Asia Focus: To peg or not to peg: HKD and CNY: For decades, HKD has served as the convertibility intermediary of the CNY. This role of HKD is diminishing as the CNY becomes more convertible. But this is not the end of the HKD itself, nor it implies a straight forward HKD-CNY peg. Any market speculation on USD/HKD deviating from the 7.75-7.85 convertibility undertaking zone offers good arbitrage opportunities.

Economy Highlights

China: Despite a slowing US economy and austerity measures, China's economy will continue to defy gravity in 2007. Inflation may rise, as might interest rates, the renminbi and China's external surplus, but all in steady and modest magnitudes.

Singapore: Robust domestic demand supported by a virtuous cycle of income-consumption growth should allow Singapore to decouple modestly from an expected export downturn in 2007 and keep GDP growth at a respectable 5.5%. While inflation should remain benign, expected increases in the GST may force the MAS to maintain its SGD appreciation bias.

Taiwan: The two-tier growth pattern continues. While the stronger than expected Q3 GDP growth has prompted us to raise our 2006 full year forecast higher to 4.5%, the CBC will need to consider its monetary policy in the light of weak domestic demand and the downside risk to exports in 2007.

Thailand: At a nine-year high, the THB is increasingly at risk to a correction, especially if exports fall and current account returns to deficit as we have expected. Politics, BoT intervention and lower interest rates could also curb the strength of THB, probably in Q2-07 onwards.

OVERVIEW

Tai Hui
+852 2821 1039, Hui.Cheung-Tai@hk.standardchartered.com

Escape from the curse of '7'

- Growth in Asia will moderate in 2007
- It needs more vigilance and less complacency
- But unlikely to see major crisis like 1987 and 1997

Some doomsayers predict 2007 could be a year of financial turmoil, as suggested by the "curse of 7", which is evident from the 1987 stock market crash and the 1997 Asia Financial Crisis. We agree that growth in Asia will moderate in 2007, and it will be a year that needs more vigilance and less complacency, but we do not see the justification for crisis.

For Asia, 2006 is an exceptionally good year. Solid domestic fundamentals and favourable external environment helped Asia navigate through series of challenges, including the threat of Avian flu, record high oil and commodity prices, repeated interest rate hikes, and sporadic political disturbances ranging from a coup in Thailand, emergency rule in the Philippines, to mass rallies in Taiwan and a nuclear test in North Korea. Riding on strong cyclical growth momentum, investors shrugged off repeated challenges and drove many of the region's equity markets to historical or cyclical highs. The MSCI Asia ex-Japan index is up 27% ytd, with most Asian markets making double-digit gains in USD terms.

Few expect Asia will repeat its above-trend performance in 2007. In fact, after three consecutive years of good growth, what determines Asia's well-being going forward is not just its ability to look for new growth sources, but also its capability to manage risks, which normally grow with complacency bred during good times. For Asia, one of the biggest risks in sight would be an abrupt slowdown in the US economy, which, while not our predicted scenario, should never be imprudently discounted.

Who is more vulnerable?
Although China has become an important trade partner for many Asian economies, the US continues to be the top driver for Asian exports. Directly and indirectly, exports to the US still amount to as much as one-third of the GDP of Hong Kong and 10-20% the GDP of several other Asian economies, as indicated in Chart 1. This means that any significant slowdown in US demand for Asian products, either triggered by a sharp US economic slowdown or abrupt weakening of the USD, could still create havoc over many Asian economies. Hong Kong, Malaysia, Singapore and Taiwan would be the most exposed. Note that Malaysia, Singapore and Taiwan are also dependent on the tech cycle, which has already peaked, in our view. At the other end of the spectrum, we expect India, Indonesia and South Korea to be more resilient.

