Asia Focus: Asia set to slow, as electronic cycle peaks: The global electronic cycle should have already peaked, and Asian economies are set to brace for an export slowdown in 2007. Unlike the previous cycle in 2001, the expected electronic down-cycle should be relatively mild and hit Asia varyingly. Increased ultimate demand from within the region should cushion Asia from a severe downturn. Caution is needed, though signs of distress are missing.

Economy Highlights

China: China's economy continues to grow strongly, but many signs of overheating are questionable, as evident from auto sales, crude oil imports and freight volume. We have raised our 2006-07 GDP growth forecasts to 10.8% and 9.7% respectively, but see no sign of sharp inflation or acute overheating.

Indonesia: As inflation eases, US interest rate peaks, and pressure on BI to boost growth increases, we expect the central bank to cut its BI policy rate more aggressively to 10.25% and the IDR to stay stable at 8,900 by YE-06.

Philippines: Economic fundamentals remain solid and we expect the BSP to stay vigilant and resist rate cuts before Q2-07. The PHP should remain well supported by strong inflows of remittances and investment.

South Korea: North Korea's nuke raised its threat to nuclear proliferation, but presented not much more risk to regional stability. There are good reasons behind the knee-jerk reaction of markets. Arguably, the issue underlines the need for more, not less, economic integration of the region, including Pyongyang.

OVERVIEW

by Nicholas Kwan

Perfect time, perfect storm

- Coup, rallies, and nuke are perfect ingredients for storm
- But they are totally ignored by Asian markets...
- ...with good reasons, but not without concern

The past month is a perfect time for a perfect storm in Asia. In the midst of the IMF's second annual meeting in Asia, troops in Bangkok staged a mid-night coup on September 19, breaking a record 14-year civilian rule. On October 9, Pyongyang launched its first nuclear test, and threatened to do more. On October 10, millions rallied on the streets of Taipei, demanding the president's resignation amid National Day celebration.

Yet, markets seemed to have turned a blind eye to heightened risks. With hardly a blip of correction, markets quickly resumed their upward trajectory and repeatedly scaled new highs. As of to date, the MSCI EM Far East index was less than 8% away from its historical peak, with the Hang Seng at a 6 year high, the Kospi at 7.8% from record, and the Taiex at 4% from its 6-year peak. The THB is trading at just 1.2% below its 7 year high, or up 9.5% ytd. The KRW is up 5.7% ytd and less than 3% away from its post-1997 peak. Are markets over complacent, too exuberant or justifiably resilient?

We believe there are good reasons for markets to remain calm and optimistic, and Asia's solid fundamentals are largely intact. However, recent developments also could signal some important undercurrents, and part of the exuberance might be overdone.

Resilience largely justified
For the optimists, events of the past month could be lauded as another proof of Asian resilience. Despite political turbulences, Asia's hallmarks of good economic housekeeping are largely intact, including strong growth momentum, robust export performance, large forex reserves, favourable external positions, good fiscal discipline and generally stable prices.

Notwithstanding the initial surprises, most of the events are not totally unexpected, hence presenting no major shocks. Thailand's coup had been rumoured for sometime, though few predicted its actual timing and happening. Taiwan's dissent towards president Chen has been brewing for months and repeated rallies have been staged since early September. North Korea's threat of nuke test is also nothing new, and was rather accurately predicted by the West just days before the launch. More positively, all these potentially violent events were passed relatively peacefully, with not a single shoot fired nor a single drop of blood shed. One may even argue that these demonstrated the 'maturity' of the Asian public at large, and politicians or armies in particular.

To some extent, there are also silver linings in the offing. In Thailand, the formation of an interim government could cut short the lengthy budget process and allow the government to jump start an economy badly in need of fiscal stimulus. In Taiwan, the peaceful rallies of millions demonstrated a highly disciplined public and rock solid stability of a bitterly split society. Even in Korea, the nuke has unexpectedly contributed to the accelerated termination of Japan's quasi-cold war with China and South Korea, providing a common ground for these largest powers of Northeast Asia to work together.

