Asia Focus: Property Prospects Promising : Recent turbulence in global equity and currency markets has rekindled concerns about the risk of another major financial crisis, more so given recent signs of distress in the US sub-prime mortgage markets. While property prices in some Asian economies have seen significant increases over the past few years, house prices in most Asian economies are still some distance from their previous peaks and lag behind income growth. We see no major property bubbles that could unsettle the region's strong economic fundamentals and send financial markets into a tailspin. In fact, resilience in regional property markets is one major factor, along with much stronger external positions and others, differentiating the current situation from pre-1997 Asia.

Economy Highlights

China: Despite the recent sell off of the stock market, China's economy continues to boom, supported by solid export and profit growth. Neither a strong CNY nor the ongoing NPC has material impact on the real economy.

New Zealand: Belated domestic adjustment and a late-cycle export spurt might have misled the authorities to over-estimate New Zealand's underlying growth momentum and potential threat of inflation. Despite its hawkish posture, the next move of the RBNZ is likely to be down, probably in Q1-08.

Singapore: Notwithstanding the latest equity market correction, Singapore's economic fundamentals remain solid. In response to the threat of a higher GST to inflation, the MAS is likely to maintain its appreciation bias of the SGD.

Taiwan: Despite the rebound in consumption and investment growth in Q4-06, Taiwan is not out of the woods yet. With the upcoming elections, the political landscape is still highly uncertain.

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

Solid economy, liquid market

- Recent market turbulence may not be over yet
- But strong liquidity should limit its impact
- Solid fundamentals should also keep damage at bay

The recent market volatility has renewed concerns whether Asia's sturdy economic performance has come to an end. After two weeks of roller coaster movements since Feb 27, when the Chinese equity market lost almost 9% and was perceived, incorrectly in our view, as triggering a chain reaction around the global financial markets, investors are yet to fully calm down. The turbulence may not be over yet, especially given the seasonal Q2 surge in investor caution seen in the past several years. Still, we believe two key factors, ample liquidity and solid economic fundamentals, to remain constructive to Asia's outlook and attractiveness to investors. While domestic politics can be a wildcard in 2007, as we have noted previously, there are few signs of crisis for the region as a whole.

Lost in translation
So far, the market turbulence over the past two weeks was different to the more significant correction observed in May/June 2006 in many ways. Until now, both the magnitude and duration of equity price declines are less severe than the 2006 episode. While the 2006 episode was set off by threats of higher US interest rates, the latest market sell-off was driven by the opposite concerns about a global slowdown. The triggers of the latest correction can be best described as 'lost in translation'. First, the US market reacted negatively to the Chinese stock collapse on Feb 27, taking it as a reflection of a Chinese economy in the freefall. In fact, China's problem is that its economy is flying too high and Beijing is hard-pressed to calm its exuberance. Second, former Fed Chairman Greenspan's warning of a 'possible recession' was taken by some Asian analysts as 'probable', setting off an initial wave of unintended disturbance. Although current Fed Chairman Bernanke later provided a more optimistic view, the damage has been done and markets are likely to remain jittery for some time to come. Yet, long-term investors should find some comfort for two reasons. First, liquidity remains ample, in our view. Second, economic fundamentals, especially that of Asia, remain sound. Although politics and policies in some Asian economies are wildcards and add to volatility, problems in isolated economies are unlikely to threaten the region as a whole.

Ample Liquidity
In terms of liquidity, most East Asian economies are still running sizeable, albeit shrinking in some cases, current account surplus. Inflows of portfolio capital might have been deterred by rising risk aversion of investors over the past weeks, as indicated by our SCB Risk Appetite Index, there are also signs of stabilisation lately (Chart 1). Inflows of long-term direct investment, however, have shown little sign of cooling.

