Asia Focus : Higher Oil Prices Need Better Policy : At USD 70 per barrel, oil is still affordable to the global economy and remains some distance from presenting the same challenges as the previous crises. However, Asia has become increasingly vulnerable given its relatively low oil efficiency and high oil dependency. While the region's vast diversity would lead to very different impacts of the high oil prices, one common challenge faced by the Asian economies is the need to adopt better and more sensible policies in addressing their challenges. As demonstrated by Indonesia's experience, market could be ruthless in punishing unsustainable measures, but could also be highly rewarding for wise moves.

Economy Highlights

Hong Kong : Solid exports and consumption should see GDP grew by a real 7% y/y in Q1-06. However, asset market needs to consolidate and broaden its base of expansion. Also, China's cooling measures should be watched, but not feared.

India : India's bank credit is growing too fast for comfort and needs to decelerate. We expect another 25bps rise in the key policy rates in July, and more tightening and active sterilisation should capital inflows surge.

Japan : Japan's two-year old recovery is spreading from companies to consumers. This would allow a faster GDP growth of 2.8% y/y in 2006, and an earlier hike in interest rates by the BoJ, probably in as early as July.

Malaysia : Market has misread the economy. Despite the April hike, interest rates in Malaysia are still too low. It is the interest rate that drives the ringgit, not the other way round. Also, inflation is the main policy concern, not economic growth.

OVERVIEW

by Tai Hui

Too good, too soon

- Asia's real economy continues to expand at solid pace
- Asset prices are rising even faster, some at exuberant rates
- While no major falloff is likely, consolidation seems needed

Asia has gone from strength to strength. Real GDP growth in China, Singapore and Korea have all accelerated in Q1-06 and exceeded expectations. Upcoming growth announcements in the rest of Asia are likely to follow the same pattern, thanks to a combination of sturdy domestic demand and export growth. Inflation is picking up in most places, but remains well behaved. Interest rates are rising, along with higher US rates and local inflation, but are far from punitive, as evident from buoyant financial market activities. Most Asian currencies have strengthened against the US dollar, and equity markets scaled new cyclical or record highs. Even the Chinese A-share market seems to have finally quitted a 54-month decline.

While performance of the real economy is broadly in line with our predictions, exuberance in selected asset markets seem to have run a bit too far too soon. Going forward, we believe some of these markets are coming close to a point of consolidation, either because they have overestimated the underlying positive factors or understated the risks behind. As we highlighted back in March, markets should be confident over the economic outlook of Asia, but not complacent.

The expansion pattern in Asia continues to hold. Impact from rising interest rates in the US and the recent surge in oil and commodity prices have remain limited. Output growth is supported by strong investment in China, improving consumption elsewhere, and robust exports across Asia. The strength in the global IT cycle appears well maintained. Semiconductor book-to-bill ratio, a leading indicator to the sector's prospect, was at its 18-month high in March. This bodes well for exporters in Singapore, Malaysia, Taiwan and Korea. Solid recovery in Japan, which boosted Japanese imports by 27% y/y in Q1-06, is also a positive factor for Asian economies.

This rosy picture, alongside with abundant liquidity, has prompted international investors to look favourably into Asian asset markets. As shown in table 1, all Asian market has outperformed the S&P 500 so far this year. The MSCI Asia ex-Japan Index has reached its highest since 1993. Benchmark stock indices in Korea, Indonesia, India and Singapore have reached historical peaks and many other markets are testing post-crisis highs. Yield spreads of Asian sovereigns and corporates are also running thin, some at record lows. Foreign investors have been heavy net buyers of equities in many Asian markets. For example, foreign investors have been net buyers of Taiwan stocks for 30 consecutive trading days between March 27 and May 9, to a total amount of TWD 269bn. In Thailand, foreigners have been net purchasers, on a monthly basis, for 6 consecutive months between Nov-05 and Apr-06. For the first four months of 2006, foreigner bought a net THB 113bn of Thai stocks, just THB 4bn shy of the amount in the whole of 2005.