On top of these, market sentiment was buoyed by more critical shifts in the global economy, specifically the peaking of US interest rates and the moderation of oil and commodity prices. For two consecutive FOMC meetings since August, the Fed has decided to hold, suspending its two-year hiking track. Although its board members still occasionally sent out hawkish comments, markets are increasingly convinced that the Fed has already done its round, just as what we have predicted. On the other hand, prices of crude oil have fallen by a quarter since mid-July, while gold price is now 20% off-peak. As a result, concerns are fading that high energy and commodity prices would drive the world into the wall.

All these are truly good news, in disguise or not. They largely explained why markets behaved so undeterred over the past month. However, these should not be taken as signs of all clearance. Complacence is always ill-afforded. Caution is needed in three areas:

1. Perception-reality gap. Although the three events were not totally unexpected, the fact that they still presented an element of surprise to the market means there is still a gap between reality and perception. For a while, markets seemed to believe that coup is out of fashion in Thailand, and Pyongyang's nuclear threat could only stay at mouth, not in arms. Reality has proved these perceptions wrong. Will the belief that things can't get much worse in Thailand, Taiwan and Korea from here be proved wrong again? It is not impossible, though unlikely, as elaborated in our analysis of the situation in the Korea peninsula. To avoid more and bigger surprises, it is time to review what other general perception or conventional wisdom could fail the reality check.
   
   
2. Risk appetite. Investor psychology is always hard to gauge and easy to swing. While Asia remains a favourite of international investors, repeated geopolitical tensions and surprises could accumulate anxiety and undermine confidence, providing the ground for a wholesale swing in sentiment once a critical mass of discomfort is built and a trigger is in place. Buoyant liquidity, high growth, strong currencies are what supporting risk appetite for Asia, but socio-political stability could swing the balance, especially given Asia's reputation as a place of living dangerously. With heightened geopolitical tension, investors are in for a period of more demanding, but arguably more rewarding, investment choices.
   
   
3. Cyclical shift. Nothing is eternal and everything has its own cycles. With US interest rates peaking and oil/commodity prices falling, one big remaining uncertainty is the sustainability of the current export up-cycle, on which much of Asia's current growth momentum is based. According to our analysis, Asia is likely to see slower export growth in the next quarter or so, primarily due to a slowdown in global electronic demand. Signs are that the slowdown would be mild and diverse, but individual economies could still face relatively harsh adjustments, especially those without a strong domestic demand to fall back on. Time is tight for these economies to jump start their domestic spending, and/or to strength access to the new growth markets like China and India.
   
   
   

ASIA FOCUS

by Nicholas Kwan, Frances Cheung

Asia set to slow, as electronic cycle peaks

- The global electronics cycle has peaked
- Asia should brace for a cyclical shift in 2007
- Caution is warranted, but no sign of distress

The electronic up-cycle has already peaked, and growth of Asian electronic exports is likely to slow. Nevertheless, unlike the previous cycle in 2001, the expected electronic downturn may come relatively gradual and has divergent impact on different Asian economies. The processing nature of Asian manufacturing activities means that the pass-through to the broader economy of downturn in the US or EU would be partial. More importantly, Asia stands to be better cushioned by increasing ultimate demand from within the region. In any case, 2007 will be a year when most Asian economies see their economic, export and credit cycles shift to lower gears. Caution is warranted, but sign of distress is still missing.

Leading indicator hints at a cyclical turn
Asian electronic exports have seen robust double-digit growth almost uninterruptedly for more than 4 years since mid-2002, when the electronic sector rebounded from the low, following the 2001 bust. However, such an extended boom is likely to reach its cyclical end in coming months, if history is any guidance.

