Asia Focus : Asia and Globalisation's Next Crisis : Ten years after the Asian financial crisis, markets seem to be getting jittery again. Currencies across Asia are again under the spotlight, while record high equity prices in the US and many Asian markets resemble the irrational exuberance that prevailed just before the previous crisis. Will there be another regional or global financial crisis? We believe it is almost inevitable. As markets become increasingly global, regulations remain stubbornly local. Until this contradiction is resolved, crisis will remain hard to avoid. But the next crisis is unlikely to be terminal, and we believe it is nowhere near us yet. The world still has time to minimise the damage of the next global financial crisis, and Asia is unlikely to be the major victim as it was in the previous one. In fact, its post-crisis recovery offers much to learn for others in crisis prevention and management.

Economy Highlights

China : Full steam ahead for China's economy as we enter yet another quarter of fast growth and low inflation - a policymaker's dream combination. We now see official growth at 10.6% this year, and 10.0% next. We also raised our interest rate forecast to two more 27bps hikes this year.

Hong Kong : As Hong Kong celebrates the 10th anniversary of the establishment of the SAR, its economy is also enjoying its best time in a decade. The test now is how to ensure the SAR's longer term resilience and competitiveness. While challenges abound, the outlook is encouraging and we have revised upward our 2007 GDP growth forecast to 5.5% from 5%.

South Korea : Despite a strong KRW and higher interest rates, Korea's twin growth engines remain stable. While the build-up of short-term external debt and large capital inflows deserve more attention, a hike in the policy call rate is unlikely.

Thailand : With a new constitution being drafted and now under public scrutiny, politics is likely to face even tougher sailing in the coming months. Output growth will continue to be dictated by external demand, and the BoT may be forced to embark on more aggressive easing.

OVERVIEW

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

Nicholas Kwan
Regional Head of Research, Asia; +852 2821 1013
Nicholas.Kwan@hk.standardchartered.com

Short term fix, long term cure

- Recent asset inflation requires better liquidity management
- A crisis can be avoided, but some correction seems inevitable
- Authorities need to divert liquidity to the real sectors

Ten weeks after the late February/early March market correction, almost all Asian equity markets have fully recovered their losses and resumed their bull run. Some have scaled new highs, underlining still ample liquidity in the region. Yet, the risk of more intermittent market corrections, possibly sharp and painful ones, remains, though we believe the probability of a widespread financial crisis is low. As signaled in the 40th Annual Meeting of the Asian Development Bank in Kyoto, central bank governors and finance ministers are well aware of such risks and are looking for ways to prevent excessive market volatility in the near term. However, we believe more structural reforms rather than quick fixes are needed, especially in directing liquidity to longer term and more productive areas.

Liquidity management is key
Asset inflation, especially equities, has been hitting the headlines in recent weeks. The Chinese stock market's meteoric rise is particularly alarming. Notwithstanding a 10% setback suffered in late February, the Shanghai A-share index still gained almost 50% year-to-date and has risen by 250% since end-05. Part of the exuberant market performance can be explained by the economy's strong growth momentum and recent removal of major market impediments like the non-tradable state-held shares. However, the market is clearly buoyed by excessive liquidity, as evident from the rapid 18% y/y M2 growth in the past five quarters. While the rest of Asia appears less bubbly, if the current equity market exuberance continues, markets would be vulnerable to more frequent jolts in coming months.

Central banks across Asia are beefing up their liquidity management efforts. China on May 11 announced further liberalisation of its Qualified Domestic Institutional Investor (QDII) scheme to expedite capital outflows. Aside from fixed income products, banks are allowed to invest their customers' money in overseas equities as well. India, Indonesia and Malaysia are using their currencies to do some of the cooling, by allowing their currencies to appreciate faster to tighten monetary conditions and to rein in inflationary pressure. The change in stance of the Indian authorities is particularly interesting. Instead of keenly defending the INR from strengthening, the RBI has allowed the currency to rise by 7% against the greenback since Mar-07. The Philippines is hinting that they may not be looking to cut interest rates soon, as well as considering ways to permit more capital outflows. The Bank of Korea has kept its call rate unchanged in May for the ninth consecutive month and remains watchful over the speculation in the local property market.

