. The oil price rise is<br />
symptomatic of India’s (and emerging markets’) strong demand<br />
• Consumption, credit and inflation slowed in Jun07-Sep07 due to <strong>the</strong> sudden<br />
increase in interest rates in <strong>the</strong> first half of 2007. All three have recovered<br />
sharply since <strong>the</strong>n. The market focus on (declining) year-on-year growth<br />
hides this pattern<br />
• Overall, as long as fuel subsidy shields consumers from higher prices,<br />
stability risks outweigh growth risks as fiscal and current account balances<br />
widen sharply. Ano<strong>the</strong>r risk is that, due to <strong>the</strong> central role played by <strong>the</strong><br />
software sector in job creation, India may be more dependent on <strong>the</strong> US<br />
than trade-to-GDP ratios suggest<br />
We expect aboveconsensus<br />
GDP<br />
growth of 8.6% in<br />
FY2008 and<br />
ano<strong>the</strong>r 25bp<br />
increase in rates<br />
1Q08 GDP review and summary outlook<br />
1Q08 GDP grew by 8.8% (YoY) Chart 1: GDP contributions - select components<br />
much higher than consensus forecast<br />
% YoY<br />
of 8.1%. This meant that fiscal 14<br />
2007 (ends Mar08) growth reached<br />
9%. The break down of <strong>the</strong> 1Q08 12<br />
GDP shows that consumption 10<br />
spending held up (8.3%) while<br />
investment spending faltered 8<br />
(10.7%). We think <strong>the</strong> latter is a<br />
logical business response to worries<br />
about US recession. We think <strong>the</strong>se<br />
concerns should decline going<br />
6<br />
4<br />
2<br />
forward. Also, <strong>the</strong> economic outlook<br />
0<br />
would be more worrisome if <strong>the</strong><br />
Dec-05 Dec-06 Dec-07<br />
GDP break down revealed that<br />
consumption had slowed and<br />
investment had held up. This is<br />
because ultimately investment<br />
Consumption<br />
Government<br />
Investment<br />
GDP<br />
outlook depends on consumption outlook. On this count, <strong>the</strong> 1Q08 GDP was<br />
positive (Chart 1). As such, we continue to expect domestic demand to support<br />
economic growth of 8.6% in FY2008 despite higher prices and rates.<br />
INDIA<br />
Domestic demand supportive but indirect US links via job market a risk<br />
We believe <strong>the</strong> labour market remains supportive of growth in consumption<br />
spending. Indeed, this is why consumption has stayed remarkably resilient in<br />
<strong>the</strong> last three quarters despite sudden rates hikes in <strong>the</strong> first half of 2007 (Chart<br />
2). However, in India, consumer and even business sentiment are quite tied to<br />
<strong>the</strong> US-dependent software sector. The outlook is, <strong>the</strong>refore, not without uncertainties.<br />
Ramya Suryanarayanan • (65) 6878 5282 • ramya@dbs.com<br />
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<strong>Economics</strong>: India<br />
Chart 2: Consumption spending accelerates<br />
Levels, s/a, INR bn, 2qma<br />
5,000<br />
4,500<br />
4,000<br />
3,500<br />
3,000<br />
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08<br />
On <strong>the</strong> surface, India’s net exports to GDP (including services such as software) is<br />
only 18% of GDP. This is very low compared to <strong>the</strong> very open East Asian economies<br />
where export shares are typically thrice as large. However, <strong>the</strong> software sector<br />
has been key to India’s growth story especially with respect to job creation and<br />
through that on consumption. Unfortunately, this sector is very dependent on<br />
<strong>the</strong> US with almost 60% of exports headed to <strong>the</strong> US. Also, <strong>the</strong>re are no hard<br />
data available on <strong>the</strong> labour market to accurately assess <strong>the</strong> relative importance<br />
of this sector for job creation.<br />
Anecdotal evidence<br />
suggests <strong>the</strong> labour<br />
market remains<br />
healthy<br />
For now, anecdotal evidence and surveys by human resource companies suggests<br />
<strong>the</strong> labour market remains healthy even as sentiment is hurt by worries over<br />
possibility of a US recession. In fact, most major software companies cite <strong>the</strong><br />
rupee (in <strong>the</strong> past) and rising domestic wages as a bigger concern than <strong>the</strong><br />
exposure to US. Also, at <strong>the</strong> margin, software export growth is coming from<br />
non-US destinations as corporates have been trying to diversify away from <strong>the</strong><br />
US. As such, most signs suggest consumption would hold up as long as US growth<br />
doesn’t fall off <strong>the</strong> cliff.<br />
As consumption demand continues to hold up, we expect a recovery in investment<br />
spending too from <strong>the</strong> weaker 1Q08 (Chart 3). We think <strong>the</strong>re is enough scope<br />
for investment spending growth of 15% in India. Manufacturing PMI surveys<br />
also point to a very strong manufacturing sector (Chart 4, next page)<br />
Chart 3: Investment spending falters<br />
Levels, s/a, INR bn, 2qma<br />
3,000<br />
2,500<br />
2,000<br />
1,500<br />
1,000<br />
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08<br />
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Chart 4: Mfg PMI points to decent growth in industrial production ahead<br />
% QoQ, saar, 2qma<br />
25<br />
IPI<br />
PMI: Output<br />
index, sa; 50= no chg<br />
70<br />
20<br />
15<br />
65<br />
10<br />
60<br />
5<br />
0<br />
Latest: Mar08 (IPI), Apr08 (PMI)<br />
-5<br />
Jan-06 Jan-07 Jan-08<br />
55<br />
50<br />
The economy<br />
slowed in Jun07-<br />
Sep07 and has<br />
recovered nicely<br />
since <strong>the</strong>n (see<br />
Charts 5 - 9 )<br />
Year-on-year numbers to rise rapidly ahead, as month-on-month already has<br />
There is a concern that growth has begun to slow in <strong>the</strong> last six months due to<br />
declining year-on-year industrial production growth numbers. Such concerns<br />
have been delaying rate hikes to control inflation. However, growth has not<br />
begun to slow now, it slowed in Jun07-Sep07 and has rebounded in <strong>the</strong> last six<br />
months. To a great extent, focus on year-on-year numbers have distorted <strong>the</strong><br />
interpretations of India’s economic data recently. To understand this, we go<br />
back to what happened in 2007 and how that has affected growth patterns.<br />
The RBI’s postponement of much needed rate hikes in 2006 (quarter-on-quarter<br />
inflation was rising rapidly <strong>the</strong>n following fuel price hikes) merely led to even<br />
higher year-on-year inflation in first quarter of 2007 and application of sudden<br />
brakes by <strong>the</strong> RBI in <strong>the</strong> first half 2007. Interest rates had to go up suddenly and<br />
sharply as <strong>the</strong> increase came later than it should have. This sudden 200-400bp<br />
increase in borrowing costs led to a temporary soft patch in consumption demand<br />
that extended from Jun07-Sep07. Consumer demand and credit have rebounded<br />
sharply since <strong>the</strong>n broadly in line with our expectations.<br />
We expected consumption to recover as we believed that rates were not at a<br />
restrictive level per se but that <strong>the</strong> speed of <strong>the</strong> increase in rates simply had to<br />
temporarily hurt demand. Hence, our expectation was for growth to recover<br />
Chart 5: Mfg goods production<br />
Levels, SA, 3mma<br />
300<br />
290<br />
280<br />
270<br />
260<br />
250<br />
240<br />
230<br />
Interest rate<br />
"shock" phase<br />
Latest: Mar08<br />
Jan-06 Jan-07 Jan-08<br />
Chart 6: Consumer goods production<br />
Levels, SA, 3mma<br />
320<br />
300<br />
280<br />
260<br />
240<br />
Interest rate<br />
"shock" phase<br />
Latest: Mar08<br />
Jan-06 Jan-07 Jan-08<br />
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Chart 7: Credit growth - heading towards 25%<br />
% YoY, 3mma & % MoM, saar (6mma)<br />
30<br />
25<br />
20<br />
Chart 8: Broad money<br />
% YoY, 3mma<br />
25<br />
20<br />
RBI intervention kept money<br />
growth high even in <strong>the</strong><br />
interest rate "shock" phase<br />
15<br />
10<br />
5<br />
RBI comfort level (~20%)<br />
Credit % m/m saar<br />
(6mma)<br />
Credit % YoY (3mma)<br />
Interest<br />
rate<br />
"shock"<br />
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
15<br />
10<br />
RBI comfort level<br />
(~17%)<br />
M3 % YoY (3mma)<br />
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
from this interest rate “shock” in <strong>the</strong> latter half of 2007 and it has. This recovery<br />
is evident in <strong>the</strong> month-on-month growth trends not only in <strong>the</strong> industrial output<br />
data (Charts 5 & 6) but also in <strong>the</strong> credit data (Chart 7). In fact, credit growth is<br />
heading towards 25% growth rate again. Money growth at 22% (YoY) is also<br />
much higher than RBI comfort level of 17% (Chart 8) though <strong>the</strong>re was no<br />
period of material moderation in money growth. This is because large capital<br />
flows and RBI intervention kept money growth strong in <strong>the</strong> interest rate “shock”<br />
phase also. This is why we believe worries about growth slowdown at a macro<br />
level are presently misplaced.<br />
Inflation to continue to rise<br />
With growth rebounding nicely from <strong>the</strong> interest rate<br />
“shock” and worries about a US recession expected to<br />
ease, inflation risks are mounting. WPI has already breached<br />
8% (YoY) as on week-ended May17. In fact, inflation<br />
may already be in double digits as suggested by large<br />
revisions to back dated data (week-ended Mar15 WPI<br />
was revised up by 200bps). In any case, WPI is underestimated<br />
due to oil subsidies. As such, we think manufacturing<br />
WPI, a measure of core inflation, risks staying above<br />
5% RBI comfort level in <strong>the</strong> next 12 months (Chart 9).<br />
Chart 9: WPI Manufacturing<br />
% YoY<br />
Inflation: two pitfalls to avoid<br />
4<br />
(1) Inflation is *not* simply due to basis effects that<br />
2<br />
will “disappear” in a few months:<br />
In fact, similar to <strong>the</strong> trend in consumer durable goods 0<br />
output and credit numbers, inflation also has been rising<br />
sharply in sequential terms after <strong>the</strong> “halt” in price<br />
growth in <strong>the</strong> interest rate “shock” phase (Chart 9).<br />
Therefore, inflation should not be brushed aside as a base effect phenomenon.<br />
Certainly, basis effects exaggerate <strong>the</strong> inflation reading and we can expect a<br />
decline in inflation in year-on-year terms especially if food price inflation moderates.<br />
(2) Inflation is not simply led by “global” factors:<br />
The fact that global commodity prices are driving up inflation should not be<br />
taken to mean that inflation is due to “global” factors (as opposed to “domestic”<br />
factors). In an integrated global market, domestic demand pressures of emerging<br />
markets like that of China and India can toge<strong>the</strong>r drive commodity price inflation<br />
even though a single country’s demand may be too small to alter global prices.<br />
12<br />
10<br />
8<br />
6<br />
RBI<br />
comfort<br />
% YoY<br />
WPI manufacturing price level (RHS)<br />
Interest rate<br />
"shock" phase<br />
Jan-06 Jan-07 Jan-08 Jan-09<br />
Levels, s/a<br />
210<br />
190<br />
170<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Even if India<br />
produced all its oil<br />
and operated as a<br />
closed economy,<br />
domestic oil prices<br />
might have risen<br />
due to oil demand<br />
We expect ano<strong>the</strong>r<br />
25bp rate hike by<br />
Sep08<br />
So again <strong>the</strong> question to ask is who and what is ultimately responsible for <strong>the</strong><br />
rising global commodity price inflation? According to our analysis, (see section<br />
“On a clear day”), in 2006, India and China toge<strong>the</strong>r accounted for two-thirds of<br />
<strong>the</strong> incremental petroleum demand and India alone accounted for about 15%<br />
of <strong>the</strong> incremental demand. In o<strong>the</strong>r words, even if India produced all its oil<br />
and operated as a closed economy, oil prices would have likely risen and fuelled<br />
inflation. Fuel subsidies are also shielding India’s demand from higher oil prices,<br />
so strong demand from India clearly plays a role in driving oil prices higher. It is<br />
for this reason that we think that India should not ignore fuel price led inflation.<br />
It is imperative in <strong>the</strong> long-run to cut subsidies, let <strong>the</strong> price mechanism work<br />
and avoid “suppressed” inflation.<br />
Interest rate: not yet peaked from a longer-run perspective<br />
It is clear that <strong>the</strong> rising headline inflation rates should not be ignored. Rising<br />
inflation pushes down real interest rates and increases wage hike demands creating<br />
a risk of wage-price spiral. Indeed, <strong>the</strong> RBI’s 25bp repo rate hike late on June 11<br />
was aimed at controlling inflation expectations. In India, fuel subsidies also<br />
suppress inflation and widen <strong>the</strong> fiscal and current account deficits. Therefore,<br />
we believe that policy rates have not peaked in India. At some point, <strong>the</strong> economy<br />
would have to factor in rising oil prices and raise rates. At that point, oil prices<br />
may also moderate as <strong>the</strong> “price mechanism” that is clogged right now by subsidies<br />
in emerging markets begins to work. None<strong>the</strong>less, our sense is that rates may<br />
yet go up in 2009. In <strong>the</strong> near-term, however, we expect only one more 25bp<br />
rate hike in 3Q08.<br />
Twin deficit scare and implications for ratings<br />
India’s current account deficit is likely to widen sharply to 2.7% of GDP in FY2008<br />
(and 1.8% of GDP estimated in FY2007) from around 1%-1.2% of GDP in preceeding<br />
years. The central government’s fiscal deficit might exceed <strong>the</strong> budgeted 2.5%<br />
of GDP by as much as 1.5%-pts on account of expenses related to central government<br />
pay revisions, farm loan waiver and duty cuts to control inflation. This calculation<br />
doesn’t include off-budget oil bonds issued to oil companies which amounts to<br />
ano<strong>the</strong>r 1.7% of GDP. However, unlike South East Asian countries, deficits are<br />
funded with domestic savings in India. India’s external debt stands at only 17%<br />
of GDP. The banking sector is also a captive market for government bonds as<br />
banks are required to hold 25% of <strong>the</strong>ir assets in cash or government bonds as<br />
part of <strong>the</strong> statutory liquidity reserve requirement. Therefore, <strong>the</strong> higher fiscal<br />
deficit, by itself, should not materially hurt <strong>the</strong> balance of payments, leading to<br />
a spiral of weaker currency and higher deficits. India also has <strong>the</strong> scope to raise<br />
corporate taxes in <strong>the</strong> short-term to fund higher subsidies - a bad move from a<br />
policy perspective but one that will help <strong>the</strong> ruling Congress-led coalition reach<br />
general elections in mid-2009 without virtually ensuring its doom. As long as oil<br />
prices do not rise fur<strong>the</strong>r, we think ratings agencies are likely to give India <strong>the</strong><br />
benefit of <strong>the</strong> doubt, seeing <strong>the</strong> present fiscal slippage as a temporary setback.<br />
Note:<br />
Annual and quarterly forecasts / references in <strong>the</strong> text and <strong>the</strong> table refer to<br />
calendar year forecasts unless specified as fiscal year (FY).<br />
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<strong>Economics</strong>: India<br />
India Economic Indicators<br />
2007** 2008(f) 2009(f) 1Q08 2Q08(f) 3Q08(f) 4Q08(f) 1Q09(f) 2Q09(f)<br />
Real output (99/00P)<br />
GDP 9.0 8.6 8.6 8.7 8.9 8.6 8.6 8.5 8.6<br />
Agriculture 4.5 2.8 3.0 2.9 4.6 3.4 0.8 2.8 3.0<br />
Industry 8.1 6.7 8.7 5.8 6.2 6.7 6.3 7.3 8.1<br />
Services 10.8 10.5 9.9 11.2 10.2 10.5 11.0 10.5 10.2<br />
Construction 9.8 13.4 10.9 12.6 17.2 12.2 15.2 9.3 10.1<br />
External (nominal)<br />
Merch exports (USD bn) 160 200 239 45 46 49 49 56 56<br />
- % YoY 25 25 20 27 29 30 18 24 21<br />
Merch imports (USD bn) 250 321 385 68 82 76 82 82 90<br />
- % YoY 31 28 20 41 45 30 22 19 9<br />
Trade balance (USD bn) -90 -121 -146 -23 -36 -27 -32 -26 -34<br />
Current a/c balance (USD bn) -21 -35 -41 -3 -18 -7 -10 0 -12<br />
% of GDP -1.8 -2.7 -2.8 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Foreign reserves(USD bn, eop) 180 329 345 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Inflation<br />
WPI inflation (% YoY) 4.6 6.8 4.9 5.7 8.3 9.0 6.7 3.4 1.8<br />
Manfg WPI (% QoQ, saar)*** 5.2 7.6 6.0 10.5 13.3 5.5 5.5 5.9 6.0<br />
O<strong>the</strong>r<br />
Nominal GDP (USD tn) 1.2 1.3 1.5 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Fiscal deficit (% of GDP) -3.0 -4.0 -4.0 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Money supply(M3, annual avg) 20 21 22 n.a. n.a. n.a. n.a. n.a. n.a.<br />
* % growth, year-on-year, unless o<strong>the</strong>rwise specified<br />
** Annual data refers to fiscal years beginning April of calendar year.<br />
*** Used as a proxy for core by <strong>the</strong> RBI<br />
IN – nominal exchange rate<br />
INR per USD<br />
44<br />
44<br />
43<br />
43<br />
42<br />
42<br />
41<br />
41<br />
40<br />
40<br />
39<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
IN – policy rate<br />
%, rev repo rate<br />
8.0<br />
7.0<br />
6.0<br />
5.0<br />
4.0<br />
Feb-01 Jul-02 Dec-03 May-05 Oct-06 Mar-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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ID: Fingers crossed<br />
• The government’s decision to raise subsidized fuel prices despite looming<br />
elections bodes well. It is ano<strong>the</strong>r step towards long-term fiscal<br />
sustainability, following <strong>the</strong> fuel price hike of 2005<br />
• But larger price adjustments will have to be made in <strong>the</strong> coming months.<br />
Even doubling <strong>the</strong> price of subsidized fuel prices is likely to leave <strong>the</strong><br />
subsidy:GDP ratio above <strong>the</strong> government’s threshold of 3%<br />
• Until fur<strong>the</strong>r policy action is taken, <strong>the</strong> rupiah and o<strong>the</strong>r Indonesian market<br />
prices could remain under pressure. The May fuel hike will slow growth<br />
to 6.0% this year. It will also add to already-high inflation; this year<br />
headline CPI will rise to 10.3%, before cooling to 7.2% next year. Such<br />
would provide cause for Bank Indonesia (BI) to lift its (new) overnight<br />
benchmark interest rate by a fur<strong>the</strong>r 75bps to 9.25% by end-3Q08<br />
• Fur<strong>the</strong>r fuel price adjustments would mean downward revisions to our<br />
growth forecasts, and higher inflation and interest rate projections.<br />
None<strong>the</strong>less subsidy cuts should be interpreted as a positive for <strong>the</strong><br />
country’s fiscal balance and macro fundamentals and should boost foreign<br />
sentiment toward <strong>the</strong> country<br />
INDONESIA<br />
Subsidized fuel<br />
prices were lifted<br />
28.7% in late May<br />
Subsidized fuel prices lifted nearly 30% in May<br />
On May 24, <strong>the</strong> Indonesian government announced for <strong>the</strong> first time in almost<br />
three years that it would raise <strong>the</strong> price of subsidized fuel. Prices of fuels used<br />
by households and consumers were upped by an average of 28.7% (fuel for<br />
industrial use is not subsidized), with premium fuel 33% more expensive at IDR<br />
6,000/ltr, diesel lifted by 28% to IDR 5,500/ltr and kerosene by 25% to IDR 2,500/<br />
ltr. The hike in subsidized prices had been flagged for some months, and given<br />
<strong>the</strong> pressure of higher oil prices on <strong>the</strong> country’s budget deficit – crude had<br />
touched a new high of above USD 135/bbl just two days prior – an adjustment<br />
in subsidized prices was inevitable.<br />
With <strong>the</strong> country importing significantly more refined oil than what it exports<br />
in crude oil (almost 60 times more in 2007, to be exact – Chart 1), <strong>the</strong> rise in oil<br />
prices had made subsiding fuel prices at home increasingly untenable. For example,<br />
our estimates indicate that for every liter of IDR 4,500 subsidized premium fuel<br />
enjoyed by Indonesians, <strong>the</strong> government was shouldering a subsidy burden almost<br />
twice that, by buying refined oil at world prices and selling <strong>the</strong> same at home at<br />
subsidized levels (Chart 2).<br />
Had fuel prices not been adjusted, our calculations suggest that this year’s budget<br />
deficit would have come close to 2.2% of GDP, a seven-year high. More significantly,<br />
<strong>the</strong> fuel subsidy would have amounted to some 3.3% of GDP – <strong>the</strong> highest since<br />
2005, and busting <strong>the</strong> administration’s unwritten rule that <strong>the</strong> subsidy:GDP ratio<br />
not exceed 3%.<br />
But much more needs to be done<br />
So, kudos to <strong>the</strong> government for making <strong>the</strong> politically tough decision to lift<br />
subsidized fuel prices - in contrast to <strong>the</strong> circumstances surrounding <strong>the</strong> (much<br />