Further to external inflows, central banks in Asia are mostly well positioned to provide more domestic liquidity if needed. As we have highlighted previously, only Japan, China and India are expected to tighten monetary policy in the next 12-18 months. That said, the latest 25bps overnight call rate hike by the Bank of Japan is likely to be the last before Q4-07. Bank of Japan has highlighted the possibility of consumer prices temporarily falling in coming months, which in turn will allow the BoJ to maintain its slow motion. This implies that the BoJ will remain the world's prime liquidity provider for an extended period, and Japanese investors will continue to seek higher return overseas and provide support to regional markets.

For the rest of Asia, Thailand and Indonesia have already embarked on interest rate cuts to support growth. In the case of Thailand, political instability in the past 12 months has weakened consumer confidence considerably, and the Bank of Thailand needs to reduce borrowing costs to boost growth. Bank Indonesia is approaching the end of its rate cut cycle after bringing its policy BI rate from 12.75% in May-06 to the current level of 9%. We expect the BI rate to fall by another 50bps this year, but the next cut could be in H2-07 as the central bank takes time to gauge the impact of previous easing. For other Asian central banks, we expect the Philippines and Malaysia to cut rates in H2-07 as inflationary pressures abate. As a result, monetary policy in the region is likely to remain relaxed and accommodative.

Finally, with China establishing a Temasek-style agency to diversify and boost return of its foreign exchange reserves, it could also add further liquidity to the Asian markets. While the authorities have yet to announce its investment strategy, and they are unlikely to be particularly transparent about it, Asian markets and economies could benefit from this move, which is expected to involve somewhere around USD 200bn.

Back to Reality
As indicated by our GDP growth forecast, Asian economic performance in 2007 is expected to remain broadly in line with expansion in 2006. Early signs are supportive of this view. Taiwanese exports for January and February grew 7.5% y/y, compared with 7.6% growth for Q4-06. This provides an early indication of the export outlook across Asia, taking into account the seasonal distortion from Lunar New Year in the first two months of the year. This is good news amid slowing expansion in US durable goods orders. Excluding transportation, US durable goods orders growth has dropped from 10.3% y/y in Q2-06 to 3.1% for the three months to Jan-07. This has yet to impact on Asian exporters, as the data and sentiment remain buoyant for now.

From the angle of domestic demand, the decline in equity markets in recent weeks has yet to have any long-lasting impact on consumer and investor sentiment. In fact, the correction should be seen as a positive as it helps to clear any "irrational exuberance" and bring investors' focus back towards fundamental valuations of assets. This is critical at the time of abundant liquidity when easy credit encourages investors to underestimate risk. A timely wake-up call should be welcome.

ASIA FOCUS

Frances Cheung
Economist, +852 2820 3609
Frances.Cheung@hk.standardchartered.com

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

Property prospects promising

- Unlike equity, property markets in Asia are far less synchronised
- While some isolated bubbles are brewing, most are well behaved
- We see no major threat to regional financial stability, though vigilance is needed

Recent turbulence in global equity and currency markets has rekindled concerns about the risk of another major financial crisis in the making. Such worries were reinforced by signs of distress in the US sub-prime mortgage markets. Given that property busts can have much larger and longer-lasting damage on the wider economy than equity market crashes, it is important for policy makers to prevent any "property bubbles" from brewing. While property prices in some Asian economies have seen significant increases over the past few years, and have prompted a few governments to tighten prudential measures, house prices in most Asian economies are still some distance from their previous peaks and lag behind income growth. We see no major property bubbles that could unsettle the region's strong economic fundamentals and send financial markets into a tailspin. In fact, resilience in regional property markets is one major factor, along with much stronger external positions and others, differentiating the current situation from pre-1997 Asia. That said, with financial leverages higher for some places now, vigilance is warranted against possible price adjustments.