Longer term cures needed
Other than short-term liquidity management, central banks and governments also need to address the longer term issue of effective liquidity allocation. While Asia's equity markets are awash with money, developments of many Asian economies are starved by underinvested physical and social infrastructure. With the exception of China, investment across Asia is still substantially below the levels (in GDP terms) before the Asian Financial Crisis. The buoyancy of equity markets has not been matched by higher real sector investment. Repeated interest rate cuts by Bank Indonesia have thus far failed to have material impacts on consumer and investor spending. This has forced the government to expedite the passage of a new investment law to improve the investment environment, and to reshuffle its cabinet to boost the efforts on privatisation. In Thailand, the current political uncertainty is severely undermining investor confidence and this is likely to remain so until a new Constitution is formed and a general election is held. In Taiwan, the run-up to the presidential election in 2008 is also likely to cloud the island's economic development, undermining business confidence and the channeling of liquidity to new production capacity. Even China's high investment rate requires more concerted efforts to ensure effective allocation of liquidity in the long term. Too much money is invested in quick-win areas like property and commodities, and too little investment is made in China's future, especially environment and education, including education of the exuberant investors. Of course, there is only so much that can be taught by the authorities on how to invest prudently. Often, the lessons that leave the greater impression are those learnt the hard way.

Yet, we are not predicting another Asian financial crisis. Asian economies have come a long way in restoring their financial health with much stronger external positions. In 2006, major developing Asian economies ran a combined current account surplus equivalent to 5.8% of GDP (3.2% excluding China), compared with a 1.1% deficit (1.9% ex-China) in 1996. They have also accumulated USD 2.4trn FX reserves (USD 3.3trn including Japan) as of Mar-07, along with the buildup of a number of bilateral currency swap arrangements among Asian central banks to mitigate short-term payment stresses. The latest agreement among the ASEAN+3 countries announced during the ADB annual meeting to establish a multilateral FX reserve pool is a further step to improve Asia's financial resilience, although actual arrangements and effectiveness of the pool are still work-in-progress.

ASIA FOCUS

Nicholas Kwan
Regional Head of Research, Asia; +852 2821 1013
Nicholas.Kwan@hk.standardchartered.com

Asia and Globalisation's Next Crisis

- A decade after the Asian financial crisis, the world is still not much safer
- The problem: markets are getting more global, but regulators remain local
- Asia is much more resilient now and offers good lessons for others

Ten years ago, a hiccup of the Thai baht triggered a financial crisis that put a whole regiment of emerging markets from Thailand to Indonesia, Korea, Russia, Turkey, Brazil, and Argentina under IMF intensive care. While the OECD markets seemed relatively unscathed at the initial stage of the global financial crisis, thanks to the Federal Reserve's abrupt easing prompted by the LTCM debacle in the aftermath of the Russian default, they nevertheless failed to escape a full blown correction when the dot-com bubble burst in 2001.

Today, markets seem to be getting jittery again, especially in Asia and America. The Thai baht once more is on focus. Currencies across Asia are again under the spotlight. US house prices are gliding near a cliff-edge, while record high equity prices in the US and many Asian markets resemble the irrational exuberance prevailed just before the previous crisis.

Will there be another regional or global financial crisis? How bad and how far will it be? We believe it is almost inevitable. As markets become increasingly global, regulations remain stubbornly local. Until this contradiction is resolved, crisis will remain hard to avoid. The next crisis, however, is unlikely to be terminal, and we believe it is still far from us, especially in Asia. The world still has time to minimise the damage of the next global financial crisis, and Asia is unlikely to be the major victim like the previous one. In fact, its post-crisis recovery offers much to learn for others in crisis prevention and management.

No imminent crisis, especially in Asia
For many, events in Thailand since last September are strikingly similar to the prelude of the 1997 crisis: a currency under attack, a central bank besieged, policies in dispute, and politics in disarray. Broadly around the region, almost all currencies are under pressure and equity prices smell expensive. However, a distinct difference between now and 10 years ago is that the region's economic fundamentals are very different.