Lim Su Sian • (65) 6878 1740 • limsusian@dbs.com<br />
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<strong>Economics</strong>: Indonesia<br />
Chart 1: Indonesia's net oil & gas position<br />
USD mn<br />
15000<br />
10000<br />
5000<br />
Chart 2: 'Market' versus subsidized premium px<br />
IDR/ltr<br />
14000<br />
12000<br />
10000<br />
8000<br />
Latest: Apr08<br />
Oct05 subsidy cut<br />
subsidy<br />
burden<br />
0<br />
-5000<br />
-10000<br />
-15000<br />
Gas<br />
Refined oil<br />
Crude oil<br />
Oil & gas net exports<br />
1998 2000 2002 2004 2006<br />
6000<br />
4000<br />
2000<br />
0<br />
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08<br />
Theoretical 'mkt' px (based on Nymex)<br />
Premium fuel<br />
larger) fuel price hike of Oct 2005, President Yudhoyono is not fresh from winning<br />
a landslide victory at <strong>the</strong> polls, but is instead heading into ano<strong>the</strong>r election in<br />
June 2009. The fuel price hike also came on top of rising food inflation – in April<br />
fresh food prices were up almost 16% YoY, and around 9% for processed food.<br />
In 2005, food prices had averaged around 7% YoY prior to <strong>the</strong> fuel price hike.<br />
But we don’t think <strong>the</strong> government’s work is finished yet, and <strong>the</strong> real political<br />
test could come in <strong>the</strong> months ahead. Following <strong>the</strong> May fuel price hike, government<br />
officials expect this year’s budget deficit to be contained between 1.8-2.0% of<br />
nominal GDP. According to our estimates*, this is entirely achievable – but only<br />
if for <strong>the</strong> remainder of <strong>the</strong> year crude oil averages USD 115/bbl or less (around<br />
USD 110/bbl for <strong>the</strong> full year), or if <strong>the</strong> rupiah does not weaken beyond 9,550 to<br />
<strong>the</strong> dollar (9,4000 per dollar for <strong>the</strong> full year) (Table 1). (In <strong>the</strong> year to date<br />
Nymex has averaged USD 107/bbl, while USD/IDR has averaged around 9,250.)<br />
Deficit:GDP ratio<br />
will be contained at<br />
1.8-2.0% - only if<br />
crude averages<br />
USD 115/bbl or less<br />
in 2H08<br />
If <strong>the</strong> subsidy:GDP ratio – and not <strong>the</strong> deficit:GDP ratio – is actually <strong>the</strong> more<br />
important, <strong>the</strong>n crude oil must average even lower. According to government<br />
officials we spoke with earlier this year, <strong>the</strong>re is an unwritten government mandate<br />
Table 1: Deficit scenarios after May fuel price hike (def % of GDP)<br />
2008 USD/IDR<br />
Nymex 1mth 9100 9200 9300 9400 9500<br />
95 1.5 1.5 1.6 1.6 1.6<br />
100 1.7 1.7 1.7 1.8 1.8<br />
105 1.8 1.8 1.9 1.9 2.0<br />
110 2.0 2.0 2.0 2.1 2.1<br />
115 2.1 2.2 2.2 2.3 2.3<br />
120 2.3 2.3 2.4 2.4 2.5<br />
125 2.5 2.5 2.5 2.6 2.6<br />
130 2.6 2.7 2.7 2.8 2.8<br />
135 2.8 2.8 2.9 2.9 3.0<br />
that <strong>the</strong> subsidy:GDP ratio not rise above 3%. Indeed, this appeared to be a<br />
trigger point for government policy action three years back – if not for <strong>the</strong><br />
steep 126% hike in subsidized fuel prices in October 2005, <strong>the</strong> subsidy:GDP ratio<br />
would have been much higher than <strong>the</strong> reported 3.4% for <strong>the</strong> year (Chart 3).<br />
Going by that rule, <strong>the</strong>n crude would need to averaged below USD 103/bbl for<br />
<strong>the</strong> second half (or USD 105/bbl for <strong>the</strong> full-year), if USD/IDR remains within <strong>the</strong><br />
8,950-9,550 range (Table 2).<br />
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The government<br />
will struggle with<br />
its deficit; oil<br />
rationing programs<br />
will not be<br />
effective<br />
In short, unless oil prices ease<br />
at least 10% in <strong>the</strong> near term<br />
and hold at those levels, and/<br />
or <strong>the</strong> rupiah appreciates, <strong>the</strong><br />
government is only just keeping<br />
its head above water where<br />
its fiscal thresholds are<br />
concerned. To a degree, plans<br />
to ration fuel consumption<br />
via <strong>the</strong> use of smart cards will<br />
help ease <strong>the</strong> total subsidy<br />
burden. But this program will<br />
be rolled out only from<br />
September, and will reportedly<br />
only be introduced in Jakarta<br />
and surrounding areas in Java.<br />
It remains to be seen how<br />
effective this system will be<br />
at curbing consumption, and<br />
Chart 3: Deficit/subsidy to GDP<br />
% of GDP<br />
4<br />
3<br />
2<br />
1<br />
0<br />
2003 2004 2005 2006 2007<br />
Oil sub % of GDP<br />
Subsidized<br />
fuel prices<br />
lifted<br />
126%<br />
Budget balance % of GDP<br />
even smuggling activity – <strong>the</strong> larger <strong>the</strong> subsidy on a good, <strong>the</strong> larger <strong>the</strong> distortion<br />
on consumption behaviour. Indeed, even after fuel prices were hiked a senior<br />
energy ministry said that consumption of subsidized gasoline is likely to rise by<br />
over 5% this year, to 20.4mn kilolitres. Next year, subsidized diesel oil consumption<br />
is expected to increase by 6%, to 12.6mn kl from an estimated 11.9mn kl this<br />
year.<br />
Table 2: Subsidy scenarios after May fuel price hike (sub % of GDP)<br />
2008 USD/IDR<br />
Nymex 1mth 9100 9200 9300 9400 9500<br />
95 2.5 2.5 2.6 2.6 2.7<br />
100 2.7 2.7 2.8 2.8 2.9<br />
105 2.9 2.9 3.0 3.0 3.1<br />
110 3.1 3.1 3.2 3.2 3.3<br />
115 3.3 3.4 3.4 3.5 3.5<br />
120 3.5 3.6 3.6 3.7 3.7<br />
125 3.7 3.8 3.8 3.9 3.9<br />
130 3.9 4.0 4.0 4.1 4.1<br />
135 4.1 4.2 4.2 4.3 4.3<br />
Fur<strong>the</strong>r hikes in<br />
subsidized fuel<br />
prices cannot be<br />
ruled out<br />
Ultimately, nothing will alleviate <strong>the</strong> strain on Indonesia’s deficit – or curb <strong>the</strong><br />
consumption of subsidized fuel - as quickly or directly as cutting subsidies. And<br />
this might just be <strong>the</strong> path Indonesia will continue to take. To its credit, since<br />
implementing <strong>the</strong> fuel price hike in May, <strong>the</strong> government has repeatedly emphasized<br />
that it could not rule out fur<strong>the</strong>r increases in fuel prices ahead of next year’s<br />
Presidential elections.<br />
How much will fuel prices have to be fur<strong>the</strong>r lifted by? As it stands, even after<br />
<strong>the</strong> May hike, domestic prices are still significantly below global market prices.<br />
For example, subsidized premium fuel now sells for IDR 6,000/ltr; if we make<br />
<strong>the</strong> conventional assumption that crude oil accounts for half <strong>the</strong> pump price,<br />
<strong>the</strong>n <strong>the</strong>oretically premium fuel should be retailing at above IDR 13,000! Needless<br />
to say <strong>the</strong> government would never consider scrapping fuel prices all at one go,<br />
particularly not when <strong>the</strong> elections are less than a year away. But our simulations<br />
suggest that <strong>the</strong> government may have some really tough decisions to make in<br />
<strong>the</strong> months ahead if things turn ugly - if we assume a crude oil average of USD<br />
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135/bbl for <strong>the</strong> rest of <strong>the</strong> year and a USD/IDR average of 9,550, <strong>the</strong>n doubling<br />
subsidized fuel prices as early as Sept08 would still leave <strong>the</strong> subsidy:GDP ratio<br />
at 3.1%. If we assume prices remain close to current levels, ie. crude at USD 130/<br />
bbl and USD/IDR at 9,350, <strong>the</strong>n doubling prices would bring <strong>the</strong> subsidy:GDP<br />
ratio to 3%.<br />
In <strong>the</strong> mean time, growth will cool<br />
The May fuel price hike will moderate activity, and to that end we have shaded<br />
our growth forecasts lower, to 6.0% this year and 6.3% for 2009. Our previous<br />
projections had been at 6.3% for 2008 (unchanged from 2007) and 6.5% for<br />
2009.<br />
We look for growth<br />
of 6.0% and 6.3%,<br />
in 2008 and 2009<br />
Admittedly growth has held pace so far, with GDP rising 6.3% YoY in <strong>the</strong> first<br />
quarter, unchanged from 4Q07. We think this pace of growth might hold even<br />
in 2Q08. Come <strong>the</strong> second half, however, a triple combination of higher fuel<br />
prices, higher inflation and higher interest rates will result in a relatively pronounced<br />
slowdown in growth, to a slightly sub-trend average of 5.7% YoY (Chart 4).<br />
Chart 4: Slowdown in 2H08<br />
%-pt contrib to YoY GDP growth<br />
8<br />
7<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
-1<br />
-2<br />
-3<br />
Mar-06 Dec-06 Sep-07 Jun-08<br />
<strong>DBS</strong>f 08: 6.0%<br />
Pte cons Govt cons Investment<br />
Net exports GDP YoY<br />
Chart 5: Higher inflation this year<br />
% YoY<br />
20<br />
18<br />
Headline CPI<br />
16<br />
14<br />
12<br />
Core CPI<br />
10<br />
8<br />
6<br />
BI target<br />
4<br />
2<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
<strong>DBS</strong>f<br />
10.3<br />
8.6<br />
Inflation, interest rates will rise<br />
Prior to <strong>the</strong> fuel price hike, inflation was already accelerating on higher food<br />
and energy prices, with headline CPI up at a one and a-half year high of 9% YoY<br />
in April. Naturally, <strong>the</strong> fuel price hike will exacerbate already-high inflation.<br />
Come June, when <strong>the</strong> impact of <strong>the</strong> fuel price hike will be more fully felt, we<br />
expect inflation to rise to around 12% YoY. In <strong>the</strong> months <strong>the</strong>reafter, inflation<br />
will remain above 11% YoY, taking full-year inflation to 10.3%. This is well<br />
above inflation of 6.4% in 2007, and <strong>the</strong> central bank’s inflation target of 4-6%<br />
for <strong>the</strong> year. Next year, inflation should ease to 7.2%, but this will still exceed<br />
BI’s target of 3.5-5.5% (Chart 5). To be sure, inflation particularly this year will<br />
be largely supply-driven. However, <strong>the</strong>re are also some demand-pull factors at<br />
play, as evidenced by strong import growth and <strong>the</strong> likelihood that growth this<br />
year will remain at, ra<strong>the</strong>r than below, trend.<br />
The fuel price hike<br />
will bump alreadyhigh<br />
inflation up to<br />
10.3% this year,<br />
and 7.2% next<br />
year, exceeding BI<br />
targets<br />
To cap <strong>the</strong>se pressures and also cool expectations of future inflation, we think<br />
<strong>the</strong> central bank BI is likely to lift its (new) overnight benchmark interest rate by<br />
a fur<strong>the</strong>r 75bps by end-3Q08, to 9.25%. Up until June 8 <strong>the</strong> operational target<br />
had been <strong>the</strong> 1-month SBI rate. Judging by BI’s two rate hikes since early May –<br />
ahead of <strong>the</strong> fuel price hike – BI has displayed a preference for moving in 25bp<br />
moves, small steps by historical standards. The way inflation is set to pan out,<br />
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we see no harm in BI tightening in larger doses of 50bps. However, owing ei<strong>the</strong>r<br />
to caution over <strong>the</strong> growth outlook and/or a desire to avoid appearing that it is<br />
in a panic over inflation, <strong>the</strong> central bank will likely continue moving in 25bp<br />
steps, unless <strong>the</strong>re is a significant decline in <strong>the</strong> rupiah or inflation starts to<br />
surprise far beyond expectations.<br />
Consumer <strong>the</strong> first victim<br />
Higher fuel prices, higher inflation and higher borrowing rates will take <strong>the</strong><br />
most immediate toll on consumer spending. Private consumption expenditure<br />
(PCE) growth this year should still match last year’s 5.0% pace, but this will owe<br />
largely to above-5% growth in <strong>the</strong> first half. In 2H08, PCE growth will probably<br />
average 4.5% YoY. Prior to <strong>the</strong> fuel price hike, rising inflation had already eaten<br />
noticeably into consumer confidence, which as of Apr08 is at two-year lows<br />
(Chart 6). Higher fuel prices and higher interest rates should also moderately<br />
dampen consumer demand for motor-vehicles.<br />
Chart 6: Inflation rising, c'ser confidence falling<br />
Index<br />
% YoY<br />
130<br />
0<br />
C'ser conf<br />
2<br />
120<br />
CPI YoY (RHS, inv)<br />
4<br />
110<br />
100<br />
6<br />
8<br />
10<br />
90<br />
80<br />
12<br />
14<br />
70<br />
60<br />
Latest: Apr08<br />
16<br />
18<br />
20<br />
Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
Chart 7: Food PCE due for an adjustment<br />
Raw and processed fd, wtd ave<br />
% YoY % YoY<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
Food inflation (inv, RHS)<br />
Real food PCE<br />
<strong>DBS</strong>f<br />
Latest: 1Q08<br />
Mar-01 Sep-02 Mar-04 Sep-05 Mar-07 Sep-08<br />
0<br />
2<br />
4<br />
6<br />
8<br />
10<br />
12<br />
14<br />
16<br />
18<br />
20<br />
Food PCE may be<br />
due for a long<br />
downward<br />
adjustment<br />
Even food PCE – almost half total consumer spending – looks set for a slowdown.<br />
Despite <strong>the</strong> run-up in food prices since 2007, real spending on food has only<br />
accelerated. This might have been fuelled by <strong>the</strong> improvement in real wage<br />
growth last year, to 4-5% YoY by our estimate. However slower economic activity<br />
overall may mean that nominal wages won’t rise as much as last year; even if<br />
<strong>the</strong>y did, high inflation will erode much of those gains. Meanwhile <strong>the</strong> rise in<br />
food prices will probably become more pronounced in 2H08; back in 2005 <strong>the</strong>re<br />
were clearly pass-through effects between higher subsidized fuel prices and<br />
food prices (Chart 7). Indeed, if higher food prices are here to stay for <strong>the</strong><br />
medium-term (as organizations like <strong>the</strong> World Bank have concluded), <strong>the</strong>n <strong>the</strong><br />
downward adjustment in food PCE growth could drag out for longer than<br />
compared to non-food spending.<br />
Investment will slow on higher input, borrowing costs<br />
Public-private<br />
projects will keep<br />
investment growth<br />
decent<br />
In contrast to consumption, investment growth will be stronger than last year,<br />
at 11% versus 9.2%. Never<strong>the</strong>less on a quarterly basis it looks to us like investment<br />
growth may have already peaked in 1Q08. Spending on building and equipment<br />
surged 13.3% YoY in <strong>the</strong> first quarter, having accelerated at an almost uninterrupted<br />
pace since 3Q06. However, in <strong>the</strong> coming quarters private firms are likely to<br />
increasingly postpone <strong>the</strong>ir investment decisions, amid a more benign growth<br />
outlook, surging input costs and rising borrowing costs (Charts 8, 9). That said,<br />
<strong>the</strong> slowdown in investment growth is not going to be drastic (we’re still talking<br />
nearly 9% YoY by year-end), thanks in part to <strong>the</strong> continuance of public-private<br />
infrastructure projects.<br />
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Chart 8: Investment credit to slow on rate hikes<br />
% YoY %<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
Latest: BI rate<br />
Jun08; credit<br />
1mth SBI (RHS)<br />
<strong>DBS</strong>f<br />
Investment<br />
credit<br />
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08<br />
6<br />
7<br />
8<br />
9<br />
10<br />
11<br />
12<br />
13<br />
14<br />
Chart 9: Export prices up, but so are import prices<br />
% YoY<br />
35<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
Wholesale<br />
expt px<br />
Wholesale<br />
impt px<br />
Latest:Mar08<br />
Jan-01 Jan-03 Jan-05 Jan-07<br />
Looking at <strong>the</strong> medium to long-term, once <strong>the</strong> economic – and even fiscal uncertainty<br />
clears – rapid investment growth should return. Amid improvements to <strong>the</strong><br />
investment climate, <strong>the</strong>re has already been a significant build-up of investment<br />
interest in <strong>the</strong> country both domestically and overseas since 2005, as evidenced<br />
by <strong>the</strong> continuing surge in investment applications. Last year, foreign applications<br />
totalled USD 40.1bn (excluding <strong>the</strong> oil & gas and banking & insurance sectors),<br />
three times <strong>the</strong> amount in 2005. Domestic applications totalled USD 20.6bn,<br />
four times <strong>the</strong> amount in 2005. These are investments that will get realized in<br />
<strong>the</strong> next 1-3 years.<br />
Investment interest<br />
<strong>the</strong> country could<br />
rise even fur<strong>the</strong>r,<br />
if national budget<br />
priorities are set<br />
straight. Prior to<br />
<strong>the</strong> May subsidy cut,<br />
budget figures<br />
showed that a<br />
whopping 24% of<br />
budget spending<br />
was slated for<br />
subsidies this year,<br />
in contrast to just<br />
2% on health, 3%<br />
on public works and<br />
5% on education<br />
(Chart 10). Naturally,<br />
reductions in <strong>the</strong><br />
Chart 10: Budget expenditure breakdown, 2008 (pre-subsidy cut)<br />
% of total budget spending<br />
O<strong>the</strong>r govt<br />
agencies<br />
24%<br />
Subsidies<br />
24%<br />
Public works<br />
3%<br />
Int payments<br />
10%<br />
Health<br />
2% Defense<br />
3%<br />
Education<br />
5%<br />
Regional<br />
transfers<br />
29%<br />
country’s subsidy burden via fuel price adjustments will free up a significant<br />
amount of funds for o<strong>the</strong>r areas of expenditure that can help improve <strong>the</strong> investment<br />
climate, such as infrastructure spending.<br />
Net exports will not contribute much<br />
Meanwhile, net exports will add a negligible 0.1%-pts to overall GDP growth.<br />
Export growth has admittedly been stronger than we initially anticipated, up<br />
15% YoY in 1Q08 on robust demand for commodities. However, we are still<br />
looking for global growth to slow this year; in Asia, risks to <strong>the</strong> growth outlook<br />
are also emerging from rising energy and food inflation. The likelihood is <strong>the</strong>refore<br />
for export growth to lose some steam in <strong>the</strong> quarters ahead on a YoY basis,<br />
though shipments should still outpace last year’s, at almost 12% versus 8%.<br />
Subsidies eat up an<br />
huge proportion of<br />
government<br />
expenditure that<br />
could be better<br />
spent on improving<br />
infrastructure<br />
Net exports will<br />
contribute just<br />
0.1%-pts to overall<br />
growth<br />
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<strong>Economics</strong>: Indonesia<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Imports will rise at an even faster 14.4%, eating into <strong>the</strong> trade surplus. Import<br />
growth has also been stronger than expected this year, up 16.8% YoY in 1Q08<br />
and reflecting strong domestic demand for raw materials and capital goods. In<br />
<strong>the</strong> quarters ahead, though, we expect this to slow, mirroring <strong>the</strong> likely moderation<br />
in investment growth.<br />
Fur<strong>the</strong>r fuel price<br />
adjustments should<br />
be interpreted as a<br />
longer-term<br />
positive<br />
Fur<strong>the</strong>r fuel price hikes… or not<br />
Should oil prices continue to stay elevated, investors will want to see <strong>the</strong> government<br />
make fur<strong>the</strong>r adjustments to subsidized fuel prices. This could be done in one<br />
big step (unlikely if before next year’s elections), or several small steps. To buy<br />
itself some time until it is ready to significantly adjust price levels (till, say, after<br />
<strong>the</strong> elections), it could even index subsidized fuel prices to global levels, ra<strong>the</strong>r<br />
than keep prices of subsidized fuels at fixed levels. Such would keep <strong>the</strong> absolute<br />
amount of <strong>the</strong> subsidy burden steady, and in turn contain deficit ratios within<br />
acceptable limits.<br />
Naturally, following fur<strong>the</strong>r fuel price adjustments our growth forecasts will<br />
have to be trimmed, while our inflation and interest rate forecasts will have to<br />
be raised. These changes will depend on <strong>the</strong> magnitude and timing of <strong>the</strong> subsidy<br />
cuts. Still, any fuel price adjustments should be interpreted as a positive – every<br />
fuel subsidy cut brings <strong>the</strong> country one step closer towards <strong>the</strong> elimination of<br />
subsidies altoge<strong>the</strong>r, which will remove significant stress and uncertainty on<br />
<strong>the</strong> country’s finances, and will also result in resources being allocated much<br />
more efficiently.<br />
The risk in <strong>the</strong> coming months is a delayed - or worse, absent - government<br />
response amid a continued rise in oil prices. Such would intensify investor concerns<br />
over <strong>the</strong> budget deficit, putting <strong>the</strong> rupiah at risk of fur<strong>the</strong>r weakness. Probably<br />
not quite as weak as <strong>the</strong> 10,400 level against <strong>the</strong> USD as we saw in 2005, given<br />
that <strong>the</strong> level of foreign reserves have almost doubled since. But weak enough<br />