Such optimism may be justified by strong economic fundamentals, but we do have doubts over the sustainability of their momentum in coming months. This concern was partially reflected in the sharp correction seen on May 11 where several markets, such as HK & Singapore, have seen their biggest one-day fall in two years. As we noted in this section of the March edition of Asia Focus, investors have downplayed the political events in Thailand and the Philippines, as a stamp of approval of the institutional development in these countries. The impressive gain in Indonesia this year was a catch-up to the underperformance in 2005 brought by the economic and political uncertainty from fuel price hike. Although growth prospects in Asia this year should remain positive, we believe this is already largely factored in by financial market investors. To maintain the current momentum in the Asian asset markets, it therefore needs more fresh positive drivers, which would be increasingly difficult to come by.

On the negative side, while no major downside risk is apparent, investors might have constructed their own mouse-traps by overstating the positive outlook or underestimating the few risk factors around. For example, while Japan's recovery is a net positive for Asia, it will also pose an intermittent threat to regional financial stability as it tightens its domestic liquidity condition. The BoJ's daily current account balance has fallen from JPY 30trn in early April to less than JPY 17trn in just over one month. At the current pace, this could fall to the legally required level of JPY 6trn by late June/early July, paving the way for rise in interest rates in Q3-06. There is already evidence of the unwinding of the carry trade that uses the JPY as a funding currency to invest in high yield currencies. This suggests liquidity from Japanese investors to Asia could reduce, at least temporarily, which in turn could affect risk appetite negatively. Extending this argument further, the global risk appetite is at an abnormally high level and a reversal of this could trigger correction in emerging markets.

Another risk factor is the US. While we agree with the market consensus that the US could remain a goldilock economy in the next 12-18 months, not sufficient attention is paid to the alternative scenarios. The Fed has left the door open for further rate hikes following the May FOMC meeting. Short term spikes in oil prices, brought by geopolitical uncertainty or supply disruption, could still trigger a hawkish reaction from the Fed. US consumers, while remain exuberant, are seeing their wealth increasingly capped by a slowing housing market. Closer to home, China is embarking on a renewed wave of macroeconomic controls aimed at cooling investment, lending and the real estate market. These measures, including a surprise 27bps rate hike on April 27, are designed to shift economic growth to a lower and more sustainable level. However, landing an economy is more sophisticated than landing a space shuttle, especially in the case of China, the risk of overshoot should never be underestimated.

ASIA FOCUS

by Gavin Redknap, Nicholas Kwan

Higher oil prices need better policy

- At USD 70 per barrel, oil is still affordable for the global economy
- But Asia has become increasingly vulnerable
- Yet, policy can make major differences

There seems to be no getting away from the issue of oil prices. Just as markets had got used to the idea that crude oil prices would stay around the elevated level of USD 60 per barrel (pb) reached in 2005, recent weeks have seen crude climb even higher, coming close to touching USD 75pb in early May. Fears that USD 50pb in 2004 and USD 60pb in 2005 would cause the global economy to fold were confounded. Could USD 70pb in 2006 be the trigger?

Nominal, real and actual cost of oil
As oil prices have continued to rise over the past few years, optimists have tended to downplay the significance of ever higher prices by pointing out that in real term, prices were not at the sort of levels seen during the oil crises of the 1970s and early 1980s. For some time, this argument has seemed sound. However, the latest rise in oil prices has brought the real price, as deflated by US CPI, to record levels too.

This may suggest that, indeed, USD 70pb could be the trigger for some more worrying reaction in the global economy than has thus far been seen. However, the real oil price only tells part of the story. Because of improved efficiency in the use of oil, as well as more diversified energy sources, the world is much less dependent on oil these days than 20-30 years ago, hence less affected by higher oil prices. The price shocks of the 1970s and early 1980s had the effect of forcing most economies to become more efficient in oil use. Per unit of output, the world today needs about two-thirds as much oil as it did in the 1970s. The industrialized economies are even more efficient, requiring only half the amount of oil needed 30 years ago to produce the same unit of output today.

Taking this increase in efficiency and reduced dependency into account along with the real oil price, a measure of the actual 'cost' of oil to the global economy can be derived. As chart 1 shows, even with oil prices at current levels, this cost is still about 40% below that seen in the early 1980s. At current levels, at least, it appears that the global economy can weather the impact of high oil prices.