Another characteristic of the Asian economic upswing in the past three years is that economic expansion was relatively well balanced, driven by both external and domestic demand, with the latter contributing an increasingly important share of output growth over the past year. The vertical axis of Chart 1 shows that such domestic demand was responsible for at least 55% of headline GDP growth for East Asian economies in the first three quarters of 2006, with the exception of Taiwan. This came during a period when the cost of borrowing was rising across Asia, even though real interest rates remain relatively favourable. Strong domestic demand should at least partly offset any export deterioration.

Combining the two factors, countries that are closest to the bottom right corner of Chart 1 should be the most vulnerable to a downturn in the US. Here, Taiwan tops the list, given its large exposure to the US and weak momentum in domestic demand growth. Hong Kong, Malaysia, Singapore and Thailand are of medium risk given that their large exposure to the US could be partly offset by significant domestic growth momentum. By a similar yardstick, China, India, Indonesia, the Philippines and South Korea are the least at risk.

Many Asian central banks are already monitoring such downside risks closely and incorporating such possibilities in their monetary and exchange rate policy considerations, as reflected in recent comments of many senior central bank officials. The exceptions are the region's big three economies, namely China, India and Japan, who continue to maintain their tightening bias to pre-empt inflation risk and overheating of the domestic economy. However, even for these Asian hawks, it is arguable that they are also busy preparing for the unlikely event of a sharply worse scenario of the US economy. The BoJ's call for higher rates can be seen as preparing the ground for future cuts in any downturn, while the RBI's recent asymmetric treatment of its repo and reverse repo rates seems to be prompted by concerns about a soft external environment.

ASIA FOCUS

Nicholas Kwan
+852 2821 1013, Nicholas.Kwan@hk.standardchartered.com

To peg or not to peg: HKD and CNY

- For decades, HKD has served as the convertibility intermediary of CNY
- This role of HKD is diminishing as the CNY becomes more convertible
- But this is not the end of HKD itself, nor does it imply a straight forward HKD-CNY peg

November 27, 2006 marks the date when the Chinese yuan (CNY), or renminbi, officially traded within the Convertibility Undertaking (CU) zone of the Hong Kong Dollar (HKD). This is a well-anticipated development. Yet, when the moment of truth descends, it remains an eventful issue that preoccupied news headlines. Incidentally, the event coincided with a periodic correction of regional equity markets, which saw the Hang Seng Index suffering a post-911 record decline of almost 3% on November 28. Anticipated or incidental, the event nevertheless renews some frequently asked questions about the future of the HKD. How long will the HKD-CNY parity last? Will it lead to a marriage between the two currencies? Or will this mark the beginning of the end of the HKD?

We believe the HKD-CNY parity will not last long, perhaps no more than six months. The two currencies, notwithstanding their growing ties, will remain separated for years to come, if not decades. The current HKD-USD peg, for all practical purposes, will remain untouched for the foreseeable future. This means that any market speculation on USD/HKD deviating from the 7.75-7.85 CU zone would offer a good arbitrage opportunity.

On parity, not unprecedented
Despite its fanfare, now is not the first time that the CNY traded on a par with the HKD. Going back in 1993, the CNY had briefly traded 1:1 with the HKD in the grey market when the Chinese currency suffered a free fall from 5.8 to nearly 10.0 per USD amid serious economic imbalances on the Mainland. In fact, over the past 26 years since China started its economic reform, the CNY had traded above parity to the HKD for half of the time. For those concerned that the HKD may trade below par to the CNY and take it as a sign of HKD weakness or even termination, they should be reminded that back in 1980, the CNY was officially traded at 1.50 per USD, or 0.31 per HKD. It is interesting how quickly history can be forgotten, and more interestingly, how much misunderstanding there is in the relationship between the two currencies.