to push BI into defending <strong>the</strong> currency via more aggressive rate hikes than we<br />
have currently factored in.<br />
Notes<br />
* For details on our methodology, please refer to our focus note, “Indonesia:<br />
Oil and <strong>the</strong> budget - discomfort levels”, November 21, 2007<br />
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<strong>Economics</strong>: Indonesia<br />
Indonesia Economic Indicators<br />
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Output and Demand<br />
Real GDP growth 6.3 6.0 6.3 6.3 6.3 5.8 5.6 6.1 6.3<br />
Private consumption 5.0 5.0 5.3 5.5 5.4 4.6 4.4 4.9 5.2<br />
Government consumption 3.9 6.1 6.8 3.6 7.5 8.0 5.0 11.0 8.0<br />
Gross fixed capital formation 9.2 11.0 9.4 13.3 12.3 10.2 8.7 9.0 9.5<br />
Net exports (IDRtrn, 00P) 181.5 184.3 190.8 52.9 48.3 37.3 45.9 54.0 47.7<br />
Exports 8.0 11.9 8.2 15.0 12.4 10.2 10.3 8.4 7.8<br />
Imports 8.9 14.4 9.2 16.8 15.3 14.1 11.8 10.0 9.8<br />
External<br />
Merch exports (USDbn) 114 144 164 34 37 36 38 40 41<br />
- % chg 13 26 14 31 30 23 22 18 13<br />
Merch imports (USDbn) 74 103 118 23 27 26 26 28 31<br />
- % chg 22 38 15 50 50 30 25 21 15<br />
Merch trade balance (USD bn) 40 42 46 10 10 10 12 12 10<br />
Current account bal (USD bn) 11.8 13.3 14.5 3.8 3.5 2.8 3.2 4.0 3.5<br />
% of GDP 2.7 2.7 2.7 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Foreign reserves (USD bn, eop) 57 60 66 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Inflation<br />
CPI inflation 6.4 10.3 7.2 7.5 10.3 11.7 11.4 9.7 7.5<br />
O<strong>the</strong>r<br />
Nominal GDP (USDbn) 433 484 546 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Budget deficit (% of GDP) -1.5 -2.3 -2.5 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Total external debt (USD bn) 137 143 146 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP 32 30 27 n.a. n.a. n.a. n.a. n.a. n.a.<br />
* % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
ID – nominal exchange rate<br />
IDR per USD<br />
9,580<br />
9,440<br />
9,300<br />
9,160<br />
9,020<br />
8,880<br />
8,740<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
ID – policy rate<br />
%, 1 mth SBI rate<br />
19.0<br />
17.0<br />
15.0<br />
13.0<br />
11.0<br />
9.0<br />
7.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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MY: Biting <strong>the</strong> bullet<br />
• Prime Minister Badawi finally announced <strong>the</strong> much anticipated restructuring<br />
of <strong>the</strong> energy subsidy program<br />
• Malaysia is expected to remain a net exporter of crude oil until 2014 and<br />
current restructuring is expected to bring about longer-term fiscal<br />
sustainability and economic efficiency<br />
• However, <strong>the</strong> subsidy cuts are expected to stoke inflation and cause growth<br />
to slow<br />
• Inflation will peak at 5.8% in Jun08 and is set to average 4.5% for <strong>the</strong> full<br />
year. Our inflation forecast for 2009 has also been lifted to 3.3%<br />
• We expect Bank Negara to hike <strong>the</strong> policy rate by 50bps at <strong>the</strong> next policy<br />
meeting in July, to anchor inflation expectations and to prevent secondround<br />
effects of inflation<br />
• Growth is expected to moderate to 5.1% for <strong>the</strong> year. Our 2009 growth<br />
forecast has also been trimmed to 5.8%<br />
MALAYSIA<br />
The restructuring<br />
of Malaysia’s<br />
energy subsidy<br />
program is<br />
expected to save<br />
<strong>the</strong> government<br />
some MYR 13.7bn<br />
Revision to <strong>the</strong><br />
subsidy program<br />
will negatively<br />
impact consumers<br />
Short term pain, long term gain<br />
After weeks of speculation, Prime Minister Badawi finally announced <strong>the</strong> much<br />
anticipated restructuring of <strong>the</strong> fuel subsidy program. The changes, effective<br />
June 5, have lifted petrol prices by 41% to MYR 2.70/ltr, and diesel prices by<br />
MYR 1 to MYR 2.58/ltr. Prices will be reviewed on a monthly basis hereafter. In<br />
addition, power tariffs for commercial users will rise by 26% while Tenaga will<br />
introduce a new power-tariff structure from 1 July. Prices of gas supplied by<br />
Petronas will also double as part of this restructuring process. All in, <strong>the</strong> restructuring<br />
process is expected to help <strong>the</strong> government save about MYR 13.7bn this year.<br />
Separately, to fur<strong>the</strong>r shore up its revenue, <strong>the</strong> government is also imposing a<br />
windfall tax of 5%-15% on palm oil millers, for crude palm oil priced above<br />
MYR 2,000 per metric ton.<br />
The revision to <strong>the</strong> subsidy Chart 1: Higher oil prices lifted oil trade balance<br />
program will help to improve MYR mn<br />
USD/bbl<br />
<strong>the</strong> government’s fiscal<br />
140<br />
position, but not without<br />
Oil trade balance<br />
6000<br />
short-term detrimental effects<br />
Oil prices<br />
120<br />
on consumers. In order to<br />
5000<br />
soften this impact, particularly<br />
100<br />
for <strong>the</strong> lower income group,<br />
<strong>the</strong> government will offer<br />
cash rebates for <strong>the</strong> first 800<br />
litres of petrol used by owners<br />
4000<br />
3000<br />
80<br />
60<br />
of small cars and motorcycle. 2000<br />
This is equivalent to a rebate<br />
40<br />
of about MYR 625 for <strong>the</strong><br />
year for owners of cars below<br />
2000cc, and MYR 150 for<br />
1000<br />
0<br />
20<br />
0<br />
motorcycles. Road tax for<br />
cars below 2000cc will also<br />
Jan-99 Jan-01 Jan-03 Jan-05 Jan-07<br />
be lowered by MYR 200. Fur<strong>the</strong>rmore, some of <strong>the</strong> savings from <strong>the</strong> new measures<br />
will be diverted to food subsidies to benefit <strong>the</strong> poor more directly.<br />
Irvin Seah • (65) 6878 6727 • irvinseah@dbs.com<br />
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<strong>Economics</strong>: Malaysia<br />
The reforms to <strong>the</strong> fuel subsidy program is a positive for medium-term fiscal<br />
sustainability, and will mean better resource allocation. Admittedly, unlike Indonesia,<br />
which recently also reduced fuel subsidies, Malaysia is a net exporter of oil and<br />
related products, and on <strong>the</strong> surface <strong>the</strong>re appears to be no reason why higher<br />
oil revenues cannot be used to indefinitely maintain fuel subsidies. As is clear<br />
from Chart 1, Malaysia’s trade surplus in<br />
oil has escalated in line with crude oil prices,<br />
coming to MYR 38bn last year. According<br />
to <strong>the</strong> domestic trade minister, <strong>the</strong> economy<br />
earns MYR 250mn a year in revenue for<br />
every USD 1 increase in crude prices.<br />
In this context, one can understand why<br />
<strong>the</strong> hike in fuel prices left Malaysians fuming<br />
and baffled. They were expecting an increase,<br />
but not as high as 41%. Critics also pointed<br />
out that after <strong>the</strong> price adjustments, Malaysia<br />
now has <strong>the</strong> highest domestic petrol prices<br />
among <strong>the</strong> net petroleum-exporting countries<br />
(Table 1).<br />
But all <strong>the</strong>se arguments ignore <strong>the</strong> likelihood that Malaysia will become a net<br />
oil importer in 2014, given <strong>the</strong> current trend in oil demand and its existing oil<br />
reserves. The fuel subsidy would also have cost <strong>the</strong> government as much as MYR<br />
56bn this year (based on current crude oil prices of about USD 130/bbl), or about<br />
a third of government expenditure in 2008, had prices not been adjusted. Even<br />
after <strong>the</strong> subsidy cuts, <strong>the</strong> government expects a budget deficit of about 3.1%<br />
of GDP this year. This is not a high number, but it would be if Malaysia turns<br />
into a net importer of oil and energy subsidies have not been adjusted.<br />
In addition, <strong>the</strong> fuel subsidy program is regressive and tends to benefit <strong>the</strong> rich<br />
more than <strong>the</strong> poor. Subsidies also distort market mechanisms; by artificially<br />
keeping prices low, demand for fuel is higher than what it would be, had prices<br />
been allowed to adjust. It results in wasteful consumption and encourages smuggling,<br />
due to <strong>the</strong> gap between international and domestic prices. Thus, resources are<br />
not well allocated to those who need <strong>the</strong> fuel <strong>the</strong> most, and inefficiency sets in.<br />
Still, while reducing subsidies will bring about long-term gains for Malaysia in<br />
<strong>the</strong> form of a more competitive<br />
and efficient economy, some<br />
short-term pain will have to<br />
be endured.<br />
Inflation set to rise<br />
The most obvious and<br />
immediate impact on <strong>the</strong><br />
economy would be higher<br />
inflation. Our estimation shows<br />
that for every 10% increase<br />
in fuel prices, month-on-month<br />
inflation will rise by 0.7%-<br />
pts. The main increase should<br />
come from <strong>the</strong> transport and<br />
HW (housing, water, electricity,<br />
gas and o<strong>the</strong>r fuels) sectors.<br />
With that, overall CPI inflation<br />
should rise sharply to about<br />
5.8% YoY in June, lifting full<br />
Table 1: Petrol prices in selected oil<br />
producing countries<br />
Country<br />
Domestic petrol prices<br />
(MYR/litre)<br />
Malaysia 2.70<br />
Indonesia 1.86<br />
Saudi Arabia 0.38<br />
Iran 0.35<br />
Nigeria 0.32<br />
Turkmenistan 0.25<br />
Venezuela 0.16<br />
Chart 2: Policy tightening needed to tame inflation<br />
% YoY<br />
7.3<br />
<strong>DBS</strong>f<br />
6.3<br />
5.3<br />
4.3<br />
3.3<br />
2.3<br />
1.3<br />
Inflation<br />
OPR<br />
Fuel subsidy cut<br />
50bps rate hike<br />
Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08<br />
year inflation to about 4.5% (Chart 2). Inflation for 2009 will be around 3.3%,<br />
up from our previous 2.0% forecast as <strong>the</strong> inflationary impact spills over to<br />
1H09.<br />
Its all about<br />
medium term fiscal<br />
sustainability and<br />
better resource<br />
allocation<br />
Inflation is<br />
expected to rise<br />
sharply to 4.5% for<br />
<strong>the</strong> full year<br />
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<strong>Economics</strong>: Malaysia<br />
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Bank Negara to<br />
hike <strong>the</strong> policy rate<br />
50bps in 3Q08, to<br />
4.0%<br />
Policy action needed<br />
Higher inflation will push real interest rates towards negative territory, if <strong>the</strong>y<br />
are not already <strong>the</strong>re (Chart 3). Adjusted for inflation, real deposit rates were at<br />
-1.63% in Apr08. Real policy rates and lending rates will most likely fall fur<strong>the</strong>r<br />
if inflation spikes to 5.8% in June on <strong>the</strong> fuel price hike. A negative real interest<br />
rate scenario favours borrowers, and risks fuelling asset inflation. As general<br />
prices rise, so could inflation expectations, resulting in even higher inflation<br />
going forward. For example, if workers demand higher wages in anticipation<br />
of fur<strong>the</strong>r price increases, it will inevitably set off a second round of price increase.<br />
Thus, policy action is needed now to anchor inflation expectations, and to prevent<br />
second-round inflationary effects. We expect Bank Negara to hike <strong>the</strong> policy<br />
rate by 50bps at <strong>the</strong> next policy meeting in July (Chart 2), taking <strong>the</strong> Overnight<br />
Policy Rate to 4%. In fact, while no policy meeting is planned for June, we do<br />
not discount <strong>the</strong> possibility of an inter-meeting hike. In addition, while <strong>the</strong><br />
inflationary effects of <strong>the</strong> fuel price hikes are expected to be transient and will<br />
likely wear off after 12 months, <strong>the</strong> government has hinted that this may just<br />
be <strong>the</strong> first of a string of subsidy cuts. Overall, inflationary pressure will remain<br />
high amid risks of higher global commodity prices and fur<strong>the</strong>r hikes in subsidized<br />
fuel prices. The central bank sounded hawkish in its most recent policy statement,<br />
and we believe <strong>the</strong> rhetoric will remain so in <strong>the</strong> next few quarters given <strong>the</strong><br />
outlook on inflation.<br />
Chart 3: Real interest rates heading south<br />
%, % pa<br />
6<br />
5<br />
4<br />
Real policy rate<br />
Real deposit rate<br />
Real lending rate<br />
3<br />
2<br />
1<br />
0<br />
-1<br />
-2<br />
-3<br />
-4<br />
Latest: Apr08<br />
Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07<br />
Chart 4: Growth likely to moderate<br />
%-pt contribution<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
Net exports<br />
Investment<br />
Govt expenditure<br />
Pvt consumption<br />
GDP growth<br />
Latest: 1Q08<br />
Mar-05 Mar-06 Mar-07 Mar-08<br />
Growth will be affected<br />
The impact on growth will be mixed. Although savings from <strong>the</strong> subsidies can<br />
be used to stimulate growth, we think that this is more likely to happen in <strong>the</strong><br />
longer term than in <strong>the</strong> near term. In fact, <strong>the</strong> government has not publicly<br />
explained how <strong>the</strong> savings from <strong>the</strong> subsidy cuts will be used. While we assume<br />
that effort will be put into upgrading <strong>the</strong> existing transport network, work will<br />
probably start at a later stage and benefits will only be reaped in <strong>the</strong> longer<br />
term.<br />
In <strong>the</strong> near term, domestic demand will be most affected by <strong>the</strong> fuel price hike.<br />
In particular, private consumption, which registered robust growth of 11.6%<br />
YoY and contributed 3.6%-pts to overall GDP growth, is expected to moderate<br />
to an average of 7.3% for <strong>the</strong> full year (Charts 4 and 5). Government expenditure,<br />
which grew by a robust 10.5% YoY in 1Q08 (making a 0.7%-pt contribution to<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: Malaysia<br />
growth) will also be shaved. We reckon that growth in government spending<br />
could slow to an average of 5.5% for <strong>the</strong> year, as <strong>the</strong> government cuts down on<br />
its energy subsidies. Delays or postponements of some government projects due<br />
to political differences between <strong>the</strong> Federal and opposition state governments<br />
may fur<strong>the</strong>r complicate matters and slow down <strong>the</strong> disbursement of government<br />
funding. Investment growth will likewise be affected. Capital investment rose<br />
6.0% YoY and contributed 0.8%-pts to overall growth in 1Q08. Given ongoing<br />
political uncertainty, a moderation in <strong>the</strong> growth outlook as well as possibly<br />
higher interest rates going forward, investment growth will probably taper off<br />
to an average pace of 5.7% for <strong>the</strong> year.<br />
Domestic demand<br />
will be most<br />
affected<br />
The slowdown in domestic demand will be compounded by an anticipated decline<br />
on <strong>the</strong> external front. Although net export growth has been higher than expected<br />
at 26.4% YoY in 1Q08, it was underscored by a low base in <strong>the</strong> same period last<br />
year and helped by much slower import growth of 3.4%. Overall export growth<br />
in fact moderated to 6.0% YoY in 1Q08, down from 7.8% YoY in <strong>the</strong> previous<br />
quarter.<br />
Chart 5: Domestic demand set to moderate<br />
% YoY<br />
16 Pvt consumption Govt expenditure<br />
14<br />
Investment<br />
<strong>DBS</strong>f<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
Mar-05 Mar-06 Mar-07 Mar-08<br />
Chart 6: GDP growth forecast revised down to<br />
% YoY<br />
8.0<br />
7.5<br />
7.0<br />
6.5<br />
6.0<br />
5.5<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
GDP<br />
GDP growth (previous)<br />
GDP growth (latest)<br />
Mar-05 Mar-06 Mar-07 Mar-08<br />
MYR mn<br />
150000<br />
140000<br />
130000<br />
120000<br />
110000<br />
100000<br />
90000<br />
80000<br />
70000<br />
60000<br />
While <strong>the</strong> underlying fundamentals of <strong>the</strong> Malaysian economy have been strong,<br />
near-term downside risk to growth remains high. The broader weakness in global<br />
demand is expected to continue weighing on export-oriented sectors. The domestic<br />
segment will be affected by higher inflation, monetary tightening as well as<br />
sentiment-dampening fuel subsidy cuts. With that, we expect overall GDP growth<br />
to moderate to 5.1% this year, down from our previous forecast of 5.8% (Chart<br />
6). Growth next year is expected to register 5.8%, a tad below our previous<br />
forecast of 6.0% owing to spill-over effects.<br />
Growth is expected<br />
to moderate to<br />
5.1% this year<br />
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Malaysia Economic Indicators<br />
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP growth 6.3 5.1 5.8 7.1 4.8 4.2 4.1 5.3 4.6<br />
Private consumption 11.7 7.8 5.9 11.8 7.7 5.7 5.8 4.9 5.7<br />
Government consumption 6.4 6.9 4.0 10.5 6.3 7.1 3.7 5.0 4.3<br />
Gross fixed capital formation 10.2 5.7 10.7 6.0 5.5 5.3 5.7 9.9 12.2<br />
Net exports (MYRbn, 00P) 77.1 71.6 67.8 20.3 15.9 20.0 15.4 17.4 12.2<br />
Exports 3.7 5.8 7.1 6.0 5.1 4.6 7.6 7.4 7.8<br />
Imports 4.1 6.9 8.8 3.4 6.8 7.1 10.2 10.8 11.3<br />
External (nominal)<br />
Exports (MYR bn) 605 646 701 152 164 161 169 158 177<br />
Imports (MYR bn) 505 544 581 125 135 141 143 132 145<br />
Trade balance (MYR bn) 100 102 120 27 29 21 26 26 32<br />
Current account bal (USD bn) 29 33 38 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP 15.5 16.1 16.9 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Foreign reserves<br />
(USD bn, yr-end) 99 146 190 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Inflation<br />
CPI inflation 2.0 4.5 3.3 2.6 4.0 5.8 5.6 5.1 4.1<br />
O<strong>the</strong>r<br />
Nominal GDP (USDbn) 189 206 227 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Fiscal balance (% of GDP) -3.2 -3.5 -3.4 n.a. n.a. n.a. n.a. n.a. n.a.<br />
- % growth, year-on-year, unless o<strong>the</strong>rwise specified<br />
MY – nominal exchange rate<br />
MYR per USD<br />
3.60<br />
MY – policy rate<br />
%, OPR<br />
4.0<br />
3.50<br />
3.5<br />
3.40<br />
3.0<br />
3.30<br />
3.20<br />
3.10<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
2.5<br />
2.0<br />
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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<strong>Economics</strong>: Malaysia<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
TH: Politics over economics<br />
• In <strong>the</strong> first quarter, Thai economy grew by 6% (YoY) and 5.6% (QoQ, saar)<br />
driven by strong export growth and modest recovery in domestic demand<br />
• However, since <strong>the</strong>n, <strong>the</strong> political situation has deteriorated sharply with<br />
anti-government protests on <strong>the</strong> rise in Bangkok. In fact, risks of a coup<br />
have risen sharply in May08 / Jun08. In our central scenario, we assume <strong>the</strong><br />
current turmoil continues<br />
• The lack of political stability and <strong>the</strong> rise in cost of living should prevent<br />
any material recovery in domestic demand. Yet, strong economic<br />
fundamentals and competitiveness in manufacturing should keep export<br />
strong. We, <strong>the</strong>refore, look for 5% and 4.7% GDP growth in ‘08 and ‘09<br />
• There is still sense in reducing <strong>the</strong> degree of policy accommodation.<br />
Therefore, we have maintained our forecast for rates to be lifted by 50bps<br />
to 3.75% in 4Q08. A 3Q08 rate hike, however, cannot be ruled out.<br />
1Q08 GDP review and summary outlook<br />
Political instability<br />
is likely to hurt<br />
domestic demand<br />
In <strong>the</strong> first quarter, Thai economy grew by 6% (YoY) and 5.6% (QoQ, saar) driven<br />
by strong export growth, modest recovery in domestic demand and inventory<br />
accumulation. The data particularly reveal Thailand’s export competitiveness -<br />
exports grew by 8.7% (YoY) or 23% (QoQ, saar). Consumption spending expanded<br />
by 5.5% (QoQ, saar) but was weaker than our expectations and unimpressive in<br />
YoY terms (2.6%). Private investment spending grew by 6.5% (YoY) but slowed<br />
down to 1% (QoQ, saar) in sequential terms. Oddly, government spending -<br />
consumption and investment - slowed sharply (Charts 1 & 2).<br />
Going forward, although economic fundamentals are sound, lack of political<br />
stability should hurt domestic demand. This coupled with <strong>the</strong> rise in cost of<br />
living and worries about higher inflation should keep domestic demand below<br />
potential. Therefore, we recently downgraded our 2008 and 2009 GDP forecast<br />
Chart 1: GDP contribution by expenditure<br />
Chart 2: GDP growth<br />
% YoY<br />
8<br />
6<br />
4<br />
2<br />
0<br />
% QoQ, 2qma<br />
8<br />
6<br />
GDP growth (sequential terms)<br />
THAILAND<br />
-2<br />
-4<br />
-6<br />
-8<br />
Errors<br />
Net Exports<br />
Government<br />
Investment + Stocks<br />
Consumption<br />
GDP<br />
Sep-06 Mar-07 Sep-07 Mar-08<br />
4<br />
Latest: Mar08<br />
2<br />
Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07<br />
Ramya Suryanarayanan • (65) 6878 5282 • ramya@dbs.com<br />
