Asia Focus : Intra-Asia Investment Reinforces Integration : Asia is the biggest direct investor of Asia itself. This, along with the dominance of intra-Asian trade, reinforces the trend that growth in Asia is increasingly driven by intra-regional integration. China is by far the largest host of FDI in the region, but perceptions that China is crowding out its Asian neighbours in FDI inflows need careful examination. More likely, the relationship is both competitive and complementary, or at the minimum, not a zero-sum game. Going forward, it is more important to emphasize the quality, not the quantity, of investment. To facilitate that, a more open and level playing field would be more important than special privileges and incentives offered to potential investors.

Economy Highlights

China : the economy is challenged by a wave of liquidity, neither orthodox monetary nor CNY policy seems helpful. More tightening of lending seems inevitable, and imminent.

Singapore : strong Q1 GDP numbers underline good growth prospects; expected election results yield more-than-expected changes; new gaming policy would breed new activities and values.

Taiwan : strong exports to support a higher 3.8% GDP growth in 2006, but domestic demand would remain soft. Ample liquidity to keep CBC vigilant with steady rate hikes.

Thailand : political uncertainty likely to stay until year-end, and risk remains on the downside. Interest rates should have peaked, and THB likely to under-perform.

OVERVIEW

by Tai Hui, Nicholas Kwan

Back to reality

- Recent market corrections are no prelude to crisis
- But are medicines to bring investors back to reality
- It's time to focus back on fundamentals, which are good

Last August, the mini-rupiah crisis in Indonesia served as a wake-up call to authorities in Jakarta to put their acts together. They did, and things quickly turned for the better. Last month, emerging markets corrected sharply, serving as timely stimulants to bring investors back to reality. The shocks are necessary and inevitable, given progressive reduction in global excess liquidity and increasing exuberance in selected markets. However, they are no prelude to major crisis. In fact, once markets are clear of short-term euphoria and investors refocus on the reality, strong fundamentals will put Asia on an even more balanced and sustainable growth track.

Over the past month, prospects of higher interest rates in the US and Asia, plus concern over the impact from higher oil prices have triggered sharp market corrections across Asia. The MSCI Asia ex-Japan index has fallen by 17% between May 9 and June 13. Asian currencies have also generally weakened against the USD, some like the IDR by as much as 8%, as investors pulled back from their emerging market exposures.

To some extent, recent tightening moves of the Asian central banks are already behind the curve, albeit not severely. For most Asian central banks, their current interest rate up-cycles have started about 4-17 months after the US Fed. One may argue that more flexible exchange rate regimes and improved fundamentals like large external surpluses have allowed Asian central banks to act more independently from the US Fed. However, to the extent that such independence was granted by investors' exuberance, which was dictated by global liquidity condition, such independence would ultimately be affected by the main source of such liquidity - US monetary policy, as evident recently.

Even without the progressive reduction in global excess liquidity, Asian central banks need to respond to their own economic conditions and tighten gradually as output gap narrows and the threat of inflation heightens. This is crucial for the preservation of their credibility and their newly gained independence. Failing this, penalty could be heavy, as demonstrated by Indonesia's experience. It is good that Asian central banks have faced up to this challenge and moved in the right direction. Even better, we see investors finally awake to such reality and become more risk sensitive in their investment.

While market may continue to adjust and fluctuate in the near future, we reiterate our optimism on the growth prospects of the real economy in the region. In Q1-06, economic growth in Asia has generally exceeded expectation. Contrary to the general perception that growth was largely driven by exports, which has stayed robust due to strong IT demand, much of Asia's output growth during the quarter was domestically generated. Specifically, domestic demand was responsible for 65% to 90% of the output growth in Hong Kong, Indonesia, South Korea, Japan and the Philippines. Taiwan and Singapore were the only exceptions, where domestic demand contributed 24% and 26% of GDP growth, respectively, with net exports accounted for much of the growth.