Four stages of CNY and the changing roles of HKD
No doubt, the two currencies have a perplexing relationship. In the first three decades of the CNY's existence, China's door was almost completely closed to international markets and the CNY was basically non-convertible. Exchange value of the CNY, officially quoted at a steady appreciation path from 2.4 per USD in the mid 1950s to 1.5 in 1980, hardly bore much meaning during this period. Foreign trade accounted for less than 10% of China's GDP and was mostly conducted with the Soviet bloc under barter or other non-monetary trade arrangements. Non-trade external transactions like investment and bank borrowings were basically non-existent. Hong Kong was the primary gateway for trade with the West, but it hardly accounted for 10% of China's foreign trade. The two currencies barely had much interaction.

Changes started in 1980 when China embarked on its historic open-door policy. Its foreign trade ballooned exponentially, up 20 times in 13 years. China's large appetite for foreign products at its early stage of reform and industrialisation means that its trade account was constantly in deficit (except for a few recession years). Given China's underdeveloped export infrastructure, currency depreciation became the primary instrument to promote exports and restrain the trade deficit, and Hong Kong became the prime venue for foreign trade. As a result, Hong Kong's share in China's exports exploded from 10% to 70% (Chart 2), while the CNY steadily depreciated against the HKD, which acted as China's key currency for trade denomination and settlement.

By the early 1990s, the improved export infrastructure has much diluted the significance of price competition in China's export formula. Instead, China's huge appetite for capital investment gradually took precedence in its foreign dealings, as evident from its rising investment ratio. A stable CNY that can preserve the capital value of foreign investment and provide the certainty of future earnings is arguably more important than a constantly depreciating currency, especially when huge price advantage has already been gained from a decade-long depreciation. As such, the switch of CNY to a quasi-fix regime in 1994 was by no means an accident, although it appeared to be introduced abruptly under the 1993 payment crisis. Such a regime change of the CNY accorded HKD a new role as the prime intermediary to capital flows into China, which was just in time to replace its traditional trade medium function - a role that faded with the current-account convertibility of the CNY in 1996 and was evident from Hong Kong's falling share in China's exports. Under the new CNY regime, China's investment ratio increased, along with the inflow of foreign capital and Hong Kong's contribution to such inflows (Charts 2, 3).

July 2005 marked the latest CNY regime change. Again, there is no accident that the CNY shifted from fix to float. As the Chinese economy turns more open and developed, a move towards full convertibility to embrace full integration with the global economy is just a matter of time. More importantly, when China becomes an economy increasingly short in resources but rich in capital, it makes more sense to allow the CNY to strengthen so as to facilitate its quest for resources abroad. However, such a CNY regime change renewed questions about the role of the HKD, which could be seen as losing its traditional value as China's external account intermediary, or even the value of its very existence.

A marriage of convenience, not conviction
It is not surprising that the convergence of CNY and HKD has fueled speculation of a marriage between HKD and CNY. But we see this more a marriage of convenience than conviction. In fact, given the current appreciation path of the CNY, we believe that in perhaps no more than six months, the CNY will divorce the HKD and move out of the latter's 7.75-7.85 CU zone.

For the current CNY-HKD marriage to last, it would mean a de facto CNY-HKD peg, which would be difficult, if not impossible, without a fully convertible CNY. Pegging a fully convertible HKD to a partially convertible CNY will undermine HKD's credibility and offer no benefit to the CNY and China. Optimists may argue that full convertibility of the CNY should not be far away, given China's large foreign reserves and gradual capital account liberalisation. Yet, we should not underestimate the challenges ahead, especially in three areas:

First, there has to be an active CNY foreign exchange market. Significant progress has been made, such as the market making system. But more are needed in the development of spot, forward, futures and swaps markets for investors to invest and hedge their risks if the CNY is to be more widely traded and freely floated. Although China's trade volume is bigger than Japan's, daily forex transactions of CNY are less than 1% of that of the JPY (Chart 4).

Second, financial institutions in the Mainland need to be better prepared to enter the international financial world, by becoming more competitive, better capitalised and supervised. Progress of financial sector reform is promising, but it is more the beginning than the end.