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<strong>Economics</strong>: Thailand<br />
to 5% (vs 5.6% earlier) and 4.7% (vs 5.2% earlier). Domestic demand should still<br />
do much better than <strong>the</strong> dismal showing in 2007 (assuming we do not actually<br />
see ano<strong>the</strong>r coup).<br />
No end in sight to political stand-off<br />
We are particularly concerned that <strong>the</strong>re is no end in sight to <strong>the</strong> political instability<br />
that erupted with anti-Thaksin protests in 2005. As democratic institutions such<br />
as <strong>the</strong> judiciary and <strong>the</strong> constitution court were believed to be subverted by expremier<br />
Thaksin, <strong>the</strong> military justified a coup on <strong>the</strong> grounds that it is <strong>the</strong> only<br />
viable solution to non-violently end anti-government protests. Many Thais in<br />
Bangkok even hoped <strong>the</strong> coup would turn out to be a solution for <strong>the</strong> political<br />
woes once <strong>the</strong> military made it clear that this was a temporary move meant to<br />
restore <strong>the</strong> independence of democratic institutions. Following that, democratic<br />
elections were expected to return stability to <strong>the</strong> country with <strong>the</strong> hope that<br />
<strong>the</strong> Democratic party may return to power. As we know, this did not happen<br />
and political uncertainties have only worsened in 2008. Obviously, staging a<br />
coup again and / or holding fresh elections again will not result in different,<br />
more favourable and stable outcomes. But ano<strong>the</strong>r coup is certainly a material<br />
risk and would be disastrous for <strong>the</strong> Thai economy.<br />
One main reason for <strong>the</strong> return of political instability is that <strong>the</strong> country is<br />
polarized with people in Bangkok against Thaksin and <strong>the</strong> (majority) rural Thais<br />
in favour of Thaksin. This means elections are likely to bring some form of<br />
Thaksin’s Thai Rak Thai (TRT) back in power. This, in turn, leads to government<br />
policies and functioning that bring people in Bangkok on streets in anti-government<br />
protests. The charter change agenda is just a policy that has brought out <strong>the</strong>se<br />
deep divisions in <strong>the</strong> forefront. As such, it appears likely that political uncertainty<br />
is here to stay.<br />
Politics to hurt confidence and consumption recovery<br />
Consumption spending grew by around 3% (QoQ, saar, smoo<strong>the</strong>d) in <strong>the</strong> last<br />
two quarters, double <strong>the</strong> rate that prevailed in <strong>the</strong> preceeding 12 months (Chart<br />
3). Going forward, deterioration in politics implies consumption should stay<br />
below trend (~5%). We expect a continuation of 3% sequential growth ahead<br />
as consumer confidence should begin to deteriorate once again. It is interesting<br />
to note that despite political worries, <strong>the</strong> “present” and “future” confidence<br />
sub-indices have diverged in <strong>the</strong> last 12 months (Chart 4). The “future” was<br />
generally expected to be much better than <strong>the</strong> “present”. In o<strong>the</strong>r words a<br />
resolution was always expected for <strong>the</strong> political woes which were seen as relatively<br />
There is little hope<br />
for an end to <strong>the</strong><br />
political stand-off<br />
as elections have<br />
failed to resolve<br />
outstanding issues<br />
Future subcomponent<br />
(Chart<br />
4) of consumer<br />
confidence might<br />
begin to fall<br />
Chart 3: Personal consumption vs avg wages<br />
% YoY % YoY, 2qma<br />
9<br />
8<br />
Chart 4: Consumer confidence - "future" to drop?<br />
Index<br />
98<br />
6<br />
3<br />
0<br />
6<br />
4<br />
2<br />
0<br />
88<br />
78<br />
-3<br />
Mar-<br />
01<br />
Mar-<br />
02<br />
Mar-<br />
03<br />
Mar-<br />
04<br />
Mar-<br />
05<br />
Mar-<br />
06<br />
Mar-<br />
07<br />
Private consumption indicator<br />
Avg wages (RHS)<br />
Mar-<br />
08<br />
-2<br />
68<br />
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08<br />
Consumer confidence: present<br />
Consumer confidence: future<br />
Consumer confidence: future income<br />
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<strong>Economics</strong>: Thailand<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
short-term. However, as we discussed in <strong>the</strong> previous paragraph, both <strong>the</strong> coup<br />
and <strong>the</strong> general elections have failed to bring political stability, revealing instead<br />
<strong>the</strong> deep divisions in Thai society at present. This means that confidence that<br />
<strong>the</strong> political mess can be resolved in <strong>the</strong> future should begin to fade. This may<br />
drag <strong>the</strong> “future” confidence sub-index down towards <strong>the</strong> “present” index at<br />
some point. This, in turn, is negative for <strong>the</strong> longer term outlook. Thankfully,<br />
we can still count on <strong>the</strong> relatively healthy labour market and strong farm<br />
incomes in 1Q08 to support consumption spending at around 3%.<br />
Investment - expected only in export oriented sectors where capacity is tight<br />
In 1Q08, investment spending began to turn around (Chart 5) in light of elevated<br />
capacity utilisation rates and pent up demand, especially in export-oriented<br />
sectors. Indeed, business sentiment, especially with regards to investment turned<br />
around sharply according to a BoT survey (Chart 6).<br />
Chart 5: Investment vs capacity utilisation<br />
% YoY %<br />
20<br />
77<br />
Chart 6: Business sentiment: investment sub-index<br />
Index<br />
58<br />
15<br />
10<br />
5<br />
75<br />
73<br />
71<br />
56<br />
54<br />
52<br />
50<br />
0<br />
-5<br />
Gross capital formation<br />
Capacity Utilisation<br />
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08<br />
69<br />
67<br />
48<br />
46<br />
Mar-00 Mar-02 Mar-04 Mar-06 Mar-08<br />
However, <strong>the</strong> renewed spike up in political uncertainty implies that fur<strong>the</strong>r<br />
recovery in investment should be restricted to sectors and companies with very<br />
high capacity utilisation where orders cannot be met unless capacity is expanded.<br />
Capacity utilisation is now running above 90% in some sectors such as electrical<br />
and electronic, food, chemicals and paper (Chart 7). This should help support<br />
investment spending growth at 5%-6%, a little better than <strong>the</strong> 3% growth seen<br />
in 2006 and 2007, but disappointing none<strong>the</strong>less.<br />
Chart 7: Capacity utilisation - 90% in many sectors even as headline rate is not high<br />
%, 4qma<br />
105<br />
Mar-05<br />
Mar-08<br />
100<br />
95<br />
90<br />
85<br />
80<br />
75<br />
70<br />
65<br />
60<br />
Paper Chem Petro<br />
pdts<br />
IC<br />
Disk<br />
drives<br />
Zinc<br />
Comm.<br />
Car<br />
Tyre<br />
Wshg<br />
Mach<br />
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<strong>Economics</strong>: Thailand<br />
Exports going strong - around 15% if price effect is taken into account<br />
Export growth has accelerated in <strong>the</strong> last three months. Exports grew by 28%<br />
(YoY) and 20% (3mma) in Apr08. After accounting for higher commodity prices,<br />
manufacturing exports appear to be growing at circa 15% annual rate. This is<br />
illustrated in <strong>the</strong> chart below. Petroleum products, jewellery, and manufactured<br />
food (bright red bar in <strong>the</strong> chart), all of which have seen unusually large price<br />
increases, are <strong>the</strong> key drivers behind <strong>the</strong> rise in exports in <strong>the</strong> last six months<br />
(Chart 8). In any case, 15% export growth rate is indeed remarkable considering<br />
that <strong>the</strong> US struggles with 1% annualised consumption spending.<br />
Accounting for<br />
commodity price<br />
jump still means<br />
Thai export growth<br />
is around 15%<br />
Chart 8: Mfg exports by commodity accounting for commodity price rise<br />
% pt- YoY, 3mma<br />
40<br />
35<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
Machinery (mainly PC)<br />
Vehicles and parts<br />
Base metal<br />
Oil, jewellery, food (px effect)<br />
Electronics (IC, HDD)<br />
Electrical appliance<br />
All <strong>the</strong> rest<br />
Mfg exports<br />
0<br />
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08<br />
The 1Q08 GDP report showed that exports in real terms rose by 5.7% (QoQ, sa)<br />
or 23% annualised. Exports expanded at a similar rate in 4Q07. Clearly, Thai<br />
manufacturing sector is competitive in many electrical and (low-end) electronic<br />
products. In <strong>the</strong> past year, exports to Asia and o<strong>the</strong>r emerging markets have<br />
been <strong>the</strong> key driver of Thai export growth (Chart 9). Fur<strong>the</strong>rmore, Asia (ex-Thai)<br />
exports to US has also been very weak (Chart 10). In o<strong>the</strong>r words, final demand<br />
doesn’t merely lie in <strong>the</strong> US and exports to Asia have not been merely recycled<br />
to <strong>the</strong> US. As such, even as US economic growth is weak, we are confident that<br />
Thai exports should grow at <strong>the</strong> annual rate of 15% going forward. This should<br />
support full year 2008 export growth at 20%.<br />
Thai exports to<br />
Asia not merely<br />
headed to US<br />
Chart 9: Exports to Asia driving export growth….<br />
% YoY, 3mma<br />
35<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
TH exports: to Asia<br />
Th exports: to US<br />
Apr-06 Oct-06 Apr-07 Oct-07 Apr-08<br />
Chart 10: …and <strong>the</strong>se are not merely headed to US<br />
% YoY, 3mma<br />
35<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
TH exports: to Asia<br />
Asia ex-Thai exports: to US<br />
Apr-06 Oct-06 Apr-07 Oct-07 Apr-08<br />
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<strong>Economics</strong>: Thailand<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
There is still some<br />
sense in reducing<br />
<strong>the</strong> degree of<br />
policy<br />
accomodation<br />
Inflation and monetary policy<br />
We recently lifted our 2008 CPI forecast again to 6.4%. Inflation is really a wild<br />
card this year. If we see a big drop in food prices, inflation can decline pretty<br />
rapidly. Conversely, if food and fuel prices increase fur<strong>the</strong>r or do not decline,<br />
<strong>the</strong>n inflation will be higher than our forecast. In any case, core inflation would<br />
head higher as higher crude oil price results in higher transportation costs which<br />
in turn push <strong>the</strong> price of nearly all products higher.<br />
We think <strong>the</strong> BoT would not mechanically react to higher core inflation. Ra<strong>the</strong>r,<br />
<strong>the</strong> key question policy makers will ask is whe<strong>the</strong>r this is a one-off increase in<br />
price level or is <strong>the</strong>re a risk of a more permanent increase in inflation. The<br />
answer to this question depends on inflation expectations and strength of domestic<br />
demand. This, in turn, depends on a return to normalcy on <strong>the</strong> political front, a<br />
normalcy that is not simply a temporary calm before <strong>the</strong> storm.<br />
The point is that if politics continues to disappoint, <strong>the</strong>n BoT can afford to keep<br />
rates at accommodative levels. However, we think <strong>the</strong>re is sense in reducing <strong>the</strong><br />
degree of accommodation at some point. Therefore, we have maintained our<br />
forecast for rates to be lifted by 50bps to 3.75% by end-08 despite downgrading<br />
<strong>the</strong> GDP forecast. We think it is more likely that this hike comes in 4Q08 than<br />
3Q08. Uncertainties on global growth should ease by fourth quarter and <strong>the</strong><br />
degree of domestic demand recovery in Thailand should also be apparent. An<br />
earlier rate hike, however, cannot be ruled out.<br />
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<strong>Economics</strong>: Thailand<br />
Thailand Economic Indicators<br />
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP growth (88P) 4.8 5.0 4.7 6.0 5.7 4.7 3.7 3.5 4.4<br />
Private consumption 1.5 3.3 3.3 2.6 3.6 3.1 3.8 3.0 3.2<br />
Government consumption 10.8 1.7 6.0 -0.1 1.2 1.7 4.1 7.7 6.4<br />
Gross Fixed capital formation 1.4 4.3 6.0 5.4 4.7 4.0 3.3 4.8 5.7<br />
Chg in Stocks (THB bn) 1.8 2.0 3.2 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Net exports (THBbn) 673 786 834 187 151 220 227 186 160<br />
Exports 7.1 10.1 6.1 9 10 14 8 4 6<br />
Imports 3.5 8.1 6.1 10 10 8 5 6 6<br />
External<br />
Merch exports (USDbn) 151 181 203 43 44 48 48 47 49<br />
- % YoY 18 20 12 26 22 24 13 9 12<br />
Merch imports (USDbn) 139 174 195 41 45 43 44 46 50<br />
- % YoY 10 25 12 34 30 21 16 10 11<br />
Trade balance (USD bn) 12 7 8 -1 -1 5 4 1 -1<br />
Current account balance (USD bn) 15 12 13 -1 -1 5 6 5 -1<br />
% of GDP 6.1 3.7 3.4 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Inflation<br />
CPI inflation 2.2 6.4 2.8 5.0 7.0 7.7 5.9 4.1 2.1<br />
O<strong>the</strong>r<br />
Nominal GDP (USDbn) 244 330 384 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Unemployment rate, % 1.0 0.8 1.0 n.a. n.a. n.a. n.a. n.a. n.a.<br />
* % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
TH – nominal exchange rate<br />
THB per USD<br />
34<br />
TH – policy rate<br />
%, 1-day RRP<br />
5.0<br />
33<br />
32<br />
4.5<br />
31<br />
4.0<br />
30<br />
29<br />
3.5<br />
28<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
3.0<br />
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
119
<strong>Economics</strong>: Singapore<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
SG: Inflation woes<br />
• Inflation has continued to rise owing to both domestic and external factors<br />
• The effectiveness of exchange rate policy – Singapore’s policy tool – in<br />
containing inflation is limited<br />
• Inflation will remain high for <strong>the</strong> rest of <strong>the</strong> year. Full year average inflation<br />
will register 6.4%<br />
• GDP growth in 1Q08 was strong at 6.7% YoY, led by investment,<br />
consumption and government spending. Net exports were a drag<br />
• The next two quarters will see slower growth, led by a declining<br />
manufacturing sector. But full-year growth remains on track to hit 6.0%,<br />
with growth of 6.8% expected in 2009<br />
CPI inflation in April<br />
clocked 7.5% YoY<br />
Inflation continues to escalate<br />
Consumer prices rose by a very fast 7.5% YoY in April (Chart 1). Food price<br />
inflation hit 8.5% while transport and communication prices rose 7.0% as a<br />
result of dearer petrol, as well as higher taxi fares and car prices. Housing costs<br />
spiked 11.8%, driven by higher electricity tariffs and rentals.<br />
Chart 1: Inflation still rising<br />
% YoY<br />
8.0<br />
7.0<br />
6.0<br />
5.0<br />
4.0<br />
3.0<br />
2.0<br />
1.0<br />
0.0<br />
-1.0<br />
Inflation<br />
Core inflation<br />
Inflation hit<br />
7.5% in Apr08<br />
Latest: Apr08 -2<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
Chart 2: Food inflation may moderate<br />
% YoY<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
CPI - food<br />
Domestic supply px index - food<br />
Import px index - food<br />
Latest: Apr08<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
SINGAPORE<br />
Inflation has continued to rise on <strong>the</strong> back of both domestic and external factors.<br />
Domestically, <strong>the</strong> effects of <strong>the</strong> upward revision to <strong>the</strong> Annual Values of homes,<br />
hike in taxi fares, ERP charges, higher fuel and car prices will continue to linger<br />
on headline CPI inflation. Externally, although food prices are showing signs of<br />
moderating (Chart 2), crude oil prices have continued to surprise to <strong>the</strong> upside,<br />
creating tremendous imported inflationary pressure for this small and open<br />
economy (Chart 3). The price of crude oil has already surged beyond USD 130/<br />
Irvin Seah • (65) 6878 6727 • irvinseah@dbs.com<br />
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<strong>Economics</strong>: Singapore<br />
bbl and looks likely to remain <strong>the</strong>re for a while. With supply-side tightness,<br />
strong demand and speculative pressure, energy prices may remain elevated for<br />
<strong>the</strong> rest of <strong>the</strong> year.<br />
Chart 3: High oil prices will remain a threat<br />
USD/bbl<br />
140<br />
130<br />
120<br />
110<br />
100<br />
90<br />
80<br />
70<br />
60<br />
50<br />
Oil prices (Brent)<br />
40<br />
Jan-07 Mar-07 Jun-07 Sep-07 Dec-07 Feb-08 May-08<br />
Chart 4: Recent tightening in policy<br />
110<br />
Re-centering of<br />
108<br />
<strong>the</strong> policy band<br />
106<br />
104<br />
102<br />
100<br />
98<br />
96<br />
94<br />
Modest increase<br />
in slope<br />
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08<br />
110<br />
108<br />
106<br />
104<br />
102<br />
100<br />
98<br />
96<br />
94<br />
Exchange rate policy is limited<br />
The central bank clearly understands <strong>the</strong> risk of rising inflation and its impact<br />
on <strong>the</strong> broader economy. It has tightened monetary policy twice in <strong>the</strong> past<br />
year (Chart 4). In its most recent move in Apr08, <strong>the</strong> Monetary Authority of<br />
Singapore (MAS) re-centred its SGD NEER policy band by moving <strong>the</strong> centre of<br />
<strong>the</strong> band to <strong>the</strong> prevailing NEER level. The width and slope (or appreciation<br />
pace) of <strong>the</strong> band were left unchanged. Essentially, <strong>the</strong> original upper limit of<br />
<strong>the</strong> SGD NEER policy band became <strong>the</strong> centre of <strong>the</strong> new band, resulting in a<br />
one-off appreciation of about 1.5% for <strong>the</strong> SGD NEER.<br />
But <strong>the</strong> effectiveness of MAS’ exchange rate policy in containing inflation is<br />
limited. The exchange rate policy alone is not <strong>the</strong> cure-all for inflation. Instead,<br />
it should be viewed merely as a cushion against supply-side pressures, especially<br />
those stemming from high commodity prices. A stronger currency will help to<br />
offset <strong>the</strong> impact of imported inflationary, but only partially - since <strong>the</strong> start of<br />
Exchange rate<br />
policy cannot<br />
always contain<br />
inflation<br />
Chart 5: Domestic inflation has been rising too<br />
% YoY<br />
Chart 6: Strong SGD is hurting exports<br />
% YoY SGD/USD<br />
10<br />
20<br />
NODX growth<br />
1.70<br />
15<br />
1.65<br />
8<br />
SGD/USD<br />
Tradable CPI<br />
1.60<br />
10<br />
Non-tradable CPI<br />
6<br />
1.55<br />
5<br />
1.50<br />
4<br />
0<br />
1.45<br />
-5<br />
1.40<br />
2<br />
1.35<br />
-10<br />
1.30<br />
0<br />
-15<br />
Latest: Apr08<br />
1.25<br />
-2<br />
Latest : Apr08 -20<br />
1.20<br />
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08<br />
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<strong>the</strong> year, <strong>the</strong> SGD has appreciated 6% against <strong>the</strong> USD, versus an almost 40%<br />
surge in crude oil prices.<br />
The exchange rate policy is also ineffective in stemming domestically-induced<br />
inflation, which we believe Singapore is also experiencing as a result of strong<br />
growth over <strong>the</strong> last few years. Domestic inflation, as proxied by non-tradable<br />
CPI inflation, has been rising along with imported inflation (represented by<br />
tradable CPI inflation) (Chart 5). Lastly, <strong>the</strong> exchange rate policy has a significant<br />
flip-side - that of a stronger currency weighing on export growth (Chart 6).<br />
Inflation should moderate but full-year average will remain high<br />
Inflation should<br />
peak at 8.1% YoY in<br />
Jun08<br />
Inflationary pressure will remain high in <strong>the</strong> near-term. We expect <strong>the</strong> CPI to<br />
peak at 8.1% YoY in Jun08, which will bring average inflation in 1H08 to 7.2%<br />
(Chart 7). The base-year effects of <strong>the</strong> GST hike in 2007 will disappear from July,<br />
resulting in a 2%-pt drop in YoY inflation for that month. However, it is unlikely<br />
to bring much comfort, given that <strong>the</strong> rise in commodity prices is not showing<br />
any sign of abating. Inflation in <strong>the</strong> second half of <strong>the</strong> year will <strong>the</strong>refore likely<br />
remain high, at about 5.6%. With that, full year inflation will register 6.4%, up<br />
slightly from our previous forecast of 6.0%. Our inflation forecast for 2009<br />
remains at 2.8%.<br />
With inflation this year likely to burst through <strong>the</strong> 5.0-6.0% comfort zone of<br />
policymakers, <strong>the</strong>re is some risk that policy will be tightened fur<strong>the</strong>r to rein in<br />
inflation. However, based on our estimates inflation will most likely be on its<br />
way down when <strong>the</strong> central bank next decides on policy in October. Unless<br />
commodity prices - particularly crude oil - continue to surprise to <strong>the</strong> upside,<br />
<strong>the</strong> central bank is likely to hold back on tightening policy, given concerns over<br />
<strong>the</strong> growth outlook in <strong>the</strong> next few quarters.<br />