Looking ahead, there are few signs suggesting an imminent slowdown in either domestic or external demand. China is showing no sign of slowing. Investment in May grew 31.9% y/y despite a surprise rate hike in late April and macroeconomic cooling measures aimed at curbing investment. The US housing market and personal consumption are softening, but corporate spending, and hence demand for IT exports from Asia, continues to be supported by robust profit growth. These factors should underpin Asia's export performance at least for Q3-06.

In line with this upbeat assessment, most Asian central banks have focused their policies on curbing inflation. In the past few weeks, the central banks in Thailand, South Korea, India have raised their benchmark policy rates by 25bps, citing inflation concerns. We have rightly anticipated the hikes from the Bank of Korea and the Bank of Thailand, although the market was looking for no change. While the hike from Reserve Bank of India was an inter-meeting move, we have warned that the RBI would push rates higher even though it had decided to hold rates unchanged in its April policy meeting. Over the weekend, the People's Bank of China has announced its decision to raise the Reserve Requirement Ratio of the major commercial banks by 50bps to 8.0%, to be effective on July 5. Before the end of June, we expect Taiwan's central bank to raise its discount rate by 12.5bps to 2.5% in its Q2 monetary policy meeting.

Looking into H2-06, the bias of interest rate risk in Asia is still on the upside, with the exception of Indonesia, where we anticipate lower policy rate. In Q3-06, we expect interest rate hikes from Japan, Malaysia, South Korea, Taiwan and the Philippines. Supply-side risks, such as unexpected surge in global energy and commodity prices, could prompt central banks to tighten further than our current forecast. Robust domestic demand, especially in the case of Malaysia and South Korea, is another reason to push monetary policy beyond neutral. Further to raising benchmark interest rates, central banks and governments can also permit their currencies to appreciate, reducing the need to sterilise excess liquidity and limiting the impact of higher import prices.

Despite the prospects of still-higher rates and reducing liquidity, there is no point to panic. Notwithstanding relatively high asset prices in selected areas, there is no clear imbalances in most Asian economies and the region is nowhere close to any major financial or economic crisis. In fact, recent adjustments of Asian equities and currencies have significantly reduced the excesses in Asian asset markets. Real estates may become less affordable in selected places like Beijing and Mumbai, but prices in most other Asian cities are still well below their previous peaks. Leverage of most corporates and households are still at cyclical lows, after years of balance-sheet restoration since the Asian financial crisis. Strong growth momentum and solid external payments positions, with the accumulation of over USD 2trn forex reserves by Asian central banks, would cushion the region from major shocks. Last but not least, increasingly proactive and professional macro-economic managements should provide the region with additional safeguards. In fact, less-inflated asset prices, more realistic risk assessment and more credible policies would provide Asia with a more sustainable and solid growth base going forward.

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

Intra-Asia investment reinforces integration

- Asia is its own largest direct investor
- FDI flows are not zero-sum games
- Quality is more important than quantity

Asia is the biggest direct investor of Asia itself. This, along with the dominance of intra-Asian trade, reinforces the trend that growth in Asia is increasingly driven by intra-regional integration. China is by far the largest host of FDI in the region, but perceptions that China is crowding out its Asian neighbours in FDI inflows need careful examination. More likely, the relationship is both competitive and complementary, or at the minimum, not a zero-sum game. Going forward, it is more important to emphasize the quality, not the quantity, of investment. To facilitate that, a more open and level playing field would be more important than special privileges and incentives offered to potential investors.

Asia's largest direct investor: Asia, particularly Hong Kong
In 2004, intra-Asia direct investment accounted for about 40% of Asia's total FDI inflows, more than the total of the EU and US. Out of a total USD 138bn FDI absorbed by the 11 Asian economies from Japan to India in 2004, we estimate that about USD 54bn came from Asia itself, while European and American investors contributed USD 22.6bn and USD 19.5bn respectively. In terms of individual FDI recipients, Asia contributed 57% of FDI inflows into China last year, nearly half of those into Indonesia and Thailand, and 44% of those into the Philippines. In reciprocal, Asia is also the main destination for Asia's outward FDI. Asia is the destination for over 70% total FDI outflows from Taiwan, over 50% (90% if outflows to British Virgin Island and Bermuda are excluded) from Hong Kong and Korea, and over 30% from Japan.