Historically, demand for Asian electronic exports has been highly correlated with the North America semiconductor book-to-bill ratio (Chart 1), with the ratio being a pretty good leading indicator for the overall global electronic cycle. In September 2006, the latest data available, this ratio dropped from a cyclical peak of 1.14 in June 2006 to 1.00, the expansion-contraction watershed level. Previous up-cycles for the semiconductor sector (characterised by rising book-to-bill ratios) spanned over 12-15 months. With the current uptrend having lasted for around 16 months already, it is likely that the book-to-bill ratio's latest drop signals a turning point in the cycle, rather than any seasonal deviation amidst a continued uptrend. Normally, the ratio sheds light on demand for semiconductor products, and to a broader sense for electronic products, with a lead time of about three months. It is therefore reasonable to expect that demand for Asian electronic products can still hold up till end-2006. However, beyond this quarter, growth in Asian electronic exports is likely to decelerate.

World electronic sales amounted to around USD 1trn in 2005, of which semiconductor products accounted for about a quarter. Others include consumer electronics, telecommunication and computing equipments, electronics distribution and contract manufacturing. Different segments within the electronic sector are highly inter-related, and the technology chain begins with semiconductors manufacturing. The semiconductor cycle is a widely used proxy for the electronic cycle given that semiconductors are essential components to all electronic products. While the book-to-bill ratio is commonly seen as a good leading indicator, we try to look at other relevant indicators to gauge or confirm where we are in the electronic boom-bust cycle.

On the supply situation in electronic products, US inventories of computers and electronics have been building up since early 2004 (Chart 2). But the current level is still 30% below the high observed during the peak in 2001. One caveat in reading the inventory level from a historical perspective is the possible structural shift lower in inventory-sales ratio due to technological advancement and better supply chain practices. Nevertheless, with inventory level not particularly high, the supply situation is not acting very much against the sector's prospect.

One may even be further relieved by the demand situation. US new orders for computers and electronics have been increasing in tandem with supply. Indeed, the gap between inventory and sales is narrowing (Chart 2). During the peak in 2001, inventory was enough to cover more than two months of orders, whereas it can cover around 1.5 months now. But it is true that world semiconductor sales growth has decelerated to high single-digit now versus around 20-30% in late 2004/early 2005 (Chart 3). All these imply a cyclical downturn is setting in, albeit a mild one.

Looking at inventory alone may be misleading. The interpretation on inventory accumulation depends on which phase the sector is in, which would need to take into account also the changes in shipments/sales. During the expansionary phase, inventory is drawn down as supply does not catch up with rising demand. In the accumulation phase, manufacturers accumulate inventory to meet the continued rise in demand. Since a full business cycle normally needs to go through the expansion-accumulation phases, before it enters into the consolidation (slowing sales but still rising inventory) and adjustment phases (falling sales and falling inventory), this suggests that the downturn of the electronic cycles may still be some quarters away from a rise in inventory, and there may be different development in different markets. For example, the US electronic sector is now in the inventory accumulation phase (rising shipments and inventories), whereas the Japanese semiconductor sector (Chart 4) seems to be hovering between the accumulation phase and the expansionary phase (rising shipments but falling inventories). The above indicators do not point to a unified outlook. But at least it shows that while the electronic cycle may have already peaked, downturn is not imminent, or will not be as severe as the last cycle.

Asia will be hit, varyingly
Turning to Asia in particular, what will be the impact of an electronic down-cycle on their exports and the broader economies? Around half of Asian exports are related to electronics and machineries. Asian electronic exports are highly correlated with the book-to-bill ratio. If history is any guide, the book-to-bill ratio needs to drop significantly below 1 to drive Asian electronic exports into a severe setback. Given the current indication, this is unlikely.