Chart 7: Inflation forecast for 2008<br />
% YoY <strong>DBS</strong>f<br />
9.0<br />
Inflation should<br />
8.0<br />
peak at 8.1% in<br />
7.0<br />
Jun08<br />
6.0<br />
Inflation<br />
5.0<br />
Core inflation<br />
4.0<br />
3.0<br />
2.0<br />
1.0<br />
0.0<br />
-1.0<br />
Jan-05 Jan-06 Jan-07 Jan-08<br />
Chart 8: Net exports still <strong>the</strong> main drag on growth<br />
%-pt contribution<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
-20<br />
Latest: 1Q08<br />
Net Exports<br />
GFCF<br />
Govt Consumption<br />
Pvt Consumption<br />
GDP Growth<br />
Net exports subtracted<br />
17%-pt from growth<br />
Mar-05 Mar-06 Mar-07 Mar-08<br />
Decent growth in 1Q08<br />
First quarter GDP<br />
growth clocked<br />
6.7%<br />
While <strong>the</strong> outlook for <strong>the</strong> next two quarters is not rosy, growth in <strong>the</strong> first<br />
quarter was decent, with GDP growth clocking 6.7% YoY, led by a robust expansion<br />
in investment. Gross Fixed Capital Formation (GFCF) surged 30% YoY in <strong>the</strong><br />
quarter, contributing a chunky 16.5%-pts to overall GDP growth (Chart 8). However,<br />
against <strong>the</strong> backdrop of slowing global demand, net exports contracted 27.7%<br />
YoY, shaving 17%-pts from growth. While export growth was reasonably strong<br />
at 9.2% YoY, it was offset by even stronger import growth of 13.8% YoY. Private<br />
consumption and government spending also increased, up 4.1% YoY and 3.2%<br />
YoY respectively. Overall, domestic demand has been buffering <strong>the</strong> Singapore<br />
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<strong>Economics</strong>: Singapore<br />
economy against <strong>the</strong> decline in external demand. Still, <strong>the</strong> risks remain biased<br />
to <strong>the</strong> downside going forward, as we expect <strong>the</strong> US-led decline in global demand<br />
to weigh on growth in <strong>the</strong> next two quarters.<br />
Slower growth ahead<br />
The manufacturing sector, which posted a stunning 12.4% YoY expansion in <strong>the</strong><br />
first quarter, may bear <strong>the</strong> brunt of this global slowdown. Already, higher frequency<br />
indicators like industrial output data is pointing to signs of moderation in <strong>the</strong><br />
sector (Chart 9). For example, electronics output contracted by about 5.1% YoY<br />
in Apr08 versus a rise of 5.4% YoY in 1Q08. With <strong>the</strong> US semicon-making equipment<br />
(SEMI) book-to-bill ratio not showing any signs of turning around, it seems that<br />
<strong>the</strong> tech-sector recovery which many had anticipated would occur in second<br />
half is not going to materialise (Chart 10). Although <strong>the</strong> biomedical segment<br />
may provide some much needed support from time to time, it is highly volatile<br />
in nature. A good example would be April’s industrial output figure, which fell<br />
5.7% YoY due to a drastic 28% YoY contraction in pharmaceutical output. So,<br />
against <strong>the</strong> broader backdrop of a slowing global demand, <strong>the</strong> manufacturing<br />
sector may start to lose steam from <strong>the</strong> second quarter onwards before a turnaround<br />
in <strong>the</strong> fourth, on hopes of a recovery in <strong>the</strong> US.<br />
The manufacturing<br />
sector may lose<br />
steam<br />
Chart 9: Manufacturing set to moderate<br />
index, 3mma<br />
140<br />
130<br />
120<br />
110<br />
Manufacturing<br />
showing signs of<br />
moderation<br />
Chart 10: Electronics not turning around<br />
ratio<br />
1.3<br />
1.2<br />
Latest: Apr07<br />
1.1<br />
1.0<br />
% YoY<br />
40<br />
20<br />
0<br />
100<br />
90<br />
80<br />
70<br />
Pharmaceuticals<br />
Electronics<br />
Overall manufacturing<br />
May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08<br />
0.9<br />
0.8<br />
0.7<br />
0.6<br />
Global semicon sales<br />
SEMI book-to-bill (LHS)<br />
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08<br />
-20<br />
-40<br />
-60<br />
But some segments will remain resilient<br />
In <strong>the</strong> quarters ahead, export-oriented and sentiment-sensitive sectors (such as<br />
manufacturing, and some financial and real estate services) will be more affected<br />
by <strong>the</strong> deterioration in <strong>the</strong> external environment and heightened risk aversion<br />
in <strong>the</strong> asset markets. Domestic and region-oriented sectors such as construction,<br />
marine engineering and tourism should perform better, providing some support<br />
to <strong>the</strong> economy. In general, economic activity in Asia is expected to remain<br />
fairly resilient in <strong>the</strong> near term, reflecting strong domestic demand and underlying<br />
growth momentum. Fur<strong>the</strong>rmore, Asian financial institutions are also less affected<br />
by <strong>the</strong> subprime crisis in <strong>the</strong> US.<br />
Overall, it will no doubt be a challenging year for <strong>the</strong> Singapore economy, as it<br />
faces <strong>the</strong> prospect of slower growth and higher inflation. Yet, <strong>the</strong> underlying<br />
fundamentals of <strong>the</strong> economy remain strong. Our assessment is that <strong>the</strong> economy<br />
is still on track to post growth of 6.0% for this year and 6.8% in 2009 despite <strong>the</strong><br />
near term risks to growth.<br />
The economy is still<br />
on track to post 6%<br />
growth this year<br />
and 6.8% next<br />
year<br />
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Singapore Economic Indicators<br />
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
Real GDP (00P) 7.7 6.0 6.8 6.7 5.6 5.3 6.3 7.3 6.7<br />
Private consumption 4.6 4.4 4.7 4.7 4.5 4.2 4.0 4.4 4.5<br />
Government consumption 2.5 4.1 2.4 10.2 3.0 2.0 1.2 2.5 2.3<br />
Gross fixed investment 20.6 23.7 11.7 30.0 25.0 22.1 17.8 12.8 11.0<br />
Net exports (SGDbn) 66 59 63 11 15 19 14 13 15<br />
Exports (% YoY) 6.6 6.6 7.3 9.2 6.1 5.0 6.0 7.3 7.3<br />
Imports (% YoY) 6.8 8.8 7.3 13.8 8.0 7.3 6.3 6.3 7.5<br />
Real supply<br />
Goods producing industries 7.3 7.3 6.9 12.2 8.5 4.1 4.5 8.2 7.7<br />
Manufacturing 5.9 6.3 6.5 12.4 7.5 2.5 2.7 6.9 7.0<br />
Construction 20.3 16.4 12.1 14.7 19.7 16.0 15.5 17.9 15.6<br />
Services 8.1 8.4 7.2 7.5 7.8 8.9 9.5 7.4 6.6<br />
External (nominal)<br />
Non-oil domestic exports 2.3 2.3 5.7 0.6 2.7 -0.7 6.8 8.0 5.3<br />
Current account balance (USD bn) 41 45 52 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP 25 25 26 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Foreign reserves (USD bn) 163 179 203 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Inflation<br />
CPI inflation 2.1 6.4 2.8 6.6 7.7 6.2 5.0 3.5 2.5<br />
O<strong>the</strong>r<br />
Nominal GDP (USDbn) 162 181 199 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Unemployment rate (%, sa, eop) 2.0 2.0 1.7 2.0 2.3 2.4 2.0 2.1 1.9<br />
- % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
SG – nominal exchange rate<br />
SGD per USD<br />
1.58<br />
1.55<br />
1.52<br />
1.49<br />
1.46<br />
1.43<br />
1.40<br />
1.37<br />
1.34<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
SG – 3mth SIBOR<br />
% pa<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
1.5<br />
1.0<br />
0.5<br />
0.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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PH: Back-tracking<br />
• Things have turned topsy-turvy in <strong>the</strong> Philippines. Growth has been weaker<br />
than expected and inflation is at a ten-year high<br />
• First-quarter growth was low 5.2% YoY and 4Q07 growth was revised<br />
downward to 6.4%. Although <strong>the</strong> revision made little difference to 2007<br />
growth – fast 7.2% growth was recorded, <strong>the</strong> highest since 1981 – <strong>the</strong> pace<br />
is now slowing. As surging inflation and higher interest rates take <strong>the</strong>ir<br />
toll, growth this year should fall to 5.2% before recovering to 6% in 2009<br />
• Inflation this year should average 9%, far above <strong>the</strong> central bank target of<br />
3%-5%. We expect <strong>the</strong> BSP to continue lifting interest rates in 2H08, taking<br />
<strong>the</strong> reverse repo (overnight borrowing) and repo (overnight lending) rates<br />
75bps higher, to 6% and 8% respectively<br />
• To cushion against slower growth, <strong>the</strong> government has deferred plans to<br />
balance its budget this year. It is looking at spending up to PHP 1.26trn,<br />
which it estimates will take <strong>the</strong> deficit to GDP ratio to 1%. We do not see<br />
any risks to its projections; indeed chances are for an even slightly smaller<br />
ratio of around 0.8%<br />
PHILIPPINES<br />
Following <strong>the</strong> 1Q07<br />
GDP report, we<br />
have cut our<br />
growth forecast to<br />
5.4% for 2008 and<br />
6% for 2009<br />
Growth slows<br />
It is no exaggeration to say that first-quarter GDP growth was a shocker. We had<br />
been expecting a slowdown from <strong>the</strong> blistering pace of growth in 2007, but not<br />
that slow. The economy expanded just 5.2% YoY in 1Q08, versus our sub-consensus<br />
forecast of 5.8%. Growth in 4Q07 was shaved a whole percentage point lower<br />
from earlier estimates, to 6.4% YoY. Although <strong>the</strong> fourth-quarter revision was<br />
“compensated” for by an upgrade to <strong>the</strong> 2Q07 numbers, which kept growth for<br />
<strong>the</strong> full 2007 still robust at 7.2%, it still meant a very different growth profile<br />
from <strong>the</strong> one we were looking<br />
at three months back (Chart<br />
1). Back <strong>the</strong>n we would have<br />
guessed a much more gradual<br />
slowdown from 2007, to <strong>the</strong><br />
tune of 6.6% in 2008 and 6.7%<br />
in 2009. Now, however, <strong>the</strong><br />
adjustment appears somewhat<br />
sharper, and for this year and<br />
<strong>the</strong> next we have revised our<br />
growth forecasts lower, to 5.4%<br />
and 6% respectively. The reasons<br />
for <strong>the</strong> slowdown remain <strong>the</strong><br />
same as we have previously<br />
laid out, with both domestic<br />
and external demand set to<br />
deteriorate, but now to a greater<br />
degree than we initially<br />
estimated (Chart 2).<br />
Chart 1: Growth profile sharply lower<br />
% YoY<br />
8.5<br />
8.0<br />
7.5<br />
7.0<br />
6.5<br />
6.0<br />
5.5<br />
5.0<br />
Growth path<br />
as at 1Q08<br />
Growth path<br />
as at 4Q07<br />
7.4<br />
6.4<br />
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08<br />
5.2<br />
Lim Su Sian • (65) 6878 1740 • limsusian@dbs.com<br />
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<strong>Economics</strong>: Philippines<br />
Inflation to hit consumer spending<br />
A key negative factor weighing<br />
on <strong>the</strong> consumption outlook<br />
in <strong>the</strong> coming quarters is inflation,<br />
and this year we expect real<br />
private consumption expenditure<br />
(PCE) growth to slip to 5.4%,<br />
before returning to 5.8% in<br />
2009, <strong>the</strong> same pace as 2007.<br />
As prices rise, <strong>the</strong> amount of<br />
goods consumers can purchase<br />
for <strong>the</strong> same amount of money<br />
shrinks. This erosion of purchasing<br />
power was already evident in<br />
1Q08. Although we found <strong>the</strong><br />
slowdown in first quarter<br />
consumption growth to be too<br />
sharp and not quite<br />
commensurate with <strong>the</strong> rise<br />
Chart 2: Growth to slow this year<br />
%-pt contrib to YoY GDP growth<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
<strong>DBS</strong>f 08: 5.4%,<br />
09: 6.0%<br />
Dec-06 Dec-07 Dec-08 Dec-09<br />
PCE GCE Investment<br />
Stat disc Net exports GDP YoY<br />
in inflation, <strong>the</strong> negative correlation between prices and spending over time is<br />
clear (Chart 3).<br />
Chart 3: Inflation vs real spending<br />
% YoY<br />
6.5<br />
6.0<br />
5.5<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
CPI<br />
inflation,<br />
RHS (inv)<br />
PCE growth<br />
Latest: 1Q08<br />
% YoY, inv<br />
Mar-02 Mar-04 Mar-06 Mar-08<br />
0<br />
1<br />
2<br />
3<br />
4<br />
5<br />
6<br />
7<br />
8<br />
9<br />
Chart 4: Headline inflation busts BSP's target<br />
% YoY<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
BSP inflation<br />
target<br />
<strong>DBS</strong>f 08: 9%<br />
Headline CPI<br />
Latest: May08<br />
Jan-03 Jul-04 Jan-06 Jul-07 Jan-09<br />
We expect inflation to rise fur<strong>the</strong>r in coming quarters on <strong>the</strong> back of food and<br />
fuel prices. For <strong>the</strong> second quarter we only have April and May data in hand,<br />
but headline inflation has already averaged a whopping 9% YoY. This compares<br />
to an average of 5.5% YoY in 1Q08. Based on current trends, and on <strong>the</strong> observation<br />
that prices generally face much greater resistance adjusting downwards than<br />
upwards, our estimates suggest that headline inflation will surpass 10% YoY in<br />
<strong>the</strong> remaining months of <strong>the</strong> year, peaking at above 11% YoY in Sept/Oct. Such<br />
will take inflation for <strong>the</strong> year to 9%. More specifically, food inflation could rise<br />
to above 16% YoY later this year. Given that food accounts for over 53% of<br />
total consumer spending, this surge in prices must have an adverse impact on<br />
PCE growth. Next year, as base-year effects wear off and assuming some stability<br />
in energy prices, inflation should print 4.8% (Chart 4).<br />
Prices have more<br />
room to rise;<br />
inflation this year<br />
will average 9%,<br />
and 4.8% in 2009<br />
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With its inflation<br />
target shattered,<br />
<strong>the</strong> central bank<br />
will lift interest<br />
rates by a fur<strong>the</strong>r<br />
75bps, taking <strong>the</strong><br />
repo rate to 7.25%<br />
by end-08<br />
Slower growth in<br />
<strong>the</strong> US will weigh<br />
on remittances;<br />
peso weakness<br />
helps only to a<br />
degree<br />
Business spending<br />
will rise by a decent<br />
7% this year, but<br />
largely on public<br />
spending<br />
As will interest rate hikes<br />
Still, our inflation forecasts are well above <strong>the</strong> BSP’s inflation targets for this<br />
year and <strong>the</strong> next. This year <strong>the</strong> central bank’s inflation target is at 3-5%, and<br />
next year inflation is targeted at 2.5-4.5%. In view of this, we expect <strong>the</strong> central<br />
bank to continue <strong>the</strong> tightening cycle it embarked on earlier this month. The<br />
overnight reverse repo (borrowing) and repo (lending) rates were lifted 25bps<br />
to 5.25% and 7.25% respectively, and we expect a fur<strong>the</strong>r 75bps of tightening<br />
before <strong>the</strong> year is up, to be delivered in three moderate steps of 25bp each.<br />
These interest rate hikes should help to contain risks of a wage-price spiral by<br />
dampening activity. Under pressure from <strong>the</strong> unions to mitigate <strong>the</strong> impact of<br />
higher food and fuel prices on workers, <strong>the</strong> government in mid-May mandated<br />
a nation-wide increase in private-sector minimum wages, to be rolled out in <strong>the</strong><br />
different regions over <strong>the</strong> next few months. Some areas (like metro Manila) will<br />
see moderate hikes of around 5%, but increments in some provinces will come<br />
to around 10%. Some of <strong>the</strong>se wage increments will also come on top of previous<br />
wage orders still currently being implemented. As part of a longer-standing<br />
plan, public sector workers are also set to receive a 10% pay rise on July 1.<br />
Admittedly, even after lifting rates by a fur<strong>the</strong>r 75bps, monetary policy can still<br />
be described as “loose”; after adjusting interest rates for inflation, <strong>the</strong>y are<br />
negative. In o<strong>the</strong>r words, <strong>the</strong> value of money sitting in a consumer’s bank deposit<br />
actually decays, and <strong>the</strong>re is greater incentive for him to take it out to spend or<br />
invest. But free spending would occur only if consumers had no concerns over<br />
economic and labour market prospects.<br />
Clearly this will not be <strong>the</strong> Chart 5: Remittances and real US GDP growth<br />
case in <strong>the</strong> coming quarters.<br />
We continue to expect <strong>the</strong> US<br />
% YoY % YoY, 3mma<br />
to fall short of longer-term 4.5<br />
30<br />
potential growth both this year<br />
Remittances<br />
4.0<br />
and <strong>the</strong> next, having pencilled<br />
(RHS)<br />
US GDP<br />
25<br />
3.5<br />
in growth of 2.0% and 2.6%<br />
respectively; potential growth 3.0<br />
20<br />
is widely thought to be between 2.5<br />
2.75-3.25%. Given that <strong>the</strong> US<br />
15<br />
2.0<br />
accounts for 53% of <strong>the</strong><br />
Philippines’ remitted earnings 1.5<br />
10<br />
and 17% of <strong>the</strong> export market, 1.0<br />
this will have a negative bearing<br />
5<br />
on domestic wage and spending<br />
0.5<br />
patterns (Chart 5). Fur<strong>the</strong>r 0.0<br />
0<br />
weakness in <strong>the</strong> peso this year Mar-02 Mar-04 Mar-06 Mar-08<br />
will help soften <strong>the</strong> blow on<br />
both remitted earnings and<br />
exports – we expect USD/PHP to end <strong>the</strong> year at 47.00 – but not sufficiently.<br />
Investment to remain robust on public spending<br />
Investment spending was <strong>the</strong> only component in <strong>the</strong> first quarter GDP figures<br />
that did not disappoint us, and while we believe last year’s 11.8% surge in<br />
capital outlays will not be replicated, investment this year should still rise a<br />
decent 7.0%. However, this is likely to ride on public, ra<strong>the</strong>r than private outlays.<br />
As input costs like oil and commodities continue to rise and it becomes increasingly<br />
difficult to pass on higher costs to consumers, private firms will feel greater<br />
margin pressure. In such an environment, business spending plans will naturally<br />
be deferred. Indeed, private-sector investment indicators so far this year have<br />
been very weak. According to <strong>the</strong> BSP’s second-quarter Business Expectations<br />
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Survey, only a net 12.6% of firms were optimistic over conditions in <strong>the</strong> current<br />
quarter, a 17.3pt plunge from <strong>the</strong> 1Q08 reading and <strong>the</strong> lowest in three years.<br />
For <strong>the</strong> quarter ahead – or 3Q08 - only a net 16.6% were optimistic, a 24.4pt<br />
drop from <strong>the</strong> previous reading (Chart 6).<br />
The unwillingness of <strong>the</strong> private sector to spend will contrast sharply against<br />
ongoing public spending on infrastructure. Plans to balance <strong>the</strong> budget this<br />
year have been pushed aside (possibly till as late as 2010, judging by official<br />
comments), and this year’s PHP 1.23trn budget now looks set to be upped to PHP<br />
1.255trn. This is a sum that includes a PHP 18.6bn windfall from <strong>the</strong> 12% VAT on<br />
petroleum products. Details of <strong>the</strong> new budget have not yet been released, but<br />
under <strong>the</strong> previous spending plan, some PHP 113bn – or 9.2% of <strong>the</strong> budget –<br />
was to have been spent on infrastructure items such roads, bridges, airports and<br />
sea ports.<br />
The private sector<br />
will hold back<br />
spending, but <strong>the</strong><br />
government is<br />
planning fiscal<br />
stimulus<br />
Chart 6: Business expectations plunge<br />
Business Outlook index<br />
60<br />
50<br />
40<br />
Chart 7: Balanced budget goal out <strong>the</strong> window<br />
% of GDP<br />
1<br />
0<br />
-1<br />
30<br />
-2<br />
20<br />
10<br />
0<br />
Current qtr<br />
Next qtr<br />
-3<br />
-4<br />
Govt<br />
forecast<br />
-10<br />
Latest: 1Q08<br />
-5<br />
-20<br />
Dec-04 Dec-05 Dec-06 Dec-07<br />
-6<br />
1997 1999 2001 2003 2005 2007<br />
According to Finance Secretary Teves, <strong>the</strong> increased spending will take <strong>the</strong> budget<br />
deficit to at most PHP 75bn, or 1% of GDP (Chart 7). This implies revenues of at<br />
least PHP 1.18trn will be needed. Based on our growth assumptions, this should<br />
be achievable, with some room for expenditure to even slightly exceed current<br />
plans.<br />
External outlook still rough<br />
As with consumption, <strong>the</strong><br />
country’s external trade<br />
performance this past quarter<br />
has been disappointing, and<br />
we now look for net exports<br />
to subtract a hefty 1.6%-pts<br />
from <strong>the</strong> overall growth<br />
headline. Real exports in <strong>the</strong><br />
first quarter contracted 11.1%<br />
YoY, <strong>the</strong> first decline in six<br />
years. Imports, reflecting export<br />
trends and weaker domestic<br />
demand, also declined, by<br />
6.6%. As is evident from Chart<br />
8, <strong>the</strong> drop in exports occurred<br />
on a combination of weak<br />
external demand particularly<br />
Chart 8: Exports feeling <strong>the</strong> pain on all fronts<br />
% YoY, 3mma Ratio<br />
25<br />
USD terms 1.3<br />
20<br />
PHP terms<br />
1.2<br />
15<br />
10<br />
1.1<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
-20<br />
US Semicon BB<br />
ratio (RHS)<br />
Latest: Exports Mar08,<br />