Interestingly, among the Asian economies, Hong Kong is the largest single investor, having contributed USD 18.3bn or 13.3% of the total FDI received by Asia in 2004. This is next only to the US, which invested USD 1.2bn more than Hong Kong during the year. However, when aggregating the FDI flows between 2001 and 2004, Hong Kong's USD 67.3bn investment made in Asia was 30% more than the USD 51.9bn made by the US, and only 10% less than the USD 74.7bn invested by all EU countries in Asia during the four years (Chart 2).

What seems perplexing is Japan's relatively timid direct investment position in Asia and the world. According to UNCTAD (United Nations Council for Trade and Development), Japan's FDI outflow amounted to USD 31bn in 2004, with a total outward investment stock of USD 370.5bn. Comparing with Hong Kong's USD39.8bn outflow in 2004 and USD 405.6bn outward stock, Japan's numbers appear excessively small given that the Japanese economy is 24 times bigger and its current account surplus is 8-fold larger than that of Hong Kong. To some extent, Hong Kong's FDI data could be inflated by its role as a financial intermediary. However, given that Singapore and Taiwan, whose GDP are 3-8% of Japan's, have also invested half to one-third the amount made by Japanese investors in Asia in 2004, it is obvious that Japan's direct investment in Asia is overly conservative.

Another interesting point is about China. It is the single largest FDI destination in Asia as well as the developing world, having absorbed 40% of Asia's and 10% of the world's FDI inflows in 2004. However, it is also a major and increasingly important investor in Asia. In 2004, China invested USD 8.8bn in Asia, accounting for 6.4% of the region's FDI inflows. It ranked the third among all Asian investors, next only to Hong Kong and Japan, but more than Singapore, Taiwan and Korea. One caveat is that 90% of China's investment in Asia is in Hong Kong. While this is not surprising, given close relationship between the two places, the data could be somewhat inflated by round-tripping and double-counting. However, given China's growing hunger for overseas resources and its mounting foreign reserves, its emergence as an increasingly important outward investor is just a matter of time. According to UNCTAD, China's accumulated outward investment amounted to USD 39bn at end-2004, 16% of its USD 245bn inward stock (Chart 3).

China vs. Others: not a zero-sum game
There is no denial that China's dominance in the developing world could lead to reduced FDI flows to other competing economies, especially in the short term. This is evident from comparing the FDI flows into China versus those into the four ASEAN economies of Indonesia, Malaysia, Philippines and Thailand (ASEAN4). In 1993, ASEAN4 absorbed about 40% as much FDI as China. This ratio has dropped steadily to only 5% in 2001. However, much of the change came after the Asian financial crisis when most of the ASEAN countries were hit hard while China remained relatively untouched. In fact, China also suffered, albeit less severely, from lower inflows after the crisis. Since 2002 when the crisis-hit countries gradually rebounded, the ratio has been stabilized at about 10% (Chart 4). More importantly, both in the pre-crisis period of 1993-97 and during the post-SARS recovery period of 2003-2004, FDI inflows into both ASEAN4 and China were growing hand in hand, implying that as long as domestic economic conditions of individual country are positive, investors could invest in more than one site and FDI would not necessarily be mutually exclusive. Given growing inter-connectivity of modern manufacturing and further development of global supply chains, investment in China will increasingly be connected to investment elsewhere. While competition for investor dollar will continue, cooperation and coordination among different investments will also increase.