A decade ago, almost every Asian economy was in (external) deficit. Now everybody is running a current account surplus. Ten years ago, most Asian central banks were short of forex reserves to defend their currencies. Now they have too much to keep their currencies from appreciating (Chart 1). Although Asian equity prices are now running at or near record highs, most P/E ratios are still 10-70% below their previous peaks (Chart 2). Property prices in a few Asian economies are at elevated levels, but relative to income or rental yields, prices are still lagging 20-30% behind previous peaks (Chart 3). Banks in Asia, many of which contributed to the previous crisis with huge asset-liability mismatches and razor-thin capital, are now more prudently managed and much better capitalised. Asian governments, while generally in weaker fiscal positions after spending billions in post-crisis rescue operations and suffering years of slow growth, are now stronger in their crisis-management capacity given accumulated experience, better policy frameworks and improved cross-country support and coordination, especially within the region. Moreover, after years of balance sheet rehabilitation, Asian corporations and households are generally less leveraged today than 10 years ago (Chart 4).

Yet, it is undeniable that selected Asian economies are facing growing financial stress, either due to less healthy fundamentals, poor policies, or cyclical misfortune. This could lead to problems or even crisis, as evident in the cases of Indonesia and Thailand over the past two years. Attention is needed in areas like asset price inflation in China and India, rising short-term foreign debts in Korea, and policy malaise in Thailand and Taiwan. However, for such isolated weaknesses to become a regional or bigger crisis, we need much weaker fundamentals and bigger policy mistakes around the region - a situation still missing on our radar screen.

The world is still far from immune
Beyond Asia, however, the picture is less sanguine. While many victims of the previous crises also have substantially strengthened their fundamentals, there are still some laggers and underperformers. Current account deficits and inflation in many East European economies are getting worrisome, growth momentum in some South Asian countries is still dampened by heavy debt burden. America's twin deficits have yet to see any genuine improvements, and the health of its housing market is disturbing.

More importantly, as the world's capital markets get more globalised, regulation and supervision of markets remain largely local. From investors (e.g. private equity, venture capital, hedge funds) to intermediaries (banks, securities and insurance firms, exchanges) to issuers (corporates, governments), cross-border consolidation is ever growing in size and sophistication. This is evident from several cross-country mega M&As among banks and exchanges in recent months.

In line with phenomenal growth of global financial markets, the risk of their natural downside like externalities, market failure or imperfection also increases. This needs to be addressed through improved governance and sensible policies, which in turn requires strengthened architecture of the global financial and economic system. Unfortunately, progress in this area is lagging far behind market development, despite elevated concern during the previous crises.

Crisis-management abilities of multilateral financial institutions like the World Bank, IMF, BIS and ADB remains handicapped by their poor mandate, weak governance, limited resources and misguided policies. The recent incident regarding the integrity of the World Bank's top management is a case in point. Governance of the IMF is still an agenda item for discussion. The BIS' board and agenda is still dominated by the G10 despite its expanded membership. Policy priorities adopted by these institutions toward anti-corruption and exchange rate flexibility have yielded vague benefits at best. The G7 has achieved little in terms of policy coordination but more as a regular talking shop. The Financial Stability Forum (FSF) formed after the previous crisis is busy looking for its next agenda and risks being unemployed. The ADB's latest annual meeting was preoccupied by its search for a new role.

To be fair, some progress has been made to strengthen market self-regulation, specifically through the development and adoption of best practices, increased transparency and accountability, improved competition and mandate, plus a few multilateral market surveillance initiatives like FSAP (Financial Sector Assessment Program) and SDDS (Special Data Dissemination Standard). However, the global financial architecture remains ill-equiped to manage the challenges brought by globalisation and is far from immune to the next global financial crisis.