BB ratio Apr08<br />
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08<br />
1.0<br />
0.9<br />
0.8<br />
0.7<br />
0.6<br />
Net exports will<br />
subtract 1.6%-pts<br />
from growth this<br />
year<br />
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Demand from US,<br />
Asia to weaken<br />
fur<strong>the</strong>r<br />
for electronics, and a much stronger peso. In <strong>the</strong> quarters ahead, exports should<br />
find some reprieve from <strong>the</strong> 9% or so depreciation we expect in <strong>the</strong> peso – as<br />
mentioned earlier, we expect USD/PHP to rise to 47.00 by <strong>the</strong> year-end.<br />
But clearly <strong>the</strong> Philippines’ export growth is underperforming Asia, suggesting<br />
a lack of competitiveness; for example, countries such as Thailand saw real export<br />
growth of 8.7% YoY in 1Q08. Adding to this, global growth is set to slow fur<strong>the</strong>r<br />
this year. We expect growth in <strong>the</strong> Asia 10 economies (including China and<br />
India) to slow to 6.1% on average, from 7.0% last year. US and Japan should<br />
average 1.9%, from 2.1%. Combined, <strong>the</strong>se economies make up almost 80% of<br />
Philippines exports. Fur<strong>the</strong>r slippage in shipments <strong>the</strong>refore looks likely. We<br />
have revised our real export forecast downwards to factor in a 7.9% drop, while<br />
imports should decline 5.1%.<br />
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Philippines Economic Indicators<br />
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
Real GDP growth 7.2 5.4 6.0 5.2 5.4 5.2 5.7 5.7 5.5<br />
Private consumption 5.8 5.4 5.8 5.1 5.8 5.4 5.4 6.2 5.6<br />
Government consumption 8.3 9.9 4.5 -1.0 15.0 13.5 11.2 5.0 1.0<br />
Gross fixed capital formation 11.8 7.0 5.4 6.6 8.0 7.0 6.5 5.0 3.0<br />
Net exports (PHP bn, 85P) 51.0 29.3 34.6 0.9 10.4 24.8 -6.8 2.4 11.9<br />
Exports 5.6 -7.9 12.1 -11.1 -13.5 -8.0 2.0 8.0 15.0<br />
Imports -4.5 -5.1 11.8 -6.6 -9.0 -6.0 1.0 7.0 15.0<br />
External (nominal)<br />
Merch exports (USD bn) 50.5 49.4 52.7 12.5 11.4 12.1 13.4 13.3 12.2<br />
- % YoY 6.4 -2.1 6.6 2.8 -8.2 -5.3 2.4 6.2 7.5<br />
Merch imports (USD bn) 55.5 65.7 71.3 14.6 16.0 17.5 17.6 16.1 17.2<br />
- % YoY 7.2 18.3 8.5 20.1 20.2 18.4 15.2 10.4 7.2<br />
Merch trade balance (USD bn) -5.0 -16.3 -18.6 -2.1 -4.7 -5.4 -4.1 -2.8 -5.0<br />
Current account balance (USD bn) 6.4 4.8 6.4 5.8 5.1 5.2 4.8 5.0 5.6<br />
% of GDP 4.3 2.8 3.3 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Foreign reserves, USD bn 34 37 48 37 36 36 37 41 45<br />
Inflation<br />
CPI inflation 2.8 9.0 4.8 5.5 9.3 10.7 10.6 8.9 5.2<br />
O<strong>the</strong>r<br />
Nominal GDP (USD bn) 148 169 192 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Budget deficit (% of GDP) -0.9 -1.0 -0.5 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Total external debt (USD bn) 52 51 50 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP 35 30 26 n.a. n.a. n.a. n.a. n.a. n.a.<br />
* % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
PH – nominal exchange rate<br />
PHP per USD<br />
48<br />
46<br />
44<br />
42<br />
PH – policy rate<br />
%, o/n rev repo<br />
14.0<br />
12.0<br />
10.0<br />
8.0<br />
6.0<br />
40<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
4.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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VIETNAM<br />
<strong>Economics</strong>: Vietnam<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
VN: Growing pains<br />
• Inflation has reached a crisis stage and strong measures are needed to cool<br />
<strong>the</strong> economy<br />
• The State Bank of Vietnam (SBV) raised interest rates sharply again on 10<br />
Jun08, less than a month after <strong>the</strong> previous hike, in a bid to tame inflation.<br />
• Yet, despite <strong>the</strong> measures by <strong>the</strong> government to rein in inflation, it is unlikely<br />
to abate in <strong>the</strong> near term and is set to average about 26.3% for <strong>the</strong> full year<br />
• Vietnam’s widening trade deficit is ano<strong>the</strong>r concern. The trade deficit has<br />
ballooned to 53% of GDP in 1Q08 on an unadjusted basis<br />
• With fiscal and monetary tightening, and <strong>the</strong> negative impact of high<br />
inflation, growth this year will be sub-par at 6.4%<br />
CPI inflation surged<br />
to 25.2% YoY in<br />
May08<br />
Inflation worries<br />
Inflation worry in Vietnam has taken a new dimension in recent days. CPI inflation<br />
surged to 25.2% YoY in May08 , as food prices continue to drive <strong>the</strong> headline<br />
number upwards (Chart 1). Overall food and foodstuffs prices were up 42.4%<br />
compared to a year ago while prices of primary food items were up a shocking<br />
67.8% YoY! The situation is worrisome as food items take up about 40% of <strong>the</strong><br />
overall CPI basket and prices are unlikely to stabilize in <strong>the</strong> near term. The rice<br />
crisis spreading across Asia and much of <strong>the</strong> world threatens to keep prices<br />
elevated. Global supply is unlikely to catch up with demand from both speculative<br />
and real sources in <strong>the</strong> short-term and with that, grain prices are expected to<br />
stay high in <strong>the</strong> near term. Earlier on, <strong>the</strong> Vietnamese government has taken<br />
measures to curb domestic speculation in addition to tighter export controls on<br />
rice. However, food inflation is also increasingly spreading into prices of o<strong>the</strong>r<br />
non food items.<br />
Apart from commodity prices, <strong>the</strong> inflation problem in Vietnam is also partly<br />
due to excessive liquidity. Money supply growth registered about 46% increase<br />
by end 2007 according to <strong>the</strong> Asian Development Bank (Chart 2). Sharp increase<br />
Chart 1: High inflation is a key concern<br />
% YoY<br />
45<br />
42.4%<br />
40<br />
35<br />
Overall CPI inflation<br />
Food<br />
25.5%<br />
30<br />
CPI inflation ex food<br />
25<br />
20 Latest: May08<br />
15<br />
10<br />
5<br />
0<br />
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08<br />
Chart 2: Excessive liquidity also stoking inflation<br />
VND bn<br />
% YoY<br />
1600000<br />
50<br />
Money supply, M2<br />
1400000<br />
45<br />
M2 growth (RHS)<br />
40<br />
1200000<br />
35<br />
1000000<br />
30<br />
800000<br />
25<br />
600000<br />
20<br />
15<br />
400000<br />
10<br />
200000<br />
5<br />
0<br />
0<br />
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04<br />
Irvin Seah • (65) 6878 6727 • irvinseah@dbs.com<br />
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<strong>Economics</strong>: Vietnam<br />
in FDI inflows, remittances and portfolio investment betting on <strong>the</strong> property<br />
and equity market boom in 2007 are probably <strong>the</strong> key reasons. The banking<br />
sector is flooded with cash and <strong>the</strong> aggressive credit extension by commercial<br />
banks to earn market share probably exacerbated <strong>the</strong> situation.<br />
Indeed, <strong>the</strong> inflation problem in Vietnam has reached a crisis stage and drastic<br />
counter-measures are needed to bring an overheated economy into order. After<br />
some drastic tightening move on 19 May, <strong>the</strong> State Bank of Vietnam (SBV) again<br />
raised all three policy rates by 200bps on 10 June in a desperate bid to tame<br />
inflation. That’s two series of sharp rate hikes within a month. The prime/base<br />
rate was raised to 14%. The discount rate and refinance rate were lifted to 13%<br />
and 15% respectively. Yet, <strong>the</strong> drastic and painful monetary tightening was<br />
needed to contain <strong>the</strong> excess liquidity in <strong>the</strong> system and to ensure banks have<br />
<strong>the</strong> mechanism available to mobilize deposits if necessary.<br />
Apart from monetary measures, <strong>the</strong> government has also adopted administrative<br />
measures to tame inflation. For example, <strong>the</strong> government froze prices of 10<br />
“essential” goods until June. They include petrol, electricity, coal, water, cement,<br />
steel, school fees and hospital fees, bus, rail and air travel. The government also<br />
promised to cut fiscal expenses by 10% through belt tightening. That is essentially<br />
a contractionary yet necessary fiscal policy which will surely affect overall growth<br />
outlook as many public infrastructure projects will be postponed as a result.<br />
More tightening needed<br />
Despite <strong>the</strong> desperate<br />
measures by <strong>the</strong> government<br />
to rein in inflation, it is unlikely<br />
to abate in <strong>the</strong> near term.<br />
In fact, our estimation based<br />
on <strong>the</strong> current global trend<br />
for crude oil and food prices<br />
point to even higher inflation<br />
ahead. Moreover, effects of<br />
<strong>the</strong> monetary tightening will<br />
take time to filter through<br />
<strong>the</strong> system while <strong>the</strong> declining<br />
VND is complicating matters.<br />
Full year inflation in Vietnam<br />
is estimated to average 26.3%<br />
and will easily breach <strong>the</strong><br />
30% level once some of <strong>the</strong><br />
existing subsidies are lifted<br />
Chart 3: More tightening needed to tame inflation<br />
% YoY, % pa<br />
<strong>DBS</strong>f<br />
40<br />
30<br />
20<br />
10<br />
0<br />
-10<br />
-20<br />
-30<br />
Real prime rate<br />
Inflation<br />
Prime rate<br />
Jan-07 Jul-07 Jan-08 Jul-08<br />
(Chart 3). However, inflation in 2009 should taper off to 15% on average as<br />
growth moderates and <strong>the</strong> tightening measures start to take effect.<br />
None<strong>the</strong>less, more tightening may be needed in <strong>the</strong> near term to keep <strong>the</strong> lid<br />
on inflation. In fact, <strong>the</strong> real base rate (inflation adjusted) is expected to remain<br />
in negative territory in <strong>the</strong> near term until mid 2009, which will gives more<br />
room for rate hikes (Chart 3). The government has demonstrated its will to fight<br />
inflation in its recent tightening moves. With that, we expect <strong>the</strong> base rate to<br />
be lifted by ano<strong>the</strong>r 200bps in <strong>the</strong> next 2 quarters to 16% to help clamp down<br />
inflation.<br />
Inflation has<br />
reached <strong>the</strong> crisis<br />
stage and strong<br />
counter-measures<br />
are needed<br />
Despite tightening,<br />
inflation will hit<br />
26.3% for <strong>the</strong> year<br />
Expect ano<strong>the</strong>r<br />
200bps hike in base<br />
rate<br />
Widening trade deficit is ano<strong>the</strong>r big concern<br />
Apart from inflation, Vietnam’s widening trade deficit is ano<strong>the</strong>r big concern.<br />
Trade deficit registered USD 14.4bn in May year-to-date, about four times higher<br />
than a year ago and already surpassed <strong>the</strong> deficit for <strong>the</strong> entire 2007 (Chart 4).<br />
Trade deficit exploded from about 18% of nominal GDP for <strong>the</strong> whole of 2007<br />
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to about 53% (seasonally unadjusted) for just <strong>the</strong> first quarter of this year. The<br />
27.5% rise in exports was dwarfed by a staggering 70.5% increase in imports.<br />
High oil prices is also aggravating <strong>the</strong> problem. With oil prices well above USD130/<br />
bbl, <strong>the</strong> value of crude export rose 46%, but a near doubling in imports of<br />
refined products turned a USD 976mn oil surplus in 2007 to a USD 334mn deficit<br />
Chart 4: Trade deficit exploded<br />
% of nom. GDP, nsa<br />
10<br />
0<br />
-10<br />
-20<br />
-30<br />
-40<br />
-50<br />
0.7<br />
-7.0 -7.9 -7.9<br />
Trade bal / Nom. GDP<br />
Chart 5: Oil balance turned negative<br />
USD mn<br />
1200<br />
1000<br />
800 Oil trade balance<br />
600<br />
400<br />
200<br />
0<br />
-200<br />
-13.0 -15.2 -16.2 -17.5<br />
-52.6<br />
-60<br />
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08<br />
-400<br />
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08<br />
The oil balance<br />
turned negative on<br />
<strong>the</strong> back of high oil<br />
prices<br />
The trade deficit<br />
ballooned to 53%<br />
of GDP in 1Q08<br />
now (Chart 5). Vietnam is a crude oil exporter but imported large quantity of<br />
refined petroleum for domestic consumption. The ballooning oil deficit is not<br />
only causing pain on <strong>the</strong> trade account but also feeding into inflation. But its<br />
not all about oil. Petroleum imports formed only about 13% of total imports as<br />
of May08. Huge increases were also seen in many o<strong>the</strong>r import products, reflecting<br />
<strong>the</strong> strong domestic investment demand.<br />
With <strong>the</strong> ongoing trend in Chart 6: Trade & current acc. have deteriorated<br />
both exports and imports,<br />
% of nom. GDP<br />
trade deficit could well register<br />
10<br />
a massive USD 24bn this year<br />
even if we assume an 5<br />
improvement in <strong>the</strong> trade 0<br />
balance given a weaker<br />
currency (Chart 7). That is<br />
-5<br />
about twice <strong>the</strong> amount -10<br />
recorded in 2007 and about<br />
-15<br />
29.3% of overall nominal GDP<br />
this year! The current account -20<br />
Current account balance<br />
will likely be dragged down -25<br />
Trade balance<br />
as well. The current account<br />
-30<br />
balance already registered<br />
a shortfall of USD 6.7bn in -35<br />
2007 (based on IMF estimates), 1998 2000 2002 2004 2006 2008f<br />
about 9.4% of nominal GDP<br />
and will likely fall fur<strong>the</strong>r given <strong>the</strong> recent trend in <strong>the</strong> trade account. With <strong>the</strong><br />
likelihood of sharp current account outflow, <strong>the</strong>re is risk of a balance of payment<br />
(BOP) shortfall if fur<strong>the</strong>r deterioration in Vietnam macro stability triggers a reversal<br />
in capital flows. However, with a competitive labour force, large pool of natural<br />
resources and appropriate measures from <strong>the</strong> government, Vietnam is expected<br />
to remain attractive to foreign investors in <strong>the</strong> medium term. We believe that a<br />
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<strong>Economics</strong>: Vietnam<br />
steady inflow of FDI plus an improving services trade account will provide <strong>the</strong><br />
counter-balance to <strong>the</strong> deficit position in <strong>the</strong> merchandise trade account.<br />
In addition, <strong>the</strong>re is substantial ground to believe that a weaker VND could help<br />
to alleviate <strong>the</strong> trade account problem. Yet, we do not expect <strong>the</strong> SBV to deviate<br />
substantially from <strong>the</strong> current downward crawling peg against <strong>the</strong> USD. The<br />
pace of depreciation may accelerate in an attempt to close <strong>the</strong> gap in <strong>the</strong> current<br />
account but a collapse in <strong>the</strong> currency is unlikely given Vietnam’s positive long<br />
term growth outlook. However, a weaker currency may invite higher imported<br />
inflation and, <strong>the</strong>refore, it is probably not <strong>the</strong> most preferred policy instrument<br />
for <strong>the</strong> problem in Vietnam right now. We believe <strong>the</strong> government will instead<br />
place its bet on domestic monetary tightening, administrative and o<strong>the</strong>r controls<br />
on credit as well as fiscal contraction to engineer a soft landing for <strong>the</strong> economy.<br />
Tough action needed to rectify previous policy flaws<br />
The inflation problem in Vietnam has revealed <strong>the</strong> underlying policy inconsistency<br />
in <strong>the</strong> system. The government’s loose monetary and fiscal policy framework<br />
complicated by <strong>the</strong> sharp rise in foreign capital inflows last year are probably<br />
<strong>the</strong> main reasons for <strong>the</strong> recent spate of inflation. The inflationary impact of<br />
<strong>the</strong>se capital inflows has been exacerbated by <strong>the</strong> inability to fully sterilize <strong>the</strong><br />
inflows due to its undeveloped capital markets. Couple that with <strong>the</strong> deteriorating<br />
current account, partly <strong>the</strong> result of “excessive” domestic demand, Vietnam is<br />
at <strong>the</strong> crossroads as far as policy is concerned. The government needs to act<br />
swiftly and decisively in its tightening measures to prevent runaway inflation<br />
and a fallout in <strong>the</strong> balance of payment account. The recent tightening move<br />
by <strong>the</strong> central bank is certainly <strong>the</strong> right way forward but more needs to be<br />
done to rectify <strong>the</strong> problem. Hence, we expect fur<strong>the</strong>r monetary as well as fiscal<br />
tightening by <strong>the</strong> government going forward.<br />
Growth is likely to under-perform<br />
With <strong>the</strong> concurrent fiscal and Chart 7: GDP growth will moderate<br />
monetary tightening, negative<br />
% YoY<br />
impact of high inflation on<br />
domestic consumption, weak 9.0<br />
Real GDP growth<br />
investment and consumer 8.5<br />
<strong>DBS</strong>f<br />
sentiment on <strong>the</strong> back of spikes<br />
in interest rates, growth will surely 8.0<br />
undershoot. Growth in <strong>the</strong> first 7.5<br />
quarter registered 7.5% which<br />
led to <strong>the</strong> downgrade in <strong>the</strong> official 7.0<br />
growth target to 7.0%, down 6.5<br />
from 8% earlier on. We reckon<br />
that against <strong>the</strong> backdrop of rapidly 6.0<br />
Latest: 1Q08<br />
deteriorating fundamentals,<br />
5.5<br />
growth for <strong>the</strong> full year could<br />
end up worse than expected at 5.0<br />
6.4% before improving to 6.9% Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09<br />
in 2009 when confidence in <strong>the</strong><br />
economy returns (Chart 8). Indeed, near term downside risks to growth remain<br />
extremely high and <strong>the</strong>re could be many pitfalls along <strong>the</strong> way. Bitter and painful<br />
restructuring will be necessary to prevent similar economic crisis from happening<br />
in future.<br />
A weaker VND<br />
could help to<br />
alleviate <strong>the</strong> trade<br />
deficit<br />
The government<br />
must act decisively<br />
in its tightening<br />
measures<br />
Growth for <strong>the</strong> full<br />
year should<br />
register 6.4%<br />
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Vietnam Economic Indicators<br />
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP growth 8.5 6.4 6.9 7.5 6.0 5.8 6.4 6.5 6.4<br />
Real supply<br />
Agriculture & forestry 3.4 3.4 3.4 3.2 3.2 3.4 3.8 3.7 3.2<br />
Industry & construction 10.6 6.6 7.4 8.0 6.1 5.9 6.4 6.4 6.6<br />
Services 8.7 7.5 7.8 8.3 7.6 6.6 7.6 7.5 8.0<br />
External (nominal)<br />
Exports (USD bn) 48.4 63.1 85.5 13.2 15.7 16.2 18.1 17.7 21.2<br />
Imports (USD bn) 60.8 87.6 98.6 21.5 23.8 20.7 21.5 24.9 27.0<br />
Trade balance (USD bn) -12.4 -24.4 -13.1 -8.3 -8.2 -4.5 -3.4 -7.2 -5.8<br />
Current account bal (USD bn) -6.7 -11.7 -5.7 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP -9 -14 -6 n.a. n.a. n.a. n.a. n.a. n.a.<br />
(USD bn, yr-end)<br />
Inflation<br />
CPI inflation 8.3 26.3 15.0 16.4 24.8 31.5 32.3 25.1 16.6<br />
O<strong>the</strong>r<br />
Nominal GDP (USDbn) 71.4 82 92.5 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Unemployment rate (%, sa, eop) 3.8 3.7 4.2 n.a. n.a. n.a. n.a. n.a. n.a.<br />
- % change, year-on-year, unless o<strong>the</strong>rwise specified<br />
- Figures may deviate from official sources due to difference in reporting format<br />
VN – nominal exchange rate<br />
VND per USD<br />
16400<br />
16280<br />
16160<br />
16040<br />
15920<br />
15800<br />
01/01/200705/11/200709/20/200701/30/200806/10/2008<br />
VN – prime interest rate<br />
% pa<br />
15.0<br />
14.0<br />
13.0<br />
12.0<br />
11.0<br />
10.0<br />
9.0<br />
8.0<br />
7.0<br />
6.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
136
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: Vietnam<br />
This page is intentionally left blank<br />
137
UNITED STATES<br />
<strong>Economics</strong>: United States<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
US: Forecasts rising<br />
• The US will handily avoid recession this year<br />
• “Consensus” growth forecasts are rapidly heading northward<br />
• But <strong>the</strong> US came closer to recession than we imagined and remains weak.<br />
Domestic demand growth has been zero for two full quarters<br />
• US growth is being kept alive by foreign demand. It has accounted for<br />
100% of US growth for <strong>the</strong> past two quarters and 46% over <strong>the</strong> past<br />
year. That is 2-3 times what foreign demand ever contributed to China’s<br />
growth<br />
• Domestic demand will be stronger in Q2 and especially in Q3 and Q4<br />
• Oil prices are a burden but it is being paid in real time. Oil is not a<br />
hammer waiting to fall on growth<br />
• The Fed will hike rates by 50bps in 4Q08, by ano<strong>the</strong>r 75bps in 1Q09 and<br />
ano<strong>the</strong>r 75bps in 2Q09. That would put Fed funds at 4% by Jun09<br />
Forecasts are going up<br />
Recession is not on<br />
<strong>the</strong> cards. But<br />
domestic demand is<br />
nowhere to be<br />