The same is true for the investor economies. While FDI inflows are generally seen as a positive, there have been concerns on the hollowing-out effect of FDI outflows. Outflows of FDI directly affect domestic production facilities, investment, trade and domestic employment opportunities. But on the optimistic side, which we believe is the likely longer-term outcome, FDI outflows help enhance corporate competitiveness of the investing companies, and trigger more employment back home for overseas subsidiaries management and support for R&D. Apart from promoting exports of the recipient economy, exports of the source economy may benefit too, from sourcing of input or intermediate products by these overseas subsidiaries.

This probably explains why there is relatively less resistance in the major capital exporting economies like Korea and Hong Kong about their investment outflows into China. Even in Taiwan, where government policies have been heavily affected by political rather than economic considerations and investment into the Mainland has been persistently discouraged, economic reality has resulted in the Mainland becoming the largest and most favoured outward investment destiny as well as the largest trading partner of Taiwan.

Quality more important than quantity
With Asia now accounting for half of the developing world's FDI inflows and one-fifth of the world's total inflows, the key for FDI flows is increasingly turning to the quality rather than the quantity of investment. China, for example has become an increasingly important capital exporter despite its being the largest FDI host. Similarly, outward investment has also been rising in ASEAN4. In pursuit for more and better FDI, many governments have incorporated investment promotion provisions in their bilateral or regional free trade or economic cooperation agreements (FTAs). However, similar to the case of trade liberalisation where it remains debatable whether FTAs help or hinder trade development, it is also unclear to what extent investment can be promoted by special privileges or incentives offered in bilateral or regional pacts.

Some FDI provisions give competitive advantage on certain sectors to countries covered by the FTAs, and discriminate against those of other countries not covered by the FTAs. This could have two drawbacks, notwithstanding presumed benefits from investments attracted by the special arrangements. First, it may attract the wrong kind of investment, especially those that have no natural competitive advantage and would fail without special privileges. This in turn would undermine efficient allocation of resources. Second, it may set the wrong policy direction by trying to hand pick investors rather than to provide a fair and business friendly environment to enable the most competitive investors to flourish. In particular, governments should pay more attention to intellectual property rights (IPRs) and competition policies which help create a level playing field for foreign investors. They should focus on overall liberalisation of industries rather than selective industry targeting.

China

by Stephen Green

China's Poseidon adventure

- China is challenged by a wave of liquidity
- Orthodox monetary and FX policy are not being used
- More tightening of lending seems inevitable, and imminent

It seems China's economy is now going through its own Poseidon adventure. The story will be familiar. A big ship hits a big wave of water, flips upside-down and the soaked passengers valiantly attempt to escape by fighting their way out in a direction that no one can quite decide upon. Since 2003, when appreciation expectations on the CNY began, a wave of liquidity has hit China. The leaky capital account has not helped. Policy-makers continue their debate about the escape route. The major difference here, fortunately, is that the Chinese economy has not flipped. Instead, it is still growing fast, as Chart 1 shows. Clearly, there are limits to our metaphor. But it still suggests two questions: How to stop the water and which way out? We believe monetary tightening is the answer, albeit selectively. While no serious damage is done yet, time is tight for Beijing to put its act together.

How to stop the water?
The liquidity is coming in through FDI (recently revised upwards to USD 79bn in 2005), the trade surplus (a record USD 13bn in May 2006) and informal flows. In addition, there is still-strong overall corporate profitability growth. In Q1, corporate bank deposits grew 15.8% y/y. But the banks are not well equipped to hold these waters back, so lending increased by nearly as much; CNY loans rose 14.7% y/y in Q1. And whereas many held back on lending during 2004-05 in order to meet the new 8% risk-adjusted capital adequacy ratio, some now meet this target. In addition, banks have come under pressure from local officials to meet the 11th Five Year Plan objectives.

Which way out?
One way to stop the flows is significant exchange rate appreciation. But after two months of directionless trading around 8.0 (see Chart 2), this looks unlikely. Why? Here are four ideas:

(1) A lack of policy driver at the highest level, thanks to recent absence of Vice Premier Huang Ju.
(2) Fear of exacerbating the export slowdown (see Chart 3), although export growth of 25% y/y in May should undermine such fears.
(3) Lack of US pressure. The Grassley-Baucus Bill may pass before November, but it only means (i) No increase in voting rights for China at the IMF and (ii) No 'market economy' status from the US, both are survivable.
(4) The authorities do not know how to proceed.