Efficiency and dependency
For Asia, the implications are unfortunately somewhat less sanguine. The region has two major factors going against it: its low level of crude oil endowment, and relatively low efficiency in the use of oil - a result of the rapid industrialisation since the 1970s and the prevalence across the region of various forms of fuel subsidy. While these subsidies have helped to shield economies from the impact of sharp swings in fuel prices, they have also acted to prevent the region from becoming more economical in energy use. The result is that given current prices, the cost of oil per unit output in Asia is already at levels last seen in the 1980s.

As a whole, Asian economies seem already at risk from high oil prices. Yet the level of risk differs widely between places. As a rule, the higher an economy's energy efficiency and the lower its dependency on imported oil, the less vulnerable it is to the impact of high oil prices. However, given substantial differences in terms of external balance, government finance, price and economic structure of different Asian economies, the impact of high oil prices on each economy could still be very different.

One sharp difference between economies is their oil efficiency, expressed in terms of the cost of oil input per unit of output (set at USD1,000 GDP here). According to this measure, the oil input cost of Japan is just one third that of Korea. The Southeast Asian economies are the most oil inefficient among the Asian economies, while the Greater China economies fare relatively better, with their oil costs per unit output all running below Asia's average (chart 3).

One caveat in reading this measure of oil efficiency is the impact of economic and energy structures of the respective economy. For instance, Singapore, which hosts a large oil refinery industry, has a very high oil input cost per unit GDP due to the extraordinarily high oil-content of its economic structure rather than low oil efficiency. On the other hand, China's relatively low oil cost per unit output does not necessarily reflect its high efficiency in oil usage. Instead, it more likely reflects China's low dependency on oil as its primary energy source. Despite its being the world's second largest oil consumer, China relies on oil for only 22% of its energy needs, of which about half is imported. Nearly 70% of China's energy comes from coal, of which China has abundant reserves. In fact, when we take into account of all different sources of energy, China's energy efficiency is the lowest among the Asian economies. It requires 0.72 ton oil equivalent (toe) of energy to produce USD1,000 output in 2005, almost three times the world's average of 0.25 toe or six times more than Japan's 0.11 toe (chart 4).

China is fortunate that its low oil dependency has substantially offset the negative impact of its low oil efficiency. In any case, economies with high oil input cost per unit output would generally face more difficulties than the lower ones under the current high oil price environment. In this respect, Southeast Asian economies would be under more pressures.

Policy can make a difference
Another common indicator used to measure an economy's vulnerability to high oil prices is net oil imports, usually expressed in GDP terms (chart 5). On this measure, the large oil imports of Thailand clearly poses some concern. While this is a fair assessment, one irony is that one of the presumably least vulnerable economies implied by this indicator - Indonesia - had at one time become the worst hit by the current oil price upsurge. The problem, as been well acknowledged and actively addressed now, came from Jakarta's policy of heavily subsidising fuel prices, which was seen by the market as unsustainable and hence triggered a mini-crisis of confidence. Indonesia's experience served as a timely wake up call for other Asian economies, many of them have scaled back their fuel subsidies progressively since then. This is encouraging especially for those with relatively weak fiscal position and low oil efficiency.

While reduced fuel subsidies may lead to faster inflation pass through and dampen output growth, Indonesia's experience shows that policymakers usually underestimate the effectiveness of market adjustments and overestimate the damage of high oil prices. For example, the use of long-term contracts and derivative hedging, on top of the strengthening of most Asian currencies, has limited the actual increase in oil import prices in many Asian economies to only about half of the rise in international markets. The impact of oil on inflation is also limited by two other factors in Asia. First, crude import costs account for only about one-third or less of the retail prices of oil products in Japan, Korea and Hong Kong. Second, oil and oil products generally account for only about 3% of the CPI basket in Asia, much less than the weight of food which has seen prices falling across the region.

This suggests that there should be relatively little to fear from continuing to remove subsidies, albeit in a gradual manner. In the longer term, such a move is essential anyway - Asia's relative lack of resources demands greater fuel efficiency, and achieving that will help to lock in stability.

Given their strong growth momentum, relatively low inflation, and strong external positions, most Asian economies are still in a strong position to weather the challenges of high oil prices. However, their relatively low oil efficiency and high oil dependency imply that their margins of comfort are getting dangerously thin at current crude price level. Some countries like Thailand, Indonesia and the Philippines may face slower growth in the near term, as higher oil prices and reduced subsidies begin to dampen household purchasing power. Some others like India could suffer a wider current account deficit and a weak currency, as oil import bill rises higher. However, as demonstrated by the experience of Indonesia, markets can and do react strongly to policy that is not considered credible. With oil prices likely to remain elevated, the need to develop sensible policy is clear. Markets will be on the look-out to punish those who fail to do so.