The start of the latest global boom in house prices has been driven by the low interest rate environment and extended income growth. For Asia in more recent years, the property markets are further boosted by increased external liquidity which flowed to equities and bonds initially but gradually find their ways into real assets. With outstanding mortgage debts and house prices ever increasing, policy makers are increasingly concerned about possible bubbles in certain areas. However, from a historical perspective, much of the latest increases in Asian property prices should be seen as a recovery from their previous downturn. By analysing the current stage of the property markets and various indicators, we believe that bubbles are still confined to isolated areas and are unlikely to jeopardise overall stability of the region's financial systems.

Higher prices, but many are still far from peak
The cycles in property prices differ across Asian economies, but prices have been rising generally in the recent two to three years. Focusing on the house prices in recent quarters will give an impression that there is a risk for bubbles to build up in some economies. In South Korea, house prices rose by 11.6% during 2006. In China, prices surged by 20.7%. Government authorities have shown their concerns about the "overheating" in the property markets in these two places, and pertinent policies to cool things down have been introduced. In Thailand, prices for single-detached houses were flat last year after rising by 7.2% in 2005, but more speculation has been on condominiums. In Singapore, residential property prices have risen by over 11% since 2004, whereas in Hong Kong, house prices have rebounded 57% from its trough since mid-2003.

However, house prices per se do not tell much about the valuations and where the market is in a cycle. For example, house prices dropped by over 30% from the high in mid-1996 to the low at end-1998 in Singapore, before rebounding by 40% towards 2000. In Hong Kong, prices slumped by 66% between 1997 and 2003, before rebounding to half of the peak level in the two years after SARS. Currently, Hong Kong's property prices are still 47% below its historial peak, while Singapore is still 11% below record (Chart 1).

Higher prices partly due to supply shortages
While most of Asia's house prices have been recovering from the downturn following the Asian Financial Crisis, part of the price recovery was contributed by supply reduction over the years. Construction output as a percentage of GDP, a large part of which is property related, has been declining in most Asian economies and is still some way off the peaks seen during the mid to late 1990s (Charts 2 & 3). In Hong Kong, construction output once amounted to just over 10% of GDP in 1999. This ratio was at a much tamer 6.2% in the year to Q3-2006. Korea's recent ratio was at 8%, compared to around 11% during 1993. Indeed, for economies with weaker domestic demand, the construction/GDP ratios have been dropping steadily. In Taiwan, it dropped from 5.5% in 1993 to 2% now, and Thailand from 7% to 3.1%. This suggests that the recent price increases reflect more a recovery process induced by slackened supply than a booming market stressed by excessive demand. The major exceptions are India and China, where the construction/GDP ratios have risen from 5.2% to 6.8% and almost doubled to 11% respectively between 1993 and 2005.

Comfortable valuation levels
Another way to gauge the risk of property bubble is the valuation of real estate. In this respect, the house price-to-rental ratio can be seen as an analogue to the price/earnings ratio for equities. It gauges to what extent the price of a property is justified by the income it can generate. Due to data availability, we compare current ratios to the high during the past one and a half decade for selected Asian economies. For places where rental indices are not readily available, we use the housing components under the consumer price indices as proxies.

In Hong Kong, the price/rental ratio is now around 17% below the peak seen during 1997. The ratio for Korea is 28% below the high in 1991, and for Taiwan 23% lower than in 1993. In Singapore the ratio using the CPI as proxies was 36% off the peak in 1996. But in China, the price/rental ratio more than doubled between 1998 and 2006. In Thailand, the ratio has surpassed the previous peak during the early 1990s by 10%. However, a higher price/rental ratio could be due to relatively high prices or low rentals. With property prices more than quadrupled, China's case is clearly due to the former and underlines the brewing of bubbles. But the case of Thailand is less clear cut, as property prices rose 47% in 13 years, rentals increased by only 30% during the same period. In this respect, we also need to look at the measure of affordability to see whether house prices are reasonably supported by incomes.

Thanks to robust economic growth in the past years, per capita nominal income in Asian economies have been increasing steadily, resulting in falling house price to income ratios in general. Housing affordability of the four NIEs and Thailand are now 37-58% better than their previous peaks in the 1990s (Chart 4). Against the backdrop of firm economic fundamentals but decelerating growth, any property market adjustments are more likely to result in healthy corrections rather than major busts.