seen<br />
Notwithstanding all <strong>the</strong> hoopla back in January and February, <strong>the</strong> US will handily<br />
avoid recession this year. First quarter GDP grew by 0.9% (QoQ, saar) and consensus<br />
forecasts for second quarter growth are rapidly heading northward. Consensus<br />
now expects <strong>the</strong> same 1.5% growth in <strong>the</strong> second quarter that we do. With<br />
continued (and importantly, non-cyclical) core consumption growth, fiscal injections<br />
worth 1.4% of GDP coming on stream and <strong>the</strong> best global balance in 20 years,<br />
growth should rise fur<strong>the</strong>r in Q3 and Q4. We expect GDP to expand by 2.5%<br />
and 2.75%, respectively, implying full year average growth of 2% in 2008. That’s<br />
a tad shy of last year’s growth (2.2%), a tad lower than last quarter’s ‘08 forecast<br />
(2.1%) and a country mile away from recession.<br />
US - GDP and domestic demand growth<br />
%YoY, 2qma<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
GDP<br />
(total demand)<br />
Dom Demand<br />
2.5%<br />
GDP:<br />
1.6 ppts<br />
DD:<br />
2.7 ppts<br />
1.5<br />
1.0<br />
1.5%<br />
1.7%<br />
Sep-<br />
03<br />
Mar-<br />
04<br />
Sep-<br />
04<br />
Mar-<br />
05<br />
Sep-<br />
05<br />
Mar-<br />
06<br />
Sep-<br />
06<br />
Mar-<br />
07<br />
Sep-<br />
07<br />
Mar-<br />
08<br />
David Carbon • (65) 6878 9548 • davidcarbon@dbs.com<br />
138
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: United States<br />
Is everything fine in America? Decidedly not.<br />
In fact, <strong>the</strong> US came a lot closer to recession<br />
than we expected and risks for such remain.<br />
GDP growth remains positive but American demand<br />
– <strong>the</strong> sum of consumption, investment and<br />
government spending – has not grown one iota<br />
for two quarters.<br />
How does GDP grow when domestic demand<br />
does not? Who is buying <strong>the</strong> incremental output?<br />
Foreigners. Net purchases by foreigners of US<br />
goods have delivered every penny of US growth<br />
since 3Q07. That contribution has risen but it’s<br />
not new. Over <strong>the</strong> past year, foreigners have<br />
US – foreign contribution to GDP growth Mar07-Mar08<br />
USDbn/qtr, saar, 00P<br />
Contribution<br />
(1) (2) (2)-(1) to GDP chg<br />
Mar-07 Mar-08 Change (%)<br />
GDP 11,413 11,702 289<br />
Net exports -612 -480 132 46<br />
Exports 1,355 1,474 119 41<br />
Imports 1,967 1,954 -13 -4<br />
Dom Demand* 12,025 12,182 157 54<br />
* GDP less net exports<br />
bought 46% of <strong>the</strong> increase in US GDP. That’s 2-3 times what foreign demand<br />
ever contributed to China’s growth and <strong>the</strong> US used to do a lot of complaining<br />
about China living off <strong>the</strong> rest of <strong>the</strong> world. Good thing <strong>the</strong> stone throwing has<br />
eased of late because <strong>the</strong> US house is looking pretty glassy at <strong>the</strong> moment.<br />
Growth in <strong>the</strong> second quarter will remain fragile but a bigger portion of it<br />
should come from domestic demand. Consumption should again grow by about<br />
1% (QoQ, saar) and, because it accounts for about 70% of GDP, should (again)<br />
deliver about .7 points of headline growth. Investment should make a decent<br />
contribution in Q2 compared to <strong>the</strong> empty plate it was in Q1. Durable goods<br />
orders and shipments point to capex growth of 4%-5%.<br />
Housing construction continues to fall. It, and new home sales, have been<br />
dropping at a 25% annualized pace for 2.5 years now and nei<strong>the</strong>r show no any<br />
sign of abating yet. The good news is, <strong>the</strong> cost of <strong>the</strong> construction drop is<br />
known and relatively small. It has been knocking off about 1 percentage point<br />
from GDP growth every quarter for 2.5 years, turning 3% growth into 2%, or<br />
2% into 1%, and so on. That’s a drag but it’s not deadly. We continue to expect<br />
it to fade considerably in 2H08 but such an outcome is not crucial to <strong>the</strong> forecast.<br />
Besides foreign demand, what has kept <strong>the</strong> US clock ticking (and will continue<br />
to) is consumption, core consumption mainly. This may sound funny because<br />
what has had <strong>the</strong> worriers worried for <strong>the</strong> past few years is not <strong>the</strong> housing<br />
sector per se, but that weakness <strong>the</strong>re would spill over into consumption. Our<br />
view on consumption and on <strong>the</strong> risk it poses for recession is pretty much flipped<br />
around from this. In our view, consumption – especially core consumption, <strong>the</strong><br />
US - real consumption of services<br />
US$bn, 2000p, seas adj.<br />
4800<br />
4700<br />
Consumption<br />
prevents /<br />
attenuates a<br />
recession. It<br />
doesn’t cause one<br />
4600<br />
4500<br />
4400<br />
4300<br />
4200<br />
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08<br />
139
<strong>Economics</strong>: United States<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Higher oil prices are<br />
a burden but it is<br />
paid for in real<br />
time. Oil prices are<br />
not a hammer<br />
waiting to fall on<br />
future growth<br />
everyday nuts and bolts of total expenditure, most of which has to be spent in<br />
good times and bad – is what attenuates, or drags an economy out of recession<br />
when it has fallen into one for some o<strong>the</strong>r reason. It is not what pulls an<br />
economy into recession.<br />
The solid straight line of services consumption growth shown in <strong>the</strong> picture on<br />
<strong>the</strong> previous page is a good indication of what we’re talking about. Investment<br />
may fall, jobs may fall and, eventually, total consumption may fall. But core<br />
consumption, 60% of GDP, grinds forward. It’s not fast, it’s not sexy but it is big<br />
and reliable and for <strong>the</strong>se reasons it tends to keep growth on track.<br />
Oil<br />
Total consumption is certainly facing some headwinds of late but that has more<br />
to do oil prices and <strong>the</strong> price of gasoline than anything else. Oil prices have<br />
tripled since January 2005 and vehicle sales have been falling since July of <strong>the</strong><br />
same year. The surge in crude (50%) and pump (35%) prices since January has<br />
thrown even more cold water on sales.<br />
Higher oil prices are a burden but <strong>the</strong>y appear compellingly to have been driven<br />
by strong global demand and income growth over <strong>the</strong> past 5-6 years (see Economic<br />
Overview, “On a clear day”, above). On this time frame, oil prices have grown<br />
fivefold. Growth in most parts of <strong>the</strong> world ‘survived’ <strong>the</strong> high oil prices because<br />
it drove <strong>the</strong> high oil prices.<br />
In this light, US growth faces headwinds from oil prices no greater or less than<br />
it has faced for <strong>the</strong> past five years. Fur<strong>the</strong>r rises in oil prices would have fur<strong>the</strong>r<br />
impacts on things like vehicle sales but it would not lower GDP growth later this<br />
year any more than it already has over <strong>the</strong> past five years.<br />
To be sure, US growth is not sterling at <strong>the</strong> moment. And foreign growth is<br />
driving oil prices more than growth in <strong>the</strong> US, Japan or Europe, where oil consumption<br />
has fallen for <strong>the</strong> past three years if not <strong>the</strong> past 12 (see “On a clear day”). Is <strong>the</strong><br />
US suffering weak growth because foreigners are pushing up <strong>the</strong> price of oil?<br />
No. US growth is weak because of <strong>the</strong> US subprime crisis and <strong>the</strong> collapse in <strong>the</strong><br />
housing market. Foreign demand, as we discussed earlier, is <strong>the</strong> only thing<br />
keeping US growth alive right now. So if foreigners are pushing up <strong>the</strong> price of<br />
oil, that is <strong>the</strong> price of <strong>the</strong>ir keeping US growth afloat at <strong>the</strong> same time.<br />
Global growth<br />
‘survived’ higher oil<br />
prices because it<br />
drove higher oil<br />
prices<br />
US - core inflation<br />
% YoY, core PCE and core CPI<br />
3.0<br />
core CPI<br />
2.8<br />
2.6<br />
2.4<br />
2.2<br />
2.0<br />
Actuals thru April<br />
1.8<br />
core PCE<br />
1.6 Sep06<br />
Aug07<br />
Apr08 Aug08<br />
1.4<br />
Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09<br />
140
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: United States<br />
United States Economic Indicators<br />
2007 --- 2008 --- -- 2009 --<br />
2007 2008(f) 2009(f) Q4 Q1 Q2 (f) Q3 (f) Q4 (f) Q1 (f) Q2 (f)<br />
Output & Demand<br />
Real GDP* 2.2 2.0 2.6 0.6 0.9 1.6 2.5 2.7 2.8 2.8<br />
Private consumption 2.9 1.7 2.1 2.3 1.0 1.0 2.0 2.2 2.2 2.2<br />
Business investment 4.7 4.8 5.9 6.0 -0.3 3.5 7.0 7.0 5.0 6.0<br />
Residential construction -17.0 -20.1 -2.7 -25.2 -25.5 -20.0 -10.0 -5.0 1.0 2.0<br />
Government spending 2.0 2.4 2.3 1.9 2.0 2.3 2.3 2.3 2.3 2.3<br />
Exports (G&S) 8.1 6.4 5.6 6.5 2.8 5.5 4.7 3.3 6.6 6.5<br />
Imports (G&S) 1.9 0.3 4.0 -1.4 -2.6 2.0 2.5 2.5 5.0 5.0<br />
Net exports ($bn, 00P, ar) -556 -470 -465 -503 -480 -470 -465 -465 -465 -465<br />
Stocks (chg, $bn, 00P, ar) 5 -4 5 -18 -14 0 0 0 5 5<br />
Contribution to GDP (pct pts)<br />
Domestic final sales (C+FI+G) 2.1 1.4 2.5 1.5 0.0 0.8 2.3 2.7 2.6 2.8<br />
Net exports 0.6 0.7 0.0 1.0 0.8 0.3 0.2 0.0 0.0 0.0<br />
Inventories -0.3 -0.1 0.1 -1.7 0.1 0.5 0.0 0.0 0.2 0.0<br />
Inflation<br />
GDP deflator (% YoY, pd avg) 2.0 1.9 2.3<br />
CPI (% YoY, pd avg) 2.9 3.8 2.6 4.0 4.2 3.9 3.9 3.4 3.0 2.5<br />
CPI core (% YoY, pd avg) 2.3 2.5 2.3 2.3 2.4 2.6 2.5 2.5 2.3 2.3<br />
PCE core (% YoY, pd avg) 2.1 2.4 2.1 2.1 2.0 2.4 2.5 2.4 2.2 2.2<br />
External accounts<br />
Current acct balance ($bn) -739 -734 -785<br />
Current account (% of GDP) -5.3 -5.1 -5.2<br />
O<strong>the</strong>r<br />
Nominal GDP (US$ trn) 13.8 14.4 15.1<br />
Federal budget bal (% of GDP) -0.9 -1.5 -2.5<br />
Nonfarm payroll** 115 -2 126 80 -82 -35 25 85 120 125<br />
Unemployment rate (%, pd avg) 4.6 5.2 5.1 4.8 4.9 5.3 5.3 5.2 5.2 5.2<br />
* % period on period at seas adj annualized rate, unless o<strong>the</strong>rwise specified<br />
** Change, x1000, month avg<br />
Fed<br />
We revised our Fed forecast in mid-May, bringing forward our expectations for<br />
<strong>the</strong> first round of Fed hikes to 4Q08 from 1Q09. We look for 50bps of hikes<br />
<strong>the</strong>n, mainly on <strong>the</strong> view that growth will be running between 2.5% and 2.75%.<br />
Interest rates simply do not belong at 2.00% with growth of this sort, especially<br />
in an environment of relatively high and perhaps still rising inflation at yearend.<br />
Oil prices, currently at USD135/bbl (Brent & WTIC), will continue to drive headline<br />
and core inflation higher through <strong>the</strong> summer months. We expect core CPI and<br />
PCE inflation to rise to 2.6% YoY by August – well outside <strong>the</strong> Fed’s comfort<br />
zone of 1% to 2% – and, if oil prices continue to rise, inflation would not stop<br />
<strong>the</strong>re as we currently anticipate.<br />
In <strong>the</strong> event, we look for ano<strong>the</strong>r 75bps of Fed hikes in each of 1Q09 and 2Q09.<br />
That would leave Fed funds at 4.00% by July09. With neutral Fed funds at<br />
about 4.75%, <strong>the</strong> expectation must be for fur<strong>the</strong>r hikes in 3Q09.<br />
We expect 50bps of<br />
hikes in 4Q08,<br />
followed by 75bps<br />
of hikes in each of<br />
1Q09 and 2Q09.<br />
That would put Fed<br />
funds at 4.00% by<br />
Jul09<br />
Sources:<br />
Sources for all charts and tables are CEIC and Bloomberg .<br />
141
<strong>Economics</strong>: Japan<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
JP: What virtuous cycle?<br />
• In <strong>the</strong> past three months, <strong>the</strong> markets have swung from worrying about a<br />
recession to factoring in a rate hike by <strong>the</strong> BOJ by <strong>the</strong> year-end. Nei<strong>the</strong>r<br />
scenario will materialize<br />
• There will be no recession but growth will fall to 1.6% in 2008 from 2% in<br />
2007<br />
• This year, <strong>the</strong> 1.0% (QoQ, sa) expansion recorded in 1Q08 will be as good<br />
as it gets. The central bank’s “virtuous cycle” between exports, production,<br />
profits and business and household spending has gained no traction. The<br />
gradual decay in export growth since early 2006 has become more<br />
pronounced, owing to cooler demand from Asia and <strong>the</strong> US. Corporate<br />
margins are being squeezed by higher fuel and commodity prices.<br />
Households have little prospect of seeing wage growth emerge from longterm<br />
stagnation; as inflation rises, <strong>the</strong> likelihood is for consumers to tighten<br />
<strong>the</strong>ir belts<br />
• In this context, <strong>the</strong> Bank of Japan (BOJ) has no room to lift <strong>the</strong> overnight<br />
call target rate of 0.50% this year. Rising inflationary expectations, however,<br />
raise <strong>the</strong> odds that <strong>the</strong> central bank could seize <strong>the</strong> opportunity to lift<br />
interest rates if economic data improves. This could come as early as 1Q09;<br />
although we have ‘downgraded’ <strong>the</strong> annual average YoY growth rate to<br />
1.6% for 2009, in QoQ terms growth should actually average a relatively<br />
stronger 0.7%, versus a 0.3% QoQ average this year<br />
JAPAN<br />
The global<br />
electronics cycle<br />
remains in a slump<br />
Exports will keep slowing…<br />
In 1Q08, exports rose by a surprisingly strong (seasonally adjusted) 4% QoQ,<br />
despite <strong>the</strong> yen having appreciated by about <strong>the</strong> same degree in real tradeweighted<br />
terms. In <strong>the</strong> next six months, we expect <strong>the</strong> yen to give back some of<br />
those gains, with our forecast being for USD/JPY to finish <strong>the</strong> year at 107.00. But<br />
this will mean little for <strong>the</strong> export growth outlook, in <strong>the</strong> face of what will be<br />
continued weakness in <strong>the</strong> global<br />
electronics cycle. The hopeful<br />
pick-up in <strong>the</strong> US semiconductor<br />
equipment book-to-bill ratio<br />
in 4Q07 has all but dissipated,<br />
and as at Apr08 <strong>the</strong> ratio is<br />
almost back down to where<br />
it was six months ago - a subparity<br />
0.81. Given that <strong>the</strong> bookto-bill<br />
ratio tends to lead Japan’s<br />
export cycle by about three<br />
to six months, shipments are<br />
likely to remain soft for <strong>the</strong><br />
remainder of <strong>the</strong> year (Chart<br />
1).<br />
Fur<strong>the</strong>r putting <strong>the</strong> brakes on<br />
export growth will be <strong>the</strong><br />
slowdown in global growth<br />
-10<br />
-15<br />
Lim Su Sian • (65) 6878 1740 • limsusian@dbs.com<br />
Chart 1: Electronics cycle still in <strong>the</strong> doldrums<br />
% YoY Ratio<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
US semi BB ratio<br />
(RHS)<br />
Merch exports<br />
Latest: Apr08<br />
Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07<br />
1.6<br />
1.4<br />
1.2<br />
1.0<br />
0.8<br />
0.6<br />
0.4<br />
0.2<br />
0.0<br />
142
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: Japan<br />
this year, particularly in Asia,<br />
which now buys close to half<br />
Japan’s exports. This year we expect<br />
growth in <strong>the</strong> Asia 10 economies<br />
(including China and India) to<br />
slow to 6.1% on average, from<br />
7.0% last year. The US, while<br />
skirting a recession, will also see<br />
sub-par growth of 2.0%; this market<br />
accounts for around 18% of Japan’s<br />
exports. So, even as demand from<br />
markets like Central and Eastern<br />
Europe continues to barrel on<br />
at over 40% YoY every month,<br />
cooler economic growth in Japan’s<br />
key markets will still result in<br />
declining shipments, as has been<br />
<strong>the</strong> case for <strong>the</strong> past several months<br />
(Chart 2).<br />
In quarter-on-quarter terms, this means markedly slower export growth of 2.3%<br />
QoQ on average for <strong>the</strong> next three quarters. In YoY terms, however, export<br />
growth for <strong>the</strong> full year will look a (misleadingly) strong 12.2%, from 8.6% in<br />
2007. Sequentially, import growth will also be moderate at 1.8-2% QoQ, though<br />
in annual average YoY terms this translates to a 6.0% rise. Net of imports, exports<br />
should contribute 1.2%-pts to overall GDP growth for <strong>the</strong> year.<br />
… fur<strong>the</strong>r hurting corporate earnings<br />
Chart 2: Export contributions from Asia, US falling<br />
%-pt contrib to export growth<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08<br />
Asia<br />
C&E Europe, Russia<br />
Rest of world<br />
Latest: Apr08<br />
N. America<br />
Mid-East<br />
Exports, % YoY<br />
The soft conditions facing exporters, which account for some 20% of <strong>the</strong> economy,<br />
will not help overall corporate earnings, which are already under significant<br />
strain owing to <strong>the</strong> surge in cost of inputs like oil and commodities. According<br />
to <strong>the</strong> MOF’s first-quarter corporate survey, revenues fell 1.5% YoY during <strong>the</strong><br />
quarter, largely reflecting a contraction in revenues among non-manufacturers.<br />
More notably, operating profits were down 14.2% YoY across all industries, <strong>the</strong><br />
biggest decline in six years (Chart 3). According to our estimates, profit margins<br />
peaked in <strong>the</strong> second to third quarter of 2007, and are currently undergoing a<br />
relatively sharp correction in both <strong>the</strong> manufacturing and non-manufacturing<br />
sectors (Chart 4).<br />
These poor business conditions explain why we saw business spending growth<br />
of just 0.2% QoQ in 1Q08. Indeed, for <strong>the</strong> remainder of <strong>the</strong> year we believe<br />
Demand from Asia,<br />
US is weakening<br />
Export growth to<br />
slow<br />
Cooling external<br />
demand and higher<br />
input costs are<br />
hurting corporate<br />
profits<br />
Chart 3: Sales, profits contracting<br />
% YoY<br />
40<br />
30<br />
20<br />
10<br />
0<br />
-10<br />
-20<br />
-30<br />
-40<br />
Operating<br />
profits<br />
Sales<br />
Latest: 1Q08<br />
Jun-97 Jun-99 Jun-01 Jun-03 Jun-05 Jun-07<br />
Chart 4: Profit margins rapidly thinning<br />
Profit to sales ratio, sa<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
Latest: 1Q08<br />
All indust<br />
Manuf<br />
Non-manuf<br />
Jun-97 Jun-99 Jun-01 Jun-03 Jun-05 Jun-07<br />
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Business outlays<br />
will fall 1.4% this<br />
year<br />
business spending will actually contract, in both sequential and year-on-year<br />
terms. For <strong>the</strong> full year, private non-residential investment should fall 1.4%,<br />
compared to a 1.9% gain in 2007. Even after factoring in a sharp (technical)<br />
recovery in residential investment, total private investment will still be down<br />
1.1% on <strong>the</strong> year.<br />
No chance of wage growth<br />
With profit earnings and margins under pressure, it is hard to see wage growth<br />
emerging from its long-term stagnation any time soon. Since Dec07 cash earnings<br />
have rebounded slightly (to a negligible 1% YoY as of Apr08), but as evident<br />
from Chart 5, earnings for <strong>the</strong> past few years have spent much more time declining<br />
than rising. Indeed, since <strong>the</strong> Asian crisis of 1997, earnings have in fact contracted<br />
0.7% YoY on average, in part reflecting <strong>the</strong> shift by employers towards (cheaper)<br />
part-time workers.<br />
The job market is<br />
weakening<br />
The stagnation in wage growth occurred in spite of a significant recovery in <strong>the</strong><br />
labour market, particularly between 2003 and 2007; <strong>the</strong> rate of unemployment<br />
fell nearly to pre-crisis levels, and <strong>the</strong>re were significantly more jobs per applicant<br />
than before <strong>the</strong> crisis. Since end-2007, however, labour market conditions have<br />
weakened – <strong>the</strong>re is now less than one job per applicant (0.93 jobs as of Apr08,<br />
to be precise), and <strong>the</strong> unemployment rate stands at 4.0%, compared to a low<br />
of 3.6% in mid-2007. Now that labour market conditions are past <strong>the</strong>ir peak,<br />
<strong>the</strong>re is virtually no chance of positive wage growth in <strong>the</strong> foreseeable future<br />
(Chart 6).<br />
Chart 5: Wage growth to remain stagnant<br />
% YoY, 3mma<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
-4<br />
-6<br />
Nominal cash<br />
earnings<br />
Inflation adjusted<br />
Latest: Apr08<br />
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06<br />
Chart 6: Unemployment is rising again<br />
% Ratio<br />
6.0<br />
0.0<br />
Unemp rate sa<br />
5.5<br />
0.2<br />
5.0<br />
4.5<br />
0.4<br />
4.0<br />
0.6<br />
3.5<br />
0.8<br />
3.0<br />
Job-applic ratio,<br />
1.0<br />
2.5<br />
sa (RHS, inv)<br />
2.0<br />
1.2<br />
1.5<br />
1.4<br />
1.0<br />
Latest: Apr08<br />
1.6<br />
Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06<br />
Consumer spending will slow<br />