Hong Kong

by Tai Hui

Real growth, virtual risks

- Real economy supported by solid exports and consumption
- Asset market needs to consolidate and broaden its base
- China's cooling measures should be watched, not feared

The Hong Kong economy continues to grow at strong momentum, but two risk factors deserve more attention going forward. First, Mainland China's new efforts to cool excessive investment and lending growth. Second, substantial gains in asset prices, especially equities. Neither is expected to derail Hong Kong's solid growth momentum, but their developments could still affect the trajectory of the current growth cycle.

Solid 7% growth in Q1-06
In Q1-06, we expect the Hong Kong economy to expand by a real 7% y/y, moderating from 7.6% in Q4-05 but still well above its 4-5% growth potential. As we highlighted in March, both domestic and external economic fundamentals in Hong Kong are constructive to growth (chart 2), and this is expected to continue. Retail sales expanded by 6% y/y in Q1-06, picking up from 5.3% in Q4-05. Contribution to growth from net exports of goods maybe a small negative, as trade deficit widened from HKD 37bn in Q1-06 from HKD 26bn a year ago. However, this should be more than offset by the strong performance in the trade in services, such as logistics, tourism and professional services. Tourist arrivals grew 13.8% y/y in Q1-06, while sturdy labour demand in the service sector is indicative of the upbeat business environment.

Chilling wind from the north
While the growth momentum is expected to persist in the next 6-9 months, there are two potential risks to watch out for. First, Mainland China is embarking on another wave of macroeconomic consolidation. An unexpected 27bp-hike in bank lending rates on April 27 has sent a clear signal on the authorities' determination to curb investment and lending growth. Not surprisingly, this was backed by administrative measures to control fixed asset investment in specific industries, such as cement and aluminium. Given the close economic linkages between the Mainland and Hong Kong, these tightening measures could dampen some of Hong Kong's economic activities, both in the real sector and the financial markets.

In comparison with the previous tightening cycle in 2004, Beijing's latest measures remain relatively mild. While more follow-up actions are expected, including both sector specific measures and across-the-board liquidity tightening, the overall objective of the Chinese authorities is not to stamp the brake of economic growth, but to shift the growth momentum from a limited investment hot-spots to a broader base, especially in private consumption, hence making growth more sustainable as outlined in the 11th Five Year Plan. With this understanding and given the absence of imminent threats, the aggregate demand from China is likely to stay firm, although the type of goods and services generated maybe different. Furthermore, the previous bout of macroeconomic cooling measures in 2004 has made little impression on Hong Kong's real economy, as the ups and downs of the Hong Kong economy is more related to China's external performance rather than domestic investment (chart 3).

However, the impact on Hong Kong's financial markets could be different. Individual Mainland companies listed in Hong Kong could be hit by specific austerity measures in the Mainland. So far, the market has only knee-jerk reactions. This could be due to the prospects of substantial capital inflows from Chinese investors triggered by the newly announced QDII (Qualified Domestic Institutional Investor) scheme, as well as the general optimism on the local asset market.

Financial markets may need to consolidate
The second risk we see facing Hong Kong in H2-06 is the consolidation in the local asset market, especially in equities. The equity market has seen some impressive gains since the start of the year. The Hang Seng Index has gained 16% year-to-date, with a 40% jump in the Hang Seng China Enterprises (H-shares) Index to a 12-year high. Furthermore, initial public offerings (IPOs) were also very well received with oversubscription reaching several hundred times for some listings.

The property market had gone through a similar surge back in YE-03 to Q1-05, where the headline property price index rose 63%. Yet it has since been in consolidation mode prompted by rising interest rates and overvaluation concern. It is not surprising that the equity market could go through a similar consolidation in the near term. While pockets of overvaluation are possible, the risk of bubble is still relatively small at the broad level. Hang Seng Index's P/E ratio remains low by historical standard (chart 5).