Complacency ill-afforded
To the extent that the latest wave of globalisation was fueled by the availability of cheap money, due largely to low interest rates in industrial economies, that drove investors across border to search for higher yields, we need to be mindful that such moves of capital market globalisation have also raised the risk and leverages of the global financial system. Concentration of risks on or via specific markets (e.g. sub-prime mortgage in the US), intermediaries (hedge funds), structured products (credit derivatives, carry trade), and areas (East Europe) could amplify the impact of abrupt market adjustments. Globalisation of financial institutions (banks) may diversify risk with stronger capital and wider exposure, but it could also raise the risk of contagion and supervisory mismatch or regulatory arbitrage.

Fortunately, growth momentum of the world economy remains robust. Until now, a weakening US economy appears sufficiently offset by rebounds in Europe and Japan, plus strong growth in emerging Asia, especially China and India. Global liquidity stays buoyant despite higher interest rates in Europe, Japan, China and India, especially given the prospects for US rate cuts going forward. Improvements made in the financial health of individual economies hit by the previous crises, as elaborated earlier in Asia's case, also provided a cushion to any imminent distress. We believe the underlining fundamental of the global economy remains solid and another global or regional financial crisis remains some distance away, especially in Asia.

However, complacency is ill-afforded and governments need to put their acts together soon to prevent, or at least minimise, the damage of the next crisis. In this respect, Asia's latest efforts to reinforce their firewall through the pooling of FX reserves and expansion of regional financial cooperation deserve more attention and could offer valuable lessons for others. While details of the new ASEAN+3 reserve pooling facilities are yet to be worked out and their effectiveness remains untested, the move itself is a continuation of Asia's search for an effective complement to the existing international lender-of-last-resort facilities monopolised by the IMF. It is too early to tell whether the move is a revival of the aborted idea of Asia Monetary Fund, but it resembles the search for alternative regional trade agreements (RTAs) to complement the multilateral arrangements under the World Trade Organisation (WTO). Some may argue that such regional moves will undermine global efforts to promote trade and economic growth, but history in the trade arena proves that these two initiatives should not necessarily be mutually exclusive. Instead, there is much room for mutual support and reinforcement. In this respect, Asia's latest move to expand their regional financial cooperation should be welcomed and could offer good lessons for others in addressing future global financial crises.

CHINA

Stephen Green
Senior Economist, +86 21 5887 1230 extn.5223
Stephen.Green@cn.standardchartered.com

The Golden Age continues

- China's GDP is probably growing even faster than 11% y/y
- Our 4% CNY-USD appreciaton view looks persuasive again
- Risk of a stock market correction rises as exuberance continues

Full steam ahead for China's economy as we enter yet another quarter of fast growth and low inflation - a policymaker's dream combination. In fact, being a China economist over the last few weeks has been, well, a bit boring really. Just about every economist in the land has been asked what they think about growth, liquidity, and of course the stock market, and the answers are much of a much-ness. Everyone agrees the economy is growing fast - and will likely continue doing so. Our freight proxy index (which we think is a decent proxy for overall industrial activity) is still strong, and has picked up in recent months, as Chart 1 shows. We recently revised up our 2007 growth forecast (which we should have done a long-time ago given our fundamentally bullish stance). We now see official growth at 10.6% this year, and 10.0% next. Bear in mind also evidence that we are growing even faster than official rates. Adding up the nominal GDPs for China's 31 provinces last year provides a GDP figure of CNY 22,969bn (USD 2,945bn), 9.7% more than the national number of CNY 20,940bn (USD 2,684bn). Adjust for inflation and provincial data suggests growth in 2006 of 13.2%, compared to 10.7%, the official national number. There is reason to believe the provinces are still measuring service sector output growth more accurately than Beijing, so one is tempted to add 2.5ppts to official growth figures.