Leverage playing catch-up?
As to the extent how households and the wider economies will be affected by any house price adjustments or even busts, leverage levels provide a key gauge. Higher leverage points to a possibly larger wealth effect, more severe balance sheet adjustment and impact on the banking system as well. Outstanding mortgages as percentages to GDP have been rising quite steadily in China, Korea and Taiwan (Chart 5). For Hong Kong and Singapore, while the ratios have been dropping since 2003, their absolute levels are higher than those in other Asian economies. That said, these mortgage/GDP ratios in Asia are still shy of the 70-80% in the US and UK.

The surges in mortgages in China and Korea can be viewed as playing catch-up, though the speed of which still warrants some due attention. Before 1997, outstanding mortgages were negligible in China. The recent up-cycle of the property market started in 1998, where mortgages have been ballooning upon easy credits. Between 1997 and 2005, outstanding mortgages rose from below 1% of GDP to 32%. In Korea, the percentage rose from 9.4% in 2000 to 24.7% last year. If the levels of mortgages somehow reflect the development of the financial systems, it also follows naturally that the mortgage/GDP ratios are higher in Hong Kong and Singapore.

One other indicator that can help assess the risk of property bubbles is the mortgage delinquency ratio. Unfortunately, such an indicator is available only in Hong Kong, where the latest level is at a negligible 0.2%, down from a peak of 1.4% in Q1-01. However, based on a broader measure of the non-performing loan ratio to total bank lending, almost all Asian economies are improving and at healthy levels, ranging from 0.8% in Korea to 6.7% in the Philippines. Although NPLs are normally lagging rather than leading indicators, the current low levels should offer good cushion for any foreseeable price shocks in the property sector.

CHINA

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

Stocks fall, but economy booms

- Shares have absorbed as much liquidity as they can, for now
- Profit and export growth remains robust
- CNY is now appreciating at 5% y/y, but expected to slow

Despite the recent selloff of the stock market, China's economy continues to boom, supported by solid export and profit growth. Neither a strong CNY nor the ongoing NPC has material impact on the real economy.

China's stock market has never been a good bell-weather of the state of economy - and recent events show that is still the case. After the Shanghai composite index broke 3,000 on February 26, the market fell 9% the next day, recovered 4%, and then fell 3% on March 1. This roller-coaster ride is occurring in the absence of any new economic data, corporate profit news or new policies. We think the share market, over-buoyed by domestic liquidity, has reached its short-term ceiling - and will likely only see mild upside in the coming months (Chart 1). Market capitalisation has increased from USD 400bn (17% of GDP) at YE-2005 to USD 1,337bn YE-2006 (49% of GDP), an increase of USD 937bn. Historical price earnings (P/E) ratios now average 38 times at the Shanghai Stock Exchange (SSE), still nowhere near the 60 times peak in 2001, but high compared to the 15 times level a year ago. State share reform, the legacy of the likely-to-be-soon-promoted securities regulator chairman, Shang Fulin, has underpinned this confidence, but with senior officials evidently nervous about the potential for a bubble, we see limited potential for upside from here, especially in the run-up to the 17th Party Congress this autumn.

Fundamentally, though, the economy remains strong - and more importantly for investors, so do profits. Our freight index continues to signal robust industrial activity (Chart 2). While official industrial value-added growth has moderated from the 2003-04 super-boom, it is still running at 25% y/y, faster than before the boom, despite higher raw material prices, 'excess capacity', labour shortages etc. (Chart 3). Overall, industrial gross profit margins have strengthened - they were 2.7% in 1999, 5.7% in 2005 and 6.0% in 2006. In case one doubts the official numbers, a private PMI survey of 400 companies rose to 53 in Feb-07, indicating growing confidence in the private sector.