Moreover, Asia Pacific accounts for increasing shares of global semiconductor sales (Chart 5). In the mid-1990s, US was the largest market, accounting for over 30% of total world electronic sales. Over the past decade, this share declined to 18% in 2005. Meanwhile, the share of Asia Pacific rose from 20.5% in 1995 to 45.4% last year. Increase in world semiconductor sales has been led by sales to Asia Pacific particularly in recent months. More sales heading to Asia Pacific region signals more production integration within the region with established supply chains, thus mitigating any adverse impact from cooling US or European demand.

The impact on individual economies depends on the relative importance of its electronic exports. Over 60% of the total exports from China, South Korea and the Philippines are electronics and machineries related. Hong Kong, Malaysia, Singapore and Taiwan also have around half of their exports in these products. Yet, the situation is more complicated than the headline figures suggest. Many of Asia's manufacturing activities involve assembling and outward processing, and Asia imports large amount of capital goods or parts for its electronic manufacturing. This means imports of these capital goods may decline in tandem with falling demand for end-use electronic products, resulting in a milder net effect on the overall economy. That is also why it is a common practice to monitor Asian imports of capital goods as a gauge of export performance in the months ahead.

During H1-06, an increasing amount of Asia's output growth was driven by domestic demand, notably Hong Kong, South Korea, Japan and India. However, economies where domestic demand remains weak could face tougher sailing in 2007 against a backdrop of expected global electronic down-cycle. Although no sign of distress is apparent across the region, caution is needed in monitoring the credit and sales conditions as the cycle turns.

CHINA

by Stephen Green

Flying high, but not seemingly hot

- China's economy continues to grow strongly
- But many signs of overheating are questionable
- As evident from auto sales, freight, and oil import data

China is growing strongly, but not as overheated as it may seem. We recently raised our GDP growth forecasts to a stellar 10.8% y/y in 2006 and 9.7% in 2007. We believe that as long as inflation remains contained (our CPI forecast for 2006 remains at 1.5%), threats of overheating may be overdone. As far as we are concerned, the August data did not signal the beginning-of-the-end of China's current economic boom, as analysts with more faith than us in the monthly numbers have argued (see OTG on 26th September 2006). To support our view, we look at autos, crude oil and freight.

Auto: over-capacity seems exaggerated
Auto production is one sector to which the over-capacity crowd point frequently. It is easy to get scared: add all the manufacturers' announced plans for their capacity and one reaches silly numbers - 11m units by 2010 is one estimate. Inundated with cars that no one will buy, mass bankruptcies follow, and everyone loses their shirts.

There are four reasons to question this scenario. First, a lot of the official capacity in this sector is old, including all-but-insolvent state-backed manufacturers who are making old models that do not sell. They will soon be closed down. Second, predicted capacity is not realistic. Investors, both domestic and foreign, have long caught on to the trick of making big announcements for their future investments, winning press attention and plaudits from local officials, only to roll them out slowly, if ever. Third, the sales numbers do not support the over-capacity view. Unit sales growth has slowed since the beginning of 2006, but remains above 10% y/y (Chart 1). Total production is now some 600,000 units a month (the average of the last six months), with sales more or less keeping pace. The recent build up in inventory, nowhere nearly as big as that in 2004-05, looks like it is being sold. Concerns that petrol prices would rise in H2-06, dragging on sales, now look unfounded with crude oil falling to around USD60/barrel. Margins in the auto sector remain steady.

Fourth, China is an increasingly large exporter of auto parts (Chart 2). Firms like Cherry and Geely are slowly moving up the production chain, manufacturing simple parts and cheap cars which will soon (15 years?) be able to compete overseas like Hyundai and Toyota did before. Brilliance recently announced plans to export 3,000 sedans to Europe - and looking at establishing production in South Africa to gain experience and market entry. Also, Beijing is not averse to protecting its own firms - in September it delayed a WTO investigation into US-EU allegations that it used a 60% import tariff to force foreign firms in China to source car parts locally.