To the extend that the equity market has run ahead of the real economy based on positive expectations like the peaking of interest rates, capital inflow from QDII, and the general strength of the Hong Kong and Chinese economy, materialisation of these expectations could reinforce growth in H2-06. But this would need to be weighed against the possibility of higher oil prices, decline in risk appetite or any upside surprises in US or local interest rates.

India

by Shuchita Mehta

Credit growth: slower the better

- This credit cycle is more healthy
- But slower credit growth is desirable
- We believe RBI will hike key policy rates by 25bp in July

India's bank credit is growing too fast for comfort and needs to decelerate from the current 30% y/y break-neck rate to a more sustainable 18-20% level in 2006/07. We expect another 25bps rise in key policy rates in July, and more tightening and active sterlisation should capital inflows surge. While consumption and asset prices may moderate, economic growth would remain at a healthy and more sustainable 7%.

A different and better credit cycle
In the last credit up-cycle of the mid-1990s, India Inc. went on an investment binge in textiles, steel, and a few other industries. Credit growth topped 25% and drove interest rates to double digits, only to be disrupted by the Asian financial crisis. Weak global commodity prices and lower import tariffs driven by India's WTO commitment then aggravated the overcapacity problem of Indian industries, undermined their ability to service high interest loans and led to mounting non-performing assets in banks.

Thereafter, interest rate deregulation in 1997 and sluggish corporate loan demand led to a sharp decline in interest rates. The jump in expatriate remittances post 9/11, and strong export growth and capital inflows revived money supply. This was sustained by a rising domestic savings rate, up to 29% from the low twenties in the 1990s. This helped companies to retire high cost debt. Capitalising on falling yield and growing liquidity in the system, banks invested heavily in government securities, up to a peak of 45% of bank deposits in early April 2004. The high trading profits together with prepayments helped banks clean up their books. Foreclosure norms also become stricter, aiding debt restructuring and recovery.

Since 2000, bank credit has expanded nearly 3.3 times, well greater than the 80% expansion in nominal GDP. This is not totally surprising given a small 42% credit-to-GDP ratio, which was lower than most low and middle income countries. But the more important factors behind the current credit upswing are broader economic reforms along with financial market deepening. In particular, tax incentives for house purchase and others fueled retail credit demand, pushing up the credit-to-deposit ratio from 51% in Sep-01 to 70.6% today. This retail momentum was supplemented by equally strong surge in corporate credit demand over the past year and half. Aided by strong economic growth and profitability, Indian companies are again looking to invest. Meanwhile, the government is also keen to boost credit delivery to the SME and agricultural sectors. Regulatory prudence also makes a difference. The Reserve Bank of India has raised the risk weightings for personal and real estate loans relatively early in this cycle. On top of this, policy rates were hiked by 100bps to 5.5% while mortgage rates were up by about 300bps.

Need for slower credit growth
A broad based economic upswing, along with improved risk management, should make the current credit up-cycle less vulnerable to shocks. Yet, further moderation in credit growth is needed to maintain sustainable expansion of the economy, especially in managing the following risks:

First, record high oil and commodity prices would require higher interest rates and slower credit growth to contain inflation, including expectations. Also, exceptionally strong risk appetite of international investors has raised the risk of large capital outflows at time of sentiment reversal. More prudent credit policies are needed now to limit the damage of any sharp tightening that may be triggered by such reversal.

Second, Indian banks have funded their lending activities primarily via deposits. However, recently the relative share of non-deposit sources of funding has increased, leading to higher risks in maturity mismatch and liquidity management, especially in a rising interest rate environment. A longer term solution is to expand long term funding sources like insurance, pension funds, etc., but in the short run, credit expansion may need to be restrained.

Third, despite relatively benign wholesale and consumer price inflation, asset prices are bubbling. Aside from record high equity prices, commodities and property prices are getting quite inflated, partly supported by bank lending to real estate, capital markets, and personal sectors, which are some of the riskier sectors. To prevent the making of major asset boom-bust cycle that would be detrimental to sustained economic growth, higher interest rates and more prudent credit policies are needed.

With incremental bank lending reaching a significant 11.2% of India's USD 796bn GDP in 2005/06 and bank credit growth still running at 30%, we believe the RBI will raise key interest rates by at least 25bps. This should support more sustainable economic growth down the road, especially given a more healthy credit cycle.