In the trade sector, margins have overall strengthened, despite CNY appreciation. The CNY has appreciated 4.7% against USD since July 2005, and has also appreciated on a trade-weighted basis by some 6.6%. Import growth from developed markets has revived, after slowing in H1-2005, suggesting no significant slowdown in investment - since imports from the US/EU tend to be capital intensive (machinery, IT, planes etc.). In fact, we think urban fixed-asset investment (FAI) numbers will surprise on the upside in Jan-Feb, when we finally get the data. On exports to developed markets, sales to EU have accelerated with revival in Germany and Japan in H2-2006. US demand for PRC goods are growing steadily. 'Real' (i.e. non-processing) import growth has revived, suggesting still strong domestic activity. It remains at about 20-22% y/y. 'Real' export growth is accelerating (currently 35-40% y/y), suggesting that PRC firms are moving up the value-chain and taking export share from foreign-invested firms (Chart 4). Such "export substitution" by PRC firms will drive the overall surplus up. For anyone hoping for a smaller trade surplus this year, the momentum here is not encouraging.

Little impact from CNY and NPC
Partly as a result, Beijing seems happier with faster CNY appreciation. The implied yearly rate of appreciation (using a centred 20-trading day average) of CNY vs USD is volatile, but at present is moving at about 5% y/y (Chart 5). We think we will see a moderate slowing as the year goes on, bringing us in at 4% by year end. Key to next three years is USD-CNY, not the trade-weighted basket, since Beijing is keen to give exporters clear guidance. Some 80% of trade is invoiced in USD.

The ongoing 10th National People's Congress plenary session (March 5-16) is likely to have only limited market implications. Two major new laws are being tabled for deliberation. The Corporate Tax law merges domestic and foreign firm tax levels to 25% in 2008, with lots of grandfathering and exceptions for key industries. (In other words, this is happening too slowly to have much impact on the trade surplus in 2007-08.) Second is the much more controversial Property Law, which is important for providing a secure base for ownership, but got slammed by the New Left in previous sessions.

One issue that is likely to attract lots of interest is the new China FX Investment Fund. We understand that the Ministry of Finance (MoF) plans to issue CNY-denominated debt into the inter-bank market, using the funds raised to 'buy' FX assets from the PBoC's SAFE-administered reserves. Former MoF vice minister Lou Jiwei is the man in charge. The USD 200bn scale was an initial PBoC/MoF proposal for the size of the entity although we suspect that it will be gradually raised/allocated. Debate about the fund's mandate is on-going, although we think it is likely to support the Strategic Petroleum Reserve (SPR), currently in Phase I of development (with an aim of 88m barrel capacity by YE-2007). Investments in going concerns in overseas markets are also possible.

NEW ZEALAND

Frances Cheung
Economist, +852 2820 3609
Frances.Cheung@hk.standardchartered.com

Risk of overkill

- The economy's strength and shift are misread
- Concerns about inflation are overdone
- Interest rates should have peaked, despite a hawkish RBNZ

Belated domestic adjustment and a late-cycle export spurt might have misled the authorities to over-estimate New Zealand's underlying growth momentum and potential threat of inflation. The latest hike by the Reserve Bank of New Zealand (RBNZ) could therefore cause unnecessary damage to the economy's growth rebalancing efforts. Going forward, as export earnings decelerate with easing commodity prices and cooling global demand, the policy focus may have to change again. We maintain our view that interest rates should have peaked and the economy can ill-afford further rate hikes. Despite its hawkish posture, the next rate move of the RBNZ is likely to be down, probably in Q1-08.

Growth rebalancing: Too early to celebrate
On surface, New Zealand's efforts to rebalance its growth structure seem to be paying off. Narrowing deficits of the trade and current accounts have contributed positively to economic growth since Q2-06, while domestic demand cooled off and scrapped 2.4 percentage points out of Q3 GDP growth. As a result, economic growth stayed stable at 0.9% y/y and 1.0% in Q2 and Q3 respectively.