Crude oil: imports not just for consumption
Net crude oil import volume rose 34% y/y in Aug 2006, and has been running higher this year than last (Chart 3). This normally means faster growth, but not necessarily the case here. First, oil only accounts for one-fifth of total energy use, and imports only account for 40% of total oil use. Second, imports are very volatile, neither following global price movements nor internal demand, but rather changes in domestic retail prices. The recent pick-up can largely be explained by the hike in product (petrol, diesel) retail prices in Apr-May, which encouraged refiners to start importing crude again (since they could sell it at higher prices on the street). With global crude prices hovering around USD60/barrel, China now has its retail prices more or less in line with those of other countries. This means refiners should be happy to import, which will underpin continued high import demand in H2-06.

The third reason why oil imports are not a good proxy for growth is the filling of the Strategic Petroleum Reserve (SPR), whose first base at Zhenhai has just been completed. Officially, China has just 21-day crude import cover (thanks to PetroChina's and Sinopec's holdings), compared to the 118-day of the US. The government confirmed on Oct 17 that SPR filling had already started. But overall, it is worth noting that Zhenhai has just 33m barrels of capacity, equivalent to about four days' use, not enough to really move the markets - barring of course the psychological impact.

Freight: high growth continues but steady
If crude oil import numbers are not a good proxy for economic activity, then perhaps freight is. We have previously highlighted our freight index - a combination of land, rail and air freight - which indicates continuing strong economic growth. This proxy has one big weakness - it relies on large enterprises directly reporting their freight to the government, and so misses out on many small firms' activities. However, Chart 5 shows ship container traffic growth - data which comes from the ports - and they are holding steady at high rates. Of particular interest is the acceleration in container traffic inland, perhaps suggesting that even as China's external trade sector calms, domestic trade is booming ever-stronger. China slowing? Not likely. Neither overheating.

INDONESIA

by Fauzi Icshan

Very confident BI

- BI will continue to cut its BI rate aggressively well into H1-07
- We have lowered our BI rate target to 10.25% from 10.75% by YE-06
- We also revised our USD/IDR forecast to 8,900 from 8,600 by YE-06

As inflation eases, US interest rate peaks, and pressure on Bank Indonesia to boost growth rises, we believe BI will cut its policy rate more aggressively to 10.25% by YE-06, down from our previous forecast of 10.75%. Consequently, we also revised our YE-06 USD/IDR forecast to 8,900 from 8,600.

Reasons to be aggressive
For the third consecutive month, BI has cut its policy BI rate by 50bps, down to 10.75% in Oct-06. Governor Burhanuddin even said that the BI rate could be cut to 10.0% by YE-06 and to 8.5% by YE-07. While this appears a bit too aggressive, we see three factors behind BI's bold moves.

First, Inflation is likely to fall further as the one-time inflationary impact of the 126% hike in domestic fuel prices in Oct-05 dissipates. Inflation has fallen from 17.1% y/y at YE-05 to 14.6% in Sep-06. We expect it to drop to 7.5% by YE-06, given the government's signal that it will not hike fuel prices or electricity tariffs in Q4-06 as international oil prices moderate. Second, BI is under pressure to help the government achieve its ambitious 5.8% GDP growth target for 2006. Although GDP growth has accelerated from 4.7% y/y in Q1-06 to 5.2% in Q2, it is still running below the government's target. With fiscal disbursal in H1-06 less than 32% of the annual budget, fiscal stimulus is unlikely to do the job.

Third, BI arguably had raised its policy rate more than necessary to restore investor confidence after the IDR "mini-crisis" in Aug-05 and to control inflation after the fuel price hike in Q4-05. As inflation falls, the IDR stabilised and US interest rate likely to have peaked, it is time to correct the excess. Our previous forecasts of BI rate cuts have been cautious mainly due to uncertainties over US interest rates and oil prices. As these two factors turn more positive, we now believe more aggressive cuts are likely. Consequently, rapidly narrowing USD-IDR interest rate differential also prompted us to change our YE-06 USD/IDR forecast to 8,900 from 8,600.