Japan

by Frances Cheung

Welcome back: consumers

- At long last, Japanese consumers are returning
- A broad based recovery will boost GDP by 2.8% in 2006
- BoJ may start hiking rates in as early as July, at minor steps

Japan's two-year old recovery is spreading from companies to consumers. Promising corporate profits and sustained exports have supported investment, created new jobs, raised income and are gradually reviving consumer confidence. Accordingly, we have revised upward our 2006 GDP growth forecast to 2.8% y/y from 2.0%. Meanwhile, the current account balance (CAB) with the Bank of Japan (BoJ) has been declining at an accelerated pace, probably encouraged by sustained momentum of the current recovery. While we still expect a policy interest rate hike in Q3-06, this may happen in as early as July rather than later in the quarter.

Disappearance of the three excesses
The March Tankan survey of corporate sentiment underpinned our view of a broadening recovery. In addition to large manufacturers, upbeat sentiment is spreading to small companies and non-manufacturers. The three excesses, namely excess product supply, excess production capacity, and excess labour supply, are progressively vanishing (charts 1 and 2). Capacity utilization has returned to the peaks seen in 1997 and 2000, with February's utilization operating ratio at 104.4 (vs. an average 100 in 2000). Profit margins, returns on asset and equity were quite healthy in historical terms. These imply that corporate investment is likely to remain firm this year, adding to the growth momentum.

From companies to consumers
More importantly, the household sector is starting to share the optimism of business. Household income had been lagging behind movements in nominal GDP since the onset of the current recovery in 2003, due to ample supply of irregular workers and corporate emphasis on profitability. Only when the Tankan diffusion index showed labour shortages in mid-2005, did wages start to rise (charts 2 and 4). Now the jobless rate is at a 7-year low of 4.1%, and the job-to-applicant ratio rose above 1, the first in more than a decade. A tight labour market should lead to further wage rises, in our view.

Given gradual increases in income, consumer spending is like to recover soon. This in turn can spur corporate revenue and lead to a broader based and more sustainable recovery. In April, consumer confidence rose to 50, the pessimism-optimism watershed level, the first time since June 1990. Separately, government survey on family income and expenditure showed that household propensity to consume has been rising quite rapidly, thanks to more bullish consumer sentiment and an aging population. We believe rising wages, better employment opportunities, and improving consumer confidence would gradually fuel consumer spending down the road.

On the external front, solid expansion of the electronic sector boosted exports by 18% y/y in Q1-06. Imports, however, grew at an even stronger 27% y/y in Q1-06, after a solid 15.7% expansion in 2005. Improving domestic demand would likely lead to higher import growth and smaller trade surplus, but steady external demand should remain supportive to the recovery.

Rate hike expected in July, the earliest
Turning to monetary policy, market is still focused on when and how the BoJ will start to raise its policy interest rates. CAB has been dropping more rapidly in April than in March when the BoJ formally announced the death of its quantitative easing policy. This development resulted in a 7.2% y/y drop in the monetary base in April, the biggest since records began in 1970.

From recent pace of reduction, CAB is likely to reach the JPY 6trn level - the minimum required reserves level - by late June or early July. By then, the BoJ may start considering raising rate, in our view. Based on historical trend and demand situation, there will unlikely be any material impact on short term rates as long as the CAB is still above JPY 6trn. Thus far, reaction in the short rates to the scale back of CAB has been tame, with 3m JPY Libor up less than 10bps since March 9.

We expect the overnight call rate to rise to 0.25% by end-Q3, and further to 0.50% by the end of this year. The risk to our forecasts is an earlier rate hike should the CAB drop even more rapidly. Having said that, we believe the BoJ will be extremely cautious towards a tightening policy given its past history in handling monetary policy.

A sustained and broadening recovery and expectations for higher interest rates would support the JPY, moreso given the large amount of JPY carry trade position (estimated by some at about USD 100bn) that needs to be unwound. Although demand for higher return overseas assets would also rise and checks the strength of JPY, especially around the key USD-JPY 110 and 105 levels, the risk to our JPY forecasts is clearly on the upside, i.e. a stronger JPY, as the growth and interest rate cycles of the US and Japan move in opposite directions.