Looking deeper, however, we would caution any premature celebration. First, the recent pick up in exports was largely due to a good agricultural season and rising commodity prices, especially dairy products which are on tight supply. But both factors are hard to repeat. Gradual alleviation of supply shortages, especially against the backdrop of a global slowdown, is likely to see weaker commodity prices and lower export earnings. Export of services has been subdued on limited inbound tourists, in part due to the strength of the NZD. The latest rate hike, with its support to a strong NZD, would squeeze export margins and risk dampening exports in coming months.

Second, although recent economic indicators point to some revival in domestic activity, many of which are supported by a tight labour market that may not be sustainable as exports ease and investment continues to weaken. While labour cost maintained a strong 3.2% y/y growth, helped by a tight labour market with a low 3.7% jobless rate in Q4-06, companies are having difficulty passing on the higher costs to consumers. Some companies are reportedly holding back their investment projects due to high labour costs. With the prospects of weaker exports and investment, labour market should ease and dampen wage as well as domestic demand growth.

No major upside risk to inflation
CPI inflation dropped quite significantly to 2.6% y/y in Q4 from 3.5% in Q3. Lower inflation expectations, as reflected from latest survey measures, will also help to reduce the risk of spillover into medium-term prices and wage setting behaviour. This should help alleviate inflationary pressures. The RBNZ's own CPI forecasts also suggest that inflation will be within its target band of between 1% and 3% under the Policy Targets Agreement in both 2007 and 2008. We forecasts inflation to average 2.4% y/y in 2007, with a benign 1.9% GDP growth.

Housing the hot spot?
The RBNZ raised its Official Cash Rate (OCR) to 7.5% at its March 8 MPC meeting, as expected by the market but against our call for no change. Behind the move, the main reason cited by the RBNZ was the resilient housing market, supported by the tight labour market and an expansionary fiscal policy. In response to the three rate hikes by the RBNZ in 2005, banks accepted lower premiums over the OCR on mortgage loans amidst intense competition. The spread between the effective mortgage rate and the OCR narrowed from over 90bps in the beginning of 2005 to 48bps at end-2005. Housing activities were in part supported by this easy credit.

Looking ahead, we think there are reasons not to be complacent. First, since the start of 2006, the interest rate spread has been widening gradually. Second, household leverage has been increasing rapidly over the years. Outstanding mortgages have risen from 55% of GDP at end-1998 to over 80% now. With rising rates and leverages, households have become more stretched.

RBNZ to keep rates steady
We maintain our view that rates should have peaked and the economy can ill-afford further hikes. Focusing too much on the resilience in the housing market may risk missing the bigger picture. Underlying economic fundamentals as argued above are less rosy than as suggested by the current activity in the housing market alone. Further rate hikes may also boost the NZD which in turn will affect exports adversely. That said, given the central bank's concern over the robustness in the real estate sector and the upside risks to medium-term inflation pressures, interest rate cuts seem unlikely.

With the current tight labour market and capacity constraint, it is prudent for the central bank to monitor closely inflation risks. We expect the easing cycle to start probably as late as Q1-08. On money market rates, in view of the benign economic outlook, we expect the spread between 3m and 12m NZD Libor to narrow slightly in coming months, from around 22bps currently to 14-15bps in the later part of this year.

SINGAPORE

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

Fundamentals intact

- Equity market correction has limited impact on fundamentals
- Shift of liquidity from equity market to drive SIBOR lower
- MAS to maintain the current SGD stance in April

Notwithstanding the latest equity market correction, Singapore's economic fundamentals remain solid. The funds that fled the stock market have largely stayed onshore, with minimal impact on the currency but near-term dampening effect on local interest rates. While lower corporate tax rates announced in the FY2007/08 Budget should enhance medium-term business competitiveness, a higher GST and its offsetting relief package could spur domestic consumption in the short run. In response to the threat of a higher GST to inflation, the MAS is likely to maintain its appreciation bias of the SGD in its April policy meeting.