Signs of improvement
Despite sharp BI rate cuts, improving external payments have kept the IDR stable. Thanks to slower import growth and high export prices of commodities, trade surplus rose to USD 18.1bn in H1-06 from USD 12.3bn a year ago, raising the current account surplus to USD 4.5bn in H1-06 from USD 0.8bn in H1-05. This boosted Indonesia's FX reserves from USD 34.7bn at YE-05 to USD 42.3bn in Sep-06, and encouraged BI to fully prepay its USD 7.5bn debt owed to the IMF during the Asian financial crisis. Prepayment was made in two trenches, USD 3.7bn in June and the rest in Oct, four years before due.

As external payment improves, fiscal deficit is also under better control and sovereign ratings being upgraded. But these have yet to arrest growing poverty and unemployment. The government estimated the fuel price hike had raised Indonesia's poor (living on less than IDR 5,000 or USD 0.55 a day) to 17.8% of the population (39.1mn people) by Mar-06 from 16.0% (35.2mn) in Feb-05, reversing the downtrend from 23.4% in 1999. The government claimed that, without its cash-benefit program that gives IDR 100,000 (USD 10.9) a month to each of the 19.2mn registered poor households, the poor population would have risen to over 50mn. Critics, however, said the official figures were still an underestimation as over 48mn people (22% of population) were registered to receive free rice and excluded from the poverty count. Meanwhile unemployment rate rose to 11.2% from 10.8% at YE-05. Rising poverty and unemployment have raised pressures on the government (and BI) to boost the economy.

Ambitious 2007 budget
To address the growing pressure to stimulate growth and reduce poverty, President Yudhoyono had unveiled an ambitious budget for 2007, with the following key targets and assumptions:

(1) GDP growth rate of 6.3% (vs. 5.9% target in 2006);
(2) USD/IDR exchange rate to average 9,300 (9,900);
(3) Inflation rate to average 6.5% (8.0%);
(4) 3-month SBI rate to average 8.5% (9.5%); and
(5) Oil price to average USD 65pbl (USD 57pbl).

Hoping to increase fiscal stimulus, the government has increased its 2007 budget deficit to IDR 33.1trn (0.9% of GDP) from IDR 22.4trn (0.7%) budgeted in 2006 and an actual deficit of IDR 14trn (0.5%) in 2005. In general, the government's 2007 budget assumptions do not deviate much from our own forecasts. The only major exception is GDP growth, which we believe is likely to struggle to exceed 6% in 2007.

Since the budget is unlikely to be implemented without changes by the parliament, we believe the issue is not the budget itself, but its implementation. The government is being criticised for under-spending and its weak fiscal performance, which is seen as a major factor contributing to the weak GDP growth in H1-06. If past fiscal performance in 2005 and H1-06 is an indicator of future achievements, we worry that fiscal stimulus will remain weak and the government's ambitious 2007 GDP growth target will likely be missed.

PHILIPPINES

by Frances Cheung

Flying on twin engines

- Economic fundamentals remain solid
- BSP to stay vigilant, no rate cut before Q2-07
- PHP to be supported by strong inflows

Economic fundamentals of the Philippines remain solid, with domestic consumption supported by strong overseas worker remittances and exports holding up well. Looking ahead, an increasing number of overseas workers should support remittance inflows, while exports are likely to stay strong, albeit less buoyant. This would strengthen the external position, support growth and allow further fiscal consolidation. As growth momentum continues but inflation decelerates, the BSP may keep its overnight borrowing rate at 7.5% through Q1-07. Strong external position should also push the PHP higher to 48.50 by Q1-07.

The Philippine economy expanded by a strong 5.5% y/y in Q2-06, supported by both domestic and external demand. Personal consumption rose by a real 5.2% y/y, while exports of goods and services surged by 22.2% y/y, accelerating from the 5.1% and 12.5% growth in Q1-06 respectively. Investment continued to be a drag on overall growth, sustaining its two year decline with a 5.4% drop in Q2-06. The services sector continued to be the biggest contributor to growth, the agricultural sector also performed well on favourable weather and improved technology.