Economists have also just about exhausted the 'what to do about all the liquidity?' question. Non-processing export growth has picked up in recent months (Chart 2), as China's heavy industry (steel, aluminum, chemicals) investment is now seeking overseas markets for its output. That is another reason to expect the trade surplus to continue to grow. The answer is PBoC bills, reserve requirement hikes, lending controls, and interest rate increases (we recently raised our forecast for the later to two more 27bps hikes this year, and expect the next one in Q2). The lack of a rate hike after the strong Q1 numbers suggests that Beijing is happier than before that the current dynamics are sustainable. And this policy of holding the line on monetary aggregate growth and the mildest of tightening on the real side will likely to continue. Chart 3 shows just how successful the sterilisation operations have been - while the top lines show the accumulated FX inflows, the bottom line shows the accumulated amount actually let into the economy. Not a lot, meaning M2 growth remains at 17-18% y/y. And the currency? Apart from some head-scratching over why the pace of appreciation has slowed to some 2.5% on an annualized basis over the last two months (Chart 4), nothing much new to report here either. No new ideas in Beijing on what to do, and no new substance from Washington. There are a variety of possible explanations for the slower pace. The People's Bank may be trying to beat up those taking a bet in the NDF market by manipulating offshore expectations. Or it may have wanted to prepare for faster appreciation before and after the May 23-24th US-China Strategic Economic Dialogue (SED) in D.C. (see OTG in Asia, May 9th 2007, 'Standard Chartered goes to Washington'). We have no special insights into which, if any, of these explains the CNY's quick-quick-slow moves. Suffice to say we are looking good with our 4% appreciation against USD view, against market consensus of 5-6% by year end.

Then there is the stock market, which continues to power forward, as Chart 5 shows. Valuations are of course stretched, but the only trigger for a plateau being reached for prices, or a correction, that we can see is slowing profit growth or State Council action. We remain fundamentally bullish in the short (three-month) term, with obvious risk of volatility, based on two basic views. First, the China Securities Regulatory Commission (CSRC) believes rising prices is useful for pushing through new policies, as well as supporting brokerage sector restructuring (rising valuations forgive a whole lot of old sins). Other senior officials are concerned about what they see as a bubble collapsing with nasty consequences for individual investors, but they have to win over the State Council - and that takes time. Policies which could shake the market include a capital gains tax (which make a lot of sense from a progressive taxation point of view) or selling off of state shares. Two, sentiment on the street is still maximum bullish. Anecdotal reports suggest that many QFII investors remain long equities, and domestic funds have no problems raising new money. Recent profit news has been positive. However, we should face facts: the fundamentals do not support these valuations, so at one point the market is going to have to plateau or correct. The risks of a move from the State Council, with an indication that it would prefer the former outcome are 50/50 now, and will rise as the Shanghai index moves closer to its record historical P/E of about 60X. Without such a move, liquidity will likely keep pushing valuations higher, though more slowly, and the risk of a serious correction rises when bad profit news hits. Today's market is worth some 50% of GDP, which is getting close to the macro-economic significance of mature markets like America's. In other words, today's boom is probably boosting investment and consumption. Any bust tomorrow will do the opposite. The critical question then is when and how will this Golden Age end? We still put our money on a gradual and soft slowdown, but sometimes it all feels just a little too good to be true.

HONG KONG

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

Nicholas Kwan
Regional Head of Research, Asia; +852 2821 1013
Nicholas.Kwan@hk.standardchartered.com

Worst of times, best of times

- The economy has fully recovered from one of its worst decades
- Now is the best time for long term strategic positioning
- Outlook is encouraging, we raise 2007 growth forecast to 5.5%

As Hong Kong celebrates the 10th anniversary of the establishment of the Special Administrative Region (SAR), its economy is also enjoying its best time in a decade. After three full years of recovery from its worst time in over three decades, the SAR has now fully restored its economic health. The test now is how to ensure the SAR's longer term resilience and competitiveness, which would be the key policy focus of Chief Executive (CE) Donald Tsang and his re-structured government in their new five-year term starting this July. While challenges are abound, outlook is encouraging and we have revised upward our 2007 GDP growth forecast to 5.5% from 5%.