Malaysia

by Joseph Tan

Three market misreadings

- Despite the April hike, interest rates are still too low
- OPR drives MYR, not the other round
- Inflation, not economic growth, is the concern

Liquidity in Malaysia remains too much for comfort and interest rates too low to check the strong underlying inflation pressures, despite a 25bps hike in the Overnight Policy Rate (OPR) on April 26. Similarly, the Malaysian Ringgit (MYR) is too weak to curb import prices or to dampen economic growth, notwithstanding its 4.6% appreciation against the USD year-to-date. We believe the Bank Negara (BNM) will continue its measured hike of the OPR in May and July. The MYR could strengthen to 3.52 by end-2006, but GDP growth would stay solid at 5.5% in 2006.

Market misread BNM
In its last policy meeting on April 26, BNM raised the OPR by 25bps in line with our expectation, but the majority of the market expected no change to the base rate. Why did the BNM act against the market's consensus? This is by no means a misfortune in the fortune-telling exercise of central bank watch. It goes all the way back to some of the market's profound misreading of the Malaysian economy in general, and its monetary policy in specific.

First, many in the market claimed that because the MYR had strengthened 4.6% versus the USD year-to-date, it would lower imported inflation and reduced the need for BNM to hike. While the appreciation versus the USD has been marked, the MYR has actually weakened versus most regional currencies (chart 1). Malaysia has extensive trade links with the rest of Asia and unless the MYR strengthens significantly versus regional currencies, the effect on imported inflation will remain limited.

Those who hold the view that MYR strength means fewer hikes have also likely missed the point that Malaysia's monetary policy is centred on interest rates. It should be the OPR driving the MYR, not the other way round. Being open on its capital and current accounts, BNM can choose to control the OPR or the MYR, but not both. Maintaining the OPR while other central banks are raising interest rates will make other currencies more attractive in yield and reduce MYR strength. BNM is playing catch up to other regional central banks in raising rates (table 1) and is correct not to focus on recent MYR strength as this can quickly turn if they had not raised interest rates.

Second, many argue that inflation in Malaysia is cost-pushed due to higher oil prices and therefore raising interest rates is not effective in countering inflation. Chart 2 shows the effect on inflation of the two fuel price hikes in July 2005 and February 2006. In those cases, prices were raised 19% and 23% respectively but the effect on inflation is significantly different. In the first round inflation went up by 0.7 percentage point (ppt), while in the latest round inflation shot up by 1.6ppt, though the difference between the two price hikes was a mere 4%. This suggests that inflation in Malaysia is not all cost push. In fact, with BNM reportedly sending audit teams to local banks to scrutinise consumer lending policies, it suggests that BNM is worried about further credit extension to consumers, a consequence of excess liquidity in the banking system.

Third, inflation has an ability to spiral out of control when certain quarters of the economy raise prices of goods and services in anticipation of higher future costs. By raising the OPR 25bps in April, BNM has correctly sent the signal that they are serious about keeping inflation in check and this can dampen future inflation expectations. Recent comments from Governor Zeti that interest rates are still below neutral even after the April hike reinforces our call held since December 2005 that BNM will raise the OPR to 4% by July (+25bps each at the May 22 and July 28 meetings) and increasingly the market consensus is also gravitating towards this view.

Currently, the real level of interest rates in Malaysia is still negative (chart 3) and we expect nominal interest rates to rise to compensate at least for the effect of inflation. With BNM having an inflation forecast of 3.5% to 4% for 2006, OPR at 4% will just about bring real interest rates to zero. However, we do not expect BNM to be overly aggressive and the risk to our forecast is perhaps another 25bps hike in August depending on the inflation data. We have also recently revised our USD/MYR forecast to 3.52 by end-2006 to reflect a series of measured interest rate hikes lending further strength to the MYR.

The worry is inflation, not growth
One reason why some quarters of the market are so dovish on interest rates is because of their concern about growth. But recent industrial production data point to a robust 5% y/y GDP growth in Q1-06 (chart 4). Recent Asian data on electronics production and exports suggest some upside surprises and with the US demand still robust, we have fine-tuned our 2006 GDP growth forecast to 5.5% from 5.0% previously. The fuel price hike of 23% also means that our 2006 inflation forecast now seems low. Factoring in the latest data, we have revised up our 2006 inflation forecast to 3.6% from 2.5% previously.

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