Looking ahead, we expect economic growth in H2-06 to edge down slightly, but remains firm, with the economy expected to expand by 5.1% for full year 2006. On the domestic front, consumption should remain buoyed by strong remittances from overseas foreign workers (OFW), which amount to around 10% of GDP. An increasing number of OFW deployed to the Middle East and Asia points to more remittances in coming months. Externally, merchandise exports have been surprising on the upside of late, surging by 21.3% y/y in Aug. Export growth may slow in coming months, but should still be a decent 10% plus. GDP growth in 2007 may ease further to 4.5% as the upturn in global electronic demand moves closer to a cyclical end. Electronics account for over 60% of Philippine exports.

BSP to stay vigilant
Inflation eased further to 5.7% y/y in September. This of course would give the BSP more flexibility in managing its monetary policy. Recently, the central bank commented that "rate cut will be a major consideration in the next meeting in November", fuelling market speculation of an early rate cut. We however maintain our view that the first rate cut will have to wait till Q2-07. First, while trending downwards, inflation still averaged 6.8% y/y in Jan-Sep and is still well above the central bank's target of 4-5%. In its latest monetary statement, the BSP acknowledged "the inflation outlook remains at risk from energy-related cost-side pressures" and "potential second-round pressures linked to wage-setting behaviour". We believe the central bank will remain vigilant. Second, current strong growth momentum means there is little need to use monetary policy to stimulate growth. Total bank lending is rising by above 3% y/y, and broad money supply by some 12-13% y/y, pointing to enough liquidity in the market.

Fiscal consolidation continues
September saw a fiscal deficit of PHP 16.2bn, following the fourth monthly surplus this year recorded in August. So far, while revenue growth was the key reason behind ongoing fiscal improvement this year, tame expenditure growth also played a part. Spending has only increased by 8.4% y/y in Jan-Sep 2006 vs. the full-year target of 16.6%, mainly due to the failure of the Senate to pass this year's budget. More infrastructure spending could lead to more deficits in the near future - but this should not be a major concern. Overall, we expect the FY2006 deficit to come in at PHP 113bn, smaller than the government's target of PHP 125bn, as expenditure is likely to miss the original target even with the supplementary budget.

The government remains determined to achieve a balanced budget by 2008. While we do expect further fiscal consolidation, a balanced budget in 2008 would be difficult. Without the one-off effect of EVAT, revenue growth beyond 2006 will depend on organic growth and more effective tax collection, which means revenue growth will slow. However, global slowdown by then may require a more expansionist fiscal policy, especially given President Arroyo's investment programme which could speed up public spending. We expect fiscal deficits to be at 1.4% and 1.0% of GDP for 2007 and 2008 respectively. Indeed, our forecasts of continued narrowing of the fiscal deficit in the next two years assume slower spending growth. The risk is our budget forecasts may still be too optimistic. In our view, the government's focus should be on enhancing the investment environment and boosting domestic demand, rather than simply balancing the budget.

Peso supported by inflows
We remain positive on the PHP given the economy's strong external position. Following the deficits in Apr and May, external payment returned to surpluses since Jun, supported by continued inflows of OFW remittances and FDI. We forecast the PHP to strengthen against the USD to 49.00 by YE-06 and further to 48.50 by Q1-07. While the government has expressed concern about a strong peso's adverse impact on exports, it remains a useful tool in containing inflation.