The worst of times
The first 10 years of the Hong Kong SAR has seen one of the economy's longest and deepest recession in the post-war years with 18 quarters of year-on-year output decline, or eight quarters in real terms (Chart 1). The onset of the Asian financial crisis kicked off over five years of deflation with a 70% collapse in property prices, sent over 100,000 homeowners or one-fifth of the mortgage holders into negative equity, tripled the bankruptcy rate of business, depleted almost half of the fiscal reserve (HK$ 210bn in total) accumulated in half a century. It took fully eight years for Hong Kong to restore its nominal GDP to the 1997 level.

A recovery of such a distressed economy requires more than cyclical factors. Aside from favourable external environment, fundamental domestic policy changes and structural adjustments are crucial to Hong Kong's economic turnaround. With the benefit of hindsight, a U-turn in the government's housing policy in November 2002 and the initiation of the Hong Kong-Mainland Closer Economic Partnership Agreement (CEPA) in mid-2003 were key to Hong Kong's recovery. The former signified not just a retreat of the government from its misguided housing policy, but also a fundamental rethink of the government's role in the domestic economy, especially the quasi-public sectors like transport, housing, health care, education and social services. CEPA, which has since been reinforced by three annual supplements, symbolised a breakthrough in the government's role in Hong Kong-Mainland economic relationship.

The best of times
Impacts of the above moves are obvious. Property price recovered half of its decline, the tourist and stock markets were buoyed by waves of Mainland visitors and IPOs. Jobless rate dropped to a 8-year low and fiscal surplus reached a second-record high (Chart 2). Growth in Q1-07 remained strong with a 9% y/y export growth, 9.4% rise in retail sales, 27% more property transaction, and a 58% jump in stock turnover. This prompted us to raise our 2007 GDP growth forecast from 5% to 5.5%.

The challenge now is how to build on these successes to form a more sustainable growth platform. In light of a new term of the Chief Executive, a new cabinet, a new decade of the SAR and a new Five-Year-Plan in China, some believe new policy direction and economic structure are needed to push the SAR into a new era. There are no shortages of grand idea: from hi-tech to creative industries, and from commodity futures to Islamic financing.

The real challenge: back to basics
We believe this would be a recipe for another disaster, probably similar to what we have suffered in the first decade of the SAR. Hong Kong's success never came from any new thinking or grand blue-print of any genius or great thinkers. It is always the force of market that leads Hong Kong through the rough seas of global competition. It is also the prime lesson we learnt from the past decade, as evident from the two key measures we highlighted earlier, which basically boil down to the government's retreat from the housing market and the reduction of cross-border market barriers (tariffs, tourist quota and visa, professional qualification restrictions...etc.).

The real challenge is to stick to the basics. It is important that the government continues to pursue existing reforms in various public and quasi-public sectors to minimise unwarranted administrative distortions and maximise market-based checks and incentives, and to improve the physical, human and operating environment to support business, especially cross-border activities. This is not just for further improvement of the government's fiscal position, but more for the health and efficiency of the public sector and the facilitation of smooth and constant transformation of the broader economy. Over the past five decades, the Hong Kong economy has at least gone through four structural transformations, from an entrepot in the early 50s to an export-manufacturer in the 60-70s, to a China trade window in the 80s and a regional/international service centre in the 90s. None of these transformations encountered as severe a distress as the last decade, when adjustments were hindered by a rigid and outsized public sector, in our view.

SOUTH KOREA

Chongwoo Chun
Senior Economist, +822 3702 5045
ChongWoo.Chun@scfirstbank.com

Nicholas Kwan
Regional Head of Research, Asia; +852 2821 1013
Nicholas.Kwan@hk.standardchartered.com

Eunhye Yoon
Research Assistant, +822 3702 5072
EunHye.Yoon@scfirstbank.com

Resilient, but not without concern

- GDP growth and inflation to remain steady
- Buildup of short-term foreign debt deserves attention
- But interest rate is likely to remain unchanged in 2007

Despite a strong KRW and higher interest rates, Korea's twin growth engines remain stable, underlining significant resilience of the economy. While the build-up of short-term external debt and large capital inflows deserve more attention and will probably attract regulatory action, a hike in the policy call rate is unlikely despite hawkish rhetoric of the central bank.