Third, China's monetary regime needs to be more developed, especially if a HKD-CNY peg implies Hong Kong will tie its monetary policy to China's. Strong institutions need to be supported by effective monetary tools and prudent monetary management, which would take years, if not decades, to establish.

Even when the CNY becomes fully convertible, we still need the CNY to have gained sufficient credibility and depth in the international financial markets to facilitate it becoming a reliable partner or a viable alternative to the HKD. Notwithstanding Hong Kong's small geographical size, the HKD is now the world's ninth (or Asia's second) most widely traded currency. HKD-denominated stocks constitute the world's 11th largest pool of internationally traded equity securities. The city is also the world's seventh's largest recipient of foreign direct investment and the ninth largest derivative market. Without deep and liquid CNY money and capital markets, a formal peg or merger with the HKD could make the Chinese financial system vulnerable to substantial 'external' shocks originated from or transmitted through the highly open Hong Kong financial system.

Feasibility vs desirability
Once the CNY is fully convertible and China's financial and monetary systems become mature and credible enough, it would be economically feasible to formally link the HKD with the CNY. But technically it would still require some adjustments like expanding the CNY's role in Hong Kong's payment/settlement systems and reserve holdings. Moreover, feasibility does not imply desirability, especially if much of Hong Kong's economic and financial transactions with the outside world are still denominated and settled in USD.

For a full replacement of the HKD by CNY, some convergence criteria would need to be met. China and Hong Kong need to be rather homogeneous in terms of their stages of economic development, business cycles and costs of living. With China growing rapidly and Hong Kong remaining on a stable path, it would be a matter of time when the two places converge in economic development. Of course, the decision to maintain or change the "one country-two currencies" system would involve more than economic considerations. The current Basic Law stipulates that the HKD has to remain at least until 2047. Also, no matter how integrated the two economies, as long as Hong Kong remains more internationally connected than most other parts of China, a separate HKD may still serve as a monetary cushion between the Mainland and the international financial system.

CHINA

Stephen Green
+8621 5887 5223, Stephen.Green@cn.standardchartered.com

Back to the future

- USD/CNY to rise steadily to 7.56 by YE-07 with rising surpluses
- Growth to stay strong at 9.7% in 2007 under stimulative policies
- Inflation may rise to 3%, forcing one more 27bps rate hike in H1-07

Despite a slowing US economy and austerity measures, Mainland China's economy will continue to defy gravity in 2007. Inflation may rise, as might interest rates, the renminbi and China's external surplus, but all in steady and modest magnitudes. To elaborate our benign outlook for 2007, we thought we would start from how we did last year predicting the future. As indicated in Table 1, out of the five key indicators we forecast on Sep 30, 2005, we got three right, and improved the others via mid-2006 revisions. We hope that understanding where we went wrong last year should help us improve our forecasting ability this year.

CNY to rise by 3-4%, interest rates up by 27bps
In 2006, we stood firm in the belief that the CNY was set for a 3% appreciation against the dollar for the year, initially forecasting USD/CNY7.85 by YE-06 in Sep-05, and then adjusting to 7.80 in Mar-06. This was an important forecast since CNY policy was a big factor in Asian currency trends in 2006, a key for China's domestic economy, and also of course politically sensitive. We resisted the temptation to think that the reform on July 21, 2005 signaled a series of big downward moves, and the temptation in Q1-06 to get much more aggressive. At the time, with all the talk of macro-economic adjustment, a number of analysts were calling for 7.30-7.50 by YE-06. Instead, we talked about the CNY being the 'last tool in the box' for cooling the economy. In 2007, we think the de facto 3% consensus in Beijing will hold, taking us to 7.56 by YE-07. The risk is on the strong side though, as export dynamism strengthens the PBoC's pro-appreciation case, but we believe the ceiling is 4%, 7.49. The game-changer is inflation - if it rises a lot, faster appreciation would get more support.