For spot trading to really develop we need real two-way risk, but we will only get that after more appreciation. At the same time, down in the engine room, SAFE is busy re-structuring the current and capital accounts to get liquidity out, dispersing pressure on the PBoC to revalue. The quota on outward direct investment by Chinese firms has now been abolished. Recent FX conversion rule changes for corporates are much more radical than the market has expected, and SAFE indicated there was significant conversion of CNY into USD among individuals since May 1. But there is more to do. We are still waiting for detailed rules on QDII - and with some USD 1bn entering each day, these capital account rules are not a sufficient solution.

Monetary policy is another way out. We thought that higher inter-bank rates, lower bank excess reserves, and more sterilisation by the People's Bank (worth CNY 56bn in Q1-06, compared to CNY 33bn in Q1-05), would push rates up in Q1-06. Instead, they went down to 5.85%, falling 22bps from Q4-05. With inflation running at 3.9% (the Q1 deflator), and assuming stable inflation expectations, the real rate is 2% - too low. Chart 4 shows sterilisation adjusted for changes in government deposits at the PBoC. These rise during the year as taxes are collected, which has a sterilising effect, and are then spent in Q4. Factor this in, and it is clear that the central bank did not get heavy with the liquidity situation until 2006. It clearly needs to do more especially after bank loan growth of CNY 209.4bn (USD 26.1bn) in May, nearly double that of the same month last year. By end May, new loans totaled CNY 2.12trn, 85% of the annual quota set by the PBoC. The reserve requirement hike to 8%, kicking in on July 5, is one of a number of measures which are partly resolving money market liquidity.

Damage limited, but time is tight
So far, the flood has not caused tremendous damage. House prices continue to come under pressure, but are not terribly worrying for us at least - year-on-year growth in May was 5.8%. Stocks are still up on October, partly thanks to the liquidity - but also to non-tradable share reform. By the end of Q1, 768 listed companies (57% of the total) had made state share restructuring proposals. Recent falls in equities reflect profit-taking in an environment where corporate profit margins continue to decline. This is partly because of commodity prices rising. The price index for producer inputs rose 6.5% y/y in Q1, while ex-factory prices rose only 2.9%. That said, petrol at the Chinese pump was up 33.5% y/y in Q1 as the National Development and Reform Commission (NDRC, the ex-planning authority) partly got to grip with the challenge of bringing China's oil prices into sync with everyone else's. Chart 5 shows, however, that prices in China remain well below US prices, which are themselves of course low on international standards. More pain for China's new car-owning classes is on the way. Hopefully, more pain for those enjoying easy credit as well.

Singapore

by Joseph Tan

Progress in prospects, politics and policy

- Good growth prospects underlined by strong Q1 GDP numbers
- Expected election results yield more than expected changes
- New gaming policy to breed new activities and values

The past quarter has seen significant progresses in Singapore's economic prospects, politics and policy implementation. An exceptionally strong and broad-based growth in Q1-06 supported our positive view about Singapore's growth prospects and reinforced our elevated 6.5% growth forecast for 2006. While the ruling People's Action Party's election success is well anticipated, key cabinet changes that followed are more significant than expected. Meanwhile, the award of the Integrated Resort (IR) casino project marked a major step in implementing a new gaming policy, which could have significant long-term impact on the island-state's socio-economic development.

Broad-based growth prompts higher forecast
At 10.6% y/y, Singapore's final Q1 GDP growth exceeded both market expectations (10.1%) as well as the initial flash estimate (9.1%). Compared with Q4-05, when growth printed 8.7% y/y, improvements in Q1-06 were across-the-board, except for construction. A 10.6% GDP growth in Q1-06 is equivalent to a 2.7% increase in the full-year GDP. This obviously makes the original official 2006 growth target of 4-6% look too conservative. In response, the government raised its target to 5-7%, which is in line with our 2006 growth forecast of 6.5%. Our forecast was last revised on April 12.