Steady as it goes
Korea's Q1 GDP grew by a real 4.0% y/y, same as the previous quarter with stronger private consumption and facility investment but weaker net exports (Chart 1). While high oil prices had curbed net exports' contribution to growth, exports of goods and services continued to defy the gravity of a strong KRW and grew by a robust 11.2%, slightly higher than the 10.5% of Q4-06.

Domestic demand also stayed resilient with solid job growth in services and investment. Facility investment, which grew 10.3% y/y - almost doubled its 5.3% growth in the previous quarter, is particularly encouraging. Spurred partly by a higher 81.6% capacity utilisation rate, the rise in investment reflected strong investor confidence, as indicated by the improving leading composite indicator and business survey index. On consumption, retail sales grew by 4.1% y/y in Q1-07, marginally lower than the 4.6% growth in Q4-06. This was partly due to slackened auto sales and a weaker 4% y/y increase in national household income, down from 5.4% in the previous quarter.

Heightened interest rates and reserve ratios are beginning to have their impacts felt, as seen from the recent increases in the delinquency ratios of household and credit card debts (Chart 2). Higher property tax burden to be effective in Q4-07 could also limit consumption spending going forward. However, a robust 7.1% growth in Q1 urban household income and sustained rebound of the consumer sentiment index over the past two quarters implied that consumer demand should remain largely stable.

Inflation trends up but remains contained
Inflation pressure has picked up in recent months (Chart 3). Much of the recent increases in service prices is due to one-off factors like increases in education fees and bus fares. Food prices remain relatively stable and may ease with increasing agricultural imports (including beef) from the US under the Korea-US Free Trade Agreement (FTA). While the FTA is yet to be ratified by parliaments of the signing parties, Korea has already resumed beef imports from the US. Oil prices may still pose some uncertainties to the inflation outlook, but given slower US growth, a quantum leap similar to 2006 is unlikely.

A bigger concern would be asset price inflation, underlined by the 12% year-to-date increase of the KOSPI stock index, and a 12% y/y rise in housing prices during the first four months of this year. Yet, given initial signs of a property price correction after the introduction of higher property tax and other anti-speculation measures, the Bank of Korea (BoK) may feel less obliged to tighten further, even though it is likely to maintain its hawkish rhetoric. On balance, we expect inflation to remain well contained given the absence of any strong demand pull or cost push pressures. We keep our inflation forecast at 2.3% for 2007.

Short-term foreign debt fuels liquidity
The rise in liquidity is another concern, especially short-term external debt which rose 72.4% y/y in Q4 2006 and now accounts for 48% of Korea's forex reserves, the highest level since 2004. This can be attributed to FX hedging of exporters and the use of foreign funding by foreign bank branches in response to a strong KRW. Fortunately, the heightened reserve ratio seems to be restraining short-term liquidity (M1-MMF) growth and is curbing mortgage demand (Chart 4). Also, bank lending is shifting to small and medium enterprises, which should support output and reduce property speculation.

However, it is likely that more regulatory action will be taken to restrain external borrowing, as hinted by the recent move of the Financial Supervisory Service (FSS) to tighten financial reporting of foreign banks (see OTG on 7th May, 2007). This may include the introduction of tax disincentives and tighter liquidity ratios, but it is unlikely to use across-the-board interest rate hikes, especially given the looming of year-end presidential elections. We maintain our view that the BoK will keep its policy call rate unchanged at 4.5% in the remainder of 2007. While there are signs that the current inventory cycle may be close to its bottom (Chart 5), a clear turnaround is probably still 2-3 quarters away, based on experience of previous cycles.