Inflationary pressures are on the up. We forecast 1.5% y/y growth in consumer prices (CPI) for 2006, and look to be spot on. We were below most market and official forecasts (2-3%) because we thought manufacturing would keep pace with demand, the good harvest plus the massive grain price rises in 2005 would mean food prices would remain capped, and that oil product prices would not be raised that much (We were probably a bit too skeptical on the later, as product prices were raised 12-15% in H1-06). With food prices now rising, we recently raised our forecast for 2007 CPI to 3.0%, and 2.5% in 2008. CPI is widely viewed as under-stated, and could still be the game-changer on rates and FX. We called the Aug-06 bank rate hike right. And we are now looking for a single 27bps hike in deposit and lending rates in H1-07. We think that food inflation will give the PBoC more lee-way to get another rise, particularly if investment surges, as we expect in Q1.

9.7% GDP growth, USD 1.4trn FX reserves
There were two important numbers we revised during mid-2006. One was GDP growth. Along with the market we seriously underestimated growth, forecasting 8.5% in Q3-05, compared to 10.2-10.8% (likely reality). Back then, consensus was that the economy was slowing because of squeezed margins, lower profitability, slowing export markets et al. During H1-06, however, we argued that administrative measures were only tackling real estate, not the wider economy, that monetary and exchange rate policies remained stimulative, that the slowdown was actually very slow. In Sep-06, we questioned the official data and raised our forecasts. We think growth in 2007 will be 9.7%, the slowdown being driven by a slowing US, rather than domestic activity. A resurgent Euro-zone means continued export growth.

We were right on the button with the FX reserves forecast. Our USD 1,100bn forecast created a bit of a stir onshore (we were reported to be the first to stick our heads above USD 1trn). Reserves hit USD 1,009bn in Oct-06, and we now expect USD 1,410bn by YE-07. Our understanding of how we would get there though was mistaken. On the current account, we forecast a surplus of only USD 70bn in 2006. The USD 281bn expected increase in FX reserves was, we thought, mostly through foreign direct investment (USD 80bn in 2005) and other capital inflows. This was wrong. It was only in June 2006 that we revised the C/A forecast up to USD 217bn, and the capital/financial account surplus to USD 58bn. This was well above official estimates at the time of USD 100-130bn.

What we did not understand well in 2005 was the effect of processing trade, which will account for 48% of China's USD 1,761bn trade this year (a massive 68% of GDP), and how it is driving the surplus up. The only way one stops bigger surpluses is by getting rid of processing, but manufacturing FDI is still entering (albeit at slower rates, about USD 5-6bn a month). The authorities need to move more quickly to remove export incentives, such as the still substantial VAT rebates. Recent data suggests we still under-estimated the C/A number. We now think the goods surplus should be USD 182bn (and the total surplus USD 208bn on a BoP basis), which should mean a C/A surplus of around USD 230bn, 8.8% of GDP, in 2006. We do not expect any relief until 2008, when the effects of CNY appreciation and rising costs will force more manufacturers offshore. Until then expect bigger C/A surpluses, 9.6% in 2007.

SINGAPORE

Joseph Tan
+65 6530 3464, Joseph.Tan@sg.standardchartered.com

A two-speed economy

- Robust domestic demand to decouple from export slowdown
- GDP growth may ease to a more sustainable 5.5% in 2007
- MAS to keep SGD on the strong side, subject to GST hike

Robust domestic demand supported by a virtuous cycle of income-consumption growth should allow Singapore to decouple modestly from an expected export downturn in 2007. This should see GDP growth maintained at a respectable 5.5%, down from an estimated 7.9% in 2006 but arguably at a more sustainable and balanced pace. While inflation should remain benign, expected increases in the Goods and Services Tax (GST) rate may force the Monetary Authority of Singapore (MAS) to maintain its SGD appreciation bias to safeguard potential inflationary pressures. Local interest rates, however, should stay in a tight range of 3-3.375% given resilient loan demand and falling external rates.