Solid growth momentum
Singapore's final Q4-06 GDP figures came in stronger than the initial flash estimate at 6.6% y/y, or 7.9% q/q. This raised full-year 2006 real GDP growth to 7.9% from the preliminary estimate of 7.7%. In view of the strong underlining growth momentum, the Ministry of Trade and Industry (MTI) revised upward its 2007 GDP growth forecast from the previous 4-6% range to 4.5-6.5%. This puts our 2007 GDP growth forecast of 5.5% right in the middle of the government's forecast range. Nothing in the latest GDP data has changed our view on the economy, where the fundamentals are still strong. However, as we have noted earlier, the economy is likely to operate at two speeds with the domestic sector outperforming the external front (Chart 1).

Limited impact of equity market correction
The recent correction in the equity market, where the Straits Times Index fell 10% from its peak, appears to have only limited impact on the real economy (Chart 2). Earlier in Jan-07, we have warned that the equity market had overextended itself and a correction was very much in order (see On-The-Ground report released on 26th Jan 2007). While the unwinding of the yen carry trade, which saw USD/JPY collapse from 122.0 to 115.5, has exacerbated the rout in equities, there were little spillover effects in USD/SGD (Chart 3).

More importantly, the funds that had left the equity market remained largely onshore, shifting mainly to the debt and interbank markets and pushing bond yields and interest rates lower. As a result, the SGD was little affected, and we have revised our end-Q1 3M SGD SIBOR forecast down to 3.25% from 3.38% previously. Thus far, this equity correction has not turned into a bear market and we expect some recovery once the dust settles. As losses in equity are largely offset by gains in bonds, the impact on the economy, if any, should be limited and be confined to the short term.

Budget boosts competitiveness
The FY2007/08 Budget announced in February was broadly in line with market expectations. Starting from the Year of Assessment (YA) 2008, the headline corporate income tax rate will be cut by 2 percentage points to 18%, which is just 0.5% above Hong Kong's current level (Table1). To make up for the lost revenue, the Goods and Services Tax (GST) will be raised to 7% from 5% with effect from July 1. To dilute the impact of a higher GST rate, the Ministry of Finance announced a SGD 4bn GST offset package, spreading over five years. The package is aimed at cushioning the lower income group and to minimise the dampening effect on local consumption. As we have seen in the previous round of GST hike, there is likely to be a spike in consumption, particularly for big ticket items, in Q2-07 just before the 2% rate hike. This should give a boost to retail sales, at least in the near term.

While the cut in corporate taxes is undoubtedly a positive in the long run, employer's contribution to the Central Provident Fund will also be revived to 14.5% from 13.0% with effect from 1 July 2007. Coupled with the hike in GST, this should raise business costs in the near term. Overall, the budget can be considered mildly expansionary and serves two purposes: 1) to maintain Singapore's long term competitiveness; 2) to address the growing income inequality. How effective these two objectives will be achieved is yet to be seen, but the budget deficit of SGD 1.3bn is likely to be an over-statement, given the government's conservative record, and is unlikely to affect Singapore's credit rating.

MAS to maintain its SGD appreciation bias
As we have said earlier, the hike in GST would put more pressure on prices and the Monetary Authority of Singapore is likely to maintain its current stance of a modest and gradual appreciation on the SGD. Despite a benign inflation figure of 0.3% y/y in Jan-07, we expect the MAS to keep its stance as a precautionary measure, at least until October 2007 (Chart 4). There is a strong chance that the MAS could shift to a neutral stance at the October policy meeting should oil prices stay below USD 60 per barrel, especially if the second-order effects of the GST hike on inflation remain well contained.