THAILAND

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

Nicholas Kwan
Regional Head of Research, Asia; +852 2821 1013
Nicholas.Kwan@hk.standardchartered.com

Sailing rough, but resilient

- Politics could get worse before it gets better
- Growth depends on exports and monetary easing
- Beware of short-term risks, but long-term resilience

Almost eight months after the September military coup, Thai politics remains unsettled, leading economic policies to nowhere but confusion. With a new constitution being drafted and now under public scrutiny, politics is likely to face even tougher sailing in coming months. Pitfalls abound, from the consultation and passage of the new constitution, to the promised general elections toward end-07. Tensions among different vested interests are likely to escalate, forcing economic policies to drift further. As such, output growth will continue be dictated by external demand, while domestic consumers and investors alike will stay sidelined. The BoT may be forced to embark on more aggressive easing, given a malaise on the fiscal front. While large trade and current account surpluses will support the THB at elevated levels near-term, the currency is vulnerable to sharp decline triggered by politics. A newly signed Japan-Thailand Economic Partnership Agreement (JTEPA) may offer new opportunities to business, but much may have to wait for its actual enactment in 2008 and more importantly, the return of political normality.

New constitution: a tough sell
On May 8, the three largest political parties of Democrat, Chart Thai, and Mahachon jointly issued a statement denouncing the draft new constitution tabled for public consultation. Opposition to the draft is not surprising but the joint action of the three rival parties implies a much stronger resistance than expected. This not only smells bad for the new constitution, which will be put up for universal suffrage this summer, but also underlines a more difficult confrontation ahead among the ruling junta, the politicians and the public. A blockage of the new constitution will hold up the year-end general elections and the return to civilian rule, extending political uncertainties and policy malaise.

Exports and lower rates to support growth
Until now, damage on the Thai economy remains relatively mild. GDP grew by a real 4.2% y/y in Q4-06, down from the cyclical peak of 6.1% in Q1-06. However, there are signs that the economy is accelerating its deterioration. Both private consumption and investment indices are falling, with consumer confidence dipping to a near six-year low in Mar-07. Tax revenue fell by 4.2% y/y in Apr-07. Import growth decelerated from 18% y/y in Jul-06 to 0.6% in Mar-07 in USD terms, reflecting sharply weaker domestic demand. In fact, the collapse in imports amid stable double-digit export expansion has contributed to a record USD 2.2bn surplus in both trade and current accounts in Mar-07, driving the THB stronger in the onshore market. Currently, the THB is trading at its nine-year high against the USD. This means that the Thai economy is running with just the export engine, which would spell trouble if external demand deteriorates as expected in later this year. A new free trade agreement with Japan (JTEPA) signed on Apr 3 may raise optimism, but it will become effective only in 2008 and is unlikely to provide much near-term support to Thai exports.

Before a clear return of political normality, new policy initiatives would be difficult to raise and implement. In particular, a deteriorating fiscal position could prevent the introduction of any major fiscal stimulus, including the multi-billion infrastructure projects. Thus far, tax revenue has fallen behind budget and is likely to breach the 1.7% GDP deficit target. This will leave the monetary arm as the prime growth supporter in coming months. In light of the rougher-than-expected political landscape, accelerating deterioration of consumer and investor sentiment, and a weaker fiscal stance, the BoT may have to adopt a more aggressive monetary easing to cushion the economy from any sharp slowdown. We expect the BoT to cut its 1-day repo rate by 50bps at its next MPC meeting on May 23, to be followed by two more 25bps cuts in the subsequent MPC meetings in July and August. This will take the policy rate down to 3.0%, a full 100bps decline from the current level.

Long-term resilience, short-term risks
How effective such aggressive easing will arrest the current downturn is unclear, but we remain confident that the Thai economy is still resilient enough to avoid any deep secular decline. Aside from robust export performance, which underlines strong competitiveness of the export sector, a key resilient factor is the economy's strong external payments position, as demonstrated by a large USD 69bn forex reserve, which is 80% more than the pre-97 level and enough to cover Thailand's total foreign debt. Domestically, low debt leverage in the real sector and better capitalised banks should also cushion the economy from any extreme financial distress. These would provide a strong base of recovery once the political outlook is cleared. However, for 2007, we maintain our view that GDP growth is set for a lower 3.8%, compared with last year's 5.0% growth. We also maintain that the THB could face substantial downside risks in coming months, especially if political conditions deteriorate.

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