Drilling into the subcomponents of GDP (Table 1), the manufacturing sector saw the strongest expansion at 20% y/y, thanks to a still robust global IT sector led by strong demand for consumer electronics. However, there are signs that this will moderate slightly moving forward. US new orders for personal computers and components suggest a slowing down from Q2-06 onwards (Chart 1). While the export-manufacturing sector may moderate, it could be mitigated by the domestic economy. The unemployment rate in Q1-06 continues to remain low at 2.6%, similar to Q4-05. Job creation for Q1-06 at 45,000 is higher than the 35,300 registered in Q4-05 (Chart 2). Retail sales for Q1-06 stayed strong, up 8.0% y/y and close to the 8.2% in Q4-05.

Expected results, more-than-expected changes
The ruling PAP won its 12th consecutive election with 82 (out of 84) seats in parliament. The result in itself is not surprising. What is worth mentioning is the fall in the margin of victory. At the last general election in 2001, the PAP won 75% of votes cast compared to 67% won in this election. This drop in margin is unlikely to affect investor sentiment as PAP still forms the majority in government and policy continuity is a trademark. Nevertheless, the government has indicated its intention to engage the population with more open dialogue.

PM Lee also announced the new line up for his cabinet which contains a few key reshuffles. The one of most interest to the market will be Minister Tharman Shanmugaratnam who relinquished his deputy chairman role at the Monetary Authority of Singapore (MAS) and assumed the 2nd Finance Minister portfolio. Tharman is no stranger to the markets, having spent more than 20 years in the MAS, and his appointment should instill confidence and continuity in financial sector development.

Casino brings new growth and values
The only soft spot in the Q1 GDP performance came from the construction sector which contracted 1.3% y/y, more severe than the 0.8% decline recorded in Q4-05. However, this could change in as early as Q3-06, when the first Integrated Resort casino project awarded to Las Vegas Sands in May is expected to start construction. The project may cost USD 3.2bn. But more significantly, it signifies a major step in implementing Singapore's new gaming policy, which could have long-term socio-economic implications, both in terms of the kind of economic activities encouraged and the social values promoted.

Meanwhile, the MAS indicated that the project could boost loan demand, suggesting upward pressure on local interest rates. But the CEO of Las Vegas Sands said the project, slated to be finished in 2009, will likely be funded by external sources, both equity and debt, but not dependent on Singapore. Hence, the project's impact on local interest rates should be minimal.

Recently, the 3m SGD SIBOR has tracked USD rates higher (Chart 3), but lacklustre loan demand kept it at below 3.5%. We believe 3m SIBOR is likely to peak at 3.5% and gradually taper off to 3.375% by YE-06. Meanwhile, inflation in Singapore remains benign. Recent data shows inflation tapering off despite high oil prices (Chart 4). The pass-through effects from high oil prices have been muted and the market consensus is for inflation to average 1.5% for 2006, similar to our forecast of 1.6%. The MAS also said recently that the current policy has helped to contain domestic inflationary pressures and expected inflation to moderate in 2007. We expect the MAS to maintain its policy of modest and gradual appreciation of the SGD at the October policy meeting. We estimate that this policy gives room for the SGD nominal effective exchange rate to appreciate 2% per annum.

Taiwan

by Tai Hui

Two-speed economy

- Strong exports to support a higher 3.8% GDP growth in 2006
- But domestic demand would remain soft
- Ample liquidity to keep CBC vigilant with steady rate hikes

With the strength in the IT product cycle, we have upgraded our GDP growth forecast for Taiwan to 3.8% from 3.3% for 2006, and to 4.1% from 3.5% for 2007. However, soft domestic demand remains a major growth constraint. This two-tier growth pattern is expected to continue for much of this year, especially since the central bank is expected to tighten further. Given the recent hikes in electricity and fuel prices, we believe the Central Bank of China (CBC) would remain vigilant about inflation and raise its rediscount rate further by 12.5bps in each of its quarterly MPC meeting this year to 2.75% by end-06.