The lack of wage growth going forward is a negative for <strong>the</strong> consumer spending<br />
outlook, and in <strong>the</strong> remaining three quarters of <strong>the</strong> year we expect real private<br />
consumption expenditure (PCE) to drop back to around 0.1% QoQ, from an<br />
unusually strong 0.8% QoQ rise in 1Q08. For <strong>the</strong> full year, PCE will slow to 1.4%<br />
from 1.5% in 2007.<br />
Inflation is hurting<br />
consumers<br />
Going forward, households will have to continue grappling not only with wage<br />
stagnation, but also, as is <strong>the</strong> case with <strong>the</strong> corporate sector, rising prices. Where<br />
rising prices eat into firms’ margins, within <strong>the</strong> household sector <strong>the</strong>y eat into<br />
wage growth and purchasing power. Referring again to Chart 5, we can see that<br />
after adjusting for inflation, wages in Apr08 were up only 0.2% YoY, versus a<br />
nominal 0.8%.<br />
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To be sure, headline inflation of around 1% YoY (as Japan has been experiencing<br />
so far this year) is still very modest by most standards. But this small number,<br />
combined with flat wages, deteriorating job prospects and increased economic<br />
uncertainty overall has severely knocked <strong>the</strong> wind out of consumer sentiment<br />
(Chart 7).<br />
Chart 7: Consumer confidence jumps off <strong>the</strong> cliff<br />
Index, nsa<br />
51<br />
49<br />
47<br />
45<br />
43<br />
41<br />
39<br />
37<br />
35<br />
Latest: Apr08<br />
C'ser confidence,<br />
all h'holds<br />
nationwide<br />
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08<br />
Chart 8: Faster inflation ahead<br />
% YoY<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
-1<br />
-2<br />
-3<br />
-4<br />
Corp goods pxs<br />
Corp service pxs<br />
Headline CPI<br />
Latest: Apr08;<br />
CGPI May08<br />
Jan-02 Jul-03 Jan-05 Jul-06 Jan-08<br />
In <strong>the</strong> months ahead, sentiment - and hence actual spending data - are set to<br />
worsen fur<strong>the</strong>r, given <strong>the</strong> likelihood that inflation will accelerate. The slower<br />
headline inflation reading of 0.8% YoY in April reflected a 15% drop in gasoline<br />
prices nationwide, after <strong>the</strong> government failed to renew a tax bill that expired<br />
on April 1. The tax was, however, reinstated in May, meaning <strong>the</strong> slower inflation<br />
reading was temporary. Fur<strong>the</strong>rmore, judging by how quickly wholesale prices<br />
(as measured by <strong>the</strong> corporate goods price index) have surged above consumer<br />
prices, firms will probably have more price increments to pass on to consumers<br />
fur<strong>the</strong>r down <strong>the</strong> road (Chart 8). Assuming that inflation heads back above 1%<br />
YoY for most of <strong>the</strong> remainder of <strong>the</strong> year, <strong>the</strong>n inflation this year should average<br />
1.1%, compared to zero price gains in 2007. ‘Core’ inflation will closely match<br />
<strong>the</strong> headline, since it excludes only fresh food prices; last year core inflation was<br />
also at 0%.<br />
Not much relief on<br />
<strong>the</strong> inflation front,<br />
with CPI due to rise<br />
1.1% this year<br />
BOJ to stand pat, eye on inflation expectations<br />
The outlook we have painted above clearly looks anaemic, and for <strong>the</strong> year we<br />
expect overall GDP growth to slow to 1.6%, from 2% in 2007. In quarter-onquarter<br />
terms, growth will average 0.3%. Against this backdrop, <strong>the</strong> BOJ will<br />
have no room to lift its overnight call target rate of 0.50% this year.<br />
Rates will be kept<br />
on hold this year<br />
That said, <strong>the</strong> trend remains for higher inflation, however mild. More importantly,<br />
longer-term expectations of future inflation – which are what policymakers<br />
ultimately strive to keep stable - are also on <strong>the</strong> rise, and BOJ officials would no<br />
doubt be keeping a close eye on developments on that front.<br />
In its last two quarterly Opinion Surveys, <strong>the</strong>re has been a swing in <strong>the</strong> percentage<br />
of respondents who believe prices will rise, particularly on a one-year horizon.<br />
In 3Q07, 71.7% of respondents believed prices would go up ei<strong>the</strong>r slightly or<br />
significantly in a year’s time; in 4Q07 and 1Q08 this percentage rose to around<br />
86% (Charts 9). On a five-year horizon, <strong>the</strong> increase was less marked, from 82%<br />
in 3Q07 to almost 85% by 1Q08 (Chart 10). In terms of <strong>the</strong> level of inflation,<br />
respondents went from looking for a median 3% annual inflation rate in 3Q07<br />
(on a one-year horizon), to around 5% in <strong>the</strong> 4Q07 and 1Q08 surveys.<br />
Inflation, and<br />
inflation<br />
expectations, are<br />
rising<br />
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Chart 9: Outlook for prices, 1yr from date of survey<br />
Sep-07<br />
Survey<br />
Dec-07<br />
Mar-08<br />
0% 20% 40% 60% 80% 100%<br />
Will go up significantly<br />
Will go up slightly<br />
Will remain almost unchanged<br />
Will go down slightly<br />
Will go down significantly<br />
Source: BOJ 33rd Opinion Survey on <strong>the</strong> General Public's Views and Behaviour<br />
Chart 10: Outlook for prices, 5yrs from date of survey<br />
Sep-07<br />
Survey<br />
Dec-07<br />
Mar-08<br />
0% 20% 40% 60% 80% 100%<br />
Will go up significantly<br />
Will go up slightly<br />
Will remain almost unchanged<br />
Will go down slightly<br />
Will go down significantly<br />
Source: BOJ 33rd Opinion Survey on <strong>the</strong> General Public's Views and Behaviour<br />
The BOJ will lift<br />
rates <strong>the</strong> first<br />
chance it gets,<br />
maybe as early as<br />
1Q09<br />
The rise in inflationary expectations, if persistent in <strong>the</strong> coming quarters, will<br />
raise <strong>the</strong> odds of <strong>the</strong> central bank lifting interest rates at <strong>the</strong> earliest possible<br />
opportunity. This could come as soon as economic data improves, possibly as<br />
early as 1Q09. Although we have ‘downgraded’ <strong>the</strong> annual average YoY growth<br />
rate for 2009 to 1.6%, in QoQ terms growth should actually average a relatively<br />
stronger 0.7%. To that end, we continue to look for interest rate normalisation<br />
to resume in 1Q09, with a modest 25bp hike in <strong>the</strong> overnight call rate target to<br />
0.75%. This will be followed by a fur<strong>the</strong>r 25bp hike in 2H09, taking <strong>the</strong> call rate<br />
target to 1.0%.<br />
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<strong>Economics</strong>: Japan<br />
Japan Economic Indicators<br />
2007f 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP growth 2.0 1.6 1.6 1.0 0.3 -0.4 0.1 0.6 0.6<br />
Private consumption 1.5 1.4 1.1 0.8 0.1 0.1 0.2 0.3 0.3<br />
Pte resid & non-resid invest -0.1 -1.1 0.9 0.8 0.7 -1.8 -0.7 0.9 0.8<br />
Government spending 0.1 -0.2 -0.9 -0.17 -0.3 -0.3 -0.2 -0.2 -0.2<br />
Net exports (JPYbn, 00P) 26.2 33.1 39.7 7.0 7.6 7.9 8.3 8.6 8.9<br />
Exports (G&S) 8.6 11.6 11.3 4.0 2.7 1.5 2.5 2.9 2.9<br />
Imports (G&S) 1.8 5.3 7.0 1.4 2.0 2.0 1.8 1.5 1.5<br />
External (nominal)<br />
Merch exports (JPY trn) 84.1 89.1 93.5 21.3 22.8 22.4 22.5 22.2 23.9<br />
- % YoY 11.8 5.9 5.0 5.0 9.0 4.9 4.7 4.0 4.5<br />
Merch imports (JPY trn) 73.1 81.3 90.4 21.3 22.8 22.4 22.5 22.2 23.9<br />
- % YoY 8.3 11.2 11.3 9.8 10.0 12.0 13.0 13.0 12.4<br />
Merch trade balance (JPY trn) 11.0 7.8 3.0 2.1 2.9 1.9 0.9 0.5 1.5<br />
Current acct balance (USD bn) 216.2 247.7 235.1 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP 4.8 4.9 4.6 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Inflation<br />
CPI, % YoY 0.0 1.1 0.6 1.0 1.1 1.3 1.0 0.9 0.7<br />
O<strong>the</strong>r<br />
Nominal GDP (USD bn) 4,462 5,050 5,123 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Unemployment rate (%, sa, ave) 3.9 4.3 4.5 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Foreign reserves (USD bn) 973 1,061 1,146 n.a. n.a. n.a. n.a. n.a. n.a.<br />
* % change, period-on-period, seas adj, unless o<strong>the</strong>rwise specified<br />
JP – nominal exchange rate<br />
JPY per USD<br />
126<br />
121<br />
116<br />
111<br />
106<br />
101<br />
96<br />
6/11/2007 10/10/2007 2/8/2008 6/10/2008<br />
JP – policy rate<br />
%, call rate<br />
0.5<br />
0.4<br />
0.3<br />
0.2<br />
0.1<br />
0.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
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EZ: ECB eyes wages<br />
• 1Q08 GDP surprised on <strong>the</strong> upside thanks to investment growth. Exconstruction<br />
GDP grew by 2.8% (QoQ, saar)<br />
• Going forward, consumption should recover due to higher wages and help<br />
keep growth near potential ( ~2%) in 2008 and probably in 2009 as well<br />
• As consumption recovers and export growth remains healthy, high capacity<br />
utilisation rates should support investment spending<br />
• Euro strength has been a positive thus far, helping to curb imported supplyside<br />
inflation. It has also supported Eurozone’s nominal USD import demand<br />
and hence global growth in <strong>the</strong> face of US slowdown<br />
• We expect one rate hike in Jul08. Wage developments are central to <strong>the</strong><br />
growth, inflation and interest rate outlook<br />
1Q08 GDP exconstruction<br />
grew<br />
by 0.7% (QoQ, sa)<br />
or 2.8% (saar)<br />
1Q08 GDP review and summary outlook<br />
1Q08 growth surprised on <strong>the</strong> upside at 0.8% (QoQ, sa) or 3.2% (QoQ, saar), led<br />
by a surge in investment (10.7%). While temporary factors, such as mild wea<strong>the</strong>r<br />
in Europe, pushed construction spending higher, ex-construction GDP also grew<br />
by 0.7% (QoQ, sa) or 2.8% annualised. This reflects largely <strong>the</strong> strength of business<br />
investment spending. Consumption spending recovered slightly from 4Q07 but<br />
remained subdued (0.6%).<br />
Going forward, investment growth should moderate and consumption should<br />
pick up slowly and steadily in line with higher wages. This implies that overall<br />
GDP growth should stay around potential. We continue to look for 2% GDP<br />
growth in 2008 and 2009 (Chart 1 &2).<br />
Both growth and inflation uncertainties remain high. Insufficient real wage<br />
growth, fur<strong>the</strong>r rise in commodity prices and higher interest rates are <strong>the</strong> main<br />
downside risks to growth. While inflation risks lie to <strong>the</strong> upside, in <strong>the</strong> policy<br />
relevant time horizon (18-24 months), we think inflation risks are not material.<br />
EUROZONE<br />
Chart 1: GDP growth - around potential<br />
%, YoY, annual data<br />
6<br />
5<br />
4<br />
3<br />
2<br />
Potential GDP<br />
1<br />
0<br />
-1<br />
1992 1994 1996 1998 2000 2002 2004 2006 2008F<br />
Chart 2: Contributions to GDP growth<br />
%-pts, QoQ, saar<br />
4<br />
3<br />
2<br />
1<br />
0<br />
-1<br />
-2<br />
Mar-04 Mar-06 Mar-08<br />
Pvt Consmptn<br />
Invst exp<br />
GDP<br />
<strong>DBS</strong><br />
F'cast<br />
Govt exp<br />
Net Exports<br />
Ramya Suryanarayanan • (65) 6878 5282 • ramya@dbs.com<br />
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Consumption supported by strong labour market<br />
While higher food and fuel prices have hurt sentiment and demand in 4Q07 and<br />
1Q08, sentiment is still better than average 2000-07 levels, and even above 2004<br />
level. Both periods saw average quarterly growth of 1.5% in consumption (QoQ,<br />
smoo<strong>the</strong>d). A comparison of US and Eurozone consumer confidence also shows<br />
that while both indices are falling, Eurozone’s index is still at elevated levels<br />
(Chart 3).<br />
Importantly, <strong>the</strong> labour market is still supportive of wages, and unemployment<br />
is at decade lows (Chart 4). High level of unionisation of labour also supports<br />
wage growth in <strong>the</strong> face of rising prices. In Germany, for example, wage negotiations<br />
concluded thus far have ended with circa 5% rise in wages in 2008. This is well<br />
above <strong>the</strong> 3% average inflation expected in 2008. As such, we are comfortable<br />
with our forecast for 1.1% (QoQ, saar) and 1.5% quarterly consumption growth<br />
in 2008 and 2009.<br />
Consumption<br />
should pick up with<br />
higher wages<br />
keeping growth<br />
near potential<br />
Chart 3: Consumer confidence<br />
Chart 4: Unemployment to stay at decade lows<br />
EZ Index<br />
5<br />
0<br />
-5<br />
-10<br />
EZ (LHS)<br />
2000-07 avg<br />
(EZ:-10, US:90)<br />
US (RHS)<br />
US Index<br />
119<br />
109<br />
99<br />
89<br />
%, sa<br />
11<br />
10<br />
9<br />
-15<br />
79<br />
8<br />
-20<br />
69<br />
Latest: May08<br />
-25<br />
59<br />
May-00 May-02 May-04 May-06 May-08<br />
7<br />
Latest: Apr08<br />
6<br />
Jan-93 Jan-97 Jan-01 Jan-05 Jan-09<br />
Investment - consumption pick up and capacity utilisation support<br />
As consumption recovers and remains supportive of growth, <strong>the</strong> elevated levels<br />
of capacity utilisation should drive investment spending (Chart 5). Despite falling<br />
sharply, <strong>the</strong> business climate index remains above average of 2005 and 2000-07<br />
Chart 5: Capacity utilisation vs investment spending<br />
% % YoY<br />
86<br />
10<br />
Chart 6: Business climate - better than 2004/05<br />
Index<br />
2<br />
84<br />
6<br />
1<br />
2000-07 avg<br />
(~ 0.13)<br />
82<br />
2<br />
0<br />
80<br />
-2<br />
78<br />
76<br />
Capacity Utilisation<br />
GCF % (RHS)<br />
Mar-93 Mar-98 Mar-03 Mar-08<br />
-6<br />
-10<br />
-1<br />
Latest: May08<br />
-2<br />
May-00 May-02 May-04 May-06 May-08<br />
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levels (Chart 6). Despite higher input costs, that corporate earnings growth still<br />
rose by 9% (YoY) in Apr08 for companies listed in <strong>the</strong> Dow Jones EURO STOXX<br />
index. Interest rates are also not at restrictive levels. On <strong>the</strong> whole, we expect<br />
investment to still support growth.<br />
Exports are a key support<br />
Export growth has been a key support for growth in 2006 and 2007. Net exports<br />
has added 0.9%-pt and 0.2%-pt to <strong>the</strong> full year GDP growth rate in 2006 and<br />
2007. In 2008, we expect net exports to continue to add 0.2%-pt to growth, thus<br />
playing a key role in keeping overall growth around potential. One factor that<br />
is overemphasized with regards to export growth rate is <strong>the</strong> strength of <strong>the</strong><br />
euro. In <strong>the</strong> present context, we do not read euro strength as a negative.<br />
Euro strength has<br />
helped Eurozone<br />
support global<br />
growth and curb<br />
inflation in <strong>the</strong> face<br />
of US slowdown<br />
Euro strength - is it good or bad?<br />
In 1Q08, <strong>the</strong> euro was up circa 8% (YoY) in real trade weighted terms or real<br />
effective exchange rate (REER) terms. Higher input costs and a streng<strong>the</strong>ning<br />
euro are often toge<strong>the</strong>r cited as negative factors for exports. However, a streng<strong>the</strong>ning<br />
euro acts in opposition to higher input costs in practice. If <strong>the</strong> euro were not<br />
stronger, exporters’ margins would anyway be lowered by higher input costs.<br />
Pointing to EUR strength as a separate negative is, <strong>the</strong>refore, not meaningful.<br />
Indeed, despite a streng<strong>the</strong>ning euro, export growth (Chart 7) held up in 1Q08<br />
at around 5% (YoY and QoQ, saar, 2qma). This is hardly an evidence of erosion<br />
of export competitiveness. In contrast, in 2003, when <strong>the</strong> euro had streng<strong>the</strong>ned<br />
by 12% in REER terms, exports hardly grew.<br />
In fact, to <strong>the</strong> extent that a stronger EUR helps curb inflation and support purchasing<br />
power in <strong>the</strong> Eurozone, we see <strong>the</strong> stronger euro as a positive. One of <strong>the</strong> biggest<br />
benefits of a stronger euro is that it helps cushion <strong>the</strong> global economy (and by<br />
extension <strong>the</strong> Eurozone) from <strong>the</strong> drag of a slowing US economy. In terms of<br />
pure size, Eurozone economy has almost doubled in nominal USD terms in 2008<br />
compared to 2000 - USD 13trn vs USD 6trn. Thus, from being about 60% <strong>the</strong> size<br />
of <strong>the</strong> US, <strong>the</strong> Eurozone has expanded to almost 90% <strong>the</strong> size of <strong>the</strong> US.<br />
Of course, this is not a structural change, but ra<strong>the</strong>r a cyclical currency led change.<br />
Yet, this has helped <strong>the</strong> Eurozone play a major role in supporting global demand<br />
growth and offset slowing US demand. This is especially evident if we consider<br />
<strong>the</strong> growth in GDP in nominal USD terms which is relevant as an indication of<br />
strength of Eurozone’s import demand. Eurozone GDP grew by 16% in nominal<br />
terms in 2007. If <strong>the</strong> EUR had not appreciated, GDP growth would have been<br />
Chart 7: Annual real export growth<br />
%, YoY, annual data<br />
10<br />
9<br />
8<br />
7<br />
6<br />
5<br />
4<br />
3<br />
2<br />
1<br />
12% REER<br />
growth<br />
4Q07-1Q08 saw 8% (YoY) REER<br />
growth & 5% export growth<br />
2000 2002 2004 2006 2008F<br />
Chart 8: EZ GDP growth - stronger EUR cushions<br />
US slowdown<br />
% p.a, nom GDP, USD<br />
20<br />
GDP (EUR/USD at 2004 level:1.24)<br />
GDP (prevailing EUR/USD rates)<br />
16<br />
12<br />
8<br />
4<br />
0<br />
2005 2006 2007 2008F<br />
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<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
<strong>Economics</strong>: Eurozone<br />
only 5% (Chart 8). This also meant that a quarter of global GDP growth in 2007<br />
came from <strong>the</strong> Eurozone even as <strong>the</strong> contribution of <strong>the</strong> US fell to a mere 12%.<br />
Inflation and monetary policy - one 25bp rate in July<br />
Inflation should average 3% in 2008 assuming we see oil prices moderate ano<strong>the</strong>r<br />
10%-15% from <strong>the</strong> levels prevailing in May08. However, if prices continue to<br />
rise, inflation should surprise on <strong>the</strong> upside in 2008 and 2009. The longer term<br />
inflation outlook depends also on how consumers adapt to <strong>the</strong> higher prices<br />
and whe<strong>the</strong>r higher wages prove sufficient to cope with higher prices. After <strong>the</strong><br />
May08 policy communication when <strong>the</strong> ECB signalled a rate hike in <strong>the</strong> upcoming<br />
meeting, we added a 25bps hike to <strong>the</strong> rate call for 3Q08. This is expected to<br />
come in July as long as oil prices do not decline sharply. On <strong>the</strong> o<strong>the</strong>r hand, if<br />
oil prices drop dramatically, rate hike bets should be off. To be sure, as long as<br />
growth stays not far from potential (2.0%-2.25%), <strong>the</strong> ECB can justify an “insurance”<br />
rate hike to control inflation expectations. This is why we did not spell out any<br />
rate cuts in our monetary policy trajectory previously. We do not think one or<br />
two rate hikes would derail growth. However, a series of rate hikes taking policy<br />
interest rates towards 5% is quite likely to slow growth.<br />
We expect one<br />
rate hike in Jul08<br />
and remain<br />
unwilling to pencil<br />
in rate cuts in <strong>the</strong><br />
medium-term<br />
151
<strong>Economics</strong>: Eurozone<br />
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong><br />
Eurozone Economic Indicators<br />
2007 2008f 2009f 1Q08 2Q08f 3Q08f 4Q08f 1Q09f 2Q09f<br />
Real output and demand<br />
GDP growth (00P) 2.6 2.0 2.0 3.2 0.6 2.2 2.2 2.0 2.1<br />
Private consumption 1.6 0.9 1.4 0.6 0.8 1.3 1.5 1.5 1.5<br />
Government consumption 2.3 1.6 2.0 1.5 2.2 2.2 2.2 1.8 2.0<br />
Gross capital formation 4.3 3.7 3.0 10.7 -2.0 4.0 4.0 3.0 3.0<br />
Net exports (EURbn) 123 137 148 33 34 36 37 37 37<br />
Exports (G&S) 6 5 4 8 4 4 4 4 4<br />
Imports (G&S) 5 4 4 7 4 4 4 4 4<br />
External (nominal)<br />
Merch exports (EURbn) 1504 1617 1716 387 404 407 419 413 429<br />
- % YoY 8 8 6 7 8 8 7 7 6<br />
Merch imports (EURbn) 1448 1546 1618 389 376 378 402 408 5<br />
- % YoY 6 7 5 10 6 5 5 5 5<br />
Trade balance (EUR bn) 56 71 98 -3 28 28 17 5 35<br />
Current account balance (USD bn) 26 46 86 n.a. n.a. n.a. n.a. n.a. n.a.<br />
% of GDP 0.2 0.3 0.6 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Inflation<br />
HICP (harmonized, % YoY) 2.1 3.0 2.1 3.3 3.4 3.1 2.2 1.8 1.7<br />
O<strong>the</strong>r<br />
Nominal GDP (USD tn) 12.2 14.2 13.6 n.a. n.a. n.a. n.a. n.a. n.a.<br />
Unemployment rate (%, sa, eop) 7.2 7.2 7.2 7.1 7.2 7.2 7.2 7.2 7.2<br />
EU – nominal exchange rate<br />
USD per EUR<br />
1.56<br />
1.53<br />
1.50<br />
1.47<br />
1.44<br />
1.41<br />
1.38<br />
1.35<br />
1.32<br />
1.29<br />
3/12/2007 7/11/2007 11/9/2007 3/11/2008<br />
EU – policy rate<br />
%, refi rate<br />
6.0<br />
5.0<br />
4.0<br />
3.0<br />
2.0<br />
1.0<br />
Jan-01 Nov-02 Sep-04 Jul-06 May-08<br />
Sources for charts and tables are CEIC, Bloomberg and <strong>DBS</strong> Research (forecasts and data transformations)<br />
152
<strong>Economics</strong> – <strong>Markets</strong> – <strong>Strategy</strong> 3Q 2008<br />
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