TAIWAN

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

Need to secure domestic demand

- Rebound in consumption and investment has yet to take root
- CBC expected to hike 12.5bps in Q1 to bring rates to neutral
- Political uncertainty rising ahead of key elections

Despite the rebound in consumption and investment growth in Q4-06, Taiwan is not out of the woods yet. High capacity utilisation has yet to trigger a new wave of capital investment. Consumers remain cautious despite a steady job market and rising property prices. With the upcoming elections, the political landscape is still highly uncertain, especially given the president's latest drive for independence.

Modest growth amid weak confidence
For much of 2006, Taiwan's growth was driven by exports, with investment and consumption largely a bystander. The Q4-06 growth figures suggest some mild improvements, despite extended political rallies during the period that should have dampened growth. Personal consumption expenditure grew by 2.4% y/y in the quarter, the highest in five quarters. Investment rose 5.7%, the strongest since Q2-05. Combined with government spending and change in stocks, domestic demand contributed three-quarters of the 4% growth in Q4-06, compared with just 10% contribution for the first three quarters of the year.

However, this does not imply that Taiwan's domestic demand has gained a new life. The growth figures were partly inflated by a low base of comparison, especially for investment which suffered a 10.9% y/y decline in Q4-05 due to a sharp 25% fall in machinery and equipment investment. Moreover, investor and consumer sentiment is far from secure. The consumer confidence index is still hovering below the 70-mark. The component breakdown suggests households are still concerned about finance and the economic outlook. The latest equity market correction could dampen sentiment further, albeit temporarily.

Capacity utilisation is running high at above 80%, close to the cyclical peak of the past two and a half decades. However, no corresponding increase in fixed capital formation is observed, conceivably due to two factors. First is uncertainties about the global economic outlook. the US semi-conductor book-to-bill ratio had declined for four consecutive months up to Oct-06 and stayed below the neutral 1.0 level until Dec-06. While the Jan-07 ratio rebounded to 1.06, the highest since Jul-06, it would be hard to expect investors to turn aggressive, especially given other disappointing developments like slowing growth of US durable goods orders (excluding transportation) and the recent stock market correction.

The second reason for sluggish investment in Taiwan is the diversion of investment to areas outside of the island, especially to the Mainland. Over the years, approved investment from Taiwan to mainland China has been rising steadily, reaching USD 6bn for the 12 months to Nov-06 (Chart 5). Notably, the figure is an underestimation since it excludes investment from retained earnings by Taiwanese companies that have already invested in the Mainland.

Some may blame the central bank for weak investment growth. However, we believe that the steady interest rate hikes by the Central Bank of China (CBC) since 2004 had only limited impact on investment. With a 137.5bps hike in the policy discount rate between late 2004 and now, the magnitude of the official tightening was small. Ample liquidity and intense competition among banks had further limited the rise in actual borrowing costs. For example, the secondary commercial paper rates for 90 days only rose 80bps during the same period. We do expect another 12.5bps hike in the Q1-07 MPC meeting from the CBC, due to take place in late March. Our forecast of another 12.5bps hike in Q2-07 is somewhat less certain. However, it remains unlikely that the expected gradual tightening will have any drastic dampening effect on investor sentiment, even with a hike in Q2-07.

Political uncertainties rise
Taiwan will have two important elections in the next 12 months, the Legislative Yuan elections in Dec-07 and the presidential elections in Q1-08. With the recent indictment of opposition KMT former chairman Ma Ying-jeou, a widely perceived front-runner to the presidential election before the charges, the race has become even more uncertain. With Taiwan's economic performance disappointing in recent years, the ruling DPP may choose to use the more controversial independence issues as its campaign driver. Indeed, President Chen Shui-bian said on March 4 that Taiwan will need to become independent, amend its constitution and rename itself to reflect the independent status.

Such a high-risk tactic could invite strong reactions from Beijing and Washington. Although we still believe that the risk of military confrontation remains extremely low, tensions across the Taiwan Straits are likely to escalate in coming months. As a result, current discussions on closer economic interaction, including greater tourist flows from the Mainland to Taiwan, are likely to be delayed or significantly watered down.

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