The Taiwanese economy expanded by 4.9% y/y in Q1-06. About three-quarters or 3.8 percentage points (ppts) of this growth came from net exports of goods and services (table 1). The remaining 1.1 ppts was derived from domestic demand. Personal consumption rose 2.1% y/y, the weakest since Q3-04, and gross fixed capital formation contracted by 4%. Lacklustre consumer confidence, burdened by household debts and clouded economic outlook, has dampened growth momentum. This is expected to persist for much of this year. Consumer confidence index has dipped below the 70 point mark (chart 1), which was last seen in the post-dotcom/Sept 11 period. Investment growth is also undermined by business migration offshore, mainly to mainland China.

Despite the weakness in domestic demand, we have upgraded Taiwan's economic growth forecast for 2006 to 3.8% on the back of its strong export performance. Exports are expected to grow 10% this year, riding on the expansion phase of the IT cycle and robust demand from mainland China. The semi-conductor book-to-bill ratio for April was at its strongest in two years, reflecting strong demand for chip products. This is closely linked to the solid performance of the US economy. China has been another key supporting factor of Taiwan exports. In Q1-06, Taiwan's total exports grew 11.4% y/y in USD term. Over half, or 53% of this growth came from exports to the mainland and Hong Kong. Given that exports is now the critical growth engine for the island, monetary policy decisions made by the US Federal Reserve and macroeconomic cooling measures from Beijing will be critical to Taiwan's performance in H2-06.

Meanwhile, import growth has been suppressed by soft demand for capital and consumer goods, although higher energy and commodity prices have pushed raw material imports substantially higher. The combination of robust export expansion and slower import growth should lead to a larger current account surplus, which will support liquidity and underpin our revision to the island's economic growth forecast.

On local monetary policy, the CBC is focusing on inflation, especially on the hikes in wholesale fuel prices and electricity tariffs. Current inflationary pressure remains benign despite the surge in energy prices. Headline inflation averaged 1.4% y/y for the first five months of the year, compared with the central bank's target of keeping inflation below 2%. Meanwhile, core inflation, which excludes fresh food and energy, only averaged 0.61% y/y. The direct impact on inflation from the 8% hike in wholesale fuel prices in late April and the 6% electricity tariff hike on July 1 should be limited. Real rediscount rate, CBC's benchmark policy rate minus headline inflation, should remain in positive territory and this should allow the central bank to tighten monetary policy at a gradual pace. We expect 12.5bps hike in each of its quarterly MPC meeting, with the next move to take place on June 29. The rediscount rate is expected to rise from the current level of 2.375% to 2.75% by end-06.

There are two wildcards that could force interest rates higher than our current projection. The first is higher inflation. If energy prices fail to stabilise in H2 and rise further, pressure to raise retail prices for fuel and power will persist. Food prices can also surge temporarily due to seasonal factors, such as typhoons. Both of these could affect inflation expectation and require fine management by the central bank.

The second is the expansion in money supply. M2 has risen by 6.6% y/y on average in the first four months of the year, a full percentage point above the central bank's 5.5% growth target. Steady capital inflows into Taiwan over the past 6-9 months have put upward pressure on money supply growth. The central bank has tried to sterilize these inflows by issuing negotiable certificate of deposit (NCD), but higher interest rates could be called to service if needed.

Despite the recent uncertainty in local politics, we believe that any negative impact on the TWD and financial markets is likely to be limited and short-lived, as reflected by past experience of local and cross-straits political incidents. Rising interest rates, albeit at very gradual pace, a strong export sector and large current account surplus should provide sufficient attraction to foreign investors.