SOUTH KOREA

by Chongwoo Chun, Nicholas Kwan

Resilient, not complacent

- North Korea's nuke raised its threat, but not much more risk
- Market's knee-jerk reaction reflects resilience, not complacence
- More, not less, economic integration is needed

Finally, North Korea's nuclear threat becomes a close reality after its self-proclaimed nuclear test on October 9. Suddenly, the world, especially Northeast Asia, looks much more vulnerable. However, financial markets seem to read things differently. After a short knee-jerk reaction, which saw a 0.5-2.5% drop in the KRW, JPY and Asian stocks, markets quickly resumed normality and some even continued to scale new highs. The yield of 3 year Korean Treasury edged up by 5 bps during the week (Chart 1). We believe this reflects calculated resilience rather than misguided complacence.

While North Korea's nuke might have added to the region's perceived risk, it has not seriously destabilised the broader geopolitical balance. Economically, it also bears little imminent significance. In fact, it could be a benefit in disguise if it drives South Korea closer with its neighbours, both politically and economically.

A bigger threat, not necessarily a higher risk
For South Korea, a nuclear-armed North would present a bigger military threat, but it may not add much to its risk. For decades, Seoul has been living dangerously anyway. Even without the nuke, North Korea has enough missiles (guided or misguided) and conventional warheads to damage, paralyse or even flatten South Korea's economic heartland, if it chooses to. But the price to pay for doing so would most likely be the North's very own survival. Over the years, what has held back the North from attacking the South is not so much of whether it has the nuke to do the job, but the absence of military strength to win and the economic power to stay on course.

For the North, the only reason to start a war without any chance of winning - short of sheer miscalculation - is when a war becomes the last resort to survival, typically when the regime is under attack and near extinct. The nuke is therefore not a weapon to attack, but a tool to defend (by offence), blackmail or bargain. This partly explains markets' quick rebound once the risk of serious military reprisal or severe economic sanctions aimed at a regime collapse in the North appears to be removed. While the North may gain some bargaining power and sound more defiant, it is also unlikely to raise its stake much higher from here, as the value of any weapon of intimidation will decline with the frequency of its application. The more Pyongyang escalates the tension, the less card it will be left to play.

Could be a benefit in disguise
In a broader context, there are still concerns that the North's nuke will accelerate nuclear proliferation and trigger arms race in Asia, especially the Northeast. Ironically, thus far the nuke has achieved just the opposite, by encouraging China, South Korea and Japan to patch up and work closer with each other. While the nuke test might be partly aimed at disrupting Japanese Prime Minister Abe's visit to Beijing and Seoul, it failed to derail the effort to end Japan's quasi-cold war with its two neighbours over the past five years. Along with heightened risk in North Korea, one may argue that the broader geopolitical stability of Northeast Asia has actually improved.

Historically, events in North Korea barely have much economic impact on the South (Chart 2). Economically, aside from an outbreak of war, the biggest threat to the South is a sudden regime collapse in Pyongyang that forces Seoul to opt for an immediate reunification. Given the experience of German reunification which ended with a sharp recession, any make-shift reunification of the two Koreas could generate huge financial stress on the South. This is especially so since the economic gap between the two Koreas are much larger than the two Germanys (table 1).

Barring the above drastic scenarios, economic sanctions on the North should only have limited and indirect damage on the South. Given that the North only accounts for 0.2% of South Korea's total trade, any disruption to North-South economic exchanges would have only insignificant impact. Other negative economic impacts of the nuke test could come from weaker confidence or lower credit ratings of the South, but initial indications are that neither one is dampened in any obvious magnitude.

Longer term, like politics, one may even argue that the incident could offer some economic benefits to South Korea if it prompts accelerated rather than reduced economic integration of the region, including the North. One reason why Pyongyang acts erratically is its lack of economic incentive to make peace, given its minimal external economic ties. In contrast, South Korea's heavy investment and trade with China have boosted their common ground (Chart 3). Over the years, North Korea's trade dependence on China and South Korea has grown substantially (Chart 4). Its two special zones, Kaesong for manufacturing and Kumgang for tourism, have also provided new links with the world economy. While these are still too small to make an impact, the nuke test shows that they need to be boosted rather than blocked.