Singapore's Q3 GDP was revised marginally higher to 7.2% y/y. This is in line with our expectation, but a tad lower than the market consensus. On a q/q basis, the figure was actually revised down from the initial flash estimate of 6.0% to 5.7%. The strong performance of the economy in the first three quarters yielded an average growth rate of 8.7% and this prompted the Ministry of Trade and Industry (MTI) to revise upward their 2006 target from 6.5-7.5% to 7.5-8.0%. This upward revision was well anticipated by market and the new forecast range is in line with our 7.9% growth forecast for 2006.

Growth to moderate to 5.5% in 2007
The MTI also released its growth forecast for 2007, which is in a range of 4-6%. While the MTI's new forecast is not particularly useful as the wide range encompasses basically the entire market's forecasts, it nevertheless sets the stage for slower economic growth in 2007. The Composite Leading Index, which comprises sub indices like new orders received, new companies formed, unit labour cost and usually leads GDP growth by two quarters, is pointing to softer economic growth over the next six months (chart 1).

We expect growth in 2007 to moderate from 7.9% in 2006 to 5.5% in 2007. The pace of moderation however will not be uniform and we could see a decoupling of the domestic and export sectors in 2007. The export sector which is heavily dependent on the external environment is already showing signs of moderation. Leading indicators, such as US new orders for personal computers (PC) and components and the semiconductor book-to-bill ratio, are all trending down (chart 2), which will undercut exports and industrial output.

The domestic sector however is likely to show a very different picture. With the Straits Times Index (STI) hitting new highs and the property market now in an upturn (chart 3), the domestic sector is entering a virtuous cycle. The construction sector, which had been contracting for 19 quarters, is benefiting from growing investment demand and expanding at 2.3% y/y s.a. in Q3-06. The labour market, which saw 123,000 jobs created in the first three quarters of 2006 compared to 113,300 jobs for the whole of 2005, is likely to stay healthy in 2007 despite the moderation in growth. With the domestic sector remains resilient, GDP growth should stay close to trend despite weaker exports.

GST to dictate monetary and SGD stance
The MAS expects inflation to stay in a range of 0.5-1.5% for 2007, very much unchanged from the inflationary picture in 2006. Average inflation for the first 10 months of this year is 1.0%. Moving into Q1-07, inflation is likely to dip below 1% on a y/y basis. However, the 2007/08 Budget to be announced on Feb 15 should see a hike in the GST, adding pressure on consumer prices. Currently, the government is still debating whether the GST hike would be in one step or phased in from the current 5% to an expected 7%. To mitigate the effects, however, the government has promised to freeze public charges in 2007. Should the government adopt a phase-in approach, the benign inflationary environment is likely to prompt the MAS to shift to a neutral stance on the SGD (chart 4) at the April policy meeting, especially if oil prices continue to stay muted. The risk is if the GST is raised by 2 percentage points in one go, then the MAS could keep the SGD appreciation stance as precaution.

Interbank interest rates are affected by two key factors in 2007. First, the resilient domestic sector and rising loans demand would keep rates supported. Second, falling US rates and still ample liquidity could pressure the SIBOR down (chart 5). The net effect is likely to keep the 3M SGD SIBOR in a tight range of 3.0%-3.375% for 2007, in our view.

TAIWAN

Tai Hui
+852 2821 1039, Hui.Cheung-Tai@hk.standardchartered.com

Decision time for the CBC

- Export-led expansion remains in place...
- ... but downside risk looms for 2007
- CBC may need to reassess its policy priorities

The two-tier growth pattern in Taiwan continues with exports doing much of the heavy lifting in maintaining the island's economic expansion. While the stronger than expected Q3 GDP growth has prompted us to revise our full year forecast higher to 4.5%, the Central Bank of China (CBC) will need to consider its monetary policy in the light of weak domestic demand and the downside risk to exports in 2007. With inflationary pressure easing, the central bank can afford to pause monetary tightening after one final hike of 12.5bps in December.