Thailand

by Usara Wilaipich

Political uncertainty remains a drag

- Political uncertainty likely to stay until year-end
- Risk to growth remains on the downside
- Rates peaked, THB to under-perform

We remain THB bullish in the near-term given expected ending of the US Fed's tightening cycle. Recent market volatility that took the THB down by 2.4% should also allow some rooms for the THB to retrace part of its lost ground against the USD. Longer run, however, political uncertainties would cap the strength of the Thai economy and its currency. The THB is therefore expected to under-perform other Asian currencies in the rest of 2006.

Political risks reduced, but uncertainties remain
Since the King's landmark speech on April 25, asking Thailand's top three courts to find legal solutions to the political stalmate, Thailand's political stability has greatly improved. However, uncertainty remains before a new general election is held, probably by the end of 2006. The Constitutional Court ruled on May 8 that the April 2 general election was unlawful and ordered to organise a new election. The Court ruled that the Election Commission (EC) had violated the law by inappropriately organising the April 2 election. Since then, the political scene has been relatively quiet, partly due to the looming of the 60th anniversary of the King's accession to the throne on June 9-13. Yet, political risks are not totally out. Two key events could still pose substantial downside risks.

1. Possible delay of the new election. Despite the setting of a new election date - October 15 - by the Election Commission (EC), the next election may not proceed as smoothly as market anticipates and it may take much longer to conduct. The EC's decision was made by only three of its five commissioners, breaching the regulation that requires at least four EC members' attendance. The breach was technically disputable, as absence of the other two members were due to their resignation. However, Thailand's top courts had demanded the remaining three EC commissioners to resign as they were judged as not politically neutral and the three-member EC had insufficient members to make decision. Thus far, the three EC commissioners have refused to follow the courts' order, creating another stalemate in the election process. Should the current EC commissioners be forced to resign, it would take at least a month to find their replacements and to seek the Senate's approval. The longer this process drags on, the more likely is for the new election to be further postponed.

2. Risk of renewed rallies to oust the EC. In case the current EC insists on staying, the opposition may renege on their promises and refuse to participate in the new election. Worse still, growing public discontent may see renewed rallies to oust the EC, pushing Thailand back to the vicious cycle of political paralysis.

Domestic demand dampened
With the absence of a functioning parliament, major policy initiatives and public projects are likely to be held back. One obvious victim would be the mega infrastructure projects, which are likely to be further delayed. Also, the FY2007 budget will be deferred until the next calendar year. This may not impose imminent fiscal problem as long as the government continues to run a balanced budget. However, uncertainties in public spending and policies are likely to undermine business confidence and spending, especially those related to the public projects. Overall economic activities are therefore likely to cool down further in H2-06. In Q1-06, the Thai economy grew by 6.0% y/y, thanks for robust exports. However, this could well be the strongest quarter in 2006, and we believe full-year growth will be limited to 4.1%, down from 4.5% in 2005.

Interest rates peaked, THB to under-perform
With this background, it is not surprising to see the authorities' policy concern shifting to growth from inflation, as evident from a series of downward revision in official GDP forecasts. At its latest monetary policy meeting, the BoT hinted that it is ready for a pause after having hiked interest rates for 13 times to 5.0%. Going forward, we believe that monetary policy will have to take on a greater role in supporting the economy amid a handicapped fiscal arm. Moreover, earlier strength of the THB should help to contain price pressures in H2-06.

Given expected ending of the US Fed's tightening cycle and the recent correction of THB in line with other emerging market currencies, we believe there are rooms for the THB to regain some of its lost ground in the near term, probably resulting in a mild appreciation against the USD in H2-06. However, comparing with other regional currencies, the THB may still under-perform, as prolonged political uncertainty weighs on foreign investment and domestic spending. Also, given the peaking of Thai interest rates, the THB may appear less attractive as most other Asian central banks continue raising rates in the rest of this year. We expect the THB to close the year at 37.50 vs. the USD, and to trade at 37.30 by Q1-07.

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