Strong exports, soft imports prompt higher forecast
Taiwan's Q3-06 growth was above expectations, at 5% y/y in real terms. As a result, we have revised our full year forecast for 2006 higher to 4.5%, from 3.8%. However, we believe the headline growth figures disguise the fundamental softness of the economy. Domestic demand, which includes personal and government consumption, and gross fixed capital formation, only contributed one-fifth of the headline GDP growth in Q3. The other fourth-fifths came from net exports. This has been the pattern observed in recent quarters, as credit card issues and the uncertain economic and political outlook have dampened consumer and investor confidence. This was reflected by the fact that Taiwan's consumer confidence index in Oct-06 hit its lowest since Nov-01.

On the external side, the strong performance of the tech sector was a major factor behind good export growth. Exports of goods and services, in real terms, expanded by 13.1% y/y in Q3-06 - the fifth consecutive quarter of double-digit expansion. At the same time, soft domestic demand also helped to reduce imports of goods and services, leading to substantial increase in the current account surplus and contributed additional growth to headline GDP.

The trend in domestic demand is likely to persist in coming quarters. Although the worst of the credit card debt issue seems to be over, as shown by the steady decline in bank write-offs, consumer spending may take time to rebound given an uncertain economic outlook and clouded political landscape of the island. While gross fixed capital formation may rebound slightly in Q4-06 due to a low base effect, long-term investments remain rare and are largely focused on the Mainland where many Taiwanese manufacturers have relocated their factories.

Export growth is expected to moderate going forward with the peaking of the tech cycle. The semiconductor book-to-bill ratio continues to drift lower, indicating further easing in demand for IT products. The Semiconductor Equipment and Materials International (SEMI), an international industry group, forecasts recently that sales of chip manufacturing, testing and assembly machines will grow by a more moderate 3.7% in 2007, following three consecutive years of double-digit growth. As a result of the expected slowdown in exports and modest domestic demand, we maintain our full-year growth forecast of 4.1% for 2007.

CBC may need to reconsider its priorities
Given the cautious economic outlook, the CBC may need to reassess its monetary policy priorities. In the recent monetary policy committee meetings, the CBC has pledged to bring interest rates back to neutral. Although it did not specify where neutral rate is, recent decline in inflation in Taiwan implies that real interest rates are on the rise, which may reduce the CBC's urgency to push for further hikes. Headline inflation for the first 10 months of the year fell to 0.6%, from 1.4% in H1-06, following a sharp decline in food prices in recent months. Lower energy prices also helps to contain inflationary pressure.

Furthermore, the TWD has strengthened since late October following the slide of the USD, although its gain on a nominal effective exchange rate basis has been relatively mild. Between Oct 25 and Dec 13, the TWD gained 2.6% against the USD.

Broadly speaking, the decline in inflation risk, weakness in domestic demand, and a gradually strengthening TWD should provide the CBC with more room to relax its monetary policy. However, we believe the CBC may still go for one more 12.5bps hike in its Q4-06 MPC meeting to be convened on Dec 28. This would be consistent with the official comments made after the previous MPC meeting and gives the CBC a safety margin to insure against premature peaking. This is particularly important given the challenge of still excess liquidity in the money market and the banking system. Thus far, higher benchmark policy rates have failed to prompt corresponding rise in money market rates and bank lending rates in Taiwan.

If that is the case, the post meeting comments of the next MPC meeting will be an important opportunity for the central bank to signal any change in its thinking about interest rate policy. While they may still talk tough, following the Fed's approach, they are also likely to give the first signal of interest rates peaking in the next MPC meeting.

THAILAND

Usara Wilaipich
+662 724 8878, Usara.Wilaipich@th.standardchartered.com

Beware of a THB correction in 2007

- At a nine-year high, the THB is increasingly at risk to a correction
- Especially if exports fall and current account returns to deficit
- Politics and BoT are likely to curb THB strength

2006 has seen Thailand going through many of its cyclical turns. GDP growth peaked at 6.1% y/y in Q1-06, inflation topped 6.2% y/y in May-06, and policy interest rate peaked at 5.0% in Jul-06. In 2007, a major twist and turn would be the THB, which has risen by 15% ytd against the USD as Asia's top performing currency. This is notwithstanding rounds of negative news like separatist ambushes in the south, a government paralysed by months of street protests and repeated election wrangles, and a military coup unseen in over a decade. While the recent USD sell-off may see the THB turn even stronger in Q1-07, we believe it is also coming close to a point of reversal and could see a correction, probably a sharp one, in Q2-07 onwards.

In 2006, the THB was bolstered by a combination of factors. The first round of THB appreciation in H1-06 from 41.10 to 38.10 was due largely to one-off capital inflows related to foreign purchases of the controversial SHIN Corp shares. The second round of swift THB appreciation started since October was driven mainly by foreign purchases of Thai stocks, reflecting improved investor confidence after the coup on September 19 appeared to have put an end to the year-long political deadlock.

Entering 2007, however, we see growing risks of a potential sharp THB correction from Q2-07 onwards. While the THB could gain further in Q1-07, given our view of a broad USD sell-off, it is unlikely to escape a correction further down the road. In fact, the higher the THB goes, the sharper and longer its correction could be. A resumption to strength may take longer than our current thinking of Q4-07.

A return to current account deficit
Despite the accounting changes in balance of payments, which has worsened the current account (C/A) balance figures, Thailand continued to post a C/A surplus of USD 514mn during the first ten months of this year. In 2007, we nonetheless expect the C/A to shift back into deficit of about USD 2.3bn, or 1.0% of GDP, due to a greater trade deficit. Given cooling global demand and a strong THB, exports are unlikely to stay buoyant in 2007. Meanwhile, imports are expected to increase with growing public investment in mass transit projects, which would boost demand for capital goods.

Time to take profit?
Thus far, foreigners have bought a net THB 100bn of Thai stocks in 2006, on top of the THB 200bn net purchase made in 2005. Year-to-date, the SET index has gained 19.7% in USD terms, largely contributed by a 15% appreciation of the THB. With the THB reaching its multi-year high, chances are that foreign investors may consider cashing in their existing profits before the THB peaks. This is especially so if there are signs of renewed political uncertainty in H2-07 when the interim government is expected to face some key challenges. One such uncertainty is the drafting of a new Constitution which has to be finished within a year. The other one is the holding of new general elections under the new Constitution before the end of 2007. Any delay in the two events could again dampen investor confidence.

The risk of more BoT interventions
Over the past months, the BoT has sent repeated warnings on the strength of THB. It is unlikely that the BoT will allow the THB to strengthen much more in 2007, especially if exports are to slow as we have predicted. On December 4, the BoT prohibited banks from doing sell/buyback transactions with non-residents on THB-denominated bonds. It also required foreigners buying THB T-bills, BoT bonds or LBs to hold for at least 3 months. Moreover, it barred non-residents from lending THB to onshore players for less than 6 months without an underlying asset, up from 3 months previously.

These measures, aimed at curbing the strength of THB, were introduced on top of earlier measures announced on November 8, which banned financial institutions to issue or sell Bills of Exchange of all maturities to non-residents. Thus far, market reaction to these measures appears muted, which actually raises the risk of inviting more drastic actions from the BoT as it has vowed, such as a withholding tax on short-term inflows.

Lower interest rates in H2-07
In 2006, the BoT hiked its policy rates for four times to keep inflation in check. With oil prices peaked and inflation easing steadily, there is growing room for the BoT to switch to a more relaxed monetary policy. We believe the first move to cut rates, albeit marginally, will come in H2-07. This, in turn, would add to the push for a THB correction some time in 2007. Specifically, we expect the THB to weaken against the USD to 37.00 in Q2-07, and 38.00 in Q3-07, before appreciating back to 37.30 in Q4-07.